UB-FA-2011- 4

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Financial Accounting &Analysis

Union Bank Staff Training College

Shankar Jaganathan

March 26, 2011

Accounting Standards: The Need and their Content

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JSFinancial Accounting & Analysis-Topics

2

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 Statements4. 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 systems7. Accounting for Equity Markets (April 13)

Share premium, EPS, Book value, Bonus issue, Stock split, USGAAP and IFRS

8. Project Presentation (April 24)

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JSAccountancy: The

Sequence

3

Bookkeeping FinancialStatements

Financial

Analysis &

Interpretation

Balance Sheet

Profit & Loss Stmt

Cash Flow Stmt.

Accounting Standards

Basis for Preparing

Financial Statements

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A. The Need for AccountingStandards

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JSThe Birth: Hat-trick of events

The hat-trick years -1967-69

Location: Great Britain

Setting: Takeover battles

1st ball: GEC AEI

2nd ball: Courtaulds International Paints

3rd ball: Leasco -Pergamon

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JS1st 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

A return of only 5% on 220 m investments

Diversified into all segments of market

Reports results for the first half year of 1967 in September 3.7 m profits lower than 6.9 m in 1966

Poor results trigger GEC to bid for AEI

120 m for the business offered

AEI Directors rejected the bid triggering a battle6

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JS1st ball GEC AEI October 20th: AEI formally rejects the offer and announces

Rationalization of business; sale of assets to realize 20 m

Forecast profit of 10 m for1967 vs. 9.2 m in 1966

Forecast profit of 16 m in 1968 and 20 m in 1969

October 30, GEC raised bid to 152 m

Raises its own profit forecast to 21 m for1967 from 19.5

Forecasts profit of 24 m for1968

November 2, AEI rejects the bid

Same day, GEC raises bid to 160 m &

Attacks profit forecast of AEI

This scuffle led to a proxy war

GEC won the proxy war 7

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JS1st ball GEC AEI After GEC took over, they announced AEI results for 1967

A loss of 4.5 million reported vs. 10 m profit forecast by

AEI

AEI directors published a rejoinder their request for jointmeeting 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 mwas lower valuation of stock & contracts

Neither the directors nor we have found it possible to judgethe extent to which the increase in this charge reflects thedifference in approach on the part of management under new

control Auditors note in the AEI accounts

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JS2nd ball: Courtaulds InternationalPaints

International Paints a leading brand in UK in business from1881

Dufay Bitumastic made a takeover bid for InternationalPaints

Before the offer expired, Courtaulds announced that theywill bid, if the Dufay bid failed

As desired by Courtaulds, Dufay bid failed and Courtauldstook-over International Paints

Courtaulds was surprised by the quality of profits reportedby International Paints

Chairman of Courtaulds wrote to the President of Instituteof Chartered Accountants of England and Wales,complaining about multiple accounting policies and theproblem of reconciling pre-acquisition profits with post-acquisition profits

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JS3rd 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 Pergamons auditors were Chalmers Impey, a respected British firm

Leasco appointed Price Waterhouse to conduct a special audit

The special audit reflects a loss of60 k against a reported

profit of1.5 m; the difference was mainly due to:

560 k of profit on sale to a related company (owned by Chairman)

Not considering the loss of a associate encyclopedia company

The acquisition was called off, leading to a lengthy legal battle

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JSICAEW response Statement of Intent on Accounting Standards issued in the

1970 with the objective of:

Narrowing the areas of difference and variety in accounting

practice;

Disclosing accounting bases;

Disclosing departures from established accounting standards;

Exposing major proposals on accounting standards for

consultation.

Statement announced the formation of Accounting Standards

Steering Committee, which was subsequently called

Accounting Standards Committee.

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JSIndian Accounting Standards ICAI responsible for Accounting standards in India

Accounting Standards Board set up in 1977

Till date 29 accounting standards issued and enforced

Revenue 02

Costs 04

Assets 06

Liabilities 03

Generic 09

Specific 05

Total 29

AS 8: Accounting forR&D is withdrawn;

Hence we have 28 Accounting Standards today

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JSAccounting Standards issued but notEffective

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

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JSEnterprises classified into multiplecategories

Enterprises classified into three levels

Level I

Level II

Level III

Level II and III considered Small and Medium Enterprises

Accounting Standards are of two types

Measurement standards

Disclosure standards

All accounting standards applicable to Level I

For Level II and Level III exempt from accounting standardsfocused on disclosures

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JSLevels DefinedLEVEL I Listed enterprises: debt or equity listed in stock exchange Enterprises planning to list their securities Enterprises with turnover exceeds Rs.50 crores Commercial, industrial or business enterprise having borrowing

including public deposits in excess of Rs.10 crores

Subsidiary company whose parent company presentsconsolidated results

Banks Financial institutions Insurance companiesLEVEL II (Enterprises not in level I) and

Turnover of more than Rs.40 lacs and less than Rs.50 crores Borrowings in excess of Rs.1 crore and less than Rs.10 crores Holding and subsidiary enterprises of any one of the aboveLEVEL III Enterprises not covered in Level I and Level II

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JSAS 1: Disclosure of AccountingPolicies

Objective: Promote better understanding of financial statements and

comparison between enterprises

Fundamental Assumptions need not be disclosed

Going concern, Consistency, Accrual basis

Disclose only if these assumptions are not made

Consideration in selection of accounting policies

Prudence: profit not estimated and provision made for liabilities

Substance over form

Materiality: knowledge of which might influence the decision of

the user of financial statements

16Answer to the first two cases GEC-AEI & Courtaulds International Paints

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JSAS 1: Disclosure of Accounting Policies Areas in which Accounting policies differ:

1. Methods of depreciation, depletion and amortization

2. Treatment of expenditure during construction period

3. Conversion or translation of foreign currency items

4. Valuation of inventories

5. Treatment of goodwill

6. Valuation of Investments

7. Treatment of retirement benefits

8. Recognition of profit on long term contracts

9. Valuation of contingent liabilities 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

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JS

B. Recognizing Income andAccounting for Costs

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JSPayment 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

Other variants Consignment Sales

Sale on returnable basis

Sale subject to Acceptance

19Revenue recognition a challenge of Accrual Accounting

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JSRevenue Recognitions (AS) 9Covers

- 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 andother subsidies

Revenue defined1. The gross inflow of cash receivables or other considerations

arising in the ordinary course of business from sale ofgoods, service or use by other of enterprise resources

2. Completed services contract method

3. Proportionate completion method20

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JSRevenue 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 priceServices- Proportionate completion method

- When more than one act is required for performance

- Revenue recognized based on contract value, associated cost, numberof acts,

- when services cover indeterminate acts over a period of time, on

straight line basis, unless otherwise specified- Completed services contract method

- execution of a single act, or the final services are so significant that theservice is not considered concluded if the final act is not done

- Revenue recognized when the final act takes place

- Others interest accrues; Royalty based on contract, Dividend based on right to receive 21

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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

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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

money back guarantee is given is given to customers

- Consignment sale-O

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

delivery or in line with value delivered if not proportionate2

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JSRevenue Recognition (AS) 9Some 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 service24

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JSIdentifying Good revenue recognitionPolicy 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

Other forms of Receivables Unearned / Unbilled revenue

Absence of wide fluctuations in revenue (variance in line

with industry fluctuations acceptable)

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Receivables is the Barometer of Revenue recognition policy

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JSAccounting for ConstructionContracts (AS) 7 Though named Construction contracts applies to all contracts

that have the following feature:

Date at which contract activity is entered into and

date when the activity is completed usuallyfalls 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 measured26

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JSAccounting 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

Insurance, design and technical assistance and construction

overhead

Cost that cannot be included are General Administration cost,

Selling Cost, R&D Cost, Depreciation on idle plant

Contract revenue and contract costs recognized by reference

to the stage of completion of activity

Expected loss on contract should be expensed immediately on

identification27

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JSAccounting for ConstructionContracts (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 bereliably 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 immediately28

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JSAccounting for ConstructionContracts (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

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JSAS 6: Accounting for Depreciation Objective: Disclosure of depreciation policy necessary to appreciate

the view presented in financial statements

Applies to all depreciable assets except

Forests, plantations and similar regenerative natural resources

Wasting assets like minerals, oils, natural gas and similar non-

regenerative assets

Expenditure on R&D

Goodwill Livestock

Depreciation: wearing out, consumption or other loss of value of

depreciable asset arising from use, effluxion of time, obsolescence

through technology or market changes 30

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JSComputation 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 31

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JSEstimating useful life of an

asset Pre-determined by legal or contractual limits, e.g. lease holdpremises

Directly governed by extraction or consumption e.g. moulds anddies

Extent of use, physical wear and tear e.g. plant and machinery Obsolescence arising from:

- Technology

- Improvement in production methods

- Change in market demand

- Legal restrictions

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JSWhat 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 itsenterprise for an economic benefit

AS 26 requires all these expenses to be expensed when incurred

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JSAccounting for borrowing cost (AS 16) 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, exchangedifference arising from foreign currency borrowing

Borrowing cost directly associated with acquisition,

construction or production of asset capitalized

- Conditions necessary:

1. expenditure incurred during construction period,

2. borrowing cost incurred, and

3. activities are necessary to prepare the asset for its intended use34

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C. Valuing Assets andRecognizing Liabilities

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JSTypes of Assets

Based on nature

Physical assets, financial assets & intangible assets

Based on intention of holder Current assets and long term assets

Based on Balance Sheet classification byCompanies law

Fixed Assets, Investments & Current Assets

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JSAS 22 Accounting for Taxes onIncome

Objective: 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

37The boom in the leasing industry in 1980s and 1990s

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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 38

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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

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Disclosure:

Deferred tax assets and deferred tax

liabilities should be reflected separately inthe balance sheet

Break up of Deferred tax assets and Deferred

tax liabilities should be given in the Notes toAccounts

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JSPrinciples 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 costs41

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JSValuation 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 gases42

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JSPrinciples of Inventory ValuationBasis 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 classification43

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JSAS 10 Fixed Assets Objective: 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 notheld 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 asset44

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JSAS 10 Fixed Assets Amount substituted for historical cost:

Value determined by competent appraisers

Increase in value of fixed asset cannot be credited to Profit and

loss account; this amount is credit toR

evaluation reserveshown as part ofNet-worth and not available for distribution as

dividend

Revaluation of assets cannot be done selectively, it must be

undertaken for a whole class of asset within a unit

Gross book value: Historical cost or other amountssubstituted 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 shown45

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JSHow will you account forthis 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

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JSImplicit Interest in Lease rentalCash flows & Implicit interest working

Implicit Interest rate 15.65%

Year Rs. Lacs

Year 0 -5.000 $5.00

Year 1 1.5

Year 2 1.5Year 3 1.5

Year 4 1.5Year 5 + RV 1.6Year Rental Interest Loan rpd Principal

Year 0 -5.000Year 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

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JSAS 19 Accounting for Leases

Objective: 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

Operating lease: other than a financial lease

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JSAS 19 Accounting for Leases Interest rate implicit in lease: discount rate that

equals minimum lease value plus un-guaranteedresidual value to the fair value of the leased assetat the inception of lease

Accounting for financial lease: Lessee should recognize the lease as an asset and

liability, value of asset must equal fair value of heleased asset

Lease payment made should be apportioned

between finance charge and balance towards theliability

Depreciation of the asset should be accounted asper AS 6

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JSAS 19 Accounting for Leases

Accounting forOperating lease:

accounted as expense on a straight line basis

over the lease period or where more representative

over the time pattern of users benefit

Should disclose by way of note the future minimum

lease payment under non-cancelable operating

lease

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JSThe 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 Altmans 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?

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Documents

UB-FA-2011- 4