Financial Accounting for Management: An Analytical Perspective

INANCIAL ACCOUNTING FOR MANAGEMENT An Analytical Perspective This page is intentionally left blank. INANCIAL ACCOUNTING FOR MANAGEMENT An Analytical Perspective FiFth edition AMBRISH GUPTA Senior Professor Finance and Accounts FORE School of Management New Delhi Delhi • Chennai Copyright © 2016 Pearson India Education Services Pvt. Ltd Published by Pearson India Education Services Pvt. Ltd, CIN: U72200TN2005PTC057128, formerly known as TutorVista Global Pvt. Ltd, licensee of Pearson Education in South Asia No part of this eBook may be used or reproduced in any manner whatsoever without the publisher’s prior written consent. This eBook may or may not include all assets that were part of the print version. The publisher reserves the right to remove any material in this eBook at any time. ISBN: 978-93-325-5949-3 eISBN: 978-93-325- 7360-4 Head Office: A-8 (A), 7th Floor, Knowledge Boulevard, Sector 62, Noida 201 309, Uttar Pradesh, India. Registered Office: Module G4, Ground Floor, Elnet Software City, TS-140, Block 2 & 9 Rajiv Gandhi Salai, Taramani, Chennai 600 113, Tamil Nadu, India. Fax: 080-30461003, Phone: 080-30461060 www.pearson.co.in, Email: companysecretary.india@pearson.com To My Father and My Late Mother This page is intentionally left blank. BRIEF CONTENTS PART 1: THE FOUNDATION Chapter 1 Measurement of Profit and Financial Position: I Business Transactions to Recording in Journal 2 Chapter 2 Measurement of Profit and Financial Position: II Journal to Trial Balance 32 Chapter 3 Measurement of Profit and Financial Position: III Trial Balance to Balance Sheet and Profit and Loss Account: Non-corporate Entities 59 Chapter 4 Measurement of Profit and Financial Position: IV Corporate Entities 75 Chapter 5 Vertical Financial Statements of Corporate Entities 128 Chapter 6 Specific Day Books 141 PART 2: CONCEPTS AND PRINCIPLES Chapter 7 Conceptual Framework of Financial Statements 162 Chapter 8 Generally Accepted Accounting Principles 177 PART 3: ASSET VALUATION Chapter 9 Valuation of Tangible Fixed Assets 194 Chapter 10 Depreciation on Fixed Assets 222 Chapter 11 Valuation of Assets under Finance Lease and Intangible Assets, Amortization and Asset Impairment 248 Chapter 12 Valuation of Inventories 280 Chapter 13 Valuation of Investments 308 viii Brief Contents PART 4: UNDERSTANDING THE ANNUAL REPORT Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes to Accounts and Significant Accounting Policies 340 Chapter 15 Other Mandatory Financial Reports 389 PART 5: FINANCIAL STATEMENT ANALYSIS Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings 414 Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I Multi-step, Horizontal, Vertical and Trend Analyses and Analytical Balance Sheet 436 Chapter 18 Financial Statement Analysis and the Tool Kit of the Analyst: II Earnings Per Share (EPS) Analysis 476 Chapter 19 Financial Statement Analysis and the Tool Kit of the Analyst: III Ratio Analysis 498 Chapter 20 Construction and Analysis of Corporate Cash Flow Statement 548 Chapter 21 Model for Strategic and Integrated Managerial Financial Analysis of Annual Report 606 PART 6: MORE ON FINANCIAL REPORTING AND ANALYSIS Chapter 22 Analysis of Information from Sources Other than Annual Reports and Inter-company Comparison 616 Chapter 23 Analysis of Group Performance: Consolidated Financial Reporting 632 Chapter 24 Emerging Dimensions in Voluntary Financial Reporting: Contemporary Analytical Techniques 679 CONTENTS Outstanding Pedagogical Features xxvii List of Companies Whose Cases and Financial Practices/Information Have Been Incorporated in This Book xxxv Preface to the Fifth Edition xxxvii Preface xli About the Author xlv PART 1: THE FOUNDATION Chapter 1 Measurement of Profit and Financial Position: I Business Transactions to Recording in Journal Introduction India—The Place of Origin of Modern Accounting The Anatomy of Business Assets Liabilities Financial Position Income Expenses Financial Performance The Accounting Process Analysis, Documentation and Recording of Business Transactions Analysis Wonderland of Debit and Credit Dual Aspect Concept Accrual Concept/Mercantile System of Accounting Documentation: Voucher Recording: Journal Application of the Fundamental Accounting Concepts A. Dual Aspect Concept B. Business Entity Concept C. Accrual Concept Application of Other Fundamental Accounting Concepts Cost Concept Business Entity Concept Further Illustrated Concluding Remarks Keywords References Exercises 3 4 5 5 6 7 7 7 7 8 9 9 10 12 14 17 17 22 22 22 22 26 26 26 27 27 27 28 chapter 1 Measurement of Profit and Financial Position: I Business Transactions to Recording in Journal Monetary Business Transactions Transaction Analysis Documentation Recording The process that leads to the measurement of financial performance and position of an enterprise is known as Accounting Cycle. Accounting Cycle forms the very basis of financial accounting. This chapter covers the cycle up to recording in journal. 2 x Contents Chapter 2 Measurement of Profit and Financial Position: II Journal to Trial Balance Introduction Classifying Business Transactions Summarising Business Transactions Application of Other Fundamental Accounting Concepts Realisation Concept Money Measurement Concept Further Illustration of Some Fundamental Accounting Concepts Note on Computerized Accounting System Alternative Presentation of Ledger Using Tally Concluding Remarks Keywords Exercises, Cases 32 33 33 36 43 43 43 47 53 54 55 55 55 chapter 2 Measurement of Profit and Financial Position: II Journal to Trial Balance Recording Documentation Transaction Analysis Classification MONETARY BUSINESS TRANSACTIONS Summarizing: Trial Balance The process that leads to the measurement of financial performance and position of an enterprise is known as Accounting Cycle. Accounting Cycle forms the very basis of financial accounting. This chapter covers the cycle up to trial balance. Chapter 3 Measurement of Profit and Financial Position: III Trial Balance to Balance Sheet and Profit and Loss Account: Non-corporate Entities 3 Measurement of Profit and Financial Position: III Trial balance to Balance Sheet and Profit and Loss Account: Non-corporate Entities Monetary Transactions Trial Balance Transaction Analysis Analysis of Trial Balance Documentation Adjustments Recording Inventory Valuation Classification Summarizing: Trial Balance Construction of Financial Statements Balance Sheet P & L Account Brief Analysis of Results This chapter finally completes the accounting process of measuring the business performance and financial position by illustrating the construction of balance sheet and profit and loss account of Non-corporate entities. Introduction Measurement of Business Income and Financial Position Trial Balance to Balance Sheet and Profit and Loss Account Analysis of Trial Balance Need for Adjustments Inventory Valuation Construction of Balance Sheet and Profit and Loss Account General Instructions and Observations for Preparing the Two Financial Statements Brief Analysis of the Financial Statements of Bharat Scientific Products Enterprise Recap of Fundamental Accounting Concepts Recap of Adjustments Concluding Remarks Keywords Exercises, Cases 59 60 60 61 61 62 63 64 65 67 70 70 71 71 72 Contents Chapter 4 Measurement of Profit and Financial Position: IV Corporate Entities 75 Introduction Basic Features of the Company form of Business Organization Registration Under the Companies Act Types of Companies Preliminary Expenses Board of Directors Financial Statements of Companies Share Capital Public Issue Expenses Accounting Treatment of Share Capital Form of Financial Statements Some Features of Financial Statements Issue of Shares at a Premium Bonus Shares Recap of Adjustments Concluding Remarks Keywords References Exercises 76 78 78 79 80 80 80 81 83 83 98 99 106 107 117 118 118 119 120 xi 4 Measurement of Profit and Financial Position: IV Corporate Entities From non-corporate, this chapter moves over to measurement of profit and financial position of corporate entities. Company form of business organisation has certain peculiar features and its financial statements are drawn in the format prescribed by the companies act, 2013. Chapter 5 Vertical Financial Statements of Corporate Entities 5 Vertical Financial Statements of Corporate Entities SHASHAANK INDUSTRIES LTD. BALANCE SHEET AS AT 31-03-20CY EQUITY AND LIABILITIES Shareholders’ Funds Share capital Reserves and surplus Note No. Amount (`) 1 2 14,95,000 1,22,570 16,17,570 Sub-total…. Non-current Liabilities Long-term borrowings Other Long term liabilities Long-term provisions 3 5,85,000 …. ….. 5,85,000 Sub-total…. Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions 4 Sub-total….. TOTAL….. 9,85,250 6,45,540 1,15,761 2,46,143 19,92,694 41,95,264 The corporate financial statements are now required to be presented in vertical form. Hence it is necessary to develop knowledge of how they are constructed. Introduction Vertical Form of Financial Statements Key Distinctive Features of the New Format Process of Construction of Financial Statements in the New Form Vertical Financial Statements of Shashaank Industries Ltd. Merits and Demerits of Vertical Format Treatment of ‘Miscellaneous Expenditure Not W/O’ and ‘Debit Balance of Statement of Profit and Loss’ Treatment of Tax Expenses Concluding Remarks Keywords References Exercises 128 129 129 131 132 133 138 139 139 139 140 140 140 xii Contents Chapter 6 Specific Day Books 141 Introduction Specific Daybooks/Journals Purchase Book/Purchase Day Book/Purchase Journal Sales Book/Sales Day Book/Sales Journal Cash Book/Cash Day Book/Cash Journal Concluding Remarks Keywords Exercises 142 142 142 146 149 156 157 157 6 Specific Day Books PART 2: CONCEPTS AND PRINCIPLES Chapter 7 Conceptual Framework of Financial Statements 162 Introduction Purpose of the Framework 163 164 7 Conceptual Framework of Financial Statements High Quality Financial Accounting , Reporting and Analysis Comparability Balancing among Characteristics Neutrality Prudence Completeness Faithful Representation Substance over Form Relevance Materiality Understandability Concepts of Capital, Its Maintenance & Profit Determination Recognition and Measurement of the Elements of Fin. Statements cial Statements cteristics of Finan ns Qualitative Chara Assumptio Fundamental ments Financial State mation Needs Objective of r Infor nts ts and Thei l Stateme ncial Statemen of Financia Users of Fina ents and Elem Components In the dynamic and complex business environment of the day, it has become imperative to have a strong conceptual framework for accounting and financial statements that sets out the principles and concepts underlying their preparation and presentation. Increase in the volume of business often necessitates the maintaining of specific day books for specific voluminous transactions of the same type, more particularly in the case of corporate entities. It is necessary to understand their respective roles. Scope and Coverage Components of Financial Statements Research in Financial Reporting Objective of Financial Statements Users and Their Information Needs Assumptions Underlying Preparation of Financial Statements Qualitative Characteristics of Financial Statements Constraints on Qualitative Characteristics True and Fair View Definitions, Characteristics, Recognition and Measurement of the Elements of Financial Statements Concepts of Capital and Capital Maintenance Concluding Remarks Keywords References Exercises 164 165 165 167 168 170 171 173 173 174 174 174 175 175 176 Contents Chapter 8 Generally Accepted Accounting Principles 177 Introduction Sources of GAAPs Conceptual Framework of Financial Statements Accounting Concepts and Principles Other than Those Covered by the Framework Requirements of the Companies Act Vertical Financial Statements of Nestle India Ltd. Accounting Standards Formulated by ICAI Convergence with International Financial Reporting Standards (IFRSs) Requirements of SEBI Requirements of Income Tax Act ICAI’s Standard on Accounting Policies: The Mother Standard AS-5: Net Profit or Loss for the Period, Prior Period and Changes in Accounting Policies Research in Financial Reporting Concluding Remarks Keywords References Exercises 178 178 178 xiii 8 179 179 182 182 Generally Accepted Accounting Principles 184 185 186 187 187 188 190 190 190 191 The corporate accounts and financial statements are prepared and presented on the basis of Generally Accepted Accounting Principles (GAAPs) as being presented above. Effective formulation of GAAPs assumes great importance in view of their far-reaching impact on the quality of reported earnings. PART 3: ASSET VALUATION 9 Valuation of Tangible Fixed Assets Tangible fixed assets, such as plant and machinery, enable companies to produce goods/services and provide marketing and administrative support to their businesses. They lead to the generation of operational revenue, which speaks of their crucial importance. Hence, the need for their proper valuation. Chapter 9 Valuation of Tangible Fixed Assets 194 Introduction Valuation of Fixed Assets Meaning, Identification and Significance of Fixed Assets Research in Financial Reporting Scope and Coverage Principles and Norms of Standard Accounting Treatment Determinants of Value of Fixed Assets Valuation of Fixed Assets in Special Cases Identification of Certain Specific Fixed Assets Revaluation of Fixed Assets Retirements and Disposals Disclosures in Financial Statements Impact of Government Grants and Borrowing Costs on Fixed Assets Valuation Accounting for Government Grants Borrowing Costs 195 195 195 196 198 198 198 201 203 204 205 205 206 206 209 xiv Contents Corporate Financial Practices Valuation of Wasting, Non-Regenerative, Assets Corporate Financial Practices Concluding Remarks Keywords References Exercises, Cases 213 215 215 217 217 217 218 10 Depreciation on Fixed Assets Chapter 10 Depreciation on Fixed Assets 222 Introduction Depreciation Accounting Meaning and Significance of Depreciation Research in Financial Reporting Scope and Coverage Principles and Norms of Standard Accounting Treatment Determinants of Depreciation Methods of Depreciation Statutory Requirements and Compliance Book Profit and Taxable Profit MAT and Deferred Tax Consistency Principle: Change in Method Depreciation Charge in Special Cases Revaluation of Fixed Assets and Depreciation Profit/Loss on Disposal of Fixed Assets Disclosures in Financial Statements 223 223 224 224 225 11 Valuation of Assets under Finance Lease and Intangible Assets, Amortization and Asset Impairment 225 226 226 231 234 235 235 237 237 240 241 Corporate Financial Practices Depletion of Wasting, Non-regenerative, Assets Corporate Financial Practices Concluding Remarks Keywords References Exercises, Cases Value of fixed assets keeps on reducing over their useful lives due to their use. This reduction, known as depreciation, is charged to profit and loss account. Depreciation has a significant bearing on the measurement of financial performance and position. 241 243 243 244 244 244 245 Chapter 11 Valuation of Assets under Finance Lease and Intangible Assets, Amortization and Asset Impairment 248 The contemporary issues relating to fixed assets—finance lease, intangibles, their amortisation and asset impairment—are providing a face-lift to the financial statements. The emphasis is on substance over form, prudence, ensuring the sanctity of the financial statements and quality of earnings. Introduction Assets Under Finance Lease Meaning of Lease and Finance Lease Substance over Form Principles and Norms of Standard Accounting Treatment Disclosures in Financial Statements Corporate Financial Practices 249 249 249 250 250 255 256 Contents xv Position Under the Income Tax Act Intangible Assets and Their Amortisation Goodwill Meaning and Significance of Intangible Assets Principles and Norms of Standard Accounting Treatment Rates of Depreciation as Per Appendix I—Rule 5 of the Income Tax Rules Disclosures in Financial Statements Corporate Financial Practices Impairment of Assets Meaning and Significance Principles and Norms of Standard Accounting Treatment Disclosures in Financial Statements Corporate Financial Practices Concluding Remarks Keywords References Exercises, Cases 258 259 259 259 262 267 267 268 270 270 271 274 275 277 277 277 278 Chapter 12 Valuation of Inventories 280 Introduction Valuation of Inventories Meaning and Significance of Inventories Research in Financial Reporting Scope and Coverage Construction Contracts Service Providers Shares etc. held as Stock-in-Trade Livestock and Agricultural etc. Products Principles and Norms of Standard Accounting Treatment Valuation Policy Cost of Inventories Cost Formulas Illustrations on the Methods of Valuation FIFO LIFO WAC Impact of the Three Methods of Valuation on COGs, Gross Profit and Net Profit: A Comparison Impact on COGS and Gross Profit Impact on Net Profit Techniques for the Measurement of Cost Net Realisable Value NRV and ITS Impact on Valuation of Inventory, COGs, Gross Profit and Net Profit 281 281 282 283 285 285 285 286 286 286 286 286 289 291 291 293 293 294 294 294 295 296 298 12 Valuation of Inventories Inventories such as raw materials and finished goods in general, and in manufacturing companies in particular, constitute the second largest item after fixed assets. Therefore, they require a fair valuation so that the financial statements fairly portray the performance and financial position of the business. xvi Contents Disclosures in Financial Statements Corporate Financial Practices Concluding Remarks Keywords References Exercises, Cases 300 300 302 302 303 304 Chapter 13 Valuation of Investments Introduction Valuation of Investments Meaning and Significance of Investments Research in Financial Reporting Scope and Coverage Forms of Investments and Establishment of their Market Values Active Market or Absence Thereof Principles and Norms of Standard Accounting Treatment Classification of Investments Cost of Investments Valuation/Carrying Amount of Investments in the Balance Sheet Reclassification of Investments Determination of Cost of Investments in Cases of Rights Issue Disposal of Investments Shares and Other Securities held as Stock-in-Trade Disclosures in Financial Statements Investments in Subsidiary/Associate Companies Corporate Financial Practices Investments in Jointly Controlled Entities Corporate Financial Practices Concluding Remarks Keywords References Exercises, Cases 308 309 310 310 310 313 314 314 314 314 315 13 Valuation of Investments 318 320 321 323 324 324 325 325 329 330 333 333 333 334 Investments in general, and in manufacturing companies in particular, represent deployment of surplus funds to earn dividends, interest, rentals and capital appreciation for strategic reasons. Investments represent major assets and business activities for investment companies. Their performance depends on the results of this activity. xvii Contents PART 4: UNDERSTANDING THE ANNUAL REPORT Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes to Accounts and Significant Accounting Policies 340 Introduction 341 Brief Profile of Nestle India Ltd. 342 Financial Statements of Nestle India Ltd. 343 Balance Sheet 344 Statement of Profit and Loss 345 Features of the Financial Statements 346 Corporate Financial Statements Understanding the Inter-Linkage of the Financial Along With Notes to Accounts and Statements 346 Significant Accounting Policies Understanding the Various Accounts of Balance Sheet and Notes Thereto 347 Shareholders’ Funds 347 Current Liabilities 352 Non-current Assets 354 Current Assets 359 Understanding the Various Accounts of the Statement of Profit and Loss and Notes Thereto 363 Revenue from Operations 363 Cost of Materials Consumed 364 Changes in Inventories of Finished Goods, Work-in-Progress and Stock-in-Trade 365 Employee Benefits Expense 365 Depreciation 366 Impairment loss on Fixed Assets 367 Profit from Operations 368 Other Income 368 Finance Costs 369 Employee Benefit Expense Due to Passage of Time 369 Net Provision for Contingencies (Others) 370 Profit before Corporate Social Responsibility Expenses, Exceptional Items and Taxation 370 Corporate Social Responsibility Expenses 371 Exceptional Items 371 Profit before Taxation 371 Tax Expense 371 Profit after Taxation 372 Earnings per Share 372 A Brief on Deferred Tax Assets and Liabilities 372 Purpose Served by AS-22 374 Concluding Remarks 374 14 NESTLE INDIA LIMITED Understanding the annual report is a precursor to analysing it. This chapter attempts developing its understanding with reference to the case of Nestle India Ltd. xviii Contents Keywords References Exercises, Cases Appendix Employee Stock Option Plans 374 375 375 377 377 Chapter 15 Other Mandatory Financial Reports 389 Introduction 390 Auditors’ Report 391 Requirements of the Companies Act 391 Companies (Auditors’ Report) Order, 2003 or CARO 392 Corporate Financial Practices 396 Review of the Auditors’ Report of Nestlé 399 Directors’ Report 400 Requirements of the Companies Act 400 Corporate Financial Practices 401 Review of the Directors’ Report of Nestlé 402 Corporate Governance Report 402 Objective and Importance of Corporate Governance 402 Suggested List of Items for Corporate Governance Report 403 Non-mandatory Requirements 405 Review of Nestlé’s Report on Corporate Governance 405 Management Discussion and Analysis Report 405 Report and Its Contents 405 Significance of MD&A 406 Review of Nestlé’s MD&A Report 406 Report on Corporate Social Responsibility (CSR) Activities Requirements of the Companies Act, 2013 Review of Nestlé’s Report on CSR Activities Concluding Remarks Keywords References Exercises, Cases 15 Other Mandatory Financial Reports Corporate annual reports contain, in addition to financial statements, some other financial reports as well. Auditors’ report is an instrument of discharging attest function and expressing opinion about the truth and fairness of financial performance and position. Corporate governance report seeks to report the effectiveness with which the management is discharging its responsibility of running the corporate affairs. Management discussion and analysis report seeks to present the management’s analysis of the physical and financial performance of the company with a brief on future outlook. Report on CSR activities seeks to report the details of such activities together with the mandatory social spend. 407 407 408 409 409 410 410 Contents xix PART 5: FINANCIAL STATEMENT ANALYSIS Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings 414 Introduction Quality of Earnings Limitations of Financial Statements Leverage Provided by GAAPs Window Dressing Creative Accounting/Creative Financial Practices Non-provision of Diminution in the Value of Long-term Investments Changes in Accounting Policies Extending the Accounting Year Non-provisioning of Expenses and Doubtful/Disputed Debts Contingent Liabilities Not Provided for Impact of Other Income and Exceptional/ Extraordinary Items Some More Cases Beating Window Dressing Further Care in Analysis Regulatory Efforts in Ensuring Quality of Earnings ICAI Awards for Excellence in Financial Reporting 17 Financial Statement Analysis and the Tool Kit of the Analyst: I Multi-step, Horizontal, Vertical and Trend Analyses and Analytical Balance Sheet CORPORATE FINANCIAL PRACTICES Liberty Shoes Ltd. Extracts from Annual Report 2001–2002 Particulars 1994–95 1995–96 1996–97 1997–98 1998–99 1999– 2000* 2000– 2001* 2001– 2002 3041.07 4470.50 5398.68 6696.78 7667.94 7612.13 8520.00 7352.16 RESULTS FOR THE YEAR Sales & Other Income Index Profit before Depreciation & Tax Index Profit before Tax Index Profit after Tax Index Equity Dividend (total outlay) 1.00 1.47 1.78 2.20 2.52 2.50 2.80 2.42 890.25 1019.22 1038.72 1126.54 1273.86 1278.38 1262.77 1083.07 1.00 1.14 1.17 1.27 1.43 1.44 1.42 1.22 802.43 862.13 862.30 921.46 1010.47 996.73 966.35 786.27 1.00 1.07 1.07 1.15 1.26 1.24 1.20 0.98 627.56 744.02 731.30 756.46 837.97 740.73 590.191 620.36 1.00 1.19 1.17 1.21 1.34 1.18 0.94 0.99 – 157.68 254.01 254.01 278.85 380.25 228.15 253.50 Financial statement analysis seeks to evaluate the performance, financial strength, ability to generate enough cash and the growth outlook of a company. A number of tools are available in the tool kit of the analyst for this purpose. Five of them are covered here. 415 415 416 416 417 417 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings 417 419 421 421 422 Window dressing of financial statements is resorted to by the managements to portray a rosier performance and financial position of the company than actuals to suit their motives. An analyst needs to beat window dressing for a meaningful assessment of the quality of earnings. 422 425 426 Background Objective Categories of the Awards Awards to be Distributed Important Factors for Selection of Awardees Award Winners Concluding Remarks Keywords References Exercises, Cases 426 427 427 427 428 428 428 428 430 431 431 431 432 Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I Multi-step, Horizontal, Vertical and Trend Analyses and Analytical Balance Sheet 436 Introduction Objectives of Analysis Various Stakeholders and Their Interests Tool Kit of the Financial Analyst 437 437 438 438 xx Contents Tools and Techniques Multi-step Statement of Profit and Loss The Tool Format of Multi-step Statement of Profit and Loss Analysis of Multi-step Income Statement of Bajaj Auto Ltd. Horizontal Analysis The Tool Horizontal Analysis of Bajaj Auto Ltd. Balance Sheet Overall Assessment Common-sized Analysis The Tool Comparative Common-sized Analysis of Bajaj Auto Ltd. and TVS Motor Company Ltd. Statement of Profit and Loss Balance Sheet Overall Assessment Trend Analysis The Tool Trend Analysis of Liberty Quantitative Details Position at The Year End Overall Assessment Analytical Balance Sheet The Tool Review of Analytical Balance Sheet of Shopper’s Stop Ltd. Concluding Remarks Keywords References Exercises, Cases Chapter 18 Financial Statement Analysis and the Tool Kit of the Analyst: II Earnings Per Share (EPS) Analysis 476 Introduction Earnings Per Share Significance of EPS Scope and Coverage Principles and Norms of Standard Accounting Treatment Presentation of BEPS and DEPS Measurement of BEPS Measurement of DEPS An Illustration Now Follows to Clarify the Above Discussion Restatement of EPS Consequent to Issue of Non-resource Generating Equity Shares After the Balance Sheet Date 477 477 478 478 18 Financial Statement Analysis and the Tool Kit of the Analyst: II Earnings per Share (EPS) Analysis 479 479 479 486 487 493 Earnings Per Share (EPS) is the single most important ratio for the investors, capital market and company valuation. EPS gets dilutive under certain circumstances. Dilutive EPS is the real sustainable EPS. 439 439 439 439 444 444 444 448 449 449 450 450 456 456 457 458 459 459 459 462 462 462 462 462 464 464 465 465 465 xxi Contents Per Share Information Other Than BEPS and DEPS Disclosures in Financial Statements Concluding Remarks Keywords References Exercises, Cases 494 494 495 495 495 496 Chapter 19 Financial Statement Analysis and the Tool Kit of the Analyst: III Ratio Analysis 498 Introduction 499 Ratio Analysis 499 Classification of Ratios 500 Structure of Discussion of Ratios 500 Background Note on Innovative Approach towards Deriving Various Ratios 501 Return on Investment (ROI) Ratios 504 ROI Ratios of Grasim Industries Ltd. 508 Solvency Ratios 509 Solvency Ratios of Grasim Industries Ltd. 512 Liquidity Ratios 514 Liquidity Ratios of Grasim Industries Ltd. 518 Resources’ Efficiency or Turnover Ratios 520 Resources Efficiency Ratios of Grasim Industries Ltd. 522 Profitability/Profit Margin Ratios 523 Multi-step Profit Margin(s) to Net Revenue from Operations Ratios of Grasim Industries Ltd. 524 Ratios of Individual ‘Other Expenses’ to Net Revenue from Operations (%) of Grasim Industries Ltd. 527 Ratios of Other Income (non-operating), Exceptional/Extra-ordinary Items and Effective Tax Rate to PBT of Grasim Industries Ltd. DU Pont Analysis DU Pont Analysis of Grasim Industries Ltd. Valuation or Capital Market Ratios Valuation Ratios of Grasim Industries Ltd. Overall Ratio Analysis of Grasim Industries Ltd. Industry Benchmarking Analysis of Grasim vis-à-vis industry Core Ratios Concluding Remarks Keywords References Exercises, Cases 19 Ratio 1. RONW Financial Statement Analysis and the Tool Kit of the Analyst: III Ratio Analysis Formula N PAT X100 D Net Worth:Equity 2. EPS 3. CEPS GRASIM INDUSTRIES LTD. ROI RATIOS 2011–12 ` crores Result% 1177.00 × 100 13.66% 91.72 Plus, Reserves and surplus 8,524.85 N PAT 1,177.00 D Wtd. Av. No. of Eq. Shares O/S-Crores N PAT Plus, Non cash charges D Wtd. Av. No. of Eq. Shares O/S-Crores 2010–11 Result` Result% 1181.71 × 100 15.47% Comparison 2011-12/ 2010-11 Result` Change Direction of change –11.70% Down 128.87 –0.40% Down 148.09 –2.70% Down 91.71 7,547.85 128.35 1,181.71 144.08 1108.71 9.17 1,177.00 ` crores 9.17 144.20 176.29 9.17 9.17 Analysis continues with Ratio Analysis. It is a more focussed and comprehensive tool of analysis in that it establishes cause and effect relationships between either two items of balance sheet or of profit and loss account or both the balance sheet as well as profit and loss account. 530 530 532 533 536 538 539 539 540 541 541 542 542 xxii Contents Chapter 20 Construction and Analysis of Corporate Cash Flow Statement 548 20 Introduction 549 Features of Cash Flow Statement Nestle 552 Reporting Cash Flow Statement 553 Meaning and Significance of Cash Flow Statement 553 Construction and Analysis of Scope and Coverage 554 Corporate Cash Flow Statement Principles and Norms of Standard Accounting Treatment 554 Cash and Cash Equivalents and Accounting Policy on Their Composition 554 Basis for Classification of Activities 555 Operating Activities 555 Investing Activities 556 Financing Activities 557 Methods of Reporting Cash Flows 557 Issues Requiring Special Considerations 559 Non-cash Investing and Financing Transactions 560 Restricted Cash and Cash Equivalents 561 Additional Information 561 Disclosures in Cash Flow Statement 561 Construction of Cash Flow Statement from Abridged Balance Sheet When No Additional Information is Provided: Indirect Method 562 Construction of Cash Flow Statement from The Abridged Balance Sheet When More Notes and Additional Information is Provided: Indirect Method 575 Analysis of Cash Flow Statements 593 Concluding Remarks 594 Keywords 594 References 594 Exercises, Cases 595 NESTLÉ INDIA LTD. CASH FLOW STATEMENT For the Year Ended 31st December, 2014 2014 (` in millions) 2013 (` in millions) 17,743.5 16,780.2 (70.0) (873.2) 39.7 74.5 3,375.4 142.3 81.1 20,513.3 (138.1) (830.9) (6.3) (12.1) 3,299.5 365.1 99.4 19,556.8 (142.8) 336.7 16,440.2 32.9 (483.9) 17,964.0 Nestlé A. CASH FLOW FROM OPERATING ACTIVITIES Net profit before tax Adjustments for: Exceptional items Other income considered separately Unrealised exchange differences Deficit/ (Surplus) on fixed assets sold/scrapped/written off (net) Depreciation Finance costs Impairment loss on fixed assets Operating profit before working capital changes Adjustments for: Decrease/(increase) in trade receivables Decrease/(increase) in loans & advances and other assets Net cash from operating activities Cash flow statement depicts the cash generated and utilised by a company. It is imperative to have a sound knowledge and understanding of the corporate cash flow statements as reported in annual reports, as illustrated here through the case of Nestlé India Ltd. 21 Model for Strategic and Integrated Managerial Financial Analysis of Annual Report It is time now to begin a strategic and integrated managerial analysis of corporate financial statements and financial reports forming part of an annual report. Keeping this in view a comprehensive model has been developed based on the annual report of Nestlé India Ltd. Chapter 21 Model for Strategic and Integrated Managerial Financial Analysis of Annual Report 606 Introduction Objectives of Strategic and Integrated Analysis Model Framework for Integrated Analysis Detailed Model Concluding Remarks Keywords References Exercises 607 607 608 608 613 613 613 614 Contents xxiii PART 6: MORE ON FINANCIAL REPORTING AND ANALYSIS Chapter 22 Analysis of Information from Sources Other than Annual Reports and Inter-company Comparison 616 Introduction Significance of Other Sources Details of Other Sources of Financial Information Study of Some Samples Research Report from Capital Market News Items from The Economic Times CFDS Portal: Corporate Filing and Dissemination System Inter-Company Comparative Analysis and Analysis Against Industry Aggregates Concluding Remarks Keywords References Exercises, Cases Chapter 23 Analysis of Group Performance: Consolidated Financial Reporting 617 617 617 618 618 620 22 Analysis of Information from Sources Other than Annual Reports and Inter-company Comparison 624 625 626 627 627 628 Virtually endless sources of financial information are available outside the published annual report. The continuous availability of financial and business information after its publication is most crucial for an analyst to keep himself updated. These sources fill this gap, that too with accompanied analysis. 632 Introduction Consolidation of Subsidiaries 23 Analysis of Group Performance: Consolidated Financial Reporting Prime Bank Ltd. (Holding Company) Prime Securities Ltd. (Subsidiary) 95% 60% 74% 100% Prime Home Finance Ltd. (Subsidiary) Prime V enture Capital Ltd. (Subsidiary) 90% Prime Life Insurance Ltd. (Subsidiary) Prime AMC Ltd. (Subsidiary) Capital provided by the shareholders of the parent company flows into other group companies. Various stakeholders of the parent company, particularly the investors, are concerned to know how the investments made in the group companies, out of money they provided to the parent company, are faring. Consolidated financial statements bring out the real profitability and financial position of the group to the fore. Consolidated Financial Statements Meaning of Consolidated Financial Statements Significance of Consolidated Financial Statements Scope and Coverage Parent, Subsidiary and Group Control Principles and Norms of Standard Accounting Treatment Global Consolidation The Process of Consolidation Minority Interest as on 31-03-2007 Status of the Consolidated Financial Statements Application of Other Accounting Standards Disclosures in Financial Statements Consolidation of Associates Accounting for Investments in Associates in Consolidated Financial Statements Associate and Significant Influence 633 634 634 634 635 635 635 636 636 636 637 655 657 657 657 659 659 659 xxiv Contents Principles and Norms of Standard Accounting Treatment The Equity Method Further Issues Disclosures in Consolidated Financial Statements Consolidation of Joint Ventures Financial Reporting of Interests in Joint Ventures Types of Joint Ventures Jointly Controlled Operations Nature of the Joint Venture Principles and Norms of Standard Accounting Treatment Jointly Controlled Assets Nature of the Joint Venture Principles and Norms of Standard Accounting Treatment Jointly Controlled Entities Nature of the Joint Venture Principles and Norms of Standard Accounting Treatment Disclosures in Financial Statements Associates and Joint Ventures Analysis of Performance of ICICI Bank Ltd. As a Group Concluding Remarks Keywords References Exercise 659 660 664 664 665 665 666 666 666 666 667 667 667 668 668 668 669 673 675 676 677 677 678 24 Emerging Dimensions in Voluntary Financial Reporting: Contemporary Analytical Techniques 679 Introduction Need for Voluntary Information Growing Complexity of Financial Statements Emergence of Contemporary Techniques Value Reporting™ The Value ReportingTM paradigm The Value ReportingTM Disclosure Model Intangible Assets Score Sheet Intangible Assets Human Resources Intellectual Property Assets Internal Assets External Assets The Score Sheet Analysis (As Per Annual Report) Infosys Intangible Assets Score Sheet Human Resources Valuation Value-added Statement Brand Valuation 680 681 681 681 682 683 683 684 685 685 685 685 685 685 685 686 688 689 691 24 Emerging Dimensions in Voluntary Financial Reporting: Contemporary Analytical Techniques Accounting has been witnessing the emergence of new dimensions, as mentioned above, in voluntary financial reporting. These techniques have yet to find widespread popularity. Yet they strengthen the decision-making of the stakeholders. Leading companies, such as Infosys, have been providing such information in their annual reports. Contents xxv The Strength of the Invisible Valuing the Brand Methodology Brand Valuation Balance Sheet (Including Intangible Assets) Current-cost-adjusted Financial Statements Balance Sheet Profit and Loss Account Economic Value-added (EVA®) Statement Economic Value-added Analysis Concluding Remarks Keywords References Exercises 691 691 691 692 693 694 694 695 697 697 699 699 699 700 Appendix 1 Present Value of An Annuity of Rupee 1 Paid at The Year End 702 Appendix 2 Present Value Factor of A Lump Sum (PVF) of Re 1 703 Index 679 APPENDICES APPENDIX 1: PRESENT VALUE OF AN ANNUITY OF RUPEE 1 PAID AT THE YEAR END APPENDIX 2: PRESENT VALUE FACTOR OF A LUMP SUM (PVF) OF RE 1 This page is intentionally left blank. OUTSTANDING PEDAGOGICAL FEATURES The outstanding pedagogical features in the book have been designed to chart a clear and well-targeted route map for students’ understanding and knowledge enhancement. These features are: 1. Chapter Openers Every chapter opens with a pictorial/diagrammatic presentation and a nugget description of what lies ahead in the chapter. Openers will initiate and stimulate the students’ interest. 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings 2. Chapter Objectives An exhaustive list of chapter objectives provides details of the issues whose knowledge and understanding the students are expected to develop by the time they finish a particular chapter. CHAPTER OBJECTIVES This chapter seeks to enable you to develop knowledge and understanding of: 1 The fact that modern accounting owes its origin to India. 2 The anatomy of business and its relationship with financial accounting. 3 The steps involved in the process of accounting, up to recording, that leads to the measurement of profit and financial position. 4 How to do documentation of business transactions by way of vouchers. 5 How to do recording of vouchers in journal. 6 Application of certain fundamental accounting concepts in the process. 7 Basic features of partnership firm and their implications for financial accounting. Thus enabling you to be able to complete the accounting cycle in the chapters that follow. Window dressing of financial statements is resorted to by the managements to portray a rosier performance and financial position of the company than actuals to suit their motives. An analyst needs to beat window dressing for a meaningful assessment of the quality of earnings. BIRD’S EYE VIEW The Anatomy of Business 3. Bird’s Eye View Box Regular bird’s eye view boxes, which provide a snapshot of the subject matter covered, enable students to know the coverage of a particular section and help them in quick revision. n Assets — Fixed assets — Current assets — Investments n Liabilities — Long term (non-current) liabilities — Current liabilities n Financial Position n Income n Expenses n Financial Performance xxviii outstanding PedagogiCal features 4. Web site Resource Box During the course of discussion, regular references have been provided, side-by-side, to the Web site resources on the subject matter covered to enable the students to know more on the subject. For more details refer to the ‘Guide to the Companies Act’ by A Ramaiya or any other book on company law. WWW Visit www.mca.gov.in if you wish to update yourself on company law matters. 5. Publication Resource Box Likewise, regular references have been provided, side-by-side, to the related books on the subject matter covered to enable the students to further enhance their knowledge. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. Do you agree with the following statements? 1. Since assets are debited, increase in assets has to be debited and decrease credited. 2. Since liabilities are credited, increase in liabilities has to be credited and decrease debited. 3. Since income is credited, increase in income has to be credited and decrease debited. 4. Since expenses are debited, increase in expenses has to be debited and decrease credited. 6. Before You Move Further, Stop... Box These boxes, containing discussion questions, have been provided at regular intervals in the chapters. The objective is to enable the students test and firm up the knowledge acquired by them in a particular section before moving over to the next. It will encourage sharing of knowledge and help them widen their horizons. 7. Chapter Illustrations A large number of illustrations are provided in the text of each chapter. These illustrations aim at supporting the conceptual input provided during the text of the chapters with the practicals and prepare the students to effectively handle the chapter-end exercises. CASE 2 Horizontal Financial Statements of Bajaj Auto Ltd. REPORT BAJAJ AUTO LIMITED Distinctly Ahead……………….Since 1945 A. Case Studies A large number of case studies have been illustrated and analysed during the text throughout the book. A vast number of illustrations are case-centric. What is more, barring one case, all others represent real life case studies of a large number of leading Indian corporates and MNCs. The cases seek to illustrate to the students analysis of complex financial accounting issues through real life business situations and appropriate decision-making. B. Corporate Financial Practices These are again leading corporates’ case studies, in large numbers, illustrated to drive home some complex issue but whose analysis has been left to the students. BALANCE SHEET AS AT 31ST MARCH Note No. 2012 (` in Crore) 2011 EQUITY AND LIABILITIES Shareholders’ funds Share capital Reserves and surplus 2 3 289.37 5,751.70 6,041.07 289.37 4,620.85 4,910.22 Non-current liabilities Long-term borrowings Deferred tax liabilities (net) Other long-term liabilities Long-term provisions 4 5 6 7 97.48 48.44 157.07 111.85 414.84 133.88 29.71 193.71 124.54 481.84 Current liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions 8 9 9 7 – 2,003.08 559.04 2,063.04 4,625.16 157.84 1,789.26 477.11 1,431.26 3,855.47 Particulars CORPORATE FINANCIAL PRACTICES INDIAN OIL CORPORATION LTD. Annual Report 2001–02 REPORT Extracts from Schedule E—Fixed Assets JOINTLY OWNED FIXED ASSETS (` in Lakhs) Total Fixed Assets of the Company Gross Block as at 31.03.02 Total Depreciation and Amortisation up to 31.03.02 W.D.V. as at 31.03.02 29,74,061.06 10,96,081.90 18,77,979.16 Details of Company’s Share of Jointly Owned Assets Included Above (` in Lakhs) Assets Particulars Name of Joint Owners Original Cost Accumulated Depreciated & Amortization W.D.V. as at 31.03.02 Land—Freehold HPC/IBP 119.02 0.00 119.02 Land—Leasehold BPC/IBP 95.31 10.50 84.81 Buildings HPC 42.54 7.38 35.16 xxix outstanding PedagogiCal features C. Corporate Window Dressing/Creative Financial Practices These illustrations are again drawn from real life practices of leading corporates to show how the financial statements are window dressed to present a position rosier than reality to suit the motives of the management. These are titled as ‘Creative Financial Practices’ and presented in Chapter 16. EXHIBIT 1 CREATIVE FINANCIAL PRACTICES LIBERTY SHOES LTD. Extracts from the Schedules of Significant Accounting Policies and Notes on Accounts from Annual Reports REPORT INVESTMENT IN JOINT VENTURE: LIBERTY & NINO, RUSSIA NON-PROVISION OF DIMINUTION IN THE VALUE OF LONG-TERM INVESTMENTS Annual Report 1994–95: Note 10 The company has made an investment of ` 1,67,73,640/- under a joint venture with Liberty & Nino, Russia. No trading/ manufacturing activities are being carried out by the joint venture. The Company has taken steps for realization of the investment and the realisable value is not ascertainable. Annual Report 1995–96: Note 6 REPORT NESTLÉ INDIA LTD. CASH FLOW STATEMENT For the Year Ended 31st December, 2014 2014 2013 (` in millions) (` in millions) A. CASH FLOW FROM OPERATING ACTIVITIES Net profit before tax Adjustments for: Exceptional items 17,743.5 16,780.2 (70.0) (138.1) E. Computational/Numerical Illustrations The main focus of these illustrations, accompanied by computer icon, is on demonstrating to and guiding the students in the core accounting treatment of various issues, say, preparation of balance sheet, income statement and cash flow statement, valuation of assets and computation of ratios, etc. They contain some analytical elements as well. D. Exhibits Chapters 14 and 20 contain exhibits representing balance sheet, profit and loss account, cash flow statement and all schedules to accounts from the annual report of Nestle. These have been discussed and analysed for a systematic and integrated reading and understanding of the entire annual report. ILLUSTRATION 6 SHAABAASH LTD. ANTI-DILUTIVE CONVERTIBLE DEBENTURES Shaabaash Ltd. supplies you with the following details for the year 2006-07. Determine its BEPS and DEPS. ` and Nos. of Shares (In crores) Net profit 1.30 No. of equity shares outstanding (FV ` 10) 1.00 No. of 15% convertible debentures of ` 100 each issued on 1st April 2006. Each compulsorily convertible into 4 equity shares of ` 10 each at a premium of ` 15 each. 20.00 lakh Interest expense on convertible debentures 3.00 Income tax relating to interest expense (35%) 1.05 SOLUTION ILLUSTRATION F. Analytical Illustrations The main focus of these illustrations, accompanied by analysis icon, is on demonstrating to and guiding the students to carry out financial analysis of the information generated/ given in the illustration, put the analysis crisply and make appropriate decisions. They contain some numerical elements as well. 3 LEPICIER CYRILLE COSMETICS LTD. COMPARATIVE STUDY OF STATUTORY DEPRECIATION PROVISIONS BOOK PROFIT AND TAXABLE PROFIT Lepicier Cyrille Cosmetics Ltd. purchases a machine costing ` 150 lacs and factory building for ` 5 lacs on 1st April 2006. Assume that the company does not own any other depreciable asset. Work out the first year depreciation as per SLM and WDV methods for all the three shifts under the Companies act and as per the Income Tax act. Also work out the book profit and taxable profit for the year 2006–07 assuming that the profit before depreciation but after providing for all other expenses for the year was ` 80 lacs. Analyse the results. SOLUTION First Year Depreciation Income Tax Act SLM Companies Act WDV (WDV) SHIFTS SHIFTS Single Double Triple Single Double 10.34% 13.91% 20.87% Triple Rates of depreciation: n Factory building 10% n Machine 15% 3.34% 4.75% 7.42% 10% 27.82% Amount of depreciation (`): n Factory building n Machine 50,000 16,700 16,700 16,700 50,000 50,000 50,000 22,50,000 7,12,500 11,13,000 15,51,000 20,86,500 31,30,500 41,73,000 xxx REPORT outstanding PedagogiCal features RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors CLOSING INVENTORY AND OTHER DETAILS AS ON 31st MARCH 2006 ` in Crores Sl. No. Company Industry Total Assets Closing Inventory Closing Inventory to Total Assets Sales Inventory Holding Period (Days) PBT for The Year 1 Asian Hotels Ltd. Hotels– Tourism 633 8 1% 328 9 87 2 Bharti Airtel Ltd. Telecom 19,030 18 0.09% 11,229 0.59 2,286 3 Indraprastha Medical Corporation Ltd. Hospital– Healthcare 259 6 2% 205 11 22 4 Indraprastha Gas Ltd. Natural Gas 517 18 3% 521 13 160 5 ITC Ltd. FMCG 13,084 2,636 20% 9,791 98 3,269 6 JK Cement Ltd. Cement– Hosing related 1,466 84 6% 874 35 52 7 Ranbaxy Laboratories Ltd. Healthcare 4,661 891 19% 3,570 91 190 G. Research in Financial Reporting This feature has been introduced to emphasize and bring home the significance of the financial issues under discussion for a true and fair reporting of corporate performance and financial position and other aspects. In most cases, it culls out relevant data from select Indian corporates across industry sectors and analyses the same to arrive at meaningful conclusions. It is accompanied with the icon of a microscope. The top left-hand icon signifies that the data has been extracted from individual company’s annual reports. H. IFRS Convergence India is moving towards convergence with International Financial Reporting Standards (IFRS). Institute of Chartered Accountants of India (ICAI) has developed and submitted to the ministry of corporate affairs a set of 35 IFRS converged Indian Accounting Standards (Ind ASs). Their implementation was initially planned to be w.e.f. 1.04.2011 in a phased manner. However, the ministry has deferred their implementation until various issues including tax-related issues are resolved with the concerned departments and, therefore, the date of IFRS CONVERGED IND AS 1 VS EXISTING AS 1 implementation of the Ind ASs will be notified at WWW a later date. In the meantime, to keep the students DISCLOSURE OF ACCOUNTING POLICIES AND PRESENTATION OF FINANCIAL STATEMENTS in readiness for full-fledged understanding of IFRS The IFRS Converged Ind AS 1 corresponding to existing AS 1 on Disclosure of Accounting Policies is titled as converged Ind ASs when implemented, key distinc‘Presentation of Financial Statements’. Key distinctive features of Converged Ind AS 1, as related to the matter covered above, are as under: tive features thereof versus existing accounting 1 The Converged Ind AS 1 generally deals with presentation of financial statements, along with the disclosure of standards have been explained in the text at relaccounting policies, whereas existing Ind AS 1 deals only with the disclosure of accounting policies. The scope by the Converged Ind AS 1 is thus much wider evant places in various chapters. A template has 2 covered The Converged Ind AS 1 requires disclosure of judgments made by management while framing of accounting policies. For example, why life of patent assumed to be 15 years. been developed for this purpose, an example of 3 The converged Ind AS 1 requires presentation of: which appears, as shown here. The icon on the top• Single statement of profit and loss including components of other comprehensive income (a new item). • Balance sheet including a statement of changes in equity (a new item) as a part of the balance sheet. left is symbolic of Convergence. • Balance sheet as at the beginning of the earliest period when an entity applies an accounting policy retrospectively or www.icai.org makes a retrospective restatement of items in the financial statements, or when it reclassifies items in its financial statements. I. New Format of Financial Statements The Companies act 1956 has been replaced by the new Companies act 2013. Schedule III to the act has prescribed new vertical format of financial statements for corporate entities. Chapter 5 ‘Vertical Financial Statements of Corporate Entities’ has been introduced for a thorough study and illustration of the new format. Chapter 14 ‘Corporate Financial Statements of Nestle India Ltd. along With Notes to Accounts and Significant Accounting Policies’ has been introduced for a thorough examination of annual report of Nestle India Ltd. for the year ending 31st December, 2014 in the new format. Further in all the chapters on financial analysis, all the illustrations and exercises of real life companies have been replaced by their recent new format financial statements. NESTLE INDIA LIMITED outstanding PedagogiCal features xxxi J. Integrated Project This is a research-based integrated project. Chapter 21 is devoted to developing a model for strategic and integrated managerial financial analysis of annual report of Nestlé. The students will be enormously benefited by this project in developing and analysing an integrated project of some other corporate of their choice as per the exercises given in chapters 14 and 21. K. Examples of Leading Companies in the Running Text The discussion on the conceptual issues in the running text has been further enriched by giving large number of examples of leading corporates with their names emboldened. It will help the readers establish connectivity between the concepts and the corporate practices. L. Example / For Example Emboldened in the Text A large number of examples have been given in the running text. The words ‘Example’/ ‘For example’, ‘Examples’ have been emboldened to catch the attention of the students. Consistency principle not violated Consistency principle is not supposed to have been violated when different methods of depreciation are used for: n Different kind of assets, for example, SLM for buildings and WDV for machinery or SLM for one kind of machinery and WDV for another kind. We have noted earlier that type of asset is one of the determinants of the method of depreciation to be adopted. n Similar assets acquired up to a particular date and thereafter, for example, SLM on machinery acquired up to 31-03-2005 and WDV for that acquired on or after 1-04-2005. n Similar assets located in different geographical regions, for example, WDV for machines in Delhi plant and SLM for same machines at Mumbai plant. This case is however questionable. Further suppose, in a public issue, valuation report was submitted to the client on 28th February and prospectus filed on 15th April. Cost of services rendered during March in the preparation of prospectus represents work-in-progress for SBI Capital Markets Ltd. which it should ideally recognize in its financial statements drawn for the year ended 31st March since the part of the service has already been rendered for which fee will be received thereafter. AS-2 does not apply to such inventory of work-in-progress of service providers. A perusal of the 2005–06 annual reports of SBI Capital Markets Ltd., Satyam Computer Services Ltd., Infosys Technologies Ltd. and TATA Consultancy Services Ltd. reveals that none of these companies has recognised work-in-progress on this count. The sample suggests that Indian service providing industry does not recognize revenue for services rendered but remaining unpaid as on the balance sheet date. xxxii outstanding PedagogiCal features 8. Keywords Keywords, provided at the end of each chapter, will help the students recap the subject faster and enhance their accounting and financial vocabulary. Keywords n Accounting Process/Cycle n Dual Aspect Concept n Naame ( n Accrual Concept n Hindustani Bahikhaataa n Owner’s Capital/Equity n Assets n Balance sheet identity n Basic Accounting Equation n Business Entity Concept n Cost Concept Paddhati ( n J.F. n Jamaa ( ) n Journal n Sutras ( ) 9. References Next to keywords is given the consolidated list of all the resources, referred to in a chapter, sorted out according to the sources of referenced material. This feature has a lot of recall and recap value. It includes: (a) Web sites (b) Books and Magazines (c) Annual Reports (d) Newspapers (e) IPO (f) Capitaline Plus 10. Chapter-end Exercises A large number of exercises are given at the end of each chapter. Suitable icons representing their characteristics accompany almost all of them. These aim to develop wide and varied skill sets in the students. ) ) n Trial Balance n Upanisads ( n Vedas ( ) ) n Voucher WWW 1. Bombay Stock Exchange, www.bseindia.com 2. Ministry of Company Affairs, Government of India, www.mca.gov.in 3. Rallis India Ltd., www. rallis.co.in 4. Sona Koyo Steering Systems Limited, www.sonagroup.com. 5. Hindalco Industries Ltd., www.hindalco.com 1. Taxmann’s Companies Act, Taxmann Allied Services (P.) Ltd., New Delhi, 2015. 2. Guide to the Companies Act, A. Ramaiya, Wadhwa and Company, Nagpur, 2014. REPORT 1. Hindalco Industries Ltd., Annual Report, 2005–06. 2. Sona Koyo Steering Systems Limited, Annual Report, 2005–06. S NEW The Economic Times, business daily: n Hindustan Lever Ltd. n ITC Ltd. Reliance Petroleum Limited, Red Herring Prospectus, April 2006. Capitaline Plus outstanding PedagogiCal features xxxiii exercises CASE 1 A. Case Studies A large number of blue chip corporates’ case studies, on the lines of cases illustrated and expanded further, are the major highlights of chapter-end exercises. Like illustrations, exercises are also case-centric. The cases are well structured, elaborate, objective-oriented and to the point. All these cases seek to develop an integrated competency set of core numerical skills, financial analysis, evaluation of financial policies and practices, appropriate decision-making and crisp report writing in the students. B. Integrated Group Projects Group project exercises start from Chapter 14 and continue all through the text there onwards. These are basically research based and well structured. The purpose behind the group projects is to facilitate the students apply the knowledge, gained by them through the case of Nestle, to some other prominent corporates of their choice and thus build up a strong understanding of the financial and other reports and develop competencies in analysing and interpreting them strategically and integratively for necessary decision-making. C. Computational/Numerical Exercises The main focus of these exercises is on developing core computational skills in the students for accounting treatment of various matters on the lines of computational/numerical illustrations. They contain some analytical elements as well. Numerical illustrations will help the students handle these exercises well. D. Analytical Exercises The main focus of these exercises, on the lines of analytical illustrations, is on developing the student’s skill to carry out financial analysis, appropriate decision-making and crisp report writing to enhance written analysis and communication skills. They contain some numerical elements as well. Analytical illustrations will help the students handle these exercises well. E. WAC (Written Analysis and Communication) Exercises/Group Assignments A general ‘Written Analysis and Communication (WAC)’ paper is taught as a core paper in MBA programmes in a large number of institutes and universities. These exercises seek to enhance the WAC skills of the students with respect to accounting and financial information, an essential aspect of the corporate finance professionals’ day-to-day activity. Hence, exercises on WAC in a large number of chapters. F. MOC (Managerial Oral Communication) Group Assignments Further to WAC, a general ‘Managerial Oral Communication (MOC)’ paper is also taught as a core paper in MBA programmes. These exercises seek to enhance the MOC and PowerPoint Presentation skills of the students with respect to accounting and financial information. These exercises have been set in a collaborative environment. Inter-group competition is an integral part of these exercises. In most chapters, MOC presentation requirements by the student groups on group project exercises also follow the latter. This will help all groups to learn from each other about the financial practices of a large number of corporates across industries. xxxiv outstanding PedagogiCal features G. Capitaline Plus/CMIE Prowess Data-based Exercises These exercises, in chapters 22, seek to encourage the students search the above mentioned major financial databases of our country built on and around corporate annual reports and other related voluminous information, for example, the industry information, newspaper clippings and share prices. They seek to develop a research orientation among the students. OPEN EXERCISES H. Open Exercises These exercises, in chapters 18, 22, 23 and 24, seek to encourage the students to explore a wide open field comprising Web sites, CFDS Portal system, newspapers, magazines, etc. to find out financial and business information, analyse the same and thus widen their horizons. I. Integration of Exercises Through Various Chapters To provide a holistic view of and to take a particular exercise to its logical conclusion, wherever required, such exercises have been integrated through various chapters. For example, the case of Maruti Suzuki Ltd. is spread over chapters 17, 19 and 20. LIST OF COMPANIES WHOSE CASES and FINANCIAL PRACTICES/INFORMATION HAVE BEEN INCORPORATED IN THIS BOOK SI No. Company Industry Reference Chapter No. 1 Asian Hotels Ltd. Hotels 9, 10, 11, 12 2 Bajaj Auto Ltd. Two wheelers 17 3 Bharti Airtel Ltd. (Earlier, Bharti Tele-Ventures Ltd.) Telecom 9, 10, 11, 12, 13 4 Boeing Company USA Aerospace 20 5 Britannia Industries Ltd. Food Processing: MNC 22 6 Cadila Healthcare Ltd. Pharmaceuticals 16 7 Century Textiles Ltd. Diversified: Mega 22 8 Cholamandalam DBS Finance Ltd. Finance and Investment 13 9 Colgate Palmolive (India) Ltd. Personal Care: MNC 11, 13, 23 10 Crosswords book stores Ltd. Retail book stores 16 11 Dabur India Ltd. Diversified: Large 14, 22 12 DCM Shriram Consolidated Ltd. Diversified: Large 22 13 Dr. Reddy’s Laboratories Ltd. Pharmaceuticals 8 14 Duncans Industries Ltd. Diversified: Mega 22 15 GlaxoSmithkline Consumer Healthcare Ltd. Food Processing: MNC 22 16 Grasim Industries Ltd. Diversified: Mega 19, 22 17 HDFC Ltd. Housing Finance 13 18 Hero MotoCorp Ltd. Automobiles: Motorcycles 20 19 Hindalco Industries Ltd. Aluminium 4, 13 20 Hindustan Lever Ltd. Diversified: Mega 16, 22 21 Hindustan Motors Ltd. Automobiles: Passenger Cars 15, 16 22 ICICI Bank Ltd. Private Sector Bank 8, 13, 23 23 i-flex Solutions Ltd. Computers: Software—Large 8 24 Indian Oil Corporation Ltd. Refineries 4, 9 25 Indo Rama Synthetics (India) Ltd. Textiles: Spinning 15 26 Indraprastha Gas Ltd. Natural Gas 9, 10, 11, 12, 13 27 Indraprastha Medical Corporation Ltd. Hospital—Healthcare 9, 10, 11, 12 xxxvi list of ComPanies Whose Cases and finanCial PraCtiCes 28 Infosys Technologies Ltd. Computers: Software—Large 9, 10, 11, 13, 24 29 INTEL Corporation (US) Microprocessors 20 30 ITC Ltd. Diversified 9, 10, 11, 12, 13, 22 31 Kesoram Industries Ltd. Diversified: Large 22 32 JAIPRAKASH Associates Ltd. Construction 16 33 JK Cement Ltd. Cement 9, 10, 11, 12, 16 34 Larsen & Toubro Ltd. Diversified: Mega 11, 22 35 Liberty Shoes Ltd. Leather/Leather Products 16, 17, 18, 24 36 Maruti Suzuki Ltd. Automobiles: Passenger Cars 19, 17, 20 37 Nestle India Ltd. Food Processing: MNC 11, 14, 15, 20, 21, 22 38 NTPC Ltd. Energy 23 39 Oil and Natural Gas Corporation Ltd. Oil Drilling 8, 9, 10 40 Ranbaxy Laboratories Ltd. Pharmaceuticals 9, 10, 11, 12, 13 41 Rallis India Ltd. Pest/Agro 4 42 Reliance Energy Ltd. Power Generation 9, 10, 11, 12, 13, 16 43 Reliance Industries Ltd. Diversified: Mega 7, 8, 9, 10, 11, 12, 13, 17, 19, 22, 23 44 Reliance Petroleum Ltd. Refineries 4 45 SBI Capital Markets Ltd. Finance: Merchant Banking 13 46 Shoppers’ Stop Ltd. Retail 9, 10, 11, 12, 17 47 Skyline India Ltd. (Imaginary Company) 48 Tata Motors Ltd. Auto-LCVs/HCVs 7 20 49 Titan Industries Ltd. Watches and Jewellery 11, 12, 17, 20 50 Torrent Cables Ltd. Cables: Power 22 51 TVS Motor Company Ltd. Two wheelers 17 52 Voltas Ltd. Diversified: Mega 22 53 Whirlpool of India Ltd. Domestic Appliances 9, 10 PREFACE TO THE FIFTH EDITION Financial Accounting for Management: An Analytical Perspective is now into its fifth edition. In between the first and the fourth editions, while maintaining the original focus and character of the book, many major additions and improvements have been made, such as changes in the anatomy of the book, addition of new chapters, addition of an appendix on ESOP in the erstwhile chapter 11, increase in number of corporate cases from 38 to 53, substantial expansion of numerous chapters, introduction of new pedagogical features, addition of a large number of new illustrations and exercises, further simplification of the subject matter, convergence with international financial reporting standards (IFRS convergence), and new vertical format of financial statements as per the revised schedule VI of the Companies Act, 1956. Now, I am happy to present before the readers the fifth edition of Financial Accounting for Management: An Analytical Perspective in a more contemporary layout and in two colours. This edition comes with substantial changes and revision of its subject matter and updation in the light of statutory requirements, notably Schedule III of the new Companies Act 2013 prescribing a new format of vertical financial statements. The changes and revision have been brought about by introduction of new chapters, substantial rewriting of certain initial chapters, introduction of simpler and smaller illustrations, and including new exercises for all chapters. Content that is no longer relevant to the current scenario have been deleted. Consequently the book is now organized into 6 parts, 24 chapters and 2 appendices as against 8 parts, 28 chapters and 6 appendices in the 4th edition. The new chapter arrangement—vis-à-vis the 4th edition—is as follows: Parts and Chapters in the 5th Edition Chapter No. Chapter Description Nature of Change Corresponding Old Chapter No. in 4th Edition PART 1: THE FOUNDATION 1 Measurement of Profit and Financial Position: I, Business Transactions to Recording in Journal Substantially Rewritten 1 2 Measurement of Profit and Financial Position: II, Journal to Trial Balance Substantially Rewritten 1 3 Measurement of Profit and Financial Position: III, Trial balance to Balance Sheet and Profit and Loss Account: Non-corporate Entities Substantially Rewritten 2 4 Measurement of Profit and Financial Position: IV, Corporate Entities Updated 3 5 Vertical Financial Statements of Corporate Entities Totally new chapter … 6 Specific Day Books Totally new chapter … (Continued) xxxviii PrefaCe to the fifth edition Parts and Chapters in the 5th Edition Chapter No. Chapter Description Nature of Change Corresponding Old Chapter No. in 4th Edition PART 2: CONCEPTS AND PRINCIPLES 7 Conceptual Framework of Financial Statements Updation and pruning 4 8 Generally Accepted Accounting Principles Updation and pruning 5 PART 3: ASSET VALUATION 9 Valuation of Tangible Fixed Assets No change 6 10 Depreciation on Fixed Assets No change 7 11 Valuation of Assets Under Finance Lease and Intangible Assets, Amortization and Asset Impairment No change 8 12 Valuation of Inventories No change 9 13 Valuation of Investments No change 10 PART 4: UNDERSTANDING THE ANNUAL REPORT 14 Corporate Financial Statements of Nestle India Ltd. along With Notes to Accounts and Significant Accounting Policies Totally new chapter and consolidation 11, 12, 13 15 Other Mandatory Financial Reports Consolidation and updation 15, 16 PART 5: FINANCIAL STATEMENT ANALYSIS 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings Minor changes 17 17 Financial Statement Analysis and the Tool Kit of the Analyst: I, Multi-step, Horizontal, Vertical and Trend Analyses and Analytical Balance Sheet Updated 18 18 Financial Statement Analysis and the Tool Kit of the Analyst: II, Earnings Per Share (EPS) Analysis No Change 19 19 Financial Statement Analysis and the Tool Kit of the Analyst: III, Ratio Analysis Updated 20 20 Construction and Analysis of Corporate Cash Flow Statement Updation and consolidation 14, 21 21 Model for Strategic and Integrated Managerial Financial Analysis of Annual Report Revision 22 PART 6: MORE ON FINANCIAL REPORTING AND ANALYSIS 22 Analysis of Information From Sources Other Than Annual Reports and Intercompany Comparison No Change 25 23 Analysis of Group Performance: Consolidated Financial Reporting No Change 26 24 Emerging Dimensions in Voluntary Financial Reporting: Contemporary Analytical Techniques No Change 28 PrefaCe to the fifth edition xxxix The Companies Act 1956 has been replaced by the new Companies Act 2013. Schedule III of the Act has prescribed new vertical format of financial statements for corporate entities. Chapter 5 on Vertical Financial Statements of Corporate Entities has been introduced for a thorough study and illustration of the new format. Corporate Financial Statements of Nestle India Ltd. along With Notes to Accounts and Significant Accounting Policies (Chapter 14) has been introduced for a thorough examination of the annual report of Nestle India Ltd. (for the year ending 31st December, 2014) in the new format. Furthermore, in all the chapters on financial analysis and all the illustrations and exercises of real-life companies have been replaced by their recent format of financial statements. Chapter 15 has been updated in view of the latest changes, such as Corporate Social Reporting. Chapter 20 represents consolidation and revision of Chapter 14 and 21 in the earlier edition. Chapter 6 on Specific Day Books has been introduced on the basis of feedback received from instructors. Chapter No. 23, 24 and 27 of the 4th edition have not been retained in this edition as it was felt that they were not needed. Likewise appendices 1 to 3 and 6 of the 4th edition have become redundant and hence not retained. For accessing the annual report 2014 of Nestle India Ltd., a separate online link is being provided on the back cover of the book. This edition comes out with expansion, enrichment, simplification and aesthetic improvement of subject matter in more ways than one. The new features in this edition are: 1. More exhaustive explanations, examples and exercises throughout the book 2. Addition of a large number of simple and smaller illustrations and exercises 3. Publication in two colours 4. New and interesting icons for each pedagogical feature 5. References updated to recent editions of the books 6. Certain chapters deleted due to the redundancy of content. All the changes, revisions, consolidations, and improvements brought about have ultimately resulted in significantly reducing the number of pages in this edition. Finally, I wholeheartedly acknowledge the support provided to this book by innumerable teachers from India and abroad through its adoption and providing constructive feedback. I have drawn upon many of them in shaping this edition and humbly look forward to their continued support. I may be reached at ambrish@fsm.ac.in. Ambrish GuptA This page is intentionally left blank. PREFACE I am happy to place Financial Accounting for Management: An Analytical Perspective, before the students, teachers and other readers. The inspiration to write this book came from my MBA teaching experience coupled with a realization, strengthened further by some of my colleagues who shared their views with me as well as students’ demand, that they needed, on the subject, an analysis and decision-making-oriented book with real life applications catering to the needs of the MBA students. I also saw an opportunity, in this realization, to bring a practitioner’s perspective to the book by drawing upon my industrial experience in the area of finance. It took more than two years to transform this inspiration into outcome. The Context and Purpose Financial Accounting is known as the language of business. and rightly so since it measures, translates and sums up the impact of all business activities into financial terms in the form of financial statements, namely the balance sheet, income statement and cash flow statement, and facilitates an enterprise to analyse and assess periodically whether it is running profitably and enjoys a sound financial health or not. Based on this financial information a business formulates its strategies for revenue enhancement, cost economies, efficiency improvements, restructuring of its operations and further expansion/diversification for creating and enhancing the wealth of its shareholders. Financial statements, nowadays, are no longer meant for just the promoters or owners of an enterprise. The growing complexities of modern-day business have put heavy demands on the enterprises in the preparation and presentation of their financial statements and other financial reports for the various stakeholders. These complexities are manifest, for example, in l the separation of ownership and management l public participation in the capital l dependence upon the lending institutions l multiplicity of legal interventions l divergence between the requirements of accounting standards and fiscal laws l global fund-raising and, therefore, compliance with the US and international financial reporting standards l increasing pressure for harmonization of financial reporting internationally l introduction of complex financial instruments l emergence of proactive institutional investors l general public awareness and l ever-increasing and, now, predominant role and influence of the regulatory authorities on the operations of the enterprises. Obviously, the students of MBA/PGDM/PGDBM and other allied courses, such as MFC and MBE, need to develop a sound understanding of financial accounting and skills in analysing its outcome, that is, financial state- xlii PrefaCe ments and other financial reports such as directors’ report, corporate governance report, and management discussion and analysis report, to be able to make effective decisions when they proceed to join the corporate world. This book has been brought out in this context and seeks to serve the purposes as stated above. Focus The needs of the MBA/MFC/MBE students in learning financial accounting are different from those of students of professional accounting courses like chartered accountancy. For the former, after initiation into the basic accounting activity that leads to the preparation of financial statements, emphasis needs to be placed on their analysis leading to strategic decision-making. in other words, they need to get more analytical input than the knowledge of accounting process, which is just a means to achieve the major objective of developing analytical and interpretation skills. The literature that is available on the subject generally concentrates more on the means and pays far less attention than required to the objective. The book seeks to correct this imbalance and provide to the students with an analytical perspective all through the text. The book, thus, focuses more on the analysis, interpretation and strategic decision-making. Target Audience 1. Primarily meant for students of MBA/PGDM/PGDBM and MFC/MBE. 2. Students of CA, CWA, CS, CFA, CPA, CAIIB will also find the book very useful due to its emphasis on analysis. 3. Quite useful for management development/in-company training programmes on finance, accounting and analysis for finance as well as non-finance executives. 4. Finance professionals in accounting firms and industry will also benefit from the book by updating themselves with the latest in financial reporting and analysis. From collegiate to corporate management bigwigs, it is expected that the book will meet the requirements of all users. Organization A. Parts 1. The Foundation 2. Concepts and Principles 3. Asset Valuation 4. Understanding Corporate Financial Statements and Other Financial Reports Included in Annual Reports 5. Financial Statement Analysis 6. Strategic and Integrated Managerial Analysis of Corporate Financial Statements and Other Financial Reports of Nestlé India Ltd. forming Part of Its Annual Report 7. More on Financial Analysis 8. Contemporary Issues in Financial Reporting and Analysis These parts contain, in all, twenty-eight chapters. B. Appendices at the End of Part 8 1. Brief Profile of Nestlé India Ltd. 2. Annual report of Nestlé for the year ended 31.12.2001. 3. Certain extracts from annual report of Nestlé for the year ended 31.12.2000. 4. Present Value of an annuity of Rupee 1 paid at the year-end. PrefaCe xliii 5. Present Value Factor of a lump sum (PVF) of Re 1 6. Cash flow statement of Nestlé India Ltd. for the year ended 31 December 2001 as prepared from its entire annual report. C. Subject Index Unique Features 1. Student-friendly. Written in a lecture mode and conversational style. Classroom simulative. 2. Case study–centric and analysis-oriented. A practical business oriented analysis keeping in mind the realworld financial practices of blue-chips corporates. Cases and financial practices of 62 leading companies, Indian as well as multinational, have been covered. 3. Enriched by my own industry experience, independent thinking and research on the subject, resulting into providing a practitioner’s perspective and making the text thoroughly enjoyable. 4. Thorough discussion on Conceptual Framework of Financial Statements and contemporary issues such as Generally Accepted Accounting Principles (GAAPs), Valuation of Assets Under Finance Lease, Intangible Assets, Amortization and Asset Impairment, Earnings Per Share (EPS) Analysis, Analysis of Group Performance: Consolidated Financial Reporting and Employee Stock Option Plans. 5. Accounting Standards interwoven with the text throughout the book, in a non-technical language, to the extent possible—instead of bundling them in a separate chapter—with the objective of making their understanding more and more contextual and enjoyable. 6. Thorough coverage of Significant Accounting Policies and Notes to Accounts, Auditors’ Report, Directors’ Report, Corporate Governance Report, Management Discussion and Analysis Report, Quality of Earnings, Window Dressing, and Information from Sources Other than Corporate Annual Reports. 7. A systematic, organized and integrated reading and understanding of financial statements and reports through the case of Nestle India Ltd., based on its external annual financial reporting, in Part 4 of the book. 8. A model developed for a strategic analysis and interpretation of the annual report comprising an integration of financial, qualitative and quantitative information, with the objective of giving recommendations to the management on strategic issues emanating out of analysis and suggesting more transparency in financial reporting. 9. Nestle’s full annual report analysed as per the said model in Chapter 23 in Part 6. Special emphasis laid on contemporary financial issues such as Corporate Governance, Segment Reporting, Related Party Disclosures, Earnings Per Share, Impairment Loss, Accounting for Taxes on Income and Contingency Provision, and analysed threadbare. 10. Innovative analytical techniques like Per Employee Analysis and Per Equity Share Analysis introduced. 11. Detailed discussion on Global Financial Reporting. 12. Coverage of emerging dimensions in financial reporting, that is, Value reporting(TM) comprising Intangible asset scorecard, Human resource accounting, Value-added statement, Brand valuation, Balance sheet including intangible assets, Economic Value-added (EVA®) statement, Enterprise value and Current-costadjusted financial statements. External Resource Support to Teachers Three external resources are hosted on www.pearsoned.co.in/ambrishgupta to support those teachers who adopt this book. The publishers will provide them password to access these resources. xliv PrefaCe 1. Instructors’ Manual This manual seeks to explain to the instructors the purposes and objectives of different types of exercises, case studies and group projects, their focus areas, learning purported to be gained by the students and how to approach and address them. 2. Solutions Manual This manual provides solutions to the chapter-end exercises. It acts as a ready reckoner for instructors and aims to save their time. At places, particularly in the analysis part of the exercises/case studies/projects, instructors may have views different from those expressed in the solutions manual. in such cases, they should discuss their own perspectives with the students as well. 3. PowerPoint Presentation Slides This package of comprehensive chapter-wise PowerPoint presentation slides of the whole text, including illustrations, will, I hope enable the instructors derive fully the advantages intended from the package. It will save their quality time and should lead to more interactive class discussions and visual reinforcement of financial accounting, reporting and analysis techniques. Acknowledgements My thanks and gratitude to all those who have helped, encouraged and supported me all through this project: my institution FORE and its management; my publisher Pearson Education, their editorial team and panel reviewers, for their positive opinions on the book; my students, my friends, my secretary Sonika and my immediate family—Usha, Kamal and Bharat. Kamal and Bharat always kept me on my toes with queries like ‘When are you going to finish the book,’ ‘Why don’t you finish it early,’ and seeking regular progress reports from me. Really it is these teenager sons of mine and their mother Usha, who suffered a lot as a result of their neglect by me during the period this project was underway but never complained,and who played an instrumental role in the completion of this project by their constant and persistent encouragement. Feedback I seek critical reviews, comments and observations from my readers in an effort to improve the further edition of this book. I may be reached at ambrish@fsm.ac.in. Ambrish GuptA ABOUT THE AUTHOR Dr Ambrish Gupta, M.Com., Ph.D., FCA, Chartered Accountant, is a senior professor in finance and accounting area at FORE School of Management, New Delhi. He is a recipient of the ‘Distinguished Management Teacher’ and ‘Rashtriya Gaurav’ awards. Dr Gupta possesses over 32 years of experience in management teaching, research, academic administration, investment banking and primary capital market. He has three books to his name—two authored and one edited. He has also published 28 papers in leading journals and other publications, 2 case studies with The Case Centre, UK/USA, 10 working papers under the aegis of FORE and 4 papers in the proceedings of international conferences in Germany, Macau (China), Thailand and India and 5 chapters in edited books. His areas of teaching and research interests are: • • • • • • Investment banking and primary capital market Contemporary corporate reporting practices Project appraisal and financing Financial accounting, reporting and analysis IFRS convergence of Indian accounting standards and their impact on the quality of financial reporting and corporate financial health Corporate governance and social responsibility He has provided research guidance to 60 major research projects of PGDM/MBA students and one Ph.D. scholar (Theses awarded). He has delivered numerous talks on topics related to his interest areas in MDPs and seminars including for IAAS officers. He is at present: • • • • • • • • • • Co-editor—International Journal ‘GSTF Business Review’, Singapore. Member—Editorial board-Universal Journal of Accounting and Finance, USA. Member—Editorial board-International Research Journal ‘Public and Municipal Finance’, Ukraine. Member—Program Committee-Series of Annual International Conferences on Accounting and Finance, Global Science and Technology Forum, Singapore. Fellow Member—The Institute of Chartered Accountants of India. Member—Doctoral committee-Department of Management-Jamia Hamdard University, Delhi. Member—Editorial advisory board-International Journal of Management Science Review, Jamia Hamdard University, Delhi. Member-National editorial advisory board—Journal of Management Research and Analysis, Delhi. Member—Editorial board-Indian Journal of Finance, Delhi. Member—Editorial board-Indian Journal of Research in Capital Markets, Delhi. xlvi • • • aBout the author Member—Editorial board-ELK Asia Pacific Journal of Project Management and Control, Delhi. Member—Capital market committee-PHD Chamber of Commerce and Industry, Delhi. Member—CFO Guild, the Institute of Chartered Accountants of India. At FORE he has been: • • • Area chairperson (Finance and Accounts) for 6 years. Programme Director (PGDM-Working Managers’ Group) for two years. Member/chairman of various committees. Prior to 1997, he spent 14 years in industry. He held leadership positions such as Director, Senior Vice President, and Country Head in the investment banking industry for 12 years. As an investment banker, he advised a large number of corporate clients and managed and marketed 85 IPOs/Rights equity issues and private debt placements. He also visited plants of a number of leading companies in India and addressed more than 50 conferences relating to IPOs attended by corporate finance managers, capital market intermediaries, national & regional press and investors. PART 1 THE FOUNDATION Chapter 1: MEASUREMENT OF PROFIT AND FINANCIAL POSITION: I BUSINESS TRANSACTIONS TO RECORDING IN JOURNAL Chapter 2: MEASUREMENT OF PROFIT AND FINANCIAL POSITION: II JOURNAL TO TRIAL BALANCE Chapter 3: MEASUREMENT OF PROFIT AND FINANCIAL POSITION: III TRIAL BALANCE TO BALANCE SHEET AND PROFIT AND LOSS ACCOUNT: NON-CORPORATE ENTITIES Chapter 4: MEASUREMENT OF PROFIT AND FINANCIAL POSITION: IV CORPORATE ENTITIES Chapter 5: VERTICAL FINANCIAL STATEMENTS OF CORPORATE ENTITIES Chapter 6: SPECIFIC DAY BOOKS chapter 1 Measurement of Profit and Financial Position: I Business Transactions to Recording in Journal Monetary Business Transactions Transaction Analysis Documentation Recording The process that leads to the measurement of financial performance and position of an enterprise is known as Accounting Cycle. Accounting Cycle forms the very basis of financial accounting. This chapter covers the cycle up to recording in journal. Chapter 1 Measurement of Profit and Financial Position: I 3 CH AP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 The fact that modern accounting owes its origin to India. 2 The anatomy of business and its relationship with financial accounting. 3 The steps involved in the process of accounting, up to recording, that leads to the measurement of profit and financial position. 4 How to do documentation of business transactions by way of vouchers. 5 How to do recording of vouchers in journal. 6 Application of certain fundamental accounting concepts in the process. 7 Basic features of partnership firm and their implications for financial accounting. Thus enabling you to be able to complete the accounting cycle in the chapters that follow. INTRODUCTION Suppose your friend Sachin possesses a surplus of ` 10 crore. What should Sachin do with this money? One option is to invest it in a safe avenue with fixed stream of regular income, say; in a bank fixed deposit which earns him interest income of 9% per annum (p.a.). However Sachin, being quite enterprising, decides to embark upon a business. Do you wonder “Why”? Simple! Sachin wants a return of more than 9% p.a., or in other words, his motive is to earn profit. Any business for that matter is started with the objective of making money on money invested therein. For example, Reliance Industries Ltd., the largest private sector company in India, is running a huge oil & gas, petrochemicals and textile business with thousands of crores of rupees invested therein by its promoters and millions of other shareholders. As yet another example, Arcelor Mittal Steel Company, Luxembourg, is operating the largest steel empire in the world with billions of U S Dollars. Simply these businesses, and for that matter all businesses, need to earn a decent profit to keep their shareholders happy. The questions that arise are how to ascertain whether the business is earning profit or not, are the profits earned decent or not, is the business in red, etc.? Financial Accounting comes to the rescue of the enterprise here. It enables preparation of financial statements, namely the Profit and Loss Account and the Balance Sheet, which measure the financial performance, i.e., the profit earned or the loss suffered and the financial position, i.e., what is the status of the money invested or what the enterprise owns and what it owes, respectively. How these financial statements are prepared? What is the process that leads to their preparation? Or in other words how do we ascertain the financial performance of a business for a given period and its financial position as on a given date? These and many other related questions will be answered in this and the next chapters. However, before we move further it will be interesting at this stage to peep into the history of financial accounting and see that the roots of modern accounting lie in ancient India. 4 Financial Accounting for Management INDIA—THE PLACE OF ORIGIN OF MODERN ACCOUNTING History of the Accountancy Profession in India, Volume I, researched and written by Shri G.P. Kapadia and published by the Institute of Chartered Accountants of India in the year 1972, and reprinted in 1988, is a classic treatise on the subject. Here are some extracts from the first chapter of the book. The birth of double entry book-keeping is suggested to have been at Want to know more the hands of a Franciscan Monk, Luca Pacioli, who published a book in about the history of 1494, a philosophical and mathematical work, which included a treatise accounting? Refer to on book-keeping. Chapter 1 of this treatise. (However), sufficient evidence exists to lead one to conclude that the art and practice of accounting, as a highly developed system, was in vogue in ). India even during the times of the Vedas ( ), Sutras ( ) and the Upanishads ( Indication about the existence of the profession or vocation of an accountant can be had from the rich material available in respect of the evolution of industry and commerce in olden times. The business that was carried on included a very extensive and developed entrepot trade and commercial activities extended to various parts of the world. It is, therefore, not surprising if one finds the system of trade organizations developed to a very high level in ancient India. It is certain that at least about the 5th century, B.C., if not much earlier, “Crafts and commerce were flourishing, highly organized corporately, under conditions of individual and corporate competition, the leading men therefore the friends and counsellors of kings…” and Indians in those times had a thorough familiarity with money and credit, ages before 7th century A.D. (Camb. History of India, p. 219.) The profuse references given with regard to the pre-Vedic and Vedic times should confirm the position that accountancy existed in a highly developed form even in those days in India. We are in a position to surmise that the art and practice of accounting had existed on our soil even before the days of Babylonian empire and that a highly developed system was in vogue in India even during the time of the Vedas. Clear references, as were indicated, are found in the various treatises dating back to the period of the Vedas and the Upanishads to various professions and vocations in existence at that time and the profession of accountant is clearly one of them, and taking these aspects and considerations, one could come to a natural conclusion that accountancy had its origin in India. In conclusion, a reference needs to be made to a pertinent observation made by Alexander Hamilton F.R.S., the noted orientalist. In the Book Review in “Monthly Review” 26 (1798) page 129, he stated as under: ‘We would remark that the Banias* of India have been from time immemorial, in possession of the method of book-keeping by double entry, and that Venice was the emporium of Indian commerce at the time at which Friar Lucas’s (Pacioli’s) treatise appeared’. (Hindustani From the above extracts we may conclude with surety that the Bahikhaataa Paddhati/Indian System of Accounting) is a fully developed scientific system of dou(Naame/Debit) and (Jamaa/Credit), which was invented and ble entry accounting, based on practiced thousands of years ago and refined over these years. Luca Pacioli’s references are just a few centuries old. Modern day double entry accounting is also based on the two pillars of debit and credit. These— debit, credit and double entry accounting—will be discussed a little later. As financial accounting seeks to measure the financial performance and position of business, we need to first understand the anatomy of business, and then we will move over to the accounting process. * Banias mean Businessmen. Chapter 1 Measurement of Profit and Financial Position: I 5 THE ANATOMY OF BUSINESS Let us take an example. Suppose Radhika Enterprises, promoted by Radhika Agarwal as her proprietary firm, enters business of textile manufacturing. How does it do that? It invests in land, factory buildBIRD’S EYE VIEW ing, administrative building, plant and machinery, vehicles, furniture The Anatomy of Business and office equipments etc. to produce and sell textiles and earn profit. Radhika contributes partly her own money and partly born Assets rows a term loan repayable over five years, say, for example from — Fixed assets Delhi Financial Corporation, to finance her investment. Once the — Current assets — Investments plant is constructed and commissioned, the firm needs further funds n Liabilities for its normal operating cycle, that is, to purchase raw materials, — Long term (non-current) liabilities produce textiles, sell them to customers, realise cash and pay back — Current liabilities to the suppliers from whom credit availed. In this process the firm n Financial Position may not be able to sell its entire production, and otherwise also it n Income needs to stock reasonable quantities of its finished goods to be able n Expenses to execute orders quickly, and thus it will have to carry inventory n Financial Performance of finished goods. Likewise the production process may take a few days to convert raw materials into finished goods thus leading to work-in-progress inventory. The firm would also like to maintain inventory of raw materials so that the production process is not held up for want of materials. Likewise it may have to sell its textiles to customers on credit. Again it may have to pay to the suppliers immediately on purchase of materials or even in advance. It also needs cash to meet day to day expenses on its establishment. Naturally Radhika Enterprises needs further funds to finance these activities. Partly they come from Radhika and partly from, say, State Bank of India in the form of bank overdraft or cash credit limits. In the business credit may also be available from suppliers against raw materials purchased as well as advances from customers against sale and to that extent these sources also become a source of finance for these activities. Establishment of business and subsequent business operations lead to creation of assets and liabilities and generation of income and incurring of expenses towards that generation. Let us develop a basic understanding of what these terms ‘Assets’, ‘Liabilities’, ‘Income’ and ‘Expenses’ mean and convey and how they constitute ‘Financial Position’ and ‘Financial Performance’ before we proceed further. Assets We have referred above to resources like land, buildings, plant and machinery, vehicles, furniture, office equipments, inventories of raw materials, work-in-progress and finished goods, amount receivable from customers to whom finished goods sold on credit, commonly referred to as debtors, advances to suppliers of raw materials and cash. These resources are known as assets. Assets thus collectively refer to the resources controlled by a business enterprise which enable it carry out its business operations for generating revenue. Assets are usually of two types-fixed and current. At times there can be one more asset known as investments. Fixed assets In the example of Radhika Enterprises given above land, buildings, plant and machinery, vehicles, furniture and office equipments represent physical infrastructure of the firm or its fixed assets as they enable the firm produce textiles and provide marketing and administrative support to business on an ongoing basis over their life span. These assets provide a long term economic benefit, 6 Financial Accounting for Management usually spanning beyond one year, to the firm but they themselves are not held for sale. Hence the term fixed assets. Current assets In the above example, inventories of raw materials, work-in-progress and finished goods, debtors, advances to suppliers of raw materials and cash, needed for the operating cycle as discussed, represent current assets. These assets are held for consumption (raw materials and workin- progress) or for sale (finished goods) and are expected to be realised in cash (debtors) or in kind, for example, through the supplies of raw materials (advances to suppliers) during the operating cycle. Cash itself is a current asset held for financing other current assets, fixed assets and meeting day to day expenses. Investments Business is supposed to generate profit. When generated this profit may be further deployed in the fixed and current assets to expand the business activities. In case however if there is no further scope for expansion or the owner does not want to expand, this profit piles up in the form of cash or surplus funds. These funds however cannot be kept idle and are therefore invested into, say, shares and debentures of companies like, for example, Reliance, Tata Motors, Grasim and ONGC etc. to name a few. Investments thus represent assets held by an enterprise for earning income by way of dividends, interest or gain on their disposal known as capital gain. There is however a risk of losing money also on their disposal known as capital loss. Liabilities We have referred above to sources of financing the assets, like Radhika’s contribution, commonly referred to as owners’ capital, term loan, bank borrowings for financing current assets, amount payable to suppliers from whom raw materials purchased on credit, commonly referred to as creditors and advances from customers. These sources represent liabilities since they have to be paid back (Radhika’s capital, term loan, bank borrowings and creditors) and settled through delivery of textiles (advances from customers). Liabilities are thus the obligations of the business enterprise that arise in the course of its business operations and are to be discharged/settled in future. It should be interesting for you to note that even though Radhika Agarwal is the proprietor of Radhika Enterprises; her capital represents a liability for the latter as it, as a business entity, is independent of its proprietor and has to return this capital to Radhika in the event of the closure of the business. Otherwise also Radhika can with draw the surplus capital from Radhika Enterprises any time. You need to be clear that we are discussing here about the liabilities of Radhika Enterprises, the business enterprise, and not of Radhika, the individual who may have other interests as well. Liabilities thus represent those payable to outsiders and that to the owner. Liabilities are usually of two types-long term and short term or current. Long term (non-current) liabilities In the above example term loan for financing the fixed assets is repayable over five years. Any liability repayable over a period exceeding one year is termed as a long term liability. Likewise Radhika’s capital is also a long term liability as it represents a long term perpetual commitment of the proprietor towards the firm. Current liabilities In the above example bank borrowings for financing current assets, creditors and advances from customers represent current liabilities. Current liabilities have to be essentially discharged during the operating cycle (creditors and advances from customers) and in any case within one year (bank borrowings for financing current assets as the banks sanction these for a year). Hence the term current liabilities. Chapter 1 Measurement of Profit and Financial Position: I 7 Financial Position Assets and liabilities put together constitute the financial position of the enterprise. They are tabulated in a statement known as Balance Sheet. As discussed above assets represent the resources at the command of the enterprise, outside liabilities the money owed by it to the outsiders and the excess of the former over the later to the owner. More the excess of assets over the outside liabilities more strong is the financial position and vice versa. From this follows, what is known as, the basic accounting equation expressed as under: nn Assets = Liabilities, or nn Assets = Outside Liabilities plus Owner’s Capital, or nn Assets less Outside Liabilities = Owner’s Capital The basic accounting equation is also known as the balance sheet identity. Let us now turn our attention to Income, Expenses and Financial Performance. Income Business activities of an enterprise generate revenue or income for it. Sale of goods is the most common business income. For example, Radhika Enterprises earns its income by selling textiles to its customers. In a business there may be other incidental incomes also, for example, export incentives and cash discount. Business also earns through interest and dividends from investments. Income also includes gains such as capital gains on disposal of investments as discussed above. A business engaged in services earns its main income not through sale but through fees for rendering services. For example, JM Financial Ltd., the well known investment banking company earns its revenue from fees for managing initial public offers and mergers and acquisitions etc. for its client companies. Income, once earned, is earned for good and is not payable back. It becomes the resource of the enterprise. Expenses Expenses are incurred in the course of the business operations of the enterprise towards generating income. For example, Radhika Enterprises incurs lots of expenses like raw materials consumed for producing textiles, production expenses like wages, power, fuel etc., administrative expenses like salaries, office rent, travelling and conveyance etc. and marketing expenses like publicity and advertisements etc. to be able to effect sale of textiles. Expenses are known as revenue expenses also as they represent the cost of generating the revenue and, once incurred, they are incurred for good and no further materials are delivered or service is rendered by the payee or in other words no further economic benefit is derived from them. Expenses also include losses, for example, capital loss on sale of investments as discussed earlier or loss due to fire or loss on sale of old fixed assets etc. Financial Performance Expenses and losses are charged against income and gains. Income and expenses are tabulated in a statement known as Profit & Loss Account. Excess of income and gains over expenses and losses represents net profit earned by the business and net loss in a vice versa case. Obviously net profit increases the capital of the owner and net loss reduces it. Net profit thus strengthens the financial 8 Financial Accounting for Management position of the enterprise and net loss eats into it. Profit is the motive behind business, and therefore all efforts of the owner are directed towards earning and further enhancing it, though losses also occur in a large number of cases. Basic accounting equation, illustrated earlier, can now be further expanded as under: nn Assets = Liabilities, or nn Assets = Outside Liabilities plus Owner’s Capital, or nn Assets less Outside Liabilities = Owner’s Capital, or nn Assets less Outside Liabilities = Owner’s Brought in Capital less Owner’s Drawings plus Net Profit (–Net Loss), or nn Assets less Outside Liabilities = Owner’s Brought in Capital less Owner’s Drawings plus Income less Expenses BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Are you convinced about India being the birth place of modern accounting? 2. Are you clear how business is structured and how financial accounting is related to it? Narrate. 3. Why should assets be equal to liabilities? What does the basic accounting equation convey? To enrich your discussion, add your own ideas, thoughts and practical inputs. And now we discuss the accounting process. THE ACCOUNTING PROCESS The process that leads to the measurement of financial performance and position of an enterprise passes through the following stages: 1. Analysis of business transactions that are capable of being expressed in terms of money, as per the rules of debit and credit as discussed a little later. A business enterprise carries out a number of activities and executes a number of transactions that could relate to purchase, sale, receipts and payments, etc. as seen above. 2. Documentation of business transactions by way of what is known BIRD’S EYE VIEW as voucher. The Accounting Process 3. Recording of vouchers in a daybook called journal/journal and specific day books. Daybook is the book which records transactions n Analysis of Transactions n Documentation: Voucher chronologically on a daily basis, and, hence the term. n Recording 4. Classifying the transactions so recorded by their nature. For n Classifying: Ledger example, putting all purchase transactions at one place chronon Summarising: Trial Balance logically so as to enable an understanding of the total build-up n Bifurcating the Trial Balance: Profit and and effect of that particular activity. This is done through a book Loss Account and Balance Sheet called ledger. Chapter 1 Measurement of Profit and Financial Position: I 9 5. Summarizing the transactions so classified to understand and appreciate the total build-up and effect of various activities. This is done through a statement called trial balance. This document provides the net effect of all the transactions, by their nature, carried out by the enterprise during a particular period. 6. Bifurcating the trial balance into statement of profit and loss and balance sheet to measure the financial performance and position, respectively, of the enterprise. The process mentioned above is also known as accounting cycle or accounting process. It is the very basis of financial accounting, reporting and analysis. This process has been organised in this book as under: nn Analysis of business transactions to recording: this chapter. nn Classifying and summarising: next chapter. nn Statement of profit and loss and balance sheet: next to next chapter. Let us illustrate the accounting process, beginning with documentation and recording. ANALYSIS, DOCUMENTATION AND RECORDING OF BUSINESS TRANSACTIONS Analysis Documentation and recording is based on what is known as the dual aspect concept. What it means is that every transaction has two sides. For example, in the case of cash sale the business receives cash from the customer in lieu of giving away the product to him. Therefore, the accounting process should show how much cash has been received, represented by how much sale. In case the goods have been sold on credit, that is, the amount due will be received in future on an agreed date, the accounting process should show how much is due from the customer against how much sale. Every transaction is therefore recorded on two sides, represented by debit and credit. Each transaction is debited and credited to what is known as account, represented by the nature and effect of the dual aspects of the transaction. Debit and credit and the dual aspect concept or the double entry system is the foundation of the entire accounting system. Accounting cannot take shape without the double entry system. It is, therefore, essential to visit the wonderland of debit and credit and develop a clear understanding thereof. BIRD’S EYE VIEW Analysis, Documentation and Recording of Business Transactions n Analysis n Wonderland of Debit and Credit — Reversal of income and expenses — Personal accounts n Dual Aspect Concept — Cash: An asset — Double entries — Credit transactions n Accrual Concept/Mercantile System of Accounting — The receiver and the giver n Documentation: Voucher n Recording: Journal 10 Financial Accounting for Management Wonderland of Debit and Credit When the firm… 1. Pays cash… It needs to… Debit (Dr.) n n n 2. Receives cash… Credit (Cr.) n n The receiver, i.e., his personal account, if, recoverable from him either in cash or in kind, or, paid to him in discharge of a liability in full or in part. What comes in: Assets (other than personal accounts). Expenses/Reversal of income The giver, i.e., his personal account, if, repayable to him either in cash or in kind, i.e., if a liability is created, or, received from him in realisation of dues in full or in part. What goes out: Assets (other than personal accounts). n Income/Reversal of expenses Wondering why ‘Dr.’ for debit when the latter does not contain ‘R’? It is a practice that has become a tradition, apparent motive being to match ‘Dr.’ with ‘Cr.’. It needs to be noted that receiver means the person who receives cash and giver means the person who gives cash. Now you might think, and rightly so, that when an asset is purchased or an expense incurred the payment has necessarily to be made to a person, i.e., there has to be a receiver. Likewise in case a liability arises say a loan taken, or an asset sold or income earned money has to be necessarily received from a person, i.e., there has to be a giver. This thought leads you to a dilemma as to when to debit the receiver or asset or expense in the former case and when to credit the giver or asset or income in the latter. Let us understand. 1. Suppose Radhika Enterprises purchases furniture worth ` 1 lakh from Delite Furnishers and pays cash immediately. Since it has simultaneously received an asset in lieu of payment it will debit Furniture account and not Delite Furnishers. Value having been received and nothing being recoverable any more from the receiver, Delite Furnishers, their account cannot be debited: A. Dr. Furniture…..` 1, 00,000 Had ` 1 lakh been paid in advance, and delivery of furniture were to take place after, say, a month; personal account of Delite Furnishers would have been debited since this advance is recoverable from them in kind, i.e., by way of receipt of furniture. B. Dr. Delite Furnishers…..` 1, 00,000 2. Suppose further that Radhika Enterprises gives a loan of ` 1 lakh to Krishna & Co., a proprietary firm of Radhika’s friend Krishna, personal account of Krishna & Co., the receiver, will be debited as this money is to be recovered from them in cash. C. Dr. Krishna & Co……..` 1, 00,000 3. Again if Radhika Enterprises purchases raw materials worth ` 5 lakh from SM industries Ltd. against cash payment and pays salary of ` 10 thousand to an employee, Rajiv Sharma, for his services for the month of, say, June, both the payments being in the nature of expenses Raw Material Purchases or just the purchases and Salaries accounts respectively will be debited and not the personal accounts of the two receivers as nothing is due from them anymore. D. Dr. Purchase………` 5, 00,000 E. Dr. Salary………....` 10, 000 Had they been paid in advance of delivery or rendering of service their personal accounts would have been debited. Chapter 1 Measurement of Profit and Financial Position: I 11 F. Dr. SM Industries Ltd….…..` 5, 00,000 G. Dr. Rajiv Sharma … ..` 10,000 Let us now talk about the giver. 1. Suppose Radhika Enterprises sells an used set of three chairs and one table to one of its employees Nidhi Mathur for ` 6 thousand and receives cash immediately. Since it has simultaneously disposed of an asset in lieu of amount received it will credit furniture account and not Nidhi Mathur. Value having been delivered and nothing being payable any more to the giver, Nidhi Mathur, her account can not be credited. H. Cr. Furniture …..` 6, 000 Had ` 6 thousand been received in advance, and delivery of furniture were to take place after, say, a month; personal account of Nidhi Mathur would have been credited since this advance is repayable to her in kind, i.e., by way of delivery of furniture. I. Cr. Nidhi Mathur ……` 6, 000 2. Suppose further that Radhika Enterprises gets a loan of ` 5 crore from Delhi Financial Corporation. Here, Personal account of the corporation, the giver, will be credited as this money is repayable to them in cash. Again In the above example, when Krishna & Co. pays back the loan, its personal account will be credited as this money of ` 1lakh has been received from the giver, Krishna & Co., in realisation of outstanding dues. J. Cr. Delhi Financial Corporation ……..` 500, 00,000 K. Cr. Krishna & Co. ...…...................…..` 1, 00,000 3. Again if Radhika Enterprises sells textiles worth ` 10 lakh to Mahesh Chand & Sons against cash payment the receipt being in the nature of income Sales account will be credited and not the personal account of the giver, Mahesh Chand & Sons, as nothing is payable or due to that firm any more. L. Cr. Sales......…..` 10, 00,000 Had the money been received from Mahesh Chand & Sons in advance against delivery of textiles their personal account would have been credited. M. Cr. Mahesh Chand & Co....…..` 10, 00,000 Reversal of income and expenses Income and expenses recorded earlier may have to be fully or partly reversed subsequently. In the above example if Radhika Enterprises receives back textiles worth ` 25 thousand from Mahesh Chand & Sons or returns back to SM industries Ltd. raw materials worth ` 15 thousand, the effect of the two transactions is reduction in income and expenses respectively of the firm. Radhika Enterprises will therefore debit sales (or, sales return account) for the first transaction and credit purchases account (or, purchases return account) for the second transaction thus reversing partly the earlier income and expense. There will be cash outgo of ` 25 thousand in the first case and cash inflow of ` 15 thousand in the later. The following entries will take place: N. Dr. Sales/Sales Return.......................` 25, 000 O. Cr. Purchase/Purchase Return...........` 15, 000 Personal accounts It may be interesting to note that personal accounts, when advances or loans are given to them, themselves become the assets of the business. It should also be clear by now that personal accounts, when advances or loans are received from them, represent liabilities for the business. 12 Financial Accounting for Management Dual Aspect Concept Since every transaction has to be recorded on two sides each cash payment and cash receipt will be accounted for in the form of a double entry as shown hereunder: When the firm… 1. Pays cash Double entry that it makes… Dr.: n The receiver, i.e., his personal account, if, recoverable from him either in cash or in kind, or, paid to him in discharge of a liability in full or in part, or n What comes in: Assets (other than personal accounts), or 2. Receives cash Cr.: Dr.: Cr.: n n n n Expenses/Reversal of income Cash Cash The giver, i.e., his personal account, if, repayable to him either in cash or in kind, i.e., if a liability is created, or, received from him in realisation of dues in full or in part, or n What goes out: Assets (other than personal accounts), or n Income/Reversal of expenses Cash–An asset As per the dual aspect concept cash received is being debited and cash paid credited. You have been told earlier that cash itself is an asset. That is why the cash received (asset coming in) is debited and cash paid (asset going out) credited. Interesting? Double entries Now the double entry for each transaction from ‘A to O’ explained earlier will be completed as under: A. Furniture purchased for cash: Dr. Furniture…..` 1, 00,000 Cr. Cash ……………….. ` 1, 00,000 (Furniture purchased from Delite Furnishers.) B. Advance given for furniture: Dr. Delite Furnishers…..` 1, 00,000 Cr. Cash ………………............... ` 1, 00,000 (Advance given for furniture to be received.) C. Loan given to a party: Dr. Krishna & Co……..` 1, 00,000 Cr. Cash ………………...............` 1, 00,000 (Loan given to the party) D. Raw material purchased for cash: Dr. Purchase………` 5, 00,000 Cr. Cash……………............. ` 5, 00,000 (Raw material purchased from SM industries Ltd.) E. Salary paid: Chapter 1 Measurement of Profit and Financial Position: I Dr. Salary………..` 10, 000 Cr. Cash …………........... ` 10, 000 (Salary paid to Rajiv Sharma for June.) F. Advance given for raw materials: Dr. SM Industries Ltd….…..` 5, 00,000 Cr. Cash ………………...................... ` 5, 00,000 (Advance given for raw materials to be received.) G. Advance given against services: Dr. Rajiv Sharma …..` 10,000 Cr. Cash ………………........` 10,000 (Advance given against services to be rendered for June.) H. Sale of furniture for cash: Dr. Cash …..................` 6, 000 Cr. Furniture ………………. ` 6, 000 (Furniture sold to Nidhi Mathur.) I. Advance received against furniture: Dr. Cash …..................` 6, 000 Cr. Nidhi Mathur ……………` 6, 000 (Advance received against delivery of furniture.) J. Loan received: Dr. Cash …....................................` 500, 00,000 Cr. Delhi Financial Corporation ………….......` 500, 00,000 (Loan received from the corporation.) K. Loan given earlier received back: Dr. Cash …....................................` 1, 00,000 Cr. Krishna & Co. ……............................…` 1, 00,000 (Loan amount received back.) L. Sale for cash: Dr. Cash …...........................` 10, 00,000 Cr. Sales.................................. ………..` 10, 00,000 (Sale to Mahesh Chand & Sons.) M. Advance received against sale: Dr. Cash …...........................` 10, 00,000 Cr. Mahesh Chand & Co....... ………...` 10, 00,000 (Advance received against goods to be sold.) N. Cash paid for sale retuned: Dr. Sales/Sales Return................` 25, 000 Cr. Cash...................................................` 25, 000 (Cash paid for sales returned by Mahesh Chand & Sons.) 13 14 Financial Accounting for Management O. Cash received for materials returned back: Dr. Cash..............................................` 15, 000 Cr. Purchase/Purchase Return.........................` 15, 000 (Cash received for materials returned back to SM industries Ltd.) Credit transactions Business transactions are however not recorded on just the cash basis. Getting and allowing credit is very common in business and the accounting duly recognises this. Hence it follows what is known as accrual concept. A brief discussion on this concept follows. Accrual accounting is popularly known as Mercantile System of Accounting. Accrual Concept/Mercantile System of Accounting According to this concept, the effects of transactions are recognised at the stage of their occurrence itself, i.e., when they accrue, and not when cash is actually received or paid, and reported in the financial statements of the corresponding period of occurrence. For example, if Radhika Enterprises sells textiles worth ` 10 lakh to its customer, Mahesh Chand & Sons, on 15th March and the payment is to be received on 15th April, this sale transaction, delivery having been given and money having become due from the customer, will be accounted for on 15th March itself by debiting, Mahesh Chand & Sons and crediting sales: 15 March. Sale on credit: Dr. Mahesh Chand & Sons.......` 10, 00,000 Cr. Sales ....................................................` 10, 00,000 (Sale on one month’s credit.) When the cash is actually received on 15th April it becomes a cash receipt transaction and will be accounted for again on that date on the basis of rules discussed above, i.e., debit cash and credit Mahesh Chand & Sons. 15 April. Payment received against credit sale: Dr. Cash.....................................` 10, 00, 000 Cr. Mahesh Chand & Sons..........................` 10, 00,000 (Payment received for credit sale already made.) Likewise if purchases of raw materials of ` 5 lakh have been done from its supplier, SM industries Ltd., on 20th March, though the payment is to be made on 5th May, the purchase transaction, delivery having been received and money having become due to the supplier, will find place in the books of account on 20th March and not 5th May. 20 March. Purchase of raw materials on credit: Dr. Purchase………` 5, 00,000 Cr. SM industries Ltd.............` 5, 00,000 (Raw material purchased from SM industries Ltd. on 45 days credit.) When the cash is actually paid on 5th May it becomes a cash payment transaction and will be accounted for again on that date on the basis of above rules. 5 May. Payment made against credit purchase: Dr. SM Industries Ltd….…..` 5, 00,000 Cr. Cash ……………….......................` 5, 00,000 (Payment made for purchase on credit.) Chapter 1 Measurement of Profit and Financial Position: I 15 Thus following the dual aspect concept each credit transaction will be accounted for as under: When the firm… 1. Instead of paying cash, gets credit 2. Instead of receiving cash, allows credit Double entry that it makes… Dr.: n What comes in: Assets (other than personal accounts), or Cr.: Dr.: Cr.: n Expenses/Reversal of income n The giver (vendor or service provider), i.e., his personal account. n The receiver (vendee or service beneficiary), i.e., his personal account. n What goes out: Assets (other than personal accounts), or n Income/Reversal of expenses The receiver and the giver It needs to be understood that in case of cash transactions receiver means the person who receives cash and giver means the person who gives cash as noted earlier whereas in credit transactions receiver means the person who receives assets (other than cash) or products i.e., the vendee or services, i.e., the service beneficiary and giver means the person who gives assets (other than cash) or products, i.e., the vendor or services, i.e., the service provider. This clarity is essential for clarity of dual aspect concept and mercantile system of accounting. Let us get back to the example of Radhika Enterprises to further clarify the dual aspect concept. 1. Suppose Furniture (` 1lakh) was purchased from Delite Furnishers on 1st October on a month’s credit, furniture account (asset coming in) will be debited and Delite Furnisher’s account (the giver) credited on that date. After a month on 1st November when cash is paid Delite Furnisher’s account (the receiver) will be debited and cash account credited. 1 October: Furniture purchased on a month’s credit: Dr. Furniture......................` 1, 00, 000 Cr. Delite Furnishers..........................` 1, 00, 000 (Furniture purchased on a month’s credit.) 1 November: Payment made for furniture purchased: Dr. Delite Furnishers............ ` 1, 00, 000 Cr. Cash................................................ ` 1, 00, 000 (Cash paid towards furniture purchased on credit.) 2. In case of raw materials (` 5 lakh) purchased, purchase account (expenses) will be debited and SM industries Ltd.’s account (the giver) credited on the date of purchase, i.e., 20th March. On the date of payment, i.e., 5th May SM industries Ltd.’s account (the receiver) will be debited and cash account credited. 20 March: Raw materials purchased on credit: Dr. Purchase.........................` 5, 00,000 Cr. SM industries Ltd. ........................` 5, 00,000 (Raw materials purchased on 45 day’s credit.) 5 May: Payment made for raw material purchased: Dr. SM industries Ltd.........` 5, 00,000 Cr. Cash .............................................` 5, 00,000 (Payment made for raw materials purchased on credit.) 16 Financial Accounting for Management 3. In case of services rendered by Rajiv Sharma for the month of June, if the payment (` 10 thousand) is to be made to him in the following July, salaries account (expenses) will be debited and Rajiv Sharma’s account (the giver of services or service provider) credited on 30th June. In the month of July on the date of payment, say 7th July, Rajiv Sharma’s account (the receiver) will be debited and cash account credited. In practice however services received in day to day running of the enterprise are not expensed on accrual basis rather expensed on the date of payment. The expenses for services remaining unpaid on the last date of the period/year whose financial performance is being measured are however accounted for on accrual basis on that closing date. The same is true vice versa for miscellaneous income like interest earned. 30 June: Salary due to Rajiv Sharma for June: Dr. Salaries ............` 10, 000 Cr. Rajiv Sharma ................` 10, 000 (Salary due for June.) 7 July: Payment of salary to Rajiv Sharma: Dr. Rajiv Sharma ......` 10, 000 Cr. Cash..................................` 10, 000 (Salary for June paid.) 4. In case of sale of used furniture (` 6 thousand) to Nidhi Mathur, suppose it was sold on 1st November on a month’s credit, account of Nidhi Mathur (the receiver) will be debited and furniture account (asset going out) credited on that date. When the cash is received, i.e., on 1st December cash account will be debited and account of Nidhi Mathur (the giver) credited. 1 November: Credit sale of furniture: Dr. Nidhi Mathur..........` 6, 000 Cr. Furniture........................... ` 6, 000 (Old furniture sold on a month’s credit.) 1 December: Cash received towards credit sale of furniture: Dr. Cash...................` 6, 000 Cr. Nidhi Mathur............... ` 6, 000 (Cash received towards credit sale of furniture.) 5. In case of sale of textiles (` 10 lakh) on 15th March, account of Mahesh Chand & Sons (the receiver) will be debited and sales account (income) credited on that date. On the date of cash receipt, i.e., 15th April cash account will be debited and account of Mahesh Chand & Sons (the giver) credited. 15 March: Credit sale: Dr. Mahesh Chand & Sons……..........` 10, 00,000 Cr. Sales………………………………………… ` 10, 00,000 (Textiles sold on a month’s credit.) 15 April: Payment received towards credit sale: Dr. Cash……………………….....….… ` 10, 00,000 Cr. Mahesh Chand & Sons ………………………..` 10, 00,000 (Cash received towards credit sales.) Chapter 1 Measurement of Profit and Financial Position: I 17 Service provider Let us now take the example of JM Financial Services Ltd. to clarify when receiver is a service beneficiary. Suppose JM Financial Ltd. manages the public issue of National Power Finance Corporation Ltd., and raises the bill of ` 5 crore for public issue management services on the latter on 5th May, for payment to be received on 15th June next, it will debit the account of Power Finance Corporation Ltd., (the receiver of services or service beneficiary) and credit public issue management fee (income) on 5th May. When the payment is received on 15th June it will debit cash account and credit the account of Power Finance Corporation Ltd. (the giver). 5 May: Public issue management fee becoming due: Dr. National Power Finance Corporation Ltd………` 500,00,000 Cr. Public Issue Management Fee……………............……….. ` 500,00,000 (Bill raised for public issue management fee.) 15 June: Payment received against services rendered: Dr. Cash...........................................................500, 00,000 Cr. National Power Finance Corporation Ltd.......………` 500, 00,00 (Payment received towards services rendered.) Documentation: Voucher Once analysed, and having decided the types of accounts to be debited and credited, business transactions are documented by way of a document known as voucher. The anatomy of voucher has been shown in illustration 1 that follows. Each voucher is serially numbered and provides the original record of a transaction. In the case of purchase, sale, expenses etc. the concerned bill, invoice, cash memo etc. is also attached to the voucher which forms its integral part. Recording: Journal As mentioned earlier, recording is done in the journal. The journal contains five columns, namely: 1. Date 2. Voucher number 3. Account heads and description of the transaction 4. Ledger folio, and 5. Amount (` ). This column is further sub-divided into debit and credit. BIRD’S EYE VIEW Recording : Journal n Proprietorship firms n Partnership firms n Corporate entities BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. Do you agree with the following statements? 1. Since assets are debited, increase in assets has to be debited and decrease credited. 2. Since liabilities are credited, increase in liabilities has to be credited and decrease debited. 3. Since income is credited, increase in income has to be credited and decrease debited. 4. Since expenses are debited, increase in expenses has to be debited and decrease credited. To enrich your discussion, add your own ideas, thoughts and practical inputs. 18 Financial Accounting for Management Proprietorship firms We now take up a simple case of a proprietary concern Kamal Appliances Company to illustrate how business transactions are analysed, documented by means of the vouchers and recorded through the journal. ILLUSTRATION 1 KAMAL APPLIANCES COMPANY Analysis, Documentation and Recording Kamal Gupta promotes Kamal Appliances Company, his proprietary firm, on January 1, 20CY. The following are the details of the transactions entered into by the firm during the month of January. Required: Please execute the following requirements: 1. Analyse the transactions with reference to the rules of recording and dual aspect concept. 2. Prepare the voucher for the first transaction, and 3. Record all the transactions in the journal of the firm. Date January 1 2 5 6 15 20 25 28 30 31 Transaction No. 1 2 3 4 5 6 7 8 9 10 Transactions Received cash from Kamal Gupta towards his capital Purchased appliances for cash Sold appliances for cash Opened account with HDFC Bank. Deposited cash. Purchased appliances on credit from INALSA Co. Sold appliances on credit to Aakaanksha Traders Issued cheque to INALSA Co. Received cheque from Aakaanksha Traders Paid selling commission to agent by cheque Paid rent expense for the month in cash Amount (`) 2,00,000 1,80,000 2,40,000 2,50,000 1,50,000 2,10,000 1,00,000 1,60,000 13,500 5,000 Note: The date January1, 20CY, or any date ending with 20CY, in the illustrations and exercises reflects Current Year as CY. Chapter 1 Measurement of Profit and Financial Position: I 19 The solution now follows. First the analysis: SOLUTION TO ILLUSTRATION 1 1.1 KAMAL APPLIANCES COMPANY Analysis of Transactions Analysis of the above transactions with reference to rules of Recording and Dual Aspect Concept is carried out as under. Tr. No. Rules Debit Credit 1 What comes in: asset—cash The giver: liability towards the proprietor 2 Expenses What goes out: asset—cash 3 What comes in: asset—cash Income 4 The receiver: recoverable/What comes in: asset What goes out: asset—cash 5 Expenses The giver: repayable 6 The receiver: recoverable Income 7 The receiver: discharge of liability. What goes out: asset/ The giver: realisation 8 What comes in: asset /The receiver: recoverable The giver: realisation 9 Expenses What goes out: asset /The giver: realisation 10 Expenses What goes out: asset—cash Please note the following: 1. Tr. No. 4: HDFC Bank could be viewed as a receiver, though ultimately representing an asset, when an account is opened and cash deposited with it. Alternatively it could straightway be viewed as an asset, in the form of cash-at-bank, created by the outgo of another asset, that is, cash-in-hand. Whatever view one takes, HDFC Bank is to be debited. When cash-at-bank is to be utilized, a cheque can be issued and HDFC Bank credited. This is illustrated in Tr. No. 7. 2. Tr. No. 2: Purchase of goods, dealt with in the business, is an expense to the extent sold. That which remains unsold on a given date represents an asset in the form of inventory. 20 Financial Accounting for Management Now the documentation: SOLUTION TO ILLUSTRATION 1 KAMAL APPLIANCES COMPANY Documentation 1.2 How the first transaction, that is, introduction of capital by the proprietor, is documented is illustrated through the voucher shown below. The various columns of the voucher are self-explanatory. Received from Kamal Gupta…………............. the sum of Rupees ... …………..….………………………......……………...…….. ................................................by Cash/Cheque No. ............................ STAMP Receiver’s Signature on account of.....................................................………….................... ……………………………….................. ` VOUCHER Kamal Appliances Company Voucher No.…001 B-15, Metro House, Vikas Marg, Delhi. Journal Folio No….001 DEBIT Cash Date…01-01-20CY AMOUNT ` P. 2,00,000 00 Total ` 2,00,000 00 2,00,000 00 Rupees (in words): Two lakh only. Total ` 2,00,000 Description: Received cash from Kamal Gupta towards his capital. Prepared Checked 00 CREDIT Kamal Gupta’s Capital Accountant/Office Assistant Accounts Officer Proprietor The above voucher shows the documentation of a receipt transaction. In case of a payment transaction, say, transactions no. 2 and 10 the receiver acknowledges the fact of payment received on the left hand side of the voucher or issues a receipt which is attached to the voucher. Solution to requirement 3 now follows. Please note the following in the solution: 1. Folio number on the top of the journal reflects the number of the page of the journal daybook on which the transaction is recorded. 2. A/C is the short form of account. There is no need to add the word A/C at the end of the account head in an entry. 3. L.F. stands for Ledger Folio and reflects the page of the ledger on which the corresponding account has been opened and posted. Ledger folios for various accounts are numbered serially starting with the first account in the first transaction. 4. Description of the transaction needs to be short but capable of conveying the meaning. 5. Suffixes are used to denote the specific nature of personal accounts, both liabilities and assets. Note the account: Kamal Gupta’s Capital in the illustration. 6. Journal is totalled to ensure that all the vouchers have been recorded with same amounts on both the sides—debit as well as credit. Chapter 1 Measurement of Profit and Financial Position: I SOLUTION TO ILLUSTRATION 1 21 KAMAL APPLIANCES COMPANY Recording 1.3 Journal 1.01.20CY to 31.01.20CY Date 20CY January 1 2 5 6 15 20 25 28 30 31 Voucher No. 001 002 003 004 005 006 007 008 009 010 Dr.…Cash 001 Folio No. ....001 Amount (`) Debit Credit 2,00,000 Cr.…Kamal Gupta’s Capital 002 2,00,000 (Received cash from Kamal Gupta towards his capital.) Dr.…Purchases 003 Cr.… Cash 001 (Appliances purchased.) Dr.…Cash 001 Cr.… Sales 004 (Appliances sold.) Dr.…HDFC Bank 005 Cr.…Cash 001 (Bank account opened. Deposited cash.) Dr.… Purchases 003 Cr.… INALSA Co. 006 (Purchased appliances on credit.) Dr.…Aakaanksha Traders 007 Cr.… Sales 004 (Sold appliances on credit.) Dr.... INALSA Co. 006 Cr.... HDFC Bank 005 (Cheque issued.) Dr.…HDFC Bank 005 Cr.… Aakaanksha Traders 007 (Cheque received.) Dr....Selling Commission. 008 Cr.... HDFC Bank 005 (Commission paid to agent through cheque.) Dr.…Office Rent 009 Cr.… Cash 001 Account Heads and Description of the Transaction L. F. 1,80,000 1,80,000 2,40,000 2,40,000 2,50,000 2,50,000 1,50,000 1,50,000 2,10,000 2,10,000 1,00,000 1,00,000 1,60,000 1,60,000 13,500 13,500 5,000 5000 (Office rent paid for January.) Total........... 15,08,500 15,08,500 22 Financial Accounting for Management APPLICATION OF THE FUNDAMENTAL ACCOUNTING CONCEPTS Various fundamental concepts or doc trines or conventions are followed in accounting. Those that have been applied in this illustration are being discussed here. BIRD’S EYE VIEW Application of the Fundamental Accounting Concepts n Dual aspect concept n Business entity concept n Accrual concept A. Dual Aspect Concept Each transaction has been recorded on two sides through double entry. This is in accordance with the Dual Aspect Concept discussed earlier. B. Business Entity Concept Voucher No. 001: Capital contributed by the proprietor, Kamal Gupta, has been recorded and credited to his account. You may wonder how a transaction with the owner of the business could be recognized and recorded in his own business. This is due to the Business Entity Concept that distinguishes the owner and his business entity so that personal affairs of the owner are clearly distinguished from the affairs of the business and they do not influence the latter’s performance and financial position. For the business enterprise, that is, Kamal Appliances Company, its proprietor Kamal Gupta is like an outsider as we are maintaining here the books of accounts of Kamal Appliances Company, and not Kamal Gupta. C. Accrual Concept Voucher No. 005: Appliances have been purchased on credit. No cash has been paid. But the transaction has been recorded. This is because the firm is under obligation to make payment against this purchase on a later date. This treatment is in accordance with the Accrual Concept or the Mercantile System of Accounting already discussed earlier. Voucher number 006 relating to credit sale is another example of this concept. Payment in this case will be made at a later date. Partnership firms The above exercise of Kamal Appliances Company illustrated the accounting process with reference to sole proprietorship firms. Businesses are however organized in other forms as well. When a person does not possess sufficient funds for carrying out the business that he wants he may look around for a likeminded person willing to share his resources with him. He may thus enter into partnership with him and both of them then become partners. Again a person may possess resources but not the technical expertise and therefore he may invite a technical expert to become his partner. There may be many more situations causing a partnership. For example, two chartered accountants, despite both of them being experts in finance, may forge a partnership to run a bigger business than they could run individually. Partnership is governed by the Indian Partnership Act, 1932. Some basic features of partnership are as under: 1. Partnership can be entered into between minimum of two persons and maximum of ten, in case of a banking business, and twenty in case of any other business. 2. There has to be an agreement between the partners to carry out business in partnership. The agreement can be written as well as oral. It is however advisable to make a written agreement. 3. One or more partners can be the managing partners as well and in that case remuneration as agreed may also be paid to them. Chapter 1 Measurement of Profit and Financial Position: I 23 4. The firm is liable to income tax. 5. The profit (or loss) of the partnership firm, after paying partner’s remuneration if any, and tax is shared between the partners in the agreed ratio. The accounting process for partnership firms is exactly the same as for proprietorships. However the features of a partnership, in their simplest form, have the following implications for accounting: 1. Capital account of each partner has to be opened separately. 2. Likewise drawings accounts have also to be opened separately for each of them. 3. Net profit (or loss) of the firm is appropriated from the profit and loss account to partners’ respective capital accounts in the agreed proportion. 4. Sum total of individual partner’s capital plus net profit (minus loss) minus drawings represents the total capital of the firm. An illustration on partnership firm now follows. ILLUSTRATION K.K. DESIGNER FURNITURE CENTRE Analysis and Recording 2 Kartik and Kushik enter in to a fifty-fifty partnership on April 1, 20CY. They form a firm K.K. Designer Furniture Centre primarily to engage in the business of trading readymade chairs. It is agreed that Kartik will be the managing partner responsible for running the affairs of the firm and in that capacity will be entitled to a salary of ` 15,000 per month. The following are the details of the transactions entered in to by the firm during April. Date Transaction Transactions Amount (`) no. April 1 2 3 4 1 2 3 4 5 5 6 6 7 7 11 8 15 9 30 30 10 11 30 12 Received cash from Kartik and Kushik towards their capital Opened current account with Yes Bank. Deposited cash. Purchased furniture for the use of the firm. Issued cheque. Purchased chairs from United Furniture Industries Ltd. on credit of 30 days. Received 3% trade discount from the vendor. (Amount shown here is before trade discount). Sold chairs to Arpita Public School on credit of 21 days. Allowed 2% trade discount to the customer. (Amount shown here is before trade discount.) Chairs returned (being defective) by Arpita Public School. (Amount shown here is net of trade discount.) Chairs returned by Arpita Public School returned back to United Furniture Industries Ltd. (Purchase price of these chairs shown here is net of trade discount.) Paid cheque to United Furniture Industries Ltd. before the due date. Availed 1.50% cash discount. (Amount shown here is before the discount). Received cheque from Arpita Public School before the due date. Allowed 1% cash discount. (Amount shown here is before the discount). Paid salary to office assistant by cheque Got a short term unsecured loan (for 6 months) from Yes Bank. The bank credited the loan amount to the current account of the firm. Kartik and Kushik (each one) made withdrawals by way of cheques for their personal use. Required: 1. Analyse the transactions with reference to the rules of recording and dual aspect concept, and 2. Record all the transactions in the journal of K.K. Designer Furniture Centre. 8,00,000 7,50,000 45,000 7,25,000 9,00,000 50,000 40,000 6,00,000 7,00,000 6,000 10,00,000 10,000 24 Financial Accounting for Management Solution follows. SOLUTION TO ILLUSTRATION 2 2.1 Tr. No. K.K. DESIGNER FURNITURE CENTRE Analysis of Transactions 3 4 5 6 7 8 Rules Debit Credit What comes in: asset—cash The givers: liability towards the partners The receiver: recoverable/What comes in: asset-cash What goes out: asset—cash at bank What comes in: asset What goes out: asset/ The giver: realisation Expenses The giver: repayable The receiver: recoverable Income Reversal of income The giver: repayable The receiver: recoverable Reversal of expenses The receiver: discharge of liability • What goes out: asset/ The giver: realisation 9 • What comes in: asset/ The giver: realisation 10 11 12 • Expenses Expenses What comes in: asset /The receiver: recoverable The receivers: recoverable from the partners/ discharge of liability towards them 1 2 • Income The giver: realisation What goes out: asset/ The giver: realisation The giver: repayable-creation of liability What goes out: asset/ The giver: realisation Please note the following: Tr. No. 12: Cheques issued to Kartik and Kushik for their personal use may be viewed either as recoverable from them or part discharge of liability towards capital brought in by them thus adjustable against their capital. Now the journal: Please note the following in the solution: 1. Voucher No. 001: The entry made here is known as compound entry. A compound entry is one which has more than one heads on either side. Such entries facilitate passing one entry for all similar transactions occurred simultaneously. 2. Purchases (voucher no. 4) reflect the buying of goods traded in by the firm. Other buying, that is, assets (voucher no. 3–furniture) are debited to their natural heads. 3. Voucher No. 004: It is usual in business to negotiate discount. The liability on buyer is to pay net purchase price only. Hence, net amount receivable by the vendor = ` 7,25,000 – (7,25, 000*3/100), that is, 7,25,000 – 21,750 = 7,03,250. 4. Voucher No. 005: For the reason explained above for voucher no. 4, the vendor is entitled to receive amount net of discount only. Hence, net amount receivable from the buyer = ` 9,00,000 – (9,00,000*2/100), that is, 9,00,000 – 18,000 = 8, 82,000. 5. Voucher No. 6: The effect of this transaction is as if original sale to Arpita Public School was equal to ` 8,82,000 – 50,000 = 8,32,000. Therefore sales account can also be debited instead of sales return account. The first treatment is however preferred since it facilitates information about total sales return on a particular date. Sales return is also called return inwards. Chapter 1 Measurement of Profit and Financial Position: I 25 6. Voucher No. 7: Same logic as applicable to sales return applies to purchase return as well. Hence purchase return account is credited instead of purchase account. Purchase return is also known as return outwards. 7. Voucher No. 8: If the seller agrees, he allows cash discount for early payment (due date 3 May here). This cash discount is the income of the buyer as he pays less than the due amount in full discharge of amount due. 8. Voucher No. 9: Same logic as in voucher No. 8 above applies here also. 9. Voucher No. 12 & 13: Since two separate cheques will be issued, two vouchers will be prepared. 10. Suffixes are used to denote the specific nature of personal accounts, both liabilities and assets. Note the account: Yes Bank Term Loan Account in the illustration. SOLUTION TO ILLUSTRATION 2 K.K. DESIGNER FURNITURE CENTRE Recording 2.2 Journal 1.04.20CY to 30.04.20CY Date 20CY April 1 2 Voucher No. 001 002 Account Heads and Description of the Transaction L. F. Folio No. ....001 Amount (`) Debit Credit 8,00,000 Dr.…Cash 001 Cr.…Kartik’s capital 002 4,00,000 Cr.....Kushik’s capital 003 4,00,000 (Received cash from the partners towards their capital.) Dr.…Yes Bank Current Account 004 7,50,000 Cr.…Cash 3 4 5 6 7 003 004 005 006 007 7,50,000 (Bank account opened. Deposited cash.) Dr.…Furniture 005 Cr.…Yes Bank Current Account 004 (Furniture purchased for office use.) Dr.… Purchases 006 Cr.… United Furniture Industries Ltd. 007 (Purchased chairs on 30 days credit.) Dr.…Arpita Public School 008 Cr.… Sales 009 (Chairs sold on 21 days credit.) Dr....Sales Return 010 Cr.... Arpita Public School 008 (Defective chairs retuned by the buyer.) Dr....United Furniture Industries Ltd. 007 Cr....Purchase Return 011 (Defective chairs returned to the seller.) 45,000 45,000 7,03,250 7,03,250 8,82,000 8,82,000 50,000 50,000 40,000 40,000 26 11 15 30 30 30 30 Financial Accounting for Management 008 009 010 011 12 13 Dr.... United Furniture Industries Ltd. 007 Cr....Cash Discount Received 012 6,00,000 9,000 Cr....Yes Bank Current Account 004 5,91,000 (Cheque issued net of cash discount.) Dr....Cash Discount Allowed 013 7,000 Dr.…Yes Bank Current Account 004 6,93,000 Cr.…Arpita Public School 008 (Cheque received net of cash discount.) Dr....Salaries 014 Cr....Yes Bank Current Account 004 (Paid to office assistant.) Dr.… Yes Bank Current Account 004 Cr.… Yes Bank Term Loan Account 015 (Availed unsecured loan for 6 months.) Dr....Kartik’s Drawings 016 Cr....Yes Bank Current Account 004 (Withdrawal for personal use.) Dr....Kushik’s Drawings 017 Cr....Yes Bank Current Account 004 7,00,000 6,000 6,000 10,00,000 10,00,000 10,000 10,000 10,000 10,000 (Withdrawal for personal use.) Total........... 55,96,250 55,96,250 APPLICATION OF OTHER FUNDAMENTAL ACCOUNTING CONCEPTS Cost Concept Transaction number 4 is an example of the cost concept. Though the value of the purchase is ` 7, 25,000, it will be recorded at the cost to the firm, that is, ` 7, 03,250 net of trade discount. Alternatively, the firm could record the purchase at ` 7,25,000 and credit ` 21,750 to trade discount earned account, net effect being the same. However, the first treatment is more desirable in the interest of correct portrayal of inventory valuation as we will see in the chapter on valuation of inventories. Business Entity Concept Further Illustrated BIRD’S EYE VIEW Application of Other Fundamental Accounting Concepts n Cost concept n Business entity concept further illustrated Tr. No. 12 and 13: Withdrawals made by Kartik and Kushik for their personal use have been debited to their personal accounts. This is again due to the Business Entity Concept that distinguishes the owners and their business entity so that personal affairs of the owners are clearly distinguished from the affairs of the business and they do not influence the latter’s performance and financial position. For the business enterprise, that is, K.K. Designer Furniture Centre, its partners Kartik and Kushik are like outsiders as discussed and demonstrated in the earlier illustration as well. Chapter 1 Measurement of Profit and Financial Position: I 27 Corporate entities Company form of business organisation, denoted by the suffix of Private Limited or Limited such as Citigroup Global Markets Private Limited and Nestle India Limited, is the most popular form of business today. As far as its accounting process is concerned it is basically the same as discussed above. However due to its peculiar features certain accounting issues related to capital, debentures and format of financial statements etc. arise which need to be appropriately understood. We will discuss and illustrate the corporate accounting system in a separate chapter later on. CONCLUDING REMARKS We will continue with the accounting process in the next chapter, which is devoted to illustrating how business transactions are classified and summarized. The illustrations of Kamal Appliances Company (proprietorship) and K.K. Designer Furniture Centre (partnership firms) will continue for this purpose. The exercises given at the end of this chapter, both for proprietorship as well as partnership firms, will also continue for the purpose in the next chapter. The accounting process for non-corporate entities will thus be completed there upto the trial balance. Thereafter we will move over to financial statements of non-corporate entities in the succeeding chapter. Keywords n Accounting Process/Cycle n Dual Aspect Concept n Accrual Concept n Hindustani Bahikhaataa n Assets n Balance sheet identity n Basic Accounting Equation n Business Entity Concept n Cost Concept n Credit/Cr. n Debit/Dr. WWW Paddhati ) ( n J.F. n Jamaa ( ) n Journal n L.F. n Ledger n Money Measurement Concept n Naame ( ) n Owner’s Capital/Equity n Sutras ( ) n Trial Balance n Upanisads ( ) n Vedas ( ) n Voucher 1. Arcelor Mittal S.A., Luxembourg, www.arcelormittal.com 1. History of the Accountancy Profession in India, Volume I, Shri G.P. Kapadia, ICAI, New Delhi, 1988. 28 Financial Accounting for Management exercises Ex. 1 AMAN HOME PRODUCTS Transaction Analysis and Journal Aman Sachdeva promotes, Aman Home Products, his proprietary firm, on April 1, 20CY. The following are the details of the transactions entered into by the firm during the month of April. Date April 1 2 5 6 15 20 25 28 30 31 Transaction No. 1 2 3 4 5 6 7 8 9 10 Transactions Received cash from Aman Sachdeva towards his capital Purchased home products for cash Sold home products for cash Opened account with ICICI Bank. Deposited cash. Purchased home products on credit from GAMSONG Co. Sold home products on credit to Bhaskar Traders Issued cheque to GAMSONG Co. Received cheque from Bhaskar Traders Paid selling commission to agent by cheque Paid rent expense for the month in cash Amount (`) 12,00,000 10,80,000 14,40,000 15,00,000 13,50,000 12,60,000 12,00,000 10,00,000 73,000 15,000 Required: Please execute the following requirements in the books of accounts of the firm: 1. Analyse the transactions with reference to the rules of recording and dual aspect concept, and 2. Record all the transactions in the journal. Ex. 2 SURYA MEDICAL EQUIPMENTS Transaction Analysis and Recording Ashish Agrawal forms a proprietary firm Surya Medical Equipments on 1 April, 20CY. The firm intends to engage in the business of sophisticated personal care equipments. The following are the details of the transactions entered in to by the firm during April. Date April 1 2 3 4 Transaction No. Transactions Amount (`) 1 2 3 4 10,00,000 9,50,000 55,000 9,00,000 5 5 6 6 Received cash from Ashish Agrawal towards his capital Opened current account with Axis Bank. Deposited cash. Purchased furniture for the use of the firm. Issued cheque. Purchased ‘Automatic Blood Pressure Monitors’ from Tomron Healthcare Company Ltd. on credit of 30 days. Received 2% trade discount from the vendor. (Amount shown here is before trade discount). Sold Monitors to Shubham Medical Store on credit of 21 days. Allowed 1% trade discount to the customer. (Amount shown here is before trade discount.) Monitors returned (being defective) by Shubham Medical Store. (Amount shown here is net of trade discount.) 11,00,000 60,000 Chapter 1 Measurement of Profit and Financial Position: I 7 7 11 8 15 9 30 30 10 11 30 12 29 Monitors returned by Shubham Medical Store returned back to Tomron Healthcare Company Ltd. (Purchase price of these Monitors shown here is net of trade discount.) Paid cheque to Tomron Healthcare Company Ltd. before the due date. Availed 1% cash discount. (Amount shown here is before the discount). Received cheque from Shubham Medical Store before the due date. Allowed 1% cash discount. (Amount shown here is before the discount). Paid salary to office assistant by cheque Got a short term unsecured loan (for 6 months) from Axis Bank. The bank credited the loan amount to the current account of the firm. Ashish Agrawal made withdrawal by way of cheques for his personal use. 50,000 6,50,000 8,00,000 8,000 12,00,000 8,000 Required: 1. Analyse the transactions with reference to the rules of recording and dual aspect concept, and 2. Record all the transactions in the journal of Surya Medical Equipments. Ex. 3 SHAHRUKH KHANNA AND SONS Transaction Analysis and Journal Shahrukh Khanna promotes Shahrukh Khanna and Sons, his proprietary firm, to start business of trading in mobile phones on 1st April 2006. He hires a showroom at D-15, South Ext., New Delhi @ ` 12,000 P.M inclusive of electricity expenses. The following are the details of the transactions entered into by the firm during the month of April. Date Tr. No. Transactions April 1 April 1 April 2 1 2 3 Shahrukh Khanna brings his capital in cash. Opened a current account with HDFC Bank. Purchased a Santro car. Paid cheque for ` 70,000. Balance ` 2,80,000 term loan from HDFC Bank, against security of car, repayable over 3 years in equal monthly installments with interest @12% P.A. payable monthly on reducing balance method. First installment to fall due on May 1. Purchased furniture. Issued cheque. Purchased mobile phones as under from Nokia Ltd.: April 3 April 4 4 5 Amount (Rupees) 6,50,000 6,25,000 3,50,000 1,10,000 4,35,000 1. 25 pieces ‘Elegant’ model @ ` 6,000 each. 2. 40 pieces ‘Executive’ model @ ` 4,000 each. April 5 6 3. 50 pieces ‘Economy’ model @ ` 2, 500 each. Issued cheque. Showroom inaugurated by a friend film star Mallika Kapoor without charges. However other expenses incurred on inauguration in cash. April 5 7 Sold mobile phones as under for cash: 10,000 75,000 1. 5 pieces ‘Elegant’ model @ ` 6,600 each. 2. 4 pieces ‘Executive’ model @ ` 4,500 each. April 6 April 13 8 9 3. 8 pieces ‘Economy’ model @ ` 3, 000 each. Cash collected on April 5 deposited in HDFC Bank C/A. Sold mobile phones as under to a corporate customer: 1. 15 pieces ‘Elegant’ model @ ` 6,500 each. 2. 25 pieces ‘Executive’ model @ ` 4,400 each. 3. 30 pieces ‘Economy’ model @ ` 2, 900 each. Received cheque. Deposited in HDFC Bank C/A. … 2,94,500 30 April 18 10 Financial Accounting for Management Purchased mobile phones as under from Nokia Ltd.: 4,46,000 1. 25 pieces ‘Elegant’ model @ ` 6,050 each. 2. 35 pieces ‘Executive’ model @ ` 4,050 each. 3. 60 pieces ‘Economy’ model @ ` 2, 550 each. April 25 11 Issued cheque for ` 3, 46,000. Balance to be paid after 3 weeks. Sold mobile phones as under to a corporate customer Aamir Corporation Ltd. 1. 20 pieces ‘Elegant’ model @ ` 6,075 each. : 4,44,375 2. 35 pieces ‘Executive’ model @ ` 4,075 each. April 30 April 30 April 30 April 30 12 13 14 15 3. 70 pieces ‘Economy’ model @ ` 2, 575 each. Received cheque for ` 4,00,000. Deposited in HDFC Bank C/A. Balance receivable on 2nd May next. Salary paid to the salesgirl Gauri Singh for April by cheque. Salary paid to the peon Kashi Nath for April in cash. Issued cheque for office rent for April. Paid by cheque to petrol pump for April’s consumption of Santro. 6,500 3,500 12,000 5,000 Required: 1. Analyse the above transactions with reference to rules of recording and dual aspect concept. 2. Record all the transactions in the journal of Shahrukh Khanna and Sons. Ex. 4 KANIKA AND GAURAV MANAGEMENT CONSULTANTS Partnership Firm Transaction Analysis and Journal Gaurav Lal and Kanika Raj, both MBAs from the renowned FSM School of Management and having worked in the industry in various capacities for over ten years, called it a day and decided to be on their own. They enter into a partnership on 1st July 2006 and form a firm Kanika and Gaurav Management Consultants. They agree to bring in capital of ` Six Lacs in the ratio of Gaurav 3 and Kanika 2, maintain their personal drawings in that ratio and share the profits or losses of the firm also in the same proportion. They hire a furnished office at G-40, Fort, Mumbai @ ` 17,000 P.M. inclusive of electricity. They also get two telephones already connected for which they have to make monthly payment to the owner. They also appoint one financial analyst Pawan Sharma; research associate Neena Kapoor and peon Satish Rane. The following are the details of the transactions entered into by the firm during the month of July. Chapter 1 Measurement of Profit and Financial Position: I 31 Date Tr. No. Transactions July 1 July 1 July 1 July 2 1 2 3 4 July 4 July 5 July 5 July 20 July 27 July 29 July 30 July 30 July 30 July 30 July 30 July 30 July 30 July 31 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Gaurav Lal brings his capital in cash. Kanika Raj brings her capital in cash. Opened a current account with ICICI Bank. Purchased an Esteem car. Paid cheque for ` 1, 40,000. Balance ` 3, 60,000 term loan from ICICI Bank, against security of car, repayable over 3 years in equal monthly installments with interest @12% P.A. payable monthly on reducing balance method. First installment to fall due on August 1. Purchased 4 computers with printers. Issued cheque. Subscribed to Capitaline plus database for a year. Issued cheque. Subscribed to five business magazines for a year. Issued cheque to the subscription agency. Raised bill for consulting fee on Modi Ventures ltd. Received cheque from Modi Ventures ltd. and deposited in ICICI Bank C/A. Raised bill for consulting fee on Bata and Tata Ltd. Paid cheque to the office owner towards telephones’ use for the month. Salary paid to Pawan Sharma for the month by cheque. Salary paid to Neena Kapoor for the month by cheque. Salary paid to Satish Rane for the month in cash. Issued cheque for office rent for the month. Paid by cheque to petrol pump for the month’s consumption of Esteem. Cheque issued to Gaurav for personal use. Cheque issued to Kanika for personal use. Required: 1. Analyse the above transactions with reference to rules of recording and dual aspect concept. 2. Record all the transactions in the journal of Kanika and Gaurav Management Consultants. Amount (Rupees) 3,60,000 2,40,000 5,75,000 5,00,000 1,80,000 1,25,000 3,500 75,000 75,000 1,15,000 4,500 25,000 10,000 4,000 17,000 5,000 6,000 4,000 chapter 2 Measurement of Profit and Financial Position: II Journal to Trial Balance Recording Documentation Transaction Analysis Classification MONETARY BUSINESS TRANSACTIONS Summarizing: Trial Balance The process that leads to the measurement of financial performance and position of an enterprise is known as Accounting Cycle. Accounting Cycle forms the very basis of financial accounting. This chapter covers the cycle up to trial balance. Chapter 2 Measurement of Profit and Financial Position: II 33 CH AP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 How to classify the business transactions from journal through ledger. 2 How to analyse the ledger. 3 How to summarise the business transactions from ledger in trial balance. 4 Application of certain fundamental accounting concepts in the process. 5 Key features of computerized accounting system. Thus enabling you to be able to complete the accounting cycle in the chapter that follows. INTRODUCTION In the last chapter, we understood how business transactions are analyzed, documented and recorded in journal. This process was illustrated with the businesses of Kamal Appliances Company, a proprietary firm and K.K. Designer Furniture Centre, a partnership firm. This chapter further dwells upon the accounting process and moves further from recording to classifying through ledger and summarizing through trial balance. Both the illustrations as mentioned above will continue for the purpose. Towards the end of the chapter a comprehensive case of Bharat Scientific Products Enterprise, illustrating wholesomely the process of transaction analysis, recording, classifying and summarizing, will also be taken up. CLASSIFYING BUSINESS TRANSACTIONS As mentioned earlier, classification is done in the ledger by the nature of the transactions, or by each account. The process is known as Posting of the accounts from the journal to the ledger. The name of the account and the number of the page of the ledger on which a particular account appears is mentioned on the top of the ledger. It contains six columns, namely, date, voucher number, particulars, J.F., amount (`) and balance. The amount column is further sub-divided into debit and credit. The last ‘balance’ column is further sub-divided into Dr. and Cr. and Amount (`) to indicate whether the balance represents a debit or a credit. An account appearing on the debit side of the journal is posted on the debit side of the ledger by writing “To............ (Name of the credit account) ” and brief description, if required, to explain the posting and that appearing on the credit side by writing “By........... (Name of the debit account)” and brief description, if required. Balancing is based on the following rules: 1. A debit entry represents Dr. Balance. 2. Next debit entry adds to the previous Dr. Balance. 3. Next credit entry reduces the previous Dr. Balance and in case the amount of this entry is more than the previous Dr. Balance, it turns into Cr. Balance to the extent of excess amount. 34 Financial Accounting for Management 4. A credit entry represents Cr. Balance. 5. Next credit entry adds to the previous Cr. Balance. 6. Next debit entry reduces the previous Cr. Balance and in case the amount of this entry is more than the previous Cr. Balance, it turns into Dr. Balance to the extent of excess amount. 7. A Dr. Balance with the subsequent credit entry of an equal amount becomes zero. 8. A Cr. Balance with the subsequent debit entry of an equal amount becomes zero. We now move over to Illustration 1 which demonstrates how the business transactions are classified. Please note the following features of the ledger in the illustration: 1. The format shown here is the one practically used in business and industry. 2. The accounts have been opened one by one as they appear in the journal. Additional row is inserted in the accounts as and when a new posting is done. 3. J.F. stands for journal folio and reflects the page of the journal from where the corresponding account has been posted. 4. The account facilitates knowing the position at the end of every transaction and date and enables a firm to prepare its trial balance on any given date. 5. In practice the word A/C is not mentioned against the postings. 6. Periodical totalling of debit and credit sides of the account is done to confirm the balance. It also provides a summary of the transactions. ILLUSTRATION 1 KAMAL APPLIANCES COMPANY Classifying Business Transactions Moving further, classify the business transactions of Kamal Appliances Company as recorded in the journal prepared in the earlier chapter and post them in to the ledger of the firm. The solution follows: SOLUTION TO ILLUSTRATION KAMAL APPLIANCES COMPANY Classifying Business Transactions 1 Ledger 1.01.20CY to 31.01.20CY Account... Cash Date 20CY January 1 2 Folio No 001 Voucher No. 001 002 Particulars To Kamal Gupta’s capital By purchases J. F. 001 001 Amount (`) Debit Credit 2,00,000 1,80,000 Balance Dr/Cr Amount (`) Dr. 2,00,000 Dr. 20,000 Chapter 2 Measurement of Profit and Financial Position: II 5 6 30 003 004 010 To sales By HDFC Bank By office rent 001 001 001 Total Account... Kamal Gupta’s Capital Date Voucher No. 20CY January 1 001 Particulars 4,40,000 J. F. By cash 001 Total Account... Purchases Date Voucher Particulars No. 20CY January 2 002 To cash 15 005 To INALSA Co. J. F. 001 001 Total Account... Sales Date Voucher No. 20CY January 5 20 003 006 Account... HDFC Bank Date Voucher No. 20CY January 6 004 25 007 28 008 30 009 Account... INALSA Co. Date Voucher No. 20CY January 15 005 25 007 Particulars J. F. By cash By Aakaanksha Traders Total 001 001 Particulars J. F. To cash. Account opened. By INALSA Co. To Aakaanksha Traders By selling commission Total 001 001 001 001 Particulars 001 001 Total 2,50,000 5,000 4,35,000 Dr. Dr Dr Dr 2,60,000 10,000 5,000 5,000 Amount (`) Debit Credit 2,00,000 .... 2,00,000 Folio No 002 Balance Dr/Cr Amount (`) Cr. 2,00,000 Cr. 2,00,000 Amount (`) Debit Credit 1,80,000 1,50,000 3,30,000 Folio No 003 Balance Dr/Cr Amount (`) Dr 1,80,000 Dr 3,30,000 Dr 3,30,000 Amount (`) Debit Credit Folio No....004 Balance Dr/Cr Amount (`) .... J. F. By purchases To HDFC Bank 2,40,000 35 2,40,000 2,10,000 4,50,000 Cr Cr Cr 2,40,000 4,50,000 4,50,000 Amount (`) Debit Credit 2,50,000 1,00,000 1,60,000 13,500 4,10,000 1,13,500 Folio No...005 Balance Dr/Cr Amount (`) Dr 2,50,000 Dr 1,50,000 Dr 3,10,000 Dr 2,96,500 Dr 2,96,500 Amount (`) Debit Credit 1,50,000 1,00,000 1,00,000 1,50,000 Folio No...006 Balance Dr/Cr Amount (`) Cr 1,50,000 Cr 50,000 Cr 50,000 36 Financial Accounting for Management Account... Aakaanksha Traders Date Voucher Particulars No. 20CY January 20 006 To sales 28 008 By HDFC Bank J. F. 001 001 Total Account... Selling Commission Date Voucher Particulars No. 20CY January 30 009 To HDFC Bank J. F. 001 Total Account... Office Rent Date Voucher Particulars No. 20CY January 30 010 To cash J. F. 001 Total Amount (`) Debit Credit 2,10,000 1,60,000 2,10,000 1,60,000 Folio No...007 Balance Dr/Cr Amount (`) Dr 2,10,000 Dr 50,000 Dr 50,000 Amount (`) Debit Credit 13,500 13,500 .... Folio No...008 Balance Dr/Cr Amount (`) Dr 13,500 Dr 13,500 Amount (`) Debit Credit 5,000 5,000 .... Folio No...009 Balance Dr/Cr Amount (`) Dr 5,000 Dr 5,000 SUMMARISING BUSINESS TRANSACTIONS After classification, transactions are summarized in a statement known as trial balance. The trial balance contains three columns, namely, Account Heads, L.F. and Amount (`). The third column is further sub-divided into Debit and Credit. Each account having a balance in the ledger is traced to the trial balance from there. We now move over to Illustration 2 which demonstrates how the business transactions are summarised. ILLUSTRATION 2 KAMAL APPLIANCES COMPANY Summarising Business Transactions Moving further, summarize the business transactions of Kamal Appliances Company as classified in the ledger, prepared in the earlier illustration , in the form of trial balance of the firm. Chapter 2 Measurement of Profit and Financial Position: II 37 The solution follows: SOLUTION TO ILLUSTRATION 2 KAMAL APPLIANCES COMPANY Summarising Business Transactions Trial Balance As on 31 January 20CY Account Heads L.F. Cash Kamal Gupta’s capital Purchases Sales HDFC Bank INALSA Co. Aakaanksha Traders Selling commission Office rent 001 002 003 004 005 006 007 008 009 Total Amount (`) Debit Credit 5,000 2,00,000 3,30,000 4,50,000 2,96,500 50,000 50,000 13,500 5,000 7,00,000 7,00,000 Please Note: 1. Both sides of the trial balance need to match. This follows from the principle of double entry of every transaction. 2. Once the trial balance matches, it is a prima-facie evidence of correctness of the accounting process. A big sigh of relief to the accountants. 3. There is a complete trail of transactions from documentation to summarising, which can be fully tracked when needed. 4. A trial balance can be drawn on any given date from the ledger as balances in the accounts are known after every transaction. Partnership firms The above exercise of Kamal Appliances Company illustrated the accounting process with reference to sole proprietorship firms. Illustration of K.K. Designer Furniture Centre on partnership firm now follows. ILLUSTRATION 3 K.K. DESIGNER FURNITURE CENTRE Classifying Business Transactions Moving further, classify the business transactions of K.K. Designer Furniture Centre as recorded in the journal in the previous chapter and post them in to the ledger of the firm. 38 Financial Accounting for Management The solution follows: SOLUTION TO ILLUSTRATION K.K. DESIGNER FURNITURE CENTRE Classifying Business Transactions 3 Ledger 1.04.20CY to 30.04.20CY Account...Cash Date 20CY April 1 2 Voucher No. Particulars J. F. 001 001 002 To Kartik’s capital To Kushik’s capital By Yes Bank current account Total 001 001 001 Particulars J. F. Account...Kartik’s Capital Date Voucher No. 20CY April 1 001 By cash 001 Total Account...Kushik’s Capital Date Voucher Particulars No. 20CY April 1 001 By cash Total Account...Yes Bank Current Account Date Voucher Particulars No. 20CY April 2 3 11 15 30 30 30 30 002 003 008 009 010 011 012 013 To cash By furniture By United Furniture Industries Ltd. To Arpita public school By salaries To Yes Bank term loan account By Kartik’s drawings By Kushik’s drawings Total J. F. 001 J. F. 001 001 001 001 001 001 001 001 Amount (`) Debit Credit 4,00,000 4,00,000 7,50,000 8,00,000 7,50,000 Folio No...001 Balance Dr/Cr Amount (`) Dr 4,00,000 Dr 8,00,000 Dr 50,000 Dr 50,000 Amount (`) Debit Credit 4,00,000 4,00,000 Folio No...002 Balance Dr/Cr Amount (`) Cr 4,00,000 Cr 4,00,000 Amount (`) Debit Credit 4,00,000 4,00,000 Folio No...003 Balance Dr/Cr Amount (`) Cr 4,00,000 Cr 4,00,000 Amount (`) Debit Credit 7,50,000 45,000 5,91,000 6,93,000 6,000 10,00,000 10,000 10,000 24,43,000 6,62,000 Folio No...004 Balance Dr/Cr Amount (`) Dr 7,50,000 Dr 7,05,000 Dr 1,14,000 Dr 8,07,000 Dr 8,01,000 Dr 18,01,000 Dr 17,91,000 Dr 17,81,000 Dr 17,81,000 Chapter 2 Measurement of Profit and Financial Position: II Account....Furniture Date Voucher No. 20CY April 3 003 Particulars J. F. To Yes Bank current account 001 Total Account....Purchases Date Voucher Particulars No. 20CY April 4 004 To United Furniture Industries Ltd. Total Account....United Furniture Industries Ltd. Date Voucher Particulars No. 20CY April 4 7 11 004 007 008 008 001 J. F. By purchases To purchase return To cash discount received To Yes Bank current account Total Account....Arpita public school Date Voucher Particulars No. 20CY April 5 005 To sales 6 006 By sales return 15 009 By cash discount allowed 15 009 By Yes Bank current account Total Account....Sales Date 20CY April 5 J. F. 001 001 001 001 J. F. 001 001 001 001 Voucher No. Particulars J. F. 005 By Arpita public school Total 001 Particulars J. F. Account....Sales Return Date Voucher No. 20CY April 6 006 To Arpita public school 001 Total 39 Amount (`) Debit Credit 45,000 45,000 Folio No...005 Balance Dr/Cr Amount (`) Dr 45,000 Dr 45,000 Amount (`) Debit Credit 7,03,250 Folio No...006 Balance Dr/Cr Amount (`) Dr 7,03,250 7,03,250 Dr 7,03,250 Amount (`) Debit Credit 7,03,250 40,000 9,000 5,91,000 6,40,000 7,03,250 Folio No...007 Balance Dr/Cr Amount (`) Cr 7,03,250 Cr 6,63,250 Cr 6,54,250 Cr 63,250 Cr 63,250 Amount (`) Debit Credit 8,82,000 50,000 7,000 6,93,000 8,82,000 7,50,000 Folio No...008 Balance Dr/Cr Amount (`) Dr 8,82,000 Dr 8,32,000 Dr 8,25,000 Dr 1,32,000 Dr 1,32,000 Amount (`) Debit Credit 8,82,000 8,82,000 Folio No...009 Balance Dr/Cr Amount (`) Cr 8,82,000 Cr 8,82,000 Amount (`) Debit Credit 50,000 50,000 Folio No...010 Balance Dr/Cr Amount (`) Dr 50,000 Dr 50,000 40 Financial Accounting for Management Account....Purchase Return Date Voucher No. 20CY April 7 007 Particulars J. F. By United Furniture Industries Ltd. 001 Total Account....Cash Discount Received Date Voucher No. 20CY April 11 008 Particulars J. F. By United Furniture Industries Ltd. Total 001 Account....Cash Discount Allowed Date Voucher No. 20CY April 15 009 Particulars J. F. To Arpita public school 001 Total Account....Salaries Date Voucher No. 20CY April 30 010 Particulars J. F. To Yes Bank current account 001 Total Account....Yes Bank Unsecured Loan Account Date Voucher Particulars No. 20CY April 30 011 By Yes Bank current account Total J. F. 001 Amount (`) Debit Credit 40,000 40,000 Folio No...011 Balance Dr/Cr Amount (`) Cr 40,000 Cr 40,000 Amount (`) Debit Credit 9,000 9,000 Folio No...012 Balance Dr/Cr Amount (`) Cr 9,000 Cr 9,000 Amount (`) Debit Credit 7,000 7,000 Folio No...013 Balance Dr/Cr Amount (`) Dr 7,000 Dr 7,000 Amount (`) Debit Credit 6,000 6,000 Folio No...014 Balance Dr/Cr Amount (`) Dr 6,000 Dr 6,000 Amount (`) Debit Credit 10,00,000 10,00,000 Folio No...015 Balance Dr/Cr Amount (`) Cr 10,00,000 Cr 10,00,000 Account....Kartik’s Drawings Date Voucher No. 20CY April 30 012 Folio No...016 Particulars J. F. To Yes Bank current account 001 Total Account....Kushik’s Drawings Date Voucher No. 20CY April 30 013 Amount (`) Debit Particulars J. F. To Yes Bank current account 001 Total Credit 10,000 10,000 Amount (`) Debit Credit 10,000 10,000 Balance Dr/Cr Amount (`) Dr Dr 10,000 10,000 Folio No...017 Balance Dr/Cr Amount (`) Dr 10,000 Dr 10,000 Chapter 2 Measurement of Profit and Financial Position: II 41 ILLUSTRATION 4 K.K. DESIGNER FURNITURE CENTRE Summarising Business Transactions Moving further, summarize the business transactions of K.K. Designer Furniture Centre as classified in the ledger, prepared in the earlier illustration , in the form of trial balance of the firm. The solution follows: SOLUTION TO ILLUSTRATION 4 K.K. DESIGNER FURNITURE CENTRE Summarizing Business Transactions Trial Balance as on 30-04-20CY Account Heads L.F. Cash Kartik’s capital Kushik’s capital Yes Bank current account Furniture Purchases United Furniture Industries Ltd. Arpita Public School Sales Sales return Purchase return Cash discount received Cash discount allowed Salaries Yes bank unsecured loan account Kartik’s drawings Kushik’s drawings 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Total.... CASE Amount (`) Dr Cr 50,000 4,00,000 4,00,000 17,81,000 45,000 7,03,250 63,250 1,32,000 8,82,000 50,000 40,000 9,000 7,000 6,000 10,00,000 10,000 10,000 27,94,250 27,94,250 A Comprehensive Case: Bharat Scientific Products Enterprise We now take a comprehensive case. The case seeks to: n Provide a real business-like sequence, flow and types of transactions. n Cover a wider variety of business transactions than those covered in the earlier Illustrations. n Interpret each and every ledger account to emphasize its management information value. n Illustrate how computerised system of accounting works. 42 Financial Accounting for Management ILLUSTRATION 5 BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Transaction Analysis, Journal, Ledger and Trial Balance Bharat Gupta promotes Bharat Scientific Products Enterprise, his proprietary concern, to start business of trading in personal scientific products, such as calculators, thermometers, barometers and blood pressure monitors etc. on April 1, 20CY. He hires an office at A-12, Agarwal Complex, Vikas Marg, Delhi–110092 @ ` 2,500 p.m. The following are the details of the transactions entered into by the firm during the month of April. Please carry out the following requirements: 1. An analysis of the transactions 2. Record them in the journal of the business 3. Post the transactions from the journal to ledger. Briefly interpret each account, and 4. Prepare the trial balance as on 30 April, 20CY. Date April, 20CY 1 1 1 1 Tr. No. 1 2 3 4 The firm received cash from Bharat Gupta towards his capital. Opened a current account with State Bank of India. Issued cheque for office rent for April. Purchased one scooter from Regent Automobiles on credit. All initial costs including insurance borne by the vendor. 1 5 Paid cheque towards down payment for scooter. Balance loan, against security of scooter, payable in 12 monthly instalments starting May 1 with interest @ 12% p.a. on reducing balance. Purchased office furniture for cash for use in office. Purchased office equipments for use in office. Paid cheque. Purchased 45 scientific calculators. Issued cheque. Sold 10 scientific calculators. Received cheque. Deposited in SBI. Cheque issued for advertisement in the local daily Delhi Times. Purchased 75 scientific calculators from ABC & Co. on 15 days’ credit. Sold 25 scientific calculators to RIL & Co. on credit of one week. Sold 5 scientific calculators for cash. Received cheque from RIL & Co. Issued cheque to ABC & Co. Purchased 30 scientific calculators from ABC & Co. on 15 days’ credit. Sold 20 scientific calculators to RIL & Co. on credit of one week. Salary paid to the office assistant Sudaamaa in cash. Issued cheque to Bharat Gupta for his personal use. Cash paid to the office owner for using his telephone during April. Cash paid to Preet Fill Station towards petrol consumed by the scooter during the month. Appointed one peon Naveen (joining date 1 May) on a monthly salary of `.. Ordered Emm Ell Printers to print office stationary costing `....... State Bank of India sanctioned a cash credit limit of `................. Received order for 50 scientific calculators from Ram Ganga Enterprise. Sale however could not be effected. 2 2 5 8 10 12 16 19 23 27 28 28 30 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Transactions Amount (`) 1,50,000 1,35,000 2,500 31,500 7,500 8,500 11,500 45,000 12,500 2,200 75,750 31,875 6,425 31,875 75,750 30,450 25,600 3,500 4,000 650 550 3,000 1,250 2,00,000 65,000 Chapter 2 Measurement of Profit and Financial Position: II 43 Before we move further to analyse the transactions, we need to understand the application of some other fundamental accounting concepts as illustrated in this case and the mechanism of computerised accounting system in brief. APPLICATION OF OTHER FUNDAMENTAL ACCOUNTING CONCEPTS Realisation Concept Look at the Tr. No. 22 and 23, entered into on 30 April, BIRD’S EYE VIEW relating to the appointment of staff and placement of order for stationery. No entries are to be recorded for these Fundamental Accounting transactions in the journal, as there is neither a cash outgo Concepts Covered in this Chapter nor incurrence of any obligation on the firm. Obligation n Realisation Concept will arise only after the rendering of services by the staff, n Money Measurement Concept during next month, and supply of stationery by Emm Ell n Accrual Concept Printers. Entries will be recorded at that time. This is in n Cost Concept accordance with the realisation concept. Sanction of cash credit limit by the bank on 30 April (Tr. No. 24) is another example of this concept. Entry will be recorded only when the limit is utilised. Also look at the last Tr. No. 25 regarding the order received for supplying 50 scientific calculators. The order was, however, not executed. Hence, no journal entry is to be recorded. Events that have not taken place, or realized, are not recognized. Of course, the likely impact of events that have already taken place is recognized on an estimated basis, particularly when the impact is likely to be adverse. Just imagine what will be the result of recording an unexecuted order! The management would get a handle to inflate the sales and profit artificially. Money Measurement Concept Salary paid to the staff has to be recorded, as and when due, because amount payable in terms of money has been determined at the time of their appointment, as you have noted earlier. But how does the staff perform, what is the quality of their services are some characteristics that cannot be recorded in the accounting system. This follows from the money measurement concept which allows only those transactions to be recorded that can be measured in terms of money, otherwise not. Salary paid to staff is measurable in terms of money but not the quality of service rendered by them. Quality of staff therefore does not appear as an asset (or a liability) in the balance sheet of a business. An organisation runs with the efficiency and expertise (or otherwise) of its employees and promoters. The end result of business depends on these key drivers. Though the financial statements depict the performance of business but not of the key drivers themselves behind that performance. This is a big limitation of the financial statements but a virtue also at the same time as it does not let the element of subjectivity enter the financial statements. 44 Financial Accounting for Management The solution follows: SOLUTION TO ILLUSTRATION 5 5.1 BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Analysis of Transactions Analysis of the above transactions with reference to rules of Recording and Dual Aspect Concept is carried out as under. Tr. No. Rules Debit Credit 1 What comes in: asset—cash. The giver: liability towards the proprietor. 2 The receiver: recoverable/What comes in: asset. What goes out: asset—cash. 3 Expenses. The giver: realisation/What goes out: asset. 4 What comes in: asset. The giver: repayable. 5 The receiver: discharge of liability. The giver: realisation/What goes out: asset. 6 What comes in: asset. What goes out: asset—cash. 7 What comes in: asset. The giver: realisation/What goes out: asset. 8 Expenses. The giver: realisation/What goes out: asset. 9 The receiver: recoverable/What comes in: asset. Income. 10 Expenses. The giver: realisation/What goes out: asset. 11 Expenses. The giver: repayable. 12 The receiver: recoverable. Income. 13 What comes in: asset—cash. Income. 14 What comes in: asset /The receiver: recoverable. The giver: realisation. 15 The receiver: discharge of liability. The giver: realisation/What goes out: asset. 16 Expenses. The giver: repayable. 17 The receiver: recoverable. Income. 18 Expenses. What goes out: asset—cash. 19 The receiver: recoverable from the proprietor/ discharge The giver: realisation/What goes out: asset. of liability. 20 Expenses. What goes out: asset—cash. 21 Expenses. What goes out: asset—cash. 22-25 No entries. Now follows the journal. Please note the following in the illustration: 1. Folio number on the top of the journal reflects the number of the page of the journal on which the transaction is recorded. 2. Transactions have been recorded on five pages of the journal as shown in the illustration. Hence, Split in the journal folios. 3. ‘Owner’s Equity’ and ‘Owner’s Drawings’ are the more contemporary terms for the capital and drawings of the proprietor/partners. Hence the use thereof in this illustration. 4. Each folio of the journal is totalled to ensure that all the vouchers have been recorded with same amounts on both the sides—debit as well as credit. 45 Chapter 2 Measurement of Profit and Financial Position: II SOLUTION TO ILLUSTRATION 5 BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Recording 5.2 Journal 1.04.20CY to 30.04.20CY Date 20CY April 1 1 1 1 1 001 Dr.…Cash 001 Folio No. 001 Amount (`) Debit Credit 1,50,000 002 1,50,000 002 Cr.…Owner’s Equity (Received cash from Bharat Gupta towards his capital.) Dr.…State Bank of India Current A/C 003 Cr.… Cash (Opened a current account with State Bank of India.) Dr.…Office Rent 004 Cr.… State Bank of India Current A/C (Office rent paid for April.) Dr.…Scooter 005 Cr.…Regent Automobiles (Purchased one scooter from Regent Automobiles on credit.) Dr.… Regent Automobiles Voucher No. Account Heads and Description of the Transaction L. F. 003 1,35,000 001 004 1,35,000 2,500 003 005 Cr.… State Bank of India Current A/C (Paid cheque towards down payment.) 2,500 31,500 006 006 31,500 7,500 003 Total 7,500 3,26,500 3,26,500 Folio No. 002 Date 20CY April 2 2 5 8 10 Voucher No. Account Heads and Description of the Transaction L. F. 006 Dr.…Furniture 007 Amount (`) Debit Credit 8,500 001 8,500 007 Cr.…Cash (Purchased office furniture.) Dr.…Office Equipments 003 008 Cr.… State Bank of India Current A/C (Purchased office equipments.) Dr.… Purchases 003 009 Cr.… State Bank of India Current A/C (Purchased 45 calculators.) Dr.… State Bank of India Current A/C 010 010 Cr.…Sales (Sold 10 calculators.) Dr.…Advertisement and Publicity Cr.… State Bank of India Current A/C (Paid for advertisement in Delhi Times.) 003 008 009 003 011 Total 11,500 11,500 45,000 45,000 12,500 12,500 2,200 2,200 79,700 79,700 46 Financial Accounting for Management Folio No. 003 Date 20CY April 12 16 19 23 27 Voucher No. Account Heads and Description of the Transaction L. F. 011 Dr.… Purchases 009 012 012 Cr.… ABC & Co. (Purchased 75 calculators on 15 days’ credit.) Dr.… RIL & Co. 013 Cr.… Sales (Sold 25 calculators on credit of one week.) Dr.… Cash 014 Cr.… Sales (Sold 5 calculators.) Dr.… State Bank of India Current A/C 015 Cr.… RIL & Co. (Received cheque from the customer.) Dr.… ABC & Co. 013 Amount (`) Debit Credit 75,750 75,750 31,875 010 001 31,875 6,425 010 003 6,425 31,875 013 012 Cr.… State Bank of India Current A/C (Issued cheque to the supplier.) 31,875 75,750 003 Total 75,750 2,21,675 2,21,675 Folio No. 004 Date 20CY April 28 28 30 30 30 Voucher No. 016 Account Heads and Description of the Transaction L. F. Dr.… Purchases 009 Amount (`) Debit Credit 30,450 Cr.… ABC & Co. 012 30,450 (Purchased 30 calculators on 15 days’ credit.) Dr.… RIL & Co. 013 Cr.… Sales 010 018 (Sold 20 calculators on credit of one week.) Dr.…Salaries 014 001 019 Cr.…Cash (Salary paid to the office assistant Sudaamaa for April.) Dr.…Owner’s Drawings 003 020 Cr.… State Bank of India Current A/C (Issued cheque to Bharat Gupta for his personal use.) Dr.…Telephone Expenses Cr.…Cash (Cash paid to the office owner for using his telephone during April.) 001 017 015 016 Total 25,600 25,600 3,500 3,500 4,000 4,000 650 650 64,200 64,200 Chapter 2 Measurement of Profit and Financial Position: II 47 Folio No. 005 Date Voucher No. 20CY April 30 021 Account Heads and Description of the Transaction L. F. Dr.…Vehicle Expenses 017 Cr.…Cash (Cash paid to Preet Fill Station towards petrol consumed by the scooter during April.) Total 001 Amount (`) Debit Credit 550 550 550 550 FURTHER ILLUSTRATION OF SOME FUNDAMENTAL ACCOUNTING CONCEPTS A. Accrual Concept Voucher No. 004: A scooter has been purchased on credit and only a part of the consideration has been paid as down payment. But the transaction has been recorded at total price. This is because the firm is under obligation to discharge the outstanding amount. This treatment is in accordance with the Accrual Concept or the Mercantile System of Accounting already discussed earlier. Voucher Nos. 011, 012, 016 and 017 are other examples of this concept. B. Cost Concept Voucher No. 004: All initial costs including insurance related to the scooter have been borne by the vendor. There is neither an outgo from the firm on this count nor a liability to pay. Hence there is no recording in the accounts. This is in accordance with the Cost Concept. The concept allows transactions to be recorded at the actual cost to the enterprise, paid or payable, irrespective of the actual value or market price of the object involved in the transaction. Thus, it lends objectivity to the system and eliminates arbitrary values being put on and recorded. However, when an enterprise receives a commodity or an asset free of cost, say land from the government, it is recorded at a nominal value, say rupee one, to bring the transaction on the record and to reflect it in the financial statements. We now move over to the ledger and its interpretation. SOLUTION TO ILLUSTRATION 5 BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Classifying Business Transactions and Their Interpretation 5.3 Ledger 1.04.20CY to 30.04.20CY Folio No...001 Account...Cash Date 20CY April 1 1 2 19 Voucher No. Particulars 001 002 006 013 To Bharat Gupta’s capital By State Bank of India C/A By furniture To sales J. F. 001 001 002 003 Amount (`) Debit Credit 1,50,000 1,35,000 8,500 6,425 Dr/Cr. Dr. Dr. Dr. Dr. Balance Amount (`) 1,50,000 15,000 6,500 12,925 48 30 30 30 Financial Accounting for Management 018 020 021 By salary to Sudaamaa By telephone expenses By vehicle expenses 004 004 005 Total 1,56,425 3,500 650 550 1,48,200 Dr. Dr. Dr. Dr. 9,425 8,775 8,225 8,225 Interpretation: Bharat Scientific Products Enterprise (BSPE, hereafter) received cash aggregating to ` 1,56,425 during the month of April, out of which it spent ` 1,48,200 and had cash-in-hand of ` 8,225 at the close of the month for further use. Account...Owner’s Capital Date Voucher No. 20CY April 1 001 Particulars J. F. By cash 001 Total Amount (`) Debit Credit 1,50,000 ... 1,50,000 Folio No...002 Balance Dr/Cr. Amount (`) Cr. 1,50,000 Cr. 1,50,000 Interpretation: BSPE received ` 1,50,000 in cash from its proprietor Bharat Gupta towards initial capital to start the business. The firm owes this money to the proprietor and it is repayable to him in the course of winding up of the firm or may be withdrawn by him as and when needed, subject of course to the financial condition of the firm. Account...State Bank of India Current A/C Date 20CY April 1 1 1 2 5 8 10 23 27 30 Voucher No. 002 003 005 007 008 009 010 014 015 019 Folio No...003 Particulars J. F. To cash—opening of current a/c By office rent By Regent Automobiles By office equipments By purchase To sales By advertisement and publicity To RIL & Co. By ABC & Co. By Bharat Gupta’s drawings 001 001 001 002 002 002 002 003 003 004 Total Amount (`) Debit Credit 1,35,000 2,500 7,500 11,500 45,000 12,500 2,200 31,875 75,750 4,000 1,79,375 1,48,450 Dr/Cr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Balance Amount (`) 1,35,000 1,32,500 1,25,000 1,13,500 68,500 81,000 78,800 1,10,675 34,925 30,925 30,925 Interpretation: BSPE opened a current a/c with SBI and deposited ` 1,35,000 therein out of the cash that it received initially from Bharat Gupta. No business keeps more cash in hand than needed initially and for its day-to-day cash expenses and emergent needs. Depositing the cash with a bank and operating through receiving and issuing cheques is a common business practice. Sums aggregating to ` 1,79,375 were deposited in the account by way of cash and cheques during the month; a total of ` 1,48,450 was utilized towards various purposes in carrying out the operations of the firm and finally it had cash-atbank amounting to ` 30,925 at the end of the month. Chapter 2 Measurement of Profit and Financial Position: II Account...Office Rent Date Voucher No. 20CY April 1 003 Particulars J. F. To State Bank of India C/A 001 Total 49 Folio No...004 Amount (`) Balance Debit Credit Dr/Cr. Amount (`) 2,500 Dr 2,500 2,500 — Dr. 2,500 Interpretation: BSPE incurred and paid, out of cash-at-bank, expenses of ` 2,500 towards office rent for the month. Account...Scooter Date Voucher No. 20CY April 1 004 Particulars J. F. To Regent Automobiles 001 Folio No...005 Balance Amount (`) Debit Credit 31,500 31,500 Total Dr/Cr. — Dr Dr. Amount (`) 31,500 31,500 Interpretation: BSPE purchased a scooter from Regent Automobiles on credit for carrying out the activities of the firm. The firm has thus acquired a fixed asset of ` 31,500. Account...Regent Automobiles Date Voucher No. 20CY April 1 1 004 005 Particulars J. F. By scooter To State Bank of India C/A Total 001 001 Amount (`) Debit Credit 31,500 7,500 7,500 31,500 Folio No...006 Balance Dr/Cr. Amount (`) Cr. 31,500 Cr. 24,000 Cr. 24,000 Interpretation: BSPE purchased a scooter for ` 31,500 from Regent Automobiles on credit, made down payment of ` 7,500 out of cash-at-bank and balance ` 24,000 remains payable to the vendor as per the terms of the purchase. The firm has thus incurred a liability of ` 24,000 towards Regent Automobiles, to be discharged in future. Account...Furniture Date Voucher No. 20CY April 2 006 Particulars J. F. To cash 002 Total Amount (`) Debit Credit 8,500 8,500 — Folio No...007 Balance Dr/Cr. Amount (`) Dr 8,500 Dr. 8,500 Interpretation: BSPE purchased office furniture for ` 8,500 in cash. The firm has thus further acquired fixed assets equivalent to this amount. Account...Office Equipments Date Voucher Particulars No. 20CY April 2 007 To State Bank of India C/A J. F. 002 Total Amount (`) Debit Credit 11,500 11,500 — Folio No...008 Balance Dr/Cr. Amount (`) Dr 11,500 Dr. 11,500 50 Financial Accounting for Management Interpretation: BSPE purchased office equipments for ` 11,500 by using cash- at-bank. The firm has thus further acquired fixed assets equivalent to this amount. Account...Purchases Date Voucher No. 20CY April 5 008 12 28 011 016 Particulars J. F. To State Bank of India C/A 002 — 45 calculators To ABC & Co. — 75 calculators To ABC & Co. — 30 calculators 003 004 Amount (`) Debit Credit 45,000 75,750 30,450 1,51,200 Total — Folio No...009 Balance Dr/Cr. Amount (`) Dr. 45,000 Dr. Dr. Dr. 1,20,750 1,51,200 1,51,200 Interpretation: BSPE purchased in three lots scientific calculators, the product it deals in, by using cash-at-bank as well as on credit, aggregating to ` 1,51,200 during the month. The firm has thus incurred expenses to the extent the quantity of the product is sold and acquired current assets in the form of inventory of unsold quantity as at the end of the month. Account...Sales Date Voucher No. 20CY April 8 009 16 19 28 012 013 017 Particulars J. F. By State Bank of India C/A 002 –10 calculators By RIL & Co. – 25 calculators By cash – 5 calculators By RIL & Co. – 20 calculators 003 003 004 Total Amount (`) Debit Credit 12,500 31,875 6,425 25,600 — 76,400 Folio No...010 Balance Dr/Cr. Amount (`) Cr. 12,500 Cr. Cr. Cr. Cr. 44,375 50,800 76,400 76,400 Interpretation: BSPE sold scientific calculators four times during the month, for cash and cheque as well as on credit, aggregating to ` 76,400. The firm has generated operational revenue to that extent. Account...Advertisement and Publicity Date Voucher Particulars No. 20CY April 10 010 J. F. To State Bank of India C/A 002 Total Amount (`) Debit Credit 2,200 2,200 — Folio No...011 Balance Dr/Cr. Amount (`) Dr. 2,200 Dr. 2,200 Interpretation: BSPE incurred and paid advertising expenses of ` 2,200 during the month by utilizing cash-at-bank. Account...ABC & Co. Date Voucher No. 20CY April 12 27 28 011 015 016 Particulars J. F. By purchase To State Bank of India C/A By purchase Total 003 003 004 Amount (`) Debit Credit 75,750 75,750 30,450 75,750 1,06,200 Folio No...012 Balance Dr/Cr. Amount (`) Cr. 75,750 — Cr. 30,450 Cr. 30,450 Chapter 2 Measurement of Profit and Financial Position: II 51 Interpretation: BSPE purchased scientific calculators aggregating to ` 1,06,200 from ABC & Co. during the month, paid for the first lot amounting to ` 75,750 and the balance ` 30,450 is outstanding as payable to the supplier as at the close of the month. The firm has thus incurred a current liability of ` 30,450 in the form of creditors. Account...RIL & Co. Date Voucher No. 20CY April 16 23 28 012 014 017 Particulars J. F. To sales By State Bank of India C/A To sales Amount (`) Debit Credit 31,875 31,875 25,600 57,475 31,875 003 003 004 Total Folio No...013 Balance Dr/Cr. Amount (`) Dr. 31,875 —Dr. 25,600 Dr. 25,600 Interpretation: BSPE sold scientific calculators aggregating to ` 57,475 to RIL & Co. during the month, received cheque for the first lot amounting to ` 31,875 and the balance ` 25,600 is outstanding as recoverable from the buyer as at the close of the month. The firm has thus created a current asset of ` 25,600 in the form of debtors. Account...Salaries Date Voucher No. 20CY April 30 018 Particulars J. F. To cash paid to Sudaamaa 004 Total Amount (`) Debit Credit 3,500 3,500 — Folio No...014 Balance Dr/Cr. Amount (`) Dr. 3,500 Dr. 3,500 Interpretation: BSPE availed the services of Sudaamaa during the month and thus incurred and paid salary expenses of ` 3,500 to him in cash. Account...Owner’s Drawings Date Voucher Particulars No. 20CY April 30 019 To State Bank of India C/A—Cheque to Bharat for his personal use Total J. F. 004 Amount (`) Debit Credit 4,000 4,000 — Folio No...015 Balance Dr/Cr. Amount (`) Dr. 4,000 Dr. 4,000 Interpretation: Bharat Gupta withdrew from the SBI current a/c of the firm ` 4,000 for personal use during the month. To that extent his capital in the firm stands reduced and thus the obligation of the firm as well. Account...Telephone Expenses Date Voucher No. 20CY April 30 020 Particulars J. F. To cash paid to office owner Total 004 Amount (`) Debit Credit 650 650 — Folio No...016 Balance Dr/Cr. Amount (`) Dr. 650 Dr. 650 Interpretation: BSPE incurred and paid telephone expenses of ` 650 in cash during the month. 52 Financial Accounting for Management Account...Vehicle Expenses Date Voucher No. 20CY April 30 021 Particulars J. F. To cash paid to Preet Fill Station Total 005 Amount (`) Debit Credit 550 550 — Folio No...017 Balance Dr/Cr. Amount (`) Dr. 550 Dr. 550 Interpretation: BSPE incurred and paid in cash ` 550 towards petrol for the scooter. Now, over to the trial balance. SOLUTION TO ILLUSTRATION 5 5.4 BHARAT PERSONAL SCIENTIFIC PRODUCTS ENTERPRISE Summarizing Business Transactions Trial Balance as on 30 April 20CY Account Heads L.F. Cash Owner’s Capital State Bank of India C/A Office Rent Scooter Regent Automobiles Furniture Office Equipments Purchases Sales Advertisement and Publicity ABC & Co. RIL & Co. Salaries Owner’s Drawings Telephone Expenses Vehicle Expenses 001 002 003 004 005 006 007 008 009 010 011 012 013 014 015 016 017 Total Amount (`) Debit 8,225 Credit 1,50,000 30,925 2,500 31,500 24,000 8,500 11,500 1,51,200 76,400 2,200 30,450 25,600 3,500 4,000 650 550 2,80,850 2,80,850 Are you wondering how sales could be less than purchases, that too by almost 50 per cent, and therefore probably thinking that BSPE has suffered heavy losses in the very beginning of its business? Please don’t jump to conclusions. The figures here are in value terms and not quantitative. The fact is that the firm has purchased a total of 150 calculators and sold a total of 60 units, that is, only 40 per cent of purchase, and has 90 units in hand as on 30th April as inventory which it can sell in the coming days and thus generate further revenue. 53 Chapter 2 Measurement of Profit and Financial Position: II NOTE ON COMPUTERIZED ACCOUNTING SYSTEM Here a few words about the computerised accounting system. The computer software is programmed in such a manner that once the voucher is entered in the system, journal, ledger and trial balance are automatically generated. The system thus works online and provides these reports for any given period and at any given date. Generally, a particular code is allotted to each account and the ledger and trial balance emerge in the order of these codes. However, many softwares are now available which do not require the use of codes, thus conveniencing the accountant, and provide these two reports in an alphabetical order of accounts. Tally is one such software. Computerized system has its own procedural features. Basic ones are as under: 1. L.F. is not mentioned in the journal since ledger accounts are shown on the screen in alphabetical order and printed accordingly on continuous stationery. 2. Journal need not be totalled as the computer matches the figures on debit and credit side at the time of entry of voucher itself. 3. The J.F. is not mentioned in the ledger. The trail of the transaction is tracked through the voucher number. 4. ‘Particulars’ column of the ledger is divided into ‘Account’ and ‘Description’. 5. Each entry in the ledger accounts takes and shows, as it is, the description of the transaction as given in the journal. All of these features are illustrated here through the journal of first two transactions and ledger of cash account of BSPE. SOLVED ILLUSTRATION 6 Date 20CY April BHARAT PERSONAL SCIENTIFIC PRODUCTS ENTERPRISE Voucher No. 1 001 Computerised Accounting Journal and Cash Account 1.04.20CY to 30.04.20CY Account Heads and Description of the Transaction Dr.…Cash Amount (`) Debit Credit 1,50,000 Cr.…Owner’s Equity 1 002 (Received cash from Bharat Gupta towards his capital.) Dr.…State Bank of India Current A/C Cr.… Cash (Opened a current account with State Bank of India.) 1,50,000 1,35,000 1,35,000 54 Financial Accounting for Management Account......Cash Date Voucher no. 20CY April Account To Owner’s Equity By State Bank of India C/A By Furniture To Sales By Salary 1 001 1 002 2 19 30 006 013 018 30 020 By Telephone Expenses 30 021 By Vehicle Expenses Particulars Amount (`) Balance Description Debit Credit Dr/Cr Amount (`) (Received cash from Bharat 1,50,000 Dr. 1,50,000 Gupta towards his capital.) (Opened a current account 1,35,000 Dr. 15,000 with State Bank of India.) (Purchased office furniture.) 8,500 Dr. 6,500 (Sold 5 calculators.) 6,425 Dr. 12,925 (Salary paid to the office 3,500 Dr. 9,425 assistant Sudaamaa for April.) (Cash paid to the office 650 Dr. 8,775 owner for using his telephone during April.) (Cash paid to Preet Fill 550 Dr. 8,225 Station towards petrol consumed by the scooter during April.) Total 1,56,425 1,48,200 Dr. 8,225 ALTERNATIVE PRESENTATION OF LEDGER USING TALLY In computerised systems, or even in manual ones, the account head in the Particulars column may be put in a different manner. For example, the well-known accounting software Tally prefixes Cr. in place of ‘To’ and Dr. in place of ‘By’ to the account head as shown hereunder in the Cash Account of BSPE. This treatment indicates the side on which the corresponding double entry has been posted in the ledger. Account......Cash Date Voucher no. 20CY April 2 006 Account Cr. Owner’s Equity Dr. State Bank of India C/A Dr. Furniture 19 30 013 018 Cr. Sales Dr. Salary 30 020 Dr. Telephone Expenses 30 021 Dr. Vehicle Expenses 1 001 1 002 Particulars Amount (`) Balance Description Debit Credit Dr/Cr Amount (`) (Received cash from Bharat 1,50,000 Dr. 1,50,000 Gupta towards his capital.) (Opened a current account with 1,35,000 Dr. 15,000 State Bank of India.) (Purchased office furniture.) 8,500 Dr. 6,500 (Sold 5 calculators.) 6,425 (Salary paid to the office assis3,500 tant Sudaamaa for April.) (Cash paid to the office owner 650 for using his telephone during April.) (Cash paid to Preet Fill Station 550 towards petrol consumed by the scooter during April.) Total 1,56,425 1,48,200 Dr. Dr. 12,925 9,425 Dr. 8,775 Dr. 8,225 Dr. 8,225 Chapter 2 Measurement of Profit and Financial Position: II 55 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is the significance of fundamental accounting concepts for financial statements? 2. Interpret each ledger account of K.K. Designer Furniture Centre briefly. To enrich your discussion, add your own ideas, thoughts and practical inputs. CONCLUDING REMARKS We will continue with the accounting process in the next chapter, which is devoted to illustrating how balance sheet and profit & loss account are prepared from the trial balance. The case of Bharat Scientific Products Enterprise will continue for this purpose. The exercises given at the end of this chapter, both for proprietorship as well as partnership firms, will also continue for the purpose in the next chapter. The accounting process for non-corporate entities will thus be completed there. Thereafter we will move over to corporate entities in the succeeding chapter. Keywords n Accrual Concept n Money Measurement Concept n Computerized Accounting n Realisation Concept System n Cost Concept n Ledger n Tally n Partnership Firms n Owner’s Equity n Owner’s Drawings n Trial Balance exercises Ex. 1 AMAN HOME PRODUCTS Preparation of Ledger Moving further, classify the business transactions of Aman Home Products as recorded in the journal prepared in the previous chapter and post them in to the ledger of the firm. 56 Financial Accounting for Management Ex. 2 AMAN HOME PRODUCTS Preparation of Trial Balance Moving further, summarize the business transactions of Aman Home Products as classified in the ledger prepared in Ex. 1 above in the form of a trial balance. Ex. 3 SURYA MEDICAL EQUIPMENTS Preparation of Ledger Moving further, classify the business transactions of Surya Medical Equipments as recorded in the journal in the previous chapter and post them in to the ledger of the firm. Ex. 4 SURYA MEDICAL EQUIPMENTS Preparation of Trial Balance Moving further, summarize the business transactions of Surya Medical Equipments as classified in the ledger prepared in Ex. 3 above in the form of a trial balance. Ex. 5 SHAHRUKH KHANNA AND SONS Ledger and Its Interpretation Having recorded the transactions of Shahrukh Khanna and Sons in the Journal in the previous chapter, now: 1. Classify them through ledger accounts, and 2. Briefly interpret each ledger account. Ex. 6 SHAHRUKH KHANNA AND SONS Trial Balance After having classified the transactions of Shahrukh Khanna and Sons, now, summarize them in a Trial Balance. Chapter 2 Measurement of Profit and Financial Position: II 57 Ex. 7 KANIKA AND GAURAV MANAGEMENT CONSULTANTS Partnership Firm Ledger and Its Interpretation Having recorded the transactions of Kanika and Gaurav Management Consultants in the Journal in the previous chapter, now: 1. Classify them through ledger accounts, and 2. Briefly interpret each ledger account. Ex. 8 KANIKA AND GAURAV MANAGEMENT CONSULTANTS Partnership Firm Trial Balance After having classified the transactions of Kanika and Gaurav Management Consultants, now, summarize them in a Trial Balance. Ex. 9 CASE 1 COMPREHENSIVE CASE OF MONIK TRADERS Monik Varma promotes Monik Traders, his proprietary firm, to start a business of trading in Product A on 1 April 20CY. He hires an office at C-12, Sikka Complex, Preet Vihar, Delhi–110092 @ ` 3,000 p.m. The following are the details of the transactions entered into by the firm during the month of April. Date April 1 April 1 April 1 April 1 Tr. No. 1 2 3 4 April 1 5 April 2 April 2 April 5 April 8 6 7 8 9 Transactions Received cash from Monik Varma towards his capital. Opened a current account with State Bank of India. Issued cheque for office rent for April. Purchased one scooter from Regent Automobiles on credit. All initial costs including insurance borne by the vendor. Paid cheque towards down payment for scooter. Balance loan, against security of scooter, payable in 12 monthly instalments starting May 1 with interest @ 12% p.a. on reducing balance. Purchased office furniture for cash. Purchased office equipments. Paid cheque. Purchased 60 units of product A. Issued cheque. Sold 20 units of product A. Received cheque. Deposited in SBI. Amount (`) 2,25,000 2,00,000 3,000 32,000 8,000 12,750 17,250 66,000 27,500 58 April 10 April 12 April 16 April 19 April 23 April 27 April 28 April 28 April 30 April 30 April 30 April 30 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Financial Accounting for Management Cheque issued for advertisement in the local daily Delhi Times. Purchased 85 units of A from BCA & Co. on 15 days’ credit. Sold 35 units of A to LIR & Co. on credit of one week. Sold 10 units of A for cash. Received cheque from LIR & Co. Issued cheque to BCA & Co. Purchased 30 units of A from BCA & Co. on 15 days’ credit. Sold 40 units of A to LIR & Co. on credit of one week. Salary paid to the office assistant Ajay Bafna in cash. Issued cheque to Monik Varma for his personal use. Cash paid to the office owner for using his telephone during April. Cash paid to Preet Fill Station towards petrol consumed by the scooter during the month. Appointed one salesman Rajesh (joining date 1 May) on a monthly salary of `....... Ordered Rajdhani Stationers to supply office stationary costing `....... State Bank of India sanctioned a cash credit limit of `................. Received order for 60 units of A from Shyam Associates. Sale however could not be effected. Required 1. Analyse the above transactions with reference to the rules of recording and dual aspect concept. 2. Record all the transactions in the Journal of Monik Traders. 3. Classify them through ledger accounts. 4. Briefly interpret each ledger account. 5. Summarize the transactions in the form of a trial balance as on 30 April, 20CY. 6. Briefly comment on the significance of trial balance. 2,500 1,07,525 55,825 16,100 55,825 1,07,525 38,100 64,000 3,500 5,000 750 625 6,000 2,500 1,00,000 96,000 3 Measurement of Profit and Financial Position: III Trial balance to Balance Sheet and Profit and Loss Account: Non-corporate Entities Monetary Transactions Trial Balance Transaction Analysis Analysis of Trial Balance Documentation Adjustments Recording Inventory Valuation Classification Summarizing: Trial Balance Construction of Financial Statements Balance Sheet P & L Account Brief Analysis of Results This chapter finally completes the accounting process of measuring the business performance and financial position by illustrating the construction of balance sheet and profit and loss account of Non-corporate entities. 60 Financial Accounting for Management CHAP T ER O BJ ECT IVES This chapter seeks to enable you to develop knowledge and understanding of: 1 The completion of the accounting process. 2 How to do analysis of the trial balance. 3 The need for adjustment entries. 4 The implications of the matching principle. 5 How to do valuation of inventory. 6 How to construct non-corporate balance sheet and profit and loss account. 7 Considerations in preparing balance sheet and profit and loss account. 8 How to carry out a brief assessment of the performance of non corporate business in terms of profit earned/loss suffered and financial condition. Thus enabling you to be in a position to prepare and analyze non-corporate financial statements which will act as a stepping stone to comprehend corporate financial statements that follow in the next chapter. INTRODUCTION In the last chapters, we saw how business transactions are documented, recorded in the journal, classified through the ledger and finally summarised in the trial balance. This accounting cycle was illustrated through the businesses of Kamal Appliances Company, K. K. Designer Furniture Centre and Bharat Scientific Products Enterprise. We saw that the transactions of Bharat Scientific Products Enterprise promoted by Bharat Gupta were more broad based and voluminous. Let us continue with the case of Bharat Scientific Products Enterprise. Bharat Gupta now wants to know as to where his firm stands after one month of business. He wants to assess whether the firm has made a profit or suffered a loss and how much in either case. He also wants to know the position of his financial resources of `1,50,000 that he had invested in the business initially. He wants to understand how much, and in what form/s, his firm owns and how much, and to whom all, it has to pay as on 30th April 20CY. MEASUREMENT OF BUSINESS INCOME AND FINANCIAL POSITION To help Bharat Gupta achieve his objective, we need to prepare a balance sheet as on 30 April 20CY and a profit and loss account for the month of April. Balance sheet and profit and loss account are the two primary and most significant financial statements. The former serves the purpose of determining the financial position of a business and the latter its profitability. You have already developed a basic understanding of assets, liabilities, income and expenses and how they constitute the balance sheet and profit and loss account in the first chapter. You would do well at this stage to recap those parts of the first chapter. CASE BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Chapter 3 Measurement of Profit and Financial Position: III 61 ILLUSTRATION 1 BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Balance Sheet and Profit and Loss Account We now proceed to illustrate the process of constructing the balance sheet and profit and loss account continuing with the case of Bharat Scientific Products Enterprise. TRIAL BALANCE TO BALANCE SHEET AND PROFIT AND LOSS ACCOUNT BIRD’S EYE VIEW Analysis of Trial Balance We studied in the last chapter that the final stage of the accounting cycle seeks to bifurcate the trial balance into balance sheet and profit and loss account. The profit and loss account is again divided into two parts—the first one showing Gross Profit and the next Net Profit. The first part is also known as Trading Account. But as is the practice, both parts are constructed in one statement and put together known as profit and loss account though the title ‘Trading and Profit and Loss Account’ is also in vogue. In other words, it means that the trial balance forms the basis for preparing these two statements. We, therefore, need to reproduce here the trial balance of Bharat Scientific Products Enterprise and allocate the various accounts to balance sheet, with their analysis into assets and liabilities, and to profit and loss account, with their analysis into income and expenses. Measurement of Business Income and Financial Position: Trial Balance to Balance Sheet and Profit and Loss Account n Analysis of Trial Balance — Going concern concept and capital and revenue expenditure/receipts n Need for Adjustments — The matching principle n Inventory Valuation n Construction of Balance Sheet and Profit and Loss Account — General instructions and observations for preparing the two financial statements n Brief Analysis of Financial Statements SOLUTION TO ILLUSTRATION 1 1.1 ANALYSIS OF TRIAL BALANCE SI. No. Account Heads 1 2 3 4 5 6 Cash Bharat Gupta’s Capital State Bank of India C/A Office Rent Scooter Regent Automobiles BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Trial Balance, with Analysis, as on 30.04.20CY. L.F. Amount (`) Analysis 001 002 003 004 005 006 Debit 8,225 30,925 2,500 31,500 Allocation to Credit Current asset 1,50,000 Capital liability Cash-at-bank—current asset Expense Fixed asset 24,000 Secured loan—liability Balance sheet Balance sheet Balance sheet P & L A/C Balance sheet Balance sheet 62 7 8 9 10 11 12 13 14 15 Financial Accounting for Management Furniture Office Equipments Purchases (see note below) Sales Advertisement and Publicity ABC & Co. RIL & Co. Salaries Bharat Gupta’s Drawings 007 008 009 010 011 012 013 014 015 8,500 11,500 1,51,200 Fixed asset Balance sheet Fixed asset Balance sheet Expense Trading A/C 76,400 Income Trading A/C 2,200 Expense P & L A/C 30,450 Creditor—current liability Balance sheet 25,600 Debtor—current asset Balance sheet 3,500 Expense P & L A/C 4,000 Advance—current asset Balance sheet (reduction in capital) 16 Telephone Expenses 016 650 Expense P & L A/C 17 Vehicle Expenses 017 550 Expense P & L A/C Total 2,80,850 2,80,850 Note: Quantity purchased, to the extent sold, represents an expense and that unsold an asset, being inventory. You had studied the rules of debit and credit in the first chapter. The above analysis of the trial balance reaffirms that debits represent assets & expenses and credits represent liabilities & income. Going concern concept and capital and revenue expenditure/receipts Before we proceed further it is essential to understand the basic factor behind analysing different accounts into assets, liabilities, income and expenses. This factor is known as Going Concern Concept. As per this concept it is assumed that an enterprise will normally continue in operation for the foreseeable future. Hence, it has neither the intention nor the need to liquidate or curtail materially the scale of its operations. It is this concept that leads to making a distinction between Capital and Revenue Expenditure. Capital expenditure means an expenditure whose benefit accrues over a long term, say, beyond one year. It is also due to the Going Concern Concept that fixed assets are generally carried in the balance sheet at their cost (minus depreciation) and not at their current values even if they are lower. Accounts classified as fixed assets in the above illustration represent capital expenditure. Revenue expenditure means an expenditure whose benefit expires within one year. Accounts classified as expenses in the above illustration represent revenue expenditure. Only the revenue expenses enter the profit and loss account. Likewise a distinction between Capital and Revenue Receipts is equally important. Generally, receipts meant for financing assets, such as, owner’s capital, loans, and subsidy from the government are considered as capital receipts. Advances received from customers also represent capital receipts. Receipts generated through business operations are revenue receipts. Sale is the best example of revenue receipt. Only revenue receipts enter the profit and loss account. The going concern concept thus plays a major role in the determination of profitability. Need for Adjustments Before we proceed to construct the two financial statements, we need to understand that some adjustments are required to be carried out to certain accounts and their balances as appearing in the trial balance above. What are these accounts, how to identify them, what adjustments need to be done to them and to what extent? These are the questions that assume importance and that need to be addressed Chapter 3 Measurement of Profit and Financial Position: III 63 at this stage. The guiding principle behind identifying, recording and measuring in most adjustments is what is known as the Matching Principle. The matching principle Matching principle is one of the pillars of accounting. According to it, while drawing the financial statement for a given period, income recorded in the profit and loss account needs to be matched and correlated with all the expenses, which have led to the generation of that income. The implications of this principle are that if an expense has been incurred, though not paid, it needs to be recognised in the profit and loss account for that period and if an expense has been paid in advance it has not to be. Also, if an income has become due, though not received, it needs to be recognised in the profit and loss account for that period and likewise an income, though not due but received in advance, has not to be. Only then can the true profitability for a given period and financial position as on a given date, of a business, be ascertained. The application of matching principle is made possible by accrual concept studied in the last chapter. SOLUTION TO ILLUSTRATION 1 1.2 NEED FOR ADJUSTMENTS BHARAT SCIENTIFIC PRODUCTS ENTERPRISE IDENTIFICATION OF ADJUSTMENTS Let us apply matching principle to the case of Bharat Scientific Products Enterprise for the purpose of drawing its financial statements for the month of April 20CY. We need to scrutinise each and every ledger account for the purpose and identify the expenses, which need to be adjusted for matching with the income and any adjustments to income itself. This process leads us to the following observations: 1. Scooter: Purchased one on 1st April. Used for purposes of business. This leads to depreciation in the value of the scooter. Hence a suitable expense to be charged to the profit and loss account on this count. The Income Tax Act allows a depreciation of 25% on scooter, which is to be apportioned pro rata. That is `656 (31500*0.25*1/12). 2. Regent Automobiles: Interest payable on the loan of `24,000 @ 12% p.a. on reducing balance starting 1st May. Interest for April (`240) to be charged as an expense. 3. Furniture: Purchased on 2nd April. Rest of the observation as per scooter. The Income Tax Act allows a depreciation of 15% on furniture, which is to be apportioned pro rata. `106 (for full month, not 29 days, for simplicity). 4. Office Equipments: Purchased on 2nd April. Rest of the observation as per scooter. The Income Tax Act allows a depreciation of 25% on these items, which is to be apportioned pro rata. `240 (for full month, not 29 days, for simplicity). 5. Purchase/Inventory: What needs to be ascertained is whether the firm has sold/used the entire quantity purchased or there lies some unsold inventory on 30th April. Profit and loss account has to be charged only with the cost of quantity sold. We need to prepare an inventory account of scientific calculators for this purpose. Inventory Valuation Given below is the inventory account of scientific calculators to ascertain the quantity in hand as on 30th April. Thereafter the valuation together with its basis has been shown. 64 Financial Accounting for Management SOLUTION TO ILLUSTRATION 1 1.3 INVENTORY VALUATION BHARAT SCIENTIFIC PRODUCTS ENTERPRISE SCIENTIFIC CALCULATORS—INVENTORY ACCOUNT Date Vr. No. Purchase Price (`) 5 008 45,000 45 8 009 12 011 75,750 75 20CY April Units Receipts Issues Balance 45 10 35 110 16 012 25 85 19 013 5 80 28 016 28 017 30,450 Total 30 150 110 20 90 60 90 We note that only 60 units, out of 150 purchased, have been sold, leaving an inventory of 90 units on 30th April 20CY. Therefore the cost of only 60 units will be charged to the profit and loss account and that of 90 units will be shown in the balance sheet as inventory, a current asset. Let us work out the cost of inventory. There are many methods of inventory valuation, which we will discuss in detail in the chapter on inventory valuation. Assuming that, at every sale, the units sold were drawn from the earliest lot first, the closing inventory represents 30 units purchased on April 28 and the balance 60 units out of 75 units purchased on April 12. The valuation will thus be: Units 60 30 90 VALUATION OF INVENTORY Computation 60*75750/75 ..... .... Value (`) 60,600 30,450 91,050 Construction of Balance Sheet and Profit and Loss Account Armed with the above analysis, and the understanding of the need for various adjustments and valuation of inventories, we are now in a position to prepare the balance sheet and profit and loss account of Bharat Scientific Products Enterprise. These have been drawn here in the horizontal form. Balance sheet displays assets on its right side and liabilities on its left. Profit and loss account displays income on the right side and expenses on the left. As noted earlier, the profit and loss account is again divided into two parts—the first one showing gross profit and the second net profit. Gross profit Here a few words about gross profit. It is the difference between net sales and cost of goods sold (COGS). COGS represents the cost of the quantity of the product sold together with expenses incidental to purchase, such as freight in the case of a trading firm, and this plus the cost of conversion of raw materials into finished goods in the case of a manufacturing firm. Gross profit represents trading margin and hence the term trading account. Chapter 3 Measurement of Profit and Financial Position: III 65 General Instructions and Observations for Preparing the Two Financial Statements Please note the following general instructions and observations for preparing the two financial statements: 1. Draw both the statements simultaneously. Identify the numbers of accounts to enter the two statements to draw rows accordingly. Draw inner column of amount for adjustments. Make spacing between fixed assets and current assets on the assets side and between proprietor’s capital, loans and current liabilities on the liability side. Likewise, make space between the two parts of the profit and loss account. 2. Post various accounts from the trial balance to the statement they belong to. Put the amount of account requiring adjustment in the inner column. 3. Make adjustments wherever required, one by one, and put the final figure of the adjusted account in the outer column. Please note that every adjustment has to be effected at two places in accordance with the dual aspect concept. 4. Closing inventory could either be disclosed as a deduction from purchases or alternatively on the income side of the profit and loss account, as has been done here and as is the practice with the horizontal form. 5. Now work out profit/loss from the profit and loss account. Excess of income over expenses represents profit and vice versa. First work out the gross profit in the first part of the profit and loss account. Bring it down to the second part and then finally work out the net profit/loss. Transfer this net profit/loss to the proprietor’s capital in the balance sheet as it is payable to/ recoverable from him by the firm. In case of net profit add it to the capital and in case of net loss deduct there from. 6. If your working is correct the two sides of the balance sheet must tally. If not, try to find out where you have erred. 7. Depreciation under the Income Tax Act is allowed for a full year if the asset is used even for 180 days during the year. In case it is used for less than 180 days, depreciation is allowed only for half year. In the case of Bharat Scientific Products Enterprise, however, it has been provided only for a month as the issue of 180 days or otherwise will come up only at the end of the year. Moreover, though the furniture and office equipments have been purchased on 2nd April, to keep the matter simple, depreciation has been provided for the full month, and not 29 days. 8. No expense towards income tax has been charged in the accounts of the firm, since Bharat Gupta might be having income from other sources as well and he will be liable to pay tax on his entire income. 66 Financial Accounting for Management SOLUTION TO ILLUSTRATION 1 1.4 CONSTRUCTION OF BALANCE SHEET AND PROFIT AND LOSS ACCOUNT Liabilities Bharat Gupta’s Capital: Capital brought in Less: Bharat Gupta’s Drawings Balance Add: Net profit transferred from P & L A/C Secured Loan: From Regent Automobiles Add: Interest Due Current Liabilities: Creditors—ABC & Co. Total BHARAT SCIENTIFIC PRODUCTS ENTERPRISE Balance Sheet as on 30.04.20CY Amount Assets (`) Fixed Assets: 1,50,000 Office Equipments 4,000 Less: Dep. @ 25% 1,46,000 5,608 Amount (`) 11,500 240 1,51,608 Furniture 24,000 240 11,260 8,500 24,240 Less: Dep. @ 15% Scooter Less: Dep. @ 25% 30,450 Current Assets: Inventory Debtors-RIL & Co. Cash-in-hand Balance in Current Account— State Bank of India 2,06,298 Total BHARAT SCINTIFIC PRODUCTS ENTERPRISE Profit and Loss Account for the Month Ended 30-04-20CY Expenses Amount Income (`) Purchases 1,51,200 Sales Gross Profit c/d 16,250 Closing Inventory Total 1,67,450 Total Office Rent 2,500 Gross Profit b/d Advertisement and Publicity 2,200 Salaries 3,500 Telephone Expenses 650 Vehicle Expenses 550 Depreciation on: • Office Equipments 240 • Furniture 106 • Scooter 656 1,002 Interest on Loan 240 Net Profit Added to Bharat Gupta’s Capital 5,608 Total 16,250 Total 106 31,500 656 8,394 30,844 91,050 25,600 8,225 30,925 2,06,298 Amount (`) 76,400 91,050 1,67,450 16,250 16,250 Chapter 3 Measurement of Profit and Financial Position: III 67 Recall the discussion on financial performance and position and rules of debit and credit in the first chapter. It will be interesting to note the following from the above financial statements: 1. Reduction in expenses (purchases) creates an asset (closing inventory). 2. Expenses (depreciation) reduce assets (fixed assets). 3. Expenses (interest on loan) increase liabilities (secured loan). 4. Drawings reduce the capital of the owner and net profit increases it. Brief Analysis of the Financial Statements of Bharat Scientific Products Enterprise You may recall that Bharat Gupta wanted to know where his firm stood after one month of business. Towards this he wanted to assess: 1. Whether his firm has made a profit or suffered a loss and how much in either case. 2. How much, and in what form/s, his firm owns and how much, and to whom all, it has to pay. 3. The position of his financial resources of `1,50,000 that he had invested in the business initially. Let us attempt an assessment: SOLUTION TO ILLUSTRATION 1 1.5 1. BRIEF ANALYSIS OF FINANCIAL STATEMENTS BHARAT SCIENTIFIC PRODUCTS ENTERPRISE The firm has earned a net profit of `5,608 in the very first month of its operations. By any standard a fabulous annualised return of around 45% on an investment of `1,50,000. 2. The firm owns assets to the extent of `2,06,298 and owes to outsiders, Regent Automobiles and ABC & Co., `54,690. 3. The capital of Bharat Gupta, even after withdrawal of `4,000 by him, has grown to `1,51,608. This is the amount that the firm owes to him. It may be noted that it is the residual figure of all assets minus outside liabilities (`2,06,298 – 54,690 = `1,51,608), thus proving the basic accounting equation. The above analysis amply demonstrates the objectives served by the financial statements. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Bring out the role played by the going concern concept in the determination of business performance and financial position. 2. Bring out the role played by the matching principle in the determination of business performance and financial position. 3. Net profit earned by Bharat Scientific Products Enterprise adds to the resources of the firm and hence it represents an asset. How come then that it has been taken to liabilities? To enrich your discussion, add your own ideas, thoughts and practical inputs. 68 Financial Accounting for Management Partnership firms As mentioned in the last chapter the accounting process for partnership firms is exactly the same as for proprietorships. Only difference is that the capital and drawings accounts have to be opened separately for each partner and profit/loss has to be transferred to their respective capital accounts. In the illustration on partnership, K. K. Designer Furniture Centre, given in the last chapter you had completed the accounting process up to trial balance. The illustration continues in this chapter as well to complete the accounting process by preparing the profit and loss account and the balance sheet of the firm. ILLUSTRATION 2 K.K. DESIGNER FURNITURE CENTRE Balance Sheet and Profit and Loss Account For the purpose of drawing the financial statements, the trial balance of the firm is reproduced here from the last chapter. K.K. DESIGNER FURNITURE CENTRE Trial Balance as on 30-04-20CY Account Heads L.F. Amount (`) Dr Cash Kartik’s capital Kushik’s capital Yes Bank current account Furniture Purchases United Furniture Industries Ltd. Arpita Public School Sales Sales return Purchase return Cash discount received Cash discount allowed Salaries Yes bank loan account Kartik’s drawings Kushik’s drawings 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Total Cr 50,000 4,00,000 4,00,000 17,81,000 45,000 7,03,250 63,250 1,32,000 8,82,000 50,000 40,000 9,000 7,000 6,000 10,00,000 10,000 10,000 27,94,250 Further, the following adjustments have to be made: 1. Closing inventory as on 30-04-20CY amounts to `22,000. 2. Depreciation has to be provided on furniture @ 10% pa for full month of April. 3. Salary of `15,000 is payable to Kartik as on 30-04-20CY. 4. The firm is liable to pay income tax @ 30%. 27,94,250 69 Chapter 3 Measurement of Profit and Financial Position: III SOLUTION TO ILLUSTRATION 2 2.1 CONSTRUCTION OF BALANCE SHEET AND PROFIT AND LOSS ACCOUNT LIABILITIES Partners’ capital: Kartik Capital brought in Add: Salary payable Less: Drawings Balance Add: Net profit Kushik Capital brought in Less: Drawings Balance Add: Net profit Total capital..... Unsecured loans: Yes bank loan account Current liabilities: Creditors: United Furniture Industries Ltd. Provision for income tax Total... K.K. DESIGNER FURNITURE CENTRE BALANCE SHEET AS ON 30-04-20CY ` ASSETS Fixed assets: Furniture 4,00,000 Less: Depreciation @ 10% 15,000 Current assets: (10,000) Cash 4,05,000 Yes Bank current account 59,981 4,64,981 Debtors: Arpita Public School Inventory 4,00,000 (10,000) 3,90,000 59,981 4,49,981 9,14,962 ` 45,000 375 44,625 50,000 17,81,000 1,32,000 22,000 10,00,000 63,250 51,413 20,29,625 Total... Profit and Loss Account for the Month Ended 30-04-20CY ` INCOME Purchases 7,03,250 Sales Less: Purchase return 40,000 6,63,250 Less: Sales return To gross profit c/d 1,90,750 Closing inventory Total... 8,54,000 Total.... Cash discount allowed 7,000 By gross profit b/d Salaries 6,000 Cash discount received Add: Payable to Kartik 15,000 21,000 Depreciation 375 Provision for income tax 51,413 Net profit c/d 1,19,962 Total... 1,99,750 Total... Transferred to partners’ capital Net profit b/d accounts equally: Kartik 59,981 Kushik 59,981 1,19,962 Total... 1,19,962 Total... 20,29,625 EXPENSES ` 8,82,000 50,000 8,32,000 22,000 8,54,000 1,90,750 9,000 1,99,750 1,19,962 1,19,962 70 Financial Accounting for Management Notes: 1. Provision for income tax: 30% of {1, 99,750 minus (7,000+21,000+375)} = 51,413. It is a current liability towards the Government of India. 2. Salary payable to Kartik has been added to his capital account instead of showing as a current liability to match with the treatment given to his drawings. 3. Total capital is shown in the liabilities side for information only. Not to be doubly added. SOLUTION TO ILLUSTRATION 2 2.2 1. BRIEF ANALYSIS OF FINANCIAL STATEMENTS K.K. DESIGNER FURNITURE CENTRE The firm has earned a net profit of `1,19,962 in the very first month of its operations. A fabulous annualised return of around 180% on an investment of `8,00,000. 2. The firm owns assets to the extent of `20,29,625 and owes to outsiders `11,14,663. 3. The initial capital of Kartik and Kushik `8,00,000, even after withdrawals , has grown to `9,14,962. This is the amount that the firm owes to them. RECAP OF FUNDAMENTAL ACCOUNTING CONCEPTS We have discussed and illustrated in the earlier as well as in this chapter a number of fundamental accounting concepts. To recap, the list is as under: 1. Business entity concept 2. Accrual concept 3. Going concern concept 4. Dual aspect concept 5. Cost concept 6. Money measurement concept 7. Realisation concept RECAP OF ADJUSTMENTS We have discussed herein above the need for making various adjustments to the figures appearing in the trial balance in order to prepare a meaningful balance sheet and profit and loss account and illustrated a large number of them. To recap, the list is as under: 1. Depreciation on fixed assets 2. Closing inventory 3. Interest due on loan 4. Salary payable to managing partner 5. Other expenses due but not paid 6. Provision for income tax Chapter 3 Measurement of Profit and Financial Position: III 71 More adjustments will follow in the chapter on construction of financial statements of corporate entities. The basic technique behind making adjustments is to assess the impact of a required adjustment on two accounts and to carry it out accordingly as illustrated above. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Bring out the significance of carrying out relevant adjustments in the determination of business performance and financial position. 2. How the basic features of partnership affect financial accounting process from trial balance to financial statements? Relate your discussion with the illustration of K. K. Designer Furniture Centre. 3. Can you now describe in your own words the ‘what’ and ‘why’ of the financial statements? Test your understanding. To enrich your discussion, add your own ideas, thoughts and practical inputs. CONCLUDING REMARKS This chapter completes the accounting process, which starts with the documentation of business transactions and moves through their recording, classifying and summarising before finally measuring the business performance and financial position of non-corporate entities. The first three chapters, including this one, have provided a good grounding in the practical aspects of financial accounting. By now you must have developed a fair understanding of what a business is, how it moves and how its performance is measured and evaluated. You will now be initiated into measuring the performance and financial position of company form of business organization in the next chapter. Keywords n Capital Expenditure n Depreciation n Loans n Capital Receipt n Drawings n Net Profit n Closing Inventory n Finished Goods n Revenue Expenditure n Company n Fixed Assets n Revenue Receipts n Cost of Goods Sold (COGS) n Going Concern Concept n Subsidy n Current Assets n Gross Profit n Trading Account n Current Liabilities n Investments n Trading Margin 72 Financial Accounting for Management exercises Ex. 1 AMAN HOME PRODUCTS Construction of Balance Sheet and Profit and Loss Account and their Analysis Refer to the case of AMAN HOME PRODUCTS given in the exercises in the last chapter. Aman now wants to know as to where his firm stands after one month of running. Help him. Towards this purpose comply with the following requirements. Requirements: 1. Analysis of the trial balance as already prepared. 2. Make adjustment for closing inventory amounting to `50,000. 3. Construction of the balance sheet. 4. Construction of the profit and loss account. 5. Brief analysis of the financial statements. Ex. 2 SURYA MEDICAL EQUIPMENTS Construction of Balance Sheet and Profit and Loss Account and their Analysis Refer to the case of SURYA MEDICAL EQUIPMENTS given in the exercises in the last chapter. Ashish Agrawal now wants to know as to where his firm stands after one month of running. Help him. Towards this purpose comply with the following requirements. Requirements: 1. Analysis of the trial balance as already prepared. 2. Make following adjustments: • Depreciation on furniture @ 10% pa. • Closing inventory amounting to `75,000. 3. Construction of the balance sheet. 4. Construction of the profit and loss account. 5. Brief analysis of the financial statements. Chapter 3 Measurement of Profit and Financial Position: III 73 Ex. 3 SHAHRUKH KHANNA AND SONS Construction of Balance Sheet and Profit and Loss Account and their analysis Refer to the case of Shahrukh Khanna and Sons given in the exercises in the last chapter. Shahrukh Khanna now wants to know as to where his firm stands after one month of running. Help him. Towards this purpose comply with the following requirements. Requirements: 1. Analysis of the trial balance as already prepared. 2. Identification of the adjustments needed. Compute depreciation at the rates specified as under: Car Furniture 20% As per Bharat Scientific Products Enterprise 3. Valuation of inventory. Assume the same basis of valuation as in the case of Bharat Scientific Products Enterprise. 4. Construction of the balance sheet. 5. Construction of the profit and loss account. 6. Brief analysis of the financial statements. Ex. 4 KANIKA AND GAURAV MANAGEMENT CONSULTANTS Partnership Firm Construction of Balance Sheet and Profit and Loss Account and their analysis Refer to the case of Kanika and Gaurav Management Consultants given in the exercises in the last chapter. Gaurav and Kanika now want to know as to where their firm stands after one month of running. Help them. Towards this purpose comply with the following requirements. Requirements: 1. Analysis of the trial balance as already prepared. 2. Identification of the adjustments needed. Compute depreciation at the rates specified as under: Car Computers As per Shahrukh Khanna and Sons 60% PA 3. Construction of the balance sheet. 4. Construction of the profit and loss account. 5. Brief analysis of the financial statements. (Hint: No need to prepare the trading account. Just prepare the profit and loss account and transfer the profit to the two partners’ capital accounts.) 74 Financial Accounting for Management Ex. 5 CASE COMPREHENSIVE CASE OF MONIK TRADERS Construction of Balance Sheet and Profit and Loss Account and their analysis Refer to the case of Monik Traders given in the exercises of the last chapter. Monik Varma now wants to know as to where his firm stands after one month of running of the business. Help him. Towards this purpose comply with the following requirements. Requirements: 1. Analysis of the trial balance as already prepared. 2. Identification of the adjustments needed. Apply the same rates of depreciation as done in the case of Bharat Scientific Products Enterprise illustrated in this chapter. 3. Valuation of inventory. Assume the same basis of valuation as in the case of Bharat Scientific Products Enterprise. 4. Construction of the balance sheet. 5. Construction of the profit and loss account. 6. Brief analysis of the financial statements. 4 Measurement of Profit and Financial Position: IV Corporate Entities From non-corporate, this chapter moves over to measurement of profit and financial position of corporate entities. Company form of business organisation has certain peculiar features and its financial statements are drawn in the format prescribed by the companies act, 2013. 76 Financial Accounting for Management C HAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 What are the basic features of the company form of business organization. 2 How a company is incorporated. 3 What types of companies are incorporated. 4 What are preliminary expenses and why they have to be incurred. 5 How does the board of directors function. 6 What types of share capital can be issued and what are its features that make company form of business popular. 7 What are public issue expenses and why they have to be incurred. 8 How the share capital is accounted for. 9 What is share forfeiture and how to account for it. 10 What is issue of shares for consideration other than cash and how to accounted for it. 11 What are the form and basic features of financial statements of companies. 12 How to prepare the balance sheet and profit and loss account of a company. 13 How to analyse the performance of a company in brief. 14 What is a premium issue and how to accounted for it. 15 What are bonus shares and how to account for them. Thus enabling you to be in a position to deeply understand the nuances of corporate financial statements, reporting and analysis now onwards. INTRODUCTION The last chapter was devoted to financial statements of non corporate entities. But how do companies, for example, Bajaj Auto Ltd., Bharat Heavy Electricals Ltd., HDFC Bank Ltd., Maruti Udyog Ltd., Reliance Industries Ltd. and TCS Ltd. etc., commanding the heights of economic activity, prepare their financial statements and measure their profit and financial position? Does that involve any peculiarities? To address these and many more related issues this chapter seeks to initiate you into corporate financial statements and their brief analysis. From now onwards the whole book concentrates on corporate financial statements, reporting and analysis. You may be aware that, in the present day economic environment, the company form of business organization is the most preferred form of business especially for sizeable business activity. Why? We will see a little later. In the mean time it could be of interest for you to know the top 30 Indian companies that constitute the Bombay Stock Exchange Sensitivity Index, that is, BSE - SENSEX, which is considered to be the pulse of Indian capital market and barometer of corporate performance in India. 77 Chapter 4 Measurement of Profit and Financial Position: IV ILLUSTRATION 1 WWW BSE-SENSEX www.bseindia.com Constituent Companies as on 25th October 2007 Sl. No. Company Name Sector 1 ACC Ltd. Housing Related 2 Ambuja Cements Ltd. Housing Related 3 Bajaj Auto Ltd. Transport Equipments 4 Bharat Heavy Electricals Ltd. Capital Goods 5 Bharti Airtel Ltd. Telecom 6 Cipla Ltd. Healthcare 7 Dr Reddy’s Laboratories Ltd. Healthcare 8 Grasim Industries Ltd. Diversified 9 HDFC Ltd. Finance 10 HDFC Bank Ltd. Finance 11 Hindalco Industries Ltd. Metal, Metal Products & Mining 12 Hindustan Unilever Ltd. FMCG 13 ICICI Bank Ltd. Finance 14 Infosys Technologies Ltd. Information Technology 15 ITC Ltd. FMCG 16 Larsen & Toubro Limited Capital Goods 17 Mahindra & Mahindra Ltd. Transport Equipments 18 Maruti Udyog Ltd. Transport Equipments 19 NTPC Ltd. Power 20 ONGC Ltd. Oil & Gas 21 Ranbaxy Laboratories Ltd. Healthcare 22 Reliance Communication Ltd. Telecom 23 Reliance Energy Ltd. Power 24 Reliance Industries Ltd. Oil & Gas 25 Satyam Computer Services Ltd. Information Technology 26 State Bank of India Finance 27 Tata Consultancy Services Ltd. Information Technology 28 Tata Motors Ltd. Transport Equipments 29 Tata Steel Ltd. Metal, Metal Products & Mining 30 Wipro Ltd. Information Technology Notes: 1. Source: Bombay Stock Exchange Web site: www.bseindia.com. Visit the site for more details about Sensex. Click: Indices – SENSEX. 2. Sector classification: As per Bombay Stock Exchange. 78 Financial Accounting for Management Let us now turn our attention to discussing certain peculiarities of the company form of business organisation. BASIC FEATURES OF THE COMPANY FORM OF BUSINESS ORGANIZATION Up to now you have seen illustrations and exercises of proprietorship and partnership firms. However when business grows an individual or a few individuals may not be in a position to meet its funding requirements. Likewise when a big business is planned, its requirement of funds may be beyond the capacity of the promotBIRD’S EYE VIEW ers. Company form of organisation comes to the rescue of the busiBasic Features of the nessmen in such situations. Company Form of Business Organisation n Registration under the Companies Registration under the Companies Act Act — Memorandum of association — Articles of association n Types of Companies — Public limited companies — Private limited companies n Preliminary Expenses n Board of Directors The promoters of the business have to register their business organisation with the Registrar of Companies (ROC) under the Companies Act, 1956. The name of the company is granted subject to availability. If a particular name is not available then the promoters have to seek some other name. Once registered a Certificate of Incorporation is issued by the ROC signifying that the company has come into existence. A company may be registered with unlimited liability or liability limited to guarantee of members or liability limited to shareholding. In general parlance, however, when we talk about a company it is presumed that we are talking about a company limited For more details refer to the by shares unless otherwise specified. In practice most of the compa‘Guide to the Companies nies are formed with liability of their members limited by shares. The Act’ by A Ramaiya or any discussion in this chapter is with reference to such companies only other book on company law. unlessotherwise mentioned. The registration process involves registration of two important documents: Memorandum of Association and Articles of Association. Memorandum of association This document is the constitution of the company laying its foundation. It mainly contains: 1. The name of the company. 2. The name of the state in which its registered office is situated. 3. The objects of the company, say, the company has been formed to carry on the business of telecom, for example, Bharti Airtel Ltd. 4. A statement that the liability of the members is limited. 5. Authorised share capital of the company. 6. Number of shares to be taken by each subscriber to the memorandum. The promoters have to subscribe their names to the memorandum of association agreeing to take not less then 1 share each (subscription clause). Articles of association This document lays down the rules for internal management of the company. Matters such as issue of shares and debentures, rights of members, shareholders’ meetings, Chapter 4 Measurement of Profit and Financial Position: IV 79 An illustration is provided on subscribing to the memorandum. ILLUSTRATION 2 JAY RAJ HEALTHCARE LTD. Subscribers to the Memorandum We, the following persons whose names and addresses are subscribed, are desirous of being formed into a company in pursuance of this memorandum of association, and we respectively agree to take the number of shares in the capital of the company set opposite our respective names. Subscribers Name Address Occupation Number of shares taken 1. Rajan Shah D-6, Sabarmati Street, Ahmedabad. Industrialist 100 2. Soma Shah D-6, Sabarmati Street, Ahmedabad. Housewife 100 3. Amok Shah D-6, Sabarmati Street, Ahmedabad. Industrialist 100 4. Sajan Shah D-6, Sabarmati Street, Ahmedabad. Doctor 100 5. Armada Dubashi A-15, Amrapali Street, Ahmedabad. Industrialist 100 6. Jay Dubashi A-15, Amrapali Street, Ahmedabad. Industrialist 100 7. Veena Dubashi A-15, Amrapali Street, Ahmedabad. Housewife 100 Total... 700 Members of the Company These subscribers are the members of Jay Raj Healthcare Ltd. Allottees of further shares also become members of the company. appointment of directors and managing director/s, directors’ remuneration and powers, board meetings, borrowings, accounts and audit and buy back of shares etc. are included in the articles. A private limited company having share capital has to register the articles manadatorily. A public limited company having share capital has the option to register or not to register the articles. If it opts not to register this document it has to follow the regulations contained in Table ‘A’ of Schedule I to the companies act. However it is customary for such companies as well to have their own registered articles. Articles are subordinate to and controlled by the memorandum. They can not override the latter. Types of Companies Broadly two types of companies can be formed – Public Limited and Private Limited. Public limited companies The word ‘Limited/Ltd.’ at the end of the name of a company, for example, IDBI Bank Ltd., indicates that the company is a public limited company, having limited liability. The significance of limited liability is that the contributors of share capital of the company are liable towards the discharge of the liabilities of the company only up to their contribution as against proprietary and partnership firms where their liability is unlimited, 80 Financial Accounting for Management that is, their personal assets can also be attached for discharging the business liabilities. This is the biggest feature of a company that appeals the promoters and hence it is the most preferred form of business organization especially for sizeable business activity. A public limited company may be formed with minimum of seven members or shareholders and without any upper limit. Such a company can raise capital from public at large through the stock exchanges, for example, National Stock Exchange, and become a listed company whose shares can be traded at the exchange. Company needs to receive minimum of 90% subscription in the public issue before it becomes entitled to proceed with the allotment. A public limited company needs to obtain a Certificate of Commencement of Business from the ROC in addition to the certificate of incorporation. Private limited companies Even small businessmen can run a limited liability business with all the advantages of proprietorship and partnership, that is, without parting with their absolute control over the business. The companies act allows formation of private limited companies to facilitate such businessmen. The words Private Limited / Pvt. Ltd.’ are suffixed to the name of such a company, for example, Praxis Consulting & Information Services Pvt. Ltd. It indicates that the company is a privately held company with limited liability. A private limited company may be formed with just two members or shareholders and it can not have more than fifty shareholders. That is why such a company is also called family-owned or one-man company. Employees and former employees, who were members at the time of employment and continue to be so, are not counted in the upper limit of fifty. It needs to be understood that private limited companies are not meant to be the exclusive preserve of small business. Even big business can be organized in the form of a private limited company specially when the promoters have no dearth of capital and they want to keep the company away from the public domain. For example, Hindustan Coca-Cola Beverages Private Ltd., the makers of Coca Cola and Haldiram Marketing Pvt. Ltd., the renowned makers of Indian namkeens, sweets and snacks etc. Preliminary Expenses Formation of a company under the companies act requires some expenses to be incurred, for example, fee for name availability and registration charges payable to the ROC, printing of memorandum and articles of association, stamp duty thereon and fees payable to the Chartered Accountant handling company formation etc. These expenses are termed as Preliminary Expenses. Board of Directors In both the public limited as well as private limited companies a board of directors looks after the business of the company. Directors are usually from among the promoters. Eminent people from outside are also appointed to the board. Day to day affairs are looked after by the managing or executive director/s subject to overall superintendence and control of the board of directors. Managing or executive director/s may be from among the promoters or professionally hired executives. FINANCIAL STATEMENTS OF COMPANIES In substance the financial statements of companies are prepared on the basis of the same principles as apply to any other form of organization. Companies follow exactly the same accounting process that has been discussed so far in the earlier chapters. However as they are regulated by the Companies Act, 81 Chapter 4 Measurement of Profit and Financial Position: IV BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Make an industry-wise listing of Sensex companies. Could you give some suggestions for further broad basing of Sensex? 2. What is the distinction between memorandum of association and articles of association? 3. Who are the members of a company? 4. Distinguish between a public limited company and a private limited company. Which one you will prefer to promote? Under what circumstances? 5. What is the role of the board of directors? Apprise yourself of the boards of a few Sensex companies either from their websites or Capitaline Plus database. To enrich your discussion, add your own ideas, thoughts and practical inputs. it prescribes certain requirements about books of accounts and contents and disclosure requirements in the financial statements of companies. These have been discussed in detail in the chapter on Generally Accepted Accounting Principles that follows the next chapter. At this stage some specific requirements about the financial statements of companies are being discussed here in brief to prepare the ground for you to be able to delve into corporate accounting, reporting and analysis in depth from the next chapter onwards. Share Capital Unlike the non corporate entities where the entire capital is brought in by the proprietor or the partners, in the case of a company it is brought in by the promoters, their friends, relatives and associates as well as the general public in case of listed companies. The capital is also transferable. The entire capital is therefore divided into shares of fixed denomination, which are issued to their subscribrs. The shareholding is inscribed in and acknowledged by way of share certificate/s issued by the company. The capital is known as share capital and shareholders get dividend out of the profits of the company as return on their investment. Transferability of share capital ensures the perpetuity of the company. Company form of organization is therefore the most preferred form of borrowers for the lending institutions. Division of share capital Share capital of a company is divided into authorised, issued, subscribed, called-up and paid-up capital. Authorised capital: Maximum capital that a company may raise is authorised by its constitution, that is, memorandum of association. This is called authorized capital. As and when needed the memorandum may be amended, as per the provisions of the companies act, to raise higher amount of capital, that is, to increase the authorised capital. Authorized capital may be raised in more than one trench. BIRD’S EYE VIEW Financial Statements of Companies n Share Capital n Public Issue Expenses n Accounting Treatment of Share Capital n Form of Financial Statements n Some Features of Financial Statements Issue of Shares at a Premium n Bonus Shares n BIRD’S EYE VIEW Share Capital n Division of Share Capital — Authorised capital — Issued capital — Subscribed capital — Called-up Capital — Paid-up Capital n Types of Share Capital — Preference share capital — Equity share capital 82 Financial Accounting for Management Issued capital: Issued capital is that part of the authorised capital which the company has actually issued at a given point in time. Subscribed capital: Subscribed capital is that part of the issued capital that has actually been subscribed to by the investors. As per the companies act a company may go ahead with the allotment of capital if at least 90% of the amount issued has been subscribed to by the investors in case of a public issue. Called-up capital: Called-up capital is that part of the subscribed capital that a company has actually called on the investors. A company may call the capital in trenches, say, partly on application, partly on allotment and balance in one or more calls. However now-a-days the companies usually call the entire amount by the time of allotment, though cases of staggered raising are also noticed. Paid-up capital: The amount though called-up but not paid by any shareholder, is shown, separately for directors and other shareholders, by way of deduction from called-up capital thus showing the final paid-up capital of the company. If the called-up amount is not fully paid by any shareholder/s company may forfeit the amount that has been paid partly. Original amount paid on shares forfeited is added to the paid-up capital. Instead many a companies disclose this item under the head reserves and surplus. In practice, however, in most company balance sheets issued, subscribed, called-up and paid-up capital is the same figure. CASE 1 Hindalco Industries Ltd. Consider the following case of a staggered capital raising in an issue floated by Hindalco Industries Ltd. WWW HINDALCO INDUSTRIES LTD. Annual Report 2005–06 REPORT www.hindalco.com Raising Capital in Trenches Hindalco Industries Ltd. came out with a rights issue, i.e., issue to existing shareholders, of 23,15,21,031 equity shares of Re. 1 each at a price of ` 96 each aggregating to ` 22,22.60 crores during 2005–06. The terms of issue were: 1. ` 24 per share, i.e., ` 555.65 crores on application 2. ` 24 per share, i.e., ` 555.65 crores over 9–12 months from allotment, and 3. Balance ` 48, i.e., ` 11, 11.30 crores over18–24 months from allotment. The capital was raised for financing the expansion plans of the company. Types of share capital Share Capital of a company includes Equity Share Capital and could also include Preference Share Capital, though the later is not a preferred mode of raising capital. Preference share capital It represents that part of the share capital of a company which enjoys preferential rights in respect of payments of fixed dividend and repayment of capital in case of liquidation of the company. Depending upon the terms of issue, preference share capital may be redeemable or irredeemable, may carry cumulative or non-cumulative dividend at a predetermined rate and may or may not be convertible into equity share capital. It needs to be understood that in case of loss or inadequacy of profit or Visit www.mca.gov.in directors not recommending a dividend despite enough profit in a particular if you wish to update year if the dividend on preference share capital remains partly or fully unpaid, WWW yourself on company the right of the non-cumulative preference shareholders to dividend for that law matters. year lapses. Thus they will not be entitled to arrears of dividend from succeed- 83 Chapter 4 Measurement of Profit and Financial Position: IV ing years’ profits but the cumulative preference shareholders will be. Likewise if dividend is not paid partly or fully and the non-cumulative preference shares are redeemed in the meanwhile, their holders’ right to dividend lapses. In the case of cumulative preference shares, their holders may continue to be entitled to arrears if there are specific stipulations attached to the issue of shares to that effect. Equity share capital: It is the capital, which is not a preference capital. What it means is that equity shareholders have a residual right in the profits of the company after meeting preference dividend and in the assets of the company after meeting the claim of preference shareholders in the case of liquidation. It also means that equity shareholders are entitled to the entire profits of the company after payment of dividend on preference capital. They are, and not the preference shareholders, the real owners of the company in fact. Public Issue Expenses A limited company that floats a public issue incurs lots of expenses for raising resources from the public. These expenses include fees to the managers to the issue and legal advisers, fees paid to Securities and Exchange Board of India (SEBI) for filing of prospectus, fees to ROC, underwriting commission, brokerage to members of stock exchanges, printing and publication of application forms and prospectuses, advertising and marketing expenses, bank charges, fees to the registrars to the issue, listing fee to stock exchange/s and other miscellaneous expenses. These expenses are termed as Public Issue Expenses. Likewise listed companies incur substantial expenses on rights issue as well. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is a share? 2. Distinguish between equity capital and preference capital. Which one you would like to invest in? Why? 3. Hindalco raised capital in trenches. Can you make out why? How do the shareholders benefit from such issues? To enrich your discussion, add your own ideas, thoughts and practical inputs. BIRD’S EYE VIEW Accounting Treatment of Share Capital After having explained the characteristic features of share capital we turn to its accounting treatment in corporate accounts. Equity share capital A few illustrations now follow to demonstrate the accounting treatment of equity share capital. Private limited company: First a simple case of a private ltd. company. Accounting Treatment of Share Capital n Equity Share Capital — Private limited company — Public Limited Company—public issue — Presentation of share capital in the balance sheet — Forfeiture of shares — Issue of shares for consideration other than cash n Preference share capital 84 Financial Accounting for Management ILLUSTRATION 3 JAI MALA CLOTHES PVT. LTD. Share Capital of a Private Ltd. Company Seth Jai Prakash and his wife Sethani Mala Devi promoted a company Jai Mala Clothes Pvt. Ltd. on 1st April 2006 with an authorised capital of 5 lac equity shares of ` 10 each totalling ` 50 Lacs. Company formation expenses of ` 1, 20,000 were incurred by Seth Jai Prakash out of his pocket. Both of them had subscribed their names to the memorandum of association agreeing to take 100 shares each. The same day company held a general meeting of its two members, namely, Seth Jai Prakash and Sethani Mala Devi, and took the following decisions: 1. Called upon Seth Jai Prakash and Sethani Mala Devi to bring in full amount of shares agreed to be taken by them in the memorandum. 2. Approved preliminary expenses incurred by Seth Jai Prakash. 3. Formed the board of directors of the company consisting of Seth Jai Prakash and Sethani Mala Devi. 4. Appointed Seth Jai Prakash as its Managing Director. 5. Decided to issue 1, 99,800 equity shares to Seth Jai Prakash and Sethani Mala Devi with full amount payable on application. Seth Jai Prakash and Sethani Mala Devi brought in cash of ` 2,000 towards the cost of initial subscription on the same day and the shares were allotted to them by the board immediately. Cash of ` 1,000 was deposited in the ICICI bank in company’s current account ICICI CA 9211 opened the same day. Out of further 1, 99,800 shares, Seth Jai Prakash agreed to subscribe to 1, 89,900 shares and Sethani Mala Devi 9,900. On 2nd April both submitted their applications with cheques of corresponding amounts which were deposited in the bank. The board of directors allotted shares to them in full on 5th April. Preliminary expenses were reimbursed to Seth Jai Prakash by the company on 5th April. Record these transactions and summarize them in a trial balance. SOLUTION TO ILLUSTRATION 3 3.1 JAI MALA CLOTHES PVT. LTD. JOURNAL Date 2006 April Voucher No. 1 1 1 2 Account Heads and Description of the Transaction L. F. Debit Dr.… Cash Cr.… Equity Share Capital (100 each equity shares allotted to Seth Jai Prakash and Sethani Mala Devi as subscribers to memorandum of association.) 2,000 Dr.… ICICI CA 9211 Cr.… Cash (Opened current account.) 1,000 Amount (`) Credit 2,000 1,000 Dr.… Preliminary Expenses Cr.… Seth Jai Prakash (Company formation expenses due to him.) 1,20,000 Dr.… ICICI CA 9211 Cr.… Equity Share Application Money 19,98,000 1,20,000 19,98,000 Chapter 4 Measurement of Profit and Financial Position: IV 85 (Received cheques from Seth Jai Prakash for 1,89,900 shares and from Sethani Mala Devi for 9, 900 towards application money.) 5 5 Dr.… Equity Share Application Money Cr.… Equity Share Capital (1,89,900 equity shares allotted to Seth Jai Prakash and 9,900 to Sethani Mala Devi.) 19,98,000 Dr.… Seth Jai Prakash Cr.… ICICI CA 9211 (Company formation expenses reimbursed to him.) 1,20,000 19,98,000 1,20,000 Notes: 1. Shares allotted to Seth Jai Prakash and Sethani Mala Devi may be credited to their personal accounts, that is, ‘Seth Jai Prakash – Equity Share Capital’ and ‘Sethani Mala Devi–Equity Share Capital’ on the lines of proprietorship and partnership firms. However as a matter of practice ‘Equity Share Capital’ is the account opened to reflect such transactions collectively. Either way meaning is the same. 2. In case of non-corporate entities proprietor’s or partners’ capital accounts are credited directly on receipt of capital. In case of companies the same treatment is accorded to the shares subscribed to by the promoters in the memorandum of association as they commit to take those specified number of shares, become liable to pay for them and allotment therefore becomes a mere formality. However in case of subsequent issue of shares, the company first decides the quantum of shares to be issued, then invites applications for them, may get oversubscription or undersubscription and contribution towards capital technically becomes ‘capital’ of the company only after the board of directors allots the issued shares. Hence the recording in two stages: application and allotment. This process may not be very visible in case of private ltd. companies but is highly visible in case of public ltd. companies raising public issue as we will see in the next illustration. 3. Application money received from Seth Jai Prakash and Sethani Mala Devi may be credited to their personal accounts, that is, ‘Seth Jai Prakash – Application Money’ and ‘Sethani Mala Devi– Application Money’. However as a matter of practice ‘Equity Share Application Money’ is the account opened to reflect such transactions collectively. Either way meaning is the same. And now the ledger. SOLUTION TO ILLUSTRATION 3 3.2 JAI MALA CLOTHES PVT. LTD. LEDGER Account… Date 2006 April Cash Voucher No. Folio No…. Particulars J. F. 1 To equity share capital 1 By ICICI CA 9211 Total... Amount (`) Debit Credit 2,000 2,000 Dr./Cr. Balance Amount (`) Dr. 2,000 1,000 Dr. 1,000 1,000 Dr. 1,000 86 Account… Date 2006 April Financial Accounting for Management Equity Share Capital Voucher No. Folio No…. Particulars J. F. 1 By cash 5 By equity share application money Total... Account… Date 2006 April … ICICI CA 9211 Voucher No. Particulars J. F. To cash 2 To equity share application money 5 April 1 Date 2006 April Particulars J. F. Particulars Cr. 20,00,000 Dr./Cr. Balance Amount (`) 19,98,000 Dr. 19,99,000 1,20,000 Dr. 18,79,000 1,20,000 Dr. 18,79,000 Amount (`) Debit Credit 1,20,000 To ICICI CA 9211 … Amount (`) Debit Credit Dr./Cr. Balance Amount (`) Dr. 1,20,000 Dr. 1,20,000 1,20,000 Equity Share Application Money Particulars By ICICI CA 9211 5 To equity share capital Cr. … NIL 1,20,000 … NIL Amount (`) Debit Credit 19,98,000 Total... Balance Amount (`) 1,20,000 Folio No…. J. F. 2 Dr./Cr. 1,20,000 1,20,000 Total... April 20,00,000 1,20,000 J. F. 5 Voucher No. 20,00,000 Folio No…. By preliminary expenses Date 2006 Cr. 1,000 Seth Jai Prakash 1 Account… 19,98,000 Folio No…. To Seth Jai Prakash Voucher No. 2,000 Dr. 19,99,000 Total... Account… Cr. 1,000 Preliminary Expenses Voucher No. Balance Amount (`) 2,000 Amount (`) Debit Credit By Seth Jai Prakash Total... Date 2006 Dr./Cr. Folio No…. 1 Account… Amount (`) Debit Credit 19,98,000 19,98,000 19,98,000 Dr./Cr. Balance Amount (`) Cr. 19,98,000 … NIL … NIL 87 Chapter 4 Measurement of Profit and Financial Position: IV Now follows the trial balance. SOLUTION TO ILLUSTRATION 3 3.3 JAI MALA CLOTHES PVT. LTD. TRIAL BALANCE AS ON 5TH APRIL 2006. Amount (`) Account Heads L. F. Cash Debit Credit 1,000 Equity Share Capital 20,00,000 ICICI CA 9211 18,79,000 Preliminary Expenses 1,20,000 Total… 20,00,000 20,00,000 Public limited company—Public Issue: Let us now illustrate the case of a public ltd. company raising capital through public issue. ILLUSTRATION 4 SATYADEEP HOUSING INFRASTRUCTURE LTD. SHARE CAPITAL OF A PUBLIC LTD. COMPANY Pradeep Agarwal and Satyendra Singh, two close friends, together with their associates promoted a company Satyadeep Housing Infrastructure Ltd. on 1st April 2006 with an authorised capital of 3 crore equity shares of ` 10 each totalling ` 30 crores. Company formation expenses of ` 16.50 lacs were incurred by Satyendra Singh out of his pocket. Both of them had subscribed, along with their five associates, their names to the memorandum of association agreeing to take up 100 shares each. The same day company held a general meeting of its seven members and took the following decisions: 1. Called upon the subscribers to the memorandum to bring in full amount of shares agreed to be taken by them in the memorandum. 2. Approved preliminary expenses incurred by Satyendra Singh. 3. Formed the board of directors of the company consisting of Pradeep Agarwal, Satyendra Singh and Lt. Col. (Retd.) Ravi Kant Singh, an expert in real estate. 4. Appointed Pradeep Agarwal as its Chairman and Lt. Col. (Retd.) Ravi Kant Singh as its Managing Director. 5. Decided to augment the capital of the company to 2.50 crore shares in the following manner: Number of Shares Subscribers to the memorandum Promoters and Directors : 1. Pradeep Agarwal 2. Satyendra Singh 3. Lt. Col. (Retd.) Ravi Kant Singh 700 49,50,000 49,49,300 1,00,000 Public issue 99,99,300 1,50,00,000 Total…. 2,50,00,000 88 Financial Accounting for Management 6. Terms of raising the further capital were decided as under: A. Promoters and directors: ` 10 on application. B. Public issue: n ` 3 on application n ` 3 on allotment n ` 2 on first call, and n ` 2 on second call. All the subscribers to the memorandum brought in cash of ` 7,000 towards the cost of initial subscription on the same day and the shares were allotted to them by the board immediately. Cash of ` 5,000 was deposited in the IDBI bank in company’s current account IDBI CA 325 opened the same day. On 3rd April the promoters and directors submitted their applications for further shares with cheques of corresponding amounts which were deposited in the bank. The board of directors allotted shares to them in full on 7th April. The same day ` 9 crores were transferred to IDBI Bank in a fixed deposit account IDBI FD 1234 in the name of the company. Preliminary expenses were reimbursed by the company to Satyendra Singh on 7th April. Formalities for the public issue then started. Public issue expenses incurred so far to the tune of ` 80, 00,000 were paid on 25th June. The public issue opened on 1st July and closed on 5th July. Applications were received for 1,40,00,000 shares and deposited in ‘IDBI – Satyadeep Housing – Public Issue’ account with IDBI bank. All the applicants were allotted the shares in full on 20th July. Allotment money was required to be paid on 31st July. Rest of the public issue expenses amounting to ` 65, 00,000 were paid out of ‘IDBI – Satyadeep Housing – Public Issue’ account on 25th July and the balance in the account was released by IDBI the same day which was transferred to IDBI FD 1465. ‘IDBI – Satyadeep Housing – Public Issue’ account was closed then. Shareholders paid the allotment money in full on the due date which was deposited in ‘IDBI– Satyadeep Housing – Allotment Money’ account with IDBI bank. On the same day the board decided to make the first call which was to be paid on 31st August. On 5th August ‘IDBI – Satyadeep Housing – Allotment Money’ account was closed after transferring the entire allotment money to IDBI FD 1536. All the shareholders, except 100 holding 4 lac shares in total, paid the call money in full on the due date which was deposited in ‘IDBI – Satyadeep Housing – Call Money’ account with IDBI bank. On 4th September ‘IDBI – Satyadeep Housing – Call Money’ account was closed after transferring the entire call money to IDBI FD 1775. Record these transactions and summarize them in a trial balance. SOLUTION TO ILLUSTRATION 4 4.2 SATYADEEP HOUSING INFRASTRUCTURE LTD. JOURNAL Date 2006 April Voucher Account Heads and Description of the No. Transaction 1 1 1 L. F. Debit Dr.… Cash Cr.… Equity Share Capital (100 each equity shares allotted to Seven subscribers to memorandum of association.) 7,000 Dr.… IDBI CA 325 Cr.… Cash (Opened current account.) 5,000 Dr.… Preliminary Expenses Cr.… Satyendra Singh (Company formation expenses due to him.) Amount (`) Credit 7,000 5,000 16,50,000 16,50,000 Chapter 4 Measurement of Profit and Financial Position: IV 3 7 7 7 June July 25 5 20 25 25 31 31 August August 5 31 Dr.… IDBI CA 325 Cr.… Equity Share Application (Received cheques from 3 promoters and directors towards application money.) 9,99,93,000 Dr.… Equity Share Application Cr.… Equity Share Capital (99,99,300 equity shares allotted to 3 promoters and directors) 9,99,93,000 Dr.… IDBI FD 1234 Cr.… IDBI CA 325 (Opened fixed deposit account.) 9,00,00,000 9,99,93,000 9,99,93,000 9,00,00,000 Dr.… Satyendra Singh Cr.… IDBI CA 325 (Company formation expenses paid to him.) 16,50,000 Dr.… Public Issue Expenses Cr.… IDBI CA 325 (Paid to various parties.) 80,00,000 16,50,000 80,00,000 Dr.… IDBI-Satyadeep Housing-Public Issue Cr.… Equity Share Application (Received cheques between 1st July and 5th July in public issue for 1.40 crore equity shares towards application money.) 4,20,00,000 Dr.… Equity Share Application Cr.… Equity Share Capital (1.40 crore equity shares allotted to public.) 4,20,00,000 Dr.… Public Issue Expenses Cr.… IDBI - Satyadeep Housing-Public Issue (Paid to various parties.) 65,00,000 Dr.… IDBI FD 1465 Cr.… IDBI - Satyadeep Housing-Public Issue (Public issue collection released by IDBI.) 3,55,00,000 Dr.… Equity Share Allotment Cr.… Equity Share Capital (Allotment money due on 1.40 crore equity shares.) 4,20,00,000 Dr.… IDBI – Satyadeep Housing – Allotment Money Cr.… Equity Share Allotment (Public issue allotment money received.) 89 4,20,00,000 4,20,00,000 65,00,000 3,55,00,000 4,20,00,000 4,20,00,000 4,20,00,000 Dr.… IDBI FD 1536 Cr.… IDBI – Satyadeep Housing – Allotment Money (Allotment money collected transferred to FD account.) 4,20,00,000 Dr.… Equity Share First Call Cr.… Equity Share Capital (First call money due on 1.40 crore equity shares.) 2,80,00,000 4,20,00,000 2,80,00,000 90 Financial Accounting for Management Dr.… IDBI – Satyadeep Housing – Call Money Cr.… Equity Share First Call (Public issue first call money received on 1.36 crore shares.) 31 2,72,00,000 Dr.… Calls-in-Arrears Cr.… Equity Share First Call (First call money in arrears from 100 shareholders holding 4 lac shares.) 31 September 2,72,00,000 4 8,00,000 8,00,000 Dr.… IDBI FD 1775 Cr.… IDBI – Satyadeep Housing – Call Money (First call money collected transferred to FD account.) 2,72,00,000 2,72,00,000 Notes: 1. Application Money: Proceeds between 1st to 5th July aggregated and recorded on the latter date. 2. Calls-in-Arrears: Balance of ` 8,00,000 can be left in the Equity Share First Call account also. However the usual practice is to close this account and transfer the balance to Calls-in-Arrears account. Now follows the ledger. SOLUTION TO ILLUSTRATION 4 4.2 SATYADEEP HOUSING INFRASTRUCTURE LTD. LEDGER Account… Date 2006 April Cash Voucher No. Folio No…. Particulars J. F. 1 To equity share capital 1 By IDBI CA 325 7,000 Total... Account… Date 2006 Amount (`) Debit Credit 7,000 Equity Share Capital Voucher No. Particulars April 1 By cash 7 July 20 Dr./Cr. Balance Amount (`) Dr. 7,000 5,000 Dr. 2,000 5,000 Dr. 2,000 Folio No…. J. F. Amount (`) Debit Credit Dr./Cr. Balance Amount (`) 7,000 Cr. 7,000 By equity share application 9,99,93,000 Cr. 10,00,00,000 By equity share application 4,20,00,000 Cr. 14,20,00,000 31 By equity share allotment 4,20,00,000 Cr. 18,40,00,000 August 31 By equity share first call 2,80,00,000 Cr. 21,20,00,000 21,20,00,000 Cr. 21,20,00,000 Total… … Chapter 4 Measurement of Profit and Financial Position: IV Account… Date 2006 April June IDBI CA 325 Voucher No. Folio No…. Particulars J. F. To cash To equity share application 7 By IDBI FD 1234 9,00,00,000 7 By Satyendra Singh 25 By public issue expenses Date 2006 5,000 9,99,98,000 1 Account… Date 2006 Particulars J. F. July 99,98,000 16,50,000 Dr. 83,48,000 80,00,000 Dr. 3,48,000 9,96,50,000 Dr. 3,48,000 Amount (`) Debit Credit 16,50,000 … Balance Amount (`) Dr. 16,50,000 Dr. 16,50,000 Folio No…. Particulars J. F. By preliminary expenses 7 To IDBI CA 325 Amount (`) Debit Credit Dr./Cr. 16,50,000 16,50,000 16,50,000 16,50,000 Equity Share Application Voucher No. Dr./Cr. 16,50,000 Total… April 9,99,98,000 Dr. Satyendra Singh 1 Date 2006 Dr. Folio No…. To Satyendra Singh Voucher No. Account… 5,000 Preliminary Expenses Voucher No. Balance Amount (`) Dr. 9,99,93,000 Total… April Dr./Cr. 3 Total… April Amount (`) Debit Credit 1 Account… 91 Particulars By IDBI CA 325 7 To equity share capital 5 By IDBI - Satyadeep Housing-Public Issue 20 To equity share capital Debit Amount (`) Credit 9,99,93,000 Total… Cr. 16,50,000 … NIL … NIL Folio No…. J. F. 3 Balance Amount (`) 9,99,93,000 4,20,00,000 4,20,00,000 14,19,93,000 14,19,93,000 Dr./Cr. Balance Amount (`) Cr. 9,99,93,000 … NIL Cr. 4,20,00,000 … NIL … Nil 92 Account… Date 2006 April Financial Accounting for Management IDBI FD 1234 Voucher No. 7 Folio No…. Amount (`) Particulars J.F. To IDBI CA 325 Date 2006 Credit 9,00,00,000 Total… Account… Debit 9,00,00,000 Public Issue Expenses Voucher No. Particulars J.F. Dr. 80,00,000 Dr. 1,45,00,000 Dr. 1,45,00,000 To IDBI – Satyadeep Housing-Public Issue 65,00,000 Total… 1,45,00,000 July J.F. To equity share application 25 By public issue expenses 25 By IDBI FD 1465 Total… Account… Date 2006 July 25 Date 2006 July Folio No…. Dr./Cr. Balance Amount (`) 4,20,00,000 Dr. 4,20,00,000 4,20,00,000 65,00,000 Dr. 3,55,00,000 3,55,00,000 … NIL 4,20,00,000 … NIL Folio No…. Particulars J.F. Debit Amount (`) Credit To IDBI – Satyadeep Housing-Public Issue 3,55,00,000 Total… 3,55,00,000 … Equity Share Allotment Voucher No. Balance Amount (`) Amount (`) Debit Credit IDBI FD 1465 Voucher No. Account… … IDBI–Satyadeep Housing–Public Issue 5 9,00,00,000 80,00,000 To IDBI CA 325 25 Particulars 9,00,00,000 Dr. Dr./Cr. 25 Voucher No. Dr. Folio No…. July Date 2006 Balance Amount (`) Amount (`) Debit Credit June Account… … Dr./Cr. Particulars To equity share capital 31 By IDBI – Satyadeep Housing – Allotment Money Total… Balance Amount (`) Dr. 3,55,00,000 Dr. 3,55,00,000 Folio No…. J.F. 31 Dr./Cr. Amount (`) Debit Credit Dr./Cr. Balance Amount (`) 4,20,00,000 Dr. 4,20,00,000 4,20,00,000 … NIL 4,20,00,000 … NIL 4,20,00,000 93 Chapter 4 Measurement of Profit and Financial Position: IV IDBI–Satyadeep Housing–Allotment Money Account… Date 2006 Voucher No. Particulars J. F. July 31 To equity share allotment August 5 By IDBI FD 1536 Total… Dr./Cr. Balance Amount (`) 4,20,00,000 4,20,00,000 Dr. 4,20,00,000 4,20,00,000 … NIL 4,20,00,000 … NIL IDBI FD 1536 Account… Date 2006 August Folio No…. Amount (`) Debit Credit Voucher No. 5 Folio No…. Particulars J. F. To IDBI–Satyadeep Housing–Allotment Money Debit Amount (`) Credit 4,20,00,000 Total… 4,20,00,000 … Equity Share First Call Account… Date 2006 Voucher No. August 31 Particulars J. F. Debit Amount (`) Credit 2,80,00,000 By IDBI–Satyadeep Housing–Call Money 31 2,72,00,000 By calls-in-arrears Total… 2,80,00,000 Date 2006 Voucher No. Particulars J. F. August 31 To equity share call money September 4 By IDBI FD 1775 Total… Dr. 4,20,00,000 Dr. 4,20,00,000 Debit Dr./Cr. Balance Amount (`) Dr. 2,80,00,000 Dr. 8,00,000 8,00,000 … Nil 2,80,00,000 … Nil IDBI–Satyadeep Housing–Call Money Account… Balance Amount (`) Folio No…. To equity share capital 31 Dr./Cr. Folio No…. Amount (`) Credit 2,72,00,000 2,72,00,000 Dr./Cr. Dr. Balance Amount (`) 2,72,00,000 2,72,00,000 … NIL 2,72,00,000 … NIL 94 Financial Accounting for Management Calls-in-Arrears Account… Date 2006 Voucher No. August 31 Folio No…. Particulars J. F. To equity share first call Amount (`) Credit Dr./Cr. 8,00,000 Total… 8,00,000 … IDBI FD 1775 Account… Date 2006 September Debit Dr. 8,00,000 Dr. 8,00,000 Folio No…. Voucher No. Particulars 4 Balance Amount (`) J. F. To IDBI–Satyadeep Housing – Call Money Total… Amount (`) Debit Credit Dr./Cr. 2,72,00,000 Dr. 2,72,00,000 Dr. 2,72,00,000 2,72,00,000 … Balance Amount (`) Now follows the trial balance. SOLUTION TO ILLUSTRATION 4 4.3 SATYADEEP HOUSING INFRASTRUCTURE LTD. TRIAL BALANCE AS ON 31ST AUGUST 2006. Amount (`) Account Heads L. F. Cash Debit Credit 2,000 Equity Share Capital 21,20,00,000 IDBI CA 325 3,48,000 Preliminary Expenses 16,50,000 IDBI FD 1234 9,00,00,000 Public Issue Expenses 1,45,00,000 IDBI FD 1465 3,55,00,000 IDBI FD 1536 4,20,00,000 Calls-in-Arrears 8,00,000 IDBI FD 1775 2,72,00,000 Total… 21,20,00,000 21,20,00,000 Chapter 4 Measurement of Profit and Financial Position: IV 95 Presentation of share capital in the balance sheet: Share capital of Satyadeep Housing Infrastructure Ltd. will be disclosed in the balance sheet of the company as illustrated here. ILLUSTRATION 5 SATYADEEP HOUSING INFRASTRUCTURE LTD. PRESENTATION OF SHARE CAPITAL IN THE BALANCE SHEET As on 31st August 2006 Liabilities Share Capital Authorised: 3 crore equity shares of ` 10 each. Issued: 2.50 crore equity shares of ` 10 each. Subscribed: 2.40 crore equity shares of ` 10 each. Called-Up: • 1 crore equity shares-` 10 each • 1.40 crore equity shares-` 8 each Paid-Up: • Called-Up capital as above • Less: Calls-in-Arrears Amount (`) 30,00,00,000 25,00,00,000 24,00,00,000 10,00,00,000 11,20,00,000 21,20,00,000 21,20,00,000 8,00,000 21,12,00,000 Note: Only the paid-up capital will be added to other liabilities in the full balance sheet. Rests of the capital details are included for information only. Forfeiture of shares: Suppose in the above illustration Satyadeep Housing Infrastructure Ltd. decides, on 30 September 2006, to forfeit the 4 lac shares on which first call money of ` 2 each has not been paid by 100 shareholders. The implications of this decision mean: n These 4 lac shares will be treated as if unsubscribed. n ` 24 lacs already paid by the shareholders stand forfeited. n Calls-in-Arrears of ` 8 lacs are automatically no more due from the shareholders. Therefore the following entry will be passed to give effect to forfeiture: Dr… Equity Share Capital Cr… Calls-in-Arrears Cr… Equity Shares Forfeited (4 lac shares forfeited due to non payment of first call money.) ` 32,00,000 ` 8,00,000 ` 24,00,000 96 Financial Accounting for Management The directors are free to issue these shares to any other person/s now. Share capital of Satyadeep Housing Infrastructure Ltd. will now be disclosed in the balance sheet of the company as under. ILLUSTRATION 6 SATYADEEP HOUSING INFRASTRUCTURE LTD. PRESENTATION OF SHARE CAPITAL IN THE BALANCE SHEET ON FORFEITURE OF SHARES As on 30th September 2006 Liabilities Share Capital Authorised: 3 crore equity shares of ` 10 each. Issued: 2.50 crore equity shares of ` 10 each. Subscribed: 2.36 crore equity shares of ` 10 each. Called-Up: • 1 crore equity shares-` 10 each • 1.36 crore equity shares-` 8 each Paid-Up: • Called-Up capital as above • Add: Amount Paid-up on Shares Forfeited Amount (`) 30,00,00,000 25,00,00,000 23,60,00,000 10,00,00,000 10,88,00,000 20,88,00,000 20,88,00,000 24,00,000 21,12,00,000 Notes: 1. Now 1.36 crore shares are shown as subscribed as against 1.40 crores before forfeiture. 2. Companies follow the practice of showing the amount paid-up on shares forfeited as a reserve also. For example, see annual report 2005-06 of Sona Koyo Steering Systems Limited at www. sonagroup.com. Issue of shares for consideration other than cash: When a company purchases another business or merges another company into itself, it may issue share capital in lieu of paying cash. Likewise instead of cash a company may issue its shares in consideration for some other asset purchased. For example, suppose Satyadeep Housing Infrastructure Ltd. purchases land worth ` 1.50 crores on 10th October, the seller agrees to take equity shares of the company in lieu thereof and accordingly it issues 15 lac equity shares. The effect of this transaction will be recorded as under: Dr… Land Cr… Equity Share Capital (15 lac shares issued in lieu of land purchased.) ` 1,50,00,000 ` 1,50,00,000 Chapter 4 Measurement of Profit and Financial Position: IV 97 Preference share capital The accounting treatment of preference share capital is exactly the same as illustrated above for equity capital. The only change will be in the nomenclature, that is, the word ‘Preference’ will replace the word ‘Equity’ in all the related account heads. The new account heads will be: n Preference Share Application n Preference Share Allotment n Preference Share First Call n Preference Share Second Call n Preference Share Capital CASE 2 Rallis India Limited We now present the case of Rallis India Limited to make you understand how a company having equity as well as preference share capital discloses the same in its balance sheet. REPORT Rallis India Limited Annual Report 2005–06 WWW www.rallis.co.in SHARE CAPITAL ` lacs As at 31st March, 2006 As at 31st March, 2005 Schedule 1. Share Capital Authorised: 50,000,000 Equity Shares of ` 10/-each 5,000.00 150,000,000 Cumulative Redeemable Preference Shares of ` 10/-each 5,000.00 15,000.00 15,000.00 20,000.00 20,000.00 Issued and Subscribed: 11,984,593 Equity Shares of ` 10/- each Add: Amount paid-up on forfeited shares 88,000,000 7.5% Cumulative Redeemable Preference Shares of ` 10/- each 1,198.46 0.02 1,198.46 1,198.48 0.02 1,198.48 8,800.00 8,800.00 9,998.48 9,998.48 Notes: 1. Of the above Equity Shares, 2,604,140 shares of ` 10/-each were allotted as fully paid-up pursuant to contracts without payment being received in cash and 1,144,700 shares of ` 10/- each were issued as fully paid up Bonus Shares by capitalisation from General Reserve. 2. 7.5% Cumulative Redeemable Preference Shares of ` 10/- each, of an aggregate value of ` 880, 000,000/-were allotted on a “Private Placement” basis on 3rd February, 2004. The preference shares are redeemable at the end of 66 months from the date of allotment. 98 Financial Accounting for Management Observations and discussions on the share capital of Rallis India Limited now follow. 1. The authorized capital has not mentioned the rate of dividend on preference shares which means that the company can decide the same at the time of issue. 2. The company has not used the terms ‘Called-up’ and ‘Paid-up’, just ‘Issued and Subscribed’. This shows diversity in corporate financial practices. 3. A negligible amount of ` Two thousands has been forfeited on equity shares. 4. 26,04,140 equity shares have been issued for consideration in kind. 5. 11,44,700 equity shares have been issued as bonus shares. More on bonus issue later in this chapter. 6. Thus Rallis India Limited has received cash on only 82,35,753 equity shares. 7. This is a unique case having more preference capital than equity. 8. Unlike equity shares, preference shares have not been issued to public. The prefix 7.5% indicates the rate of dividend payable thereon. Form of Financial Statements Vertical format of the balance sheet and statement of profit and loss of companies has been prescribed in Schedule III to the Companies Act, 2013. We will study the requirements of Schedule III in detail in the chapter on ‘Generally Accepted Accounting Principles’. It is, however, essential at this stage to understand the simpler and compressed version of horizontal form of corporate balance sheet and statement of profit and loss for a manufacturing/trading company so as to be able to understand the vertical format later on with relative ease. Balance Sheet of ……………(Name of the Company) as at ……………..… Figures for the Previous Year (`) Liabilities Figures for the Figures for the Current Year Previous Year (`) (`) Assests Figures for the Current Year (`) …. Share Capital …. …. Fixed Assets … …. Reserves and Surplus …. …. Investments …. …. Secured Loans …. …. Current Assets …. Unsecured Loans …. …. Loans and Advances: …. Current Liabilities …. and Provisions: …. …. A. Current Liabilities …. …. B. Provisions .… A. Current Assets …. …. B. Loans and Advances …. …. Miscellaneous Expendi- …. ture (to the extent not written off or adjusted) Profit and Loss Account .… Total …. …. Total …. …. .… Chapter 4 Measurement of Profit and Financial Position: IV 99 Profit and Loss Account of ……………(Name of the Company) for the Year Ended ............ Expenses Figures for the Current Year (`) Figures for the Previous Year (`) Opening Inventory Purchases net of returns Wages Other manufacturing/ trading expenses expenses Gross Profit c/d Total… Salaries Administrative and selling expenses Interest charges Depreciation/amortization Preliminary Exps. w/o Provision for Income Tax Net Profit c/d Total… Transfer to General Reserve/other reserves …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. …. Proposed Dividend: • Preference shares • Equity shares Surplus Carried to Balance Sheet Total… Income Sales net of returns Closing Inventory Total… Gross Profit b/d Other income Total… Balance in the profit and loss account as on the 1st day of the year Net Profit for the year b/d Total… Figures for the Current Year (`) …. …. Figures for the Previous Year (`) …. …. …. …. …. …. …. …. …. …. …. …. …. …. Some Features of Financial Statements 1. It may be observed that a company has to provide previous year’s figures as well to facilitate comparison for analysis. 2. A company, being a separate legal entity, is liable to pay income tax on its prof its irrespective of the income of its shareholders. Hence income tax expense is provided for in the prof it and loss account. 3. Net prof it earned by the company after providing for dividend is disclosed under the heading ‘Reserves and Surplus’. Dividend exceeding 10% of the paid-up capital can be declared only after transferring the prescribed percentage of current year’s net prof it to general reserve. The idea behind creating general reserve is to restrict the distribution of prof its so that the company could fall back upon them in future when needed. Reserves and surplus belong to the equity shareholders just like the net prof it belongs to the proprietor and partners in the case of non-corporate entities as seen in the earlier chapter. 100 Financial Accounting for Management 4. ‘Miscellaneous Expenditure’ on the assets side reflects revenue expenses capitalised, and charged to revenue over a number of years, to the extent not written off. Preliminary expenses, that is, company formation expenses and public issue expenses are common examples. 5. Loss is shown in the assets side below the head ‘Miscellaneous expenditure’ or deducted from revenue reserves under the head ‘Reserves and Surplus’. 6. A company’s prof it and loss account contains the third component known as profit and loss appropriation account. But the practice is to prepare trading, prof it and loss and prof it and loss appropriation accounts in one statement and call it as prof it and loss account. It has also to provide the previous year’s f igures. 7. The f inal f igure of share capital plus reserves and surplus minus miscellaneous expenditure not written off, including the loss, represents total shareholders’ funds. This minus the preference capital represents equity shareholders’ funds or net worth just like the capital of proprietor and partners. Detailed requirements of the Companies Act regarding f inancial statements are discussed in the chapter on generally accepted accounting principles. With this introduction to companies and their accounts, we now illustrate the preparation of f inancial statements of a company. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Why do companies go public? Can a private limited company float a public issue? 2. Compare illustration no. 5 and 6. What are the differences noted by you? Why the final figure of paid-up capital is the same in both the cases? 3. Rallis Indiaan Limited has issued preference shares on private placement basis. Guess who could Now follows illustration on constructing corporate financial statements. be the probable allottees. Try to find out from the annual report. Or, else talk to your professor. 4. Scan a few companies’ balance sheets in their printed annual reports or from their websites to understand the corporate practices in the disclosure of division of capital and types of capital. Discuss. To enrich your discussion, add your own ideas, thoughts and practical inputs. 101 Chapter 4 Measurement of Profit and Financial Position: IV Now follows an illustration on constructing corporate financial statements. ILLUSTRATION 7 MAMTA FASHIONS PVT. LTD. The following is the trial balance of Mamta Fashions Pvt. Ltd. as on 31st March 2006. Sl. No. Account Heads Debit Amount (`) Credit 1 Premises 3,60,800 2 Plant and machinery 4,95,000 3 Opening inventory 1,12,500 4 Debtors 1,06,050 5 Land 87,500 6 Cash in hand 4,725 7 Current account—ABN Amro Bank 45,500 8 Bills receivable 58,875 9 Purchases 10 Preliminary expenses 27,00,000 7,500 11 Wages 86,970 12 General expenses 10,252 13 Salaries 90,338 14 Bad debts 3,165 15 Interest on term loan 27,000 16 Equity share capital 3,00,000 17 10% Preference share capital 1,00,000 18 Secured term loan from Delhi Financial Corporation @ 12% p.a. 4,50,000 19 P&L A/C balance as on 1.04.2005 39,375 20 Bills payable 55,500 21 Creditors 22 Sales 23 General reserve as on 1.04.2005 37,500 24 Central sales tax payable 10,800 83,000 31,20,000 Total… Further information: 1. Authorised share capital of the company is as under: n 1,00,000 equity shares of ` 10 each. n 1,000 preference shares of ` 100 each. 41,96,175 41,96,175 102 Financial Accounting for Management 2. Issued share capital of the company is as under: n 30,000 equity shares. n 1,000 preference shares 3. Depreciation is to be provided for @ 10% on premises and 14% on plant and machinery. 4. 20% of preliminary expenses are to be written off. 5. Interest on term loan is due for six months. 6. Bills receivable ` 25,000 were dishonoured. Effect was not carried out. 7. Doubtful debts are to be provided for ` 3,000. 8. Value of inventory on 31.03.2006 is ` 1, 35,000. 9. Income tax is to be provided for @ 35%. 10. The board of directors recommends dividend on preference shares and a dividend of 12% on equity shares after transferring 5% of net profit to general reserve. Please do the rounding of general reserve to next hundred rupees. Required 1. Prepare the following financial statements of Mamta Fashions Pvt. Ltd.: a. Balance sheet as at 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. The statements are prepared as under: SOLUTION TO ILLUSTRATION 7 7.1a MAMTA FASHIONS PVT. LTD. BALANCE SHEET AS ON 31ST MARCH 2006 Liabilities Amount (`) Assets Share Capital Fixed Assets Authorized: • 1, 00,000 Equity Shares of ` 10 each. • 1,000 10% Preference Shares of ` 100 each. Land Issued, Subscribed, Called-up and Paid-up: • 30,000 Equity Shares of ` 10 each. • 1,000 10% Preference Shares of ` 100 each. Reserves and Surplus Amount (`) 87,500 10,00,000 1,00,000 Premises Less: Dep. @ 10% 3,60,800 36,080 3,24,720 Plant & Machinery Less: Dep.@ 14% 4,95,000 69,300 4,25,700 3,00,000 1,00,000 103 Chapter 4 Measurement of Profit and Financial Position: IV General Reserve: As on 1.04.2005 Add: Created during the year Surplus in P&L A/C 37,500 2,900 Current Assets, Loans & Advances 40,400 47,607 Current Assets: Secured Loans Inventory Term loan from Delhi Financial Corporation Debtors Add: Bills Receivable Dishonoured 4,50,000 1, 35,000 1,06,050 25,000 1,31,050 Less: Provision for Doubtful Debts 3,000 1,28,050 Current Liabilities and Provisions Bills Receivable Less: Dishonoured 58,875 25,000 33,875 A. Current Liabilities: Cash-in-hand 4,725 Current AccountABN Amro Bank 45,500 Creditors 83,000 Bills Payable 55,500 Miscellaneous Expenditure Central Sales Tax Payable 10,800 Preliminary Expenses Less: 1/5th w/o Interest Due on Term Loan 27,000 7,500 1,500 6,000 B. Provisions: Income Tax 30,763 Proposed Dividend 46,000 Total… 11,91,070 Total… 11,91,070 SOLUTION TO ILLUSTRATION 7 MAMTA FASHIONS PVT. LTD. 7.1b&c PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH 2006. Expenses Amount (`) Income Amount (`) Opening Inventory 1,12,500 Sales 31,20,000 Purchases 27,00,000 Closing Inventory 1, 35,000 Wages 86,970 Gross Profit c/d Total… Salaries 3,55,530 32,55,000 90,338 Total… Gross Profit b/d 32,55,000 3,55,530 104 Financial Accounting for Management Interest on Term Loan Add: Interest due 27,000 27,000 General Expenses Depreciation on: • Premises • Plant and Machinery 54,000 10,252 36,080 69,300 Bad Debts 1,05,380 3,165 Provision for Doubtful Debts 3,000 Preliminary Exps. w/o 1,500 Provision for Income Tax 30,763 Net Profit c/d 57,132 Total… 3,55,530 Transfer to General Reserve Proposed Dividend: • Preference shares • Equity shares 2,900 10,000 36,000 Total… 3,55,530 Balance as on 1st April 2005 39,375 Net Profit for the year b/d 57,132 Total… 96,507 46,000 Surplus Carried to Balance Sheet 47,607 Total… 96,507 Notes: 1. Previous year figures omitted in the absence of information. 2. It is always assumed that the land does not depreciate. 3. Schedule VI to the companies act requires disclosure of fixed assets at original cost minus depreciation accumulated to date. In the absence of information such disclosure is not possible. 4. Bills Receivable and Payable: In the business, at times, debtors are realised and creditors are discharged through negotiable instruments, i.e., promissory notes (pronotes) and bills of exchange (bills). A pronote is a written promise by a person (say, V.V. Kapoor Garments Ltd.) to unconditionally pay a certain sum of money on the due date to another person (say, Binod Kumar Textiles Ltd.) or to a person (say, Pranay Kumar Yarns Ltd.) as per that another person’s (i.e. Binod Kumar Textiles Ltd.’s) instructions. A bill represents a written order by a person (say, P.N. Singh Steels Ltd.) to another person (say, A.K.Puri Leaf Springs Ltd.) to unconditionally pay a certain sum of money on the due date to the former (i.e., P.N. Singh Steels Ltd.) or to a person (say, Vivek Kumar Rolling Mill Ltd.) as per the former’s (i.e., P.N. Singh Steels Ltd.’s) instructions and the order duly accepted by the latter (i.e., A.K. Puri Leaf Springs Ltd.). Due dates are decided as per the terms of credit period allowed and availed. When a person gets a promise from or when his order is accepted by his debtor it becomes a bill receivable. When a person gives a promise to or when he accepts the order of his creditor it becomes a bill payable. On receipt of bills receivable and issue of bills payable accounts of concerned debtors and creditors, respectively, are squared and two new accounts bills receivable and bills payable come into existence. By now you should have understood that the former represents an asset and the latter a liability. Chapter 4 Measurement of Profit and Financial Position: IV 105 The advantages of bills receivable and payable are that they: n represent further commitment by the debtors to the creditors, n can be endorsed in favour of other creditors, and n can be discounted with the bank by the holder before their due dates at some charges thus improving the liquidity of the business. 5. Bills Receivable and Payable Dishonoured: When the bills receivable and payable are not paid on the due date, that is, when they are dishonoured they become useless and the original position is restored. It means that the bills receivable and payable accounts are reversed and the accounts of concerned debtors and creditors are reinstated. 6. Provision for Doubtful Debts: This account is part of the provisions on the liabilities side. But the usual practice is to disclose the debtors net of provision. 7. Central Sales Tax Payable: The tax is collected from the customers on sale on behalf of the state government and paid to it periodically. Balance unpaid on a given date represents a liability towards the government. 8. Bad debts appearing in the trial balance mean that debtors have already been written off. 9. Provision for income tax amounting to ` 30,763 has been made @ 35% of ‘net profit before such provision (` 30,763 + 57,132 = ` 87,895)’. It represents a liability towards the government. 10. Balance in profit and loss account as on 1-04-2005 has been taken to profit and loss appropriation account. Could also be taken directly to the liabilities side and current year’s balance then added thereto. 11. 5% of net profit of ` 57,132, that is, ` 2, 857 rounded off to ` 2,900, transferred to general reserve. 12. Proposed dividend represents a liability towards the shareholders. SOLUTION TO ILLUSTRATION 7 7.2 MAMTA FASHIONS PVT. LTD. Analysis of the Performance of the Company Mamta Fashions Pvt. Ltd. has earned a return of 12.76% for the year 2005–06 for its equity shareholders as under: ` Net profit available for equity shareholders: Net profit as per profit and loss account 57,132 Less: Dividend to preference shareholders 10,000 Balance …A 47,132 Equity shareholders’ funds, beginning of the year 2005-06: Equity share capital 3, 00,000 106 Financial Accounting for Management General reserve as on 1.04.2005 37,500 Balance in profit and loss account as on 1.04.2005 39,375 3,76,875 Less : Miscellaneous expenditure not w/o as on 1.04.2005 7,500 Total…B 3,69,375 Return on equity shareholders’ funds …A*100/B 12.76% On the face of it a return of 12.76% is not very encouraging, particularly in view of cost of borrowing of 12%. Also, for analysis purposes, comparison with the last year’s financial statements will reveal whether the company has done better or worse than the preceding year. Again, to know whether it has performed at par with or better or worse than the industry it operates in, financial statements of such other companies also need to be compared. Hence the need for historical trends and industry comparison. Detailed analysis of corporate financial statements along these lines will take place later in one of the parts of the book on Financial Statement Analysis. To put the performance in a different perspective, Mamta Fashions Pvt. Ltd. has earned Earning Per Share (EPS) of ` 1.57, that is, ` 47,132 / 30,000 equity shares. This aspect will be further analysed later in the chapter on Ratio Analysis. Issue of Shares at a Premium A company may issue its shares at a premium as well, that is, at more than their face value provided there are takers for the same. Generally well established companies or new companies promoted by well established companies are able to raise premium. In such a case the liability of the company CASE 3 Reliance Petroleum Ltd. Consider the following case of Reliance Petroleum Ltd. on premium issue. RELIANCE PETROLEUM LTD. Capital Raised Through IPO in April 2006 Reliance Petroleum Ltd. (RPL) issued 180 crore equity shares 0f ` 10 each for ` 60 each, that is, at a premium of ` 50 each during April 2006 for cash as under: n 45 crore to Pre-IPO investors comprising Foreign Institutional Investors, Indian Financial Institutions and Banks, and n 135 crore through IP0, out of which 90 crores to its promoter company Reliance Industries Limited and rest to public. It thus raised a total of ` 10,800 crores through these two transactions. That apart Reliance Industries Limited had earlier, that is, before the IPO, subscribed to 270 crore equity shares of the company at par. In the balance sheet of RPL the effect of these transactions will be disclosed as under: Rupees in Crores Equity Capital-Issued, subscribed and paid up: 450 crore equity shares of ` 10 each. 4,500.00 Out of above: n 270 crore shares of ` 10 each issued at par. n 180 crore shares of ` 10 each issued at a premium of ` 50 each. Reserves and Surplus: Share premium 9,000.00 (Source: Red Herring Prospectus of RPL dated 5th April 2006. Chapter 4 Measurement of Profit and Financial Position: IV 107 towards its shareholders is limited to face value of the shares or the amount paid towards face value in case of partly paid up shares. For example, you have already seen in the earlier case of Hindalco Industries Ltd. that the company charged a premium of ` 95 on every share of Re. 1 each. Let us look at another case. Bonus Shares As discussed earlier, accumulated profits and reserves belong to the equity holders. At times, companies issue shares to them without any consideration, that is, out of the accumulated profits and reserves. For example, in the case of Mamta Fashions Pvt Ltd. it has accumulated ` 88,007 in general reserve and surplus in profit and loss account. On 15 May 2006 the company decides to issue 6,000 equity shares to its equity shareholders by capitalising part of this amount. Such shares are known as bonus shares. Every equity shareholder of Mamta Fashions Pvt Ltd. will get 1 bonus share for every 5 shares held by him. The effect of this transaction will be as under: 1. Equity share capital will increase to 36,000 shares, that is, to ` 3,60,000, that is, by ` 60,000. 2. General reserve of ` 40,400 will reduce to zero. 3. Balance ` 19,600 will be drawn out of surplus of ` 47,607 in profit and loss account thus reducing it to ` 28,007. Hence, the following journal entry will be recorded to give effect to the above: Dr… General Reserve Dr… Profit and Loss Account Cr… Equity Share Capital (6,000 shares issued as bonus shares.) ` 40,400 ` 19,600 ` 60,000 You have noted earlier that Rallis India Ltd. has issued 11, 44,700 equity shares as bonus shares. We hope the case is now more clear to you. We now proceed with another illustration on constructing corporate financial statements. ILLUSTRATION 8 SHASHAANK INDUSTRIES LIMITED The following is the trial balance of Shashaank Industries Ltd. as on 31st March 2006. Sl. No. 1 2 3 4 5 6 Account Heads Cash-in-hand Current account—Punjab National Bank Income tax paid in advance Factory building Plant and machinery Vehicles Debit 13,440 33,020 2,45,000 8,98,800 11,49,470 87,500 Amount (`) Credit 108 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 Financial Accounting for Management Furniture Preliminary expenses Debtors Share capital Calls-in-arrear Creditors Secured term loan from Bank of India @ 15% p.a. Balance in profit and loss a/c as on 1st April 2005 Inventory as on 1st April 2005 Wages Manufacturing expenses Purchases Purchase return Freight inwards Freight outwards Interest on loans Electricity and power—factory General office expenses Directors’ meeting fees Salaries—office Auditors’ fees Managing directors’ remuneration Electricity and power—office Office rent Sales Sales return Working capital limit from Bank of India—secured Fixed deposits—unsecured loans-Long term-@15% p.a. Bad debts Prepaid expenses Advances to employees Interest on advances Advertising expenses Investment in equity shares of Reliance Industries Ltd.-Long term Expenses payable Goodwill Total... 72,500 21,000 11,50,800 15,00,000 5,000 6,45,540 4,50,000 60,480 13,04,940 7,68,180 1,34,680 47,84,500 68,950 34,370 64,820 2,27,000 99,470 60,270 12,000 2,55,000 8,750 1,32,480 23,800 60,000 81,89,300 88,480 9,85,250 2,03,000 12,500 31,500 15,000 1500 1,50,000 50,000 10,250 1,20,000 1,21,14,270 1,21,14,270 Further information: 1. Authorised share capital of the company consists of 2,50,000 equity shares of ` 10 each. The company has issued 1,50,000 shares. 2. Value of inventory as on 31st March 2006: ` 8,73,880. 3. One third of preliminary expenses to be written off. Chapter 4 Measurement of Profit and Financial Position: IV 109 4. Interest is due on term loan for 3 months. 5. Doubtful debts to be provided for @ 5%. 6. Interest due on advances to employees: ` 500. 7. Inventories destroyed by fire: ` 45,000. Claim admitted by the insurance company: ` 40,000. 8. Purchases include ` 50,000 towards purchase of a computer on 1st April 2005. 9. Electricity and power—factory includes ` 2,450 relating to office. 10. Advertising expenses are expected to provide long-term benefit for three years. 11. One third of goodwill to be amortized. 12. Depreciation to be provided for @ 10% on building, 18% on furniture, 26% on vehicles, 14% on plant and machinery and computers. 13. Commission payable to the managing director @ 3% of net profit before charging commission. 14. Income tax to be provided for @ 40%. 15. The board of directors recommends a dividend of 15% after transferring 10% of net profit to general reserve. Required 1. Prepare the following financial statements of Shashaank Industries Ltd.: a. Balance sheet as on 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. SOLUTION TO ILLUSTRATION 8 8.1a SHASHAANK INDUSTRIES LTD. Balance Sheet as on 31st March 2006 Liabilities Amount (`) Assets Amount (`) Share Capital Fixed Assets Authorized 2,50,000 equity shares of ` 10 each. Goodwill Less: 1/3rd Amortised 1,20,000 40,000 Factory Building 8,98,800 Less: Dep. @ 10% 89,880 Issued, Subscribed, called and Paid-up: 1,50,000 equity shares of ` 10 each. Less: Calls-in-Arrear 80,000 25,00,000 15,00,000 5,000 14,95,000 8,08,920 110 Financial Accounting for Management The statements are prepared as under: Reserves and Surplus General Reserve Balance in P & L A/C Plant & Machinery Less: Dep.@ 14% 11,49,470 1,60,926 9,88,544 40,034 Computer Less: Dep. @ 14% 50,000 7,000 43,000 1,96,536 Furniture Less: Dep. @ 18% 72,500 13,050 59,450 Vehicles Less: Dep. @ 26% 87,500 22,750 64,750 Secured Loans Term Loan from Bank of India 4,50,000 Investments Working Capital Limit from Bank of India 9,85,250 Equity Shares of Reliance Industries Ltd.-Long term Unsecured Loans Fixed Deposits-Long term 2,03,000 A. Current Assets: Current Liabilities and Provisions Inventory A. Current Liabilities: Debtors Less: Provision for Doubtful Debts Creditors 6,45,540 Expenses Payable Add: Commission Payable to MD 20,636 Interest Due on Term Loan Proposed Dividend 8,73,880 11,50,800 57,540 10,93,260 Due from Insurance Co. 40,000 Cash-in-hand 13,440 Current Account—Punjab National Bank 33,020 10,250 30,886 16,875 B. Provisions: Income Tax Less: Advance Tax Paid 50,000 Current Assets, Loans & Advances 2,66,893 2,45,000 B. Loans & Advances: 21,893 2,24,250 Prepaid Expenses 31,500 Advances to Employees Add: Interest Accrued 15,000 500 15,500 21,000 7,000 14,000 Miscellaneous Expenditure Preliminary Expenses Less: 1/3rd W/o Total 43,09,264 Deferred Advertising Expenses 1,00,000 Total 43,09,264 111 Chapter 4 Measurement of Profit and Financial Position: IV SOLUTION TO ILLUSTRATION 8 SHASHAANK INDUSTRIES LTD. 8.1b&c PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH 2006 Expenses Amount (`) Income Opening Inventory 13,04,940 Sales Less: Sales Return Closing Inventory Purchases Less: Purchase Return Less: Inventories Destroyed in fire Less: Computer 47,84,500 68,950 45,000 50,000 Freight Inwards Amount (`) 81,89,300 88,480 81,00,820 8,73,880 46,20,550 34,370 Wages 7,68,180 Manufacturing Expenses 1,34,680 Electricity and Power— Factory Less: Related to Office 99,470 2,450 Gross Profit c/d 97,020 20,14,960 Total 89,74,700 Total Salaries 2,55,000 Gross Profit b/d Managing Director’s Remuneration 1,32,480 Interest on Advances Add: Interest Accrued Directors’ Meeting Fees Interest on Loans Add: Interest due on Term Loan Depreciation: n Plant and machinery n Factory building n Vehicles n Computer n Furniture 12,000 2,27,000 16,875 2,43,875 1,60,926 89,880 22,750 7,000 13,050 2,93,606 Amortisation of Goodwill Electricity and Power—Office Add: Trd. from Factory 40,000 23,800 2,450 26,250 Office Rent 60,000 General Office Expenses 60,270 89,74,700 20,14,960 1,500 500 2,000 112 Financial Accounting for Management Advertising Expenses Less: Expenses Deferred 1,50,000 1,00,000 50,000 Freight Outwards 64,820 Bad Debts 12,500 Provision for Doubtful Debts 57,540 Preliminary Exps. W/o 7,000 Auditors’ Fee 8,750 Loss due to fire 5,000 Managing Director’s Commission 20,636 Provision for Income Tax 2,66,893 Net Profit c/d 4,00,340 Total 20,16,960 Total 20,16,960 Transfer to General Reserve 40,034 Balance as on 1st April 2005 60,480 Proposed Dividend 2,24,250 Balance Carried to Balance Sheet 1,96,536 Total 4,60,820 Net Profit for the year b/d Total 4,00,340 4,60,820 Notes 1. Previous year figures omitted. 2. Bad debts, prepaid expenses and expenses payable appearing in the trial balance mean that related adjustments have already been made. 3. Provision for income tax has been shown net of advance tax. 4. Goodwill represents an intangible asset. 5. Advertising expenses have been deferred over two years in future. It is an example of creation of a fictitious asset. 6. Loss of inventory due to fire is not a trading loss. Hence, shown in profit and loss account. 7. Commission payable to the managing director has been calculated @ 3% of ‘net profit before such commission and provision for income tax (` 20,636 + 2,66,893 + 4,00,340 = ` 6,87,869)’. 8. Provision for income tax has been made @ 40% of ‘net profit before such provision (` 2,66,893 + 4,00,340 = ` 6,67,233)’. 9. 10% of net profit of ` 4,00,340 transferred to general reserve. 10. Dividend provided for @ 15% on paid-up share capital net of calls-in-arrears. Chapter 4 Measurement of Profit and Financial Position: IV 113 SOLUTION TO ILLUSTRATION 8 8.2 SHASHAANK INDUSTRIES LTD. Analysis of the Performance of the Company Shashaank Industries Ltd. has earned a return of 26.09% for the year 2005–06 for its equity shareholders as under: 2005–06 ` Net profit as per profit and loss account … A 2004–05 ` 4,00,340 … Equity share capital, net 14,95,000 14, 95,000 Balance in profit and loss account 1,96,536 60,480 Equity shareholders’ funds, year end: General reserve 40,034 … 17,31,570 15,55,480 Less : Miscellaneous expenditure not w/o 1,14,000 21,000 Net worth…B 16,17,570 15,34,480 26.09% … ` 2.68 … ` 83,090 or, 5.41% … … ` 10.82 ` 10.26 Return on equity shareholders’ funds (return on net worth or RONW)…A*100/ 15,34,480 EPS…A/1, 49,500, being the effective number of shares. Growth in equity shareholders’ funds (16,17,570 – 15,34,480).… or, 83,090 * 100/15,34,480 Book value or net worth per share…B/1,49,500 Though last year’s figures are not available, yet it may be reasonably concluded that current year’s performance of the company has been far better in view of the following: No balance in the general reserve as on 1.04.2005 signifying that the company has never paid a dividend exceeding 10%. n A low accumulated balance of ` 60,480 in the profit and loss account as on 1.04.2005. n On the face of it a return of 26.09% is really commendable. However to know whether the company has performed at par with or better or worse than the industry it operates in, financial statements of such other companies need to be compared. Shareholder’ funds, and hence the book value per share, have grown despite proposed dividend and heavy advertising expenses. 114 Financial Accounting for Management Now we illustrate a loss case to enable you understand how the loss is treated in the corporate financial statements. ILLUSTRATION 9 ITPL FINANCE LIMITED The following is the trial balance of ITPL Finance Limited as on 31st March 2006. Sl. No. Account Heads Debit 1 Share capital 2 Share premium 3 Investments : Equity shares of NDFC Ltd. 4 Cash at bank in current account 5 Fixed deposits with banks 6 Cash in hand 1,256 7 Tax deducted at source 37,420 8 Expenses payable 9 Preliminary expenses 10 Balance in profit and loss account, 1-04-2005 11 Loss on sale of investments 12 Interest on fixed deposits with banks 13 Bank charges Amount (`) Credit 4,00,00,000 1,00,00,000 49,75,000 18,550 10,55,367 21,050 32,840 4,28,23,210 11,25,775 54,278 110 14 Legal and professional charges 4,600 15 Stationary 1,200 Total… 5,00,75,328 Further information: 1. Authorised share capital of the company is 50,00,000 equity shares of ` 10 each. 2. 20,00,000 shares were issued at a premium of ` 5 each. 3. Interest accrued on fixed deposits with banks for the year ` 364. 4. Audit fee for the year payable ` 5,000. 5. Other expenses payable for the year: n Legal and professional charges ` 4,400 n Travelling and conveyance expenses ` 2,250 6. Preliminary expenses to be written off ` 16,420. 5,00,75,328 Chapter 4 Measurement of Profit and Financial Position: IV 115 Required 1. Prepare the following financial statements of ITPL Finance Limited: a. Balance sheet as at 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. The statements are prepared as under: SOLUTION TO ILLUSTRATION 9 9.1a ITPL FINANCE LIMITED BALANCE SHEET AS ON 31ST MARCH 2006 Amount (`) Liabilities Share Capital Investments Authorised: 50,00,000 Equity Shares of ` 10 each. 5,00,00,000 Issued, Subscribed, Called-up and Paid-up: 40,00,000 Equity Shares of ` 10 each. Out of above, 20,00,000 shares issued at a premium of ` 5 each. Equity shares of NDFC Ltd. 49,75,000 Current Assets, Loans & Advances 4,00,00,000 Reserves and Surplus Current Assets: Share premium 1,00,00,000 Cash-in-hand Current Liabilities and Provisions Cash at bank in current account A. Current Liabilities: Fixed deposits with banks Add: Interest accrued Expenses payable Add: n Audit fee n Legal and professional charges n Travelling and conveyance Amount (`) Assets 21,050 1,256 18,550 10,55,367 364 10,55,731 Loans & Advances: 5,000 4,400 2,250 32,700 Tax deducted at source 37,420 116 Financial Accounting for Management Miscellaneous Expenditure, to the extent not W/O Preliminary Expenses Less: W/O 32,840 16,420 Balance in Profit and Loss: A/C Total… 5,00,32,700 16,420 4,39,28,323 Total… 5,00,32,700 SOLUTION TO ILLUSTRATION 9 ITPL FINANCE LIMITED 9.1b&c PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH 2006. Expenses Amount (`) Loss on sale of investments 11,25,775 Bank charges 110 Legal and professional charges Add: Payable 4,600 4,400 1,200 Audit fee 5,000 Travelling and conveyance 2,250 11,59,755 Balance as on 1st April 2005 4,28,23,210 Total… 54,278 364 54,642 Net loss for the year c/d 11,05,113 Total… 11,59,755 16,420 Total… Net loss for the year b/d Interest on fixed deposits with banks Add: Interest accrued Amount (`) 9,000 Stationary Preliminary Exps. w/o Income Balance carried to balance sheet 4,39,28,323 11,05,113 4,39,28,323 Total… 4,39,28,323 Note: ITPL Finance Limited being a finance company, trading account can not be prepared. Chapter 4 Measurement of Profit and Financial Position: IV 117 SOLUTION TO ILLUSTRATION 9 9.2 ITPL FINANCE LIMITED Analysis of the Performance of the Company ITPL Finance Limited has suffered a loss of ` 11,05,113 during the year 2005–06. It has earned a negative EPS of Re. 0.28. Accumulated losses have led the financial position of the company to be in a bad shape as its net worth has reduced to ` 60,55,257 as under: ` ` Equity shareholders’ funds as on 31st March 2006: Equity share capital 4,00, 00,000 Share premium 1,00, 00,000 5,00,00,000 Less: Balance in profit and loss account 4,39,28,323 Miscellaneous expenditure not w/o 16,420 Net worth… 4,39,44,743 60,55,257 It means that initial investment of shareholders, i.e., ` 5,00,00,000 has been wiped out to the extent of ` 4,39,44,743. Book value of a share of ` 10 therefore stands at a meager ` 1.51. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Bring out the distinctive features of corporate financial statements vis-à-vis non-corporate entities. 2. Discuss the value of bills receivable for the business. 3. Discuss the benefits of premium issue to the issuer company. 4. Discuss the benefits of bonus issue to the shareholders. 5. When accumulated loss reduces the net worth, why it is not disclosed by way of deduction from share capital in the balance sheet? Opine. To enrich your discussion, add your own ideas, thoughts and practical inputs. RECAP OF ADJUSTMENTS We have discussed and illustrated in the earlier as well as in this chapter a large number of adjustments to the figures appearing in the trial balance in order to measure the true profit and financial position of an enterprise. To recap, the list is as under: 1. Depreciation on fixed assets 2. Closing inventory 3. Expenses due but not paid 118 Financial Accounting for Management 4. Prepaid expenses 5. Bad debts 6. Income accrued but not received 7. Write off of preliminary expenses 8. Provision for doubtful debts 9. Bills receivable dishonoured 10. Loss due to fire 11. Correction in classification of capital expenditure as revenue expense 12. Inter-transfer from trading account to profit and loss account 13. Deferment of revenue expenditure 14. Amortisation of intangible assets 15. Managerial remuneration 16. Provision for income tax 17. Proposed dividend 18. Transfer to general reserve These are the most common adjustments. CONCLUDING REMARKS This chapter initiated you into the peculiarities of corporate businesses and determination of their financial performance and position. It is hoped that by now you have developed a reasonably fair practical understanding of corporate financial statements. You should now be in a firm position to further this understanding and appreciate and command the nuances of corporate financial statements, reporting and analysis, for business decision making, which will be discussed and illustrated in great detail and depth from the next chapter onwards. Keywords n n Forfeiture n Preliminary Expenses n Allotment Money Application Money n Authorized Share Capital n Bonus Shares n Call Money n Called-up Capital n Calls-in-Arrears n Dividend n Earning Per Share (EPS) n Equity Share Capital n General Reserve n Preference Share Capital n Generally Accepted Accounting n Profit and Loss Appropriation Principles n Intangible Asset n Issued Capital n Listed Company n Memorandum of Association n One-man Company n Paid-up Capital Account n Public Issue n Rights Issue n Share Certificate n Subscribed Capital Chapter 4 Measurement of Profit and Financial Position: IV 119 1. Taxmann’s Companies Act, Taxmann Allied Services (P.) Ltd., New Delhi, 2015. 2. Guide to the Companies Act, A. Ramaiya, Wadhwa and Company, Nagpur, 2014. REPORT WWW 1. Hindalco Industries Ltd., Annual Report, 2005–06. 2. Sona Koyo Steering Systems Limited, Annual Report, 2005–06. 1. Bombay Stock Exchange, www.bseindia.com 2. Ministry of Company Affairs, Government of India, www.mca.gov.in 3. Rallis India Ltd., www. rallis.co.in 4. Sona Koyo Steering Systems Limited, www.sonagroup.com. 5. Hindalco Industries Ltd., www.hindalco.com Reliance Petroleum Limited, Red Herring Prospectus, April 2006. Capitaline Plus 120 Financial Accounting for Management exercises Ex. 1 SANJAY INDUSTRIES LTD. Balance Sheet and Income Statement The following is the trial balance of Sanjay Industries Ltd. as on 31st March 2006. Accounts Dr. (`) Stock, 1st April 2005 Cr. (`) 6,75,000 Sales 30,60,000 Wages 2,70,000 Share capital (Authorised Capital 2,00,000 shares of ` 10 each) 9,00,000 Discount 27,000 Purchases 22,05,000 Carriage inward 8,550 Purchases returns 90,000 Patents & trademark 43,200 Salaries 67,500 Bills receivable 45,000 Sundry expenses 63,450 Bills payable 63,000 Rent 36,000 Debtors & creditors 2,47,500 Plant & machinery 2,61,000 Furniture & fittings 1,53,000 Cash at bank 4,15,800 General reserve 1,57,500 1,39,500 Profit & loss account, 31st March 2005 54,000 Total 44,91,000 Further information 1. Outstanding rent amounted to ` 7,200 while outstanding salaries ` 8,100 at the end of the year. 2. Make a provision for doubtful debts amounting to ` 4,590. 3. Stock on 31st March 2006 was valued at ` 7,92,000. 4. Depreciate plant & machinery @ 14% and furniture & fittings @18%. 5. Amortise patents & trademarks @ 5%. 44,91,000 Chapter 4 Measurement of Profit and Financial Position: IV 121 6. Provide for managerial remuneration @ 10% of the net profits before tax. 7. Make a provision for income tax @ 35%. 8. The Board of Directors proposes a dividend @ 10% for the year ended 31st March 2006 after transfer to General Reserve @ 5% of profit after tax. Required 1. Prepare the following financial statements of Sanjay Industries Ltd.: a. Profit and loss account for the year ended 31st March 2006. b. Profit and loss appropriation account for the year ended 31st March 2006. c. Balance sheet as on 31st March 2006. 2. Briefly comment upon the performance of the company. Ex. 2 SANGEETA UDHYOG LTD. Balance Sheet and Income Statement The following is the trial balance of Sangeeta Udhyog Ltd. as on 31st March 2006. Accounts Dr. (`) Stock, 1st April 2005 14,91,360 Wages 8,77,920 Debtors & creditors 13,15,200 Furniture 57,45,680 Carriage inwards 39,280 Returns 1,01,120 Advance payment of income tax 1,14,320 Bank loan-Secured-Long term Interest on loan 36,000 69,440 15,360 13,13,680 Plant & machinery 10,27,200 Loose tools 1,00,000 74,080 Share capital Calls-in-Arrear Rates & electricity—factory Office expenses 78,480 4,00,000 Leasehold factory building Carriage outwards 93,59,200 1,53,920 Profit & loss account, 1st April 2005 Cash-in-hand 7,37,760 40,000 Purchases & sales Manufacturing expenses Cr. (`) 32,00,000 8,000 1,40,880 64,000 122 Financial Accounting for Management Director’s fees & remuneration 96,000 Office salaries & expenses 1,04,000 Auditors’ fees 10,000 Machinery repairs 34,880 Commission 39,120 Bank current account 8,54,880 Preliminary expenses 48,000 Total 1,38,44,880 1,38,44,880 Further information 1. The authorised share capital of the company consists of 4,00,000 equity shares of ` 10 each. 2. The stock was valued at ` 9,98,720 and loose tools at ` 80,000. 3. Wages ` 15,120 and office salaries ` 9,600 are due. 4. Bank loan was taken on 1-04-2005 on interest @ 15% p.a. 5. Depreciation is to be provided on: 1. Plant & Machinery @ 14%; 2. Furniture @ 18%. 6. Write off one-third Preliminary Expenses. 7. Provide ` 68,000 on Debtors for Doubtful Debts. 8. Provide further ` 24,960 for discount on debtors. 9. Make a provision for income tax @ 35%. 10. Transfer 10% of net profits to General Reserve. 11. The Directors recommend dividend @ 10% per annum for the year ended 31st March 2006. Required 1. Prepare the following financial statements of Sangeeta Udhyog Ltd.: a. Profit and loss account for the year ended 31st March 2006. b. Profit and loss appropriation account for the year ended 31st March 2006. c. Balance sheet as on 31st March 2006. 2. Briefly comment upon the performance of the company. Ex. 3 PUSHPA ENGINEERING COMPANY LTD. Balance Sheet and Profit and Loss Account The accountant of Pushpa Engineering Company Ltd. has prepared the following trial balance of the company as on 31st March, 2006. Accounts Dr. (`) Dr. (`) Equity share capital 70,00,000 9% debentures- secured 15,00,000 Chapter 4 Measurement of Profit and Financial Position: IV 123 General reserve 25,00,000 Bank overdraft-ABN Amro Bank-secured 15,28,600 Sundry creditors 14,61,400 Sales 1,44,68,500 Rent 1,20,000 Other income 25,500 Profit & loss A/c 2,68,000 Calls-in-Arrears 40,000 Stock, 1-04-2005-finished goods 6,87,300 Stock, 1-04-2005-raw materials 9,73,000 Raw materials purchased 59,29,700 Rebates and discounts 1,20,800 Carriage inwards 2,29,200 Rates, taxes and insurance 2,20,200 Wages 52,19,800 Coal and fuel 2,52,000 Furniture and fixtures 6,50,000 Freehold land 52,00,000 Plant & Machinery 29,50,000 Engineering tools 6,65,000 Patterns 14,35,000 Goodwill 15,00,000 Sundry debtors 10,64,000 Bills receivables 5,38,000 Advertisement 60,000 Commission 2,70,000 General expenses 2,24,000 Bank current A/c—ABN Amro Bank 1,70,000 Cash in hand 70,000 Interest 3,64,000 Preliminary expenses 40,000 Total… 2,88,72,000 2,88,72,000 Further information 1. Authorised equity share capital of the company is ` 100 lacs divided into 10,00,000 shares of ` 10 each. The company has issued 7,00,000 shares. 2. The closing stocks of finished goods and raw materials were valued at ` 12,40,000 and ` 15,92,000 respectively. 3. The closing stocks of engineering tools was valued at ` 5,32,000. 4. Outstanding liabilities for wages and general expenses: ` 1,00,000 each. 124 Financial Accounting for Management 5. Depreciation to be charged: plant and machinery @ 14%, patterns @ 20%, furniture & fixtures @ 18%. 6. Provide 2% on debtors as doubtful debts after writing off ` 86,000 as bad debts. 7. Write off preliminary expenses ` 20,000. 8. Provide income tax @ 35%. 9. Create debenture redemption reserve of ` 3,00,000. 10. Dividend @ 10% on equity proposed by the board of directors. Required 1. Prepare the following financial statements of Pushpa Engineering Company Ltd.: a. Balance sheet as at 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. (Hint: Debenture redemption reserve is appropriated out of profits just like general reserve for the purpose of meeting the debenture redemption liability.) Ex. 4 MAHESH FOODS LTD. Balance Sheet and Profit and Loss Account Following trial balance as at 31st March 2006 has been prepared from the account books of Mahesh Foods Ltd. Accounts Dr. (`) Share capital Dr. (`) 24,00,000 Cash in hand 37,200 Repairs & maintenance—plant 51,600 General reserve 6,00,000 Profit and loss account 10,60,000 Raw materials inventory, 31.03.2006 16,02,000 Plant and machinery 25,80,000 Sundry creditors Land Furniture 18,40,000 4,80,000 73,200 Sundry debtors 10,40,000 Rent 1,31,800 Prepaid expenses 27,600 Advances from customers Power and fuel 3,00,000 1,52,800 Travelling and conveyance 94,600 Auditors’ fees 39,000 Cash at bank 2,48,000 Chapter 4 Measurement of Profit and Financial Position: IV Advances to staff 125 31,800 Misc. Income 3,72,600 Finished goods inventory, 1.04.2005 18,60,000 Raw materials 1,71,60,000 Sales 2,53,80,000 Building 4,44,600 Salaries 42,20,000 Wages 17,65,000 Deposits with govt. authorities 2,68,400 Cash credit-Indian bank-secured 4,00,000 Bank interest 45,000 Total… 3,23,52,600 3,23,52,600 Further information 1. The authorized capital of the company is 3 lac equity shares of ` 10 each of which 2.40 lac shares have been issued. 2. The closing stock of finished goods is valued at ` 33,50,000. 3. Depreciation to be charged: plant and machinery @ 14%, furniture & fixtures @ 18% and building @ 10%. 4. Provide for income tax @ 35%. 5. Transfer to general reserve @ 5% of net profit. Round off to next higher 100 rupees. 6. A dividend of 15% is recommended by the board of directors. Required 1. Prepare the following financial statements of Mahesh Foods Ltd.: a. Balance sheet as at 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. (Hint: Raw materials inventory, 31.03.2006, ` 16,02,000 appearing in the trial balance means that raw materials ` 1,71,60,000 represent those consumed, that is, opening inventory plus purchases less closing inventory.) Ex. 5 HINDUSTAN TEXTILES LTD. Balance Sheet and Profit and Loss Account The trial balance of Hindustan Textiles Ltd. as at 31st March 2006 is as presented hereunder. Accounts Building Plant and machinery Loose tools Dr. (`) 90,95,500 1,65,60,480 9,40,260 Cr. (`) 126 Financial Accounting for Management Furniture and fittings 3,59,330 Preliminary expenses 4,50,000 Cash in hand 1,49,071 Bank current account 1,50,100 Government bonds at cost 9,88,000 Bills receivable 31,60,900 Motor vehicles 5,50,000 Goodwill 16,00,000 Sundry debtors 20,80,000 Sundry creditors 30,87,209 General reserve 15,00,000 Profit & loss A/c 8,89,760 Bank overdraft—secured 11,18,456 Purchases and returns 8,10,10,200 Advertising 2,54,200 Sales Returns and sales 7,44,800 Legal charges 1,00,000 Carriage inwards 3,70,100 Wages 23,21,400 Rent, rates and insurance 1,90,178 Share capital 5,78,000 10,80,80,345 2,00,00,000 10% debentures—unsecured 1,00,00,000 Opening inventory 47,60,850 Income tax paid in advance 15,00,000 Deposits with excise department 8,00,000 Advances to staff 5,00,000 Trade expenses 1,50,900 Manufacturing expenses 1,35,44,690 Repairs to plant and machinery 86,800 Interim dividend @ 4% 8,00,000 Salaries 10,73,677 Interest on government bonds 40,000 Interest 10,02,334 Total… 14,52,93,770 14,52,93,770 Further information 1. The authorized capital of the company is 30 lakh equity shares of ` 10 each of which 25 lakh shares have been issued. ` 8 per share has been called up. 2. Preliminary expenses to be w/o ` 1,50,000. Chapter 4 Measurement of Profit and Financial Position: IV 3. Depreciation to be charged: n Building @ 10% n Plant and machinery @ 14% n Furniture and fittings @ 18% n Motor vehicles @ 20% 4. Goodwill to be amortised ` 4,00,000. 5. The closing stock of loose tools is valued at ` 7,30,210. 6. Face value of government bonds is ` 10,00,000. They carry interest @ 8% per annum. 7. The closing inventory is valued at ` 54,20,310. 8. Provide for bad debts @ 5%. 9. Interest includes that on debentures for 9 months. 10. Provide income tax @ 35%. 11. A final dividend of 6% is recommended by the board of directors. Required 1. Prepare the following financial statements of Hindustan Textiles Ltd.: a. Balance sheet as at 31st March 2006. b. Profit and loss account for the year ended 31st March 2006. c. Profit and loss appropriation account for the year ended 31st March 2006. 2. Briefly comment upon the performance of the company. Hints: 1. Interest on government bonds to be calculated with reference to their face value. 2. Interim dividend represents that paid during the year itself. 127 5 Vertical Financial Statements of Corporate Entities SHASHAANK INDUSTRIES LTD. BALANCE SHEET AS AT 31-03-20CY EQUITY AND LIABILITIES Shareholders’ Funds Share capital Reserves and surplus Note No. Amount (`) 1 2 14,95,000 1,22,570 16,17,570 Sub-total…. Non-current Liabilities Long-term borrowings Other Long term liabilities Long-term provisions 3 5,85,000 …. ….. 5,85,000 Sub-total…. Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions 4 Sub-total….. TOTAL….. 9,85,250 6,45,540 1,15,761 2,46,143 19,92,694 41,95,264 The corporate financial statements are now required to be presented in vertical form. Hence it is necessary to develop knowledge of how they are constructed. Chapter 5 Vertical Financial Statements of Corporate Entities 129 CHAP T ER O BJ ECT IVES This chapter seeks to enable you to develop knowledge and understanding of: 1 What the vertical form of corporate financial statements is. 2 Key distinctive features thereof. 3 The process through which financial statements are constructed in the new form, and 4 The key merits and demerits of the new form. So that you are better equipped to read and understand corporate annual reports. INTRODUCTION In the last chapter you studied the horizontal form of corporate finanRefer to Taxmann’s cial statements. However the statutory requirements of presenting the Companies Act, 2013 corporate financial statements have been moving towards vertical form for detailed Schedule III. the world over. India is no exception. Earlier Schedule VI to the old Companies Act, 1956 prescribed vertical form of balance sheet (alone). Now Schedule III to the new Companies Act, 2013 has prescribed vertical form for both the balance sheet, different than the old Schedule VI, as well as profit and loss account reterming the later as Statement of Profit and Loss. We will study in this chapter how to construct these vertical financial statements. VERTICAL FORM OF FINANCIAL STATEMENTS An abridged version of the vertical form of the two financial statements is presented hereunder. First the balance sheet: Name of the company…………….. Balance Sheet as at……………… Note No. EQUITY AND LIABILITIES Shareholders’ Funds Share capital Reserves and surplus (Rupees in………) 31-03-20CY 31-03-20PY Sub-total…. ------------- ------------- Sub-total…. --------------------- --------------------- Non-current Liabilities Long-term borrowings Deferred tax liabilities (net) Other Long term liabilities Long-term provisions 130 Financial Accounting for Management Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions Sub-total…. TOTAL….. ------------------------- ------------------------- Sub-total…. --------------------------------- --------------------------------- --------------------------------- --------------------------------- ASSETS Non-current Assets Fixed assets: ……..Tangible fixed assets ……..Intangible fixed assets …….Total fixed assets Non-current investments Long-term loans and advances Deferred tax assets (net) Other non-current assets Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and advances Other current assets Sub-total…. TOTAL………. See accompanying notes to the financial statements. And, now the statement of profit and loss: Name of the company…………….. Statement of Profit & Loss For The Year Ended……….. Note (Rupees in ………) No. 31-03-20CY 31-03-20PY Revenue from Operations: Sales …….. …….. Less: Excise duty …….. …….. Net sales …….. …….. Other operating income …….. …….. Net Revenue from Operations …….. ……. Other Income Total Revenue Expenses: Cost of materials consumed Purchases of Stock-In-Trade …….. …….. ……. ……. …….. …….. ……. ……. Chapter 5 Vertical Financial Statements of Corporate Entities Changes in inventories of finished goods, work-in-progress and stock-In-Trade Employee benefit expenses Finance costs Depreciation and amortization expenses Other expenses Total Expenses Profit before tax Tax expenses Profit after tax See accompanying notes to the financial statements. 131 …….. ……. …….. …….. …….. …….. …….. …….. …….. …….. ……. ……. ……. ……. ……. ……. ……. ……. KEY DISTINCTIVE FEATURES OF THE NEW FORMAT 1. All liabilities and assets have to be classified in to non-curBIRD’S EYE VIEW rent (long term) and current (short term). Secured loans and unsecured loans have now to be disclosed based on their tenVertical Form of Financial ure, i.e., Long-term borrowings and Short-term borrowings. Statements Further the short-term maturities out of non-current borrown Key Distinctive Features of The New ings have to be segregated and shown as other current liabiliFormat ties. Likewise short term portion of non-current liabilities has n Process of Construction of Financial to be segregated and shown as other current liabilities and Statements In The New Form long term portion of current assets has to be shown as other n Merits and Demerits of Vertical non-current assets. Format 2. ‘Miscellaneous Expenditure Not W/O’ and ‘Debit Balance of Statement of Profit and Loss’ have to be shown as deductions under the head ‘Reserves and Surplus’ on the ‘Equity and Liabilities’ side of the balance sheet. Similarly, the balance of ‘Reserves and Surplus’, after adjusting negative balance of surplus, if any, shall be shown under the head ‘Reserves and Surplus’ even if the resulting figure is in the negative. This may even result in shareholders’ funds being a negative figure. 3. Other income has been included in the revenue from operations and divided into operating income and other (non-operating) income. Operating income is incidental to the core operating activities of the company, such as, export incentives, sales of scrap and income from after-sale services etc. That is why it forms part of net revenue from operations. Other (non-operating) income, though earned in the ordinary course of business is not from core operating activities and therefore shown separately such as, dividend income, interest income and net gain/loss on sale of investments. The purpose of this division is to enable the investor analyse the income quality of the company. 4. Purchases of stock-in-trade means purchase of goods traded in or some quantities of manufactured product purchased directly from outside. 5. Allocations and appropriations, out of PAT, such as interim dividend, proposed dividend and tax thereon, bonus shares and transfer to/from reserves etc. have not to be shown in the Statement of Profit and Loss. These details will be shown under the head ‘Reserves and Surplus’ now. The corresponding liability towards proposed dividend and tax thereon will appear under the head current provisions. 132 Financial Accounting for Management BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Differentiate between horizontal and vertical form of financial statements. 2. Identify the key distinctive features of new format other than those discussed above. To enrich your discussion, add your own ideas, thoughts and practical inputs. PROCESS OF CONSTRUCTION OF FINANCIAL STATEMENTS IN THE NEW FORM In the last chapter, illustration of Shashaank Industries Ltd. was provided on constructing the horizontal financial statements. The same illustration is continued here for demonstrating the construction of vertical financial statements. The students may prepare the new format statements either right away from the ‘trial balance and further information provided there’ or convert the horizontal statements in to vertical ones. Whatever way they proceed they will have to identify the items requiring ‘notes’ for providing details of those items. The best way is to draw the bare vertical format of the two financial statements and start giving the note number to the related item starting with ‘note 1’ to share capital, complete the allocation of ‘note nos.’ in the balance sheet and continue with the ‘revenue from operations’ in the statement of profit and loss until the last item. ‘Note No’s can thus be assigned in the following manner: A. B. Item Balance sheet: Share capital Reserves and surplus Non-current liabilities Current liabilities Fixed assets Non-current assets other than fixed assets Current assets Statement of Profit & Loss: Total revenue Cost of materials consumed Purchases of Stock-In-Trade Note No. Changes in inventories of finished goods, work-in-progress and stock-In-Trade Employee benefit expenses Finance costs Depreciation and amortization expenses 11 Other expenses Tax expenses 14 15 Remarks 1 2 3 4 5 6 7 8 9 10 12 13 5 If this item is not applicable in a case, it will not be assigned any note no. If this item is not applicable in a case, it will not be assigned any note no. This figure will come from the note on fixed assets. Chapter 5 Vertical Financial Statements of Corporate Entities 133 Information from different notes may then be traced to the two statements, profit after tax worked out and traced to the note of reserves and surplus, appropriations made and miscellaneous expenditure to the extent not w/o or adjusted deducted and then the two sides of the balance sheet totaled. Hopefully the balance sheet matches if there are no mistakes in the process. It is to be noted that the note on reserves and surplus will be the last to be traced to the balance sheet since profit after tax has to be included there first. VERTICAL FINANCIAL STATEMENTS OF SHASHAANK INDUSTRIES LTD. Let us continue with the illustration of Shashaank Industries Ltd. We have used the term 31-03-20CY for 31st March, 2006 and 01-04-20PY for 1st April, 2005. Please take note of the following further information also: 1. Out of term loan from Bank of India, ` 50,000 is redeemable within one year. 2. Out of long term fixed deposits, ` 18,000 is redeemable within one year. 3. Advances to employees are recoverable after one year. First, the balance sheet. SOLUTION TO ILLUSTRATION 1 1.1a SHASHAANK INDUSTRIES LTD. BALANCE SHEET AS AT 31-03-20CY EQUITY AND LIABILITIES Shareholders’ Funds Share capital Reserves and surplus Note No. Amount (`) 1 2 14,95,000 1,22,570 16,17,570 Sub-total…. Non-current Liabilities Long-term borrowings Other Long term liabilities Long-term provisions 3 5,85,000 …. ….. 5,85,000 Sub-total…. Current Liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions 4 Sub-total….. TOTAL….. 9,85,250 6,45,540 1,15,761 2,46,143 19,92,694 41,95,264 134 Financial Accounting for Management ASSETS Non-current Assets Fixed assets: ……..Tangible fixed assets ……..Intangible fixed assets …….Total fixed assets Non-current investments Long-term loans and advances Other non-current assets 5 6 6 6 Sub-total….. Current Assets Current investments Inventories Trade receivables Cash and cash equivalents Short-term loans and advances Other current assets 19,64,664 80,000 20,44,664 50,000 …. 15,500 21,10,164 7 …. 8,73,880 10,93,260 46,460 31,500 40,000 20,85,100 41,95,264 Sub-total….. TOTAL………. See accompanying notes to the financial statements. Now, the statement of profit and loss. SOLUTION TO ILLUSTRATION 1 1.1b SHASHAANK INDUSTRIES LTD. STATEMENT OF PROFIT & LOSS FOR THE YEAR ENDED 31-03-20CY Note No. Revenue from Operations: 8 Sales Amount (`) 81,00,820 Less: Excise duty …….. Net sales 81,00,820 Other operating income …….. Net Revenue from Operations 81,00,820 Other Income Total Revenue Expenses: Cost of materials consumed Purchases of Stock-In-Trade Changes in inventories of finished goods, work-in-progress and stock-In-Trade Employee benefit expenses Finance costs 2,000 81,02,820 9 10 11 50,51,610 …….. …….. 11,76,296 2,43,875 Chapter 5 Vertical Financial Statements of Corporate Entities 5 12 Depreciation and amortization expenses Other expenses Total Expenses Profit before tax Tax expenses Profit after tax See accompanying notes to the financial statements. 13 135 3,33,606 6,30,200 74,35,587 6,67,233 2,66,893 4,00,340 Note: Previous year figures are not available. Notes to the financial statements: Note 1: Share Capital Amount (`) Authorised: 2, 50,000 equity shares of ` 10 each Issued, Subscribed and Paid-Up: 1, 50,000 equity shares of ` 10 each. Less: Calls-in-arrear 25,00,000 15,00,000 (5,000) 14,95,000 Note 2: Reserves and Surplus Amount (`) A. General Reserve: Created during the year B. Balance in P&L A/C: As on 01-04-20PY Add: Profit after tax for the year 40,034 60,480 4,00,340 4,60,820 (40,034) (2,24,250) 1,96,536 Less: Transferred to general reserve Less: Proposed dividend As on 31-03-20CY Sub-total…. Less: Miscellaneous expenditure not w/o or adjusted: 1. Preliminary expenses Less: 1/3rd W/O 2. Deferred advertising expenses Total…… 21,000 (7,000) (14,000) (1,00,000) 1,96,536 2,36,570 (1,14,000) 1,22,570 Note 3: Non-current Liabilities Amount (`) Long-term borrowings: Term Loan from Bank of India Less: Short term maturity Fixed Deposits- long term Less: Short term maturity 4,50,000 (50,000) 2,03,000 (18,000) Total……. 4,00,000 1,85,000 5,85,000 136 Financial Accounting for Management Note 4: Current Liabilities Amount (`) A. Short-term borrowings: Working Capital Limit From Bank of India B. Trade payables: Creditors C. Other current liabilities: Term Loan from Bank of India: Short term maturity Fixed Deposits: Short term maturity Expenses Payable Add: Commission Payable to MD 9,85,250 6,45,540 Sub-total…. Interest Due on term loan D. Short-term provisions: Income Tax 50,000 18,000 10,250 20,636 30,886 16,875 1,15,761 2,66,893 Less: Advance Tax Paid Sub-total…. Proposed Dividend (2,45,000) 21,893 2,24,250 2,46,143 Note 5: Fixed Assets Book value as on 1-04-PY Amortization/ depreciation for the current year 8,98,800 11,49,470 50,000 72,500 87,500 22,58,270 89,880 1,60,926 7,000 13,050 22,750 2,93,606 A. Tangible fixed assets: Factory Building Plant & Machinery Computer Furniture Vehicles Sub-total…. Amount (`) Net block as on 31-03-CY 8,08,920 9,88,544 43,000 59,450 64,750 19,64,664 B. Intangible fixed assets: Goodwill 1,20,000 40,000 80,000 Sub-total…. 1,20,000 40,000 80,000 Total… 23,78,270 3,33,606 20,44,664 NOTE: The original costs of various fixed assets are not known. Hence disclosures on the basis of book values. Note 6: Non-current Assets Other Than Fixed Assets Amount (`) A. Non-current investments: Equity shares of Reliance Industries Ltd. B. Other non-current assets: Advances to Employees Add: Interest Accrued 50,000 15,000 500 15,500 Chapter 5 Vertical Financial Statements of Corporate Entities 137 Note 7: Current Assets Amount (`) …. 8,73,880 A. Current investments B. Inventories C. Trade receivables Debtors Less: Provision for Doubtful Debts D. Cash and cash equivalents Cash-in-hand Current account-Punjab National Bank E. Short-term loans and advances Prepaid expenses F. Other current assets Due from insurance company 11,50,800 (57,540) 10,93,260 13,440 33,020 46,460 31,500 40,000 Note 8: Revenue from Operations Amount (`) A. Gross Sales Less: Sales return Net sales Other operating income Net Revenue from Operations B. Other Income Interest on advances Add: Interest accrued Total Revenue 81,89,300 (88480) 81,00,820 …….. 81,00,820 …….. 1,500 500 2,000 81,02,820 Note 9: Cost of Materials Consumed Amount (`) 13,04,940 Opening inventory Add: Purchases Less: Purchase Return Less: Inventories Destroyed In Fire Less: Computer 47,84,500 (68,950) (45,000) (50,000) Less: Closing Inventory Cost of materials consumed 46,20,550 59,25,490 8,73,880 50,51,610 Note 10: Employee Benefit Expenses Wages Salaries Managing Director’s Remuneration Managing Director’s Commission Total….. Amount (`) 7,68,180 2,55,000 1,32,480 20,636 11,76,296 138 Financial Accounting for Management Note 11: Finance Costs Amount (`) 2,27,000 16,875 2,43,875 Interest on Loans Add: Interest Due on Term Loan Total….. Note 12: Other Expenses Amount (`) 1,34,680 34,370 64,820 Manufacturing expenses Freight inwards Freight outwards Electricity and power-factory Less: Related to Office General office expenses Directors’ meeting fees Auditors’ fees Electricity and power-office Add: Transferred from Factory Office rent Bad debts Advertising expenses Less: Expenses Deferred Provision for Doubtful Debts Preliminary Exps. W/o Loss Due to Fire 99,470 (2,450) 23,800 2,450 1,50,000 (1,00,000) Total….. 97,020 60,270 12,000 8,750 26,250 60,000 12,500 50,000 57,540 7,000 5,000 6,30,200 Note 13: Tax Expenses Provision for income tax for the year Amount (`) 2,66,893 MERITS AND DEMERITS OF VERTICAL FORMAT The only demerit of vertical format is that it may seem to be more time consuming to draw it then the horizontal form. However this demerit is more than overcome by virtue of its following advantages: 1. Disclosure of sources of funds (equity and liabilities) and their application (assets) at one place. 2. The balance sheet and statement of profit and loss can be accommodated very easily in one A4 size paper each enabling availability of information at a glance. The reader can always refer to the notes to accounts to know the details. 3. Easier and better readability and hence better understandability. 4. Better visual effect, and 5. Facilitation of a quick review and analysis. The vertical financial statements thus enable an analyst grasp the information far more easily and at the same time very comprehensively. Chapter 5 Vertical Financial Statements of Corporate Entities 139 TREATMENT OF ‘MISCELLANEOUS EXPENDITURE NOT W/O’ AND ‘DEBIT BALANCE OF STATEMENT OF PROFIT AND LOSS’ You have been told earlier that ‘Miscellaneous Expenditure Not W/O’ and ‘Debit Balance of Statement of Profit and Loss’ have to be shown as deductions under the head ‘Reserves and Surplus’. Let us illustrate this treatment. Please refer to the illustration of financial statements of ITPL Finance Ltd. in the earlier chapter on ‘Measurement of profit and financial position: IV- Corporate entities’. As you have seen there, the company is a loss making company and therefore a fit case for our purpose here. In the vertical format treatment of the above three items will be made as under instead of as shown there: ITPL FINANCE LTD. Note-2: Reserves and Surplus Share premium Less: 1. Misc. expenditure not w/o: Preliminary expenses Amount (`) 1,00,00,000.00 32,840.00 Less: W/O 2. Debit balance in the statement of profit and loss: Opening balance Add: Net loss for the year Net reserves and surplus 16,420.00 16,420.00 4,28,23,210.00 11,05,113.00 4,39,28,323.00 4,39,44,743.00 (3,39,44,743.00) Shareholders’ funds in the balance sheet on the equity and liabilities side will appear as under: ITPL FINANCE LTD. Notes Shareholders’ Funds: Share capital Reserves and surplus 1 2 Amount (`) 4,00,00,000.00 (3,39,44,743.00) 60,55,257.00 TREATMENT OF TAX EXPENSES Tax expenses have to be divided between current tax and deferred tax. For details, please refer to the chapter on ‘Corporate financial statements along with notes to accounts and significant accounting policies’ in a subsequent part of the book. CONCLUDING REMARKS Having finished this chapter, you can now lay hands on a given company annual report comparatively easily. In one of the succeeding parts of the book, we will introduce you to full set of financial statements of Nestle India Ltd. Hopefully the knowledge gained by you here will enable you to better comprehend those statements. In the meanwhile, the next chapter seeks to take you back to transaction recording in specific day books necessitated by voluminous transactions of a single type, say, purchase, sales, cash and bank etc., particularly in the case of corporate businesses. 140 Financial Accounting for Management Keywords n Assets n Equity and liabilities n Corporate financial statements n Horizontal financial statements n Deferred tax assets n Notes to accounts n Deferred tax liabilities n Revenue from operations n Schedule III to the Companies Act, 2013 n Statement of profit and loss n Vertical financial statements Taxmann’s Companies Act, 2013, Taxmann Allied Services (P) Ltd., New Delhi, 2015. exercises Ex. 1 SANJAY INDUSTRIES LTD. Vertical Financial Statements Refer to the exercise on preparation and brief analysis of financial statements of Sanjay Industries Ltd. as given in the last chapter. Now convert the financial statements in to vertical format. Use the term 31-03-20CY for 31st March, 2006 and 01-04-20PY for 1st April, 2005. Ex. 2 SANGEETA UDHUOG LTD. Vertical Financial Statements Refer to the exercise on preparation and brief analysis of financial statements of Sangeeta Udhuog Ltd. as given in the last chapter. Now convert the financial statements in to vertical format. Take in to account the following further information as well: 1. ` 1, 00,000 of long term bank loan is repayable within one year. Use the term 31-03-20CY for 31st March, 2006 and 01-04-20PY for 1st April, 2005. 6 Specific Day Books Increase in the volume of business often necessitates the maintaining of specific day books for specific voluminous transactions of the same type, more particularly in the case of corporate entities. It is necessary to understand their respective roles. 142 Financial Accounting for Management CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 What necessitates the maintenance of specific day books? 2 What are the various types of specific day books? 3 How to record the transactions therein? 4 How to post the transactions there from in to the ledger? 5 The benefits of maintaining specific day books, and 6 How the cash book particularly serves as a tool of management control systems? INTRODUCTION The last chapter saw the completion of accounting cycle with the construction and analysis of corporate financial statements. This chapter takes you back to recording of transactions for a while. You have noticed that we have illustrated so far the use of only one daybook called Journal for recording various types of business transactions. However, the increase in the volume of business often necessitates the maintaining of specific daybooks for specific voluminous transactions of the same type, more particularly in the case of corporate entities. This chapter is devoted to illustrating such specific day books/journals. SPECIFIC DAYBOOKS/JOURNALS Usually the largest numbers of transactions in a trading/manufacturing business pertain to purchases, sales, bank and cash and therefore the specific day books in most cases relate to these transactions and are Specific Daybooks named with the prefixes of their nature such as: n Purchase Book 1. Purchase book/Purchase day book/Purchase journal n Sales Book 2. Sales book/ Sales day book/Sales journal n Cash Book 3. Cash book/Cash day book/Cash journal If necessitated by the number of transactions related to purchase return and sales return specific day books can be maintained for these transactions as well. Journal itself is termed as ‘Journal Proper’/’ ‘General Journal’ when specific books are maintained. BIRD’S EYE VIEW Purchase Book/Purchase Day Book/Purchase Journal This book records all ‘credit purchase’ transactions. Cash purchase is not entered here as cash transactions are recorded in the cash book. Likewise, if purchase is made by issuing a cheque the transaction will be recorded in the bank book. Purchase book contains the following columns: 1. Date of transaction 2. Transaction no. Chapter 6 Specific Day Books 143 3. Purchase invoice no 4. Name of the supplier (creditor) with details of the transaction 5. L.F., and 6. Amount (`). The amount column is further divided in to three sub-columns namely Break-Up, Net and Cumulative. The illustration of Mittal Loha Company Pvt. Ltd., that follows, demonstrates with some purchase transactions, the format of purchase book and how recording is done in it. ILLUSTRATION 1 MITTAL LOHA COMPANY PVT. LTD. Mittal Loha Company Pvt. Ltd. has been promoted by R.K. Mittal and S.N. Mittal on April 1, 20CY with a share capital of ` 10 lakh. R.K. Mittal has subscribed to the capital to the extent of ` 6 lakh and S.N. Mittal ` 4 lakh. The company enters into the following transactions of purchase during the month. It maintains a purchase book to record all such credit transactions. Please prepare journal proper and purchase book for April. Date Transaction No. Purchase Transactions April 20CY 1 CP001 10 ton scrap @ ` 29 per KG from Darbari Lal & Sons on a credit of 15 days vide invoice no. DLS/36. 11 CP002 15 ton scrap @ ` 31 per KG from Abdulla and Abdulla on a credit of 21 days vide invoice no. AA/April/ 25. Trade discount of 5% agreed. 18 Cash011 10 ton scrap @ ` 28 per KG from Sachin Scrap Dealers for cash vide cash memo no. SSD/Cash/65. 26 CP003 20 ton scrap @ ` 32 per KG from Lal Chand and Brothers on a credit of 1 month vide invoice no. LCB/CR/April/51. 30 CP004 25 ton scrap @ ` 31.50 per KG from Joshi & Narula Ispat Traders on a credit of 1 month vide invoice no. JNIT/April 20CY/51. Please note that: 1. ‘CP’ in the transaction number denotes ‘Credit purchase’. 2. ‘CP001’ denotes ‘First transaction of credit purchase’ and so on. Prefixes are used to distinguish the nature of different transactions for which specific day books and journal proper are maintained. 3. ‘Cash011’ denotes ‘Eleventh cash transaction’ of the month and so on. Solution follows. Please note the following therein: 1. Folio no. J001 in the ‘journal proper’ denotes its first page and so on. 2. L.F. no. L001 denotes ‘First page of the ledger’ and so on. 3. Ledger folios have been allotted as per the chronology of all the transactions (purchases plus others) put together. 144 Financial Accounting for Management SOLUTION TO ILLUSTRATION 1 1.1 MITTAL LOHA COMPANY PVT. LTD. Journal Proper Date Transaction no. 20CY April 1 Cash001 April 18 Cash011 Account Heads Dr….Cash Cr….Share Capital (Share capital contributed by the promoters) Dr.... Purchases Cr.... Cash (Cash purchase of scrap from Sachin Scrap Dealers) L.F. Amount (Dr) L001 L002 10,00,000 L007 L001 2,80,000 Folio no. J001 Amount (Cr) 10,00,000 2,80,000 Now follows the purchase book. Please note that ‘PB001’in the folio no. denotes ‘First page of purchase book’. SOLUTION TO ILLUSTRATION 1 1.2 MITTAL LOHA COMPANY PVT. LTD. Purchase Book for April 20CY Folio No.... PBOO1 Date 20CY April Transaction No. 1 CP001 11 26 30 CP002 CP003 CP004 Purchase Invoice No. Name of Supplier (Creditor) DLS/36 Darbari Lal & Sons 10 ton scrap @ ` 29 per KG on a credit of 45 days Abdulla and Abdulla 15 ton scrap @ ` 31 per KG on a credit of 45 days AA/April/ 25 LCB/CR/ April/51 L.F. Description of the Transaction Less: Trade discount of 5% Lal Chand and Brothers 20 ton scrap @ ` 32 per KG on a credit of 15 days JNIT/April Joshi & Narula Ispat Traders 20CY/51 25 ton scrap @ ` 31.50 per KG on a credit of 15 days Total Credit Purchase from Sundry Creditors.... Amount (`) Break-up Net Cumulative L003 2,90,000 2,90,000 4,41,750 7,31,750 6,40,000 13, 71,750 7,87,500 21,59,250 L004 4,65,000.00 23,250.00 L005 L006 L007 21,59,250 Chapter 6 Specific Day Books 145 Please note that the term ‘Sundry creditors’ means and includes all credit suppliers put together. Another term used for sundry creditors is ‘accounts payable’. Benefits of purchase book Maintaining a separate purchase book offers the following advantages: 1. The need to prepare a separate voucher is obviated. The invoice acts as voucher. 2. Double entry for each credit purchase transaction in the journal proper is obviated. This substantially reduces the chances of mistakes in recording and posting. 3. Purchase book is much more informative than the journal proper. It provides details of invoice no., quantity, rates, credit period and trade discount instantly. 4. Up to date amount of total credit purchase can be viewed at a glance without waiting for posting in the ledger. 5. Daily posting in the ledger is done only for individual suppliers’ (creditors’) accounts. Only one posting has to be done for the total credit purchase of the month in the ledger in purchase account. This enables matching of trial balance as at the end of the month. In case trial balance is to be prepared on a particular day during the month, posting can be done for total purchases till that date. 6. It also serves as a ledger account for all credit purchases. Posting in the ledger: In case of share capital brought in cash, cash a/c and share capital a/c will be posted in the ledger on April 1 as usual. In case of cash purchase, purchase a/c and cash a/c, as usual, will be posted in the ledger on April 18. Posting in the ledger from purchase book will be done on the date of the transaction to the credit of account of individual supplier (creditor). At the end of the month total purchase for the month will be posted in the debit side of the purchase a/c in the ledger. Following scenario emerges after posting: Account...Cash Date Transaction Particulars No. 20CY April 1 Cash001 To share capital April 18 Cash011 By purchases Account...Share capital April 1 Cash001 By cash Account...Darbari Lal & Sons April 1 CP001 By purchases Account...Abdulla and Abdulla April 11 CP002 By purchases Account...Lal Chand and Brothers April 26 CP003 By purchases Account...Joshi and Narula Ispat Traders April 30 CP004 By purchases Account...Purchases April 18 Cash011 To cash 30 To sundry creditors J. F. Folio No. 001 Balance Dr/Cr Amount (`) Dr 10,00,000.00 Dr 7,20,000.00 Folio No.002 Cr 10,00,000.00 Folio No. 003 J001 J001 Amount (`) Debit Credit 10,00,000.00 2,80,000.00 J001 10,00,000.00 P.B.F. PB001 2,90,000.00 Cr PB001 4,41,750.00 Cr PB001 6,40,000.00 Cr PB001 7,87,500.00 Cr 2,80,000.00 21,59,250.00 Dr Dr 2,90,000.00 Folio No....004 4,41,750.00 Folio No....005 6,40,000.00 Folio No....006 7,87,500.00 Folio No....007 2,80,000.00 24,39,250.00 146 Financial Accounting for Management The trial balance of the above transactions will appear as under: MITTAL LOHA COMPANY PVT. LTD. Sl. No. 1 2 3 4 5 6 7 TRIAL BALANCE AS ON 30-04-20CY Account heads Ledger Folio No. Cash Share capital Darbari Lal & Sons Abdulla and Abdulla Lal Chand and Brothers Joshi and Narula Ispat Traders Purchases 001 002 003 004 005 006 007 Total...... Amount (`) Debit Credit 7,20,000.00 10,00,000.00 2,90,000.00 4,41,750.00 6,40,000.00 7,87,500.00 24,39,250.00 31,59,250.00 31,59,250.00 Sales Book/Sales Day Book/Sales Journal This book records all ‘credit sale’ transactions. Cash sale is not entered here as cash transactions are recorded in the cash book. Likewise if sale is affected by way of receiving a cheque straight way the transaction will be recorded in the bank book. Sales book, on the lines of purchase book, contains the following columns: 1. Date of transaction 2. Transaction no. 3. Sale invoice no. 4. Name of the customer (debtor) with details of the transaction 5. L.F., and 7. Amount (`). The amount column is further divided in to three sub-columns namely Break-Up, Net and Cumulative. The illustration of Modern Electronics Ltd., that follows, demonstrates with some sale transactions, the format of sales book and how recording is done in it. Chapter 6 Specific Day Books 147 ILLUSTRATION 2 MODERN ELECTRONICS LTD. Shagun Jain, along with his 6 friends, promotes Modern Electronics Ltd. on April 1, 20CY with a capital of ` 25 lakh. The company enters into the following transactions of sale during the month. It has been advised to maintain a sales book to record all credit sale transactions. Please prepare journal proper and sales book for April. Date Transaction No. Sale Transactions April 20CY 1 CS001 80 TVs @ ` 25,500 per TV to Paramount Builders Ltd. on a credit of 30 days vide invoice no. ME/001. 10 CS002 50 TVs @ ` 26,000 per TV to Amrapali Hotels Ltd. on a credit of 15 days vide invoice no. ME/002. Trade discount 5%. 17 CS003 100 TVs @ ` 31,000 per TV to Super Hospital and Research Centre Ltd. on a credit of 15 days vide invoice no. ME/003. 24 CS004 45 TVs @ ` 29,400 per TV to FMS Business School on a credit of 45 days vide invoice no. ME/004. Trade discount 4%. 30 Bank 012 20 TVs @ ` 28,000 per TV to Reliable Girls Hostel by way of receipt of cheque vide invoice no. ME/Bank/001. Please note that: 1. ‘CS001’ denotes ‘First transaction of credit sale’ and so on. 2. ‘Bank 012’ denotes ‘12th transaction of the bank book’. 3. Rest of the abbreviations in this illustration and its solution follow the same logic as in the case of Mittal Loha Company Pvt. Ltd. 4. Ledger folios have been allotted as per the chronology of all the transactions (sales plus others) put together. Solution follows. SOLUTION TO ILLUSTRATION 2 2.1 MODERN ELECTRONICS LTD. Journal Proper Date 20CY April 1 April 30 Account Heads L.F. Amount (Dr) Dr….Cash Cr….Share Capital (Capital contributed by the promoters) Dr.... Bank Cr.... Sales (Sale of 20 TVs to Reliable Students Hostel against cheque.) L001 L002 25,00,000 L008 L007 5,60,000 Folio no. J001 Amount (Cr) 25,00,000 5,60,000 148 Financial Accounting for Management Now follows the sales book. Please note that ‘SB001’in the folio no. denotes ‘First page of sales book’. SOLUTION TO ILLUSTRATION 2 2.2 MODERN ELECTRONICS LTD. Sales Book for April 20CY Folio No.... SBOO1 Date Transaction 20CY No. Sales Invoice No. April 1 CS001 11 CS002 Description of the Transaction ME/001 Paramount Builders Ltd. 80 TVs @ ` 25,500 per TV on a credit of 30 days. ME/002 Amrapali Hotels Ltd. 50 TVs @ ` 26,000 per TV on a credit of 15 days. Trade discount 5%. 26 CS003 30 CS004 Name of Customer (Debtor) ME/003 Super Hospital and Research Centre Ltd. 100 TVs @ ` 31,000 per TV on a credit of 15 days. ME/004 FMS Business School 20 TVs @ ` 28,000 per TV on a credit of 45 days. Trade discount 4%. Total Credit Sales to Sundry Debtors.... L.F. Amount (`) Break-up Net Cumulative 20,40,000 20,40,000 12,35,000 32,75,000 31,00,000 63,75,000 5, 37,600 69,12,600 L003 L004 13,00,000 65,000 L005 L006 5,60,000 22,400 L007 69,12,600 Please note that the term ‘Sundry debtors’ means and includes all customers, put together, to whom credit sale is made. The other term used for sundry debtors is ‘accounts receivable’. Benefits of sales book purchase book. Maintaining a separate sales book offers the same advantages as the BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What are the benefits of maintaining a sales book? 2. How will you post the transactions from sales day book in the ledger? 3. A business with 4-5 transactions of credit sales per month should maintain a sales book or not? Opine with reasons. To enrich your discussion, add your own ideas, thoughts and practical inputs. Chapter 6 Specific Day Books 149 Cash Book/Cash Day Book/Cash Journal This book records transactions related to cash and/or bank. Depending BIRD’S EYE VIEW upon the volume of transactions a business enterprise may maintain any or more of the four types of following cash books: Types of Cash Books 1. Three column (Comprehensive) cash book. n Three column (Comprehensive) cash 2. Two column cash book. book n Two column cash book 3. Single column (Simple) cash book. n Single column (Simple) cash book 4. Bank book. n Bank book In all these cash books cash receipts, cheques/drafts received and other bank deposits, as applicable, are recorded on the debit side. Likewise cash payments, cheques/drafts issued and other withdrawals from bank, as applicable, are recorded on the credit side. No journal entries are passed for cash/cheque transactions when separate cash book/bank book is maintained. What it implies is that cash/bank accounts are not opened in the ledger. Three column cash book This book records all transactions related to cash, bank and cash discount allowed/received. Its format is as under: Date Account Heads and Description of the Transactions L. F. Debit (Amount `) Receipts/ Cash Deposits Discount Cash Bank Allowed Date Account heads and Description of the Transactions L. F. Credit (Amount `) Payments/ Cash Withdrawals Discount Cash Bank Received The illustration of Vardaan Security Systems Pvt. Ltd., which follows, demonstrates with some transactions, how recording is done in it. ILLUSTRATION 3 VARDAAN SECURITY SYSTEMS PVT. LTD. The organisation maintains a three-column cash book. It submits the details of following cash/bank transactions for the month of May 20CY. Please record them in the cash book. Date Transaction Transactions May 20CY No. 1 ...... Opening balance as per cash book: • 1 1 1 1 2 3 Cash-in-hand ` 1, 25,000 and • Bank balance in IDBI Bank current account ` 10, 90, 000. Cash ` 1, 00,000 deposited in Bank. IDBI Bank charged the account with ` 250 for issuing the cheque book. Made a one month fixed deposit of ` 2, 00,000 @ 9% PA interest rate in the bank. Issued cheque no. 123451. 150 Financial Accounting for Management 6 4 9 5 10 6 17 18 7 8 19 19 22 24 9 10 11 12 27 13 31 14 31 31 15 16 Issued cheque no. 123452 for ` 8, 71,000 to Samrat Security Products Ltd. in full and final payment of ` 8, 80, 000. Received in cash ` 5,000 towards part payment of advance given to an employee Vishnu Hotaa. Received cheque no. 693980 for ` 7, 50,000 drawn on Axis Bank from Lal Chand & Sons. Received cash ` 1, 20,000 net of cash discount of ` 5,000 from Gupta Associates. Received DD no. 758561 for ` 2, 25, 000 drawn on Canara Bank from Kale Khan & Sons in full and final discharge of ` 2, 30,000. Withdrew ` 25,000 from the bank by cheque no. 123453. Paid cash ` 96,000 net of cash discount of ` 4,000 to Saarangi Associates. Issued cheque no. 123454 for ` 10,60, 000 to Ramco Industries Ltd. Received cheque no. 248570 for ` 1, 75, 000 drawn on Punjab National Bank from Radhey Stores. Bank informed that cheque received from Radhey Stores was dishonoured on presentation and charged the account by ` 500. Bank deposited ` 2, 01,500 in the account on maturity of the fixed deposit together with interest. Salary paid to Vishnu Hotaa for the month ` 12,000 vide cheque no. 1234555. Incurred ` 5,500 in cash on purchase of an executive chair The solution follows. SOLUTION TO ILLUSTRATION 3 3 VARDAAN SECURITY SYSTEMS PVT. LTD. Cash Book Folio no. 2 Date 20CY May 1 1 9 Account L. Heads and F. Description of the Transactions Opening Balance To cash (Contra) To Vishnu Hotaa Three-column Cash Book for May 20CY Debit Date Account L. 20CY heads and F. (Amount `) Description May Receipts/Deposits Cash of the Discount Transactions Cash Bank Allowed 1,25,000 10,90,000 1 By bank (Contra) 1,00,000 1 By bank charges 5,000 1 (For cheque book) By fixed deposit (For 1 month @ 9% pa. Cheque no. 123451). Credit (Amount `) Payments/ Cash Withdrawals Discount Cash Bank Received 1,00,000 250 2,00,000 Chapter 6 Specific Day Books 10 To Lal Chand & Sons 7,50,000 6 (Cheque no. 693980. Axis Bank.) 17 18 19 24 31 31 To Gupta Associates (Received in full and final payment.) To kale khan & sons (Received in full and final discharge. DD no. 758561) To bank (Contra) To Radhey Stores (Cheque no. 248570. PNB.) To fixed deposit (Credited to account by the bank on maturity.) To interest 1,20,000 2,24,000 19 6,000 19 By Saarangi Associates 22 By Ramco Industries Ltd. (Cheque no. 123454.) By Radhey Stores 25,000 1,75,000 27 2,00,000 27 8,71,000 (Paid in full and final payment. Cheque no. 124352) By cash cheque no. 123453 (Contra) 5,000 9,000 25,000 96,000 4,000 10,60,000 1,75,000 (Cheque no. 248570 dishonoured.) By bank charges 500 (On cheque dishonoured.) 1,500 31 By salaries 31 (Paid to Vishnu Hotaa for April. Cheque no. 123455.) By Furniture (Credited to account by the bank on maturity of FD.) 31 Grand total.... By Samrat security products 151 2,75,000 25,40,500 11,000 (Purchased one executive chair.) Total.... Closing Balance Grand total....... 12,000 5,500 2,01,500 23,43,750 73,500 1,96,750 2,75,000 25,40,500 13,000 152 Financial Accounting for Management Please note that: 1. Cash balance at any point of time has to be positive, that is, debit balance, for the simple reason that no one can spend more cash than one possesses. At best the cash balance can be zero. Therefore if the cash book shows a negative (credit) balance then it means that there is some error in the book which needs to be corrected. However the bank balances can be negative (credit) also as the firm may enjoy overdraft facility. 2. Cash deposited in or withdrawn from the bank appears on both the sides of the cash book, that is, in cash as well as bank column completing the cross recording in both the accounts on the opposite side. Such transactions are noted in the book as ‘contra entries’. 3. In actual practice, cash book is balanced daily. The illustration here is balanced at the month end for demonstration purpose only. 4. Each entry from the cash book has to be posted to the related account in the ledger. Closing cash balance is directly taken to the trial balance. 5. Cash discount allowed and Cash discount received are not balanced. Rather they are totalled at the month end and then the total is posted in the corresponding ledger account. Two column cash book This book is a lighter version of three column cash book. It records transactions related only to cash and cash discount allowed/received. Its format is as under: Date Account Heads and Description of the Transactions L. F. Debit (Amount `) Cash Cash Receipts Discount Allowed Date Account heads and Description of the Transactions L. F. Credit (Amount `) Cash Cash Payments Discount Received Continuing with the case of Vardaan Security Systems Pvt. Ltd., illustration 4 demonstrates how recording is done therein. ILLUSTRATION 4 VARDAAN SECURITY SYSTEMS PVT. LTD. If the company were following two-column cash book, find out which of the transactions as given in illustration 3 qualify for recording therein and demonstrate how they will be recorded. Solution follows. Transaction No. 1, 5, 7, 9, 10 and 16 qualify for recording in the cash book which is demonstrated hereunder. Chapter 6 Specific Day Books 153 SOLUTION TO ILLUSTRATION 4 4 VARDAAN SECURITY SYSTEMS PVT. LTD. Date Account Heads L. 20CY and Description of F. the Transactions May Opening Balance To Vishnu Hotaa To Gupta Associates 1 9 17 Cash Book Folio no. 2 Two Column Cash Book for May 20CY Debit Date Account heads L. 20CY and Description of F. (Amount `) the Transactions May Cash Cash Receipts Discount Allowed 1,25,000 1 By bank 5,000 1,20,000 5,000 19 By Saarangi Associates (Received in full and final payment.) To bank 19 25,000 31 31 Grand total.... 2,75,000 5,000 Credit (Amount `) Cash Cash Payments Discount Received 1,00,000 96,000 By Furniture (Purchased one executive chair.) Total.... Closing Balance Grand total....... 4,000 5,500 2,01,500 73,500 2,75,000 4,000 Single column (simple) cash book This book is the simplest of all cash books as it records only cash transactions. Cash discounts allowed/received are not recorded here. They are recorded in the journal proper by way of vouchers. The format of this book is as under: Date Account Heads and Description of the Transactions L. F. Debit (Amount `) Receipts Cash Date Account heads and Description of the Transactions L. F. Debit (Amount `) Receipts Cash Continuing with the case of Vardaan Security Systems Pvt. Ltd., illustration 5 demonstrates how recording is done therein. ILLUSTRATION 5 VARDAAN SECURITY SYSTEMS PVT. LTD. If the company were following single column (simple) cash book, find out which of the transactions as given in illustration 3 qualify for recording therein and demonstrate how they will be recorded. 154 Financial Accounting for Management Solution follows. Again transaction No. 1, 5, 7 (without discount allowed), 9, 10 (without discount received) and 16 qualify for recording in the simple cash book as well which is demonstrated hereunder. SOLUTION TO ILLUSTRATION 5 5 Date 20CY May 1 9 17 19 VARDAAN SECURITY SYSTEMS PVT. LTD. Cash Book Folio no. 2 Single-column (Simple) Cash Book for May 20CY Account Heads and L. F. Debit Date Account Heads and L. F. Credit Description of the (Amount `) 20CY Description of the (Amount `) Transactions Receipts May Transactions Payments Cash Cash Opening Balance 1,25,000 1 By bank 1,00,000 To Vishnu Hotaa 5,000 19 By Saarangi 96,000 Associates To Gupta Associates 1,20,000 31 By Furniture 5,500 (Received in full and (Purchased one final payment.) executive chair.) To bank 25,000 31 Grand total.... 2,75,000 Total.... Closing Balance Grand total....... 2,01,500 73,500 2,75,000 Bank book Like single column cash book this book is also a simple book as it records only bank related transactions. Its format is as under: Date Account Heads and Description of the Transactions L. F. Debit (Amount `) Deposits Bank Date Account Heads and Description of the Transactions L. F. Credit (Amount `) Withdrawals Bank Continuing with the case of Vardaan Security Systems Pvt. Ltd., illustration 6 demonstrates how recording is done therein. ILLUSTRATION 6 VARDAAN SECURITY SYSTEMS PVT. LTD. If the company were following single column (simple) bank book, find out which of the transactions as given in illustration 3 qualify for recording therein and demonstrate how they will be recorded. Chapter 6 Specific Day Books 155 Solution follows. Transaction No. 2 to 4, 6, 8, 9 and 11 to 15 qualify for recording in the bank book which is demonstrated hereunder. SOLUTION TO ILLUSTRATION 6 6 Date 20CY May VARDAAN SECURITY SYSTEMS PVT. LTD. Account Heads and Description of the Transactions 1 Opening Balance 1 To cash 10 L. F. Cash Book Folio no. 2 Bank Book for May 20CY Debit Date Account Heads and L. F. Credit (Amount `) 20CY Description of the (Amount `) Deposits May Transactions Withdrawals Bank Bank 10,90,000 1 By bank charges 250 1,00,000 To Lal Chand & Sons 7,50,000 1 6 (Cheque no. 693980. Axis Bank.) 18 To kale khan & sons 24 (Received in full and final discharge. DD no. 758561) To Radhey Stores 31 (Cheque no. 248570. PNB.) To fixed deposit 31 (Credited to account by the bank on maturity.) To interest 2,24,000 19 (For 1 month @ 9% pa. Cheque no. 123451). By Samrat security products (Paid in full and final payment. Cheque no. 124352) By cash 2,00,000 8,71,000 25,000 (Cheque no. 124353) 1,75,000 22 Ramco Industries Ltd. 10,60,000 (Cheque no. 123454.) 2,00,000 1,500 27 By Radhey Stores 27 (Cheque no. 248570 dishonoured.) By bank charges (Credited to account by the bank on maturity of FD.) 1,75,000 500 (On cheque dishonoured.) 31 Grand total.... (For cheque book) By fixed deposit 25,40,500 By salaries (Paid to Vishnu Hotaa for April. Cheque no. 123455.) Total.... Closing Balance Grand total....... 12,000 23,43,750 1,96,750 25,40,500 156 Financial Accounting for Management Benefits of cash book Maintaining a separate cash book offers the following advantages: 1. The need to prepare a separate voucher is obviated. The receipt/payment memo acts as voucher. 2. Double entry for each transaction in the journal is obviated. This substantially reduces the chances of mistakes in recording and posting. 3. It also serves as a ledger account (for cash/bank) for all practical purposes. Control function The cash book serves as a tool of management control systems in following ways: 1. When all business transactions are recorded in the journal, postings there from to the ledger are done at the end of the day. Therefore the cashier has no way to check the correctness of physical cash which he holds. Maintaining a cash book obviates this difficulty as the balance as per the cash book can be matched with physical cash during the day itself. 2. Similar is the case of bank account. The cashier can match the bank balance as per the book with bank statement the next day or whenever he visits the bank or through the internet. This helps in recording those transactions which are left from the cash book. For example bank charges, interest and cheques dishonoured etc. This enables the firm to know to what extent (amount) cheques could be issued. Bank reconciliation statement is also prepared for the purpose periodically. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. If a company banks with 10 banks, it should maintain one bank book for all of them or 10 bank books? Opine with reasons. 2. How will you post the transactions from bank book in the ledger? To enrich your discussion, add your own ideas, thoughts and practical inputs. CONCLUDING REMARKS This chapter initiated you in to the need, maintenance and benefits of specific day books. It is hoped that by now you are well equipped with the practical understanding of businesses and their accounting needs. The next chapter seeks to carry a discussion on the conceptual framework of financial statements. It is hoped that the practical understanding gained by you so far will help you in developing a sound conceptual understanding of what and why of financial statements on the basis of which they need to be prepared and reported. Chapter 6 Specific Day Books 157 Keywords n Accounts payable n General Journal n Sundry debtors n Accounts receivable n Journal Proper n Three column cash book n Bank book n Purchase book n Two column cash book n Cash book n Sales book n Contra entries n Sundry creditors exercises Ex. 1 GUPTA HEALTH PRODUCTS PVT. LTD. Purchase Book Gupta Health Products Pvt. Ltd. has been promoted by Richa Gupta and her associates on April 1, 20CY. The company enters into the following transactions of purchase during the month. It maintains a purchase book to record all such credit transactions. Please prepare purchase book for April. Date April 20CY 2 Transaction No. Purchase Transactions CP001 12 CP002 19 Cash005 25 CP003 30 CP004 30 CP005 300 diabetes monitors@ ` 900 per piece from Accurate Pharmaceutical Ltd. on a credit of 15 days vide invoice no. APL/20. 350 blood pressure monitors @ ` 1325 per piece from Sun Health Appliances Ltd. on a credit of 21 days vide invoice no. SHAL/April/ 29. Trade discount of 7% agreed. 200 BP monitors @ ` 1200 per piece from Baxiran Pharma Ltd. for cash vide cash memo no. BPL/Cash/34. 250 BP monitors @ ` 1455 per piece from Pinlu Laboratories Ltd. on a credit of 1 month vide invoice no. PLL/CR/April/28. 350 diabetes monitors @ ` 950 per piece from Patanjali Health Care Ltd. on a credit of 1 month vide invoice no. PHCL/April 20CY/39. 150 BP monitors @ ` 1425 per piece from Dacila Medical Instruments Ltd. on a credit of 1 month vide invoice no. DMIL/15. 158 Financial Accounting for Management Ex. 2 INNOVATIVE BATHING SOLUTIONS LTD. Sales Book Innovative Bathing Solutions Ltd. has been promoted by Rita Goel and her associates on April 1, 20CY. The company enters into the following transactions of sale during the month. It has been advised to maintain a sales book to record all credit sale transactions. Please prepare sales book for April. Date April 20CY 3 Transaction No. Sale Transactions CS001 9 CS002 14 CS003 21 CS004 25 CS005 30 Bank 012 50 Multi-Function Bath Units (MBUs) @ ` 1, 44,500 per unit to Examo Constructions Ltd. on a credit of 30 days vide invoice no. IBS/001. 60 MBUs @ ` 1, 48,000 per unit to Express Towers Ltd. on a credit of 15 days vide invoice no. IBS/002. Trade discount 4%. 55 MBUs @ ` 1, 49,000 per unit to HRC Studio Apartments Ltd. on a credit of 15 days vide invoice no. IBS/003. 30 MBUs @ ` 1, 51,000 per unit to Saya Apartments Ltd. on a credit of 45 days vide invoice no. IBS/004. Trade discount 2%. 70 MBUs @ ` 1, 51,000 per unit to Superanchal Builders Ltd. on a credit of 21 days vide invoice no. IBS/005. Trade discount 3%. 4 MBUs @ ` 1, 45,000 per unit to D. K. Goel by way of receipt of draft vide invoice no. IBS/ Bank/001. Ex. 3 SUPER COMPUTERS PVT. LTD. Three Column Cash Book The organisation maintains a three-column cash book. It submits the details of following cash/bank transactions for the month of May 20CY. Please record them in the three column cash book. Date May 20CY 1 Transaction No. ...... Transactions Opening balance as per cash book: • 1 1 1 1 2 3 7 4 11 11 5 6 Cash-in-hand ` 1, 80,000 and • Bank balance in ICICI Bank current account ` 12, 46, 950. Cash ` 1, 20,000 deposited in Bank. ICICI Bank charged the account with ` 300 for issuing the cheque book. Made a one month fixed deposit of ` 3, 00,000 @ 9% PA interest rate with the ICICI Bank. Issued cheque no. 125001. Issued cheque no. 125002 for ` 9, 25,000 to HPL Computer Products Ltd. in full and final payment of ` 9, 50, 000. Received in cash ` 10,000 towards part payment of advance given to an employee Ajayanand Das. Received cheque no. 456789 for ` 8, 25,000 drawn on Yes Bank from Fortune Institute of Management. Chapter 6 Specific Day Books 16 20 7 8 20 22 24 25 28 9 10 11 12 13 31 14 31 31 15 16 159 Received cash ` 1, 44,000 net of cash discount of ` 6,000 from Sikka Associates. Received DD no. 910112 for ` 2, 45, 000 drawn on Kotak Mahindra Bank from Indo-Asian Institute of Management in full and final discharge of ` 2, 50,000. Deposited ` 50,000 in the ICICI Bank. Paid cash ` 97,000 net of cash discount of ` 3,000 to Raj Associates. Issued cheque no. 125003 for ` 9, 75, 000 to HPL Computer Products Ltd. Received cheque no. 101112 for ` 2, 25, 000 drawn on State Bank of India from SPG Associates. ICICI Bank informed that cheque received from SPG Associates was dishonoured on presentation and charged the account by ` 450. ICICI Bank deposited ` 3, 02,250 in the account on maturity of the fixed deposit together with interest. Salary paid to Ajayanand Das for the month ` 15,000 vide cheque no. 125004. Incurred ` 8,400 in cash on purchase of a chair and table. Ex. 4 SUPER COMPUTERS PVT. LTD. Two Column Cash Book Continue with ex.3 and record the relevant transactions in the two-column cash book. Ex. 5 SUPER COMPUTERS PVT. LTD. Single Column Cash Book Continue with ex.3 and record the relevant transactions in the simple cash book. Ex. 6 SUPER COMPUTERS PVT. LTD. Bank Book Continue with ex.3 and record the relevant transactions in the bank book. This page is intentionally left blank. PART 2 CONCEPTS AND PRINCIPLES Chapter 7: CONCEPTUAL FRAMEWORK OF FINANCIAL STATEMENTS Chapter 8: GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 7 Conceptual Framework of Financial Statements High Quality Financial Accountin g, Reporting and Analysis Comparability Balancing among Characteristics Completeness Prudence Neutrality Substance over Form Faithful Representation Materiality Relevance Understandability Concepts of Capital, Its Maintenance & Profit Determin ation Recognition and Measurement of the Elements of Fin. Statements ements Financial Stat aracteristics of ns io pt m Qualitative Ch su l As Fundamenta atements Financial St ion Needs Objective of eir Informat Th d an ts ments en te em ta at S St l l ia ia nanc nanc Users of Fi ents of Fi m le E d nts an Compone In the dynamic and complex business environment of the day, it has become imperative to have a strong conceptual framework for accounting and financial statements that sets out the principles and concepts underlying their preparation and presentation. Chapter 7 Conceptual Framework of Financial Statements 163 CHAP T ER O BJ ECT IVES This chapter seeks to enable you to develop knowledge and understanding of: 1 The need for and purpose of conceptual framework of accounting and financial statements. 2 What constitutes the components of financial statements. 3 The objectives served by the financial statements. 4 Who are the users of financial statements and what are their information needs. 5 Assumptions underlying the preparation of financial statements. 6 Qualitative characteristics of financial statements and constraints thereon. 7 What is the true and fair view of financial statements. 8 The definitions of elements of financial statements, when they are recognised and how they are measured. 9 What are the concepts of capital and how they give rise to the concepts of capital maintenance. And thus enabling you to realise that a strong conceptual base is the backbone of financial accounting, reporting and analysis. INTRODUCTION Financial statements, nowadays, are no longer meant for just the promoters or owners of an enterprise. The growing complexities of the modern day business have put heavy demands on the enterprises in the preparation and presentation of their financial statements. These complexities are manifest, for example, in the separation of ownership and management, large scale public participation in the capital without virtually having any say in the functioning of the enterprise, dependence of the enterprise upon the lending institutions, legal interventions; for example of the Companies Act and Income Tax Act, in the preparation and presentation of the financial statements, multiplicity of legislation having a bearing upon them and, worse, pulling in opposite directions at times, divergence between the requirements of accounting treatment and fiscal laws, global fund raising; and, therefore, the global investors’ needs for translation of financial statements in the language that they understand, that is, compliance with the US and international financial reporting standards, increasing pressure for harmonization of financial reporting internationally, introduction of complex financial instruments, emergence of proactive institutional investors, both domestic as well as foreign, general public awareness and ever increasing and, now, predominant role and influence of the regulatory authorities such as Securities and Exchange Board of India (SEBI), Reserve Bank of India (RBI), Insurance Regulatory and Development Authority (IRDA) etc., on the operations of the enterprises. It is not uncommon now to find corporate annual reports running into hundred, two hundred and even more pages. It, therefore, becomes imperative in such a dynamic and complex environment to have a solid conceptual base for financial accounting and the preparation and presentation of financial Visit www.icai.org for a statements. full text of the Framework. In this context we will discuss here the key features of the ‘Framework WWW Click: Resources— for the Preparation and Presentation of Financial Statements’ (Framework) Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI). 164 Financial Accounting for Management PURPOSE OF THE FRAMEWORK The framework, which is not an accounting standard, sets out the principles and concepts that underlie the preparation and presentation of financial statements for external us. The conceptual framework creates a base for financial statements which assists the: 1. Preparers in applying accounting standards and in dealing with topics that have yet to form the subject of an accounting standard. 2. Auditors in forming an opinion as to whether financial statements conform to accounting standards or not. BIRD’S EYE VIEW Purpose of the Framework Assistance to: n Preparers n Auditors n Users of Financial Statements n Accounting Standards Board 3. Users in analysing and interpreting the information contained in financial statements prepared in conformity with accounting standards, and 4. The Accounting Standards Board (ASB) of the ICAI in the development of future accounting standards and in its review of existing ones relating to the preparation and presentation of financial statements for reducing the number of alternative accounting treatments permitted by accounting standards. SCOPE AND COVERAGE For serving the above stated purposes, the framework deals with the following: 1. Components of financial statements. 2. Objective of financial statements. 3. Users and their information needs. BIRD’S EYE VIEW 4. Assumptions underlying the preparation of financial statements. Scope of the 5. Qualitative characteristics that determine the usefulness of information Framework provided in the financial statements and constraints on relevant and relin Components of Financial able information. Statements 6. Definitions, recognition and measurement of the elements that go into n Objective of Financial the construction of financial statements. Statements 7. Concepts of capital and capital maintenance. n Users and Their Information Needs The framework deals with general-purpose financial statements (‘financial statements’) of all reporting enterprises engaged in commercial, n Qualitative Characteristics and industrial and business activities, both in public and private sectors. Such Constraints-on Relevant and financial statements are prepared and presented at least annually with a Reliable Information view to meet the common information needs of a wide range of users for n Elements of Financial whom they are the major source of financial information. Such financial Statements statements, therefore, need to be prepared and presented keeping their n Concepts of Capital and Capital Maintenance needs in view. Special purpose financial reports, for example, prospectuses and computations prepared for taxation purposes are outside the scope of this framework, though, it may be applied in the making of such reports where permitted by their requirements. n Underlying Assumptions 165 Chapter 7 Conceptual Framework of Financial Statements COMPONENTS OF FINANCIAL STATEMENTS Financial statements are the most important part of financial reporting. A complete set of financial statements normally comprises: 1. Balance sheet 2. Statement of profit and loss (or ‘income statement’) 3. Cash flow statement, and 4. Notes to accounts and accounting policies and other statements and explanations including information based on or derived from and to be read with financial statements, for example, segment performance, related party transactions, and managerial remuneration. BIRD’S EYE VIEW Components of Financial Statements n Balance Sheet n Statement of Profit and Loss n Cash Flow Statement n Notes to Accounts and Accounting Policies Items such as directors’ report, chairman’s statement, management discussion and analysis (MDA) and similar items are not considered as financial statements though included in an annual report as its integral parts. The preceding chapters have introduced you to the construction of simple balance sheets and income statements. Construction of cash flow statements will be dealt with in the chapter on Understanding and Constructing Corporate Cash Flow Statement. Advanced analysis of all the components of financial statements will follow from the chapter on Valuation of Fixed Assets onwards. Research in Financial Reporting Consider the case of Tata Motors Ltd. on what financial statements and reports can be presented in the annual report. CASE 1 Tata Motors Ltd. REPORTS RESEARCH IN FINANCIAL REPORTING TATA MOTORS LTD. Annual Report 2012–13 FINANCIAL STATEMENTS AND REPORTS PRESENTED IN THE ANNUAL REPORT Visit www.tatamotors.com, the site of Tata Motors Ltd. Refer to its annual report for the year 2012–13. The report provides the following information. Locate this information at different places in the annual report. Try to apprise yourself. n Financial Statements: 1. 2. 3. 4. Balance Sheet Profit and Loss Statement Cash Flow Statement Notes to Accounts n Statutory Reports: 1. 2. 3. 4. 5. 6. Notice of AGM Directors’ Report Management’s Discussion and Analysis Report on Corporate Governance Secretarial Audit Report Independent Auditors’ Report 166 Financial Accounting for Management n Financial Highlights (voluntary): n Corporate Overview (voluntary): 1. 2. 3. Financial Performance Summarised Balance Sheet and Statement of Profit and Loss Standalone Funds Flow Statement 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. Corporate Information Mission, Vision and Values Chairman’s Statement Board of Directors Delivering Experiences Key Performance Indicators Products and Brands Global Presence Milestones Driving Accountability Focusing on Customers and Products Emphasising Excellence Delivering with Speed Sustainability Awards and Achievements n Consolidated Accounts (that is, including subsidiary companies) n Details of Subsidiary Companies n Summarized Consolidated Balance Sheet and Statement of Profit and Loss BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Why do we need a conceptual framework for financial statements? What is its significance? 2. Why don’t internal users require a framework? 3. Why are statements like directors’ report, chairman’s statement and MDA, not considered as financial statements?.To firm up your opinion study these statements in the annual report of Tata Motors Ltd. 4. Tata Motors Ltd. has provided summarized balance sheet and profit and loss account, financial statistics since the inception of the company in 1945–46 and corporate social responsibility report. What is the purpose served by these reports? To enrich your discussion, add your own ideas, thoughts and practical inputs. Chapter 7 Conceptual Framework of Financial Statements 167 OBJECTIVE OF FINANCIAL STATEMENTS The objective of financial statements is to provide information about the financial position, performance and cash flows of an enterprise to help the various users carry out an evaluation of the ability of the enterprise to generate cash and cash equivalents and of the timing and certainty of generation for necessary decision-making. Financial statements prepared for this purpose meet the common needs of most us. However, they do not provide all the information that users may need as n they largely portray the financial effects of past events n throw little light on the future direction of growth, and n do not necessarily provide non-financial information. Financial statements also show the results of the stewardship and accountability of the management. Based on these results, the present investors may decide to reappoint or replace the management. A discussion on financial position, performance and cash flows follows. Financial position The financial position of an enterprise depends on the economic resources it controls, its financial structure, liquidity and solvency, and capacity to adapt to changes in the environment in which it operates. 1. Economic resources: Information about the economic resources controlled by the enterprise and its capacity in the past to alter these BIRD’S EYE VIEW resources is useful in predicting the ability of the enterprise to generate cash and cash equivalents in the future. Objective of Financial Statements 2. Financial structure: Information about the financial structure of an enterprise is useful in predicting its present and future borrowing Information about: n Financial Position needs, likely success in raising further finance and how future profits — Economic resources and cash flows will be distributed among the financi. — Financial structure 3. Liquidity and solvency: Liquidity means the availability of cash to — Liquidity and solvency meet short-term financial commitments. Solvency means the availn Performance ability of cash to meet long-term financial commitments. Information n Cash Flows about liquidity and solvency is useful in predicting the ability of the enterprise to meet its financial commitments in time. Performance Performance of an enterprise, in particular its profitability, leads to assessment of potential changes in the economic resources that it is likely to control in the future. Information about performance is useful in predicting the capacity of the enterprise to generate internal cash flows and in forming judgements about its effectiveness to employ additional resources generated. Cash flows Cash flows information of an enterprise is useful in evaluating its investing, financing and operating activities. This information is useful in providing the users with a basis to assess the ability of the enterprise to generate cash and cash equivalents and to meet the needs of the enterprise to utilise those cash flows. Three interrelated components of financial statements provide the above information. Balance sheet primarily provides information about financial position; statement of profit and loss about performance; and cash flow statement about cash flows. Notes and supplementary schedules, i.e. notes to accounts and accounting policies, as mentioned earlier, also form an integral part of the three interrelated components of financial statements. 168 Financial Accounting for Management USERS AND THEIR INFORMATION NEEDS The various users of financial statements and other reports included in an annual report and their information needs include: 1. Present and potential investors, being the key stakeholders and risk capital providers, are concerned with the return on their investments and the risks inherent therein. They need information to help them determine whether they should hold or sell their investments or take fresh exposure as well as to assess the ability of the enterprise to pay dividends. 2. Employees and their representative groups need information about the stability and profitability of their employer enterprise. They are interested in information that enables them to assess the ability of the enterprise to provide remuneration, retirement benefits and opportunities of unhindered employment and growth. 3. Lenders need information that enables them to determine whether their loans and the interest thereon will be BIRD’S EYE VIEW serviced in time. Lenders are interested in the long-term solvency of the borrower enterprise. Users of Financial Statements 4. Suppliers and other trade creditors need information n Present and Potential Investors that enables them to determine whether amounts owing n Employees and Their Representative Groups to them will be paid in time. Trade creditors are genern Lenders ally interested in short-term liquidity of the customer n Suppliers and Other Trade Creditors enterprise and its continuance, especially when they n Customers are heavily dependent on the customer. n Governments and Their Agencies n Public 5. Customers need information about the quality of prodn Management ucts, credit policy and the continuance of the supplier n Others: Portfolio Managers, Investment Advisors, enterprise, especially when they are dependent on the Databases, Business Magazines, Economic supplier. Newspapers and Researchers 6. Governments and their agencies are interested in the activities of enterprises, as they require information to regulate the activities of enterprises and determine taxation policies, and to serve as the basis for determination of national income and similar statistics. They also need information for formulating industrial and economic policies, prescribing and strengthening the norms for recognition and measurement of certain expenses, and presenting financial statements. 7. Public need information about the trends and recent developments in the prosperity of the enterprise and the range of its activities, particularly those that affect them. For example, successful enterprises may discharge a lot of social responsibility. 8. Management is interested in the information contained in the financial statements to evaluate its own performance and devise the growth plans for the enterprise. Responsibility for the preparation and presentation of the financial statements of the enterprise also lies with its management. Financial statements provide a basis to the management for IPO valuation, valuation of the company, brand and goodwill and valuation of other companies for the purposes of mergers, acquisitions and takeov. With the capital markets playing a pre-eminent role as the providers of capital to the industry, both equity and debt, a new aggressive class of proactive institutional investors, domestic as well as Chapter 7 Conceptual Framework of Financial Statements 169 foreign, mutual funds, stock exchanges, SEBI, self-regulatory organizations in the capital market, portfolio managers, investment advisors, various databases, business magazines, researchers and research organisations, financial intelligence groups of economic newspapers and investors’ associations, have emerged as the major pressure groups on the listed companies to virtually bare themselves with financial information, which goes much beyond the mandatory requirements. CASE 2 Reliance Industries Ltd. Consider the following case of Reliance Industries Ltd. Most of the given information has been provided by the company in its annual report under the heads ‘Financial Highlights’, ‘Key Indicators’ and ‘Growth without Limits’. REPORT RELIANCE INDUSTRIES LTD. Annual Report 2005–06 USERS AND THEIR INFORMATION NEEDS Abridged Financial Information Sl. No. Financial Highlights 2005–06 (` in crores) 2004–05 (` in crores) 1. Turnover 89,124 73,164 2. Profit before Interest and Tax - PBIT (Company’s capacity to meet interest liability) 11,581 10,538 3. Interest 877 1,469 4. Profit before Tax (PBT) 10,704 9069 5. Provision for Taxation 1,635 1,497 6. Profit After Tax (PAT) 9,069 7,572 7. Equity Dividend 100% 75% 8. Equity Share Capital 1,393 1,393 9. Reserves and Surplus 48,411 39,010 10. Net Worth 11. Market Capitalisation (Value of Total Equity Capital in the Capital Market) 12. Number of Employees 13. Employees’ Remuneration 14. Per Employee Remuneration 15. Contribution to National Exchequer 49,804 40,403 1,10,958 76,079 12,540 12,113 978 846 ` 7.8 lacs ` 6.98 lacs 15,950 13,972 65.1 54.2 Key Indicators 16. Earnings Per Share – ` 170 Financial Accounting for Management 17. Book Value Per Share – ` 357.4 289.9 18. Debt: Equity Ratio (Long-term Debt to Net Worth) 0.44:1 0.46:1 19. Net Profit Margin % (PAT to Turnover) 10.2 10.3 20. RONW% 22.7 21.9 21. Current Ratio (Current Assets to Current Liabilities) 22. Credit allowed to Customers 1.49:1 1.66:1 17 days 20 days Share In India’s Economy 2.8% of India’s GDP 23. Revenues equivalent to… 24. Exports equivalent to… 8.2% of India’s total exports 25. Indirect taxes paid equivalent to… 8% of Government of India’s indirect tax revenues Discharge of Social Responsibility 26. Charity and Donation 25.70 38.31 USE OF THIS INFORMATION TO VARIOUS STAKEHOLDERS This entire information is of common use to all the users since it informs them about the performance of the company. However some information is of specific use to different users: Users Specifically Useful Information n Present and Potential Investors Sl. No. 7, 11, 16,17,19, 20 n Employees Sl. No. 12, 13,14 n Lenders Sl. No. 2, 3, 18 n Suppliers Sl. No. 21 n Customers Sl. No. 22 n Government Sl. No. 5, 15, 23, 24, 25 n Public Sl. No. 5, 12,15, 23, 24, 25, 26 n Management Sl. No. 1, 6, 10, 11 ASSUMPTIONS UNDERLYING PREPARATION OF FINANCIAL STATEMENTS In order to serve their objectives, financial statements are prepared on the basis of three fundamental assumptions: 1. Accrual Basis: According to this assumation, the effects of transactions and other events are recognised when they occur, and not when cash or cash equivalent is received or paid, and reported in the financial statements of the corresponding periods. You would recall that the application of this assumption was amply illustrated in the chapter on Measurement of Profit and Financial Position I. Financial statements prepared on this BIRD’S EYE VIEW basis inform users not only of past events involving the payment and Assumptions Underlying receipt of cash but also of obligations to pay cash in the future and of Preparation of Financial Statements resources that represent cash to be received in the future. Hence, they n Accrual Basis provide full information about the financial effects of the past transacn Going Concern tions and other events, which is most useful in economic decision-makn Consistency ing of the us. Cash flow statement is, however, prepared on cash basis. Chapter 7 Conceptual Framework of Financial Statements 171 2. Going Concern: It is normally assumed that an enterprise will continue in operation for the foreseeable future. Hence, it has neither the intention nor the need to liquidate or curtail materially the scale of its operations. If such an intention or need exists, the financial statements may have to be prepared on a different basis with its disclosure. You would recall that the application of this assumption, and its far reaching implications for the financial statements, were amply illustrated in the chapter on Measurement of Profit and Financial Position II. 3. Consistency: In order to achieve comparability of the financial statements of an enterprise over time, the accounting policies are followed consistently from one period to another. A change in an accounting policy is made only in certain exceptional circumstances that need to be disclosed. QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS Qualitative characteristics are the attributes that make the information BIRD’S EYE VIEW provided in financial statements useful to us. The four principal qualitative Qualitative characteristics are: Characteristics of Financial 1. Understandability: Information provided in the financial stateStatements ments must be readily understandable. For this purpose, it is n Understandability assumed that users have a reasonable knowledge of business, econ Relevance nomic activities, and accounting and they study the information n Materiality with reasonable diligence. However, information about complex n Reliability: matters that should be included in the financial statements because — Faithful representation of its relevance to the decision-making needs of users should not — Substance over form be excluded merely on the ground that it may be too difficult to — Neutrality understand. In recent years, complexity in the financial statements — Prudence has been on the rise. For example, accounting issues such as — Completeness — Comparability mentioned hereunder, at times, pose difficulty to the readers in understanding them: n Deferred income tax n Diluted earnings per share n Impairment of assets n Employee stock option plans n Finance lease n Research for and development of intangible assets n Effects of changes in foreign exchange rates n Mergers and amalgamations n Related party disclosures n Consolidated financial statements The list is just illustrative. And, there seems to be no end in sight to the growing complexity. In fact it is bound to grow further with accounting bodies, the world over, formulating more and more accounting standards. 172 Financial Accounting for Management 2. Relevance: Information must be relevant to the decision-making needs of us. Information has the quality of relevance when it can influence the decisions of users by helping them evaluate past and present, confirm or correct their past evaluations, and predict future outcomes. Information about financial position and past performance is frequently used as the basis for predicting future financial position and performance. The ability to make predictions from financial statements is enhanced by the manner in which the information is disclosed. For example, the disclosure of unusual, abnormal and infrequent items of income and expense enhances the predictive value of the statement of profit and loss. Examples of such items of income and expense are sale of long term investments, disposal of joint ventures, sale of fixed assets, and one time payment to employees on voluntary retirement and so on. 3. Materiality: Information is material if its misstatement, i.e., either omission or erroneous statement, could influence the decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the item or error, judged in the particular circumstances of its misstatement. Materiality affects relevance. 4. Reliability: Information has the quality of reliability when it is free from material error and bias. Reliability aspect has many implications: (i) Faithful representation: Information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria. At times information may be relevant but so unreliable in representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action against the enterprise are highly uncertain, it may be inappropriate for the enterprise to recognise the amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim by way of a note. (ii) Substance over form: It is necessary to account for and present transactions in accordance with their substance and economic reality and not merely their legal form, in cases where ILLUSTRATION 1 BEST SHOES LTD. MATERIALITY An employee of Best Shoes Ltd. embezzled ` 4,50,000 during the year ended 31st March 2006. The company, instead of treating this amount as a loss, showed it as recoverable from the employee in its balance sheet. The net profit of the company for the year was ` 6,54,78,506. Do you think that this treatment makes any material impact on the assessment of the profitability of the company? OPINION No. Though the prudent treatment would be to treat the embezzled amount as a loss during 2005–06 and show it as income as and when received back, yet a small amount of ` 4.50 lacs makes no material difference to the assessment of the profitability of the company in view of its size vis-à-vis the net profit. Chapter 7 Conceptual Framework of Financial Statements 173 substance and form are not consistent with each other. For example, where rights and beneficial interest in an immovable property are transferred but the documentation and legal formalities are pending, “Substance over Form” demands the recording of acquisition/disposal. (iii) Neutrality: The information contained in the financial statements must be free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the user’s decision-making or judgement in order to achieve a predetermined result. Lots of examples, on how neutrality is shown the backdoor by corporate managements, are illustrated in the chapter on ‘Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in the Financial Statements’. (iv) Prudence: Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, so that assets or income are not overstated and liabilities or expenses not understated. The exercise of prudence, however, does not allow the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses. (v) Completeness: The information contained in financial statements must be complete within the bounds of materiality and cost. Lots of examples, on how the corporate managements hide more than they reveal, are illustrated in the chapter on ‘Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in the Financial Statements’. (vi) Comparability: Users wish and must be able to compare the financial statements of an enterprise through time to carry out trend analysis and to compare the financial statements of different enterprises in order to evaluate their relative strengths and weaknesses. Hence, it is important that the: n Financial statements show corresponding information for the preceding period. n Accounting policies are followed consistently. n Users are informed of the accounting policies, employed in the preparation of the financial statements, any changes in those polices with reasons and the effects of such changes. n Accounting standards are complied with. The need for comparability is not allowed to become an impediment to the introduction of improved accounting policies. It is not appropriate for an enterprise to continue a particular accounting policy in the same manner if it is not in keeping with the characteristics of relevance and reliability and when more relevant and reliable alternatives are available. Constraints on Qualitative Characteristics However, there are certain constraints on the supply of relevant and reliable information. These are striking a balance between 1. Timeliness and reliability 2. Benefit and cost, and 3. Qualitative characteristics themselves. True and Fair View Financial statements are frequently described as showing a true and fair view of the financial position, performance and cash flows of an enterprise. The application of the principal qualitative characteristics 174 Financial Accounting for Management and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view. Definitions, Characteristics, Recognition and Measurement of the Elements of Financial Statements This section of the framework defines and establishes the characteristics of the elements of financial statements, i.e., financial position (assets, liabilities and equity), performance (income and expenses) and cash flows. It further sets the recognition and measurement criteria for them. A detailed discussion on them has already taken place in the earlier chapters. Concepts of Capital and Capital Maintenance Capital is defined in financial and physical terms and so is determined the capital maintenance. Financial concept allows the reporting of financial statements at historical cost. Physical concept is used when there is a need to present them in terms of current purchasing power of Rupee. The world over historical cost based financial statements alone are recognised by the legal and regulatory bodies. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. 2. 3. 4. 5. 6. There may be information required by users, other than investors, which may not be available in the financial statements. Visualise such information needs for each of them. How can they get such information? What are the objectives purported to be served by the financial statements? How do they meet the financial information needs of their various users? Get annual report of a company. Look for the “Notes to Accounts and Accounting Policies”. What kind of financial information do they contain? How does it supplement the information provided by the three main statements? Is accrual basis superior to cash basis in meeting the economic decision-making needs of the users of financial statements? Why or why not? “Qualitative characteristics are the attributes that make the information contained in the financial statements useful to the users.” Examine this statement. Specially discuss the need for and implications of comparability in this context. What is “True and Fair View”? To enrich your discussion, add your own ideas, thoughts and practical inputs. CONCLUDING REMARKS The ‘framework’ thus lays down a strong conceptual foundation to identify, recognise and measure the various elements of financial statements; lists the fundamental assumptions that go into their preparation; elaborates the concepts of capital and capital maintenance having a bearing on the determination Chapter 7 Conceptual Framework of Financial Statements 175 of profit; identifies the key qualitative attributes of the financial statements to make them more useful and provide a true and fair view of the financial position, performance and cash flows of an enterprise to the various interests associated with it to help them in their economic decision-making. A strong conceptual base is the backbone of financial accounting, reporting and analysis. With this understanding, we now move over to the next chapter on generally accepted accounting principles. Keywords n Accounting Policies n Finance lease n Prudence n Accounting Standard n Future Economic Benefits n Qualitative Characteristics of n Annual Report n Going Concern n Cash Flow Statement n International Financial Reporting n Realisable Value n Management Discussion n Retained Earnings n Chairman’s Statement n Current Cost n Current Purchasing Power n Diluted earnings per share n Employee stock option plans Standards and Analysis (MDA) n Matching Principle n Materiality Financial Statements n Related party disclosures n Substance over Form n True and Fair View WWW 1. Framework for the Preparation and Presentation of Financial Statements, ICAI, www.icai.org REPORT 1. Reliance Industries Limited, Annual Report 2005–06. 2. Tata Motors Ltd., Annual Report 2012–13. 176 Financial Accounting for Management exercises Ex. 1 HINDUSTAN INDUSTRIAL CORPORATION LTD. WAC (Written Analysis and Communication) Exercise Mr. G.C. Gupta, the erstwhile Marketing Director of Hindustan Industrial Corporation Ltd., has recently taken over as the Managing Director of the company. He is an engineer by qualification and a marketing genius by profession. Hitherto marketing had been his domain. In that capacity he understands very well the financial impact of marketing activities of the company and so far he had been able to present the sales reports, with their financial implications, in the board meetings of the company. However, he used to get lost when the agenda of the meetings moved to a review of the overall performance and financial position of the company. Now, being the MD, he himself has to carry out such reviews regularly, as well as present them in the board meetings and face queries from the board members on financial matt. He, therefore, feels that he should have a reasonably good understanding of the corporate financial statements. He calls the Chief Financial Officer (CFO) of the company, Mr. Lokesh Gupta, and discusses his requirement with him. The CFO informs him that there exists a strong conceptual framework of financial statements, which, inter alia, assists the corporate management and other users in evaluating the financial position, performance and cash flows of a company. The MD, always eager and willing to learn new things and with an eye for detail, requests the CFO to prepare a brief report containing the gist of the conceptual framework, not exceeding Six A4 size pages with adequate margins and normal space between the paragraphs. Required Suppose you were the CFO. Please make the report. Business reports need to be brief, concise and precise. They also need to be drafted in simple language devoid of any jargon to the best possible extent. Keep these considerations in mind while preparing the gist. Ex. 2 MOC (Managerial Oral Communication) Group Assignment Having understood the contents of this chapter, you, as the manager of Section A comprising 50 students of MBA 1st year course, are required to form groups of five students each. Include yourself in one of the groups. All the groups have to prepare a 20-minute Powerpoint presentation on the contents of this chapter. Take the help of your professor to form a panel of three students from Section B. All the groups have to make the presentation before this panel in the presence of all the students of Section A. After all the presentations are over, the panel has to decide the winner group and the first and second runners-up. Request your professor to lend his supervision to this exercise. 8 Generally Accepted Accounting Principles The corporate accounts and financial statements are prepared and presented on the basis of Generally Accepted Accounting Principles (GAAPs) as being presented above. Effective formulation of GAAPs assumes great importance in view of their far-reaching impact on the quality of reported earnings. 178 Financial Accounting for Management CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 What constitutes generally accepted accounting principles. 2 The requirements of the Companies Act regarding accounts and financial statements. 3 The applicability and scope of and authority attached to the accounting standards issued by the ICAI. 4 The efforts and directives of regulatory bodies like SEBI towards GAAPs. 5 The accounting standards formulated under the Income Tax Act. 6 The status of the harmonisation of the accounting standards at the national level. 7 The requirements of AS-1: Disclosure of Accounting Policies. 8 When the changes in the accounting policies can be made as per AS-5. INTRODUCTION The corporate accounts and financial statements are prepared and presented on the basis of Generally Accepted Accounting Principles (GAAPs). While there is no specific definition of what constitutes GAAPs, the accounts and statements are said to have been drawn and presented on this basis when they comply with the: 1. Conceptual Framework of financial statements. 2. Accounting concepts and principles other than those covered by the Framework. 3. Requirements of Companies Act and rules made thereunder. 4. Accounting standards formulated by the ICAI. 5. Directives of regulatory bodies like the SEBI, RBI, IRDA etc. 6. Requirements of Income Tax Act and rules made thereunder. BIRD’S EYE VIEW These bases may also include the formulation of accountSources of GAAPs ing standards under the Companies and the Income Tax Acts n Conceptual Framework of Financial and by SEBI, and such standards/requirements may at times Statements be at variance with each other and the accounting standards n Accounting Concepts and Principles of ICAI. Other Than Those Covered by the Let us now discuss the GAAPs and their sources. Framework n Requirements of the Companies’ Act and Rules Made Thereunder n Accounting Standards Formulated by the ICAI n Requirements of SEBI n Requirements of Income Tax Act and Rules made Thereunder SOURCES OF GAAPs Conceptual Framework of Financial Statements The contents and requirements of the Framework have already been discussed in the last chapter. Chapter 8 Generally Accepted Accounting Principles 179 Accounting Concepts and Principles Other Than Those Covered by the Framework These concepts have already been discussed in detail in the earlier chapters. Requirements of the Companies Act Various provisions of the Companies Act 2013 regarding accounts and financial statements are mentioned hereunder. BIRD’S EYE VIEW Books of accounts Section 128 of the act provides Requirements of the that: Companies Act 1. Every company needs to prepare and keep at its n Books of Accounts registered office books of accounts and other reln Financial Statements evant books and papers and financial statements n Accounting Standards to be for every financial year Prescribed by the Central 2. Which give a true and fair view of the state Government of affairs of the company, including that of its n Schedule III-Vertical Form of branch ffices and explain the transactions effectFinancial Statements ed both at the registered office and its branches, and 3. Such books need to be kept on accrual basis and according to the double entry system of accounting. 4. Further, the company may keep the books of accounts and papers in electronic mode also. Financial statements Section 129 of the act provides that the financial statements should: 1. Give a true and fair view of the state of affairs of the company 2. Comply with the accounting standards as notified under section 133 of the act 3. Be in the form prescribed in schedule III to the act, and 4. Be in accordance with the accounting standards. Accounting standards to be prescribed by the central government Section 133 of the act empowRefer to 2015 edition of Taxmann’s Companies ers the central government to: Act 2013 for original text 1. Prescribe the standards of accounting as recomof relevant requirements. mended by the Institute of Chartered Accountants of India 2. In consultation with and after examination of the recommendations of National Financial Reporting Authority. Schedule III-Vertical form of financial statements This schedule replaces the erstwhile Schedule VI of the Companies Act 1956 and prescribes the new vertical form of both the Balance Sheet as well as the profit and loss account rechristened as Statement of Profit and Loss. The new formats are as given hereunder: 180 Financial Accounting for Management VERTICAL FORM OF BALANCE SHEET Name of the Company........... Balance Sheet as at................ Note (Rupees in………) No. Figures as at the Figures as at the close of the current close of the previous reporting period reporting period I. EQUITY AND LIABILITIES 1. Shareholders’ Funds a Share capital b c II. Reserves and Surplus Money received against share warrants Sub-total…. 2. Share Application Money Pending Allotment 3. Non-current Liabilities a Long-term borrowings b Deferred tax liabilities (Net) c Other Long term liabilities d Long-term provisions Sub-total…. 4. Current Liabilities a Short-term borrowings b Trade payables c Other current liabilities d Short-term provisions Sub-total…. TOTAL….. ASSETS 1. Non-current Assets a Fixed assets i Tangible assets ii Intangible assets iii Capital work-in-progress iv Intangible assets under development Sub-total…. Non-current investments Deferred tax assets (net) Long-term loans and advances Other non-current assets Sub-total…. Current Assets a Current investments b Inventories c Trade receivables b c d e 2. ----- ----- ----------------- ----------------- --------------------- --------------------- --------------------- --------------------- ----------------- ----------------- ------------------------- ------------------------- ------------- ------------- Chapter 8 Generally Accepted Accounting Principles d e f Cash and cash equivalents Short-term loans and advances Other current assets Sub-total…. TOTAL………. See accompanying notes to the financial statements. --------------------- 181 --------------------- VERTICAL FORM OF STATEMENT OF PROFIT & LOSS I II III IV Name of the company…………….. Statement of Profit and Loss for the Year Ended……….. Note (Rupees in ………) No. Figures for the cur- Figures for the previrent reporting period ous reporting period Revenue from Operations …….. ……. Other Income Total Revenue (I+II) Expenses: 1. Cost of materials consumed 2. Purchases of Stock-In-Trade 3. Changes in inventories of finished goods, work-in-progress and stock-In-Trade 4. Employee benefit expenses 5. Finance costs 6. Depreciation and amortization expense 7. Other expenses 8. Total Expenses V Profit before exceptional and extraordinary items and tax (III – IV) VI Exceptional items VII Profit before extraordinary items and tax (V – VI) VIII Extraordinary items IX Profit before tax (VII – VIII) X Tax expenses: 1. Current tax 2. Deferred tax 3. Total tax XI Profit (Loss) for the period from continuing operations after tax (IX-X) XII Profit/(Loss) from discontinuing operations net of taxes XIII Profit (Loss) for the period after tax (XI + XII) XIV Earnings per equity share (in Rupees): 1. Basic 2. Diluted See accompanying notes to the financial statements. …….. …….. ……. ……. …….. …….. …….. ……. ……. ……. …….. …….. …….. …….. …….. …….. ……. ……. ……. ……. ……. ……. …….. …….. ……. ……. …….. …….. …….. …….. …….. …….. …….. ……. ……. ……. ……. ……. ……. ……. …….. ……. …….. ……. …….. …….. ……. ……. 182 Financial Accounting for Management Vertical Financial Statements of Nestle India Ltd. A subsequent chapter “Corporate Financial Statements” illustrates and discusses at length the balance sheet and statement of profit and loss of Nestle India Ltd. in the vertical form. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What do you understand by GAAPs? 2. Outline the role played by the requirements of the Companies Act towards quality of financial statements. To enrich your discussion, add your own ideas, thoughts and practical inputs. Accounting Standards Formulated by ICAI WWW The Institute of Chartered Accountants of India, recognising the need to harmonise the diverse accounting policies and practices in use in India, and hence to formulate accounting standards, constituted the Accounting Standards Board on 21st April, 1977. The Accounting standards seek to establish the principles and norms of standard benchmark treatment of financial accounting, reporting and disclosure issues which have to be complied with to ensure that financial statements are prepared in accordance with generally accepted accounting standards. Visit www.icai.org. Click: ResourcesAccounting Standards. Refer to ‘Preface to the Statements of Accounting Standards’ for full text of the issues covered here. BIRD’S EYE VIEW Accounting Standards Formulated by ICAI n Accounting Standards Board n Details of the Accounting Standards n Authority Attached to Accounting Standards Accounting Standards Board Accounting standards issued by the ICAI are formulated by its Accounting Standards Board (ASB) after taking into consideration the applicable laws, customs, usages and business environment prevailing in India. Details of the accounting standards The following table provides the list of accounting standards (AS) issued by the ICAI as on date. Chapter 8 Generally Accepted Accounting Principles WWW 183 ACCOUNTING STANDARDS AS No. Title AS-1 Disclosure of Accounting Policies AS-2 Valuation of Inventories AS-3 Cash Flow Statements AS-4 Contingencies and Events Occurring after the Balance Sheet Date AS-5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies AS-6 Depreciation Accounting AS-7 AS-8 AS-9 AS-10 AS-11 AS-12 AS-13 AS-14 AS-15 AS-16 AS-17 AS-18 AS-19 AS-20 AS-21 AS-22 AS-23 AS-24 AS-25 AS-26 AS-27 AS-28 AS-29 AS 30 Construction Contracts Accounting for Research and Development (withdrawn) Revenue Recognition Accounting for Fixed Assets The Effects of Changes in Foreign Exchange Rates Accounting for Government Grants Accounting for Investments Accounting for Amalgamations Employee Benefits Borrowing Costs Segment Reporting Related Party Disclosures Leases Earnings Per Share Consolidated Financial Statements Accounting for Taxes on Income Accounting for Investments in Associates in Consolidated Financial Statements Discontinuing Operations Interim Financial Reporting Intangible Assets Financial Reporting of Interest in Joint Ventures Impairment of Assets Provisions, Contingent Liabilities and Contingent Assets Financial Instruments: Recognition and Measurement and Limited Revisions to AS 2, AS 11 (revised 2003), AS 21, AS 23, AS 26, AS 27, AS 28 and AS 29 Financial Instruments: Presentation Financial Instruments: Disclosures, and limited revision to Accounting Standard (AS) 19, Leases AS 31 AS 32 A large number of accounting standards mentioned above have been discussed and analysed in detail at various places in the book. Of the above accounting standards up to and including AS-29 are mandatory and the other three are non-mandatory. 184 Financial Accounting for Management Authority attached to accounting standards The standards are mandatory in nature and the auditors have to ensure their compliance by the companies in making out their accounts and financial statements. Reporting adequately any non-compliance or deviation is the responsibility of the statutory auditors. These standards have now assumed greater importance and significance in that the company law has thrust the responsibility on the company managements to legally comply with them, as seen earlier, and they thus carry with them the statutory authority now. Convergence with International Financial Reporting Standards (IFRSs) IFRS converged Indian Accounting Standards (Ind ASs) Reliable, consistent and uniform financial reporting is important part of good corporate governance practices worldwide in order to enhance the credibility of the businesses in the eyes of the investors and other stakeholders to take well informed decisions. In tune with the global developments and in pursuance of G-20 commitment given by India the ICAI has prepared the near final IFRS converged 35 Ind ASs, as tabulated below, and sent them to the National Advisory Committee on Accounting Standards (NACAS) of the Ministry of Corporate Affairs, Government of India. These are subject to any changes, which may be made by the ministry before their notification. (This is the situation as on 01-04-2012). Any differences in the Ind AS vis-à-vis. corresponding IFRS are given in Appendix 1 appearing at the end of each Ind AS. IFRS CONVERGED INDIAN ACCOUNTING STANDARDS WWW www.icai.org The Ind AS nos. here correspond to their IFRS counterparts. You will notice that after Ind AS 40, at serial no. 27, the next no. starts with 101. Actually standards issued by the erstwhile International Accounting Standards Committee (IASC) were known as IAS 1 and so on. When the name of IASC was changed to IASB (International Accounting Standards Board) it started issuing standards starting with no.1 again with the prefix of IFRS, e.g., IFRS 1, while retaining the nomenclature of earlier standards as IAS. ICAI has aligned the numbers of its Ind ASs, together with their titles, with those of IASB for ready reference. Just instead of 1 it has used 101. Whether IAS or IFRS, they are all popularly referred to as IFRSs. IASB is the accounting standards setting body of IFRS Foundation. Hence this popularity. Sl. No. Ind AS No. Title 1 2 3 4 5 6 7 8 9 10 11 12 13 Ind AS 1 Ind AS 2 Ind AS 7 Ind AS 8 Ind AS 10 Ind AS 12 Ind AS 16 Ind AS 17 Ind AS 18 Ind AS 19 Ind AS 20 Ind AS 21 Ind AS 23 Presentation of Financial Statements Inventories Statement of Cash Flows Accounting Policies, Changes in Accounting Estimates and Errors Events after the Reporting Period Income Taxes Property, Plant and Equipment Leases Revenue Employee Benefits Accounting for Government Grants and Disclosure of Government Assistance The Effects of Changes in Foreign Exchange Rates Borrowing Costs Chapter 8 Generally Accepted Accounting Principles 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Ind AS 24 Ind AS 27 Ind AS 28 Ind AS 29 Ind AS 31 Ind AS 32 Ind AS 33 Ind AS 34 Ind AS 36 Ind AS 37 Ind AS 38 Ind AS 40 Ind AS 101 Ind AS 102 Ind AS 103 Ind AS 104 Ind AS 105 Ind AS 106 Ind AS 107 Ind AS 108 Ind AS 109 Ind AS 110 Ind AS 111 Ind AS 112 Ind AS 113 Ind AS 114 Ind AS 115 185 Related Party Disclosures Separate Financial Statements Investments in Associates and Joint Ventures Financial Reporting in Hyperinflationary Economies Interests in Joint Ventures Financial Instruments: Presentation Earnings per Share Interim Financial Reporting Impairment of Assets Provisions, Contingent Liabilities and Contingent Assets Intangible Assets Investment Property First-time Adoption of Indian Accounting Standards Share based Payment Business Combinations Insurance Contracts Non- current Assets Held for Sale and Discontinued Operations Exploration for and Evaluation of Mineral Resources Financial Instruments: Disclosures Operating Segments Financial Instruments Consolidated Financial Statements Joint Arrangements Disclosure of Interests in Other Entities Fair Value Measurement Regulatory Deferral Accounts Revenue from Contracts with Customers Implementation of IFRS converged Ind ASs Ministry of Corporate Affairs vide GSR dated 16 February, 2015 has issued the Companies (Indian Accounting Standards) Rules, 2015 which require companies other than banking, insurance and non-banking finance companies to prepare their financial statements according to the following roadmap. 1. 2. 3. Companies, listed or unlisted, having net worth of ` 500 crore or more. Listed companies having net worth of less than ` 500 crore. Unlisted companies having net worth of ` 250 crore or more but less than ` 500 crore. Accounting periods beginning on or after 1 April, 2016. Accounting periods beginning on or after 1April, 2017. Accounting periods beginning on or after 1April, 2017. Companies other than the above will continue to prepare their financial statements in accordance with the existing accounting standards (ASs). To keep the students in readiness for full fledged understanding of Ind ASs when implemented, key distinctive features thereof vs. existing accounting standards have been explained in the text at relevant places. Requirements of SEBI Accounting standards committee In an effort to streamline financial reporting, and to recommend to SEBI continuous disclosure requirements for compliance by the listed companies, SEBI has constituted a standing committee known as the Accounting Standards Committee. The committee meets from time to time 186 Financial Accounting for Management BIRD’S EYE VIEW Accounting Standards Formulated by ICAI n Accounting Standards Committee and those of its recommendations as are accepted by SEBI are implemented for compliance by the listed companies. Generally, SEBI makes changes in the listing agreement to ensure their implementation. In this context, we will study hereunder some significant clauses of the agreement related to financial statements and financial reporting. n Clause 41 of the Listing Agreement Clause 41 of the Listing Agreement This clause deals with furnishing to the stock exchange and publishing in newspapers the n Clause 50 of the Listing Agreement quarterly unaudited financial results within one month of the quarter end. These results need to include segment results and consolidated results. They need to be based on consistent financial policies, comply with the accounting standard on taxes on income and are subject to limited review by the auditors. n Clause 49 of the Listing Agreement Clause 49 of the Listing Agreement: Corporate Governance This clause deals with the corporate governance requirements to be complied with by the listed companies. Included within these are many requirements having a critical bearing on the corporate financial accounting, reporting and disclosure policies and practices. They have been discussed in the chapter ‘Other Financial Reports’. WWW Interested in seeing the full listing agreement? Visit www.nseindia.com. Click: Equity—Listing Clause 50 of the Listing Agreement The company will mandatorily comply with all the Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI) from time to time. Requirements of Income Tax Act Section 145 of the Income Tax Act deals with the method of accounting to be followed by the income tax payer in respect of his business income, and recognises both cash as well as mercantile or accrual systems either of which should be regularly followed by the assessee. Refer to 2015 edition of The act thus allows even companies to follow the cash system. It is Taxmann’s Income Tax Act noteworthy here that the Companies Act, as we have seen earlier, for text of this section. allows only the mercantile system for corporate assessees. To that extent there is variance in the requirements set by the two acts. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Accounting standards are applicable only to material items. Discuss with examples. 2. What is the usefulness of quarterly and half yearly financial information to investors? 3. Discuss the role of SEBI in improving the quality of financial reporting and harmonization with the accounting standards of ICAI. To enrich your discussion, add your own ideas, thoughts and practical inputs. Chapter 8 Generally Accepted Accounting Principles 187 But the Companies Act, being the specific act regulating companies, prevails over the Income Tax Act. ICAI’S STANDARD ON ACCOUNTING POLICIES: THE MOTHER STANDARD Any discussion on GAAPs will remain incomplete without studying AS-1 on Disclosure of Accounting Policies issued by the ICAI. It is important at this stage to study and analyse the requirements of this basic, rather, mother standard, which has a bearing on the financial statements of all types of enterprises and which acts as a guide in compliance with the rest of the standards. The accounting policies refer to the specific accounting principles and the methods of applying those principles adopted by an enterprise in the preparation and presentation of its financial statements. The standard has provided an illustrative but by no means exhaustive list of the areas in which different accounting policies may be adopted by different enterprises, for example methods of depreciation, valuation of inventories, investments and fixed assets etc. An enterprise needs to select such accounting policies that enable the financial statements, prepared and presented on the basis of such accounting policies, to represent a true and fair view of the financial position and profitability. Mainly considerations of prudence, substance over form and materiality govern the selection and application of such accounting policies. The acceptance and use of generally accepted accounting assumptions, that is, Going Concern, Consistency and Accrual, is presumed as per AS-1. Hence, they are usually not specifically stated in the financial statements. However, their non-compliance is required to be disclosed. AS-5: NET PROFIT OR LOSS FOR THE PERIOD, PRIOR PERIOD AND CHANGES IN ACCOUNTING POLICIES It will be worthwhile to note at this stage that as per para 29 of AS-5, a change in an accountancy policy should be made only: 1. When the statute governing the enterprise requires the adoption of the new policy, or 2. To comply with the requirements of an accounting standard, or 3. When change is considered to result in a more appropriate preparation or presentation of the financial statements of the enterprise. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Discuss the role of AS-1 as the mother standard in improving the quality of financial reporting. 2. Can you suggest some more situations justifying a change in accouting policy over and above the requirements of AS-5? To enrich your discussion, add your own ideas, thoughts and practical inputs. 188 Financial Accounting for Management IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standards (Ind ASs) on the subject: IFRS CONVERGED IND AS 1 VS EXISTING AS 1 DISCLOSURE OF ACCOUNTING POLICIES AND PRESENTATION OF FINANCIAL STATEMENTS WWW www.icai.org The IFRS Converged Ind AS 1 corresponding to existing AS 1 on Disclosure of Accounting Policies is titled as ‘Presentation of Financial Statements’. Key distinctive features of Converged Ind AS 1, as related to the matter covered above, are as under: 1 The Converged Ind AS 1 generally deals with presentation of financial statements, along with the disclosure of accounting policies, whereas existing Ind AS 1 deals only with the disclosure of accounting policies. The scope covered by the Converged Ind AS 1 is thus much wider 2 The Converged Ind AS 1 requires disclosure of judgments made by management while framing of accounting policies. For example, why life of patent assumed to be 15 years. 3 The converged Ind AS 1 requires presentation of: • Single statement of profit and loss including components of other comprehensive income (a new item). • Balance sheet including a statement of changes in equity (a new item) as a part of the balance sheet. • Balance sheet as at the beginning of the earliest period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in the financial statements, or when it reclassifies items in its financial statements. IFRS CONVERGED IND AS 8 VS EXISTING AS 5 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS WWW www.icai.org The IFRS Converged Ind AS 8 corresponding to existing AS 5 on Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies is titled as ‘Accounting Policies, Changes in Accounting Estimates and Errors’. Key distinctive features of Converged Ind AS 8, as related to the matter covered above, are as under: 1. As per the converged Ind AS 8 an entity shall change an accounting policy only if the change: • Is required by an Ind AS or • Results in the financial statements providing more reliable and relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. Existing AS 5 also allows the situation where change in accounting policy is required by statute. 2. The converged Ind AS 8 requires that changes in accounting policies should be accounted for with retrospective effect, i.e., the earlier period financial statements should be readjusted so as to facilitate comparison. RESEARCH IN FINANCIAL REPORTING Companies usually disclose their compliance with GAAPs in the schedule of notes to accounts and significant accounting policies. Presented hereunder are extracts from the 2005–06 annual reports of a few prominent Indian companies from different sectors of economy to apprise you of such disclosures. Chapter 8 Generally Accepted Accounting Principles REPORT 189 RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors BASIS OF ACCOUNTING / PRESENTATION / PREPARATION OF FINANCIAL STATEMENTS Reliance Industries Ltd. The financial statements are prepared under the historical cost convention in accordance with the generally accepted accounting principles in India and the provisions of the Companies Act, 1956, except for certain fixed assets which are revalued. Oil and Natural Gas Corporation Ltd. The financial statements are prepared under the historical cost conventions in accordance with Generally Accepted Accounting Principles (GAAP), under the Successful Efforts Method as per the Guidance Note on Accounting for Oil And Gas Producing Activities issued by the Institute of Chartered Accountants of India and provisions of the companies act, 1956. Generally, revenues are recognized on accrual basis with provision made for known losses and expenses. ICICI Bank Ltd. The accounting and reporting policies of ICICI Bank used in the preparation of these financial statements conform to Generally Accepted Accounting Principles (‘GAAP’) in India, the guidelines issued by Reserve Bank of India (“RBI”) from time to time and practices generally prevalent within the banking industry in India. The Bank follows the accrual method of accounting except where otherwise stated, and the historical cost convention. The preparation of financial statements requires the management to make estimates and assumptions considered in the reported amounts of assets and liabilities (including contingent liabilities) as of the date of the financial statements and the reported income and expenses during the reporting period. Management believes that the estimates used in the preparation of the financial statements are prudent and reasonable. Future results could differ from these estimates. i-flex Solutions Ltd. The financial statements are prepared under the historical cost convention, on the accrual basis of accounting, in conformity with accounting principles generally accepted in India and in accordance with the Accounting Standards referred to in Section 211 (3C) of the Companies Act, 1956 (‘the Act’). The accounting policies applied by the Company are consistent with those used in the previous year. The significant accounting policies adopted by the Company, in respect of the financial statements are set out below (omitted here). Dr. Reddy’s Laboratories Ltd. The financial statements of Dr. Reddy’s Laboratories Limited (‘Dr.Reddys’ or ‘the Company’) have been prepared and presented under the historical cost convention on the accrual basis of accounting in accordance with the accounting principles generally accepted in India (‘GAAP’) and comply with the mandatory Accounting Standards (‘AS’) issued by the Institute of Chartered Accountants of India to the extent applicable and with the relevant provisions of the Companies Act, 1956. The financial statements are presented in Indian rupees rounded off to the nearest thousand. 190 Financial Accounting for Management You will observe that despite diversity in disclosures, from short to very elaborate, the undercurrent is essentially the same in all cases. CONCLUDING REMARKS What we note from the above discussion is that effective formulation of GAAPs assumes great importance in view of their far-reaching impact on the quality of financial statements. It is, therefore, essential that there is a completely harmonised effort in this direction, which includes doing away with the multiplicity of authorities indulging in this activity. Various government bodies and acts may require compliance with a lot many requirements on the part of the preparers of the financial statements but they need to abide by the standards formulated by the ICAI. This will put pressure on ICAI also and in its own interest it will be better for this apex body of the accounting profession to act fast for meeting the requirements of different agencies by formulating new and new accounting standards and thus save its status as the sole accounting standards developing body in the country. Keywords n Abridged Balance Sheet n Accounting Standards n Consolidated Financial Statements n Contingent Liabilities n Corporate Governance WWW Fundamental Accounting Assumptions n Generally Accepted Accounting Principles (GAAPs) n Horizontal Balance Sheet n IFRSs n Ind ASs n n Listed Companies n Parent Company n Segment Results n Subsidiary Company n Vertical Form of Financial Statements 1. Preface to the Statement of Accounting Standards, www.icai.org 2. Listing Agreement, www.nseindia.com 3. Disclosure of Accounting Policies, AS-1, ICAI, www.icai.org 4. SEBI, www.sebi.gov.in 5. Net Profit or Loss for the Period, Prior Period and Changes in Accounting Policies, AS-5, ICAI, www.icai.org 6. Companies (Accounting Standards) Rules, 2006. Notification no. G.S.R. 739(E) dated 7.12.2006, www.mca.gov.in 7. Companies (Indian Accounting Standards) Rules, 2015, www.mca.gov.in Chapter 8 Generally Accepted Accounting Principles 191 1. Taxmann’s Companies Act, Taxmann Allied Services (P.) Ltd., New Delhi, 2015. 2. Guide to the Companies Act, A. Ramaiya, Wadhwa and Company, Nagpur, 2006. 3. Bharat’s Income Tax Act, Bharat Law House Pvt. Ltd., New Delhi, 2015. 4. Bharat’s Income Tax Rules, Bharat Law House Pvt. Ltd., New Delhi, 2015. REPORT 1. Dr. Reddy’s Laboratories Ltd., Annual Report, 2005–06. 2. ICICI Bank Ltd., Annual Report, 2005–06. 3. i-flex Solutions Ltd., Annual Report, 2005–06. 4. Oil and Natural Gas Corporation Ltd., Annual Report, 2005–06. 5. Reliance Industries Ltd., Annual Report, 2005–06. exercises Ex. 1 WAC (Written Analysis and Communication) Exercise Recall Exercise 1 of Chapter 4. The MD, Mr. G.C. Gupta, having understood the gist of the conceptual framework of financial statements, is now interested in the understanding of GAAPs, because of their obvious influence on the financial statements. He requests the CFO, Mr. Lokesh Gupta, to prepare in a brief report, containing, not exceeding four A4-size pages with adequate margin and normal space between the paragraphs. Required Suppose that you are the CFO. Please make the report. Business reports need to be brief, concise and precise. They also need to be drafted in a simple language, devoid of any jargon to the best possible extent. Keep these considerations in mind while preparing the gist. Ex. 2 MOC (Managerial Oral Communication) Group Assignment Having understood the contents of this chapter, you, as the manager of Section B comprising 50 students of MBA 1st year course, are required to form groups of five students each. Include yourself in one of the groups. All the groups have to prepare a 20-minute Powerpoint presentation on the contents of this chapter. Take the help of your professor to form a panel of three students from Section A. All the groups have to make the presentation before this panel in the presence of all the students of Section B. After all the presentations are over the panel has to decide the winner group and the first and second runners-up. Request your professor to lend his supervision to this exercise. This page is intentionally left blank. PART 3 ASSET VALUATION Chapter 9: VALUATION OF TANGIBLE FIXED ASSETS Chapter 10: DEPRECIATION ON FIXED ASSETS Chapter 11: VALUATION OF ASSETS UNDER FINANCE LEASE AND INTANGIBLE ASSETS, AMORTISATION AND ASSET IMPAIRMENT Chapter 12: VALUATION OF INVENTORIES Chapter 13: VALUATION OF INVESTMENTS 9 Valuation of Tangible Fixed Assets Tangible fixed assets, such as plant and machinery, enable companies to produce goods/services and provide marketing and administrative support to their businesses. They lead to the generation of operational revenue, which speaks of their crucial importance. Hence, the need for their proper valuation. Chapter 9 Valuation of Tangible Fixed Assets 195 CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 Meaning, identification and significance of tangible fixed assets. 2 Research in corporate financial reporting on fixed assets. 3 Scope and coverage of AS-10 on ‘Valuation of Fixed Assets’. 4 Principles and norms of standard accounting treatment of valuation of fixed assets and other related issues. 5 Disclosure requirements in respect of fixed assets in the financial statements. 6 Treatment of impact of government grants on fixed asset valuation and related disclosures. 7 Treatment of impact of borrowing costs on fixed asset valuation and related disclosures. 8 Related corporate financial practices. INTRODUCTION Fixed assets, such as land, buildings, plant and machinery, vehicles, furniture and fixtures, and equipments are the assets that enable a company reach the stage where it is ready to carry out its business operations. For example, in the case of manufacturing companies, these assets enable them to produce goods and provide marketing and administrative support to the business operations. Thus, they lead to the generation of operational revenue, which speaks of their crucial importance. In the case of manufacturing companies, they generally command the lion’s share of the total assets. Fixed assets can be tangible like the ones mentioned above and capital work-in-progress, that is, fixed assets under construction/installation as well as intangible such as goodwill and brand. The discussion in this chapter is with reference to tangible fixed assets. Intangible fixed assets are covered in a subsequent chapter. VALUATION OF FIXED ASSETS The ICAI has issued Accounting Standard (AS-10) ‘Accounting for Fixed Visit www.icai.org for Assets’, which defines fixed assets, sets out their significance, specifies the original text of AS—10. fixed assets excluded from its scope and coverage and prescribes the princiWWW Click: Resources— ples and norms of standard accounting treatment for various aspects of fixed Accounting Standards. assets valuation and accounting, i.e., identification, measurement, valuation, revaluation, retirements and disposals and disclosure requirements in financial statements prepared on historical cost basis, including revaluation. Let us discuss, understand and analyse these. MEANING, IDENTIFICATION AND SIGNIFICANCE OF FIXED ASSETS Fixed assets represent assets held with the intention of being used for the purpose of producing or providing goods or services and are not held for sale in the normal course of business. Any expenditure 196 Financial Accounting for Management BIRD’S EYE VIEW AS-10: Accounting for Fixed Assets n Meaning, identification and Significance of Fixed Assets n Scope and Coverage n Principles and Norms of Standard Accounting Treatment: — Determinants of value of fixed assets — Valuation in special cases — Identification of certain specific fixed assets — Revaluation of fixed assets — Retirements and disposals n Disclosure Requirements that meets these criteria is identified and recognised as a fixed asset in the financial statements. And if the fixed asset has a physical existence it is classified as tangible fixed asset. These assets play a very important role in the measurement and presentation of performance and financial position as: 1. Fixed assets often comprise a significant portion of the total assets of an enterprise and therefore are important in the presentation, assessment and evaluation of its financial position and strength. 2. The determination of whether an expense represents a fixed asset or a revenue expense can have material effect on a company’s reported results of operations. Hence, the need for proper recognition and measurement of an expense as a fixed asset. Research in Financial Reporting Look at the following research findings that bring out the significance of fixed assets very profusely. REPORT RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors TANGIBLE FIXED ASSETS AND OTHER RELATED DETAILS AS ON 31 MARCH 2006 ` in Crores Total Assets Tangible Fixed Tangible Plant Assets Fixed and to Total Assets Machinery Assets Sl. No. Company Industry 1 Asian Hotels Ltd. Hotels – Tourism 633 565 156 89% Plant and Machinery to Tangible Depreciation Fixed for the Assets year PBT for the year 28% 21 87 2 Bharti Airtel Ltd. Telecom 19,030 13,735 10,769 72% 78% 1,412 2,286 3 Indraprastha Medical Corporation Ltd. Hospital – 259 166 77 64% 46% 13 22 Healthcare 4 Indraprastha Gas Ltd. Natural Gas 517 395 298 76% 75% 57 160 5 Infosys Information Technologies Ltd. Technology 9,114 2,133 438 23% 21% 409 2,724 6 ITC Ltd. 13,084 4,333 2,313 33% 53% 320 3,269 FMCG 197 Chapter 9 Valuation of Tangible Fixed Assets 7 JK Cement Ltd. Cement – Housing related 1,466 949 738 65% 78% 42 52 8 Ranbaxy Laboratories Ltd. Healthcare 4,661 1,572 802 34% 51% 76 190 9 Reliance Energy Ltd. Power 14,582 2,866 1,833 20% 64% 414 781 10 Reliance Industries Ltd. Oil and Gas 93,095 61,558 47,932 66% 78% 4,710 10,704 11 Shoppers’ Stop Ltd. Retail 413 119 35 29% 29% 12 40 Notes: 1. Data: Derived from respective annual reports. 2. Total assets: Include current assets and loans & advances on gross basis, that is, without deducting current liabilities and provisions. 3. All tangible fixed assets: Net of accumulated depreciation and inclusive of capital work-in-progress. 4. Depreciation: Relates to tangible fixed assets only. 5. Asian Hotels Ltd.: Main fixed asset, that is, buildings amounts to ` 253 crores (45% of tangible fixed assets). 6. Indraprastha Medical Corporation Ltd.: Plant and Machinery include medical equipments. 7. Infosys Technologies Ltd.: Plant and Machinery include computer equipments. Main fixed asset, that is, buildings amounts to ` 843 crores (40% of tangible fixed assets). 8. Ranbaxy Laboratories Ltd.: Year ended 31.12.2005. 9. Shoppers’ Stop Ltd.: Plant and Machinery represent air conditioning and other equipments. Other main fixed assets, that is, furniture & fixtures amount to ` 32 crores (27% of tangible fixed assets) and leasehold improvements amount to ` 37 crores (31% of tangible fixed assets). You will appreciate that: 1. Tangible fixed assets vary from 20% (Reliance Energy Ltd.) to 89% (Asian Hotels Ltd.) of total assets, that too towards the upper end of the band in most cases, depending upon the industry. That shows they represent major part of the assets. 2. Plant and machinery vary from 21% (Infosys Technologies Ltd.) to 78% (Bharti Airtel Ltd., JK Cement Ltd. and Reliance Industries Ltd.) of tangible fixed assets, that too towards the upper end of the band in most cases. That shows the relative importance of plant and machinery among the tangible fixed assets. 3. Buildings constitute the largest item of fixed assets, much larger than plant and machinery, in hotel and information technology industries. See Asian Hotels Ltd. (45% of tangible fixed assets) and Infosys Technologies Ltd. (40% of tangible fixed assets). The retail sector does not have any specific plant and machinery due to its very nature. Main fixed assets in this sector are furniture & fixtures, air conditioning and other equipments and leasehold improvements, that is, improvements carried out on leased store buildings to improve their functional utility, to make them more comfortable for the shoppers and to make their appearance more appealing. See Shoppers’ Stop Ltd. (Put together they constitute 87% of tangible fixed assets in its case). 4. A comparison of the magnitude of these fixed assets with the corresponding PBT and total assets figures reveals the heavy dependence of true and fair measurement of PBT and financial position on the identification and measurement of tangible fixed assets in that wrong capitalization of revenue expenses or vice versa, that is, charging capital expenses to revenue will lead 198 Financial Accounting for Management to distortions in the value of fixed assets and therefore in depreciation and operating expenses. This may alter the PBT, tax liability, PAT and size of the balance sheet materially. Bharti Airtel Ltd. and Reliance Industries Ltd. present burning examples. SCOPE AND COVERAGE The standard deals with accounting for such fixed assets as land, buildings, plant and machinery, vehicles, furniture and fittings, included in financial statements prepared on the historical cost basis. The standard, however, covers limited revaluation of fixed assets within the overall historical cost framework. The standard does not cover leased assets and wasting assets, that is, assets created through expenditure on exploration and extraction of non-regenerative resources like minerals, oil and natural gas etc. The discussion on leased assets follows in a subsequent chapter. An illustration on corporate financial practices on non-regenerative resources will follow in the current chapter in due course. PRINCIPLES AND NORMS OF STANDARD ACCOUNTING TREATMENT Let us now proceed to discuss the principles and norms of standard benchmark treatment of fixed assets valuation and accounting in the financial statements. Determinants of Value of Fixed Assets Cost of fixed assets is determined in the following manner: 1. The cost comprises purchase price net of trade discounts and rebates but inclusive of import duties and other non-refundable taxes and any directly attributable cost of bringing the asset to its working condition, for example, site preparation, initial delivery cost, installation cost such as special foundation for plant, and professional fees of architects and engineers. 2. The cost may change subsequent to acquisition or construction on account of exchange rate fluctuations and subsequent price adjustments etc. The subject matter of exchange rate fluctuations and their treatment Want to know more about is separately covered by AS-11 ‘The Effects of Changes in Foreign AS-11? Visit www.icai. Exchange Rates’. ICAI revised this standard in the year 2003 to preWWW org. Click: Resources— scribe that exchange rate fluctuations will not be adjusted to the cost Accounting Standards. of the fixed assets rather recognized as income or as expenses w.e.f. the accounting periods commencing on or after 1.4.2004. Schedule VI to the Companies Act however continues to prescribe the former treatment. AS-11 clarifies that pending the amendment, if any, to Schedule VI, a company adopting the former treatment will still be considered to be complying with revised AS-11. The readers will therefore find both the treatments being followed by different companies in their annual reports. 3. Administration and other general overhead expenses, as are specifically attributable to construction of a project, that is, the expenditure incurred on start-up, commissioning, test runs and experimental production, or to the acquisition of a fixed asset or bringing it to its working condition, are included as part of the cost. 4. The cost of a self-constructed fixed asset comprises those costs that relate directly to that specific asset and those that are attributable to the construction of many assets in general and can be allocated to the specific asset. Other considerations as applicable to outsourced fixed assets, as mentioned above, equally apply to the self-constructed fixed assets. Chapter 9 Valuation of Tangible Fixed Assets 199 5. When a fixed asset is acquired in exchange for another asset, its cost is usually determined by reference to the fair market value (FMV) of the asset given or the FMV of the asset acquired if the latter is more clearly evident. In case of a part- exchange, such cost is adjusted for balancing receipt or payment of cash or other consideration. An alternative accounting treatment that is sometimes used for an exchange of assets, particularly when the assets exchanged are similar, BIRD’S EYE VIEW is to record the asset acquired at the net book value of the asset given Determinants of Value up. In case of a part- exchange, such cost is adjusted for balancing of Fixed Assets receipt or payment of cash or other consideration. n Purchase Price First treatment is therefore the preferred treatment. n Changes in Cost due to Exchange When a fixed asset is acquired in exchange for shares or other Rate Fluctuations etc. securities in the enterprise, it is usually recorded at its FMV, or the n Administration and General FMV of the securities issued, whichever is more clearly evident. Overheads FMV refers to the price that would be agreed to in an open and n Self-Constructed Fixed Asset unrestricted market between knowledgeable and willing parties dealing n Fixed Asset acquired in Exchange at arm’s length who are fully informed and are not under any compuln Subsequent Expenditure sion to transact. 6. Subsequent expenditure incurred in relation to an item of fixed asset is added to its cost when it increases the future benefits from the existing asset beyond its previously assessed benefits. For example, extension of a building or replacement of the old compressor by a new one in an air-conditioner. ILLUSTRATION 1 ARPIT INDUSTRIES LTD. DETERMINATION OF COST OF FIXED ASSETS Arpit Industries Ltd. purchased a machine. The details are as under: Required 1. Determine the cost of the machine. 2. State the accounting policy on valuation of machine. Details Amount (`) Amount (`) Invoice Price: List Price 50,00,000 Less: Trade Discount 1,00,000 Balance 49,00,000 Add: Sales Tax and Excise Duty 6,00,000 CENVAT Credit Available on Excise Duty Included Above 55,00,000 4,00,000 Transportation Charges to Factory Site 25,000 Special Foundation and Installation Charges 75,000 200 Financial Accounting for Management SOLUTION Requirement 1 Cost of the machine is determined as under: Details Amount (`) Invoice price—Net 55,00,000 Less: CENVAT credit available 4,00,000 Add: Transportation charges to factory site Amount (`) 51,00,000 25,000 Add: Special foundation and installation charges 75,000 Cost of the machine 52,00,000 Requirement 2 The company values its machines on invoice price net of CENVAT plus transportation charges up to the factory site and expenses incurred on special foundation and installation. ILLUSTRATION 2 DISHA APPARELS LTD. DETERMINATION OF COST OF FIXED ASSETS ON EXCHANGE Disha Apparels Ltd. part exchanged its old generator set with a new one from Achal Machines Ltd. Net book value of the old set was `2,85,600. However the vendor assessed its exchange value at ` 2,65,000 to which Disha Apparels Ltd. agreed. The selling price of the new set as per the company price list was ` 4,35,000 subject to a further discount of `10,000 in case of a outright sale deal. The discount was however not available for exchange case and therefore Disha Apparels Ltd. paid ` 1,70,000 by way of cheque drawn on its Allahabad Bank current account to the vendor. Determine the cost at which the new generator set will be recorded in the financial statements of Disha Apparels Ltd. How will the old set be treated? SOLUTION 1. Preferred Treatment: In this case FMV of the asset given is ` 2,65,000. FMV of the asset acquired is ` 4,25,000. Between the two, the latter FMV is supposed to be more clearly evident since the selling price is the standard price for the whole market. FMV agreed for the old set would be influenced by subjective element in the absence of standard price for an old set. Hence the new set will be recognized at ` 4,25,000. Now that the old set has been disposed of it will be eliminated from the financial statements and the loss on its exchange will be charged to profit and loss account. The whole transaction can be summed up as under: Dr.... New Generator Set Dr.... Profit and Loss Account (Balancing Figure) ` 4,25,000 ` 30,600 Cr.... Old Generator Set ` 2,85,600 Cr.... Allahabad Bank CA (Exchange of old generator set with new set.) ` 1,70,000 4,55,600 4,55,600 Chapter 9 Valuation of Tangible Fixed Assets 201 Had the new set been valued at the FMV of the asset given it would be recognized at ` 4,35,000 (that is, ` 2,65,000 plus ` 1,70,000). The whole transaction would then be summed up as under: Dr.... New Generator Set Dr.... Profit and Loss Account (Balancing Figure) ` 4,35,000 ` 20,600 Cr.... Old Generator Set ` 2,85,600 Cr.... Allahabad Bank CA (Exchange of old generator set with new set.) ` 1,70,000 4,55,600 4,55,600 However it will be more appropriate in this case to value the new set at ` 4,25,000. 2. Alternative Treatment: Net book value of the old generator set is ` 2,85,600. Additional cash paid is ` 1,70,000. The new generator set will therefore be recognized at ` 4,55,600. Old generator set will be eliminated from the financial statements. The whole transaction can be summed up as under: Dr.... New Generator Set ` 4,55,600 Cr.... Old Generator Set ` 2,85,600 Cr.... Allahabad Bank CA (Exchange of old generator set with new generator set.) ` 1,70,000 4,55,600 4,55,600 Clearly the different treatments have varying impact on the asset valuation and loss on its exchange. Following the FMV of new generator set has produced most conservative results. An illustration on determination of cost of fixed assets of a project under construction will follow in the current chapter in due course. Valuation of Fixed Assets in Special Cases The two cases, as mentioned hereunder, require special treatment for valuation: Jointly owned fixed assets In the case of jointly owned fixed assets for common use by, say oil companies, (otherwise than as a jointly controlled entity), the extent of the enterprise’s share in such assets, and the proportion of the original cost, accumulated depreciation and written down value should be stated in the balance sheet. Alternatively, the pro rata cost of such jointly owned assets may be grouped together with similar fully owned assets with an appropriate disclosure. Corporate financial practices Here is how Indian Oil Corporation Ltd. treated its jointly owned assets. Study these disclosures. 202 CASE Financial Accounting for Management 1 Indian Oil Corporation Ltd. CORPORATE FINANCIAL PRACTICES INDIAN OIL CORPORATION LTD. Annual Report 2001–02 REPORT Extracts from Schedule E—Fixed Assets JOINTLY OWNED FIXED ASSETS (` in Lakhs) Total Fixed Assets of the Company Gross Block as at 31.03.02 Total Depreciation and Amortisation up to 31.03.02 W.D.V. as at 31.03.02 29,74,061.06 10,96,081.90 18,77,979.16 Details of Company’s Share of Jointly Owned Assets Included Above (` in Lakhs) Assets Particulars Name of Joint Owners Original Cost Accumulated Depreciated & Amortization W.D.V. as at 31.03.02 Land—Freehold HPC/IBP 119.02 0.00 119.02 Land—Leasehold BPC/IBP 95.31 10.50 84.81 Buildings HPC 42.54 7.38 35.16 Plant and Machinery HPC/BPC/IBP/GSFC/ IPCL/ACC/CSIR 1,157.46 304.10 853.36 Transport Equipment RAILWAYS 18,234.86 8,875.95 9,358.91 Railway Sidings HPC/BPC 2,243.85 592.05 1,651.80 Drainage, Sewage & Water Supply GSFC 99.40 94.43 4.97 21,992.44 9,884.41 12,108.03 Basket purchase Where several fixed assets are purchased for a consolidated price, the consideration is apportioned to the various assets on a fair basis as determined by a competent valuer. Basket purchase takes place when all or select fixed assets of an existing entity, without any of its liabilities, are purchased. Chapter 9 Valuation of Tangible Fixed Assets ILLUSTRATION 203 SUNAINA T.V. NETWORK LTD. DETERMINATION OF COST OF FIXED ASSETS IN CASE OF BASKET PURCHASE 3 Sunaina T.V. Network Ltd. purchased some fixed assets for a consolidated price. The details are as under. Details of the market values of these assets as appraised by a valuer are also given. Determine the cost of each asset. Details Consolidated Price (`) Market Values (`) Land … 1,80,00,000 Building Built Thereon … 2,70,00,000 Furniture and Fixtures … 54,00,000 Machines and Equipments for Pay Channel Infrastructure … 12,96,00,000 15,00,00,000 18,00,00,000 Total SOLUTION Cost of various assets is determined as under: Details Market Values (`) Ratio of Market Value of Each Asset to Total Market Value Cost of Each Asset (`) Land 1,80,00,000 10% 1,50,00,000 Building Built Thereon 2,70,00,000 15% 2,25,00,000 Furniture and Fixtures 54,00,000 3% 45,00,000 Machines and Equipments for Pay Channel Infrastructure 12,96,00,000 72% 10,80,00,000 18,00,00,000 100% 15,00,00,000 Total Note: Cost of each asset has been worked out in the ratio of market value of each asset to total market value as applied to consolidated price. The assets will be recognised in the balance sheet at their individual cost so arrived at and depreciation charged thereon. Identification of Certain Specific Fixed Assets BIRD’S EYE VIEW Certain fixed assets are identified on the bases mentioned hereunder: Identification of Certain 1. Individually insignificant items may be aggregated into single asset Specific Fixed Assets items. This will obviate the charging, to the profit and loss account, n Individually Insignificant Items of an item of immaterial amount, which could otherwise have been n Machinery Spares included as fixed asset due to its long-term utility. For example, n Component Parts individual office chairs and tables are aggregated into total chairs and total tables. 2. Machinery spares are usually charged to the profit and loss account as and when they are consumed. If, however, they can be used only in connection with a specific item of fixed asset and their use is infrequent, they may be capitalized and allocated on a systematic basis over 204 Financial Accounting for Management the remaining useful life of the principal item. For example, gear boxes used in a hydraulic press. 3. Component parts of an item of fixed asset, if they are separable, and have different useful lives may be treated as separate assets, for example, an aircraft and its engine. BIRD’S EYE VIEW Revaluation of Fixed Assets Revaluation of Fixed Assets Sometimes financial statements prepared on the historical cost basis include part or all the fixed assets at a valuation that substitutes their historical costs, and depreciation is accordingly calculated on revalued n Different Bases of Revaluation amounts. The following principles govern the treatment of revaluation n Presentation of Revalued Amounts n Selection of Assets for Revaluation and other incidental matters: n Recoverable Amount of Assets 1. Different bases of revaluation are sometimes used to determine n Increase on Revaluation — the book value of the separate items within each of the categories Revaluation Reserve of fixed assets or for the different categories of fixed assets. The n Decrease on Revaluation most preferred method of restating fixed assets is appraisal by competent valuers. Indexation with general or specific price indices and reference to current prices are the other methods sometimes used. Revaluation arrived at through these methods is periodically cross-checked with appraisal method revaluation. 2. The revalued amounts of fixed assets are presented in financial statements by restating both the gross book value and accumulated depreciation so as to give a net book value equal to the net revalued amount. 3. When a fixed asset is revalued, an entire class of assets should be revalued, or the selection of assets for revaluation should be made on a systematic basis, for example, a whole class of assets in a plant. 4. The revaluation of a class of fixed assets should not result in the net book value of that class being greater than the recoverable amount of assets of that class. 5. An increase in net book value arising on revaluation of fixed assets is credited directly to owner’s interests under the heading revaluation reserves and is regarded as not available for distribution. At times, an increase to be recorded is a reversal of a previous decrease arising on revaluation which has been charged to the profit and loss statement, in which case the increase is credited to profit and loss account to the extent that it offsets the previously recorded decrease. For example, suppose Yellow Chilies Ltd. carried out a revaluation of its fixed assets 3 years before which led to a decrease of ` 5 crores. The company charged this loss to profit and loss account. During the current year revaluation was carried out again leading to an increase of ` 7 crores. This year ` 5 crores will be credited to the profit and loss account and ` 2 crores to Revaluation Reserve. 6. A decrease on revaluation is charged to the profit and loss account unless it reverses a corresponding amount in the revaluation reserve if it is considered to be related to a previous increase on revaluation. For example, suppose Black Chilies Ltd. carried out a revaluation of its fixed assets 4 years before which led to an increase of ` 1 crore. The company credited this gain to Revaluation Reserve. During the current year revaluation was carried out again leading to a decrease of ` 2.50 crores. This year `1.50 crores will be debited to the profit and loss account and Revaluation Reserve will become nil. An Illustration on revaluation of fixed assets follows in the next chapter on depreciation. Chapter 9 Valuation of Tangible Fixed Assets 205 Retirements and Disposals Retirement and disposal of fixed assets are dealt with as under: 1. Material items retired from active use and held for disposal are stated at the lower of their net book value and net realisable value and shown separately in the financial statements. 2. A fixed asset is eliminated from the financial statements on disposal or when no further benefit is expected from its use. 3. A loss arising from the retirement, or gain or loss arising from disposal of a fixed asset that is carried at cost is charged/credited to the profit and loss account. 4. Loss or gain arising from disposal of a fixed asset that is carried at revalued amount is charged to the profit and loss statement unless, in the case of loss, it reverses a corresponding amount in the revaluation reserve. The corresponding amount standing in the revaluation reserve following the retirement or disposal of an asset may be transferred to the general reserve. An illustration on loss arising on disposal of a fixed asset through exchange with another has been provided earlier. One more illustration on the subject will follow in the next chapter on depreciation. DISCLOSURES IN FINANCIAL STATEMENTS The following information needs to be disclosed in the balance sheet in respect of fixed assets: 1. Gross book values (costs) and net book values of fixed assets at the beginning and end of an accounting period showing additions, disposals, acquisitions and other movements. 2. Expenditure incurred towards fixed assets in the course of construction or acquisition. 3. Additional disclosures where fixed assets are stated at revalued amounts: a. Revalued amounts substituted for historical costs. b. The method adopted to compute the revalued amounts. c. The nature of indices used if any, in case of non-appraised revaluation. d. The year of any appraisal made. e. Whether an external valuer was involved. 4. Disclosures as per AS-1 as discussed in the last chapter. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What are fixed assets? Why are they so important? 2. Why would a company like to revalue its fixed assets? What are its advantages? 3. How are certain specific fixed assets identified? 4. How are retirements and disposals treated? 5. Bring out the information value of disclosures related to fixed assets. To enrich your discussion, add your own ideas, thoughts and practical inputs. 206 Financial Accounting for Management IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 16 VS EXISTING AS 10 WWW PROPERTY, PLANT AND EQUIPMENT www.icai.org The IFRS converged Ind AS 16 corresponding to existing AS 10 on Accounting for Fixed Assets is titled as ‘Property, Plant and Equipment’. Key distinctive features of Converged Ind AS 16 are as under: 1 Converged Ind AS 16 is based on the component approach. Under this approach, each major part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item is depreciated separately. As a corollary, cost of replacing such parts is capitalized. The cost of replacing those parts which have not been depreciated separately is also capitalized with the consequent derecognition of the replaced parts. 2 Converged Ind AS 16 requires an entity to choose, after initial recognition, either the cost model or the revaluation model as its accounting policy and to apply that policy to an entire class of property, plant and equipment. It requires that under revaluation model, revaluation be made with reference to the fair value of items of property, plant and equipment. It also requires that revaluations should be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. Existing AS 10 also recognizes revaluation of fixed assets. However, the revaluation approach adopted therein is ad hoc in nature, as it does not require the adoption of fair value basis as its accounting policy or revaluation of assets with regularity. It also provides an option for selection of assets within a class for revaluation on systematic basis. 3 Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. 4 Further, converged Ind AS 105 ‘Non-current Assets Held for Sale and Discontinued Operations’ provides that an entity shall measure a non-current asset (or a group of assets) classified as held for sale at the lower of its carrying amount and fair value less costs to sell. IMPACT OF GOVERNMENT GRANTS AND BORROWING COSTS ON FIXED ASSETS VALUATION We have discussed above the principles of valuation of fixed assets. The cost of fixed assets is further influenced by two factors for which necessary adjustments are required. These are government grants and borrowing costs. The principles and norms of standard accounting treatment in respect of these two are dealt with by AS-12 and AS-16 respectively. We will cover here their essence. BIRD’S EYE VIEW AS-12: Accounting for Government Grants n Specific Grants —Capital approach —Income approach n Non-monetary Assets at a Concessional Rate n General Grants for a Project n Recognition of Government Grants n Disclosure Requirements Accounting for Government Grants Specific grants The government, for many reasons, provides capital grants at times, for example, to promote an industry. Grants related to specific fixed assets are government grants whose primary condition is that an enterprise qualifying for them should purchase, construct or otherwise acquire such assets. For example, installation of a power saving or a pollution control device. Two alternative treatments are available to account for such grants: Chapter 9 Valuation of Tangible Fixed Assets 207 1. Capital approach The grant is shown as a deduction from the gross value of the asset concerned in arriving at its book value. The grant is thus recognised in the profit and loss statement over the useful life of a depreciable asset by way of a reduced depreciation charge. Where the grant equals the whole, or virtually the whole of the cost of the asset, the asset is shown in the balance sheet at a nominal value. 2. Income approach As per the other alternative, grants related to depreciable assets are treated as deferred income, which is recognised in the profit and loss statement on a systematic and rational basis over the useful life of the asset. Such allocation to income is usually made over the periods, and in the proportions in which depreciation on related assets is charged. Grants related to non-depreciable assets are credited to capital reserve under this method. However, if a grant related to a non-depreciable asset requires the fulfillment of certain obligations, for example, procurement of raw materials from small scale undertakings, even at a higher price, say, for five years, the grant is credited to income over the same period over which the cost of meeting such obligations is charged to income. Want to know more about The deferred income part of the grant is suitably disclosed in the AS-12? Visit www.icai. balance sheet. For example, in the case of a company, it is shown WWW org Click: Resources— after ‘Reserves and Surplus’ but before ‘Secured Loans’ with a Accounting Standards. suitable description, for example, ‘Deferred Government Grants’. AS-12 recognises both alternatives as equally acceptable. No preference is attached to any one. Second alternative, however, seems to be better as it is fully informative. Non-monetary assets at a concessional rate Government grants in the form of non-monetary non-depreciable assets, for example, land given at a concessional rate, are accounted for on the basis of their acquisition cost and not at their actual price. In case a non-monetary asset is given free of cost, it is recognised at a nominal value. General grants for a project When the Government grants are not earmarked for a specific asset rather given with reference to the total investment in a project, for example, central or state investment subsidy, they acquire the character of promoters’ contribution towards the project cost and are, therefore, recognised as capital reserve being part of owners’ equity. Grants related to income Government grants related to income, say pricing subsidies to the oil and fertilizers industries, are directly credited to the profit and loss account. Recognition of government grants Government grants are recognised in the financial statements only when there is reasonable assurance that: 1. The enterprise will comply with the conditions attached to them, for example, a grant may be available only if the project employs 500 or more people, and 2. The grants will be ultimately received. Grants related to income Government grants related to income, say pricing subsidies to the oil and fertilizers industries, are directly credited to the profit and loss account. Disclosure requirements The following disclosures need to be made in the financial statements in respect of government grants: n The nature and extent of government grants recognised in the financial statements, including grants of non-monetary non-depreciable assets given at a concessional rate or free of cost, and n The accounting policy adopted including the methods of presentation in the financial statements. 208 Financial Accounting for Management ILLUSTRATION 4 BALACHANDRAN ELECTRONICS LTD. TREATMENT OF GOVERNMENT GRANT AND ITS IMPACT ON VALUATION OF FIXED ASSET Balachandran Electronics Ltd. acquires a machine whose total cost comes to ` 315 lacs. The company received a grant of ` 35 lacs from the central government against the machine. Determine its book value under the two alternatives. Useful life of the machine is 5 years. Depreciation will be apportioned in equal trenches @ 20% over 5 years. Determine depreciation under the two alternatives and show how the grant will be treated in the financial statements. SOLUTION First Alternative: Amount (`) Cost of the Machine 3,15,00,000 Less: Government Grant 35,00,000 Book Value 2,80,00,000 Depreciation in this case will be applied to ` 2,80,00,000, that is, ` 56,00,000 every year. Second Alternative: Book Value of the machine under the second alternative: ` 3,15,00,000. Depreciation in this case will be ` 63,00,000 every year. Grant of ` 35,00,000 will be treated as deferred income and allocated to income over the periods, and, in the proportions in which depreciation on machine is charged. Since the machine has a useful life of 5 years and thus depreciated @ 20% p.a. as above, the following will be the treatment of grant: Year 1 Year 2 Year 3 Year 4 Year 5 ` ` ` ` ` … … … … … 35,00,000 28,00,000 21,00,000 14,00,000 7,00,000 BALANCE SHEET Sources of Funds: Reserves and Surplus Deferred government grantsLess: Transferred to profit and loss account @ 20% of grant received 7,00,000 7,00,000 7,00,000 7,00,000 7,00,000 Added to sources of funds 28,00,000 21,00,000 14,00,000 7,00,000 Nil … … … … … 63,00,000 63,00,000 63,00,000 63,00,000 63,00,000 Government grants 7,00,000 7,00,000 7,00,000 7,00,000 7,00,000 Net expense charge to profit and loss account 56,00,000 56,00,000 56,00,000 56,00,000 56,00,000 Secured Loans PROFIT AND LOSS ACCOUNT Expenses: Depreciation Income: Please note that net charge to profit and loss account, in this case also, is the same as under the first alternative, that is, equal to depreciation charge. 2nd alternative however provides more elaborate information. Note: In practice companies disclose the deferred government grants under the head ‘capital reserves’ as well. Chapter 9 Valuation of Tangible Fixed Assets 209 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. How government grants benefit the trade and industry? 2. Which approach you will recommend: capital or income? To enrich your discussion, add your own ideas, thoughts and practical inputs. IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 20 VS EXISTING AS 12 ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE WWW www.icai.org The IFRS converged Ind AS 20 corresponding to existing AS 12 on Accounting for Government Grants is titled as ‘Accounting for Government Grants and Disclosure of Government Assistance’. Key distinctive features of Converged Ind AS 20 are as under: 1 Converged Ind AS 20 is based on the principle that all government grants would normally have certain obligations attached to them and these grants related to non-depreciable assets also should be recognized as income over the periods which bear the cost of meeting the obligation. It, therefore, specifically prohibits recognition of such grants directly in the shareholders’ funds. 2 Following the same principle Converged Ind AS 20 does not recognize general government grants for a project of the nature of promoters’ contribution. It, accordingly, requires all such grants also to be recognized as income over the periods which bear the cost of meeting the obligation. 3 Converged Ind AS 20 requires to value non-monetary grants in the form of non-monetary assets, given at a concessional rate or free of cost at their fair value, since it results into presentation of more relevant information and is conceptually superior as compared to valuation at a nominal amount. Borrowing Costs Capitalisation Borrowing costs are interest and other costs, for example, processing fee and upfront fee, incurred by an enterprise in connection with the borrowing of funds either for specific fixed BIRD’S EYE VIEW assets or for projects or for general purposes. Borrowing costs incurred for general purposes, for example, workAS-16: Borrowing Costs ing capital are charged to revenue. Borrowing costs that n Capitalisation are directly attributable to the acquisition or construcn Substantial Period of Time tion of a fixed asset are capitalised as part of the cost n Specific Borrowings of that asset. The amount of borrowing costs capitalised n Borrowings for Projects n General Borrowings during a period should not exceed the amount of born Disclosure Requirements rowing costs incurred during that period. 210 Financial Accounting for Management The capitalisation of borrowing costs, as part of the cost of a fixed asset, is done when all the following conditions are satisfied: n Expenditure for the acquisition or construction of an asset is being incurred. n Borrowing costs are being incurred. n Activities that are necessary to prepare the asset for its intended use are in progress. In other words, borrowing costs are capitalised only up to the point the asset is ready for its intended use or when substantially all the activities necessary to prepare the asset for its intended use are complete. Thereafter they are charged to the profit and loss account. Substantial period of time Borrowing costs are capitalised only when the asset is estimated to take a substantial period of time to get ready for its intended use. The issue as to what constitutes a substantial period of time primarily depends on the facts and circumstances of each case. However, ordinarily, a period of twelve months is considered as substantial period of time unless a shorter period can be justified in the case. What follows from this is that in case of a project under construction borrowing costs should be capitalised even if it takes, say, just six months to complete. The criterion of twelve months should apply to a specific asset, say, to construction of a building. Specific borrowings When funds are borrowed specifically for the purpose of obtaining a fixed asset, the amount of borrowing costs eligible for capitalisation on that asset is determined as the actual borrowing costs incurred on that borrowing during the period the asset is being readied for use less any income on the temporary investment of those borrowings. Borrowings for projects When funds are borrowed as a means to part finance the cost of a project, all borrowing costs incurred during the construction period are capitalised and allocated to various fixed assets like land, building, plant & machinery and miscellaneous fixed assets in the ratio of their basic cost. Once the project is ready for commercial production they are charged to the profit and loss account. General borrowings When funds are borrowed generally and used for the purpose of obtaining a fixed asset, the amount of borrowing costs eligible for capitalization is determined by applying a capitalisation rate to the expenditure on that asset. The capitalisation rate is the weighted average of the borrowing costs applicable to the general borrowings of the enterprise that are outstanding during the period. For example, two general borrowings of 10% debentures of ` 60 crores and 12% fixed deposit loan of ` 120 crores will result in a weighted average cost of borrowing of 11.33% {(10% 3 60) 1 (12% 3 120)/180}. An enterprise often raises borrowings which are meant for general corporate purposes, that is, for smooth running of its operations Want to know more about or for taking advantage of better investment opportunities and not AS-16? Visit www.icai.org earmarked for a specific asset or project, for example, fixed deposits, WWW Click: Resourcesdebentures and security deposits. These borrowings may be used to Accounting Standards. acquire fixed assets as well. Even working capital borrowing limits are at times diverted towards obtaining fixed assets. Normally these borrowings carry different rates of interest. Disclosure requirements The following disclosures need to be made in the financial statements in respect of borrowing costs: n The accounting policy adopted for borrowing costs, and n The amount of borrowing costs capitalised during the period. Chapter 9 Valuation of Tangible Fixed Assets ILLUSTRATION 211 RATI UDHYOG LTD. DETERMINATION OF COST OF FIXED ASSETS OF A PROJECT UNDER CONSTRUCTION 5 Rati Udhyog Ltd. has established a new project. Details of fixed assets and expenditure incurred during the construction of the project are given hereunder. Determine the cost of each asset at the end of completion of the project, ready for commercial production. Details Amount (`) Land 1,25,00,000 Buildings 2,50,00,000 Plant and Machinery 20,75,00,000 Misc. Fixed Assets 50,00,000 Pre-operative Administrative Expenses on Start-up, Commissioning, Test Runs and Experimental Production 1,50,00,000 Interest on Term Loans during the Construction Period 1,80,00,000 Total 28,30,00,000 SOLUTION Cost of the assets is determined as under: Assets Basic Cost of Assets (`) Ratio of Basic Cost of Each Asset to Total Cost (`) Pre-operative Administrative Expenses (`) Interest during Construction Period (`) Final Cost of Assets (`) 1,25,00,000 5% 7,50,000 9,00,000 1,41,50,000 Buildings 2,50,00,000 10% 15,00,000 18,00,000 2,83,00,000 Plant and Machinery 20,75,00,000 83% 1,24,50,000 1,49,40,000 23,48,90,000 Land Misc. Fixed Assets 50,00,000 2% 3,00,000 3,60,000 56,60,000 Total 25,00,00,000 100% 1,50,00,000 1,80,00,000 28,30,00,000 Note: Pre-operative expenses and interest have been apportioned to various fixed assets in the ratio of basic cost of each asset to the total cost. The assets will be recognised in the balance sheet at their final cost on the last day of the preoperative period. And depreciation will be charged on all assets, except land, on the final cost, first operating period onwards. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Bring out the significance of government grants in influencing the profitability and financial position of a company. 2. Of the two alternative treatments of government grants, which one is preferable? Why? 3. Discuss the impact of capitalisation of borrowing costs on the financial statements. To enrich your discussion, add your own ideas, thoughts and practical inputs. 212 Financial Accounting for Management IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 23 VS EXISTING AS 16 WWW BORROWING COSTS www.icai.org Key distinctive features of IFRS Converged Ind AS 23 ‘Borrowing Costs’ corresponding to existing AS 16 are as under: Converged Ind AS 23 requires calculating the interest expense to be capitalized using the Effective Interest Rate Method as described in Converged Ind AS 39 ‘Financial Instruments: Recognition and Measurement’. An illustration on interest expense as per effective interest rate method and amortized cost follows: Illustration: Dhruv and Varda Ltd. borrow ` 500 lacs @ 14% P.A. from IDICI Ltd. as a term loan for constructing a building. Interest has to be paid every year end. The loan is repayable in 5 equal installments every year end. Dhruv and Varda Ltd. pay upfront fee of 1% to IDICI Ltd. The company also pays a fee of 1% to the consultant engaged for the purpose. The building will take a year for completion. Determine the borrowing costs to be capitalized using the effective interest rate method. Solution: Let us first workout Cash outflows in year 1to 5: TABLE 1 Principal Repayment Outstanding Balance ` in Lacs Year Term Loan Taken Interest paid Cash Outflows (Principal Repayment + Interest Paid) 0 500.00 …. 500.00 …. … 1 …. 100.00 400.00 70.00 170.00 2 …. 100.00 300.00 56.00 156.00 3 …. 100.00 200.00 42.00 142.00 4 …. 100.00 100.00 28.00 128.00 5 100.00 …. 14.00 114.00 Total….. 500.00 …. 210.00 710.00 5 Note: Interest paid calculated @14% on last year’s outstanding balance. Now the main working: TABLE 2 ` in Lacs 1 2 3 4 Year Cash Flows Remaining Principal Balance or Amortized Cost Interest Payable 0 490.00 490.00 …. 1 –170.00 393.06 73.06 Principal Repayment …. 96.94 2 –156.00 295.67 58.61 97.39 3 –142.00 197.75 44.08 97.92 4 –128.00 99.23 29.48 98.52 5 –114.00 0.03 14.80 99.20 Total…..220.03 Total…489.97 Total outflow.…–710.00… IRR, i.e., EIR 5 14.91% Chapter 9 Valuation of Tangible Fixed Assets 213 Notes: 1 Column 2: Cash inflow in year 0 (490.00) 5 Principal loan (500) – Upfront fee (5.00) – Consultant’s fee (5.00). This is the Remaining Principal Balance or Amortized Cost in year 0 as per the effective interest rate method. 2 Cash outflows in year 1 to 5: As per table 1.Self explanatory. 3 IRR of these cash flows is 14.91% (Arrived at by feeding the outflows and inflows in Excel software). This is the Effective Interest Rate (EIR). 4 Interest payable in column 4 5 Remaining Principal Balance in the beginning of the year* EIR. For example, for year 1(73.06) 5 490.00*14.91%. 5 Principal Repayment in column 5 5 Total cash outflow in column 2-Interest payable in column 4. Thus for year 1 (96.94) 5 170.00 – 73.06. Remaining principal balance in year 1(393.06) 5 490.00 – 96.94. 6 Procedure repeated for all the years. 7 The working may now be summed up as under: ‘Out of total cash outflow of 710.00 over 5 years, interest payable amounts to 220.03 and principal repayment amounts to 489.97. 1st year’s Interest of 73.06 is to be capitalized and rest of the years (as per column 4) it has to be charged to respective year’s income statement. As against principal balance of 490.00, 489.97 have been paid. 0.03 represents rounding effect. Balance sheets of the respective years will show the amortized cost of loan as per column 3’ CORPORATE FINANCIAL PRACTICES You should now be in a position to understand and appreciate how the corporates carry out valuation/ revaluation of tangible fixed assets and how they disclose them in their annual reports. Being presented hereunder is the case of Whirlpool of India Limited. Please go through the same and attempt the requirements given at the end of the chapter. CASE 2 Whirlpool of India Limited CORPORATE FINANCIAL PRACTICES Whirlpool of India Limited Annual Report 2005–06 REPORT DETAILS OF FIXED ASSETS, RELATED SIGNIFICANT ACCOUNTING POLICIES AND PROFIT/LOSS ON DISPOSAL THEREOF DETAILS OF FIXED ASSETS AS APPEARING ON THE FACE OF THE BALANCE SHEET: Fixed Assets As on 31.03.06 (` in Lacs) As on 31.03.05 (` in Lacs) Gross Block………………….. Schedule – ‘E’ 61,475.42 60,020.59 Less: Depreciation 30,079.12 26,728.68 31,396.30 33,291.91 Capital Work In Progress 95.45 175.96 Capital Advances 273.76 262.80 Net Block Author’s note: Capital Work In Progress represents fixed assets under construction. ‘Capital advances’ represents advances given to suppliers for acquisition of fixed assets. As at 01.04.05 GROSS BLOCK Additions Deletions / Adjustments As at 31.03.06 As at 01.04.05 DEPRECIATION For the Deletions / year Adjustments As at 31.03.06 (` in Lacs) NET BLOCK As at As at 31.03.06 31.03.05 4. Additions to Gross Block of Buildings, Plant & Machinery and Furniture & Fixture above is after deducting grant received amounting to `62.33 lacs (Previous Year NIL), `318.74 lacs (Previous Year `652.03 lacs) and `21.79 lacs (Previous Year NIL) respectively. 5. Gross Block of Furniture, Fixture & Office Equipment include assets taken on finance lease and capitalised amounting to `84.82 lacs (Previous Year `84.82 lacs). Accumulated Depreciation on above assets as of March 31, 2006 is `80.58 lacs (Previous Year `77.23 lacs). Net Block `4.24 lacs (Previous Year `7.59 lacs). Tangible Assets Land Freehold 1,470.12 – (113.60) 1,356.52 – – – – 1,356.52 1,470.12 Land Leasehold 470.45 – – 470.45 35.82 5.06 – 40.88 429.57 434.63 Leasehold Improvements 95.39 21.95 – 117.34 87.61 6.78 – 94.39 22.95 7.78 Buildings 7,557.15 285.24 (69.81) 7,772.58 2,101.38 230.12 (38.39) 2,293.11 5,479.47 5,455.77 Plant & Machinery 48,523.35 1,446.55 (369.91) 49,599.99 23,270.28 3,279.86 (291.70) 26,258.44 23,341.55 25,253.07 Furniture, Fixture & Office Equipment 1,710.93 284.58 (25.80) 1,969.71 1,051.29 168.04 (7.53) 1,211.80 757.91 659.64 Vehicles 63.71 2.82 (7.19) 59.34 52.81 5.04 (6.84) 51.01 8.33 10.90 Intangible Asset SAP Software 129.49 – – 129.49 129.49 – – 129.49 – – TOTAL 60,020.59 2,041.14 (586.31) 61,475.42 26,728.68 3,694.90 (344.46) 30,079.12 31,396.30 33,291.91 Previous Year 58,854.99 1,690.68 (525.08) 60,020.59 23,835.94 3,256.54 (363.80) 26,728.68 33,291.91 35,019.05 Notes: 1. Additions/ (deletions) to Plant & Machinery include `15.31 lacs (Previous Year `0.48 lacs) on account of foreign exchange fluctuation. 2. Depreciation includes `39.66 lacs (Previous Year `39.66 lacs), depreciation on Fixed Assets revalued, which has been recouped from Revaluation Reserve. 3. The Company originally revalued its Fixed Assets of the Refrigerator Division based on valuation report of the independent valuer during financial year 1992–93. Net additions to Fixed Assets on account of such revaluation was `11, 362.28 lacs. In 1995–96, the Company again revalued the fixed assets of the Division and reversed the revaluation reserve created in 1992–93. Additions to revaluation reserve (over historical cost) during 1995–96 were as follows: 1995-96 Land - Freehold 2,160.40 Land - Leasehold 213.42 Building 1,652.57 Plant & Machinery 3,243.10 DESCRIPTION SCHEDULE - ‘E’ FIXED ASSETS Chapter 9 Valuation of Tangible Fixed Assets 215 EXTRACTS FROM SCHEDULE – ‘P’ B. SIGNIFICANT ACCOUNTING POLICIES Fixed Assets a. Fixed Assets are stated at cost or revalued amount less accumulated depreciation. b. The cost of a Fixed Asset comprises of its purchase price and any cost directly attributable to bringing the asset to its working condition for its intended use. Expenditure incurred on account of additions, improvements and renewals is capitalised. Repairs & maintenance expenditure is charged to the Profit and Loss Account. c. Cost and accumulated depreciation pertaining to Fixed Assets disposed off are removed from the accounts at the time of disposal. Any resultant gain or loss is included in the Profit and Loss Account. 8. Grant a. Grants are recognized when there is reasonable assurance that the grant will be received and conditions attached to them are complied with. b. Grant received against specific asset is shown as a deduction from its gross value. Where the grant received equals the whole, or virtually the whole, of the cost of the asset, the asset is shown at a nominal value. 12. Borrowing Costs Borrowing costs that are attributable to the acquisition of or construction of qualifying assets are capitalized as part of the cost of such assets. A qualifying asset is one that necessarily takes substantial period of time to get ready for its intended use. All other borrowing costs are charged to revenue. 6. EXTRACT FROM SCHEDULE – ‘N’ ADMINISTRATIVE & SELLING EXPENSES Loss on Disposal/Write off of Fixed Assets (Net) For the Year ended 31.03.06 (` in Lacs) For the Year ended 31.03.05 (` in Lacs) 41.99 89.44 VALUATION OF WASTING, NON-REGENERATIVE, ASSETS You may recall having been informed earlier that special considerations apply to the valuation of wasting, non-regenerative, assets. What can be such considerations? Case of Oil and Natural Gas Corporation Ltd. is being presented here to illustrate them. Corporate Financial Practices Oil and Natural Gas Corporation Ltd. is in the business of oil and gas exploration and production. It is often quoted as the most valuable Indian company. It values its main fixed assets, that is, oil and gas producing properties on the basis that is known as successful efforts method of accounting in its industry. Please go through the case and attempt the requirements given at the end of the chapter. 216 3 Financial Accounting for Management CASE Oil and Natural Gas Corporation Ltd. REPORT CORPORATE FINANCIAL PRACTICES Oil and Natural Gas Corporation Ltd. Annual Report 2005–06 WWW www.omgcindia.com VALUATION OF OIL AND GAS PRODUCING PROPERTIES AS PER THE SUCCESSFUL EFFORTS METHOD OF ACCOUNTING A. DETAILS OF FIXED ASSETS: The company has shown assets represented by Producing Properties, Exploratory/Development Wells- In-Progress, Other Fixed Assets and Capital Work-In-Progress separately under the head Fixed Assets as under: As at 31.03.2006 (` in Crores) Gross Block Depreciation / Depletion Net Block Fixed assets 47,882 Depreciation 40,040 7,842 Producing properties 56,089 Depletion 28,506 27,583 Capital work-in-progress … … … 2,830 Exploratory / development wells-in-progress … … … 2,960 B. SCHEDULE-27: SIGNIFICANT ACCOUNTING POLICIES: 2. Exploration, Development and Production Costs: 2.1 Survey Costs Cost of Surveys and prospecting activities conducted in the search of oil and gas are expensed in the year in which these are incurred. 2.2 Exploratory/ Development Wells in Progress 2.2.1 All acquisition costs, exploration costs involved in drilling and equipping exploratory and appraisal wells, cost of drilling exploratory type strata graphic test wells are initially capitalised as exploratory wells in progress till the time these are either transferred to producing properties on completion or expensed in the year when determined to be dry or of no further use, as the case may be. 2.2.2 All wells under “exploratory wells in progress” which are more than two years old from the date of completion of drilling are charged to Profit and Loss Account except those wells which have proved reserves and the development of the fields in which the wells are located has been planned. 2.2.3 All costs relating to development wells are initially capitalized as development wells in progress and transferred to producing properties on completion. 2.3 Producing Properties 2.3.1 Producing properties are created in respect of an area/field having proved developed oil and gas reserves, when the well in the area/field is ready to commence commercial production. 2.3.2 Cost of temporary occupation of land, successful exploratory wells, all development wells and all related development costs including depreciation on support equipment and facilities and estimated future abandonment costs are capitalised and reflected as Producing Properties. 2.3.3 Depletion of Producing Properties (See next chapter on depreciation). 2.4 General Administrative Overheads General Administrative Overheads at Assets, Basins, Services, Regions and Headquarters are charged to Profit and Loss Account. Chapter 9 Valuation of Tangible Fixed Assets 217 2.5 Production Costs Production costs include pre-well head and post well head expenses including depreciation and applicable operating costs of support equipment and facilities. 4. Abandonment Cost 4.1 The full eventual liability towards costs relating to dismantling, abandoning and restoring offshore well sites and allied facilities is recognized at the initial stage as cost of producing property and liability for abandonment cost, based on the latest technical assessment available at current costs with the Company. 4.2 Cost relating to dismantling, abandoning and restoring onshore well sites and allied facilities are accounted for in the year in which such costs are incurred as the salvage value is expected to take care of the abandonment costs. CONCLUDING REMARKS We learnt in this chapter about the various aspects of fixed assets valuation. We also gained knowledge of corporate financial practice of leading Indian companies on the subject. Armed with this knowledge, we now move to the next chapter on depreciation, where an integrated study of fixed assets and depreciation will be carried out. Keywords n Accumulated Depreciation n Fair Market Value n Non-monetary Assets n Amortized Cost n Fair Value n Non-regenerative Resources n Basket Purchase n Government Grants n Pre-operative Administrative n Borrowing Costs n Gross Book Value Expenses n Capital Reserve n Held for Disposal n Property, Plant & Equipment n Cash Flows n Installation Cost n Regenerative Natural Resources n Component Approach n Jointly Controlled Entity n Retirements n Cost Model n Jointly Owned Fixed Assets n Revaluation n Deferred Income n IRR n Leased Assets n Net Book Value n Net Realizable Value n Non-depreciable Assets n Revaluation Model n Depreciable Assets n Effective Interest Rate Method n Exchange Fluctuations WWW n Tangible Fixed Assets n Test Runs n Wasting Assets 1. Accounting for Fixed Assets, AS-10, www.icai.org. 2. The Effects of Changes in Foreign Exchane Rates, AS-11, www.icai.org. 3. Accounting for Government Grants, AS-12, www.icai.org. 4. Borrowing Costs, AS-16, www.icai.org. 218 Financial Accounting for Management 1. Asian Hotels Ltd., Annual Report, 2005–06. 2. Bharti Airtel Ltd., Annual Report, 2005–06. 3. Indian Oil Corporation Ltd., Annual Report, 2001–02. 4. Indraprastha Gas Ltd., Annual Report, 2005–06. 5. Indraprastha Medical Corporation Ltd., Annual Report, 2005–06. 6. Infosys Technologies Ltd., Annual Report, 2005–06. 7. ITC Ltd., Annual Report, 2005–06. 8. JK Cement Ltd., Annual Report, 2005–06. 9. Oil and Natural Gas Corporation Ltd., Annual Report, 2005–06. 10. Ranbaxy Laboratories Ltd., Annual Report, 2005–06. 11. Reliance Energy Ltd., Annual Report, 2005–06. 12. Reliance Industries Ltd., Annual Report, 2005–06. 13. Shoppers’ Stop Ltd., Annual Report, 2005–06. 14. Whirlpool of India Limited, Annual Report, 2005–06. REPORT exercises Ex. 1 Shiva Industries Ltd. Determination of Cost of Fixed Assets Shiva Industries Ltd. purchased a machine. The details are as under. Determine the cost of the machine. Details Amount (`) Amount (`) Invoice Price List Price 75,00,000 Less: Trade Discount 1,50,000 Balance 73,50,000 Add: Sales Tax and Excise Duty 9,00,000 82,50,000 CENVAT Credit Available on Excise Duty Included Above ... 6,00,000 Transportation Charges to Factory Site ... 37,500 Special Foundation and Installation Charges ... 1,12,500 Chapter 9 Valuation of Tangible Fixed Assets 219 Ex. 2 DR. KAPIL SETH’S IMAGING CENTRE LTD. Determination of Cost of Fixed Assets on Exchange Dr. Kapil Seth’s Imaging Centre Ltd. part exchanged its old X-ray machine with a new one from Rajneesh Medical Equipments Ltd. Net book value of the old X-ray machine was ` 4,68,345. However the vendor assessed its exchange value at ` 4,25,000 to which Dr. Kapil Seth’s Imaging Centre Ltd. agreed. The selling price of the new X-ray machine as per the company price list was ` 12,58,000 subject to a further discount of ` 12,580 in case of an outright sale deal. The discount was, however, not available for exchange case and, therefore, Dr. Kapil Seth’s Imaging Centre Ltd. paid ` 8,33,000 by way of cheque drawn on its Corporation Bank current account to Rajneesh Medical Equipments Ltd. Determine the cost at which the new X-ray machine will be recorded in the financial statements of Dr. Kapil Seth’s Imaging Centre Ltd. How will the old X-ray machine be treated? Ex. 3 Shikha entertainment Ltd. Basket Purchase Shikha Entertainment Ltd. purchased some fixed assets for a consolidated price. The details are as under. Details of the market values of these assets as appraised by a valuer are also given. Determine the cost of each asset. Details Consolidated Price (`) Market Values (`) Land ... 4,05,00,000 Building Built Thereon ... 5,40,00,000 Furniture and Fixtures ... 1,35,00,000 Machines and Equipments for Pay Channel Infrastructure Total ... 16,20,00,000 22,50,00,000 27,00,00,000 Ex. 4 BHASKAR FOODS LTD. Treatment of Government Grant and its Impact on Valuation of Fixed Asset Bhaskar Foods Ltd. acquires a machine whose total cost comes to ` 270 lacs. The company received a grant of ` 24 lacs from the central government against the machine. Determine its book value under the two alternatives. Useful life of the machine is 6 years. Depreciation will be apportioned in equal trenches over 6 years. Determine depreciation under the two alternatives and show how the grant will be treated in the financial statements. Offer your comments on which alternative is better. Why? Again: Do this exercise based on WDV method of depreciation after learning it in the next chapter. 220 Financial Accounting for Management Ex. 5 Dhruv Udhyog Ltd. Valuation When Project Ready for Commercial Production Dhruv Udhyog Ltd. has established a new project. Details of fixed assets and expenditure incurred during the construction of the project are given hereunder. Determine the cost of each asset at the end of completion of the project, ready for commercial production. Details Amount (`) Land 2,25,00,000 Buildings 4,50,00,000 Plant and Machinery 29,25,00,000 Misc. Fixed Assets 1,50,00,000 Pre-operative Administrative Expenses on Start-up, Commissioning, Test Runs and Experimental Production 2,25,00,000 Interest on Term Loans during the Construction Period 2,70,00,000 Total 42,45,00,000 Ex. 6 MOC (Managerial Oral Communication) Group Assignment Following the guidelines provided in the MOC Group Assignment in Chapter 4, prepare a 10-minute Powerpoint presentation on the contents of this chapter. Bring out the various issues related to fixed assets valuation and their significance very clearly. Ex. 7 CASE 1 WHIRLPOOL OF INDIA LTD. Case on Corporate Financial Practices—Valuation/Revaluation of Tangible Fixed Assets Refer to the extracts from annual report 2005-06 of the Whirlpool of India Limited regarding its fixed assets, related significant accounting policies and profit/loss on disposal thereof as illustrated in this chapter. Having gone through the information provided therein, answer the following questions: 1. Has Whirlpool made the disclosures related to fixed assets and other incidental matters (except depreciation) in accordance with the GAAP requirements? (Skip intangible assets, note no. 2 on depreciation and note no. 5 on assets under finance lease, as covered in schedule ‘E’, “and revaluation”at this stage. These issues have been covered in the chapters that follow). 2. Has Whirlpool followed correct accounting policies in respect of fixed assets, grants and borrowing costs? 3. How much sale consideration Whirlpool might have realized during 2005–06 on assets disposed off ? Chapter 9 Valuation of Tangible Fixed Assets 221 Ex. 8 CASE 2 OIL AND NATURAL GAS CORPORATION LTD. Case on Corporate Financial Practices—Valuation of Wasting Assets: Oil and Gas Producing Properties Refer to the extracts from annual report 2005-06 of the Oil and Natural Gas Corporation Ltd. regarding valuation of its oil and gas producing properties as per the successful efforts method of accounting and related significant accounting policies as illustrated in this chapter. Having gone through the information provided therein, answer the following questions: 1. What are the broad characteristics of the operations of ONGC? 2. The valuation of oil producing properties by ONGC is so different from the principles of valuation of general fixed assets as studied by you. What considerations guide this treatment? 10 Depreciation on Fixed Assets Value of fixed assets keeps on reducing over their useful lives due to their use. This reduction, known as depreciation, is charged to profit and loss account. Depreciation has a significant bearing on the measurement of financial performance and position. Chapter 10 Depreciation on Fixed Assets 223 CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 Meaning and significance of depreciation. 2 Scope and coverage of AS-6 on ‘Depreciation Accounting’. 3 Principles and norms of standard accounting treatment of depreciation, methods of depreciation and other related issues. 4 Impact of different methods of depreciation on profit and tax. 5 Requirements of the Companies Act regarding depreciation. 6 Requirements of the Income Tax Act regarding depreciation. 7 Minimum alternate tax and deferred tax. 8 Disclosure requirements in respect of depreciation in the financial statements. INTRODUCTION Fixed assets, as discussed in the last chapter, are long-lived assets but not ever-living, except for freehold land. Why? Because they undergo wear and tear due to their use, become obsolete, like computers, or deplete due to extraction, like mines. Likewise, the leasehold land reverts to the lesser at the end of the lease period. Thus, the long-term investment made into fixed assets keeps reducing over the years or, so to say, over the useful life of the assets. Such reduction or consumption by use of the assets by a company is known as depreciation. It is charged to the profit and loss account over the useful life of the assets. Depreciation has a significant bearing on the measurement of financial performance. We will discuss the subject in detail hereunder. DEPRECIATION ACCOUNTING The ICAI issued the Accounting Standard (AS-6) “Depreciation Visit www.icai.org for Accounting” in November 1982 which was superseded by revised stanoriginal text of revised dard, of the same number, that came into effect in respect of accounting WWW AS-6. Click: Resources— periods commencing on or after 1st April 1995. The revised standard Accounting Standards. defines depreciation and depreciable assets, sets out the significance of depreciation, specifies the fixed assets excluded from its scope and coverage, and prescribes the principles and norms of standard accounting treatment for various aspects of depreciation accounting. These include determinants of depreciation, methods of depreciation, statutory requirements and compliances, consistency principle and depreciation charge in special cases, and disclosure requirements in financial statements prepared on historical cost basis, including revaluation. Let us understand, discuss and analysis these. 224 Financial Accounting for Management MEANING AND SIGNIFICANCE OF DEPRECIATION Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation represents the charge of a fair proportion of the depreciable amount of an asset to profit and loss account in each accounting period BIRD’S EYE VIEW during the expected useful life of the asset. Depreciable amount of a AS-6: Depreciation depreciable asset represents its historical cost, or revalued amount subAccounting stituted for historical cost in the financial statements, less the estimated residual value. Depreciation includes amortization of assets, like goodn Meaning and Significance of Depreciation will, whose useful life is predetermined. n Scope and Coverage Depreciation plays a significant role in determining and presenting n Principles and Norms of Standard the results of operations and financial position of an enterprise. It is Accounting Treatment: charged in each accounting period with reference to the extent of the — Determinants of depreciation depreciable amount irrespective of the increase in the market value of — Methods of depreciation the assets, if any. — Statutory requirements and compliance — Consistency principle — Depreciation charge in special cases — Revaluation of Fixed Assets and depreciation n Disclosure Requirements Research in Financial Reporting Recall the companies analysed under this head in the last chapter. Data of same companies are researched here further to bring out the significance of depreciation very profusely. REPORT RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors DEPRECIATION AND OTHER RELATED DETAILS FOR THE YEAR ENDED 31 MARCH 2006 ` in Crores Sl. No. Company Industry 1 Asian Hotels Ltd. Hotels–Tourism 2 Bharti Airtel Ltd. 3 Indraprastha Medical Corporation Ltd. 4 Indraprastha Gas Ltd. 5 6 Depreciation for the year PBT for the year PBTD for the year Depreciation to PBTD 21 87 108 19% Telecom 1,412 2,286 3,698 38% Hospital– Healthcare 13 22 35 37% Natural Gas 57 160 217 26% Infosys Technologies Ltd. Information Technology 409 2,724 3,133 13% ITC Ltd. FMCG 320 3,269 3,589 9% 7 JK Cement Ltd. Cement–Housing related 42 52 94 45% 8 Ranbaxy Laboratories Ltd. Healthcare 76 190 266 29% Chapter 10 Depreciation on Fixed Assets 9 Reliance Energy Ltd. Power 10 Reliance Industries Ltd. Oil and Gas 11 Shoppers’ Stop Ltd. Retail 225 414 781 1,195 35% 4,710 10,704 15,414 31% 12 40 52 23% Notes: 1. Data: Derived from respective annual reports. 2. Depreciation: Relates to tangible fixed assets only. 3. PBTD: Profit before tax and depreciation. 4. Ranbaxy Laboratories Ltd.: Year ended 31-12-2005. You will appreciate that: 1. Depreciation expense varies from 9% (ITC Ltd.) to 45% (JK Cement Ltd.) of PBTD, that too towards the upper end of the band in most cases, depending upon the industry. It shows that depreciation amounts to a major expense item in corporate financial statements. 2. Hence, in continuation to a true and fair identification and measurement of fixed assets, as seen in the last chapter, a fair assessment of depreciation charge thereon is crucial for true measurement and disclosure of profit and financial position. Bharti Airtel Ltd., Indraprastha Medical Corporation Ltd., JK Cement Ltd., Reliance Energy Ltd. and Reliance Industries Ltd. present burning examples. SCOPE AND COVERAGE The standard deals with depreciation accounting and applies to all depreciable assets as specified in AS-10 as mentioned under the heading “scope and coverage” in the preceding chapter on Valuation of Tangible Fixed Assets. Further it applies to fixed assets acquired on finance lease but not to wasting assets. Depreciable assets are assets which: 1. Are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business. 2. Are expected to be used during more than one accounting period. 3. Have limited useful life. The standard thus covers fixed assets other than those specifically excluded. It does not apply to investment property (See chapter on valuation of investments) and land unless it has a limited useful life for the enterprise. PRINCIPLES AND NORMS OF STANDARD ACCOUNTING TREATMENT Let us now proceed to discuss the principles and norms of standard benchmark treatment of depreciation accounting in the financial statements. 226 Financial Accounting for Management Determinants of Depreciation The amount of depreciation is assessed and charged to the profit and loss account on the basis of the following: 1. Historical cost or revalued amount of the depreciable asset. BIRD’S EYE VIEW 2. Expected useful life of the depreciable asset. 3. Estimated residual value of the depreciable asset. Determinants of Depreciation Let us discuss these three basic considerations in providing depreciation. n Historical Cost or Revalued Amount n Expected Useful Life n Estimated Residual Value Historical cost or revalued amount This aspect has already been discussed in the preceding chapter on valuation of tangible fixed assets. Expected useful life The useful life of a depreciable asset means: 1. The period over which the asset is expected to be used, or 2. The number of production or similar units expected to be obtained from the use of the asset. The useful life of a depreciable asset is usually estimated on the basis of various factors including experience with similar types of assets. Estimation requires managerial judgement in the light of technical considerations, for example, likelihood of obsolescence of technology, commercial considerations, for example, change in consumer preferences, product life cycle, accounting and legal requirements, for example, the requirements of the Companies Act which prescribes rates of depreciation on fixed assets on the basis of presumed useful lives, and at times is a difficult job particularly in cases of assets using new technology or assets used in the production of a new product or in the provision of a new service and, therefore, calls for some reasonable basis in each case. The useful life of a depreciable asset is usually shorter than its physical life and is: n Dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors, for example, the number of shifts for which the asset is to be used, repair and maintenance practice of the enterprise etc. n Reduced by obsolescence arising from factors, for example, technological changes, improvement in production methods, change in market demand for the product, change in service output of the asset and legal or other restrictions. n Pre-determined by legal or contractual limits on use, for example, the expiry dates of related leases. n Directly governed by extraction or consumption as in the case of mines or oil wells. Estimated residual value Residual value means the amount expected to be realised on disposal of an asset at the end of its useful life. Clearly, estimation of residual value is a difficult job. If such value is considered insignificant, it is normally regarded as nil. However, if it is likely to be significant then it is estimated at the time of acquisition/installation of the asset or at the time of its revaluation. The realisable value of a similar asset, which has reached the end of its BIRD’S EYE VIEW useful life and has operated under conditions similar to those in which the proposed Methods of asset will be used, could form one of the bases for determining the residual value Depreciation of the proposed asset. n Straight Line Method— SLM n Written Down Value Method—WDV n Impact of SLM and WDV on Profits and Tax Methods of Depreciation Several methods of allocating depreciation over the useful life of the assets are available. However, the Straight Line Method (SLM) and the Reducing Balance or Written Down Value Method (WDV) are the two most common methods Chapter 10 Depreciation on Fixed Assets 227 employed in industrial and commercial enterprises. The management of a business selects the most appropriate method(s) based on various important factors, such as: n Type of asset, say, prone to fast obsolescence. n The nature of the use of such asset, whether frequent or infrequent. n Circumstances prevailing in the business, for example, ongoing lockout or plant operating far below its normal capacity. n Tax considerations, as discussed later. A combination of more than one method is sometimes used. Full depreciation is often allocated in respect of depreciable assets that do not have material value in the accounting period itself in which they are acquired. Let us talk about SLM and WDV in detail: SLM Straight-line method is a simple and easy-to-use method of charging depreciation. As the name indicates, under this method, depreciation is charged evenly over the useful life of the asset. The amount to be charged is, therefore, calculated by dividing the cost of the depreciable asset minus its residual value by the number of years the asset is expected to be used for. SLM is more appropriate in cases where the benefit to be gained from the use of the asset is likely to have an even spread over its useful life. The formula for working out SLM depreciation is as under: Depreciation charge 5 Cost of asset 2 Estimated residual value Expected useful life The depreciation charge divided by the cost of the asset provides the rate of SLM depreciation. ILLUSTRATION 1 ARPIT INDUSTRIES LTD. SLM Let us continue with the illustration 1 of Arpit Industries Ltd. as given in the last chapter. Apart from the cost, some more information is now provided hereunder. Details Cost of the Machine Expected Useful Life (Years) Consideration Expected on Disposal Estimated Cost of Removal of the Machine for Disposal Estimated Realisable Value Required 1. Determine the rate of depreciation as per SLM. 2. Determine the annual depreciation and accumulated depreciation for all the years as per SLM. 3. Show the disclosure of machine in the balance sheet for all the years. 4. State the accounting policy on depreciation of machine. Amount (`) 52,00,000 5 2,80,000 20,000 2,60,000 228 Financial Accounting for Management SOLUTION Req. 1. Rate of Depreciation l Computation of annual depreciation ` 52,00,000 2 2,60,000 5 l Hence the rate of depreciation 5 ` 9,88,000 3 100 ` 52,00,000 5 ` 9,88,000 5 19% Req. 2. Annual Depreciation and Accumulated Depreciation Year Annual Depreciation (`) Accumulated Depreciation (`) 1 9,88,000 9,88,000 2 9,88,000 19,76,000 3 9,88,000 29,64,000 4 9,88,000 39,52,000 5 9,88,000 49,40,000 Total 49,40,000 … Req. 3. Disclosure of Machine in the Balance Sheet Details Amount (`) Year Fixed Assets—Machine: 1 2 3 4 5 52,00,000 52,00,000 52,00,000 52,00,000 52,00,000 n Depreciation for the year n Accumulated depreciation as 9,88,000 9,88,000 9,88,000 9,88,000 9,88,000 at the beginning of the year n Total … 9,88,000 9,88,000 19,76,000 19,76,000 29,64,000 29,64,000 39,52,000 39,52,000 49,40,000 Net Book Value 42,12,000 32,24,000 22,36,000 12,48,000 2,60,000 Cost Accumulated Depreciation Req. 4. Accounting Policy The company provides depreciation on machine as per the straight-line method expecting its useful life to be five years and estimating its residual value to be 5% of the cost. Thus, effectively, the depreciation is provided @ 19% p.a. WDV This is an accelerated method of depreciation and, therefore, results in a higher depreciation charge in the early years of the asset’s use and tends to reduce in lateral years. The depreciation charge is thus unevenly spread over the useful life of the asset. The advocates of this method argue that it helps to even out the total charges as expense for the use of the asset each year. They state that depreciation is not the only cost charged, that there are repairs and maintenance costs as well and that these costs usually increase with the age of the asset. Therefore, to equate total costs for each year of use, depreciation cost should fall as the repairs and maintenance costs increase. This method is, therefore, more appropriate in cases where the benefit to be gained from the use of the asset is likely to be more in its earlier years of use. Chapter 10 Depreciation on Fixed Assets 229 The following formula is applied to arrive at the percentage rate of depreciation under this method: Rate of depriciation = 1 – n Estimated residual value Cost of asset where n 5 Expected useful life of the asset in number of years. The rate so arrived at is applied to the cost of the asset in the first year and to the written down value of the asset, that is, cost minus accumulated depreciation already charged, from the second year onwards. Both the methods are widely prevalent and the choice is governed by the factors mentioned above. Both, however, result in the same amount of total depreciation charge over the useful life of the asset. ILLUSTRATION 2 ARPIT INDUSTRIES LTD. WDV Let us continue with the illustration of Arpit Industries Ltd. Required 1. Determine the rate of depreciation as per WDV. 2. Determine the annual depreciation and accumulated depreciation for all the years as per WDV. 3. Show the disclosure of machine in the balance sheet for all the years. 4. State the accounting policy on depreciation of machine. SOLUTION Req. 1. Rate of Depreciation 1– 5 2,60,000 = 1– 0.54928 = 0.45072 or 45.0 07% 52,00,000 Req. 2. (a) Computation of First Year’s Depreciation ` 52,00,000 3 45.07 100 5 ` 23,43,640 (b) Annual Depreciation and Accumulated Depreciation: Second year onwards the rate of 45.07% has been applied to the net book value of the previous year as shown in the table in requirement 3. Year 5 depreciation has been increased from ` 2,13,368 to ` 2,13,415 (1 47) to settle the cumulative impact of rounding off of the depreciation rate. 230 Financial Accounting for Management Year Annual Depreciation (`) Accumulated Depreciation (`) 1 23,43,640 23,43,640 2 12,87,361 36,31,001 3 7,07,148 43,38,149 4 3,88,436 47,26,585 5 2,13,415 49,40,000 Total 49,40,000 … Req. 3. Disclosure of Machine in the Balance Sheet Details Amount (`) Year Fixed Assets—Machine 1 2 3 4 5 52,00,000 52,00,000 52,00,000 52,00,000 52,00,000 n Depreciation for the year n Accumulated depreciation as 23,43,640 12,87,361 7,07,148 3,88,436 2,13,415 at the beginning of the year n Total … 23,43,640 23,43,640 36,31,001 36,31,001 43,38,149 43,38,149 47,26,585 47,26,585 49,40,000 Net Book Value 28,56,360 15,68,999 8,61,851 4,73,415 2,60,000 Cost Accumulated Depreciation: Req. 4. Accounting Policy: The company provides depreciation on machine as per written down value method expecting its useful life to be five years and estimating its residual value to be 5% of the cost. Thus, effectively, the depreciation is provided @ 45.07% p.a. Comparative Assessment of the impact of SLM and WDV on profits and tax You will note from the above two illustrations that: 1. The total depreciation charge over the useful life of the machine is the same and so is the net book value at the end of 5 years. 2. SLM depreciation is uniform over 5 years while WDV depreciation is continuously declining. 3. First year WDV depreciation is 2.37 times of SLM. Third year onwards the trend reverses and SLM charge is much higher particularly in the 4th and 5th years. 4. If the company chooses WDV method, then in the first two years its profits will be obviously lower and hence a lower tax liability. From the third year onwards the situation will reverse and the company will be paying more income tax. This is subject to income tax rates remaining the same over the useful life of the machine. 5. However, the total depreciation over the useful life of the machine being the same, on a cumulative basis the tax liability of the company under both the methods will remain the same. But WDV has some of the following advantages: n Gain on account of time value of money due to deferring of tax liability. n Likely gain in case the tax rates decline in future. However, there is a risk of increased rates as well. But this risk may be made good by the time value gain. n Better cash flows during the initial years, enabling the company to earn further on the tax deferred. 6. The analysis in point 4 and 5 is based on conceptual economic considerations. These considerations assume that methods and rates of depreciation as per the statute governing the enterprise, for Chapter 10 Depreciation on Fixed Assets 231 example, companies act and the income tax act are the same. In practice, however, that may not be the case. Hence, the tax liability will be governed by the income tax act. Discussion on this issue follows. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is depreciation? Outline its significance in determining profitability. 2. Discuss the key elements in determining depreciation. 3. Discuss the impact of alternate methods of depreciation on profits and taxes. To enrich your discussion, add your own ideas, thoughts and practical inputs. Statutory Requirements and Compliance Two important statutes, namely, The Income Tax Act and The Companies Act contain provisions relating to depreciation which need to be complied with by every company. Let us discuss them in brief. BIRD’S EYE VIEW Statutory Requirements and Compliance n Requirements of the Companies Act — Rates of depreciation as per Requirements of the Companies Act schedule XIV Often the statute governing an enterprise may provide the basis for — Choice of the method computation of depreciation. For example, the Companies Act, 1956, — Life of plant and machinery items lays down the rates of depreciation in respect of various assets, to be n Provisions of the Income Tax Act adopted in the preparation of corporate financial statements. Where, — Rates of depreciation as per appendix I — rule 5 however, the management’s estimate of the useful life of an asset is — MAT and deferred tax shorter than that envisaged under the relevant statute, for example, where the depreciation rate as per management estimates is higher than as per the statute, the depreciation is computed by applying the higher rate. If, however, the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than the statutory rate can be applied only in accordance with the requirements of the statute, if any, and subject to the disclosure of the fact in the financial statements. Refer to 2010 edition of Two sections of the Act, namely, Sections 205 and 350, deal with Taxmann’s Companies Act depreciation to be provided by a company in its accounts. Section 205 for original text of relevant provides that no company can declare or pay any dividend out of its profrequirements. its without providing for depreciation. The section further provides that depreciation has to be provided as under: (a) As specified in Section 350, or (b) As arrived at by dividing 95% of the original cost of the asset by the specified period. ‘Specified period’ has been defined to mean the number of years at the end of which at least 95% of the original cost of the asset will have been provided for by way of depreciation if it were to be calculated in accordance with Section 350. Section 350 in turn prescribes that depreciation has to be provided at the rates specified in Schedule XIV to the Companies Act. 232 Financial Accounting for Management Rates of depreciation as per Schedule XIV The table below provides a glimpse of the rates of depreciation of common items of fixed assets as contained in Schedule XIV: Sl. No. 1. 2. Assets WDV SLM Buildings: n Factory Buildings 10% 3.34% n Other Buildings 5% 1.63% n Purely Temporary Erections, such as, wooden structures 100% 100% 4.75% Plant and Machinery: General Rates: n l Single shift 13.91% l Double shift 20.87% 7.42% l Triple shift 27.82% 10.34% Special Rates for Different Items 3. Electrical Fittings, Installations and Machines 4. Vehicles: n Cycles, electrically operated vehicles n Motor cars, motor cycles, scooters and other mopeds n Commercial vehicles such as motor buses and lorries other than those used in a business of running them on hire As specified 13.91% 4.75% 20% 7.07% 25.89% 9.5% 30% 11.31% 18.1% 6.33% 5. Furniture and Fittings: General Rates 6. Accounting Machines, Air-conditioners, calculators, office machinery, typewriters etc. 13.91% 4.75% 7. Data Processing Machines Including Computers 40% 16.21% 8. Individual Assets Costing ` 5,000 or Less 100% 100% Choice of the method Companies are free to choose either of the two methods: WDV or SLM. The schedule further prescribes that: 1. The depreciation is to be charged on pro rata basis. 2. Double or triple shift charge has to be proportionate to the number of days worked double or triple shift. 3. Disclosure of the following is to be made in the accounts: n Depreciation method used, and n Depreciation rates or useful lives of the assets if different from the principal rates specified in the schedule. Life of plant and machinery items The following computation reveals that life of plant and machinery items, in general, has been assumed to be 20 years under the Companies Act: Chapter 10 Depreciation on Fixed Assets Details 233 Amount ( `) Suppose the cost of asset is... 100 Less: Residual Value @ 5% as mentioned above 5 Depreciable Amount 95 Rate of SLM Depreciation for Single Shift 4.75% Hence, Useful Life...95/4.75 20 years Provisions of the Income Tax Act Section 32 of the Income Tax Act, Rule 5 of the Income Tax Rules and appendices thereto, deal with depreciation. The salient features of various provisions regarding depreciation under the Income Tax Act and Rules are as under: 1. Only the WDV method is recognised except in case of power genRefer to 2010 edition of eration and distribution undertakings. Bharat’s Income Tax Act 2. ‘Block of assets’ method is followed. This method allows for groupand Rules for original text of relevant requirements. ing of assets that carry the same rate of depreciation. 3. Full depreciation is allowed if the asset is used for 180 days or more during the year. In case of use for less than 180 days, the depreciation is restricted to 50%. 4. Unlike the Companies Act, the Income Tax Act does not allow shift depreciation on plant and machinery. Rates of depreciation as per Appendix I-Rule 5 The table below provides a glimpse of the rates of depreciation of common items of fixed assets, with effect from 1.04.2006, that is, assessment year 2006–07, as contained in Appendix I: Sl. No. 1. 2. Assets WDV Buildings: n Buildings other than those used mainly for residential purposes n Buildings used mainly for residential purposes n Purely temporary erections, such as wooden structures 10% 5% 100% Plant and Machinery: n General rates n Special rates for different items 3. Electrical Fittings 4. Vehicles: n General rates n Motor cars other than those used in a business of running them on hire n Special rates for commercial vehicles 15% As specified 15% 15% 15% As specified 5. Furniture and Fittings 10% 6. Accounting Machines, air-conditioners, calculators, office machinery, typewriters etc. 15% 7. Computers including computer software 60% 234 Financial Accounting for Management Book Profit and Taxable Profit It needs to be noted that companies have to provide depreciation in their financial statements at the rates provided in Schedule XIV, either following the WDV or SLM method. Their taxable income is, however, calculated on the basis of WDV rates as per the Income Tax Act. The rates of depreciation being different under the two acts and companies act further providing the option of WDV or SLM, this results in two sets of profit-book profit as per the financial statements and taxable profit as per the income tax act. An illustration will make this clear. ILLUSTRATION 3 LEPICIER CYRILLE COSMETICS LTD. COMPARATIVE STUDY OF STATUTORY DEPRECIATION PROVISIONS BOOK PROFIT AND TAXABLE PROFIT Lepicier Cyrille Cosmetics Ltd. purchases a machine costing ` 150 lacs and factory building for ` 5 lacs on 1st April 2006. Assume that the company does not own any other depreciable asset. Work out the first year depreciation as per SLM and WDV methods for all the three shifts under the Companies act and as per the Income Tax act. Also work out the book profit and taxable profit for the year 2006–07 assuming that the profit before depreciation but after providing for all other expenses for the year was ` 80 lacs. Analyse the results. SOLUTION First Year Depreciation Income Tax Act Companies Act SLM (WDV) WDV SHIFTS Single Double SHIFTS Triple Single Double Triple Rates of depreciation: n Factory building 10% n 3.34% 10% Machine 15% 4.75% 7.42% 10.34% 13.91% 20.87% 27.82% 50,000 16,700 16,700 16,700 50,000 50,000 50,000 Amount of depreciation (`): n Factory building n Machine 22,50,000 7,12,500 11,13,000 15,51,000 20,86,500 31,30,500 41,73,000 n Total 23,00,000 7,29,200 11,29,700 15,67,700 21,36,500 31,80,500 42,23,000 Profit before depreciation (`) 80,00,000 PBT…Book Profit … 72,70,800 68,70,300 64,32,300 58,63,500 48,19,500 37,77,000 PBT…Taxable Profit 57, 00,000 … … … … … … Analysis: 1. Companies act depreciation is higher than Income Tax act depreciation only in cases of double and triple shift working as per WDV. Hence the book profit is lower than the taxable profit in these two situations. 2. Income Tax act depreciation is higher than Companies act depreciation in all other situations. Hence the book profit is higher than the taxable profit in all other situations. Chapter 10 Depreciation on Fixed Assets 235 MAT and deferred tax Please note that: 1. Companies are now required to pay a minimum alternate tax (MAT) of 18% of their book profits, that is, profit as per profit and loss account, even though their taxable income may be nil or less than 18% of their book profits, after taking into account other deductions, as per the provisions of the Income Tax Act. This has led companies to change their depreciation accounting policy from SLM to WDV to reduce their book profits, and in the case of ever expanding companies, for example, Reliance Industries Ltd., the tax liability keeps deferring on this count. 2. As seen earlier, total depreciation cannot be more than the depreciable amount of the machine, that is, ` 150 lacs irrespective of the method adopted. What it means is that over the useful life of the machine, the company will be paying the same amount of tax presuming there is no change in the tax rates. Therefore, the tax advantage of earlier years will give way to a higher tax liability in later years, or in other words, company will just be deferring its tax liability. The accounting standards now require companies to measure their deferred taxes and make provision for them in their income statement. This subject has been dealt at length later on in the chapters on ‘Corporate Profit and Loss Account’ and ‘Strategic and Integrated Managerial Financial Analysis of Nestlé India Ltd. Based on the Model’. Consistency Principle: Change in Method Consistency principle is to be followed in providing depreciation. The method of depreciation, once adopted, needs to be applied consistently to provide comparability of the results of the operations of the enterprise from period to period. A change from one method to another can be done only: n When the statute governing the enterprise requires the adoption of the new method, or n To comply with the requirements of an accounting standard, or n When change is considered to result in a more appropriate preparation or presentation of the financial statements of the enterprise. For example, switching over from SLM to WDV on the introduction of minimum alternate tax to align book profit with taxable profit. When such a change in the method of depreciation is done, depreciation is recomputed, in accordance with the new method, with retrospective effect, that is, from the date of the asset coming into use. The deficiency or surplus arising from recomputation is charged or credited to the profit and loss account in the year in which the method is changed. Such a change is treated as a change in accounting policy and its effect is quantified and disclosed. Consistency principle not violated Consistency principle is not supposed to have been violated when different methods of depreciation are used for: n Different kind of assets, for example, SLM for buildings and WDV for machinery or SLM for one kind of machinery and WDV for another kind. We have noted earlier that type of asset is one of the determinants of the method of depreciation to be adopted. n Similar assets acquired up to a particular date and thereafter, for example, SLM on machinery acquired up to 31-03-2005 and WDV for that acquired on or after 1-04-2005. n Similar assets located in different geographical regions, for example, WDV for machines in Delhi plant and SLM for same machines at Mumbai plant. This case is however questionable. 236 Financial Accounting for Management ILLUSTRATION 4 ARPIT INDUSTRIES LTD. CHANGE IN THE METHOD OF DEPRECIATION Let us continue with the illustration of Arpit Industries Ltd. let us assume that the company adopted SLM in the first year but decided to shift to WDV in the 3rd year. Analyse the impact of this change on the financial statements of the company. SOLUTION Amount (`) Year Cost 3 4 5 52,00,000 52,00,000 52,00,000 7,07,148 3,88,436 2,13,415 … … Accumulated Depreciation: n n Depreciation for the year as per WDV Additional depreciation as per WDV for the 1st and 2nd year to be charged in current year (Note 1) 16,55,001 n Total Depreciation for the year…Sub total 23,62,149 3,88,436 2,13,415 n Accumulated depreciation as at the beginning of the year…SLM 19,76,000 … … n Accumulated depreciation as at the beginning of the year…WDV n Total Net book value … 43,38,149 47,26,585 43,38,149 47,26,585 49,40,000 8,61,851 4,73,415 2,60,000 Notes: 1. Additional depreciation as per WDV for the 1st and 2nd year to be charged in current (3rd) year: Year WDV SLM Additional Depreciation 1 23,43,640 9,88,000 13,55,640 2 12,87,361 9,88,000 2,99,361 36,31,001 19,76,000 16,55,001 Total… 2. In the 3rd year, the profit and loss account will be charged with depreciation of ` 23,62,149 as against ` 9,88,000 as per the erstwhile SLM method. Analysis: Thus the depreciation method change to WDV in the 3rd year has led to recomputation of depreciation as per the changed method with retrospective effect. 3rd year profit and loss account will be charged with total of the depreciation for the current year as per the new method and additional depreciation required due to method change, that is, 1st and 2nd years’ combined deficiency of SLM vis-à-vis WDV. Thus the 3rd year profit will be suppressed. Net book value in the 3rd year balance sheet is now exactly the same as if WDV method were followed from day one. 4th year onwards depreciation charge to the profit and loss account and disclosure of accumulated depreciation and net book value in the balance sheet will be in a manner as if SLM was never followed and WDV was being followed from the day one. Now in the 4th and 5th years the depreciation charge will be lower than as per SLM. However the advantage to the company in future will be through higher WDV depreciation charge on additional fixed assets purchased. Companies in continuous expansion/diversification/modernization mode thus avail higher than SLM depreciation charge year after year. Chapter 10 Depreciation on Fixed Assets 237 Depreciation Charge in Special Cases Exchange fluctuations Where the historical cost of an asset has undergone a change on account of exchange fluctuations, price adjustments and changes in duties, and so on, the depreciation on the revised unamortised depreciable amount is provided prospectively over the residual useful life of the asset. However you may recall, as mentioned in the last chapter on valuation of tangible fixed assets, that the treatment of exchange rate fluctuations as covered by AS-11 ‘The Effects of Changes in Foreign Exchange Rates’ has undergone a change w.e.f. the accounting periods commencing on or after 1.4.2004 such that the exchange rate fluctuations will not be adjusted to the cost of the fixed assets rather recognised as income or as expenses. It was also mentioned there that a company can follow either of the treatments since schedule VI to the companies act continues to prescribe the adjustment of currency fluctuWWW ations to cost of asset. The readers will therefore find both the treatments being followed by different companies in their annual reports. BIRD’S EYE VIEW Depreciation Charge in Special Cases n Exchange Fluctuations n Subsequent Expenditure n Revision of Useful Life Want to know more about AS-11? Visit www.icai. org. Click: ResourcesAccounting Standards. Subsequent expenditure Subsequent expenditure of a capital nature on an existing asset, which becomes an integral part of the existing asset, is depreciated over the remaining useful life of that asset. As a practical measure, however, depreciation is sometimes provided on such addition or extension at the rate that is applied to an existing asset. Any subsequent addition or extension, which retains a separate identity and is capable of being used after the existing asset is disposed of, is depreciated independently on the basis of an estimate of its own useful life, for example, gaskit in a car or engine in the aircraft. Revision of useful life The estimates of useful lives, for example, as they are based on management’s judgement, of major assets may need periodical review. The unamortized depreciable amount of the asset is charged, in case of revision, to profit and loss account over the revised remaining useful life of the asset. Revaluation of Fixed Assets and Depreciation As mentioned in the last chapter, now follows an illustration on revaluation of fixed assets and treatment of depreciation in such a situation. 238 Financial Accounting for Management ILLUSTRATION 5 ARPIT INDUSTRIES LTD. REVALUATION OF FIXED ASSETS AND DEPRECIATION Let us continue with the illustration 1 of Arpit Industries Ltd. following SLM depreciation. In the beginning of the 4th year a valuer appraises the machine to be worth ` 65 lacs with an estimated residual value of ` 3.25 lacs. How will the change in the value of the machine, the changed depreciation and revaluation reserve be disclosed in the balance sheet from 4th year onwards? SOLUTION Computation of Annual Depreciation on Revalued Amount ` 65,00,000 2 3,25,000 = ` 12,35,000 5 12,35,000 3 100 = 19% 65,00,000 Net book value of the machine at the beginning of the 4th year on revalued amount: ` 65,00,000 – (12,35,000 3 3, that is, 37,05,000) = ` 27,95,000 Net book value at the beginning of the 4th year as per historical cost: ` 22,36,000 Hence, the net increase in the book value, or revaluation reserve = ` 5,59,000 Disclosure of Machine in the Balance Sheet: Rate of depreciation = Details Amount (`) Year Fixed Assets—Machine: 4 Cost 52,00,000 Add: increase on revaluation 13,00,000 5 65,00,000** 65,00,000 Accumulated depreciation: Accumulated depreciation as at the beginning of the year 29,64,000 49,40,000 Add: accumulated depreciation on increase on revaluation, i.e., ` 13,00,000, for the earlier 3 years @ 19% P.A. 7,41,000 … 37,05,000 … Add: depreciation on revalued amount, i.e., ` 65,00,000, for the current year Net book value 12,35,000 49,40,000 12,35,000 15,60,000 61,75,000 3,25,000 ** The machine was revalued by a valuer in the beginning of the 4th year by a gross amount of ` 13,00,000. Notes: Year 4: Total depreciation on the revalued amount for the first three years…` 12,35,000 3 3 = ` 37,05,000. Details above provide its break-up. n Disclosure of Revaluation Reserve in the Balance Sheet: Details Amount (`) Year Reserves and Surplus 4 5 Revaluation Reserve 5,59,000 5,59,000 239 Chapter 10 Depreciation on Fixed Assets Recouping the additional depreciation on revaluation from the revaluation reserve More often than not, companies follow the practice Refer to the latest edition of ‘Compendium of of recouping the additional depreciation charged on Guidance Notes’, published by the ICAI, for full account of revaluation from the revaluation reserve text of ‘Guidance Note on Treatment of Reserve instead of charging it to profit and loss account, Created on Revaluation of Fixed Assets’. courtesy the recommendatory ‘Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets’ issued by the ICAI. At one place it suggests to charge full depreciation on revalued figures in the income statement (to comply with the requirement of AS 6) and simultaneously to credit the income statement with an amount equal to additional depreciation by way of transfer from the revaluation reserve. At another place it suggests that it will be prudent not to charge additional depreciation against revaluation reserve. The guidance note not being mandatory, companies usually resort to the first suggestion. Are this suggestion and the practice desirable? See the case of Whirlpool of India Ltd. provided later in this chapter. ILLUSTRATION ARPIT INDUSTRIES LTD. PROFIT/LOSS ON DISPOSAL OF FIXED ASSETS CARRIED AT HISTORICAL COST 6 Let us continue with illustration 1 of Arpit Industries Ltd. following SLM depreciation. Assume that the company sold the machine at the end of 2 1¼2 years for ` 28,50,000. Determine the profit/loss on disposal and its treatment. Also show how the disposed machine will be treated in the financial statements. SOLUTION Amount (`) Cost 52,00,000 Accumulated depreciation: Accumulated depreciation as at the beginning of the 3rd year (end of 2nd year) 19,76,000 Add: depreciation for current 1¼2 year (` 9,88,000/2) 4,94,000 24,70,000 Net book value at the end of 2 ¼2 years 27,30,000 Selling price of the machine 28,50,000 Profit on disposal 1,20,000 1 This profit, being a gain, will be credited to profit and loss account of 3rd year. Machine will now be eliminated from the financial statements of the 3rd year. The elimination will be reflected as under: Amount (`) Gross Block Depreciation Beginning of the year Deletions Year end Machine 52,00,000 (52,00,000) Nil Previous year 52,00,000 … 52,00,000 Beginning of the year For the year Deletions 19,76,000 4,94,000 (24,70,000) 9,88,000 9,88,000 … Net Block Year end Year end Previous year end Nil Nil 32,24,000 19,76,000 32,24,000 42,12,000 240 Financial Accounting for Management Profit/Loss on Disposal of Fixed Assets As mentioned in the last chapter, now follow two illustrations on treatment of profit/loss on fixed assets disposed off—one on disposal of asset carried at historical cost and the other on revalued asset. ILLUSTRATION ARPIT INDUSTRIES LTD. PROFIT/LOSS ON DISPOSAL OF FIXED ASSETS CARRIED AT REVALUED AMOUNT 7 Continuing with the case of Arpit Industries Ltd., now assume that the company sold the revalued machine at the end of 4 1¼2 years for ` 7,80,000. Determine the profit/loss on disposal and its treatment. Also show how the disposed machine will be treated in the financial statements. SOLUTION Amount (`) Cost-Revalued amount 65,00,000 Accumulated depreciation: Accumulated depreciation as at the beginning of the 5th year 49,40,000 Add: depreciation for current 1¼2 year (` 12,35,000/2) 6,17,500 55,57,500 Net book value at the end of 4 ¼2 years 9,42,500 Selling price of the machine 7,80,000 Loss on disposal 1,62,500 1 In the year 5, this loss will be recouped from the revaluation reserve as it reverses the corresponding amount of net unrealized increase in the net book value of machine in the 4th year on account of revaluation. Thus revaluation reserve of ` 5,59,000 will be reduced to ` 3,96,500. Now, the machine having been sold, this amount represents a realized gain and will be transferred to general reserve, which means it is now available for distribution as dividend. The following table makes this clearer. Amount (`) Revaluation reserve 5,59,000 Less: loss on disposal of machine 1,62,500 Balance transferred to general reserve 3,96,500 Machine will now be eliminated from the financial statements of the 5th year. The elimination will be reflected as under: Amount (`) Gross Block Depreciation Beginning of the year Deletions Year end Machine 65,00,000 (65,00,000) Nil Previous year 65,00,000 … Beginning of the year For the year Deletions 49,40,000 6,17,500 (55,57,500) 65,00,000 37,05,000 12,35,000 … Net Block Year end Year end Previous year end Nil Nil 15,60,000 49,40,000 15,60,000 22,36,000 Chapter 10 Depreciation on Fixed Assets 241 DISCLOSURES IN FINANCIAL STATEMENTS The following information needs to be disclosed in the financial statements in respect of depreciation: 1. The historical cost, or amount substituted for historical cost, of each class of depreciable assets. 2. Total depreciation for the period for each class of assets. 3. The related accumulated depreciation. 4. Depreciation methods used. 5. Depreciation rates or the useful lives of the assets, if they are different from the principal rates specified in the statute governing the enterprise. For example, Companies Act, 1956, in cases of corporate entities. 6. Additional information: a. Effect of change in depreciation methods used to be disclosed in the year of change as per AS-1 and AS-5 as discussed in the Chapter on GAAPs. b. If an asset is disposed of, discarded, demolished, or destroyed, the net surplus or deficiency, if material, to be disclosed separately. c. In case the revaluation has a material effect on the amount of depreciation, the same needs to be disclosed separately in the year in which revaluation is carried out. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What are the implications of the depreciation as per the Companies Act and Income Tax Act for the profitability and tax liability of companies? 2. A company hitherto following the depreciation on computers as per the Companies Act depreciation rates (4.75% SLM) revises downwards, due to fast technological changes, their estimated useful life, which results in a 20% SLM rate. Has the company violated the consistency principle? Why or why not? 3. Is the practice of recouping the additional depreciation on revaluation from the revaluation reserve desirable? Why or why not? To enrich your discussion, add your own ideas, thoughts and practical inputs. CORPORATE FINANCIAL PRACTICES You should now be in a position to understand and appreciate how the corporates provide for depreciation on tangible fixed assets and how they disclose the same in their annual reports. In continuation to the last chapter, being presented hereunder is the case of Whirlpool of India Limited. Please go through the same and attempt the requirements given at the end of the chapter. 242 CASE Financial Accounting for Management 1 Whirlpool of India Limited. CORPORATE FINANCIAL PRACTICES Whirlpool of India Limited Annual Report 2005–06 REPORT DETAILS OF DEPRECIATION AND RELATED SIGNIFICANT ACCOUNTING POLICIES DEPRECIATION AS APPEARING ON THE FACE OF THE BALANCE SHEET AND IN SCHEDULE – ‘E’ OF FIXED ASSETS: See these details in the last chapter. DEPRECIATION AS APPEARING ON THE FACE OF THE PROFIT AND LOSS ACCOUNT ` In lacs Depreciation 3655.24 EXTRACTS FROM SCHEDULE – ‘P’ B. SIGNIFICANT ACCOUNTING POLICIES: 8. Depreciation Fixed Assets have been depreciated at the rates specified in the Schedule XIV of the Companies Act, 1956 using Straight Line Method (SLM), other than the following assets where depreciation has been provided at a higher rate based on useful life of specified assets. a) Depreciation on Motor Vehicles is charged over a period of 48 months. b) Depreciation on Furniture & Fixtures given to employees under the Company’s scheme is charged over a period of 48 months. c) Premium on Leasehold Land and Cost of Leasehold Improvements are amortised over the period of the lease. d) Additions to fixed assets on account of foreign exchange fluctuation are depreciated equally over the residual life of the fixed assets. e) In respect of revalued assets, the difference between the depreciation calculated on the revalued amount and original cost is recouped from the Revaluation Reserve Account. f) Capitalized leased assets are depreciated over shorter of the estimated useful life of the asset or the lease term. g) Cost of software is amortized over a period of 36 months starting from the month of project implementation. EXTRACTS FROM SCHEDULE – ‘B’ RESERVES AND SURPLUS ` in lacs Revaluation Reserve As at 01.04.05 Deductions As at 31.03.06 1663.73 39.66* 1624.07 *Depreciation on fixed assets revalued ` 39.66 lacs. IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (IND AS) on the subject: Chapter 10 Depreciation on Fixed Assets IFRS CONVERGED IND AS 16 VS EXISTING AS 6 DEPRECIATION ACCOUNTING AND PROPERTY, PLANT AND EQUIPMENT 243 WWW www.icai.org The IFRS converged Ind AS 16 ‘Property, Plant and Equipment’ deals with ‘Depreciation Accounting’ hitherto covered under existing AS 6. Its key distinctive features are as under: 1 Converged Ind AS 16 requires that the residual value and useful life of an asset be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) should be accounted for as a change in an accounting estimate. 2 Converged Ind AS 16 requires that the depreciation method applied to an asset should be reviewed at least at each financial year-end and, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method should be changed to reflect the changed pattern. In existing AS 6, change in depreciation method can be made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements. 3 Converged Ind AS 16 requires that change in depreciation method should be considered as a change in accounting estimate and treated accordingly. Thus the changed method is applied over the remaining useful life of the asset with reference to its carrying amount just before the policy change. In existing AS 6, it is considered as a change in accounting policy and treated accordingly. Thus the changed method is applied retrospectively DEPLETION OF WASTING, NON-REGENERATIVE, ASSETS Like special considerations in the valuation of such assets, as seen in the last chapter, their depreciation, or depletion, also calls for different treatment. Being presented hereunder, in continuation to the last chapter is the case of Oil and Natural Gas Corporation Ltd. Please go through the same and attempt the requirements given at the end of the chapter. Corporate Financial Practices CASE 2 Oil and Natural Gas Corporation Ltd. WWW CORPORATE FINANCIAL PRACTICES Oil and Natural Gas Corporation Ltd. Annual Report 2005–06 REPORT www.ongcindia.com DEPLETION OF PRODUCING PROPERTIES DEPLETION AS APPEARING ON THE FACE OF THE BALANCE SHEET See details in the last chapter. SCHEDULE-27: SIGNIFICANT ACCOUNTING POLICIES: 2.3.3 Depletion of Producing Properties Producing properties are depleted using the “Unit of Production Method”. The rate of depletion is computed with reference to the area covered by individual lease/licence/amortization base by considering the proved developed 244 Financial Accounting for Management reserves and related capital costs incurred including estimated future abandonment costs. In case of acquisition, cost of producing properties is depleted by considering the Proved Reserves. These reserves are estimated annually by the Reserve Estimates Committee of the Company, which follows the International Reservoir Engineering Procedures. CONCLUDING REMARKS We have studied herein above the principles and norms of standard accounting treatment of depreciation and other related issues. With this the inter-relationship of fixed assets and depreciation comes to fore. For a while, a general discussion on fixed assets valuation and depreciation is thus over. However, there are many more specific fixed assets, say, intangibles and assets held under finance lease, which require a special treatment. Armed with the knowledge gained in this chapter, we now move over to the next chapter which deals with such specific assets and related issues of amortisation and impairment. Keywords n Amortization n Estimated Residual Value n Time Value of Money n Annual Depreciation n Expected Useful Life n Wear and Tear n Block of Assets n Minimum Alternate Tax/MAT n Written Down Value (WDV) n Deferred Taxes n Physical Life n Effluxion n Straight Line Method/SLM WWW Method 1. Depreciation Accounting, AS-6, ICAI, www.icai.org. 2. Disclosure of Accounting Policies, AS-1, ICAI, www.icai.org. 3. Net Profit or Loss for the Period, Prior Period and Extraordinary Items and Changes in Accounting Policies, AS-5, ICAI, www.icai.org. 4. The Effects of Changes in Foreign Exchange Rates, AS-11, www.icai.org. 1. Taxmann’s Companies Act, Taxmann Allied Services (P.) Ltd., New Delhi, 2010. 2. Guide to the Companies Act, A. Ramaiya, Wadhwa and Company, Nagpur, 2001. 3. Bharat’s Income Tax Act, Bharat Law House Pvt. Ltd., New Delhi, 2010. 4. Bharat’s Income Tax Rules, Bharat Law House Pvt. Ltd., New Delhi, 2010. 5. Compendium of Guidance Notes’, ICAI, New Delhi, latest edition. Chapter 10 Depreciation on Fixed Assets REPORT 245 1. Asian Hotels Ltd., Annual Report, 2005–06. 2. Bharti Airtel Ltd., Annual Report, 2005–06. 3. Indraprastha Medical Corporation Ltd., Annual Report, 2005–06. 4. Indraprastha Gas Ltd., Annual Report, 2005–06. 5. Infosys Technologies Ltd., Annual Report, 2005–06. 6. ITC Ltd., Annual Report, 2005–06. 7. JK Cement Ltd., Annual Report, 2005–06. 8. Oil and Natural Gas Corporation Ltd., Annual Report, 2005–06. 9. Ranbaxy Laboratories Ltd., Annual Report, 2005–06. 10. Reliance Energy Ltd., Annual Report, 2005–06. 11. Reliance Industries Ltd., Annual Report, 2005–06. 12. Shoppers’ Stop Ltd., Annual Report, 2005–06. 13. Whirlpool of India Limited, Annual Report, 2005–06. exercises Ex. 1 Shiva Industries Ltd. SLM Continue with Exercise 1 of Shiva Industries Ltd. as given in Chapter 6. Apart from the cost, some more information is now provided hereunder. Details Cost of the Machine Expected Useful Life (Years) Consideration Expected on Disposal Estimated Cost of Removal of the Machine for Disposal Estimated Realizable Value Required 1. Determine the rate of depreciation as per SLM. 2. Determine the annual depreciation and accumulated depreciation for all the years as per SLM. 3. Show the disclosure of machine in the balance sheet for all the years. 4. State the accounting policy on depreciation of machine. Amount (`) 78,00,000 10 4,20,000 30,000 3,90,000 246 Financial Accounting for Management Ex. 2 WDV Continue with the case of Shiva Industries Ltd. as above. Required 1. Determine the rate of depreciation as per WDV. 2. Determine the annual depreciation and accumulated depreciation for all the years as per WDV. 3. Show the disclosure of machine in the balance sheet for all the years. 4. State the accounting policy on depreciation of machine. Ex. 3 Comparative Assessment of Impact of SLM and WDV Continue with the case of Shiva Industries Ltd. as above. Now assess the impact of SLM and WDV on profits and tax liability of the company. Ex. 4 Analysis of the Impact of Change in the Method of Depreciation Continuing with the case of Shiva Industries Ltd., assume that the company adopted WDV in the first year but decided to shift to SLM in the 5th year. Analyse the impact of this change on the financial statements of the company. Ex. 5 Ruchika Labs Ltd. Comparative Study of Statutory Depreciation Provisions: Book Profit and Taxable Profit Ruchika Labs Ltd. purchases a machine costing Rs. 210 lacs and factory building for Rs. 9 lacs on 1st April 2006. Assume that the company does not own any other depreciable asset. Work out the first year depreciation as per SLM and WDV methods for all the three shifts under the Companies act and as per the Income Tax Act. Also work out the book profit and taxable profit for the year 2006–07 assuming that the profit before depreciation but after providing for all other expenses for the year was Rs. 95 lacs. Analyse the results. Ex. 6 Asset Revaluation Continue with the case of Shiva Industries Ltd. as above. In the beginning of the 6th year, a valuer appraises the machine to be worth Rs. 97.50 lakh with an estimated residual value of Rs. 4,87,500. Chapter 10 Depreciation on Fixed Assets 247 Required 1. Determine the depreciation on the revalued amount. 2. Determine the amount of revaluation reserve. 3. Show the disclosure of machine and depreciation in the balance sheet from the 6th year onwards. 4. Show the disclosure of revaluation reserve in the balance sheet from the 6th year onwards. Attempt all these requirements under both the methods of depreciation. Ex. 7 Disposal of Revalued Asset Continuing with the case of Shiva Industries Ltd., now assume that the company sold the revalued machine in the beginning of the 8th year for Rs. 13, 50,000. Determine the profit/loss on disposal under the WDV method and its treatment. Also show how the disposed machine will be treated in the financial statements. Ex. 8 CASE 1 WHIRLPOOL OF INDIA LTD. Case on Corporate Financial Practices-Depreciation and Related Significant Accounting Policies This case is in continuation to the case of Whirlpool of India Ltd. as illustrated in the last chapter. Now refer further to the extracts from annual report 2005–06 of the company regarding depreciation of its tangible fixed assets and related significant accounting policies as illustrated in this chapter. Having gone through the information provided therein, answer the following questions: 1. Has Whirlpool made the disclosures related to depreciation in accordance with the requirements of AS-6? How? 2. Do you subscribe to the treatment meted out by Whirlpool to depreciation on revalued fixed assets as per note 2 of schedule - ‘E’ as illustrated in the last chapter and note 8 e) of schedule ‘P’. 3. Why did Whinpool in 1995-96 reverse the revaluation reserve created in 92–93? 4. In any case, disclosure of depreciation in the income statement is better as suggested by the ‘Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets’ or as done by Whirlpool? Analyse. 5. Has Whirlpool followed correct accounting policies in respect of depreciation? How? (Skip point no. f) on assets under finance lease and g) on intangible assets. These issues have been covered in the chapter that follows.) Ex. 9 CASE 2 OIL AND NATURAL GAS CORPORATION LTD. Case on Corporate Financial Practices—Depletion of Producing Properties This case is in continuation to the case of Oil and Natural Gas Corporation Ltd. as illustrated in the last chapter. Now refer further to the extracts from annual report 2005-06 of the company regarding depletion of its producing properties and related significant accounting policies as illustrated in this chapter. You must have noted that ONGC follows Unit of Production Method for providing depletion charge on its producing properties. Why SLM or WDV methods of depreciation are not appropriate in this case? Analyse. 11 Valuation of Assets under Finance Lease and Intangible Assets, Amortization and Asset Impairment The contemporary issues relating to fixed assets—finance lease, intangibles, their amortisation and asset impairment—are providing a face-lift to the financial statements. The emphasis is on substance over form, prudence, ensuring the sanctity of the financial statements and quality of earnings. Chapter 11 Valuation of Assets under Finance Lease 249 CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 Meaning of lease and finance lease. 2 Principles and norms of standard accounting treatment of assets held under finance lease and disclosure requirements in the financial statements as per AS-19 ‘Leases’. 3 Meaning and significance of intangible assets. 4 Principles and norms of standard accounting treatment of intangible assets and their amortization as per AS-26 ‘Intangible Assets’. 5 Depreciation of intangible assets under Income Tax Act. 6 Disclosure requirements in respect of intangible assets and their amortisation in the financial statements. 7 Meaning and significance of impairment of assets. 8 Principles and norms of standard accounting treatment of impairment of assets and disclosure requirements in the financial statements as per AS-28 ‘Impairment of Assets’. 9 Corporate financial practices in respect of finance lease, intangibles, amortisation and impairment. INTRODUCTION Chapters 9 and 10 discussed and illustrated, at length, the common varieties of fixed assets and depreciation thereon. In this chapter, we will further the discussion on certain specialised issues associated with fixed assets. These are: 1. Assets under finance lease 2. Intangible assets and their amortization, and 3. Asset impairment Let us discuss and illustrate them one by one. ASSETS UNDER FINANCE LEASE We have seen in Chapter 6 that AS-10 does not cover leased assets. Principles and norms of standard accounting treatment of these assets are dealt with by AS-19, ‘Leases’, which came into effect for the accounting periods commencing on or after 1st April 2001, that is, for fixed assets acquired on or after that date. We will discuss and analyse hereunder select and crucial provisions of AS-19 with respect to assets under finance lease in the books of the lessee. WWW Want to know more about AS-19? Visit www.icai.org. Click: Resources—Accounting Standards. Meaning of Lease and Finance Lease A lease is defined as 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. A lease is termed as finance lease if it transfers substantially all the risks and rewards incidental to the ownership of an asset though 250 Financial Accounting for Management the title may or may not eventually be transferred. Risks may include the possibilities of technological obsolescence. Rewards may include BIRD’S EYE VIEW gain from appreciation in value and sub-leasing rights. AS-19: Leases For example, a finance lease would include, individually or in n Meaning of Lease and Finance combination, cases as mentioned hereunder: Lease (a) The lease transfers ownership of the asset to the lessee by the end n Substance over Form of the lease term. n Principles and Norms of Standard (b) The lessee has a bargain purchase option for the asset and it is Accounting Treatment reasonably certain that the option will be exercised. n Disclosure Requirements (c) The lease term is for the major part of the economic life of the asset, that is, the period over which an asset is expected to be economically usable by one or more users put together. (d) The present value of the minimum lease payments amounts to approximately the fair value of the leased asset at the inception of the lease. Minimum lease payments are the payments over the lease term that the lessee is required to make to the lessor towards acquiring the economic benefits of the use of the leased asset. They may include an initial payment and balance in equated instalments. (e) The leased asset is of a specialized nature suitable only for the lessee. Substance over Form While the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its economic life, in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. It is, therefore, prudent that such transactions are accounted for and presented in accordance with their substance and financial reality and not merely with their legal form. As per the legal form, lease rental payments are charged as an expense to the profit and loss account. However the principle of prudence over form demands that assets under finance lease be accounted for in the financial statements of the lessee as if they were owned by him. Consequently the profit and loss account will be charged with depreciation and related borrowing costs and not the lease payment. If such lease transactions are not reflected in the lessee’s balance sheet, the economic resources and the level of obligations of an enterprise are understated thereby distorting financial ratios. It may be noted that AS-19 does not apply to lease agreements for using lands. Principles and Norms of Standard Accounting Treatment The AS-19, therefore, requires that at the inception of a finance lease, the lessee needs to recognise the lease as an asset and a liability at an amount equal to the fair value of the leased asset. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments, the amount recorded, as an asset and a liability, should be the present value of such payments. In calculating the present value of the minimum lease payments the discount rate is normally the interest rate implicit in the lease. Lease payments are apportioned between the finance charge and the reduction of the outstanding liability, that is, repayment of the principal. The finance charge is allocated to periods during the lease term at a constant periodic rate of interest on the outstanding liability for each period. Chapter 11 Valuation of Assets under Finance Lease 251 Since asset under finance lease is recorded as if it were an owned asset, it needs to be depreciated as well and depreciation to be charged as an expense. The depreciation policy for a leased asset needs to be consistent with that for owned depreciable assets and in accordance with AS-6, ‘Depreciation Accounting’. If there is reasonable certainty that the ownership will be transferred to the lessee on the expiry of the lease term, the asset is depreciated over its useful life. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset is fully depreciated over the shorter of the lease term or its useful life. Useful life of a leased asset is that part of the economic life over which the leased asset is expected to be used by the present lessee. Therefore in case of ownership transfer economic life and useful life are the same for the lessee. AS-19 has thus put to end the phenomenon called ‘off-balance sheet assets’. ILLUSTRATION 1 ABHISHEK SUGAR MILLS LTD. MACHINE ACQUIRED UNDER FINANCE LEASE Abhishek Sugar Mills Ltd. acquires a machine under finance lease from Shanta Leasing Ltd. on 1st April 2006. Fair value of the machine is ` 395 lacs. Its economic life is 7 years. The following are the terms of the lease: 1. Lease term: 5 years 2. Interest rate implicit in the lease: 14% per annum. 3. Initial lease payment: ` 50 lacs. 4. Subsequent lease payments of ` 100 lacs each, as rounded, to be paid annually starting 31-03-2007. 5. Lease payments are secured against the leased machine. 6. Ownership of the machine will be transferred to Abhishek Sugar Mills Ltd. on the expiry of the lease term without any further payment. Required: Following AS-19 ‘Leases’: 1. Determine the amortization schedule, that is, apportionment of minimum lease payments between the finance charges and repayment of the principal. 2. What expenses will be recognized in the profit and loss account of Abhishek Sugar Mills Ltd.? 3. How will the leased machine be treated in the balance sheet of Abhishek Sugar Mills Ltd.? 4. How will the lease liability be treated in the balance sheet of Abhishek Sugar Mills Ltd.? 5. Analyse the impact of the treatment meted out to the leased machine on the financial performance and position of Abhishek Sugar Mills Ltd. 252 Financial Accounting for Management Requirement 1: SOLUTION TO ILLUSTRATION 1 ABHISHEK SUGAR MILLS LTD. AMORTIZATION SCHEDULE 1.1 As per the table of ‘Present Value of an Annuity of Re. 1 paid at the Year End’, its present value @ 14% for 5 years is ` 3.433. Hence the present value of a corresponding annuity of ` 100 lacs comes to ` 343.30 lacs. Added to this the initial lease payment of ` 50 lacs, gross present value of minimum lease payments is thus ` 393.30 lacs which is approximately the same as fair value of the machine, that is, ` 395 lacs. Ordinarily the machine should be recognized at its fair value. However since the present value is less than the fair value, following the cost concept, the lessee Abhishek Sugar Mills Ltd. will account for it at ` 393.30 lacs. Lease Lease Payments Apportioned Payments Into… Finance Repayment of Charges the Principal (Interest) 1.04.2006: Present value on inception of the lease 1.04.2006: Initial lease payment 1st year end Amount (` in lacs) Principal Outstanding … … … 393.30 50.00 … 50.00 343.30 100.00 48.06 51.94 291.36 150.00 48.06 101.94 … 2nd year end 100.00 40.79 59.21 232.15 3rd year end 100.00 32.50 67.50 164.65 4th year end 100.00 23.05 76.95 87.70 5th year end 100.00 12.30 87.70 … Rest of the years’ sub total… 400.00 108.64 291.36 … Total… 550.00 156.70 393.30 … 1st year sub total… Notes: 1. ` 48.06 lacs are 14% of ` 343.30 lacs. ` 40.79 lacs are 14% of ` 291.36 lacs, and so on. 2. The 5th year interest charge of ` 12.28 lacs rounded to ` 12.30 lacs. 3. Table of ‘Present Value of an Annuity of Re. 1 paid at the Year End’ is given as an appendix at the end of the book. Chapter 11 Valuation of Assets under Finance Lease 253 Requirement 2: SOLUTION TO ILLUSTRATION 1 ABHISHEK SUGAR MILLS LTD. 1.2 EXPENSES TO BE RECOGNISED IN THE PROFIT AND LOSS ACCOUNT 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year Amount (` in lacs) Total Finance charges (Interest) 48.06 40.79 32.50 23.05 12.30 … … 156.70 Depreciation 56.19 56.19 56.19 56.19 56.19 56.19 56.16 393.30 104.25 96.98 88.69 79.24 68.49 56.19 56.16 550.00 Total… Note: 1. Depreciation assumed as per SLM. Hence ` 393.30 lacs charged over the useful life of 7 years. Rate of depreciation is thus 14.30%. 2. Difference of ` 0.03 lacs (` 3 thousands) in depreciation in the 7th year is due to its rounding off in earlier years. Requirement 3: SOLUTION TO ILLUSTRATION 1 1.3 ABHISHEK SUGAR MILLS LTD. TREATMENT OF LEASED MACHINE AS AN ASSET IN THE BALANCE SHEET Gross Block Depreciation Amount (` in lacs) Net Block Fixed Assets… Leased Vehicles Beginning of the year Additions during the year Year end Beginning of the year For the year Year end Year end 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year … 393.30 393.30 393.30 393.30 393.30 393.30 393.30 … … … … … … 393.30 393.30 393.30 393.30 393.30 393.30 393.30 … 56.19 112.38 168.57 224.76 280.95 337.14 56.19 56.19 56.19 56.19 56.19 56.19 56.16 56.19 112.38 168.57 224.76 280.95 337.14 393.30 337.11 280.92 224.73 168.54 112.35 56.16 Nil 254 Financial Accounting for Management Requirement 4: SOLUTION TO ILLUSTRATION 1 1.4 ABHISHEK SUGAR MILLS LTD. TREATMENT OF LEASE LIABILITY IN THE BALANCE SHEET Amount (` lacs) Secured Loans: Lease finance — Due to Shanta Leasing Ltd. As on 1.04.2006 1st year end 2nd year end 3rd year end 4th year end 343.30 291.36 232.15 164.65 87.70 Requirement 5: SOLUTION TO ILLUSTRATION 1 1.5 ABHISHEK SUGAR MILLS LTD. ANALYSIS OF THE IMPACT OF TREATMENT OF LEASED MACHINE AS OWNED ONE Impact Assessment: 1. Had lease rentals been charged as expenses, ` 550 lacs would have been fully expensed over the lease term of 5 years — ` 150 lacs in the first year and then ` 100 lacs each during the succeeding 4 years. Balance sheet in this case would not have shown the leased machine as an asset and the lease liability as a loan. 2. Accounting for the leased machine, as if it were owned, has led to charging ` 550 lacs to the profit and loss account over its useful life of 7 years. This charge is on account of interest and depreciation for the first 5 years and then depreciation alone for the next 2 years. As can be seen this charge is lower than lease rental charges during the first 5 years. Year 6 and 7 therefore show further charges on account of depreciation. It may also be noted that this charge, staring with ` 104.25 lacs in the first year, has been declining every year. It means that the first treatment leads to understatement of financial performance during the first 5 years and to overstatement during the 6th and 7th years. 1st year understatement would be ` 45.75 lacs and 6th year overstatement would be ` 56.19 lacs. 3. The second treatment has strengthened the assets side of the balance sheet. The strength has improved by a gross block of ` 393.30 lacs for 7 years and net block for 6 years, starting with ` 337.11 lacs in the 1st year. The balance sheet is thus able to show the economic resource being commanded by the lessee in the form of leased machine. 4. Likewise the obligation towards the lessor, Shanta Leasing Ltd., for enjoying the benefits of the leased machine is also being disclosed by the liabilities side of the balance sheet of Abhishek Sugar Mills Ltd. This obligation amounts to ` 343.30 lacs on the inception of the lease and reducing gradually over the years. 5. Thus the second treatment has enabled the financial statements of Abhishek Sugar Mills Ltd. to serve their purpose of providing a true and fair view of the financial performance and position of the company. Thus the solvency and liquidity risks associated with over borrowing can be properly assessed. Substance over form. Chapter 11 Valuation of Assets under Finance Lease 255 Disclosures in Financial Statements The financial statements of the lessee need, in addition to the requirements of AS-10, ‘Accounting for Fixed Assets’, AS-6, ‘Depreciation Accounting’, and the governing statute, to make the following major disclosures for finance leases: 1. Assets acquired under finance lease as segregated from the assets owned. 2. The net carrying amount for each class of such assets. 3. A reconciliation between the total of minimum lease payments outstanding at the balance sheet date and their present value for each of the following periods: n Payable not later than one year. n Payable not later than five years. n Payable later than five years. In effect it means showing break-up of total minimum lease payments to be made in future subsequent to the balance sheet date against principal outstanding liability on that date. for example, in the illustration of Abhishek Sugar Mills Ltd. the reconciliation at the end of the 1st year would work like this: As at 31.03.2007 Amount (` in Lacs) Minimum Lease Payments Present Value of Minimum Lease Payments Payable not later than 1 year Payable not later than 5 years Payable later than 5 years 100.00 59.21 300.00 232.15 … … Sub-total… 400.00 291.36 Less: Future finance charges 108.64 … Present value of minimum lease payments 291.36 291.36 It may thus be noted that the present value of minimum lease payments is nothing but the principal outstanding on the balance sheet date. 4. The total of future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date, and 5. A general description of the significant leasing arrangements. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is finance lease? 2. Do you endorse putting to end the phenomenon called ‘off-balance sheet assets’? Why or why not? To enrich your discussion, add your own ideas, thoughts and practical inputs. 1 … … … Plant and machinery Vehicles Leased Assets: Sub-total LEASED ASSETS: (Details omitted) OWNED ASSETS: Cost/Valuation ASSETS HELD UNDER FINANCE LEASES CORPORATE FINANCIAL PRACTICES Larsen & Toubro Ltd. Annual Report 2001–02 Extracts from Accounting Policies and Notes to Accounts (` in Crores) 15.30 9.89 5.41 0.01 … 0.01 15.29 9.89 5.40 … … … 0.96 0.68 0.28 … … … 0.96 0.68 0.28 … … 9.21 14.33 … 5.12 Depreciation Book Value As at As at Up to For As at As at As at 01.04.2001 Additions Deductions 31.03.2002 31-03-2001 the year Deductions 31.03.2002 31.03.2002 31.03.2001 Schedule E: Fixed Assets REPORT CASE Let us see how Larsen & Toubro Ltd. has treated its assets held under finance leases. Go through the case and attempt the exercise based on it given at the end of the chapter. CORPORATE FINANCIAL PRACTICES Chapter 11 Valuation of Assets under Finance Lease 257 Schedule D: Unsecured Loans (` in Crores) As at 31.03.2002 As at 31.03.2001 Short term loans and advances: 2.52 … n Lease finance 12.06 … Total lease finance 14.58 … n Lease finance Other loans and advances: (Details of other loans omitted). Schedule Q: Significant Accounting Policies 6. Leases (b) Lease transactions entered into on or after 1st April, 2001: i) Assets acquired under leases where the Company has substantially all the risks and rewards of ownership are classified as finance leases. Such assets are capitalised at the inception of the lease at the lower of the fair value or the present value of minimum lease payments and a liability is created for an equivalent amount. Each lease rental paid is allocated between the liability and the interest cost, so as to obtain a constant periodic rate of interest on the outstanding liability for each period. 1. Depreciation b. Leased Assets ii) Lease transactions entered into on or after 1st April, 2001. Assets acquired under finance leases are depreciated on a straight-line basis over the lease term. Where there is reasonable certainty that the Company shall obtain ownership of the assets at the end of the lease term, such assets are depreciated at the rates prescribed in Schedule XIV of the Companies Act, 1956. Notes Forming Part of Accounts 15. Leases: a. Finance Leases: i) Assets acquired prior to April 1, 2001 under finance leases have been accounted in accordance with the “Guidance Note on Leases” issued by the Institute of Chartered Accountants of India. The cost of the assets taken on lease is ` 33.19 crore, the future lease obligation against which is ` 17.24 crore as at 31st March, 2002. ii) In accordance with Accounting Standard 19 “Leases” issued by the Institute of Chartered Accountants of India and mandatorily made applicable in respect of all assets leased on or after 1st April, 2001, the assets acquired under finance leases are capitalised and a loan liability recognised for an equivalent amount. Consequently, depreciation is provided on such leases. Lease rentals paid are allocated to the liability and the interest charged to Profit & Loss Account. Consequent to the above change, the “Gross Block of Fixed Assets” is higher by ` 15.29 crore, accumulated depreciation is higher by ` 0.96 crore, depreciation for the year is higher by ` 0.96 crore, charge to Profit & Loss Account in respect of the Lease Rentals is lower by ` 1.46 crore, interest expense is higher by ` 0.76 crore and the profit for the year is lower by ` 0.26 crore. iii) (a) Assets acquired on finance lease mainly comprise cars and personal computers. The leases have a primary period, which is fixed and non-cancellable. In the case of cars, the Company has an option to renew the lease for a secondary period. The agreements provide for revision of lease rentals in the event of changes in [a] taxes, if any, leviable on the lease rentals, [b] rates of depreciation under the Income Tax Act, 1961 and [c] change in the lessor’s cost of borrowings. There are no exceptional/restrictive covenants in the lease agreements. (b) The minimum lease rentals as at 31.3.2002 and the present value as at 31.3.2002 of minimum lease payments in respect of assets acquired under finance leases are as follows: 258 Financial Accounting for Management Minimum Lease Payments ` in Crore i) Payable not later than 1 year 2.87 ii) Payable later than 1 year and not later than 5 years 16.59 iii) Payable later than 5 years 0.53 Total Minimum Lease Payments 19.99 Less: Future finance charges 5.41 Present Value of Minimum Lease Payments 14.58 Present Value of Minimum Lease Payments i) Payable not later than 1 year 2.52 ii) Payable later than 1 year and not later than 5 years 11.68 iii) Payable later than 5 years 0.38 Total Present Value of Minimum Lease Payments 14.58 Position Under the Income Tax Act It needs to be understood that the income tax act recognises only the legal form of the transaction in the case of finance lease. Accordingly it does not allow depreciation to the lessee on the leased asset since he is not the legal owner of the asset. Instead the lease rentals paid are recognized as revenue For more details refer to chapter ‘Income Under the expenses and accordingly allowed in full in Head Profits and Gains of Business or Profession’ the computation of taxable income. This is an in the book ‘Professional Approach to Direct Taxes’ instance of contrasts in the requirements of by Ahuja and Gupta, 2010 edition. different constituents of GAAPs. IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 17 VS EXISTING AS 19 WWW LEASES www.icai.org Key distinctive features of the IFRS converged Ind AS 17 ‘Leases’ corresponding to existing AS 19 are as under: 1 Converged Ind AS 17 makes a distinction between inception of lease and commencement of lease. In the existing AS 19, though both the terms are used at some places, these terms have neither been defined nor distinguished and used interchangeably. As per the converged standard, the lessee shall recognise finance leases as assets and liabilities in balance sheet at the commencement of the lease term whereas as per the existing standard such recognition is at the inception of the lease. The inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: • A lease is classified as either an operating or a finance lease; and • In the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined. Chapter 11 Valuation of Assets under Finance Lease 259 The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (i.e. the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate). 2 The converged standard requires current/non-current classification of lease liabilities if such classification is made for other liabilities. As per this classification the lease liabilities are broken into current and long term portion for disclosure in the financial statements. INTANGIBLE ASSETS AND THEIR AMORTISATION The ICAI issued AS-26, ‘Intangible Assets’ which was mandated for the accounting periods commencing on or after 1st April 2003. The subject of intangible assets was earlier dealt with by AS-10 ‘Accounting for Fixed Assets’. We will discuss and analyse hereunder, select and crucial provisions of AS-26. But before that a reference to goodwill is essential. Goodwill Goodwill is the most widely known all pervasive intangible asset that arises either on acquisition or is generated internally. Goodwill generated internally is dealt with by AS-26. Goodwill arising on acquisition continues to be governed by AS-10. According to AS-10 whenever a business is acquired for a price, payable in cash or in shares or otherwise, which is in excess of the fair value of the net assets of the business taken over, the excess is termed as ‘goodwill’. For example, if Meghna Retail Ltd. acquires the business of Vikas Mega Retail Ltd. for ` 500 crores against the fair value of the net assets of ` 440 crores of the latter, it is said to have acquired goodwill of ` 60 crores. Goodwill arises from business connections, brands and trade names, reputation of an enterprise or from other intangible benefits enjoyed by an enterprise such as quality of employees and internal systems and loyalty of customers. The standard requires that goodwill should be recorded in the books only when some consideration in money or money’s worth has been paid for it. It further mentions ‘as a matter of financial prudence, goodwill is written off over a period. However, many enterprises do not write off goodwill and retain it as an asset’. The standard does not prescribe any limit to the period over which goodwill should be written off unlike AS-26 ‘Intangible Assets’. The principles of depreciation as laid down in AS-6 ‘Depreciation Accounting’ also do not apply to goodwill. The issue of depreciation/amortization of goodwill has thus been left open to the industry by AS-10. AS-26 deals with all other intangible assets that can be identified separately from goodwill and internally generated goodwill. A discussion follows. Meaning and Significance of Intangible Assets Intangible assets are identifiable non-monetary assets, without physical Visit www.icai.org. for substance, held for use in the production or supply of goods or services, original text of AS-26. Click: for rental to others, or for administrative purposes. By their very nature, WWW Resources—Accounting therefore, they are fixed assets but without a physical existence. Standards. Apart from goodwill, enterprises frequently expend resources on the acquisition, development or enhancement of other intangible assets such as: n Trademarks and brand names. n Copyrights, patents and other industrial property rights, service and operating rights. 260 Financial Accounting for Management n Know-how: designs and prototypes, new processes or systems, recipes, formulae, models. n Licences and franchises. n Computer software. n Mastheads and publishing titles. n Motion picture films. Let us have some insights into corporate financial reporting to understand the significance of intangibles. Research in Financial Reporting Recall the companies analysed under this head in the chapters on valuation of fixed assets and depreciation. Data of the same companies are researched here further to identify the magnitude of intangible assets that they command. REPORT RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors INTANGIBLE ASSETS AND OTHER RELATED DETAILS AS ON 31st MARCH 2006. ` in Crores Sl. No. Company Industry 1 2 3 Asian Hotels Ltd. Bharti Airtel Ltd. Indraprastha Medical Corporation Ltd. Indraprastha Gas Ltd. Infosys Technologies Ltd. ITC Ltd. JK Cement Ltd. Hotel – Tourism Telecom Hospital – Healthcare 4 5 6 7 8 9 10 11 Ranbaxy Laboratories Ltd. Reliance Energy Ltd. Reliance industries Ltd. Shopper’s Stop Ltd. Tangible Fixed Assets Intangible Assets Intangible Amortisation Assets to on Intangible Tangible Fixed Assets for Assets the Year … … 12% 135 PBT for the Year 87 2,286 565 13,735 … 1,613 166 0.33 0.20% 0.50 22 395 … … … 160 2,133 4,333 … 72 … 2% … 13 2,724 3,269 949 6 0.60% 1 52 1,572 61 4% 25 190 2,866 8 0.30% 4 781 61,558 1,117 2% 141 10,704 119 4 3% 1 40 Natural Gas Information Technology FMCG Cement – Hosing related Healthcare Power Oil and Gas Retail Notes: 1. Data derived from respective annual reports. 2. All tangible fixed assets: Net of accumulated depreciation and inclusive of capital work-in-progress. 3. All intangible assets: Net of accumulated amortisation. 4. Ranbaxy Laboratories Ltd.: Year ended 31.12.2005. Chapter 11 Valuation of Assets under Finance Lease 261 It may be observed that: 1. In general, intangible assets in comparison to tangible fixed assets are insignificant in terms of money value and hence in the impact of their amortisation on PBT. 2. In proportionate terms, Bharti Airtel Ltd. holds maximum intangible assets at 12% of tangibles. 3. In terms of money value Bharti Airtel Ltd. and Reliance Industries Ltd., at ` 1,613 crores and ` 1,117 crores respectively, hold maximum intangible assets. 4. Surprisingly IT major Infosys Technologies Limited does not possess any intangible assets. As per its 2005–06 annual report it did have Intellectual Property Rights of ` 42 crores but these were fully written off during 2004–05. 5. Likewise Asian Hotels Ltd. and Indraprastha Gas Ltd. also do not possess any intangible assets. Also, though Satyam Computer Services Ltd. is not included in the above research, a perusal of its 2005–06 annual report reveals that it also did not possess any intangible assets. The next table provides the details of the types of intangible assets that the above companies controlled. REPORT RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors TYPES OF INTANGIBLE ASSETS AS ON 31st MARCH 2006 Sl. No. 1 2 3 4 5 6 7 8 Company Bharti Airtel Ltd. Industry Telecom Intangibles Software Bandwidth Licences Trademarks and Goodwill Know how, Business and Commercial Rights Goodwill Product Development Patents, Trademarks, Designs and Licences Indraprastha ITC JK Ranbaxy Reliance Reliance Shopper’s Medical Ltd. Cement LaboratEnergy Industries Stop Corporation Ltd. ories Ltd. Ltd. Ltd. Ltd. Ltd. Hospital – FMCG Cement – Healthcare Power Oil and Retail Healthcare Housing Gas related 1 196 1,416 0.33 … … 22 … … … … … 16 … … 8 … … 131 … … 3 … … … … 8 … … … … … … … … … 42 … … 6 … … … … … … … … … … … … 27 … … … … … … … 11 … … 1 262 9 10 Financial Accounting for Management Non-compete agreement compensation Technical Know how Fees Total Intangible Assets … … … … 7 … … … … … … … … … 986 … 1,613 0.33 72 6 61 8 1,117 4 Notes: 1. Data derived from respective annual reports. 2. All intangible assets: Net of accumulated amortization. 3. Ranbaxy Laboratories Ltd.: Year ended 31.12.2005. It may be observed that: 1. Software is the most common intangible asset. Except JK Cement Ltd., all other companies have this intangible. In some cases it is the only intangible possessed by them. The amount of this asset in many cases may not be significant per se but it constitutes a significant portion of their total intangibles. Clearly it is a key intangible driver of most businesses. 2. There are varied practices in grouping various intangibles and their disclosure in the annual report. 3. Only two companies ITC Ltd. and JK Cement Ltd. possess goodwill, the best known intangible asset. (ITC Ltd. has grouped goodwill with trademarks.) 4. Bharti Airtel Ltd. and Reliance Industries Ltd. hold most of their intangible assets in the form of licenses and technical know how, respectively. In the current era of knowledge/commercial rights based businesses, intangible assets, even though small in monetary terms, are playing an ever-increasing role in the assessment of financial strength of a corporate entity in that its future profitability largely depends on the strength or otherwise of intangible assets it commands. For example, how software is doing magic in the banking industry is common knowledge. Again, for telecommunication companies, the future tenure of continuity of their business and the revenue that they derive from their operations is a direct function of the telecom licenses they get. In the case of Bharti Airtel Ltd., licenses of ` 1,416 crores are the key drivers behind the acquisition and utilization of its tangible fixed assets of ` 13,735 crores and revenue of ` 11,290 crores (for the year 2005–06 as per the annual report). Valuation of Bharti Airtel Ltd. will be done not only on the basis of its tangible assets. Unexpired period of license intangible will play a major role in the valuation. Principles and Norms of Standard Accounting Treatment We now proceed to discuss the principles and norms of standard benchmark treatment of identification and accounting of intangible assets in the financial statements. Intangible assets acquired in a business purchase As noted earlier, in a business acquisition excess price paid leads to goodwill intangible. However the part or full of this excess amount may be on account of other intangible assets as well. This leads to the issues of how to identify those other intangibles and how to ascertain their cost separately. Let us understand. Identifiability of intangible assets An intangible asset, other than goodwill, needs to be an identifiable one. To be identifiable, it is necessary that such an intangible asset is clearly distinguished from Chapter 11 Valuation of Assets under Finance Lease 263 goodwill. It can be clearly distinguished from goodwill if BIRD’S EYE VIEW the asset is separable, that is, if the enterprise could rent out, sell or exchange the specific future economic benefits Intangible Assets and Their attributable to the asset without disposing of future economic Amortisation benefits that flow from other assets used in the same revenue n Goodwill earning activity. For example, brand names like INDICA AS–26: Intangible Assets and INDIGO if passenger car manufacturing assets of Tata n Meaning and Significance of Intangible Assets Motors Ltd. were being acquired. Separability, in many n Principles and Norms of Standard Accounting cases, is however, not a necessary condition for identifiTreatment ability since an enterprise may be able to identify an asset — Intangible assets acquired in a business in some other way. For example, if in a transaction of purchase acquisition of a group of assets, legal rights are also transl Identifiability of intangible assets l Recognition of intangible assets ferred, the transaction may enable an enterprise to identify — Separately acquired intangible assets the intangible asset emanating from those rights, such as — Internally generated intangible assets publication copyrights in the case of a publishing business. l Goodwill Such copyrights might have been generated internally by l Other assets the seller and not accounted for in its financial statements. l Cost Recognition of intangible assets In case of a l Specific non-recognition of certain assets business purchase an intangible asset is recognized in the — Amortisation of intangible assets financial statements if, and only if: l Accumulated amortisation relating to prior periods n It is probable that the future economic benefits, that n Disclosure requirements is, more revenue or cost saving etc., that are attributable to the asset will flow to the enterprise. n The asset is controlled by the enterprise, that is, the enterprise has the power to obtain the future economic benefits flowing from the asset and also can restrict the access of others to those benefits, and n The cost, that is, fair value of the asset can be measured reliably. Separately acquired intangible assets If an intangible asset is acquired separately, that is, independently without any tangible assets, the cost of the intangible asset can be measured reliably since the purchase consideration paid is definite and specific to that asset based on mutual agreement. The cost comprises purchase price net of trade discounts and rebates but inclusive of import duties and other non-refundable taxes and any directly attributable cost of making the asset ready for its intended use, for example, professional fees for legal services in the process of acquiring patents. Internally generated intangible assets In case an intangible asset is acquired through purchase, it does not pose much problem and is recognised in accordance with the norms stated above. However, in case of intangible assets generated internally, special considerations apply. Let us discuss them. 264 Financial Accounting for Management ILLUSTRATION 2 JASMEET HEALTHCARE LTD. DETERMINATION OF INTANGIBLE ASSETS ON PURCHASE OF BUSINESS Jasmeet Healthcare Ltd. purchased Neha Laboratories Ltd. on 31st March 2006 for a consideration of ` 360.00 crores. The fair value of the net assets of the latter, as appearing in the balance sheet as on that date and as taken over by the former, were estimated and agreed upon between the parties as under: ` in Crores Tangible fixed assets 375.00 Patents 7.00 Investments 41.00 Current assets 102.00 Total assets… 525.00 Loans 152.00 Current liabilities 63.00 Total liabilities ... 215.00 Net assets … 310.00 The buyer carried out a review of the operations of the seller and found that the latter enjoyed certain intangible assets not accounted for in its balance sheet. Such separately identified intangible assets and their estimated fair values are as under: ` in Crores Brands 22.00 Software 3.00 Technical know how 10.00 Total… 35.00 Required: Following AS-26 ‘Intangible Assets’, analyse how Jasmeet Healthcare Ltd. will recognise intangible assets arising through this transaction. SOLUTION In this case, Jasmeet Healthcare Ltd. has paid an excess consideration of ` 50.00 crores, that is, ` 360.00 crores minus ` 310.00 crores, to Neha Laboratories Ltd. Ordinarily this excess of ` 50.00 crores should be recognised as goodwill. However since it has identified and valued three separate intangibles as mentioned above amounting to ` 35.00 crores in total, goodwill will be recognised only at ` 15.00 crores. Finally the excess consideration of ` 50.00 crores will be accounted for as under: ` in Crores Brands 22.00 Software 3.00 Technical know how 10.00 Goodwill (balancing figure) 15.00 Excess consideration paid… 50.00 Balance sheet of Jasmeet Healthcare Ltd. will show a total of ` 57.00 crores as intangible assets including patents of ` 7.00 crores already recognized by Neha Laboratories Ltd. Chapter 11 Valuation of Assets under Finance Lease 265 Goodwill In some cases, expenditure, like advertising, training, start-up, research and development, VRS payments etc., is incurred to generate future economic benefits, but it does not result in the creation of an intangible asset that meets the recognition criteria mentioned above. Such expenditure is often described as contributing to internally generated goodwill. Such goodwill is not recognized as an asset because it is not an identifiable resource controlled by the enterprise that can be measured reliably at cost. Likewise, differences between the market value of an enterprise and the carrying amount of its identifiable net assets at any point in time may be due to a range of factors that affect the value of the enterprise, for example, stock market volatility, economic conditions of boom, depression or stagnation, investors’ perception, global developments etc. Hence, such differences cannot be considered to represent the cost of intangible assets (goodwill or any other) controlled by the enterprise. Other assets At times, it is difficult to assess whether an internally generated intangible asset, other than goodwill, qualifies for recognition in the financial statements. Difficulty arises in: (a) Identifying whether there is an asset that will generate probable future economic benefits. (b) Identifying the point of time of generation of above benefits, and (c) Determining the cost of the asset reliably. For example, in some cases, the cost of generating an intangible asset internally cannot be distinguished from the cost of maintaining or enhancing the enterprise’s internally generated goodwill or of running day-to-day operations. Examples of such costs would include heavy advertising, publicity and staff training expenses. Therefore, in addition to complying with the general requirements for the recognition of an intangible asset, as mentioned above, an enterprise needs to classify the generation of the asset into two phases: research phase and development phase. Research refers to original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production for sale or use. No intangible asset arising from research should be recognised in the financial statements. An intangible asset arising from development should be recognised if, and only if, an enterprise can demonstrate all of the following: (a) The technical feasibility of completing the asset so that it will be available for use or sale. (b) Its intention to complete the asset and use or sell it and its ability to use or sell it. (c) The availability of adequate technical, financial and other resources to complete the development and to use or sell the asset. (d) Its ability to measure the expenditure attributable to the asset during its development reliably. (e) How the asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the usefulness of the intangible asset internally or the existence of a market for the output of the asset or the asset itself. Cost The cost of an internally generated intangible asset is the sum of expenditure incurred from the time when the intangible asset first meets the recognition criteria. Specific non-recognition of certain assets The standard prescribes that, in addition to internally generated goodwill, internally generated brands, mastheads, publishing titles, customer lists and items similar in substance should also not also be recognized as intangible assets since the expenditure incurred on them cannot be distinguished from the cost of developing the business as a whole. 266 Financial Accounting for Management ILLUSTRATION 3&4 INTERNALLY GENERATED INTANGIBLE ASSETS SOFTWARE and WEBSITE Appendix A of AS-26 provides two illustrations on internally generated intangible assets, namely, computer software for organizational use and website. These illustrations enable the readers to have very good insights into the recognition of internally generated intangible assets based on research and development phases. If interested, study them. Visit www.icai.org. Click: Resources—Accounting Standards. Therefore, such items are not recognized as intangible assets. Amortisation of intangible assets After recognition, an intangible asset should be carried at its cost less any accumulated amortisation and any accumulated impairment losses. Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life. There is a rebuttable presumption that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use. In some cases, however, there may be persuasive evidence that the useful life of an intangible asset will be a specific period longer than ten years. For example, consider that an enterprise has purchased an exclusive right to generate hydro-electric power for sixty years. The costs of generating hydroelectric power are much lower than the costs of obtaining power from alternative sources. It is expected that the geographical area surrounding the power station will demand a significant amount of power from the power station for at least sixty years. The enterprise will amortize this commercial right over sixty years, unless there is evidence that its useful life is shorter. In such cases, the presumption that the useful life generally does not exceed ten years is rebutted. As another example, Reliance Industries Ltd. amortizes technical know how over the useful life of the underlying plant as per its 2005–06 annual report. Amortisation commences when the asset is available for use. The amortisation method used should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the straight-line method (SLM) is used. The residual value of an intangible asset is assumed to be zero unless: n There is commitment from a third party to purchase the asset, or n There is an active market for the asset and its residual value can be determined by reference to that market and it is probable that such a market will exist at the end of the asset’s useful life. Accumulated amortisation relating to prior periods As mentioned earlier, AS-26 is manadatorily applicable to financial statements covering periods commencing on or after 1st April 2003. Where, on this date, an enterprise is not amortising an intangible asset or amortising it over a period longer than the rebuttable period of 10 years and this period of 10 years since the date of acquisition of the asset has expired fully or partly on that date, the carrying amount appearing in the balance sheet in respect of that asset, to the extent of accumulated amortization not provided for earlier assuming the life of the asset to be 10 years, should be accordingly reduced from the opening balance of revenue reserves as if AS-26 were in force on that date. In a nutshell, AS-26 has adopted a very conservative approach driven by the consideration of prudence. The emphasis is on restricting the practice of capitalizing revenue expenses so that profits are not artificially inflated and once capitalised, on restricting the period of amortisation so that they are adjusted against revenue sooner than later. Restriction on the period of amortisation applies in case Chapter 11 Valuation of Assets under Finance Lease 267 of purchased intangibles as well. The standard thus restricts the management from window dressing of their company’s financial statements. Rates of Depreciation as Per Appendix I—Rule 5 of the Income Tax Rules Given below is the rate of depreciation on intangible assets, with effect from 1st April 2006, that is, assessment year 2006–07, as contained in Appendix I—Rule 5 of the Income Tax Rules: Assets WDV Intangible assets, such as know-how, patents, copyrights, trademarks, licences, franchises or any other commercial or business right of similar nature 25% Disclosures in Financial Statements The following disclosures need to be made in the financial statements in respect of each class of intangible assets, distinguishing between internally generated intangible assets and other intangible assets: 1. The useful lives or the amortization rates used. 2. The amortization methods used. 3. The gross carrying amount and the accumulated amortization, aggregated with accumulated impairment losses, at the beginning and end of the period. 4. A reconciliation of the carrying amount at the beginning and end of the period showing additions, retirements and disposals, amortization recognized, impairment losses recognized and reversed and other changes, if any. 5. If an asset is amortized over more than ten years, the reasons for doing so. 6. A description of the carrying amount and remaining amortization period of any material individual asset. 7. The carrying amounts of assets whose title is restricted. 8. The carrying amounts of assets pledged as security for liabilities. 9. The amount of commitments made for the acquisition of intangible assets. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. How do you distinguish between intangible assets and tangible assets? 2. What are the principles of recognition and measurement of internally generated intangibles? 3. How are the intangibles, once recognised, amortized? To enrich your discussion, add your own ideas, thoughts and practical inputs. 268 Financial Accounting for Management Corporate Financial Practices Given hereunder, for your understanding, are the cases of corporate financial practices in respect of intangible assets adopted by Colgate-Palmolive (India) Limited during the years 2002–03 and 2003–04. Study these cases and answer the questions based thereon given at the end of this chapter. CASE 2 COLGATE-PALMOLIVE (India) Limited CORPORATE FINANCIAL PRACTICES REPORT COLGATE-PALMOLIVE (INDIA) LIMITED Annual Report 2002–2003 EXTRACTS FROM SCHEDULES OF FIXED ASSETS AND ACCOUNTING POLICIES INTANGIBLE ASSETS Schedule 5: Fixed Assets (` in Lacs) Gross Block Amortization Intangible Assets As at 31st March, 2002 As at 31st March, 2003 Up to 31st March, 2002 Goodwill & Trademarks 27,29.81 27,29.81 Copyrights & Design 13,52.90 Technical Know-how Total… Net Block For the Year Up to 31st March, 2003 As at 31st March, 2003 As at 31st March, 2002 511.84 68.24 580.08 21,49.73 22,17.97 13,52.90 724.77 96.63 821.40 531.50 628.13 49,83.70 49,83.70 17,79.89 237.32 20,17.21 29,66.49 32,03.81 90,66.41 90,66.41 30,16.50 402.19 34,18.69 56,47.72 60,49.91 Schedule 17: Significant Accounting Policies 2. Fixed Assets: Goodwill and Trademarks are amortized over a period of 40 years. Copyrights and Design are amortized over a period of 14 years. Technical know-how is amortised over a period of 21 years. And now the case of the same company for 2003–04, being the year when AS-26 became effective. Chapter 11 Valuation of Assets under Finance Lease CASE 269 2A COLGATE-PALMOLIVE (India) Limited CORPORATE FINANCIAL PRACTICES REPORT COLGATE-PALMOLIVE (INDIA) LIMITED Annual Report 2003–2004 EXTRACTS FROM SCHEDULES OF FIXED ASSETS, ACCOUNTING POLICIES, SUPPLEMENTARY INFORMATION AND RESERVES AND SURPLUS INTANGIBLE ASSETS Schedule 5: Fixed Assets (` in Lacs) Gross Block Intangible Assets Amortization Net Block As at As at Up to 31st March, 31st March, 31st March, 2003 2004 2003 For the Year Adjustment*** Up to As at As at 31st March, 31st March, 31st March, 2004 2004 2003 Goodwill & Trademarks 27, 29.81 27, 29.81 580.08 119.43 18, 93.81 25, 93.32 136.49 21, 49.73 Copyrights & Design 13, 52.90 13, 52.90 821.40 106.31 357.55 12, 85.26 67.64 531.50 Technical Know-how 49, 83.70 49, 83.70 20, 17.21 302.58 24, 14.72 47, 34.51 249.19 29, 66.49 90, 66.41 90, 66.41 34, 18.69 528.32 46, 66.08 86, 13.09 453.32 56, 47.72 Total… *** Adjustment to General Reserve Schedule 18: Significant Accounting Policies 2. Intangible Assts : The company has revised the useful life of Goodwill & Trademarks, Copyrights & Design and Technical Know-how to 10 years. The balance useful life of Goodwill & Trademarks, Copyrights & Design and Technical Know-how as at March 31, 2004 is 6 months. (Refer note 13 of schedule 23). Schedule 23: Supplementary Information 13. During the year, the company has revised the accounting policy in respect of the useful lives of Goodwill & Trademarks, Copyrights & Design and Technical Know-how from 40 years, 14 years and 21 years respectively to 10 years. In accordance with the transitional provisions of Accounting Standard 26 – ‘Intangible Assets’, issued by The Institute of Chartered Accountants of India, ` 46,66.08 lacs being the difference in the carrying value of intangible assets, due to the change in the accounting policy has been charged to General Reserve. Had the change not been made, amortisation charged to the Profit and Loss Account would have been lower by ` 126.13 lacs with a corresponding increase in Profit before Taxation for the year. Schedule 2: Reserves and Surplus (` in Lacs) General Reserve As at 31st March, 2004 As at 31st March, 2003 Balance, beginning of the year 103,94.56 95,07.97 Less: Adjustment of intangible assets (Refer note 13 of schedule 23) 46,66.08 … 57,28.48 95,07.97 270 Financial Accounting for Management Add: Transfer from Profit and Loss Account Profit Before Taxation 10,80.00 886.59 68,08.48 103,94.56 2003–04 2002–03 151,47.74 146,48.20 IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 38 VS EXISTING AS 26 WWW INTANGIBLE ASSETS www.icai.org Key distinctive features of the IFRS converged Ind AS 38 ‘Intangible Assets’ Assets’ corresponding to existing AS 26 are as under: 1 The existing AS 26 defines an intangible asset as an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes whereas in the converged Ind AS 38, the requirement for the asset to be held for use in the production or supply of goods or services, for rental to others, or for administrative purposes has been removed from the definition of an intangible asset. Thus according to converged Ind AS 38 an intangible asset is an identifiable non-monetary asset without physical substance. The scope has thus widened. 2 The existing AS 26 is based on the assumption that the useful life of an intangible asset is always finite, and includes a rebuttable presumption that the useful life cannot exceed ten years from the date the asset is available for use. That rebuttable presumption has been removed from the converged Ind AS 38. The converged Ind AS 38 recognizes that the useful life of an intangible asset can even be indefinite when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. In such a case it should not be amortised but should be tested for impairment. IMPAIRMENT OF ASSETS The valuation of fixed assets, tangible as well as intangible, and the consequent depreciation and amortisation charge is further affected by what is known as impairment of assets. The ICAI, on this subject, has issued Accounting Standard ‘Impairment of Assets’ (AS-28) which is applicable to financial statements covering periods commencing on or after 1st April 2004. We will discuss and analyse hereunder select and crucial provisions of AS-28. Meaning and Significance Imagine that either a machine is lying dormant due to technological obsolescence or irreparable physical damage and is held for disposal or a computer’s utility has significantly declined due to arrival of a WWW higher version or the productivity of the fixed assets of a business unit is not being fully exploited due to low consumer off take as a result of competition or changes in consumer preferences and the management is convinced that the situation is not going to improve in the foreseeable future. Can you visualize the impact of such developments on the measurement and disclosure of true profitability and financial position of a Want to know more about AS-28? Visit www.icai.org. Click: Resources—Accounting Standards. Chapter 11 Valuation of Assets under Finance Lease 271 company? Hopefully you will agree that in all these three cases the market values of concerned fixed assets must have significantly declined below their net book values or, in other words, they must have impaired. And it is therefore necessary to measure impairment loss and write it off in the income statement. The standard describes an asset to have impaired when it is carried in the balance sheet at more than its recoverable amount. ‘Recoverable Amount’ refers to the higher of an asset’s net selling price and its value in use. ‘Value in Use’ represents the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life. Recoverable amount of an asset can be taken to be its value in use if its net selling price is not determinable. Again, if there is no reason to believe that an asset’s value in use materially exceeds its net selling price, the asset’s recoverable amount may be taken to be its net selling price. For example, this will often be the case for an asset that is held for disposal as its value in use will consist mainly of its estimated net disposal proceeds, since the future cash flows from continuing use of the asset until its disposal are likely to be negligible. Value in use in such cases need not be calculated. An enterprise needs to ensure that its assets are carried at no more than their recoverable amount. The resulting adjustment, if required, is described as impairment loss. What will this lead to? The balance sheet will show the value of real operating capacity of fixed assets and consequently the net worth, at a reduced level than earlier, will be a more realistic figure. The income statement in the year of booking the impairment loss will no doubt show declined, though real, profits as compared to last year but at the same time successive years’ profits will improve in terms of a higher return on net worth, the same having been reduced, leading to a higher share valuation in the capital market and making the company’s performance compare better with its peer group. Principles and Norms of Standard Accounting Treatment Let us now discuss the principles and norms of standard benchmark treatment of accounting for impairment of assets in the financial statements. Recoverable amount The standard requires that an enterprise should assess at each balance sheet date whether there is any indication that an asset may have impaired and should consider, as a minimum, the following externally and internally prevalent indications. If any such indication exists, the enterprise should estimate the recoverable amount of the asset and recognise the resultant impairment loss in its financial statements. External Indications (a) Significant decline in the market value of an asset. (b) Significant changes with an adverse effect on the enterprise, in the technological, market, economic or legal environment in which the enterprise operates or in the market to which an asset is dedicated. (c) Changes in interest rates leading to decrease in the asset’s recoverable amount materially. (d) The carrying amount of the net assets of the enterprise is more than its market capitalisation. This indication is however questionable. BIRD’S EYE VIEW AS-28: Impairment of Assets n Meaning and Significance of Impairment loss n Principles and Norms of Standard Accounting Treatment: — Recoverable amount — Value in use — Impairment loss — Reversal of impairment loss — Accumulated impairment loss relating to prior periods — Cash generating unit n Disclosure Requirements 272 Financial Accounting for Management Internal Indications (a) Evidence of physical damage of an asset. (b) Significant changes, with an adverse effect on the enterprise, in the extent to which an asset is used or is expected to be used as signified, for example, by plans to discontinue or restructure the operation to which the asset belongs, and (c) Evidence that the economic performance of an asset is, or will be, worse than expected. Value in use Value in use of an asset is estimated based on: (a) Estimating the future cash inflows arising from continuing use of the asset, that is, profit before depreciation, interest and tax also known as pre-tax operating cash flows and ‘inflows’ from its ultimate disposal, and (b) Applying the appropriate discount rate to these future cash flows. The discount rate has to be a pre-tax rate that reflects current market assessment of the time value of money and the risks specific to the asset. For all practical purposes this rate is equal to the risk free rate of return expected by the equity shareholders from similar asset as adjusted to inflation. Impairment loss An impairment loss is recognised as an expense in the statement of profit and loss unless the asset is carried at revalued amount, in which case it is treated as a decrease in revaluation. After the recognition of an impairment loss, the depreciation/amortisation charge for the asset is adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value, over its remaining useful life. Reversal of impairment loss An impairment loss recognised for an asset in prior accounting periods is reversed, either by way of credit to profit & loss account or to revaluation reserve, as the case may be, if there has been a change in the estimates of cash inflows, cash outflows or discount rates ILLUSTRATION 5 RISHI ELECTRICITY COMPANY LTD. IMPAIRMENT OF MACHINE Rishi Electricity Company Ltd. is assessing as on 31st March 2006, being its latest balance sheet date, whether there is any indication that any of its fixed assets may be impaired. Among others, it owns a machine whose net book value, that is, net of accumulated depreciation including that for 2005–06 amounting to ` 15.50 lacs, is ` 95.32 lacs. The management is of the opinion that the machine may not generate adequate returns over its remaining useful life of six years due to sluggish market conditions. Hence it estimates the future cash flows expected to arise from the continuing use of this machine and from its disposal at the end of its useful life. Details are as under: ` in lacs Year Estimated Pre-tax Operating Cash Flows Estimated Cash Flow on Disposal Total 2006–07 21.50 … 21.50 2007–08 20.85 … 20.85 2008–09 19.67 … 19.67 2009–10 17.44 … 17.44 2010–11 16.38 … 16.38 2011–12 16.23 4.86 21.09 The net selling price of the machine as on 31st March 2006 is estimated to be ` 65.50 lacs. 273 Chapter 11 Valuation of Assets under Finance Lease Required: Following AS-28 ‘Impairment of Assets’: 1. Determine the ‘Value in Use’ of the machine. The management considers 16% as an appropriate pre-tax discount rate. 2. Determine the ‘Recoverable Amount’ of the machine. 3. Determine whether the machine has impaired. If yes, to what extent? 4. If the machine has impaired, analyse its impact on the financial statements. 5. Assuming that this machine was revalued in the past and the balance sheet carried a revaluation reserve corresponding to it amounting to ` 12 lacs, how the impairment loss, if any, will be treated in the financial statements? 6. What will be the treatment of impairment loss in the financial statements, had the above revaluation reserve been ` 25 lacs? Solution follows. SOLUTION TO ILLUSTRATION 5 5.1 RISHI ELECTRICITY COMPANY LTD. DETERMINATION AND ANALYSIS OF IMPAIRMENT LOSS Requirement 1: Value in Use ` In lacs Year 2006–07 Total Estimated Cash Flows 21.50 Present Value Factor @ 16% 0.862 Present Value 18.53 2007–08 20.85 0.743 15.49 2008–09 19.67 0.641 12.61 2009–10 17.44 0.552 9.63 2010–11 16.38 0.476 7.80 2011–12 21.09 0.410 8.65 Value in use…. 72.71 Note: Table of ‘Present Value Factor of a Lump Sum (PVF) of Re. 1’ is given as an appendix at the end of the book. Requirement 2: Recoverable Amount Value in use ` 72.71 lacs, being higher than net selling price of ` 65.50 lacs, is the recoverable amount. Requirement 3: Impairment Yes, the machine has impaired as its recoverable amount is less than its net book value. The impairment loss is ` 22.61 lacs as shown hereunder: Net book value 95.32 Less: Recoverable amount 72.71 Impairment loss…. 22.61 Requirement 4: Analysis of Impact on the Financial Statements The machine will be carried in the balance sheet as on 31st March 2006 at ` 72.71 lacs instead of ` 95.32 lacs. Corresponding impairment loss of ` 22.61 lacs, over and above ` 15.50 lacs being the current year’s depreciation, will 274 Financial Accounting for Management be charged to the profit and loss account for the year 2005–06. The PBT will go down to that extent and hence the net worth. Financial statements will thus portray a true picture of the performance and financial position of the company. Depreciation in future will be charged on ` 72.71 lacs. Requirement 5: Treatment in Case of Revaluation Reserve of ` 12 lacs Impairment loss to the extent of ` 12 lacs will be adjusted against the revaluation reserve. Balance loss of ` 10.61 lacs will be charged to profit and loss account. Revaluation reserve will now become zero. Requirement 6: Treatment in Case of Revaluation Reserve of ` 25 lacs Entire impairment loss of ` 22.61 lacs will be adjusted against the revaluation reserve, the later being more than the former. There will be no charge to profit and loss account on this count. Revaluation reserve will now stand at ` 2.39 lacs. used to determine the asset’s recoverable amount since the last impairment loss was recognised. This happens due to reversal of factors that led to impairment earlier, say, market picked up or major damage repaired. The increased carrying amount of an asset due to a reversal of an impairment loss should not exceed the carrying amount that would have been determined, net of amortization or depreciation, had no impairment loss been recognized for the asset in prior accounting periods. Effectively it means that a company cannot reverse more impairment loss than it charged earlier. After a reversal of an impairment loss is recognized, the depreciation/amortization charge for the asset is adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value, over its remaining useful life. Accumulated impairment loss relating to prior periods As mentioned earlier, AS-28 is manadatorily applicable to financial statements covering periods commencing on or after 1st April 2004. Therefore if an asset had already impaired on 31st March 2004, or at the end of the immediately preceding year to the year of a voluntary early adoption of this standard as it was issued in 2002 by an enterprise, the impairment loss is to be adjusted against opening balance of revenue reserves being the accumulated impairment loss relating to prior periods unless the loss is on a revalued asset. An impairment loss on a revalued asset is adjusted directly against any revaluation reserve related to same asset only, to the extent of the reserve. The excess loss is adjusted against opening balance of revenue reserves. Cash generating unit The standard also deals with the impairment of cash generating unit of the individual asset. In case it is not possible to estimate the recoverable amount of an individual asset, an enterprise needs to determine the recoverable amount of the cash-generating unit to which the asset belongs (the asset’s cash-generating unit) as a whole. The recoverable amount of a cash-generating unit is the higher of the cash-generating unit’s net selling price and value in use determined on the basis of principles discussed earlier for individual assets. Disclosures in Financial Statements The financial statements need to disclose the following information, in respect of asset impairment, for each class of assets: 1. The amount of impairment losses recognised in the statement of profit and loss and the line item(s) of the statement of profit and loss in which those impairment losses are included. 2. The amount of reversals of impairment losses recognized in the statement of profit and loss and the line item(s) of the statement of profit and loss in which those impairment losses are reversed. 3. The amount of impairment losses recognised directly against revaluation reserve, and 4. The amount of reversals of impairment losses recognised directly in revaluation reserve. Chapter 11 Valuation of Assets under Finance Lease 275 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is impairment of assets? What is its purpose? 2. How do you account for impairment loss? 3. When is the impairment loss of earlier years reversed and how it is accounted for? To enrich your discussion, add your own ideas, thoughts and practical inputs. CORPORATE FINANCIAL PRACTICES Let us see how Nestlé India Limited has treated impairment of some of its fixed assets. Go through the case and attempt the exercise based on it given at the end of the chapter. CASE 3 Nestlé India Limited REPORT CORPORATE FINANCIAL PRACTICES NESTLÉ INDIA LIMITED Annual Report 2002 Extracts from Notes on Accounts SCHEDULE P: IMPAIRMENT OF ASSETS NOTE 2 ON ACCOUNTS In the year 2002, the Institute of Chartered Accountants of India (ICAI) had issued an Accounting Standard on Impairment of Assets (AS-28) including assets employed in continuing businesses. Although, AS-28 is mandatory from financial year beginning 1-4-2004, it encourages early implementation, which has been subscribed to by the Company. As required by AS-28, the Company has reviewed potential generation of economic benefits from fixed assets and concluded that some of the fixed assets employed in continuing businesses are currently not foreseen to generate adequate economic returns over their useful lives. Consequently, the fixed assets relating to Water and Instant Tea businesses have been written down to their recoverable amount, being the net selling price (determined based on a valuation) and fixed assets relating to a part of the Chocolates & Confectionery business have been written down to their recoverable amount, being the value in use. Fixed Assets, being building and plant and machinery aggregating ` 202,256 thousands, employed in the Water Business have been written down to ` 30,303 thousands. The impairment loss (Gross—` 171,953 thousands; Net of deferred tax credit—` 108,760 thousands) has been charged to the profit and loss account, as the impairment indicator, being low consumer off-take in a highly competitive market, has arisen during 2002. The impairment loss in respect of buildings and plant and machinery is ` 34,795 thousands and ` 137,158 thousands respectively. Full review of the business model is being undertaken. Fixed Assets, being plant and machinery aggregating ` 70,153 thousands, employed in a part of the Chocolates & Confectionery business have been written down to ` 33,773 thousands. The impairment loss (Gross—` 36,380 thousands; Net of deferred tax credit—` 23,010 thousands) has been charged to the profit and loss account, as the impairment indicator, being low consumer off-take due to shift in consumer preference, has arisen during 2002. Future cash flows have been discounted by 12% to arrive at the value in use of these assets. Fixed Assets, being building and plant and machinery aggregating ` 64,139 thousand, employed in Instant Tea Business have been impaired. The impairment loss (Gross—` 64,139 thousands; Net of deferred tax credit—` 40,568 thousands) has been charged to the General Reserve as at January 1, 2002, as the impairment indicator being continuing sluggish export market, was already existing prior to 2002. The impairment loss in respect of buildings and plant and machinery is ` 9,127 thousand and ` 55,012 thousands respectively. 276 Financial Accounting for Management NESTLÉ INDIA LTD. Annual Report 2002 Extracts from the Profit and Loss Account REPORT IMPAIRMENT OF ASSETS Profit before Impairment, Contingencies, Taxation and 2002 ( ` in thousands) 2001 ( ` in thousands) 3,714,495 2,772,571 Exceptional Item Impairment on fixed assets (refer note 2-schedule P) 212,464 13,921 Provisions for contingencies—net(refer note 3-schedule P) 313,588 180,943 3,188,443 2,577,707 Profit before Taxation and Exceptional Item You may now be interested in knowing the circumstances under which companies may reverse the impairment loss in succeeding years. See the financial practice adopted by Nestlé India Ltd. in this respect during the year 2004. CASE 3A Nestlé India Limited REPORT CORPORATE FINANCIAL PRACTICES NESTLÉ INDIA LIMITED Annual Report 2004 Extracts from Notes to the Accounts SCHEDULE P: REVERSAL OF THE IMPAIRMENT LOSS NOTE 1 b) TO THE ACCOUNTS During the year ended December 31, 2004, the company has reversed certain impairment losses recognised in earlier years and the resultant gain (Gross ` 81,336 thousands, net of deferred taxes – ` 51,573 thousands) has been credited in the profit and loss account. These reversals include: — ` 50,735 thousands relating to certain assets being used in a part of the beverage business, due to revival of sales in a buoyant export market. — ` 30,601 thousands relating to certain assets, which have been put to use after due modification in the manufacture of culinary products. Chapter 11 Valuation of Assets under Finance Lease 277 IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: WWW IFRS CONVERGED IND AS 36 VS EXISTING AS 28 IMPAIRMENT OF ASSETS www.icai.org Key distinctive features of the IFRS converged Ind AS 36 ‘Impairment of Assets’ corresponding to existing AS 28 are as under: 1 The converged Ind AS 36 requires annual impairment testing for an intangible asset with an indefinite useful life and goodwill acquired in a business combination also. The existing AS 28 does not require the annual impairment testing for the goodwill unless there is an indication of impairment. 2 The Converged Ind AS 36 prohibits the recognition of reversals of impairment loss for goodwill. CONCLUDING REMARKS We have discussed and illustrated hereinabove the contemporary issues of finance lease, intangibles, their amortization and impairment of assets. These issues caught fancy not very long ago. It is amply clear that these developments in the thinking and research on financial accounting, reporting and analysis are providing a facelift to financial statements. The emphasis is on substance over form, minimisation of the practice of inflating the balance sheet through indiscreet creation of intangible assets and prudence. These are all creditable efforts in the direction of maintaining the sanctity of the financial statements and ensuring quality of earnings. We now move over to the valuation of inventories and investments in the next two chapters. Keywords Amalgamation n Assets Impairment n Bargain Purchase Option n Carrying Amount n Commencement of Lease n Depreciation Policy n Development Phase n Discount Rate n WWW n Finance Lease n Off-balance Sheet Assets n Future Cash Inflows n Primary Period n Inception of Lease n Recoverable Amount n Internally Generated Intangible n Research & Development Assets n Leases n Lessee n Lessor n Sale and Leaseback Transaction 1. Leases, AS-19, ICAI, www.icai.org 2. Intangible Assets, AS-26, ICAI, www.icai.org 3. Impairment of Assets, AS-28, ICAI, www.icai.org n Value in Use n Vendor 278 Financial Accounting for Management 1. Professional Approach to Direct Taxes, Ahuja and Gupta, Bharat Law House Pvt. Ltd., 2010. 2. Bharat’s Income Tax Rules, Bharat Law House Pvt. Ltd., New Delhi, 2010. 1. Asian Hotels Ltd., Annual Report, 2005–06. 2. Bharti Airtel Ltd., Annual Report, 2005–06. 3. Colgate-Palmolive (India) Ltd., Annual Report 2002–2003. 4. Colgate-Palmolive (India) Ltd., Annual Report 2003–2004. 5. Indraprastha Gas Ltd., Annual Report, 2005–06. 6. Indraprastha Medical Corporation Ltd., Annual Report, 2005–06. 7. Infosys Technologies Ltd., Annual Report, 2005–06. 8. ITC Ltd., Annual Report, 2005–06. 9. JK Cement Ltd., Annual Report, 2005–06. 10. Larsen & Toubro Limited, Annual Report, 2001–2002. 11. Nestlé India Limited, Annual Report, 2002. 12. Nestlé India Limited, Annual Report, 2004. 13. Ranbaxy Laboratories Ltd., Annual Report, 2005–06. 14. Reliance Energy Ltd., Annual Report, 2005–06. 15. Reliance Industries Ltd., Annual Report, 2005–06. 16. Shoppers’ Stop Ltd., Annual Report, 2005–06. 17. Satyam Computer Services Ltd., Annual Report, 2005–06. REPORT exercises CASE 1 LARSEN AND TOUBRO LIMITED Case on Corporate Financial Practices—Assets Held under Finance Leases Refer to the extracts from the Annual Report 2001–2002 of Larsen and Toubro Limited regarding its ‘Assets Held under Finance Leases’ as illustrated in this chapter. Analyse the case and attempt the following requirements: 1. Examine the policy of the company concerning valuation of its assets held under finance leases. Is the policy in accordance with AS-19 or not? 2. Examine the depreciation policy followed by the company on assets under finance leases. Two treatments have been meted out, is it justified? 3. Had AS-19 not been followed, what would have been the impact on the financials of the company? Is the treatment mandated by AS-19 better? Why or why not? 4. Assets acquired by the company under finance lease are mainly cars and personal computers. Could you opine why is it so? 5. Do you think the information provided about present value of lease payments, if supported by the fair value information of these assets as on the balance shut date, would be a better disclosure for the analyst? Why or why not? 6. In case of owned assets, details of year wise break up of loan liability and finance charges to be discharged in future are not disclosed in the financial statements. Why so then in case of leased assets treated as owned? Any purpose served by these disclosures? Chapter 11 Valuation of Assets under Finance Lease CASE 279 2 COLGATE-PALMOLIVE (INDIA) LTD. Case on Corporate Financial Practices—Intangible Assets Refer to the extracts from the annual reports 2002–03 and 2003–04 of Colgate-Palmolive (India) Ltd. regarding intangible assets as illustrated in this chapter. Analyse the cases and attempt the following requirements: 1. Examine and analyse the compliance of AS-26 in the 2003–04 annual report. Are there any deviations? 2. Is the adjustment of past amortisation expenses, to the extent not recognised earlier, to opening general reserve justified? Should not such expenses be charged through current year’s profit and loss account? Opine. 3. Is the presumption of life of intangible assets as 10 years fairer than longer periods, such as, 40/14/21 years in this case? Opine. 4. Assess the impact of change in the intangible assets amortisation policy on the financial statements of 2003–04. 5. Why the amortization for the year 2003–04 is Rs. 528.32 lacs? Based on SLM, should it not be a different figure? Analyse. 6. Had AS-26 been followed from the day Colgate generated/acquired intangible assets what would have been the impact on its financial statements of 2002–03? Assess. CASE 3 NESTLÉ INDIA LIMITED Case on Corporate Financial Practices—Impairment of Assets and Reversal of Impairment Loss Refer to the extracts from the Annual Report 2002 of Nestlé India Ltd. regarding ‘Impairment of Assets’ and from 2004 regarding ‘Reversal of the Impairment Loss’ as illustrated in this chapter. Analyse the cases and attempt the following requirements: 1. Examine and analyse the compliance of AS-28 in the treatment and disclosure of impairment of assets. Are there any deviations? 2. Examine the reasons cited by the company for booking impairment loss of different businesses. Are they justified? 3. Is the main purpose of booking the impairment loss to make the companies disclose a neat and clean balance sheet in the present even though the impairment could be reversed also in future? Opine. 4. Though based on the principle of prudence, don’t you think that recognition of impairment loss is at variance with the going concern concept? 5. Is the reversal of impairment losses by Nestlé justified? Analyse. 12 Valuation of Inventories Inventories such as raw materials and finished goods in general, and in manufacturing companies in particular, constitute the second largest item after fixed assets. Therefore, they require a fair valuation so that the financial statements fairly portray the performance and financial position of the business. Chapter 12 Valuation of Inventories 281 CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 Meaning and significance of inventories. 2 Scope and coverage of AS-2 on ‘Valuation of Inventories’. 3 Principles and norms of standard accounting treatment of inventories, methods of inventory valuation and other related issues. 4 Impact of different methods of inventory valuation on COGS, gross profit and net profit. 5 NRV and its impact on inventory valuation, COGS, GP and NP. 6 Disclosure requirements in respect of inventories in the financial statements. INTRODUCTION Determination of the value of inventories lying unsold/unused at the year-end, or at the end of the reporting period, is very crucial to measuring the cost of goods sold and consequently to measuring and assessing the performance of business. This chapter is devoted to a detailed discussion on this important element of financial statements and its implications. Inventories, which include raw materials, goods-in-process, finished goods and stores and spares, as well as packing materials, generally constitute the second largest item in the balance sheet, the largest being fixed assets. This is true both in absolute terms as well as comparative, particularly in the case of manufacturing companies. This speaks volumes about the significance of inventories. These inventories, therefore, need to be managed in such a fashion that neither excessive inventory is held at any given point of time nor is there a shortage in their supply to the production pipeline or to meeting the sales targets in time. Management of inventories also requires, at the level of the chief financial officer, a fair valuation thereof so that the financial statements portray a fair view of the performance and financial position of the business on this count. VALUATION OF INVENTORIES The ICAI had issued Accounting Standard (AS-2), ‘Valuation of Inventories’ in June 1981, which was superseded by a revised standard, of the same number, that came into effect in respect of accounting periods commencing on or after April 1, 1999. The revised standard defines inventories, sets out their significance, specifies the inventories excluded from its scope and coverage, and prescribes the principles and norms of standard accounting treatment for various aspects of inventories valuation and Visit www.icai.com. for accounting, that is, valuation policy, cost of inventories, exclusion of original text of revised AS-2. WWW Click: Resources—Accounting certain costs, cost formulas, techniques for the measurement of cost, net realizable value, and disclosure requirements. Let us understand Standards. and analyse these. 282 Financial Accounting for Management MEANING AND SIGNIFICANCE OF INVENTORIES Inventories have been defined as assets held: 1. For sale in the ordinary course of business. 2. In the process of production for such sale, or 3. In the form of materials or supplies to be consumed in the producBIRD’S EYE VIEW tion process or in the rendering of services. AS-2: Valuation of Inventories n Meaning and Significance of Inventories n Scope and Coverage n Principles and Norms of Standard Accounting Treatment: — Valuation policy — Cost of inventories — Cost formulas — Techniques for the measurement of cost — Net realizable value n Disclosure Requirements Inventories comprise goods purchased and held for sale, such as merchandise purchased by a distributor or retailer and held for sale, computer software held for sale, or land and other property held for sale. Inventories also comprise finished goods manufactured or workin-progress, that is, goods in the process of manufacture. Inventories also include materials, maintenance supplies, consumables and loose tools required for use in the production process or in the rendering of services, say, by a hotel or a hospital. Let us understand what inventories could comprise in a particular industry. Let us consider the case of Titan Industries Ltd. Machinery spares that can be used only in connection with an item of fixed asset, and that too infrequently, are not included in the inventories. Such spares are capitalised and allocated on a systematic basis 1 CASE Titan Industries Ltd. TITAN INDUSTRIES LTD. Closing Inventory Items Extracts From Annual Report 2005–06 REPORT Titan Industries Ltd. is the manufacturer of TITAN brand watches and TANISHQ brand Jewellery, probably the most admired brands in these segments, in the country. Following are the details of inventory held by it as on 31st March, 2006: Finished Goods (Held for sale) 1 Watches 2 Jewellery Work-in-progress (Held in the process of production for sale, once finished) Units of watches and jewellery which are only partly completed on the balance sheet date. Will become finished goods once completed. Raw Materials and Bought-out Components (Held for consumption in the production process) 1 Precious metals—mainly gold 2 Brass 3 Steel 4 Components 5 Precious and semi-precious stones Titan Industries Ltd. also holds consumable stores and loose tools, that is, indirect materials, required for use in the process of production in its plants, but which do not form part of the finished product. 283 Chapter 12 Valuation of Inventories over the useful life of the principal item in accordance with Accounting Standard (AS-10), ‘Accounting for Fixed Assets’, as discussed in an earlier chapter. Determination of the value at which inventories are carried in the financial statements until the related revenues are recognised is a primary issue in accounting for inventories. Inventory valuation, therefore, plays a very important role in the measurement and presentation of financial performance and position of a company. As per AS-2, inventories of finished goods and workin-progress (W-I-P) are valued at cost or their net realizable value, whichever is lower. However raw materials consumed and other stores and supplies used in the production process are valued at cost, except in a situation when write down to net realizable value may be required, as discussed later. Research in Financial Reporting Recall the companies analysed under this head in the chapter on valuation of fixed assets. Data of same companies are researched here further to bring out the significance of inventory valuation very profusely. REPORT RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors CLOSING INVENTORY AND OTHER DETAILS AS ON 31st MARCH 2006 ` in Crores Sl. No. Company Industry Total Assets 1 Asian Hotels Ltd. Hotels– Tourism 633 2 Bharti Airtel Ltd. Telecom 3 Indraprastha Medical Corporation Ltd. 4 Closing Inventory Closing Inventory to Total Assets Sales Inventory Holding Period (Days) PBT for The Year 8 1% 328 9 87 19,030 18 0.09% 11,229 0.59 2,286 Hospital– Healthcare 259 6 2% 205 11 22 Indraprastha Gas Ltd. Natural Gas 517 18 3% 521 13 160 5 ITC Ltd. FMCG 13,084 2,636 20% 9,791 98 3,269 6 JK Cement Ltd. Cement– Hosing related 1,466 84 6% 874 35 52 7 Ranbaxy Laboratories Ltd. Healthcare 4,661 891 19% 3,570 91 190 284 Financial Accounting for Management 8 Reliance Energy Ltd. Power 14,582 295 2% 4,033 27 781 9 Reliance Industries Ltd. Oil and Gas 93,095 10,120 11% 81,211 45 10,704 10 Shoppers’ Stop Ltd. Retail 413 66 16% 588 41 40 Notes: 1. Data: Derived from respective annual reports. 2. Total assets: Include current assets and loans & advances on gross basis, that is, without deducting current liabilities and provisions. 3. Sales: Net of excise duty. Excludes other income. 4. Inventory holding period: Computed as (Closing inventory X 365/Sales). More rationally the ratio should be derived based on the Cost of Goods Sold (COGS) but replaced here by Sales figure for the sake of simplicity. Otherwise COGS will have to be worked out separately for each case. In fact based on COGS, the inventory holding period will be higher than shown here and consequently its severity. More on this in the chapter on Ratio Analysis. 5. Infosys Technologies Ltd. did not have any inventory. 6. Ranbaxy Laboratories Ltd.: Year ended 31.12.2005. You will appreciate that: 1. The extent of inventory in proportion to total assets varies from company to company depending upon the industry they belong to. Four blue chips hold significantly huge proportion of their total assets in inventory. These are ITC Ltd. (20%), Ranbaxy Laboratories Ltd. (19%), Shoppers’ Stop Ltd. (16%) and Reliance Industries Ltd. (11%). 2. This magnitude becomes more alarming when viewed in the context of Inventory Holding Period. All the companies, except Asian Hotels Ltd., Bharti Airtel Ltd., Indraprastha Medical Corporation Ltd. and Indraprastha Gas Ltd., have a high inventory holding period ranging from 98 days (ITC Ltd.) to 27 days (Reliance Energy Ltd.). What it means is that ITC Ltd. carries more than 3 months equivalent of its sales in inventory and Reliance Energy Ltd. close to a month. Others fall in between. This shows the heavy dependence of their businesses on the inventory that they need to hold. 3. These figures when compared with PBT provide startling revelations. In all cases, except Asian Hotels Ltd., Bharti Airtel Ltd., Indraprastha Medical Corporation Ltd. and Indraprastha Gas Ltd., inventory figure is either very close to or even more than the PBT. See Reliance Industries Ltd. (inventory ` 10,120 crores/PBT ` 10,704 crores) and Ranbaxy Laboratories Ltd. (inventory ` 891 crores/PBT ` 190 crores) among others. Obviously an improper valuation of inventory could have a telling impact on the PBT of these companies and consequently on their tax liability and EPS. 4. It must now be clear that, in view of the huge money blocked in the inventory and corresponding profitability, a fair valuation of inventory becomes crucial for proper assessment of a company’s financial position and performance and market value of its equity share. 285 Chapter 12 Valuation of Inventories SCOPE AND COVERAGE BIRD’S EYE VIEW AS-2 deals with accounting for all inventories except: 1. Work-in-progress arising under construction contracts; 2. Work-in-progress arising in the ordinary course of business of service providers. 3. Shares, debentures and other financial instruments held as stockin-trade, and 4. Producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases as they are valued at net realizable value in accordance with well-established practices in those industries. Exclusions from the Scope and Coverage of AS-2 n Construction Contracts n Service Providers n Shares etc. held as Stock-in-Trade n Livestock and Agricultural etc. Products Construction Contracts Work-in-progress arising under construction contracts is dealt with by Accounting Standard (AS-7), ‘Accounting for Construction Contracts’. The distinguishing feature of a construction contract is the fact that the date on which the contract is secured and the contract activity started, and the date when the contract activity is completed may fall into different accounting periods. The main issue in accounting for such contracts is the allocation of Want to know more about revenues and related costs to accounting periods over the duration of Visit www.icai.org. WWW AS-7? the contract. This in essence means assessing and measuring the value Click: Resources—Accounting of work-in-progress of the ongoing contract as on the balance sheet Standards. date. The standard prescribes the use of the percentage of completion method in accounting for construction contracts in financial statements. IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 11 VS EXISTING AS 7 WWW CONSTRUCTION CONTRACTS www.icai.org The IFRS converged Ind AS 11 corresponding to existing AS 7 on Accounting for Construction Contracts is titled as ‘Construction Contracts’. As far as the material covered here above is concerned there is no distinction between converged Ind AS 11 and existing AS 7. Service Providers Work-in-progress in the case of service providers like, consultants, software solution providers and merchant bankers etc., represents services rendered for which revenue is not recognized. Their W-I-P basically comprises related personnel costs and attributable overheads. As an example, SBI Capital Markets Ltd. is a leading merchant banker of the country. It renders services of public issue management for which it charges fees payable as per the terms of the agreement with the client. Suppose it charges fees in stages, say, on signing of the agreement, on valuation of the shares, on submission of the prospectus with SEBI, on issue opening and so on. Further suppose, in a public issue, valuation 286 Financial Accounting for Management report was submitted to the client on 28th February and prospectus filed on 15th April. Cost of services rendered during March in the preparation of prospectus represents work-in-progress for SBI Capital Markets Ltd. which it should ideally recognize in its financial statements drawn for the year ended 31st March since the part of the service has already been rendered for which fee will be received thereafter. AS-2 does not apply to such inventory of work-in-progress of service providers. A perusal of the 2005–06 annual reports of SBI Capital Markets Ltd., Satyam Computer Services Ltd., Infosys Technologies Ltd. and TATA Consultancy Services Ltd. reveals that none of these companies has recognised work-in-progress on this count. The sample suggests that Indian service providing industry does not recognize revenue for services rendered but remaining unpaid as on the balance sheet date. Shares etc. held as Stock-in-Trade Issues related to shares, debentures and other financial instruments held as stock-in-trade are discussed in the next chapter on valuation of investments. Livestock and Agricultural etc. Products Producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases are valued at net realisable value at certain stages of production. Examples could include agricultural crops when they have been harvested, or mineral oils, ores and gases when they have been extracted and sale is assured under a forward contract or a government guarantee, or when a homogenous market exists and there is negligible risk of failure to sell the inventory. AS-2 does not apply to inventories in these industries since as per AS-2 inventories are valued at the lower of cost and net realizable value, and not at net realizable value as is the case with these industries. PRINCIPLES AND NORMS OF STANDARD ACCOUNTING TREATMENT We now proceed to discuss the principles and norms of standard benchmark treatment of inventory valuation and accounting in the financial statements. BIRD’S EYE VIEW Valuation Policy Valuation Policy Raw materials etc. Raw materials, maintenance supplies, consumables and loose tools required for use in the process of production n Finished Goods and W-I-P are valued at their cost. Finished goods and W-I-P Inventories held for sale and W-I-P are valued at cost of inventories or net realisable value (NRV) thereof, whichever is lower. In case of finished goods, NRV represents the estimated selling price in the ordinary course of business minus the estimated costs necessary to make the sale. In case of W-I-P, NRV represents the estimated selling price in the ordinary course of business minus the aggregate of estimated costs of completion of W-I-P inventory and the estimated BIRD’S EYE VIEW costs necessary to make the sale. Estimates of NRV are based on the most reliable evidence, available at the time of making the estimates, Cost of Inventories regarding the amount the inventories are expected to realise when n Cost of Purchase sold. Let us discuss the implications of cost and NRV. n Cost of Conversion n Raw Materials — Allocation of overheads — Joint and by-products n Other Costs n Exclusion of Certain Costs Cost of Inventories The cost of inventories comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their Chapter 12 Valuation of Inventories 287 present location and condition. Certain costs are, however, excluded. Let us discuss in detail these costs and exclusions. Costs of purchase The purchase costs consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities, for example, CENVAT i.e., central value added tax), freight inwards and other expenditure directly attributable to the acquisition of materials, for example, octroi. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase. For all practical purposes, thus, the cost of purchase represents final invoice value, carriage and octroi minus recoverable taxes. Costs of conversion The conversion costs of inventories include costs directly related to production, for example, direct materials, direct labour as well as a systematic allocation of indirect fixed and variable production overheads that are incurred in converting raw materials into finished goods. Fixed production overheads, such as depreciation, maintenance of factory buildings and the cost of factory management and administration, are those indirect costs of production that remain relatively constant regardless of the volume of production. Variable production overheads, such as power and indirect materials—for example, oils and lubricants are those indirect costs of production that vary more or less with the volume of production. Measuring and valuing finished goods and W-I-P inventory by allocating fixed production overheads is known as valuation based on full cost or absorption cost. Allocation of overheads Fixed production overheads are allocated to conversion costs on the basis of normal capacity of the production facilities. Normal capacity represents the production expected to be achieved on an average over a number of years or seasons under normal circumstances, taking into account the loss of capacity resulting from shut down due to planned maintenance. Allocation may be done on the basis of the actual level of production if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idling of plant. However, in periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased, that is, allocation is done to actual production, so that inventories are not measured above cost. Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. ILLUSTRATION 1 SAMEER CONSUMER PRODUCTS LIMITED Allocation of Fixed Production Overheads Sameer Consumer Products Limited manufactures office chairs. Normal capacity of the factory is 50,000 chairs per annum. Following are the cost and inventory details for the year 2005–06. Raw materials cost per chair ` 1,000 Direct labour and variable production overheads per chair ` 300 Fixed production overheads for the year ` 72,00,000 Inventory as at 31st March 2006 4,000 chairs Required: Carry out the allocation of fixed production overheads and valuation of the inventory if the actual production during the year were : Situation 1 Situation 2 Situation 3 30,000 chairs 49,000 chairs 70,000 chairs 288 Financial Accounting for Management ANALYSIS AND VALUATION Let us first work out the variable cost part of the inventory of 4,000 chairs which will hold good for all the three situations Rupees Raw materials cost @ ` 1,000 per chair 40,00,000 Direct labour and variable production overheads @ ` 300 per chair 12,00,000 Variable cost 52,00,000 Now the three situations, one by one: Situation 1–Actual production during the year… 30,000 chairs: Rupees Variable cost 52,00,000 Allocation of fixed production overheads: Normal capacity 50,000 chairs Fixed production overheads for the year ` 72, 00,000 Hence, fixed production overheads per chair ` 144 Hence, fixed production overheads for 4,000 chairs 5,76,000 Value of inventory 57,76,000 If fixed overheads were allocated over 30,000 chairs, per chair fixed cost will increase to ` 240 and consequently the value of inventory will go up by ` 3,84,000 ( 4000 X ` 96, that is, `240 minus ` 144) to ` 61,60,000. Low production can not be allowed to overstate the inventory and inflate the profits. Situation 2–Actual production during the year… 49,000 chairs: Ideally, valuation should be done on the basis of normal capacity as done above. In that case the value of inventory will remain the same. However, as the actual production in this scenario is 49,000 chairs which is approximately the same as normal capacity of 50,000 chairs, fixed overheads can be allocated based on the actual production also. Valuation of inventory will then be as under: Rupees Allocation of fixed production overheads: Actual production Fixed production overheads for the year Hence, fixed production overheads per chair 49,000 chairs ` 72,00,000 ` 146.94 Hence, fixed production overheads for 4,000 chairs 5,87,760 Variable cost 52,00,000 Value of inventory 57,87,760 It may be seen that allocation of fixed overheads over actual (lower) production has led to a higher, but insignificant, inventory valuation than under situation 1. Situation 3–Actual production during the year… 70,000 chairs: Rupees Allocation of fixed production overheads: Actual production Fixed production overheads for the year Hence, fixed production overheads per chair 70,000 chairs ` 72,00,000 ` 102.86 Hence, fixed production overheads for 4,000 chairs 4,11,440 Variable cost 52,00,000 Value of inventory 56,11,440 Chapter 12 Valuation of Inventories 289 Since the actual production is higher, per chair fixed overheads have been decreased. If fixed overheads were allocated over normal capacity of 50,000 chairs, per chair fixed cost will increase to ` 144 and consequently the value of inventory will go up by ` 1,64,560 (4000 X ` 41.14, that is, `144 minus ` 102.86) to ` 57,76,000, that is, they will be measured above cost. In case of higher than normal production, normal capacity can not be allowed to overstate the inventory and inflate the profits. Joint and by-products At times or in certain industries the production process may result in more than one products being produced simultaneously, for example, joint products or a main product and a by-product. Examples of joint products would include, in the case of a refinery, say, Reliance Industries Ltd., LPG, petrol, kerosene oil, diesel and aviation fuel etc., being produced through refining of a common input, that is, crude oil. Examples of by- products would include, in the case of a sugar manufacturer, say, Balrampur Chini Mills Ltd., molasses and bagasse. If the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis, for example, the relative sales value of each product. Most by-products as well as scrap or waste materials, by their very nature, are immaterial. They are, therefore, generally valued at NRV and deducted from the cost of the main product so that the carrying amount of the main product is not materially different from its cost. Other costs Other costs are included in the cost of inventories when they are incurred in bringing the inventories to their present location and condition. For example, the costs of designing products for specific customers. Interest and other borrowing costs are usually not included in the cost of inventories as they are not considered as relating to bringing the inventories to their present location and condition. Such costs result from the capital structure and therefore do not influence the operating activity of an enterprise. Exclusion of certain costs Certain costs are excluded in determining the cost of inventories and are recognised as expenses in the period in which they are incurred, for example: n Abnormal amount of wasted materials, labour or other production costs. n Storage costs, unless the costs are necessary in the stages of production prior to a further production process. n Administrative overheads that do not contribute to bringing the inventories to their present location and condition, and n Selling and distribution costs. BIRD’S EYE VIEW Cost Formulas Materials are purchased at different prices in a year and fed to production not in one lot but in different ones. Likewise goods are produced in different lots at different raw material prices and varying direct and variable costs. The problem arises as to which price of the year to be taken as the cost of raw material and finished goods inventory then? Hence, determination of the value of inventories requires the use of cost formulas to be applied to purchases made at different prices/production achieved in lots at different costs over a period. Cost Formulas n Specific identification n Cost Flow Assumptions — FIFO — WAC — LIFO — More than one Specific identification The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects are assigned by specific 290 Financial Accounting for Management identification of their individual costs. Specific identification of costs means that specific costs are attributed to identified items of inventory. This is the most suitable treatment for items that are not ordinarily interchangeable and that are segregated for a specific project, regardless of whether they have been purchased or produced. For example, if Crompton Greaves Ltd. makes a generator set as per specification of the customer and buys certain specific motors to be fitted into this set, the cost of such motors will be identified on individual basis irrespective of the cost of other motors purchased during the year. Cost flow assumptions—FIFO and WAC In cases where there are large numbers of items of inventory that are ordinarily interchangeable, as with most enterprises, specific identification of costs is not recommended. This is because in such circumstances an enterprise could select a particular method of ascertaining the items that remain in inventories to obtain predetermined effects on the net profit or loss for the period. A variety of cost formulas, or cost flow assumptions as they are commonly known, are used to determine the cost of inventories in such cases. For examples First-in First-out (FIFO), Last-in First-out (LIFO) and Weighted Average Cost (WAC) formulas. The formula used in determining the cost of inventory needs to be selected with a view to providing the fairest possible approximation to the cost incurred in bringing the inventory to its present location and condition. The standard recognizes two such formulas—FIFO and WAC. FIFO As per the FIFO formula, it is assumed that the items of inventory which were purchased or produced first are sold or consumed first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. This formula usually assigns higher value to inventories since recent purchases/production are usually characterised by higher prices/costs. WAC As per the WAC formula, the cost of each item is determined on the basis of the weighted average of the cost of similar items at the beginning of the period and the costs of similar items purchased or produced during the period. This formula usually assigns lower value to inventories as compared to FIFO during the period of inflation. A variant of WAC, i.e., moving WAC is also followed. The revised standard does not recognise the LIFO method. Nonetheless, it is important to understand this formula as well. LIFO As per the LIFO formula, it is assumed that the items of inventory which were purchased or produced last are sold or consumed first, and consequently the items remaining in inventory at the end of the period are those most earliest purchased or produced. This formula usually assigns lowest value to inventories since earliest purchases/production are usually characterised by lower prices/costs. The formula provides a big relief to business during periods of inflation. More than one assumption The standard is silent on whether an enterprise can apply more than one formulas to different inventories. There are instances of a company having adopted a mix of them. For example, Indian Oil Corporation Ltd. valued its inventory on the following basis during 2003–04: n Raw material of crude oil....FIFO n Raw materials of base oils and additives....WAC n Finished products....WAC However, 2005–06 annual report of the company shows that crude oil has also been valued as per WAC. It needs to be noted that the actual physical flow of inventory items is of no relevance here as the formulas assume only the cost flow. 291 Chapter 12 Valuation of Inventories BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What are inventories? Bring out their significance in determining the performance of business. 2. How is the cost of inventories determined? Discuss relative merits and demerits of FIFO, WAC and LIFO. 3. What is the guiding principle behind allocation of fixed overheads to inventory? Agreed with this principle? Why or why not? 4. Should a company follow more than one cost flow assumptions for different inventories? Why or why not? To enrich your discussion, add your own ideas, thoughts and practical inputs. Illustrations on the Methods of Valuation We will now illustrate the three methods of inventory valuation. You may recall that in the case of Kamal Enterprises, we had calculated its inventory as on 30th June 2006 (refer to chapter 2). We will continue with the same case here for the purpose of illustrating the three methods. FIFO ILLUSTRATION 2 KAMAL ENTERPRISES VALUATION OF INVENTORY—FIFO Inventory account of Kamal Enterprises is reproduced hereunder. Compute the value of the closing inventory following the FIFO method. PRODUCT Y—INVENTORY ACCOUNT Date Cost of Purchase (`) 2006 April Vr. No. 5 012/013 6 014 6 015 10 016/017 Purchase Price Freight Inwards Total 2,02,000 1,550 2,03,550 Units Receipts Purchases Sales Return Issues 100 100 20 5 1,63,200 1,325 1,64,525 Balance 80 80 75 155 12 018 15 140 14 019 25 115 18 021/022 92,475 710 93,185 45 160 292 May June Financial Accounting for Management 21 023 22 024 22 91,715 760 92,475 138 45 183 3 032 30 153 10 034 35 118 122 14 035 25 038 1 28 039 40 82 29 041 5 77 5 050 8 051/052 10 053 15 055/056 5 123 25 1,65,874 1,470 1,67,344 80 1,70,000 1,470 1,71,470 80 52 132 40 92 172 15 058 2 170 25 059 45 125 28 060/061 28 062 1 174 30 065 30 068 Total 1,07,250 715 1,07,965 50 175 10 21,500 ... 21,500 10 10,22,014 490 164 174 5 321 174 SOLUTION We had assumed in this case in Chapter 2 that at every sale, the units sold were drawn from the earliest lot first. Following this assumption, the closing inventory of 174 units represents 10 units purchased on 30 June, 50 units on 28 June, 80 units on 15 June and the balance 34 units out of 80 units purchased on 8 June. Now the value of inventory is determined as under: VALUATION OF INVENTORY—FIFO Units Computation 34 1,67,344 × 34 80 71,121 80 ... 1,71,470 50 ... 1,07,965 10 ... 21,500 174 Value (`) 3,72,056 Chapter 12 Valuation of Inventories 293 LIFO ILLUSTRATION KAMAL ENTERPRISES VALUATION OF INVENTORY—LIFO 3 Using the data given in Illustration 2, compute the value of the closing inventory of Kamal Enterprises following the LIFO method. SOLUTION We now assume that the items of inventory which were purchased last are sold first. Following this assumption, the closing inventory of 174 units represents 100 units purchased on 5th April and the balance 74 units out of 80 units purchased on 10th April. Now the value of inventory is determined as under: VALUATION OF INVENTORY—LIFO Units Computation Value (`) 100 ... 2,03,550 74 1,64,525 × 74 80 1,52,186 174 3,55,736 WAC ILLUSTRATION KAMAL ENTERPRISES VALUATION OF INVENTORY—WAC 4 Using the data given in Illustration 2, compute the value of the closing inventory of Kamal Enterprises following the WAC method. SOLUTION We now need to work out the weighted average cost per unit of inventory for the three-month period and then apply this cost to the quantity of closing inventory. Now value of inventory is determined as under: VALUATION OF INVENTORY—WAC Total Units Purchased Total Purchase Price as Per ILL. 2 (`) WAC Per Unit (`) Closing Inventory (units) Value of Closing Inventory (`) Col. 1 2 3 (2/1) 4 5 (3 x 4) 490 10,22,014 2,085.74 174 3,62,919 294 Financial Accounting for Management IMPACT OF THE THREE METHODS OF VALUATION ON COGS, GROSS PROFIT AND NET PROFIT: A COMPARISON Impact on COGS and Gross Profit ILLUSTRATION 5 KAMAL ENTERPRISES COMPARISON OF IMPACT ON COGS AND GROSS PROFIT Using the data given in Illustration 2 to 4 and sales, purchase, freight inwards and GP data from the trading account as given in Chapter 2, determine the COGS and GP of Kamal Enterprises under different methods of inventory valuation and offer your comments. SOLUTION COGS and Gross Profit under different methods are computed as under: Impact on COGS and Gross Profit Amount (`) FIFO LIFO WAC 1 Sales Net of Returns 7,48,933 7,48,933 7,48,933 2 Purchases Net of Returns and Other Uses 9,88,364 9,88,364 9,88,364 3 Freight Inwards 8,000 8,000 8,000 4 Total Purchase Cost (2 + 3) 9,96,364 9,96,364 9,96,364 5 Less: Closing Inventory 3,72,056 3,55,736 3,62,919 6 COGS (4 – 5) 6,24,308 6,40,628 6,33,445 7 Gross Profit (1 - 6) 1,24,625 1,08,305 1,15,488 Comments: FIFO has provided the highest inventory value followed by WAC and LIFO in that order. Consequently COGS under the first method is lowest followed by WAC and LIFO. GP is highest under FIFO followed by WAC and LIFO. Impact on Net Profit ILLUSTRATION 6 KAMAL ENTERPRISES COMPARISON OF IMPACT ON NET PROFIT Using the data given in Illustrations 2 to 4 and from the profit and loss account as given in Chapter 2, determine the net profit of Kamal Enterprises under different methods of inventory valuation and offer your comments. SOLUTION Net profit under different methods is computed as under: Impact on Net Profit Value of Closing Inventory (`) Variation in Inventory Value over FIFO (`) FIFO LIFO WAC 3,72,056 3,55,736 3,62,919 … (–) 16,320 (–) 9,137 Chapter 12 Valuation of Inventories 295 Profit before tax (`) 42,926 26,606 33,789 Less: Income tax @ 30% (assumed for individuals) 12,878 7,982 10,317 Profit after tax (net Profit `) 30,048 18,624 23,652 Comments: FIFO has provided the highest inventory value followed by WAC and LIFO in that order. Consequently net profit under the first method is the highest followed by WAC and LIFO. LIFO is however no more allowed by AS-2, thus restricting the choice to two methods only. Switch over from FIFO in one year to WAC in the next will lead to a reduction in reported net profit and to that extent the two years’ profits will not be comparable. Vice versa is also true. Techniques for the Measurement of Cost BIRD’S EYE VIEW We talked about the ‘cost’ of inventories earlier in this chapter. This ‘cost’ may be measured through the following techniques: Actual cost Actual cost of inventories is the preferred technique of measurement for determining their values, though other techniques such as standard cost method and retail method are also in use in industries. These techniques may also be used for the measurement of cost of inventories, for convenience, if they result in approximately the actual cost. Techniques for the Measurement of Cost n Actual Cost n Standard Cost Method n Retail Method Standard cost method This method uses standard costs in place of actual costs, as it is more convenient, being based on predetermined costs. Standard costs take into account normal levels of consumption of materials and supplies, labour requirements, plant efficiency and capacity utilisation. These costs are regularly reviewed and, as and when necessary, revised in the light of current conditions so that the cost of inventories approximates the actual cost. Retail method This method is most often used in the retail trade for measuring inventories of large number of fast-moving items that have similar margins and for which it is not practicable to use other costing methods that take into account either the actual costs or standard costs. The cost of the inventory, under this technique, is determined by reducing from the sales value of the inventory the applicable percentage gross margin. The percentage used takes into consideration inventory that has been marked down to below its original selling price. An average percentage for each retail department is often used under this method. However, with the use of computers in retail trade, and even at shops and not just the big departmental stores, retail method is giving way to actual cost method. ILLUSTRATION 7 PRIYANKA KHUDRAA BAZAAR LTD. INVENTORY VALUATION—RETAIL METHOD Priyanka Khudraa Bazaar Ltd. furnishes the following details of purchase, sale etc. of its cosmetics store for the year 2005–06. At Cost (`) Opening inventory At Retail Selling Price (`) 4,50,000 5,40,000 1,06,03,000 1,52,50,000 Actual sales … 1,49,40,000 Closing inventory … 8,50,000 Purchases Determine the value of inventory of the cosmetics store as on 31st March 2006 following the retail method. 296 Financial Accounting for Management SOLUTION Average Gross Margin: At Cost (`) At Retail Selling Price (`) Opening inventory 4,50,000 5,40,000 Add: Purchases 1,06,03,000 1,52,50,000 Cosmetics available for sale 1,10,53,000 1,57,90,000 Less: Cost of cosmetics available for sale … 1,10,53,000 Inbuilt average gross margin … 47,37,000 Inbuilt average gross margin as %age of sale value of cosmetics available for sale … 30% Inventory Valuation: ` Value of closing inventory at selling price 8,50,000 Less: Average gross margin @ 30% 2,55,000 Value of closing inventory at cost 5,95,000 Alternative method: ` Opening inventory at cost 4,50,000 Add: Purchases at cost 1,06,03,000 Cosmetics available for sale at cost 1,10,53,000 Add: Gross margin earned @ 30% on sales of ` 1,49,40,000 44,82,000 1,55,35,000 Less: Actual sales 1,49,40,000 Value of closing inventory at cost BIRD’S EYE VIEW 5,95,000 Net Realisable Value As noted earlier, inventories are valued at cost or NRV, whichever is lower. The principle of writing down inventon Circumstances Justifying Write-down to NRV ries below cost to NRV is in accordance with the prudence n Basis of Write-down that assets should not be carried in the balance sheet in n Factors to be Considered in Estimating NRV excess of the amount expected to be realised from their sale n Raw Materials: Exception to Write-down or use. Let us discuss the various issues related to application of NRV, such as circumstances justifying write-down to NRV, the basis of write-down, factors to be considered in estimating NRV and cases where writedown is not to be resorted to. Net Realisable Value Chapter 12 Valuation of Inventories 297 Circumstances justifying write-down to NRV In the following circumstances the cost of inventories may not be recoverable on sale and hence their write-down below cost to NRV: (a) When their selling prices have declined. (b) When they are damaged. (c) When they have become wholly or partially obsolete. (d) When the estimated costs of completion of inventory or the estimated costs necessary to make the sale have increased. Basis of write-down The write-down of inventories below cost to NRV is usually done on an itemby-item basis. In some circumstances, however, it may be appropriate to group similar or related items, for example, when items of inventory relate to the same product line that have similar purposes or end uses and are produced and marketed in the same geographical area and cannot be practicably evaluated separately from other items in that product line. For example, Maruti Suzuki India Ltd. may group the inventory of all the ALTO cars instead of estimating NRV of each ALTO. It is to be noted that writedown of inventories based on a classification of inventory, for example, finished goods, that is, grouping the cars of all its makes or all the inventories in a particular business segment, is not appropriate. Global valuation is thus not to be resorted to. Factors to be considered in estimating NRV As noted earlier, estimates of NRV are based on the most reliable evidence available at the time of making the estimates regarding the amount the inventories are expected to realise when sold. These estimates need to take into consideration the following factors: (a) Fluctuations of price or cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date. For example, sluggishness in the industry leading to decline in the sale prices on or before the balance sheet date and the same continuing at the time of making the estimates of NRV. (b) Purpose for which the inventory is held. For example, the NRV of the quantity of inventory held to satisfy firm sales or service contracts is based on the contracted sale price. However, if the quantity of inventory held in such cases is more than the requirements of such contracts, the NRV of the excess invenWant to know more about Visit www.icai.org. tory is based on general selling prices. A situation, warranting WWW AS-29? Click: Resources—Accounting provision for contingent losses, may arise where the firm sale Standards. contracts exceed the quantities of inventory held and the enterprise has entered into firm purchase contracts to meet emergent shortfall of inventory. Decline in prices below firm purchase price will lead to a loss. These losses are dealt with in accordance with the principles set out in Accounting Standard (AS-29), ‘Provisions, Contingent Liabilities and Contingent Assets’. The standard became applicable since 1st April 2004. Para 14 of this standard provides that the amount of such a loss should be provided for, by way of a charge in the profit and loss account, if: 1. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and 2. A reliable estimate can be made of the amount of the obligation. The subject was earlier dealt with by AS-4 ‘Contingencies and Events Occuring after the Balance Sheet Date’. 298 Financial Accounting for Management IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 37 VS EXISTING AS 29 WWW PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS www.icai.org Key distinctive features of the IFRS converged Ind AS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ corresponding to existing AS 29 are as under: 1 The Converged Ind AS 37 provides that only those liabilities which exist on the balance sheet date have to be provided for even if their amount is uncertain and therefore to be estimated, for example, after sale service or repair warranties spanning over more than one year. 2 The Converged Ind AS 37 provides that contingent liabilities have not to be provided for. They however need to be disclosed by way of notes. NRV AND ITS IMPACT ON VALUATION OF INVENTORY, COGS, GROSS PROFIT AND NET PROFIT ILLUSTRATION 8 KAMAL ENTERPRISES COMPARISON OF IMPACT OF NRV ON VALUATION OF INVENTORY, COGS, GROSS PROFIT AND NET PROFIT Continuing with the case of Kamal Enterprises, trends in selling prices started showing a declining trend in the last week of June (purchases and sales of this week relate to orders placed earlier) which continued as on the date of preparing the financial statements and even later. Suppose the product had a selling price of ` 2,065 per unit as on 30th June and were sold at the same price in the month of July before drawing the financial statements, determine the NRV of the inventory as on 30th June and work out its impact on the valuation of inventory, COGS, gross profit and net profit. Use the data given in Illustration 2 to 6. SOLUTION • Computation of NRV 174 × 2065 = ` 3,59,310 • Impact on the Value of Closing Inventory Amount (`) FIFO LIFO WAC Closing Inventory at Cost as Already Computed 3,72,056 3,55,736 3,62,919 NRV 3,59,310 3,59,310 3,59,310 Lower of Cost and NRV 3,59,310 3,55,736 3,59,310 Valuation of Inventory—Finally 3,59,310 3,55,736 3,59,310 Thus the value has changed (declined) under FIFO and WAC but continues to be the same under LIFO. • Impact on COGS and Gross Profit Amount (`) FIFO LIFO WAC 1 Sales Net of Returns 7,48,933 7,48,933 7,48,933 2 Purchases Net of Returns and Other Uses 9,88,364 9,88,364 9,88,364 Chapter 12 Valuation of Inventories 3 Freight Inwards 299 8,000 8,000 8,000 4 Total Purchase Cost (2 + 3) 9,96,364 9,96,364 9,96,364 5 Less: Closing Inventory 3,59,310 3,55,736 3,59,310 6 COGS (4 – 5) 6,37,054 6,40,628 6,37,054 7 Gross Profit (1 – 6) 1,11,879 1,08,305 1,11,879 Thus COGS has gone up to the same level in the case of FIFO and WAC because of the same value of closing inventory under the two methods. COGS under LIFO remains unaffected. Accordingly GP has gone down under FIFO and WAC and has remained unchanged under LIFO. Though at the same level, now, under FIFO and WAC, the decline in GP is more pronounced in the case of the former. • Impact on Net Profit Do it yourself now. Raw materials: exception to write-down In case of a decline in the prices of materials and other supplies held for use in the production of inventories, they are not written down below cost if the finished products in which they are incorporated are expected to be sold at or above their cost. However, when it is estimated that the cost of the finished products incorporating them will exceed NRV, these materials are written down to their NRV. Since these materials are not held for sale, NRV is replaced by the replacement cost of the materials. ILLUSTRATION 9 CROWN INDIA LTD. RAW MATERIALS—WRITE DOWN TO NRV Crown India Ltd. produces one unit of product X by using one unit of raw material B. During 2005–06 B costed the company ` 3,000. Conversion cost was ` 600. As on 31st March 2006, being the balance sheet date, the replacement cost of B is ` 2,850. Analyse what will be the value of raw material B as on 31st March 2006, if: 1. The NRV of X was ` 3,800. 2. The NRV of X was ` 3,500. SOLUTION Cost of production of X: Raw material cost Conversion cost Total cost Decline in the price of B ` 3,000 600 3,600 150 Situation 1—NRV of X ` 3,800: Since the NRV of X is more than the actual cost of its production, decline in the price of B will be ignored and it will be valued at ` 3,000. 300 Financial Accounting for Management Situation 2—NRV of X ` 3,500: NRV of X has gone below its cost of production by ` 100 only as against decline in the price of B by ` 150. Therefore actual loss to the company on inventory held is only ` 100. However, as per the norms prescribed by AS-2, the quantum of loss on the finished product is not relevant, and, therefore B should be valued at ` 2,850 thus recognizing a loss of ` 150. However it may not be fair to book more loss than the actual. Ideally therefore B should be valued at ` 2,900. This is however an interpretation. Views may vary. DISCLOSURES IN FINANCIAL STATEMENTS The following information needs to be disclosed in the financial statements in respect of inventories: 1. The accounting policies adopted in measuring and valuing inventories. 2. The cost formula used in valuation, and 3. The total carrying amount of inventories and its classification appropriate to the enterprise. Finished goods, work-in-progress, raw materials, stores and spares and loose tools represent the generally practiced classification of inventories. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. How is NRV determined and under what circumstances? 2. How does the policy of ‘lower of cost’ and NRV affect COGS and profitability? To enrich your discussion, add your own ideas, thoughts and practical inputs. Corporate Financial Practices Let us continue with the case of Titan Industries Ltd. to understand how companies measure and disclose inventories in their annual reports. Please go through the case and attempt the requirements given at the end of the chapter. Chapter 12 Valuation of Inventories CASE 301 1 continued: Titan Industries Ltd. REPORT CORPORATE FINANCIAL PRACTICES Titan Industries Ltd. Annual Report 2005–06 VALUATION OF INVENTORIES A. Details of Inventories as Appearing on the Face of the Balance Sheet: ` in lakhs Schedule Current Assets, Loans and Advances: 31.03.2006 31.03.2005 37439.44 27161.82 G Inventories B. Extracts from Schedule–‘G’: Current Assets, Loans and Advances: ` in lakhs 31.03.2006 31.03.2005 351.80 328.60 Inventories: Consumable stores Loose tools 192.81 152.40 Raw materials and bought-out components 8507.84 5551.33 Work-in-progress 5445.73 4813.08 Finished goods 22941.26 16316.41 37439.44 27161.82 Total... C. Extracts from Schedule– ‘K’: Notes to the Accounts1. Significant Accounting Policies V1. Inventories: Inventories are valued at lower of cost and net realizable value. The cost of various categories of inventory is determined as follows: a. Consumable stores, loose tools, raw materials and components are valued on a moving weighted average rate. b. Work-in-progress and manufactured goods are valued on full absorption cost method based on the annual average cost of production. c. Traded goods are valued at annual average cost of purchases. D. Some More Information: ` in lakhs 31.03.2006 31.03.2005 Total assets 88410.61 79085.71 Sales 144018.50 109671.96 PBT 8688.18 3236.34 PAT 7361.98 2494.89 302 Financial Accounting for Management Notes: 1. Total assets: Include current assets and loans & advances on gross basis, that is, without deducting current liabilities and provisions. 2. Sales: Net of excise duty. Excludes other income. IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 2 VS EXISTING AS 2 WWW INVENTORIES www.icai.org The IFRS converged Ind AS 2 on Valuation of Inventories is titled as ‘Inventories’. Key distinctive features of Converged Ind AS 2 are as under: 1 The converged Ind AS 2 requires new assessment of net realizable value in each subsequent period. When the circumstances that previously caused inventories to be written down below cost to NRV no longer exist or when there is clear evidence of an increase in net realizable value because of changed economic circumstances, the amount of the write-down is reversed (i.e. the reversal is limited to the amount of the original write-down) so that the new carrying amount is the lower of the cost and the revised net realizable value. This occurs, for example, when an item of inventory that is carried at net realizable value, because its selling price has declined, is still on hand in a subsequent period and its selling price has increased. Consider this. In the year 1 end the cost and NRV of an item of inventory were ` 5,000 and 4,200 respectively. Obviously the inventory was valued and carried at ` 4,200 thus writing-down Rs 800. Now suppose this inventory still exists at the year 2 end when its NRV has increased to ` 4,600. The inventory will now be carried at ` 4,600 (still being less than cost) thus reversing the write-down of the year 1 to the extent of ` 400.The existing AS 2 does not deal with such reversal. 2 The existing AS 2 specifically provides that the formula used in determining the cost of an item of inventory should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition whereas the converged Ind AS 2 does not specifically state so and just requires the use of consistent cost formulas for all inventories having a similar nature and use to the entity. CONCLUDING REMARKS We learnt in this chapter about the various aspects of inventory valuation and illustrated the methods of its valuation and their impact on COGS, gross profit and net profit. We also learnt how a change in the valuation policy could render the accounts of the year of change incomparable with those of the previous year. Armed with this knowledge we now move to the next chapter on investment valuation. Keywords n Absorption Cost nn C n ompleted Contract Method nn Finished Goods n Administrative Overheads nn C n ontingencies and Events nn First-in First-out/FIFO nn By-product Occurring after the Balance Sheet Date nn F n ixed Production Overheads nn Goods-in-Process Chapter 12 Valuation of Inventories 303 nn Inventories nn P n ercentage of Completion Method nn Stores and Spares nn Joint Products nn Raw Materials nn V n ariable Production Overheads nn Last-in First-out/LIFO nn Retail Method nn Waste Materials nn Loose Tools nn Service Contracts nn WAC nn Machinery Spares nn Specific Identification nn N n et Realizable Value/NRV nn Standard Costs WWW REPORT 1. Valuation of Inventories, AS-2, ICAI, www.icai.org. 2. Accounting for Construction Contracts, AS-7, ICAI, www.icai.org. 3. Provisions, Contingent Liabilities and Contingent Assets, AS-29, ICAI, www.icai.org. 1. Asian Hotels Ltd., Annual Report, 2005–06. 2. Balrampur Chini Mills Ltd., Annual Report, 2005–06. 3. Bharti Airtel Ltd., Annual Report, 2005–06. 4. Crompton Greaves Ltd., Annual Report, 2005–06. 5. Indian Oil Corporation Ltd., Annual Report, 2003–04. 6. Indian Oil Corporation Ltd., Annual Report, 2005–06. 7. Indraprastha Medical Corporation Ltd., Annual Report, 2005–06. 8. Indraprastha Gas Ltd., Annual Report, 2005–06. 9. Infosys Technologies Ltd., Annual Report, 2005–06. 10. ITC Ltd., Annual Report, 2005–06. 11. JK Cement Ltd., Annual Report, 2005–06. 12. Ranbaxy Laboratories Ltd., Annual Report, 2005–06. 13. Reliance Energy Ltd., Annual Report, 2005–06. 14. Reliance Industries Ltd., Annual Report, 2005–06. 15. SBI Capital Markets Ltd., Annual Report, 2005–06. 16. Shoppers’ Stop Ltd., Annual Report, 2005–06. 17. Satyam Computer Services Ltd., Annual Report, 2005–06. 18. TATA Consultancy Services Ltd., Annual Report, 2005–06. 19. Titan Industries Ltd., Annual Report, 2005–06. 304 Financial Accounting for Management exercises CASE 1 COMPREHENSIVE CASE OF PULKIT ENTERPRISES ON INVENTORY Refer to the comprehensive case of Pulkit Enterprises as given in the exercises in Chapters 1 and 2. The following exercises 1 to 5 are based on this case. FIFO valuation has already been done by you in Chapter 2. Ex. 1 LIFO Using the data given in the case, compute the value of the closing inventory of Pulkit Enterprises as on 30th June 2006 following the LIFO method. Towards this: 1. Prepare the statement of inventory account. 2. Prepare the statement of inventory valuation. Ex. 2 Weighted Average Cost Using the data given in the case, compute the value of the closing inventory of Pulkit Enterprises as on 30th June 2006 following the WAC method. Ex. 3 Impact on COGS and GP Using the data given in the case and sales, purchase, freight inwards and GP data from the trading account as prepared by you in Chapter 2: 1. Determine the COGS and GP of Pulkit Enterprises under different methods of inventory valuation, and 2. Offer your comments. Chapter 12 Valuation of Inventories 305 Ex. 4 Impact on NP Using the data given in the case and from the profit and loss account as prepared by you in Chapter 2: 1. Determine the net profit of Pulkit Enterprises under different methods of inventory valuation, and 2. Offer your comments. Ex. 5 NRV and its Impact Suppose in the above case the product had a selling price of ` 2,075 per unit as on 30th June and were sold at the same price in the month of July before drawing the financial statements. Carry out the following analysis: 1. Determine the NRV of the inventory as on 30th June. 2. Work out its impact on the valuation of inventory. 3. Work out its impact on COGS and gross profit. 4. Work out its impact on net profit. 5. Work out its impact on the financial position. Further Carry out a comparison with the results obtained earlier without considering the NRV and offer your comments. Why is it necessary to consider NRV? Analyse. Use the data as worked out by you in Exercises 1 to 4. Ex. 6 BROWN INDIA LIMITED Allocation of Fixed Production Overheads Brown India Limited manufactures office tables. Normal capacity of the factory is 60,000 tables per annum. Following are the cost and inventory details for the year 2005–06. Raw materials cost per table ` 2,500 Variable production overheads per table ` 650 Fixed production overheads for the year ` 1,80,00,000 Inventory as at 31st March 2006 5,500 tables Required: Carry out the allocation of fixed production overheads and valuation of the inventory if the actual production during the year were: Situation 1 Situation 2 Situation 3 45,000 tables 59,500 tables 72,000 tables 306 Financial Accounting for Management Ex. 7 SHOPPERS’ DEPARTMENTAL STORES LTD. Inventory Valuation—Retail Method Shoppers’ Departmental Stores Ltd. furnishes the following details of purchase, sale etc. of its garments section for the year 2005–06. At Cost (`) At Retail Selling Price (`) 15,56,330 18,36,470 2,14,78,450 2,58,05,266 Actual sales … 2,65,72,456 Closing inventory … 10,69,280 Opening inventory Purchases Determine the value of inventory of the garments section as on 31st March 2006 following the retail method. Ex. 8 RAM LAKHAN COMPANY LTD. Raw Materials—Write down to NRV Ram Lakhan Company Ltd. produces one unit of product B by using one unit of raw material A. During 2005–06 A costed the company ` 4,200. Conversion cost was ` 850. As on 31st March 2006, being the balance sheet date, the replacement cost of A is ` 4,000. Analyse what will be the value of raw material A as on 31st March 2006, if: 1. The NRV of B was ` 5,300. 2. The NRV of B was ` 4,800. Ex. 9 CASE 2 TITAN INDUSTRIES LTD. Case on Corporate Financial Practices—Inventories Refer to the details extracted from annual report 2005–06 of Titan Industries Ltd. regarding its inventories by type and value, related significant accounting policies and other financial information as illustrated in this chapter. Having gone through the information provided therein, answer the following questions: 1. Has Titan made the disclosures related to inventories in accordance with the requirements of AS-2? How or how not? 2. Has Titan followed correct accounting policies in respect of inventory valuation in accordance with the GAAP requirements? Analyse. Any suggestions? 3. Compute, for both the years: Chapter 12 Valuation of Inventories 307 (a) Closing Inventory to Total Assets (%) (b) Inventory Holding Period (days) based on sales Comment upon the efficiency or otherwise of Titan’s inventory management compared to 2004–05. 4. Analyse the vulnerability of Titan’s PBT to its inventory valuation. 5. Relate the various raw materials with the finished products they form part of. 6. Had Titan shifted to FIFO/LIFO in 2004–05 and if the corresponding values of inventories were as under: Rupees in lakhs 31.03.2006 31.03.2005 FIFO 38998.30 25465.78 LIFO 36212.98 27889.36 6.1 Generally speaking materials prices for Titan had been (rising/declining/stagnant) during 2004–05. 6.2 Analyse the effect the FIFO cost-flow assumption would have on Titan’s reported financial statements of 2004–05: 6.2.1 COGS will be (more/less) by ` _________lakhs. 6.2.2 PBT will be ` _________lakhs. 6.2.3 Tax expense will be (more/less) by ` _________lakhs assuming a 35% tax rate. 6.2.4 PAT will be ` _________lakhs. 6.3 Generally speaking materials prices for Titan have been (rising/declining/stagnant) during 2005–06. 6.4 Analyse the effect the LIFO cost-flow assumption would have on Titan’s reported financial statements of 2005–06: 6.4.1 COGS will be (more/less) by ` _________lakhs. 6.4.2 PBT will be ` _________lakhs. 6.4.3 Tax expense will be (more/less) by ` _________lakhs assuming a 35% tax rate. 6.4.4 PAT will be ` _________lakhs. 6.5 Now analyse the effect the LIFO cost-flow assumption would have on Titan’s reported financial statements of 2004–05 and FIFO cost-flow assumption on 2005–06 statements. 7. In a period of deflation, the cost-flow assumption which results in the lowest taxable income is (FIFO/WAC/LIFO). 8. In a period of inflation, the cost-flow assumption which results in the lowest taxable income is (FIFO/WAC/LIFO). 9. In a period of deflation, the cost-flow assumption which results in the highest taxable income is (FIFO/WAC/LIFO). 10. In a period of inflation, the cost-flow assumption which results in the highest taxable income is (FIFO/WAC/LIFO). 13 Valuation of Investments Investments in general, and in manufacturing companies in particular, represent deployment of surplus funds to earn dividends, interest, rentals and capital appreciation for strategic reasons. Investments represent major assets and business activities for investment companies. Their performance depends on the results of this activity. Chapter 13 Valuation of Investments 309 CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 Meaning and significance of investments. 2 Scope and coverage of AS-13 on ‘Accounting for Investments’. 3 Various forms of investments. 4 Principles and norms of standard accounting treatment of investments, methods of valuation and other related issues. 5 Determination of fair value on reclassification of current investments into long-term and its impact on profit. 6 Determination of carrying amount of current investments into long-term and consequent impact on profit. 7 Disclosure requirements in respect of investments in the financial statements. 8 Corporate financial practices in respect of investments. 9 Treatment of investments in jointly controlled entities as per AS-27. INTRODUCTION Investments generally represent, especially in the case of manufacturing companies, deployment of surplus funds to earn income known as non-operating income. Shares and debentures of listed companies, for example, Tata Steel Ltd. and units of mutual funds, for example, SBI Mutual Fund, represent the most common types of investments. At times, however, companies commit their funds towards strategic investments as well, which may not provide any return immediately or in the short run. For example, companies may diversify into other lines of businesses through investments in associate companies, joint ventures and subsidiary companies. A subsidiary company is an enterprise that is controlled by another enterprise, known as the parent, or holding company. The control is basically characterized by the parent owning more than 50% equity of the subsidiary. A joint venture represents an entity, normally a company, whose equity is jointly owned by two or more parties and thus jointly controlled by them. An associate company represents one on which the investor has significant influence, that is, the power to participate in the financial and/or operating policy decisions of the investee but not control over those policies, and, which is neither a subsidiary nor a joint venture of the investor. Significant influence is basically characterized by the investor owning more than 20% equity of the investee company. Reliance Industries Ltd., the largest Indian private sector company, itself into energy and chemical businesses, had adopted the subsidiary companies route for its forays into communications infrastructure, infocom, telecom, power and financial services, to name a few. It has again invested in a subsidiary Reliance Retail Ltd. to carry its billion dollar retail business. Bharti Airtel Ltd. has also formed a joint venture to carry its retail business in collaboration with Wal-Mart of USA. Nestlé India Ltd., is itself a subsidiary of Nestlé S.A., Switzerland. Investments represent major amount of assets and business activities in the case of finance and investment companies. 310 Financial Accounting for Management VALUATION OF INVESTMENTS WWW The ICAI has issued Accounting Standard (AS-13), ‘Accounting for Investments’ which defines investments, sets out their significance, specifies investments by certain bodies not included in its scope and coverage, explains the forms of investments and preVisit www.icai.org for scribes the benchmark treatment for identification, measurement and original text of AS-13. recognition aspects of investments valuation and accounting, that is, Click: Resources— their classification and reclassification, cost of investments, carrying Accounting Standards. amount of investments, changes in carrying amounts, disposal of investments and disclosure requirements in financial statements. Let us understand and analyse them. MEANING AND SIGNIFICANCE OF INVESTMENTS BIRD’S EYE VIEW AS-13: Accounting for Investments n Meaning and Significance of Investments n Scope and Coverage n Forms of Investments n Principles and Norms of Standard Accounting Treatment: — Classification of investments — Cost of investments — Valuation/carrying amount of investments — Reclassification of investments — Cost of investments in cases of rights issue — Disposal of investments — Shares and other securities held as stock-in-trade n Disclosure Requirements Enterprises may hold investments for various reasons. Investments represent assets held for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Such benefits would include diversification of business through associate/subsidiary companies for a long term stream of gains as mentioned earlier. Investment activity is a significant part of operations, for example, for investment or finance companies such as banks and financial institutions. Assessment of the performance of such companies largely, or solely, depends on the results of this activity. Research in Financial Reporting Let us continue with the companies researched under this feature in the earlier chapters. Asian Hotels Ltd., Indraprastha Medical Corporation Ltd. and JK Cement Ltd. are not included here as they have nil/virtually insignificant investments and income there from. Again four more companies from the finance sector have been covered here to provide a cross-section view of investments and related aspects of non-finance and finance companies. Look at these research findings that bring out the significance of investment valuation very profusely. Company Industry Ranbaxy Healthcare Laboratories Ltd. Power Oil and Gas ITC Ltd. Reliance Energy Ltd. Reliance Industries Ltd. 4 5 6 7 93,095 14,582 4,661 13,084 9,114 Infosys Information Technologies Technology Ltd. 3 FMCG 517 Indraprastha Natural Gas Gas Ltd. 19,030 2 Telecom Bharti Airtel Ltd. RESEARCH IN FINANCIAL REPORTING Select Indian Corporates Across Industry Sectors 5,846 1,193 763 3,517 876 43 720 Investments 6% 8% 16% 27% 10% 8% 4% Investments to Total Assets 292 24 46 168 71 3 26 Income from investments for the year 5% 2% 6% 5% 8% 7% 4% Investment Income to investments 23 … 8 … 1 … … Provision for Diminution in the value of Investments INVESTMENTS AND OTHER RELATED DETAILS AS ON 31 MARCH 2006. Total Assets 1 A. Non-finance Companies: Sl. No. REPORT 10,704 781 190 3,269 2,724 160 2,286 PBT for the year (Continued) 3% 3% 24% 5% 3% 2% 1% Investment Income to PBT ` Crores Finance: Merchant Banking, Investments, Securities Trading and Leasing Finance: Housing SBI Capital Markets Ltd. HDFC Ltd. 10 11 53,398 558 2,103 2,51,389 3,876 112 69 71,547 7% 20% 3% 28% 424 53 18 4,728 11% 47% 26% 7% … 1 … 777 1,557 114 46 3,097 1. Data: Derived from respective annual reports. 2. Total assets: Include current assets and loans & advances on gross basis, that is, without deducting current liabilities and provisions. 3. Percentages rounded off. 4. Income from investments is inclusive of interest, dividend and profit/loss on sale of investments etc. as reported in the annual reports. 5. Ranbaxy Laboratories Ltd.: Year ended 31.12.2005. Notes: Cholamanda- Finance: lam DBS Equipment Finance Ltd. Financing 9 Finance: Banking ICICI Bank Ltd. 8 B. Finance Companies: 27% 46% 39% 153% Chapter 13 Valuation of Investments 313 Observations now follow: A. Non-finance Companies: 1. Investments as a proportion of total assets are not significant except in the case of ITC Ltd. (27%). and Ranbaxy Laboratories Ltd. (16%). In absolute terms, however, amounts involved are substantial in most cases. 2. Income earned from investments is very low. The return varies from 2% to 8% only. It shows that large amounts are blocked in strategic long term investments which are virtually not yielding any returns as at present and/or the large amounts of investments have been made at high market prices with long term capital appreciation in mind. 3. Investment income is not contributing much to PBT except in the case of Ranbaxy Laboratories Ltd. (24%). B. Finance Companies: 1. Investments as a proportion of total assets are very significant in the case of ICICI Bank Ltd. (28%) and SBI Capital Markets Ltd. (20%). In absolute terms, however, amounts involved are substantial in most cases. 2. Income earned from investments is quite high in the case of Cholamandalam DBS Finance Ltd. (26%) and SBI Capital Markets Ltd. (47%). The return is very low in rest of the two cases, that is, ICICI Bank Ltd. and HDFC Ltd. It shows that in these cases large amounts are blocked in strategic long term investments and/or the investments have been made at high market prices. 3. In all cases, investment income forms a very significant component of PBT (27% to 153%) showing that investing is one of their major activities, so much so that in the case of ICICI Bank Ltd. investment income is 153% of its PBT. What it means is that investment income is such a major operational revenue for ICICI Bank Ltd. that it has to meet lots of operational expenses to earn this income. That is why its PBT is less than its investment income. Provision for diminution represents the loss booked by an investor in case the value of the investment goes below its cost. ICICI Bank Ltd. has made a provision for ` 777 crores. Major issues that arise in the accounting for investments relate to determining their cost and value as on the balance sheet date. Cost determination is crucial because wrong capitalisation of revenue expenditure will have a huge bearing on the PBT in view of the proportionately much larger size of investments as seen above. Determining value as on the balance sheet date is crucial to booking a loss that might have arisen. Thus in both cases the portrayal of financial position is also affected. Hence the need for a fair valuation. SCOPE AND COVERAGE AS-13 deals with accounting for investments in the financial statements of enterprises and related disclosure requirements. The standard, however, does not cover the following: 1. The bases for recognition of interest, dividends and rentals earned on investments. Accounting Standard (AS-9), ‘Revenue Recognition’ deals with interest, dividends and rentals earned on investments. These aspects have been studied in Chapter 12 under the head ‘Income’. 2. Operating or finance leases. Already discussed in an earlier chapter. 3. Investments by retirement benefit plans and life insurance companies, and 4. Investments by mutual funds and/or related asset management companies, banks and public financial institutions and venture capital funds, as these investments and those covered under point 3 above are governed by their respective statutes, rules and regulations. 314 Financial Accounting for Management FORMS OF INVESTMENTS AND ESTABLISHMENT OF THEIR MARKET VALUES Investments may be in various forms. Physical existence of investments, or absence thereof, determines their form. 1. Some investments have no physical existence and are represented merely by certificates, for example, shares and debentures. 2. Some investments exist in a physical form, for example, land or buildings that are not intended to be occupied substantially for use by, or in the operations of, the enterprise but for sale or rentals and are known as investment property. Active Market or Absence Thereof An active market exists for some investments, from which can be established their market value, while not for others. For example, financial investments, such as shares and debentures of listed compaForms of Investments nies and government securities are traded on the stock exchanges. The n No Physical Existence trading discovers their market value. Generally no active market exists n Physical Form for buildings. Their market value could be derived from the valuer’s — Active market or absence thereof estimates, unofficial quotes by the property dealers, deal price of a similar building in the recent past, circle rates of land prescribed by the local authorities and the acuteness of the need of the buyer/seller to buy/sell the property, etc. BIRD’S EYE VIEW PRINCIPLES AND NORMS OF STANDARD ACCOUNTING TREATMENT We now proceed to discuss the principles and norms of standard accounting treatment relating to valuation of investments in the financial statements. n Classification of investments n Cost of investments n Valuation/carrying amount of investments n Reclassification of investments n Cost of investments in cases of rights issue n Disposal of investments n Shares and other securities held as stock-in-trade Classification of Investments Investments are classified as long-term investments and current investments. Current Investments A current investment is an investment that is readily realisable, for example, equity shares of an actively traded listed company like Bajaj Auto Ltd., and is intended to be held for not more than one year from the date on which such investment is made. Current investments are in the nature of current assets although the common practice is to include them in investments. BIRD’S EYE VIEW Classification of Investments n Current Investments n Long-term Investments Long-Term Investments Investments other than current investments are long-term investments, even though they may be readily marketable. For example, Steel Authority of India Ltd. may hold the shares of HDFC Bank Ltd. with a long term perspective but, in case needed, it can sell them quickly by virtue of their being listed and that too actively traded. Intent in such cases is to hold them for more Chapter 13 Valuation of Investments 315 than one year. Investments in the shares of unlisted subsidiary/associate companies are not readily realisable. For example, investment by Steel Authority of India Ltd. in its unlisted subsidiary IISCO Ujjain Pipe & Foundary Company Ltd. It is thus the intent of the management that determines whether an investment is in the nature of long term or short term. Investment properties are, however, invariably accounted for as long-term. Cost of Investments BIRD’S EYE VIEW Cost of Investments n Break-up of Cost Following are the key principles of ascertaining the cost of investments: Break-up of Cost The cost of an investment includes, in addition to its prime cost, acquisition charges such as brokerage, fees and duties, and so on. n Investment Acquired by Issue of Securities n Investment Acquired in Exchange for Another Asset n Recovery of Cost n Investments Properties ILLUSTRATION 1 SHALINI TEXTILES LTD. DETERMINATION OF COST OF INVESTMENT IN SHARES Shalini Textiles Ltd. sought the advice of an investment advisor for deployment of surplus funds of around ` 18 lakh in the stock market. The advisor advised to invest in Appollo Tubes Ltd. and charged ` 5,000 as his fee. Accordingly, the investing company bought 5,000 equity shares of Appollo Tubes Ltd. @ ` 356 per share from the NSE through a stockbroker, Sunshine Securities Ltd. The broker charged a brokerage of 0.50% Determine the cost of this investment. SOLUTION Cost of Investment in the Shares of Appollo Tubes Ltd. is determined as under: Details Prime Cost Per Share Add: Brokerage Total Cost Per Share Cost of 5,000 Shares Add: Investment Advisor’s Fee Cost of Investment The investment will be recorded in the books of Shalini Textiles Ltd. at ` 17,93,900. ` 356.00 1.78 357.78 17,88,900 5,000 17,93,900 Investment Acquired by Issue of Securities When an investment is acquired, partly or fully, by the issue of shares or other securities, its cost is equal to the fair value of the securities issued. Fair value represents the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Under appropriate circumstances, for example, in cases of listed shares, market value or net realisable value provides an evidence of fair value. Market value is the amount obtainable from the sale of an investment in an open market, net of expenses necessarily to be incurred on or before its disposal. The fair value need not necessarily be equal to the nominal or par value of the securities issued. 316 Financial Accounting for Management ILLUSTRATION 2 USHA ENERGY LTD. DETERMINATION OF COST OF INVESTMENT PROPERTY ACQUIRED BY ISSUE OF SHARES Usha Energy Ltd. buys a building for the purpose of investments. It issues 65,000 equity shares of its company, which are quoted on the day of the deal at ` 181 per share at the BSE. The brokerage payable on sale in the BSE is Re. 1 per share. The company also pays a brokerage of ` 2 lakh to the property dealer involved in the deal. The stamp duty is also incurred @ 8% of the value of the building. Determine the value of this investment property. SOLUTION Cost of Investment in the Building is determined as under: Details ` No. of Shares Issued 65,000 Fair value per share (quoted price minus brokerage on sale) ` 180 Fair Value of the Shares Issued - Add: Brokerage 1,17,00,000 2,00,000 Add: Stamp Duty for Transfer in the Name of the Company @8% of ` 1,17,00,000 Value of the Building 9,36,000 1,28,36,000 The building will be recorded in the books as long-term investment under the head ‘investments’ at a cost of ` 1,28,36,000. Investment Acquired in Exchange for Another Asset When an investment is acquired in exchange for another asset, its cost is determined with reference to the fair value of the asset given up or with reference to the fair value of the investment acquired, if it is more clearly evident. ILLUSTRATION 3 BILLIMORIA INVESTMENTS LTD. DETERMINATION OF COST OF INVESTMENT ACQUIRED IN EXCHANGE Billimoria Investments Ltd. holds 5000 shares of Frenny Power Corporation Ltd. It acquires 4000 shares of Rajeev Kapoor Khana Khazana Ltd. from Tulsi Irani Investments Ltd. in exchange for these shares. Determine the cost of shares acquired by Billimoria Investments Ltd. under the following three situations: 1. If shares of both Frenny Power Corporation Ltd. and Rajeev Kapoor Khana Khazana Ltd. were listed at NSE and their quoted prices on the day of the deal were ` 318 and ` 402 per share respectively. The brokerage payable on sale in the BSE is ` 3 per share and ` 4 per share respectively. 2. If Rajeev Kapoor Khana Khazana Ltd. were unlisted and therefore its market value were not known. 3. If Frenny Power Corporation Ltd. were unlisted. SOLUTION Cost of investment in the shares of Rajeev Kapoor Khana Khazana Ltd. is determined as under: Situation 1–Both the exchanged investments being listed: Fair value of the investment acquired ` 15,92,000 (that is, 4000 3 398). Fair value of the investment given up ` 15,75,000 (that is, 5000 3 315). Hence the cost to Billimoria Investments Ltd. of its investment in Rajeev Kapoor Khana Khazana Ltd. is ` 15,75,000. Chapter 13 Valuation of Investments 317 Situation 2–Rajeev Kapoor Khana Khazana Ltd. being unlisted: The cost to Billimoria Investments Ltd. of its investment in Rajeev Kapoor Khana Khazana Ltd. is again ` 15,75,000 being the value of the asset given up. Situation 3–Frenny Power Corporation Ltd. being unlisted: Since the market value of Rajeev Kapoor Khana Khazana Ltd., the acquired asset, is more clearly evident, the cost of this investment to Billimoria Investments Ltd. is ` 15,92,000. Note: In all the three situations if any acquisition costs, such as, investment adviser’s fee etc., have been incurred they will be added to the cost worked out above to arrive at the final cost. Recovery of Cost In some circumstances, income from investments represents a recovery of cost and not revenue. For example, when unpaid interest has accrued before the acquisition of bonds and is therefore included in the price paid for them, the subsequent receipt of interest related to pre-acquisition period is deducted from the cum-interest price paid. Likewise, when dividend on equity is declared from pre-acquisition profits, the cost of investment is normally reduced by the dividend receivable provided that it clearly represents a recovery of the cost. ILLUSTRATION 4 SHALINI TEXTILES LTD. DETERMINATION OF COST OF INVESTMENT IN BONDS PURCHASED CUM-INTEREST Shalini Textiles Ltd. purchases 10,000 8% secured redeemable bonds of the face value of ` 100 each of NTPC Ltd. on 1st July for a consideration of ` 10,60,000 net of brokerage. The interest on the bonds is payable every six months on 30th September and 31st March. Determine the cost of this investment on 30th September. SOLUTION The investment in the bonds of NTPC Ltd. will be initially recorded on 1st July at a cost of ` 10,60,000. However, this cost will be adjusted as under on 30th September: Details ` Net Purchase Consideration ` 10,60,000 Less: Interest Included in the Purchase Consideration: Interest Received on 30th September @ 8% per annum for 6 months 40,000 Less: Interest Included in the Purchase Price for Three Months from 1st April to 30th June 20,000 Cost of Bonds as on 30th September (2) 20,000 10,40,000 The investment will appear in the balance sheet of Shalini Textiles Ltd. at ` 10,40,000. Only ` 20,000 will be credited to the profit and loss account out of the interest of ` 40,000 received. 318 Financial Accounting for Management Investment Properties. In the case of investment property, the cost of any share in a cooperative society or a company, the holding of which is directly related to the right to hold the property, is added to the cost thereof. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. How would you regard shares and debentures: as tangible investments or intangible? 2. How is the cost of investments determined in different situations? To enrich your discussion, add your own ideas, thoughts and practical inputs. Valuation/Carrying Amount of Investments in the Balance Sheet Investments are valued and carried in the balance sheet in the following manner: BIRD’S EYE VIEW Valuation/Carrying Amount of Investment in the Balance Sheet n Current Investments n Long-term Investments ILLUSTRATION 5 Current Investments Current investments are carried in the balance sheet at the lower of cost and fair value determined either on an individual basis or by category of investments, such as shares and debentures, but not on an overall, or global basis. However, the individual basis approach is more prudent and therefore desirable. Any reduction to fair value is charged as a loss to the profit and loss account. SHALINI TEXTILES LTD. VALUATION/DETERMINATION OF CARRYING AMOUNT OF CURRENT INVESTMENTS ON THE BALANCE SHEET DATE If Shalini Textiles Ltd. were to continue with the classification of their investment in Appollo as current investments, and the fair market value as on the balance sheet date was ` 17,65,000, at what value will the investment be carried in the balance sheet as on that date? SOLUTION ` 17,65,000 being the lower of cost and fair value will be disclosed in the balance sheet. Balance ` 28,900, being loss, will be charged to the profit and loss account. Long-term Investments Long-term investments are carried at cost. Provision for management’s judgement of long term dimunition in case of a decline in the fair value is, however, made to each investment individually. The assessment of diminution is done on the basis of indicators of the value of an investment obtained by reference to its market value, the investee’s assets and results, the expected cash flows from the investment, the type and extent of the investor’s stake in the investee and restrictions put by the investee on disposal by the investor and so on. Long-term investments are usually Chapter 13 Valuation of Investments 319 of individual and strategic importance to the investing enterprise for example, investment of ICICI Bank Ltd. in ICICI Prudential Life Insurance Company Ltd. The carrying amount of long-term investments is, therefore, determined on an individual investment basis only. The reduction in carrying amount is reversed when there is a rise in the value of the investment or if the reasons for the reduction no longer exist. Any reduction in the carrying amount and any reversal of such reduction is charged or credited to the profit and loss account as loss or revenue as the case may be. ILLUSTRATION 6 GAUTAM FOOTWEAR LTD. PROVISION FOR DIMINUTION IN THE VALUE OF LONG TERM INVESTMENT AND REVERSAL THEREOF In April 2004, Gautam Footwear Ltd. promoted Gautam and Wahi Ltd., an unlisted joint venture company in association with Wahi Gas Ltd. It invested ` 1 crore by way of its contribution in the capital of the joint venture by subscribing to its 10 lakh equity shares of ` 10 each. The investment is obviously long term in nature. Accounting year of both Gautam Footwear Ltd. and Gautam and Wahi Ltd. is April to March. Determine the value/carrying amount of the investment of the former in the later under the following three situations on the dates mentioned: 1. On 31-03-2005, if net worth per share of Gautam and Wahi Ltd. as on that date as per its balance sheet were ` 8.50 only, as its business didn’t do well. Gautam Footwear Ltd. considers this loss to be temporary as it expects the business to pick up in the long run. 2. On 31-03-2006, if net worth per share of Gautam and Wahi Ltd. as on that date as per its balance sheet further goes down to ` 4.50. Gautam Footwear Ltd., as a matter of prudence, considers this loss to be long term, that is, other than temporary 3. On 31-03-2007, if net worth per share of Gautam and Wahi Ltd. as on that date as per its balance sheet improves to ` 7.25 as a result of unforeseen spurt in the business. SOLUTION Valuation/carrying amount of investments of Gautam Footwear Ltd. in Gautam and Wahi Ltd. will be as under: Situation 1–As on 31-03-2005 – Loss considered to be temporary: The fair value of the shares of Gautam and Wahi Ltd., as per its books, has declined to ` 8.50 per share thus registering a diminution of ` 1.50 per share. Accordingly the value of the investment of ` 1 crore has declined to ` 85 lakhs. Ordinarily a provision for diminution for ` 15 lakhs should be charged to the profit and loss account and accordingly the investment should be carried in the balance sheet at ` 85 lakhs. However since a business is started with a long term view and this being the very first year of operations management seems to be right in considering the diminution to be temporary. Hence the investment will be valued/carried in the balance sheet at ` 1 crore. Diminution not to be provided for. Situation 2–As on 31-03-2006 – Loss considered to be other than temporary: The value of the investment of ` 1 crore has further declined to ` 45 lakhs. As the management now considers this loss to be long term, that is, other than temporary, a provision for diminution for ` 55 lakhs will be charged to the profit and loss account and accordingly the investment will be carried in the balance sheet at ` 45 lakhs. Situation 3–As on 31-03-2007 – Reversal of provision for diminution: The performance of Gautam and Wahi Ltd. has shot back. Gautam Footwear Ltd. has recovered the loss of ` 5.50 per share to the extent of ` 2.75 per share (that is, ` 7.25 minus ` 4.50). Thus the carrying amount of ` 45 lacs has increased to ` 72.50 lakhs. To that extent earlier year’s reduction in the carrying amount of the investment will be reversed. Thus the profit and loss account will be credited with ` 27.50 lacs on account of revenue from this reversal and accordingly the investment will now be carried in the balance sheet at ` 72.50 lacs. 320 Financial Accounting for Management Reclassification of Investments At times it happens that management’s outlook towards investments already held undergoes a change. Accordingly it may decide to carry certain long- term investments as current and certain current investments as long-term. The cost of investments, on their reclassification, is ascertained in the following manner: 1. In case of reclassification of long-term investments as current, transfers are made at cost in the year of acquisition and at the carrying amount on the date of reclassification in a subsequent year. Thus, loss will be automatically booked on year end. 2. In case of reclassification of investments from current to long-term, transfers are made at the lower of cost in the year of acquisition/carrying amount in the subsequent year and fair value on that date. The guiding principle here is to book the loss immediately on transfer i.e., on reclassification. Any loss on reclassification of investments is charged to the profit and loss account. ILLUSTRATION 7 SHALINI TEXTILES LTD. RECLASSIFICATION OF CURRENT INVESTMENTS INTO LONG-TERM INVESTMENTS—DETERMINATION OF FAIR VALUE ON THE DATE OF TRANSFER Refer to the Illustration 1 of Shalini Textiles Ltd. The company had intended to keep the shares as current investments. However, looking at the long-term prospects of Appollo Tubes Ltd, it now wants to reclassify them as longterm investments. At what amount will it make the transfer to long-term investments in the following two situations: 1. The quoted price as on the date of transfer is ` 370 per share and brokerage of 0.50% is payable to the broker. 2. The quoted price as on the date of transfer is ` 350 per share and brokerage of 0.50% is payable to the broker. SOLUTION Situation 1: Details Market Value Per Share ` 370.00 Less: Brokerage 1.85 Net Market Value Per Share 368.15 Fair Value of 5,000 Shares 18,40,750 Fair value being more, the transfer will be effected at ` 17,93,900 being the cost. Situation 2: Details Market Value Per Share Less: Brokerage ` 350.00 1.75 Net Market Value Per Share 348.25 Fair Value of 5,000 Shares 17,41,250 Fair value being less than the cost, the transfer will be effected at ` 17,41,250. The loss of ` 52,050 will be charged to the profit and loss account. Chapter 13 Valuation of Investments 321 Determination of Cost of Investments in Cases of Rights Issue Special considerations are required for determining the cost of investments in cases of rights issues. Basically two situations arise in such cases: 1. The investor has been holding the shares much before the rights issue, that is, announcement of rights not foreseen. 2. The investor acquires shares on the announcement of rights issue on cum-right basis. Let us discuss and illustrate both the cases. Old investment When an investor has been holding the shares of a company before the rights issue announcement and the company later on comes out with a rights issue which is subscribed to by the holder of the original shares, the cost of the rights shares is added to the carrying amount of the original holding. And thus an average cost is worked out for the total holding. However the investor can renounce his rights, fully or partly, by selling them to any other person. In such a case sale consideration of rights is treated as income and therefore credited to profit and loss account instead of reducing the cost of original holding. ILLUSTRATION 8 MADHUKAR FINANCE LTD. DETERMINATION OF COST OF INVESTMENT IN CASE OF A RIGHTS ISSUE – OLD HOLDING Madhukar Finance Ltd. had acquired 2,000 shares of Krishnamurthy Aluminium Ltd. in July 2004. They were being carried in the 31-03-2006 balance sheet at ` 12,96,000. Krishnamurthy Aluminium Ltd. came out with a rights issue of 1 share each for every 2 shares held by the existing shareholders at a price of ` 450 each in the month of August 2006. Determine the cost of investment after the rights issue under the following three situations: 1. Madhukar Finance Ltd. fully subscribed to the rights shares. 2. It subscribed to only 500 rights shares and sold rest of the rights in the market for ` 260 each. 3. It did not subscribe to rights shares and sold rights of all the 1000 shares. SOLUTION Cost of investment in the shares of Krishnamurthy Aluminium Ltd., after the rights issue, is determined as under: Situation 1–Rights shares fully subscribed to: Rupees Per Share Carrying amount of the original investment of 2000 shares Add: Cost of 1000 rights shares Cost of 3000 shares after the rights issue 648 Total Rupees 12,96,000 450 4,50,000 Average 582 17,46,000 322 Financial Accounting for Management Situation 2–Subscribed to only 500 rights shares and sold rest of the rights in the market: Rupees Per Share Total Rupees Carrying amount of the original investment of 2000 shares 648 12,96,000 Add: Cost of 500 rights shares subscribed 450 2,25,000 Cost of 2500 shares after the rights issue Average 608.40 15,21,000 Sale proceeds of rest of the 500 rights, that is, ` 1,30,000 will be treated as income. Situation 3–Did not subscribe to rights shares and sold all the rights in the market: Carrying amount of the original investment of 2000 shares will remain unchanged at ` 12,96,000. Sale proceeds of 1000 rights, that is, ` 2,60,000 will be treated as income. Investment acquired on cum-right basis The holder of the original shares, on the announcement of rights issue, may dispose off his original holding on cum-right basis instead of subscribing to the rights shares. What it means is that the new investor gets the original shares together with the right to subscribe to the rights issue. Generally the rights shares are issued at a discount to their current market price. Hence the cum-right price of shares goes up on announcement/ expectation of rights. The original investor thus charges a premium for rights. In such cases, if the new investor chooses to renounce his right instead of subscribing to the rights shares and the market value of investments acquired by him immediately after their becoming ex-right is lower than the cost for which they were acquired, it is more appropriate for the aforesaid new investor to apply the sale proceeds of rights to reduce the cost of such investments to their market value. ILLUSTRATION 9 RCS INVESTMENTS LTD. DETERMINATION OF COST OF INVESTMENT IN CASE OF SHARES ACQUIRED ON CUM-RIGHT BASIS Let us continue with the above illustration of Madhukar Finance Ltd. Assume that the company disposed off its holding to RCS Investments Ltd. on a cum-right basis @ ` 900 per share. RCS Investments Ltd. decided not to subscribe to the rights and therefore renounced them @ ` 260 each. Determine the cost of shares to RCS Investments Ltd. under the following two situations: 1. The market price ex-right was ` 825 per share. 2. The market price ex-right was ` 765 per share. SOLUTION Cost of shares of Krishnamurthy Aluminium Ltd. to RCS Investments Ltd. after the rights issue is determined as under: Situation 1–Market price ex-right ` 825 per share: Rupees Per Share Total Rupees Cost of 2000 shares cum-right 900 18,00,000 Less: Market value of 2000 shares ex-right 825 16,50,000 Loss ex-right on 2000 shares 75 1,50,000 Gain on renunciation of 1000 rights shares 260 2,60,000 Chapter 13 Valuation of Investments 323 As the ex-right price has reduced the market value of 2000 shares acquired cum-right by ` 1,50,000, the gain of ` 2,60,000 on renunciation of 1000 rights shares will be applied as under: Towards reducing the cost of investment 75 Credited to profit and loss account as income 1,50,000 1,10,000 2,60,000 The investment will thus be valued at ` 16,50,000. Situation 2–Market price ex-right ` 765 per share: Rupees Per Share Total Rupees Cost of 2000 shares cum-right 900 18,00,000 Less: Market value of 2000 shares ex-right 765 15,30,000 Loss ex-right on 2000 shares 135 2,70,000 Loss being more than the gain of ` 2,60,000, entire gain will be applied towards reducing the cost of investment. The investment will thus be valued at ` 15,40,000. No income will be credited to profit and loss account. Disposal of Investments When an investment is disposed off, the difference between the carrying amount and net disposal proceeds, that is, disposal proceeds minus expenses of disposal, is charged or credited to the profit and loss account. When a part of the holding of an individual investment is disposed off, the cost/carrying amount allocated to that part is determined on the basis of the average cost/carrying amount of the total holding of the investment. ILLUSTRATION 10 VEERU AND JAY LTD. GAIN/LOSS ON DISPOSAL OF INVESTMENTS Veeru and Jay Ltd. purchased 25000 shares of Thakur’s Sholay Ltd. at a cost of ` 156.50 per share in the month of January 2006. It again purchased 25000 shares of the same company at a cost of ` 143.85 per share in February 2006. Both these investments were held as long term investments. Fair value of the shares of Thakur’s Sholay Ltd. as on 31-03-2006, that is, Veeru and Jay Ltd.’s balance sheet date was ` 131.25 per share. Veeru and Jay Ltd. considered the diminution to be temporary. Next year in the month of March 2007 it sold 30000 shares. Determine the profit/loss on disposal of shares under the following two situations: 1. If the shares were sold for ` 125.45 per share net. 2. If they were sold for ` 160.85 per share net. SOLUTION Profit/loss on disposal of investment in the shares of Thakur’s Sholay Ltd. is determined as under: Situation 1–Sold for ` 125.45 per share net: Rupees Per Share Cost of original investment of 25000 shares Add: Cost of next 25000 shares 156.50 143.85 Total Rupees 39,12,500 35,96,250 324 Financial Accounting for Management Hence cost of 50000 shares Fair value of 50000 shares as on 31.03.2006 Average 150.18 131.25 75,08,750 65,62,500 Though the fair value is less than the cost, investments will still be carried at cost as the diminution is considered to be temporary. Next year: Sale proceeds of 30000 shares 125.45 37,63,500 Average carrying amount of 30000 shares 150.18 45,05,400 Loss on disposal (24.73) (7,41,900) Profit and loss account will be charged by ` 7,41,900 during 2006–07. Investment of 30,000 shares amounting to ` 45,05,400 will be deleted from the balance sheet. Situation 2–Sold for ` 160.85 per share net: Rupees Total Per Share Rupees Sale proceeds of 30000 shares 160.85 48,25,500 Average carrying amount of 30000 shares 150.18 45,05,400 Profit on disposal 10.67 3,20,100 Profit and loss account will be credited with ` 3,20,100 during 2006–07. Investment of 30,000 shares amounting to ` 45,05,400 will be deleted from the balance sheet. Shares and Other Securities held as Stock-in-Trade Shares, debentures and other securities held as stock-in-trade, that is, for sale in the ordinary course of business, are not considered as ‘investments’. However, the manner in which they are accounted for and disclosed in the financial statements is quite similar to that applicable in respect of current investments. Accordingly the provisions of AS-13, to the extent that they relate to current investments, are also applicable to such securities held as stock-in-trade, except as under: 1. These are disclosed as ‘stock-in-trade’ under the head ‘current assets’ and not as investments. 2. The cost of their inventory as on the balance sheet date is determined by applying an appropriate cost formula, that is, FIFO or WAC, as discussed in the earlier chapter on valuation of inventories. DISCLOSURES IN FINANCIAL STATEMENTS The following information needs to be disclosed in the financial statements in respect of investments: 1. The accounting policies followed for determination of carrying amount of investments. 2. Classification of investments into current and long term, distinctly. 3. Further classification of current and long-term investments as specified in the statute governing the enterprise; otherwise, into investments in: n government or trust securities n shares, debentures or bonds n investment properties, and n others–specifying nature, for example, units of a mutual fund and post office securities like national saving certificates. Chapter 13 Valuation of Investments 325 4. The amounts included in profit and loss account for: n Gross income from investments, such as interest, dividends (separately from subsidiary companies), and rentals separately from long-term and current investments, TDS being included under advance taxes paid in the balance sheet. n Profits and losses on disposal and changes in the carrying amount of investments separately for long-term and current investments. 5. Significant restrictions on the right of ownership, realizability of investments or the remittance of income and proceeds of disposal, if any. For example, the promoter company’s investment in the promoted company’ shares, in case the later goes for an IPO, is subject to lock-in period as specified by the SEBI guidelines. 6. The aggregate amount of quoted and unquoted investments, giving the aggregate market value of quoted investments. 7. Other disclosures as specifically required by the relevant statute governing the enterprise, for example, in case of mutual funds. INVESTMENTS IN SUBSIDIARY/ASSOCIATE COMPANIES Investments in subsidiary and associate companies are dealt with in the separate financial statements of the investing company in the same manner as any other investments in accordance with AS-13 as enumerated above. CORPORATE FINANCIAL PRACTICES Let us see how Colgate-Palmolive (India) Limited has treated its investments. Go through the case and attempt the exercise based on it given at the end of the chapter. CASE 1 Colgate-Palmolive (India) Ltd. REPORT CORPORATE FINANCIAL PRACTICES COLGATE-PALMOLIVE (INDIA) LIMITED Annual Report 2001–2002 Schedule of Investments, Extracts from Schedule of Accounting Policies and Schedule of other Income INVESTMENTS Schedule 6: Investments (Unquoted, unless otherwise stated) As at 31st March, 2002 (` Lakh) A. In Government Securities—Short Term 11.55% Government of India Stock of the face value of ` Nil (Previous Year: ` 500 lakh) 10.85% Government of India Stock of the face value of ` Nil (Previous Year: ` 500 lakh) As at 31st March, 2001 (` Lakh) — 5,04.35 — 5,02.73 326 Financial Accounting for Management 12.08% Government of India Stock of the face value of ` Nil (Previous Year: ` 500 lakh) Treasury Bills of the face value of ` Nil (Previous Year: ` 1000 lakh) B. In Wholly-owned Subsidiaries at Cost—Long Term 4,50,000 (Previous Year: 4,50,000) Equity Shares of ` 10 each fully paid in Camelot Investments Company Limited 3,500 (Previous Year: 3,500) Equity Shares of ` 10 each fully paid in Multimint Leasing & Finance Limited 3,020 (Previous Year: 3,020) Equity Shares of ` 10 each fully paid in Jigs Investments Limited 302 (Previous year: 302) Equity Shares of ` 100 each fully paid in Passion Trading & Investment Company Limited 17,00,000 (Previous Year: 17,00,000) Equity Shares of Nepalese ` 100 each fully paid in Colgate-Palmolive (Nepal) Private Limited C. Other Investments at Cost—Long Term (Listed but not quoted) 9.00% (Tax Free) Secured, Redeemable, Non-convertible Bonds of Indian Railway Finance Corporation Ltd. (Railway Bonds—Sixth ‘B’ Series) of the face value of ` 300 lakh—Quoted 8.75% (Tax Free) Secured, Redeemable, Non-cumulative, Non-convertible Bonds of Konkan Railway Corporation Ltd. (5A Series) of the face value of ` 500 lakh Deep Discount, Secured, Rated, Taxable, Redeemable, Non-convertible Debentures of GE Capital Services India (Debentures Series G-5) of the face value of ` 1,300 lakh 7.80% (Tax Free) Secured, Redeemable, Non-convertible Bonds of Indian Railway Finance Corporation Ltd. (Railway Bonds—36th Series) of the face value of ` 1,500 lakh 9.25% Redeemable, Non-convertible Bonds of Hudco-Gujarat Punarnirman Special Tax Free Bonds Series 1 of the face value of ` 700 lakh 10.5% (Tax Free) Redeemable, Non-convertible Bonds of Hudco Series V D of the face value of ` 1,500 lakh Total Aggregate book value of Investments: Unquoted Listed but not quoted - 5,05.5 - 9,44.25 24,56.83 45.00 45.00 0.35 0.35 0.30 0.30 0.30 0.30 10,62.50 11,08.45 10,62.50 11,08.45 - 3,00.95 5,00.00 5,00.00 - 11,42.23 15,00.00 - 7,00.00 - 15,44.21 42,44.21 53,52.66 19,43.18 55,08.46 11,08.45 42,44.21 38,66.23 16,42.23 Investments Accounting Policy Long-term investments are valued at cost. Current investments are valued at lower of cost or fair value as on the date of the balance sheet. The company provides for diminution in value of investments, other than temporary in nature, in the financial statements. 327 Chapter 13 Valuation of Investments Schedule 13 : Other Income Interest On Bank Deposits [TDS ` 48.60 lacs (Previous Year: ` 30.70 lacs)] From Others [TDS ` 2,89.45 lacs (Previous Year: ` 2,06.27 lacs)] Cash Discount Profit on sale of Investments (Net) Profit on sale of Assets (Net) Dividend from wholly-owned subsidiary Miscellaneous Income [TDS ` 8.42 lacs (Previous Year: ` 0.79 lacs)] 2001–2002 ` Lacs Previous Year ` Lacs 1,90.35 1,58.42 15,21.83 9,32.42 87.57 1,75.15 — 6,80.00 4,40.03 30,94.93 86.97 — 3,44.18 3,87.81 10,41.61 29,51.41 IFRS CONVERGENCE Now follow key distinctive features of IFRS Converged Indian Accounting Standard (Ind AS) on the subject: IFRS CONVERGED IND AS 39 VS EXISTING AS 13 WWW VALUATION OF INVESTMENTS www.icai.org The AS 13 ‘Accounting for Investments’ has been replaced by IFRS Converged Ind AS 39 titled as ‘Financial Instruments: Recognition and Measurement.’ Key distinctive features of Converged Ind AS 39 are as under: 1. Investments are classified into 3 categories: a. Held-for-trading investments or Investments at fair value through profit or loss b. Held-to-maturity investments c. Available-for-sale investments 2. Held-for-Trading Investments An investment is classified as held for trading (HFT) if it is acquired principally with the intent and purpose of selling it in the near term. Trading means active and frequent buying and selling. Investments that are actively and frequently purchased and sold for generating short- term gains are termed as HFT investments. These are essentially short-term investments. Derivatives are also HFT investments. Measurement: On the date of acquisition HFT investment is measured at fair value, i.e., the acquisition price. Here, directly attributable transaction cost is charged to the statement of of profit and loss keeping in view the short-term nature of the investment. On subsequent reporting date HFT investment is measured at fair value as on that date. Fair value here means the price agreed to by a willing buyer and a willing seller in arm’s length transaction best reflected in quoted price. Gain/Loss in fair value change between reporting dates is recognized in profit or loss. Again keeping in view the short-term nature of the investment. Due to this characteristic these investments are also termed as ‘Investments at Fair Value Through Profit or Loss (FVTPL)’. Gain/loss on sale is again recognized in profit or loss. Exception: Investments in equity instruments that do not have a quoted market price in an active market, and therefore whose fair value cannot be reliably measured shall be measured at cost. 3. Held-to-Maturity Investments These are non-derivative investments with fixed or determinable payments and fixed maturity that are held by an entity with the positive intention and ability to hold to maturity (HTM). They may be short-term as well as 328 Financial Accounting for Management long-term depending upon the gap between the date of purchase and maturity. An equity investment cannot be designated as HTM since the instrument is perpetual, i.e., it has no fixed maturity. Measurement: On the date of acquisition HTM investment is measured at fair value, i.e., the acquisition price plus directly attributable transaction cost (note the difference with HFT). On subsequent reporting date HTM investment is measured at amortized cost applying Effective Interest Rate Method. Gain/loss on sale is recognized in profit or loss. An illustration on effective interest rate method follows after Para 4 below. 4. Available-for-Sale Investments: This is the residual category. These are those non-derivative investments that are not classified as HFT or HTM investments. Thus they are neither short-term nor long-term (till the maturity) investments. Basically they are longterm investments that are also available for sale (AFS) as and when needed. Measurement: On the date of acquisition AFS investment is measured at fair value, i.e., the acquisition price plus directly attributable transaction cost. On subsequent reporting date this investment is measured at fair value as on that date. Gain/ Loss in fair value change between reporting dates is recognized in other comprehensive income. Gain/loss on sale is recognized in profit or loss. On sale, gain/loss on fair value change earlier recognized in other comprehensive income is also reverted to profit or loss. An illustration on interest income as per effective interest rate method now follows: Illustration: Deepti Ltd. purchased 12% bonds of face value of ` 100 issued by JP Ltd. for ` 102.50 on Ist April 2010. Transaction cost incurred by the company is Re. 0.20 per bond. Coupon (interest) is payable every year on 31st March. Redemption will be @ ` 101 after 5 years. The bonds are designated by Deepti Ltd. as HTM. Computation of effective interest income and amortized cost of bond is as under. Solution: ` 1 2 Year 3 Cash Flows 4 5 Coupon (Interest) Gross Principal Total Remaining Principal Balance or Amortized Cost 0 …. –102.70 –102.70 102.70 … … 1 12.00 …. …. 102.43 11.73 0.27 2 12.00 …. …. 102.13 11.70 0.30 3 12.00 …. …. 101.79 11.66 0.34 4 12.00 …. …. 101.41 11.62 0.38 5 12.00 …. …. 101.00 11.59 0.41 5 …. 101.00 101.00 …. …. …. …. Total…..58.30 Total…1.70 Total…..60.00 Interest Due Principal Recovery IRR, i.e., EIR = 11.42% Notes: 1. Column 2: Cash outflow in year 0 (–102.70) =Purchase Price (102.50) +Transaction Cost (0.20). This is the Remaining Principal Balance or Amortized Cost in year 0. 2. Cash inflow in year 1 to 4 (12.00) = Interest received at coupon rate on face value 3. Cash inflow in year 5 = Interest received at coupon rate on face value (12.00) + Principal redeemed at premium (101.00) 4. IRR of these cash flows is 11.42%. (Arrived at by feeding the outflows and inflows in Excel software). This is the Effective Interest Rate (EIR). Chapter 13 Valuation of Investments 329 5. Interest Due in column 4 = Remaining Principal Balance in the beginning of the year* EIR. For example, for year 1(11.73) = 102.70*11.42%. 6. Principal Recovery in column 5 = Interest actually received in column 2-Interest due in column 4. Thus for year 1 interest over-received by 0.27, that is, (12.00 211.73). It means this amount has been recovered out of the remaining principal balance of year 0. 102.70 2 00.27 = 102.43. 7. Procedure repeated for all the years. 8. The working may now be summed up as under: ‘Out of coupon of 60.00 received over 5 years, interest due (as per column 4) amounts to 58.30 and principal received amounts to 1.70. Yearly interest due is credited to income statements of respective years. Out of principal cost of 102.70, 1.70 is received over 5 years and the balance 101.00 in the 5th year. Bonds are thus carried in the balance sheets at Amortized Cost as per column 3 above’. IFRS CONVERGENCE New IFRS Converged Ind AS 40 ‘Investment Property’ is also relevant here. IFRS CONVERGED IND AS 40 WWW INVESTMENT PROPERTY www.icai.org This is a new and first time standard in India on the subject of investment property. It was earlier briefly touched upon in existing AS 13 ‘Accounting for Investments’. Key distinctive features of the converged Ind AS 40 are as under. 1. An investment property is to be measured initially at its cost. Transaction costs are to be included in the initial measurement. 2. After initial recognition, an entity shall choose as its accounting policy either the fair value model or the cost model and shall apply that policy to all of its investment property. 3. After initial recognition, an entity has to measure all of its investment properties in accordance with Converged Ind AS 16 ‘Property, Plant and Equipment’ requirements for the cost model. Those investment properties that meet the criteria to be classified as held for sale are to be measured at the lower of its carrying amount and fair value less costs to sell in accordance with Converged Ind AS 105 ‘Noncurrent Assets Held for Sale and Discontinued Operations’. INVESTMENTS IN JOINTLY CONTROLLED ENTITIES Carrying out business activities through joint ventures is a common phenomenon in modern-day business. A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity, which is subject to joint control. Among other forms of joint ventures, establishment of a separate joint venture entity, in the form of a company or a partnership firm, is more common and prevalent. Each party to such an arrangement is known as ‘venturer’ and contributes its part of the investment to establish the entity and exercises joint control over the entity in terms of the stipulation of the contract. An example of a jointly controlled entity is when an enterprise commences a business in a foreign country in conjunction with the government or a private sector company in that country, by establishing a separate entity, which is jointly controlled by the enterprise and that government or the private sector company. Indraprastha Gas Ltd. is an example of a joint venture between Gas Authority of India Ltd. and Bharat Petroleum Corporation Ltd. The jointly controlled entity operates in the same way as other enterprises. The entity controls the assets of the joint venture, incurs liabilities and expenses and earns income. It enters into 330 Financial Accounting for Management contracts in its own name and raises finance for the purposes of the joint venture activity. Each venturer is entitled to a share of the results of the jointly controlled entity. A party may also contribute to the funds required by a joint venture entity without the exercise of joint control and is referred to as an ‘investor’. Treatment of investments in such entities, by the venturer as well Want to know more about as investor, is dealt with by Accounting Standard (AS-27), ‘Financial AS-27? Visit www.icai. org. Reporting of Interests in Joint Ventures’. The standard prescribes that WWW Click: Resources—Accounting both a venturer as well as an investor enterprise should account for its Standards. interest in a jointly controlled entity as an investment in accordance with AS-13 in its separate financial statements. However, further disclosure requirements in the case of a venturer have been specified, which include the following details in the separate financial statements of the venturer: 1. A list of all jointly controlled entities together with the name of the country of incorporation or residence of each entity. 2. Description of interest and proportion of ownership interest in the controlled entities. 3. The aggregate amounts of each of the assets, liabilities, income and expenses related to its interests in the jointly controlled entities in its separate financial statements. 4. Amount of capital commitments and contingent liabilities of the joint venture related to its share as well as those incurred by the venturer himself for the joint venture. CORPORATE FINANCIAL PRACTICES Let us see how Hindalco Industries Ltd. has treated investment in its joint venture IDEA Cellular Ltd. Go through the case and attempt the exercise based on it given at the end of the chapter. CASE 2 Hindalco Industries Ltd. CORPORATE FINANCIAL PRACTICES HINDALCO INDUSTRIES LTD. REPORT Annual Report 2005–06 Extracts from Schedules of Investments, Significant Accounting Policies and Notes on Accounts and Other Information INVESTMENT IN JOINT VENTURE: IDEA CELLULAR LTD. INVESTMENTS (` in Million) Investments (total as per balance sheet) Schedule As on 31st March, 2006 As on 31st March, 2005 6 39,713.11 37,021.45 Chapter 13 Valuation of Investments 331 Schedule 6: Investments A. Long Term Investments 1. Unquoted b iii. Other Shares, Debentures and Bonds-Fully paid-up (` in Million) Face Value (Rupees) Total Nos. As on 31st March, 2006 10 228,340,226 2,283.40 Equity shares of IDEA Cellular Ltd. As on 31st March, 2005 2,283.40 Schedule 23–A. Significant Accounting Policies 6. Investments (a). long term investments are carried at cost after deducting provision, in cases where the fall in market value has been considered of permanent nature. Schedule 23–B. Notes on Accounts 29: Disclosure in respect of jointly controlled entities in which the company is a joint venturer, in compliance with AS-27 on Financial Reporting of Interest in Joint Ventures: (` in Million) IDEA Cellular Ltd. (Unaudited) Particulars Country of incorporation India Percentage of share in joint venture 10.11% Assets 5,720.22 Liabilities 4,574.16 Income 3,022.76 Expenditure 2,808.67 Capital commitments (net of advance) 260.18 Contingent liabilities 239.67 OTHER INFORMATION regarding Hindalco Industries Ltd. (` in Million) For the year ended 31st March, 2006 As on 31st March, 2006 Net worth … 96,062.52 Equity share capital : FV Re 1 per share … 985.66 Effective no. of equity shares PBT Income from investment in IDEA Cellular Ltd. … 985.66 million 21,056.97 … Nil … 332 Financial Accounting for Management BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Critically analyse the principles of investment valuation and related issues. 2. How are investments in jointly controlled entities treated? 3. How does investment valuation affect the financials of a company? To enrich your discussion, add your own ideas, thoughts and practical inputs. IFRS CONVERGENCE There are some other converged standards which have a bearing on the measurement and presentation of investments. They are briefly covered here under. OTHER IFRS CONVERGED INDIAN ACCOUNTING STANDARDS RELATED TO MEASUREMENT AND PRESENTATION OF INVESTMENTS WWW www.icai.org IFRS Converged Ind AS 27: Consolidated and Separate Financial Statements’: Treatment of Subsidiaries, Jointly Controlled Entities and Associates 1. When an entity prepares separate financial statements, it has to account for investments in subsidiaries, jointly controlled entities and associates either: l l At cost, or In accordance with Ind AS 39. 2. The entity shall apply the same accounting for each category of investments. 3. Investments accounted for at cost are to be accounted for in accordance with Ind AS 105 ‘Non-current Assets Held for Sale and Discontinued Operations’ when they are classified as held for sale at the lower of their carrying amount and fair value less costs to sell in accordance with Ind AS 105. The measurement of investments accounted for in accordance with Ind AS 39 is not changed in such circumstances. 4. Investments in jointly controlled entities and associates that are accounted for in accordance with Ind AS 39 in the consolidated financial statements need to be accounted for in the same way in the investor’s separate financial statements. Converged Ind AS 28: Investment In Associates An investment in an associate has to be accounted for in the investor’s separate financial statements in accordance with Ind AS 27 as discussed above. Converged Ind AS 31: Interests In Joint Ventures An interest in a jointly controlled entity has to be accounted for in a venturer’s separate financial statements in accordance with Ind AS 27 as discussed above. Chapter 13 Valuation of Investments 333 CONCLUDING REMARKS With the discussion and illustration of investment valuation in this chapter, we have completed the valuation of all major assets like fixed assets, assets under finance lease, intangible assets and inventories and related issues of depreciation, amortisation and asset impairment including investments. Having developed an understanding of the financial statements in part 1 & 2 and asset valuation in this part, we now move over to part 4 to have a holistic understanding of balance sheet, statement of profit and loss, notes to accounts, cash flow statement and other financial reports, i.e. auditors’ report, directors’ report and corporate governance report, MD&A report and CSR report of Nestlé India Ltd. as per its annual report for the year ended 31st December 2014. Keywords n Active Market n Financial Instruments n Mutual Funds n Asset Management n Held-for-Trading (HFT) n Nominal or Par Value Companies n Associate Companies n Available-for-Sale (AFS) n Bonds n Capital Appreciation n Cum-interest Price n Cum-right Basis n Current Investment n Ex-right n Fair Value n Held-to-Maturity (HTM) n Pre-acquisition Profits n Holding Company n Quoted n Investee n Redeemable n Investment Companies n Rights Issues n Investment Property n Strategic Investments n Investments n Subsidiary Companies n Investor n Treasury Bills n Joint Control n Unquoted Investments n Long-term Investment n Venturer WWW n Market Value 1. Accounting for Investments, AS-13, ICAI, www.icai.org 2. Financial Reporting of Interests in Joint Ventures, AS-27, ICAI, www.icai.org 3. Revenue Recognition, AS-9, ICAI, www.icai.org 334 REPORT Financial Accounting for Management 1. Bharti Airtel Ltd., Annual Report, 2005–06. 2. Cholamandalam DBS Finance Ltd., Annual Report, 2005–06. 3. Colgate-Palmolive (India) Ltd., Annual Report, 2001–02. 4. HDFC Ltd., Annual Report, 2005–06. 5. Hindalco Industries Ltd., Annual Report, 2005–06. 6. ICICI Bank Ltd., Annual Report, 2005–06. 7. Indraprastha Gas Ltd., Annual Report, 2005–06. 8. Infosys Technologies Ltd., Annual Report, 2005–06. 9. ITC Ltd., Annual Report, 2005–06. 10. Ranbaxy Laboratories Ltd., Annual Report, 2005–06. 11. Reliance Energy Ltd., Annual Report, 2005–06. 12. Reliance Industries Ltd., Annual Report, 2005–06. 13. SBI Capital Markets Ltd., Annual Report, 2005–06. exercises Ex. 1 USHA CORPORATION LTD. Cost of Investment in Shares Usha Corporation Ltd. sought the advice of an investment advisor for deployment of surplus funds of around Rs. 45 lakh in the stock market. The advisor advised to invest in Bhonsle India Ltd. and charged Rs. 7,500 as his fee. Accordingly, UCL bought 8,500 equity shares of the face value of Rs. 10 each of Bhonsle @ Rs. 520 per share from NSE through a stockbroker, UTI Securities Ltd. The broker charged a brokerage of 0.50%. Determine the cost of this investment. Ex. 2 KABU ENTERPRISES LTD. Cost of Investment Property KABU Enterprises Ltd. buys a building for the purpose of investment. It issues 1,00,000 equity shares of its company, which are quoted on the day of the deal at Rs. 155 per share at the NSE. The brokerage payable on sale in the NSE is Re. 1 per share. The company also pays a brokerage of Rs. 2.50 lakh to the property dealer involved in the deal. The stamp duty is also incurred @ 8% of the value of the building. Determine the value of this investment property. Chapter 13 Valuation of Investments 335 Ex. 3 BHARTI INVESTMENTS LTD. Cost of Investment Acquired in Exchange Bharti Investments Ltd. holds 8000 shares of Phonetel Corporation Ltd. It acquires 7000 shares of Subharti Ltd. from Idea Investments Ltd. in exchange for these shares. Determine the cost of shares acquired by Bharti Investments Ltd. under the following three situations: 1. If shares of both Phonetel Corporation Ltd. and Subharti Ltd. were listed at BSE and their quoted prices on the day of the deal were Rs. 452 and Rs. 500 per share respectively. The brokerage payable on sale in the BSE is Rs. 4 per share and Rs.5 per share respectively. 2. If Subharti Ltd. were unlisted and therefore its market value were not known. 3. If Phonetel Corporation Ltd. were unlisted. Ex. 4 USHA CORPORATION LTD. Investment in Bonds Purchased cum Interest Usha Corporation Ltd. purchases 12,000 10% secured redeemable bonds of the face value of Rs. 100 each of Andhra Pradesh Power Finance Corporation Ltd. on 1st January for a consideration of Rs. 11,40,000 net of brokerage. The interest on the bonds is payable every six months on 30th September and 31st March. Determine the cost of this investment on 31st March. How much amount will be credited to the profit and loss account as interest income? Ex. 5 USHA CORPORATION LTD. Valuation/Carrying Amount of Current Investments If Usha Corporation Ltd. were to continue with the classification of its investment in Bhonsle as current investments, and the fair market value as on the balance sheet date was Rs. 42,07,500, at what value will the investment be carried in the balance sheet as on that date? What amount will be recognised in the profit and loss account and in which manner? Ex. 6 VEERU TRAVELS LTD. Provision for Diminution in the Value of Long Term Investment and Reversal Thereof In May 2004, Veeru Travels Ltd. promoted Basanti and Veeru Tonga Travels Ltd., an unlisted joint venture company in association with Basanti Tonga Ltd. It invested Rs. 2.50 crores by way of its contribution in the capital of the joint venture by subscribing to its 50 lakh equity shares of Rs. 5 each. The investment is obviously long term in nature. Accounting year of both Veeru Travels Ltd. and 336 Financial Accounting for Management Basanti and Veeru Tonga Travels Ltd. is April to March. Determine the value/carrying amount of the investment of the former in the later under the following three situations on the dates mentioned: 1. On 31.03.2005, if net worth per share of Basanti and Veeru Tonga Travels Ltd. as on that date as per its balance sheet were Rs. 3.75 only, as its business didn’t do well. Veeru Travels Ltd. considers this loss to be temporary as it expects the business to pick up in the long run. 2. On 31.03.2006, if net worth per share of Basanti and Veeru Tonga Travels Ltd. as on that date as per its balance sheet further goes down to Rs.1.90. Veeru Travels Ltd., as a matter of prudence, considers this loss to be long term, that is, other than temporary 3. On 31.03.2007, if net worth per share of Basanti and Veeru Tonga Travels Ltd. as on that date as per its balance sheet improves to Rs. 2.85 as a result of unforeseen spurt in the business. Ex. 7 USHA CORPORATION LTD. Reclassification of Current Investments into Long-term Investments Refer to Exercise 1 of Usha Corporation Ltd. The company had intended to keep the shares as current investments. However, looking at the long-term prospects of Bhonsle, it now wants to reclassify them as long-term investments. At what amount will it make the transfer to long-term investments in the following two situations: 1. The quoted price as on that date is Rs. 535 per share and brokerage of 0.50% is payable to the broker. 2. The quoted price as on that date is Rs. 505 per share and brokerage of 0.50% is payable to the broker. Ex. 8 JAI INVESTMENT AND FINANCE LTD. Determination of Cost of Investment in case of a Rights Issue–Old Holding Jai Investment and Finance Ltd. had acquired 3,000 shares of Gabbar and Sambha Ltd. in September 2004. They were being carried in the 31-03-2006 balance sheet at Rs. 17,85,000. Gabbar and Sambha Ltd. came out with a rights issue of 1 share each for every 3 shares held by the existing shareholders at a price of Rs. 398 each in the month of December 2006. Determine the cost of investment after the rights issue under the following three situations: 1. Jai Investment and Finance Ltd. fully subscribed to the rights shares. 2. It subscribed to only 600 rights shares and sold rest of the rights in the market for Rs. 63 each. 3. It did not subscribe to rights shares and sold rights of all the 1000 shares. Ex. 9 IMAM SAHEB LTD. Determination of Cost of Investment in case of Shares Acquired on CumRight Basis Let us continue with the above illustration of Jai Investment and Finance Ltd. Assume that the company disposed off its holding to Imam Saheb Ltd. on a cum-right basis @ Rs. 846 per share. Imam Saheb Ltd. decided not to subscribe to the rights and therefore renounced them @ Rs. 220 each. Determine the cost of shares to Imam Saheb Ltd. under the following two situations: 1. The market price ex-right was Rs. 775 per share. 2. The market price ex-right was Rs. 694 per share. Chapter 13 Valuation of Investments 337 Ex. 10 RAM LAL SEWA SAMITI LTD. Gain/Loss on Disposal of Investments Ram Lal Sewa Samiti Ltd. purchased 30000 shares of Sippy and Sons Ltd. at a cost of Rs. 312 per share in the month of December 2005. It again purchased 30000 shares of the same company at a cost of Rs. 285 per share in January 2006. Both these investments were held as long term investments. Fair value of the shares of Sippy and Sons Ltd. as on 31-03-2006, that is, Ram Lal Sewa Samiti Ltd.’s balance sheet date was Rs. 259 per share. Ram Lal Sewa Samiti Ltd. considered the diminution to be other than temporary. Next year in the month of February 2007 it sold 35000 shares. Determine the profit/loss on disposal of shares under the following two situations: 1. If the shares were sold for Rs. 248 per share net. 2. If they were sold for Rs. 315 per share net. Ex. 11 CASE 1 COLGATE PALMOLIVE (INDIA) LIMITED Case on Corporate Financial Practices—Investments Refer to the extracts from the Annual Report 2001–2002 of Colgate-Palmolive (India) Limited regarding its investments as illustrated in this chapter. Analyse the case and attempt the following requirements: 1. Examine the investment valuation policy of the company. Is it in accordance with the requirements of AS-13? Why or why not? 2. What are the virtues of investing in the Government of India securities? Explain. 3. Investments in wholly owned subsidiaries have been disclosed at cost. How would you know how these subsidiaries are doing and how would you assess the impact of their working on the financials of Colgate Palmolive? 4. The company has long-term ‘listed but unquoted’ investments. What do you understand by ‘listed but unquoted’? Does it mean that they were never quoted or not quoted in the recent past and that is why the company could not work out their market value? How will you find out this information? 5. Has the company made the disclosures in accordance with AS-13? Why or why not? Ex. 12 CASE 2 HINDALCO INDUSTRIES LTD. Case on Investment in Joint Venture Refer to the extracts from the annual report 2005–06 of Hindalco Industries Ltd. regarding its investment in its joint venture IDEA Cellular Ltd. as illustrated in this chapter. Analyse the case and attempt the following requirements: 1. Has the company made the disclosures in accordance with AS-27? How or how not? 2. Analyse the impact of financial position and performance of IDEA Cellular Ltd. on the financials of Hindalco Industries Ltd. 3. How do the disclosures required by AS-27 help an analyst? For your information IDEA Cellular Ltd. was running under losses for long till March 2004. It turned around in the year 2004–05. This page is intentionally left blank. PART 4 UNDERSTANDING THE ANNUAL REPORT Chapter 14: CORPORATE FINANCIAL STATEMENTS OF NESTLE INDIA LTD ALONG WITH NOTES TO ACCOUNTS AND SIGNIFICANT ACCOUNTING POLICIES Chapter 15: OTHER MANDATORY FINANCIAL REPORTS 14 Corporate Financial Statements of Nestle India Ltd Along With Notes to Accounts and Significant Accounting Policies NESTLE INDIA LIMITED Understanding the annual report is a precursor to analysing it. This chapter attempts developing its understanding with reference to the case of Nestle India Ltd. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 341 CHAP T ER O BJ ECT I V ES This chapter seeks to: 1 Study the annual report of Nestle India Ltd. 2 Present a brief profile of Nestle India Ltd. 3 Establish the features of the financial statements. 4 Develop understanding of the inter-linkage of the financial statements. 5 Develop understanding of the various accounts of balance sheet and notes thereto. 6 Develop understanding of the various accounts of statement of profit and loss and notes thereto. In order to enable you to be able to analyse the annual report of a given company. INTRODUCTION We learnt in the earlier chapters that balance sheet and statement BIRD’S EYE VIEW of profit and loss are the most important components of financial statements. The purpose of the balance sheet is to measure and Understanding the present the financial position of a company on a given date. This Annual Report financial statement is immensely useful in studying the magnin Introduction tude of the economic resources that a company commands, its n Brief Profile of Nestle India Ltd. obligations towards outsiders and preference shareholders that n Financial Statements of Nestle India are to be met out of those resources and the balance left for the Ltd. equity holdrs. In a nutshell, it depicts the asset structure of a n Features of the Financial Statements n Understanding the Inter-Linkage of company and how it has been financed. The purpose of the statethe Financial Statements ment of profit and loss is to measure and present the financial n Understanding the Various Accounts performance of a company for a given period. Profitability of a of Balance Sheet and Notes Thereto company leads to assessment of potential changes in the economn Understanding the Various Accounts ic resources that it is likely to control in the future. Information of Statement of Profit and Loss and about profit, as conveyed by the statement of profit and loss, is Notes Thereto immensely useful in predicting the capacity of the company to generate internal cash flows in future. In a nutshell, the statement of profit and loss depicts the total revenue of the company, expenditure incurred in deriving that revenue, income tax payable to the government and net profit earned. When studied over a two year period, or even longer, these two financial statements provide meaningful insights into whether the management has been able to efficiently manage the business of the company to ensure an adequate growth in the stake of the equity holders or not. Every corporate annual report additionally contains notes to the financial statements and notes on significant accounting policies. These notes seek to provide details of the various elements of the financial statements and accounting policies followed in their preparation and treatment of their major elements. In order to be able to analyse the balance sheet and the statement of profit and loss, it is imperative to have a sound knowledge and understanding of the various accounts that go into their making 342 Financial Accounting for Management together with notes thereon, principles of their treatment, their interrelationships, their relationships with accounts of other financial statements and the impact that they cause on the financial position, performance and cash flows of a company. We will study these accounts and notes thereto with reference to the annual report of Nestle India Ltd. for the year ended 2014. The accounts covered by the financial statements may vary from company to company and from industry to industry. However, the financial statements of Nestle would cover most of the accounts generally found in the statements of manufacturing companies. But before we start studying these accounts and notes, we present a brief profile of Nestle to develop a basic understanding of its business and the industry it operates in. This basic understanding, in turn, will facilitate a better understanding of its financial statements. BRIEF PROFILE OF NESTLE INDIA LTD. Snapshot • • • • • Incorporation: Chairman: Managing Director: Registered Office: Head Office: • Plants: • • • • • • • • • 1959 A. Helio Waszyk Etienne Benet M-5A, Connaught Circus, New Delhi “Nestlé House”, Jacaranda Marg, ‘M’ Block, DLF City, Phase II, Gurgaon - 122 002 (Haryana) Bicholim (Goa), Ponda (Goa), Samalkha, Dist. Panipat (Haryana), Una (Himachal Pradesh), Nanjangud, Mysore District (Karnataka), Moga (Punjab), Cherambadi, Dist. Nilgiris (Tamil Nadu), Pantnagar (Uttrakhand) Website: www.nestle.in Products: Milk Products and Nutrition, Beverages, Prepared dishes and Cooking aids, Chocolates and Confectionery Equity capital: ` 964.2 millions Face value per share: ` 10/Ownership of the holding company Nestle 6, 05, 15,079 shares (63%) S.A. in share capital: Listing of equity shares BSE No. of Employees: 7228 (year end 2014) Year end: 31st December Auditors: A.F.Ferguson & Co., Chartered Accountants Nestle India Ltd. is a subsidiary of Nestle S.A. Switzerland. It has been carrying on business activities in India since long. The company is into food processing business divided mainly among milk products and nutrition, beverages, prepared dishes and cooking aids, and chocolates and confectionery. It is the market leader in India in its business group. Business Objective As per the corporate governance report for 2014, Nestle India’s business objective and that of its management and employees is to manufacture and market the company’s products in such a way as to create value that can be sustained over the long-term for consumers, shareholders, employees, business partners and the national economy. Nestle India is conscious of the fact that the success of a corporation is a reflection of the professionalism, conduct and ethical values of its management and employees. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 343 Technology From Nestle S.A. Switzerland Nestle India Ltd., under the general license agreement with Nestle S.A., has the licence for the knowhow, patents, brands and other intellectual property, in relation to the products manufactured and/or sold by it. Access is available to the company to the proprietary technology of Nestle S.A. and the fruits of extensive centralized research and development. The diversified knowledge and expertise made available by Nestle S.A. have contributed significantly to the operations and performance of the company over the years. The company believes that being a part of Nestle Group, the ongoing technology transfer and access to the fruits of extensive research and development and authorization to use brands would help it significantly in its efforts to remain competitive. Brands Company enjoys brand leadership in its field in the country. Many of its brands like Maggi, Nescafe, Cerelac, Kitkat, Milkmaid, Lactogen and Everyday have become household names in India. FINANCIAL STATEMENTS OF NESTLE INDIA LTD. Financial statements of Nestle have been prepared in accordance with the corresponding legal and regulatory framework and Indian GAAP. The balance sheet and statement of profit and loss of the company for the year 2014, together with the accounting policy followed in their preparation, are presented in exhibit 1 and 2 respectively. Accounting Policy on The Basis of Accounting and Preparation of Financial Statements (Note-26) Note-26 to the financial statements states the accounting policy as under: The financial statements of the Company have been prepared in accordance with the Generally Accepted Accounting Principles in India (Indian GAAP) to comply with the Accounting Standards notified under Section 211(3C) of the Companies Act, 1956 (“the 1956 Act”) (which are deemed to be applicable as per Section 133 of the Companies Act, 2013, read with Rule 7 of the Companies (Accounts) Rules, 2014) and the relevant provisions of the 1956 Act/ 2013 Act, as applicable. The financial statements have been prepared on going concern basis under the historical cost convention on accrual basis. The accounting policies have been consistently applied by the Company unless otherwise stated. The Company has elected to present “Profit from Operations” as a separate line item on the face of the Statement of Profit and Loss. The Company has ascertained its operating cycle as 12 months for the purpose of current/noncurrent classification of assets and liabilities. This is based on the nature of products and the time between acquisition of assets for processing and their realisation in cash and cash equivalents. Previous year’s figures have been regrouped/reclassified wherever necessary to make them comparable with the current year’s classification/disclosure. 344 Financial Accounting for Management Balance Sheet Now follows the balance sheet in Exhibit 1. EXHIBIT 1 REPORT NESTLE INDIA LIMITED Balance Sheet as on December 31, 2014 Notes EQUITY AND LIABILITIES SHAREHOLDERS’ FUNDS Share capital Reserves and surplus NON-CURRENT LIABILITIES Long-term borrowings Deferred tax liabilities (net) Long-term provisions CURRENT LIABILITIES Short-term borrowings Trade payables Other current liabilities Short-term provisions 1 2 964.2 27,407.9 3 4 5 154.6 2,227.2 13,886.6 6 41.1 7,287.1 4,095.7 2,130.6 7 8 Total............ ASSETS NON-CURRENT ASSETS Fixed assets –Tangible assets –Capital work-in-progress 9 Non-current investments Long-term loans and advances Other non-current assets 10 11 12 2014 (` in Millions) 2013 (` in Millions) 28,372.1 964.2 22,723.3 23,687.5 16,268.4 11,894.8 2,154.7 11,933.9 25,983.4 13,554.5 58,195.0 31,766.4 2,447.8 34,214.2 3,044.6 1,299.5 – 0.1 6,330.4 5,002.5 2,138.8 33,693.1 2,947.1 36,640.2 2,241.2 1,239.4 4.7 38,558.3 CURRENT ASSETS Current investments Inventories Trade receivables Cash and bank balances Short-term loans and advances Other current assets 13 14 15 16 17 18 Total............ 5,073.6 8,441.0 991.0 4,458.2 520.7 152.2 13,471.8 63,142.7 19,636.7 58,195.0 40,125.5 6,269.6 7,359.3 842.7 7,493.6 1,013.6 38.4 23,017.2 63,142.7 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 345 See accompanying notes 1 to 47 forming part of the financial statements. ETIENNE BENET Managing Director (DIN-06702574) February 13, 2015 Gurgaon February 13, 2015 New Delhi SHOBINDER DUGGAL Director-Finance & Control and CFO (DIN-00039580) In terms of our report attached For A.F. FERGUSON & CO. Firm Registration No. – 112066W Chartered Accountants (JAIDEEP BHARGAVA) Partner Membership No. 90295 B. MURLI Sr. VP – Legal & Company Secretary Statement of Profit and Loss Now follows the statement of profit and loss in Exhibit 2. EXHIBIT 2 REPORT NESTLE INDIA LIMITED Statement of Profit and Loss for the Year ended December 31, 2014 Notes 2014 (` in millions) REVENUE Gross Sales of products Less: Excise duty Other operating revenues A. Total revenue from operations EXPENSES Cost of materials consumed Purchases of stock-in-trade Changes in inventories of finished goods, work-inprogress and stock-in-trade Employee benefits expense Depreciation Other expenses Impairment loss on fixed assets Net provision for contingencies (from operations) B. Total Expenses C. PROFIT FROM OPERATIONS (A-B) D. Other income E. Finance costs F. Employee benefits expense due to passage of time G. Net provision for contingencies (others) 19 19 20 1,01,295.0 3,232.3 98,062.7 485.7 98,548.4 2013 (` in millions) 93,798.7 3,179.7 90,619.0 391.5 91,010.5 44,825.4 1,088.5 (674.3) 39,069.9 1,100.4 1,053.2 24 25 41 7,549.1 3,375.4 24,013.4 81.1 364.3 80,622.9 17,925.5 873.2 142.3 648.3 6,856.9 3,299.5 22,176.3 99.4 413.1 74,068.7 16,941.8 830.9 365.1 558.1 27 249.5 207.4 21 22 9 23 9 27 346 Financial Accounting for Management H. PROFIT BEFORE CORPORATE SOCIAL 17,758.6 RESPONSIBILITY EXPENSE, EXCEPTIONAL ITEMS AND TAXATION (C+D-E-F-G) I. Corporate social responsibility expense 47 85.1 J. Exceptional items 28 70.0 K. PROFIT BEFORE TAXATION (H-I+J) 17,743.5 L. Tax expense –Current tax 5,824.1 –Deferred tax 72.5 5,896.6 M. PROFIT AFTER TAXATION (K-L) 11,846.9 Weighted average number of equity shares Nos. 9,64,15,716 outstanding ` Basic and Diluted Earnings Per Share (Face 122.87 value ` 10) See accompanying notes 1 to 47 forming part of the financial statements. ETIENNE BENET Managing Director (DIN-06702574) February 13, 2015 Gurgaon February 13, 2015 New Delhi SHOBINDER DUGGAL Director-Finance & Control and CFO (DIN-00039580) In terms of our report attached For A.F. FERGUSON & CO. Firm Registration No. - 112066W Chartered Accountants (JAIDEEP BHARGAVA) Partner Membership No. 90295 16,642.1 0.0 138.1 16,780.2 5,075.0 533.9 5,608.9 11,171.3 9,64,15,716 115.87 B. MURLI Sr. VP - Legal & Company Secretary FEATURES OF THE FINANCIAL STATEMENTS A perusal of Nestlé’s financial statements reveals their following features: 1. Balance sheet: Disclosure of equity and liabilities (or, sources of funds) and assets (or, application of funds) at one place. 2. Statement of profit and loss: Disclosure of revenue followed by expenses, profit from operations, profit before tax and profit after tax at one place instead of drawing and balancing the three components of a horizontal statement, that is, trading account, profit and loss account and profit and loss appropriation For full annual report of Nestle, please visit account. WWW www.nestle.in. 3. Information at a glance, easier and better readability and hence better understanding, better visual effect, and facilitation of a quick review and analysis. 4. Reference to 47 notes to the financial statements in their bottom, many of which, where relevant, have been referred to on the face of the financial statements themselves. Note-1 starts with share capital in the balance sheet. UNDERSTANDING THE INTER-LINKAGE OF THE FINANCIAL STATEMENTS As can be seen, the balance sheet is divided in to two parts. The upper part reflects equity and liabilities (or, sources of funds) and the lower part assets (or, application of funds). Equity and liabilities represent Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 347 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Discuss the features of financial statements. 2. What else do you note in the financial statements of Nestle, not mentioned above? Could you identify some more features of financial statements? Choose a company from a database or website for this purpose. 3. Statement of profit and loss balances the balance sheet. Comment. To enrich your discussion, add your own ideas, thoughts and practical inputs. shareholders’ funds (` 28,372.1 millions), non-current liabilities (` 16,268.4 millions) and current liabilities (` 13,554.5 millions) aggregating ` 58,195.0 millions. Thus total funds at the disposal of Nestle are ` 58,195.0 millions. These funds have been deployed in non-current assets (` 38,558.3 millions) and current assets (` 19,636.7 millions). Out of non-current assets, ` 34,214.2 millions that is 89%, have been applied towards revenue generating fixed assets. As per the statement of profit and loss, these fixed assets have generated operational revenue of ` 98,548.4 millions which, after meeting various expenses, has led to profit after tax of ` 11,846.9 millions. This profit belongs to the equity owners and is transferred to reserves and surplus (note-2) in the balance sheet. UNDERSTANDING THE VARIOUS ACCOUNTS OF BALANCE SHEET AND NOTES THERETO Let us now move over from account to account and the corresponding note. Let us begin with the balance sheet. We take the various items in seriatum starting equity and liabilities. Shareholders’ Funds Shareholders’ funds are divided in to share capital and reserves and surplus. Share capital Exhibit 3 contains Note-1 which provides details of share capital. It may be noted that apart from the year end figure, the note also provides useful information about movements in the capital, attendant special conditions if any, extent of ownership of holding company/ies and major controlling shareholdrs. BIRD’S EYE VIEW Understanding the Various Accounts of Balance Sheet and Notes Thereto n Equity and Liabilities: – Shareholders’ funds – Non-current liabilities – Current liabilities n Assets: – Non-current assets – Current assets 348 EXHIBIT 3 Financial Accounting for Management REPORT NESTLE INDIA LIMITED Note 1 - Share Capital No. of Shares 2014 Amount (` in Millions) 1. SHARE CAPITAL Authorised Equity shares of `10 each Issued, subscribed and fully paid up Equity shares of `10 each (a) Reconciliation of shares and amount outstanding at the beginning and at the end of the year Shares outstanding at the beginning of the year Movement during the year Shares outstanding at the end of the year (b) Rights, preferences and restrictions attached to equity shares The Company has only one class of equity shares with face value of `10 each, ranking pari passu. (c) Equity shares held by holding companies Nestlé S.A. Maggi Enterprises Limited (Ultimate holding company being Nestlé S.A) (d) Shareholders holding more than 5% of equity shares Serial No. Name of the shareholder 1 Nestle S.A. 2 Maggi Enterprises Limited No. of Shares 2013 Amount (` in Millions) 10,00,00,000 1,000.0 10,00,00,000 1,000.0 9,64,15,716 964.2 9,64,15,716 964.2 9,64,15,716 9,64,15,716 964.2 964.2 9,64,15,716 9,64,15,716 964.2 964.2 No. of shares 3,30,51,399 2,74,63,680 No. of shares 3,30,51,399 2,74,63,680 No. of shares 3,30,51,399 2,74,63,680 % of holding 34.28 28.48 No. of shares 3,30,51,399 2,74,63,680 % of holding 34.28 28.48 Reserves and Surplus Exhibit 4 contains Note-2 which provides details of reserves and surplus. It may be noted that all appropriations towards dividend and general reserve have been made via this note instead of statement of profit and loss. This is a far reaching change as compared to earlier dispensation. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes EXHIBIT 4 349 REPORT NESTLE INDIA LIMITED Note 2 - Reserves and Surplus 2014 Amount (` in Millions) 2. Reserves and Surplus (a) Capital subsidy Opening balance Add: Additions during the year Closing balance (b) General reserve Opening balance Add: Transferred from surplus in statement of profit and loss Closing balance (c) Surplus in statement of profit and loss Opening balance Add: Profit after taxation Amount available for appropriation Less: Appropriations Dividends: Interim (`50.50 per share*, Previous year `36 per share) Final - proposed (` 12.50 per share, Previous year ` 12.50 per share) Dividend distribution tax General reserve Closing balance 2013 Amount (` in Millions) 11.0 3.5 14.5 8.0 3.0 11.0 7,383.5 1,184.7 8,568.2 6,266.4 1,117.1 7,383.5 15,328.8 11,846.9 27,175.7 10,745.5 11,171.3 21,916.8 4,869.0 1,205.2 1,091.6 1,184.7 18,825.2 27,407.9 3,471.0 1,205.2 794.7 1,117.1 15,328.8 22,723.3 * includes additional interim dividend of `10.00 per share. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What is the usefulness of additional information provided in the note on share capital about movements in the capital, attendant special conditions if any, extent of ownership of holding company/ies and major controlling shareholders? 2. Do you endorse the principle of making appropriations in the note on reserves and surplus rather than the statement of profit and loss? Why or why not? To enrich your discussion, add your own ideas, thoughts and practical inputs. 350 Financial Accounting for Management Non-current Liabilities Non-current liabilities are divided in to long-term borrowings, deferred tax liabilities (net) and longterm provisions. Long-term borrowings Exhibit 5 contains Note-3 which provides details of long-term borrowings. As compared to its size, long term borrowings at ` 154.6 millions represent a miniscule figure. Company is virtually free from long term debt. EXHIBIT 5 REPORT NESTLE INDIA LIMITED Note 3 - Long Term Borrowings 2014 Amount (` in Millions) 3. LONG TERM BORROWINGS Unsecured loans Deferred VAT liabilities – State of Karnataka# – State of Himachal Pradesh## Term loan from holding company (Refer note 44) – External Commercial Borrowings (ECB) 77.5 77.1 2013 Amount (` in Millions) – 23.4 – 11,871.4 154.6 11,894.8 # Interest free, repayable after 10 years from the year of deferment in 10 equal annual instalments starting from year 2024. ## Interest free, repayable after 8 years from the year of deferment starting from year 2021. Deferred tax liabilities (net) Note-26 to the financial statements provides the taxation accounting policy of Nestle as under: Current tax is the amount of tax payable on the taxable income for the year as determined in accordance with the provisions of the Income Tax Act, 1961. Deferred tax is recognised, subject to the consideration of prudence, on timing difference, being the difference between taxable income and accounting income that originate in one period and are capable of reversal in one or more subsequent period. The policy is in accordance with Indian GAAP. Exhibit 6 contains Note-4 depicting details of deferred taxes. Various counts on which Nestle has deferred tax liabilities and assets are detailed. Finally the company has a net liability towards deferred taxes which will cause cash outflows in future. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes EXHIBIT 6 351 REPORT NESTLE INDIA LIMITED Note 4 - Deferred Taxes (Net) 2014 Amount (` in Millions) 4. DEFERRED TAXES (NET) Deferred tax liabilities Difference between book and tax depreciation Difference in inventory valuation Others Deferred tax assets Provision for contingencies Provision for compensated absences and gratuity Provision for doubtful receivables and advances Other items deductible on payment 2013 Amount (` in Millions) 3,092.9 162.7 15.4 3,271.0 2,903.8 168.4 786.2 206.1 21.8 29.7 1,043.8 2,227.2 680.2 186.8 21.5 29.0 917.5 2,154.7 3,072.2 Long-term provisions Exhibit 7 contains Note-5 depicting details of long-term provisions on account of employee benefits. EXHIBIT 7 REPORT NESTLE INDIA LIMITED Note 5 - Long Term Provisions 2014 Amount (` in Millions) 5. LONG TERM PROVISIONS Employee benefits: Pension and gratuity (Refer note 41) Other incentives and welfare benefits* Contingencies (Refer note 27) 8,780.4 790.8 2013 Amount (` in Millions) 7,500.40 9,571.2 727.9 8,228.3 4,315.4 3,705.6 13,886.6 11,933.9 * Includes compensated absences, restricted stock unit plans, long service awards and ceremonial gifts. 352 Financial Accounting for Management BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Is the net deferred tax liability of Nestle going to have material effect on its cash flows in the future? Why or why not? 2. Long-term provisions effectively play the role of non-interest bearing term loans in the financing structure of a company. Comment. To enrich your discussion, add your own ideas, thoughts and practical inputs. Current Liabilities Current liabilities are divided in to short-term borrowings, trade payables, other current liabilities and short-term provisions. Short-term borrowings Exhibit 8 contains Note-6 depicting details of short-term borrowings. Again the borrowings are insignificant. REPORT EXHIBIT 8 NESTLE INDIA LIMITED Note 6 - Short Term Borrowings 2014 Amount (` in Millions) 2013 Amount (` in Millions) 6. SHORT TERM BORROWINGS Secured loans* From banks – Bank overdraft 41.1 0.1 41.1 0.1 * The Company’s borrowing facilities, comprising fund based and non fund based limits from various bankers, are secured by way of a first pari passu charge on all movable assets (excluding plant and machinery), finished goods (including stock-in-trade), work in progress, raw materials and book debts. Trade payables There is no note. Other current liabilities Exhibit 9 contains Note-7 depicting details of other current liabilities. They are self explanatory. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 353 REPORT EXHIBIT 9 NESTLE INDIA LIMITED Note 7 - Other Current Liabilities 2014 Amount (` in Millions) 7. OTHER CURRENT LIABILITIES Statutory liabilities (sales taxes, excise duty, tax deducted at source etc.) Payables for capital expenditure Customers’ credit balances, advances and other payables Employee costs and reimbursements Book Overdraft Unpaid dividends # Sundry deposits Interest accrued but not due on borrowings Sundries 1,467.2 548.9 798.3 871.4 0.0 100.7 68.9 0.0 240.3 4,095.7 # There is no amount due and outstanding to be credited to Investor Education and Protection Fund. 2013 Amount (` in Millions) 1,338.7 937.4 787.9 753.0 738.3 102.5 59.3 12.2 273.2 5,002.5 Short-term provisions Exhibit 10 contains Note-8 depicting details of short term provisions. Note that the appropriations towards dividend and tax thereon out of surplus in the statement of profit and loss (Note-2) are included here just like the earlier dispensation. REPORT EXHIBIT 10 NESTLE INDIA LIMITED Note 8 - Short Term Provisions 2014 Amount (` in Millions) 8. SHORT TERM PROVISIONS Employee benefits: Pension (Refer note 41) Other incentives and welfare benefits* Taxation less payments Contingencies (Refer Note 27) Proposed final dividend (`12.5 per share, Previous year ` 12.5 per share) Dividend distribution tax on proposed final dividend 134.4 229.7 364.1 195.3 125.0 1,205.2 241.0 2013 Amount (` in Millions) 118.8 227.0 345.8 262.0 121.0 1,205.2 204.8 2,130.6 2,138.8 *Includes compensated absences, restricted stock unit plans/performance share unit plans, long service awards and ceremonial gifts. 354 Financial Accounting for Management BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. How the current liabilities support the current assets in business operations? Discuss. 2. What is bank overdraft? To enrich your discussion, add your own ideas, thoughts and practical inputs. We now move over to the assets side. Non-current Assets These comprise of fixed assets, non-current investments, long- term loans and advances and other non-current assets. Fixed assets Note-26 states three accounting policies related to fixed assets: Fixed assets Fixed assets are stated at cost (net of Cenvat or any other recoverable tax) less accumulated depreciation and accumulated impairment losses, if any. Cost is inclusive of freight, duties, levies, and any directly attributable cost of bringing the assets to their working condition for intended use. Profit or loss on disposal/scrapping/write off/retirement from active use of tangible assets are recognised in the statement of profit and loss Depreciation/amortisation Depreciation is provided as per the straight-line method at rates provided in Schedule XIV to the Companies Act, 1956, except for the following class of fixed assets, where the useful life has been estimated as under: Information technology equipments : Furniture and fixtures : Office equipments : Vehicles : Leasehold land and related improvements : Intangible fixed assets : 3–5 years 5 years 5 years 5 years Lease period Over their estimated useful life. Impairment of fixed assets At each balance sheet date, carrying amount of fixed assets is reviewed for any possible impairment taking into account the long term view of the underlying businesses and related variables. For the purpose of assessing impairment, assets are grouped at the levels for which there are separately identifiable cash flows (cash generating unit). If any impairment indicator exists, estimate of the recoverable amount of the fixed asset/cash generating unit to which the asset belongs is made. An impairment loss is recognised whenever the carrying amount of an asset/ cash generating unit exceeds its recoverable amount. The recoverable amount is the greater of the net selling price and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value based on an appropriate discount rate. Reversal of impairment losses recognised in earlier years is recorded when there is an indication that the impairment losses recognised for the asset/cash generating unit no longer exist or have decreased. However, the increase in carrying amount of an asset due to reversal of an impairment loss is recognised to the extent it does not exceed the carrying amount that would have been determined (net of depreciation) had no impairment loss been recognised for that asset/ cash generating unit in earlier years. Information technology equipment Office Equipment Furniture and fixtures Plant and machinery Railway siding 594.4 111.9 1,924.7 35,111.7 11.7 94.4 1.8 170.6 1,161.6 – 570.7 9,171.3 Buildings – 169.0 1,318.0 – Additions Leasehold land Cost as at December 31, 2013 Note 9 - Fixed Assets – – – – (246.2) – (90.9) (31.3) 21.1 – 137.4 409.0 – 10.1 – – 667.7 113.7 1,957.9 35,618.1 11.7 9,641.0 429.5 69.1 818.1 12,053.8 11.4 1,321.9 – 29.5 169.0 1,286.7 82.6 3.4 222.6 2,742.8 0.1 305.9 13.1 – For the year – – - 80.2 – 0.9 – – Impairment loss NET BLOCK (` in Millions) REPORT 19.2 – 83.6 366.6 – 2.1 – – 492.9 72.5 957.1 14,510.2 11.5 1,626.6 42.6 174.8 41.2 1,000.8 21,107.9 0.2 8,014.4 1,244.1 169.0 164.9 42.8 1,106.6 23,057.9 0.3 7,849.4 1,288.5 169.0 On As at As at As at deletions/ December December December adjust31, 2014 31, 2014 31, 2013 ments DEPRECIATION/AMORTISATION NESTLE INDIA LIMITED Borrowings Deletions / Cost as at As at cost/ adjust- December December Exchange ments 31, 2014 31, 2013 differences GROSS BLOCK Freehold land Tangible assets (A) 9. FIXED ASSETS EXHIBIT 11 Exhibit 11 contains Note-9 giving details of fixed assets of Nestle. It may be noted that original cost of all the fixed assets owned/ controlled by Nestle is ` 50,089.8 millions, which after writing off depreciation, amortisation and impairment loss of ` 18,323.4 stand in the books at ` 31,766.4 millions. Together with capital work-in-progress of ` 2,447.8 millions, total fixed assets constitute ` 34,214.2 millions. These assets directly generate revenue for Nestle. The policies are in accordance with the Indian GAAP. 44,275.6 Previous year 3,666.9 2,004.3 – – – 2,004.3 5.2 1,398.8 (368.4) – – – (368.4) – 309.7 577.7 – – – 577.7 0.1 35.2 588.8 15,338.5 12,232.9 588.8 49,031.6 52.5 52.5 50,089.8 536.3 14,749.7 536.3 49,501.0 16.4 3,299.5 3,375.4 – – – 3,375.4 4.9 – 99.4 81.1 – – – 81.1 293.3 471.6 – – – 471.6 0.1 21.2 Total 15,338.5 18,323.4 588.8 52.5 536.3 17,734.6 14.0 34,214.2 2,447.8 31,766.4 – – – 31,766.4 (b) Capital work-in-progress includes ` 43.6 millions (Previous year `50.8 millions) on account of ‘Finance costs’ which has been treated as capital expenditure. (a) Gross block of buildings include `54.0 millions (Previous year ` 54.0 millions) being the cost of leasehold improvements. Capital Work-in-progress 49,031.6 588.8 52.5 536.3 48,442.8 Total (A+B) Sub total Knowhow and commercial rights Management information systems Intangible assets (B) Sub total Vehicles 30.1 36,640.2 2,947.1 33,693.1 – – – 33,693.1 13.7 357 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes Non-current investments Note-26 states the accounting policy on non-current investments as under: Non-current investments are stated at cost. Provision for diminution, if any, in the value of non-current investments is made only if such decline is not temporary in nature. The policy is in accordance with Indian GAAP. Exhibit 12 contains Note-10 which gives details of non-current investments. Most of them are in tax free bonds providing tax free return to the company. Their market value (` 2,701.9 millions) is more than their book value (` 2,525.8 millions) by ` 176.10 millions. This amount represents a hidden reserve for the company. These investments earn dividend and interest income to the company. REPORT EXHIBIT 12 NESTLE INDIA LIMITED 10 - Non-current Investments Face Value No. of ` per unit Units 10. NON-CURRENT INVESTMENTS (At cost unless otherwise stated) (a) Trade Investments — Unquoted Equity Shares — Fully paid-up Sahyadri Agro and Dairy Limited (b) Other Investments — Quoted Bonds — Tax free Indian Infrastructure Finance Company Limited Indian Railway Finance Corporation Limited Indian Railway Finance Corporation Limited National Housing Bank NTPC Limited NTPC Limited Rural Electrification Corporation Limited (c) Subscription money for tax free bonds pending allotted subsequently Indian Infrastructure Finance Company Limited National Housing Bank Aggregate amount of quoted investments Market value of quoted investments Aggregate amount of unquoted investments 2014 Amount (` in Millions) No. of Units 2013 Amount (` in Millions) 10 14,15,050 518.8 13,01,805.0 477.3 1,000 5,00,000 500.0 – – 10,00,000 1,000 5,000 1,000 10,00,000 1,000 500 2,20,000 57,757 4,74,974 300 2,36,000 500.1 225.9 288.8 475.0 300.0 236.0 2,525.8 500.0 – – 4,74,974.0 – – 500.1 – – 475.0 – – 975.1 – 500.0 – 3,044.6 2,525.8 2,701.9 518.8 288.8 2,241.2 975.1 975.1 1,266.1 358 Financial Accounting for Management Long-term loans and advances Exhibit 13 contains Note-11 which gives details of long-term loans and advances. All of them are considered good. Provision for doubtful advances has been made fully. These facts indicate that the quality of long-term loans and advances is very good. All of them are recoverable. REPORT EXHIBIT 13 NESTLE INDIA LIMITED Note 11– Long-Term Loans and Advances 2014 Amount (` in Millions) 11. LONG-TERM LOANS AND ADVANCES Secured, considered good Loans and advances to employees Unsecured, considered good Loans and advances to employees Payments/pre-deposits under protest with government authorities Security deposits Capital advances Prepaid expenses Unsecured, considered doubtful Other receivables Less: Provision for doubtful receivables 103.2 (103.2) 2013 Amount (` in Millions) 14.1 29.1 358.0 619.3 397.1 499.0 285.8 19.3 3.0 1,285.4 283.8 25.6 4.8 1,210.3 0.0 1,299.5 103.2 (103.2) 0.0 1,239.4 Other non-current assets Exhibit 14 contains Note-12 which gives details of other non-current assets. These are nil as at 2014 year end. EXHIBIT 14 REPORT NESTLE INDIA LIMITED Note 12 - Other Non-current Assets 12. OTHER NON-CURRENT ASSETS Interest accrued on tax free long term bonds 2014 Amount (` in Millions) 2013 Amount (` in Millions) – – 4.7 4.7 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 359 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Long-term investments represent funds not needed by the company in the short term. Hence they represent idle funds. Opine. 2. Why Nestle is still showing other receivables despite a nil figure? To enrich your discussion, add your own ideas, thoughts and practical inputs. Current Assets These comprise of current investments, inventories, trade receivables, cash and bank balances, short-term loans and advances and other current assets. Current investments Note-26 states the accounting policy on current investments as under: Current investments are stated at lower of cost or fair value. The policy is in accordance with Indian GAAP. Exhibit 15 contains Note-13 giving details of current investments. These are all highly liquid and traded funds. Their market price is more than the book value by ` 29.2 millions again pointing at a hidden reserve. These investments/certificates of deposits earn dividend and interest income to the company. REPORT EXHIBIT 15 NESTLE INDIA LIMITED Note 13 - Current Investments Face Value No. of ` per unit Units 13. CURRENT INVESTMENTS (Non trade, Quoted, at cost or fair value, whichever is lower) Government Securities Treasury Bills Mutual Funds–Debt Birla Sun Life Cash Plus - Daily Dividend Direct Plan - Reinvestment 2014 Amount (` in Millions) No. of Units 2013 Amount (` in Millions) 100 2,00,00,000 1,967.2 3,35,00,000 3,288.9 100 – – 49,79,984 499.0 360 Financial Accounting for Management DWS Insta Cash Plus Fund Direct Plan Annual Bonus DWS Insta Cash Plus Fund Direct Plan - Daily Dividend - Reinvestment HDFC Liquid Fund - Direct Plan - Dividend Daily Reinvestment ICICI Prudential Liquid - Regular Plan - Daily Dividend Reliance Liquid Fund - Treasury Plan - Daily Dividend Option Dividend Reinvestment SBI Premier Liquid Fund - Direct Plan - Daily Dividend Certificate of Deposits with schedule banks 100 4,61,456 45.3 7,09,933 115.4 100 16,04,577 160.9 13,07,066 131.1 10 3,79,30,740 386.8 4,88,44,055 498.1 100 43,12,214 431.5 49,60,186 496.3 1,000 3,11,049 475.5 3,25,734 498.0 1,000 3,70,726 371.9 4,95,819 497.4 1,00,000 12,500 1,871.9 1,234.5 2,500 2,735.3 245.4 5,073.6 5,102.8 Market value / repurchase price of quoted investments 6,269.6 6,302.1 Inventories Note-26 states the accounting policy on inventories as under: Inventories are stated at cost or net realisable value, whichever is lower. The basis of determining cost for various categories of inventories is as follows: Raw and packing materials: Stock-in-trade (Goods purchased for resale): Stores and spare parts: Work-in-progress and finished goods: First-in-first out First-in-first out Weighted average Material cost plus appropriate share of production overheads and excise duty, wherever applicable The policy is in accordance with Indian GAAP. Exhibit 16 contains Note-14 giving details of various classes of inventories which is self explanatory. EXHIBIT 16 REPORT NESTLE INDIA LIMITED Note 14 - Inventories 14. INVENTORIES (at cost or net realisable value, whichever is lower) Raw materials {Includes in transit `293.6 millions (Previous year ` 190.4 millions)} Packing materials {Includes in transit `5.9 millions (Previous year ` 6.5 millions)} 2014 Amount (` in Millions) 2013 Amount (` in Millions) 2,845.5 2,367.0 264.6 304.5 361 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes Work-in-progress* Finished goods* Stock-in-trade (goods purchased for resale)* {Includes in transit `33.0 millions (Previous year `37.5 millions)} Stores and spares {Includes in transit `11.6 millions (Previous year `19.6 millions)} 901.9 3,815.5 95.5 700.2 3,333.2 88.4 518.0 566.0 8,441.0 7,359.3 * Refer note 37 (for class-wise details of these items.) Trade receivables Exhibit 17 contains Note-15 giving details of trade receivables. All of them are considered good. Most of them are highly liquid as being receivable in less than 6 months. Provision for doubtful receivables has been made fully. These facts indicate that the quality of trade receivables is very good. All of them are recoverable. One more point here. Trade receivables are just ` 991.0 millions as against trade payables of ` 7,287.1 millions. It means that it is availing 7.35 more times suppliers’ credit than it is allowing to its customrs. Earning money from suppliers’ interest free money. EXHIBIT 17 REPORT NESTLE INDIA LIMITED Note 15 - Trade Receivables (Unsecured) 2014 Amount (` in Millions) 15. TRADE RECEIVABLES (UNSECURED) Considered good Over six months from the due date for payment Others Considered doubtful Over six months from the due date for payment Others Less: Provision for doubtful trade receivables 26.3 964.7 7.9 29.5 991.0 37.4 1,028.4 (37.4) 991.0 2013 Amount (` in Millions) 59.8 782.9 11.7 28.3 842.7 40.0 882.7 (40.0) 842.7 Cash and bank balances Exhibit 18 contains Note-16 giving details of cash and bank balances. It may be noted that most of the bank balance is in the form of deposits earning interest income to the company. 362 EXHIBIT 18 Financial Accounting for Management REPORT NESTLE INDIA LIMITED Note 16 - Cash and Bank Balances 2014 Amount (` in Millions) 16. CASH AND BANK BALANCES (a) Cash and cash equivalents Balances with banks – on current accounts – on deposit accounts Cheques, drafts on hand including remittances in transit (b) Other bank balances Unpaid dividend accounts 61.9 4,227.8 67.8 4,357.5 2013 Amount (` in Millions) 60.4 7,310.70 20.0 7,391.1 100.7 4458.2 102.5 7493.6 Short-term loans and advances Exhibit 19 contains Note-17 giving details of short-term loans and advances. All of them are considered good. Provision for doubtful advances has been made fully. These facts indicate that their quality is very good. All of them are recoverable. EXHIBIT 19 REPORT NESTLE INDIA LIMITED Note 17 - Short-Term Loans and Advances 2014 (` in Millions) 17. SHORT-TERM LOANS AND ADVANCES Secured, considered good 10.7 Loans and advances to employees Unsecured, considered good Subscription money for tax free bonds refunded subsequently – Balances with government authorities 90.5 Loans and advances to employees 137.9 Suppliers’ advances, debit balances and other receivables* 196.0 Security deposits 44.7 Prepaid expenses 36.8 Others 4.1 510.0 Unsecured, considered doubtful Security deposits, vendor balances and other receivables 14.7 Less: Provision for doubtful receivables (14.7) 0.0 520.7 *Includes `55.5 millions (Previous year `68.6 millions) from related parties. 2013 (` in Millions) 15.6 511.2 115.6 133.0 139.0 37.0 23.6 38.6 998.0 11.5 (11.5) 0.0 1,013.6 363 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes Other current assets Exhibit 20 contains Note-18 giving details of other current assets. These represent a small amount of interest accrued. REPORT EXHIBIT 20 NESTLE INDIA LIMITED Note 18 - Other Current Assets 18. OTHER CURRENT ASSETS Interest accrued on bank deposits/ long term bonds - tax free 2014 (` in Millions) 2013 (` in Millions) 152.2 152.2 38.4 38.4 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Book value of current quoted investments is ` 5,073.6 millions whereas their market value / repurchase price is ` 5,102.8 millions? Does it augur well for the company? How? 2. Why Nestle is still showing security deposits, vendor balances and other receivables despite a zero figure? To enrich your discussion, add your own ideas, thoughts and practical inputs. UNDERSTANDING THE VARIOUS ACCOUNTS OF THE STATEMENT OF PROFIT AND LOSS AND NOTES THERETO Let us now move to the statement of profit and loss for an account to account discussion and the corresponding notes. We take the various items in seriatum starting revenue from operations. Revenue from Operations This comprises of sale of goods and other operating revenues. Note-26 states the revenue recognition policy of Nestle as under: BIRD’S EYE VIEW Understanding the Various Accounts of Statement of Profit and Loss and Notes Thereto n Revenue from Operations n Expenses n Profit from Operations n Profit before Corporate Social Responsibility Expense, Exceptional Items and Taxation n Profit before Taxation n Profit after Taxation n Earnings Per Share Revenue from sale of goods is recognised on transfer of significant risks and rewards of ownership in the goods to the buyer which is generally at the time of dispatch to the customer. Sales are recorded net of returns (if any), trade discounts, rebates, other pricing discounts to trade/consumer and value added tax/sales tax. 364 Financial Accounting for Management The policy is in accordance with the Indian GAAP. Exhibit 21 contains Note-19 giving details of revenue from operations. Sale of products, that is, Milk Products and Nutrition, Beverages, Prepared dishes and Cooking aids, Chocolates and Confectionery, is net of excise duty since this duty is collected from the customers on behalf of and paid to the government. Other operating revenues represent revenues incidental to the operations of the company. REPORT EXHIBIT 21 NESTLE INDIA LIMITED Note 19 - Revenue From Operations 2014 (` in Millions) 19. REVENUE FROM OPERATIONS (a) Sale of products (Refer note 37) (For class wise details) Domestic Export Less: Excise duty (b) Other operating revenues Export incentives Other operating income (mainly scrap sales) 94,853.2 6,441.8 1,01,295.0 3,232.3 266.0 219.7 98,062.7 485.7 98,548.4 2013 (` in Millions) 87,537.4 6,261.3 93,798.7 3,179.7 194.6 196.9 90,619.0 391.5 91,010.5 Cost of Materials Consumed As per Note-34, Nestle consumes various raw materials such as milk, sugar, tea, coffee, edible oils, fruits and vegetable concentrates etc. to manufacture its products as detailed earlier. Exhibit 22 contains Note-20 which gives monetary details of total raw materials consumed and packing material consumed for packaging the products. EXHIBIT 22 REPORT NESTLE INDIA LIMITED Note 20 - Cost of Materials Consumed 2014 (` in Millions) 20. COST OF MATERIALS CONSUMED Raw materials (Refer note 34) (for item wise details) Packing materials 37,243.9 7581.5 44,825.4 2013 (` in Millions) 32,036.4 7,033.5 39,069.9 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 365 Changes in Inventories of Finished Goods, Work-In-Progress and Stock-In-Trade Exhibit 23 contains Note-21 which shows (increase)/decrease in closing inventories related to finished/ semi-finished products. An (increase) shows unrealized income and a decrease an expense. Both however are reported under the head ‘Expenses’ in the statement of profit and loss. Excise duty part of the finished goods inventory has been reduced as it is a third party (government) entitlement. When the finished goods are sold this part goes to the government. EXHIBIT 23 REPORT NESTLE INDIA LIMITED Note 21 - Changes in Inventories of Finished Goods, Work-in-progress and Stock-in-trade 2014 (` in Millions) 21. CHANGES IN INVENTORIES OF FINISHED GOODS, WORK-IN-PROGRESS AND STOCKIN-TRADE Opening stock Finished goods 3,333.2 Work-in-progress 700.2 Stock-in-trade 88.4 4,121.8 Closing Stock Finished goods Work-in-progress Stock-in-trade Net (increase)/decrease in opening and closing stock Net movement in excise duty on finished goods 3,815.5 901.9 95.5 4,812.9 2013 (` in Millions) 3,653.4 1,372.4 155.7 5,181.5 3,333.2 700.2 88.4 4,121.8 (691.1) 1,059.7 16.8 (6.5) (674.3) 1,053.2 Employee Benefits Expense Exhibit 24 contains Note-22 which shows details of employee benefits expense. The term is far wider than the term salary as it includes a plethora of other benefits, as mentioned in the note, granted to the employees. As on 31st December 2014, Nestle had 7228 employees on its rolls as mentioned earlier. That means that average benefit expense per employee was ` 10, 44,425. Not bad. 366 EXHIBIT 24 Financial Accounting for Management REPORT NESTLE INDIA LIMITED Note 22 - Employee Benefits Expense 2014 (` in Millions) 22. EMPLOYEE BENEFITS EXPENSE Salaries, wages, bonus, pension, gratuity, performance incentives etc. (Refer note 41: for retirement benefit plans) Contribution to provident and other funds Staff welfare expenses 2013 (` in Millions) 6,873.4 6,191.8 258.2 417.5 7,549.1 221.3 443.8 6,856.9 Depreciation Depreciation accounting policy has already been examined earlier under the head ‘fixed assets’. The amount of ` 3375.4 millions comes from Exhibit 11(Note-9). Other expenses Exhibit 23 contains Note-21 which shows details of other expenses representing manufacturing, marketing and administrative expenses. Notable among them are a high of ` 4454.7 millions on account of advertising and sales promotion (a unique aspect of businesses of FMCG companies) and ` 3512.0 millions payable to the parent company on account of licence fee for technology supply. EXHIBIT 25 REPORT NESTLE INDIA LIMITED Note 23 - Other Expenses 23. OTHER EXPENSES Finished goods handling, transport and distribution Advertising and sales promotion Power and fuel General licence fees (net of taxes) Information technology and management information systems Maintenance and repairs – Plant and machinery – Buildings – Others Rates and taxes Travelling Rent 650.6 83.3 135.6 2014 (` in Millions) 2013 (` in Millions) 4,794.5 4,454.7 3,843.3 3,512.0 886.7 4,373.5 3,954.8 3,853.8 3,087.1 802.2 869.5 802.0 686.0 681.6 559.7 122.6 103.7 786.0 716.9 704.2 607.3 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes Contract manufacturing charges Consumption of stores and spare parts Less: Charge to other revenue accounts Training Withholding tax on general licence fees Laboratory (quality testing) Market research Milk collection and district development Security Charges Exchange differences Insurance Miscellaneous 367 661.8 832.5 (341.8) 490.7 379.3 351.3 191.0 163.8 161.8 109.8 98.8 29.8 845.0 24,013.4 714.7 714.4 (291.8) 422.6 257.4 308.8 166.8 168.6 175.9 95.5 179.3 28.3 772.6 22,176.3 Impairment loss on Fixed Assets Accounting policy on impairment loss has already been examined earlier under the head ‘fixed assets’. The amount of ` 81.1 millions comes from Exhibit 11(Note-9). Net povision for contingencies (from operations) Exhibit 26 contains Note-27 which shows abridged details of net provision for contingencies. `364.3 millions have been provided for contingencies related to litigations and disputes. Probable outcome of these contingencies depends upon external authorities’ judgment. EXHIBIT 26 REPORT NESTLE INDIA LIMITED Note 27 - Net Provision for Contingencies (Abriged) 27. NET PROVISION FOR CONTINGENCIES The Company has created a contingency provision of `734.8 millions (Previous year `736.4 millions) for various contingencies resulting mainly from matters, which are under litigation / related disputes and other uncertainties requiring management judgement. The Company has also reversed, utilised/settled contingency provision of `121.0 millions (Previous year `115.9 millions) due to the satisfactory settlement of certain litigations for which provision is no longer required. Out of this, `364.3 millions (Previous year `413.1 millions) has been recognised as contingencies from operations and balance amount of `249.5 millions [Previous year `(207.4 millions] as others. Notes: (a) Litigations and related disputes—represents estimates made mainly for probable claims arising out of litigations/ disputes pending with authorities under various statutes (i.e. Income Tax, Excise Duty, Service Tax, Entry tax, Sales and Purchase Tax etc.). The probability and the timing of the outflow with regard to these matters depend on the ultimate settlement /conclusion with the relevant authorities. (b) Others—include estimates made for products sold by the Company which are covered under free replacement warranty on becoming unfit for human consumption during the prescribed shelf life. The timing and probability of outflow with regard to these matters will depend on the external environment and the consequent decision/ conclusion by the Management. 368 Financial Accounting for Management Profit from Operations This is the resultant figure from total revenue from operations minus total operational expenses as detailed above. Nestle has earned total revenue from operations amounting to ` 98,548.4 millions. After meeting total operational expenses of ` 80,622.9 millions it has earned a net profit of ` 17,925.5 millions from operations. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Should excise duty be shown as a deduction from sales? Why or why not? 2. Showing net movement in excise duty on finished goods means that finished goods inventory has been recognised in the financial statements net of it. Right or wrong? 3. Consumption of stores and spare parts could have been shown straight away net of charge to other revenue heads. What is the significance of showing details? 4. How will disclosure of expenses divided in to manufacturing, administrative and selling expenses, instead of as required above, help you as an analyst? 5. Work out the ratio of ‘profit from operations’ to ‘total revenue from operations’. What does it indicate? To enrich your discussion, add your own ideas, thoughts and practical inputs. Other Income Note-26 states the accounting policy for other income as under: Interest on investments/loans is recognised on a time proportion basis. Dividend income on investments is recognised when the right to receive the payment is established. Exhibit 27 contains Note-24 which shows details of other income. Though incidental to business this income from interest, dividend and capital gain on investments is classified as non-operational as it is not generated by the core operations of the company. EXHIBIT 27 REPORT NESTLE INDIA LIMITED Note 24 - Other Income 2014 (` in Millions) 24. OTHER INCOME Dividend on mutual funds, current - non trade investments Profit on sale of mutual funds, current - non trade investments Interest on bank deposits, investments and employee loans etc. (Tax deducted at source `38.4 millions, Previous year `41.4millions) Interest on tax free long term bonds 2013 (` in Millions) 103.7 1.6 587.7 107.3 0.0 717.2 180.2 873.2 6.4 830.9 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 369 Finance Costs Note-26 states the accounting policy on borrowing costs as under: Borrowing costs directly attributable to acquisition or construction of fixed assets which take substantial period of time to get ready for their intended use are treated as addition/reduction to capital expenditure in accordance with accounting standard 16 on ‘Borrowing Costs’ and notification no. GSR 225 (E) dated March 31, 2009 and subsequent clarification via circular no. 25/2012 dated August 09, 2012 issued by Ministry of Corporate Affairs, Government of India. Other borrowing costs are charged to the statement of profit and loss. The policy is in accordance with Indian GAAP. Exhibit 28 contains Note-25 which shows details of finance costs. Keeping in view the size of Nestle, the figure is insignificant as the company is hardly geared. EXHIBIT 28 REPORT NESTLE INDIA LIMITED Note 25 - Finance Costs 2014 (` in Millions) 25. FINANCE COSTS Interest on: Borrowings - External Commercial Borrowings (Refer note 44) Others Exchange differences Less: Treated as (addition)/ reduction to capital expenditure 133.5 8.8 (375.6) 2013 (` in Millions) 364.0 (233.3) 375.6 142.3 6.1 1,371.9 1,742.0 (1,376.9) 365.1 Employee Benefit Expense Due To Passage of Time These are basically pension and gratuity expenses. Exhibit 29 contains Note-41 which shows details of expenses under this head. 370 Financial Accounting for Management REPORT EXHIBIT 29 NESTLE INDIA LIMITED Note 41 - Employee Benefit Plans (Abridged) 41. EMPLOYEE BENEFIT PLANS This is a long note dealing with the following aspects of employee benefit expense: 1. Defined contribution plans 2. Defined benefit plans 3. Status of the defined benefit plans Total employee benefits expense due to passage of time charged in statement of profit and loss is ` 648.3 millions (Previous year ` 558.1millions). This includes ` 599.0 millions (Previous year ` 517.2 millions) towards pension and gratuity and ` 49.3 millions (Previous year ` 40.9 millions) towards compensated absences and long service awards. Those interested may refer to the annual report of Nestle. Net Provision for Contingencies (Others) Exhibit 26 containing Note-27 which shows abridged details of net provision for contingencies has been depicted earlier. `249.5 millions have been provided for contingencies related to issues other than litigations and disputes. Probable outcome of these contingencies depends upon management’s judgment. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Outline the role of other income in forecasting the consistency of revenues. 2. The note on other income has shown the details of assets on which other income has been earned. Work out the ratio of ‘other income’ to those assets. Compare with the ratio of ‘profit from operations’ to ‘total revenue from operations’ as worked out earlier. What lessons do you draw? 3. Gain on account of exchange differences could have been treated as other income instead of deducting from applicable capital expenditure. Which treatment is better? Why? 4. Provision for contingencies represents application of which accounting principle-conservatism or materiality? Why? To enrich your discussion, add your own ideas, thoughts and practical inputs. Profit before Corporate Social Responsibility Expenses, Exceptional Items and Taxation Profit from operations plus other income minus finance costs, employee benefit expenses due to passage of time and net provision for contingencies (others) have resulted in this profit of ` 17,758.6 millions Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 371 Corporate Social Responsibility Expenses Exhibit 30 containing Note-47 shows that company has spent ` 85.1 millions on obligatory corporate social responsibility expenses introduced by the Companies Act, 2013. EXHIBIT 30 REPORT NESTLE INDIA LIMITED Note 47- Corporate Social Responsibility Expenses 47. CORPORATE SOCIAL RESPONSIBILITY EXPENSES During the year, the Company has incurred ` 85.1 millions towards corporate social responsibility activities in accordance with section 135 of the Companies Act, 2013. The Company also has outstanding commitments of `38.6 millions as on 31st December, 2014 towards corporate social responsibility projects. This includes expenditure on projects which are relatively long term in nature and costs spread over several months. Exceptional Items Exhibit 31 containing Note-28 shows that Nestle has earned a gain of ` 70.0 millions on sale of real estate which the company has classified as an exceptional item. EXHIBIT 31 REPORT NESTLE INDIA LIMITED Note 28- Exceptional Items 28. EXCEPTIONAL ITEMS Profit on sale of real estate 2014 (` in Millions) 2013 (` in Millions) 70.0 138.1 Profit before Taxation Nestle has earned a profit before tax of ` 17,743.5 millions for the year 2014. This figure is arrived at by deducting corporate social responsibilities expenses from and adding exceptional items to profit before corporate social responsibility expenses, exceptional items and taxation. Tax Expense On its PBT, Nestle has provided for tax expense ` 5,896.6 comprising current tax of ` 5,842.1 millions and deferred tax of ` 72.5 millions. 372 Financial Accounting for Management Profit after Taxation Finally Nestle has earned a net profit of ` 11,846.9 millions for the year 2014 which represents a marginal increase of ` 675.6 millions over 2013. This profit belongs to its shareholders and has been therefore been transferred to reserves and surplus. Appropriations towards dividend and general reserve out of it have been made there as seen earlier. Earnings per Share The bottom of the statement of profit and loss shows that Nestle has earned a basic and diluted EPS of ` 122.87 per ` 10 face value of a share as against previous year’s ` 115.87. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Can you guess what type of expenses might have been covered under the head corporate social responsibility expenses? If not refer to the annual report and find out. 2. Should profit on sale of real estate not be classified as other income? Argue. 3. Work out the ratio of ‘profit after taxation’ to ‘total revenue from operations’ for both the years. What do the results indicate? 4. What does the increase in EPS indicate? Discuss. 5. Consult your professor on basic and diluted EPS. To enrich your discussion, add your own ideas, thoughts and practical inputs. A BRIEF ON DEFERRED TAX ASSETS AND LIABILITIES You have seen above that an element ‘deferred tax liability-net’ appears in the balance sheet of Nestle. Here follows a brief thereon. While the corporates, as separate legal entities and their accounting disclosure requirements are being governed by the Companies Act, the income tax payable on their PBT is governed by the Income Tax Act, 1961. The act provides a detailed mechanism for calculating and determining the taxable income. It disallows certain expenses incurred by a company; allows certain expenses not when provided for but when actually paid, allows more than the amount incurred in certain cases and provides rebates and reliefs in a number of other cases. What it means is that in most cases the PBT as arrived at as per the profit and loss account is not the profit for tax purposes. The profit for tax purposes may be lower or higher than PBT as per the financial statements. Deferred tax assets and liabilities arise due to timing differences between the period of charging the expenses in the books and their actual allowance by the tax laws. For example, provision for contingencies gets tax deduction not in the year of provision but in the year of its actual outcome. Actual tax paid during the year of provision is more which is recovered on the happening of the outcome of the contingency. This leads to deferred tax asset in the year of provisioning. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 373 Likewise how depreciation, among others, leads to creation of deferred tax liability needs to be understood. Income tax act allows depreciation as per WDV method whereas the companies act allows the companies to charge depreciation as per SLM. You have seen earlier in the chapter on depreciation on fixed assets that WDV method results in a higher depreciation in earlier years and lower in lateral years while SLM results in lower depreciation in earlier years and higher in lateral years. However, total depreciation over the useful life of the fixed assets cannot be more than the depreciable amount of the fixed assets irrespective of the method adopted. What it means is that over the useful life of the assets, the company will be paying the same amount of tax presuming there is no change in the tax rates. Therefore, the tax advantage of earlier years will give way to a higher tax liability in later years, or in other words, company will just be deferring its tax liability leading to creation of deferred tax liability. In recent years there have been attempts by the accounting bodies the world over to elaborate the provision for tax into provision for current tax and that for deferred tax so as to bring the tax provision to as close to a provision on book profits, that is, profit before tax as per the statement of profit and loss, as possible. The ICAI has also issued AS-22 ‘Accounting for Taxes on Income’ to deal with the subject. The standard prescribes the principles and norms of standard accounting treatment of current and deferred taxes. A simple example will illustrate how to treat current and deferred taxes in the financial statements. Statement of Profit and Loss Profit before the following expenses and tax Depreciation Provision for contingencies PBT (Book profit) ` million 60.00 12.00 6.00 18.00 42.00 Depreciation allowable as per the income tax is ` 20 million. Provision for contingencies as per the income tax will be allowed as a deduction from income in the year it materializes and paid for actually. Tax rate has been assumed to be 30% for simplicity. Treatment of income tax is shown hereunder. A. Tax as per book profit B. Tax as per income tax: PBT (Book profit) Add: Provision for contingencies Less: Additional depreciation Taxable profit Tax thereon (current tax) ` million 12.60 PBT*0.30 (42.00*0.30) 20.00–12.00 42.00 6.00 48.00 8.00 40.00 12.00 40.00*0.30 C. Difference between tax as per income tax and book profit, former being lower D. Deferred taxes: Deferred tax liability on depreciation Deferred tax asset on provision for contingencies Net deferred tax liability 0.60 8*0.30 6*0.30 2.40 1.80 0.60 374 Financial Accounting for Management E. Statement of profit and loss: PBT (Book profit) Tax expense: • Current tax • Deferred tax PAT F. 42.00 12.00 0.60 Balance sheet, liabilities side: Non-current liabilities Deferred tax liability (net) 12.60 39.40 0.60 Purpose Served by AS-22 A perusal of deferred tax enables the various stakeholders to understand and analyse the magnitude of deferred tax and its impact on the future cash flows of the company. In the case of outstanding deferred tax liabilities the impact will be negative and in the case of outstanding deferred tax assets the impact will be positive. In the case of Nestle, Note-4 above shows the details of its accumulated deferred tax liabilities and assets. Nestle is having “Net Deferred Tax Liabilities” of ` 2,227.2 million outstanding as on 31st December, 2014. The negative impact of this liability in the future is going to be material in view of “Current Tax” of ` 5,824.1 million. The future cash flows are, therefore, likely to bear a significant adverse impact. CONCLUDING REMARKS Hopefully you have understood the annual report of Nestle well. You are now equipped with knowledge necessary to carry out financial analysis of Nestle or for that matter of any company. The next part of the book is devoted to financial statement analysis. First five chapters of that part illustrate the use of tools and techniques of analysis and the last chapter provides a wholesome model for a strategic and integrated financial analysis of Nestlé’s annual report 2014. However, before moving to that part we will study the other mandatory financial reports forming part of the annual report thus making its understanding complete. Knowledge gained in this chapter and the next chapter will enable you to carry out the analysis. Keywords n Bank overdraft n Diluted EPS n Nestle n Bonds n Dividend distribution tax n Notes to the financial n Changes in inventories of finished goods, work-inprogress and stock-in-trade n Corporate social responsibility n Deferred taxes Employee benefit plans n EPS n Exceptional items n Exchange differences n Indian GAAP statements n Profit from operations n Provision for Contingencies n Treasury bills Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 375 REPORT Nestle India Ltd., Annual Report, 2014 (www.nestle.in) exercises Ex. 1 GROUP PROJECT Form group of 3 to 4 members. Having understood the financial statements, together with notes thereto, of Nestle India Ltd., and after learning the tools and techniques of financial analysis in the next part of the book, you need to attempt a financial analysis of the company as per the ‘Model for Strategic and Integrated Managerial Financial Analysis of Annual Report’ provided in chapter 21 of that part. In case you choose a company of your choice for the purpose you are free to do that. In that case: 1. Develop a general understanding of the business of the company. 2. Identify the parental lineage/group affiliation of the company. 3. Develop some understanding of the industry it operates in, from the information available in the report or databases like Capitaline Plus or CMIE Prowess. 4. Familiarize yourself with the details about its directors, auditors, bankers, lending institutions, plant locations, corporate office, and so on. 5. Make a brief list of the above details. 6. Develop an understanding of the annual report of the company on the lines illustrated in this chapter in respect of Nestle. Find out if there are any exceptionally high items of expenses, capitalization of revenue expenditure or some extraordinary income, etc. If yes, make a brief summary thereof. This will be of use while carrying out the financial analysis. Prepare a project folder and place the list and summaries referred to above there. A copy of the annual report will be the last document in this folder. Seek the guidance of your professor wherever needed. This project will be further taken up in chapter 21. 376 Financial Accounting for Management Ex. 2 Decision making as Stakeholders Suppose you were a: a. Shareholder b. Prospective investor c. Investment adviser d. Corporate raider e. Senior employee f. Lending institution: • Already having lent • Approached to lend g. Supplier h. Customer i. Income tax officer Examine the financial statements of Nestle or your chosen company as above. Find out the information that serves your purpose, and identify what further information you will need for your decision making. Justify the use of the information found and information needed further. Ex. 3 MOC (Managerial Oral Communication) Group Assignment Having understood corporate financial statements well, you as the manager of section A comprising of 50 students of MBA first year course, are required to arrange a 30-minute PowerPoint presentation by each of the groups on their understanding of the financial statements of the company they chose as above. Take the help of your professor to form a panel of three students from section B. All the groups have to make the presentations before this panel in the presence of all the students of section A. after all the presentations are over the panel has to decide the winner group and the first and the second runners-up. Request your professor to lend his supervision to this exercise. Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 377 APPENDIX Employee Stock Option Plans 1. Introduction Employee Stock Option Schemes/ Plans (ESOS/ESOP) are fast emerging as yet another form of employee compensation to attract and retain the talented employees. Under the scheme, employees are given an option, that is, a right but no obligation, to subscribe at a future date a predetermined number of securities offered by the employer company or even its holding company at a predetermined price. Obviously the offer has to be at a discount to the market price of the security. ESOS passes through three distinct pheses: 1. Grant, that is, issue of options to the employees subject to vesting. 2. Vesting, that is, entitlement of the employee to subscribe to the securities against the granted options on a predetermined future date, subject to exercising. 3. Exercising, that is, making actual application for the securities along with application money within the specified exercise period after vesting is over. 2. The Accounting Treatment ESOS have implications for the share capital in the sense that the company will have a larger capital base in future when the options are exercised but the obligation has arisen in the present for such increase in capital. ESOS, therefore, affect the determination of EPS as we will see later in that chapter. SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 govern these two schemes. The accounting treatment of ESOS as prescribed by the SEBI is as under: WWW Visit www.sebi.gov.in for full guidelines. Click: legal framework > guidelines. 1. In respect of options granted during any accounting period, the accounting value of the options is treated as another form of employee compensation in the financial statements of the company. 2. The accounting value of options is equal to the aggregate, for overall employee stock options granted during the accounting period, of the intrinsic value of the option or, if the company so chooses, the fair value of the option. Intrinsic value means the excess of the market price of the share under ESOS over the exercise price of the option (including up –front payment, if any). Market price means the latest available closing price, prior to the date of the meeting of the Board of Directors, in which options are granted, on the stock exchange on which the shares of the company are listed. If the shares are listed on more than one stock exchange, then the stock exchange where there is highest trading volume on the said date is considered. Exercise price means the price payable by the employee for exercising the option granted to him under ESOS. Fair value of an option means the price that shall be calculated for that option in an arm’s length transaction between a willing buyer and a willing seller. The fair value is estimated using an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account as of the grant date the exercise price and expected life of the option, the current price in the market of the underlying stock and its expected volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option. 3. Where the accounting value is accounted for as employee compensation in accordance with the above, it is debited to deferred employee compensation expenses and credited to employee stock options outstanding, deferred expenses are amortised on a straight-line basis over the vesting period. 4. When an unvested option lapses by virtue of the employee not conforming to the vesting conditions after the accounting value of the option has already been accounted for as employee compensation, this accounting treatment is reversed by a credit to employee compensation expense equal to the amortized portion of the accounting value of the lapsed options and a credit to deferred employee compensation expenses equal to the unamortized portion. 5. When a vested option lapses on expiry of the exercise period, after the intrinsic/fair value of the option has already been accounted for as employee compensation, this accounting treatment is reversed by a credit to employee compensation expense and debit to employee stock options outstanding. 6. Employee Stock Options Outstanding appears in the Balance Sheet as part of Net Worth or Shareholders’ Equity. Deferred Employee Compensation will appear in the Balance Sheet as a negative item as part of Net Worth or Shareholders’ Equity, that is, under the head ‘Miscellaneous Expenditure Not W/O’. The accounting treatment specified above is illustrated through the following example: 378 ILLUSTRATION 1 Financial Accounting for Management EQUAL OPPORTUNITY EMPLOYER LTD. ACCOUNTING TREATMENT OF ESOS/ESOP Equal Opportunity Employer Ltd. granted 500 options on 1.4.2003 at ` 40 when the market price of the underlying share was ` 160. The vesting period is two and a half years. The maximum exercise period is one year. 150 unvested options lapsed on 1.5.2005. The company again granted 400 new options on 1.10.2005 at ` 150 when the market price of the underlying share was ` 325. The vesting period for these new options is two years. The maximum exercise period for them again is one year.300 old options were exercised on 30.6.2006 and 50 vested old options lapsed at the end of the exercise period, i.e., on 30.9.2006. Show the accounting treatment up to 31.3.2007. SOLUTION TO ILLUSTRATION 1 1.1 EQUAL OPPORTUNITY EMPLOYER LTD. ACCOUNTING TREATMENT OF ESOS/ESOP All amounts in rupees Year 2003-04: The accounting value ( intrinsic value in this case) of the options is: 500 x (160-40) = 500 x 120 = ` 60,000 Journal 1/4/2003 Dr… Deferred Employee Compensation Expenses 60,000 Cr… Employee Stock Options Outstanding 60,000 (Grant of 500 options at a discount of ` 120 each) 31.3/2004 Dr… Employee Compensation Expenses 24,000 Cr… Deferred Employee Compensation Expenses 24,000 (Amortisation of the deferred compensation expenses over two and a half years on straight-line basis) Ledger A/C…Deferred Employee Compensation Expenses 1/4/2003 31.3/2004 To Employee Stock Options Outstanding: grant of 500 options Dr. 60,000 By Employee Compensation Expenses: amortisation for one year Total… Cr. 60,000 Balance Dr. 60,000 24,000 Dr. 36,000 24,000 Dr. 36,000 60,000 Cr. 60,000 60,000 Cr. 60,000 A/C…Employee Stock Options Outstanding 1/4/2003 By Deferred Employee Compensation Expenses: grant of 500 options Total… … 379 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes A/C…Employee Compensation Expenses 31/3/2004 To Deferred Employee Compensation Expenses: amortisation for one year 24,000 Total… 24,000 … Dr. 24,000 Dr. 24,000 Profit and Loss A/C EXPENDITURE: Employee Compensation Expenses (amortised) 24,000 Balance (loss) taken to balance sheet (24,000) Balance Sheet SOURCES OF FUNDS: Share Capital/Reserves and Surplus: Employee Stock Options Outstanding: 500 options granted during the year 60,000 Total 60,000 APPLICATION OF FUNDS: Miscellaneous Expenditure (to the extent not written off) n Deferred Employee Compensation Expenses: Accounting value of options issued during the year 60,000 Less: Amortized for one year 24,000 Balance n 36,000 Balance in profit and loss a/c 24,000 Total SOLUTION TO ILLUSTRATION 1 1.2 60,000 EQUAL OPPORTUNITY EMPLOYER LTD. ACCOUNTING TREATMENT OF ESOS/ESOP All amounts in rupees Year 2004–05: Journal 31/3/2005 Dr… Employee Compensation Expenses Cr… Deferred Employee Compensation Expenses (Amortization of the deferred compensation expenses over two and a half years on straight-line basis) 24,000 24,000 380 Financial Accounting for Management Ledger A/C…Deferred Employee Compensation Expenses 1/4/2004 To balance b/f 31.3/2005 By Employee Compensation Expenses: amortization for one year Dr. Cr. 36,000 Total… 36,000 Balance Dr. 36,000 24,000 Dr. 12,000 24,000 Dr. 12,000 60,000 Cr. 60,000 60,000 Cr. 60,000 Dr. 24,000 Dr. 24,000 A/C…Employee Stock Options Outstanding 1/4/2004 By balance b/f Total… … A/C…Employee Compensation Expenses 31/3/2005 To Deferred Employee Compensation Expenses: amortization for one year 24,000 Total… 24,000 … Profit and Loss A/C EXPENDITURE: Employee Compensation Expenses (amortized) 24,000 Dr. Balance in profit and loss a/c b/f 24,000 Balance (loss) taken to balance sheet (48,000) Balance Sheet SOURCES OF FUNDS: Share Capital/Reserves and Surplus: Employee Stock Options Outstanding: 60,000 Total 60,000 APPLICATION OF FUNDS: Miscellaneous Expenditure (to the extent not written off) n Deferred Employee Compensation Expenses: Balance as per last year 36,000 Less: Amortized for one year 24,000 Balance n 12,000 Balance in profit and loss a/c 48,000 Total 60,000 381 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes SOLUTION TO ILLUSTRATION 1 1.3 EQUAL OPPORTUNITY EMPLOYER LTD. ACCOUNTING TREATMENT OF ESOS/ESOP All amounts in rupees Year 2005–06: Journal 1/5/2005 Dr… Employee Stock Options Outstanding 18,000 Cr… Employee Compensation Expenses 14,400 Cr… Deferred Employee Compensation Expenses 3,600 (Reversal of compensation accounting on lapse of 150 unvested options) The accounting value of the new options is: 400 x (325-150) = 400 x 175 = ` 70,000 1/10/2005 Dr… Deferred Employee Compensation Expenses 70,000 Cr… Employee Stock Options Outstanding 70,000 (Grant of 400 new options at a discount of ` 175 each) 31/3/2006 Dr… Employee Compensation Expenses 8,400 Cr… Deferred Employee Compensation Expenses 8,400 (Amortisation of the deferred compensation expenses of 350 old options over two and a half years on straight-line basis) 31/3/2006 Dr… Employee Compensation Expenses 17,500 Cr… Deferred Employee Compensation Expenses 17,500 (Amortisation of the deferred compensation expenses of new options over two years on straight-line basis, current year for 6 months only)) Ledger A/C…Deferred Employee Compensation Expenses 1/4/2004 To balance b/f 1/5/2005 By Employee Stock Options Outstanding: 150 unvested options lapsed Dr. Cr. 12,000 3,600 Balance Dr. 12,000 Dr. 8,400 Dr. 78,400 1/10/2005 To Employee Stock Options Outstanding: grant of 400 new options 31.3/2006 By Employee Compensation Expenses: amortisation of 350 old options 8,400 Dr. 70,000 By Employee Compensation Expenses: amortisation of 400 new options for six months 17,500 Dr. 52,500 29,500 Dr. 52,500 31.3/2006 Total… 70,000 82,000 382 Financial Accounting for Management A/C…Employee Stock Options Outstanding 1/4/2005 By balance b/f 60,000 1/5/2005 To Employee Compensation Expenses: reversal on lapse of 150 old options 1/5/2005 To Deferred Employee Compensation Expenses: 150 unvested options lapsed 1/10/2005 By Deferred Employee Compensation Expenses: grant of 400 new options Total… Cr. 60,000 14,400 Cr. 45,600 3,600 Cr. 42,000 18,000 70,000 Cr. 1,12,000 1,30,000 Cr. 1,12,000 14,400 Cr. 14,400 Cr. 6,000 A/C…Employee Compensation Expenses 1/5/2005 By Employee Stock Options Outstanding: reversal on lapse of 150 old options 31/3/2006 To Deferred Employee Compensation Expenses : amortisation of 350 old options 8,400 31/3/2006 To Deferred Employee Compensation Expenses: amortisation of 400 new options for six months 17,500 Total… 25,900 14,400 Dr. 11,500 Dr. 11,500 Profit and Loss A/C EXPENDITURE: Employee Compensation Expenses 11,500 Dr. Balance in profit and loss a/c b/f 48,000 Balance (loss) taken to balance sheet (59,500) Balance Sheet SOURCES OF FUNDS: Share Capital/Reserves and Surplus: Employee Stock Options Outstanding: Balance as per last year 60,000 Less: Lapsed during the year 18,000 42,000 Add: new options granted during the year 70,000 Total…. 1,12,000 APPLICATION OF FUNDS: Miscellaneous Expenditure (to the extent not written off) n Deferred Employee Compensation Expenses: Balance as per last year 12,000 Add: Accounting value of new options issued during the year 70,000 82,000 Less: Options lapsed 8,400 73,600 Less: Amortized for one year: 1,12,000 383 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes Old options 3,600 New options 17,500 21,100 Balance n 52,500 Balance in profit and loss a/c 59,500 Total…. SOLUTION TO ILLUSTRATION 1 1,12,000 EQUAL OPPORTUNITY EMPLOYER LTD. ACCOUNTING TREATMENT OF ESOS/ESOP 1.4 All amounts in rupees Year 2006–07: Journal 30/6/2006 Dr… Bank 12,000 Dr… Employee Stock Options Outstanding 36,000 Cr… Equity Capital 3,000 Cr… Share Premium 45,000 (Exercise of 300 old options at an exercise price of ` 40 each and an accounting value of Rs 120 each) 01/10/2006 Dr... Employee Stock Options Outstanding 6000 Cr… Employee Compensation Expenses 6000 (Reversal of compensation accounting on lapse of 50 vested old options at the end of exercise period) 31/3/2007 Dr… Employee Compensation Expenses 35,000 Cr… Deferred Employee Compensation Expenses 35,000 (Amortisation of the deferred compensation expenses of new options over two years on straight-line basis,)) Ledger A/C…Deferred Employee Compensation Expenses 1/4/2006 To balance b/f 31/3/2007 By Employee Compensation Expenses : amortisation of new options for one year Dr. Cr. 52,500 Total… 52,500 Balance Dr. 52,500 35,000 Dr. 17,500 35,000 Dr. 17,500 384 Financial Accounting for Management A/C…Employee Stock Options Outstanding 1/4/2006 By balance b/f 1,12,000 30/6/2006 To equity capital and premium: 300 old options exercised 01/10/2006 To Employee Compensation Expenses: lapse of 50 old vested options Total… Cr. 1,12,000 36,000 Cr. 76,000 6,000 Cr. 70,000 1,12,000 Cr. 70,000 6,000 Cr. 6,000 Dr. 29,000 6,000 Dr. 29,000 Dr. 12,000 Dr. 12,000 3.000 Cr. 3.000 3.000 Cr. 3.000 45,000 Cr. 45,000 45,000 Cr. 45,000 42,000 A/C…Employee Compensation Expenses 1/10/2006 By Employee Stock Options Outstanding 31/3/2007 To Deferred Employee Compensation Expenses Total… 35,000 35,000 A/C…Bank 30/6/2006 To equity capital and premium 12,000 Total… 12,000 … A/C…Equity Capital 30/6/2006 By Bank and Employee Stock Options Outstanding: Exercise of 300 old options at an exercise price of ` 40 each and an accounting value of Rs 120 each Total… … A/C… Share Premium 30/6/2006 By Bank and Employee Stock Options Outstanding: Exercise of 300 old options at an exercise price of ` 40 each and an accounting value of Rs 120 each Total… … Profit and Loss A/C EXPENDITURE: Employee Compensation Expenses 29,000 Dr. Balance in profit and loss a/c b/f 59,500 Balance (loss) taken to balance sheet (88,500) Balance Sheet SOURCES OF FUNDS: Share Capital/Reserves and Surplus: n Equity capital: 300 shares of ` 10 each issued during the year n Employee Stock Options Outstanding: Balance as per last year 3,000 1,12,000 Less: Adjusted against issue of equity at premium 36,000 Less: 50 old vested shares lapsed during the year 6,000 Balance n 70,000 Share premium: on 300 equity shares @ ` 150 each issued during the year Total… 45,000 1,18,000 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes 385 APPLICATION OF FUNDS: Cash at Bank 12,000 Miscellaneous Expenditure (to the extent not written off) n Deferred Employee Compensation Expenses: Balance as per last year 52,500 Less: new options amortized for one year 35,000 Balance n 17,500 Balance in profit and loss a/c 88,500 Total…. 1,18,000 Disclosures in the Directors’ Report The SEBI guidelines require certain disclosures on ESOS/ESOP in the directors’ report. The same are being illustrated here with the case of Dabur India Ltd. for the year 2006–07. CASE 1 Dabur India Ltd. Dabur has made the following disclosures in its directors’ report. A perusal of these disclosures will enable you understand the SEBI requirements and their purpose. REPORT DABUR INDIA LTD. Annual Report 2006–2007 Disclosures on ESOP in the Directors’ Report Empolyees Stock Option Plan During the year 34,06,123 options in 9 trenches were granted to eligible employees of the Company in terms of Employees Stock Option Plan (Dabur ESOP 2000). During the year, 24,72,137 options were exercised by the employees after vesting. Accordingly, the Company made the allotment of 3,74,468 equity shares on 25th May, 2006, 3,50,514 equity shares on 21st August, 2006 and 17,47,155 equity shares on 13th March, 2007 against the options exercised by the employees. The particulars of options issued under the said Plan as required by SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 are appended as ‘Annexure-‘4’ and form part of this report. Annexure – ‘4’ Disclosure regarding Employees Stock Option Plan pursuant to the SEBI (Employees Stock Option Scheme and Employees Stock Purchase Scheme) Guidelines, 1999 and forming part of the Directors’ Report for the year ended 31st March, 2007. 386 Financial Accounting for Management S. No. Particulars For the year Cumulative 34,06,123 1,13,81,660 1. Number of Options granted 2. Pricing formula 3. Options vested 24,81,287 34,33,590 4. Options exercised 24,72,137 34,06,940 5. Total number of shares arising as a result of exercise of option 24,72,137 39,08,699 6. Options lapsed/Cancelled 15,00,862 18,50,112 7. Variation in terms of options None None 8. Money realized by exercise of options `24,72,137/- `38,90,399/- 9. Total number of options in force 61,24,608 61,24,608 10. I. II. Each option carries the right to the holder to apply for equity shares of the Company at par. Employees-wise details of options granted during the year to : Senior managerial personnel: During the year Mr. P.D. Narang Group Director – Corp. Affairs 542052 Mr. Sunil Duggal Chief Executive Officer 535907 Mr. Charanjit Mohan Executive Director – Operations 263497 Mr. V.S. Sitaram Executive Director – CCD 130208 Mr. Nitin Ghadiyar Executive Director – CHD 183614 Mr. N.Venkatakrishnan Executive VP – Commercial 154437 Mr. Jude Magima Executive VP – CPPD 192906 Mr. A. Sudhakar Executive VP – Human Resources 154437 Mr. Devender Garg Executive VP – Marketing (CCD) 188347 Mr. Rajan Varma Chief Financial Officer 122007 Mr. George Angelo VP – Sales 120000 Employees who received the options amounting to 5% or more of options granted during the year: Mr. P.D. Narang Group Director – Corp. Affairs 542052 Mr. Sunil Duggal Chief Executive Officer 535907 Mr. Charanjit Mohan Executive Director – Operations 263497 Mr. Nitin Ghadiyar Executive Director – CHD 183614 Chapter 14 Corporate Financial Statements of Nestle India Ltd Along With Notes III. 387 Mr. Jude Magima Executive VP – CPPD 192906 Mr. Devender Garg Executive VP – Marketing (CCD) 188347 Employees who received the options during the year equal to or exceeding 1% of the issued capital of the Company at the time of grant: None 11. Diluted earning per share (EPS) pursuant to issuance of options under ESOP 12. The Company had been using intrinsic value method of accounting ESOP expenses as prescribed by SEBI (Employees Stock Option Scheme and Employees Stock Purchase Scheme) Guidelines 1999, to account for stock options issued under Dabur ESOP 2000, the Company’s stock option scheme. Under this method, compensation expenses are recorded on the basis of excess of the market price of share at the date of grant of option over exercise price of the option. `2.90 As allowed by the above referred SEBI Guidelines the company has decided to continue to apply the intrinsic value method of accounting and the disclosure required as per Para 12(I) of the Guidelines are given herein below: (` in lacs) Net profit after tax, as reported in audited accounts 25207.63 Add: Stock Option compensation expenses charged in above reported profit 1035.37 Deduct: Stock option compensation expenses determined under fair value method (Black Scholes model) 1058.59 Net profit after tax, as adjusted 25184.41 Impact on profit (i.e. profit would have been lower by) 13. 23.22 Earning per share (`) Basic Diluted - As reported 2.93 2.90 - As adjusted 2.93 2.90 - Impact on EPS 0.003 0.003 Weighted average exercise price (per option) `1 Weighted average fair value of per option: (per Intrinsic value method) `119.84 (per black scholes model) `118.61 388 14. Financial Accounting for Management The fair value of each option is estimated using the Black Scholes model after applying the following weighted average assumptions: – Risk free interest rate – Expected life 6.27 1 to 5 years – Expected volatility 7.42% – Expected Dividend 175 – Price of underlying shares in the market at the time of option grant `120.84 15 Other Mandatory Financial Reports Corporate annual reports contain, in addition to financial statements, some other financial reports as well. Auditors’ report is an instrument of discharging attest function and expressing opinion about the truth and fairness of financial performance and position. Corporate governance report seeks to report the effectiveness with which the management is discharging its responsibility of running the corporate affairs. Management discussion and analysis report seeks to present the management’s analysis of the physical and financial performance of the company with a brief on future outlook. Report on CSR activities seeks to report the details of such activities together with the mandatory social spend. 390 Financial Accounting for Management CHAP T ER O BJ ECT I V ES This chapter seeks to enable you to develop knowledge and understanding of: 1 The purpose of auditors’ report, its coverage as per the requirements of the Companies Act and other related issues. 2 Qualifications in the auditors’ report and corporate financial practices related thereto. 3 The purpose of directors’ report, its coverage as per the requirements of the Companies Act and other related issues. 4 Corporate financial practices in respect of directors’ response, in their report, to auditors’ qualifications. 5 The objective and importance of corporate governance and contents of corporate governance report. 6 The management discussion and analysis report, its contents and significance. 7 The basic role, responsibilities and obligations of a company and its board of directors towards discharge of mandatory CSR activities. 8 Corporate financial practices in respect of corporate governance, MD&A and CSR activities through the case of Nestle India Ltd. INTRODUCTION A company’s annual report contains not only the financial statements, notes thereto and significant accounting policies followed in preparing them, but also certain other financial reports as well. The most common and statutorily required reports are as under: 1. Auditors’ report 2. Directors’ report 3. Corporate governance report and, within that or separately, Management discussion and analysis report. 4. Report on Corporate Social Responsibility (CSR) activities. We will cover the first two reports in this chapter and the third one in the next. The first two reports are mandated by the Companies Act. The first two and the fourth reports are mandated by the companies act and the third one by the stock exchange listing agreement. The auditors’ report is an instrument of discharging attest function and expressing opinion about the ‘truth and fairness’ of financial position and performance, conveyed by the financial statements, by the company auditors. Directors’ report is the annual score card of the management of the company, of their performance as reflected in the performance of the company, to its shareholders. Corporate governance report seeks to report the effectiveness with which the management is discharging its responsibility of running the corporate affairs transparently. Management discussion and analysis report seeks to present the management’s analysis of the physical and financial performance of the company with a brief on future outlook. Report on CSR activities seeks to report the details of such activities together with how the company has incurred the mandatory social spend of 2% of its profits. A discussion now follows on these reports and their respective requirements. Chapter 15 Other Mandatory Financial Reports 391 AUDITORS’ REPORT Requirements of the Companies Act Section 143 of the Companies Act 2013 deals with the auditors’ report and provides as under: 1. The auditor shall make a report to the members of the company on the accounts examined by him, and on every balance sheet and profit and loss account and on every other document, which is to be part of or annexed to the balance sheet or profit and loss account. 2. The report shall state whether, in his opinion and to the best of his information and according to the explanations given to him the said accounts: (a) Give the information required by the Companies Act in the Refer to 2015 edition of manner so required, and: Taxmann’s Companies Act (b) Give a true and fair view: 2013 for original text of n In the case of the balance sheet, of the state of the comparelevant requirements. ny’s affairs as at the end of its financial year, n In the case of the profit and loss account, of the profit or loss for that financial year, and n In the case of the cash flow statement, of the cash flows for that financial year. 3. The auditor’s report shall also state: (a) Whether he has obtained all the information and explanations, which to the best of his knowledge and belief were BIRD’S EYE VIEW necessary for the purposes of his audit. (b) Whether, in his opinion, proper books of account as required Auditor’s Report by law have been kept by the company so far as appears n Requirements of the Companies Act from his examination of those books, and proper returns n CARO adequate for the purposes of his audit have been received n Corporate Financial Practices from branches not visited by him. n Review of Nestlé’s Audit Report (c) Whether the report on the accounts of any branch office audited by a person other than the company’s auditor has been forwarded to him and how he has dealt with the same in preparing the auditors’ report. (d) Whether the company’s balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and returns. (e) Whether, in his opinion, the profit and loss account and balance sheet comply with the accounting standards. (f) In thick type or in italics the observations or comments of the auditors which have any adverse effect on the functioning of the company. (g) Whether any director is disqualified from being appointed as director under sub-section (2) of Section 164. The clause mentioned above disqualifies a person from being appointed as a company director if such person is already a director of a public company which: n Has not filed the annual accounts and annual returns for any continuous three financial years; or n Has failed to repay its deposit or interest thereon on due date or redeem its debentures on due date or pay dividend on due date and such failure continues for one year or more. 392 Financial Accounting for Management 4. Where any of the matters referred to in 2b or 3a to 3e above is answered in the negative or with a qualification, the auditor’s report shall state the reason for the answer. 5. The Central Government may direct that, in the case of such class or description of companies as may be specified, the auditor’s report shall also include a statement on such matters as may be specified therein. Companies (Auditors’ Report) Order, 2003 or CARO In pursuance of the requirement 5 above, the central government had issued ‘The Manufacturing and Other Companies (Auditors’ Report) Order, 1988 popularly known as MAOCARO. It was replaced in 2003 by a new order known as CARO. The matters to be reported in the auditors’ report were revised and substantially expanded thus placing greater responsibility upon the statutory BIRD’S EYE VIEW auditors. CARO n Applicability n Matters to be Included in the Auditor’s Report — Fixed assets — Inventory — Loans granted to/taken from companies and firms in which directors are interested — Internal control system — Transactions (other than loans) with companies and firms in which directors are interested — Public deposits — Internal audit system — Cost accounts and records — Statutory dues — Accumulated losses — Default in repayment of loans — Loans granted against securities (shares etc.) — Chit fund, Nidhi /mutual benefit fund/societies Applicability CARO is applicable to all companies except the following: 1. Banking, insurance and section 25 (not for profit) companies. 2. A private limited company, which at any point of time during the financial year, complies with the following: n Paid-up capital and reserves not more than rupees fifty lakh, n Loan outstanding not exceeding rupees twenty five lakh from any bank or financial institution, and n Turnover not exceeding rupees five crore. Matters to be included in the auditor’s report The auditor’s report shall include a statement on the following matters. 1. Fixed assets: a. Whether the company is maintaining proper records showing full particulars, including quantitative details and situation of fixed assets; b. Whether these fixed assets have been physically verified by the management at reasonable intervals; whether any material discrepancies were noticed on such verification and if so, whether the same have been properly dealt with in the books of account; and c. If a substantial part of fixed assets have been disposed off during the year, whether it has affected the going concern. 2. Inventory: a. Whether physical verification of inventory has been conducted at reasonable intervals by the management; b. Are the procedures of physical verification of inventory followed by the management reasonable and adequate in relation to the size of the company and the nature of its business? If not, the inadequacies in such procedures should be reported; Chapter 15 Other Mandatory Financial Reports 393 c. Whether the company is maintaining proper records of inventory — Companies dealing in and whether any material discrepancies were noticed on physical securities verification and if so, whether the same have been properly dealt — Third party guarantees with in the books of account. — Application of loans for the 3. Loans granted to/taken from companies and firms in which intended purpose directors are interested: — Use of short term funds for a. Has the company granted any loans, secured or unsecured to long term investment — Preferential allotment companies, firms or other parties covered in the register main— Creation of charge on tained under Section 301 of the Act. If so, give the number of debentures parties and amount involved in the transactions; — End use of public issue b. Whether the rate of interest and other terms and conditions of — Frauds loans given by the company, secured or unsecured, are prima n Reasons to be Stated for facie prejudicial to the interest of the company; Unfavourable or Qualified c. Whether repayment of the principal amount and interest are also Answers n Significance and Implications of regular; Auditor’s Report d. If overdue amount is more than Rupees one lakh, whether reasonable steps have been taken by the company for recovery of the principal and interest; e. Has the company taken any loans, secured or unsecured from companies, firms or other parties covered in the register maintained under section 301 of the Act. If so, give the number of parties and the amount involved in the transactions; f. Whether the rate of interest and other terms and conditions of loans taken by the company, secured or unsecured, are prima facie prejudicial to the interest of the company; and g. Whether payment of the principal amount and interest are also regular. 4. Internal control system: Is there an adequate internal control system commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods and services? Whether there is a continuing failure to correct major weaknesses in internal control system. 5. Transactions (other than loans) with companies and firms in which directors are interested: a. Whether the particulars of contracts or arrangements referred to in Section 301 of the Act have been entered in the register required to be maintained under that section; b. Whether transactions made in pursuance of such contracts and arrangements have been made at prices which are reasonable having regard to the prevailing market prices at the relevant time. (This information is required only in case of transactions exceeding the value of five lakh rupees in respect of any party and in any one financial year.) 6. Public deposits: In case the company has accepted deposits from the public, whether the directives issued by the Reserve Bank of India and the provisions of sections 58A and 58AA or any other relevant provisions of the Act and the rules framed there under, where applicable, have been complied with. If not, the nature of contraventions should be stated; If an order has been passed by Company Law Board or 394 Financial Accounting for Management National Company Law Tribunal or Reserve Bank of India or any court or any other tribunal whether the same has been complied with or not? 7. Internal audit system: In the case of listed companies and/or other companies having a paid-up capital and reserves exceeding ` 50 lakhs as at the commencement of the financial year concerned, or having an average annual turnover exceeding five crore rupees for a period of three consecutive financial years immediately preceding the financial year concerned, whether the company has an internal audit system commensurate with its size and nature of its business. 8. Cost accounts and records: Where maintenance of cost records has been prescribed by the Central Government under clause (d) of subsection (1) of section 209 of the Act, whether such accounts and records have been made and maintained. 9. Statutory dues: a. Is the company regular in depositing undisputed statutory dues including Provident Fund, Investor Education and Protection Fund, Employees’ State Insurance, Income Tax, Sales Tax, Wealth Tax, Service Tax, Custom Duty, Excise Duty, cess and any other statutory dues with the appropriate authorities and if not, the extent of the arrears of outstanding statutory dues as at the last day of the financial year concerned for a period of more than six months from the date they became payable, shall be indicated by the auditor. b. In case dues of income tax/ sales tax/service tax/custom duty/excise duty/cess have not been deposited on account of any dispute, then the amounts involved and the forum where dispute is pending may please be mentioned. (A mere representation to the Department shall not constitute the dispute). 10. Accumulated losses: Whether in case of a company which has been registered for a period not less than five years, its accumulated losses at the end of the financial year are not less than fifty per cent of its net worth and whether it has incurred cash losses in such financial year and in the immediately preceding financial year. 11. Default in repayment of loans: Whether the company has defaulted in repayment of dues to a financial institution or bank or debenture holders? If yes, the period and amount of default to be reported. 12. Loans granted against securities (shares etc.): Whether adequate documents and records are maintained in cases where the company has granted loans and advances on the basis of security by way of pledge of shares, debentures and other securities. If not, the deficiencies to be pointed out. 13. Chit fund, Nidhi/mutual benefit fund/societies: Whether the provisions of any special statute applicable to chit fund have been duly complied with? In respect of Nidhi/mutual benefit fund/societies: a. Whether the net-owned funds to deposit liability ratio is more than 1:20 as on the date of balance sheet; b. Whether the company has complied with the prudential norms on income recognition and provisioning against sub-standard/doubtful/loss assets; Chapter 15 Other Mandatory Financial Reports 395 c. Whether the company has adequate procedures for appraisal of credit proposals/requests, assessment of credit needs and repayment capacity of the borrowers; d. Whether the repayment schedule of various loans granted by the Nidhi is based on the repayment capacity of the borrower. 14. Companies dealing in securities: If the company is dealing or trading in shares, securities, debentures and other investments, whether proper records have been maintained of the transactions and contracts and whether timely entries have been made therein; also whether the shares, securities, debentures and other investments have been held by the company, in its own name except to the extent of the exemption, if any, granted under section 49 of the Act. 15. Third party guarantees: Whether the company has given any guarantee for loans taken by others from bank or financial institutions, the terms and conditions whereof are prejudicial to the interest of the company; 16. Application of loans for the intended purpose: Whether term loans were applied for the purpose for which the loans were obtained. 17. Use of short term funds for long term investment: Whether the funds raised on short-term basis have been used for long term investment; If yes, the nature and amount is to be indicated. 18. Preferential allotment: Whether the company has made any preferential allotment of shares to parties and companies covered in the Register maintained under Section 301 of the Act, and if so whether the price at which shares have been issued is prejudicial to the interest of the company. 19. Creation of charge on debentures: Whether security or charge has been created in respect of debentures issued? 20. End use of public issue: Whether the management has disclosed on the end use of money raised by public issues and the same has been verified. 21. Frauds: Whether any fraud on or by the company has been noticed or reported during the year; If yes, the nature and the amount involved is to be indicated. Reasons to be stated for unfavourable or qualified answers: Where, in the auditor’s report, the answer to any of the questions referred to above is unfavourable or qualified, the auditor’s report shall also state the reasons for such unfavourable or qualified answer, as the case may be. Where the auditor is unable to express any opinion in answer to a particular question, his report shall indicate such fact together with the reasons why it is not possible for him to give an answer to such question. Significance and implications of auditor’ report: The auditors’ report acts as a catalyst towards ensuring a better quality of financial performance and position and reporting thereof and financial discipline. Let us see how: 396 Financial Accounting for Management The auditors’ report is divided into two parts: 1. First part expressing the auditors’ view on true and fairness or otherwise of state of affairs of the company in the case of the balance sheet, profit in the case of profit and loss account and cash flows in the case of cash flow statement; and 2. Second part covering opinions, views and comments on certain matters, crucial to the functioning of the business and financial performance and position of the company, as specified by CARO. The aspects covered speak for themselves. An examination of the issues mentioned in these two parts and their implications for determining a true and fair profitability and state of affairs of the company clearly reveal that the auditors’ report acts as a catalyst towards ensuring the protection of the company’s assets, protection of the company’s interest in related party transactions, a better quality of financial performance and position and reporting thereof and financial discipline. The aspects covered establish clearly the role of auditors in contributing their might towards more effective corporate governance having direct impact on the creation and enhancement, or otherwise, of shareholders’ and other stakeholders’ value. The auditors are supposed to be the trustees of investors’ interest and their conduct of audit needs to be guided by this consideration. The readers may recall the cases of Enron and WorldCom where question marks were raised on the role of Arthur Anderson and which was put under scanner by the regulatory authorities. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Outline the basic purpose of auditors’ report. 2. Bring out the role of audit report in ensuring and improving financial discipline. To enrich your discussion, add your own ideas, thoughts and practical inputs. Corporate Financial Practices Given hereunder, for your understanding, are two cases of corporate financial practices in respect of qualifications in the auditors’ report. One of the cases has been drawn from Indo Rama Synthetics (India) Limited and the other one from Hindustan Motors Limited. Study these disclosures and answer the questions based on these cases at the end of this chapter. Chapter 15 Other Mandatory Financial Reports CASE 397 1 Indo Rama Synthetics (India) Limited REPORT CORPORATE FINANCIAL PRACTICES Indo Rama Synthetics (India) Limited. Annual Report 2000–2001 QUALIFICATIONS IN THE AUDITORS’ REPORT Extracts from the Auditors’ Report 3. Attention is drawn to Note No. 6 in Schedule 15 regarding non-provision of debts and interest receivable outstanding since long amounting to ` 429,073 thousands. As stated in the said Note, the Company has initiated legal action against some of the parties while it is also in the process of arriving at settlement with some of the other parties. In view thereof, the exact impact on the Company’s operational results for the year and on its accumulated losses as at the balance sheet date due to above non-provision is presently not ascertainable. Subject to our comments in para 3 above and also read with our comments in paras 1 and 2 above*, in our opinion and to the best of our information and according to the explanations given to us, the said statements of account, read together with the Notes appearing in Schedule “15”, give the information required by the Companies Act, 1956 in the manner so required and give a true and fair view: (i) In the case of Balance Sheet, of the state of affairs of the Company as at 31st March, 2001; and (ii) In the case of Profit and Loss Account, of the profit of the Company for the year ended on that date. *General report inclusions. Extracts from Schedule 15 on Notes on Accounts MANAGEMENT’S VIEWPOINT Note 6: Sundry Debtors amounting to ` 300,097 thousands (Previous year ` 226,705 thousands) are outstanding since long. No provision has been made there against since the management has initiated legal action in some of the cases while it is also in the process of arriving at settlement with some of these parties and is hopeful of recovering a substantial portion of the above amount. Also, no provision has been made against interest receivable on overdue debts amounting to ` 128,976 thousands (Previous year ` 130,293 thousands) which is outstanding since earlier years. Information on operational results of the company: ` in millions Loss before tax 2000–01 1999–00 1998–99 1997–98 –74 –79 –1,596 –873 Note: The loss for the year 2000-01 is after ignoring the effect of transfer of ` 261 millions from the revaluation reserve to the profit and loss account. Otherwise the reported profit is ` 187 million. No such transfer has taken place in the earlier years reported. 398 CASE Financial Accounting for Management 2 Hindustan Motors Limited REPORT CORPORATE FINANCIAL PRACTICES Hindustan Motors Limited Annual Report 2001–2002 QUALIFICATIONS IN THE AUDITORS’ REPORT Extracts from the Auditors’ Report (v) In our opinion, the Balance Sheet and the Profit & Loss Account have been drawn up in accordance with the Accounting Standards referred to in sub-section 3(c) of Section 211 of the Companies Act, 1956 except for Accounting Standard-2 with respect to the inclusion of CENVAT element in the inventories [Note 6(a) on Schedule 22] and Accounting Standard 15 in respect of following matters as indicated in Note nos. 6(b) to (d) on Schedule 22. (a) Non-provision of leave liability in respect of employees. (b) Non-provision of a part of gratuity liability. (c) Non-provision of future monthly compensation payments to the employees under Voluntary Early Retirement Scheme. (vi) Attention is drawn to the following notes on Schedule 22 whose impact on the Company’s Loss/Reserves is indicated in the respective notes below: (a) Note No. 6(a) regarding inclusive method of accounting followed by the company and consideration of cenvat element on inputs included in closing stock of finished goods, for the purpose of excise duty provision as on the Balance Sheet date, resulting into a net increase in loss for the year by ` 241.62 lacs (after adjusting ` 1392.49 lacs being the cenvat element included in the opening inventories). (b) Note No. 6(b) regarding non-provision of leave liability for employees amounting to ` 463.37 lacs, as the same is accounted for on cash basis. (c) Note No. 6(c) regarding non-provision of a part of gratuity liability amounting to ` 2663.16 lacs. (d) Note No. 6(d) regarding non-provision of future monthly compensation amounting to ` 1.618.83 lacs payable to the employees under Voluntary Retirement Scheme. (e) Note No. 9 regarding non-provision of doubtful/disputed debts, claims and advances aggregating to ` 890.76 lacs, the impact whereof on the company’s loss is presently not ascertainable. (f) Note No. 14(b) regarding pending approval for a part of the remuneration paid to the Managing/Executive Directors. (g) Note No. 15(a) regarding differential salary & wages (Amount unascertainable) for the period from 1st June 2000 to 8th February 2001, in respect of the employees of the erstwhile EED unit, pending finalisation of the agreement. Without considering item No. vi(e) to (g) above, whose impact on the Company’s loss/reserves is not presently ascertainable, and the impact of items vi(a) to (d) above been considered, the loss for the year would have been ` 9281.54 lacs (including ` 3247.60 lacs for earlier years) as against the reported loss of ` 3385.31 lakhs and the Profit & Loss Account Debit Balance would have been ` 69,55.83 lacs, as against the reported figures of ` 1059.60 lacs. Subject to the above and read together with other ‘Notes’ appearing on Schedule 22 the said Statements of Account, in our opinion and to the best of our information and according to the explanations given to us, give the information required by the Companies Act, 1956 in the manner so required and subject to Para (v) above, give a true and fair view in conformity with the accounting principles generally accepted in India: (a) In the case of Balance Sheet, of the state of affairs of the Company as at 31st March 2002; and (b) In the case of Profit & Loss Account, of the Loss of the Company for the year ended on that date. Chapter 15 Other Mandatory Financial Reports 399 EXTRACTS FROM SCHEDULE 22 ON ACCOUNTING POLICIES AND NOTES ON ACCOUNTS MANAGEMENT’S VIEWPOINT 6. The Company has duly complied with the Accounting Standards referred to in sub-section 3(c) of Section 211 of the Companies Act, 1956 except in respect of the following matters for reasons mentioned therein: (a) The Company, in view of the provisions of Section 145A of the Income Tax Act, 1961 has continued to follow the CENVAT inclusive method of accounting in respect of purchases, inventories, consumption etc. Further, as in the past, the amount of Cenvat element on inputs included in Closing Stock of finished goods as on the Balance Sheet date, although charged off to Revenue due to inclusive method of accounting, has been considered while making the provision for Excise duty at the close of the year, since the said amount remains recoverable with respect to the year end finished goods stock. Due to the above accounting method which is not in conformity with Accounting Standard 2, the loss for the year is higher by ` 241.62 lacs (after adjusting ` 392.49 lacs being the Cenvat element included in the opening inventories). (b) In the opinion of the management, Leave is meant to be availed of and the employees have been advised to plan their leave in advance while in service and also immediately before Superannuation. Accordingly, Leave Encashment liability for the year has been recognised and provided for only when such encashment was allowed. The quantum of unprovided leave liability on actuarial basis works out to ` 463.37 lacs (` 630.75 lacs) as on the Balance Sheet date. (c) The unprovided liability towards gratuity contribution to LIC, based on actuarial valuation, works out to ` 2,144.19 lacs (` 1304.30 lacs) as per premium amount demanded by LIC which would be covered through payments in future years, to ensure that the accrued gratuity liability is paid off as and when due to the employees. In addition, an amount of ` 518.97 lacs is required to be paid in respect of employees opted for VERS, which will also be accounted for as and when paid. (d) Compensation payable to employees, who have opted for the benefits under the Voluntary Early Retirement Scheme which envisages deferred payments on monthly basis, is being accounted for as and when payable. The present value of future monthly payments under the Scheme as on the Balance Sheet date as per actuarial valuation amounts to ` 1,618.83 lacs (` 329.05 lacs). 9. Disputed/Doubtful debts, claims and advances etc. aggregating to ` 890.76 lacs (` 982.56 lacs) have not been provided for, pending final settlement of relevant matters. However, the Company is hopeful to recover the above debts, claims etc. 14. (b) (i) The re-appointment of Managing Director for a period of 5 years with effect from 08-01-2002 is subject to the approval of Shareholders, although Central Government’s approval thereof is already received. (ii) In view of inadequate profits and/or revision of pay during the year, the remuneration to Managing & Executive Directors has exceeded the approval/ limits laid down under Schedule XIII of the Companies Act, 1956 by ` 7.39 lacs, which is subject to the approval of Shareholders/Central Government. 15. (a) The Company’s agreement with its employees at erstwhile Earthmoving Equipment Division (EED) at Trivellore had expired in May 2000. As per the terms of sale of said division, the liability for differential salaries and wages for the period from 1st June 2000 to 8th February 2001 would be borne by the Company. However, the above liability towards additional Salaries/Wages, being presently unascertainable, would be accounted for after finalisation of the said agreement with employees. Review of the Auditors’ Report of Nestlé Please go through the auditors’ report of Nestle India Ltd. for the year ended 31st December, 2014. Find out the compliance of the requirements of the companies act. 400 Financial Accounting for Management DIRECTORS’ REPORT Requirements of the Companies Act Section 134 of the Companies Act 2013 deals with the directors’ report and provides as under: 1. There shall be attached to every balance sheet laid before a company in general meeting, a report by its Board of directors, with respect to: Refer to 2015 edition of n The state of the company’s affairs. Taxmann’s Companies Act for original text of n The amounts, if any, which it proposes to carry to any reserves in relevant requirements. such balance sheet. n The amount, if any, which it recommends should be paid by way of dividend. n Material changes and commitments, if any, affecting the financial position of the company, which have occurred between the end of the financial year and the date of the report. n The conservation of energy; technology absorption, foreign exchange earnings and outgo. 2. The Board’s report shall, so far as it is material for the appreciation of the state of the company’s affairs by its members and will not in the Board’s opinion be harmful to the business of the company or any of its subsidiaries, deal with any changes, which have occurred during the financial year: n In the nature of the company’s business. n In the company’s subsidiaries or in the nature of their business; and n Generally in the classes of business in which the company has an interest. 3. The Board’s report shall also include a Directors’ Responsibility Statement, indicating therein: n That in the preparation of the annual accounts, the applicable accounting standards had been followed along with proper explaBIRD’S EYE VIEW nation relating to material departures. Directors’ Report n That the directors had selected such accounting policies and applied n Requirements of the Companies Act them consistently and made judgments and estimates that are reaas to Contents sonable and prudent so as to give a true and fair view of the state n Corporate Financial Practices of affairs of the company at the end of the financial year and of the n Review of Directors’ Report of Nestlé profit or loss of the company for that period. n That the directors had taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the provisions of this Act for safeguarding the assets of the company and for preventing and detecting fraud and other irregularities. n That the directors had prepared the annual accounts on a going concern basis. 4. The Board is also bound to give the fullest information and explanations in its report on every reservation, qualification or adverse remark contained in the auditors’ report. 5. The Board’s report has also to specify the reasons for the failure, if any, to complete the buy-back within the time specified. 6. The Board’s report shall also include a statement showing the name of every employee of the company who: n If employed throughout the financial year, was in receipt of remuneration for that year which, in the aggregate, was not less than the prescribed sum (` 24 lacs per annum with effect from 17.4.2002). Chapter 15 Other Mandatory Financial Reports 401 n If employed for a part of the financial year, was in receipt of remuneration for any part of that year, at a rate, which, in the aggregate, was not less than the sum, prescribed per month (` 2 lacs per month with effect from 17.4.2002). n If employed throughout the financial year or part thereof, was in receipt of remuneration in that year which, in the aggregate, or as the case may be, at a rate which, in the aggregate, is in excess of that drawn by the managing director or whole-time director or manager and holds by himself or along with his spouse and dependent children, not less than two per cent, of the equity shares of the company. The report will specify whether any such employee is a relative of any director or manager of the company and if so, the name of such director. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Outline the basic purpose of the directors’ report and its relevance for the various stakeholders. 2. Does the detailed list of employees drawing ` 2 lakh per month serve any purpose? Can this information be narrowed down? How? To enrich your discussion, add your own ideas, thoughts and practical inputs. Corporate Financial Practices In continuation with the cases of Indo Rama Synthetics (India) Limited and Hindustan Motors Limited, given hereunder for your understanding, are corporate financial practices followed by these two companies in respect of information and explanations provided by the directors, in their report, on the qualifications in the auditors’ report. Study these disclosures and answer the questions based on these cases at the end of this chapter. CASE 3 Indo Rama Synthetics (India) Limited CORPORATE FINANCIAL PRACTICES Indo Rama Synthetics (India) Limited Annual Report 2000–2001 Extracts from the Directors’ Report REPORT DIRECTORS’ EXPLANATIONS TO QUALIFICATIONS IN AUDITORS’ REPORT AUDITORS AND THEIR OBSERVATIONS M/s S.R. Batliboi & Company, Chartered Accountants, Auditors of the Company will retire at the forthcoming Annual General Meeting and are eligible for re-appointment. The observations of the Auditors referred to in the Auditor’s Report have been suitably explained in the Notes on Accounts. 402 CASE Financial Accounting for Management 4 Hindustan Motors Limited REPORT CORPORATE FINANCIAL PRACTICES Hindustan Motors Limited Annual Report 2001–2002 Extracts from the Directors’ Report DIRECTORS’ EXPLANATIONS TO QUALIFICATIONS IN THE AUDITORS’ REPORT (a) DIRECTORS’ RESPONSIBILITY STATEMENT The Board of Directors confirms that A. In the preparation of the annual accounts, for the year ended 31st March, 2002, all the applicable accounting standards prescribed by the Institute of Chartered Accountants of India have been followed, except the following accounting standard as stated below: * Accounting Standard 2—Valuation of inventories The Company, in view of the provisions of Section 145A of the Income Tax Act, 1961 continues to follow the Modvat/ Cenvat inclusive method of accounting in respect of purchases, consumption and inventories, as referred to in Note no. 6(a) of Schedule 22 to the Accounts. * Accounting Standard 15—Accounting for Retirement Benefits The practice being followed by the Company in respect of accounting for leave liability, contribution towards meeting gratuity liability and payments being made to employees who have opted for monthly payments under Voluntary Early Retirement Schemes, on cash basis have been referred to in Notes 6(b), (c) and (d), respectively, of Schedule 22 to the Accounts. Review of the Directors’ Report of Nestlé Please go through the directors’ report of Nestle India Ltd. for the year ended 31st December, 2014. Develop an understanding of the report. CORPORATE GOVERNANCE REPORT Objective and Importance of Corporate Governance On the objective of corporate governance, the landmark Kumar Mangalam Birla Committee report had observed as under: “Corporate governance has several claimants-shareholders and BIRD’S EYE VIEW other stakeholders-which include suppliers, customers, creditors, the Corporate Governance bankers, the employees of the company, the government and the society Report at large. The committee, therefore, agreed that the fundamental objective of corporate governance is the enhancement of shareholder value, n Objective and Importance of Corp-orate Governance keeping in view the interests of other stakeholders.” n Suggested List of Items for Yet another extract from the report underlines the need and imporCorporate Governance Report tance of corporate governance: n Non-mandatory Requirements “Strong corporate governance is (thus) indispensable to resilient n Review of Nestlé’s Report on and vibrant capital markets and is an important instrument of investor Corporate Governance protection”. Chapter 15 Other Mandatory Financial Reports 403 Corporate governance is ensured through various independent committees of the board of directors, such as, Audit Committee, Nomination and Remuneration Committee and Stakeholders’ Grievance Committee. The board itself has to be composed of independent directors in addition to the controlling management. Suggested List of Items for Corporate Governance Report At the behest of Securities and Exchange Board of India (SEBI), For full details of clause Clause 49 of the stock exchange listing agreement casts upon the list49, refer to the IPO listing ing companies responsibility to provide a report on corporate goverWWW agreement at http://www. nance as a part of annual report. Annexure XII to the listing agreement nse-india.com provides a suggested list of items to be included in the report which is as under: 1. A brief statement on company’s philosophy on code of governance. 2. Board of Directors: a. Composition and category of directors, for example, promoter, executive, nonexecutive independent non-executive, nominee director, which institution represented as lender or as equity investor. b. Attendance of each director at the Board meetings and the last AGM. c. Number of other Boards or Board Committees in which he/she is a member or Chairperson. d. Number of Board meetings held, dates on which held. 3. Audit Committee: a. Brief description of terms of reference b. Composition, name of members and Chairperson c. Meetings and attendance during the year 4. Nomination and Remuneration Committee: a. Brief description of terms of reference b. Composition, name of members and Chairperson c. Attendance during the year d. Remuneration policy e. Details of remuneration to all the directors, as per format in main report. 5. Stakeholders’ Grievance Committee: a. Name of non-executive director heading the committee b. Name and designation of compliance officer c. Number of shareholders’ complaints received so far d. Number not solved to the satisfaction of shareholders e. Number of pending complaints 6. General Body meetings: a. Location and time, where last three AGMs held. b. Whether any special resolutions passed in the previous 3 AGMs c. Whether any special resolution passed last year through postal ballot – details of voting pattern 404 Financial Accounting for Management d. Person who conducted the postal ballot exercise e. Whether any special resolution is proposed to be conducted through postal ballot f. Procedure for postal ballot 7. Disclosures: a. Disclosures on materially significant related party transactions that may have potential conflict with the interests of company at large. b. Details of non-compliance by the company, penalties, and strictures imposed on the company by Stock Exchange or SEBI or any statutory authority, on any matter related to capital markets, during the last three years. c. Whistle Blower policy and affirmation that no personnel have been denied access to the audit committee. d. Details of compliance with mandatory requirements and adoption of the non-mandatory requirements of this clause 8. Means of communication: a. Quarterly results b. Newspapers wherein results normally published c. Any website, where displayed d. Whether it also displays official news releases; and e. The presentations made to institutional investors or to the analysts. 9. General Shareholder information: a. AGM: Date, time and venue b. Financial year c. Date of book closure d. Dividend payment date e. Listing on stock exchanges f. Stock code g. Market price data: High., Low during each month in last financial year h. Performance in comparison to broad-based indices such as BSE Sensex, CRISIL index etc. i. Registrar and transfer agents j. Share transfer system k. Distribution of shareholding l. Dematerialization of shares and liquidity m. Outstanding GDRs/ADRs/Warrants or any Convertible instruments, conversion date and likely impact on equity n. Plant locations o. Address for correspondence Chapter 15 Other Mandatory Financial Reports 405 Non-mandatory Requirements Annexure XIII to the listing agreement prescribes the following non-mandatory requirements: 1. The Board A non-executive Chairman may be entitled to maintain a Chairman’s office at the company’s expense and also allowed reimbursement of expenses incurred in performance of his duties. 2. Shareholder Rights A half-yearly declaration of financial performance including summary of the significant events in last six-months, may be sent to each household of shareholders. 3. Audit Qualifications Company may move towards a regime of unqualified financial statements. 4. Separate posts of Chairman and CEO The company may appoint separate persons to the post of Chairman and Managing Director/CEO. 5. Reporting of Internal Auditor The Internal auditor may report directly to the Audit Committee. Review of Nestlé’s Report on Corporate Governance Please go through the Nestle India Ltd.’ report on corporate governance for the year ended 31st December, 2014. Develop an understanding of the report. Examine its compliance with the requirements of clause 49. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Outline the basic purpose of corporate governance. 2. Bring out the role of SEBI and clause 49 in ensuring good corporate governance. To enrich your discussion, add your own ideas, thoughts and practical inputs. MANAGEMENT DISCUSSION AND ANALYSIS REPORT Report and Its Contents As per clause 49, within the overall framework of corporate governance report, either as part of the directors’ report or as an addition thereto, a Management Discussion and Analysis (MD&A) report should form part of the annual report to the shareholders. The MD&A should include discussion on the following matters within the limits set by the company’s competitive position: BIRD’S EYE VIEW MD&A Report n Report and its Contents n Significance of MD&A n Review of Nestlé’s MD&A Report 406 1 2 3 4 5 6 7 8 Financial Accounting for Management Industry structure and development Opportunities and threats Segment-wise or product-wise performance Outlook Risks and concerns Internal control systems and their adequacy Discussion on financial performance with respect to operational performance Material developments in human resources/industrial relations, including number of people employed. Significance of MD&A A discussion on the above matters shows the importance of MD&A report. It is to be emphasized that MD&A report provides an overall condensed view of the industry in which the company operates, the position of the company in the industry, its strengths and weaknesses, opportunities available and threats and risks it faces, strategies of the company to exploit opportunities and fight threats, being the key drivers of top and bottom lines. It also gives an analysis of the financial performance and position as reported in the financial statements with reasons for changes therein with respect to major heads, which is otherwise not possible for lay investors to carry out; further analysis of performance by segments, so vital for the analyst; and the expected outlook of the company for the coming year in terms of growth in profitability to provide an indication of the future to enable shareholders and investors to take their decision to continue with the company, or exit or enter. The report also informs the stakeholders what steps the company is taking to improve its internal operational efficiencies and how it is taking care of its human capital, the two key internal drivers of bottom line of a company. The report thus helps stakeholders in understanding the key internal and external drivers of bottom line. Within the CGR, the overriding importance of MD&A report may be gauged from the following observations made by the Kumar Mangalam Birla Committee in its report: “Adequate financial reporting and disclosure are the cornerstones of good corporate governance. It is the blood that fills the veins of transparent corporate disclosure and high-quality accounting practices. It is the muscle that moves a viable and accessible financial reporting structure. Without financial reporting premised on sound, honest numbers, capital market will collapse upon themselves”. Most blue chips therefore present MD&A report point-to-point very distinctly in a separate section in their annual reports. Review of Nestlé’s MD&A Report Please go through the Nestle India Ltd.’ MD&A report, provided as a part of the corporate governance report, for the year ended 31st December, 2014. Develop an understanding of the report. Examine its compliance with the requirements of clause 49. Chapter 15 Other Mandatory Financial Reports 407 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Outline the basic purpose of MD&A Report. 2. Should the MD&A report be presented separately or as part of corporate governance report as done by Nestle? To enrich your discussion, add your own ideas, thoughts and practical inputs. REPORT ON CORPORATE SOCIAL RESPONSIBILITY (CSR) ACTIVITIES Requirements of the Companies Act, 2013 For the first time in the world, a state, India, has introduced a mandatory obligation on the corporate sector to discharge social responsibility through the Companies Act, 2013 Refer to 2015 edition of effective April 1, 2014. Mandatory CSR norms are governed by the folTaxmann’s Companies lowing regulatory framework under the newly enacted Companies Act, Act, 2013 for original text 2013: of relevant requirements. a. Relevant sections of the act: 134, 135, 166 and 198. b. Schedule VII of the act, and c. Companies (Corporate Social Responsibility Policy) Rules, 2014 Within this regulatory framework, the Companies Act casts basic role, responsibilities and obligations of a company and its board of directors towards disBIRD’S EYE VIEW charge of CSR. Accordingly every company having a net worth of INR 500 crore or more, or turnover of INR 1,000 crore or more, or net profit Report on Corporate of INR 5 crore or more, during any financial year needs to spend 2% of Social Responsibility its net profits on social activities. Schedule VII of the act specifies the (CSR) Activities activities that could be undertaken towards this purpose. These activities n Requirements of the Companies are: Act, 2013 n Review of Nestlé’s Report on a. Poverty alleviation and healthcare CSR Activities b. Promoting education c. Promoting gender equality d. Ensuring environmental sustainability e. Protection of national heritage, art and culture f. Measures for the benefit of armed forces veterans, war widows and their dependents. g. Promoting sports h. Contribution to various government relief funds i. Technology incubation j. Rural development projects. 408 Financial Accounting for Management Companies (Corporate Social Responsibility Policy) Rules, 2014 make detailed rules and specify processes for the discharge of CSR obligations cast by the act. These rules require a company to provide annual report covering the following: 1. A brief outline of the company’s CSR policy, including overview of projects or programs proposed to be undertaken and a reference to the web-link to the CSR policy and projects or programs. 2. The Composition of the CSR Committee. 3. Average net profit of the company for the last three financial years. 4. Prescribed CSR Expenditure (two percent of the average net profit). 5. Details of CSR amount spent during the financial year: a. Total amount to be spent for the financial year; b. Amount unspent, if any; c. Manner in which the amount was spent during the financial year (project/program/activity wise): n CSR project or activity identified n Sector/s in which the project is covered n Projects or programs (Local area or others. The states and districts where projects or programs were undertaken to be specified). n Amount outlay (budget) project or programs wise n Amount spent on the projects or programs’ Sub-heads (Direct expenditure on projects or programs, Overheads). n Cumulative expenditure up to the reporting period n Amount spent directly or through implementing agency (Details of the implementing agency to be given) n Total amount spent 6. In case the company has failed to spend the two per cent, of the average net profit of the last three financial years or any part thereof, the company shall provide the reasons for not spending the amount in its board report. 7. A responsibility statement of the CSR Committee that the implementation and monitoring of CSR Policy, is in compliance with CSR objectives and policy of the company. Review of Nestlé’s Report on CSR Activities Please go through the Nestle India Ltd.’ report on CSR activities for the year ended 31st December, 2014. Develop an understanding of the report. Examine its compliance with the requirements of the companies act. Chapter 15 Other Mandatory Financial Reports 409 BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Should corporates be dictated to spend on CSR activities? Should they be forced to step in where the government fails in discharging its responsibilities? 2. What use the CSR report is for various stakeholders? To enrich your discussion, add your own ideas, thoughts and practical inputs. CONCLUDING REMARKS We studied above the role and importance of auditors’ report in ensuring financial discipline in a company and the directors’ responsibility towards ensuring that financial statements are drawn in accordance with the requirements of accounting standards and other statutory norms. Directors are also required to respond to the audit qualifications, if any, in their report and to make a declaration about fulfilment of their responsibility towards quality of financial statements. We also studied the role and importance of corporate governance report, MD&A report and CSR report. Obviously, these five reports form the backbone of financial accounting, reporting and analysis. We now move over to part five on financial statement analysis. Keywords n Annual Report n Directors’ Report n Nomination Committee n Audit Committee n Directors’ Responsibility n Proper Books of Account n Auditors n Auditors’ Report n Buy-back n CARO n Clause 49 n CSR Activities n CSR Committee n CSR Policy n CSR Report n Corporate Governance Report Statement n Finance, Investment, Chit Fund, Nidhi or Mutual Benefit Company n Going Concern Basis n Independent Directors n Kumar Mangalam Birla Committee n Listed Companies n MAOCARO n MD&A Report n Qualifications in the Auditors’ Report n Remuneration Committee n Stakeholders’ Grievance Committee n Shareholder Value n True and Fair View 410 WWW Financial Accounting for Management 1. Listing Agreement, National Stock Exchange, www.nse-india.com 1. Taxmann’s Companies Act 2013, Taxmann Allied Services (P.) Ltd., New Delhi, 2015. 2. Guide to the Companies Act, A. Ramaiya, Wadhwa and Company, Nagpur, Latest Edition, 2006. 3. The Manufacturing and Other Companies (Auditor’s Report) Order, 1988. 4. Companies (Auditor’s Report) Order, 2003. REPORT 1. Indo Rama Synthetics (India) Ltd., Annual Report, 2000–01. 2. Hindustan Motors Ltd., Annual Report, 2001–02. 3. Nestlé India Ltd., Annual Report, 2014. exercises Ex. 1 CASE 1 Case on Corporate Financial Practices—Qualifications in Auditors’ Report—Indo Rama Synthetics (India) Limited Refer to the extracts from the annual report 2000–2001 of Indo Rama Synthetics (India) Limited regarding qualifications in its auditors’ report, management’s viewpoint and directors’ explanations on these qualifications in board’s report as illustrated in this chapter. Analyse the case and attempt the following requirements: 1. Is it justified on the part of the company not to make provision for long outstanding dues? Cannot a best judgement estimate be made? Or it is because of losses that they have not made the provision? Chapter 15 Other Mandatory Financial Reports 411 2. The company itself admits that the dues are outstanding since long. Should it then not specify the period, for a better assessment of their recoverability and impact on financial results? 3. Are the explanations offered by the management, and accepted by the auditors, regarding the non-ascertainability of the likely impact of these outstandings on the operational results of the company tenable? 4. In view of the details about the continuous losses suffered by the company over the past years, are the auditors justified in expressing their opinion that the accounts represent a true and fair view? 5. In your view, is the disclosure of directors’ explanation in the board report adequate? Ex. 2 CASE 2 Case on Corporate Financial Practices—Qualifications in Auditors’ Report—Hindustan Motors Limited Refer to the extracts from the annual report 2001–2002 of Hindustan Motors Limited regarding qualifications in its auditors’ report, management’s viewpoint and directors’ explanations on these qualifications in the board’s report as illustrated in this chapter. Analyse the case and attempt the following requirements: 1. Don’t you think that reasonable estimates of the extent to which doubtful/disputed debts could become bad and of the liability towards additional salary and wages can be made so that they could be recognized in the financial statements? What could be the motives of the company in not doing so? 2. Are the explanations offered by the management, and accepted by the auditors, regarding the non-ascertainability of the likely impact of these outstandings on the operational results of the company justified? 3. It has been reported that due to various non-provisionings, loss for the year would have been ` 9,281.54 lakh (including ` 3,247.60 lakh for earlier years) as against the reported loss of ` 3,385.31 lakh. The difference amounts to a whopping ` 5,896.23 lakh. Is it still a true and fair view as expressed by the auditors? Is it justified? 4. In your view, is the disclosure of directors’ explanation in the board report adequate? Ex. 3 WAC (Written Analysis and Communication) Exercise Recall Exercise 1 of Chapter 7. The MD, Mr. G. C. Gupta is now interested in understanding the coverage of auditors’ report, directors’ report, corporate governance report, MD&A report and CSR report for obvious reasons. He requests the CFO, Mr. Lokesh Gupta, to prepare in brief a report, not exceeding five A4-size pages with adequate margins and normal space between the paragraphs. Required: Suppose you were the CFO. Please prepare the report. Business reports need to be brief and precise. They also need to be drafted in a simple language devoid of any technical jargon to the best possible extent. Keep these considerations in mind while preparing the list. 412 Financial Accounting for Management Ex. 4 MOC (Managerial Oral Communication) Group Assignment Having understood the contents of this chapter, you, as the manager of Section B comprising of 50 students of MBA 1st year course, are required to form groups of five students each. Include yourself in one of the groups. All the groups have to prepare a 20-minute Powerpoint presentation on the contents of this chapter. Take the help of your professor to form a panel of three students from Section A. All the groups have to make the presentation before this panel in the presence of all the students of Section B. After all the presentations are over, the panel has to decide the winner group and the first and second runners-up. Request your professor to lend his supervision to this exercise. PART 5 FINANCIAL STATEMENT ANALYSIS Chapter 16: QUALITY OF EARNINGS: WINDOW DRESSING, CREATIVE FINANCIAL PRACTICES AND ISSUES RELATED TO QUALITY OF DISCLOSURES IN REPORTED EARNINGS Chapter 17: FINANCIAL STATEMENT ANALYSIS AND THE TOOL KIT OF THE ANALYST: I MULTI-STEP, HORIZONTAL, VERTICAL, AND TREND ANALYSES AND ANALYTICAL BALANCE SHEET Chapter 18: FINANCIAL STATEMENT ANALYSIS AND THE TOOL KIT OF THE ANALYST: II EARNINGS PER SHARE (EPS) ANALYSIS Chapter 19: FINANCIAL STATEMENT ANALYSIS AND THE TOOL KIT OF THE ANALYST: III RATIO ANALYSIS Chapter 20: CONSTRUCTION AND ANALYSIS OF CORPORATE CASH FLOW STATEMENT Chapter 21: MODEL FOR STRATEGIC AND INTEGRATED MANAGERIAL FINANCIAL ANALYSIS OF ANNUAL REPORT 16 Quality of Earnings: Window Dressing, Creative Financial Practices and Issues Related to Quality of Disclosures in Reported Earnings Window dressing of financial statements is resorted to by the managements to portray a rosier performance and financial position of the company than actuals to suit their motives. An analyst needs to beat window dressing for a meaningful assessment of the quality of earnings. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 415 CHAP T ER O BJ ECT IVES This chapter seeks to enable you to develop knowledge and understanding of: 1 What is quality of earnings and its significance in evaluating corporate performance. 2 Limitations of financial statements caused by leverage provided by GAAPs and window dressing. 3 Creative accounting/creative financial practices resorted to by the corporates. 4 Impact of other income/extraordinary items on profits and corporate financial practices in respect thereof. 5 How to beat window dressing. 6 Some specific issues in quality of disclosures in reported earnings. 7 Care in financial analysis needed to be taken by the analyst. 8 The regulatory efforts in ensuring quality of earnings. So that you are in a position to effectively carry out financial analysis. INTRODUCTION As noted in the earlier chapters of the book we will devote this part to strategic and integrated managerial analysis of corporate financial statements and other financial reports forming part of a corporate annual report. Analysis is carried out with certain objectives and purposes, which we will discuss in the next chapter. There are certain tools and techniques of analysis, which will also be covered in the chapters that follow. However, before we study the objectives, purpose, tools and techniques of analysis, we need to understand what is quality of earnings, how it is affected by creative financial practices and how the financial statements are window dressed to present a picture different than the reality. We will take up these issues in this chapter. QUALITY OF EARNINGS BIRD’S EYE VIEW The main objective of financial statements is to provide information about the financial position, performance and cash flows of an enterprise to enable a stakeholder to fairly predict the future profitability and cash flows of the enterprise so as to make decisions regarding the enterprise or its shares. This is possible only when the reported earnings are of a high quality, which in turn means that they are recognised and measured in accordance with GAAPs, derived from the core business operations of the enterprise and are close to reality, that is, neither overstated nor understated. Thus, earnings are said to be of high quality when they possess the following features: (a) Derived from core business operations; (b) Recognised, measured and presented in accordance with GAAPs; (c) Principal qualitative characteristics of financial statement preparation adhered to; Quality of Earnings n Introduction n Quality of Earnings n Limitations of Financial Statements n Leverage Provided by GAAPs n Window Dressing n Creative Accounting/Creative Financial Practices n Impact of Other Income and Exceptional/Extraordinary Items n Beating Window Dressing n Specific Issues in the Quality of Disclosures in Reported Earnings n Further Care in Analysis n Regulatory Efforts in Ensuring Quality of Earnings 416 Financial Accounting for Management (d) Accounting policies chosen, where GAAPs allow choice, consistently followed; (e) Close to reality, i.e. neither overstated nor understated; (f ) High chances of continuation and sustenance of the past earnings in future; and thus (g) A fair prediction of future profitability and cash flows possible. LIMITATIONS OF FINANCIAL STATEMENTS Quality of earnings, however, suffers from certain limitations of financial statements. These limitations stem basically from two sources: 1. Leverage provided by GAAPs in the choice of accounting policies and changes therein; 2. Window dressing in accounts and financial statements. A discussion on these issues follows. Leverage Provided By GAAPs GAAPs provide leverage to the management in influencing the bottom line in two ways: 1. The accounting standards permit the management choice between alternative accounting policies in certain areas. These have been pointed out by AS-1 itself as seen in Chapter 5. Choices and discretion are available in the following areas: n Valuation of fixed assets n Methods of depreciation n Assets under finance lease n Treatment of intangible assets and their amortisation n Impairment of assets n Valuation of inventories n Recognition of profit on long-term contracts n Valuation of investments n Treatment of contingent liabilities n Cash flow statements n Segment Reporting These are just the more common areas where alternatives are available. These have been discussed at length in different chapters earlier. 2. AS-5 allows the management changes in accounting policies “when change is considered to result in a more appropriate preparation or presentation of the financial statements of the enterprise.” While the provision is well intended it leaves the management with a handle to justify the appropriateness of its decision to effect Visit www.icai.org for a change suiting to its own requirements. See, for example, the cases original text of AS-1 and WWW AS-5. Click: Resources— of Cadila Healthcare Ltd. and Liberty Shoes Ltd. on extension of the accounting year which follow a little later. Accounting Standards. It is clear from the above discussion that even within the framework of GAAPs it is possible for the management to fabricate the bottom Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 417 line, thus affecting the quality of earnings and making it difficult for the analyst to predict the future profitability of the company. Window Dressing Please recall the ‘qualitative characteristics of financial statements’ discussed earlier in Chapter 4 ‘Conceptual Framework of Financial Statements’. One or the other of these characteristics is ruined by what is known as window dressing. Financial statements are said to be widow dressed when the management tries to portray a rosier performance and financial position of the company than is true, to suit its motives. The motives could be to fetch a better price for its IPO or merger, borrowing from financial institutions, to protect the image of the company or to get better remuneration from the promoters in case the ownership and management are different. The list is endless. Window dressing may take many forms, for example: 1. Non-operational/non-recurring income being the major source of income. For example, sale of investments or fixed assets. Hence the need to look at the details of ‘other income’. 2. Non-provision of diminution in the value of long-term investments due to discretion available to the management. 3. Capitalisation or deferment of revenue expenses to inflate the bottom line. 4. Revaluation of fixed assets to show a better financial position. 5. Extention of the accounting year to cover up a major loss or to include a major likely gain of immediately following 2–3 months. 6. Advancing the billing on the customers towards the year-end to inflate the top line as well as the bottom line. 7. Inadequate or no provision for doubtful debts to inflate the financial position and the bottom line. 8. Increasing the estimates of useful life of fixed assets to charge a lower depreciation. 9. No separate disclosure of prior-period adjustments or extraordinary income. This is merely an illustrative list and not an exhaustive one. In fact, the dimensions of window dressing are as diverse and varied as human ingenuity. You may recall the cases of Indo-Rama Synthetics Ltd. and Hindustan Motors Ltd. demonstrated in an earlier chapter on “Other Financial Reports 1: Auditors………….”. You may realize that they are related to window dressing. However, the discussion there was from the perspective of the responsibilities of auditors and management. Revisit them and explore them from the angle of window dressing now. CREATIVE ACCOUNTING/CREATIVE FINANCIAL PRACTICES Hereunder are given some live cases of window dressing resorted to by various companies by adopting creative accounting or creative financial practices and management discretion available in many areas as pointed earlier. Go through them very carefully and attempt the exercises based on them given at the end of the chapter. Non-provision of Diminution in the Value of Long-term Investments Here are extracts from the annual report of Liberty Shoes Ltd. for the years 1994–95 to 2000–01 on the issue. 418 CASE Financial Accounting for Management 1 Liberty Shoes Ltd. CREATIVE FINANCIAL PRACTICES LIBERTY SHOES LTD. Extracts from the Schedules of Significant Accounting Policies and Notes on Accounts from Annual Reports REPORT INVESTMENT IN JOINT VENTURE: LIBERTY & NINO, RUSSIA NON-PROVISION OF DIMINUTION IN THE VALUE OF LONG-TERM INVESTMENTS Annual Report 1994–95: Note 10 The company has made an investment of ` 1,67,73,640/- under a joint venture with Liberty & Nino, Russia. No trading/ manufacturing activities are being carried out by the joint venture. The Company has taken steps for realization of the investment and the realisable value is not ascertainable. Annual Report 1995–96: Note 6 The Company had made an investment of ` 1,67,73,640/- under a joint venture agreement with Liberty & Nino, Russia. No trading/manufacturing activities have been carried out by the Joint Venture during the year. The Company has taken steps for realisation of the investment and the realisable value is not ascertainable. Annual Report 1996–97 The Company had made an investment of ` 1,67,73,640,/- under a joint venture Agreement with Liberty & Nino, Russia. No trading/manufacturing activities have been carried out by the Joint Venture during the year. The Company has taken steps for realisation of the investment and the realisable value is not ascertainable. Annual Report 1997–98: Note 5 The Company has made an investment of ` 1,67,73,640/- in joint venture Liberty & Nino, Russia. During the year, the credit balance of ` 16,12,259/- has been adjusted. Further the Company has taken steps for the realisation of the remaining investment. However, the realisable value is not ascertainable. Annual Report 1998–99: Note 5 The Company has made an investment of ` 1,51,61,380/- in joint venture Liberty & Nino, Russia. The Company has taken steps for the realisation of the same. However, the realisable value is not ascertainable. Annual Report 1999–2000: Note 5 The Company has made an investment of ` 1,67,73,640/- in joint venture M/s. Liberty & Nino at Russia. During the year 1997-98, the outstanding balance of this joint venture to the extent of ` 16,12,259 has been adjusted in the books of the Company. For the realisation of the remaining amount of ` 1,51,61,380/-, the company has been pursuing its efforts with the concerned authorities. However, as on date its realisable value is not ascertainable. Annual Report 2000-01: Note 5 The Company has made an investment of ` 1,51,61,380/- in joint venture M/s.Liberty and Nino in Russia as on 31st March, 2001. Considering the closure of business of the joint venture and moreover the uncertainty of its realisable value, the Board of Directors of the Company has decided to make provision for the diminution in the value of investment in the books of accounts. The Company has also approached Reserve Bank of India for their approval to write off the amount of investment in the books. However the company would continue its efforts to realise the investment along with the accrued profits with the concerned authorities. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 419 Extracts from the profit and loss account: (Amount in `) Particulars 31-03-2001 for 9 months 30-06-2000 for 15 months Profit before extraordinary items and tax 7,24,75,935 12,45,90,959 Extraordinary loss due to provision made for diminution in value of investment 1,51,61,380 - Profit after extraordinary items but before tax 5,73,14,555 12,45,90,959 Provision for taxation 1,30,50,000 3,20,00,000 Profit after Tax 4,42,64,555 Schedule 6 to the balance sheet: 9,25,90,959 (Amount in `) 31-03-2001 for 9 months 30-06-2000 for 15 months 1,51,61,380 1,51,61,380 INVESTMENTS (Valued at Cost) (a) Joint Venture Liberty & Nino at Russia (Unquoted) Less: Provision for diminution in value 1,51,61,380 — Total (a) — 1,51,61,380 4,22,561 4,22,561 Total (b) 4,22,561 4,22,561 Total (a+b) 4,22,561 1,55,83,941 4,46,125 4,73,774 (b) 16.25% of ICICI Regular income Bonds, 1997 (Quoted) Market Value of Quoted Investments Extracts from the directors’ report: The decline in the profit margin is primarily due to trading operations having lesser margin, which the Company carried during the year under review. But, these trading operations have now been discontinued. The other significant reason, which can be attributed to this decline is provision for the diminution in the value of the Company’s investments in Joint Venture, Liberty & Nino in Russia. Your Directors were compelled to resort to this step considering the closure of the operations of the Joint Venture in 1994 and uncertainty of the value of the investment. This mainly happened due to the political and economic turmoil in Russia as a result of disintegration of USSR in 1991. Had this provision not been made, the profit margins would have attained the previous level. Changes in Accounting Policies Here is a news item about Cadila Healthcare Ltd. reported in the Hindustan Times of 4th August 2001 about changes in the accounting policies by the company in respect of: n Increasing the Estimates of Useful Life of Intangible Assets n Adjusting Unamortised Public Issue Expenses against Share Premium 420 CASE Financial Accounting for Management 2 Cadila Healthcare Ltd. CREATIVE FINANCIAL PRACTICES CADILA HEALTHCARE LTD. S NEW CHANGES IN ACCOUNTING POLICIES • Increasing the Estimates of Useful Life of Intangible Assets • Adjusting Unamortised Public Issue Expenses against Share Premium CADILA HEALTHCARE PROFITS OVERSTATED FOR FY 01 Girish Singhal New Delhi, August 3 CADILA HEALTHCARE Ltd., a Zydus Cadila group company, has overstated its profits by ` 4.91 crore for the financial year 2000–01. A qualification in this regard has been made in the report of Cadila’s statutory auditors—R.R. Patel & Co. and Mukesh M. Shah & Co.—on company’s financial statements for the said fiscal. The overstatement of profits has mainly arisen on two separate accounts namely “amortization of trademarks and technical know how” and “public issue expenses written off during the year”. Hitherto, Cadila used to amortize the trademarks and technical know how over a period of five years. But the company changed its accounting policy during 2000–01 and reassessed the estimated economic life of these assets as seventeen years. Accordingly, the trademarks and technical know how have been amortized during 2000–01 based on their revised estimated economic life. On account of this change, ` 94.69 lakh has been written back to the P&L A/c for 2000–01. Had it been considered on earlier basis, the net profit for 2000–01 and the net block as at March 31,2001 would have been lower by ` 2.26 crore without making any impact on the previous year’s profits. In respect of public issue expenses, the company till last year followed the policy as envisaged in the Income Tax Act, 1961 which requires them to be written off over a period of five years (60 months). Accordingly, in 1999– 2000, Cadila had written off its public issue expenses pro-rata for two months. However, during 2000–01, the company had adjusted the unamortised public issue expense of ` 12.83 crore against the share premium account under the head ‘Reserves & Surplus’. Had it been considered on earlier basis, the profit for 2000–01 would have been lower by ` 2.65 crore without making any impact on the previous year’s profits. Cadila had reported a 63 per cent rise in its net profit for the financial year 2000–01 at ` 65.31 crore as against the net profit of ` 39.97 crore registered in 1999–2000. Sales turnover for the year increased by just 9 per cent at ` 523.82 crore (` 480.53 crore). The company’s operating profit (profit before interest, depreciation and tax) for 2000–01 stood at ` 88.1 crore and profit before tax at ` 70.81 crore, registering an increase. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 421 Extending the Accounting Year Here are the extracts from the annual report of Liberty Shoes Ltd. for the year 1999–00 on the issue. CASE 3 Liberty Shoes Ltd. CREATIVE FINANCIAL PRACTICES LIBERTY SHOES LTD. Annual Report 1999–2000 Extracts from the Directors’ Report REPORT EXTENTION OF THE ACCOUNTING YEAR FINANCIAL HIGHLIGHTS: The financial results as on 30th June, 2000 are for the period of 15 months as compared to the previous 12 months period ended on 31st March, 1999 and are therefore not comparable. The intention of extending the financial year by 3 months from 31st March to 30th June was to implement the then ongoing restructuring programme. However, considering its complexity and financial burden on the company, this programme has been postponed for the time being but will be pursued again at the earliest possible opportunity. Non-provisioning of Expenses and Doubtful/Disputed Debts In Chapter 15 we studied the non-provisioning of expenses and doubtful/disputed dues by Hindustan Motors Ltd. and auditors’ qualifications thereon. We had then focused our attention on requirements on the auditors and the directors as to how to report on such matters. Here we will focus on the impact of that non-provisioning on window-dressing the financial results of the company. CASE 4 Hindustan Motors Ltd. REPORT CREATIVE FINANCIAL PRACTICES HINDUSTAN MOTORS LIMITED Annual Report 2001–02 NON-PROVISIONING OF EXPENSES AND DOUBTFUL/DISPUTED DEBTS Extracts from the Auditors’ Report and Notes to Accounts: ` in lacs Non-provision of leave liability 463.37 Non-provision of a part of gratuity liability 2,663.16 Non-provision of further monthly compensation 1,618.83 Non-provision of doubtful/disputed debts claims and advances whose impact is not ascertainable Net Worth: `16,778.25 Lacs 890.76 422 Financial Accounting for Management Contingent Liabilities Not Provided For Recap the illustration of contingent liabilities not provided for by Liberty Shoes Ltd. in Chapter 13. Study it from the angle of their impact on the results and the financial position. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. What do you understand by quality of earnings? How is it affected even by GAAPs? 2. What are window dressing and creative accounting/creative financial practices? How do they affect the quality of earnings? To enrich your discussion, add your own ideas, thoughts and practical inputs. IMPACT OF OTHER INCOME AND EXCEPTIONAL/EXTRAORDINARY ITEMS At times, non-operating income is either a major source of income or the net profit arises only due to other income. In the later case it is definitely an example of window dressing. In the earlier case the other income might arise due to dividend and interest income on accumulated savings and thus may not tantamount to window dressing. Yet, the study of its recurrence and its impact on current income and likely income in the future is essential to evaluate the future predictability of the income of a company. Likewise the extraordinary items influence the reported income in a large number of cases. AS-5 ‘Net Profit or Loss for the Period, Prior Period and extraordinary Items and Changes in Accounting Policies’ issued by the ICAI defines extraordinary items as “income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly”. It goes on to add that “virtually all items of income and expense Visit www.icai.org for full text included in the determination of net profit or loss for WWW of AS-5. Click: Resources— the period arise in the course of the ordinary activities of Accounting Standards. an enterprise. Therefore, only on rare occasions does an event or transaction give rise to an extraordinary item”. It further adds that “examples of events or transactions that generally give rise to extraordinary items for most enterprises are: n Attachment of the property of the enterprise, or n An earthquake”. The corporate sector and the accounting practitioners, however, do not seem to be subscribing to this view, and rightly so since accepting this narrow view means that there will hardly be an exceptional item in any corporate balance sheet. Therefore, actual corporate financial practices take a broader view, a view based on the principle of substance over form, materiality and prudence, and treat items like income from transfer of trademarks or sale of a business, etc. as extraordinary or exceptional items. You have seen earlier that Liberty Shoes Ltd. has treated the loss due to provision made for diminution in the value of investment in its joint venture, Liberty and Nino, Russia, as an extraordinary item. In the case of the financial statements of Ranbaxy Laboratories Ltd., given as an illustration in Chapter 14 also, you have seen the illustrations of different items of extraordinary income relating to compensation income on closure of a contract and for dispute of patent. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 423 On the issues of other income constituting a major source of net income and exceptional items, given hereunder are the extracts from the annual report of Hindustan Lever Ltd. for the year ended 31st December 2001. Go through them and attempt the exercise based on it given at the end of the chapter. CASE 5 Hindustan Lever Ltd. REPORT CREATIVE FINANCIAL PRACTICES HINDUSTAN LEVER LIMITED Extracts from Annual Report 2001 IMPACT OF OTHER INCOME AND EXCEPTIONAL/EXTRAORDINARY ITEMS Profit and Loss Account for the Year Ended 31 December 2001 Notes 2001 ` in lakhs 2000 ` in lakhs INCOME Sales 1 10,97,189.69 10,60,378.96 Other income 2 38,179.05 34,507.30 11,35,368.74 10,94,886.26 (9,25,791.13) (9,13,968.37) (14,465.97) (13,093.85) Total EXPENDITURE Operating expenses 3-5 Depreciation Interest 6 Total Profit before Taxation and Exceptional Items Taxation for the year — Current Tax 9 — Deferred Tax Profit after Taxation and before Exceptional Items Exceptional items (net of tax) 13 NET PROFIT Taxation adjustments of previous years (net) Balance brought forward Release from Investment Allowance Reserve Available for distribution 17 (774.42) (1,31,473) (9,41,031.52) (9,28,376.95) 1,94,337.22 1,66,509.31 (39,769.00) (35,500.00) (473.00) - 1,54,095.22 1,31,009.31 10,036.13 - 1,64,131.13 1,31,009.31 (101.36) (1,723.07) 44,298.62 19,284.19 - 18.00 2,08,328.61 1,52,034.57 2001 ` in lakhs 2000 ` in lakhs 5,415.81 3,907.39 Note: Appropriations Omitted. Note 2 to Profit and Loss Account: OTHER INCOME Other income Income from services rendered 424 Financial Accounting for Management Interest received – bank and other accounts (gross) (Tax deducted at source ` 1,648.43 lakhs; 2000—` 2,105.09 lakhs)8,685.58 9,342.52 Interest received – non-trade (gross) (Note 7) (Tax deducted at source ` 916.18 lakhs; 2000—` 759.64 lakhs) 10,540.84 Dividend income – subsidiaries – long term (gross) (Tax deducted at source ` 11.49 lakhs; 2000 – ` 10.53 lakhs) 1,819.72 4,553.97 Dividend income – Trade – long term (gross) 11,567.41 941.63 1,108.41 Dividend income – non-trade – long term (gross) 1,380.05 1,326.51 Dividend income – non-trade – current (gross) 2,143.86 – Surplus on disposal of investment (net) 4,449.44 – Miscellaneous income 2,802.12 2,701.09 38,179.05 34,507.30 2001 ` in lakhs 2000 ` in lakhs (i) Transfer of trademarks pertaining to Animal Feeds business 2,259.49 – (ii) Profit arising from the sale of the Quest Flavours and Fragrances Business, etc. (Refer Note 15 (ii) below) 11,986.00 – (iii) Profit arising from the sale of the Nickel Catalyst and Adhesives businesses 1,714.14 – Note 13 to Profit and Loss Account: EXCEPTIONAL ITEMS 15,959.63 – (iv) Costs incurred for discontinuance of the Thermometer operations Total exceptional income (1,100.00) – (v) Provision for estimated losses on disposal of fixed assets consequent to the restructuring of Culinary manufacturing operations (1,924.75) – (vi) Provision for estimated costs on restructuring of the ice cream operations (4,304.23) – (vii) Provision for additional liability for retirement/post-retirement benefits and other employee benefits arising from reduction in interest rates and consequent review of assumptions used for actuarial valuations. (6,328.76) – (13,657.74) – 2,301.89 – —Credit on current tax 107.10 – —Credit on deferred tax 4,760.14 – 2,867.00 – Total tax credit 7,734.24 – Exceptional items (net of tax) 10,036.13 – Total exceptional expenditure Net Taxation on the above (viii) One-time reduction in tax liability arising from the amalgamation of International Best Foods Limited with the Company Note 15 (ii) to Profit and Loss Account The Quest Flavours and Fragrances business was sold to Lakme Lever Limited (LLL), a subsidiary company (since renamed as Quest International India Limited), effective 1st April, 2001, consequent to an agreement having been entered into with the ICI Group. In terms of the agreement, the shareholding of HLL in LLL has been reduced to 49% in July 2001. Profit arising from these transactions (including ` 3,989.20 lakhs as surplus on disposal of long-term investment) amounting to ` 11,986.00 lakhs (net of tax ` 11,986.00 lakhs) has been accounted for as exceptional item. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 425 Some more cases: 1. EXTRA-ORDINARY INCOME JAIPRAKASH ASSOCIATES LTD. ` crores Sales 2005–06 2004–05 3307.39 2908.09 PBT as reported 328.75 PBT as reported (including the following extra-ordinary income) 764.56 Profit on sale of shares of Jaiprakash Hydro- Power Ltd. 361.37 PBT excluding this income would have been ` 403.19 crores 2. DEPRECIATION ON REVALUATION RECOUPED FROM PROFIT AND LOSS ACCOUNT JK CEMENT LTD. ` lacs 2005–06 2004–05 Sales 87369.94 32941.11 PBT as reported (after the following credit) 5220.93 1079.72 Depreciation on revalued assets recouped from revaluation reserve and credited to Profit and Loss Account 1238.98 526.28 PBT excluding this credit would have been ` 3981.95 lacs and 553.44 lacs respectively 3. OTHER (NON-OPERATING) INCOME AND DEPRECIATION ON REVALUATION RECOUPED FROM PROFIT AND LOSS ACCOUNT RELIANCE ENERGY LTD. ` crores 2005–06 2004–05 Sales 4033.49 4133.72 PBT as reported (including the following two items) 781.47 569.31 Non-operating income (dividend, interest, swap income etc.) 565.09 454.59 Depreciation on revalued assets recouped from general reserve and credited to Profit and Loss Account 64.38 132.82 PBT excluding this credit would have been ` 500.71 crores and 321.77 crores respectively 4. AMORTISATION OF INTANGIBLE ASSETS OVER A PERIOD LONGER THAN 10 YEARS CROSSWORD BOOKSTORES LTD. (a subsidiary of Shopper’s Stop Ltd.) ` lacs 2006–07 2005–06 Sales 3896.16 5040.83 PBT as reported (after amortisation) (14.29) (266.59) Amortisation charged by the company on Goodwill, Trademarks and Patents assuming their life to be 20 years 71.64 71.64 PBT with the benchmark assumption of life to be 10 years would have been ` (85.93) lacs, i.e., (14.29+71.64) and (338.23) lacs, i.e., (266.59 + 71.64). 426 Financial Accounting for Management BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Analyse the impact of window dressing on the profitability in all the above cases. Can the impact affect the market valuation of the companies concerned? 2. In the case of Reliance Energy Ltd. how will your analysis change if you were informed that the interest and finance charges paid by the company were ` 191.88 crores and ` 134.82 crores during 2005-06 and 2004-05 respectively? To enrich your discussion, add your own ideas, thoughts and practical inputs. BEATING WINDOW DRESSING Now that we have to live with the street smart managements and their window dressed financial statements, we can just make some efforts and resort to the following measures to beat window dressing to be successful, to the extent possible, in analysing financial statements: n Careful study of ‘notes to accounts and accounting policies’ annexed to the financial statements and an assessment of the variations in policies, accounting estimates, extraordinary items and contingent liabilities. n Assessment of the financial impact of qualifications in auditors’ report on the corporate profitability and financial position. n Study of chairman’s statement, directors’ report, corporate governance report, particularly the management discussion and analysis (MD & A) contained therein and integrating them with the study of financial statements. n Comparison of basic and diluted EPS to predict the EPS sustainable in future. n Analysis of related party transactions to find out whether any undue benefit is being provided to them at the cost of the company. n Analysis of segment results to analyse whether any line of business is making a dent on the overall bottom line. The suggestions are not exhaustive. Learn to read between the lines. FURTHER CARE IN ANALYSIS Ultimately, the financial analyst needs to take the following further care in analysis: n Analysis of trends over a longer period to confirm current year findings. n Interpretation of results against industry benchmarks. n Analysis of ‘core ratios’ only. n Inter-firm comparison to find out the impact of variations in accounting policies and comparative performance of different lines of businesses in the case of conglomerate companies. A detailed discussion on Trend Analysis, Other Tools of Analysis and Ratio Analysis, including what are ‘Core Ratios’, will take place in the forthcoming chapters. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 427 REGULATORY EFFORTS IN ENSURING QUALITY OF EARNINGS Apart from the Accounting Standards’ requirements, there have been continuous efforts in recent years by the government and regulatory authorities to improve the quality of reported earnings. We have seen that one of the major effects of the auditors’ report is to bring more financial discipline in the affairs of a company. This report has for decades, however, been only one such handle though it was also expanded by CARO. Realising that it is not enough, the following measures have been taken by the Central Government and SEBI in the recent past to improve the quality of earnings: n Audit committee under the Companies Act. n Directors’ Responsibility Statement in the BOD report. n Audit committee as per the corporate governance norms stipulated by SEBI. The responsibilities cast on the above committees and boards through these instruments have already been dealt with at different places in this text. The basic objective behind these efforts is to force greater financial discipline in the corporate sector and to ensure reporting of better quality of earnings. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Do you agree with the definition of extraordinary items provided by AS-5? Why or why not? 2. How can one beat window dressing? Add to what has already been discussed earlier. 3. Are the regulatory efforts in ensuring the quality of earnings sufficient? Why or why not? To enrich your discussion, add your own ideas, thoughts and practical inputs. ICAI AWARDS FOR EXCELLENCE IN FINANCIAL REPORTING The ICAI recognising the need for high quality financial reporting has instituted the ICAI awards for excellence in financial reporting. Details are as under. Background With the shift in the emphasis from the concept of ‘shareholders’ to ‘stakeholders’; the professionalisation of management; the increasing information needs of various users of financial statements; and the enactment and amendments in various laws requiring greater transparency and accountability on the part of management, the concept of financial reporting has increasingly gained significance during recent years. The objective of financial Visit www.icai.org for origreporting is to provide more transparent, and relevant information inal text of the scheme. to various interested parties. Annual reports continue to be the most Click: (www.icai.org/icaiWWW important and easily accessible medium for dissemination of such root/ announcements/ information. It is to the annual report as a whole that one must look at announ1077.pdf). to ascertain the discharge of management’s responsibility to report to 428 Financial Accounting for Management BIRD’S EYE VIEW ICAI Awards for Excellence in Financial Reporting n Background n Objective n Categories of the Awards n Awards to be Distributed n Important Factors for Selection of Awardees n Award Winners various stakeholders. It no longer only forms the basis of investment decisions but is also oriented towards improving public relations by containing the disclosure of the role of an enterprise in discharging its duties and responsibilities towards the society as a whole. Thus, the need for improvement in the preparation and presentation of financial and other qualitative information in the annual reports is self-evident. In a step towards promoting better standards in financial reporting and preparation and presentation of annual report, the Institute started the ICAI Awards for Excellence in Financial Reporting as early as 1958 and has been holding it annually thereafter. Objective The awards are meant to recognise and encourage excellence in the preparation and presentation of financial information with the mission of greater accountability and well-informed decision making. Categories of the Awards The awards have been classified into seven categories. Category…. 1 Manufacturing and Trading enterprises (including processing, mining, plantations, oil and gas enterprises) 2 Finance sector (including NBFCs, mutual funds, investment bankers, HFCs, etc.) 3 Service sector (including hotels, consultancy, transport, stock exchanges, R&D, private hospitals) 4 Banking, Insurance and Financial Institutions 5 Information Technology, Communication and Entertainment enterprises 6 Infrastructure & Construction sector (including power generation and supply, port trusts, roads) 7 Others (Section 25 companies, educational institutions, NGOs, charitable hospitals and other organizations) In a case, where an organization is engaged in more than one business, the dominant source of revenue will determine the category to which the organisation belongs. Awards to be Distributed The ICAI awards one Gold Shield and one Silver Shield in each category for the best entry and the next best entry, respectively. Important Factors for Selection of Awardees The criteria for the selection of awardees have been laid down as under: 1. Compliance with the legal requirements in the preparation and presentation of financial statements as specified by the relevant statute, e.g., the Companies Act, 1956, in case of companies. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 429 2. Basic quality of accounts as judged from the qualifications in the auditor’s report, notes to the accounts and compliance with the generally accepted accounting principles such as those enunciated in the Accounting Standards, Statements, Guidance Notes, etc., issued by the Council of the Institute of Chartered Accountants of India and its various Committees. 3. The nature and quality of information presented in the accounts to make the disclosures meaningful. For example: a. Sufficient details of revenues/expenses for financial analysis, e.g., distinction between manufacturing costs, selling cost, administrative cost. b. Use of vertical form as against the conventional “T” form; judicious use of schedules; use of sub-totals; manner of showing comparative figures; ease of getting at figures. c. Extent to which additional financial information is provided to the readers through charts and graphs. d. Extent of clarity, lucidity and comprehensiveness of the information contained in the financial statements, in the context of a layman. e. Financial highlights and ratios. f. Inclusion of one or more of the information like value added statement, break-up of operations, organisation chart, location of factories/branches, human resource accounting, inflation adjusted accounts, social accounts, etc. 4. The extent to which the (i) Reports of the Governing Body such as Board of Directors Report and/ or (ii) Chairman’s Statement, if any, are informative. The following aspects are generally considered relevant in this regard: a. Availability of information regarding different segments and units of the entity, i.e., whether details about each product/service and units, and whether located in the same area or spread in different geographical locations, are given. b. Information regarding financial operations, capital raised during the year, financial requirements, borrowings, etc. In respect of multi-product/multi-unit organizations, whether details as per (a) above have been given for financial operations. c. Employee relations. d. Industry problems and problems peculiar to the enterprise. e. Information regarding social concerns (e.g., contribution to conservation and development of environment and ecology). f. Information on contribution to community development projects, (e.g., medical institutions, educational institutions, provision of sanitary and drinking water, etc.), particularly in areas around location of entity. g. Post-balance sheet events not requiring adjustment in accounts but material enough to warrant disclosure and future plans, programmes, market conditions, profitability forecast, environment friendliness, etc. h. Manner of review of performance, plans and prospects by the company. i. Compliance report on the Corporate Governance, clearly indicating non-compliance with any of the mandatory requirements with the reasons therefor. j. Directors’ Responsibility Statement required under section 217(2AA) of the Companies Act, 1956. 5. Layout of contents, general appearance, presentation and quality of printing. 6. Timeliness in presenting accounts based on the date of the notice of the Annual General Meeting in respect of which the Annual Report is circulated to the shareholders. 430 Financial Accounting for Management Award Winners It will be interesting to know the front runners in financial reporting in India. The list of Award Winners for the year 2005–06 is provided hereunder. List of Award Winners of ‘ICAI Awards for Excellence in Financial Reporting’ for the year 2005–06 Category I II Award Name of the Entity Annual Report and Accounts for the year ended Manufacturing and Trading enterprises (including processing, mining, plantations, oil and gas enterprises) Gold Shield Shopper’s Stop Limited Decided not to give this award. March 31, 2006 Finance sector (including NBFCs, mutual funds, investment bankers, HFCs, etc.) Gold Shield Decided not to give any award under this category. Decided not to give any award under this category. …. Bombay Stock Exchange Limited Blue Dart Express Limited March 31, 2006 III Service sector (including hotels, consultancy, transport, stock exchanges, R&D, private hospitals) IV Banking, Insurance and Financial Institutions Silver Shield Silver Shield Gold Shield Silver Shield …. …. December 31, 2005 Silver Shield ICICI Lombard General Insurance Company Limited Decided not to give this award. March 31, 2006 …. Gold Shield V Information Technology, Communication and Entertainment enterprises Gold Shield Infosys Technologies Limited March 31, 2006 Silver Shield MphasiS BFL Limited March 31, 2006 VI Infrastructure & Construction sector (including power generation and supply, port trusts, roads) Gold Shield The Tata Power Company Limited Decided not to give this award. March 31, 2006 Others (Section 25 companies, educational institutions, NGOs, charitable hospitals and other organizations) Gold Shield Decided not to give this award. Decided not to give this award. …. VII Silver Shield Silver Shield …. …. Source: www.icai.org-members-funds/awards-excellence in financial reporting. BEFORE YOU MOVE FURTHER... Stop. Think over, Discuss and Debate in Small Groups. 1. Could you suggest some more criteria to be included in the ICAI awards? 2. Visit the Web sites of award winning companies. Analyse what made their annual reports win. To enrich your discussion, add your own ideas, thoughts and practical inputs. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 431 CONCLUDING REMARKS What we have discussed above on quality of earnings, window dressing and creative financial practices is not the last word on the issue. Window dressing and creative accounting go hand-in-hand with human ingenuity. There are, thus, endless means to influence the quality of earnings reported. Therefore, finally the financial analyst needs to understand that: n Analysis is a post-mortem and not a cure. It leads to identification of areas for further investigation. n It only provides an insight into the future outlook of the company and how to improve this outlook through strategic decision-making based on the identified areas of investigation. n The imagination and judgement of the analyst and his knowledge of economy and industry are crucial to a meaningful and objective financial analysis. Keywords n Accounting Estimates n Extraordinary Income/ITEMS n Advancing the Billing n Future Predictability n Core Business n Industry Benchmarks Operations n Creative Accounting n Creative Financial Practices n Deferment of Revenue Expenses n Diluted EPS WWW n Inter-firm Comparison n Limitations of Financial Statements n Net Profit or Loss for the Period n Non-operating Income n Non-provisioning of Expenses n Prior-period Items/Adjustments n Post-Balance Sheet Events n Quality of Earnings n Reported Earnings n Unamortised Public Issue Expenses n Window Dressing n Non-recurring Income 1. Disclosure of Accounting Policies, AS-1, ICAI, www.icai.org 2. Net Profit or Loss for the Period, Prior Period and Extraordainary Items and Changes in Accounting Policies, AS-5, ICAI, www.icai.org 3. www.icai.org/icairoot/announcements/announ1077.pdf). 4. www.icai.org-members-funds/awards-excellence in financial reporting 432 Financial Accounting for Management 1. Liberty Shoes Ltd., Annual Reports, 1994–95 to 2000–2001. 2. Cadila Healthcare Ltd., Annual Report, 2000–2001. 3. Hindustan Motors Ltd., Annual Report, 2001–2002. 4. Hindustan Lever Ltd., Annual Report, 2001. 5. Nestlé India Ltd., Annual Report, 2001. 6. JAIPRAKASH Associates Ltd., Annual Report, 2005–06. 7. JK Cement Ltd., Annual Report, 2005–06. 8. Reliance Energy Ltd., Annual Report, 2005–06. 9. Crosswords book stores Ltd., Annual Report, 2005–06 and 2006–07. REPORT S NEW 1. The Hindustan Times, 4.08.2001 exercises CASE 1 Liberty Shoes Limited—Non-provision of Diminution in the Value of Long-term Investments You have gone through and understood the information available from the annual reports of the company regarding non-provision and ultimately provision after seven years of the diminution in the value of long-term investments in its joint venture, Liberty and Nino, Russia, as provided in this chapter. The following further information about the company, as taken from annual report 2000–01, is provided below: LIBERTY SHOES LTD. EXTRACTS FROM THE ANNUAL REPORT 2000–01 ` in lacs PAT 94–95 95–96 96–97 97–98 98–99 99–00** 00–01** 627.56 744.02 731.30 756.46 837.97 740.73 590.19 No. of equity shares of the face value of ` 10 each o/s all through these years: 50,70,000 (Except 94-95: 50,59,900). ** Annualised (by the company). Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices 433 Now attempt the following requirements. 1. The joint venture closed operations in 1994. Until 1999–00 the company has been stating that it is trying realization of whatever is possible, and the amount of this realisable is not ascertainable. This in turn means that provision for diminution cannot be made. How is this possible? Is the company justified in its statements year after year for seven years? Provide a well-reasoned answer. 2. What is the impact of provision made in 2000–01 on the EPS of the company? Do you feel it is the real EPS of the company for this year? And in fact, if the company’s business continues to grow as in the past, the 2001–02 EPS will show a marked improvement over 2000–01. In this case, therefore, the company should have made the provision much earlier. But it did not? Comment what considerations might have weighed in the mind of the management? Corporate tax rate for A/Y 2001–02 ... 39.55%. 3. Has the company not over-reported its profitability, EPS and net worth by not making the provision in 1994–95 or at best in 1995–96 and thus influenced its valuation in the capital market? Do you think that the non-provision in early years had a cascading effect to the advantage of the company? Why or why not? Compute the EPS for all the given years after making provision for diminution, assuming it should have been made in the earliest year and, if not, then in the next year and so on. Compare the EPS based on the information provided above with the revised EPS for all the years and comment. Corporate tax rate: 46% for A/Y 95–96 and 96–97, 43% for 97–98, 35% for 98–99 and 99–00, 38.5% for 00–01. 4. Is the company justified stating in the 2000–01 report that it will continue its efforts to realise the investment together with accrued profit despite the investment seeming to be dead. Is it prudent to paint a rosy picture of the future in such cases? Why or why not? 5. Draft a crisp two-three page report. CASE 2 Cadila Healthcare Limited—Changes in Accounting Policies You have gone through and understood the information reported by the news item captioned ‘Cadila Healthcare Profits Overstated For FY 01’, by changing accounting policies, that appeared in the Hindustan Times of 4 August 2003, as provided in this chapter. Now attempt the following requirements. 1. Offer your opinion on the justification or otherwise of increasing the estimates of useful life of intangible assets to inflate profits. 2. You have studied in Chapter 8 the requirement of AS-26 on intangible assets, that if an intangible asset is amortised over more than ten years, the reasons for doing so should be stated in the financial statements. Try to find the reasons through the Web site of the company or a database like Capitaline Plus or CMIE Prowess. 3. Offer your opinion on the justification or otherwise of Adjusting Unamortised Public Issue Expenses against Share Premium to inflate profits. Try to find the reasons given by the company for change through the Web site of the company or a database like Capitaline Plus or CMIE Prowess. 4. These two adjustments have not made any material impact on the reported profits of Cadila. However, in a weak case they might have led to the reporting of an opposite picture. In such cases, the auditors should simply qualify their report or express an opinion that the financial statements do not portray a true and fair view of the financials of the company? Opine. 5. Draft a crisp two–three page report. 434 CASE Financial Accounting for Management 3 Liberty Shoes Limited—Extension of the Accounting Year You have gone through the explanation offered by the directors behind their intention in deciding to extend the accounting year 1999– 2000 by three months in their report for the year 1999–2000, as provided in this chapter. Are you convinced with the explanation offered? Could not the company incorporate and report the results of the ongoing restructuring programme in the year 2000–01? What could have been the real intention in extending the year had the restructuring been implemented? Stretch your imagination and your knowledge of finance and come out with a rational answer. Draft a crisp onepage report. CASE 4 Hindustan Motors Limited—Non-Provisioning of Expenses and Doubtful/ Disputed Debts In Chapter 15 you were exposed to details of Non-provisioning of Expenses and Doubtful/Disputed Debts by Hindustan Motors Ltd., explanations thereon in the notes to accounts, their treatment in the auditors’ report and stand of the directors in their report. In this chapter you have been provided the summary details of those non-provisions. The following information is also being provided. Required HINDUSTAN MOTORS LTD. Extracts from the Financial Statements 2001–02 ` in lacs Loss after taxation as reported 3,385.31 Equity share capital of `10 each 16,125.68 1. Recompute the loss after making provisions not made. Tax Rate for A/Y 2002–03 ... 35.70%. 2. Compute the EPS as per reported loss. 3. Recompute the EPS after provisionings done by you in requirement 1. 4. Now study the reasons provided for non-provisioning in Chapter 15 and opine whether the reasons are justified? Assess the real motive behind non-provisioning. 5. Can you make a reasonable estimate of doubtful debts to be provided based on the information available? If yes, adjust your recomputed EPS. Measure the difference. 6. Do you think that this is a classic example of window dressing? Why or why not? 7. Draft a crisp two-page report. Chapter 16 Quality of Earnings: Window Dressing, Creative Financial Practices CASE 435 5 Liberty Shoes Limited—Contingent Liabilities Not Provided For You were exposed in Chapter 13 to details of Contingent Liabilities Not Provided For by Liberty Shoes Ltd. during the year 2001–02 as per their annual report. The following additional information is being made available to you for the same year: n Number of equity shares o/s...50,70,000. n PAT ` 620.36 lakhs n Contingent liability on account of sales tax exemption has been existing for long. Now-attempt the following requirements. 1. Sales Tax Exemption: Is the disclosure enough to enable you to estimate the extent of likelihood of the contingency maturing and assess the resultant impact on the reported profit? Opine. 2. Bills discounted against Letter of Credit (Exports) and Bank Guarantees issued on behalf of the company: What is the likelihood of these contingencies maturing? Opine. 3. Opine what are the chances of contingency towards excise matter maturing? Assuming the liability could mature, how will it affect the EPS for the year 2001–02? Tax Rate for A/Y 2002–03 ... 35.70%. CASE 6 Hindustan Lever Limited—Impact of Other Income and Exceptional/ Extraordinary Items You have gone through the following information about Hindustan Lever Ltd., as provided in this chapter, for the year ended 31 December 2001: 1. Profit and Loss Account 2. Note 2: Other Income 3. Note 13: Exceptional Items 4. Note 15 (ii) Now attempt the following requirements. 1. Measure the impact of Other Income on PBT. Is it material? Why or why not? 2. Measure the impact of Net Exceptional Income on PAT. Is it material? Why or why not? 3. But for Exceptional Expenses, how would the impact of Exceptional Income on PAT have differed? 4. Discuss each item of Other Income and Exceptional Income and Expenses with your colleagues for a thorough understanding. Seek the help of your professor where needed. 5. The company did not report any exceptional items during 2000. Do you think such items could have a volatile impact on the bottom line over years? Why or why not? 6. Finally, do such detailed disclosures of Other Income and Exceptional Items improve the quality of reporting, and therefore help in proper assessment of profitability and future outlook? Explain. 7. Draft a crisp two-page report. 17 Financial Statement Analysis and the Tool Kit of the Analyst: I Multi-step, Horizontal, Vertical and Trend Analyses and Analytical Balance Sheet CORPORATE FINANCIAL PRACTICES Liberty Shoes Ltd. Extracts from Annual Report 2001–2002 Particulars 1994–95 1995–96 1996–97 1997–98 1998–99 1999– 2000* 2000– 2001* 2001– 2002 3041.07 4470.50 5398.68 6696.78 7667.94 7612.13 8520.00 7352.16 1.00 1.47 1.78 2.20 2.52 2.50 2.80 2.42 890.25 1019.22 1038.72 1126.54 1273.86 1278.38 1262.77 1083.07 1.00 1.14 1.17 1.27 1.43 1.44 1.42 1.22 802.43 862.13 862.30 921.46 1010.47 996.73 966.35 786.27 1.00 1.07 1.07 1.15 1.26 1.24 1.20 0.98 1 620.36 RESULTS FOR THE YEAR Sales & Other Income Index Profit before Depreciation & Tax Index Profit before Tax Index Profit after Tax Index Equity Dividend (total outlay) 627.56 744.02 731.30 756.46 837.97 740.73 590.19 1.00 1.19 1.17 1.21 1.34 1.18 0.94 0.99 – 157.68 254.01 254.01 278.85 380.25 228.15 253.50 Financial statement analysis seeks to evaluate the performance, financial strength, ability to generate enough cash and the growth outlook of a company. A number of tools are available in the tool kit of the analyst for this purpose. Five of them are covered here. Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 437 CHAP T ER O BJ ECT IVES This chapter seeks to enable you to develop knowledge and understanding of: 1 The objectives of financial statement analysis. 2 The various stakeholders and their interests in the financial statements. 3 The different tools and techniques of analysis available in the tool kit of the analyst. 4 Methodologies, functions, formats and utility of five of such tools, namely, multi-step income statement, horizontal, common-sized and trend analyses and analytical balance sheet. 5 The illustrations of these tools as applied to the abridged financial statements of Bajaj Auto Ltd., TVS Motor Company Ltd., Liberty Shoes Ltd. and Shoppers Stop Ltd. and their analysis. INTRODUCTION So far, we have studied why financial statements are constructed, how this is done, what do they contain and how they reflect the performance of the business for a given period and its financial position as on a given date. We have also studied the various financial reports other than the financial statements and the purpose served by them. We have also studied the generally accepted accounting principles, which act as benchmarks for the preparation and presentation of financial statements and such other financial reports. The next issue is why these statements and reports are analysed, who are the parties interested in their analysis and how they carry out the analysis. Furthermore what care to be taken in analysis and how to ascertain whether the reported income is of a high quality or not as observed in the last chapter. OBJECTIVES OF ANALYSIS The objectives of analysis of financial statements have their genesis in the objectives of financial statements. We have been learning throughout this text that the objective of financial statements is to provide information about the financial position, performance and cash flows of an enterprise. Based on this information, objective of analysing them is to evaluate: The adequacy or otherwise of the profits earned by the company. n The adequacy or otherwise of its financial strength. n Its ability to generate enough cash and cash equivalents and the timing and certainty of their generation, and n The future growth outlook of the company. n These are very broad objectives of financial analysis and every stakeholder carries out the analysis keeping these in view. However, as we saw in the fourth chapter, there are many stakeholders who need to carry out specific analysis to serve their specific purpose. For example, a lender’s main concern is to evaluate the debt service capacity of the borrower company. Therefore, his focus will be on analysing those elements which provide him information relevant to his objective. He will thus have to cull 438 Financial Accounting for Management BIRD’S EYE VIEW Financial Statement Analysis n Objectives of Analysis n Various Stakeholders and Their Interests n Tool Kit of the Financial Analyst n Tools and Techniques Covered In this Chapter: — Multi-step income statement — Horizontal analysis — Common-sized analysis — Trend analysis — Analytical balance sheet out such information from the financial statements. Let us at this stage recall who are the various stakeholders interested in financial statement information. VARIOUS STAKEHOLDERS AND THEIR INTERESTS As seen in the fourth chapter, following is a broad, but not an exhaustive, list of the various stakholders having an interest in the financial statements and their analysis: Promoters Shareholders other than promoters n Prospective investors, such as individuals, corporate bodies, foreign institutional investors, mutual funds and strategic capital partners n Lenders, such as financial institutions, banks and public n Creditors n Customers n Employees n Government and regulatory bodies n Public at large n Management, and n Researchers and analysts n n Issues like why they need information contained in the financial statements, what are their expectations of them and what do they look for in them, etc., have been discussed in the fourth chapter. Go through the chapter to refresh your memory and for a recap as a good understanding of their motives will help you a lot in understanding the tools, techniques and nuances of analysis of financial statements and financial reports. In this background we now move over to developing an understanding of different tools and techniques of analysis. TOOL KIT OF THE FINANCIAL ANALYST The profession of accounting and finance has developed a number of tools and techniques aimed at carrying financial statement analysis. These are: 1. Multi-step income statement 2. Horizontal analysis 3. Common-sized analysis 4. Trend analysis 5. Analytical balance sheet 6. Ratio analysis 7. Cash flow analysis Though all the above-mentioned tools and techniques can be applied independent of each other, it needs to be understood that more often than not an integrated analysis of all or some of them is required, Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 439 depending upon the purpose of analysis to reach the right decision. This aspect will be thoroughly illustrated later in this text. The first five tools of analysis have been illustrated in this chapter. TOOLS AND TECHNIQUES The first five tools of analysis covered in this chapter are: 1. Multi-step income statement 2. Horizontal analysis 3. Common-sized analysis 4. Trend analysis 5. Analytical balance sheet “These have been illustrated with the cases of Bajaj Auto Ltd., TVS Motor Company Ltd., Liberty Shoes Ltd. and Shoppers Stop Ltd”. Others will follow in successive chapters. MULTI-STEP STATEMENT OF PROFIT AND LOSS The Tool We have seen in chapter 14 the statement of profit and loss of Nestle India Ltd. and observed that it starts with total revenue from operations, minuses all the expenses there from, arrives at PBT and then finally at PAT after deducting tax provision. The statement of profit and loss, however, does not show the profitability at different intermediate levels of business operations. If that were done the income statement would become much more informative about the profitability and will disclose the following 7 levels of intermediate profit leading up to PAT: 1. Gross Profit—GP 2. Profit Before Depreciation, Interest and Tax—PBDIT 3. Operating Profit—OP or PBIT 4. Profit Before Exceptional and Extraordinary Items and Tax—PBEEIT 5. Profit before Extraordinary Items and Tax—PBEIT 6. Profit Before Tax—PBT 7. Profit after Tax OR Net Profit—PAT/NP Format of Multi-step Statement of Profit and Loss Preparing a multi-step income statement from the reported statement requires, if not already given, separate information and break-up of manufacturing, administrative and selling expenses to work out GP and PBDIT. Many annual reports provide this break-up while many do not. In such cases, ‘Manufacturing Expenses’ have to be identified from the note to the financial statements on ‘Other Expenses’ and segregated. Rest of other expenses will represent ‘Marketing, Administrative and Other expenses’. Even where the break-up is provided, the separate details of employee remuneration relating to factory and other than factory is not provided in most cases. It puts a limitation on construction and analysis of a multi-step income statement. Given the full information a typical multi-Step statement of profit and loss will have the following format: 440 Financial Accounting for Management FORMAT OF MULTI-STEP STATEMENT OF PROFIT AND LOSS Amount (`) Current year Last year Sales Less: Excise duty Net sales Other operating revenue Net Revenue from Operations Expenses: Cost of materials consumed Purchases of Stock-In-Trade Changes in inventories of finished goods, work-in-progress and stock-In-Trade Manufacturing expenses Cost of goods sold (COGS) Gross profit – GP Employee benefit expenses Administrative, marketing and other expenses Profit before depreciation, interest and tax – PBDIT Depreciation and amortization expense Fixed asset impairment Operating profit – OP/PBIT Finance costs (+) Other Income (Non-operating) Profit before exceptional and extraordinary items and tax – PBEEIT (+)/(-) Exceptional items Profit before extraordinary items and tax -PBEIT (+)/(-) Extraordinary items Profit before tax – PBT Tax expenses: 1. Current tax 2. Deferred tax 3. Total tax Profit after tax – PAT CASE 1 Multi-step Statement of Profit and Loss of Bajaj Auto Ltd. We will construct and analyse here the multi-step statement of profit and loss of Bajaj Auto Limited. For this purpose, the following financial statements of the company for the year 2011–12 have been reproduced hereunder from its annual report: 1. Statement of Profit and Loss 2. Note 24 to the financial statements: ‘Other Expenses’. Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 441 REPORT BAJAJ AUTO LIMITED Distinctly Ahead……………………Since 1945 STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31ST MARCH (` in Crore) Particulars Sales Less: Excise duty Net sales Other operating revenue Net Revenue from operations Other income Total revenue (I) Expenses: Cost of raw material and components consumed Purchases of traded goods (Increase)/decrease in inventories of finished goods, work-inprogress and traded goods Employee benefits expense Finance costs Depreciation and amortization expense Other expenses Expenses, included in above items, capitalized Total expenses (II) Profit before exceptional items and tax (I-II) Exceptional items Profit before tax Tax expense Current tax Deferred tax Total tax expense Profit after tax for the year Summary of significant accounting policies followed by the company. Note No. 2012 19,827.03 946.76 18,880.27 648.71 19,528.98 608.04 2011 16,830.23 933.41 15,896.82 501.41 16,398.23 576.51 20,137.02 16,974.74 19 20 21 13,445.54 751.15 (94.15) 11,311.89 568.41 (82.79) 22 23 540.11 22.24 145.62 1,215.77 (49.43) 15,976.85 4,160.17 (134.00) 4,026.17 493.58 1.69 122.84 952.58 (16.66) 13,351.54 3,623.20 724.55 4,347.75 1,003.39 18.73 1,022.12 3,004.05 980.00 28.02 1,008.02 3,339.73 17 18 24 25 1 Bajaj Auto Ltd. Note No. 24 to the Financial Statements for the Year Ended 31st March Other expenses (` in Crore) 2012 2011 Stores and tools consumed 110.25 85.00 Power, fuel and water 101.85 86.61 Excise duty on increase/(decrease) in stocks of finished goods 12.33 1.30 Rent 10.74 11.35 442 Financial Accounting for Management Repairs to buildings Repairs to machinery Other repairs Insurance Rates and taxes Payment to auditor Directors’ fees and travelling expenses Commission to Non Executive Directors Travelling expenses Miscellaneous expenses Sales tax/VAT expenses Packing material consumed Freight and forwarding expenses Advertisement Vehicle service charges and other expenses Commission and discount Incentives and sales promotion Donations Bad debts and other irrecoverable debit balances written off Less: Provisions made in earlier years in respect of amounts written off during the year, adjusted as per contra Loss on assets sold, demolished, discarded and scrapped Provision for doubtful debts and advances Amount amortised/written off against technical know-how Amount written off against leasehold land Loss on redemption of securities, net*** 23.86 73.76 5.07 2.68 3.42 1.20 0.24 0.93 26.12 174.36 12.55 273.30 50.44 160.31 88.77 28.25 18.98 10.00 1.70 1.60 17.42 59.41 2.84 2.44 6.34 0.87 0.23 0.75 25.04 128.73 21.47 210.09 42.05 81.69 86.12 31.87 16.76 10.92 1.74 1.71 0.10 7.49 9.95 2.14 0.65 6.03 1,215.77 0.03 20.12 0.34 2.14 0.65 952.58 *** including surplus on current investments ` 1.23 crore (previous year ` Nil) The multi-step statement of profit and loss of Bajaj Auto Ltd. is presented here in illustration 1. The methodology is quite simple: 1. Just pick the relevant items from the statement of profit and loss and put them in the multi-step format. 2. Do remember to reduce the manufacturing expenses from the ‘other expenses’ as given in the note to the financial statements to arrive at ‘Marketing, Administrative and Other expenses’ for tracing them to the multi-step statement. 3. Carry out the computations and the statement is ready. This process has been illustrated in the case of Bajaj Auto Ltd. It may be noted that it presents profit position at 6 intermediate levels, and not 7, as Bajaj Auto Ltd. does not have extra-ordinary items in its statement of profit and loss. Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 443 ILLUSTRATION 1 BAJAJ AUTO LTD. Distinctly Ahead……………………Since 1945 MULTI-STEP STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31ST MARCH (` in Crore) Particulars Sales Less: Excise duty Net sales Other operating revenue Net Revenue from operations Expenses: Cost of raw material and components consumed Purchases of traded goods (Increase)/decrease in inventories of finished goods, work-in-progress and traded goods Manufacturing expenses (see working note below) Cost of goods sold (COGS) Gross profit-GP Employee benefits expense Marketing, Administrative and Other expenses (see working note below) Less: Expenses, included in above items, capitalized Profit before depreciation, interest and tax-PBDIT Depreciation and amortization expense Operating profit-OP/PBIT Finance costs (+) Other income (Non-operating) Profit before exceptional and extraordinary items and tax (PBEEIT) Exceptional items Profit before tax-PBT Tax expense Current tax Deferred tax 2012 19,827.03 946.76 18,880.27 648.71 19,528.98 2011 16,830.23 933.41 15,896.82 501.41 16,398.23 13,445.54 751.15 (94.15) 11,311.89 568.41 (82.79) 650.61 14,753.15 4,775.83 540.11 565.16 (49.43) 3,719.99 145.62 3,574.37 22.24 608.04 4,160.17 (134.00) 4,026.17 506.46 12,303.97 4,094.26 493.58 446.12 (16.66) 3,171.22 122.84 3,048.38 1.69 576.51 3,623.20 724.55 4,347.75 1,003.39 18.73 980.00 28.02 Total tax expense Profit after tax-NP/PAT 1,022.12 3,004.05 1,008.02 3,339.73 444 Financial Accounting for Management Working note on Note No. 24 ‘Other Expenses’: Details Total ‘other expenses’ as per note 24 Less: Out of which manufacturing expenses identified as below, and taken above in the multi-step statement of profit and loss Stores and tools consumed Power, fuel and water Excise duty on increase/(decrease) in stocks of finished goods Repairs to buildings Repairs to machinery Insurance Packing material consumed Freight and forwarding expenses Amount amortized/written off against technical know-how 2012 1,215.77 (` in Crore) 2011 952.58 110.25 85.00 101.85 86.61 12.33 1.30 23.86 17.42 73.76 59.41 2.68 2.44 273.30 210.09 50.44 42.05 2.14 2.14 650.61 506.46 Balance being ‘Marketing, Administrative and Other expenses’ 565.16 446.12 Note: Manufacturing expenses have been identified to the extent possible. The table may not represent exact details. Analysis of Multi-step Income Statement of Bajaj Auto Ltd. It is equally, and probably more, important to study and analyse the profitability of the company at different steps, or at intermediate levels, of business activities, in relation to Net Revenue from Operations. It may be observed that in the case of Bajaj Auto profit has increased phenomenally up to first 4 intermediate stages, that is, up to PBEEIT. However PBT (5th stage) has come down due to loss on account of exceptional items as against huge income from this item during the last year. Finally the PAT (stage 6) at ` 3,004.05 crore is also lower as compared to ` 3,339.73 crore in 2010–11 due to the above reason and further higher tax expense during 2011–12. This is despite the rise in Revenue from Operations (net) during 2011–12. However since absolute figures are not amenable to further analysis we will use this multi-step income statement for horizontal and vertical analyses that follow where its features will come to fore. HORIZONTAL ANALYSIS The Tool This is a very simple tool in the tool kit of an analyst. It facilitates a quick review of the current year’s performance and financial position of a business over the previous year. The methodology is: 1. To work out change (increase/decrease) in each item of the balance sheet and statement of profit and loss of the current year over that of the last year and, 2. To express these changes as a % age of last year’s figure. The analysis resolves around finding: Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 445 1. Whether the growth in PAT is proportionate to growth in revenue from operations (net) or not, 2. Whether growth in assets has led to a proportionate rise in revenue from operations (net) and PAT or not, and 3. To analyse the reasons for a positive as well as negative change. Let us put it in the form of a formula. (Current year’s figure – Previous year’s figure) Previous year’s figure CASE X 100 2 Horizontal Financial Statements of Bajaj Auto Ltd. The statement of profit and loss of Bajaj Auto Ltd. for the year ended 31 March 2012 has already been provided in the case 1 above. The balance sheet of the company is now appended hereunder. REPORT BAJAJ AUTO LIMITED Distinctly Ahead……………….Since 1945 BALANCE SHEET AS AT 31ST MARCH Note No. 2012 (` in Crore) 2011 EQUITY AND LIABILITIES Shareholders’ funds Share capital Reserves and surplus 2 3 289.37 5,751.70 6,041.07 289.37 4,620.85 4,910.22 Non-current liabilities Long-term borrowings Deferred tax liabilities (net) Other long-term liabilities Long-term provisions 4 5 6 7 97.48 48.44 157.07 111.85 414.84 133.88 29.71 193.71 124.54 481.84 Current liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions 8 9 9 7 – 2,003.08 559.04 2,063.04 4,625.16 11,081.07 157.84 1,789.26 477.11 1,431.26 3,855.47 9,247.53 Particulars Total 446 Financial Accounting for Management ASSETS Non-current assets Fixed assets Tangible assets Intangible assets Capital work-in-progress Intangible assets under development 10 10 Non-current investments Long-term loans and advances Other non-current assets 11 12 14 Current assets Current investments Inventories Trade receivables Cash and bank balances Short-term loans and advances Other current assets 11 15 13 16 12 14 Total Summary of significant accounting policies followed by the Company 1,479.59 2.14 11.77 29.88 1,523.38 3,786.21 579.90 1.43 5,890.92 1,478.43 4.28 69.86 1,552.57 4,035.08 226.96 401.77 6,216.38 1,096.60 678.53 422.79 1,653.83 1,042.81 295.59 5,190.15 11,081.07 686.83 547.28 359.89 228.78 992.09 216.28 3,031.15 9,247.53 1 The horizontal statement of profit and loss in the multi-step format and horizontal balance sheet of Bajaj Auto Ltd. for the year ended 31 March 2012, constructed in accordance with the methodology outlined above, are presented hereunder in illustration 2.1 and 2.2. ILLUSTRATION 2.1 BAJAJ AUTO LTD. Distinctly Ahead……………………Since 1945 HORIZONTAL STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31ST MARCH (` in Crore) Particulars Sales Less: Excise duty Net sales Other operating revenue Net Revenue from operations 2012 19,827.03 946.76 18,880.27 648.71 19,528.98 2011 16,830.23 933.41 15,896.82 501.41 16,398.23 Change-Increase/ (decrease) over 2011 ` in crore %age 2,996.80 17.81 13.35 1.43 2,983.45 18.77 147.30 29.38 3,130.75 19.09 Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I Expenses: Cost of raw material and components consumed Purchases of traded goods (Increase)/decrease in inventories of finished goods, work-in-progress and traded goods Manufacturing expenses Cost of goods sold (COGS) Gross profit-GP Employee benefits expense Marketing, administrative and other expenses Less: Expenses, included in above items, capitalized Profit before depreciation, interest and tax-PBDIT Depreciation and amortization expense Operating profit-OP/PBIT Finance costs (+) Other income (Non-operating) Profit before exceptional and extraordinary items and tax (PBEEIT) Exceptional items Profit before tax-PBT Tax expense Current tax Deferred tax Total tax expense Profit (Loss) after tax for the year after tax-NP/PAT 447 13,445.54 11,311.89 2,133.65 18.86 751.15 (94.15) 568.41 (82.79) 182.74 (11.36) 32.15 13.72 650.61 14,753.15 4,775.83 540.11 565.16 (49.43) 506.46 12,303.97 4,094.26 493.58 446.12 (16.66) 144.15 2,449.18 681.57 46.53 119.04 (32.77) 28.46 19.91 16.65 9.43 26.68 196.70 3,719.99 145.62 3,574.37 22.24 608.04 3,171.22 122.84 3,048.38 1.69 576.51 548.77 22.78 525.99 20.55 31.53 17.30 18.54 17.25 1215.98 5.47 4,160.17 (134.00) 4,026.17 3,623.20 724.55 4,347.75 536.97 (858.55) (321.58) 14.82 (118.49) (7.40) 1,003.39 18.73 1,022.12 980.00 28.02 1,008.02 23.39 (9.29) 14.10 2.39 (33.15) 1.40 3,004.05 3,339.73 (335.68) (10.05) ILLUSTRATION BAJAJ AUTO LTD. Distinctly Ahead……………….Since 1945 2.2 HORIZONTAL BALANCE SHEET AS AT 31ST MARCH (` in Crore) Particulars EQUITY AND LIABILITIES Shareholders’ funds Share capital Reserves and surplus 2012 2011 289.37 5,751.70 6,041.07 289.37 4,620.85 4,910.22 Change-Increase/(decrease) over 2011 (` in Crore) %age 1,130.85 1,130.85 0.00 24.47 23.03 448 Financial Accounting for Management Non-current liabilities Long-term borrowings Deferred tax liabilities (net) Other long-term liabilities Long-term provisions Current liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions Total ASSETS Non-current assets Fixed assets Tangible assets Intangible assets Capital work-in-progress Intangible assets under development Non-current investments Long-term loans and advances Other non-current assets Current assets Current investments Inventories Trade receivables Cash and bank balances Short-term loans and advances Other current assets Total 97.48 48.44 157.07 111.85 414.84 133.88 29.71 193.71 124.54 481.84 (36.40) 18.73 (36.64) (12.69) (67.00) (27.19) 63.04 (18.91) (10.19) (13.91) 0.00 2,003.08 559.04 2,063.04 4,625.16 11,081.07 157.84 1,789.26 477.11 1,431.26 3,855.47 9,247.53 (157.84) 213.82 81.93 631.78 769.69 1,833.54 (100.00) 11.95 17.17 44.14 19.96 19.83 1,479.59 2.14 11.77 29.88 1,523.38 3,786.21 579.90 1.43 5,890.92 1,478.43 4.28 69.86 0.00 1,552.57 4,035.08 226.96 401.77 6,216.38 0.08 (50.00) (83.15) 2,988.00 (1.88) (6.17) 155.51 (99.64) (5.24) 1,096.60 678.53 422.79 1,653.83 1,042.81 295.59 5,190.15 11,081.07 686.83 547.28 359.89 228.78 992.09 216.28 3,031.15 9,247.53 1.16 (2.14) (58.09) 29.88 (29.19) (248.87) 352.94 (400.34) (325.46) 409.77 131.25 62.90 1,425.05 50.72 79.31 2,159.00 1,833.54 59.66 23.98 17.48 622.89 5.11 36.67 71.23 19.83 Horizontal Analysis of Bajaj Auto Ltd. An analysis now follows. Statement of profit and loss: 1. Growth in Net Revenue from operations by 19.09%. 2. Increase in COGS disproportionately higher by 19.91% mainly due to very high increase of 28.46% in manufacturing expenses. This has resulted in to lower growth of 16.65% in GP. Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 449 3. Lower increase in employee benefit expense (9.43%) and higher increase in marketing, administrative and other expenses (26.68%) and expenses capitalized (196.70%) has led to growth in PBDIT by 17.30% as against improvement in GP by 16.65% only. 4. PBIT growth down to 17.25% as against 17.30% in PBDIT due to depreciation and amortization expense being higher by 18.54%. 5. PBEEIT growth badly affected, being down to 14.82%, due to high increase in finance costs (1215.98%) and very low growth in other income (non-operating) by 5.47% only. However absolute figures of finance costs not high compared to Revenue from operations (net). 6. Exceptional items, having large income last year, have shown a loss this year to the extent of 118.49%. The result is sharp decline in PBT to the tune of 7.40%. 7. Despite lower PBT during 2011-12 (` 4,026.17 crore against ` 4,347.75 crore), higher tax expense (1.40%) has ultimately resulted in a sharp decline in PAT to the extent of 10.05%. 8. The result: though profit at first four stages, i.e., GP, PBDIT, PBIT and PBEEIT, is higher in absolute terms, it has not been able to maintain growth equal to revenue from operations (net) due to higher manufacturing expenses and marketing, administrative and other expenses. It shows that operational efficiency needs to be improved. Further PBT and PAT have come down in absolute terms, the later registering a decline of 10.05% as against growth in revenue from operations (net) by 19.09% mainly due to exceptional losses. Balance Sheet 1. Total assets / liabilities up by 19.83%. 2. Net worth up by 23.03%. Long term borrowings redeemed to the extent of 27.19% and short term borrowings redeemed in full. Strong solvency position. 3. Fixed assets down by 1.88% whereas net revenue from operations grew by 19.09%. Very efficient fixed asset utilization. 4. Non-current investments declined by 6.17%. Current investments increased by 59.66%. Whereas growth in other income -Non-operating (mainly related to investments) 5.47%. Total investments (non-current plus current) in absolute terms very high: ` 4,882.81 crore and ` 4,721.91 crore respectively as on 31-03-2012 and 31-03-2011. Thus net increase in 2011-12 amounts to 1.03% only. Growth of other income in this backdrop is commendable. 5. Efficient management of trade receivables. Lower growth of 17.48% as against growth in revenue from operations (net) by 19.09%. 6. Cash and bank balances grew by a whopping 622.89% to `1653.83 crore. Overall Assessment 1. Decline in PAT despite growth in revenue from operations (net). Margins under pressure. Profits through volumes. 2. Operational efficiency needs to be improved. Need to contain manufacturing expenses and marketing, administrative and other expenses. 3. High dependence on gain on account of exceptional items. 450 Financial Accounting for Management 4. Very efficient fixed asset utilization. 5. Management of receivables efficient. 6. Total investments, cash and bank balances and short term loans and advances put together amount to ` 7,579.45 crore as on 31-03-2012 as against net worth of ` 6,041.07 crore on that date, being higher than the net worth, which means operations are being funded by liabilities and huge profit is being derived from them. Making money out of outsiders’ money most of which is non-interest bearing. 7. Extremely strong financial position. Company sitting on a large war chest. COMMON-SIZED ANALYSIS The Tool This tool is very useful in comparing the performance and financial position of two companies, either in the same industry or in different fields. Since no two balance sheets will have the same figures they cannot be compared and analyzed based on absolute figures. They have therefore to be converted into what is known as common-sized statements. The conversion process is very simple: 1. In the case of balance sheet each item is restated taking the total of ‘Equity and Liabilities’ / ‘Assets’ as 100. 2. Likewise in the case of statement of profit and loss ‘Revenue from Operations (net)’ is taken as 100 and all other items are restated proportionately. Therefore it is also known as Vertical Analysis. Common sized analysis is carried out for the same company over two or more years, to supplement the horizontal analysis and trend analysis, to study the changes in the asset-liability mix in the case of balance sheet and their impact on the profits and to study the proportion of different expenses in relation to ‘Revenue from Operations (net)’ to find out trends in corporate expense pattern so as to concentrate on cost economies in the areas of concern. Likewise a common-sized statement can be prepared for manufacturing, administrative and other expenses to make strategies to check the costs. Refer to chapter 21, section 1, for its illustration and use. CASE 3 Common-sized Financial Statements of Bajaj Auto Ltd. and TVS Motor Company Ltd. TVS Motor’s note XXII to the financial statements: ‘Other Expenses’ for the year ended 31 March 2012 is appended hereunder. This note is required to segregate manufacturing expenses out of other expenses. These details of Bajaj Auto Ltd. have already been provided earlier. Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 451 REPORT TVS MOTOR COMPANY LTD. NOTE XXII TO FINANCIAL STATEMENTS FOR THE YEAR ENDED 31 MARCH 2012 Other Expenses Consumption of stores, spares and tools Power and fuel * Rent* Repairs—buildings* Repairs—plant and equipment* Insurance Rates and taxes (excluding taxes on income) Audit fees Packing and freight charges* Advertisement and publicity* Other marketing expenses* Net loss on sale of investments (Net of gain of ` 0.01 crores) Diminution in the value of investments (i.e. adjustment to the carrying amount of investments) Loss on sale of fixed assets Miscellaneous expenses* (under this head there is no expenditure which is in excess of 1% of revenue from operations or ` 1 lakh, whichever is higher) Year ended 31-03-2012 54.24 89.77 16.05 8.34 49.84 2.37 3.09 0.29 231.83 138.82 210.49 0.09 – (` in crores) Year ended 31-03-2011 48.71 68.10 10.79 6.29 48.12 2.20 3.84 0.29 195.16 184.79 182.69 – 3.36 1.46 218.99 14.15 186.85 1,025.67 955.34 * Net of recoveries The statements of profit and loss and balance sheets of Bajaj Auto Ltd. and TVS Motor Company Ltd. for the year ended 31st March 2012, readied for common-sized analysis as discussed above, are presented in illustration 3.1 to 3.4. Both the companies operate in the same two wheeler industry. They are selected for comparison purposes. 452 Financial Accounting for Management ILLUSTRATION 3.1 BAJAJ AUTO LTD. Distinctly Ahead……………….Since 1945 COMMON-SIZED STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31ST MARCH Particulars Sales 2012 (` in Crore) Commonsized %age 101.53 19,827.03 946.76 4.85 18,880.27 96.68 648.71 3.32 19,528.98 100.00 2011 (` in Crore) Commonsized %age 102.63 16,830.23 933.41 5.69 15,896.82 96.94 501.41 3.06 16,398.23 100.00 Less: Excise duty Net sales Other operating revenue Net Revenue from operations Expenses: Cost of raw material and components consumed 13,445.54 68.85 11,311.89 68.98 Purchases of traded goods 751.15 3.85 568.41 3.47 (Increase)/decrease in inventories of finished goods, (94.15) –0.48 (82.79) –0.50 work-in-progress and traded goods Manufacturing expenses 650.61 3.33 506.46 3.09 Cost of goods sold (COGS) 14,753.15 75.54 12,303.97 75.03 Gross profit-GP 4,775.83 24.46 4,094.26 24.97 Employee benefits expense 540.11 2.77 493.58 3.01 Marketing, administrative and other expenses 565.16 2.89 446.12 2.72 Less: Expenses, included in above items, capitalized (49.43) (0.25) (16.66) (0.10) Profit before depreciation, interest and tax-PBDIT 3,719.99 19.05 3,171.22 19.34 Depreciation and amortization expense 145.62 0.75 122.84 0.75 Operating profit-OP/PBIT 3,574.37 18.30 3,048.38 18.59 Finance costs 22.24 0.11 1.69 0.01 (+) Other income (Non-operating) 608.04 3.11 576.51 3.52 Profit before exceptional and extraordinary items 4,160.17 21.30 3,623.20 22.10 and tax (PBEEIT) Exceptional items (134.00) (0.69) 724.55 4.42 Profit before tax-PBT 4,026.17 20.62 4,347.75 26.51 Tax expense Current tax 1,003.39 5.14 980.00 5.98 Deferred tax 18.73 0.10 28.02 0.17 Total tax expense 1,022.12 5.23 1,008.02 6.15 Profit (Loss) after tax for the year after tax-NP/PAT 3,004.05 15.38 3,339.73 20.37 Note: Since the calculations have been done through Excel, common-sized %ages at every stage may not add up exactly. 453 Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I ILLUSTRATION BAJAJ AUTO LTD. Distinctly Ahead……………….Since 1945 3.2 COMMON-SIZED BALANCE SHEET AS AT 31ST MARCH 2007 Particulars 2012 (` in crore) EQUITY AND LIABILITIES Shareholders’ funds Share capital Reserves and surplus Non-current liabilities Long-term borrowings Deferred tax liabilities (net) Other long-term liabilities Long-term provisions Current liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions Total ASSETS Non-current assets Fixed assets Tangible assets Intangible assets Capital work-in-progress Intangible assets under development Non-current investments Long-term loans and advances Other non-current assets Current assets Current investments Inventories Trade receivables Cash and bank balances Short-term loans and advances Other current assets Commonsized %age (` in Crore) 2011 Common-sized %age 289.37 5,751.70 6,041.07 2.61 51.91 54.52 289.37 4,620.85 4,910.22 3.13 49.97 53.10 97.48 48.44 157.07 111.85 414.84 0.88 0.44 1.42 1.01 3.74 133.88 29.71 193.71 124.54 481.84 1.45 0.32 2.09 1.35 5.21 – 2,003.08 559.04 2,063.04 4,625.16 11,081.07 – 18.08 5.05 18.62 41.74 100.00 157.84 1,789.26 477.11 1,431.26 3,855.47 9,247.53 1.71 19.35 5.16 15.48 41.69 100.00 1,479.59 2.14 11.77 29.88 1,523.38 3,786.21 579.90 1.43 5,890.92 13.35 0.02 0.11 0.27 13.75 34.17 5.23 0.01 53.16 1,478.43 4.28 69.86 – 1,552.57 4,035.08 226.96 401.77 6,216.38 15.99 0.05 0.76 – 16.79 43.63 2.45 4.34 67.22 1,096.60 9.90 686.83 7.43 678.53 6.12 547.28 5.92 422.79 3.82 359.89 3.89 1,653.83 14.92 228.78 2.47 1,042.81 9.41 992.09 10.73 295.59 2.67 216.28 2.34 5,190.15 46.84 3,031.15 32.78 Total 11,081.07 100.00 9,247.53 100.00 Note: Since the calculations have been done through Excel, common-sized %ages at every stage may not add up exactly. 454 Financial Accounting for Management ILLUSTRATION 3.3 TVS MOTOR COMPANY LIMITED COMMON-SIZED STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31ST MARCH 2012 (Rupees in crores) Year ended 31-03-2012 Commonsized %age Year ended 31-03-2011 Commonsized %age 7,126.20 100.00 6,288.02 100.00 Cost of materials consumed 5,132.28 72.02 4,650.65 73.96 Purchases of stock-in-trade 143.91 2.02 107.14 1.70 Changes in inventories of finished goods, work-in process and stock-in-trade (15.14) (0.21) (143.88) (2.29) Manufacturing expenses 436.39 6.12 368.58 5.86 Cost of goods sold (COGS) 5,697.44 79.95 4,982.49 79.24 Gross profit (GP) 1,428.76 20.05 1,305.53 20.76 Employee benefits expense 370.11 5.19 326.72 5.20 Marketing, administrative and other expenses 589.28 8.27 586.76 9.33 Profit before depeciation, interest and tax-PBDIT Depreciation and amortization expense 469.37 6.59 392.05 6.23 117.53 1.65 107.25 1.71 Operating profit (OP/PBIT) 351.84 4.94 284.80 4.53 Finance costs 57.09 0.80 72.33 1.15 (+) Other income (non-operating) 21.71 0.30 35.62 0.57 Profit before tax-PBT 316.46 4.44 248.09 3.95 (1) Current tax 65.50 0.92 72.42 1.15 (2) Deferred tax 1.89 0.03 (18.91) (0.30) (3) Total tax 67.39 0.95 53.51 0.85 Profit/(Loss) for the period -NP/PAT 249.07 3.50 194.58 3.09 Net Revenue from operations Expenses: Tax expense: Note: Since the calculations have been done through Excel, common-sized %ages at every stage may not add up exactly. Working note on ‘Other Expenses’: A. Total ‘other expenses’ as per note XXII to the financial statements B. Less: Out of which manufacturing expenses 1. Consumption of stores, spares and tools 2. Power and fuel (Rupees in crores) 2012 2011 1,025.67 955.34 54.24 89.77 48.71 68.1 Chapter 17 Financial Statement Analysis and the Tool Kit of the Analyst: I 455 3. Repairs-building 8.34 6.29 4. Repairs-plant and machinery 49.84 48.12 5. Insurance 2.37 2.2 6. Packing and freight charges 231.83 195.16 Sub-total ‘B’……..taken above 436.39 368.58 C. Balance being marketing, administrative and other expenses’ taken above’ 589.28 586.76 Note: Manufacturing expenses have been identified to the extent possible. The table may noy represent exact details. ILLUSTRATION 3.4 TVS MOTOR COMPANY LIMITED COMMON-SIZED BALANCE SHEET AS AT 31ST MARCH, 2012 As at 31-03-2012 (` in Crore) As at 31-03-2011 Commonsized %age (` in Crore) Commonsized %age I EQUITY AND LIABILITIES 1 Shareholders’ funds (a) Share capital 47.51 1.51 47.51 1.66 1,121.79 35.72 951.90 33.31 1,169.30 37.23 999.41 34.97 (a) Long-term borrowings 479.93 15.28 554.34 19.40 (b) Deferred tax liabilities (Net) 97.55 3.11 95.66 3.35 (b) Reserves and s

Financial Accounting for Management: An Analytical Perspective

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