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Financial Accounting &


Analysis

Union Bank Staff Training College


Shankar Jaganathan

March 26, 2011


Accounting Standards: The Need and their Content
Financial Accounting & Analysis
-Topics |
1. Introduction (March 6)
Course structure, methodology and evaluation
A brief history of accountancy
2. Accounting concepts, conventions & Double entry (March 12)
Accounting concepts, Conventions, Double entry accounting
3. Financial Statements (March 19)
Balance Sheet, Profit and Loss Account & Cash Flow Statements
4. Important Accounting Standards (March 26)
Need for Accounting Standards and key standards
5. Ratio Analysis or Comparative view (April 2)
Intra-industry, Inter-industry and Specific purpose analysis
6. Accounting for Internal decision making (April 9)
Cost accounting and management accounting systems
7. Accounting for Equity Markets (April 13)
Share premium, EPS, Book value, Bonus issue, Stock split, US
GAAP and IFRS
8. Project Presentation (April 24)
ë
Accountancy: The
Sequence
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Bookkeeping 
  


  

  
 

  



   


º
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A. The Need for Accounting


Standards

-
The Birth: Hat-trick of events |
The hat-trick years -1967-69
Location: Great Britain
Setting: Takeover battles
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1st ball: GEC ±AEI |
Industrial Reorganization Corporation established in 1966 to
promote rationalization in private sector
Year 1967, Electrical equipments facing tough times
Major players AEI and GEC
Attempts at friendly consolidation between the two failed
AEI performing below expectations
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Reports results for the first half year of 1967 in September
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Poor results trigger GEC to bid for AEI
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1st ball ±GEC ±AEI |
ctober 20th: AEI formally rejects the offer and announces
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ctober 30, GEC raised bid to £152 m
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November 2, AEI rejects the bid
Same day, GEC raises bid to £160 m &
 '    !
This scuffle led to a proxy war
GEC won the proxy war (
1st ball ±GEC ±AEI |
After GEC took over, they announced AEI results for 1967
  %-#
  & %
   
!
AEI directors published a rejoinder ±their request for joint
meeting to analyze difference not accepted
A Joint report of the two auditors was published
In the report the auditors quantified the difference of £14.5 m
- £5 m as matter of fact
- £9.5 m as matter of judgment, of which £8.7 m
was lower valuation of stock & contracts
µNeither the directors nor we have found it possible to judge
the extent to which the increase in this charge reflects the
difference in approach on the part of management under new
control¶ Auditors n  

  .
2nd ball: Courtaulds ±International
Paints
|
International Paints a leading brand in UK in business from
1881
Dufay Bitumastic made a takeover bid for International
Paints
Before the offer expired, Courtaulds announced that they
will bid, if the Dufay bid failed
As desired by Courtaulds, Dufay bid failed and Courtaulds
took-over International Paints
Courtaulds was surprised by the quality of profits reported
by International Paints
Chairman of Courtaulds wrote to the President of Institute
of Chartered Accountants of England and Wales,
complaining about multiple accounting policies and the
problem of reconciling pre-acquisition profits with post-
acquisition profits
*
3rd ball: Leasco -Pergamon |
Pergamon was a leading publisher of Scientific journals in UK
Leasco Data Processing Corporation was a New York based
company
Leasco negotiates to buy Pergamon and acquires 38% stake for
$22 million
Pergamon¶s auditors were Chalmers Impey, a respected British firm
Leasco appointed Price Waterhouse to conduct a special audit
The special audit reflects a loss of £60 k against a reported
profit of £1.5 m; the difference was mainly due to:
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The acquisition was called off, leading to a lengthy legal battle


ICAEW response |
µStatement of Intent on Accounting Standards¶ issued in the
1970 with the objective of:
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    -
     
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+    
 
Statement announced the formation of Accounting Standards
Steering Committee, which was subsequently called
Accounting Standards Committee.


Indian Accounting Standards |
ICAI responsible for Accounting standards in India
Accounting Standards Board set up in 1977
Till date 29 accounting standards issued and enforced
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Accounting Standards issued but not
Effective |
AS 30: Financial Instruments: Recognition and
Measurement

AS 31: Financial Instruments: Presentation

Both these accounting standards are effective for


Financial Statements prepared from

April 1, 2009, recommendatory

April 1, 2011, mandatory


Enterprises classified into multiple
categories
|
Enterprises classified into three levels
  & 
  & 
  & 
Level II and III considered Small and Medium Enterprises
Accounting Standards are of two types
   
 
     
All accounting standards applicable to Level I
For Level II and Level III exempt from accounting standards
focused on disclosures

-
Levels Defined |
LEVEL I
ƒ Listed enterprises: debt or equity listed in stock exchange
ƒ Enterprises planning to list their securities
ƒ Enterprises with turnover exceeds Rs.50 crores
ƒ Commercial, industrial or business enterprise having borrowing
including public deposits in excess of Rs.10 crores
ƒ Subsidiary company whose parent company presents
consolidated results
ƒ Banks
ƒ Financial institutions
ƒ Insurance companies
LEVEL II (Enterprises not in level I) and
ƒ Turnover of more than Rs.40 lacs and less than Rs.50 crores
ƒ Borrowings in excess of Rs.1 crore and less than Rs.10 crores
ƒ Holding and subsidiary enterprises of any one of the above
LEVEL III
ƒ Enterprises not covered in Level I and Level II

#
AS 1: Disclosure of Accounting
Policies
|
bjective: Promote better understanding of financial statements and
comparison between enterprises
Fundamental Assumptions need not be disclosed
  4    4   
      
  

Consideration in selection of accounting policies
    
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Answer to the first two cases GEC-AEI & Courtaulds ±International Paints
AS 1: Disclosure of Accounting Policies |
Areas in which Accounting policies differ:
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Accounting policies should be disclosed in one place and form part of
financial statements
Any change in accounting policy should be disclosed along with the
impact of such change
(
|

B. Recognizing Income and


Accounting for Costs

.
Payment terms in Contracts
|
Based on payment terms
" Advance payment
" Cash on delivery
" Defined credit periods e.g. 30 days or 60 days
" Payment based on milestones
" Deferred Credit ± e.g. a few years
Customer Financing
Installment payment
Hire purchase
ther variants
Consignment Sales
Sale on returnable basis
Sale subject to Acceptance

Revenue recognition a challenge of Accrual Accounting *


Revenue Recognitions (AS) 9 |
Covers
" Sale of goods
" Rendering of services
" Use by others of enterprise resources yielding interest,
royalties and dividends
Does not cover
- Revenue from Construction contracts, hire purchase, lease,
revenue from insurance contracts, government grants and
other subsidies
Revenue defined
1. The gross inflow of cash receivables or other considerations
arising in the ordinary course of business from sale of
goods, service or use by other of enterprise resources
2. Completed services contract method
3. Proportionate completion method ë
Revenue Recognition (AS) 9 |
General Principles
" Binding contract for sale (transfer of ownership for a consideration) in
Sale of goods
" Risk and reward should be transferred
" Recoverability of sale price
Services
" Proportionate completion method
" 6 
      7    

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  4
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" Completed services contract method
" 1     4    &     
&               
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" thers ± interest ±accrues; Royalty ±based on contract, Dividend ±
based on right to receive ë
Revenue Recognition (AS) 9 |
Un-certainties on Revenue recognition
" Unreasonable to assess ultimate collection: price escalation,
penal interest on delayed payments
" After sale if uncertainty of collection arises, write off as bad
debts

Disclosure
" Disclose where revenue recognition has been postponed
pending resolution of significant un-certainties
" Basis for revenue recognition is disclosed
ëë
Revenue Recognition (AS) 9 |
Some Variants highlighted, when revenue recognized
" Delivery delayed at buyers request; risk transferred
" Delivery subject to installation; if installation is simple
" Delivery subject to approval; if accepted or period for rejection
has expired
" Guaranteed sale ±giving buyer unlimited right of return; if
µmoney back guarantee¶ is given is given to customers
" Consignment sale- nly if the goods are sold by the consignee
" Cash on delivery ±only on receipt of cash
" Sales with agreement to repurchase ±not recognized as
revenue
" Subscription for services ±straight line basis over the period of
ëº
delivery or in line with value delivered if not proportionate
Revenue Recognition (AS) 9 |
Some Variants highlighted, when revenue recognized
" Installment sale ±Revenue recognized on delivery of goods,
value recognized is value less the interest cost in the price;
interest recognized proportionate to unpaid balance
" Trade discount and volume discount should be reduced from
revenue
" Installation fee ± only when equipment is installed
" Advertising and insurance agency commission ±when service
is completed
" Admission fee ±when the event has taken place
" Tuition fees ±over the course
" Entrance and membership fee ±Entrance fee is generally
capitalized, membership fee over the period of service ë-
Identifying Good revenue recognition
Policy |
Adequate and meaningful disclosure
Consistency ±no accounting policy changes unless
mandated by statute
No Prior period adjustments on account of Revenue
recognition (sales returns, revenue de-recognition)
Receivables and other working capital components in line
with or better than the industry performance
ther forms of Receivables ±Unearned / Unbilled revenue
Absence of wide fluctuations in revenue (variance in line
with industry fluctuations acceptable)

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[   
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Accounting for Construction
Contracts (AS) 7 |
Though named Construction contracts applies to all contracts
that have the following feature:
³Date at which contract activity is entered into and
date when the activity is completed usually
falls into different accounting periods.´
Construction contract is a contract for construction of an asset
or a combination of assets that are interrelated in terms of their
design, technology and function or their ultimate purpose
Contract revenue is the initial amount agreed plus variations in
contract work, claims and incentive payments
Variations, claims and incentives can be included only if they
can be reliably measured ë)
Accounting for Construction Contracts
(AS) 7 |
Contract cost includes all direct costs and costs that are
attributable to contract activity in general and can be allocated
to the contract

   4           


&  

           


   4
   4   4      

Contract revenue and contract costs recognized by reference


to the stage of completion of activity

Expected loss on contract should be expensed immediately on


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identification
Accounting for Construction
Contracts (AS) 7
|
For Fixed Price projects the following conditions to be met:
" revenue can be reliably measured
" Economic benefits will flow to the business
" Contract cost for completion and % completion can be
reliably measured
" Actual cost can be compared with the estimate
When outcome of a Construction contract cannot be estimated:
" Revenue should be recognized only to the extent of cost
incurred, which can be recovered
" Contract cost should be recognized as an expense in the
period incurred
" Expected loss should be recognized immediately
ë.
Accounting for Construction
Contracts (AS) 7
|
Change in estimate of Contract cost or revenue

" When change identified in accounting period, cumulative

impact up to earlier period should be reported as prior

period expense and disclosed separately

Enterprise should disclose the methods used to determine

Revenue

ë*
AS 6: Accounting for Depreciation |
bjective: Disclosure of depreciation policy necessary to appreciate
the view presented in financial statements
Applies to all depreciable assets except
   4   
    &   
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  4  4    
 "
   &  
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 & '
Depreciation: wearing out, consumption or other loss of value of
depreciable asset arising from use, effluxion of time, obsolescence
through technology or market changes º
Computation of
Depreciation (AS 6)
|
Depreciable assets are those that meet the following
conditions
" Expected to be used over more than one accounting period
" Have a limited useful life;
" Are held for the purpose of use in production or supply of
goods and services
Depreciation is computed based on:
" Asset cost (historical cost)
" Estimated residual value
" Useful life º
Estimating useful life of an
asset
|
Pre-determined by legal or contractual limits, e.g. lease hold
premises
Directly governed by extraction or consumption e.g. moulds and
dies
Extent of use, physical wear and tear e.g. plant and machinery
bsolescence arising from:
" Technology
" Improvement in production methods
" Change in market demand
" Legal restrictions

ºë
What is Deferred Revenue expenses |
Event based Revenue expenses, where due to scale benefits are
expected to be realized over more than one accounting period

Examples:

" Preliminary expenses

" Product launch expenses ±Advertisement

" Expenditure on relocating or reorganizing part or all of its


enterprise for an economic benefit

AS 26 requires all these expenses to be expensed when incurred

ºº
Accounting for borrowing cost (AS 16) |
ö Borrowing cost ±interest and other costs incurred in connect
with borrowing of funds
interest, amortization of discount or premium related to
borrowing, ancillary cost, finance charges, exchange
difference arising from foreign currency borrowing
Borrowing cost directly associated with acquisition,
construction or production of asset ±capitalized
" Conditions necessary:
 1        4
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º &                
º-
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C. Valuing Assets and


Recognizing Liabilities

º#
Types of Assets |
Based on nature
    4    
Based on intention of holder
     
 
Based on Balance Sheet classification by
Companies law
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AS 22 Accounting for Taxes on
Income
|
bjective: Prescribe accounting treatment for taxes on Income

Accounting Income: profit before tax in the profit and loss stmt.

Taxable Income: amount of profit or loss for the period

determined in accordance with the tax laws

Current tax: income tax payable for the period based on tax law

Tax expense: total of current tax and deferred tax for the period

Deferred tax: effect of timing difference

The boom in the leasing industry in 1980¶s and 1990¶s º(


AS 22 Accounting for Taxes on
Income
|
Timing difference: difference between taxable
income and accounting income in one period
capable of reversal in another, e.g. provision for
doubtful debts, difference in depreciation rates
between Accounts & Tax

Permanent difference: difference between taxable


income and accounting income for a period that do
not reverse subsequently º.
AS 22 Accounting for Taxes on
Income
|
Profit and loss account to consider Tax expense (i.e.
current tax + deferred tax)
Deferred tax assets are tax benefits not availed by
the enterprise, but available to it ±e.g. unabsorbed
depreciation or unabsorbed carry forward loss
Deferred tax liability is tax benefit availed in the
Profit and Loss account, that will be reversed in
future, e.g. higher tax depreciation over book
depreciation
º*
AS 22 Accounting for Taxes on
Income
|
Disclosure:
Deferred tax assets and deferred tax
liabilities should be reflected separately in
the balance sheet
Break up of Deferred tax assets and Deferred
tax liabilities should be given in the Notes to
Accounts

-
Principles of Inventory Valuation (AS) 2 |
Inventory defined as
" held for sale in the ordinary course of business
" In the process of production for such sale; or
" In the form of materials or supplies to be consumed in the
production process or in rendering services
" Does not include spares for use in fixed assets (AS) 10
Inventory to be valued at Cost or Net realizable value
Cost includes
" Cost of purchase
" Cost of conversion (normal capacity, cost of goods)
" Cost excludes interest cost, abnormal wastage, storage cost,
administrative, selling and distribution costs -
Valuation of Inventories (AS) 2 |
Effective from April 1, 1999
Applies to
- All inventories other than, specified below
Does not apply to
" Work in progress under construction contract (AS) 7
" Work in progress in the ordinary course of business of
service providers
" Financial instruments held as stock in trade
" Producers¶ inventories of livestock, agricultural and forest
products, mineral oils, ores and gases

Principles of Inventory Valuation |
Basis for Inventory Valuation
Permitted by Accounting standard
- FiFo, Weighted Average
" Standard cost / Retail method permitted for convenience
(permitted for convenience if results approximate actual)
" LiFo (not permitted by Accounting Standard)
- Retail method is where cost is arrived at by reducing the
gross margin from the sale value to arrive at value of
material consumed
Inventory policies adopted should be disclosed in financial
statements
" policies adopted in measuring inventories including cost
formula

" Total carrying amount of inventories and its classification
AS 10 Fixed Assets |
bjective: this standard deals with accounting for fixed assets
under historical cost basis
Fixed Asset: Assets held with the intention of being used for the
purpose of producing or providing goods and service and is not
held for sale in the normal course of business
Component of cost: purchase price, site preparation,
installation cost, professional fees of architects and Engineers,
expense on start-up and commissioning of project including
test runs and experimental production
Self constructed assets: same principle as above, except no
profit can be recognized on the same
Cost of addition or extension to an existing asset is added to --
existing asset
AS 10 Fixed Assets |
Amount substituted for historical cost:
 5   
  
   
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& 
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Gross book value: Historical cost or other amounts
substituted for historical cost in the books of accounts
Disclosure: Gross block, addition and disposal to be shown;
where revalued amount substituted for historical cost and
basis to be shown -#
How will you account for
this transaction?
|
Your firm purchased a car on Lease finance.

The car is available in the market for Rs.5 lacs

You have entered into a five year lease, paying an

annual rental of Rs.1.5 lacs.

You have the right to buy the car back at the end of

year 5, by paying Rs.10,000

-)
Implicit Interest in Lease rental |
  
  '

   #)#$
8   
Year 0 -5.000 $5.00
Year 1 1.5
Year 2 1.5
Year 3 1.5
Year 4 1.5
Year 5 + RV 1.6
8        
Year 0 -5.000
Year 1 1.5000 0.783 0.718 (4.28)
Year 2 1.5000 0.670 0.830 (3.45)
Year 3 1.5000 0.540 0.960 (2.49)
Year 4 1.5000 0.390 1.110 (1.38)
Year 5 1.6000 0.216 1.384 0.00

-(
AS 19 Accounting for Leases |
bjective: Prescribe accounting for lessee and lessors for

financial and operational lease

Lease: right to use an asset for an agreed period of time for a

payment or a series of payment

Finance lease: where substantially all risk and rewards of the

ownership of asset is transferred to the lessee

perating lease: other than a financial lease

-.
AS 19 Accounting for Leases |
Interest rate implicit in lease: discount rate that
equals minimum lease value plus un-guaranteed
residual value to the fair value of the leased asset
at the inception of lease
Accounting for financial lease:
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-*
AS 19 Accounting for Leases |
Accounting for perating lease:

    1      


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#
The Next Class:
Presentation
|
1. How will you decide if one industry is better than

another? Explain w.r.t. Dupont Ratio Analysis.

2. What is Altman¶s score? How can a banker use it?

3. Look at the stock exchange pages of ET or Businessline

and explain what the number reported their mean?

#