Accounting Premium

Table of Content
Title Page No
Accounting as a Financial Information System 1
Accounting for Depreciation 6
Accounting for Inventories 12
Revenue Recognition 20
Accounting Standards for Fixed Assesses 29
Accounting Standards for Investments 38
Cash Flow Statement 45
Fund Flow Statement 51
Financial Statement Analysis 53
Ratio Analysis 57
Accounting for Share Capital Transactions Including Bonus Shares,

Right Shapes 61
Employees Stock Option 68
Buy Back of Securities 85
Preparation and Presentation of Company Final Accounts 88

COMMERCE & ACCOUNTANCY 2020
ACCOUNTING AS A FINANCIAL INFORMATION SYSTEM
An accounting information system (AIS) is a structure that a business uses to
collect, store, manage, process, retrieve and report its financial data so it can be
used by accountants, consultants, business analysts, managers, chief financial
officers (CFOs), auditors, regulators, and tax agencies.
Specially trained accountants work in-depth with AIS to ensure the highest level of
accuracy in a company's financial transactions and record-keeping, as well as make
financial data easily available to those who legitimately need access to it—all
while keeping data intact andsecure.
Accounting information systems generally consist of six primary components:

people, procedures and instructions, data, software, information technology
infrastructure, and internal controls. Let's look at each component in detail.
Introduction to Accounting Information Systems
1. AISPeople
The people in AIS are simply the system users. Professionals who may need
to use an organization's AIS include accountants, consultants, business analysts,
managers, chief financial officers, and auditors. AIS helps the different
departments within a company worktogether.
For example, management can establish sales goals for which staff can then order
the appropriate amount of inventory. The inventory order notifies the accounting
department of a new payable. When sales are made, salespeople can enter
customer orders, accounting can invoice customers, the warehouse can assemble
the order, the shipping department can send it off, and the accounting department
gets notified of a new receivable. The customer service department can then track
customer shipments and the system can create sales reports for management.
Managers can also see inventory costs, shipping costs, manufacturing costs and so
on.
With well-designed AIS, everyone within an organization who is authorized to do

so can access the same system and get the same information. An AIS also
simplifies getting information to people outside of the organization, when
necessary.
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For example, consultants might use the information in an AIS to analyze the
effectiveness of the company's pricing structure by looking at cost data, sales data,
and revenue. Also, auditors can use the data to assess a company's internal
controls, financial condition and compliance with the Sarbanes-Oxley Act(SOX).
The AIS should be designed to meet the needs of the people who will be using it.
The system should also be easy to use and should improve, not hinder efficiency.
2. Procedures andInstructions
The procedure and instructions of an AIS are the methods it uses for
collecting, storing, retrieving and processing data. These methods are both manual
and automated. The data can come from both internal sources (e.g., employees)
and external sources (e.g., customers' online orders). Procedures and instructions
will be coded into AIS software—they should also be "coded" into employees
through documentation and training. To be effective, procedures and instructions
must be followedconsistently.
3. AISData
To store information, AIS must have a database structure such as structured
query language (SQL), a computer language commonly used for databases. The
AIS will also need various input screens for the different types of system users
and data entry, as well as different output formats to meet the needs of different
users and various types ofinformation.
The data contained in an AIS is all the financial information pertinent to the
organization's business practices. Any business data that impact the company's
finances should go into anAIS.
The type of data included in an AIS will depend on the nature of the business, but
it may consist of thefollowing:
 Salesorders
 Customer billingstatements
 Sales analysisreports
 Purchaserequisitions
 Vendorinvoices
 Checkregisters
 Generalledger
 Inventorydata
 Payrollinformation
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 Timekeeping
 Taxinformation
This data can then be used to prepare accounting statements and reports, such as
accounts receivable aging, depreciation/amortization schedules, trial balance, profit
and loss, and so on. Having all this data in one place—in the AIS—facilitates a
business's record-keeping, reporting, analysis, auditing, and decision-making
activities. For the data to be useful, it must be complete, correct and relevant.
On the other hand, examples of data that would not go into an AIS include memos,
correspondence, presentations, and manuals. These documents might have a
tangential relationship to the company's finances, but, excluding the standard
footnotes, they are not really part of the company's financial record-keeping.
4. AISSoftware
The software component of an AIS is the computer programs used to store,
retrieve, process, and analyze the company's financial data. Before there were
computers, an AIS was a manual, paper-based system, but today, most companies
are using computer software as the basis of the AIS. Small businesses might use
Intuit's Quick books or Sage's Sage 50 Accounting, but there are others. 2 Small to
mid-sized businesses might use SAP's Business One. Mid-sized and large
businesses might use Microsoft's Dynamics GP, Sage Group's MAS 90 or MAS
200, Oracle's PeopleSoft or Epic or Financial Management.
Quality, reliability, and security are key components of effective AIS software.
Managers rely on the information it outputs to make decisions for the company,
and they need high-quality information to make sounddecisions.
AIS software programs can be customized to meet the unique needs of different
types of businesses. If an existing program does not meet a company's needs, the
software can also be developed in-house with substantial input from end-users or
can be developed by a third-party company specifically for the organization. The
system could even be outsourced to a specialized company.
For publicly-traded companies, no matter what software program and

customization options the business chooses, Sarbanes-Oxley regulations will
dictate the structure of the AIS to some extent. This is because SOX regulations
establish internal controls and auditing procedures with which public companies
mustcomply.
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5. ITInfrastructure
Information technology infrastructure is just a fancy name for the hardware
used to operate the accounting information system. Most of these hardware items a
business would need to have anyway, including computers, mobile
devices, servers, printers, surge protectors, routers, storage media, and possibly
back-up power supply. In addition to cost, factors to consider in selecting hardware
include speed, storage capability and whether it can be expanded andupgraded.
Perhaps most importantly, the hardware selected for an AIS must be compatible
with the intended software. Ideally, it would be not just compatible, but optimal—a
clunky system will be much less helpful than a speedy one. One way businesses
can easily meet hardware and software compatibility requirements is by purchasing
a turnkey system that includes both the hardware and the software that the business
needs. Purchasing a turnkey system means, theoretically, that the business will get
an optimal combination of hardware and software for itsAIS.
A good AIS should also include a plan for maintaining, servicing, replacing and
upgrading components of the hardware system, as well as a plan for the disposal of
broken and outdated hardware so that sensitive data is completely destroyed.
6. InternalControls
The internal controls of an AIS are the security measures it contains to
protect sensitive data. These can be as simple as passwords or as complex as
biometric identification. An AIS must have internal controls to protect against
unauthorized computer access and to limit access to authorized users, which
includes some users inside the company. It must also prevent unauthorized file
access by individuals who are allowed to access only select parts of the system.
An AIS contains confidential information belonging not just to the company

but also to its employees and customers. This data may include Social Security
numbers, salary information, credit card numbers, and so on. All of the data in an
AIS should be encrypted, and access to the system should be logged and surveilled.
System activity should be traceable as well.
An AIS also needs internal controls that protect it from computer viruses,
hackers and other internal and external threats to network security. It must also be
protected from natural disasters and power surges that can cause data loss.
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How an AIS Works In Real Life
We've seen how well-designed AIS allows a business to run smoothly on a
day-to-day basis or hinders its operation if the system is poorly designed. The third
use for an AIS is that, when a business is in trouble, the data in its AIS can be used
to uncover the story of what went wrong.
The cases of WorldCom and Lehman Brothers provide two examples.
In 2002, WorldCom's internal auditors Eugene Morse and Cynthia Cooper

used the company's AIS to uncover nearly $4 billion in fraudulent expense
allocations and other accounting entries. Their investigation led to the termination
of CFO Scott Sullivan, as well as new legislation — section 404 of the Sarbanes-
Oxley Act, which regulates companies' internal financial controls and procedures.
When investigating the causes of Lehman's collapse, a review of its AIS and other
data systems was a key component, along with document collection and review,
plus witness interviews. The search for the causes of the company's failure
"required an extensive investigation and review of Lehman's operating,
trading, valuation, financial, accounting and other data systems," according to the
2,200-page, nine-volume examiner'sreport.
Lehman's systems provide an example of how an AIS should not be structured.

Examiner Anton R. Valukas' report states, "At the time of its bankruptcy filing,
Lehman maintained a patchwork of over 2,600 software systems and applications...
Many of Lehman's systems were arcane, outdated or non-standard."
The examiner decided to focus his efforts on the 96 systems that appeared most
relevant. This examination required training, study, and trial and error just to learn
how to use the systems.
Valukas' report also noted, "Lehman's systems were highly interdependent, but
their relationships were difficult to decipher and not well-documented. It took
extraordinary effort to untangle these systems to obtain the necessaryinformation."
Conclusion
The six components of an AIS all work together to help key
employees collect, store, manage, process, retrieve, and report their financial data.
Having a well-developed and maintained accounting information system that is
efficient and accurate is an indispensable component of a successfulbusiness
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ACCOUNTING FOR DEPRECIATION
Definition
Depreciation is a measure of the wearing out, consumption or other loss of
value of a depreciable asset arising from use, effluxion of time or obsolescence
through technology and market changes. Depreciation is allocated so as to charge a
fair proportion of the depreciable amount in each accounting period during the
expected useful life of the asset. Depreciation includes amortisation of assets
whose useful life ispredetermined.
Depreciable assets are assets which
(i) are expected to be used during more than one accounting period;and
(ii) have a limited useful life;and
(iii) are held by an enterprise for use in the production or supply of goods
and services, for rental to others, or for administrative purposes and not for
the purpose of sale in the ordinary course ofbusiness.
Useful life is either
(i) the period over which a depreciable asset is expected to be used by the
enterprise;or
(ii) the number of production or similar units expected to be obtained from
the use of the asset by theenterprise.
Depreciable amount of a depreciable asset is its historical cost, or other amount
substituted for historical cost1 in the financial statements, less the estimated
residual value.
Explanation
Depreciation has a significant effect in determining and presenting the
financial position and results of operations of an enterprise. Depreciation is
charged in each accounting period by reference to the extent of the depreciable
amount, irrespective of an increase in the market value of theassets.
Assessment of depreciation and the amount to be charged in respect Thereof
in an accounting period are usually based on the following three factors:
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(i) historical cost or other amount substituted for the historical cost of the
depreciable asset when the asset has beenrevalued;
(ii) expected useful life of the depreciable asset;and
(iii) estimated residual value of the depreciableasset.
Historical cost of a depreciable asset represents its money outlay or its
equivalent in connection with its acquisition, installation and commissioning as
well as for additions to or improvement thereof. The historical cost of a
depreciable asset may undergo subsequent changes arising as a result of increase or
decrease in long term liability on account of exchange fluctuations, price
adjustments, changes in duties or similarfactors.
The useful life of a depreciable asset is shorter than its physical life and is:
(i) pre-determined by legal or contractual limits, such as the expiry dates of
relatedleases;
(ii) directly governed by extraction orconsumption;
(iii) dependent on the extent of use and physical deterioration on account of
wear and tear which again depends on operational factors, such as, the
number of shifts for which the asset is to be used, repair and maintenance
policy of the enterprise etc.;and
(iv) reduced by obsolescence arising from such factorsas:
(a) technologicalchanges;
(b) improvement in productionmethods;
(c) change in market demand for the product or serviceoutput
of the asset;or
(d) legal or otherrestrictions.
Determination of the useful life of a depreciable asset is a matter of
estimation and is normally based on various factors including experience with
similar types of assets. Such estimation is more difficult for an asset using new
technology or used in the production of a new product or in the provision of a new
service but is nevertheless required on some reasonable basis.
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Any addition or extension to an existing asset which is of a capital nature 60
AS 6 and which becomes an integral part of the existing asset is depreciated over
the remaining useful life of that asset. As a practical measure, however,
depreciation is sometimes provided on such addition or extension at the rate which
is applied to an existing asset. Any addition or extension which retains a separate
identity and is capable of being used after the existing asset is disposed of, is
depreciated independently on the basis of an estimate of its own useful life.
Determination of residual value of an asset is normally a difficult matter. If
such value is considered as insignificant, it is normally regarded as nil. On the
contrary, if the residual value is likely to be significant, it is estimated at the time
of acquisition/installation, or at the time of subsequent revaluation of the asset.
One of the bases for determining the residual value would be the realisable value
of similar assets which have reached the end of their useful lives and have operated
under conditions similar to those in which the asset will beused.
The quantum of depreciation to be provided in an accounting period
involves the exercise of judgement by management in the light of technical,
commercial, accounting and legal requirements and accordingly may need
periodical review. If it is considered that the original estimate of useful life of an
asset requires any revision, the unamortised depreciable amount of the asset is
charged to revenue over the revised remaining usefullife.
There are several methods of allocating depreciation over the useful life of
the assets. Those most commonly employed in industrial and commercial
enterprises are the straightline method and the reducing balance method. The
management of a business selects the most appropriate method(s) based on various
important factors e.g., (i) type of asset, (ii) the nature of the use of such asset and
(iii) circumstances prevailing in the business. A combination of more than one
method is sometimes used. In respect of depreciable assets which do not have
material value, depreciation is often allocated fully in the accounting period in
which they are acquired.
The statute governing an enterprise may provide the basis for computation of
the depreciation. For example, the Companies Act, 1956 lays down the rates of
depreciation in respect of various assets. Where the management’s estimate of the
useful life of an asset of the enterprise is shorter than that envisaged under the
provisions of the relevant statute, the depreciation provision is appropriately
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computed by applying a higher rate. If the management’s estimate of the useful life
of the asset is longer than that envisaged under the Depreciation Accounting 61
statute, depreciation rate lower than that envisaged by the statute can be applied
only in accordance with requirements of the statute.
Where depreciable assets are disposed of, discarded, demolished or
destroyed, the net surplus or deficiency, if material, is disclosed separately.
The method of depreciation is applied consistently to provide comparability
of the results of the operations of the enterprise from period to period. A change
from one method of providing depreciation to another is made only if the adoption
of the new method is required by statute or for compliance with an accounting
standard or if it is considered that the change would result in a more appropriate
preparation or presentation of the financial statements of the enterprise. When such
a change in the method of depreciation is made, depreciation is recalculated in
accordance with the new method from the date of the asset coming into use. The
deficiency or surplus arising from retrospective recomputation of depreciation in
accordance with the new method is adjusted in the accounts in the year in which
the method of depreciation is changed. In case the change in the method results in
deficiency in depreciation in respect of past years, the deficiency is charged in the
statement of profit and loss. In case the change in the method results in surplus, the
surplus is credited to the statement of profit and loss. Such a change is treated as a
change in accounting policy and its effect is quantified anddisclosed.
Where the historical cost of an asset has undergone a change due to
circumstances specified in para 6 above, the depreciation on the revised
unamortised depreciable amount is provided prospectively over the residual useful
life of the asset.
The depreciation methods used, the total depreciation for the period for each
class of assets, the gross amount of each class of depreciable assets and the related
accumulated depreciation are disclosed in the financial statements along with the
disclosure of other accounting policies. The depreciation rates or the useful lives of
the assets are disclosed only if they are different from the principal rates specified
in the statute governing the enterprise.
In case the depreciable assets are revalued, the provision for depreciation is
based on the revalued amount on the estimate of the remaining useful life of such
assets. In case the revaluation has a material effect on the62 AS 6 amount of
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depreciation, the same is disclosed separately in the year in which revaluation is
carried out.
A change in the method of depreciation is treated as a change in an
accounting policy and is disclosed accordingly.
Main Principles
The depreciable amount of a depreciable asset should be allocated on a
systematic basis to each accounting period during the useful life of the asset.
The depreciation method selected should be applied consistently from period
to period. A change from one method of providing depreciation to another should
be made only if the adoption of the new method is required by statute or for
compliance with an accounting standard or if it is considered that the change would
result in a more appropriate preparation or presentation of the financial statements
of the enterprise. When such a change in the method of depreciation is made,
depreciation should be recalculated in accordance with the new method from the
date of the asset coming into use. The deficiency or surplus arising from
retrospective recomputation of depreciation in accordance with the new method
should be adjusted in the accounts in the year in which the method of depreciation
is changed. In case the change in the method results in deficiency in depreciation in
respect of past years, the deficiency should be charged in the statement of profit
and loss. In case the change in the method results in surplus, the surplus should be
credited to the statement of profit and loss. Such a change should be treated as a
change in accounting policy and its effect should be quantified anddisclosed.
The useful life of a depreciable asset should be estimated after considering the
following factors:
(i) expected physical wear andtear;
(ii) obsolescence;
(iii) legal or other limits on the use of theasset.
Any addition or extension which becomes an integral part of the existing
asset should be depreciated over the remaining useful life of that asset. The
depreciation on such addition or extension may also be provided at the rate applied
to the existing asset. Where an addition or extension retains a separate identityand
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is capable of being used after the existing asset is disposed of, depreciation should
be provided independently on the basis of an estimate of its own useful life.
Where the historical cost of a depreciable asset has undergone a change due
to increase or decrease in long term liability on account of exchange fluctuations,
price adjustments, changes in duties or similar factors, the depreciation on the
revised unamortised depreciable amount should be provided prospectively over the
residual useful life of the asset.
Where the depreciable assets are revalued, the provision for depreciation
should be based on the revalued amount and on the estimate of the remaining
useful lives of such assets. In case the revaluation has a material effect on the
amount of depreciation, the same should be disclosed separately in the year in
which revaluation is carriedout.
If any depreciable asset is disposed of, discarded, demolished or destroyed,
the net surplus or deficiency, if material, should be disclosed separately.
The following information should be disclosed in the financial statements:
(i) the historical cost or other amount substituted for historical cost of each
class of depreciableassets;
(ii) total depreciation for the period for each class of assets;and
(iii) the related accumulateddepreciation.
The following information should also be disclosed in the financial statements
along with the disclosure of other accountingpolicies:
(i) depreciation methods used;and
(ii) depreciation rates or the useful lives of the assets, if they are different from the
principal rates specified in the statute governing theenterprise.
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ACCOUNTING FOR INVENTORIES
The following terms are used in this Standard with the meanings specified:
Inventories are assets:
(a) held for sale in the ordinary ry course ofbusiness;
(b) in the process of production for such sale;or
(c) in the form of materials or supplies to be consumed in the production process or
in the rendering ofservices.
Net realisable value is the estimated selling price in the ordinary course of
business less the estimated costs of completion and the estimated costs necessary
to make thesale.
Fair value is the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm’s length
transaction.
Net realisable value refers to the net amount that an entity expects to realize
from the sale of inventory in the ordinary course of business. Fair value reflects the
amount for which the same inventory could be exchanged between knowledgeable
and willing buyers and sellers in the marketplace. The former is an entity-specific
value; the latter is not. Net realisable value for inventories may not equal fair value
less costs to sell.
Inventories encompass goods purchased and held for resale including, for
example, merchandise purchased by a retailer and held for resale, or land and other
property held for resale. Inventories also encompass finished goods produced, or
work in progress being produced, by the entity and include materials and supplies
awaiting use in the production process. In the case of a service provider,
inventories include the costs of the service, as described in paragraph 19, for which
the entity has not yet recognised the related revenue (see Ind AS 18,Revenue).
Measurement of inventories
Inventories shall be measured at the lower of cost and net realisable value. The cost
of inventories shall comprise all costs of purchase, costs of conversion and other
costs incurred in bringing the inventories to their present location and condition.
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Costs of purchase
The costs of purchase of inventories comprise the purchase price, import
duties and other taxes (other than those subsequently recoverable by the entity
from the taxing authorities), and transport, handling and other costs directly
attributable to the acquisition of finished goods, materials and services. Trade
discounts, rebates and other similar items are deducted in determining the costs of
purchase.
Costs of conversion
The costs of conversion of inventories include costs directly related to the
units of production, such as direct labour. They also include a systematic allocation
of fixed and variable production overheads that are incurred in converting
materials into finished goods. Fixed production overheads are those indirect costs
of production that remain relatively constant regardless of the volume of
production, such as depreciation and maintenance of factory buildings and
equipment, and the cost of factory management and administration. Variable
production overheads are those indirect costs of production that vary directly, or
nearly directly, with the volume of production, such as indirect materials and
indirectlabour.
The allocation of fixed production overheads to the costs of conversion is
based on the normal capacity of the production facilities. Normal capacity is the
production expected to be achieved on average over a number of periods or
seasons under normal circumstances, taking into account the loss of capacity
resulting from planned maintenance. The actual level of production may be used if
it approximates normal capacity. The amount of fixed overhead allocated to each
unit of production is not increased as a consequence of low production or idle
plant. Unallocated overheads are recognised as an expense in the period in which
they are incurred. In periods of abnormally high production, the amount of fixed
overhead allocated to each unit of production is decreased so that inventories are
not measured abovecost.
Variable production overheads are allocated to each unit of production on
the basis of the actual use of the productionfacilities.
A production process may result in more than one product being produced
simultaneously. This is the case, for example, when joint products are produced or
when there is a main product and a by-product. When the costs of conversion of
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each product are not separately identifiable, they are allocated between the
products on a rational and consistent basis. The allocation may be based, for
example, on the relative sales value of each product either at the stage in the
production process when the products become separately identifiable, or at the
completion of production. Most by-products, by their nature, are immaterial. When
this is the case, they are often measured at net realisable value and this value is
deducted from the cost of the main product. As a result, the carrying amount of the
main product is not materially different from itscost.
Other costs
Other costs are included in the cost of inventories only to the extent that they
are incurred in bringing the inventories to their present location and condition. For
example, it may be appropriate to include non-production overheads or the costs of
designing products for specific customers in the cost of inventories.
Examples of costs excluded from the cost of inventories and recognised as
expenses in the period in which they are incurred are:
a) abnormal amounts of wasted materials, labour or other productioncosts;
b) storage costs, unless those costs are necessary in the production process
before a further productionstage;
c) administrative overheads that do not contribute to bringing inventories to
their present location and condition;and
d) sellingcosts.
Ind AS 23, Borrowing Costs, identifies limited circumstances where
borrowing costs are included in the cost ofinventories.
An entity may purchase inventories on deferred settlement terms. When the
arrangement effectively contains a financing element, that element, for example a
difference between the purchase price for normal credit terms and the amount paid,
is recognised as interest expense over the period of the financing. Cost of
inventories of a service provider
To the extent that service providers have inventories, they measure them at
the costs of their production. These costs consist primarily of the labour and other
costs of personnel directly engaged in providing the service, including supervisory
personnel, and attributable overheads. Labour and other costs relating to sales and
general administrative personnel are not included but are recognised as expenses in
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the period in which they are incurred. The cost of inventories of a service provider
does not include profit margins or non-attributable overheads that are often
factored into prices charged by serviceproviders.
Cost of agricultural produce harvested from biological assets
In accordance with Ind AS 41, Agriculture, inventories comprising
agricultural produce that an entity has harvested from its biological assets are
measured on initial recognition at their fair value less costs to sell at the point of
harvest. This is the cost of the inventories at that date for application of this
Standard.
Techniques for the measurement of cost
Techniques for the measurement of the cost of inventories, such as the
standard cost method or the retail method, may be used for convenience if the
results approximate cost. Standard costs take into account normal levels of
materials and supplies, labour, efficiency and capacity utilisation. They are
regularly reviewed and, if necessary, revised in the light of current conditions.
The retail method is often used in the retail industry for measuring
inventories of large numbers of rapidly changing items with similar margins for
which it is impracticable to use other costing methods. The cost of the inventory is
determined by reducing the sales value of the inventory by the appropriate
percentage gross margin. The percentage used takes into consideration inventory
that has been marked down to below its original selling price. An average
percentage for each retail department is often used.
Cost Formulas
The cost of inventories of items that are not ordinarily interchangeable and
goods or services produced and segregated for specific projects shall be assigned
by using specific identification of their individualcosts.
Specific identification of cost means that specific costs are attributed to
identified items of inventory. This is the appropriate treatment for items that are
segregated for a specific project, regardless of whether they have been bought or
produced. However, specific identification of costs is inappropriate when there are
large numbers of items of inventory that are ordinarily interchangeable. In such
circumstances, the method of selecting those items that remain in inventories could
be used to obtain predetermined effects on profit or loss.
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The cost of inventories, other than those dealt with in paragraph 23, shall be
assigned by using the first-in, first-out (FIFO) or weighted average cost formula.
An entity shall use the same cost formula for all inventories having a similar nature
and use to the entity. For inventories with a different nature or use, different cost
formulas may be justified.
Indian Accounting Standard (Ind AS ) 41, Agriculture, is under formulation.
Accordingly, this paragraph would be effective from the date Ind AS 41,
Agriculture, comes into effect.
For example, inventories used in one operating segment may have a use to
the entity different from the same type of inventories used in another operating
segment.
However, a difference in geographical location of inventories (or in the
respective tax rules), by itself, is not sufficient to justify the use of different cost
formulas.
The FIFO formula assumes that the items of inventory that were purchased
or produced first are sold first, and consequently the items remaining in inventory
at the end of the period are those most recently purchased or produced. Under the
weighted average cost formula, the cost of each item is determined from the
weighted average of the cost of similar items at the beginning of a period and the
cost of similar items purchased or produced during the period. The average may be
calculated on a periodic basis, or as each additional shipment is received,
depending upon the circumstances of theentity.
Net realisable value
The cost of inventories may not be recoverable if those inventories are
damaged, if they have become wholly or partially obsolete, or if their selling prices
have declined. The cost of inventories may also not be recoverable if the estimated
costs of completion or the estimated costs to be incurred to make the sale have
increased. The practice of writing inventories down below cost to net realizable
value is consistent with the view that assets should not be carried in excess of
amounts expected to be realised from their sale or use.
Inventories are usually written down to net realisable value item by item. In
some circumstances, however, it may be appropriate to group similar or related
items.
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This may be the case with items of inventory relating to the same product
line that have similar purposes or end uses, are produced and marketed in the same
geographical area, and cannot be practicably evaluated separately from other items
in that product line. It is not appropriate to write inventories down on the basis of a
classification of inventory, for example, finished goods, or all the inventories in a
particular operating segment. Service providers generally accumulate costs in
respect of each service for which a separate selling price is charged. Therefore,
each such service is treated as a separate item.
Estimates of net realisable value are based on the most reliable evidence
available at the time the estimates are made, of the amount the inventories are
expected to realise. These estimates take into consideration fluctuations of price or
cost directly relating to events occurring after the end of the period to the extent
that such events confirm conditions existing at the end of the period.
Estimates of net realisable value also take into consideration the purpose for
which the inventory is held. For example, the net realisable value of the quantity of
inventory held to satisfy firm sales or service contracts is based on the contract
price.
If the sales contracts are for less than the inventory quantities held, the net
realizable value of the excess is based on general selling prices. Provisions may
arise from firm sales contracts in excess of inventory quantities held or from firm
purchase contracts.
Such provisions are dealt with under Ind AS 37 , Provisions, Contingent
Liabilities and Contingent Assets.
Materials and other supplies held for use in the production of inventories are
not written down below cost if the finished products in which they will be
incorporated are expected to be sold at or above cost. However, when a decline in
the price of materials indicates that the cost of the finished products exceeds net
realisable value, the materials are written down to net realisable value. In such
circumstances, the replacement cost of the materials may be the best available
measure of their net realisable value.
A new assessment is made of net realisable value in each subsequent period.
When the circumstances that previously caused inventories to be written
down below cost no longer exist or when there is clear evidence of an increase in
17
net realizable value because of changed economic circumstances, the amount of
the write-down is reversed (ie the reversal is limited to the amount of the original
write-down) so that the new carrying amount is the lower of the cost and the
revised net realisable value.
This occurs, for example, when an item of inventory that is carried at net
realizable value, because its selling price has declined, is still on hand in a
subsequent period and its selling price has increased.
Recognition as an expense
When inventories are sold, the carrying amount of those inventories shall be
recognised as an expense in the period in which the related revenue is recognised.
The amount of any write-down of inventories to net realisable value and all
losses of inventories shall be recognised as an expense in the period the write-
down or loss occurs. The amount of any reversal of any write-down of inventories,
arising from an increase in net realisable value, shall be recognized as a reduction
in the amount of inventories recognised as an expense in the period in which the
reversaloccurs.
Some inventories may be allocated to other asset accounts, for example,
inventory used as a component of self-constructed property, plant or equipment.
Inventories allocated to another asset in this way are recognised as an expense
during the useful life of that asset.
Disclosure
The financial statements shall disclose:
(a) the accounting policies adopted in measuring inventories, including the
cost formulaused;
(b) the total carrying amount of inventories and the carrying amount in
classifications appropriate to theentity;
(c) the carrying amount of inventories carried at fair value less costs tosell;
(d) the amount of inventories recognised as an expense during theperiod;
(f) the amount of any reversal of any write-down that is recognized as a
reduction in the amount of inventories recognised as expense in the period in
accordance withparagraph
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(g) the circumstances or events that led to the reversal of a writedown of
inventories in accordance withparagraph
(h) the carrying amount of inventories pledged as security forliabilities.
Information about the carrying amounts held in different classifications of
inventories and the extent of the changes in these assets is useful to financial
statement users. Common classifications of inventories are merchandise,
production supplies, materials, work in progress and finished goods. The
inventories of a service provider may be described as work inprogress.
An entity adopts a format for profit or loss that results in amounts being
disclosed other than the cost of inventories recognised as an expense during the
period. Under this format, the entity presents an analysis of expenses using a
classification based on the nature of expenses. In this case, the entity discloses the
costs recognised as an expense for raw materials and consumables, labour costs
and other costs together with the amount of the net change in inventories for the
period.
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REVENUE RECOGNITION
Definition
Revenue is the gross inflow of cash, receivables or other consideration
arising in the course of the ordinary activities of an enterprise from the sale of
goods, from the rendering of services, and from the use by others of enterprise
resources yielding interest, royalties and dividends. Revenue is measured by the
charges made to customers or clients for goods supplied and services rendered to
them and by the charges and rewards arising from the use of resources by them. In
an agency relationship, the revenue is the amount of commission and not the gross
inflow of cash, receivables or other consideration.
Completed service contract method is a method of accounting which
recognises revenue in the statement of profit and loss only when the rendering of
services under a contract is completed or substantially completed.
Proportionate completion method is a method of accounting which Revenue
Recognition recognises revenue in the statement of profit and loss proportionately
with the degree of completion of services under a contract.
Explanation
Revenue recognition is mainly concerned with the timing of recognition of
revenue in the statement of profit and loss of an enterprise. The amount of revenue
arising on a transaction is usually determined by agreement between the parties
involved in the transaction. When uncertainties exist regarding the determination
of the amount, or its associated costs, these uncertainties may influence the timing
ofrevenue
Sale of Goods
A key criterion for determining when to recognise revenue from a
transaction involving the sale of goods is that the seller has transferred the property
in the goods to the buyer for a consideration. The transfer of property in goods, in
most cases, results in or coincides with the transfer of significant risks and rewards
of ownership to the buyer. However, there may be situations where transfer of
property in goods does not coincide with the transfer of significant risks and
rewards of ownership. Revenue in such situations is recognised at the time of
transfer of significant risks and rewards of ownership to the buyer. Such casesmay
20
arise where delivery has been delayed through the fault of either the buyer or the
seller and the goods are at the risk of the party at fault as regards any loss which
might not have occurred but for such fault. Further, sometimes the parties may
agree that the risk will pass at a time different from the time when ownership
passes.
At certain stages in specific industries, such as when agricultural crops have
been harvested or mineral ores have been extracted, performance may be
substantially complete prior to the execution of the transaction generating revenue.
In such cases when sale is assured under a forward contract or a government
guarantee or where market exists and there is a negligible risk of failure to sell, the
goods involved are often valued at net realisable value. Such amounts, while not
revenue as defined in this Standard, are sometimes recognised in the statement of
profit and loss and appropriately
Rendering of Services
Revenue from service transactions is usually recognised as the service is
performed, either by the proportionate completion method or by the completed
service contractmethod.
(i) Proportionate completion method—Performance consists of the execution
of more than one act. Revenue is recognised proportionately by reference to the
performance of each act. The revenue recognised under this method would be
determined on the basis of contract value, associated costs, number of acts or other
suitable basis. For practical purposes, when services are provided by an
indeterminate number of acts over a specific period of time, revenue is recognised
on a straight line basis over the specific period unless there is evidence that some
other method better represents the pattern ofperformance.
(ii) Completed service contract method—Performance consists of the
execution of a single act. Alternatively, services are performed in more than a
single act, and the services yet to be performed are so significant in relation to the
transaction taken as a whole that performance cannot be deemed to have been
completed until the execution of those acts. The completed service contract method
is relevant to these patterns of performance and accordingly revenue is recognised
when the sole or final act takes place and the service becomeschargeable.
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The Use by Others of Enterprise Resources Yielding Interest, Royalties and
Dividends
The use by others of such enterprise resources gives rise to:
(i) interest—charges for the use of cash resources or amounts due to the
enterprise;
(ii) Royalties—charges for the use of such assets as know-how, patents,
trademarks andcopyrights;
(iii) Dividends—rewards from the holding of investments inshares.
Interest accrues, in most circumstances, on the time basis determined by the
amount outstanding and the rate applicable. Usually, discount or premium on debt
securities held is treated as though it were accruing over the period to maturity.
Royalties accrue in accordance with the terms of the relevant agreement and are
usually recognised on that basis unless, having regard to the substance of the
transactions, it is more appropriate to recognise revenue on some other systematic
and rational basis.
Revenue Recognition
Dividends from investments in shares are not recognised in the statement of
profit and loss until a right to receive payment is established.
When interest, royalties and dividends from foreign countries require exchange
permission and uncertainty in remittance is anticipated, revenue recognition may
need to be postponed.
Effect of Uncertainties on Revenue Recognition
 Recognition of revenue requires that revenue is measurable and that at
the time of sale or the rendering of the service it would not be
unreasonable to expect ultimatecollection.
 Where the ability to assess the ultimate collection with reasonable
certainty is lacking at the time of raising any claim, e.g., for escalation
of price, export incentives, interest etc., revenue recognition is
postponed to the extent of uncertainty involved. In such cases, it may
be appropriate to recognise revenue only when it is reasonably certain
that the ultimate collection will be made. Where there isno
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uncertainty as to ultimate collection, revenue is recognised at the time
of sale or rendering of service even though payments are made by
instalments.
 When the uncertainty relating to collectability arises subsequent to the
time of sale or the rendering of the service, it is more appropriate to
make a separate provision to reflect the uncertainty rather than to
adjust the amount of revenue originallyrecorded.
 An essential criterion for the recognition of revenue is that the
consideration receivable for the sale of goods, the rendering of
services or from the use by others of enterprise resources is
reasonablydeterminable.
 When such consideration is not determinable within reasonable limits,
the recognition of revenue ispostponed.
 When recognition of revenue is postponed due to the effect of
uncertainties, it is considered as revenue of the period in which it is
properlyrecognised.
Main Principles
Revenue from sales or service transactions should be recognized when the
requirements as to performance set out in paragraphs 11 and12 are satisfied,
provided that at the time of performance it is not unreasonable to expect ultimate
collection. If at the time of raising of any claim it is unreasonable to expect
ultimate collection, revenue recognition should bepostponed.
Explanation:
The amount of revenue from sales transactions (turnover) should be disclosed in
the following manner on the face of the statement of profit andloss:
Turnover(Gross) XX
Less:ExciseDuty XX
Turnover(Net) XX
The amount of excise duty to be deducted from the turnover should be the
total excise duty for the year except the excise duty related to the difference
between the closing stock and opening stock. The excise duty related to the
difference between the closing stock and opening stock should berecognised
23
separately in the statement of profit and loss, with an explanatory note in the notes
to accounts to explain the nature of the two amounts of excise duty.
In a transaction involving the sale of goods, performance should be regarded
as being achieved when the following conditions have been fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods
for a price or all significant risks and rewards of ownership have been transferred
to the buyer and the seller retains no effective control of the goods transferred to a
degree usually associated with ownership;and
(ii) no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale of thegoods.
In a transaction involving the rendering of services, performance should be
measured either under the completed service contract method or under the
proportionate completion method, whichever relates the revenue to the work
accomplished. Such performance should be regarded as being achieved when no
significant uncertainty exists Revenue Recognition regarding the amount of the
consideration that will be derived from rendering the service.
Revenue arising from the use by others of enterprise resources yielding interest,
royalties and dividends should only be recognised when no significant uncertainty
as to measurability or collectability exists.
These revenues are recognised on the following bases:
(i) Interest: on a time proportion basis taking into account theamount
Outstanding and the rateapplicable.
(ii) Royalties : on an accrual basis in accordance with the terms ofthe
relevantagreement.
Disclosure
In addition to the disclosures required by Accounting Standard 1 on ‘Disclosure of
Accounting Policies’ (AS 1), an enterprise should also disclose the circumstances
in which revenue recognition has been postponed pending the resolution of
significantuncertainties.
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Illustrations
These illustrations do not form part of the Accounting Standard. Their purpose is
to illustrate the application of the Standard to a number of commercial situations in
an endeavour to assist in clarifying application of theStandard.
A. Sale ofGoods
1. Delivery is delayed at buyer ’s request and buyer takes title and accepts billing
Revenue should be recognised notwithstanding that physical delivery has not been
completed so long as there is every expectation that delivery will be made.
However, the item must be on hand, identified and ready for delivery to the buyer
at the time the sale is recognised rather than there being simply an intention to
acquire or manufacture the goods in time fordelivery.
2. Delivered subject to conditions
(a) installation and inspection i.e. goods are sold subject to installation, inspection
etc.
Revenue should normally not be recognised until the customer accepts delivery
and installation and inspection are complete. In some cases, however, the
installation process may be so simple in nature that it may be appropriate to
recognise the sale notwithstanding that installation is not yet completed (e.g.
installation of a factory-tested television receiver normally only requires unpacking
and connecting of power andantennae).
(b) onapproval
Revenue should not be recognised until the goods have been formally accepted by
the buyer or the buyer has done an act adopting the transaction or the time period
for rejection has elapsed or where no time has been fixed, a reasonable time has
elapsed.
(c) guaranteed sales i.e. delivery is made giving the buyer an unlimited right of
return Recognition of revenue in such circumstances will depend on the substance
of the agreement. In the case of retail sales offering a guarantee of “money back if
not completely satisfied” it may be appropriate to recognise the sale but to make a
suitable provision for returns based on previous experience. In other cases, the
substance of the agreement may amount to a sale on consignment, in which case it
should be treated as indicatedbelow.
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(d) consignment sales i.e. a delivery is made whereby the recipient undertakes to
sell the goods on behalf of the consignor Revenue should not be recognised until
the goods are sold to a thirdparty.
(e) cash on delivery sales
Revenue should not be recognised until cash is received by the seller or his agent.
3. Sales where the purchaser makes a series of instalment payments to the seller,
and the seller delivers the goods only when the final payment isreceived
Revenue from such sales should not be recognised until goods are delivered.
However, when experience indicates that most such sales have been consummated,
revenue may be recognised when a significant deposit is received.
4. Special order and shipments i.e. where payment (or partial payment) is received
for goods not presently held in stock e.g. the stock is still to be manufactured or is
to be delivered directly to the customer from a thirdparty
Revenue from such sales should not be recognised until goods are manufactured,
identified and ready for delivery to the buyer by the third party.
5. Sale/repurchase agreements i.e. where seller concurrently agrees to repurchase
the same goods at a laterdate
For such transactions that are in substance a financing agreement, the resulting
cash inflow is not revenue as defined and should not be recognised asrevenue.
6. Sales to intermediate parties i.e. where goods are sold to distributors, dealers or
others forresale
Revenue from such sales can generally be recognised if significant risks of
ownership have passed; however in some situations the buyer may in substance be
an agent and in such cases the sale should be treated as a consignment sale.
7. Subscriptions forpublications
Revenue received or billed should be deferred and recognised either on a straight
line basis over time or, where the items delivered vary in value from period to
period, revenue should be based on the sales value of the item delivered in relation
to the total sales value of all items covered by the subscription.
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8. Instalmentsales
When the consideration is receivable in instalments, revenue attributable to the
sales price exclusive of interest should be recognised at the date of sale.
The interest element should be recognised as revenue, proportionately to the
unpaid balance due to theseller.
9. Trade discounts and volumerebates
Trade discounts and volume rebates received are not encompassed within the
definition of revenue, since they represent a reduction of cost. Trade discounts and
volume rebates given should be deducted in determining revenue.
B. Rendering ofServices
1. InstallationFees
In cases where installation fees are other than incidental to the sale of a product,
they should be recognised as revenue only when the equipment is installed and
accepted by the customer.
2. Advertising and insurance agencycommissions
Revenue should be recognised when the service is completed. For advertising
agencies, media commissions will normally be recognised when the related
advertisement or commercial appears before the public and the necessary
intimation is received by the agency, as opposed to production commission, which
will be recognised when the project is completed. Insurance agency commissions
should be recognised on the effective commencement or renewal dates of the
relatedpolicies.
3. Financial servicecommissions
A financial service may be rendered as a single act or may be provided over a
period of time. Similarly, charges for such services may be made as a single
amount or in stages over the period of the service or the life of the transaction to
which it relates. Such charges may be settled in full when made or added to a loan
or other account and settled in stages. The recognition of such revenue should
therefore have regardto:
(a) whether the service has been provided “once and for all” or is on a
“continuing”basis;
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(b) the incidence of the costs relating to theservice;
(c) when the payment for the service will be received. In general,
commissions charged for arranging or granting loan or other facilities should
be recognised when a binding obligation has been entered into.
Commitment, facility or loan management fees which relate to continuing
obligations or services should normally be recognized over the life of the
loan or facility having regard to the amount of the obligation outstanding,
the nature of the services provided and the timing of the costs relating
thereto.
4. Admissionfees
Revenue from artistic performances, banquets and other special events should be
recognised when the event takes place. When a subscription to a number of events
is sold, the fee should be allocated to each event on a systematic and rational basis.
5. Tuitionfees
Revenue should be recognised over the period of instruction.
6. Entrance and membershipfees
Revenue recognition from these sources will depend on the nature of the services
being provided. Entrance fee received is generally capitalised. If the membership
fee permits only membership and all other services or products are paid for
separately, or if there is a separate annual subscription, the fee should be
recognised when received. If the membership fee entitles the member to services or
publications to be provided during the year, it should be recognised on a systematic
and rational basis having regard to the timing and nature of allservices
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ACCOUNTING STANDARDS FOR FIXED ASSETS
Definition
Fixed asset is an asset held with the intention of being used for the purpose
of producing or providing goods or services and is not held for sale in the normal
course ofbusiness.
Fair market value is the price that would be agreed to in an open and unrestricted
market between knowledgeable and willing parties dealing at arm’s length who are
fully informed and are not under any compulsion to transact.
Gross book value of a fixed asset is its historical cost or other amount substituted
for historical cost in the books of account or financial statements. When this
amount is shown net of accumulated depreciation, it is termed as net book value.
Explanation
Fixed assets often comprise a significant portion of the total assets of an
enterprise, and therefore are important in the presentation of financial position.
Furthermore, the determination of whether an expenditure represents an asset or an
expense can have a material effect on an enterprise’s reported results of operations.
Identification of Fixed Assets
The definition in paragraph 6.1 gives criteria for determining whether items
are to be classified as fixed assets. Judgement is required in applying the criteria to
specific circumstances or specific types of enterprises. It may be appropriate to
aggregate individually insignificant items, and to apply the criteria to the aggregate
value. An enterprise may decide to expense an item which could otherwise have
been included as fixed asset, because the amount of the expenditure is not material.
Stand-by equipment and servicing equipment are normally capitalised.
Machinery spares are usually charged to the profit and loss statement as and when
consumed. However, if such spares can be used only in connection with an item of
fixed asset and their use is expected to be irregular, it may be appropriate to
allocate the total cost on a systematic basis over a period not exceeding the useful
life of the principalitem.
In certain circumstances, the accounting for an item of fixed asset may be
improved if the total expenditure thereon is allocated to its component parts,
provided they are in practice separable, and estimates are made of the useful lives
29
of these components. For example, rather than treat an aircraft and its engines as
one unit, it may be better to treat the engines as a separate unit if it is likely that
their useful life is shorter than that of the aircraft as a whole.
Components of Cost
The cost of an item of fixed asset comprises its purchase price, including
import duties and other non-refundable taxes or levies and any directly attributable
cost of bringing the asset to its working condition for its intended use; any trade
discounts and rebates are deducted in arriving at the purchase price. Examples of
directly attributable costs are:
(i) sitepreparation;
(ii) initial delivery and handlingcosts;
(iii) installation cost, such as special foundations for plant;and
(iv) Professional fees, for example fees of architects andengineers.
The cost of a fixed asset may undergo changes subsequent to its acquisition
or construction on account of exchange fluctuations, price adjustments, changes in
duties or similar factors.
Administration and other general overhead expenses are usually excluded from the
cost of fixed assets because they do not relate to a specific fixed asset. However, in
some circumstances, such expenses as are specifically attributable to construction
of a project or to the acquisition of a fixed asset or bringing it to its working
condition, may be included as part of the cost of the construction project or as a
part of the cost of the fixedasset.
The expenditure incurred on start-up and commissioning of the project, including
the expenditure incurred on test runs and experimental production, is usually
capitalised as an indirect element of the construction cost. However, the
expenditure incurred after the plant has begun commercial production, i.e.,
production intended for sale or captive consumption, is not capitalized and is
treated as revenue expenditure even though the contract may stipulate that the plant
will not be finally taken over until after the satisfactory completion
If the interval between the date a project is ready to commence commercial
production and the date at which commercial production actually begins is
prolonged, all expenses incurred during this period are charged to the profit and
loss statement. However, the expenditure incurred during this period is also
30
sometimes treated as deferred revenue expenditure to be amortised over a period
not exceeding 3 to 5 years after the commencement
Self-constructed Fixed Assets
In arriving at the gross book value of self-constructed fixed assets, the same
principles apply as those described in paragraphs 9.1 to 9.5. Included in the gross
book value are costs of construction that relate directly to the specific asset and
costs that are attributable to the construction activity in general and can be
allocated to the specific asset. Any internal profits are eliminated in arrivingat
Non-monetary Consideration
When a fixed asset is acquired in exchange for another asset, its cost is
usually determined by reference to the fair market value of the consideration given.
It may be appropriate to consider also the fair market value of the asset acquired if
this is more clearly evident. An alternative accounting treatment 1 It may be noted
that this paragraph relates to “all expenses” incurred during the period. This
expenditure would also include borrowing costs incurred during the said period.
Since Accounting Standard (AS) 16, Borrowing Costs, specifically deals with the
treatment of borrowing costs, the treatment provided by AS 16 would prevail over
the provisions in this respect contained in this paragraph as these provisions are
general in nature and apply to “all expenses”. that is sometimes used for an
exchange of assets, particularly when the assets exchanged are similar, is to record
the asset acquired at the net book value of the asset given up; in each case an
adjustment is made for any balancing receipt or payment of cash or other
consideration.
When a fixed asset is acquired in exchange forshares or othersecurities in the
enterprise, it is usually recorded at its fair market value, or the fair market value of
the securities issued, whichever is more clearly evident.
Improvements and Repairs
Frequently, it is difficult to determine whether subsequent expenditure
related to fixed asset represents improvements that ought to be added to the gross
book value or repairs that ought to be charged to the profit and loss statement.
Only expenditure that increases the future benefits from the existing asset beyond
its previously assessed standard of performance is included in the gross book
value, e.g., an increase incapacity.
31
The cost of an addition or extension to an existing asset which is of a capital nature
and which becomes an integral part of the existing asset is usually added to its
gross book value. Any addition or extension, which has a separate identity and is
capable of being used after the existing asset is disposed of, is accounted for
separately.
Amount Substituted for Historical Cost
Sometimes financial statements that are otherwise prepared on a historical
cost basis include part or all of fixed assets at a valuation in substitution for
historical costs and depreciation is calculated accordingly. Such financial
statements are to be distinguished from financial statements prepared on a basis
intended to reflect comprehensively the effects of
A commonly accepted and preferred method of restating fixed assets is by
appraisal, normally undertaken by competent valuers. Other methods sometimes
used are indexation and reference to current prices which when applied are cross
checked periodically by appraisal method.
The revalued amounts of fixed assets are presented in financial statements
either by restating both the gross book value and accumulated depreciation so as to
give a net book value equal to the net revalued amount or by restating the net book
value by adding therein the net increase on account of revaluation. An upward
revaluation does not provide a basis for crediting to the profit and loss statement
the accumulated depreciation existing at the date ofrevaluation.
Different bases of valuation are sometimes used in the same financial
statements to determine the book value of the separate items within each of the
categories of fixed assets or for the different categories of fixed assets.
In such cases, it is necessary to disclose the gross book value included on each
basis.
Selective revaluation of assets can lead to unrepresentative amounts being reported
in financial statements. Accordingly, when revaluations do not cover all the assets
of a given class, it is appropriate that the selection of assets to be revalued be made
on a systematic basis. For example, an enterprise may revalue a whole class of
assets within a unit.
32
It is not appropriate for the revaluation of a class of assets to result in the net
book value of that class being greater than the recoverable amount of the assets of
that class.
An increase in net book value arising on revaluation of fixed assets is
normally credited directly to owner’s interests under the heading of revaluation
reserves and is regarded as not available for distribution. A decrease in net book
value arising on revaluation of fixed assets is charged to profit and loss statement
except that, to the extent that such a decrease is considered to be related to a
previous increase on revaluation that is included in revaluation reserve, it is
sometimes charged against that earlier increase. It sometimes happens that an
increase to be recorded is a reversal of a previous decrease arising on revaluation
which has been charged to profit and loss statement in which case the increase is
credited to profit and loss statement to the extent that it offsets the previously
recorded decrease.
Retirements and Disposals
An item of fixed asset is eliminated from the financial statements on
disposal.
Items of fixed assets that have been retired from active use and are held for
disposal are stated at the lower of their net book value and net realisable value and
are shown separately in the financial statements. Any expected loss is recognised
immediately in the profit and loss statement.
In historical cost financial statements, gains orlosses arising on disposal are
generally recognised in the profit and loss statement.
Accounting for Fixed Assets
On disposal of a previously revalued item of fixed asset, the difference
between net disposal proceeds and the net book value is normally charged or
credited to the profit and loss statement except that, to the extent such a loss is
related to an increase which was previously recorded as a credit to revaluation
reserve and which has not been subsequently reversed or utilised, it is charged
directly to that account. The amount standing in revaluation reserve following the
retirement or disposal of an asset which relates to that asset may be transferred to
general reserve.
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Valuation of Fixed Assets in Special Cases
In the case of fixed assets acquired on hire purchase terms, although legal
ownership does not vest in the enterprise, such assets are recorded at their cash
value, which, if not readily available, is calculated by assuming an appropriate rate
of interest. They are shown in the balance sheet with an appropriate narration to
indicate that the enterprise does not have full ownership thereof.
Where an enterprise owns fixed assets jointly with others (otherwise than as
a partner in a firm), the extent of its share in such assets, and the proportion in the
original cost, accumulated depreciation and written down value are stated in the
balance sheet. Alternatively, the pro rata cost of such jointly owned assets is
grouped together with similar fully ownedassets.
Details of such jointly owned assets are indicated separately in the fixed
assets register.
Where several assets are purchased for a consolidated price, the
consideration is apportioned to the various assets on a fair basis as determined by
competent valuers.
Fixed Assets of Special Types
Goodwill, in general, is recorded in the books only when some consideration
in money or money’s worth has been paid for it. Whenever a business is acquired
for a price (payable either in cash or in shares or otherwise) which is in excess of
the value of the net assets of the business taken over, the excess is termed as
‘goodwill’. Goodwill arises from business connections, trade name or reputation of
an enterprise or from other intangible benefits enjoyed by an enterprise.
As a matter of financial prudence, goodwill is written off over a period.
However, many enterprises do not write off goodwill and retain it as an asset.
Main Principles
1. The gross book value of a fixed asset should be either historical cost or a
revaluation computed in accordance with thisStandard.
2. The cost of a fixed asset should comprise its purchase price and any
attributable cost of bringing the asset to its working condition for its
intendeduse.
34
3. The cost of a self-constructed fixed asset should comprise those costs that
relate directly to the specific asset and those that are attributable to the
construction activity in general and can be allocated to the specificasset.
4. When a fixed asset is acquired in exchange or in part exchangefor
another asset, the cost of the asset acquired should be recorded either at
fair market value or at the net book value of the asset given up, adjusted
for any balancing payment or receipt of cash or other consideration. For
these purposes fair market value may be determined by reference either
to the asset given up or to the asset acquired, whichever is more clearly
evident. Fixed asset acquired in exchange for shares or other securities in
the enterprise should be recorded at its fair market value, or the fair
market value of the securities issued, whichever is more clearlyevident.
5. Subsequent expenditures related to an item of fixed asset should be added
to its book value only if they increase the future benefits from the
existing asset beyond its previously assessed standard ofperformance.
6. Material items retired from active use and held for disposal should be
stated at the lower of their net book value and net realisable value and
shown separately in the financialstatements.
7. Fixed asset should be eliminated from the financial statements on
disposal or when no further benefit is expected from its use anddisposal.
8. Losses arising from the retirement or gains or losses arising from
disposal of fixed asset which is carried at cost should be recognised in the
profit and lossstatement.
9. When a fixed asset is revalued in financial statements, an entire class of
assets should be revalued, or the selection of assets for revaluation should
be made on a systematic basis. This basis should bedisclosed.
10. The revaluation in financial statements of a class of assets should not
result in the net book value of that class being greater than the
recoverable amount of assets of thatclass.
11. When a fixed asset is revalued upwards, any accumulated depreciation
existing at the date of the revaluation should not be credited to the profit
and lossstatement.
12. An increase in net book value arising on revaluation of fixed assets
should be credited directly to owners’ interests under the head of
revaluation reserve, except that, to the extent that such increase is related
to and not greater than a decrease arising on revaluationpreviously
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recorded as a charge to the profit and loss statement, it may be credited to
the profit and loss statement. A decrease in net book value arising on
revaluation of fixed asset should be charged directly to the profit and loss
statement except that to the extent that such a decrease is related to an
increase which was previously recorded as a credit to revaluation reserve
and which has not been subsequently reversed or
13. On disposal of a previously revalued item of fixed asset, the difference
between net disposal proceeds and the net book value should be charged
or credited to the profit and loss statement except that to the extent that
such a loss is related to an increase which was previously recorded as a
credit to revaluation reserve and which has not been subsequently
reversed or utilised, it may be charged directly to thataccount.
14. Fixed assets acquired on hire purchase terms should be recorded at their
cash value, which, if not readily available, should be calculated by
assuming an appropriate rate of interest. They should be shown in the
balance sheet with an appropriate narration to indicate that the enterprise
does not have full ownershipthereof.
15. In the case of fixed assets owned by the enterprise jointly with others, the
extent of the enterprise’s share in such assets, and the proportion of the
original cost, accumulated depreciation and written down value should be
stated in the balance sheet. Alternatively, the pro rata cost of such jointly
owned assets may be grouped together with similar fully owned assets
with an appropriate disclosurethereof.
16. Where several fixed assets are purchased for a consolidated price, the
consideration should be apportioned to the various assets on a fair basis
as determined by competentvaluers.
17. Goodwill should be recorded in the books only when some consideration
in money or money’s worth has been paid for it. Whenever a business is
acquired for a price (payable in cash or in shares or otherwise) which is
in excess of the value of the net assets of the business taken over, the
excess should be termed as‘goodwill’.
Disclosure
(i) gross and net book values of fixed assets at the beginning and end of an
accounting period showing additions, disposals, acquisitions and othermovements;
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(ii) expenditure incurred on account of fixed assets in the course of construction or
acquisition;and
(iii) revalued amounts substituted for historical costs of fixed assets, the method
adopted to compute the revalued amounts, the nature of indices used, the year of
any appraisal made, and whether an external valuer was involved, in case where
fixed assets are stated at revaluedamounts.
37
ACCOUNTING STANDARDS FOR INVESTMENTS
Definition
The following terms are used in this Standard with the meanings assigned:
1. Investments are assets held by an enterprise for earning income by way of
dividends, interest, and rentals, for capital appreciation, or for other benefits
to the investing enterprise. Assets held as stock-in-trade are not
‘investments’.
2. current investment is an investment that is by its nature readily realisable
and is intended to be held for not more than one year from the date on which
such investment ismade.
3. A long term investment is an investment other than a currentinvestment.
4. An investment property is an investment in land or buildings that are not
intended to be occupied substantially for use by, or in the operations of, the
investingenterprise.
5. Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an
arm’s length transaction. Under appropriate circumstances, market value or
net realisable value provides an evidence of fairvalue.
6. Market value is the amount obtainable from the sale of an investment in an
open market, net of expenses necessarily to be incurred on or before
disposal.
Explanation
Forms of Investments
 Enterprises hold investments for diverse reasons. For some enterprises,
investment activity is a significant element of operations, and assessment of
the performance of the enterprise may largely, or solely, depend on the
reported results of thisactivity.
 Some investments have no physical existence and are represented merely by
certificates or similar documents (e.g., shares) while others exist in a
physical form (e.g., buildings). The nature of an investment may be that of a
debt, other than a short or long term loan or a trade debt, representing a
monetary amount owing to the holder and usually bearing interest;
alternatively,itmaybeastakeintheresultsandnetassetsofanenterprise
38
such as an equity share. Most investments represent financial rights, but
some are tangible, such as certain investments in land or buildings.
 For some investments, an active market exists from which a market value
can be established. For such investments, market value generally provides
the best evidence of fair value. For other investments, an active market does
not exist and other means are used to determine fairvalue.
Classification of Investments
 Enterprises present financial statements that classify fixed assets,
investments and current assets into separate categories. Investments are
classified as long term investments and current investments. Current
investments are in the nature of current assets, although the common
practice may be to include them ininvestments.
 Investments other than current investments are classified as long term
investments, even though they may be readilymarketable.
Cost of Investments
The cost of an investment includes acquisition charges such as brokerage, fees and
duties.
 If an investment is acquired, or partly acquired, by the issue of shares or
other securities, the acquisition cost is the fair value of the securities issued
(which, in appropriate cases, may be indicated by the issue price as
determined by statutory authorities). The fair value may not necessarily be
equal to the nominal or par value of the securitiesissued.
 If an investment is acquired in exchange, or part exchange, for another asset,
the acquisition cost of the investment is determined by reference to the fair
value of the asset given up. It may be appropriate to consider the fair value
of the investment acquired if it is more clearlyevident.
 Interest, dividends and rentals receivables in connection with an investment
are generally regarded as income, being the return on the investment.
However, in some circumstances, such inflows represent a recovery of cost
and do not form part of income. For example, when unpaid Shares,
debentures and other securities held for sale in the ordinary course of
business are disclosed as ‘stock-in-trade’ under the head ‘current assets’.
interest has accrued before the acquisition of an interest-bearing investment
and is therefore included in the price paid for the investment, thesubsequent
39
receipt of interest is allocated between pre-acquisition and post-acquisition
periods; the pre-acquisition portion is deducted from cost.
 When dividends on equity are declared from pre-acquisition profits, a
similar treatment may apply. If it is difficult to make such an allocation
except on an arbitrary basis, the cost of investment is normally reduced by
dividends receivable only if they clearly represent a recovery of apart
 When right shares offered are subscribed for, the cost of the right shares is
added to the carrying amount of the original holding. If rights are not
subscribed for but are sold in the market, the sale proceeds are taken to the
profit and loss statement. However, where the investments are acquired on
cum-right basis and the market value of investments immediately after their
becoming ex-right is lower than the cost for which they were acquired, it
may be appropriate to apply the sale proceeds of rights to reduce the
carrying amount of such investments to the marketvalue.
Carrying Amount ofInvestments
CurrentInvestments
 The carrying amount for current investments is the lower of cost and fair
value. In respect of investments for which an active market exists, market
value generally provides the best evidence of fair value. The valuation of
current investments at lower of cost and fair value provides a prudent
method of determining the carrying amount to be stated in the balancesheet.
 Valuation of current investments on overall (or global) basis is not
considered appropriate. Sometimes, the concern of an enterprise may be
with the value of a category of related current investments and not with each
individual investment, and accordingly the investments may be carried at the
lower of cost and fair value computed categorywise (i.e. equity shares,
preference shares, convertible debentures, etc.). However, the more prudent
and appropriate method is to carry investments individually at the lower of
cost and fairvalue.
 For current investments, any reduction to fair value and any reversals of
such reductions are included in the profit and lossstatement.
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Long-term Investments
 Long-term investments are usually carried at cost. However, when there is a
decline, other than temporary, in the value of a long term investment, the
carrying amount is reduced to recognise thedecline.
 Indicators of the value of an investment are obtained by reference to its
market value, the investee’s assets and results and the expected cash flows
from the investment. The type and extent of the investor’s stake in the
investee are also taken into account. Restrictions on distributions by the
investee or on disposal by the investor may affect the value attributed to the
investment.
 Long-term investments are usually of individual importance to the investing
enterprise. The carrying amount of long-term investments is therefore
determined on an individual investmentbasis.
 Where there is a decline, other than temporary, in the carrying amounts of
long term investments, the resultant reduction in the carrying amount is
charged to the profit and loss statement. The reduction in carrying amount is
reversed when there is a rise in the value of the investment, or if the reasons
for the reduction no longerexist.
Investment Properties
The cost of any shares in a co-operative society or a company, the holding of
which is directly related to the right to hold the investment property, is added to the
carrying amount of the investment property.
Disposal of Investments
 On disposal of an investment, the difference between thecarrying
 amount and the disposal proceeds, net of expenses, is recognised in the
profit and lossstatement.
 When disposing of a part of the holding of an individual investment, the
carrying amount to be allocated to that part is to be determined on the basis
of the average carrying amount of the total holding of theinvestment.
 In respect of shares, debentures and other securities held as stock-in-trade,
the cost of stocks disposed of is determined by applying an appropriate cost
formula (e.g. first-in, first-out, average cost, etc.). These cost formulae are
the same as those specified in Accounting Standard (AS) 2, in respect of
Valuation ofInventories.
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Reclassification of Investments
Where long-term investments are reclassified as current investments,
transfers are made at the lower of cost and carrying amount at the date oftransfer.
Disclosure
The following disclosures in financial statements in relation to investments are
appropriate:—
(a) the accounting policies for the determination of carrying amount of
investments;
(b) the amounts included in profit and loss statementfor:
(i) interest, dividends (showing separately dividends from subsidiary
companies), and rentals on investments showing separately such
income from long term and current investments. Gross income should
be stated, the amount of income tax deducted at source being included
under AdvanceTaxes
1. Paid;
(ii) profits and losses on disposal of current investments and changes in
carrying amount of suchinvestments;
(iii) profits and losses on disposal of long term investments and changes in
the carrying amount of suchinvestments;
(c) significant restrictions on the right of ownership, realisability of
investments or the remittance of income and proceeds ofdisposal;
(d) the aggregate amount of quoted and unquoted investments, giving the
aggregate market value of quotedinvestments;
(e) other disclosures as specifically required by the relevant statute governing
theenterprise.
Main Principles
Classification of Investments
An enterprise should disclose current investments and long term investments
distinctly in its financial statements.
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.Further classification of current and long-term investments should be as specified
in the statute governing the enterprise. In the absence of a statutory requirement,
such further classification should disclose, where applicable, investments in:
(a) Government or Trustsecurities
(b) Shares, debentures orbonds
(c) Investmentproperties
(d) Others—specifyingnature.
Cost of Investments
The cost of an investment should include acquisition charges such as
brokerage, fees and duties.
If an investment is acquired, or partly acquired, by the issue of shares or
other securities, the acquisition cost should be the fair value of the securities issued
(which in appropriate cases may be indicated by the issue price as determined by
statutory authorities). The fair value may not necessarily be equal to the nominal or
par value of the securities issued. If an investment is acquired in exchange for
another asset, the acquisition cost of the investment should be determined by
reference to the fair value of the asset given up. Alternatively, the acquisition cost
of the investment may be determined with reference to the fair value of the
investment acquired if it is more clearly evident.
Investment Properties
An enterprise holding investment properties should account for them as long
term investments.
Carrying Amount of Investments
Investments classified as current investments should be carried in the
financial statements at the lower of cost and fair value determined either on an
individual investment basis or by category of investment, but not on an overall (or
global) basis.
Investments classified as long term investments should be carried in the
financial statements at cost. However, provision for diminution shall be made to
recognise a decline, other than temporary, in the value of the investments, such
reduction being determined and made for each investment individually.
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Changes in Carrying Amounts of Investments
Any reduction in the carrying amount and any reversals of such reductions
should be charged or credited to the profit and loss statement.
Disposal of Investments
On disposal of an investment, the difference between the carrying amount
and net disposal proceeds should be charged or credited to the profit and loss
statement.
Disclosure
(a) the accounting policies for determination of carrying amount ofinvestments;
(b) classification of investments as specified in paragraphs 26 and 27above;
(c) the amounts included in profit and loss statementfor:
(i) interest, dividends (showing separately dividends from subsidiary companies),
and rentals on investments showing separately such income from long term and
current investments. Gross income should be stated, the amount of income tax
deducted at source being included underAdvance
Taxes Paid;
(iii) profits and losses on disposal of current investments and changes in
the carrying amount of such investments;and
(iv) profits and losses on disposal of long term investments and changes in
the carrying amount of suchinvestments;
(d) significant restrictions on the right of ownership, realisability of investments or
the remittance of income and proceeds ofdisposal;
(e) the aggregate amount of quoted and unquoted investments, giving the aggregate
market value of quotedinvestments;
(f) other disclosures as specifically required by the relevant statute governing the
enterprise.
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CASH FLOW STATEMENT
What Is a Cash Flow Statement?
The statement of cash flows, or the cash flow statement, is a financial
statement that summarizes the amount of cash and cash equivalents entering and
leaving a company.
The cash flow statement (CFS) measures how well a company manages its
cash position, meaning how well the company generates cash to pay its debt
obligations and fund its operating expenses. The cash flow statement complements
the balance sheet and income statement and is a mandatory part of a company's
financial reports since 1987.
How to Use a Cash Flow Statement
The CFS allows investors to understand how a company's operations are
running, where its money is coming from, and how money is being spent. The CFS
is important since it helps investors determine whether a company is on a solid
financialfooting.
Creditors, on the other hand, can use the CFS to determine how much cash is
available (referred to as liquidity) for the company to fund its operating expenses
and pay itsdebts.
KEY TAKEAWAYS
1. A cash flow statement is a financial statement that summarizes the amount
of cash and cash equivalents entering and leaving acompany.
2. The cash flow statement measures how well a company manages its cash
position, meaning how well the company generates cash to pay its debt
obligations and fund its operatingexpenses.
3. The cash flow statement complements the balance sheet and income
statement and is a mandatory part of a company's financial reports since
1987.
The Structure of the CFS
The main components of the cash flow statement are:
 Cash from operatingactivities
 Cash from investingactivities
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 Cash from financingactivities
Disclosure of noncash activities is sometimes included when prepared under the
generally accepted accounting principles, or GAAP
It's important to note that the CFS is distinct from the income statement and
balance sheet because it does not include the amount of future incoming and
outgoing cash that has been recorded on credit. Therefore, cash is not the same as
net income, which on the income statement and balance sheet, includes cash sales
and sales made on credit.
Operating Activities
The operating activities on the CFS include any sources and uses of cash
from business activities. In other words, it reflects how much cash is generated
from a company's products or services.
Generally, changes made in cash, accounts receivable, depreciation,
inventory, and accounts payable are reflected in cash from operations.
These operating activities might include:
 Receipts from sales of goods andservices
 Interestpayments
 Income taxpayments
 Payments made to suppliers of goods and services used inproduction
 Salary and wage payments toemployees
 Rentpayments
 Any other type of operatingexpenses
In the case of a trading portfolio or an investment company, receipts from the
sale of loans, debt, or equity instruments are also included. When preparing a cash
flow statement under the indirect method, depreciation, amortization, deferred tax,
gains or losses associated with a noncurrent asset, and dividends or revenue
received from certain investing activities are also included. However, purchases or
sales of long-term assets are not included in operating activities.
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How Cash Flow Is Calculated
Cash flow is calculated by making certain adjustments to net income by
adding or subtracting differences in revenue, expenses, and credit transactions
(appearing on the balance sheet and income statement) resulting from transactions
that occur from one period to the next. These adjustments are made because non-
cash items are calculated into net income (income statement) and total assets and
liabilities (balance sheet). So, because not all transactions involve actual cash
items, many items have to be re-evaluated when calculating cash flow from
operations.
As a result, there are two methods of calculating cash flow, the direct
method, and the indirect method.
Direct Cash Flow Method
The direct method adds up all the various types of cash payments and
receipts, including cash paid to suppliers, cash receipts from customers and cash
paid out in salaries. These figures are calculated by using the beginning and ending
balances of a variety of business accounts and examining the net decrease or
increase in the accounts.
Indirect Cash Flow Method
With the indirect method, cash flow from operating activities is calculated
by first taking the net income off of a company's income statement. Because a
company’s income statement is prepared on an accrual basis, revenue is only
recognized when it is earned and not when it is received. Net income is not an
accurate representation of net cash flow from operating activities, so it becomes
necessary to adjust earnings before interest and taxes (EBIT) for items that affect
net income, even though no actual cash has yet been received or paid against them.
The indirect method also makes adjustments to add back non-operating activities
that do not affect a company's operating cashflow.
For example, depreciation is not really a cash expense; it is an amount that is
deducted from the total value of an asset that has previously been accounted for.
That is why it is added back into net sales for calculating cash flow.
The only time income from an asset is accounted for in CFS calculations is when
the asset is sold.
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Accounts Receivable and Cash Flow
Changes in accounts receivable (AR) on the balance sheet from one
accounting period to the next must also be reflected in cash flow. If accounts
receivable decreases, this implies that more cash has entered the company from
customers paying off their credit accounts—the amount by which AR has
decreased is then added to net sales. If accounts receivable increases from one
accounting period to the next, the amount of the increase must be deducted from
net sales because, although the amounts represented in AR are revenue, they are
notcash.
Inventory Value and Cash Flow
An increase in inventory, on the other hand, signals that a company has
spent more money to purchase more raw materials. If the inventory was paid with
cash, the increase in the value of inventory is deducted from net sales. A decrease
in inventory would be added to net sales. If inventory was purchased on credit, an
increase in accounts payable would occur on the balance sheet, and the amount of
the increase from one year to the other would be added to netsales.
The same logic holds true for taxes payable, salaries payable, and prepaid
insurance. If something has been paid off, then the difference in the value owed
from one year to the next has to be subtracted from net income. If there is an
amount that is still owed, then any differences will have to be added to net
earnings.
Investing Activities and Cash Flow
Investing activities include any sources and uses of cash from a company's
investments. A purchase or sale of an asset, loans made to vendors or received
from customers or any payments related to a merger or acquisition is included in
this category. In short, changes in equipment, assets, or investments relate to cash
frominvesting.
Usually, cash changes from investing are a "cash out" item, because cash is
used to buy new equipment, buildings, or short-term assets such as marketable
securities. However, when a company divests an asset, the transaction is
considered "cash in" for calculating cash frominvesting.
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Cash From Financing Activities
Cash from financing activities include the sources of cash from investors or
banks, as well as the uses of cash paid to shareholders. Payment of dividends,
payments for stock repurchases and the repayment of debt principal (loans) are
included in this category.
Changes in cash from financing are "cash in" when capital is raised, and
they're "cash out" when dividends are paid. Thus, if a company issues a bond to the
public, the company receives cash financing; however, when interest is paid to
bondholders, the company is reducing its cash.
Analyzing an Example of a CFS
Below is an example of a cash flow statement:
Cash flow statement example
From this CFS, we can see that the cash flow for FY 2017 was $1,522,000.
The bulk of the positive cash flow stems from cash earned from operations, which
is a good sign for investors. It means that core operations are generating business
and that there is enough money to buy new inventory. The purchasing of new
equipment shows that the company has the cash to invest in inventory for growth.
Finally, the amount of cash available to the company should ease investors' minds
regarding the notes payable, as cash is plentiful to cover that future loan expense.
Negative Cash Flow Statements
Of course, not all cash flow statements look this healthy or exhibit a positive
cash flow, but negative cash flow should not automatically raise a red flag without
further analysis. Sometimes, negative cash flow is the result of a company's
decision to expand its business at a certain point in time, which would be a good
thing for the future. This is why analyzing changes in cash flow from one period to
the next gives the investor a better idea of how the company is performing, and
whether or not a company may be on the brink of bankruptcy or success.
Balance Sheet and Income Statement
As we have already discussed, the cash flow statement is derived from the income
statement and the balance sheet. Net earnings from the income statement are the
figure from which the information on the CFS is deduced. As for the balance sheet,
the net cash flow in the CFS from one year to the next should equal the increaseor
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decrease of cash between the two consecutive balance sheets that apply to the
period that the cash flow statement covers. (For example, if you are calculating
cash flow for the year 2019, the balance sheets from the years 2018 and 2019
should be used.)
Conclusion
A cash flow statement is a valuable measure of strength, profitability, and of
the long-term future outlook for a company. The CFS can help determine whether
a company has enough liquidity or cash to pay its expenses. A company can use a
cash flow statement to predict future cash flow, which helps with matters of
budgeting.
For investors, the cash flow statement reflects a company's financial health
since typically the more cash that's available for business operations, the better.
However, this is not a hard and fast rule. Sometimes a negative cash flow results
from a company's growth strategy in the form of expanding its operations.
By studying the cash flow statement, an investor can get a clear picture of
how much cash a company generates and gain a solid understanding of the
financial well being of acompany.
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FUND FLOW STATEMENT
What is a Fund Flow?
Fund flow is the net of all cash inflows and outflows in and out of various
financial assets. Fund flow is usually measured on a monthly or quarterly basis; the
performance of an asset or fund is not taken into account, only share redemptions,
or outflows, and share purchases, or inflows. Net inflows create excess cash for
managers to invest, which theoretically creates demand for securities such as
stocks andbonds.
BREAKING DOWN Fund Flow
Investors and market analysts watch fund flows to gauge investor sentiment
within specific asset classes, sectors or the market as a whole. For instance, if net
fund flows for bond funds during a given month are negative by a large amount,
this signals broad-based pessimism over the fixed-income markets.
A fund flow focuses on the movement of cash only, reflecting the net
movement after examining inflows and outflows of monetary funds. These
movements can include payments to investors or payments made to the company
in exchange for goods andservices.
The fund flow does not include any funds due to be paid but have not yet
been paid. This includes arrangements where a debtor is scheduled to pay a certain
amount per a completed contract, but the payment has not been received and the
obligations on the part of the company have not been settled.
Fund Flow Statements
A fund flow statement is a disclosure of the types of inflows and outflows
the company has experienced. It is a forum in which to provide information
regarding any fund flow activity that might be out of the ordinary, such as a
higher-than-expected outflow due to an irregular expense. Further, it often
categorizes the various transaction types and sources to help track any activity
changes.
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Fund Flow Changes
If the fund flow changes, it often reflects a change in customer sentiment.
This can be related to new product releases or improvements, recent news
regarding the company or shifts in feelings on the industry as a whole. Positive
fund flow changes note an upswing in inflow, a lessening of outflow or a
combination of the two. In contrast, negative fund flow suggests lower inflows,
higher outflows orboth.
While occasional shifts may not be indicative of issues within the company,
prolonged negative fund flows can be a sign there are some issues present, as this
is a reflection of income not being sufficient to meet the company’s expenses. If
this trend continues, it could mean the company needs to acquire a form of debt to
continueoperations.
Example of Fund Flows
A roaring bull market attracted investors from the sidelines into the fray in the
early part of 2018, as was evidenced by the direction of fund flows. Investors
poured $58 billion into mutual funds and exchange-traded funds (ETFs) in the four
weeks ended Jan. 17, the fastest pace of all time. Passively managed equity ETFs
recorded $38.2 billion in outflows for the first several weeks of January, while a
net four-year peak of $5.6 billion flowed into mutual funds, suggesting a return of
positive sentiment toward active management after years of outflows as managers
underperformed the market but expected higher fees than passivemanagement.
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FINANCIAL STATEMENT ANALYSIS
What Is Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company's financial
statements for decision-making purposes. External stakeholders use it to
understand the overall health of an organization as well as to evaluate financial
performance and business value. Internal constituents use it as a monitoring tool
for managing thefinances.
Financial Statement Analysis
 The financial statements of a company record important financial data on
every aspect of a business’s activities. As such they can be evaluated on the
basis of past, current, and projectedperformance.
 In general, financial statements are centered around generally accepted
accounting principles (GAAP) in the U.S. These principles require a
company to create and maintain three main financial statements: the balance
sheet, the income statement, and the cash flow statement. Public companies
have stricter standards for financial statement reporting. Public companies
must follow GAAP standards which requires accrual accounting. Private
companies have greater flexibility in their financial statement preparation
and also have the option to use either accrual or cashaccounting.
 Several techniques are commonly used as part of financial statement
analysis. Three of the most important techniques include horizontal
analysis, vertical analysis, and ratio analysis. Horizontal analysis compares
data horizontally, by analyzing values of line items across two or more
years. Vertical analysis looks at the vertical affects line items have on other
parts of the business and also the business’s proportions. Ratio analysis uses
important ratio metrics to calculate statisticalrelationships.
Financial Statements
As mentioned, there are three main financial statements that every company
creates and monitors: the balance sheet, income statement, and cash flow
statement. Companies use these financial statements to manage the operations of
their business and also to provide reporting transparency to their stakeholders. All
three statements are interconnected and create different views of a company’s
activities andperformance.
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Balance Sheet
The balance sheet is a report of a company's financial worth in terms of book
value. It is broken into three parts to include a company’s assets, liabilities,
and shareholders' equity. Short-term assets such as cash and accounts receivable
can tell a lot about a company’s operational efficiency. Liabilities include its
expense arrangements and the debt capital it is paying off. Shareholder’s equity
includes details on equity capital investments and retained earnings from periodic
net income. The balance sheet must balance with assets minus liabilities equaling
shareholder’s equity. The resulting shareholder’s equity is considered a company’s
book value. This value is an important performance metric that increases or
decreases with the financial activities of acompany.
Income Statement
The income statement breaks down the revenue a company earns against the
expenses involved in its business to provide a bottom line, net income profit or
loss. The income statement is broken into three parts which help to analyze
business efficiency at three different points. It begins with revenue and the direct
costs associated with revenue to identify gross profit. It then moves to operating
profit which subtracts indirect expenses such as marketing costs, general costs, and
depreciation. Finally it ends with net profit which deducts interest andtaxes.
Basic analysis of the income statement usually involves the calculation of
gross profit margin, operating profit margin, and net profit margin which each
divide profit by revenue. Profit margin helps to show where company costs are low
or high at different points of the operations.
Cash Flow Statement
The cash flow statement provides an overview of the company's cash flows
from operating activities, investing activities, and financing activities. Net income
is carried over to the cash flow statement where it is included as the top line item
for operating activities. Like its title, investing activities include cash flows
involved with firm wide investments. The financing activities section includes cash
flow from both debt and equity financing. The bottom line shows how much cash a
company has available.
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Free Cash Flow and Other Valuation Statements
Companies and analysts also use free cash flow statements and other valuation
statements to analyze the value of a company. Free cash flow statements arrive at a
net present value by discounting the free cash flow a company is estimated to
generate over time. Private companies may keep a valuation statement as they
progress toward potentially going public.
KEY TAKEAWAYS
 Financial statement analysis is used by internal and external stakeholders to
evaluate business performance andvalue.
 Financial accounting calls for all companies to create a balance sheet,
income statement, and cash flow statement which form the basis for
financial statementanalysis.
 Horizontal, vertical, and ratio analysis are three techniques analystsuse when
analyzing financialstatements.
Financial Performance
Financial statements are maintained by companies daily and used internally
for business management. In general both internal and external stakeholders use
the same corporate finance methodologies for maintaining business activities and
evaluating overall financial performance.
When doing comprehensive financial statement analysis, analysts typically
use multiple years of data to facilitate horizontal analysis. Each financial statement
is also analyzed with vertical analysis to understand how different categories of the
statement are influencing results. Finally ratio analysis can be used to isolate some
performance metrics in each statement and also bring together data points across
statements collectively.
Below is a breakdown of some of the most common ratio metrics:
Balance sheet: asset turnover, quick ratio, receivables turnover, days to sales, debt
to assets, and debt to equity
Income statement: gross profit margin, operating profit margin, net profit margin,
tax ratio efficiency, and interest coverage
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Cash Flow: Cash and earnings before interest, taxes, depreciation, and
amortization (EBITDA). These metrics may be shown on a per sharebasis.
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RATIO ANALYSIS
What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company's
liquidity, operational efficiency, and profitability by comparing information
contained in its financial statements. Ratio analysis is a cornerstone of fundamental
analysis.
Outside analysts use several types of ratios to assess companies, while
corporate insiders rely on them less because of their access to more detailed
operational data about a company.
Ratio Analysis
What Does Ratio Analysis Tell You?
When investors and analysts talk about fundamental or quantitative analysis,
they are usually referring to ratio analysis. Ratio analysis involves evaluating the
performance and financial health of a company by using data from the current and
historical financial statements.
The data retrieved from the statements is used to compare a company's
performance over time to assess whether the company is improving or
deteriorating, to compare a company's financial standing with the industry average,
or to compare a company to one or more other companies operating in its sector to
see how the company stacks up.
Ratio analysis can be used to establish a trend line for one company's results
over a large number of financial reporting periods. This can highlight company
changes that would not be evident if looking at a given ratio that represents just
one point intime.
Comparing a company to its peers or its industry averages is another useful
application for ratio analysis. Calculating one ratio for competitors in a given
industry and comparing across the set of companies can reveal both positive and
negative information.
Since companies in the same industry typically have similar capital
structures and investment in fixed assets, their ratios should be substantially the
same. Different ratio results could mean that one firm has a potential issue and is
underperforming the competition, but they could also mean that a certaincompany
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is much better at generating profits than its peers. Many analysts use ratios to
review sectors, looking for the most and least valuable companies in the group.
KEY TAKEAWAYS
 Ratio analysis compares line-item data from a company's financial
statements to reveal insights regarding profitability, liquidity, operational
efficiency, andsolvency.
 Ratio analysis can be used to look at trends over time for one company or to
compare companies within an industry orsector.
 While ratios offer several types of insight, other types of information and
analysis are usually needed to form a complete picture of a company's
financialposition.
Examples of Ratio AnalysisCategories
Most investors are familiar with a few key ratios, particularly the ones that are
relatively easy to calculate and interpret. Some of these ratios include the current
ratio, return on equity (ROE), the debt-equity (D/E) ratio, the dividend payout
ratio, and the price/earnings (P/E) ratio. While there are numerous financial ratios,
they can be categorized into six main groups based on the type of analysis they
provide.
1. LiquidityRatios
Liquidity ratios measure a company's ability to pay off its short-term debts as they
come due using the company's current or quick assets. Liquidity ratios include the
current ratio, quick ratio, and working capital ratio.
2. SolvencyRatios
Also called financial leverage ratios, solvency ratios compare a company's debt
levels with its assets, equity, and earnings to evaluate whether a company can stay
afloat in the long-term by paying its long-term debt and interest on the debt.
Examples of solvency ratios include debt-equity ratio, debt-assets ratio, and
interest coverageratio.
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3. ProfitabilityRatios
These ratios show how well a company can generate profits from its operations.
Profit margin, return on assets, return on equity, return on capital employed, and
gross margin ratio are all examples of profitability ratios.
4. EfficiencyRatios
Also called activity ratios, efficiency ratios evaluate how well a company uses its
assets and liabilities to generate sales and maximize profits. Key efficiency ratios
are the asset turnover ratio, inventory turnover, and days' sales in inventory.
5. CoverageRatios
These ratios measure a company's ability to make the interest payments and other
obligations associated with its debts. The times interest earned ratio and
the debt-service coverage ratio are both examples of coverageratios.
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis and
include dividend yield, P/E ratio, earnings per share, and dividend payout ratio.
Investors use these ratios to determine what they may receive in earnings from
their investments and to predict what the trend of a stock will be in thefuture.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20,
with the majority of companies having a P/E between 15 and 25, a stock with a P/E
ratio of 7 would be considered undervalued, while one with a P/E of 50 would be
considered overvalued. The former may trend upwards in the future, while the
latter will trend downwards until it matches with its intrinsicvalue.
Examples of Ratio Analysis in Use
 Ratio analysis can provide an early warning of potential improvement or
deterioration in a company’s financial situation or performance. Analysts
engage in extensive number-crunching of the financial data in a company’s
quarterly financial reports for any suchhints.
 Successful companies generally have solid ratios in all areas, and any hints
of weakness in one area may spark a significant sell-off of the stock. Certain
ratios are closely scrutinized because of their relevance to a certain sector,
such as inventory turnover for the retail sector and days sales outstanding
(DSOs) for technologycompanies.
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 Using any ratio in any of the categories listed above should only be
considered as a starting point. Further analysis using additional ratios and
qualitative analysis should be incorporated to effectively analyze a
company's overall financialposition.
 Ratios are usually only comparable across companies in the same sector,
since an acceptable ratio in one industry may be regarded as too high to too
low in another. For example, companies in sectors such as utilities typically
have a high debt-equity ratio which is normal for its industry, while a similar
ratio for a technology company may be regarded as unsustainablyhigh.
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ACCOUNTING FOR SHARE CAPITAL TRANSACTIONS
INCLUDING BONUS SHARES, RIGHT SHARES
IFRS provides insufficient guidance regarding the actual accounting for
share capital transactions, including the issuance of shares of various classes of
equity instruments. This post offers suggestions concerning the accounting for such
transactions, which are within the spirit of IFRS, although largely drawn from
other authoritative sources (particularly the U.S. GAAP which is widely adopted in
many other countries). This is I made, however, to illustrate a wide array of actual
transactions that often need to be accountedfor.
Preferred Shares
1. Ownership interest in a corporation is made up of common and, optionally,
preferred shares. The common shares represent the residual risk-taking
ownership of the corporation after the satisfaction of all claims of creditors
and senior classes of equity. It is important that the actual common
ownership be accurately identified, since the computation of earnings per
share requires that the ultimate residual ownership class be properly
associated with that calculation, regardless of what the various equity classes
are nominallycalled.
2. Preferred shareholders are owners who have certain rights superior to those
of common shareholders. These rights will pertain either to the earnings or
the assets of thecorporation.
3. Preferences as to earnings exist when the preferred shareholders have a
stipulated dividend rate (expressed either as a dollar amount or as a
percentage of the preferred share’s par or stated value). Preferences as to
assets exist when the preferred shares have a stipulated liquidation value. If a
corporation were to liquidate, the preferred holders would be paid a specific
amount before the common shareholders would have a right to participate in
any of theproceeds
4. In practice, preferred shares are more likely to have preferences as to
earnings than as to assets. Some classes of preferred shares may have both
preferential rights, although this is rarelyencountered.
5. Preferred shares may also have the following features: participation in
earnings beyond the stipulated dividend rate; a cumulative feature, affording
the preferred shareholders the protection that their dividends in arrears, if
any, will be fully satisfied before the common shareholders participatein
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any earnings distribution; and convertibility or callability by the corporation.
Whatever preferences exist must be disclosed adequately in the financial
statements, either in the statement of financial position or in the notes.
6. In exchange for the preferences, the preferred shareholders’ rights or
privileges are limited. For instance, the right to vote may be limited to
common shareholders. The most important right denied to the preferred
shareholders, however, is the right to participate without limitation in the
earnings of the corporation. Thus, if the corporation has exceedingly large
earnings for a particular period, these earnings would accrue to the benefit of
the commonshareholders.
7. That is true even if the preferred shares are participating (itself a fairly
uncommon feature) because even participating preferred shares usually have
some upper limitation placed on its degree of participation. For example,
preferred may have a 5% cumulative dividend with a further 3%
participation right, so in any one year the limit would be an 8% return to the
preferred shareholders (plus, if applicable, the 5% per year prior year
dividends notpaid).
8. Occasionally, several classes of share capital will be categorized as common
(e.g., Class A common, Class B common, etc.). Since there can be only one
class of shares that constitutes the true residual risk-taking equity interest in
a corporation, it is clear that the other classes, even though described as
common shares, must in fact have some preferentialstatus.
9. Not uncommonly, these preferences relate to voting rights, as when a control
group holds common shares with “super voting” rights (e.g., ten votes per
share). The rights and responsibilities of each class of shareholder, even if
described as common, must be fully disclosed in the financialstatements.
Accounting For The Issuance Of Shares
The accounting for the sale of shares by a corporation depends on whether
the share capital has a par or stated value. If there is a par or stated value, the
amount of the proceeds representing the aggregate par or stated value is credited to
the common or preferred share capital account
The aggregate par or stated value is generally defined as legal capital not
subject to distribution to shareholders. Proceeds in excess of par or stated value are
credited to an additional contributed capital account. The additional contributed
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capital represents the amount in excess of the legal capital that may, under certain
defined conditions, be distributed to shareholders.
A corporation selling shares below par value credits the share capital
account for the par value and debits an offsetting discount account for the
difference between par value and the amount actuallyreceived.
If there is a discount on original issue of share capital, it serves to notify the
actual and potential creditors of the contingent liability of those investors. As a
practical matter, corporations avoided this problem by reducing par values to an
arbitrarily low amount. This reduction in par eliminated the chance that shares
would be sold for amounts below par. Where corporation laws make no distinction
between par value and amounts in excess of par, the entire proceeds from the sale
of shares may be credited to the common share capital account without distinction
between the share capital and the additional contributed capital accounts. The
following entries illustrate these concepts:
Dharma Corporation sells 100,000 shares of $5 par common share for $8 per
share cash.
[Debit]. Cash = 800,000
[Credit]. Common share = 500,000
[Credit]. Additional contributed capital = 300,000
Dharma Corporation sells 100,000 shares of no-par common share for $8 per
share cash.
[Debit]. Cash = 800,000
[Credit]. Common share = 800,000
Preferred shares will often be assigned a par value because in many cases the
preferential dividend rate is defined as a percentage of par value (e.g., 5%, $25 par
value preferred share will have a required annual dividend of $1.25). The dividend
can also be defined as a euro amount per year, thereby obviating the need for par
values.
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Share Capital Issued For Services
If the shares in a corporation are issued in exchange for services or property
rather than for cash, the transaction should be reflected at the fair value of the
property or services received. If this information is not readily available, the
transaction should be recorded at the fair value of the shares that were issued.
Where necessary, appraisals should be obtained to properly reflect the transaction.
As a final resort, a valuation by the board of directors of the shares issued
can be utilized. Shares issued to employees as compensation for services rendered
should be accounted for at the fair value of the services performed, if determinable,
or the value of the sharesissued.
Occasionally, particularly for start-up operations having limited working
capital, the controlling owners may directly compensate certain vendors or
employees. If shares are given by a major shareholder directly to an employee for
services performed for the entity, this exchange should be accounted for as a
capital contribution to the company by the major shareholder and as compensation
expense incurred by the company. Only when accounted for in this manner will
there be conformity with the general principle that all costs incurred by an entity,
including compensation, should be reflected in its financialstatements.
Issuance Of Share Units

In certain instances, common and preferred shares may be issued to
investors as a unit (e.g., a unit of one share of preferred and two shares of common
can be sold as a package). Where both of the classes of shares are publicly traded,
the proceeds from a unit offering should be allocated in proportion to the relative
market values of thesecurities.
If only one of the securities is publicly traded, the proceeds should be
allocated to the one that is publicly traded based on its known market value. Any
excess is allocated to the other. Where the market value of neither security is
known, appraisal information might be used.
The imputed fair value of one class of security, particularly the preferred
shares, can be based on the stipulated dividend rate. In this case, the amount of
proceeds remaining after the imputing of a value of the preferred shares would be
allocated to the common shares.
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The foregoing procedures would also apply if a unit offering were made of
an equity and a nonequity security such as convertible debentures, or of shares and
rights to purchase additional shares for a fixed time period.
Accounting For Share Subscriptions
Occasionally, particularly in the case of a newly organized corporation, a
contract is entered into between the corporation and prospective investors, whereby
the latter agree to purchase specified numbers of shares to be paid for over some
installment period. These share subscriptions are not the same as actual share
issuances, and the accounting differs accordingly. In some cases, laws of the
jurisdiction of incorporation will govern how subscriptions have to be accounted
for (e.g., when pro rata voting rights and dividend rights accompany partially paid
subscriptions).
The amount of share subscriptions receivable by a corporation is sometimes
treated as an asset in the statement of financial position and is categorized as
current or noncurrent in accordance with the terms of payment. However, most
subscriptions receivable are shown as a reduction of shareholders’ equity in the
same manner as treasury shares. Since subscribed shares do not have the rights and
responsibilities of actual outstanding shares, the credit is made to a shares
subscribed account instead of to the share capital accounts.
If the common shares have par or stated value, the common shares
subscribed account are credited for the aggregate par or stated value of the shares
subscribed. The excess over this amount is credited to additional contributed
capital. No distinction is made between additional contributed capital relating to
shares already issued and shares subscribed for. This treatment follows from the
distinction between legal capital and additional contributed capital. Where there is
no par or stated value, the entire amount of the common share subscribed is
credited to the shares subscribed account.
As the amount due from the prospective shareholders is collected, the share
subscriptions receivable account is credited and the proceeds are debited to the
cash account. Actual issuance of the shares, however, must await the complete
payment of the share subscription. Accordingly, the debit to common share
subscribed is not made until the subscribed shares are fully paid for and the shares
are issued. The following journal entries illustrate theseconcepts:
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1. 10,000 shares of $50 par preferred are subscribed at a price of $65 each; a
10% down payment isreceived.
[Debit]. Cash = 65,000
[Debit]. Share subscriptions receivable = 585,000
[Credit]. Preferred share subscribed = 500,000
[Credit]. Additional contributed capital = 150,000
2. 2,000 shares of no par common shares are subscribed at a price of $85 each,
with one-half received incash.
[Debit]. Cash = 85,000
[Debit]. Share subscriptions receivable = 85,000
[Credit]. Common share subscribed = 170,000
3. All preferred subscriptions are paid, and one-half of the remainingcommon

subscriptions are collected in full and subscribed shares areissued.
[Debit]. Cash [$585,000 + ($85,000 × 0.50)] = 627,500
[Credit]. Shares subscriptions receivable = 627,500
[Debit]. Preferred shares subscribed = 500,000
[Credit]. Preferred share = 500,000
[Debit]. Common shares subscribed = 127,500
[Credit]. Common shares ($170,000 × 0.75) = 127,500
When the company experiences a default by the subscriber, the accounting

will follow the provisions of the jurisdiction in which the corporation is chartered.
In some of these, the subscriber is entitled to a proportionate number of shares
based on the amount already paid on the subscriptions, sometimes reduced by the
cost incurred by the corporation in selling the remaining defaulted shares to other
shareholders.
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In other jurisdictions, the subscriber forfeits the entire investment on default.
In this case the amount already received is credited to an additional contributed
capital account that describes its source.
How To Distinguish Additional Contributed Capital (From The Par Or Stated
Value Of The Shares)?
For largely historical reasons, entities sometimes issue share capital having
par or stated value, which may be only a nominal value, such as $1 or even $0.01.
The actual share issuance will be at a much higher (market driven) amount, and the
excess of the issuance price over the par or stated value might be assigned to a
separate equity account referred to as premium on capital (common) shares or
additional contributed (paid-in) capital.
Generally, but not universally, the distinction between common shares and
additional contributed capital has little legal import, but may be maintained for
financial reporting purposes nonetheless.
Additional contributed capital represents all capital contributed to a corporation
other than that defined as par or stated value. Additional contributed capital can
arise from proceeds received from the sale of common and preferred shares in
excess of their par or stated values. It can also arise from transactions relating to
thefollowing
 Sale of shares previously issued and subsequently reacquired by the
corporation (treasuryshares)
 Retirement of previously outstandingshares
 Payment of share dividends in a manner that justifies the dividend being
recorded at the market value of the sharesdistributed
 Lapse of share purchase warrants or the forfeiture of share subscriptions, if
these result in the retaining by the corporation of any partial proceeds
received prior toforfeiture
 Warrants that are detachable frombonds
 Conversion of convertiblebonds
 Other gains on the company’s own shares, such as that which results from
certain share optionplans
When the amounts are material, the sources of additional contributed capital
should be described in the financialstatements.
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EMPLOYEES STOCK OPTION
What Are Employee Stock Options (ESOs)?

Employee stock options (ESOs) are a type of equity compensation granted
by companies to their employees and executives. Rather than granting shares of
stock directly, the company gives derivative options on the stock instead. These
options come in the form of regular call options and give the employee the right to
buy the company's stock at a specified price for a finite period of time. Terms of
ESOs will be fully spelled out for an employee in an employee stock options
agreement.
In general, the greatest benefits of a stock option are realized if a company's
stock rises above the exercise price. Typically, ESOs are issued by the company
and cannot be sold, unlike standard listed or exchange-traded options. When a
stock’s price rises above the call option exercise price, call options are exercised
and the holder obtains the company’s stock at a discount. The holder may choose
to immediately sell the stock in the open market for a profit or hold onto the stock
overtime.
KEY TAKEAWAYS
 Companies can offer ESOs as part of an equity compensationplan. 
 These grants come in the form of regular call options and give an employee
the right to buy the company’s stock at a specified price for a finite period of
time.
 ESOs can have vesting schedules which limits the ability toexercise. 
 ESOs are taxed at exercise and stockholders will be taxed if they sell their
shares in the openmarket.
Stock options are a benefit often associated with startup companies, which may
issue them in order to reward early employees when and if the company goes
public. They are awarded by some fast-growing companies as an incentive for
employees to work towards growing the value of the company's shares. Stock
options can also serve as an incentive for employees to stay with the company. The
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options are canceled if the employee leaves the company before they vest. ESOs
do not include any dividend or votingrights.
Stock Option
UnderstandingESOs
Corporate benefits for some or all employees may include equity compensation
plans. These plans are known for providing financial compensation in the form of
stock equity. ESOs are just one type of equity compensation a company may offer.
Other types of equity compensation may include:
1. Restricted Stock Grants: these give employees the right to acquire or
receive shares once certain criteria are attained, like working for a defined
number of years or meeting performancetargets.
2. Stock Appreciation Rights (SARs): SARs provide the right to the increase
in the value of a designated number of shares; such increase in value is
payable in cash or companystock.
3. Phantom Stock: this pays a future cash bonus equal to the value of a
defined number of shares; no legal transfer of share ownership usually takes
place, although the phantom stock may be convertible to actual shares if
defined trigger eventsoccur.
4. Employee Stock Purchase Plans: these plans give employees the right to
purchase company shares, usually at adiscount.
In broad terms, the commonality between all these equity compensation plans is
that they give employees and stakeholders an equity incentive to build the
company and share in its growth andsuccess.
For employees, the key benefits of any type of equity compensation plan are:
 An opportunity to share directly in the company’s success through stock
holdings
 Pride of ownership; employees may feel motivated to be fully productive
because they own a stake in thecompany
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 Provides a tangible representation of how much their contribution is worthto
theemployer
 Depending on the plan, it may offer the potential for tax savings upon sale or
disposal of theshares
The benefits of an equity compensation plan to employers are:
 It is a key tool to recruit the best and the brightest in an increasingly
integrated global economy where there is worldwide competition for top
talent
 Boosts employee job satisfaction and financial wellbeing by providing
lucrative financialincentives
 Incentivizes employees to help the company grow and succeed because they
can share in itssuccess
 May be used as a potential exit strategy for owners, in someinstances 
In terms of stock options, there are two main types:
1. Incentive stock options (ISOs), also known as statutory or qualified options,
are generally only offered to key employees and top management. They
receive preferential tax treatment in many cases, as the IRS treats gains on
such options as long-term capitalgains.
2. Non-qualified stock options (NSOs) can be granted to employees at all
levels of a company, as well as to board members and consultants. Also
known as non-statutory stock options, profits on these are considered as
ordinary income and are taxed assuch.
ImportantConcepts
1. There are two key parties in the ESO, the grantee (employee) and grantor
(employer). The grantee—also known as the optionee—can be an executive
or an employee, while the grantor is the company that employs the grantee.
The grantee is given equity compensation in the form of ESOs, usually with
certain restrictions, one of the most important of which is the vestingperiod.
2. The vesting period is the length of time that an employee must wait in order
to be able to exercise their ESOs. Why does the employee need to wait?
Because it gives the employee an incentive to perform well and stay withthe
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company. Vesting follows a pre-determined schedule that is set up by the
company at the time of the option grant.
3. ESOs are considered vested when the employee is allowed to exercise the
options and purchase the company’s stock. Note that the stock may not be
fully vested when purchased with an option in certain cases, despite exercise
of the stock options, as the company may not want to run the risk of
employees making a quick gain (by exercising their options and immediately
selling their shares) and subsequently leaving thecompany.
4. If you have received an options grant, you must carefully go through your
company's stock options plan, as well as the options agreement, to determine
the rights available and restrictions applied to employees. The stock options
plan is drafted by the company’s board of directors and contains details of
the grantee’s rights. The options agreement will provide the key details of
your option grant such as the vesting schedule, how the ESOs will vest,
shares represented by the grant, and the strike price. If you are a key
employee or executive, it may be possible to negotiate certain aspects of the
options agreement, such as a vesting schedule where the shares vest faster,
or a lower exercise price. It may also be worthwhile to discuss the options
agreement with your financial planner or wealth manager before you sign on
the dottedline.
5. ESOs typically vest in chunks over time at predetermined dates, as set out in
the vesting schedule. For example, you may be granted the right to buy
1,000 shares, with the options vesting 25% per year over four years with a
term of 10 years. So 25% of the ESOs, conferring the right to buy 250 shares
would vest in one year from the option grant date, another 25% would vest
two years from the grant date, and soon.
6. If you don’t exercise your 25% vested ESOs after year one, you would have
a cumulative increase in exercisable options. Thus, after year two, you
would now have 50% vested ESOs. If you do not exercise any of ESOs
options in the first four years, you would have 100% of the ESOs vested
after that period, which you can then exercise in full or in part. As
mentioned earlier, we had assumed that the ESOs have a term of 10 years.
This means that after 10 years, you would no longer have the right to buy
shares. Therefore, the ESOs must be exercised before the 10-year period
(counting from the date of the option grant) isup.
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7. Continuing with the above example, let’s say you exercise 25% of the ESOs
when they vest after one year. This means you would get 250 shares of the
company’s stock at the strike price. It should be emphasized that the record
price for the shares is the exercise price or strike price specified in the
options agreement, regardless of the actual market price of thestock.
Reload Option
In some ESO agreements, a company may offer a reload option. A reload option is
a nice provision to take advantage of. With a reload option, an employee can be
granted more ESOs when they exercise currently available ESOs.
ESOs and Taxation
We now arrive at the ESO spread. As will be seen later, this triggers a tax event
whereby ordinary income tax is applied to the spread.
The following points need to be borne in mind with regard to ESO taxation:
 The option grant itself is not a taxable event. The grantee or optionee is not
faced with an immediate tax liability when the options are granted by the
company. Note that usually (but not always), the exercise price of the ESOs
is set at the market price of the company’s stock on the day of the option
grant.
 Taxation begins at the time of exercise. The spread (between the exercise
price and the market price) is also known as the bargain element in tax
parlance, and is taxed at ordinary income tax rates because the IRS considers
it as part of the employee’scompensation.
 The sale of the acquired stock triggers another taxable event. If theemployee
sells the acquired shares for less than or up to one year after exercise, the
transaction would be treated as a short-term capital gain and would be taxed
at ordinary income tax rates. If the acquired shares are sold more than one
year after exercise, it would qualify for the lower capital gains taxrate. 
Let’s demonstrate this with an example. Let’s say you have ESOs with an exercise
price of $25, and with the market price of the stock at $55, wish to exercise 25% of
the 1,000 shares granted to you as per your ESOs.
The record price would be $6,250 for the shares ($25 x 250 shares). Since the
market value of the shares is $13,750, if you promptly sell the acquired shares, you
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would net pre-tax earnings of $7,500. This spread is taxed as ordinary income in
your hands in the year of exercise, even if you do not sell the shares. This aspect
can give rise to the risk of a huge tax liability, if you continue to hold the stock and
it plummets in value.
Let’s recap an important point—why are you taxed at the time of ESO exercise?
The ability to buy shares at a significant discount to the current market price (a
bargain price, in other words) is viewed by the IRS as part of the total
compensation package provided to you by your employer, and is therefore taxed at
your income tax rate. Thus, even if you do not sell the shares acquired pursuant to
your ESO exercise, you trigger a tax liability at the time of exercise.
Example of ESO Spread and Taxation.

Intrinsic Value vs. Time Value forESOs
The value of an option consists of intrinsic value and time value. Time value
depends on the amount of time remaining until expiration (the date when the ESOs
expire) and several other variables. Given that most ESOs have a stated expiration
date of up to 10 years from the date of option grant, their time value can be quite
significant. While time value can be easily calculated for exchange-traded options,
it is more challenging to calculate time value for non-traded options like ESOs,
since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical
pricing model like the well-known Black-Scholes option pricing model to compute
the fair value of your ESOs. You will need to plug inputs such as the exercise
price, time remaining, stock price, risk-free interest rate, and volatility into the
Model in order to get an estimate of the fair value of the ESO. From there, it is a
simple exercise to calculate time value, as can be seen below. Remember that
intrinsic value—which can never be negative—is zero when an option is “at the
money” (ATM) or “out of the money” (OTM); for these options, their entire value
therefore consists only of timevalue.
The exercise of an ESO will capture intrinsic value but usually gives up time value
(assuming there is any left), resulting in a potentially large hidden opportunity cost.
Assume that the calculated fair value of your ESOs is $40, as shown below.
Subtracting intrinsic value of $30 gives your ESOs a time value of $10. If you
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exercise your ESOs in this situation, you would be giving up time value of $10 per
share, or a total of $2,500 based on 250 shares.
Example of Intrinsic Value and Time Value (In the Money ESO).
The value of your ESOs is not static, but will fluctuate over time based on
movements in key inputs such as the price of the underlying stock, time to
expiration, and above all, volatility. Consider a situation where your ESOs are out
of the money (i.e., the market price of the stock is now below the ESOs exercise
price).
Example of Intrinsic Value and Time Value (Out of the Money ESO).
It would be illogical to exercise your ESOs in this scenario for two reasons. Firstly,
it is cheaper to buy the stock in the open market at $20, compared with the exercise
price of $25. Secondly, by exercising your ESOs, you would be relinquishing $15
of time value per share. If you think the stock has bottomed out and wish to acquire
it, it would be much more preferable to simply buy it at $25 and retain your ESOs,
giving you larger upside potential (with some additional risk, since you now own
the shares as well).
Comparisons to Listed Options
The biggest and most obvious difference between ESOs and listed options is that
ESOs are not traded on an exchange, and hence do not have the many benefits of
exchange-traded options.
The Value of Your ESO Is not Easy to Ascertain
Exchange-traded options, especially on the biggest stock, have a great deal of
liquidity and trade frequently, so it is easy to estimate the value of an option
portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because
there is no market price reference point. Many ESOs are granted with a term of 10
years, but there are virtually no options that trade for that length of
time. LEAPs (long-term equity anticipation securities) are among the longest-dated
options available, but even they only go two years out, which would only help if
your ESOs have two years or less to expiration. Option pricing models are
therefore crucial for you to know the value of your ESOs. Your employer is
required—on the options grant date—to specify a theoretical price of your ESOs in
your options agreement. Be sure to request this information from your company,
and also find out how the value of your ESOs has beendetermined.
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Option prices can vary widely, depending on the assumptions made in the input
variables. For example, your employer may make certain assumptions about
expected length of employment and estimated holding period before exercise,
which could shorten the time to expiration. With listed options, on the other hand,
the time to expiration is specified and cannot be arbitrarily changed. Assumptions
about volatility can also have a significant impact on option prices. If your
company assumes lower than normal levels of volatility, your ESOs would be
priced lower. It may be a good idea to get several estimates from other models to
compare them with your company’s valuation of your ESOs.
Specifications Are not Standardized
Listed options have standardized contract terms with regard to number of shares
underlying an option contract, expiration date, etc. This uniformity makes it easyto
trade options on any optionable stock, whether it is Apple or Google orQualcomm.
If you trade a call option contract, for instance, you have the right to buy 199
shares of the underlying stock at the specified strike price until expiration.
Similarly, a put option contract gives you the right to sell 100 shares ofthe
underlying stock until expiration. While ESOs do have similar rights to listed
options, the right to buy stock is not standardized and is spelled out in the options
agreement.
No Automatic Exercise
For all listed options in the U.S., the last day of trading is the third Friday of the
calendar month of the option contract. If the third Friday happens to fall on an
exchange holiday, the expiration date moves up by a day to that Thursday. At the
close of trading on the third Friday, the options associated with that month’s
contract stop trading and are automatically exercised if they are more than $0.01 (1
cent) or more in the money. Thus, if you owned one call option contract and at
expiration, the market price of the underlying stock was higher than the strike price
by one cent or more, you would own 100 shares through the automatic exercise
feature. Likewise, if you owned a put option and at expiration, the market price of
the underlying stock was lower than the strike price by one cent or more, you
would be short 100 shares through the automatic exercise feature. Note that despite
the term "automatic exercise," you still have control over the eventual outcome, by
providing alternate instructions to your broker that take precedence over any
automaticexerciseprocedures,orbyclosingoutthepositionpriorto
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expiration. With ESOs, the exact details about when they expire may differ from
one company to the next. Also, as there is no automatic exercise feature with
ESOs, you have to notify your employer if you wish to exercise youroptions.
Strike Prices
Listed options have standardized strike prices, trading in increments such as $1,
$2.50, $5, or $10, depending on the price of the underlying security (higher priced
stocks have wider increments). With ESOs, since the strike price is typically the
stock's closing price on a particular day, there are no standardized strike prices. In
the mid-2000s, an options backdating scandal in the U.S. resulted in the
resignations of many executives at top firms. This practice involved granting an
option at a previous date instead of the current date, thus setting the strike price at a
lower price than the market price on the grant date and giving an instant gain to the
option holder. Options backdating has become much more difficult since the
introduction of Sarbanes-Oxley as companies are now required to report option
grants to the SEC within two business days.1
Vesting and Acquired Stock Restrictions
Vesting gives rise to control issues that are not present in listed options. ESOs may
require the employee to attain a level of seniority or meet certain performance
targets before they vest. If the vesting criteria are not crystal clear, it may create a
murky legal situation, especially if relations sour between the employee and
employer. As well, with listed options, once you exercise your calls and obtain the
stock you can dispose of it as soon as you wish without any restrictions. However,
with acquired stock through an exercise of ESOs, there may be restrictions that
prevent you from selling the stock. Even if your ESOs have vested and you can
exercise them, the acquired stock may not be vested. This can pose a dilemma,
since you may have already paid tax on the ESO Spread (as discussed earlier) and
now hold a stock that you cannot sell (or that is declining).
Counterparty Risk
As scores of employees discovered in the aftermath of the 1990s dot-com
bust when numerous technology companies went bankrupt, counterparty risk is a
valid issue that is hardly ever considered by those who receive ESOs. With listed
options in the U.S, the Options Clearing Corporation serves as the clearinghouse
for options contracts and guarantees their performance. 2 Thus, there is zero risk
thatthecounterpartytoyouroptionstradewillbeunabletofulfilltheobligations
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imposed by the options contract. But as the counterparty to your ESOs is your
company, with no intermediary in between, it would be prudent to monitor its
financial situation to ensure that you are not left holding valueless unexercised
options, or even worse, worthless acquired stock.
Concentration Risk
You can assemble a diversified options portfolio using listed options but
with ESOs, you have concentration risk, since all your options have the same
underlying stock. In addition to your ESOs, if you also have a significant amount
of company stock in your employee stock ownership plan (ESOP), you may
unwittingly have too much exposure to your company, a concentration risk that has
been highlighted byFINRA.3
Valuation and Pricing Issues
The main determinants of an option's value are: volatility, time to expiration,
the risk free rate of interest, strike price, and the underlying stock’s price.
Understanding the interplay of these variables–especially volatility and time to
expiration–is crucial for making informed decisions about the value of your ESOs.
In the following example, we assume an ESO giving the right (when vested)
to buy 1,000 shares of the company at a strike price of $50, which is the stock's
closing price on the day of the option grant (making this an at-the-money option
upon grant). The first table below uses the Black-Scholes option pricing model to
isolate the impact of time decay while keeping volatility constant, while the second
illustrates the impact of higher volatility on option prices. (You can generate option
prices yourself using this nifty options calculator at the CBOE website). 4
As can be seen, the greater the time to expiration, the more the option is worth.
Since we assume this is an at-the-money option, its entire value consists of time
value. The first table demonstrates two fundamental options pricing principles:
1. Time value is a very important component of options pricing. If you are
awarded at-the-money ESOs with a term of 10 years, their intrinsic value is
zero, but they have a substantial amount of time value, $23.08 per option in
this case, or over $23,000 for ESOs that give you the right to buy 1,000
shares.
2. Option time decay is not linear in nature. The value of options declines as
the expiration date approaches, a phenomenon known as time decay, butthis
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time decay is not linear in nature and accelerates close to option expiry. An
option that is far out-of-the-money will decay faster than an option that is at
the money, because the probability of the former being profitable is much
lower than that of the latter.
Valuation of an ESO, assuming at-the-money, while varying time remaining
(assumes non-dividend paying stock)
Below shows option prices based on the same assumptions, except that volatility is
assumed to be 60% rather than 30%. This increase in volatility has a significant
effect on option prices. For example, with 10 years remaining to expiration, the
price of the ESO increases 53% to $35.34, while with two years remaining, the
price increases 80% to $17.45. Further on shows option prices in graphical form
for the same time remaining to expiration, at 30% and 60% volatilitylevels.
Similar results are obtained by changing the variables to levels that prevail at
present. With volatility at 10% and the risk free interest rate at 2%,
the ESOs would be priced at $11.36, $7.04, $5.01 and $3.86 with time to
expiration at 10, five, three, and two yearsrespectively.
Valuation of an ESO, assuming at-the-money, while varying volatility

(assumes non-dividend paying stock).
The key takeaway from this section is that merely because your ESOs have no
intrinsic value, do not make the naive assumption that they are worthless. Because
of their lengthy time to expiration compared to listed options, ESOs have a
significant amount of time value that should not be frittered away through early
exercise.
Risk and Reward Associated with Owning ESOs
Early or Premature Exercise
 As a way to reduce risk and lock in gains, early or premature exercise of
ESOs must be carefully considered, since there is a large potential tax hit
and big opportunity cost in the form of forfeited time value. In this section,
we discuss the process of early exercise and explain financial objectives and
risks.
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 When an ESO is granted, it has a hypothetical value that—because it is an
at-the-money option—is pure time value. This time value decays at a rate
known as theta, which is a square root function of timeremaining.
 Assume you hold ESOs that are worth $35,000 upon grant, as discussed in
the earlier sections. You believe in the long-term prospects of your company
and plan to hold your ESOs until expiration. Below shows the value
composition—intrinsic value plus time value—for ITM, ATM, and OTM
options.
Value Composition for In, Out and At the Money ESO Option With Strike of
$50 (Prices in Thousands)
A hypothetical ESO option with the right to buy 1,000 shares. The numbers have
been rounded to nearest thousandth.
Even if you begin to gain intrinsic value as the price of the underlying stock rises,
you will be shedding time value along the way (although not proportionately). For
example, for an in-the-money ESO with a $50 exercise price and a stock price of
$75, there will be less time value and more intrinsic value, for more value overall.
The out-of-the-money options (bottom set of bars) show only pure time value of
$17,500, while the at-the-money options have time value of $35,000. The further
out of the money that an option is, the less time value it has, because the odds of it
becoming profitable are increasingly slim. As an option gets more in the money
and acquires more intrinsic value, this forms a greater proportion of the total option
value. In fact for a deeply in-the-money option, time value is an insignificant
component of its value, compared with intrinsic value. When intrinsic value
becomes value at risk, many option holders look to lock in all or part of this gain,
but in doing so, they not only give up time value but also incur a hefty taxbill.
Tax Liabilities for ESOs
We cannot emphasize this point enough—the biggest downsides of premature
exercise are the big tax event it induces, and the loss of time value. You are taxed
at ordinary income tax rates on the ESO spread or intrinsic value gain, at rates as
high as 40%. What’s more, it is all due in the same tax year and paid upon
exercise, with another likely tax hit at the sale or disposition of the acquired stock.
Evenifyouhavecapitallosseselsewhereinyourportfolio,youcanonlyapply
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$3,000 per year of these losses against your compensation gains to offset the tax
liability.
After you have acquired stock that presumably has appreciated in value, you are
faced with the choice of liquidating the stock or holding it. If you sell immediately
upon exercise, you have locked in your compensation "gains" (the difference
between the exercise price and stock market price).
But if you hold the stock, and then sell later on after it appreciates, you may have
more taxes to pay. Remember that the stock price on the day you exercised your
ESOs is now your "basis price." If you sell the stock less than a year after exercise,
you will have to pay short-term capital gains tax. To get the lower, long-term
capital gains rate, you would have to hold the shares for more than a year. You
thus end up paying two taxes—compensation and capitalgains.
Many ESO holders may also find themselves in the unfortunate position of holding
on to shares that reverse their initial gains after exercise, as the following example
demonstrates. Let’s say you have ESOs that give you the right to buy 1,000 shares
at $50, and the stock is trading at $75 with five more years to expiration. As you
are worried about the market outlook or the company’s prospects, you exercise
your ESOs to lock in the spread of$25.
You now decide to sell one-half your holdings (of 1,000 shares) and keep the
other half for potential future gains. Here’s how the math stacks up:
 Exercised at $75 and paid compensation tax on the full spread of $25 x
1,000 shares @ 40% =$10,000
 Sold 500 shares at $75 for a gain of$12,500
 Your after-tax gains at this point: $12,500 – $10,000 =$2,500
 You are now holding 500 shares with a basis price of $75, with $12,500 in
unrealized gains (but already tax paidfor)
 Let’s assume the stock now declines to $50 beforeyear-end
 Your holding of 500 shares has now lost $25 per share or $12,500, since you
acquired the shares through exercise (and already paid tax at$75) 
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 If you now sell these 500 shares at $50, you can only apply $3,000 of these
losses in the same tax year, with the rest to be applied in future years with
the samelimit
To summarize:
 You paid $10,000 in compensation tax atexercise
 Locked in $2,500 in after-tax gains on 500shares
 Broke even on 500 shares, but have losses of $12,500 that you can write off
per year by$3,000
Note that this does not count the time value lost from early exercise, which could
be quite significant with five years left for expiration. Having sold your holdings,
you also no longer have the potential to gain from an upward move in the stock.
That said, while it seldom makes sense to exercise listed options early, the non-
tradable nature and other limitations of ESOs may make their early exercise
necessary in the followingsituations:
 Need for Cashflow: Oftentimes, the need for immediate cashflow may
offset the opportunity cost of time value lost and justify the taximpact 
 Portfolio Diversification: As mentioned earlier, an overly concentrated
position in the company’s stock would necessitate early exercise and
liquidation in order to achieve portfoliodiversification 
 Stock or Market Outlook: Rather than see all gains dissipate and turn into
losses on account of a deteriorating outlook for the stock or equity market in
general, it may be preferable to lock in gains through earlyexercise 
 Delivery for a Hedging Strategy: Writing calls to gain premium income
may require the delivery of stock (discussed in the nextsection)
Basic Hedging Strategies
We discuss some basic ESO hedging techniques in this section, with the caveat
that this is not intended to be specialized investment advice. We strongly
recommend that you discuss any hedging strategies with your financial planner or
wealth manager.
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We use options on Facebook (FB) to demonstrate hedging concepts. Facebook
closed at $175.13 on Nov. 29, 2017, at which time the longest-dated options
available on the stock were the January 2020 calls and puts.5
Let’s assume you are granted ESOs to buy 500 shares of FB on Nov. 29, 2017,
which vest in 1/3 increments over the next three years, and have 10 years to
expiration.
For reference, the Jan. 2020 $175 calls on FB are priced at $32.81 (ignoring bid-
ask spreads for simplicity), while the Jan. 2020 $175 puts are at $24.05. 6
Here are three basic hedging strategies, based on your assessment of the stock’s
outlook. To keep things simple, we assume that you wish to hedge the potential
500-share long position to just past three years (i.e., Jan. 2020).
1. Write Calls: The assumption here is that you are neutral to moderately
bullish on FB, in which case one possibility to get time value decay working
in your favor is by writing calls. While writing naked or uncovered calls is
very risky business and not one we recommend, in your case, your short call
position would be covered by the 500 shares you can acquire through
exercise of the ESOs. You therefore write five contracts (each contract
covers 100 shares) with a strike price of $250, which would fetchyou
$10.55 in premium (per share), for a total of $5,275 (excluding costs such as
commission, margin interest etc). If the stock goes sideways or trades lower
over the next three years, you pocket the premium, and repeat the strategy
after three years. If the stock rockets higher and your FB shares are "called"
away,youwouldstillreceive$250perFBshare,whichalongwiththe
$10.55 premium, equates to a return of almost 50%. (Note that your shares
are unlikely to be called away well before the three-year expiration because
the option buyer would not wish to lose time value through early exercise).
Another alternative is to write one call contract one year out, another
contract two years out, and three contracts three yearsout.
2. Buy Puts: Let’s say that although you are a loyal FB employee, you are a
tad bearish on its prospects. This strategy of buying puts will only provide
you downside protection, but will not resolve the time decay issue. You
think the stock could trade below $150 over the next three years, and
therefore buy the Jan. 2020 $150 puts that are available at $14.20. Your
outlay in this case would be $7,100 for five contracts. You would breakeven
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if FB trades at $135.80 and would make money if the stock trades below that
level. If the stock does not decline below $150 by Jan. 2020, you would lose
the full $7,100, and if the stock trades between $135.80 and $150 by Jan.
2020, you would recoup part of the premium paid. This strategy would not
require you to exercise your ESOs and can be pursued as a stand-alone
strategy as well.
3. Costless Collar: This strategy enables you to construct a collar that
establishes a trading band for your FB holdings, at no or minimal upfront
cost. It consists of a covered call, with part or all of the premium received
usedtobuyaput.Inthiscase,writingtheJan.2020$215callswillfetch
$19.90 in premium, which can be used to buy the Jan. 2020 $165 puts at
$19.52. In this strategy, your stock runs the risk of being called away if it
trades above $215, but your downside risk is capped at $165.
Of these strategies, writing calls is the only one where you can offset the erosion of
time value in your ESOs by getting time decay working in your favor. Buying puts
aggravates the issue of time decay but is a good strategy to hedge downside risk,
while the costless collar has minimal cost but does not resolve the issue of ESO
time decay.
Conclusion
 ESOs are a form of equity compensation granted by companies to their
employees and executives. Like a regular call option, an ESO gives the
holder the right to purchase the underlying asset—the company’s stock—at
a specified price for a finite period of time. ESOs are not the only form of
equity compensation, but they are among the mostcommon.
 Stock options are of two main types. Incentive stock options, generally only
offered to key employees and top management, receive preferential tax
treatment in many cases, as the IRS treats gains on such options as long-term
capital gains. Non-qualified stock options (NSOs) can be granted to
employees at all levels of a company, as well as to board members and
consultants. Also known as non-statutory stock options, profits on these are
considered as ordinary income and are taxed assuch.
 While the option grant is not a taxable event, taxation begins at the time of
exerciseandthesaleofacquiredstockalsotriggersanothertaxableevent.
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Tax payable at the time of exercise is a major deterrent against early exercise
of ESOs.
 ESOs differ from exchange-traded or listed options in many ways—as they
are not traded, their value is not easy to ascertain. Unlike listed options,
ESOs do not have standardized specifications or automatic exercise.
Counterparty risk and concentration risk are two risks of which ESO holders
should becognizant.
 Although ESOs have no intrinsic value at option grant, it would be naïve to
assume that they are worthless. Because of their lengthy time to expiration
compared to listed options, ESOs have a significant amount of time value
that should not be frittered away through earlyexercise.
 Despite the large tax liability and loss of time value incurred through early
exercise, it may be justified in certain cases, such as when cashflow is
needed, portfolio diversification is required, the stock or market outlook is
deteriorating, or stock needs to be delivered for a hedging strategy using
calls.
 Basic ESO hedging strategies include writing calls, buying puts, and
constructing costless collars. Of these strategies, writing calls is the only one
where the erosion of time value in ESOs can be offset by getting time decay
working in one’sfavor.
 ESO holders should be familiar with their company’s stock options plan as
well as their options agreement to understand restrictions and clauses
therein. They should also consult their financial planner or wealth manager
to gain the maximum benefit of this potentially lucrative component of
compensation.
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BUY-BACK OF SECURITIES
What Is a Buyback?
A buyback, also known as a share repurchase, is when a company buys its
own outstanding shares to reduce the number of shares available on the open
market. Companies buy back shares for a number of reasons, such as to increase
the value of remaining shares available by reducing the supply or to prevent
other shareholders from taking a controllingstake.
How Does a "Buyback"Work?
UnderstandingBuybacks
A buyback allows companies to invest in themselves. Reducing the number of
shares outstanding on the market increases the proportion of shares owned by
investors. A company may feel its shares are undervalued and do a buyback to
provide investors with a return. And because the company is bullish on its current
operations, a buyback also boosts the proportion of earnings that a share is
allocated. This will raise the stock price if the same price-to-earnings (P/E) ratio is
maintained.
The share repurchase reduces the number of existing shares, making each worth a
greater percentage of the corporation. The stock’s EPS thus increases while
the price-to-earnings ratio (P/E) decreases or the stock price increases. A share
repurchase demonstrates to investors that the business has sufficient cash set aside
for emergencies and a low probability of economictroubles.
Another reason for a buyback is for compensation purposes. Companies often
award their employees and management with stock rewards and stock options. To
make due on rewards and options, companies buy back shares and issue them to
employees and management. This helps avoid the dilution of existing
shareholders.
Because share buybacks are carried out using a firm's retained earnings, the net
economic effect to investors would be the same as if those retained earnings were
paid out as shareholder dividends.
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How Companies Perform a Buyback
Buybacks are carried out in twoways:
1. Shareholders might be presented with a tender offer, where they have the
option to submit, or tender, all or a portion of their shares within a given
time frame at a premium to the current market price. This premium
compensates investors for tendering their shares rather than holding onto
them.
2. Companies buy back shares on the open market over an extended period of
time and may even have an outlined share repurchase program that
purchases shares at certain times or at regularintervals.
A company can fund its buyback by taking on debt, with cash on hand or with its
cash flow from operations.
An expanded share buyback is an increase in a company’s existing share
repurchase plan. An expanded share buyback accelerates a company’s share
repurchase plan and leads to a faster contraction of its share float. The market
impact of an expanded share buyback depends on its magnitude. A large, expanded
buyback is likely to cause the share price torise.
The buyback ratio considers the buyback dollars spent over the past year, divided
by its market capitalization at the beginning of the buyback period. The buyback
ratio enables a comparison of the potential impact of repurchases across different
companies. It is also a good indicator of a company’s ability to return value to its
shareholders since companies that engage in regular buybacks have historically
outperformed the broad market.
KEY TAKEAWAYS
 A buyback is when a corporation purchases its own shares in the stock
market.
 A repurchase reduces the number of shares outstanding, thereby inflating
(positive) earnings per share and, often, the value of thestock.
 A share repurchase can demonstrate to investors that the business has
sufficient cash set aside for emergencies and a low probability of economic
troubles.
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Example of a Buyback
A company's stock price has underperformed its competitor's stock even though it
has had a solid year financially. To reward investors and provide a return to them,
the company announces a share buyback program to repurchase 10 percent of its
outstanding shares at the current market price.
The company had $1 million in earnings and 1 million outstanding shares before
the buyback, equating to earnings per share (EPS) of $1. Trading at a $20 per share
stock price, its P/E ratio is 20. With all else being equal, 100,000 shares would be
repurchased and the new EPS would be $1.11, or $1 million in earnings spread out
over 900,000 shares. To keep the same P/E ratio of 20, shares would need to trade
up 11 percent, to $22.22.
$1 Trillion
Buybacks in 2018 among all US companies surpassed this amount for the first
time in history. Apple, Inc. alone authorized $100 billion in buybacks during
2018.
Criticisms of Share Buybacks
A share buyback can give investors the impression that the corporation does not
have other profitable opportunities for growth, which is an issue for growth
investors looking for revenue and profit increases. A corporation is not obligated to
repurchase shares due to changes in the marketplace or economy.
Repurchasing shares puts a business in a precarious situation if the economy takes
a downturn or the corporation faces financial issues it cannot cover. Others allege
that sometimes buybacks are used to inflate share price artificially in the market,
which can also lead to higher executive bonuses. (For related reading, see "4
Reasons Investors LikeBuybacks")
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PREPARATION AND PRESENTATION OF COMPANY FINAL
ACCOUNTS
At every general meeting of the company, the Board of Directors of the

company shall lay before the company:
(i) A Balance Sheet as at the end of theperiod;
(ii) A Profit and Loss Account for theperiod;
(iii) In the case of companies not carrying on business for profit there must be an
Income and Expenditure Account instead of Profit and LossAccount.
The Profit and Loss Account shall relate:
(i) In the case of first annual general meeting from the date of incorporation to a
date not later than 9 months previous to the date of themeeting;
(ii) In the case of any subsequent annual general meeting, from the date
immediately after the date of the last account to a date not later than 6 months
previous to the date of themeeting;
(iii) The period of accounts which is the financial year of the company—may be
more or less than a calendar year, but it shall not exceed 15 months. It may extend
to 18 months where special permission has been taken from the Registrar. Sec. 210
states that if any person (being a director of a company) fails to take all reasonable
steps to comply with the provisions, he shall be punishable with imprisonment for
a term which may extend to 6 months or with fine which may extend to Rs.1,000,
or withboth.
According to Sec. 210A(1) of the Companies (Amendment) Act, 1999, the Central
Government may, by notification in the Official Gazette, constitute an Advisory
Committee—to be called the National Advisory Committee on Accounting
Standards—to advise the Central Government on the formulation and laying down
of accounting policies and accounting standards for adoption by companies orclass
ofcompanies.
88
Constitution:
The Advisory Committee shall consist of the following members, viz.:
(a) A chairperson who shall be a person of eminence well-versed in accountancy,
finance, business administration, business law, economics or similardiscipline;
(b) One member, each nominated by the Institute of Chartered Accountants of
India, constituted under the Chartered Accountants Act, 1949, the Institute of Cost
and Works Accountants of India constituted under the Cost and Works
Accountants Act, 1959, and the Institute of Company Secretaries of India—
constituted under the Company Secretary Act,1980;
(c) One representative of the Central Government to be nominated byit;
(d) One representative of the Reserve Bank ofIndia;
(e) One representative of the Comptroller and Auditor General of India to be
nominated by him;
(f) A person who holds or has held the office of professor in accountancy, finance
or business management in any university or deemeduniversity;
(g) The Chairman of the Central Board of Direct Taxes constituted under Central
Board of Revenue Act, 1963, or hisnominee;
(h) Two members to represent the Chamber of Commerce and Industry to be
nominated by the Central Government;and
(i) One representative of SEBI to be nominated by it—[Sec. 210 A(2)].
Function:
The Advisory Committee shall give its recommendations to the Central
Government on such matters of accounting policies and standards and auditing as
may be referred to it for advice from time to time [Sec. 210 A (3)].
Term of Office:
The members of the Advisory Committee shall hold office for such terms as may
be determined by the Central Government at the time of their appointment. Any
vacancy in the membership in the committee shall be filled by the Central
Government in the same manner as the member whose vacancy occurred was filled
[Sec. 210A(4)].
89
Form and Contents of Balance Sheet and Profit and Loss Account:
Profit and Loss Account and the Balance Sheet are to be prepared in accordance
with the requirements of Sec. 211 and Schedule VI of the Companies Act, 1956.
Part I of the Schedule contains the prescribed form of Balance Sheet and Part II
contains the Profit and Loss Account.
Sub-section (1) of Sec. 211 of Companies Act requires: Every Balance Sheet of a
company shall give a true and fair view of the state of affairs of the company as at
the end of the financial year and shall, subject to the provisions of this section, be
in the form set out in Part I of Schedule VI, or as near thereto as circumstances
admit, or in such other forms as may be approved by the Central Government
either generally or any particular case; and in preparing the Balance Sheet, due
regard shall be had, as far as may be, to the general instructions for preparation of
Balance Sheet under the heading ‘Notes’ at the end of thatpart:
Provided that nothing contained in this sub-section shall apply to any Insurance or
Banking Company or any company engaged in the generation or supply of
electricity, or to any other class of company for which a form of Balance Sheet has
been specified in or under the Act governing such class of company.
However, the Central Government may, by notification in the Official Gazette,
exempt any class of companies from compliance with any of the requirements in
Schedule VI if, in its opinion, it is necessary to grant the exemption in the public
interest. Any such exemption may be granted either unconditionally or subject to
such conditions as may be specified in the notification.
The Central Government may, on the application, or with the consent of the Board
of Directors of the company, by order, modify in relation to the company any of
the requirements of this Act as to the matters to be stated in the company’s Balance
Sheet or Profit and Loss Account for the purpose of adapting them to the
circumstances of the company”—Sec.211(4).
Every Profit and Loss Account of a company shall give a true and fair view of the
profit or loss of the company for this financial year. The form set out in Part II of
Schedule VI does not, however, apply to any Banking or Insurance company or to
any other class of company for which a form of Profit and Loss Account has been
specified.
90
Every Balance Sheet of a company shall give a true and fair view of the state of
affairs of the company, as at the end of the financial year, and shall be in the form
of Accounting Standards set out in Part I, Schedule VI to the Act or as near thereto
as circumstances admit or in such other forms as the Central Government may
approve—Sec. 211. Every Profit and Loss Account also must comply with the
Accounting Standards.
If they do not comply with the Accounting Standards such companies must
disclose:
(i) Deviation from the accountingstandards;
(ii) The reasons for such deviation;and
(iii) The financial effect, ifany.
The Profit and Loss Account and the Balance Sheet of a company must not
be treated as not disclosing a true and fair view of the state of affairs of the
company, simply by reason of the fact that they do not disclose in the case of:
(a) Insurance Company— (Matters not required to be disclosed by the Insurance
Act,1938);
(b) Banking Company— (Matters not required to be disclosed by the Banking
Companies Act,1949);
(c) A company engaged in the generation or supply of electricity (Matters not
required to be disclosed by the Indian Electricity Act, 1910, and by the Electricity
(Supply) Act,1948);
(d) A company governed by the Special Acts, for the time being in force—
(Matters not required to be disclosed by that Special Act);and
(e) Any matter which are not required to be disclosed as per ScheduleVI.
For the purpose of Sec. 211, except where the context otherwise requires, any
reference to a Profit and Loss Account or Balance Sheet shall include any notes or
91
documents annexed thereto, giving information required by this Act, and allowed
by this Act to be given in the form of such notes or documents.
Where the person responsible for securing compliance with the provisions of Sec.
211 fails to take all reasonable steps to do so, he shall be punishable for a term
which may extend to 6 months or with fine which may extend to Rs. 1,000, or
both. But no such person shall be sentenced to imprisonment for any offence under
Sec. 211 unless the same was committedwilfully.
Similarly, Sec. 211(8) states that this person may entrust any other competent and
reliable person with the discharge of responsibility u/s 211 and, if he was in a
position to discharge it, he shall be liable for any default in complying with the
requirements of Sec. 211. In that case he shall be punishable with a fine what may
extend to Rs.10,000 or with imprisonment for a term which may extend to 6
months, or withboth.
True and Fairview:
According to Sec. 211 of the Companies Act every Balance Sheet of a company
must give a true and fair view of the state of affairs of the company and every
Profit and Loss Account must give a true and fair view of the profit or loss (i.e., the
result of the operation) of acompany.
From the above, it becomes clear that the Balance Sheet and the Profit and Loss
Account must satisfy:
(i) The Balance Sheet and Profit and Loss Account should be drawn up in
accordance with the requirements of Schedule VI, unless otherwise required by
law.
(ii) There must not be any concealment of material facts, over-statements and
under-statements in the Balance Sheet and Profit and Loss Account, i.e., financial
statement must not be window-dressed.
(iii) Assets and liabilities should properly be valued,i.e.
(a) Value of Fixed Assets should correctly be ascertained after charging proper
depreciation.
(b) Current Asset, like stock, should be valued on a consistentbasis.
92
(c) Contingent Liabilities, if any, should be ascertained fairly and stated as a
footnote.
(d) Proper provision should be made against knownliabilities.
(iv) All expenses and losses, incomes and gains must be included in the Profit and
LossAccount.
(v) Usually expenses and incomes should separately be stated and must not be
mixed up with generaltransactions.
(vi) Books of Accounts should be maintained as per Sec. 209 which will help to
make the Profit and Loss Account and the Balance Sheet and will exhibit a true
and fair view of the state of affairs of thecompany.
93
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Table of Content

Accounting as a Financial Information System 1

Accounting for Depreciation 6

Accounting for Inventories 12

Accounting Standards for Fixed Assesses 29

Accounting Standards for Investments 38

Cash Flow Statement 45

Fund Flow Statement 51

Financial Statement Analysis 53

Accounting for Share Capital Transactions Including Bonus Shares,

Employees Stock Option 68

Buy Back of Securities 85

Preparation and Presentation of Company Final Accounts 88

Accounting information systems generally consist of six primary components:

Introduction to Accounting Information Systems

With well-designed AIS, everyone within an organization who is authorized to do

For publicly-traded companies, no matter what software program and

An AIS contains confidential information belonging not just to the company

The cases of WorldCom and Lehman Brothers provide two examples.

In 2002, WorldCom's internal auditors Eugene Morse and Cynthia Cooper

Lehman's systems provide an example of how an AIS should not be structured.

Issuance Of Share Units

3. All preferred subscriptions are paid, and one-half of the remainingcommon

When the company experiences a default by the subscriber, the accounting

What Are Employee Stock Options (ESOs)?

Example of ESO Spread and Taxation.

Valuation of an ESO, assuming at-the-money, while varying volatility

At every general meeting of the company, the Board of Directors of the

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