MASTER OF BUSINESS
ADMINISTRATION (MBA)
III YEAR (FINANCE)
PAPER III
CORPORATE FINANCIAL
ACCOUNTING
WRITTEN BY
SEHBA HUSSAIN
EDITTED BY
PROF. SHAKOOR KHAN
MASTER OF BUSINESS
ADMINISTRATION (MBA)
III YEAR (FINANCE)
PAPER III
CORPORATE FINANCIAL
ACCOUNTING
BLOCK 1
INTRODUCTION TO CORPORATE
FINANCIAL ACCONTING
2
PAPER III
CORPORATE FINANCIAL ACCOUNTING
BLOCK 1
INTRODUCTION TO CORPORATE FINANCIAL
ACCOUNTING
CONTENTS
Page number
Unit 1 Fundamentals of Corporate Financial Accounting
5
Unit 2 Accounting for investment decisions
28
Unit 3 Human Resource and Value Added Accounting
65
3
BLOCK 1 INTRODUCTION TO CORPORATE
FINANCIAL ACCOUNTING
Corporate financial accounting is an important area of consideration of all business units.
There is a corporate financial aspect to almost every decision made by a business. This
block presents to you the introduction to corporate financial accounting and various types
of financial accounting practices with the help of three consecutive units.
Unit 1 is about fundamental concepts of corporate financial accounting. After its
introduction unit moves on discussing accounting theory, postulates and conventions
followed by accounting equations. Accounting of price level changes and significance
and limitations of price level accounting with techniques and models of price level
accounting will be explained in detailed manner.
Unit 2 focuses on accounting for investment decisions and social accounting. Various
accounting approaches to investment decisions will be described and concept,
significance and scope of social accounting will be highlighted with help of suitable
illustrations and cases. Finally social auditing will be explained in the detail.
Unit 3 of this block highlights the Human resource and value added accounting and
related concepts. Areas of discussion of this unit include conceptual frame and HRA
scenario; the need for human resource accounting; information management in HRA;
approaches to analyse human resource; measures for assessing individual value; human
resource practices in India and value added accounting
4
UNIT 1
FUNDAMENTALS OF CORPORATE FINANCIAL
ACCOUNTING
Objectives
After studying this unit, you should be able to understand and appreciate:





The concept of corporate finance and accounting for corporate finance
Accounting theory, postulates and conventions
Accounting equations and calculations with its relevance
Significance and limitations of price level accounting
The techniques and models of price level accounting
Structure
1.1 Introduction to corporate finance
1.2 Corporate financial accounting
1.3 Accounting theory, postulates and conventions
1.4 Accounting equations
1.5 Accounting of price level changes
1.6 Significance and limitations of price level accounting
1.7 Techniques and models of price level accounting
1.8 Summary
1.9 Further readings
1.1 INTRODUCTION TO CORPORATE FINANCE
Corporate finance is an area of finance dealing with financial decisions business
enterprises make and the tools and analysis used to make these decisions. The primary
goal of corporate finance is to maximize corporate value while managing the firm's
financial risks. Although it is in principle different from managerial finance which studies
the financial decisions of all firms, rather than corporations alone, the main concepts in
the study of corporate finance are applicable to the financial problems of all kinds of
firms.
The discipline can be divided into long-term and short-term decisions and techniques.
Capital investment decisions are long-term choices about which projects receive
investment, whether to finance that investment with equity or debt, and when or whether
to pay dividends to shareholders. On the other hand, the short term decisions can be
grouped under the heading "Working capital management". This subject deals with the
short-term balance of current assets and current liabilities; the focus here is on managing
5
cash, inventories, and short-term borrowing and lending (such as the terms on credit
extended to customers).
The terms corporate finance and corporate financier are also associated with investment
banking. The typical role of an investment bank is to evaluate the company's financial
needs and raise the appropriate type of capital that best fits those needs.
1.1.1 Investment decisions
Capital investment decisions are long-term corporate finance decisions relating to fixed
assets and capital structure. Decisions are based on several inter-related criteria. (1)
Corporate management seeks to maximize the value of the firm by investing in projects
which yield a positive net present value when valued using an appropriate discount rate.
(2) These projects must also be financed appropriately. (3) If no such opportunities exist,
maximizing shareholder value dictates that management must return excess cash to
shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise
an investment decision, a financing decision, and a dividend decision.
1. The investment decision
Management must allocate limited resources between competing opportunities (projects)
in a process known as capital budgeting. Making this capital allocation decision requires
estimating the value of each opportunity or project, which is a function of the size, timing
and predictability of future cash flows.
a. Project valuation
In general, each project's value will be estimated using a discounted cash flow (DCF)
valuation, and the opportunity with the highest value, as measured by the resultant net
present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951;
see also Fisher separation theorem, John Burr Williams: theory). This requires estimating
the size and timing of all of the incremental cash flows resulting from the project. Such
future cash flows are then discounted to determine their present value (see Time value of
money). These present values are then summed, and this sum net of the initial investment
outlay is the NPV.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount
rate - often termed, the project "hurdle rate" - is critical to making an appropriate
decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the
project appropriate discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and must take into account the
financing mix. Managers use models such as the CAPM or the APT to estimate a
discount rate appropriate for a particular project, and use the weighted average cost of
capital (WACC) to reflect the financing mix selected. (A common error in choosing a
discount rate for a project is to apply a WACC that applies to the entire firm. Such an
6
approach may not be appropriate where the risk of a particular project differs markedly
from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection
criteria in corporate finance. These are visible from the DCF and include discounted
payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
Alternatives (complements) to NPV include MVA / EVA (Stern Stewart & Co) and APV
(Stewart Myers). See list of valuation topics.
b. Valuing flexibility
In many cases, for example R&D projects, a project may open (or close) paths of action
to the company, but this reality will not typically be captured in a strict NPV approach
Management will therefore (sometimes) employ tools which place an explicit value on
these options. So, whereas in a DCF valuation the most likely or average or scenario
specific cash flows are discounted, here the “flexibile and staged nature” of the
investment is modelled, and hence "all" potential payoffs are considered. The difference
between the two valuations is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real options analysis
(ROA); they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and consequent
management decisions. (For example, a company would build a factory given that
demand for its product exceeded a certain level during the pilot-phase, and
outsource production otherwise. In turn, given further demand, it would similarly
expand the factory, and maintain it otherwise. In a DCF model, by contrast, there
is no "branching" - each scenario must be modelled separately.) In the decision
tree, each management decision in response to an "event" generates a "branch" or
"path" which the company could follow; the probabilities of each event are
determined or specified by management. Once the tree is constructed: (1) "all"
possible events and their resultant paths are visible to management; (2) given this
“knowledge” of the events that could follow, management chooses the actions
corresponding to the highest value path probability weighted; (3) then, assuming
rational decision making, this path is taken as representative of project value. See
Decision theory: Choice under uncertainty.

ROA is usually used when the value of a project is contingent on the value of
some other asset or underlying variable. (For example, the viability of a mining
project is contingent on the price of gold; if the price is too low, management will
abandon the mining rights, if sufficiently high, management will develop the ore
body. Again, a DCF valuation would capture only one of these outcomes.) Here:
(1) using financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option; (2) an
appropriate valuation technique is then employed - usually a variant on the
Binomial options model or a bespoke simulation model, while Black Scholes type
7
formulae are used less often - see Contingent claim valuation. (3) The "true" value
of the project is then the NPV of the "most likely" scenario plus the option value.
(Real options in corporate finance were first discussed by Stewart Myers in 1977;
viewing corporate strategy as a series of options was originally per Timothy
Luehrman, in the late 1990s.)
c. Quantifying uncertainty
Given the uncertainty inherent in project forecasting and valuation, analysts will wish to
assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF
model. In a typical sensitivity analysis the analyst will vary one key factor while holding
all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor
is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst
will determine NPV at various growth rates in annual revenue as specified (usually at set
increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this
formula. Often, several variables may be of interest, and their various combinations
produce a "value-surface" (or even a "value-space"), where NPV is then a function of
several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a
scenario comprises a particular outcome for economy-wide, "global" factors (demand for
the product, exchange rates, commodity prices, etc...) as well as for company-specific
factors (unit costs, etc...). As an example, the analyst may specify specific revenue
growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best
Case"), where all key inputs are adjusted so as to be consistent with the growth
assumptions, and calculate the NPV for each. Note that for scenario based analysis, the
various combinations of inputs must be internally consistent, whereas for the sensitivity
approach these need not be so. An application of this methodology is to determine an
"unbiased" NPV, where management determines a (subjective) probability for each
scenario – the NPV for the project is then the probability-weighted average of the various
scenarios.
A further advancement is to construct stochastic or probabilistic financial models – as
opposed to the traditional static and deterministic models as above. For this purpose, the
most common method is to use Monte Carlo simulation to analyze the project’s NPV.
This method was introduced to finance by David B. Hertz in 1964, although has only
recently become common: today analysts are even able to run simulations in spreadsheet
based DCF models, typically using an add-in, such as Crystal Ball. Using simulation, the
cash flow components that are (heavily) impacted by uncertainty are simulated,
mathematically reflecting their "random characteristics". Here, in contrast to the scenario
approach above, the simulation produces several thousand random but possible
outcomes, or "trials"; see Monte Carlo Simulation versus “What If” Scenarios. The
output is then a histogram of project NPV, and the average NPV of the potential
investment – as well as its volatility and other sensitivities – is then observed. This
histogram provides information not visible from the static DCF: for example, it allows for
8
an estimate of the probability that a project has a net present value greater than zero (or
any other value).
Continuing the above example: instead of assigning three discrete values to revenue
growth, and to the other relevant variables, the analyst would assign an appropriate
probability distribution to each variable (commonly triangular or beta), and, where
possible, specify the observed or supposed correlation between the variables. These
distributions would then be "sampled" repeatedly - incorporating this correlation - so as
to generate several thousand scenarios, with corresponding valuations, which are then
used to generate the NPV histogram. The resultant statistics (average NPV and standard
deviation of NPV) will be a more accurate mirror of the project's "randomness" than the
variance observed under the scenario based approach.
2. The financing decision
Achieving the goals of corporate finance requires that any corporate investment be
financed appropriately. As above, since both hurdle rate and cash flows (and hence the
riskiness of the firm) will be affected, the financing mix can impact the valuation.
Management must therefore identify the "optimal mix" of financing—the capital
structure that results in maximum value. (See Balance sheet, WACC, Fisher separation
theorem; but, see also the Modigliani-Miller theorem.)
The sources of financing will, generically, comprise some combination of debt and equity
financing. Financing a project through debt results in a liability or obligation that must be
serviced, thus entailing cash flow implications independent of the project's degree of
success. Equity financing is less risky with respect to cash flow commitments, but results
in a dilution of ownership, control and earnings. The cost of equity is also typically higher
than the cost of debt (see CAPM and WACC), and so equity financing may result in an
increased hurdle rate which may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the asset being financed as
closely as possible, in terms of both timing and cash flows.
One of the main theories of how firms make their financing decisions is the Pecking
Order Theory, which suggests that firms avoid external financing while they have
internal financing available and avoid new equity financing while they can engage in new
debt financing at reasonably low interest rates. Another major theory is the Trade-Off
Theory in which firms are assumed to trade-off the tax benefits of debt with the
bankruptcy costs of debt when making their decisions. An emerging area in finance
theory is right-financing whereby investment banks and corporations can enhance
investment return and company value over time by determining the right investment
objectives, policy framework, institutional structure, source of financing (debt or equity)
and expenditure framework within a given economy and under given market conditions.
One last theory about this decision is the Market timing hypothesis which states that
firms look for the cheaper type of financing regardless of their current levels of internal
resources, debt and equity.
9
3. The dividend decision
Whether to issue dividends, and what amount, is calculated mainly on the basis of the
company's inappropriated profit and it’s earning prospects for the coming year. If there
are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then
management must return excess cash to investors. These free cash flows comprise cash
remaining after all business expenses have been met.
This is the general case, however there are exceptions. For example, investors in a
"Growth stock", expect that the company will, almost by definition, retain earnings so as
to fund growth internally. In other cases, even though an opportunity is currently NPV
negative, management may consider “investment flexibility” / potential payoffs and
decide to retain cash flows; see above and Real options.
Management must also decide on the form of the dividend distribution, generally as cash
dividends or via a share buyback. Various factors may be taken into consideration: where
shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a
stock buyback, in both cases increasing the value of shares outstanding. Alternatively,
some companies will pay "dividends" from stock rather than in cash; see Corporate
action. Today, it is generally accepted that dividend policy is value neutral (see
Modigliani-Miller theorem).
1.2 CORPORATE FINANCIAL ACCOUNTING
The concept of corporate financial accounting is used to maintain the financial
accounting of a business. The main goal of financial accounting techniques opted by the
businesses and firms is to estimate and then increase the firm's value. The corporate
financial accounting deals with the policies or financial issues that are associated with
attaining the financial goal of the firm. The accounting decisions taken by the firms
include decisions regarding investment, capital formation, merger and acquisition and
dividend
distribution
amongst
the
shareholders.
The corporate financial accounting maintains the balance sheet valuation of the firm's
assets and liabilities. The managers of the firm take necessary decisions to increase the
values of shares while increasing the value of the firm. The equity values of the firm are
observed at different points in time and the financial decisions that are taken by the
management can be judged effectively on that ground. The fundamental way of
measuring the equity value of a company is done by subtracting the liabilities from the
assets in the balance sheet.
But it is often seen that the book value of the firm's equity value don't find resemblance in
the real life. This is because the assets of the firm are recorded in the balance sheet at
historical rate that may be different from the present market value and also because some
assets of the firm such as trademarks, patents, talented managers and loyal customers are
not included in the balance sheet. Hence we can say that the balance sheet method is
simple
but
is
not
accurate.
10
Determining the future flow of cash is another way to measure the value of the firm. A
model to evaluate the firm is designed on cash flow giving a better picture of the
effectiveness
of
the
financial
decisions.
Other ways of calculating the value of firm are:











Cash cycle
Assets
Revenue, Inventory and Expenses
Financial Ratios
Bank Loans
Sustainable Growth
Uses and Sources of Cash
Firm Value, Debt Value and Equity Value
Capital Structure
Cost of Capital
Risk Premiums
1.3 ACCOUNTING THEORY, POSTULATES AND CONVENTIONS
All fields of knowledge have theories to base its practices. That is, theories play a crucial
role in formulating postulates, principles so that it can develop objectives, rules,
procedures and methods to continue to revise the methods based on the development of
theories. In this essay, I will discuss what are theory, accounting theory, nature and role
of accounting, descriptive, normative and positive theories in accounting and the present
normative accounting theory of conceptual framework. As well, we will discuss
accounting postulates, concepts and principles, which are based on accounting theories.
The purpose of theory plays an important part in any field. This applies to accounting
also. The most important utility of theories in any field of inquiry is that it is a source of
new knowledge as they change with new insights by continuous research in any
particular field by the researchers who are acknowledged by the profession because of
their expertise, integrity, experience and knowledge in that field. In this context,
accounting needs theories so that it can develop new knowledge continually as in other
fields
such
as
science,
social
science,
psychology
etc.
The nature of accounting is primarily a statement which has some basic principles and
concepts. That is the nature of accounting is defined by an accounting theory. In essence
the nature of accounting can be defined as follows:
“The nature of accounting is a process of identifying, measuring and communicating
economic information to permit informed judgments and decisions by users of
information”.
11
1.3.1 The Measurement-Communication System
In the measurement communication system the accountant is the transmitter of
accounting information. He sends the message in a financial report form to the users or
receivers of this crucial information. The accountant is influential in identifying
economic information, objectives and in the same time he is also affected by the firm’s
environment. The receivers of accounting information in the communication system
interpret the information about the firm and then make economic decisions. In this
communication system one can see the communication system is basically based on
human behavior. As well, the accounting practitioners are governed by conventions and
authority. That is their accounting procedures and accounting policies are largely
determined by conventions and authority. In addition, the accounting researchers like in
any other field develop accounting theories by systematic study in the accounting field.
1.3.2 Functions of theories
Basically theories have three functions. The first function of theory or theories is to
explain. For example why an accountant do not do a particular accounting method
because of ethical codes and accounting standards require him to use such methods and
he uses these accounting methods to protect him from sanctions imposed by
accounting bodies and for his own self interest of not being able to practice and earn an
income if he does not obey to authority and sanctions.
The second function of theory is to predict. For example in accounting a theory may
predict cosmetic accounting changes may not affect share price if the capital market is
efficient and share price is not based only on accounting information but other
information as well and there fore accounting methods changes may not affect share
prices. The third function of a theory is to prescribe or recommend. For example in
accounting the accounting theory may recommend current cost accounting because of its
utility or should be used to provide as it may provide useful information to users.
However, all theories do not have all these functions. Some theories explain, some
explain and predict, some predict only and some only recommend.
1.3.3 History of Accounting Theory
The history of accounting can be categorized in to descriptive theory period before 1955,
normative theory period between 1956 and 1974 and positive accounting theory period
after 1976.
However, currently mostly many advanced countries at least one can say the accounting
theories are based on conceptual frame work based on primarily by normative accounting
theories as well as in some accounting issues positive accounting theories are used to
explain behavior of managers and the impact of accounting on capital market
performance in general.
12
The examples of descriptive accounting theories used before 1955 are based on
observations and what is used in accounting a particular economic event mostly is adopted
as a method for that transaction in a particular field. For example if depreciation is used
in practice applying a certain method then that is accepted as a method of accounting if it
is widely used. That is, descriptive accounting theories guide accounting methods,
principles and conventions.
After 1956, the normative accounting theories governed to prescribe what should be
done. For example, after 1956 norms of best practice was developed by the incorporation
of usefulness of accounting information. This not necessarily based on observation. Due
to Normative accounting theories decision usefulness theories were developed and also
measurement issues and income concepts became important. As well, the normative
accounting theories gave birth to conceptual frame works projects.
After 1975 on wards because of dissatisfaction with normative theories positive
accounting theories became important. For example these theories enable the accounting
profession to explain and predict that what should be done based not necessarily based on
observation. That is the positive accounting theories are basically a specific scientific
method of inquiry in to specific accounting issues. The in accounting the important
positive accounting theories are capital market based research, contracting theory,
behavioral research.
1.3.4 The hierarchical position of financial accounting objectives,
postulates and theoretical concepts, principles of accounting and
accounting techniques
In accounting, the financial accounting objectives determine the postulates and
theoretical accounting concepts. The theoretical concepts and postulates determine
accounting principles. The accounting principles determine accounting techniques.
That is, the hierarchical positions of these related concepts are as follows:




Financial accounting objectives
Accounting postulates and Theoretical accounting concepts
Accounting principles
Accounting techniques, method, rules and procedures
1.3.5 Accounting Postulates, concepts and principles
The basic accounting postulates are accounting entity postulate, Going concern postulate,
unit of measure postulate and accounting period postulate. Theoretical accounting
concepts are propriety theory, fund theory, entity theory. The accounting principles are
revenue recognition, cost and matching, uniformity and comparability, consistency and
full disclosure, materiality and conservatism. Most of the postulates, theoretical
accounting concepts and principles are derived from descriptive accounting theories.
13
1.3.6 Critique of the development of accounting rules
The critique of the development of accounting rules mostly come from the insistence on
descriptive accounting theories historically. The development applying this accounting
theory gave birth to Generally Accepted Accounting Practice. They are piecemeal in
nature and they produced inconsistencies as well they were incapable to handle unusual
economic events. They also gave birth to creative accounting. These developments of
accounting rules were due to problems of lack of general theory, permissiveness of
accounting practice, inconsistency of practices, and defense against political interference.
To address these deficiencies conceptual framework was proposed. This is a normative
method of theory development. It is premised on the user needs driving the formulation
of rules and other operational procedures for use in practice.
1.3.7 The definition of Conceptual framework
The conceptual frame work is a system of fundamentals and interrelated objectives which
is expected to lead to consistent standards that prescribes the nature, function and limits
of financial accounting and reporting.
1.4 ACCOUNTING EQUATION
The accounting equation is Assets = Liabilities + Owner's (Stockholders') Equity. The
accounting equation should remain in balance at all times because of double-entry
accounting or bookkeeping. (Double-entry means that every transaction will affect at
least
two
accounts
in
the
general
ledger.)
Here are some examples of how the accounting equation remains in balance. An owner's
investment into the company will increase the company's assets and will also increase
owner's equity. When the company borrows money from its bank, the company's assets
increase and the company's liabilities increase. When the company repays the loan, the
company's assets decrease and the company's liabilities decrease. If the company pays
cash for a new delivery van, one asset (cash) will decrease and another asset (vehicles)
will increase. If a company provides a service to a client and immediately receives cash,
the company's assets increase and the company's owner's equity will increase because it
has earned revenue. If the company provides a service and allows the client to pay in 30
days, the company has increased its assets (Accounts Receivable) and has also increased
its owner's equity because it has earned service revenue. If the company runs a radio
advertisement and agrees to pay later, the company will incur an expense that will reduce
owner's
equity
and
has
increased
its
liabilities.
From our examples, you can see that owner's equity increased when the owner made an
investment in the business and also when revenues were earned. Owner's equity
decreased when the owner withdrew assets from the business and when expenses were
incurred.
This
leads
us
to
the
expanded
accounting
equation:
14
Assets = Liabilities + Owner's Equity + Revenues – Expenses – Draws
Now if we discuss it in detail we find that from the large, multi-national corporation
down to the corner beauty salon, every business transaction will have an effect on a
company’s financial position. The financial position of a company is measured by the
following items:
1. Assets (what it owns)
2. Liabilities (what it owes to others)
3. Owner’s Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to
understand how these three amounts relate to each other. The accounting equation for a
sole proprietorship is:
Assets = Liabilities + Owner’s Equity
The accounting equation for a corporation is:
Assets = Liabilities + Stockholders’ Equity
Assets are a company’s resources—things the company owns. Examples of assets include
cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings,
equipment, and goodwill. From the accounting equation, we see that the amount of assets
must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.
Liabilities are a company’s obligations—amounts the company owes. Examples of
liabilities include notes or loans payable, accounts payable, salaries and wages payable,
interest payable, and income taxes payable (if the company is a regular corporation).
Liabilities can be viewed in two ways:
(1)
as
claims
by
creditors
against
the
company’s
assets,
and
(2) a source—along with owner or stockholder equity—of the company’s assets.
Owner’s equity or stockholders’ equity is the amount left over after liabilities are
deducted from assets:
Assets – Liabilities = Owner’s (or Stockholders’) Equity.
Owner’s or stockholders’ equity also reports the amounts invested into the company by
the owners plus the cumulative net income of the company that has not been withdrawn
or distributed to the owners.
If a company keeps accurate records, the accounting equation will always be “in
balance,” meaning the left side should always equal the right side. The balance is
maintained because every business transaction affects at least two of a company’s
accounts. For example, when a company borrows money from a bank, the company’s
assets will increase and its liabilities will increase by the same amount. When a company
15
purchases inventory for cash, one asset will increase and one asset will decrease. Because
there are two or more accounts affected by every transaction, the accounting system is
referred to as double entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the
company’s general ledger. Each account in the general ledger is designated as to its type:
asset, liability, owner’s equity, revenue, expense, gain, or loss account.
Example
A student buys a computer for Rs.945. This student borrowed Rs.500 from his best friend
and saved another Rs.445 from his part-time job. Now his assets are worth Rs.945,
liabilities are Rs.500, and equity Rs.445.
The formula can be rewritten:
Assets - Liabilities = (Shareholders or Owners equity)
Now it shows owner's interest is equal to property (assets) minus debts (liabilities). Since
in a company owners are shareholders, owner's interest is called shareholder's equity.
Every accounting transaction affects at least one element of the equation, but always
balances. Simplest transactions also include:
Transaction
Shareholder's
Assets Liabilities
Explanation
Number
Equity
1
+ 6,000
+ 6,000
Issuing stocks for cash or other assets
Buying assets by borrowing money
2
+ 10,000 + 10,000
(taking a loan from a bank or simply
buying on credit)
Selling assets for cash to pay off
3
− 900
− 900
liabilities: both assets and liabilities are
reduced
Buying assets by paying cash by
4
+ 1,000 + 400
+ 600
shareholder's money (600) and by
borrowing money (400)
5
+ 700
+ 700
Earning revenues
Paying expenses (e.g. rent or
6
− 200
− 200
professional fees) or dividends
Recording expenses, but not paying
7
+ 100
− 100
them at the moment
8
− 500
− 500
Paying a debt that you owe
Receiving cash for sale of an asset: one
9
0
0
0
asset is exchanged for another; no
change in assets or liabilities
16
1.5 ACCOUNTING OF PRICE LEVEL CHANGES
Price changes have pervasive effects on financial statements, and good analysis must
recognize those effects and incorporate them into valuation decisions. It is wellunderstood that in an inflationary environment, conventional historical cost accounting
results in an understatement of operating assets and a mismatching of allocated costs and
revenues. The mismatching occurs because revenues reflect current general price levels
and conventional depreciation reflects past price levels. Business managers, investors and
government officials closely watch corporate profits. The trend of these profits plays a
significant role in the levels of employment, and in the national economic policy.
However, a strong argument may be made that much of the corporate profit reported
today is an illusion.
Accounting for changing price levels is of great interest. Where inflation (or deflation) is
an issue the relevance and reliability of traditional financial statements prepared on a
historical cost basis is called into question. But making price level adjustments is not
straightforward. There are competing conceptual approaches, an understanding of which
will help students to understand both the benefits and the limitations of the more popular
accounting models--typically, historical cost with adjustments for fair value in certain
circumstances.
1.5.1 Inflation
Since we started understanding things around us, we all used to listen from our
Grandparents about the things and articles especially Gold & Ghee being cheaper in their
times.
That time we used to think that why the things were cheaper in our Grandparents' time
and why had they started becoming costlier. So this question would keep us puzzled.
But now as we have grown in our knowledge and understanding, we have come to know
about the phenomenon of Inflation which in layman's language is known as the state of
rising pricing or the falling value of money was the greatest reason behind this.
Now emerges the question that what exactly is the Inflation?
Inflation is a global phenomenon in present day times. There is hardly any country in the
capitalist world today which is not afflicted by the spectre of inflation.
Different economists have defined inflation in different words like Prof. Crowther has
defined inflation "as a state in which the value of money is falling, i.e., prices are rising."
In the words of Prof. Paul Einzig, "Inflation is that state of disequilibrium in which an
expansion of purchasing power tends to cause or is the effect of an increase of the price
level." Both the definition have emphasized on the rising prices of the goods.
17
The basic factors behind the inflation are either the rising demand or the shortening of
supply due to any reason.
Effect of Inflation on Business
The impact of inflation on business can be bifurcated into two parts like
1. Impact on costs and revenue
2. Impact on assets and liabilities
As far as impact of inflation on costs and revenues is concerned, definitely both will rise
but whether they result into extraordinary profits will be determined by that how much
opening stock was available at old prices with the company and how much later the
demand for increasing wages is entertained by the company.
In case of monetary assets and liabilities, a company will lose in case of being creditor
and gain in case of being debtor in real terms.
If we talk about other assets like building, land and other securities, the company will be
having holding gains in monetary terms but may have neutral impact in real terms due to
the rise in prices on the one hand but fall in value of money on the other.
1.5.2 Historical cost basis in financial statements
Fair value accounting (also called replacement cost accounting or current cost
accounting) was widely used in the 19th and early 20th centuries, but historical cost
accounting became more widespread after values overstated during the 1920s were
reversed during the Great Depression of the 1930s. Most principles of historical cost
accounting were developed after the Wall Street Crash of 1929, including the
presumption of a stable currency.
1.5.3 Measuring unit principle
Under a historical cost-based system of accounting, inflation leads to two basic problems.
First, many of the historical numbers appearing on financial statements are not
economically relevant because prices have changed since they were incurred. Second,
since the numbers on financial statements represent dollars expended at different points
of time and, in turn, embody different amounts of purchasing power, they are simply not
additive. Hence, adding cash of Rs.10,000 held on December 31, 2002, with Rs.10,000
representing the cost of land acquired in 1955 (when the price level was significantly
lower) is a dubious operation because of the significantly different amount of purchasing
power represented by the two numbers.
By adding dollar amounts that represent different amounts of purchasing power, the
resulting sum is misleading, as would be adding 10,000 dollars to 10,000 Euros to get a
18
total of 20,000. Likewise subtracting dollar amounts that represent different amounts of
purchasing power may result in an apparent capital gain which is actually a capital loss. If
a building purchased in 1970 for Rs.20,000 is sold in 2006 for Rs.200,000 when its
replacement cost is Rs.300,000, the apparent gain of Rs.180,000 is illusory..
1.5.4 Misleading reporting under historical cost accounting
“In most countries, primary financial statements are prepared on the historical cost basis
of accounting without regard either to changes in the general level of prices or to
increases in specific prices of assets held, except to the extent that property, plant and
equipment and investments may be revalued.”
Ignoring general price level changes in financial reporting creates distortions in financial
statements such as






reported profits may exceed the earnings that could be distributed to shareholders
without impairing the company's ongoing operations
the asset values for inventory, equipment and plant do not reflect their economic
value to the business
future earnings are not easily projected from historical earnings
the impact of price changes on monetary assets and liabilities is not clear
future capital needs are difficult to forecast and may lead to increased leverage,
which increases the business's risk
when real economic performance is distorted, these distortions lead to social and
political consequences that damage businesses (examples: poor tax policies and
public misconceptions regarding corporate behavior)
1.6 SIGNIFICANCE AND LIMITATIONS OF PRICE LEVEL
ACCOUNTING
The impact of inflation comes in the form of rising prices of output and assets. As the
financial accounts are kept on Historical cost basis, so they don't take into consideration
the impact of rise in the prices of assets and output. This may sometimes result into the
overstated profits, under priced assets and misleading picture of Business etc.
So, the financial statements prepared under historical accounting are generally proved to
be statements of historical facts and do not reflect the current worth of business. This
deprives the users of accounts like management, shareholders, and creditors etc. to have a
right picture of business to make appropriate decisions.
Hence, this leads towards the need for Inflation Accounting. Inflation accounting is a
term describing a range of accounting systems designed to correct problems arising from
historical cost accounting in the presence of inflation.
The significance of price level accounting emerges from the inherent limitations of the
historical cost accounting system. Following are the limitations of historical accounting:
19
1. Historical accounts do not consider the unrealised holding gains arising from the rise in
the monetary value of the assets due to inflation.
2. The objective of charging depreciation is to spread the cost of the asset over its useful
life and make reserve for its replacement in the future. But it does not take into account
the impact of inflation over the replacement cost which may result into the inadequate
charge of depreciation.
3. Under historical accounting, inventories acquired at old prices are matched against
revenues expressed at current prices. In the period of inflation, this may lead to the
overstatement of profits due mixing up of holding gains and operating gains.
4. Future earnings are not easily projected from historical earnings.
In the last few years, price level accounting has been adopted as a supplementary
financial statement in the United States and the United Kingdom. This comes after more
than 50 years of debate about methods of adjusting financial accounts for inflation.
Accountants in the United Kingdom and the United States have discussed the effect of
inflation on financial statements since the early 1900s, beginning with index number
theory and purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money
was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting,
which was about Constant Purchasing Power Accounting. This model by Sweeney was
used by The American Institute of Certified Public Accountants for their 1963 research
study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by
the Accounting Principles Board (USA), the Financial Standards Board (USA), and the
Accounting Standards Steering Committee (UK). Sweeney advocated using a price index
that covers everything in the gross national product. In March 1979, the Financial
Accounting Standards Board (FASB) wrote Constant Dollar Accounting, which
advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust
accounts
because
it
is
calculated
every
month.
During the Great Depression, some corporations restated their financial statements to
reflect inflation. At times during the past 50 years standard-setting organizations have
encouraged companies to supplement cost-based financial statements with price-level
adjusted statements. During a period of high inflation in the 1970s, the FASB was
reviewing a draft proposal for price-level adjusted statements when the Securities and
Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of
the largest US corporations to provide supplemental information based on replacement
cost. The FASB withdrew the draft proposal.
20
1.6.1 Limitations of price level Accounting
Though Inflation Accounting is more practical approach for the true reflection of
financial status of the company, there are certain limitations which are not allowing this
to be a popular system of accounting. Following are the limitations:
1. Change in the price level is a continuous process.
2. This system makes the calculations a tedious task because of too many conversions
and calculations.
3. This system has not been given preference by tax authorities.
1.7 TECHNIQUES AND MODELS OF PRICE LEVEL
ACCOUNTING
To measure the impact of changing price levels on financial statements, following are the
techniques used:
1. Current Purchasing Power (CPP) Method
Under this method of adjusting accounts to price changes, all items in the financial
statements are restated in terms of a constant unit of money i.e. in terms of general
purchasing power. For measuring changes in the price level and incorporating the
changes in the financial statements we use General Price Index, which may be considered
to be a barometer meant for the purpose. The index is used to convert the values of
various items in the Balance Sheet and Profit and Loss Account. This method takes into
account the changes in the general purchasing power of money and ignores the actual rise
or fall in the price of the given item. CPP method involves the refurnishing of historical
figures at current purchasing power. For this purpose, historical figures are converted into
value of purchasing power at the end of the period. Two index numbers are required: one
showing the general price level at the end of the period and the other reflecting the same
at the date of the transaction.
Profit under this method is an increase in the value of the net asset over a period, all
valuations being made in terms of current purchasing power.
Purchasing power and capital maintenance
CPPA was developed on the basis of a view that in times of rising prices, if an entity
were to distribute unadjusted profits based on historical costs, the result could be a
reduction in the real value of an entity – that is in real terms the entity could
otherwise distribute part of its capital.
21
Current purchase power accounting with its reliance on the use of indices is
generally accepted as being easier and less costly to apply than methods that rely
upon current valuations of particular assets.
Performing current purchase power adjustments
When applying CPPA, all adjustments are done at the end of the period, with the
adjustments being applied to accounts prepared under the historical cost convention.
a.
Non-monetary assets can be defined as those assets whose monetary equivalents
will change over times as a result of inflation, and would include such things as
plant and equipment and inventory. Net monetary assets would be defined as
monetary assets less monetary liabilities.
b.
It is stressed that under CPPA, no change in the purchase power of entity is
assumed to arise as a result of holding non-monetary assets. Under general price
level accounting, non-monetary assets are restated to current purchasing power
and no gain or loss is recognized. Purchasing power losses arise only as a result of
holding net monetary assets.
c.
Possible limitation – the information generated under CPPA might actually be
confusing to users. Another potential limitation that no support of CPPA as it is
irrelevant for decision making.
2. Current Cost Accounting (CCA) Method
The Current Cost Accounting is an alternative to the Current Purchasing Power Method.
The CCA method matches current revenues with the current cost of the resources which
are consumed in earning them.
Changes in the general price level are measured by Index Numbers. Specific price change
occurs if price of a particular asset changes without any general price change. Under this
method, asset are valued at current cost which is the cost at which asset can be replaced
as on a date.
While the Current Purchasing Power (CPP) method is known as the General Price Level
approach, the Current Cost Accounting (CCA) method is known as Specific Price Level
approach or Replacement Cost Accounting.
Current cost accounting (CCA) is one of the various alternatives to historical cost
accounting that has tended to gain the most acceptable.
Edwards and Bell decided to reject historical cost accounting and current purchasing
power accounting in favor of a method that considered actual valuation.
22
CCA differentiates between profits from trading, and those gains that result from holding
an asset.
Edwards and Bell adopt a physical capital maintenance approach to income recognition.
In this approach, which determines valuations on the basis of replacement cost, operating
income represents realized revenues, less the replacement cost of the assets in question.
Edwards and Bell believe operating profit is best calculated by using replacement costs as
the approach to profit calculation – operating profit – is derived after ensuring that the
operating capacity of the organization is maintained intact. (Page 103 Chapter 4)
The current cost operating profit before holding gains and losses, and the realised holdig
gains, are both tied to the notion of realization, and hence the sum of two equates to
historical cost profit. Holding gains are deemed to be different to trading income as they
are due to market-wide movements, most of which are beyond the control of
Management.
Some of the criticism relates to its reliance (CCA) on replacement costs but what is the
rationale for replacement cost?
3. Business profits Concept
2 components of current cost accounting are
1. Current operating profit (COP) and
2. Realizable cost savings (RCS).
COP – is the excess of the current value of the output sold over the current cost of the
related inputs.
RCS – are the increase in the current cost of the assets held by the firm in the current
period.
The term we use for realizable cost saving is “holding gains /losses” which can be
realized or unrealized. (IAS Investment property – holding gain of revaluation surplus is
unrealized but is treated as business profit in income statement).
For example two companies with different set up years – Company A 10 years earlier
than others. The operating profit of A will be larger because of lower depreciation
expenses, thus giving the impression that A is more efficient than the others.
In fact, the larger profit of Company A is not due to the efficiency of the managers in
operating the firm in the current years. Rather, it reflects the efficiency of the manager of
10 years ago in starting the business and purchasing the assets at that time.
4. Exit price accounting
23
MacNeal’s argument – He contended that conventional accounting principles do not
serve the decision-oriented investor well; they provide financial statements that may be
misleading or false. Accountant should report all profits and losses and values as
determined in competitive markets. MacNeal suggested that
a.
b.
c.
d.
Marketable assets should be valued at market price (exit price),
Non marketable reproducible assets at replacement cost and
Occasional no marketable, non reproducible assets at original cost
Income should include all profit and loss, whether realized or not.
Chamber’s argument – CoCoA (Continuously contemporary accounting)
Chambers sees the business firm as an adaptive entity engaged in buying and selling
goods and services. It is governed by the decision of its managers who are cognisant
of the owner’s objectives. The notion of adaptive behavior implies a continual
attempt to adjust to the competitive business environment for the sake of survival.
He argued that the purchase price, or current cost, does not reveal the firm’s
capability to go into the market with cash for the purpose of adapting itself to
present conditions – Current cash equivalent is the price of the assets.
The concept of adaptive behavior sees the firms as always being ready to dispose of
the asset if this action is in its best interest. Adaptive behavior, therefore, calls for
knowledge of the cash and current cash equivalents of the firm’s net assets. He
admits that every asset has, in principle, a value in exchange (market value) and a
value in use.
Sterling’s argument – He believed that there is one method to determine income that is
superior to all others. He concluded that the present price of wheat is the one item of
information relevant to all the decisions.
Other advantages are Additive, Allocation, Reality and Objectivity
1. Profit concept – Bell, a current cost advocate, asserts that an evaluation of the
expected plans against the actual outcome must be made and a meaningful profit is the
measurement of performance in terms of what was originally intended.
Rationale: Accounting is to measure the profitability of the firm in a given period and it
means the effectiveness of the actual performance of the company in utilizing the
resources entrusted to it.
Argument against Exit price:

Using exit price (the opportunity cost), however, does not provide the relevant
data to match against revenues to measure the relevant success or failure, this is,
the performance of the firm. Accounting must measure past events, those that
24
actually happened, rather than those that might happen if a firm does something
other than what was planned.

Weston concluded that the exit price accounting does not supply useful profit
information.
2 Value in use versus value in exchange
Both historical cost and current cost advocates accuse exit price proponents of ignoring
the concept of value in use. The former (HCA) believes such value is represented by
acquisition cost and the later (CCA) current cost.
Rationale: An asset that is held rather than sold out must be worth more to its owner than
its exit price, otherwise, it would be sold.
It is argued that exit price represents the opportunity cost but this may not always be
justified. The opportunity cost of using an asset in the company is derived by the value
foregone of the next best alternative, which is not necessarily to sell it.
A firm can consider an asset to have value because of its use in the business rather than
its sale
3. Additivity
Exit price proponent claims that accounting measurements, if they are to be objective,
must only be based on past and present events.
Anticipatory calculations cannot be added together with current figures.
Critics point out, however, that Chamber’s current cash equivalent of assets s to be
determined on the assumption of a gradual and orderly liquidation.
The concept of current cash equivalent, with its emphasis on sever ability of assets, does
not recognize the possibility of selling assets as one package.
Finally, exit price accounting, as proposed by both Chambers and Sterling, does not give
adequate consideration to intangible factors.
1.7.1 Price level accounting models
Inflation accounting is not fair value accounting. Inflation accounting, also called price
level accounting, is similar to converting financial statements into another currency using
an exchange rate. Under some (not all) inflation accounting models, historical costs are
converted to price-level adjusted costs using general or specific price indexes.
1. Income statement general price-level adjustment example
25
On the income statement, depreciation is adjusted for changes in general price
levels based on a general price index.
2001 2002
2003
Total
Revenue
33,000 36,302
39,931
109,233
Depreciation
30,000 31,500 (a) 33,000 (b) 94,500
Operating income
3,000 4,802
6,931
14,733
Purchasing power loss 1,500 (c) 3,000 (d) 4,500
Net income
3,000 3,302
3,931
10,233
(a) 30,000 x 105/100 = 31,500
(b) 30,000 x 110/100 = 33,000
(c) (30,000 x 105/100) - 30,000 = 1,500
(d) (63,000 x 110/105) - 63,000 = 3,000
2. Constant dollar accounting
Constant dollar accounting is an accounting model that converts non monetary assets and
equities from historical dollars to current dollars using a general price index. This is
similar to a currency conversion from old dollars to new dollars. Monetary items are not
adjusted, so they gain or lose purchasing power. There are no holding gains or losses
recognized in converting values.
3. International standard for hyperinflationary accounting
The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the
cumulative inflation rate over three years is approaching, or exceeds, 100%."
Companies are required to restate their historical cost financial reports in terms of the
period end hyperinflation rate in order to make these financial reports more meaningful.
The restatement of historical cost financial statements in terms of IAS 29 does not signify
the abolishment of the historical cost model. This is confirmed by
PricewaterhouseCoopers: "Inflation-adjusted financial statements are an extension to, not
a departure from, historical cost accounting."
Activity 1
1. Write a short essay on significance of corporate finance in today’s business
scenario.
2. What do you understand by accounting of price level changes? Discuss its
limitations.
26
3. Explain different techniques of price level accounting.
4. Write short notes on accounting theory and accounting equations.
1.8 SUMMARY
This unit focuses on concepts related to corporate finance and corporate financial
accounting. It has been explained that the primary goal of corporate finance is to
maximize corporate value while managing the firm's financial risks. Although it is in
principle different from managerial finance which studies the financial decisions of all
firms, rather than corporations alone, the main concepts in the study of corporate finance
are applicable to the financial problems of all kinds of firms. Later in the unit, accounting
theory, postulates and conventions were described followed by discussion on accounting
equations. Another important area of concern of the unit was accounting of price level
changes. Significance and limitations of price level accounting and techniques and
models of price level accounting were discussed in the final sections.
1.9 FURTHER READINGS

Baxter, W.T. (1975), Accounting Values and Inflation, London: McGraw-Hill.

Copeland, T.E. and J.F Weston. Financial theory and corporate policy, 2nd
edition Addison – Wesley, 1983

Smith. Keith V and George W. Gallinger. Readings on short term financial
management. 3rd edition West Publishing company 1988

Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983
27
UNIT 2
ACCOUNTING FOR INVESTMENT DECISIONS AND
SOCIAL ACCOUNTING
Objectives
After studying this unit, you should be able to understand:




The approaches to accounting for investment decisions
The concept of social accounting and its relevance
Purpose and scope of social accounting
Approach to social auditing
Structure
2.1 Introduction
2.2 Accounting approaches to investment decisions
2.3 Social accounting
2.4 Purpose and scope of social accounting
2.5 Social accounting case
2.6 Social auditing
2.7 Summary
2.8 Further readings
2.1 INTRODUCTION
Not all investments are made with the goal of turning a quick profit. Many investments
are acquired with the intent of holding them for an extended period of time. The
appropriate accounting methodology depends on obtaining a deeper understanding of the
nature/intent of the particular investment. You have already seen the accounting for
"trading securities" where the intent was near future resale for profit. But, many
investments are acquired with longer-term goals in mind.
For example, one company may acquire a majority (more than 50%) of the stock of
another. In this case, the acquirer (known as the parent) must consolidate the accounts of
the subsidiary. At the end of this chapter we will briefly illustrate the accounting for such
"control" scenarios.
Sometimes, one company may acquire a substantial amount of the stock of another
without obtaining control. This situation generally arises when the ownership level rises
above 20%, but stays below the 50% level that will trigger consolidation. In these cases,
the investor is deemed to have the ability to significantly influence the investee
28
company. Accounting rules specify the "equity method" of accounting for such
investments. This, too, will be illustrated within this unit.
Not all investments are in stock. Sometimes a company may invest in a "bond" (you
have no doubt heard the term "stocks and bonds"). A bond payable is a mere "promise"
(i.e., bond) to "pay" (i.e., payable). Thus, the issuer of a bond payable receives money
today from an investor in exchange for the issuer's promise to repay the money in the
future (as you would expect, repayments will include not only amounts borrowed, but
will also have added interest).
Although investors may acquire bonds for "trading purposes," they are more apt to be
obtained for the long-pull. In the latter case, the bond investment would be said to be
acquired with the intent of holding it to maturity (its final payment date) -- thus, earning
the name "held-to-maturity" investments. Held-to-maturity investments are afforded a
special treatment, which is generally known as the amortized cost approach.
By default, the final category for an investment is known as the "available for sale"
category. When an investment is not trading, not held-to-maturity, not involving
consolidation, and not involving the equity method, by default, it is considered to be an
"available for sale" investment. Even though this is a default category, do not assume it
to be unimportant. Massive amounts of investments are so classified within typical
corporate accounting records. We will begin our look at long-term investments by
examining this important category of investments.
2.2 ACCOUNTING APPROACHES TO INVESTMENT DECISIONS
The following table shows the methods you should be familiar with the types of
investments along with basic accounting approaches.
29
1. THE FAIR VALUE MEASUREMENT OPTION
The Financial Accounting Standards Board recently issued a new standard, "The Fair
Value Option for Financial Assets and Financial Liabilities." Companies may now elect
to measure certain financial assets at fair value. This new ruling essentially allows many
"available for sale" and "held to maturity" investments to instead be measured at fair
value (with unrealized gains and losses reported in earnings), similar to the approach
previously limited to trading securities. It is difficult to predict how many companies
will select this new accounting option, but it is indicative of a continuing evolution
toward valued-based accounting in lieu of traditional historical cost-based approaches.
2. AVAILABLE
SECURITIES
FOR
SALE
SECURITIES;
SIMILAR
TO
TRADING
The accounting for "available for sale" securities will look quite similar to the accounting
for trading securities. In both cases, the investment asset account will be reflected at fair
value. If you do not recall the accounting for trading securities, it may be helpful to
review that material via the indicated link.
To be sure, there is one big difference between the accounting for trading securities and
available-for-sale securities. This difference pertains to the recognition of the changes in
value. For trading securities, the changes in value were recorded in operating income.
However, such is not the case for available-for-sale securities. Here, the changes in value
go into a special account. We will call this account Unrealized Gain/Loss- OCI, where
"OCI" will represent "Other Comprehensive Income."
3. OTHER COMPREHENSIVE INCOME
This notion of other comprehensive income is somewhat unique and requires special
discussion at this time. There is a long history of accounting evolution that explains how
the accounting rule makers eventually came to develop the concept of OCI. To make a
long story short, most transactions and events make their way through the income
statement. As a result, it can be said that the income statement is "all-inclusive." Once
upon a time, this was not the case; only operational items were included in the income
statement. Nonrecurring or nonoperating related transactions and events were charged or
credited directly to equity, bypassing the income statement entirely (a "current operating"
concept of income).
Importantly, you must take note that the accounting profession now embraces the allinclusive approach to measuring income. In fact, a deeper study of accounting will reveal
that the income statement structure can grow in complexity to capture various types of
unique transactions and events (e.g., extraordinary gains and losses, etc.) -- but, the
income statement does capture those transactions and events, however odd they may
appear.
30
There are a few areas where accounting rules have evolved to provide for special
circumstances/"exceptions." And, OCI is intended to capture those exceptions. One
exception is the Unrealized Gain/Loss - OCI on available-for-sale securities. As you will
soon see, the changes in value on such securities are recognized, not in operating income
as with trading securities, but instead in this unique account. The OCI gain/loss is
generally charged or credited directly to an equity account (Accumulated OCI), thereby
bypassing the income statement ( there are a variety of reporting options for OCI, and the
most popular is described here).
Illustration
Assume that Webster Company acquired an investment in Merriam Corporation. The
intent was not for trading purposes, control, or to exert significant influence. The
following entry was needed on March 3, 20X6, the day Webster bought stock of
Merriam:
3-3-X6
Available for Sale Securities
Cash
To record the purchase of 5,000
shares of Merriam stock at Rs.10 per
share
50,000
50,000
Next, assume that financial statements were being prepared on March 31. By that date,
Merriam's stock declined to Rs.9 per share. Accounting rules require that the investment
"be written down" to current value, with a corresponding charge against OCI. The charge
is recorded as follows:
3-31-X6
Unrealized Gain/Loss - OCI
Available for Sale Securities
To record a Rs.1 per share decrease
in the value of 5,000 shares of
Merriam stock
5,000
5,000
This charge against OCI will reduce stockholders' equity (the balance sheet remains in
balance with both assets and equity being decreased by like amounts). But, net income is
not reduced, as there is no charge to a "normal" income statement account. The rationale
here, whether you agree or disagree, is that the net income is not affected by temporary
31
fluctuations in market value -- since the intent is to hold the investment for a longer term
period.
During April, the stock of Merriam bounced up Rs.3 per share to Rs.12. Webster now
needs to prepare this adjustment:
4-30-X6
Available for Sale Securities
Unrealized Gain/Loss - OCI
To record a Rs.3 per share increase in
the value of 5,000 shares of Merriam
stock
15,000
15,000
Notice that the three journal entries now have the available for sale securities valued at
Rs.60,000 (Rs.50,000 - Rs.5,000 + Rs.15,000). This is equal to their market value (Rs.12
X 5,000 = Rs.60,000). The OCI has been adjusted for a total of Rs.10,000 credit
(Rs.5,000 debit and Rs.15,000 credit). This cumulative credit corresponds to the total
increase in value of the original Rs.50,000 investment.
The preceding illustration assumed a single investment. However, the treatment would
be the same even if the available for sale securities consisted of a portfolio of many
investments. That is, each and every investment would be adjusted to fair value.
4. ALTERNATIVE -- A VALUATION ADJUSTMENTS ACCOUNT
As an alternative to directly adjusting the Available for Sale Securities account, some
companies may maintain a separate Valuation Adjustments account that is added to or
subtracted from the Available for Sale Securities account. The results are the same; the
reasons for using the alternative approach are to provide additional information that may
be needed for more complex accounting and tax purposes.
Dividends and interests
Dividends or interest received on available for sale securities is reported as income and
included in the income statement:
32
9-15-X5
Cash
Dividend Income
To record receipt of dividend on
available for sale security investment
75
75
The Balance Sheet appearance
The above discussion would produce the following balance sheet presentation of
available for sale securities at March 31 and April 30. To aid the illustration, all accounts
are held constant during the month of April, with the exception of those that change
because of the fluctuation in value of Merriam's stock.
(All figures in Rupees)
33
In reviewing this illustration, note that Available for Sale Securities are customarily
classified in the Long-term Investments section of the balance sheet. And, take note the
OCI adjustment is merely appended to stockholders' equity.
5. HELD TO MATURITY SECURITIES
INVESTMENTS IN BONDS
It was noted earlier that certain types of financial instruments have a fixed maturity date;
the most typical of such instruments are "bonds." The held to maturity securities are to
be accounted for by the amortized cost method.
34
To elaborate, if you or I wish to borrow money we would typically approach a bank or
other lender and they would likely be able to accommodate our request. But, a corporate
giant's credit needs may exceed the lending capacity of any single bank or lender.
Therefore, the large corporate borrower may instead issue "bonds," thereby splitting a
large loan into many small units. For example, a bond issuer may borrow
Rs.500,000,000 by issuing 500,000 individual bonds with a face amount of Rs.1,000 each
(500,000 X Rs.1,000 = Rs.500,000,000). If you or I wished to loan some money to that
corporate giant, we could do so by simply buying ("investing in") one or more of their
bonds.
The specifics of bonds will be covered in much greater detail in a subsequent chapter,
where we will look at a full range of issues from the perspective of the issuer (i.e.,
borrower). However, for now we are only going to consider bonds from the investor
perspective. You need to understand just a few basics:
(1) each bond will have an associated "face value" (e.g., Rs.1,000) that corresponds to
the amount of principal to be paid at maturity,
(2) each bond will have a contract or stated interest rate (e.g., 5% -- meaning that the
bond pays interest each year equal to 5% of the face amount), and
(3) each bond will have a term (e.g., 10 years -- meaning the bonds mature 10 years from
the designated issue date). In other words, a Rs.1,000, 5%, 10-year bond would pay
Rs.50 per year for 10 years (as interest), and then pay Rs.1,000 at the stated maturity date
10 years after the original date of the bond.
THE ISSUE PRICE
How much would you pay for the above 5%, 10-year bond: Exactly Rs.1,000, more than
Rs.1,000, or less than Rs.1,000? The answer to this question depends on many factors,
including the credit-worthiness of the issuer, the remaining time to maturity, and the
overall market conditions. If the "going rate" of interest for other bonds was 8%, you
would likely avoid this 5% bond (or, only buy it if it were issued at a deep discount).
On the other hand, the 5% rate might look pretty good if the "going rate" was 3% for
other similar bonds (in which case you might actually pay a premium to get the bond).
So, bonds might have an issue price that is at their face value (also known as "par"), or
above (at a premium) or below (at a discount) face. The price of a bond is typically
stated as percentage of face; for example 103 would mean 103% of face, or Rs.1,030.
The specific calculations that are used to determine the price one would pay for a
particular bond are revealed in a subsequent chapter.
35
RECORDING THE INITIAL INVESTMENT
An Investment in Bonds account (at the purchase price plus brokerage fees and other
incidental acquisition costs) is established at the time of purchase. Importantly, premiums
and discounts are not recorded in separate accounts:
Illustration of bonds purchased at par
1-1-X3
Investment in Bonds
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at par -interest payable semiannually
5,000
5,000
The above entry reflects a bond purchase as described, while the following entry reflects
the correct accounting for the receipt of the first interest payment after 6 months.
6-30-X3
Cash
125
Interest Income
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest X
6/12 months)
125
Now, the entry that is recorded on June 30 would be repeated with each subsequent
interest payment -- continuing through the final interest payment on December 31, 20X5.
In addition, at maturity, when the bond principal is repaid, the investor would make this
final accounting entry:
12-31-X5
Cash
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
5,000
36
Illustration of bonds purchased at a premium
When bonds are purchased at a premium, the investor pays more than the face value up
front. However, the bond's maturity value is unchanged; thus, the amount due at maturity
is less than the initial issue price! This may seem unfair, but consider that the investor is
likely generating higher annual interest receipts than on other available bonds -- that is
why the premium was paid to begin with.
So, it all sort of comes out even in the end. Assume the same facts as for the above bond
illustration, but this time imagine that the market rate of interest was something less than
5%. Now, the 5% bonds would be very attractive, and entice investors to pay a premium:
1-1-X3
Investment in Bonds
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at 106 -interest payable semiannually
5,300
5,300
The above entry assumes the investor paid 106% of par (Rs.5,000 X 106% = Rs.5,300).
However, remember that only Rs.5,000 will be repaid at maturity. Thus, the investor will
be "out" Rs.300 over the life of the bond. Thus, accrual accounting dictates that this
Rs.300 "cost" be amortized ("recognized over the life of the bond") as a reduction of the
interest income:
6-30-X3
Cash
Interest Income
Investment in Bonds
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest X
6/12 months = Rs.125; Rs.300
premium X 6 months/36 months =
Rs.50 amortization)
125
75
50
The preceding entry is undoubtedly one of the more confusing entries in accounting, and
bears additional explanation. Even though Rs.125 was received, only Rs.75 is being
37
recorded as interest income. The other Rs.50 is treated as a return of the initial
investment; it corresponds to the premium amortization (Rs.300 premium allocated
evenly over the life of the bond -- Rs.300 X (6 months/36 months)) and is credited
against the Investment in Bonds account.
This process of premium amortization (and the above entry) would be repeated with each
interest payment date. Therefore, after three years, the Investment in Bonds account
would be reduced to Rs.5,000 (Rs.5,300 - (Rs.50 amortization X 6 semiannual interest
recordings)).
This method of tracking amortized cost is called the straight-line method. There is
another conceptually superior approach to amortization, called the effective-interest
method, that will be revealed in later chapters. However, it is a bit more complex and the
straight-line method presented here is acceptable so long as its results are not materially
different than would result under the effective-interest method.
In addition, at maturity, when the bond principal is repaid, the investor would make this
final accounting entry:
12-31-X5
Cash
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
5,000
In an attempt to make sense of the above, perhaps it is helpful to reflect on just the "cash
out" and the "cash in." How much cash did the investor pay out? It was Rs.5,300; the
amount of the initial investment. How much cash did the investor get back? It was
Rs.5,750; Rs.125 every 6 months for 3 years and Rs.5,000 at maturity.
What is the difference? It is Rs.450 (Rs.5,750 - Rs.5,300) -- which is equal to the income
recognized above (Rs.75 every 6 months, for 3 years). At its very essence, accounting
measures the change in money as income. Bond accounting is no exception, although it
is sometimes illusive to see. The following "amortization" table reveals certain facts
about the bond investment accounting, and is worth studying to be sure you understand
each amount in the table. Be sure to "tie" the amounts in the table to the entries above:
38
Sometimes, complex topics like this are easier to understand when you think about the
balance sheet impact of a transaction. For example, on 12-31-X4, Cash is increased
Rs.125, but the Investment in Bond account is decreased by Rs.50 (dropping from
Rs.5,150 to Rs.5,100). Thus, total assets increased by a net of Rs.75. The balance sheet
remains in balance because the corresponding Rs.75 of interest income causes a
corresponding increase in retained earnings.
Illustration of bonds purchased at a discount
The discount scenario is very similar to the premium scenario, but "in reverse." When
bonds are purchased at a discount, the investor pays less than the face value up front.
However, the bond's maturity value is unchanged; thus, the amount due at maturity is
more than the initial issue price! This may seem like a bargain, but consider that the
investor is likely getting lower annual interest receipts than is available on other bonds -that is why the discount existed in the first place.
Assume the same facts as for the previous bond illustration, except imagine that the
market rate of interest was something more than 5%. Now, the 5% bonds would not be
very attractive, and investors would only be willing to buy them at a discount:
39
1-1-X3
Investment in Bonds
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at 97 -interest payable semiannually
4,850
4,850
The above entry assumes the investor paid 97% of par (Rs.5,000 X 97% = Rs.4,850).
However, remember that a full Rs.5,000 will be repaid at maturity. Thus, the investor
will get an additional Rs.150 over the life of the bond. Accrual accounting dictates that
this Rs.150 "benefit" be recognized over the life of the bond as an increase in interest
income:
6-30-X3
Cash
125
Investment in Bonds
25
Interest Income
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest
X 6/12 months = Rs.125; Rs.150
discount X 6 months/36 months =
Rs.25 amortization)
150
The preceding entry would be repeated at each interest payment date. Again, further
explanation may prove helpful. In addition to the Rs.125 received, another Rs.25 of
interest income is recorded. The other Rs.25 is added to the Investment in Bonds
account; as it corresponds to the discount amortization (Rs.150 discount allocated evenly
over the life of the bond -- Rs.150 X (6 months/36 months)).
This process of discount amortization would be repeated with each interest payment.
Therefore, after three years, the Investment in Bonds account would be increased to
Rs.5,000 (Rs.4,850 + (Rs.25 amortization X 6 semiannual interest recordings)). This is
another example of the straight-line method of amortization since the amount of interest
is the same each period.
When the bond principal is repaid at maturity, the investor would also make this final
accounting entry:
40
12-31-X5
Cash
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
5,000
Let's consider the "cash out" and the "cash in." How much cash did the investor pay out?
It was Rs.4,850; the amount of the initial investment. How much cash did the investor
get back? It is the same as it was in the preceding illustration -- Rs.5,750; Rs.125 every
6 months for 3 years and Rs.5,000 at maturity. What is the difference? It is Rs.900
(Rs.5,750 - Rs.4,850) -- which is equal to the income recognized above (Rs.150 every 6
months, for 3 years). Be sure to "tie" the amounts in the following amortization table to
the related entries:
Can you picture the balance sheet impact on 6-30-X5? Cash increased by Rs.125, and
the Investment in Bond account increased Rs.25. Thus, total assets increased by Rs.150.
The balance sheet remains in balance because the corresponding Rs.150 of interest
income causes a corresponding increase in retained earnings.
6. THE EQUITY METHOD OF ACCOUNTING
41
THE EQUITY METHOD
On occasion, an investor may acquire enough ownership in the stock of another company
to permit the exercise of "significant influence" over the investee company. For example,
the investor has some direction over corporate policy, and can sway the election of the
board of directors and other matters of corporate governance and decision making.
Generally, this is deemed to occur when one company owns more than 20% of the stock
of the other -- although the ultimate decision about the existence of "significant
influence" remains a matter of judgment based on an assessment of all facts and
circumstances.
Once significant influence is present, generally accepted accounting principles require
that the investment be accounted for under the "equity method" (rather than the methods
previously discussed, such as those applicable to trading securities or available for sale
securities).
With the equity method, the accounting for an investment is set to track the "equity" of
the investee. That is, when the investee makes money (and experiences a corresponding
increase in equity), the investor will similarly record its share of that profit (and viceversa for a loss). The initial accounting commences by recording the investment at cost:
4-1-X3
Investment
Cash
To record the purchase of 5,000
shares of Legg stock at Rs.10 per
share. Legg has 20,000 shares
outstanding, and the investment in
25% of Legg (5,000/20,000 = 25%) is
sufficient to give the investor
significant influence
50,000
50,000
Next, assume that Legg reports income for the three-month period ending June 30, 20X3,
in the amount of Rs.10,000. The investor would simultaneously record its "share" of this
reported income as follows:
6-30-X3
Investment
Investment Income
To record investor's share of Legg's
reported income (25% X Rs.10,000)
2,500
2,500
42
Importantly, this entry causes the Investment account to increase by the investor's share
of the investee's increase in its own equity (i.e., Legg's equity increased Rs.10,000, and
the entry causes the investor's Investment account to increase by Rs.2,500), thus the name
"equity method." Notice, too, that the credit causes the investor to recognize income of
Rs.2,500, again corresponding to its share of Legg's reported income for the period. Of
course, a loss would be reported in just the opposite fashion.
When Legg pays out dividends (and decreases its equity), the investor will need to reduce
its Investment account:
7-01-X3
Cash
Investment
To record the receipt of Rs.1,000 in
dividends from Legg -- Legg declared
and paid a total of Rs.4,000 (Rs.4,000
X 25% = Rs.1,000)
1,000
1,000
The above entry is based on the assumption that Legg declared and paid a Rs.4,000
dividend on July 1. This treats dividends as a return of the investment (not income,
because the income is recorded as it is earned rather than when distributed). In the case
of dividends, notice that the investee's equity reduction is met with a corresponding
proportionate reduction of the Investment account on the books of the investor.
Note that market-value adjustments are usually not utilized when the equity method is
employed. Essentially, the Investment account tracks the equity of the investee,
increasing as the investee reports income and decreasing as the investee distributes
dividends.
7. INVESTMENTS REQUIRING CONSOLIDATION
CONCEPT OF CONTROL
You only need to casually review the pages of most any business press before you will
notice a story about one business buying another. Such acquisitions are common and
number in the thousands annually. Typically, such transactions are effected rather
simply, by the acquirer simply buying a majority of the stock of the target company. This
majority position enables the purchaser to exercise control over the other company;
electing a majority of the board of directors, which in turn sets the direction for the
company. Control is ordinarily established once ownership jumps over the 50% mark,
43
but management contracts and other similar arrangements may allow control to occur at
other levels.
ECONOMIC ENTITY CONCEPT AND CONTROL
The acquired company may continue to operate, and maintain its own legal existence. In
other words, assume Premier Tools Company bought 100% of the stock of Sledge
Hammer Company. Sledge (now a "subsidiary" of Premier the "parent") will continue to
operate and maintain its own legal existence. It will merely be under new ownership.
But, even though it is a separate legal entity, it is viewed by accountants as part of a
larger "economic entity."
The intertwining of ownership means that Parent and Sub are "one" as it relates to
economic performance and outcomes. Therefore, accounting rules require that parent
companies "consolidate" their financial reports, and include all the assets, liabilities, and
operating results of all controlled subsidiaries. When you look at the financial statements
of a conglomerate like General Electric, what you are actually seeing is the consolidated
picture of many separate companies owned by GE.
ACCOUNTING ISSUES
Although the processes of consolidation can become quite complex (at many universities,
an entire course may be devoted to this subject alone), the basic principles are
straightforward. Assume that Premier's "separate" (before consolidating) balance sheet,
immediately after purchasing 100% of Sledge's stock, appeared as follows:
Notice the highlighted Investment in Sledge account below, indicating that Premier paid
Rs.400,000 for the stock of Sledge. Do take note that the Rs.400,000 was not paid to
Sledge; it was paid to the former owners of Sledge. Sledge merely has a new owner, but
it is otherwise "unchanged" by the acquisition. Assume Sledge's separate balance sheet
looks like as shown below.
Let's examine carefully what Premier got for its Rs.400,000 investment. Premier became
the sole owner of Sledge, which has assets that are reported on Sledge's books at
Rs.450,000, and liabilities that are reported at Rs.150,000. The resulting net book value
(Rs.450,000 - Rs.150,000 = Rs.300,000) is reflected as Sledge's total stockholders'
equity. Now, you notice that Premier paid Rs.100,000 in excess of book value for Sledge
(Rs.400,000 - Rs.300,000).
44
This excess is quite common, and is often called "purchase differential" (the difference
between the price paid for another company, and the net book value of its assets and
liabilities). Why would Premier pay such a premium? Remember that assets and
liabilities are not necessarily reported at fair value.
For example, the land held by Sledge is reported at its cost, and its current value may
differ (let's assume Sledge's land is really worth Rs.110,000, or Rs.35,000 more than its
carrying value of Rs.75,000). That would explain part of the purchase differential. Let
us assume that all other identifiable assets and liabilities are carried at their fair values.
But what about the other Rs.65,000 of purchase differential (Rs.100,000 total differential
minus the Rs.35,000 attributable to specifically identified assets or liabilities)?
45
GOODWILL
Whenever one business buys another, and pays more than the fair value of all the
identifiable pieces, the excess is termed "goodwill." This has always struck me as an odd
term -- but I suppose it is easier to attach this odd name, in lieu of using a more
descriptive account title like: Excess of Purchase Price Over Fair Value of Identifiable
Assets Acquired in a Purchase Business Combination. So, when you see Goodwill in the
corporate accounts, you now know what it means. It only arises from the purchase of one
business by another. Many companies may have implicit goodwill, but it is not recorded
until it arises from an actual acquisition (that is, it is bought and paid for in a arm's-length
transaction).
Perhaps we should consider why someone would be willing to pay such a premium.
There are many possible scenarios, but suffice it to say that many businesses are worth
more than than their identifiable pieces. A movie rental store, with its business location
and established customer base, is perhaps worth more than the movies, display
equipment, and check-out stands it holds. A law firm is hopefully worth more than its
46
desks, books, and computers. An oil company is likely far more valuable than its drilling
and pumping gear. Consider the value of a brand name that may not be on the books but
has instead been established by years of marketing. And, let's not forget that a business
combination may eliminate some amount of competition; some businesses will pay a lot
to be rid of a competitor.
THE CONSOLIDATED BALANCE SHEET
No matter how goodwill arises, the accountant's challenge is to measure and report it in
the consolidated statements -- along with all the other assets and liabilities of the parent
and sub. Study the following consolidated balance sheet for Premier and Sledge, clicking
on the account title links to see how the related dollar amounts are calculated:
Premier Tools Company and Consolidated Subsidiaries
Balance Sheet
March 31, 20X3
Assets
Current Assets
Cash
Rs.150,000
Trading
70,000
securities
Accounts
110,000
receivable
Inventories
220,000
Rs.550,000
Property, Plant
& Equip.
Land
Note payable Rs.240,000
Mortgage
liability
Rs.135,000
Building and
equipment
375,000 510,000
(net)
Intangible
Assets
Patent
Rs.225,000
Goodwill
Total assets
Liabilities
Current
Liabilities
Accounts
Rs.160,000
payable
Salaries
30,000
payable
Interest
10,000
Rs.200,000
payable
Long-term
Liabilities
65,000
Total
liabilities
110,000
350,000
Rs.550,000
Stockholders'
equity
Capital stock Rs.300,000
Retained
290,000
500,000
earnings
Total
stockholders'
800,000
equity
Total
Rs.1,350,000
Liabilities
Rs.1,350,000
and equity
47
In the above illustration, take note of several important points. First, the Investment in
Sledge account is absent because it has effectively been replaced with the individual
assets and liabilities of Sledge. Second, the assets acquired from Sledge, including
goodwill, have been pulled into the consolidated balance sheet at the price paid for them
(for example, take special note of the calculations relating to the Land account).
Finally, note the consolidated stockholders' equity amounts are the same as from
Premier's separate balance sheet. This result is expected since Premier's separate
accounts include the ownership of Sledge via the Investment in Sledge account (which
has now been replaced by the actual assets and liabilities of Sledge).
It may appear a bit mysterious as to how the above balance sheet "balances" -- there is an
orderly worksheet process that can be shown to explain how this consolidated balance
sheet comes together, and that is best reserved for advanced accounting classes -- for now
simply understand that the consolidated balance sheet encompasses the assets (excluding
the investment account), liabilities, and equity of the parent at their dollar amounts
reflected on the parent's books, along with the assets (including goodwill) and liabilities
of the sub adjusted to their values based on the price paid by the parent for its ownership
in the sub.
THE CONSOLIDATED INCOME STATEMENT
Although it will not be illustrated here, it is important to know that the income statements
of the parent and sub will be consolidated post-acquisition. That is, in future months,
quarters, and years, the consolidated income statement will reflect the revenues and
expenses of both the parent and sub added together. This process is ordinarily
straightforward. But, an occasional wrinkle will arise.
For instance, if the parent paid a premium in the acquisition for depreciable assets and/or
inventory, the amount of consolidated depreciation expense and/or cost of goods sold
may need to be tweaked to reflect alternative amounts from those reported in the separate
statements. And, if the parent and sub have done business with one another, adjustments
will be needed to avoid reporting intercompany transactions. We never want to report
internal transactions between affiliates as actual sales. To do so can easily and rather
obviously open the door to manipulated financial results.
2.3 SOCIAL ACCOUNTING
Social accounting (also known as social and environmental accounting, corporate social
reporting, corporate social responsibility reporting, non-financial reporting, or
sustainability accounting) is the process of communicating the social and environmental
effects of organizations' economic actions to particular interest groups within society and
to society at large.
48
Social accounting is commonly used in the context of business, or corporate social
responsibility (CSR), although any organisation, including NGOs, charities, and
government agencies may engage in social accounting.
Social accounting emphasises the notion of corporate accountability. D. Crowther defines
social accounting in this sense as "an approach to reporting a firm’s activities which
stresses the need for the identification of socially relevant behaviour, the determination of
those to whom the company is accountable for its social performance and the
development of appropriate measures and reporting techniques."
Social accounting is often used as an umbrella term to describe a broad field of research
and practice. The use of more narrow terms to express a specific interest is thus not
uncommon. Environmental accounting may e.g. specifically refer to the research or
practice of accounting for an organisation's impact on the natural environment.
Sustainability accounting is often used to express the measuring and the quantitative
analysis of social and economic sustainability.
2.4 PURPOSE AND SCOPE OF SOCIAL ACCOUNTING
Social accounting challenges conventional accounting in particular financial accounting.
It gives a narrow image of the interaction between society and organizations, and thus
artificially constraining the subject of accounting.
Social accounting, a largely normative concept, seeks to broaden the scope of accounting
in the sense that it should:

concern itself with more than only economic events;

not be exclusively expressed in financial terms;

be accountable to a broader group of stakeholders;

broaden its purpose beyond reporting financial success.
It points to the fact that companies influence their external environment (both positively
and negatively) through their actions and should therefore account for these effects as
part of their standard accounting practices. Social accounting is in this sense closely
related to the economic concept of externality.
Social accounting offers an alternative account of significant economic entities. It has the
"potential to expose the tension between pursuing economic profit and the pursuit of
social
and
environmental
objectives".
The purpose of social accounting can be approached from two different angles, namely
for management control purposes or accountability purposes.
49
2.4.1 Accountability
Social accounting for accountability purposes is designed to support and facilitate the
pursuit of society's objectives. These objectives can be manifold but can typically be
described in terms of social and environmental desirability and sustainability. In order to
make informed choices on these objectives, the flow of information in society in general,
and in accounting in particular, needs to cater for democratic decision-making. In
democratic systems, Gray argues, there must then be flows of information in which those
controlling the resources provide accounts to society of their use of those resources: a
system of corporate accountability.
Society is seen to profit from implementing a social and environmental approach to
accounting in a number of ways, e.g.:

Honoring stakeholders' rights of information;

Balancing corporate power with corporate responsibility;

Increasing transparency of corporate activity;

Identifying social and environmental costs of economic success.
2.4.2 Management control
Social accounting for the purpose of management control is designed to support and
facilitate
the
achievement
of
an
organization's
own
objectives.
Because social accounting is concerned with substantial self-reporting on a systemic
level, individual reports are often referred to as social audits.
Organizations are seen to benefit from implementing social accounting practices in a
number of ways, e.g.:

Increased information for decision-making;

More accurate product or service costing;

Enhanced image management and Public Relations;

Identification of social responsibilities;

Identification of market development opportunities;

Maintaining legitimacy.
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According to BITC the "process of reporting on responsible businesses performance to
stakeholders" (i.e. social accounting) helps integrate such practices into business
practices, as well as identifying future risks and opportunities.
The management control view thus focuses on the individual organization.
Critics of this approach point out that the benign nature of companies is assumed. Here,
responsibility, and accountability, is largely left in the hands of the organization
concerned.
2.4.3 Scope
1. Formal accountability
In social accounting the focus tends to be on larger organisations such as multinational
corporations (MNCs), and their visible, external accounts rather than informally produced
accounts or accounts for internal use. The need for formality in making MNCs
accountability is given by the spatial, financial and cultural distance of these
organisations to those who are affecting and affected by it.
Social accounting also questions the reduction of all meaningful information to financial
form. Financial data is seen as only one element of the accounting language.
2. Self-reporting and third party audits
In most countries, existing legislation only regulates a fraction of accounting for socially
relevant corporate activity. In consequence, most available social, environmental and
sustainability reports are produced voluntarily by organisations and in that sense often
resemble financial statements. While companies' efforts in this regard are usually
commended, there seems to be a tension between voluntary reporting and accountability,
for companies are likely to produce reports favoring their interests.
The re-arrangement of social and environmental data companies already produce as part
of their normal reporting practice into an independent social audit is called a silent or
shadow account.
An alternative phenomenon is the creation of external social audits by groups or
individuals independent of the accountable organisation and typically without its
encouragement. External social audits thus also attempt to blur the boundaries between
organisations and society and to establish social accounting as a fluid two-way
communication process. Companies are sought to be held accountable regardless of their
approval. It is in this sense that external audits part with attempts to establish social
accounting as an intrinsic feature of organisational behaviour. The reports of Social Audit
Ltd in the 1970s on e.g. Tube Investments, Avon Rubber and Coalite and Chemical, laid
the foundations for much of the later work on social audits.
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3. Reporting areas
Unlike in financial accounting, the matter of interest is by definition less clear-cut in
social accounting; this is due to an aspired all-encompassing approach to corporate
activity. It is generally agreed that social accounting will cover an organisations
relationship with the natural environment, its employees, and ethical issues concentrating
upon consumers and products, as well as local and international communities. Other
issues include corporate action on questions of ethnicity and gender.
4. Audience
Social accounting supersedes the traditional audit audience, which is mainly composed of
a company's shareholders and the financial community, by providing information to all of
the organisation's stakeholders. A stakeholder of an organisation is anyone who can
influence or is influenced by the organisation. This often includes, but is not limited to,
suppliers of inputs, employees and trade unions, consumers, members of local
communities, society at large and governments. Different stakeholders have different
rights of information. These rights can be stipulated by law, but also by non-legal codes,
corporate values, mission statements and moral rights. The rights of information are thus
determined by "society, the organisation and its stakeholders".
2.4.4 Environmental accounting
Environmental accounting is a subset of social accounting, focuses on the cost structure
and environmental performance of a company. It principally describes the preparation,
presentation, and communication of information related to an organisation’s interaction
with the natural environment. Although environmental accounting is most commonly
undertaken as voluntary self-reporting by companies, third-party reports by government
agencies, NGOs and other bodies posit to pressure for environmental accountability.
Accounting for impacts on the environment may occur within a company’s financial
statements, relating to liabilities, commitments and contingencies for the remediation of
contaminated lands or other financial concerns arising from pollution. Such reporting
essentially expresses financial issues arising from environmental legislation.
More typically, environmental accounting describes the reporting of quantitative and
detailed environmental data within the non-financial sections of the annual report or in
separate (including online) environmental reports. Such reports may account for pollution
emissions, resources used, or wildlife habitat damaged or re-established.
In their reports, large companies commonly place primary emphasis on eco-efficiency,
referring to the reduction of resource and energy use and waste production per unit of
product or service. A complete picture which accounts for all inputs, outputs and wastes
of the organisation, must not necessarily emerge. Whilst companies can often
demonstrate great success in eco-efficiency, their ecological footprint, that is an estimate
of total environmental impact, may move independently following changes in output.
52
Legislation for compulsory environmental reporting exists in some form e.g. in Denmark,
Netherlands, Australia and Korea. The United Nations has been highly involved in the
adoption of environmental accounting practices, most notably in the United Nations
Division for Sustainable Development publication Environmental Management
Accounting Procedures and Principles (2002).
In short, the object is to account for economic effects of all environmental activities of
the firm to promote quality of life. Accordingly, accounting is used in a broader sense to
include financial, cost and management accounting issues including control functions like
internal and external audits. Some of relevant issues are:

How to recognize environmental effects on conventional accounting practice and
framing accounting policies accordingly?

Are the environment-related costs and revenues separately identified, measured
and reported in the conventional system?

What are environmental costs? Is there proper allocation of hidden environmental
costs for better decision-making?

Are the amount incurred, if any, for taking necessary environmental measures
during the period sub-divided into suitable heads, such as:
o Liquids effluent treatment;
o Waste gas and air treatment;
o Solid waste treatment;
o Analysis, control and compliance;
o Remediation;
o Recycling;
o Accident and safety, and
o Others, if any,

What is the financial and operational effect of environmental protection measures
on the capital expenditure and earnings of the company in the current year? Do
they have any specific impact an future periods?

Is the capital expenditure decision making process suitably adjusted for justifying
“green technology”?
53

What policy is followed regarding amortization of environment related capital
expenditure?

Does the existing system of recording and reporting company’s liabilities and
provisions take into consideration environmental issues?

How does the company treat additional expenditure incurred for training of
employees to enhance their environmental awareness?

How much is spent annually on research and development to innovate
environment friendly processes and products?

Is there any scope for setting up a catastrophe reserves?

Does the product innovation decision take care of environment friendless? Does it
involve additional cost?

What are environmental benefits? Can these benefits be identified, measured and
disclosed under suitable classification, such as —
o Process benefits;
o Product benefits;
o Fiscal benefits, and
o Overall other benefits

What is the impact on profitability of the company for getting ISO 14000
accreditation and for following ISO 14001 standards? Can ISO 14001 increase net
operating profit of the company?

What accounting standards do we need for measurement and reporting of
economic activities that take care of environmental issues? Did the FASB or
IASB issue any such standard? How can ICAI cooperate with other notable
international accounting standard-setters to formulate a suitable accounting
standard to capture identification, measurement and disclosure of environment
costs and benefits of a firm in India?

Has the company introduced a separate environmental audit system? If yes, who
forms part of the audit team – employees or external persons? What is the
composition of the team?

Does the environmental audit report form part of the statutory audit report or
separate environmental report? l What is the level of social responsibility
reporting in the annual report of the company? Does the reporting of a
54
environmental activities form part of social responsibility and shown separately?
Or, is it shown only as a part of Director’s Report?

Does the company show expenses on environmental activities in the annual report
under a separate head or are they clubbed with items of operating expenses?
The above and many other similar issues become pertinent for discussion in the context
of accounting for corporate environmental management. It would be impossible to
delineate here all of them for the constraint of volume. Accordingly, only a few of them
are discussed here briefly.
Accounting Policies
Accounting policies form the basis of measurement and reporting of economic activities
of the firm and are critical for understanding its accounting numbers contained in the
annual reports. The environmental awareness of the firm, translation of the awareness
into environmental measures leading to some economic actives and treatment of
environment-related expenses can be captured well only when accounting policies of the
firm make a suitable disclosure of them in appropriate places of the financial statements.
In India, Accounting Standard (AS) 1, Disclosure of Accounting Policies, deals with the
disclosure of significant accounting policies to be followed for preparation and
presentation of financial statements. The purpose of this standard is to promote better
understanding of financial statements by making the disclosure of significant accounting
policies in the financial statements and the manner of doing so. Such disclosure facilitates
a more meaningful inter-period and inter-firm comparison.
Reporting Principles and Contents
Preparation and presentation of corporate financial reports are governed by Generally
Accepted Accounting Principles (GAAP) that are applicable in a particular context.
Reporting of environmental performances of the firm is generally considered as a part of
Corporate Social Reporting (CSR) and is likely to be guided by the same principles,
guidelines and regulatory provisions. In this context, issues concerning sustainability are
generally raised.
Sustainable economic development encompasses economic, environmental and social
performances of the company. The Royal Dutch/Shell Group of Companies considers
sustainable development reporting in an interesting way as shown in Figure 1.
Therefore, from the standpoint of sustainability, reporting may assume a different
dimension. Accordingly, the reporting principles and contents rooted in the premise of
sustainability are briefly discussed below.
55
Reporting Principles
The Global Reporting Initiative (GRI) Guidelines (June, 2000) presented a first version
of the principles that are essential to produce a balanced and reasonable report on an
organisation’s economic, environmental and social performance. GRI (2002) presents a
revised set of principles with the benefit of time and learning through application of the
June 2000 Guidelines. These principles are designed with the long term in mind and are
expected to create an enduring foundation upon which performance measurement will
continue to evolve on new knowledge and learning.
Figure 1
Contents of the reports
Part C of GRI Guidelines suggests the content of the report in five sections, vis.
(i) Description of vision and strategy;
(ii) A profile of reporting organisation’s structure and operations and of the scope of the
report;
56
(iii) Governance structure and management systems;
(iv) Content index, and
(v) Performance indicators (economic, environmental, social and integrated, if possible)
performance indicators.
Performance indicators are grouped in terms of the three dimensions of the conventional
definition of sustainability

Economic, environmental and social. Table 1 contains performance indicators
according to a hierarchy of category, aspect and indicator. Performance indicators
may be expressed either in qualitative or quantitative form or in both. Quantitative
indicators are auditable and are more authentic information to rely upon.
Qualitative indicators may be complementary to present a complete picture of an
organisation’s economic, environmental and social performance. In a highly
complex situation, where it is not possible to identify or measure quantitative
indicators that capture the organisation’s contribution

Positive or negative

To economic, environmental and social conditions, qualitative information may
be the most appropriate one.
2.4.5 Applications of social accounting
Social accounting is a widespread practice in a number of large organisations in the
United Kingdom. Royal Dutch Shell, BP, British Telecom, The Co-operative Bank, The
Body Shop, and United Utilities all publish independently audited social and
sustainability accounts. In many instances the reports are produced in (partial or full)
compliance with the sustainability reporting guidelines set by the Global Reporting
Initiative (GRI).
Traidcraft plc, the fair trade organisation, claims to be the first public limited company to
publish audited social accounts in the UK, starting in 1993.
57
58
2.4.6 Format
Companies and other organisations (such as NGOs) may publish annual corporate
responsibility reports, in print or online. The reporting format can also include summary
or overview documents for certain stakeholders, a corporate responsibility or
sustainability section on its corporate website, or integrate social accounting into its
annual report and accounts.
Companies may seek to adopt a social accounting format that is audience specific and
appropriate. For example, H&M, asks stakeholders how they would like to receive
reports on its website; Vodafone publishes separate reports for 11 of its operating
companies as well as publishing an internal report in 2005; Weyerhaeuser produced a
tabloid-size, four-page mini-report in addition to its full sustainability report
2.5 SOCIAL ACCOUNTING CASE
Sir Adrian Cadbury and CSR
Sir Adrian Cadbury was a senior executive with the Cadbury group for many years and
was the chairman of one of several UK Government Commissions on Corporate
Governance. In October 2004 he gave a speech at the annual conference of the Chartered
Institute of Personnel and Development in which he said a number of vital things,
including:
"A UK consumer survey asks shoppers every month: 'How important is the social
responsibility of a business to you when you are purchasing a product?' In 1998, 28%
answered 'very important'; by 2000 that figure had risen to 46%. The figures are
meaningless: the trend is significant."
Then he makes rather a bold and uncompromising statement:
"I have no difficulty with a quoted company declaring its purpose as being solely to
generate profit for its shareholders while keeping within the law, but to make no further
concession to society's interests. Its shareholders, its employees and all those with whom
it deals know where they stand. Its minimalist social policy stems directly from its values
and meets the tests of clarity, commitment and congruence. I believe that society's
interest lies in honest disclosure of purpose and values, not in attempting to impose
social responsibility standards of some kind. What is not in either a company's or
society's interest are stated policies which are insincere and no more than window
dressing."
The above statement is strengthened when Sir Adrian later says:
"The social responsibilities of companies need to be clear, consistent, anchored to their
values and at times stood by in the face of public clamour."
59
Source: The Challenge of Corporate Social Responsibility, Sir Adrian Cadbury, CIPD Conference 2003, Business in the
Community
In other words, Sir Adrian is in no doubt that a company should live by its own values
and if CSR is not at the top of its list of corporate values then, providing it is living within
the law, it cannot be criticised. Sir Adrian was reported in the Daily Telegraph, however,
as follows:
"...in many cases society would be better off if such companies ignored the campaigners
and concentrated on making a profit."
Source: Don't give in to pressure groups, by Richard Tyler, The Daily Telegraph, 7 October 2004
Whilst not everyone will agree with Sir Adrian's position on CSR, the Telegraph
portrayal of that position was less than favourable and a full reading of both the speech
and the article will reap its own reward.
2.6 SOCIAL AUDITING
Social Audit is a tool with which government departments can plan, manage and measu
re non financial activities and monitor both internal and external consequences
of the department/organisation's social and commercial operations. It is an
instrument of social accountability for an organisation. In other words, Social
Audit may be defined as an in‐ depth scrutiny and analysis of the working of
any public utility vis à vis its social relevance. Social Audit gained significance
especially after the 73rd
Amendment of the Constitution relating to
Panchayat Raj Institutions.
2.6.1 Purpose of the Social Audit
This tool is designed to be a handy, easy to use reference that not only answers basic qu
estions about Social Audit, reasons for conducting Social Audit, and most
importantly gives easy to follow steps for all those interested in using Social Audit.
The purpose of conducting Social Audit is not to find fault with the individual functionar
ies but to assess the performance in terms of social, environmental and
community
goals
of
the
organisation. It is a way of measuring the extent to which an organisation lives up to the
shared values and objectives it has committed itself to. It provides an assessment
of
the
impact
of
an
organisations non
financial objectives through systematic and regular monitoring, based on the
views of its stakeholders.
2.6.2 Salient Features
The foremost principle of Social Audit is to achieve continuously improved
60
performances
in
relation
to
the
chosen
social
objectives.
Eight specific key principles have been identified from Social Auditing practices around
the world. They are:
1. Multi Perspective/Polyvocal.
Aims to reflect the views (voices) of all those people (stakeholders) involved with or affe
cted by the organisation/department/programme.
2. Comprehensive
Aims to (eventually) report on all aspects of the organisations work and
performance.
3. Participatory
Encourages participation of stakeholders and sharing of their values
4. Multidirectional
Stakeholders share and give feedback on multiple aspects.
5. Regular
Aims to produce social accounts on a regular basis so that the concept and the
practice become embedded in the culture of the organisation covering all the activities.
6. Comparative
Provides a means, whereby, the organisation can compare its own
performance each year and against appropriate external norms or benchmarks; and provid
e for comparisons with organisations doing similar work and reporting in similar fashion.
7. Verification
Ensures that the social accounts are audited by a suitably experienced person or agency w
ith no vested interests in the organisation.
8. Disclosure
Ensures that the audited accounts are disclosed to stakeholders
wider community in the interests of accountability and transparency.
and
the
So how does a company put all of its social accounting and reporting together? Well, first
of all it has to start with a social audit. That is, someone has to verify that when
Manchester United, for example, say that they are aiming at curbing racism in football
that they actually did something to achieve that aim.
61
Here are some definitions of social audit that might be helpful:
'Social Audit is a method for organisations to plan, manage and measure non-financial
activities and to monitor both the internal and external consequences of the
organisation's social and commercial operations.'
Source: Social Audit Toolkit (1997) Freer Spreckley, Social Enterprise Partnership
'Social Auditing is a process which, enables organisations and agencies to assess and
demonstrate their social, community and environmental benefits and limitations. It is a
way to measure the extent to which an organisation lives up to the shared values and
objectives it has committed itself to promote.'
Source: Social Economy Agency for Northern Ireland
'Social auditing is the process whereby an organisation can account for its social
performance, report on and improve that performance. It assesses the social impact and
ethical behaviour of an organisation in relation to its aims and those of its stakeholders.'
Source: New Economics Foundation
It should be clear from everything we have said that before a social audit can take place
you have to be clear about:

Objectives - what you are trying to do as an organisation, both internally and
externally

Action plans - how you are going to do it

Indicators - how you will measure and record the extent to which you are doing it
When these are in place, it is easy to design simple procedures to log what is going on
from day to day (social bookkeeping), to tally up the indicators every now and again
(social accounting) and make sure that you are on target, or to do something about it if
you are not!
2.6.3 Who Carries Out Social Audits?
From the samples we have seen here, social auditors are largely the same as financial or
statutory auditors. Take a look at all of the social accounts that we have discussed here
and you will see that this is true. However, for other, perhaps smaller, organisations it is
not necessarily vital that a fully qualified auditor or accountant takes the job on.
62
The key characteristic of a social auditor must be independence and remoteness. That is,
the social audit must be carried out by someone who does not work for the organisation
that s/he is auditing and it is helpful if the auditor is not, for example, a shareholder in the
organisation. It might even be helpful for the auditor to know nothing about the products
and processes of the organisation when they first begin their audit so that they start their
work completely cleanly!
The social auditing process requires an intermittent but clear time commitment from a
key person within the organisation. This social auditor liases with others in the
organisation and designs, co-ordinates, analyses and documents the information collected
during the process.
Social auditing information is collected through research methods that include social
bookkeeping, surveys and case studies. The objectives of the organisation are the starting
point from which indicators of impact are determined, stakeholders identified and
research tools designed in detail.
The collection of information is an on-going process, often done in 12-month cycles and
resulting in the organisation establishing social bookkeeping and the preparation of an
annual social audit document/report.
Experience has shown that it is important to provide training to the social auditor as well
as mentoring during the first few years. If well facilitated, social auditors from different
organisations can become self-supporting for subsequent years.
Activity 2
1. Discuss various accounting approaches to investment decisions. What do you
understand by valuation adjustment account?
2. Write an essay on social accounting.
3. Discuss the need of social auditing in today’s scenario.
4. Write short note on environment accounting.
2.7 SUMMARY
This unit highlighted various approaches of accounting relevant to investment decisions.
Unit also throws light on social account concepts. In earlier sections unit introduces main
approaches of accounting to investment decisions. Social accounting was explained as a
process of communicating the social and environmental effects of organizations'
economic actions to particular interest groups within society and to society at large.
Purpose and scope of social accounting was described in next sections followed by
discussion
on
social
auditing
which
was
explained
as
63
a tool with which government departments can plan, manage and measure non financial
activities and monitor both internal and external consequences of the
department/organisation's social and commercial operations.
2.8 FURTHER READINGS

Beranek, W. Analysis of financial decisions, Richard D Irwin, 1963.

D. Crowther, Social and Environmental Accounting (London: Financial Times
Prentice Hall, 2000

M.R. Mathews,'Towards a Mega-Theory of Accounting' in: Gray and Guthrie,
Social Accounting, Mega Accounting and Beyond: A Festschrift in Honour of
MR Mathews CSEAR Publishing, 2007.

R.H. Gray, 'Thirty Years of Social Accounting, Reporting and Auditing: what (if
anything) have we learnt?', Business Ethics: A European View 10(1) 2001.
64
UNIT 3
HUMAN RESOURCE AND VALUE ADDED ACCOUNTING
Objectives
After studying this unit you should be able to:







Understand the conceptual framework of human resource accounting
Know the need for human resource accounting
Appreciate the concept of information management in human resource accounting
Be aware about the approaches to analyse human resource involved in business
Have the understanding about measures for assessing individual value
Discuss the scenario of human resource practices in India
Explain the value added accounting and related concepts
Structure
3.1 Introduction
3.2 Conceptual frame and HRA scenario
3.3 The need for human resource accounting
3.4 Information management in HRA
3.5 Approaches to analyse human resource
3.6 Measures for assessing individual value
3.7 Human resource practices in India
3.8 Value added accounting
3.9 Summary
3.10 Further readings
3.1 INTRODUCTION
Human resource accounting is not a new issue in the field of finance. Economists
consider human capital as a production factor, and they explore different ways of
measuring its investment in education, health, and other areas. Accountants have
recognized the value of human assets for at least 70 years. Research into true human
resource accounting began in the 1960s by Rensis Likert [Bowers, 1973]. Likert defends
long-term planning by strong pressure on human resources' qualitative variables,
resulting in greater benefits in the long run.
Looking at different proposals [Conner, 1991], the resource theory considers human
resources in a more explicit way. This theory considers that the competitive position of a
firm depends on its specific and not duplicated assets. The most specific (and not
duplicated) asset that an enterprise has is its personnel. It takes advantage of their
interdependent knowledge. That would explain why some firms are more productive than
others. With the same technology, a solid human resource team makes all the difference.
65
The American Accounting Association [1970] defines human resource accounting as "the
human resources identification and measuring process and also its communication to the
interested parties."
There are two reasons for including human resources in accounting. First, people are a
valuable resource to a firm so long as they perform services that can be quantified. The
firm need not own a person for him to be considered a resource. Second, the value of a
person as a resource depends on how he is employed. So management style will also
influence the human resource value.
The past few decades have witnessed a global transition from manufacturing to service
based economies. The fundamental difference between the two lies in the very nature of
their assets. In the former, the physical assets like plant, machinery, material etc. are of
utmost importance. In contrast, in the latter, knowledge and attitudes of the employees
assume greater significance. For instance, in the case of an IT firm, the value of its
physical assets is negligible when compared with the value of the knowledge and skills of
its personnel. Similarly, in hospitals, academic institutions, consulting firms etc., the total
worth of the organization depends mainly on the skills of its employees and the services
they render.
Hence, the success of these organizations is contingent on the quality of their Human
Resource- its knowledge, skills, competence, motivation and understanding of the
organizational culture. In knowledge –driven economies therefore, it is imperative that
the humans be recognized as an integral part of the total worth of an organization.
However, in order to estimate and project the worth of the human capital, it is necessary
that some method of quantifying the worth of the knowledge, motivation, skills, and
contribution of the human element as well as that of the organizational processes, like
recruitment, selection, training etc., which are used to build and support these human
aspects, is developed. Human resource accounting (HRA) denotes just this process of
Quantification/measurement of the Human Resource.
3.2 CONCEPTUAL FRAME AND HRA SCENARIO
Human resources, like any other asset, bring with them several costs (Table 1). Using
criteria to determine elements that can be recorded [Financial Accounting Standards
Board, 1984, 1993; International Accounting Standards Committee, 1989, 1994], Table 2
shows the possibilities of considering human resources as an asset [Financial Accounting
Standards Board, 1984, 1993] and as a current expense.
66
3.2.1 HRA scenario
It is true that worldwide, knowledge has become the key determinant for economic and
business success, but Indian companies focus on ‘Return on Investment’ (RoI), with very
few concrete steps being taken to track ‘Return on Knowledge’.
What is needed is measurement of abilities of all employees in a company, at every level,
to produce value from their knowledge and capability. “Human Resource Accounting
(HRA) is basically an information system that tells management what changes are
67
occurring over time to the human resources of the business. HRA also involves
accounting for investment in people and their replacement costs, and also the economic
value of people in an organization,” says P K Gupta, the director of strategic
development-intercontinental operations, of Legato Systems India. The current
accounting system is not able to provide the actual value of employee capabilities and
knowledge. This indirectly affects future investments of a company, as each year the cost
on human resource development and recruitment increases.
Experts point out that the information generated by HRA systems can be put to use for
taking a variety of managerial decisions like recruitment planning, turnover analysis,
personnel advancement analysis and capital budgeting, which can help companies save a
lot of trouble in the future.
Human is the core factor and which is required to be recognized prior to any other 'M's
But till now an urgent need based modification is required while identifying and
measuring data about human resources. In this paper my objective is to identify the
extensive use of Lev & Schwartz model of Human resource accounting, in spite of
several criticized from various sides regarding its applicability. Further more, it also
portrays the applicability in wide variety of organization of such model (some pubic
sector
units
and
IT
based
sector).
Human is the buzzword in the modern knowledge based society. It is the most vital input
on which the success & failure of the organization very much depend upon. Starting from
the classical economist to modern human capital economist such development in
considered to be a continuous process.
Figure 1
It is one of the most important 'M' associated, which is considered while taken care of
4M's associated with any organization and they are money machines, materials and men.
68
But the most interesting thing is that the first three are recognized and find a place in the
assets side of the Balance sheet of the organization. But in case of fourth one ambiguity
prevails among the accountant. In spite of its usefulness has been acclaimed is various
literature over the decades but its application still remain a suspectable issue, the IASB
and the ASB in different countries have not been able to formulate any specific
accounting standard for measurement & reporting of such valuable elements.
It is a popular phenomenon among the Indian corporate world is to disclose information
relating to human resource in annual statements. In this context, it is necessary to conduct
a study to assess the disclosure pattern of HRA information in Indian corporate World.
It first promulgated by BHEL (Bharat Heavy Electrical Ltd), a leading public enterprise,
during the financial year 1972-73. Later it was also adopted by other leading public and
private sector Organization in the subsequent years. Some of them are Hindustan
Machine Tools Ltd.(HMTL). Oil and Natural Gas Corporation Ltd.(ONGC), NTPC,
Cochin Refineries Ltd. (CRL), Madras Refineries Ltd.,(MRL), Associated Cement
Company Ltd.(ACC) and Infosys Technologies Ltd.(ITL).
However, adaptability of various model (mainly Lev and Schwartz model, Flamholtz
model and Jaggi and Lev model) and discount rate fixation and disclosure pattern ie.
either age wise, skill wise etc in BHEL, SAIL, MMTC (Minerals & Metals Trading
Corporation Of India Ltd.) HMTL, NTP make it clear, that there has been no uniformity
among Indian enterprises regarding HRA disclosure.
3.2.3 The ways of presentation of HRA information disclosed by some of
the companies
Name of the
organization
BHEL
SAIL
HRA introduce
in the year
1973 – 74
1983 – 84
Model
Lev & Schwartz model
Lev & Schwartz model with
Some refinements as suggested by Eric.G.
Flamholtz& Jaggi and Lev
Discount
rate (in%)
12
14
MMTC
1982 – 83
Lev & Schwartz model
12
ONGC
1981 – 82
Lev & Schwartz model
12.25
NTPC
1984 – 85
Lev & Schwartz model
12
1999
Lev & Schwartz model
12.96
2006-07
Lev & Schwartz model
14.97
INFOSYS
69
PRODUCTIVITY & PERFORMANCE INDICATORS
Source: Secondary
Terminology used:
1) PBT-Profit Before Tax
2) HR- Human Resource
3) TA-Total Assets
4) Turn-Turnover ( or Sales)
5) FA-Fixed Assets
6) VA- Value Added
3.2.4 Human Resource Accounting Disclosures
Public Sector Enterprises
1. Bharat Heavy Electricals Limited (BHEL)
2. Steel Authority of India Limited (SAIL)
3. Cement Corporation of India Limited (CCI)
4. Oil and Natural Gas Commission (ONGC)
5. Electronics India Limited
6. Engineers India Limited
7. Hindustan Shipyard
8. National Thermal Power Corporation Limited (NTPC)
Private Sector Enterprise
1. Infosys
70
Models of Human Capital Valuation
Many models have been created to value human capital. Some are based on historic costs
while some are based on future earnings. But each has its own limitations and one model
has proved to be more valid than other. Although the Lev and Schwartz model has been
the most widely use model for its ease of use & convenience.
The Lev & Schwortz Model
The Lev and Schwartz model states that the human resource of a co is the summation of
value of all the Net present value (NPV) of expenditure on employees. The human capital
embodied in a person of age r is the present value of his earning from employment
Under this model, the following steps are adopted to determine HR Value.
i) Classification of the entire labour force into certain homogeneous groups like skilled,
unskilled, semiskilled etc. and in accordance with different classed and age wise.eg. In
Infosys the classification is based on software professionals & support staff etc.
ii) Construction of average earning stream for each group.eg. At Infosys Incremental
earnings based on group/ age have been considered.
iii) Discounting the average earnings at a predetermined rate in order to get present value
of human resource's of each group.
iv) Aggregation of the present value of different groups which represent the capitalized
future earnings of the concern as a whole,
Where, Vr = the value of an Individual r years old
I (t) = the individual's annual earnings up to retirement
t
= retirement age
r = a discount rate specific to the cost of capital to the company.
3.3 THE NEED FOR HUMAN RESOURCE ACCOUNTING
How true is this oft-repeated statement made by the management of all knowledge-driven
companies? The problem in fact starts when it comes to assessing the real value of human
assets. While most organisations can readily give detailed information about their
71
tangible assets like plant and machinery, land and buildings, transport and office
equipment, there is no formal record of investment in employees. Human assets
accounting or human resource accounting (HRA), which stands for measurement and
reporting of the cost and value of people as organisational resources, is still to become an
accepted trend in the Indian IT industry.
It is true that worldwide, knowledge has become the key determinant for economic and
business success, but Indian companies focus on ‘Return on Investment’ (RoI), with very
few concrete steps being taken to track ‘Return on Knowledge’.
What is needed is measurement of abilities of all employees in a company, at every level,
to produce value from their knowledge and capability. “Human Resource Accounting
(HRA) is basically an information system that tells management what changes are
occurring over time to the human resources of the business.
HRA also involves accounting for investment in people and their replacement costs, and
also the economic value of people in an organisation,” says P K Gupta, the director of
strategic development-intercontinental operations, of Legato Systems India. The current
accounting system is not able to provide the actual value of employee capabilities and
knowledge. This indirectly affects future investments of a company, as each year the cost
on human resource development and recruitment increases.
Experts point out that the information generated by HRA systems can be put to use for
taking a variety of managerial decisions like recruitment planning, turnover analysis,
personnel advancement analysis and capital budgeting, which can help companies save a
lot of trouble in the future.
3.3.1 on balance sheet
Organisations can actually find out how much they can earn from an individual, as the
intellectual assets of a company are often worth three or four times the tangible book
value. Human capital also provides expert services such as consulting, financial planning
and assurance services, which are valuable, and very much in demand.
Realising this, many companies world-over are making HRA as a necessary element on
their balance sheets. One of the best examples is of the Denmark Government. The
Danish Ministry of Business and Industry has issued a directive that with effect from the
trading year 2005, all companies registered in Denmark will be required to include in
their annual reports information on customers, processes and human capital. A minimum
of five measures for each is required, and comparison with the previous two years must
be shown. Figures for investment in intellectual capital must be shown and compared
with the previous two years. A narrative should accompany each set of figures.
Information for investors about intellectual capital, both current and future, should
occupy at least one third of the report. Where relevant, information must also be provided
regarding care for the environment.
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In India, there are very few companies like BHEL, Infosys and Reliance Industries,
which have implemented HRA and some are working on it. Infosys, which started
showing human resource as an asset in its balance sheet, has been reaping high market
valuations. NIIT has been following a similar method called Economic Value Addition
(EVA), which also helps in assessing the real value that an employee can fetch for the
company.
Experts point out that companies can derive many benefits by going in for HRA. Not
only can they measure the return on capital employed on total organisational assets
(including the human assets), but the resources can also be planned accordingly. “Once
organisations realise the actual benefit and take it as a growth process, it will only help
them in increasing their shareholders’ value. When a company is able to assess an
individual’s worth, it helps in increasing its own worth,” says Ajay Sharma, senior HR
manager of Cadence Systems.
Basically HRA can be tracked through two methods—cost-based analysis and valuebased analysis. The cost-based approach focuses on the cost parameters, which may
relate to historical cost, replacement cost, or opportunity cost. The value-based approach
suggests that the value of human resources depends upon their capacity to generate
revenue. This approach can be further sub-divided into two broad categories: nonmonetary and monetary.
The disposition of resources can also be examined by allocating relative human asset
values to different job grades. HRA also helps in examining expenditure on personnel
and in re-appraisal of expenditure on services and training. It can also serve as a key
factor in case of mergers and takeover decisions, where the human asset value becomes a
relevant factor. Another very significant role, which HRA can help in creating, is
goodwill for a company. The company can project itself in having best practices with
superior policies in place. Experts believe that this may help the organisation attract more
investments.
3.3.2 The deterrents
While HRA as a concept has been present in India for more than a decade, with BHEL
taking a lead, it is only now that the awareness is being translated into application.
However, Gupta points out that in terms of awareness and acceptance, the level is still
low as many companies take little initiative to make the numbers public to shareholders,
despite having the data.
Another major deterrent is the lack of an industry standard. This means that every
company has to evolve its own standard,
which can become a tedious process, considering that most of them are still involved in
improving their business. Industry bodies like Nasscom can help set a standard.
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Another aspect working against the acceptance of HRA is the need for extensive research
that it entails. Many companies do not want to go into the intricacies of finding the value
of their human resources.
3.4 INFORMATION MANAGEMENT IN HRA
Like any accounting exercise, the HRA too depends heavily on the availability of
relevant and accurate information. HRA is essentially a tool to facilitate better planning
and decision making based on the information regarding actual HR costs and
organizational returns. The kind of data that needs to be managed systematically depends
upon the purpose for which the HRA is being used by an organization.
For example, if the purpose is to control the personnel costs, a system of standard costs
for personnel recruitment, selection and training has to be developed. It helps in
analyzing projected and actual costs of manpower and thereby, in taking remedial action,
wherever necessary. Information on turnover costs generates awareness regarding the
actual cost of turnover and highlights the need for efforts by the management towards
retention of manpower.
Accountability in the management process is often enhanced when information involving
an evaluation of managerial effectiveness is generated.
Finally, information on the intangibles like intellectual capital/human capital becomes
necessary to measure the true worth of the organization. This information, though
unaudited, needs to be communicated to the board and the stockholders
3.5 APPROACHES TO ANALYSE HUMAN RESOURCE
The biggest challenge in HRA is that of assigning monetary values to different
dimensions of HR costs, investments and the worth of employees. The two main
approaches usually employed for this are:
1. The cost approach which involves methods based on the costs incurred by the
company, with regard to an employee.
2. The economic value approach which includes methods based on the economic value
of the human resources and their contribution to the company’s gains. This approach
looks at human resources as assets and tries to identify the stream of benefits flowing
from the asset.
Various costs and there relevance to HRA are discussed as following.
3.5.1 Training and Selection Cost Analysis
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No doubt, when a firm invests in human resources by acquisition and training, it
anticipates a future generation of profits and services that will be produced by these
assets. One of the techniques showing a greater capacity to stimulate efficiency is based
on the idea that an employee who is induced to get to know his job better is more
productive and quicker on the job.
Training in firms is an activity that develops the worker's capacity to improve efficiency
and job quality, therefore, the enterprise increases its profitability. The training concept is
generally used to define three different issues which, in practice, are difficult to
distinguish: capacitation, training, and development. Capacitation is the worker's
acquisition of knowledge and skills necessary for his job. Training better adapts the
worker to the job, and development focuses on promotion to higher job levels.
Even though there are different training classifications, the one proposed reports several
criteria:
1) When does training take place? It can be at the contracting moment or any moment
during employment.
2) How long is the training period? It can take from one or two days to one or two weeks.
In some cases, it can take six months, one year, or more.
3) Does this training relate to the nature of the job by updating an employee's knowledge
and teaching new techniques or does it open doors to new skills not related to the
worker's professional activity?
4) Is there internal or external training taking place?
The criteria based on the job's nature is also proposed by AECA [1994] in its managerial
accounting document Number 6 where it distinguishes between creative training and
competitive strategy training. Therefore, creative training comes from the firm's planning
process and makes personnel capable of doing their job. On the contrary, competitive
strategic training maintains the firm's competitive level. Inside creative training, three
different actions can be distinguished that will incur some expenses.
Those training expenses are related to jobs and profession evolution, improvements in
global services, and innovation or change in projects. In any case, expenses derived from
creative training are considered long-term because they increase the firm's added value.
In other words, with creative training, the firm becomes more competitive and increases
its income. Expenses derived from competitive strategic training will be considered as
current expenses since they appear as a consequence of short-term actions that maintain
the firm's competitive level, even though its absence may lead to a decrease in the
employee's qualifications.
Treatment from a Financial Accounting Perspective
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Following the definitions already explained, as long as future benefits are expected to
come from these training costs, they can be treated as assets. However, this does not hold
true in reality. As Cea García [1990] states:
"There is a clear absence of correspondence between the real assets in the present firms
and those recognised in the balance sheet... In fact, assets are too related to its juridical
conception (that is, owned by the firm...), in front of a pure economic approach where
asset is every instrument or way that can be used in the production-distribution firm's
process or, in general, every category of economic value which can be transformed into
goods or service or any instrument at the service of the firm or that the firm uses,
regardless [of] its juridical state...and also all those goods and rights that the firm does not
own now but used to own or will own later on, by virtue of collateral contracts or
agreements which may induce it."
So, a diagnosis is reached about the predominant asset concept. This situation can be
explained by two important problems that are met when referring to intangibles: Identify
the assets cost and estimate the period in which the asset should be amortized.
In international accounting, besides clearly recognizing some items as assets (cash, stock,
machinery, and so on) there is great debate whether certain other items are considered
capitalization. These are known as deferred charges in English accounting literature. It
can be said then that not only are the limits unclear between intangible, fixed assets and
deferred charges, but also which elements are considered assets and which elements are
considered expenses.
Treatment from a Managerial Accounting Perspective
Personnel working for a determined enterprise are actually participating in a valuecreation process. That is, any economic activity makes the firm incur costs. One
traditional classification takes into account the cost categories of raw materials, industrial
plants, and personnel. When adding income flow to an organization's market goods and
services, if it is superior to the cost flow, it becomes added value. This value is a
consequence of the interaction between material and human resources in production.
Because it is difficult to know and measure value, accounting has used substituted
measures such as acquisition cost, substitution cost, and even opportunity cost .
3.5.2 Historical Costs
When referring to training costs, historical costs mean the sacrifice necessary to hire and
train people. Determining training costs is difficult when training takes place in-house,
considering teachers' and organizers' dedication, occupied rooms, salaries and staff
welfare expenses with no remuneration, general expenses, and so on. It is much easier to
have external training. we can divide all these costs into the groups of acquisition costs
and learning costs. Table 3 further divides acquisition costs, and Table 4 further divides
learning costs.
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From the management accounting point of view, an accurate estimation of the learning
factor is essential to obtain a good prediction of the product cost and is also important in
the labor force. On the other hand, the enterprise can make decisions about its human
resource investments if it knows which benefits will be reported. In this sense, the
learning factor or experience curve provides information for decision-making and
resolution of problems regarding the rising costs of the labor force where new fabrication
processes or specialized jobs are important. In both cases, the cost will decrease as long
as employees get to know their jobs better.
3.5.3 Substitution Costs
Likert [Bowers, 1973] imagines an extreme situation for the firm's management:
"Suppose that tomorrow all the jobs are empty, but you still have available all the rest of
the resources: buildings, factories, industrial plants, patents, stocks, money, and so on;
except, of course, for the personnel. How much time would it take you to recruit the
necessary personnel, train it until they are able to assume all the existing functions at the
present competitive level and integrate it in the organisation in the same way they now
are?"
The mental exercise necessary to rebuild an organization is an excellent way to attract
attention to human resources, which is now seen in a new light. Certainly, Professor
Likert's fiction includes the implicit posing of human resource valuation under
substitution (or replacement) cost criteria.
Even though Likert's proposal is very unlikely, it enables calculating the cost of totally
substituting (or replacing) human resources. To calculate substitution cost, figure in the
cost of sacrifice to replace a human resource that is already employed. This cost includes
exit costs of the leaving employee and recruiting and training of the replacement.
3.5.4 Opportunity Costs
Some authors consider that opportunity costs are not the alternative to historical costs nor
substitution costs, but estimates these costs without mistake. Opportunity costs are
considered as "an asset value when [they are] the target of an alternative use" [Hekimian
and Jones, 1967].
Cost valuation is based upon the conflict of interest that can take place in a firm's
internal, fictitious market where several organizational units (divisions) participate. These
units must be profit centers, that is, their objectives must be expressed in terms of
profitability.
3.5.5 Exit Cost Analysis
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Exit costs can be classified into the three categories [Ripoll and Labatut, 1994] of lost
efficiency prior to separation, job vacancy cost during the new search, and termination
pay.
Treatment
It is difficult to put a value on lost efficiency prior to separation. Productivity per
employee seems to be the most adequate measure. However, this measure (generally
calculated by means of a ratio) is not problem-free. For example, consider administrative
or management jobs where productivity is so hard (if not impossible) to identify. The
vacancy cost prevents taking into account how much the firm ceases to gain because the
employee is not working there anymore. If this loss is expressed according to the
productivity ratio, the same problems arise that were discussed in previous points (except
for the estimated wasted return percentage that, in this case, becomes unnecessary).
Regarding termination pay, accounting normally refers to this as indemnities.
Referring to the indemnity accounting treatment, is it necessary to record a provision for
the total possible indemnities of the staff? That is, does an expense or loss exist, whether
potential or real, and is the provision necessary? Use the example of an employee who
spends his entire professional life in a firm from the beginning through retirement. It is
obvious that the provision is not necessary. The provision has been recorded to the debit
of expenses; therefore, it remains that the previous entry cannot possibly be recorded
because future events in this particular issue are unknown. The provision entry must not
be recorded for the entire staff because this would be acting against the accrual, register,
and prudent accounting principles. When is the best moment for recording a staff
indemnity provision? An indemnity provision must be recorded only when the enterprise
has decided to put an end to the existing contracts and has already estimated (based upon
the prevailing law) the quantity accrued. Recording the provision beforehand would not
be correct because the firm's decision is still needed, not just personal opinions.
Do any restrictive factors exist for recording it? Not only is this not trivial, but it poses an
important problem. It is obvious that if a firm cannot financially afford the indemnities
because it does not have enough cash, then the provision must not be recorded. Since the
firm is not able to pay it, the liability does not exist.
Referring to the indemnities accrued or paid to the staff when finishing their contracts,
two questions arise that are heavily discussed in accounting literature. Must the
indemnities be classified in the profit and loss account as operating or extraordinary
expenses? Can indemnities be considered an asset? At this point, two different situations
can be distinguished. There are those firms that because of their size, activity, or other
factors, have a high personnel turnover; therefore, indemnities are a frequent issue. In this
case, it seems reasonable that its accounting treatment must be inside operating expenses
because, here, indemnities become something quite usual.
However, there are those firms that need to cancel contracts for the firm to survive. In
this case, indemnities must be classified as extraordinary expenses because they comply
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with certain conditions. They do not form part of the typical and ordinary activities of the
firm and they are not supposed to happen frequently. If the extraordinary expense
definition holds true, then, no doubt, indemnity expenses can be considered
extraordinary.
It can be concluded that personnel indemnities are a necessary expense for the firm, so
they should never be considered an asset. The reason is obvious. As a general rule, an
asset is a good or a right that the firm owns in a determined moment. Other elements are
also considered assets such as prepayment adjustments or capitalized expenses, which are
neither a good nor an expense but are considered assets for other reasons. Indemnities,
because of their nature, cannot be included in any of the previous concepts. However, it
could be argued that the concept is greater than these definitions, therefore, something is
lacking. Obviously, this possibility could be considered, but logic and common sense
says that when a firm pays an indemnity to an employee, it has an expense and is not
buying or creating an asset.
Some authors argue that if accrued indemnities make it possible for a firm to increase its
profits by means of decreasing the firm's expenses, then these indemnities should
logically be registered as assets and considered as deferred expenses, strictly following
the principle of income and expense correlation. Real situations are considered above
accounting principles, whether generally accepted or not. An asset is an asset and by no
means can an element be recorded as an asset only to justify an accounting principle.
3.5.6 Economic value approach
The value of an object, in economic terms, is the present value of the services that it is
expected to render in future. Similarly, the economic value of human resources is the
present worth of the services that they are likely to render in future. This may be the
value of individuals, groups or the total human organization. The methods for calculating
the economic value of individuals may be classified into monetary and non-monetary
methods.
3.6 MEASURES FOR ASSESSING INDIVIDUAL VALUE
Measures for assessing individual value can be divided into two: 1) monetary measures
2) non monetary measures
3.6.1 Monetary measures
a) Flamholtz’s model of determinants of Individual Value to Formal Organizations
According to Flamholtz, the value of an individual is the present worth of the services
that he is likely to render to the organization in future. As an individual moves from one
position to another, at the same level or at different levels, the profile of the services
provided by him is likely to change. The present cumulative value of all the possible
services that may be rendered by him during his/her association with the organization is
the value of the individual.
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b) Flamholtz’s Stochastic Rewards Valuation Model
The movement or progress of people through organizational ‘states’ or a ‘role’ is called a
stochastic process. The Stochastic Rewards Model is a direct way of measuring a
person’s expected conditional value and expected realizable value. It is based on the
assumption that an individual generates value as he occupies and moves along
organizational roles, and renders service to the organization. It presupposes that a person
will move from one state in the organization, to another, during a specified period of
time.
3.6.2 Non- monetary methods for determining value
The non-monetary methods for assessing the economic value of human resources also
measure the Human Resource but not in dollar or money terms. Rather they rely on
various indices or ratings and rankings. These methods may be used as surrogates of
monetary methods and also have a predictive value. The non-monetary methods may
refer to a simple inventory of skills and capabilities of people within an organization or to
the application of some behavioral measurement technique to assess the benefits gained
from the Human resource of an organisation.
1. The skills or capability inventory is a simple listing of the education, knowledge,
experience and skills of the firm’s human resources.
2. Performance evaluation measures used in HRA include ratings, and rankings. Ratings
reflect a person’s performance in relation to a set of scales. They are scores assigned to
characteristics possessed by the individual. These characteristics include skills, judgment,
knowledge, interpersonal skills, intelligence etc. Ranking is an ordinal form of rating in
which the superiors rank their subordinates on one or more dimensions, mentioned above.
3. Assessment of potential determines a person’s capacity for promotion and
development. It usually employs a trait approach in which the traits essential for a
position are identified. The extent to which the person possesses these traits is then
assessed.
4. Attitude measurements are used to assess employees’ attitudes towards their job, pay,
working conditions, etc., in order to determine their job satisfaction and dissatisfaction
3.7 HUMAN RESOURCE ACCOUNTING (HRA) PRACTICES IN
INDIA
Success of corporate undertakings purely depends upon the quality of human resources. It
is accentuated that; Human element is the most important input in any corporate
enterprise. The investments directed to raise knowledge; skills and aptitudes of the work
force of the organization are the investments in human resource. In this context, it is
worth while to examine and human resource accounting practices in corporate sector in
India.
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Human resource accounting is of recent origin and is struggling for acceptance. .It is
clearly said that, Human resources accounting is an accounting measurement system and
a large body of literature has been published in the last decade setting for the various
procedures for measurement. At the same time the theory and underlying concepts of
accounting measurement have received sizeable attention from academics and a
substantial body of literature has developed. The conventional accountings of human
resources are not recognized as physical or financial assets.
Though Human Resources Accounting was introduced way back in the 1980s, it started
gaining popularity in India after it was adopted and popularized by NLC. Human
Resources accounting, also known as Human Asset Accounting, involved identifying,
measuring, capturing, tracking and analyzing the potential of the human resources of a
company and communicating the resultant information to the stakeholders of the
company. It was a method by which a cost was assigned to every employee when
recruited, and the value that the employee would generate in the future. Human Resource
accounting reflected the potential of the human resources of an organization in monetary
terms, in its financial statements.
Even though the situation prevails, yet, a growing trend towards the measurement and
reporting of human resources particularly in public sector is noticeable during the past
few years. BHEL, Cement Corporation of India, ONGC, Engineers India Ltd., National
Thermal Corporation, Minerals and Metals Trading Corporation, Madras Refineries, Oil
India Ltd., Associated Cement Companies, SPIC, Metallurgical and Engineering
consultants India Limited, Cochin Refineries Ltd. Etc. are some of the organizations,
which have started disclosing some valuable information regarding human resources in
their financial statements. It is needless to mention here that, the importance of human
resources in business organization as productive resources was by and large ignored by
the accountants until two decades ago.
During the early and mid 1980’s, behavioral scientists attacked the conventional
accounting system for its failure to value the human resources of the organization along
with its other material resources. In this changing perspective the accountants were also
called upon to play their role by assigning monetary value to the human resources
deployed in the organization. Human Resource Accounting involves the dimension of
cost incurred by the organization for all the personnel function. Hence the issue is to be
addressed is how to measure the economic value of the people to the organization and
various cost based measures to be taken for human resources.
The two main components of Human Resources Accounting were investment related to
employees and the value generated by them. Investment in human capital included all
costs incurred in increasing and upgrading the employees’ skill sets and knowledge of
human resources. The output that an organization generated from human resources was
regarded as the value of its human resources. Human Resources accounting is used to
measure the performance of all the people in the organization, and when this was made
available to the stakeholders in the form of a report, it helped them to take critical
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investment decisions. All the models stressed that human capital was considered an
investment for future earnings, and not expenditure.
For valuing human resources, different models have been developed. Some of them are
opportunity cost Approach, standard cost approach, current purchasing power Approach,
Lev and Schwartz present value of future earnings Model Flam holtz’s stochastic rewards
valuation Models etc. Of these, the model suggested by Lev and Schwartz has become
popular. Under this method, the future earnings of the human resources of the
organization until their retirement is aggregated and discounted at the cost of capital to
arrive at the present value.
Human resources accounting system consists of two aspects namely:
a)
The investment made in human resources
b)
The value human resource
Measurement of the investments in human resources will help to evaluate the charges in
human resource investment over a period of time. The information generated by the
analysis of investment in human resources has many applications for managerial
purposes. The organizational human performance can be evaluated with the help of such
an analysis. It also helps in guiding the management to frame policies for human
resource management. The present performance result will act as input for future
planning and the present planning will have its impact on future result. The same
relationship is also applicable to the areas of managerial applications in relation to the
human resource planning and control. Investment in human resources can be highlighted
under two heads, namely,
3.7.1 Investment pattern
The human resource investment usually consists of the following items:1)
Expenditure on advertisement for recruitment
2)
Cost of selection
3)
Training cost
4)
On the job training cost
5)
Subsistence allowance
6)
Contribution to provident Fund
7)
Educational tour expenses
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8)
Medical expenses
9)
Ex-gratia payments
10) Employee’s Welfare Fund
All these items influence directly or indirectly the human resources and the productivity
of the organization.
3.7.2 Investment in current costs
After analyzing the investment pattern in the human resources of an organization the
current cost of human resources can be ascertained. For this purpose, current cost is
defined as the cost incurred with which derives benefit of current nature. These are the
costs, which have little bearing on future cost. Thus, the expenses incurred for the
maintenance of human resources are termed as current costs. Current cost consists of
salary and wages, Dearness allowance, overtime wages, bonus, house rent allowance,
special pay and personal pay.
Amidst this background, it is significant to mention that the importance and value of
human assets were recognized in the early 1990s when there was a major increase in
employment in firms in service, technology and other knowledge-based sectors. In the
firms in these sectors, the intangible assets, especially human resources, contributed
significantly to the building of shareholder value. The critical success factor for any
knowledge-based company was its highly skilled and intellectual workforce. Soon after,
the manufacturing industry also seemed to realize the importance of people and started
perceiving its employees as strategic assets.
For instance, if two manufacturing companies had similar capital and used similar
technology, then it was only their employees who were the major differentiating factor.
Due to the above development, the need for valuing human assets besides traditional
accounting of tangible assets was increasingly experienced.
3.7.3 HRA cases in India
1. ROLTA INDIA PVT LTD
Rolta India limited is an Indian company operating in India and overseas. It provides
software/information technology based engineering and geospatial solutions and services
to customers across the world and has executed projects in more than 35 countries. Rolta
is headquartered in Mumbai and operates through a network of twelve regional/branch
offices in India and seven subsidiaries located in USA, Canada, UK, The Netherlands,
Germany, Saudi Arabia and UAE. It is listed on the Bombay Stock Exchange and
National Stock Exchange in India.
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Rolta is India’s leading provider of GIS/GeoEngineering solutions and services and one
of the major AM/FM/GIS photogrammetry service providers in the world for segments
such as Defense, Environment, Electric, Telecom, Gas, Emergency Services,
Municipalities and Airports. The company’s customer base for GIS projects is spread
across 17 countries with multi million dollar projects executed in various parts of the
world. Rolta is also leading provider of plant design automation solutions and services in
India and one of the major plant information management services providers worldwide.
The company’s customer base for such business is spread across 22 countries with over
500 projects executed in various parts of the world. To move up the value chain in the
engineering domain, the company has established a joint venture with Stone & Webster
Inc., USA, namely SWRL- Stone & Webster Rolta Limited. SWRL has access to Stone
& Webster’s proprietary technology. This joint venture provides high quality engineering
services worldwide and undertakes selective refinery, petrochemicals and power projects
in India.
The company provides eSecurity implementation services, rapid application development
and software testing services to its customers worldwide. In on-going partnership with
CA’s, the company has executed over 350 projects globally in 18 countries. Rolta
globally has around 2500 employees. Nearly 75% of the company’s workforce has
engineering qualifications, including significant numbers with master’s degrees or
doctorates and Rolta ensures constant ongoing training to its professionals. The annual
IDC-DQ best Employers Survey has consistently ranked the company as one of the top
employers in the IT industry in India.
Rolta quality standards are benchmarked to world class levels, with top quality
certifications such as ISO 9001:2000, BS 7799, and SEI CMM level 5. The British
Standards Institution (BSI) has awarded Rolta the BS15000 certification for its entire
range of IT service management processes. This unique accreditation has been bestowed
on less than 25 companies globally.
Measuring the intangibles
A company’s balance sheet discloses the financial position or rather health of the
company. The financial position of an enterprise is influenced by the economic resources,
financial structure, liquidity, solvency and its capacity to adapt to changes in the
environment. However, it is becoming increasingly clear that intangible assets have a
significant role in defining the growth of a company. So often, the search for the added
value invariably leads us to calculating and evaluating the intangible assets of the
business.
A Concept of Economic Value Added (EVA)
Economic Value Added (EVA) is the financial performance measure that aims to capture
the true economic profit of an enterprise. EVA is developed to be a measure more
directly linked to creation shareholder wealth over time. Hence, it focuses on maximizing
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the shareholders wealth and helps company management to create value for shareholders.
EVA refers to the net operating profits of the company which is opportunity cost.
EVA is calculated as Net operating Profit after tax (NOPAT) – (Capital*Cost of Capital)
Generally, all intangible assets are being measured in terms of economic value added by
those particular intangible assets.
HUMAN RESOURCE VALUATION
Human resource or human capital valuation refers to identifying and measuring the value
of human resources of a company. Employees are the most valuable resources of
companies in the services sector more so in knowledge based sectors. Like all other
resources, employees possess value because they provide future services resulting in
future earnings. There are various approaches/models that help in valuation of Human
resources in a company like Historical cost method, Replacement cost method,
Opportunity cost method. Rolta bases its calculation on Economic Approach Model.
According to this model, an estimate of the future earnings during the remaining life in
the organization of the employee has to be forecasted.
Secondly, we have to arrive at the present value by discounting the estimated earnings at
the employee’s cost of capital which includes all direct and indirect benefits earned both
in India and abroad. This will be called the Total Human Resource Value. A note of
caution has to be maintained here. In order to estimate future earnings from total labor
force, any organization can not go on a haphazard way.
It can divide the human resources into homogenous groups such as skilled, semiskilled,
technical, managerial staff etc. And in accordance with different classes and age groups,
average earning stream for different classes and age groups are prepared separately for
each groups or classes. Then the discounted present value for human capital is computed.
The aggregate present value of different groups represents the capitalized future earnings
of the firm as a whole which will be called as Total Value of Human Resources.
As a Third step, Total revenues will be divided by Total Human Resource Value. Here,
an observer will find the per employee portion of revenue upon its value.
Finally, the Revenues per employee will be divided by per employee portion of revenue
of its value. The derived value will be the value of human resource per employee.
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Table 5
Source: A report on Case Study on Measuring Intangible Assets – Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
Human resource value of Rolta India Pvt. Ltd. over the years has found northwards
movement. In FY 2002, the HR Value was Rs. 10.96 Million which grew at the rate of
16.78 % in 2003 and reached to the value of Rs. 12.8 Million. The growth in HR value
found quantum jump of 23.59 % in the FY 2004 as compared to FY 2003 where total
human resource value was Rs. 12.8 million which reached to Rs. 15.82 million in 2004.
The compounded growth rate of maximization of Human resources value is around 13 %
over the last three years under review.
87
Figure: 2 Human Resource Value of Rolta India
Source: A report on Case Study on Measuring Intangible Assets – Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
Critical Evaluation of Human Resource Valuation Model
This model basically takes care of time value of money by taking into account future
value of earnings. It takes into account the earning potential of the employees thus
recognizing them as assets. However, the model is slightly far from practicability since it
assumes that employees will stick to the same position, which is being currently,
occupied thus ruling out the possibility of change in role because of promotion or
demotion. Secondly, the method of calculation especially future forecast of earning
capacities of employees in the remaining life of their employment is highly subjective
and needs detailed calculation.
2. INFOSYS
Infosys Technologies Ltd. provides consulting and IT services to clients globally - as
partners to conceptualize and realize technology driven business transformation
initiatives. With over 58,000 employees worldwide, they use a low-risk Global Delivery
Model (GDM) to accelerate schedules with a high degree of time and cost predictability.
As one of the pioneers in strategic offshore outsourcing of software services, Infosys has
leveraged the global trend of offshore outsourcing. Even as many software outsourcing
companies were blamed for diverting global jobs to cheaper offshore outsourcing
destinations like India and China, Infosys was recently applauded by Wired magazine for
its unique offshore outsourcing strategy — it singled out Infosys for turning the
outsourcing myth around and bringing jobs back to the US.
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Infosys provides end-to-end business solutions that leverage technology. They provide
solutions for a dynamic environment where business and technology strategies converge.
Their approach focuses on new ways of business combining IT innovation and adoption
while also leveraging an organization's current IT assets. They work with large global
corporations and new generation technology companies - to build new products or
services and to implement prudent business and technology strategies in today's dynamic
digital environment.
Infosys' Vision
"To be a globally respected corporation that provides best-of-breed business solutions,
leveraging technology, delivered by best-in-class people."
Infosys' Mission Statement:
"To achieve our objectives in an environment of fairness, honesty, and courtesy towards
our clients, employees, vendors and society at large."
The values that drive them: C-LIFE
Customer Delight: A commitment to surpassing our customer expectations.
Leadership by Example: A commitment to set standards in our business and transactions
and be an exemplar for the industry and our own teams.
Integrity and Transparency: A commitment to be ethical, sincere and open in our
dealings.
Fairness: A commitment to be objective and transaction-oriented, thereby earning trust
and respect.
Pursuit of Excellence: A commitment to strive relentlessly, to constantly improve
ourselves, our teams, our services and products so as to become the best.
HUMAN RESOURCE ACCOUNTING
Infosys uses the Lev & Schwartz model to compute the value of human resources. The
evaluation is based on the present value of the future earnings of the employees and on
the following assumptions:
o Employee compensation includes all direct and indirect benefits earned both in
India and abroad.
o The incremental earnings based on group / age has been considered.
o The future earnings have been discounted at 13.63% (previous year – 14.09%),
the cost of capital for us. Beta has been assumed at 0.98, the beta for us in India.
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In the financial year 1995-96, Infosys Technologies (Infosys) became the first software
company to value its human resources in India. The company used the Lev & Schwartz
Model (Refer Exhibit I) and valued its human resources assets at Rs 1.86 billion. Infosys
had always given utmost importance to the role of employees in contributing to the
company's success. Analysts felt that human resources accounting (HRA) was a step
further in Infosys' focus on its employees. Narayana Murthy (Murthy), the then chairman
and managing director of Infosys, said: "Comparing this figure over the years will tell us
whether the value of our human resources is appreciating or not. For a knowledge
intensive company like ours, that is vital information."
The concept of HRA was not new in India. HRA was pioneered by public sector
companies like Bharat Heavy Electronics Ltd. (BHEL) and Steel Authority of India Ltd.
(SAIL) way back in the 1970s. However, the concept did not gain much popularity and
acceptance during that time.
It was only in the mid-1990s, after Infosys started valuing its employees, that the concept
gained popularity in India. By 2002, HR accounting had been introduced by leading
software companies like Satyam Computers and DSQ Software, as well as leading
manufacturing
firms
like
Reliance
Industries.
HR managers were quick to respond on the above developments by stating that more and
more organizations had now started to realize the importance of skilled workforce. They
felt that to be successful in highly competitive markets, companies require to
continuously improve the level of performance of their workforce.
HRA enabled companies to understand whether the skill sets of their human capital was
appreciating or not. R. Krishnaswamy, an actuarial accountant, said, "The value can be
used internally by an organization to make comparisons from unit to unit, from year to
year, as well as within its industry."
Stock market analysts felt that the 'comprehensive disclosure policy' was becoming a
differentiating factor among companies in various industries. Yezdi H. Malegam,
managing director, S.B. Billimoria & Company commented, "In the last few years,
people are realizing that their intangible assets are worth much more than their tangible
ones. Now an attempt is being made to put a value to these intangibles, and to bring these
hidden
values
to
book."
Analysts felt that HRA was an investor-friendly disclosure, and assured stakeholders that
the company had the right human capital to meet its future business requirements
The assets of an organization could be broadly classified into tangible and intangible
assets. Tangible assets referred to all the physical assets which could be presented in the
balance sheet including plant and machinery, investments in securities, inventories, cash,
cash equivalents and bank balance, marketable securities, accounts and notes receivables,
finance receivables, equipment on operating leases, etc.
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Intangible assets included the goodwill, brand value and human assets of a company. The
human assets involved the capabilities, knowledge, skills and talents of employees in an
organization.
In the past, less importance was given by organizations to value their human assets.
Moreover, it was also considered difficult to value them since there were no defined
parameters of valuation. Companies did not value human resources as these were never
treated as an asset in the past. All investments related to employees, including salary as
well as recruitment and training costs were considered as expenditures.
In addition, accountants also felt that the stakeholders2 of a company may not accept the
concept
of
placing
a
monetary
value
on
human
resources.
The importance and value of human assets started to be recognized in the early 1990s
when there was a major increase in employment in firms in service, technology and other
knowledge-based sectors3. In the firms in these sectors, the intangible assets, especially
human resources, contributed significantly to the building of shareholder value. The
critical success factor for any knowledge-based company was its skilled and intellectual
workforce.
HRA in Practice at Infosys
Infosys' HRA model was based on the present value of the employees' future earnings
with the following assumptions:
• An employee's salary package included all benefits, whether direct or otherwise, earned
both in India and in a foreign nation.
• The additional earnings on the basis of age and group were also taken into account.
To calculate the value of its human assets in 1995-96, all the 1,172 employees of Infosys
were divided into five groups, based on their average age. Each group's average
compensation was calculated. Infosys also calculated the compensation of each employee
at retirement by using an average rate of increment.
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Table: 6 Value added statement
Source: A report on Case Study on Measuring Intangible Assets – Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
HRA - The Benefits at Infosys
The benefits of adopting HRA were manifold. It helped an organization to take
managerial decisions based on the availability and the necessity of human resources.
When the human resources were quantified, it gave the investors and other clients true
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insights into the organization and its future potential. Proper valuation of human
resources helped organizations to eliminate the negative effects of redundant labor.
This, in turn, helped them to channelize the available skills, talents, knowledge and
experience of their employees more efficiently. By adopting and implementing HRA in
an organization, the following important information could be obtained:
• Cost per employee
• Human capital investment ratio
• The amount of wealth created by each employee
• The profit created by each employee
• The ratio of salary paid to the total revenue generated
• Average salary of each employee
• Employee absenteeism rates
• Employee turnover rate and retention rate
3. SATYAM COMPUTER SERVICES LIMITED
Satyam Computer Services Limited is also frontrunner in taking stock of and valuing the
intangible assets. However, few progressive businesses worldwide tread such a path now.
The conventional approach hardly reflects the true picture as it does not take into account
the cumulative value of intangible assets that play such a decisive role in modern
business building initiatives.
Intangible assets are those assets that create value beyond tangible assets. Typically, book
values determine the value of hard assets of a particular business, while the process of
valuation of intangible assets would help determine other value creators such as the
potential, and the ability to earn.
Significantly, the computation of the true value of a company requires a comprehensive
assessment of both tangible and intangible assets. Intangible assets such as brands, human
resources value, etc. are beginning to for, and rightly so, the major percentage of the
economic value of successful businesses. Satyam, with its vision high and steady,
believes that the real strength of the balance sheet of a company is reflected only if its
tangible as well as intangible assets are taken into account. Satyam, being in the
knowledge based industry, with the global operations, valuation, of its human resources
and brand is highly important and could be equally insightful to stakeholders.
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HUMAN RESOURCE VALUATION
There are several models to evaluate the Human Resources (HR) value. Satyam, just like
other sample companies have used the Lev & Schwartz model earnings are dependent on
age alone.
Table 7 Summary of the HR value
Source: A report on Case Study on Measuring Intangible Assets – Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
The future earnings have been discounted at 17.01%, being the weighted Average Cost of
Capital (WACC) for the past five years. The Associate cost for the year 2005-06 at Rs.
2700.67 crores, was 11.56% of the Human Resource Value.
Figure: 3 Human Resource Value for Satyam
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Source: A report on Case Study on Measuring Intangible Assets – Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
3.8 VALUE ADDED ACCOUNTING
The most basic concept to measure the income and performance of an economic entity or
even a whole economy is the value added created by its economic activities. To create
value is the central focus of any economic action and transaction. Therefore the concept
of value added has been used in various organisations.
Value added is a measure of economic performance of an economic entity which has a
fairly long history of application in economics. It has been regarded as increase in wealth
of an economic entity. Thus it is a particular concept of income measurement. It has its
traditional roots in macro-economics, especially regarding the calculation of national
income which is measured by the productive performance of a national economy and
which is called National Product or Domestic Product.
These notions represent the value added of a national economy during a specific period.
Other than this universally common use of the value added concept it has also been
discussed and practiced as a useful economic and performance indicator in different areas
of economics and business administration. The fact that it represents the result of a
calculation means that the value added concept is related very much to accounting. But in
contrast to the traditional income calculation one of its major characteristics is that it can
be and has been used not only in one or two accounting areas but in all three types of
systems:
• National accounting
• Financial accounting and
• Managerial accounting.
This result from the fact that the phenomena of value added is an inherent part of all
economic activities. The objective to add value is the driving force for every economic
aim because it represents the creation of wealth.
In contrast to income calculation which is always defined internationally as revenues
minus expenses, value added can be defined in two ways, which shows the second crucial
characteristic of the value added concept. This is often referred to as the "dichotomy" of
value added. The first way to calculate value added is the so-called subtractive or
indirect method, which is defined as follows:
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So value added can - comparable to accounting income - also be regarded as a net figure.
It expresses the value an economic entity (such as a person, a company, an industry, or an
entire national economy) adds to the goods and services it received (purchased) from
other entities through its own economic (productive, creative) activities.
Due to the fact that all the created wealth is also appropriated in some way the value
added can also be computed by the so-called additive or direct method which represents
the sum of appropriated parts of the created wealth. Those parts represent primarily the
remuneration of the productive factors which have led to the wealth creation. So, for
example, in relation to a company the additive method (direct method) of value added
calculation is shown as follows:
These two formulas reveal the characteristic content of the value added concept which
can be split up into a performance and a social aspect. The performance aspect is
expressed by the indirect method and the social aspect by the direct one.
It is said that value added puts the economic activity of a company in a social context
because it makes obvious that economic transactions have social implications in the use
made of productive capacity which is furnished by other economic sources, segments of
society, and in remunerating them with parts of the wealth created through its economic
operations. In terms of a company the productive factors are represented by the different
stakeholder-groups.
Thus, value added is a much broader performance measure than net income, because it is
not focused on and biased by the viewpoint of the equity-capital provider but it reveals
the "income of the entity" which belongs to, and has to be distributed to, all stakeholders.
Therefore the underlying "concept of the firm" is a coalition of various stakeholders.
Looking at the broad definition it can be easily understood that the extent of value added
depends on the classification of specific items as output or input and how the
remunerations of the different productive factors are defined. The numerous value added
concepts which can be found in literature and practice in different organisations and/or
for different purposes vary in the light of the specific classifications and definitions
adopted for the various items of the value added calculation. The major differences are
related to the following areas and questions:
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Definition of output
• Are only sales or total production the basis of the calculation?
• Are intangible items included or not?
• Are only operating revenues relevant or also income from other activities, such as rent,
and investments?
Definition of input
• Is depreciation treated as input?
• Are duties for public services treated as input?
Limits to inclusions
• Extraordinary items?
• Indirect taxes and subsidies?
Definition of the shares of value added appropriation
• What are the components of the employees' share?
• What are the components of the government's share?
• What are the components of the capital providers' share?
• Should there be a share "retained in business"?
Measurement
• Is historical cost or current cost the basis?
• Is there a nominal or a real valuation?
• Are different purchasing powers taken into account?
The actual and potential applications show clearly the double-sided nature of the value
added concept, that is to say, the performance measurement and the social aspect. Due to
its characteristic of wealth creation measurement the value added concept has been
discussed as a mean to estimate the productivity of economic entities, through their
efficiency in the use of productive factors, such as work-force and capital. Efficiency is
the crucial objective of economic behaviour because it relates the amount of output to the
respective input. For this purpose value added is often used as the relevant output figure.
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Related to this productivity measurement function value added can be used - in the place
of income or in combination with income - as a basis for employees incentive schemes
for their participation in an appropriate and fair manner in the results of productivity
increases and at the same time to motivate them to improve their efficiency
The amount of added value related to the total output of an economic unit indicates the
structure of the business activities of this entity. Vertical integration illustrates how much
an entity has created value by its own through its operating activities
In considering the social aspect of the value added concept it has been discussed as a
basis for computing a Company's contributions to the social security system.
Additionally, corporate reporting of added value during a period and its calculation in the
annual report has been regarded as useful information for the employees in particular and
is therefore an instrument of social reporting.
It has to be noted that not only value added by itself but more particularly ratios which
put value added in relation to other items are regarded as useful indicators and analytical
instruments. The appropriation of value added is usually represented in the following
way, which is particularly characterized by its differenciation between "added costs" and
"income".
In this "three-dimensional-perspective" of accounting the concept of value added is an
essential notion, because it is the only performance measure which can be used sensibly
in all three accounting systems.
Therefore, political and economical institutions, have regarded value added as one of the
most important figures in accounting. Delsol states for example that "accounting
recognition of value added allows coherence to be established between national accounts
and private sector accounting. Such a common approach will obviously be very useful for
the rapid elaboration of National Statistics through the summing of enterprises' added
value".
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Added value is not a management objective in the same sense as production levels are,
but it is an analysis tool. As such it holds a privileged place in the measurements,
balances and ratios which are at the root of all financial analysis
3.8.1 Value Added Concept - Financial Statements Analysis
There is a long tradition of the use of value added as a tool for analysing Financial
Statements companies can choose in their single company as well as consolidated
accounts either the "total cost format" (presentation by nature) or the "cost of sales
format" (presentation by function).
Only the first mentioned of these formats enables an external analyst to calculate the
value added sufficiently precisely because of its cost classification by nature and the
treatment of increases in inventories of work-in process and finished goods as revenues.
Income statements disclosed in the cost of sales format do not provide the necessary data
and information for a value added calculation. Because of the increasing number of
companies (especially large multinationals) which switch from the traditional "total cost
format" to the universally more popular "cost of sales format" the value added analysis is
becoming more and more difficult for financial analysts
There is no standardized version of the value added definition. Most of the analysts adapt
the definition to the analytical purpose they would like to achieve. Nevertheless, some
general characteristics of the value added definition which is used for financial analysis
can be recognized as follows:

Production is the key figure of output;

All revenues (other than income from investments and interests) are regarded as
value added from operations;

Depreciation is regarded as input; that means that a net value added is calculated;

Value added from operating activities, from non-operating activities and from
extraordinary events are separated;

There are no adjustments for indirect taxes, subsidies, leases and costs of external
personnel;

Value added appropriation is spread between:
o
o
o
o
Share to employees
Government’s share
Creditors' share
Investors' share
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The general aim of the value added calculation by external analysts is to build up
appropriate ratios and to investigate their development over the years or compare them
with other companies. The most common ratios are related to the performance,
productivity and structural analysis, and to the analysis of the distribution (appropriation)
of value added.
External analysts are not alone in using the value added figure for analytical purposes,
companies also do so in comparing their ratios with the ratios of their major competitors.
This corporate analytical interest, called "benchmarking", has become increasingly
popular during the last few years. Among the key benchmarking criteria are the different
productivity levels of the companies. Since value added based productivity ratios are
regarded as the most useful, companies try to estimate the value added of their
competitors.
Activity 3
1. Discuss the need for human resource accounting. Throw light on human resource
accounting practices in India.
2. Write a brief note on information management in HRA.
3. List various measures for assessing individual value.
4. What do you understand by value added accounting? Discuss financial statement
analysis in value added concept.
3.9 SUMMARY
This unit considerably discusses Human resource accounting and value added
accounting. In knowledge based sectors where human resources are considered to be the
key elements for monitoring the business activities to attend their goals successfully, may
not overlooked this side. Hence, considering the great significance of HRA proper
initiation should be taken by the government along with that other professional &
accounting bodies both at the national & international levels for the measurement &
reporting of such valuable assets. After discussing the need of HRA, unit moves on
explaining information management in human resource accounting. The next area of
consideration was discussion on approaches to analyze human resources.
Measures to assess individual value were described in detail and human resource
practices in India were revealed. Cases of Indian companies which are using human
resource accounting as an unbeatable tool were discussed. Finally concept of value added
accounting was focused with suitable illustrations.
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3.10 FURTHER READINGS

Blau, Gary E. Human Resource Accounting, 1st ed. Scarsdale, N.Y.: Work in
America Institute, 1978.

Caplan, Edwin H. and Landekich, Stephen. Human Resource Accounting: Past,
Present and Future. New York: National Association of Accountants, 1974.

Cascio, Wayne F. Costing Human Resources: The Financial Impact of Behavior
in Organizations, 3rd ed. Boston: PWS-Kent Pub. Co., 1991.

Flamholtz, Eric. Human resource accounting : [advances in concepts, methods,
and applications]. 2nd edition San Francisco : Jossey-Bass, 1985.

Monti–Belkaoui Janice and Riahi–Belkaoui Ahmed. Human Resource Valuation:
A Guide to Strategies and Techniques. Quorum Books: Westport, Connecticut–
London, 1995.
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