Notes On Financial Accounting

INTRODUCTION TO FINANCIAL ACCOUNTING
by Prof. Pankaj Gupta
WHY STUDY FINANCIAL ACCOUNTING

In every business, there takes place numerous transactions with various parties like owners, bank,
customers, suppliers etc. Imagine, if Financial accounting is not present and you have to record
numbers, there are high chances that you will miss the important ones and hence error may occur in
estimating business performance (you must have realized this in my initial classes in Prep week). Error
would be because of not following a systematic process taking effect of each transaction into accounts.
Also, every firm should follow a common procedure in collecting transactions information so that a
comparison can be made between two firms. Moreover, it’s a statutory requirement to have proper
record of transactions and prepare financial statements at the end of the year. Financial accounting
helps us. Accounting is a manmade artefact and follows certain rules, guidelines and concepts. Like
in a system, Accounting system also need input, process and output.
WHAT IS FINANCIAL STATEMENT

How is business doing? To know this, reading Financial Statements helps. Financial Statement is like
report card of company. Reading it is skill and you will learn about the same in the later part of this
course. There are mainly four types of statements – Balance Sheet, Owner’s Equity Statement, Income
Statement, and Cash Flow Statement.
Balance sheet is record of sources and resources, i.e. it keeps a balance of assets (application of fund)
and Liabilities & Owners’ Equity (sources of fund). It’s a snapshot of a company at a point of time.
The statement of owners’ equity – Tells about the change in owners’ stake due to profits, dividends,
return of capital and other transaction a period (this will be described when we talk about a real
company example)
Income Statement provides the income details of a company during the period. Whatever is leftover
income being the part of Retained Earnings will be shown in the Balance sheet under Owners’ equity
head. This is because owners’ have control over income, and therefore reflected in balance sheet.
Cash Flow Statement provides details about the cash position in company due to business activities
(financing, investing, and operating).
Financial statements are prepared through following a systematic accounting procedure in which we
identify, analyze, classify, and systematically record the transactions. Then we prepare a summary
sheet of the transactions which is known as Financial Statements. We will discuss the more formal
definition of Financial Accounting in the core course. Here my purpose is to give you a fair amount
of understanding of financial statements. There are several concepts and principles behind the
statements which we shall discuss in due course of time. These concepts are so intuitive and
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understandable that sometimes we don’t need this to talk about. But, we will highlight those in the
core course. For example – Money measurement concept, which says we record the transaction which
can be defined in terms of money. Some of you will say of course this has to! Similarly, ten other
concepts will be the part of discussion in core course. Let’s begin with talking about financial
statements. I will start with the story of a basic business – Kerala Dosa Café (KDC)
KERALA DOSA CAFÉ (KDC)

After my retirement, my deep interest in restaurant business, pushed me to open a restaurant named
– Kerala Dosa Café (KDC). I am the Owner as I contributed my savings $100,000 to start KDC. I
don’t want to work anymore and asked my son to manage and run this business. My Son Atharva is
graduated from a reputed B-School and is appointed as Manager. In professional terms we have
owner-manager relationship and I have all the rights to ask Atharva about KDC’s performance
through it. As KDC is a separate entity (this is known as separate entity concept), I am more interested
in knowing business activities of KDC. In the first month after KDC started, I noticed that Atharva
note down one month’s transactions in a diary. These transactions were between KDC on side, and,
customers, fund suppliers, material suppliers on the other side.
I give you the snap shot of the diary page. Here I am making this very simple description of business
activities without need of adjustments.
Transaction No. Transaction detail Parties involved and cash

Date flow direction (if cash
involve)
1. August 1, 2020 Papa contributed $100,000 from savings and establish KDC. Cash from Owner to KDC
Papa is owner.
2. August 3, 2020 KDC borrowed $50,000 from a bank with 9% pa interest paid From Bank to KDC.
quarterly and the principle due in full at the end of two years.
3. August 4, 2020 Purchased an equipment costing $72000 for cash. The From KDC to Supplier
equipment life is 10 years and depreciation to count. of machine
4. August 5, 2020 An initial inventory of Dosa ingredients and boxes was No Cash. KDC and Supplier
purchased on credit for $ 8000. of raw material
5. August 6, 2020 During month, an additional $57500 of ingredients and boxes

was purchased on credit.
6. August 7, 2020 Dosa sales were $ 120000, all for cash Cash from Customer to KDC
7. August 8, 2020 Sales consumed $ 60000 of ingredients and boxes No cash. KDC to Customers
8. August 9, 2020 During month the KDC employees were paid $ 30000 in wages. KDC to Supplier of labor
(employees)
9. August 10, 2020 No Cash. Customer and KDC
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Catered a party for a fee of $2000 for my friend who will pay
later.
10. August 30, 2020 Customer to KDC.
My friend gave cash of $2,000 for party catered by KDC.
11. August 30, 2020 No Cash. Supplier of

bills for various utilities used were received, totaling $4500 services and KDC
12. August 30, 2020 KDC to Suppliers
During the month, $48000 of accounts payable was paid in cash.
13 August 30, 2020 KDC to Landlord
I paid $7500 rent for the month
When you recognize tax as
Additional detail – 1) The tax on income is 20% expenses in Income
2) Some transactions involve cash movement while others do not statement but, not paid, a
involve cash. This is an important point to remember. Here we liability account tax payable
follow Accrual Basis of Accounting. will be created in the
Balance sheet.
Question 1) Looking at this diary page can I call Manager and ask “How is KDC doing in August
month”. Prepare the performance/productivity card or Income Statement during the month?
2) What is KDC’s financial position as on August 30, 2020?
3) Can you tell me the cash available with KDC after a month of operations?
Homework for meeting on July 13, 2021: Students try this diary page exercise in your Notebook and
I will check this, if you have prepared the sheet. Then I will help you in answering above questions
without using accounting complex rules (with logic only)?
Without knowledge of Accounting you can try to answer and a close estimation can be made, but,
don’t you think a process is required to keep track of all transactions, so that in case if something is
missed out it is checked and corrected.
Transactions on diary page refers the business activities which KDC was involved with various parties.
Answer to homework – Refer the excel sheet you have done with me in the IITFA class session
01,02,03
FINANCIAL STATEMENTS: CAPTURING BUSINESS ACTIVITIES

Financial Statements capture business activities in a presentable form following the Accounting
Language. REMEMBER- LANGUAGE IS IMPORTANT! FINANCIAL ACCOUNTING IS
LANGUAGE OF BUSINESS.
After all this is information economics and you should learn disseminating financial information.
Below given figure shows KDC’s activity diagram. In the middle KDC (with net financial assets and
net operating assets), while on left capital suppliers – Owner and bank, and on right side customers
and suppliers shown. With the help of this chart and diary page transactions details, we can discuss
the business relationships.
Following parties covers almost all transactions mentioned in the diary
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a. Transactions with Shareholder/Owner – In KDC, I am the Owner and only shareholder with
100% equity capital. Refer Transaction number 1 in diary page.
b. Transaction with bank – SBI paid loan to KDC. Transaction number 2
c. Transactions with suppliers – of services, raw material, utilities, employees providing labor services
will come under this head. Transactions no – 3,4,5, 8,11,12 and 13.
d. Transactions with customers – All sales whether on cash or credit lie under this head. Transaction
no – 6, 7, 9 and 10.
This description holds good for a real-life company also.
From Capital market KDC From Product market
Shareholders Customers
(Owners) No 6,7, 9 and 10
1 Net
Net Operatin
Financial g Assets
Assets (involve in
(Not involve Dosa
Banks as in Dosa) manufacturing
loan provider ) Suppliers
2 No. 3, 4, 5, 8,
11, 12, 13
Fig. 1 - Business Activities diagram of KDC

Source: Penman, S. H., & Penman, S. H. (2010). Financial statement analysis and security valuation. New York:
McGraw-Hill/Irwin.
Task: Can you connect the Transaction No. on diary page with this diagram
ACTIVITY TYPE IN ACCOUNTING LANGUAGE

From Accounting point of view, we mainly have three types of activities here.
1. Financing Activity - With Banks and Shareholders.
2. Operating Activity - With customers and suppliers in running of business.
3. Investing Activity - With Suppliers creating the assets for long term use.
Note that in KDC -
• When Bank or the Owner provides capital to KDC, it is financing activity. Here owner and
bank provide cash (inflow) to KDC.
• Buying furniture (no 3), i.e. Asset building is an investing activity in which KDC pay cash
(outflow) to the supplier.
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• Paying wages to employee (No. 8) is an operating activity. This is because employees are
supplier of service (labor) which is used in productive purposes and show contribution in
operating performance. KDC pay cash (outflow) to labor.
• These activities may impact the cash flow. We will frequently talk about these activities in this
course.
Task: Discuss and classify remaining transactions into these categories.
I FINANCIAL STATEMENTS USING LOGIC

Since statements capture the activities in monetary terms, here we will use few jargons to present them
and interpret it. Let’s begin with simple Balance sheet of one day only, i.e. as on August 1, 2020. Here
I will explain the meaning of jargons and interpret numbers.
One transactions record in Balance Sheet: KDC
Balance Sheet is a snapshot of the company which tells us about the financial position at a point of
time. Let’s refer to the diary page and the first transaction between owner and KDC. This transaction
is going to affect the financial position of the company, i.e. Assets and owners’ claim on KDC. My
simple interpretation would be – I have started KDC through contributing $100,000, and is now
owner of it. This means that – “as a separate entity KDC has now cash available $100,000 on one
hand to run the show, and, owner has 100% control worth $100,000 on KDC. So, KDC balance
sheet will look like as below at this point of time?
KDC -Balance sheet as on August 1, 2020
Assets Liabilities & Owners’ Equity
Assets Liabilities 0
Cash 100,000 Owners’ capital
Capital 100,000
Total 100,000_____ Total 100,000
• Right hand side (RHS) equals the left-hand side (LHS), i.e. $100,000. In other words, sources
of fund and resource/application of fund is equal.
• I contributed $100,000 to become owner, the cash balance with KDC is $100,000, i.e. KDC
as an entity is controlled by me (100% stake). Let us imagine, if KDC is dissolved in the
evening, I will get $100,000 back and no cash with KDC.
• This Transaction involve two accounts – Cash and Capital account (what is an account?)
B/S changes after another transaction on August 3, 2020

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Balance sheet as on August 3, 2020
Assets Liabilities
Cash 100,000 Loan 50,000
Cash 50,000 Owners’ capital
Capital 100,000
Total 150,000 Total 150,000
On August 03, 2020, SBI provides loan to KDC. This is a financing activity. This transaction increases
the cash balance and liability by the same amount of $50,000.
What do you understand after the loan transaction -
• Cash (LHS) account is gone up by $50,000. And, loan account (RHS) is also gone up by $50,000.
• Both sides remain equal, i.e. total is $150,000 on both sides after this transaction.
• Transaction have an effect on two accounts – Cash A/C and Loan A/C.
• If KDC is shut down on August 3, 2020 evening, the total amount in the cash balance ($50,000) will
be distributed amongst the bank and owner in the preferential order.
• First the payment will be made to the bank. After paying to creditors, the remaining sum is given to
the owners/shareholders. This is rule.
• Here KDC will return $50,000 cash to SBI and close the loan. And, after deducting all expenses like
Atharva’s salary etcetera, the remaining sum will be given to the owner. In theory, I will put the
remaining cash $100,000 (my bank’s saving account or locker in the house).
BALANCE SHEET AS ON AUGUST, 30, 2020

Now let’s have look on the Balance sheet including all transactions given on diary page. Let’s try to
understand the meaning of each line item as given in the format balance sheet (Table4).
Format of Balance Sheet - the format of balance sheet is simple here and when required I will explain you the
changed format. In few text books you will see the terms like Sources of funds and Application of
funds in place of Asset, and, Liabilities & O/E. This is very intuitive of using terms like ‘Sources’ and
‘Application’.
Table 4: Balance sheet as on August 30, 2020
Assets Liabilities
Current Assets Non-current Liabilities
Cash and Bank Balance Financial Liabilities
Inventory Loan
Accounts receivables Trade payables
Investments (short term) Other Financial liabilities
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Loans and Advances given Provisions
Other current assets Deferred tax liabilities
Other long-term liabilities
Non-Current Assets Current liabilities
Plant property and equipment (PPE) Accounts payable
Accumulated Depreciation Short-term borrowings
Capital work in progress Short-term provisions
Intangible assets Other current liabilities
Investments (long term) Interest payable
Deferred tax asset
Other non-current asset Owners’ capital
Equity (Capital)
Other Equity
Retained Earnings
Total 191,400 Total 191,400
Task:
Relate every transaction and the accounts being affected.
Also, discuss if KDC is shut down on August 30, who will get the money first and how much will they get.
LET US SUMMARIZE THE LEARNINGS FROM BALANCE SHEET

• The two sides of the balance sheet remain “BALANCE” after every transaction.
• Balance sheet provides snapshot image/position of the company at a point of time.
• Every transaction affect two accounts (dual aspects concept)
• KDC is separate entity (separate entity concept)
INCOME STATEMENT: KDC

Table 5: Income Statement during the year 2021
Particulars Amount (in Rs.)
Sales revenue
Less: Cost of goods sold
Gross Margin
Operating Expenses
Depreciation
Rent Expense
Interest expense
Wages
Utilities expense
Less: Total Operating Expenses
Profit Before tax
Less: Tax expense
Net Income
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Income Statement provides details of the performance of company during the time period. The
productive efforts are noted in I/S and the performance in the form of net income is estimated after
deducting all expenses from revenue. This net income will go to the Owners’ Equity Head under
retained earnings in that year. In KDC, the net income $ 14980 is mentioned in table 4 under the
head retained earnings.
You may refer to different terms for income like gross profit/income, Profit before depreciation,
interest, tax and amortization (PBDITA), Net operating income or Net operating profit after tax
(NOPAT).
Gross Profit/Margin – It is calculated after deducting the cost of goods sold from sales revenue. Sales
revenue is the amount received from customers through selling product. Cost of goods sold covers all
expenses apart from the operating expenses to deliver the product or services.
The above income statement format is simple while the real company formats follow some standard format as
prescribed in Indian Accounting Standard (IAS-1)
Exercise: What is Profit-before-dividend-interest and Taxes (PBDIT) in the above table? Why it is important?
Net Income:
Cash Flow Statement

Cash flow statement is record of cash inflow and outflow due to financing, investing and operating activities in a firm.
For example – when loan was given by SBI to KDC, there is a cash inflow of $50,000. Similarly, when you pay for
rent, it is an outflow of $7,500 from KDC. Paying rent is an operating activity while receiving loan is a financing
activity.
Task: In KDC case, categorize various transactions into financing, investing and operating activity and thus effect on
cash inflow and outflow.
Cash Flow Statement for KDC
No. Cash flow due to Activity no & type Cash Inflow Cash Outflow
transaction type
1 From owner Financing
2 Rent Paid Operating
3 Loan received Financing
4 Equipment purchases
5 No cash effect
6 Sales Operating
7 No Cash effect
8 Wages paid Operating
9 No cash effect
10 No cash effect
11 Other liabilities paid Financing
12 No cash effect
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13 Sales Operating
Total cash Inflow

Total Cash outflow
Net cash = Inflow-outflow 1,14,500
1. Here I have ignored the proper method and format. Initially, I wish to give you an idea of cash flow statements.
We will talk about methods, later. For now, most important for you is to understand transactions effect on
cash balance. Either the cash inflows or outflow due to transactions involving cash. Further, those transaction
activities can be either, financing, investing or operating.
2. The net balance (1,14,500) at the end of the year is reflected in the Balance sheet under cash item. The net
cash in the next year will be determined by following formula
Ending Balance of Cash = The beginning balance (1,14,500) + net cash flow in the 2nd year
3. The transactions no. 5, 7, 9, 10, 10 have no effect on cash balance so these are not taken here.
4. We will talk about preparation of CFS in detail in coming sessions.
5. While preparing financial statements, some basic concepts and principles like – Separate entity concept, money
measurement concept, Accrual basis of accounting, matching concept etc. are implicitly either assumed or were
ignored in the class discussion. These concepts are building blocks of Financial Statements which we will talk in section
II
FINANCIAL STATEMENT USERS

So far, we have understood that Financial Statements are summary outputs of Business activities.
Now let’s talk about users who use statements, extensively. There are mainly two types of users.
1. Internal users like manager, employee, owner board of director etc. is interested in knowing
this information.
2. The external users such as public shareholders (another type of owners), banks, analyst, FIIs,
mutual funds, tax authority etc.
These statements indicate the financial health of the business. As users, you can gauge the
performance from ratios being generated from the financial statements. That’s why users like
Financial Analysts, and investors remain always interested in financial statements. You must have
observed the day a company disclose financial results, and company’s stock prices either goes up or
down in before or after the date of result.
Task: why company’s stock prices go up or down the day financial results disclosed?
Till now, we have prepared three financial statements intuitively using basic logic and arguments. Few
points to note:
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1) We are missing some Basic Concepts of Accounting which are the building block of Financial
Statements. There are total five concepts used in B/S and 6 concepts for I/S. These concepts are so
intuitive that you must not have realized the importance of it. But, now when we discuss formally
financial statements, a description of those concepts is important. Chapter 1 of RN text explain these
concepts under the heading Accounting Principles.
2) Here these statements are prepared using Accrual Basis of Accounting not Cash Basis.
Throughout the course, we are going to use accrual basis of accounting. I will come back to this
concept in next session.
3) In balance sheet the Accounting Equation Assets = Liabilities + Owners’ Equity holds good after
every transaction. RN text chapter 2 talks in detail about the transactions effect on accounting
equation. You can explore this through doing some exercises.
Okay, so after preparatory sessions, you have learnt analysing the effect of transactions on three statements
intuitively. These statements for KDC are as given below
Income statement during December,

2021 Cash Flow Statement
Sales revenue 1,22,000

Inflow Outflow
Cost of sales -60,000
Gross Profit 62,000 Due to Owner's contribution 1,00,000
Operating Expenses Due to Loan received 50,000
Depreciation expenses -600 Due to Equipment purchase 72000
Interest Expense -375 Due to payments to Supplier 48000
Salary expenses -30,000
Due to Sales 122000
Rent expenses -7,500
Due to Rent 7500
Utilities Expenses -4500
Profit Before Tax 19,025 Due to Salary 30000
Tax expense -3805 Total 2,72,000 157500
Profit afer tax 15,220 Net Cash balance 1,14,500
Balance sheet as on 31/12/2021
Assets Liabilities & O/E

Cash 114500
Accounts receivable 0 Loan 50,000
Inventory 5500 Accounts Payable 17500
Utilities Payable 4500
PPE 71400 Tax Liability 3805
Interest Payable 375
Owner's capital 100000
Retained Earnings 15220
Total 191400 191400
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You can see the link between three financial statements. As this is the first month of operations,
the link will be explored further when we discuss financial statements for next time period.
The standard format of statements follows the guidelines as set by Indian Accounting Standards.
You will find this when discuss the real-life company statements.
Now, I will discuss the more formal approach to understand and preparation of Financial
Statements in the Session 01 FA.
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Financial Accounting
Module I: Preparation of Financial Statements (FS)
Session 01 to 05
Here onwards, I will have more formal discussion on financial statements. Financial Statements are
based on some Basic Concepts, and prepared through following an Accounting Process.
Next 05 sessions are for explaining you the Basic Concepts and Accounting Process.
PREPARING FINANCIAL STATEMENTS
In KDC diary page you had only 13-14 transactions/event to input in financial statements. You could
do this easily understanding transactions’ effect on financial statements. Like I explained you in the
Preparatory week.
Now, what if there are thousands of transactions in a year with customers, suppliers, banks and owner?
You will be lost somewhere or will make some error if you don’t follow a systematic record keeping
approach. This proper record keeping system follows an accounting process.
Also, the Financial Statements are based on some basic principles and concepts which sometimes
seems so intuitive that we can skip but, few are so important that any misunderstanding may cause
serious errors.
Let’s start with those Eleven Concepts. Out of eleven concepts, five are to be used in Balance Sheet
and Six concepts explain the Income Statements. The brief description of these concepts is available
on table 1 in next page.
Accounting Concepts
To prepare the financial statements as discussed previously, certain rules are required to be followed.
Atharva, the manager of KDC has to make sure that the financial statements are prepared and
communicated effectively to the related parties. These parties include shareholders (me), suppliers,
customers etc. Every business owner and manager in this world cannot sit together and decide on
these rules and principles. So, there are a number of national and international bodies that frame
these guidelines. These guidelines serve as the basis for recording, analysing and presentation of
financial information.
If next year, Atharva would want to compare the financial performance with the previous year, he
would only be able to do so if the same methods and procedures are used for the preparation of
financial statements. Otherwise, it will be a hard-to-do thing.
The concepts, principles, assumptions required for this purpose are as follows:
1. Money Measurement concept: Atharva will include only those items related to the business in
financial statements that can be measured in terms of money. Say, there are workers in the cafe
but only the items they shall produce or sell will be accounted for in the financial statements. The
financial statements will not concern itself with what was the motivation level of the worker while
working, how the leadership style impacted more or less production etc.
2. The Entity concept: It tells that the business owner and the owner are different from each other.
I started KDC, but my personal transactions with someone not related to the business would not
be considered here. For example, the owner spent $3,000 on paying rent of the business space and
he has also spent $5,000 on the education of his child. The accountant will only record the rent
paid by the owner as it is related with business and the later expenses will not be recorded as it
comes in the personal matters of the owner.
The financial statements will be prepared from the company’s viewpoint and not the owner's.
If I (the owner) bring in additional capital into the business, it will be treated as a liability on
the balance sheet of the business.
3. The Going Concern concept: This assumes that the business is going to be there for an
indefinite period of time. In a business, there are both prepaid transactions and accrued transactions.
These are possible only due to this concept. Additionally, the calculation of depreciation is based on
the expected life of the asset, which is only possible if it is assumed that the business will be there in
the future.
4. The Cost concept: KDC bought a building for the eatery area. Now, this building would be
recorded at its cost value in the books and not on the market value. Year after year, in the balance
sheet, such fixed assets shall be recorded at their acquisition costs and subsequently, depreciation
shall be adjusted after every year. Say, this building was bought for a total of $1,00,000. In the
accounting books, its value would be entered at cost price, i.e. $1,00,000. After four years, the value
of the building goes up to $5,00,000. However, the accounting records would continue to show the
value of the building at the cost price of $1,00,000 less depreciation.
Ques: Can there be any inputs why recording assets on their market price is irrelevant?
5. The Dual Aspect concept: It states that every transaction has two aspects- a debit and a credit.
When an entity records a transaction, both of these elements are affected. Say, the building bought
will impact two accounts- Fixed asset (Building) and Cash. The building account will increase whereas
cash will decrease as cash is paid for acquiring the asset.
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Further, the accounting concepts applicable to the Income statement are as follows:
6. The Accounting Period concept: Although the business is assumed to continue for an
indefinite time period to measure its performance, it is required that the life of the business is divided
into several blocks which may be years, quarters etc. Generally, the accounting period used is 1 year.
After a year, financial statements are prepared to ascertain how the business fared over that period
and how the balance sheet stands at that point.
7. The Conservatism Concept: This concept states that the profit should not be recorded until
it is realized. However, losses even those not realized but with the remote possibility of occurring
should be included in the financial statements. For example, Almost all businesses sell their products
on credit. Businesses are therefore advised to estimate debts that they believe will not be recovered by
making a provision for such debts.
Basically,
• If there is uncertainty about a loss or potential loss - then you should record it.
• If there is uncertainty about a gain or potential gain - then you should not record it.
8. The Realization Concept: This concept states that a revenue should be recorded only when it
is earned and not when cash changes hands. The important thing is that revenue is earned only when
the goods are transferred or when services are rendered. Say, the sales made by KDC can be recognised
at the time of sale even if the sale is on credit and cash will be received in future.
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9. The Matching Concept: It states that the revenues and their corresponding expenses are to be
recorded in the same period. In other words, the firms record the revenue earned plus the expenses
incurred to earn that revenue in the same period. The main objective of this is to avoid overstating
and understating the earnings for a period.
10. The Consistency Principle: It states that a company should follow the methods of accounting
and estimations same across the periods and should not make frequent changes in these methods.
However, cases of changes in estimation methods may arise and in those situations an explanation
for change in method is explained. Also, auditors may also put a remark for making change in method
and its likely implications in general.
11. The Materiality Concept: The materiality concept says that the accounting of trivial matters
should be avoided.
Another way of looking at materiality concept – We should not avoid the transactions which are of
material size and have implications on performance.
Therefore, the concept dictates that the material transactions of sizeable amount should be taken into
account in a given period.
THE ACCOUNTING RECORD SYSTEM

To prepare financial statements a proper Six step process is followed. For a small size company, like
KDC, having few transactions in a year, we may skip to follow the process but, it is inevitable when
there are numerous transactions and chances of error is more.
This transaction record system Analyze, classify, verify and systematically record the transactions and
helps in preparing the financial statements. There are six steps to follow
Six Steps:
•Identify which two accounts involved

1. Analyze Transaction
•Use Golden rule to decide debit/credit entry
•Mark Debit and Credit
2. Post Journal Entries
•Idenitfy if adjusting entry required?
3. Prepare Ledger /T accounts •Ledger balance for each account
4. Identify, analyze and post •Analyze adjusting entries

adjusting entries •Accounting concepts will help
5. Closing entries & Trial •Journalize for adjusting entries
Balance •Close the T accounts and prepare trial balance
•Prepare I/S in the format
6. Prepare Financial Statements
•Prepare Balalnce sheet in format
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Useful terminologies
Before you proceed let’s talk about few terminologies.

1) An Account is a device which calculates the net change.
Let me show you the picture of few accounts –
Cash (A)
Dr. Cr
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This cash account has Debit on LHS and Credit entries on RHS.
By nature, two accounts are either Temporary or Permanent.
2) Permanent accounts are those which are period-ending balances and carried forward as the
beginning balance of the next period. For example –
i) In KDC the cash 114500 is the ending balance of August month that will be the beginning balance
of the next month. Whatever cash generated/consumed in September month will be adjusted with
this and net Cash of September month will be calculated. Beginning Balance + Cash Inflow in
September – Cash Outflow in September = Ending Cash Balance for September
ii) For Inventory, the August month Ending Balance Rs. 5500 will be the beginning balance for
September month. So, if you wish to calculate Inventory Ending balance of September you will use
the following formula –
Beginning Inventory + Purchases during September – COGS = Ending Inventory of September
Anyways, similar type of entries you will deal in the Step 2 when you will prepare ledger and estimate
balance figure.
3) Temporary Accounts are one which are not shown on B/S. For example, all revenues and expenses
accounts can be categorized under this and written under Retained earnings accounts, which is
reflected on the Balance Sheet.
So, there can be ‘n’ number of accounts to remember which varies from business to business. Here,
***I am adding a possible list of accounts which might come across in this course. Apart from this, if
any new account come across, it will be explained and add to this list.
• Cash • Capital stock/owners’ capital
• Accounts receivable • Retained earnings
• Inventory • Sales revenue
• Prepaid insurance • Interest revenue
• Land
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• Building • Salaries
• Property, Plant and Equipment • Wages

(PPE)
• Accumulated Depreciation (contra- • Supplies expenses

asset account)
• Accounts payable • Rent expenses
• Notes payable (short term) • Utilities expenses
• Wages payable • Telephone expenses
• Interest payable • Advertising expenses
• Unearned revenue • Depreciation expenses
• Loan payable • Interest expenses
• Accrued interest expenses • Income tax expenses
• Accrued utilities expenses
• IDENTIFY ACCOUNTS AS PERMANENT & TEMPORARY?
• WHICH PART OF I/S AND B/S the ‘Account’ belong to? Mention A, L and O/E in brackets)
4) Ledger - A ledger is a group of accounts. You will see the structure of ledger in Step 3.
5) Debit and Credit – Most important for you to understand accounting process. In any account, the
debit entry is on the LHS and credit entry is on the RHS. This is arbitrary allotment and there is no
logic for this.
So, an account whether A, L or O/E in nature, all will have the same structure and will be shown in
step 2.
Now, you can ask the question how a particular account (cash, inventory, accounts payable) etc. would
have debit or credit entry?
This can be answered if you know the Golden rule of accounting.
6) Golden Rules of Accounting – I will use Accounting equation
ASSETS = LIABILITIES + OE + RE
reformulating above equation,
ASSETS = LIABILITIES + OE + REVENUE – EXPENSES
ASSETS + EXPENSES = LIABILITIES + OE + REVENUE
18
Rule 1 – All Assets + Expenses are debit accounts, and, Liabilities + OE + Revenue accounts are credit
accounts
Rule 2 – If in a transaction, Assets + Expenses level goes up it will be a debit entry if it goes down it
will be a credit entry. Reverse is true for RHS accounts, i.e. if Liabilities + OE + Revenue goes up it
will be credit entry and debit, otherwise.
***You have to think from company’ perspective because you are preparing Financial Statements of
Company
***These two Rules will help you most while making journal entries and you have to remember this.
Guys, there is no logic behind this man-made artefact. Pacioli, the originator of accounting equation,
used the same way and every on follows this.
Case – KDC diary page

Now, let me discuss step-by-step approach of preparing the financial statement of first month of KDC.
Step 1 – Analyze the transactions - we need to identify two accounts involved, their nature (whether
it’s A, L, O/E, Expense, or Revenue) and decide which account should be a debit and which should
be a credit.
Let’s consider KDC one-page diary details as given below (I am changing numbers, now)
Transaction No. Transaction detail Step 1: Analyzing

Date transactions and identifying
accounts decide Dr./Cr.
based on Golden rule
1. August 1, 2020 Papa contributed $5000 from savings and establish KDC. Papa Dr. Cash (A) to
is owner. Cr. Owners’ capital (O/E)
2. August 3, 2020 KDC paid $750 rent for the month of August. Dr. Pre-paid rent (A) to
Cr. Cash (A)
3. August 4, 2020 KDC borrowed $4000 from a bank on a 9 percent note payable, Dr. Cash (A) to
with interest payable quarterly and the principle due in full at Cr. Note Payable (L)
the end of two years.
4. August 5, 2020 Purchased equipment costing $ 7200 for cash. The life of Dr. PPE (A) to
equipment is 10 years. Cr. Cash (A)
5. August 6, 2020 An initial inventory of Dosa ingredients and boxes was Dr. Inventory (A) to
purchased on credit for $ 800. Cr. Accounts Payable (L)
6. August 7, 2020 In the month Dosa sales were $ 12000, all for cash Dr. Cash (A) to
Cr. Sales Revenue (Rev)
7. August 8, 2020 Sales consumed $ 6000 of ingredients and boxes Dr. COGS (Exp) to
Cr. Inventory (A)
8. August 9, 2020 During month the KDC employees were paid $ 3000 in wages. Dr. Wage expenses (Exp)
Cr. Cash (A)
9. August 10, 2020 Dr. Inventory (A)
19
During month, an additional $5750 of ingredients and boxes was Cr. Accounts Payable (L)
purchased on credit.
10. August 30, 2020 Dr. Utilities Expenses (Exp)
At the end of month, bills for various utilities used were Cr. Utilities Payable (L)
received, totaling $450
11. August 30, 2020 Dr. Accounts Payable (L)
During the month, $4800 of accounts payable was paid. Cr. Cash (A)
12. August 30, 2020 Dr. Accounts Receivable (A)

On 30th of month, the firm catered a party for a fee of $200. Cr. Sales Revenue (Rev)
Because the customer was your friend and you told the
customer that payment can be any day later in the month.
13 August 31, 2020 Dr. Cash (A)
On last day of month, you received $200 from your friend for Cr. Accounts receivable (A)
the party catered by KDC
Apart from adjusting

Additional detail – 1) The tax on income is 20% entries, we will make a
2) Some transactions involve cash movement while others do not closing entry for tax in the
involve cash. This is an important point to remember. Here we last.
follow Accrual Basis of Accounting.
Step 2 - Journal Entry sheet will look like this:
STEP-1&2 JOURNAL ENTRIES

Transaction details Dr Cr
Cash (A) 5000
Day 1 To Capital (OE) 5000
Prepaid rent expenses (A) 750
Day 2 To Cash (A) 750

Cash (A) 4000
Day 3 To Notes payable (L) 4000
Equipment (A) 7200
Inventory (A) 800

Day 5 To Accounts payable (L) 800
Cash (A) 12000

Day 6 To Sales (Rev) 12000
Cost of goods sold (Exp) 6000
Day 7 To Inventory (A) 6000
Wage expense (Exp) 3000
20
Inventory (A) 5750
Day 9 To Accounts payable 5750
Utilities expense (Exp) 450
Accounts payable (L) 4800
Accounts receivable (A) 200
Day 12 To Sales revenue (Rev) 200
Cash (A) 200
Day 13 To Accounts receivable (A) 200
21
Step 3 – Preparing Ledger/T Accounts
Now, we will prepare T accounts, or ledger for each account in the format given below
ASSETS = Liabilities + O/E

Cash Notes Payable Capital A/C
Dr. Cr Dr. Cr. Dr. Cr.
0 0 5000
5000 750 4000 5000
4000 7200 4000
12000 4800
200 3000 Accounts Payable Retained earnings
5450 Dr. Cr. Dr. Cr
800 6000 12000
5750 3000 200
Equipment 4800 450 450
Dr. Cr.
7200 2200
7200
Inventory 9450 12200

Dr. Cr. 2750
800 6000
5750
550
Prepaid rent expense

Dr. Cr
750
750
Accounts receivable
Dr. Cr.
200 200
0
Note following:
i) Here, in each account, the beginning balance is zero because it is the first month of operation of KDC.
ii) The ending balance is estimated in each account considering whether an account is an asset account or credit
account (Golden rule 1). For example Cash (Asset) is a debit-balance account and Notes Payable (Liability) is a credit-
balance account.
iii) here, we have still not input T accounts for adjusting entries, we will do it after preparing trial balance.
For example –
1) LHS T accounts –
Cash Account – here beginning balance is 0 and we know that cash (A) is a debit balance account, so we will deduct
all credit entries from debit entries and balance will be a debit balance, i.e.
0 + 5000 + 4000 + 12000 + 200 = Rs. 5450 debit entry.
For inventory,
Beginning inventory + purchases – COGS = Ending Inventory
= 0 + (800 + 5750) – 6000 = 550 (debit balance)
Similarly all other asset accounts are closed.
2) RHS T accounts –
Notes payable – RHS accounts are credit balances and so, the ending balance will be the credit entry. Just opposite to
LHS side accounts.
Accounts payable account has many credit entries and one debit entry. The beginning balance is zero because it is first
month of operations so, the ending balance is calculated as
0+800+5750+450 – 4800 = 2200 (credit balance)
Similarly, other RHS accounts are estimated and closed.
***We prepare Retained earnings (R/E) as T account (permanent) which includes all revenue and
expenses (temporary) accounts. As you know from golden rule 1 that all expenses are debit accounts
and revenues are credit accounts so we will input accordingly in the R/E account. The R/E account
is a part of O/E so it will be a credit balance account and close accordingly.
Step 3 – Have a look at the Trial Balance
TRIAL BALANCE
Trial Balance for Kerala Dosa Corner on August 31, 20XX
Particulars Debit balance($) Credit balance ($)
Cash 5450
Equipment 7200
Inventory 550
Pre-paid rent Expense 750
Notes Payable 4000
Accounts Payable 2200
Capital A/C 5000
Retained earnings 2750
Total 13950 13950
So, here trial balance after the input of original entries looks balance. So, should we go ahead?
Or, it needs more entries to recognize and redo the trial balance as to proceed to step 4 & 5.
23
Here, we have missed out several adjusting entries to recognize and also the entry for tax in R/E
account. So, now we will move to the next steps and recognize the adjusting entries, journalize
those entries, write the trial balance and go further.
Please, note you could recognize the adjusting entries in step 1&2 also and can go further, like I
explain you in the class. But, here, I just tried to make a point that, “trial balance can be balanced
but, not error free”
Step 4 – Adjusting Entries & Closing the Balance in T accounts
To make adjusting entries, we will take the help of all the concepts we learned earlier.
Adjusting Entry for Prepaid rent - As you know the prepaid rent (A) was created for cash. Since the
rent was for the month, therefore at the end of month when we are supposed to prepare financial
statements, we will expense this prepaid rent asset account. This means that at the end of month
Prepaid rent (A) is completely used towards using facility and since this contributed in the operating
of business, it’s an expense of the month. Therefore, at the end of the month Rent expense (Exp)
account will came into existence (will go up) and Prepaid Rent account (A) will go away (down).
Now, for this adjusting entry we will apply golden rule 2 and the journal entry will be
14. Rent Expense (Exp) 750

Prepaid rent expense (A) 750
The concept behind this is – Matching concept. This identifies the expense of month and deduction
of asset (prepaid rent).
Adjusting entry for Notes payable (L) – You see the loan (Notes payable) was given, and interest
terms were mentioned. “The interest was 9% pa and payable quarterly and Principle will be paid after 2
years”
This implies that, i) there is no principle repayment in the one-month period and interest will be paid
after 3 months.
So, in August we should not make any calculation for interest expense and principle repayment?
It can be inferred that the loan provided by bank is to maintain capital and run business, effectively.
To keep the balance of $ 4000 (notes payable) with KDC, bank charges interest (cost of capital).
Therefore, the interest expense for the month can be identified and should be matched against
revenue of $ 12,200. This is matching concept. The monthly interest expense is = 4000*9%/12 = $30
Now, since we have not paid anything towards interest to the bank, the liability account “Accrued
interest” will increase (burden on KDC).
24
Therefore, the adjusting entry will include two accounts in identifying this transaction – Interest
Expense (Exp) and Accrued Interest (L)
The journal entry would be :
15. Interest Expense (Exp) 30

Accrued Interest (L) 30
Adjusting entry for PPE – it is given in transaction no 4 that, the life of the equipment is 10 years.
This means that every month PPE will be prone to “rear and tear charges” and after 120 months, the
final value of equipment will be zero. This rear and tear charge on tangible asset like machine is
known as Depreciation (For intangible asset, we follow amortization, remember Jatin case, the
license!)
Depreciation as an expense of August month can be calculated if we use straight line method (there
are other method also for estimating depreciation. we will talk about it in Module 2).
Straight line method says, that the asset value after 120 month is zero and today it is 7200, so one
month depreciation = (7200 – 0 )/120 = $60
This Depreciation you will match as an expense fot August Month reducing the value of asset.
Depreciation expense (Exp) account will be affected here and as it goes up will be a debit entry (rule
2). This is a non-cash expense and will cause reduction in the book value of PPE (A).
Here, if you identify this adjusting entry what will be other account going to affect?
As you are not going to pay anything for it (Depreciation is a non-cash expense) and this should cause
reduction in the book value of PPE, we introduce another account called Accumulated Depreciation
(A).
Please, note that it’s a Contra-asset account and is requirement for US GAAP to show accumulated
depreciation in the balance sheet. This way a reader can figure out how much the reduction in BV of
PPE due to accumulated depreciation.
So, the adjusting entry would be
16. Depreciation Expense (Exp) 60

Accumulated Depreciation (A) 60
We will show these adjusting entries in the T accounts and finally a tax expense will also be calculated
following matching concept and that’s how we will close the retained earnings account.
The adjusting entry for tax expense of the month will be:
17. Tax Expense (Exp) ??

Tax payable (L) ??
Let’s have a look on R/E account:

25
Retained earnings
Dr. Cr
6000 12000
3000 200
450
750
60
30
10290 12200
1910
Here Profit before tax = 1910
Tax @ 20% = 0.20*1910 = $382
So the tax expense of the month will be $ 382 and since it is not paid as per the information, we will
create tax payable liability account. The adjusting closing entry would be:
Tax Expense (Exp) 382

Tax payable (L) 382
Let’s close R/E permanent account for the month:
Retained earnings
Dr. Cr
6000 12000
3000 200
450
750
60
30
10290 12200
1910
382
1910 - 382 = 1510 (net income to add in
the B/S)
So, the journal entry register and T accounts will look like
Journal Entry:
26
STEP-1&2 JOURNAL ENTRIES
Transaction details Dr Cr
Cash (A) 5000
Day 1 To Capital (OE) 5000
Prepaid rent expenses (A) 750

Cash (A) 4000
Day 3 To Notes payable (L) 4000
Equipment (A) 7200
Inventory (A) 800

Cash (A) 12000

Day 6 To Sales (Rev) 12000
Cost of goods sold (Exp) 6000
Day 7 To Inventory (A) 6000
Wage expense (Exp) 3000
Inventory (A) 5750
Day 9 To Accounts payable 5750
Utilities expense (Exp) 450
Accounts payable (L) 4800
Accounts receivable (A) 200
Day 12 To Sales revenue (Rev) 200
Cash (A) 200
Day 13 To Accounts receivable 200
Adjusting entry for rent Rent expense (Exp) 750
expense To Prepaid expense (A) 750
Adjustng Entry for Depreciation expense (Exp) 60
Depreciation To Accumulated dep (A) 60
Adjusting entry for Interest expense (OE) 30
accrued interest To Accrued interest (L) 30
Adjuting & clsoing entry Tax expense (Exp) 382
for Tax expense To Tax Payable (L) 382
T accounts:
27
ASSETS = Liabilities + O/E
Cash Notes Payable Capital A/C
Dr. Cr Dr. Cr. Dr. Cr.
0 0 5000
5000 750 4000 5000
4000 7200 4000
12000 4800
200 3000 Accounts Payable Retained earnings
5450 To Balance Dr. Cr. Dr. Cr

5450 800 6000 12000
5750 3000 200

Equipment 450 450
Dr. Cr. 4800 750
7200 2200 60
7200 30
Accrued Interest 382
Inventory Accounts receivable Dr. Cr. 10672 12200
Dr. Cr. Dr. Cr. 30 1528
800 6000 200 200 30
5750 0
550 Tax Payable
Dr. Cr.
Prepaid expense Accumulated Depn 382
Dr. Cr Dr. Cr. 382
750 750 60
0 60
Acc dep is a contra asset account. It's balance will be a
credit entry and it will shown in the balance sheet as
negative number.
Step 5 - Final Trial Balance
TRIAL BALANCE
Trial Balance for Kerala Dosa Corner on August 31, 20XX
Particulars Debit balance($) Credit balance ($)
Cash 5450
Equipment 7200
Inventory 550
Accumulated Depreciation 60
Accrued Interest 30
Notes Payable 4000
Tax Payable 382
Accounts Payable 2200
Capital A/C 5000
Retained earnings 1528
Total 13200 13200
From R/E accounts and trial balance, we can prepare Income Statement and Balance Sheet.
28
Step 6 – Preparation of Financial Statements
Income Statement
Sales Revenue 12200
Less: COGS 6000
Gorss Margin 6200
Operating Expenses
Depreciation expense 60
Rent Expense 750
Wage Expense 3000
Interest Expenses 30
Utilities Expense 450
Profit before tax 1910

Less: Tax expense 382
NOPAT/NET INCOME 1528
BALANCE SHEET
KDC Inc.
Balance Sheet as on August 31, 20XX
Assets $ Liability & O/E $
Cash 5450 Paid- in capital 5000
add: Net Income/ Retained
Prepaid expenses a/c
0 earnings 1528
PPE 7200
Accumulated
Depreciation -60 Notes Payable 4000
Accounts payable 2200
Inventory 550 Accrued Interest 30
Accounts receivable 0 Tax Payable 382
Total 13140 Total 13140
Do remember here accumulated depreciation will be shown under Equipment as negative balance
(contra-asset) account.
29
The next month business activities can be further detailed and you may be asked to prepare the I/S
for the next month, and B/S on last day , i.e. September 30, 2021.
If you are quick enough, you may skip few steps like journal entry and can quickly prepare T accounts,
close it, and, prepare trial balance for I/S and B/S!!
Group Assignment – Grade Based
Question 1 – For KDC, prepare the Income Statement, Balance Sheet and Cashflow statement for
the following Month, September 30, 2021. The following transaction took place in September –
Transaction No. Transaction detail

Date
1. Sep 1, 2020 Papa contributed $1,00,000 more to expand business.
2. Sep 3, 2020 The company purchased land on Sep 03 for $30,000. The company financed the
purchase with a $20,000 loan from National Bank and paid the remaining
$10,000 with cash. The loan was to be repaid in equal principal payments over
3 years. The interest rate was 8% pa, and interest was payable at the end of each
month when the principal payment was made.
3. Sep 4, 2020 Purchases of inventory were made throughout the month costing $31,000, $
24,000 of which was paid in cash and $7,000 was purchased on credit.
4. Sep 5, 2020 Sales totalled $ 50,000 was made, of which $40,000 were cash sales, and $10,000
were sales on account (credit sales).
5. Sep 6, 2020 Operating expenses incurred were $15,000, all paid in cash.
6. Sep 7, 2020 Payment made to National Bank totalled $1,300, $1000 of which was for
repayment of the loan principle, and $300 of which was for payment of interest.
These payments were related to the loan the company had obtained on Sep 3,
2021.
7. Sep 8, 2020 Collections on account totalled $6000 during the month.
8. On Sep 1, KDC paid $5000 to an advertising company for a series of ads that
would run throughout the month.
30
9. Sep 10, 2021 KDC signed a contract with a customer for $2000 of party to cater next month.
The tax is 20% .
10. Sep 5, 2021 Sales consumed goods of $25,000.
31
Session 06 to 08
The Statement of Cashflows
Now we will talk about the third report –

Statement of Cash Flows (SCF). SCF is derived
from other financial statements – 2 Years Balance
Sheet and one year’s income statement.
è The questions on accrual estimates highlights the importance of cash flows. Cash
receipts and payments result from three business activities (financing, operating
and investing).
è Cash from operating activities is estimated through two methods – direct and
indirect method. Direct method considers the cash receipts from customers and
payments to suppliers, employees and government. Indirect method considers
undoing of accruals and non-operating items from net income.
è Cash flow from investing activities considers cash receipts/payments from PPE,
investments, interest and dividend income.
è Cash flow from financing considers the debt payments, equity capital, and
dividend payments.
è Non-cash investing and financing activities are considered outside the SCF.
32
ð Income not the same as Increase in Cash
Always remember that income of a period is the net change in Retained earnings, which is not the
same as increase in cash.
For example in KDC, during August month when loan $4000 was received, there was an increase in
cash by $4000 and equal increase in Loan liability account but, there was no change in retained
earnings. No income was generated from this transaction activity. This is a borrowing transaction,
not an earnings transaction.
Similarly, inventory purchase caused decrease in cash and increase in inventory account. This is an
asset purchase transaction, not an earnings transaction.
Similarly, in the sales of 12000 for the inventory costing 6000 did result in income. The income was
6000 but increase in cash was 12000.
In short, a business entity income is not the same as increase in cash. Several reasons
1) Income is estimated following accrual basis method not cash method.
2) Cash may increase/decrease due to activities which has no relation with the revenue. For example
– borrowing, purchasing assets etc.
ð Why we should be interested in knowing the Increase in Cash

As you know primarily a business has three main activities – operating, investing and financing
activities. While income statement is concerned only about the operating activities of business during
the period, SCF tells about the cash level affected due to all three activities.
Knowing the cash flow level is important for both the shareholders and lenders as these will be
concerned about their return (dividend) and interest, respectively. Other stakeholders like suppliers,
employees, tax authorities may also be interested into knowing about the cash generation abilities to
fulfil the obligations.
The cash flow provides accurate details of cash numbers as it involves no allocations or estimations,
i.e. it is objective and free from subjectivity and judgements.
While, Balance sheet and I/S are based on judgements and estimates but, provides better information
about an entity’s financial status and operating performance than cash flow numbers.
While the balance sheet provides the snapshot/status of a company at a point of time, Income
statement provides the income during the month. Income during the month is estimation of revenue
and expenses which might not occur on cash basis (credit sales, depreciation etc). Therefore, analysts,
investors, lenders, govt might be interested in knowing your future prospects which is based on the
cash generating abilities.
33
I would like to strengthen further the importance of cash. Let’s consider KDC which has revenue
but, no cash. If KDC can pay back to suppliers. Can you buy inventory for the next month. Can you
expand your business if you wish to, No!!
SCF tells us about the company’s liquidity position, financial flexibility, profitability and risk!
The companies which follow good cash management practices used to have sufficient amount of
liquid assets and cash.
SCF results from three business activities – Operating, Financing and

Investing Activities
Category Inflows due to Outflows due to

Operating • Cash sales • Purchase of materials
Producing and delivering • Unearned revenue and services,
goods and services inventory
• Payment of salaries
• Payment of taxes and
duties
Investing • Sales of Property, • Purchase of
Buying PPE, and making disposing PPE investments
investments • Sale of Investments • Acquisition of
• Sale of Business business
• Interest receipt and
dividend income
Financing • Issue of shares • Buyback of shares
Obtaining and returning • Issue of bonds • Repayment of Bonds
funds • Proceeds from loans • Repayment of Loans
• Payment of interest
and dividends
Non-cash Investing and Financing Activities
• Converting debt into equity

• Converting preference shares into shares
• Purchasing a building by incurring a mortgage to the seller
• Obtaining an asset on. a finance lease
These activities don’t involve any cash inflow/outflow. no effect on SCF.
34
Attempt Test You understanding 13.1 (RN)
Preparing SCF –
To prepare SCF the format is given as below. Here, we separately show the cash flow (inflow or
outflow) due to operating, investing and financing activity. The net cash flow is the sum of these three
separate numbers as shown in table –
Statement of Cash Flow
1) Cash From Operating Activities

Net Income 200
Depreciation 120
Accounts receivables (87)

Inventories (47)
Accounts Payables 56
Income taxes payable 1
Gain on disposing an asset (20)
Deferred taxes. 5
CFO 228
2) Cash from Investing Activities

Plant and Equipment, net (500)
Investment Securities 50
Proceeds from sale of asset 20
CFI (430)
3) Cash From Financing Activities

Short-term borrowings (21)
Long term Debt 335
Common stock (at $1 par) 10
Additional paid in capital 34
Dividend (60)
CFF 298
Net Cash Flow (1) + (2) + (3) 96
35
Preparing Cash Flow from operating activity (CFO)
To estimate CFO there are two methods – i) Indirect method and ii) Direct Method
Most popular one here is indirect method as it clearly shows the reconciliation of net income into
CFO. We are always interested into knowing how from NI we arrive at the cash, which is possible in
indirect method. In this course we focusing only on indirect method to avoid any more confusion.
i) Indirect method –Here we start with the net income number and undo the accruals
and non-cash, non-operating items from it. In essence we will write NI first and then
adjust it for revenues and expenses items that don’t involve cash receipts and cash
payments in the current period to arrive at net cash flow from operating activities.
Some of you may ask the reason to start from income statement?
You see, income statement tells you about the operating activity (earnings activity) for the period. And
you also know that income statement is prepared through following accrual method, i.e., we identify
few revenues (credit sales etc) which do not increase the cash level but increase the income number
(overstating the income), and, expenses like depreciation (non-cash expense) which reduces the
income (understating income) but, actually not causing any decrease in cash income. This way the
period’s net cash flow from operating activity is different than the period’s net income.
Thus, those items of which effect is overstating (understating) the income should be subtracted (add)
back to NI to get to know about cash from operating activity.
Here, I will deal this one by one for a company Fairway Corporation of which 2 years’ B/S and I/S
is given below:
Fairway Corporation
Balance Sheets as of December 31, 2009 and 2010
2009 2010 Change
Assets
Current Assets
Cash and Cash Equivalents 230 326 96
Accounts receivables 586 673 87

Inventories 610 657 47
36
Total Current Assets 1426 1656 230
Noncurrent Assets
Plant and equipment, at cost 2000 2350 350
Accumulated Depreciation -1000 -970 30
Plant and Equipment, net 1000 1380 380
Investment Securities 450 400 -50
Total noncurrent assets 1450 1780 330
Total Assets 2876 3436 560
Liabilities and Shareholders’ Equity

Current Liabilities
Accounts Payables 332 388 56
Income taxes payable 9 10 1
Short-term borrowings 147 126 -21
Total current Liabilities 488 524 36
Long term Debt 500 835 335
Deferred taxes. 65 70 5
Total liabilities 1053 1429 376
Shareholders’ Equity
Common stock (at $1 par) 50 60 10
Additional paid in capital 133 167 34
Retained Earnings 1640 1780 140
Total Shareholders' Equity 1823 2007 184
Total Liabilities and Shareholders’ Equity 2876 3436 560
Income Statement
Sales Revenue 3190
Cost of Sales 2290
Gross Margin 900

Expenses:
Depreciation 120
Other expenses 477

Income taxes 103 700
Net Income 200

Retained earnings, December 31, 2009 1640
37
Add: 2010 net income 200
Less: Cash Dividends -60
Retained earnings, December 31, 2010 1780
Additional information
1) new equipment was purchased on cash worth $ 500
2) disposal of a fully depreciated asset having original cost of $150
3) When asset was disposed off we receive 20 as gain.
4) A new investment in investment securities ($25) and securities sales ($75) happened.
5) A new short term borrowing of $15 and repayment of loan of $36 also happened.
6) A long term repayment of $40 and new loan of $375 was taken.
Let’s begin with NI
Net Income = 200

Depreciation = 120 - Non cash
Increase in Accounts receivables = (87) - Change in Working capital
Increase in Inventory = (47) Change in Working capital
Increase in Accounts payable = 56 Change in Working capital
Increase in Income taxes payable = 1 Change in Working capital
Gain on disposal of asset = (20) - Non-operating
Increase in deferred taxes = 5 Change in Working capital
Cash From Operating Activity = 228
In NI, a) we add depreciation of the year; b) deduct the increase in accounts receivables, inventory,
and gains on disposal of asset; c) we add increase in accounts payable, tax payable and deferred tax.
What is the logic behind this add/subtract of operating activity line items?
To understand this, you have to identify the impact of such activities (line items) on net income and
compare this with cash level. Remember NI is different than CFO due to accruals, non-cash, and
non-operating activities
Logic of adding depreciation in NI - Depreciation is a non-cash expense. So, including this in income
statement under expense head means that we are understating the NI compared to cash during the
period. In this way, if you were asked to know CFO, you will add this back to NI.
Logic of deducting increase in Accounts receivable – Increase in Accounts receivable is an operating

activity so it will impact CFO. If A/C receivables go up this hints that credit sales were made which
have had overstated the NI number compared from cash actually available. Therefore to know about
cash from NI, we have to deduct this increase in A/C receivables from NI, in other words to know
the true cash position we are undoing accrual revenue.
38
Another way to understand this effect is through tracking ‘T’ accounts’ mechanics.
iii)Increase in inventory when COGS is already there, and accounts payable is also increasing hints
that inventory was purchased on credit. This increase in inventory 47 refers that inventory was
purchased on credit, i.e. COGS is an understated number, i.e. income is overstated, i.e. we will
subtract an increase in inventory level.
iv) Increase in accounts payable will be treated opposite to increase in accounts receivable, i.e. add
this.
v) increase in tax payable, increase in deferred taxes will be treated same and will add up by the same
logic used earlier.
vi) cash proceeds from sale of PPE is a cash inflow but, Gain on disposal of asset is not a cash flow so
this will be subtracted from NI
Cash from Investing activity
It involves cash inflows from disposing of - assets such as PPE, investment in securities other than
cash equivalents. Cash inflow may happen due to collecting loans. The cash outflow may happen if
you acquire new PPE, invest in securities other than cash, and lending money.
We summarize it here for Fairway Corporation
Cash from Investing

Activities
Plant and Equipment, net -500
Investment Securities 50
Proceeds from sale of asset 20
CFI -430
Cash from Financing Activity
An inflow may occur if loan proceeds, equity issuance etc happened. An outflow is the consequence
of dividend payment, loan repayment, retiring stock and debt.
For fairway corporation it looks like:

Cash From Financing
Activities
39
Short-term borrowings -21
Long term Debt 335
Common stock (at $1 10
par)
Additional paid in capital 34
Dividend -60
CFF 298
So, the Net cash flow = CFO + CFI + CFF = 228 – 430 + 298 = 96 (this increase is shown in the B/S)
Applications of SCF –
SCF tells you something more about the business of a company. We will discuss the information
given in SCF here.
40
Module II
Module Objective: To explain accounting policy implications on reporting of financial statement.

This module covers a discussion on few important line items in financial statements. These are
revenues & expenses, inventory, depreciation etc. An important highlight of the module is to discuss
the convergence of Indian GAAP with International Financial Reporting Standards (IFRS) and its’
implications on reporting by Indian companies.
Session 9 & 10: Revenue Recognition

Objective To explain the revenue recognition methods to be used when the "critical
event" and "measurability" conditions for revenue recognition are not satisfied
at the point of sale.
Reading Notes
Case RN text exercises and cases
Session 11: Accounts Receivables – Measurement issues

Objective To explain the issues in the measurement of accounts receivable, allowance
for bad debts, and the accounting for actual bad debt expense and bad debt
recoveries.
Reading Notes
Case RN text exercises and cases
In this module we will talk about the various line items of Income statements and Balance sheet. First
in the list is ‘Revenue’.
Module II discuss the managerial discretion and choices in financial reporting, i.e. managers have
discretionary choices as available in the accounting standards and hence report in such a way that it
paint a different picture of company from reality. This reporting practice can be detrimental to other
investors also. So, students being an intelligent user of financial information should discuss and
debate such reporting practices.
In India, listed companies mandatorily follow Accounting standards - IndAS which is the convergence
of Indian GAAP and IFRS.
One good example of discretionary choices is ‘channel stuffing’. Due to this, the income of a period
can be inflated but, in later period when reality comes, investors feel cheated.
Similarly, discretionary choices in reporting depreciation, inventory, deferred taxes etc can be
debatable in financial reporting.
41
Session 09 – Revenue Recognition
Revenue Recognition –
Guys, so the first line item in Income statement is “Revenue”. In session 09 & 10, I will discuss the
reporting of revenue.
Financial statement users must be aware of the fact that almost half of the financial fraud cases involve improper
revenue recognition.
This is a big statement!
So, in revenue recognition includes answering two questions – 1) When – in which accounting period
– should we recognize revenue (timing)? and 2) How much revenue should we recognize?
These questions were talked about in session02 while describing Conservatism and Realization
concepts. I suggest to refer back the ch03 of AHMP from page no 64-67 to understand the relevance
of these two concepts here.
The Revenue recognition principle entails concept of conservatism and realization.
959X_ch05_108-140.qxd 3/16/101.10:54
Timing of109Revenue Recognition:
PM Page When to recognize?
Accounting: Text and Cases, 13th Edition 119
For a typical manufacturing firm, the operating cycle starts with purchase of raw material and ends
with the collection of cash from the customers. As you can see in the figure below there is a series of
long chain of events in this operating cycle, wherein,Chapter
at any pointandof
5 Revenue timeAssets
Monetary revenue
109 can be recognize.
ILLUSTRATION Collect the cash

5–1 from the customer
The Business
Operating Cycle
Customer acknowledges Purchase
receipt of the item materials
Ship the product and send Convert materials

the customer an invoice into a finished product
Receive an order for the Inspect the

product from a customer product
Store the product

in a warehouse
ILLUSTRATION 5–2 Timing of Revenue Recognition

Source: Anthony, R. N., Hawkins, D. F., & Merchant, K. A. (1999). Accounting, text and cases. McGraw-Hill/Irwin.
Revenue Recognition Typical Revenue
Event at This Time Recognition Method
In 1.accounting, we consider recognizing
Sales order received No revenue at a point of time rather than considering profit a
None
2. Deposit or advance payment received No None
part3. Goods
of this operating cycle. why? The
produced
answer is – criterion ofPercentage
For certain long-term contracts
objectivity, i.e. there is no objective way
of completion
of measuring the amount
4. Production completed; goods of profit For
stored earned inmetals
precious eachandstep of theProduction
certain operating cycle.
agricultural products
5. Goods delivered or services provided Usually Delivery
6. Customer pays account receivable Collection is uncertain Installment
Revenue recognition Principle states a revenue recognition criteria. According to this, the revenue
should be recognized in the earliest period in which
a) the entity has substantially performed what is required in order to earn income
b) the amount of income can be reliably measured,
c) the related assets received can readily be converted to cash or claims of cash.
Now, standard setting bodies like FASB, IFRS, GAAP and IndAS based on the revenue recognition
principle develop their standards to recognize revenue –
FASB - revenue should not be recognized until it’s realized or realizable and earned
IFRS - risks and rewards of ownership are transferred
GAAP - recognize revenue when it is ‘earned’
IndAS18 – What IndAS talks we will explore a little later.
various accounting standard setting bodies like SEC in US, ICAI in India develop their accounting
guidance notes to follow. SEC here is particularly more inspired from IFRS rather FASB (this is an
important point here).
IFRS says that,

revenue from sale of good can be recognized when :
i) risk and ownership of good is transferred,
ii) seller is not involved in any sense with the product,
iii) the revenue amount is measurable,
iv) economic benefits from the sale is transferable to seller,
v) the costs against this sale can be measured.
Considering above SEC issued Staff Accounting Bulletin 101 (SAB101).

SEC in US considers revenue as realized and earned when –
• persuasive evidence of an order arrangement exists

• delivery of the good made
• seller’s price determinable
• collectability of the sale proceeds is assured.
The Indian counter-part of SAB101 is IndAS18. Further, IndAS 115 is for revenue recognition in
real estate industry (combination of IndAS18 and IndAS 11). So, you see guidance notes for different
industry is different. Anyways lets stick to IndAS18 which is a detailed document describing the
definition of revenue.
Now let’s make a point here –
All the accounting standard setting bodies follow and set the recognition criteria based on the type
of business/industry and hence follow a particular revenue recognition method.
43
these possible methods are –
1.1 Delivery method – recognize revenue in which the goods are delivered and services are provided.
Also, you are reasonably sure that seller has performed all her duties to complete the sales. This is
called sales method also and we will discuss this in Grennell Farm case.
1.2 Percentage of Completion method (POCM) – This method applies where project such as
buildings, bridges, aircraft or ships etc. Because the construction/production of these products run
through several years we estimate and recognize revenue of each year on some percentage completion
formula (mentioned in the contract) basis.
Here, we count the revenue after judging the reasonable performance made irrespective of the amount
received from the customers. refer the illustration table 5-3 (AHM example, p. no 124).
ant7959X_ch05_108-140.qxd
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124
1.3. Project Completion method/completed contract method – According to this method we will
recognize revenue only when the project is completed and till then the costs incurred are taken as
assets.
114 Part 1 Financial Accounting
ILLUSTRATION 5–3 Long-Term Contract Accounting Methods
Customer Project Year-End Completed-Contract Percentage-of-Completion

Payments Costs Percent Method Method
Year Received Incurred Complete Revenues Expenses Income Revenues* Expenses Income
1 $120,000 $160,000 20 $ 0 $ 0 $ 0 $180,000 $160,000 $ 20,000
2 410,000 400,000 70 0 0 0 450,000 400,000 50,000
3 370,000
________ 240,000
_ _________ 100
____ __900,000 800,000
_______ _________ 100,000 ___
_________ 270,000
______ 240,000
_________ 30,000
_________
Total $900,000 $800,000 $900,000 $800,000 $100,000
_________ $900,000 $800,000 $100,000
________
____________ _________
*This amount for a year is the percent of completion accomplished that year times total project revenues. In this example, 20 percent, 50 percent, and 30 percent of the work
was accomplished in years 1, 2, and 3, respectively.
work proceeds as planned, the revenue is 110 percent of the costs incurred in the period.
A fixed-price contract usually specifies how the satisfactory completion of each phase
From the above table it project
of the is clearis tothat income such
be determined; waspoints
reported differently
in the project are calledunder twoIfmethods – POCM
milestones.
good project plans exist, the number of milestones
and PCM. Under PCM/CCM the income and revenue is zero in the first two years, reached enables the contractor to POCM shows it
reliably estimate the percent complete and hence the revenue earned on the contract.
in a proportion of the project5–3completed.
Illustration POCMofmay
shows the application be long-term
the two questioned contractforaccounting
it’s no relationship with
‘payments received methodsfrom customers’.
to a three-year project. Note that both methods report the same total project
income over the entire three-year period, but only the percentage-of-completion
Here the income method number of this
allocates twototalfirms arethe incomparable
to each of three years. Also noteand,
that theincome of each company is
customer pay-
incomparable across years.
ments (cash inflows) are irrelevant in determining the amount of revenue recognized
each year under either method.10
So, which method we should follow? I would say there is no right and wrong method, if, Accounting
Production
standard For certain
allows. For example,grains in
and India
other crops, the government
IndAS 18 when sets formed
price supports and assures
asked the
to follow PCM but, few
Method farmer that the products can be sold for at least these prices. The minimum amount of
companies continued to that
income follow POCM!
will be earned therefore can be reliably measured as soon as the crops have
In this situation comparison issuesthough
been harvested, even between firms
they have maysold
not been arise,
at thatand
time.most importantly
Furthermore, the such revenue
farmer’s performance has been substantially completed. In these circumstances, a
recognition impactscase
balance
can be sheet
made for items like net
recognizing worth,
revenue current
at the time of assets,
harvest. current liabilities and therefore,
This production
the economic status of projects might be questionable.
method is permitted but not required by generally accepted accounting principles
(GAAP). GAAP also permits revenue recognition when gold, silver, and similar pre-
cious metals have been produced from the mine, even though the metals have not yet
44 in the sales value of these metals have
been sold. In recent years, however, fluctuations
been large, and the rationale for the production method is therefore weaker. Relatively
few mining companies now use the production method.
Here, the suggestion is to ask analyst to reformulate the company’s statements which follows POCM
(or CCM) and then make comparisons across firms. Reformulation is not our agenda in this course!
1.4. Production method – This is more prevailed in farming business. Here you can reasonably
recognize minimum revenue when crop is harvested even though it is not sold in the market. We will
discuss this method in Grennell Farm case.
This method is not allowed by GAAP but, few industry like metal industry may follow it. However,
the method is not very reliable now.
1.5. Collection method – Let’s discuss one more method collection method according to which you
will recognize revenue only when you are reasonably certain about the amount received in cash from
sales. This method ignores any sales on credit and still count that goods in ending inventory balance
only. This method will be talked in detail in Grennell Farm case.
Over all remark: When to recognize?

Revenue recognition is an estimate which varies from industry to industry and method to method.
As long as we recognize revenue with reasonable, acceptable and objectively we will be successful in
justifying our income calculation.
Methods and accounting standards provides some guidance as discussed above.
REIT industry and revenue recognition -

In REIT we follow IndAS115 which is combination of IndAS11 and IndAS8.
IndAS formally came in to effect in 2017 which is the result of convergence of Indian GAAP and
IFRS). In 2018 it was made compulsory to listed Indian companies to follow IndAS.
Prior to the implementation of IndAS115, REIT companies were following mainly Percentage of
Completion Method (POCM) for reporting revenue as recommended by ICAI guidance notes. But,
after IndAS 115 came into existence, companies shifted to Project Completion Method (PCM) when
interpret the IndAS 115 accordingly.
However, few companies were still reporting according to POCM which raises the comparability
issues in the companies.
When we check the annual report of companies after 2018, a clear impact of adoption of new IndAS
on various line items of I/S and B/S was highlighted which further have an impact on ratios. So the
report mentions clearly the change(s) in ratios due to adoption of new accounting standards.
Guys this is an important observation because changes in ratios is not due to performance or
productivity, but, it is just due to changes in methods of accounting/revenue recognition under new
accounting standards.
I will discuss here SOBHA Developers annual report for AY 2018-2019. I am sharing this PDF file
with you and added my comments on p.no. – 28, 130, 131, 153, 221, 201 etc. Refer the PDF file
45
available on Moodle. So, what happened in 2018-2019 that SOBHA changed the revenue recognition
method from POCM to PCM. This change in revenue recognition method has significant impact on
important balance sheet items such as net worth, current assets (inventory), current liabilities which
ultimately reflects the image of company in investors eyes. So, when under new IndAS requirements
a shift in method is not real activity, the changes in ratio demands a clarification from company which
SOBHA made in the annual report to build investors’ confidence.
Session 10 – Grennell Farm Case: Three Revenue Recognition Methods
Refer the case copy in AHM textbook. The main tasks we need to do:
In illustration 5- 3 of AHM you can mention the point of recognizing revenue under three methods
– production, sales and collection. I draw this in class.
1) Prepare I/S, B/S for the year 2009
2) Comment on the market value (MV) of precious asset – Land. The Book value (BV) of it is $
3,75,000. Should we include the MV in financial statements.
3) Comment whether Grey should continue having control over Grennell Farm or should sold this.
Answer 1 – Financial Statements

Income Statement for 12/31/2009
Production Sales Method Collection method
Sales1 614100 522000 462400
BI 0 0 0
ADD: PRODUCTION 107730 107730 107730
Less: ENDING INV 0 15390 25650
COGS2 = BI + PRODUCTION – 107730 92340 82080
ENDING INV
Gross Margin 506370 429660 380320

Other Expenses 183000 183000 183000
Net Income 323370 246660 197320

Notes:
1. Sales revenue under production method = 210000*2.80 + 180000*0.10 + 30000*0.27 = 614100, here we calculate the minimum revenue
which you can generate on producing 2,10,000 bushels. Apart from this minimum revenue amount, there is appreciation in the value
inventory in cash-to-cash cycle. Which is $0.10 on 180000 bushels, $ 0.27 on 30000 bushels.
sales revenue under sales method = 180000*2.90 = 522000, here under sales method we consider only the amount sold to buyer (on cash
and credit sales both)
sales revenue under collection method ignores the credit sales amount = 522000 – 20000*2.98 = 462400
46
2. COGS can be estimated following this inequality –
Beginning Inventory + Purchase – COGS = Ending Inventory
beginning inventory is given as zero.

Purchase = production is same under three methods = 210000 * 0.513 (production cost as given in case) = 107730
Ending inventory will be zero under production method as we count the total 210000 in sales.
Ending inventory in sales method is 30000 bushels and the total production cost = 30000*0.513 = 15390
Ending inventory under collection method is 30000 + 20000 = 50000 bushels. The ending inventory cost is = 50000*0.513 = 25650
few of you have asked that, under collection method 20000 will not add up and you cited “there were no uncollected proceeds on December
31, 2009” from the case p.no 144.
This quote was mentioned about accounts receivable (for credit sales). Also, the concern is raised on whether this is doubtful or not. So, these
quotes have no relation with collection method as collection method completely ignores credit sales and hence we will count 20000 bushels
still as part of ending inventory, no matter it is about to sold. I agree with the assumption that “this credit sales is not bad debt as per
information”
In income statement rest of the process is mechanical. We deduct COGS from revenue to estimate
gross margin.
From gross margin, deduct the other expenses and estimate Net income (NI). NI will go to the R/E
account balance.
Remark:
The most optimistic income number is under production method, while, collection method provides
most objective, reliable, and conservative number. You can see the underlying reasons behind
differences in NI across three methods and summarize it.
Balance Sheet as On Dec 31, 2009
Balance Sheet as of December 31, 2009

Assets
Cash 30900 30900 30900
Accounts Receivables1 151700 59600 0
Inventory2 0 15390 25650
Land 375000 375000 375000
Building net 112500 112500 112500
Total Assets 670100 593390 544050
Liabilities & Owners' Equity
Current Liabilities 33000 33000 33000
Owner's 457500 457500 457500
47
R/E3 179600 102890 53550
Total Liabilities & O/E 670100 593390 544050
Notes:
1. Accounts receivable under production method will be = 30000*3.07 + 20000*2.98 = 151700. This
is because under production method your 20000 bushels can reliably be estimated as a credit sales
@$2.98 while the ending balance inventory may also be presumed as sales @$3.07 per bushels. This
is taken into account because on p.no. 145 in hint section it is given that ending inventory is zero
under production method, i.e. remaining 50000 will be accounts receivable.
Under sales method, 20000 bushels are part of the accounts receivable @$2.98 per bushel, i.e.
accounts receivable = 20000*2.98 = 59600
Under collection method, the accounts receivable will be zero as this method don’t consider credit
sales et al.
2. Inventory under production method is given as zero.

under sales method the ending balance inventory is 30000 bushels = 30000*0.513 = 15390
under collection method the inventory = (30000 + 20000 ) * 0.513 = 25650
3. R/E ending balance in the balance sheet is a balancing figure which we get after making Total
Liabilities & O/E as same as Total Assets. Why can’t we just add NI with R/E beginning balance and
show this number in B/S?
Let’s have a look on R/E inequality:
R/EBeginingbalance + NI – Drawings = R/EEndingbalance
So, here it is clear that some drawings could be there, which is evident from the quote, “Grennell
withdrew all of the farm’s earnings in last few years”
When we don’t know exact amount of drawings, the R/E ending balance can be calculated from
other scheme – Balancing method.
Answer 2 – Market value of Land:
Method 1 – Consider valuation for tax purpose as the sole criteria of estimating market value. So,
MV = 1050* 2000 =$ 21,000,000
Method 2 – Consider selling 100 acre at $225000. Her MV = 225000 + 1900*1050 = $ 22,200,000
The market value need not to show in the financial statements due to the reason that assets are
acquired and shown at historical cost, therefore, BV of non-current assets is shown here.
48
P.S: However, the current assets fair value is shown in the financial statements (refer p.no. 134, AHM
for detailed answer). Here due to limited information, monetary assets/current assets fair value
estimation not possible.
Answer 3 – Should Grey maintain ownership? This can be answered if we calculate the return on
investment made in the year 2009 and compare this with other avenues available to invest proceeds
received after selling the farm house.
Return on investment:
Return on Equity Investment = Return / Owners’ Equity capital
here let’s consider the most optimistic return under production method = 323370
Owners’ capital O/E = Assets – Liability
here since we are estimating the return on investment, i.e. our investments market value will be taken
into account, i.e. we should consider the MV of Land (ASSETS) in above equation. Also, we are here
trying to know the net-worth of the company in 2009, which is a function (may appreciate) if Assets
MV has gone up So,
O/E = 30900 + 151700 + 0 + 22,200,000 + 112500 – 33000 = 2482100
So, ROI = (323370/2482100)*100 = 13.07%
You may argue if Grey can earn more than 13% if she invests the proceeds received from selling farm
house. You should also consider that every year property is increasing @ 10% i.e. around 23% return
can be in other avenues?
If I were in your position, I would have recommended Grey to not to sell the farm house and maintain
ownership.
******************************************Mid Term Exam******************************************
2. Amount of Revenue: How much to recognize
In revenue recognition the amount of “Sales Revenue” in a time period is important to identify
Realization principle tells us that the amount we recognize should be ‘reasonably certain’ to receive.
If there is any doubt about any credit sales made we should not identify that amount.
When credit sales made two accounts are affected – Accounts receivable (A) and Sales Revenue (Rev).
If we consider “reasonable certainty” argument then no one can confirm if the total accounts
receivable will be realized in cash in future. You can never be 100% sure that all your customers who owed
you will honour the commitment.
49
There will be an element of uncertainty in future in collecting cash from customers. This element of
uncertainty should be well taken into account by us.
This is called as making provisions for Bad Debt.
We can make for provisions for Sales discount, Credit card sales; Sales returns; warranty etc.
REMEMBER ACCRUAL ACCOUNTING STILL EXISTS IN MAKING PROVISIONS.
Bad Debt:
Let’s say I made a $ 100 sales, and I can estimate (based on my past experience and industry practice)
that $20 of accounts receivable may default in future.
If I ignore this estimate, my Revenue, Income, Owners’ equity and Asset Account will be overly stated.
We should not do this!
Now if I trust on this estimate, I should make an adjusting entry through introducing Bad Debt
Expense Account.
The original entry would be:
Accounts receivable 100

Sales revenue 100
Adjusting entry – two methods
i) Direct write-off method – Here the Bad Debt Expense account is directly written off against
accounts receivables account.
i.e.
Bad Debt Expense 20
Account receivable 20
When we make above adjusting entry our I/S and B/S will be as follows:
Income Statement Balance Sheet

Sales revenue 100 Accounts receivable 100 – 20 = 80
Bad Debt Expense 20 Owners’ Equity 80
NI 80 Total 80 80
The direct write off method doesn’t show how much of the amount is taken as bad debt expense in
the current period. This is not a preferred method because of this drawback.
50
ii) Allowance Method – Here instead of making a direct reduction in accounts receivable account,
we introduce another account – Allowance for un-collectibles. This is a contra asset account and the
adjusting entry would be
Bad Debt Expense 20
Allowance for Uncollectible 20
The I/S and B/S would look like
Income Statement Balance Sheet

Sales revenue 100 Accounts receivable 100
Less: allowance (20)
Net Accounts receivable 80
Bad Debt Expense 20 Owners’ Equity 80
NI 80 Total 80 80
In allowance method the advantage is that you can clearly see the allowance of uncollectible separately.
Also, comparing with previous year you can estimate how much allowance for bad debt was in the
current period. This reporting has more visibility and transparency and hence may preferred under
nt7959X_ch05_108-140.qxd
128
GAAP.
3/16/10 10:54 PM Page 118
Here an implicit assumption is that we have estimated $20 bad debt based on our experience and
industry pattern. Can we have a proper method of estimating it? Refer AHM book example – The
ageing schedule method:
118 Part 1 Financial Accounting
l Accounting
ILLUSTRATION 5–4 Aging Schedule for Estimating Bad Debts
5–4 Aging Schedule for Estimating Bad Debts Estimated Allowance for
Status as of Amount Percent Doubtful
December 31, 2010 Outstanding
Estimated Uncollectible
Allowance for Accounts
Status as of
Current Amount Percent $207,605 Doubtful 1 $2,076
cember 31,Overdue:
2010 Outstanding Uncollectible Accounts
Less than 1 month $207,605 1 26,003 $2,076 1 260
1 up to 2 months 10,228 5 511
nth 2 up to 3 months 26,003 1 7,685 260 10 769
ths 3 up to 6 months 10,228 5 3,876 511 20 775
ths 6 months and over 7,685 10 _____ 6,853
____ 769 40 2,741
__
_____
ths Total 3,876 20 $262,250 775 $7,132
over _____6,853
____ 40 2,741
__
_____
$262,250 $7,132
Source: Anthony, The R.Adjusting
N., Hawkins,
Entry D. F., & Merchant, K. A. (1999). Accounting, text and cases.
McGraw-Hill/Irwin. Once the amount of the allowance has been determined, it is recorded as one of the
TheHere,
Adjusting Entry
we have assigned adjusting
theentries
percentmadeprobability
at the end ofnumber the accounting period.
to each If Essel
of the Company
accounts receivable. Older the
management estimated the allowance for
Once the amount of the allowance has been determined, it is recorded as one of thedoubtful accounts on the basis of the above
ACR entries
adjusting highermade
is the probability
at aging
the schedule,
end of thetheof becoming
entry would
accounting be bad
period. debt.Company
If Essel The total amount thus calculated is $7132 as
on Dec estimated
management 31, 2010.the allowance
dr. for
Baddoubtful accounts
Debt Expense. . . . . .on
. . .the
. . .basis
. . . . . of 7,132
the above
aging schedule, the entry would be cr. Allowance for Doubtful Accounts . . . 7,132
dr. Bad Debt Expense. . . . . . . . . . . . . . . . . 7,132
The accounts receivable section of the December 31, 2010, balance sheet would then
cr. Allowance for Doubtful Accounts . . . 7,132
appear as follows: this is the Adjusting entry
The accounts receivable section of the December 31, 2010, balance sheet would then
appear as follows: Accounts receivable
51 $262,250
Less: Allowance for doubtful accounts 7,132
Accounts receivable, net $255,118
Accounts receivable $262,250
In balance sheet it will look like:
Accounts Receivable 262250
Less: Allowance (7132)
Net Accounts Receivable 255118
Future event –
i) Suppose in future $250 amount actually default by customer. This will affect two accounts in
following way –
Accounts receivable will be reduced by 250, and allowance would also reduce by 250. i.e. accounts
receivable will be a credit entry while allowance is a debit entry in future, i.e.
The Entry will be: Dr. Cr.

Allowance for uncollectible 250
How the B/S would look like:
Accounts Receivable 262250-250 = 262000
Less: Allowance for doubtful (7132-250) = (6882)
Net Accounts receivable (no 255118

change!)
There is no effect on net accounts receivable balance.!!
ii) On the contrary to above, suppose in next time period, the $250 cash is received from the customer
whom we have put in the list of uncollectible– Cash will be debited $250 and allowance a credit entry
will be recorded.
Adjusting entry for Sales Discount
Sales discount “2/10 net of 30” refers a “2% discount to customer if he pays in first 10 days,
otherwise customer payment term is 30 days”.
52
So, when seller sell a product and in advance while recording revenue you don’t know whether
customer is going to pay within 10 days or 30 days, recording full amount is not correct. There are
three ways to record such sales revenue:
a) The discount as reduction from gross sales
b) The discount as expense of the period
c) Record only the amount net of discount. If the discount is received in future you can record this
as “discount not taken”
For example let’s say a product of 1000 is sold at 2/10 net of 30, i.e. 2% discount if sales. In this,
the accounting entry will be following:
Accounts receivable (Dr) 980
to Sales revenue (Cr) 980
When $20 is not taken by customer, and it was paid in full, we make the following entry
Dr. Cr.
Cash 1000
discount not taken 20
Adjusting entry for Credit Card Sales
Credit card sales is as same as writing a cheque by customer to the merchant.

In credit card sales when a card is swiped, the sales is booked at that point of time. Actual cash is
received by merchant next day from the bank. Bank deduct some processing charges for bearing risk
of default on card by customer. A merchant count these charges as sales discount. It is like company
selling a product discount if payment is made through credit card.
Accounting entry is:
Dr. Cr.
Cash (A) 970
Sales discount (Exp) 30
Sales revenue (Rev) 1000
Adjusting entry for Sales Returns and Allowances
Sales returns and allowances are like bad debt and treatment is similar to it.
In Bad debt case two accounts – Bad debt expense and Allowance for doubtful account was
created. Allowance was a contra asset account.
Here two accounts – Sales returns and Allowances will go to Income statement as expense
and Provision for return and allowance will be a liability account not contra asset and will go to
B/S.
Accounting Entry:
53
Dr. Cr.
Sales and Allowances (Exp) 1000
Provision for returns and Allowances (L) 1000
Some companies even do not make such treatments but they directly debit returns when product is
returned back and credit the cash/accounts receivable in that time period only. This way the actual
sale of that time period might be different than as shown in I/S. This special case is contradiction
with matching concept under the assumption that – estimation of return is difficult in advance and
effect is small. This practice is in line with Materiality concept.
Warranty Cost
As I discussed in the class, warranty cost is an expense which a merchant will incur when customers
will fill complains about defect in product.
This obligation is set on the day itself when merchant sold product to the customer and provide a
warranty. So, on accrual basis a merchant should not record all the amount as revenue from sales,
but should reflect Warranty expense in the same period when sales made and against this a liability
account – Allowance for Warranties will be introduced.
The Adjusting entry will be –
Dr. Cr.
Warranty Expense (O/E) 2000
Allowance for Warranties (L) 2000
Income tax authority don’t allow for recognizing warranty expense unless it occurs.
*******************************
So we have covered the two questions on revenue recognition – timing of revenue and amount of
revenue.
Now, let us talk about the nature of Monetary Assets and their reporting.
Monetary Assets:
A company’s monetary assets are reported differently than non-monetary assets. Non-monetary
assets are reported on historical cost or unexpired cost basis. We have following type of Monetary
assets reported differently than non-monetary assets –
Accounts receivable – realizable value
Monetary asset are reported at fair value.
Following three type of marketable securities can be reported in following ways
1.Securities held till maturity – This will be reported at cost on B/S
2.Securities for trading – Report at market value. Any unrealized gains and losses of the period will
be recorded in the income statement of the period. The entry for gain $ 5000 will be
54
Current assets:
account; that is, the write-up (or write-down) does not “flow through” the income
Cash and temporary investments $ 98.1
statement as it does in the case of trading securities.
Accounts receivable (less allowances) 536.8
Marketable securities (A) Inventories 5000 403.1
9X_ch05_108-140.qxd 1 3/18/10 1:03
Prepaid PM Page 128
expenses 207.1
Gain on
Accounting Marketable
- Vol. securities (Rev) 5000 ________
Total current assets 1,245.1
Analysis ofloss
An unrealized Monetary Assets
will have opposite
All other assets
effect and will decrease the period’s reported
2,992.0
________
income.
Total assets $4,237.1
________
________
3. Available for sale securities – Reported at market value Shareholders’
and any unrealized gains/losses directly
Some relationships that areLiabilitieshelpfuland in analyzing aEquity
company’s monetary assets are de-
credited/debited to owners’ equity
Current account. This write down method doesn’t affect income
liabilities
scribed below. They include the current ratio, the acid-test ratio, days’$1,214.6
cash, and days’
statement like the “flow through” method
All other liabilities in 2 above.
and stockholders’ equity 3,022.5
________
receivables. These ratios will be illustrated using the information given for Franklin
128 Part 1 Total liabilities and stockholders’ equity
Financial Accounting ________ $4,237.1
Company in Illustration 5–5. ________
Ratios on Monetary Assets:
Income Statement
Current Ratio As explained
Thisof
1. Current ratio – measure in
amount Chapter
can
liquidity 2, the
For
position; the current
then bereflects
divided
Year ratio
into
Ended
the isthe
flow of cash
December balance
31, 2010
cash and to determine
requirements for it;approxim
(in millions)
“days’ cash” on hand:
Net sales and revenues $6,293.9
Current assets $1,245.1
Expenses* Current ratio ! ! ! 1.035,613.2
________
Net income
Current
Cash liabilities $1,214.6
$98.1 $ 680.7
! days 24
! 7________
________
Good number is 2:1The but,current
this is ratio
not an Cash
ideal costs for
number per day industry. $14.65 per day
*Includes depreciation is the
expense most
of $265.2 commonlyevery
million. used of all balance sheet ratios. It is a measure
Two companies evennot afteronly of thethe
having company’s
same current liquidityassets butlevel,
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company of safety
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Combining these two steps, the formula for days’ cash is
proportion in currentmaintains
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focuses
Cash
absolutely smooth and
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current maturing
assets areobligations),
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assets Cash expenses
requirements
that are for " such 365 a safety margin
2. Quick Ratio (Acid-test) To of the above issue, we deduct thealso monetary
inventory andassets;
other they
would be small.
therefore exclude Since a company
inventories rarely can
and prepaid items.count
The on such is
formula an even flow, it needs a sup-
prepaid items from current assets
ply of Itliquid
mustfunds and estimate
be emphasized monetary
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current operating
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sizeMonetary does assets
buffer.
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Acid-test ratio ! ! ! 0.52
In interpreting
purchases or loan the current
repayments. ratio,
Current consideration
Thus, a firmof might
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$1,214.6 appear to of have
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currentbecauseassets isitimportant.
has just received Even if two cash companies
from bonds haveissued
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isexpense
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high current managing
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risk involved in both
well,
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expense minus the non-cash
this firm’s theaccounts
many
expense days’
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depreciation.
receivable
on hand would
and its be onlypay.aThe
inventory. few
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first
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step(Some
other
is to useanalysts
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the income
metals calculate
distrib-
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using to
cash estimate
plus cash expenses:
marketable A rough
securities approximation
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than ex- justthe“pu
utor
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penses safely
practice
and is have
subtract a lowerexpenses
verynoncash
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to avoidratioany
such than
as the clothing
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idle
This cash
total is or
thenshortage
dividedsinceof
The
distributor’s
by 365 ratio
days then
primary
to arriveindicates
current
at daily short-term
asset
cash would
needs: liquidity,
be ratherofthan
inventories cash
steel, management.)
copper, and alu-
cash.
minum shapes, which do not become obsolete and whose prices may be increasing
because of inflation. $5,348.0
Days’ A calculation Cash costs
similar to that per dayused ! in days’ !
365 days cash $14.65
can be used to see how ma
Receivables worth
4. Days’ receivables – This of sales
answers arequestion
to the represented in many
“in how accounts receivable
days the accounts (days’ saleswilloutsta
receivables
DSOs).
be collected”, i.e. it measures theThe formula
average is period for the receivables.
collection
Receivables $536.8
Days’ receivables ! Sales " 365 ! $6,293.9 " 365 ! 31 days
A rule of thumb- It should be 133%

The result of the
is also regular
called thepayment
averageperiod.
collection period for the receivables. If
Guys, work on exercisethe amount
questions in of salesand
AHMP in the denominator
practice should be
objective question oncredit sales,
this topic for which
Quiz 2.is mor
related to receivables than is total sales.
The collection period55can be related roughly to the credit terms offered by
pany. A rule of thumb is that the collection period should not exceed 11⁄3 time
ular payment period; that is, if the company’s typical terms call for payment in
Session 12-13
Accounting for Inventory and Cost of Sales
Part I: Inventory Systems and Costing Methods

So, the next line item in I/S and B/S is COGS and Inventory respectively. As you can recall that in
a manufacturing company we procure inventory which is used for manufacturing and pass through
assembly line. It can be raw material, work-in-progress, or finished goods. All three types of inventory
is taken into account and reported in the balance sheet
Further, when we sell goods (finished) to the customers, we need to account for the cost of that
product, i.e. COGS is taken into account.
Please, remember that there are two category of costs associated with manufacturing of product –
Product Costs – which are directly related to the product like material etc (inventory involved in
manufacturing goods)
Period Costs – Other than product costs.
The period costs are matched in income statement through following matching principle, like utilities
expenses, depreciation, taxes etc. you remember in KDC example.
This is just one type of classification of costs. there can be other classifications also.
So, here for Financial Reporting purposes we are concerned about beginning balance, ending balance,
purchases of inventory and COGS involved against sales.
The relationship between these is –
Beginning Inventory + Purchase – COGS = Ending inventory
What happens inside the manufacturing plant and how the accounting is done when material passes from one department to another
department is subject matter of internal control process and is covered in Cost Management (next term a course on it is available) course.
Why understanding about reporting of Inventory and COGS in financial statements is important
This is important for us because when we report how much material (inventory) was used against an
item produced and sold in the market, gives you the information about COGS.
56
COGS is deducted the sales revenue and hence Net income is determined, which ultimately goes to
O/E account in B/S.
On the other hand we invest money in acquiring and procuring inventory. Inventory remaining after
selling goods is reported in the B/S under assets.
To clarify this further, suppose an item which cost $50 was sold (selling price 100) on cash basis to
the customer, i.e. from the warehouse a reduction (D) in inventory of -$50 would happen while an
increase (D) in O/E of $100-50 = +$50 would happen.
Let’s visualize the changes (D) happened in the balance sheet and I/S due to this activity –
Income Statement
Sales 100
-COGS (50)
NI = $50
Balance sheet
DCash +$100
DInventory -$50 DO/E +$50
Total +$50 Total +$50
Due to productivity (sales) an increase in NI cause an increase in worth by $50 and reduction in
inventory by $ 50, but, cash increases by $100. This way B/S is balanced.
Now, this is reported based on the assumption that what actually item’s product cost was reported
($50) under COGS. This actually doesn’t happen always for reporting purposes.
In companies raw material keep on coming on regular basis over a period of time not always at
constant price but, the price of raw material also keep varying. This way what we consumed against
sales is not recognizable for accountants unless you do a proper inspection. And not in every business
inspection possible too.
Here, accountants are given flexibility to consider reporting methods of material consumption against
sales (COGS) and inventory. These prevailed methods follow cost flow concept and consider two
inventory valuation systems – Periodic inventory system and Perpetual inventory system.
The foundation of developing two systems and methods is based on the following two main questions
and answer of it!!
Beaker and material cost flow example -
Let’s assume that inventory/material flows in a beaker on periodic basis. The layer of beginning
inventory is in the bottom of beaker, a purchase of $7400 material happened in this period (let’s say
in month). Now suppose some sales happened in the company in this month. Let’s assume the sales
value of goods sold is $15000.
57
Here we have two basic questions which an accountant should know before preparing I/S and balance
sheet – 3/16/10 10:54 PM Page 143
7959X_ch06_141-171.qxd Accounting: Text and Cases, 13th Edition 153
1) How much is the ending inventory balance?

2) What was the cost of goods sold?
Chapter 6 Cost of Sales and Inventories 143
ILLUSTRATION
6–1
Merchandise Ending
Inventory and Flows inventory
$?
Purchases
$7,400
Available
for sale
$11,400
Cost of
goods sold
$?
$4,000 Beginning
inventory
Inventory reservoir
Source: Anthony, R. N.,

cost Hawkins,
to individualD.units
F., of
&merchandise
Merchant,may
K. A.
be (1999). Accounting,
considerable, some or alltext andmay
of them cases. McGraw-Hill/Irwin.
be excluded from merchandise product costs and reported as general operating ex-
penses of the period in which they are incurred.
To answer this we remember the inequality –
The purchase cost also is adjusted for returns and allowances and for cash discounts
given by the suppliers of the merchandise. As was the case with sales discounts
Beginning Inventory (BI) + Purchase – COGS = Ending inventory (EI)
(see Chapter 5), purchase discounts can be accounted for either by recording the pur-
chase amount as net of the discount or by recording the purchase amount at the invoice
price and recording the discount when it is taken.
In accounting, the word purchase refers not to the placing of a purchase order but
To answer any of these question, we should know about other question.
rather to the receipt of the merchandise that was ordered. No accounting entry is made
when merchandise is ordered. The entry is made only when the merchandise becomes
the property of the buyer.3
Two periodic systems
The Basic
are based on this discussion.
Think of merchandise inventory as a tank or a reservoir, as in Illustration 6–1. At the
Measurement beginning of an accounting period there is a certain amount of goods in the reservoir;
Problem this is the beginning inventory. During the period, additional merchandise is purchased
1. Periodic Inventory System - Let’s say if we can directly inspect and estimate EI, we can calculate
and added to the reservoir. Also during the period, merchandise sold is withdrawn from
the reservoir. At the end of the accounting period, the amount of goods remaining in the
COGS through following above equation. This system is called as Periodic Inventory System. Here
reservoir is the ending inventory.
we do physical inspection and estimate the EI value. Suppose in our example shown in figure it is
The amount of goods available for sale during the period is the sum of the beginning
inventory plus the purchases during the period. This sum is $11,400 in Illustration 6–1.
$2000. The problem to be discussed in this section, and indeed in most of the chapter, is how
to divide the amount of goods available for sale between (1) the ending inventory and
The COGS = BI + Purchase – EI = 4000+7400-2000 = $9400
(2) cost of goods sold. How much of the $11,400 is still on hand at the end of the period,
and how much was sold during the period? This is a significant problem because its res-
olution affects both the amount of inventory reported on the balance sheet and (perhaps
more important) the amount of profit reported on the income statement for the period.
Now, you know COGS and EI so you can prepare I/S and B/S
3
Under commercial law, goods in transit usually belong to the buyer as soon as they are delivered to
the transportation company if the terms are “FOB shipping point” (if the buyer pays the transporta-
tion costs). If the seller pays the transportation costs (“FOB destination”), title does not pass until the
2. Perpetual Inventory System – If we can identify the COGS involved against sales, we can easily find
goods arrive at the buyer’s warehouse.
out the EI to report in B/S.

Exactly the same we do in perpetual inventory system.
We keep updating the record of item which is procured, flowing through the process and involved in
the sales, i.e. closing of COGS against inventory is made. Let’s have a look on example
58
Method Illustration 6–2. In essence, this record is a subsidiary ledger account, and Merchandise
Inventory is its control account. Purchases are entered directly on this record and also deb-
ited to Merchandise Inventory; the offsetting credit is to Accounts Payable or Cash. De-
liveries of goods to customers are entered on this record and are credited to Merchandise
ILLUSTRATION Item: Cassette Deck, Model S150

6–2
Perpetual Inventory Date Receipts Shipments Balance
Card Unit Unit Unit
Units Cost Total Units Cost Total Units Cost Total
Jan. 2 40 100 4,000
12 32 100 3,200 8 100 800
14 70 100 7,000 78 100 7,800
25 56 100 5,600 22 100 2,200
27 2 100 200 * 20 100 2,000
* This entry is a purchase return to the manufacturer.
In this table, you can see that the BI is 40 units with a value of 4000. After shipment of 32 units,
remaining 8 units of value 800 is available on Jan 12.
Now on Jan 14, 70 units were purchased of value 7000, hence total balance in inventory record is 78
units worth of 7800.
On Jan 25, 56 units were shipped (sold), and remining 22 units were in the inventory.
On Jan 27, 2 units which company procured actually returned back to the supplier, i.e. a balance of
only 20 units is there.
Here how much is the COGS?

As you can easily figure out that only 56 + 32 = 88 units were shipped (sold) to the customer, i.e.
COGS of 8800
If I ask the EI?
it is, EI = 4000+(7000 – 200) -8800 = 2000
Please note that I am not showing the journal entry of theses transactions effect. You can refer p.no
156 AHMP to understand the closing of COGS account.
Above is a very simple example as the cost of acquiring inventory is constant on different dates, but,
actually this doesn’t happen.
What if material cost is changing?
Can reporting of inventory layers consumed (COGS) and EI matters!
YES. In an increasing cost trend
Inventory Costing Methods –

Let us assume that periodic system exists. There are broadly four methods of COGS estimation –
FIFO, LIFO, Average cost method, and Specific identification method.
Let us assume the cost of material is either Increasing or decreasing over a period of time
59
Consider beaker example again –
1) FIFO method - Let’s consider consumption from the bottom:

In increasing trend - When you report the consumed inventory
which comes first, it is a cheaper one as the cost trend is increasing,
i.e. you are reporting low COGS, i.e. high taxable income, high tax,
high NI, high
change in O/E. On the other hand, you are reporting the most
recent costlier material in inventory account in B/S.
So, the change in both sides of B/S is positive and equal and hence it will balance out.
The first-in-first out (FIFO) method outlined above reports low COGS, high inventory when material
cost is increasing over a period of time.
If there is a decreasing trend of cost over month, then the FIFO will report high COGS and effect
will be opposite, i.e. low NI, low O/E change, and low inventory change will be reported.
Kindly note that we are reporting numbers in financial statements through following FIFO method,
which might be different than actual situations. FIFO method is allowed as per the Accounting
standards in US, India and other countries.
2) LIFO method – When we start counting the material consumed against sales from the top of the
beaker, it is called as Last-in-first-out (LIFO).
In an increasing cost trend, following LIFO will cause high COGS and therefore low income
reporting. Also, the inventory and R/E numbers will also be low in the B/S. In a decreasing cost
trend reverse will happen.
LIFO method is not allowed in India, but, allowed in US. As per US GAAP
a firm reporting inventory following LIFO method has to report inventory
following FIFO and a balancing difference named LIFO reserve in the foot
-notes.
As you have seen in Merrimack tractors case, the LIFO reserve and FIFO
inventory was shown in the footnotes.
3) Average Cost Method – In average cost method, we consider the average cost of goods as COGS.
4) Specific Identification method- we particularly go and inspect the item which can be considered
as part of COGS.
In the class I have explained all four methods through taking an example.
60
Also, I explained you difference b/w LIFO and FIFO and preference of one method over other
method while discussing the Merrimack tractors case. Kindly refer my PPT slides and excel sheets.
I will summarise these points soon in the last.
Okay so, we have talked about:
Product cost
Periodic costs
Inventory systems
Inventory costing methods – LIFO, FIFO, Average cost, and Specific Identification assuming periodic
inventory system.
Kindly note that perpetual inventory accounting system is outside the purview of this course. You can
refer chapter 17-19 of AHMP if you wish to explore this further. Merrimack Tractors case was also
based on periodic inventory system.
Part II: Comparing Methods and Factors affecting Inventory reporting
For this discussion refer page 157-159 of AHM.
Analysis of Inventory: Ratios

Inventory turnover – refer AHM page 160
Days’ inventory – refer AHM page 160
Gross margin percentage - refer AHM page 161
Session 14-15
Accounting for Long Lived Assets (LLA)
Now we will talk about non-current assets. These assets are non-monetary in nature and provide
benefits over future several years. Long lived assets are broadly of three types -
61
Tangible Assets (TA) – PPE, furniture, machinery, land building, vehicles.
Intangible (IA) – These assets lacking physical substance like patent, trademarks, copyrights, goodwill
etc. and are of three types viz. IA with finite life, IA with infinite life, and Goodwill.
Financial assets – debt or equity we will not talk about these assets here.
Also, Lease comes under the Liability for the lessee and it is an asset for the lessor. This is also not
part of our discussion here.
The Accounting issues for long lived assets – We will focus on following four questions
I Determining the cost at acquisition

II. Allocating costs to expenses over useful life of asset– depreciation, amortization and impairment
test. Please, note land does not depreciate value is appreciated over time. Intangible asset with infinite
life and good will don’t amortized, but, pass through impairment test (will discuss later).
III. Treatment of subsequent costs incurred related to the assets (cost model vs revaluation model),
unexpected decline in the value of assets, classification of assets as per the intent with respect to intent
(held for use or held for sale).
IV. Derecognition of assets
I will discuss all four questions in order. The main focus is on understanding the principles and
concepts behind accounting and reporting of long-lived asset acquisitions, conversions of these
acquisition costs to expenses (depreciation), and disposition of such assets.
I) Long Lived Assets – Determining the Cost of Acquisition
Capitalization and Amortization: It is a Process to convert costs into assets and expenses
Recall from KDC case that, PPE purchase in August paying cash $7000 is capitalization of asset. What
we did – PPE (asset) was shown in August month B/S, and Cash was reduced (asset).
Few of you must be wondering why we have not included $7000 Cost of PPE as an expense in the
I/S. In fact few of you asked me also there. Initially I tried to apply some logic and explained - “PPE
is providing benefits for long time let’s say 15 years. So, you will use this every month and for 15 years,
therefore it seems logical to count only the proportionate cost in the month only for using that
equipment. I termed this expense as Depreciation expense of the month. You made journal entry for
Depreciation also, i.e. depreciation expense (Dr.) to Accumulated Depreciation (A). Later, in session
4, I justified that matching principle works here”.
Now, I will explain you the concept of building long term assets and counting proportionate cost as
expense against revenue of the month in I/S.
a) You have purchased PPE which provides benefits beyond a one-time period (month) only, so it is
a long term asset in which Cost have incurred. Please, remember you are not buying a short term
asset like inventory for the use of month or year.
b) Now this cost can either be considered as capitalized or be expensed for the period.
62
c) Cost here is building a long term asset – PPE, therefore costs have been incurred into capitalizing
the asset. It should be shown as investment in asset and PPE (Dr.) to Cash (cr.) journal entry would
be recorded.
d) Now PPE is providing benefits over several years and months, therefore a proportionate expense
for the monthly use of the asset should be shown in the I/S under expenses head and the same
amount be reducing the asset value. Here it is known as the cost is expensed, and this is called as
period cost.
In our particular case – PPE, in August month for the use of PPE, a one month rear and tear charge
(period cost) known as depreciation will be the expense of the month and accumulated depreciation
will be reducing the value of asset.
Following3/16/10
9X_ch07_172-219.qxd a straight
10:55 PM linePagedepreciation
173 method
Accounting:- Text
$60 depreciation
and Cases, 13th Edition was
183estimated and journal entry –
Depreciation Exp (Dr) to Accumulated Depreciation (Cr.) was recorded in August Month.
This process of recording Net asset value and counting expense (depreciation) is called as
Capitalization.
Chapter 7 Long-Lived Nonmonetary Assets and Their Amortization 173
Here, estimating the cost till useful life as expense of the month is governed by matching principle if
you remember correctly. Here the expense amount
ILLUSTRATION is decided by three criteria – useful life, residual
Asset accounts
7–1 Capitalize
value of asset,
Expenditures and and
Cash method
or of depreciation calculation 100 20
(will talk about it later).
s
Ye
as benefits are received)*

payables
(made in future periods

Expenses
You can visualize this flow, if youbeyond
Expenditures go this
back to KDC case. We use the term capital assets interchangeably
Benefits
Amortization
100
(costs incurred)
for long-lived assets.
entries
period?
Retained earnings
N
When intangible assets accounting is Expense done to 100 expenses, the accounting process is called as
o
20
Amortization. Following table summarizes capitalization/amortization
*
Amortize over five years.
ILLUSTRATION Method of Converting

7–2 Type of Asset to Expense
Types of Long-Lived
Assets and Amorti- Tangible Assets
zation Methods Land Not amortized
Plant and equipment Depreciation
Natural resources Depletion
Intangible Assets
Goodwill Not amortized*
Intangible assets (other than goodwill)—limited life Amortization
Intangible assets (other than goodwill)—indefinite life Not amortized*
Leasehold improvements Amortization
Deferred charges Amortization
Research and development costs Not capitalized
* Subject to periodic impairment test.
Source: Anthony, R.insurance

N., Hawkins,
policy D. F., &prepaid
or other Merchant, K.ItA.is (1999).
expense. Accounting,
initially recorded text and
as an asset andiscases.
con- McGraw-Hill/Irwin.
verted to an expense in one or more future periods. The difference is that the life of
most capital assets is longer than that of most prepaid expenses.
Finding Tangible Assets’ Costs at Acquisition
Illustration 7–1 uses T accounts to depict how expenditures either are expensed in
the current period (period costs) or are capitalized in an asset account and amortized
(expensed) in later periods. Note that all costs eventually become expenses, but capital
assets’ costs do so over a period of several years, whereas period costs become ex-
A capital expenditure made to acquire LLA, it is a cost of building an asset, i.e.
penses as they are incurred.
capitalization/amortization
Types of Long-
is done. This is shown in the B/S at acquisition cost.
Illustration 7–2 lists principal types of long-lived nonmonetary assets and the termi-
Since this asset provides periodic
Lived Assets nology used for the process benefits
of amortizing the costwe wish
of each to principal
type. The include the expenses, i.e. we divide the
distinc-
tion is between tangible assets and intangible assets. A tangible asset is an asset that
expenditures into capitalized
has physical substance, and
such asexpensed. A fineAnline
a building or a machine. between
intangible this
asset, such as categorization and reporting in
patent rights or copyrights, has no physical substance. Many such assets are referred to
financial statements is important
as intellectual property. for analysts to understand. A discretion used by preparer (manager)
Long-lived tangible assets are usually listed on the balance sheet under the heading
“property, plant, and equipment.” The term fixed assets is often used in informal dis-
cussion and appears in several balance sheets in this book simply because it is shorter.
Property includes land, which ordinarily is not amortized 63 because its useful life is
assumed to be indefinitely long. Plant and equipment includes buildings, machinery,
office equipment, and other types of long-lived capital assets. The accounting process
of converting the original cost of plant and equipment assets to expense is called
and reporting it can distort and change financial statement ratios (wait for some more time for details
on this).
Let’s begin with PPE.
1) Finding the cost at acquisition – PPE
You can acquire LLA through either purchase, build, or exchanging it.
1.1. Purchase – When you purchase an asset, it is recorded at cost. You can add few additional costs
like instalment or freight-in
© CFA charges
Institute. into total cost
For candidate use of acquiring
only. Not forPPE. The logic here is – these costs
distribution.
will make the PPE ready for use and future benefits. We will say that Asset in B/S is recorded and
Reading 26 ■ Long-Lived Assets
costs are capitalized. Let’s take an example to discuss which costs should we include in acquisition
(capitalized) and which one to expense.
EXAMPLE 1
Acquisition of PPE
Assume a (hypothetical) company, Trofferini S.A., incurred the following expen-
ditures to purchase a towel and tissue roll machine: €10,900 purchase price
including taxes, €200 for delivery of the machine, €300 for installation and
testing of the machine, and €100 to train staff on maintaining the machine. In
addition, the company paid a construction team €350 to reinforce the factory
floor and ceiling joists to accommodate the machine’s weight. The company also
paid €1,500 to repair the factory roof (a repair expected to extend the useful
life of the factory by five years) and €1,000 to have the exterior of the factory
and adjoining offices repainted for maintenance reasons. The repainting neither
extends the life of factory and offices nor improves their usability.
1 Which of these expenditures will be capitalised and which will be
expensed?
2 How will the treatment of these expenditures affect the company’s finan-
cial statements?
In this example we can segregate

Solution to 1:the expenditures into capitalised and expensed ones -
The company will capitalise as part of the cost of the machine all costs that are
Ans 1 – necessary to get the new machine ready for its intended use: €10,900 purchase
Capitalised expenditures for PPE–
price, €200 for delivery, €300 for installation and testing, and €350 to reinforce
the factory floor and ceiling joists
$10,900 – Direct product cost at acquisition, to accommodate the machine’s weight (which
capitalised
was machine
$200 – Delivery of the necessary required
to use the to
machine andso
use this, does not increase the value of the factory).
capitalised
$300 – Installation The €100 tototrain
necessary staffmachine,
use the is not necessary to get the asset ready for its intended
so capitalised
use and will be expensed.
$350 – without fixing the floor it is not usable
The company will capitalise the expenditure of €1,500 to repair the factory
roof because the repair is expected to extend the useful life of the factory. The
Expensed – company will expense the €1,000 to have the exterior of the factory and adjoin-
ing offices repainted because the64painting does not extend the life or alter the
productive capacity of the buildings.
Solution to 2:
$100 – Training of maintenance staff is not directly related to product. IndAS116 also not include
this. You can debate but since this has no relation with PPE so, count this as expense.
$1000 – exterior painting has no relation with PPE, so, it is an expense.
Expense capitalised other than PPE

$1500 – Repair of factory not related to PPE, but, as this increase the overall life of factory so
capitalised. Investing cash outflow.
Ans 2 – Machine/PPE = 10,900+200+300+350 = $11750 under asset. Investing cash outflow.

Factory = $1500 under asset. Investing cash outflow.
Expense in I/S = 100+1000 = $1,100, Reduces R/E & Operating cash outflow.
One student asked to consider the training costs as capitalized?

I answered him that this training is for maintaining the machine and not directly associated with it.
You can convince to consider it as capitalized only if there is argument that machine can’t be used
without incurring the training cost. This was not true in our case so, it is expense.
1.2. When we construct the Asset –
Suppose we borrow money to construct a building. We took loan and pay interest. The interest
payment till building construction is over can be treated in two ways –
when it is for personal use –
The interest paid is capitalized cost of asset and will be shown in the B/S under Building Asset -PPE.
This capitalized interest will be expensed over useful life of the building in the form of depreciation.
This is a very useful point from financial reporting point of view. This interest paid will not be an
operating expense. This is cash outflow due to financing activity.
Remember in KDC we took loan and there was the purpose – to run the business and not to build
restaurant, therefore we count interest as operating expense in the income statement.
when it is constructed for sale purpose – Suppose you are a builder in that case this building will be
the part of inventory, and interest which you are paying to finance it will be the part of inventory in
B/S. The capitalised interest will be the part of COGS when the asset is sold.
The interest payment made prior to the construction will be capitalised and classified as investing
cash outflow
IFRS may ask you to consider interest expense as operating or financing cash outflow.
US GAAP dictates to count it as operating cash outflow.
Guys, earlier in discussion on SCF we have not highlighted this point – under what head the interest
payment should be taken, either CFF or CFI but, this is a very important. Review this point carefully.
Also, suppose here if loan amount for building purpose was given/invested, the interest earned on it
will be adjusted in the interest cost capitalized. This rule is applicable under IFRS but not US GAAP.
65
operating or financing cash outflow under IFRS and is classified as an operating cash
outflow under US GAAP.
Example 2– 2
EXAMPLE
Capitalised Borrowing Costs

BILDA S.A., a hypothetical company, borrows €1,000,000 at an interest rate of
10 percent per year on 1 January 2010 to finance the construction of a factory
that will have a useful life of 40 years. Construction is completed after two
years, during which time the company earns €20,000 by temporarily investing
the loan proceeds.
1 What is the amount of interest that will be capitalised under IFRS, and
how would that amount differ from the amount that would be capitalised
under US GAAP?
2 Where will the capitalised borrowing cost appear on the company’s finan-
cial statements?
underSolution
IFRS the to 1:
capitalized amount will be $200,000 – 20000 = $180,000
UnderThe total the
GAAP amount of interest
capitalized paidwill
amount on be
the$200,000
loan during construction is €200,000 (=
€1,000,000 × 10% × 2 years). Under IFRS, the amount of borrowing cost eligible
for capitalisation
the capitalised borrowing is (interest)
reduced by costthe €20,000
will appear interest income
on the B/S from temporarily
as a component of PPE. In SCF this
investing
payment the loan
is investing cashproceeds,
outflow. so
in the amount years,
subsequent to be capitalised is €180,000.will
when the depreciation Under
be charged it will
reduceUSthe
GAAP, theexpense
interest amountpart to be capitalised is €200,000.
also.
PPE can be acquired through donation, exchange, or replacement. Please refer p.no 186 AHMP for
Solution to 2:
this discussion.
The capitalised borrowing costs will appear on the company’s balance sheet as a
component of property,
Finding plant, and equipment.
Intangible Assets’InCost
the years prior to completion
at Acquisition
of construction, the interest paid will appear on the statement of cash flows as
Threean investment
types activity.with
– i) Intangibles Overlimited
time, as theii)property
life; is depreciated,
Intangibles thelife;
with unlimited capitalised
and iii) Goodwill
interest component is part of subsequent years’ depreciation expense on the
company’s
Another income
classification – i)statement.
IA purchased in situations other than business combinations
ii) IA generated internally
iii) Assets acquired in business combinations.
i) Assets which have limited life or purchased in situations other than business combinations will be
treated same as tangible assets. They will be capitalized at fair value when acquired which is assumed
to be the same as purchase price. Analysts use judgement and assumptions in determining the fair
value. Expensing process is called as amortization which is similar to depreciation.
Accounting entry for amortization expense:
66
separate contra asset account, as is the case with accumulated depreciation. Thus, the
entry recording one year’s amortization of a five-year nonrenewable license that origi-
nally cost $50,000 would be
Amortization Expense . . . . . . . . . . . . . . . . . . . . 10,000

Licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Intangibles recognized as long-lived assets with indefinite useful lives—such as a re-

Herebroadcasting
newable we don’tlicense—are
introducenotany contraRather
amortized. assetthey
account like Accumulated
are subjected to peri- depreciation but, directly reduces
odic impairment tests. If it is determined that such an intangible asset is impaired, its
the value
carrying assetis(license)
written downaccount. Estimation
to its realizable value and aofcharge
amortization expense depends upon the schedule and is
equal to the write-
down based on assumptions and judgement.
is made to income. An intangible asset’s useful life is considered to be indefinite
if there are no legal, regulatory, contractual, competitive, economic, or other factors
thatAny such
limit its IAlife.purchases will impact SCF as investing cash outflow.
useful
ii) For the assets which are generated internally, are generally expensed when incurred. There can be
Whensome situations
one company in which
buys another a capitalization
company, might may
the purchasing company be pay
required.
more for
the acquired company than the fair value of its net assets—tangible assets plus recog-
For
nized example
intangibles, net R&D for developing
of any liabilities assumed by thea patent
purchaser.may be required
The amount by which to capitalize.
Advertisement
the purchase price exceedscanthedirectly betheexpensed
fair value of net assets isin the period.
recorded as an asset of the
acquiring company. Although sometimes reported on the balance sheet with a descrip-
In © SCF,CFA theInstitute.
costs will For candidate
be taken use only.
as operating Not for distribution.
cash outflow.
tive title such as “excess of acquisition cost over net assets acquired,” the amount is
customarily called goodwill. Reading 26 ■ Long-Lived Assets
It is important to note that goodwill arises only as part of a purchase transaction.
IFRS and US GAAP have different treatment guidelines for R&D which we need to go through
(More details are given in Chapter 12.) The buying company may be willing to pay
morecarefully.
than the fair(refer
value ofCFA material
the acquired p. noother
net assets – 383).
than goodwill because the ac-
quired company has a strong management team, a favorable reputation in the market-
place, superior production
EXAMPLE methods,
3 or other unidentifiable intangibles.
The acquisition cost of the recognized assets other than goodwill is their fair value
at the time of acquisition. Usually, these values are determined by appraisal, but in
some cases the netSoftware
book value ofDevelopment
these assets is accepted Costs
as being their fair value. If
there is evidence that the fair value differs from net book value, either higher or lower,
Assume REH AG, a hypothetical company, incurs expenditures
the fair value governs. of €1,000 per
month during the fiscal year ended 31 December 2019 to develop software for
Company A acquires all the assets of Company B, giving Company B $1,500,000 cash.
internal use. Under IFRS, the company must treat the expenditures as an expense
Company B has cash of $50,000, accounts receivable that are believed to have a realizable
value of $60,000, until the software
and acquired assets othermeets the criteria
than goodwill that are for recognition
estimated as an intangible asset, after
to have a fair
value of $1,100,000. The amount of goodwill is calculated as follows:
which time the expenditures can be capitalised as an intangible asset.
1 What is the accounting impact of the company being able to demonstrate
Total purchase price $1,500,000
Less that the software met the criteria for recognition as an intangible asset on
1 February versus 1 December?
Cash acquired $ 50,000
Accounts receivable 60,000
2 acquired
Other How assets
would the treatment
(estimated) of expenditures
1,100,000 1,210,000 differ if the company reported
_________ __________
under
Goodwill US GAAP and it had established
$ 290,000in 2018 that the project was likely
to be completed and the software used to perform the function intended?
Not 1.
Amortized
When you recognize this as intangible asset on Feb 01, then only one month expenditure will be
Goodwill cannot Solution
be amortizedto 1:any circumstances. It must be subjected to an an-
under
nualtaken as expense
impairment and go todueI/S
test. Any write-down remaining
to impairment 11 months
is charged (Feb 01 – till Dec 31) will be capitalized.
to income.
When youIfsay
the company is able to demonstrate that the software met the criteria for
it is recognizable as asset on Dec 1, then 11 months will be expense and go to I/S only
recognition as an intangible asset on 1 February, the company would recognise
one month $ 1000 will be capitalized.
the €1,000 expended in January as an expense on the income statement for the
fiscal year ended 31 December 2019. The other €11,000 of expenditures would
2. Under US GAAP, theaswhole
be recognised amountasset
an intangible will (on
be capitalized
the balancei.e. $ 12,000
sheet). spent forif software
Alternatively, the for internal
use company is not able to demonstrate that the software met the criteria for recog-
nition as an intangible asset until 1 December, the company would recognise the
iii) When €11,000
IA is acquired
expended in in
a business combination,
January through NovemberGoodwill is recognized
as an expense on the -income
statement for the fiscal year ended 31 December 2019, with the other €1,000 of
expenditures
Here purchaser recognised
of company pays as an intangible
according asset.
to the fair value of the net assets, i.e. total assets – total
liabilities Solution to 2:
67
Under US GAAP, the company would capitalise the entire €12,000 spent to
develop software for internal use.
that limit its useful life.
Goodwill When one company buys another company, the purchasing company may pay more for
the acquired company than the fair value of its net assets—tangible assets plus recog-
nized intangibles, net of any liabilities assumed by the purchaser. The amount by which
Total assets = tangible assetsprice
the purchase + intangible assets
exceeds the fair valuerecognized.
of the net assets is recorded as an asset of the
When purchaser paid price above than the fair reported
acquiring company. Although sometimes value of on the
Netbalance sheetthe
Assets, withdifference
a descrip- will be Goodwill
tive title such as “excess of acquisition cost over net assets acquired,” the amount is
and be shown in the balance
customarily sheet
called of the purchaser.
goodwill.
One notable point here is – Total asset
It is important to note thatisgoodwill
combination
arises onlyofasTA
partand IA, so what
of a purchase will happen if IA is also
transaction.
(More details are given in Chapter 12.) The buying company may be willing to pay
acquired in business
morecombinations?
than the fair value ofBasically,
the acquiredIFRS and
net assets US
other thanGAAP
goodwillhave different
because the ac- guidelines which
you can check on p.no. – 384 of
quired company has CFA
a strongmaterial.
management team, a favorable reputation in the market-
place, superior production methods, or other unidentifiable intangibles.
Remember estimating fair value
The acquisition ofrecognized
cost of the Net Assets isthansometimes
assets other difficult
goodwill is their fair value to estimate and
appraisal/valuation technique
at the required.
time of acquisition. The these
Usually, fair values
valueare of determined
Net Assets can’t bebut
by appraisal, less
in than Book value of
some cases the net book value of these assets is accepted as being their fair value. If
Net Assets. there is evidence that the fair value differs from net book value, either higher or lower,
the fair value governs.
Company A acquires all the assets of Company B, giving Company B $1,500,000 cash.
Example Company B has cash of $50,000, accounts receivable that are believed to have a realizable
value of $60,000, and acquired assets other than goodwill that are estimated to have a fair
value of $1,100,000. The amount of goodwill is calculated as follows:
Total purchase price $1,500,000

Answer - 290,000 Less
Source – Anthony et al. (1999)
Cash acquired $ 50,000
Accounts receivable 60,000
Good will is not amortized inOther
anyacquired
case.assets
Rather it is subjected
(estimated) 1,100,000
_________
to__________
annual impairment test. Any write-
1,210,000
down due to impairment is charged
Goodwill to income statement as loss $and goodwill is credited
290,000
Journal entry: Not Amortized

Impairment loss Goodwill
(Dr.) tocannot be amortized under any circumstances. It must be subjected to an an-
nual impairment test. Any write-down due to impairment is charged to income.
Goodwill (Cr.)
iv) Intangible Asset which has indefinite life will also pass through impairment test. We estimate the
carrying value as written down to realizable value and this written down will be the impairment loss
that will go to I/S. Let’s say now carrying value is $100 and realizable value is $90, $10 is impairment
loss to go to I/S and Intangible assets value will go down (credit) by $10
Journal entry:
Impairment loss (Dr.) 10
Intangible asset (Cr.) 10
Please, make a thorough understanding about meaning and interpretation of impairment for IA with
indefinite life and Goodwill.
So, capitalization and amortization is a process to convert costs into assets and expense
Impact of Capitalization and expensing on Financial Statements.
68
The example 4 on p.no – 387 provides insights how capitalization and expensing can
give different financial ratios. This is an important example to go through and
understand the impact.
II) Depreciation – Allocating costs to expenses over useful life
Here we are discussing topic on Depreciation for only reporting purpose and not tax purpose.
It is based on Matching Concept.
For tax purpose matching concept not necessarily required (refer AHMP 190).
Depreciation is a rear and tear charge of using an asset during its useful life. This rear and tear
gradually convert a new asset into obsolete one.
We follow an accounting process for this gradual conversion of PPE capitalized to cost into expense.
This process is called as depreciation.
Why should be this expense – deterioration and obsolescence of physical asset makes it no longer
useful. When it is an intangible asset we follow Amortization concept which is more or less similar.
To count depreciation as expense there are three judgements for each depreciable asset –
1. The service life of Asset – Not so easy to estimate life

2. Residual value – Can be small
3. Method of depreciation – Straight line, and accelerated depreciation method.
Depreciation accounting is just an estimate. An improper accounting for depreciation will make
financial analysts more worrisome into knowing the picture of the company.
Depreciation method –
Straight line method – Already done
Accelerated method – here we charge high depreciation in the initial years than later years.
a) Double-declining balance method - I worked on these methods in class, refer AHMP

b) Sum-of-the-years-digits method - I worked on these methods in class, refer AHMP
Case Discussion – Singapore Airline versus Delta Airlines

69
Why Airlines Industry in Depreciation Accounting Topic ?
Main Asset – planes. Reporting of depreciation matters!
In Depreciation calculation – Assumptions’ has crucial role which in turn depends upon economic
context in which airline operates, the asset-customer relationship (economics of company), and overall
business strategy of airline.
Main topics to discuss:

1. On what factors depreciation mainly depends – Life, residual value, and method. This case
talks about life only.
2. How depreciation accounting of planes is linked with the operating strategy, financial reporting
strategy and overall business strategy of the company.
Question 1 – Depreciation expense per $100 value of assets
Here,
• Depreciation value ranges from $4.75 - $11.25.
• Applying that to aircraft fleets with gross values of many billions of dollars is obviously going
to have a very material impact on companies’ depreciation expense and therefore on their
reported earnings.
• In this calculation depreciable life of asset is debatable!
70
• The useful life of SA is given as 10 years, which at least should be equal to the useful life of
DA.
Q2 - Comparing Depreciation Accounting Policies –

Factors affecting Useful Life
• It appears like the useful life of SA should be longer than DA.

• But, case facts tell that - DA has longer useful life.
• Hence other factors are probably motivating their depreciation assumptions.
Comparing Depreciation Accounting Policies – Financial Considerations
• As SA is more profitable than DA, it can bear larger depreciation expenses. Which SA has
through following more Conservative deprecation policy.
• As DA is bearing loss, it would tend to report less depreciation expenses. DA follows a Liberal
depreciation policy.
Financial Considerations – How much DA is saving through following Liberal Depreciation

expense Policy
• 1993, Average Asset Value of DA = $8872 million
• Depreciation expense = $8872*0.0475 = 421.42
• If SA were at the same asset level, Depreciation SA would have paid = $8872*0.08 = 709.76
• i.e. DA is reporting less depreciation expense = 709.76 – 421.42 = $288.34 million.
• Also, compared to previous year, DA is saving $8872 (0.06-0.0475) = $111 million, this number
is comparable to $130 million savings given in ex-4
71
DA is also saving extra dollars due to larger average age assumption
• The average age of DA = 8.8 Years

• The average age of SA = 5.1 Years
• Extra years = 3.7 years
• Showing more age, i.e. for larger time assets will be in place.
• The BV = $8872 million
• If you estimate the value of assets through including inflation factor of 3.5% (assume), its value
is 1.035^3.7*8872 = $10,076 million
• i.e. $10,076-$8872 = $1204 million more in gross asset value
• Depreciation charge if DA would have taken SA depreciation assumption = 1204*0.08 = $96
million
• This $96 million depreciation expense was saved compared to SA – Answer 3
DA’s total savings due to Liberal Depreciation policy
• In total DA saved $288.34 + $96 = $384.34 million due to its Liberal Depreciation Policy
Q4, 5
Strategy – SA vs DA
A Question arises here
If SA knew it following more conservative policy than DA why is SA is doing that?
• SA will get all the differences back in later period.
• SA get this gain in different form – Book gain through asset sale (Ex 1&5). DA got $30 million
USD, SA got $134 million in Singapore Dollars (USD $74)
• If you scale this on Gross revenue, you will find this as huge difference because DA has three
times operating revenue than SA.
• What SA is doing – it is actually depreciating the assets more in initial years and hence when it
sells the asset in market, the value they get is high (get the depreciation difference back)
• What is the advantage in doing so?
• Can you do some ratio analysis?
Leased Assets
Accounting for leased assets is different than assets acquired by companies.

In acquired assets the title of ownership is transferred and money is paid to attain the ownership title
and use of it.
In a lease, the lessor transfer the goods to lessee to use for certain time but, the title of ownership is
with lessor only.
72
In such case, it’s a financing arrangement when no ownership transferred to the lessees, i.e. he has to
return it back to the lessor. So, it should be a liability for lessee and thus assets be expensed
accordingly.
There are three types of Lease:
Operating Lease – For use of asset within the period of accounting. For example – House on rent,
vehicle on rent. In such cases the payment made to use it will be treated as expense of the period.
For example rent paid on Leased car is INR 10,000. This payment will be an expense for the month.
Rent expense (Dr) 10,000

Cash (Cr) 10,000
This is simple and no liability is recorded as asset was held for one time period only.
Capital Lease – In the case, Delta Airlines have shown assets in exhibit 2 these are capital leased
assets.
Capital lease assets are the ones which lessor provides to use for long time period say 10 years. Also,
it has almost all the rights equivalent to lessor, except ownership. In this case, since cash is not paid
to acquire it, a one-time accounting entry will be –
Dr Cr
Equipment (A) 10000
Equipment as liability (L) 10000
Now when every period the EMI is paid in cash, let’s say it is 2000 per year. In the first year, EMI
contains 1500 as capital payment and 500 as interest component, the journal entry will be as follows:
Dr Cr
Equipment as liability (L) 1500
Interest expense (Exp) 500
Cash 1500
This way Equipment Liability will be paid off in 10 years.

And Equipment asset should be expensed using depreciation expense. Let’s say for lessee, the useful
life is 10 years and straight line method is used to calculate the depreciation expense. The journal
entry will be –
Dr Cr
Depreciation Expense 1000
Accumulated Depreciation 1000
This way in 10 years asset will also be expensed and removed from the balance sheet.
73
Note that Accounting treatment for Asset and Liability is entirely independent after first entry of
asset.
For a lease to consider as capital lease following conditions should be met –
1) Ownership is transferred to the lessee at the end of the term of the lease, (2) the lessee has an option
to purchase the asset at a “bargain” price, (3) the term of the lease is 75 percent or more of the
economic life of the asset, or (4) the present value of the lease payments is 90 percent or more of the
fair value of the property (subject to certain detailed adjustments). Source: AHM
Finance Lease – Under IFRS, the capital lease is said to be finance lease if the risk and rewards related
to owning an asset is with lessee.
74
Module III
Financial Statement Analysis
AHMP Chapter 13 Wild and Subramanyam
• First, we will talk about ratios’ need, • Prospective Analysis

meaning and interpretation. • Profitability Analysis – Du Pont
Analysis
• Equity Analysis – Earnings based
models
• Credit Analysis – Liquidity and
Solvency Analysis
• Case –Sears & Roebuck co. Session 19
• My Notes
75
Financial Statement Analysis (FSA)
In your professional career you will be working in various capacities ranging from manager to
entrepreneur. You can be an analyst, investment banker involved in stock purchase or buy-sell deal
of companies, entrepreneur, or at least an investor interested in companies’ stocks. In all such
positions you will be hardly asked to prepare income statement, balance sheet, or cash flow statement
(Unless you are a Chartered accountant).
But, what you need necessarily in all spheres of life is “To analyse a business”.
Analysing and valuation of Business is an Art as well as Science.
We are in information economics business and here the information impacts the buyer and seller’s
decisions. Mostly in markets our decisions are based upon the judgment we make through analysing
qualitative and quantitative information. You are expected to be an intelligent user of Information.
In Business Analysis we process the information related to industry, economy, about business strategy,
business model and what not. But, this qualitative information is not self-sufficient. We need
numbers also to back our story to tell the audience. The most authentic and reliable quantitative
information source is financial statement. This is because Financial statements are audited and this
is an statutory requirement. Hence, presumably you can trust amongst all the available options.
In your career, whatever role you are in you will always be required to analyse the statements in one
form or other.
In our analysis, we wish to know the business activities in a company which we can sense from
financial statements in this course module.
The Full picture of Business Analysis
How to Analyze a Company

Topics:
Component Processes of
Business Analysis
Step 1
Business
Environment &
Strategy Analysis
Industry Strategy
Analysis Analysis
Step 3
Step 2 Step 2 Prospective
Accounting FSA and Ratio Analysis –
Analysis Forecasting Payoffs
Analysis
Step 4
This is an assembled slide for teaching inStep 4 and strictly for Private circulation by IIM Amritsar students batch 2021-2023, until March
classroom
Intrinsic
2021. Copying or posting is an infringement Value
of copyright.
Cost of Capital Estimate
Source: Willd and Subramaniyam (2007)

76
In this module our focus is on Step 2 and 3.
Accounting Analysis – in accounting analysis, we see the relationship between various line items of
statements, the accrual basis of accounting, and making statements ready for analysis through
incorporating the changes due to different accounting standards. This is not covered in this course
and is part of some advanced level course on FSA. Here we assume the statements are ready for our
analysis purpose.
Ratios Meaning and Interpretation – Once the statements are ready for analysis, we estimate some
ratios for meaningful interpretation. Ratios helps us in knowing about the business activities and
performance in past years. Techniques such as Du Pont Analysis, Trend Analysis will help us to
understand more about the business position in industry in past years. Usually, CEO or consultant
assigned for turn-around management remain interested in Du Pont Analysis. We discuss overall
performance ratios and segregate them into components.
A more formal approach of doing ratio analysis is to think from the perspective of shareholders and
creditors.
Credit Analysis – As a loan manager you wish to know answer of the following two questions – If the
company has enough liquidity and If the company is solvent enough or not. Liquidity Analysis and
Solvency Analysis will provide some important ratios to look here.
Equity Analysis – In equity analysis, we think from the perspective of existing shareholders or
prospective shareholders. Equity Analysis should inform us, “If the company is worth to invest or say
worth to provide our capital”
For the equity analysis, we follow the forward looking approach, i.e. Prospective analysis helps us in
knowing growth in future earnings.
Based on earnings estimates, we have two ratios to discuss here P/E and P/B ratios which are
estimated or I would say can be explained with valuation model.
So, we do Prospective Analysis and project future earnings and return numbers based on past years’
information.
Prospective Analysis – For equity analysis, we remain interested into knowing the future prospects
of business. We would want to purchase the only company’s stock which has good earnings prospects
and high growth in sales. This forward looking approach is used in valuation models and to price the
stock of a company. The pedigree of valuation models is Earnings forecast, cost of capital to the
company and assumptions on future prospects. The forecasting of earnings is based on past five years
statement details. we will forecast statements for maximum next five years (why only five years, why
not 20, 30 or 50 years? wait for some time)
Summary:
77
1. So, first we make statements ready for the analysis– ACCOUNTING ANALYSIS. (this is a
crucial step, here we are assuming that we have statements ready for analysis and need no
accounting adjustments or any mapping with reporting standards)
2. Then we make future projections through Prospective Analysis
3. Then for our purpose accordingly we either do credit or equity analysis.
Let’s discuss each of the topic one by one
Ratios Meaning and Interpretation
Broadly, there are five categories of ratios
1. Profitability Ratios
392 2. Solvency Ratios
ant7959X_ch13_367-401.qxd
3. Liquidity Ratios
4. Activity Ratios
5. Valuation Ratios
AHMP also1 provides

380 Part a laundry list of ratios as given below – Guys, find out the meaning and
Financial Accounting
Ratios summary: Interpretation

interpretation of these ratios for your exam preparation.
ILLUSTRATION 13–3 Summary of Ratios
State Discussed
Name of Ratio Formula Results as in Chapter
Overall Performance Measures

Market price per share
1. Price/earnings ratio ——— Times 13
Net income per share
Net income " Interest (1 # Tax rate)
2. Return on assets ————— Percent 13
Total asssets
Net income " Interest (1 # Tax rate)
3. Return on invested capital ————— Percent 13
Long-term liabilities " Shareholders’ equity
Net income
4. Return on shareholders’ equity ——— Percent 13
Shareholders’ equity
Profitability Measures
Gross margin
5. Gross margin percentage ——— Percent 6, 13
Net sales revenues
Net income
6. Profit margin ——— Percent 13
Net sales revenues
Net income
7. Earnings per share ——— Dollars 9
No. shares outstanding
13-25 Cash generated by operations
8. Cash Realization ———— Times 11
Net income
Tests of Investment Utilization
78 Sal es revenues
9. Asset turnover —— Times 13
Total assets
Sales revenues
10. Invested capital turnover ————— Times 13
No. shares outstanding

8. Cash Realization
Tests of Investment Utilization

Cash generated by operations
————
Net income
Times 11
Sal es revenues
9. Asset turnover —— Times 13
Total assets
Sales revenues
10. Invested capital turnover ————— Times 13
Long-term liabilities " Shareholders’ equity
Sales revenues
11. Equity turnover ——— Times 13
Sales revenues
12. Capital intensity ———— Times 13
Property, plant, and equipment
Cash
13. Days’ cash ——— Days 5
Cash expenses ! 365
Accounts receivable
14. Days’ receivables (or collection period) ——— Days 5
Sales ! 365
Inventory
15. Days’ inventory ——— Days 6
Cost of sales ! 365
ant7959X_ch13_367-401.qxd 3/16/10 10:58 PM Page 381 Cost of Accounting:
sales Text and Cases, 13th Edition 393
16. Inventory turnover —— Times 6
Inventory
Sa les revenues
17. Working capital turnover —— Times 13
Working capital

Current assets
18. Current ratio —— Ratio 5
Current liabilitChapter
ies 13 Financial Statement Analysis 381
Monetary current assets
13-26 19. Acid-test (quick) ratio ——— Ratio 5
ILLUSTRATION 13–3 (concluded ) Current liabilities
(continued)
State Discussed
Name of Ratio Formula Results as in Chapter
Tests of Financial Condition

Assets
20. Financial leverage ratio ——— Times 13
Long-term liabilities
21. Debt/equity ratio ——— Percent 8
or
Total liabilities
——— Percent 8
Long-term liabilities
22. Debt/capitalization ————— Percent 8
Long-term liabilities # Shareholders’ equity
Pretax operating profit # Interest
23. Times interest earned ———— Times 9
Interest
Cash generated operations
24. Cash flow/debt ———— Percent 11
Total debt
Tests of Dividend Policy
Dividends per share
25. Dividend yield ——— Percent 13
Market price per share
Dividends
26. Dividend payout —— Percent 13
Net income
Notes:
1. Averaging. When one term of a formula is an income statement item and the other term is a balance sheet item, it is often preferable to use the average of the beginning and
ending balance sheet amounts rather than the ending balance sheet amounts.
2. Tangible assets. Ratios involving noncurrent assets or total assets often exclude intangible assets such as goodwill and trademarks. When this is done, the word tangible is
usually used in identifying the ratio.
3. Debt. Debt ratios may exclude accounts payable, accrued liabilities, deferred income taxes, and other noninterest-bearing liabilities. The reader often has no way of knowing
whether this has been done, however. Conceptually, debt means interest-bearing liabilities.
13-27 4. Coverage ratios. Times interest earned and other coverage ratios can be calculated using pretax cash generated by operations instead of pretax operating profit.
Growth Measures 79
Analysts are also interested in the growth rate of certain key items such as sales, net in-
come, and earnings per share. These rates are often compared with the rate of inflation to
see if the company is keeping pace with inflation or experiencing real growth. Common
• Guys, ratios estimation should follow a proper interpretation and action to suggest. The
meaning and interpretation of several ratios was discussed in class and detail about these is
available in AHMP.
• There is a whole list of ratios, and you can develop new ratios which varies from industry to
industry and business to business. So, what should we do? Should we mug up all possible ratios?
For this course at least understand the ones which I discuss in class, and, understand theory of
developing a ratio/proxy. For example – Customer Life Time Value to Customer Acquisition
Cost (CLTV/CAC) is a recent ratio which is mostly used in venture capitalist funding for e-
commerce businesses. Here the point is - what this ratio conveys and how people trust and
understand from this about the business.
• Also, not every ratio category is useful for every reader of financial statements. For example –
In overall performance ratio category, market investors/traders might be interested into P/E
ratio, Investors/Shareholders may find ROE, ROA more attractive to discuss. CEO is
interested in division’s RNOA, common shareholders wants to know about ROCE only.
Further, for Credit Analysis Solvency and Liquidity Ratios are of prime concern whereas for
Equity Analysis ROE, P/E, P/B might be more useful.
So, I discuss first the Overall performance and Profitability Ratios. Few conceptual questions which
I discuss in class were:
a) What is the added advantage of using overall performance ratios?

• Profitability, financial condition, investment utilization and dividend ratios talks about a
particular aspect of business. For example – Current ratio tells us about the liquidity position
of a company, leverage ratios tells us about the debt taken per $100 dollars of equity
capital/total assets, interest coverage ratio tells us about the interest paying capacity of
company from operating income.
• Overall performance ratios such as ROIC (ROA, ROE, RNOA, ROCE are type of ROIC)
provides an integrated view and reflects an opinion about the business as a whole. It combines
Income Statement and Balance Sheet numbers together so it’s is more reliable estimate to talk
about the complete business picture.
• In Du Pont analysis we will understand the importance of overall performance measures.
b) In ROA, why we add tax adjusted interest part in Net income?
This is because in ROA we are looking at the income generated on total assets. Here, since it is not
an all equity firm, total assets are generated from debt and equity capital both. Now we know that
when a company has taken debt and repay the EMI on regular basis, the company gets rebate on
interest component. In this way, if we left this interest benefit in net income part it’s understatement
of NI, therefore we add back this component. This logical rationale adds complexity and sometimes
people also ignore for easing out the analysis.
80
n be interpreted as:
c) Is Return on Equity andROE
Return!onROA " Leverage
assets related with each other?
ther words, ROE is a function 𝑅𝑂𝐸 =

ofNET INCOME
a company’s ROA ∗
and its use of financial leverage
TOTAL ASSETS
0
e” for short, in this discussion). OWNERS A company 𝐸𝑄𝑈𝐼𝑇𝑌 TOTAL ASSETS
can improve its ROE by improving ROA
NET INCOME TOTAL ASSETS
ng more effective use of leverage. 𝑅𝑂𝐸 = Consistent with ∗ the definition given earlier, leverage
𝑇𝑂𝑇𝐴𝐿 𝐴𝑆𝑆𝐸𝑇𝑆 𝑂𝑊𝑁𝐸𝑅𝑆 0 𝐸𝑄𝑈𝐼𝑇𝑌
red as average total assets divided by average shareholders’ equity. If a company had
age (no liabilities), its leverage ratio 𝑅𝑂𝐸 would
= 𝑅𝑂𝐴 ∗equal
𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸 1.0 and ROE would exactly equal
s a company takes on liabilities, its leverage increases. As long as a company is able
ROE is a function of ROA and Financial Leverage. A company can improve its ROE by improving
w at ROA
a rate lower more
or making thaneffective
the marginal rate it can earn investing the borrowed money
use of Leverage.
siness, the company
If Leverage is debt
= 1, i.e. no making
– ROEanand effective
ROA willuse of leverage
be equal, i.e. returnand ROE would
to shareholders increase
will be equal
to return on
ge increases. Ifassets. For shareholders,
a company the return
’s borrowing coston exceeds
their capital supplied
the (ROE)rate
marginal is equal to theearn
it can returnon
company gets using the assets (ROA).
, ROE would >decline
If Leverage as leverage
1, the shareholders increased
would because
expect more earningsthefromeffect ofwhich
assets borrowing would
are financed frombe
s ROA.
debt and equity as well (high ROA). As long as the company borrows money at a lower rate than the
ng themarginal
data rate
fromof return
Exampleit can earn
7-12from
forassets
Anson(developed from financing),
Industries, the company
an analyst will be using
can examine the
debt effectively and ROE would increase. If reverse happens, the poor use of financed assets will be
ROEquestioned
and determine whether the increase from an ROE of #0.625 percent in 2002
by shareholders.
percent
Assetin 2005 iscause
utilization a function
an increaseofinROA or the
ROE. Refer theuse
tableofbelow.
leverage:
ROE ! ROA " Leverage

2005 5.92% 3.70% 1.60
2004 1.66% 1.05% 1.58
2003 1.62% 1.05% 1.54
2002 #0.62% #0.39% 1.60
r the four-year period, the company’s leverage factor was relatively stable. The pri-
son for•theIn increase in ROE
the above table, when is the increase
Leverage is almost in profi
stable tability
from measured
2002-2005 by ROA.
the more effective utilization
as ROE ofcan assets (ROA from -0.39% to 3.70%) in 4 years caused an increase in ROE (from -0.62% to
be decomposed, the individual components such as ROA can be
5.92%)
osed. Further
• Do you decomposing
remember thatROA,
in 2019,wewhencanReliance
express ROEdebt
became as laden
a product of the
company, three compo-
market and
os: shareholders became susceptible about RIL’s future prospects. In the 2019 Annual General
Meeting, Mukesh Ambani had to promise to make RIL a debt free company. Later on, JIO
(100%
Netsubsidiary
income
_______________________of RIL) got funding
Netfrom 10 investors_______________
income
__________ with in 3 months!! So, asset building
Revenue
through debt should ’justify !
high ROARexpected "
Averages shareholders equity evenueby shareholders.
Average total assets
Average total assets
" ______________________
81 (7-1b)
Average shareholders’ equity
d) Overall Performance Analysis - Du Pont Analysis:
Du Pont Analysis is to segregate an overall performance ratio into interdependent ratios. Through
segregating into ratios we see which particular ratio/aspect is dominant and which one needs an
improvement. Based on DuPont analysis you can recommend line of action or strategy for your client
firm to adopt.
ROIC is a general measure in which invested capital can be taken in following four different ways -
Remember - Invested capital is the average of two years or it can be the average of beginning and
ending capital numbers.
i) Return on Assets (ROA) – When we consider total assets. It is return divided by total assets of the
company. Total Assets are created from supplied debt and equity capital. This has a simple formula
given in the table above
ii) Return on Equity (ROE) – This is Return divided by Owners’ Equity Capital. Owners’ equity
capital includes common shareholders, preference shareholders etc.
iii) Return on Net Operating Assets (RNOA) – In divisions and businesses, not all assets fully
contribute or functional. Therefore ROA calculated above may have presented erroneous picture due
to the inclusion of idle/unproductive assets. This questions the usefulness of ROA as performance
measure. To rectify this, we can calculate return on Net Operating Assets (NOA) only. NOA is defined
as operating assets less operating liabilities. 9-42
Identifying Net Operating Asset

Operating and nonoperating activities - Distinction
BALANCE SHEET
Operating assets ..................... OA Financial liabilities .................. FL
Less operating liabilities ........ (OL) Less financial assets ............. (FA)
Net financial obligations......... NFO
Stockholders’ equity................ SE
Net operating assets.............. NOA Net financing ................ NFO + SE
The estimation of NOA is based on reformulation methods of Income statement and B/S and is not
covered in this course.
RNOA = NI/average NOA
82
• Captures the effect of leverage
(debt) capital on equity holder
return
iv) Return on Common Equity (ROCE) – When we want to know the return from common
shareholders perspective ROE is not useful as it might have preference shareholders in the
• Excludes all debt
denominator and dividend financing
payments andTherefore ROCE is more logical proxy.
to them in numerator.
preferred equity
To calculate this, in numerator we deduct dividend paid to preference shareholders from NI. In
denominator we deduct preference shareholders equity from total owners’ equity. The formula is
net income less preferred dividends

average common equity
In numerator we deducted the preference dividend from NI, and in denominator we consider
common equity which is obtained when Preference shareholders’ capital is deducted from owners’
equity. The whole point is – ROCE is more refined ratio and is useful for common shareholders.
Again ROCE also needs reformulation concepts which is outside the scope of this course.
Du Pont Analysis: Segregating ROE
As I told you the above four ratios are powerful overall performance measures. How and why? we will
explore answer of these questions here
I will consider ROE and RNOA for our discussion
Let’s go to AHMP p.no. 371, two years (2009 and 2010) financial statements. Here the return on
equity (ROE) = net income/shareholders’ equity = 680.7/1713.4 = 39.7 percent
This ROE can further segregated into component ratios as given below
NET INCOME SALES

𝑅𝑂𝐸 = ∗
OWNERS 0 𝐸𝑄𝑈𝐼𝑇𝑌 SALES
NET INCOME SALES

𝑅𝑂𝐸 = ∗
SALES OWNERS 0 𝐸𝑄𝑈𝐼𝑇𝑌
𝑅𝑂𝐸 = 𝑃𝑅𝑂𝐹𝐼𝑇 𝑀𝐴𝑅𝐺𝐼𝑁 ∗ 𝐸𝑄𝑈𝐼𝑇𝑌 𝑇𝑈𝑅𝑁𝑂𝑉𝐸𝑅
So, ROE can be defined in terms of two interdependent ratios

Remember: This two way decomposition can further be segregated as shown in the below diagram
for Franklin company
83
370
ILLUSTRATION 13–1 Factors Affecting Return on Investment*
PROFITABILITY
Sales Revenue
6,295
Gross Margin =
Cost of Sales – Net Income
3,306 ÷ 6,295 = 53%
2,989 681
= Expenses
+
5,615
Other Expenses
2,626 Profit Margin
681 ÷ 6,295 = 10.8%
Days' Cash
98
5,350 ÷ 365 Return on = Profit
= 6.7 days ÷ = Equity Margin
*
INVESTMENT UTILIZATION 39.8% Equity
Days' Receivables Turnover
537
6,295 ÷ 365 Current Assets Capital Intensity
= 31 days 6,295 ÷ 2,768
Cash 98 = 2.3 times
Accounts Noncurrent
Inventory Turnover Receivable 537 Assets
2,989 ÷ 403 Inventories 403 2,992
= 7.4 times Other 207 = Invested Capital
+
3,022
Working = Equity
Total 1,245 = – Capital
Days' Inventory Capital
30 1,713
403 Debt Capital
2,989 ÷ 365 – 1,309
= 49 days
Current Liabilities
1,215 Working Capital Equity Turnover
Turnover 6,295 ÷ 1,713
Current Ratio 6,295 ÷ 30 Debt Ratio = 3.7 times
1,245 ÷ 1,215 = 1.02 = 210 times 1,309 ÷ 3,022 = 43%
*
Numbers based on 2010 data in Illustration 13–2, rounded.
As you can see ROE is divided in profit margin and equity turnover ratios which are obtained from
NI and Equity Capital, which in turn are divided in Sales revenue, expenses, Invested capital and
Debt, respectively. These line items are further segregated into the components. This decomposition
provides insights for an analyst.
Suppose 1.02 current ratio of franklin is translating into 39.8% ROE. If there is another company
with same ROE but, current ratio 1.40, we would say this company has better liquidity condition
than Franklin.
84
Analysing Return on Assets-RNOA
Decomposition of RNOA:
As you can see from the above chart that RNOA can also be decomposed into constituents of Income
statements and Balance sheet items.
DuPont Analysis – Application
Let’s assume there are three companies (A,B, and C in order) which have same RNOA but different
profit margin and Asset turnover ratios as in the table below
First company A has a NOPAT Margin highest and lowest NOA turnover
Third Company C has lowest NOPAT Margin and highest NOA turnover
Profit margin and NOA turnover are a function of sales, i.e. are interdependent ratios. Therefore, we
can study these two for a given level RNOA 10% and graph them as in the figure.
Here a consultant can be hired by any of these three company owners and ask the consultant to revive
the company. Basically three type of questions may arise here –
i) Owner of Company C ask consultant to improve the profit margin comparable to A
ii) Owner of Company A ask consultant to improve asset turnover comparable to C
85
– Turnover is also a function of sales
• (sales/assets)
iii) Company C should target a higher RNOA 15%
iv) Company A should target a higher RNOA 15%
• Balancing act by Management to maximize RNOA
Analysis of Return on Net Operating Assets
Sales $5,000,000 $10,000,000 $10,000,000
NOPAT $500,000 $500,000 $100,000
NOA $5,000,000 $5,000,000 $1,000,000
NOPAT margin 10% 5% 1%
NOA turnover 1 2 10
Return on net operating assets 10% 10% 10%
Profit
Margin
RNOA = 15%
B
RNOA = 10%
C
Asset Turnover
• In the questions i) and ii), when consultant was asked to improve profit margin for C, and asset
turnover for A, it is sure both companies a and c will reach to the next higher RNOA level
because other ratios will be constant.
For improvement in profit margin of C, consultant has to go deeper into components of

profit like sales, NOPAT and should verfiy answers of questions related to sales, cost etc. Why
sales is low? If motivation of Sales is high? what pay structure is being followed to keep their
motivation level high? if advertisement is attractive or not. The point is sales is function of the
activities of marketing and production departments and need some clarification before
providing suggestions the owner of company C (refer the RNOA disaggregating chart above).
Here don’t confuse yourself if sales is high, NOPAT/SALES will be low!! It’s circular and for
constant cost, sales – cost will also high. If sales is high obviously NOPAT (sales – cost) will also
be high, and NOPAT/SALES in overall increase. So the point is – for given level of cost sales
86
should be improved. This is the diagnosis and how you will improve sales is part of ACTION
and STRATEGY (next step)
Similarly, if consultant feels that sales can’t be improved, then his focus must be on reducing
cost for constant sales. If consultant can provide some suggestions on reducing cost through
improving business process, the difference of Sales – cost will go up and overall Profit margin
ratio will improve. You will learn Cost management methods in Management Accounting
Course in detail. Further cost components like Administrative expenses, selling expenses can
also be controlled. If company C is successful into making margin at the same level of A, it will
reach to the higher RNOA level because asset turnover is already high. This is called as overall
performance/Du Pont analysis.
For improvement in Asset turnover of A, consultant has to go deeper into components of

operating assets. Asset turnover will go up if assets combination is in such a way that it
maximizes the sales. A consultant need to see if asset is unproductive, unnecessarily involved,
idle or waste. Corrections might be into PPE, intangibles like employees etc, cash management,
receivables management, inventory turnover etc. Also, a reduction in L-T liabilities will
improve operating assets efficiency. This is just a diagnosis and how company A will react is
part of action and Strategy which consultant can discuss further. If you can visualise a structure
of company, you can see in RNOA chart the components ratio tells you the story of the
departments – Production, inventory, quality etc.
In overall, if A achieves same asset turnover as that of C, it will reach to the next RNOA level
because profit margin is already high.
• In the question iii and iv, when consultant was given target to reach RNOA level 15%,
consultant will obviously look for an improvement in profit margin of C, and, Asset turnover
of A. Through following suggestive approach given above consultant can give suggestions to
owner of A and C to work upon and reach the higher RNOA level.
Learnings:
• Du Pont Analysis is a powerful diagnostic tool.

• It is just a tool and it depends how well action is taken and strategy is formulated.
• Be mindful that company A, B and C belong to the same industry and you can’t compare
companies of different industries with this tool. This is limitation of DuPont.
• However, you can make choices between industries to invest if you’re doing industry analysis.
• RNOA is a refined improved version of ROA. You can use ROA also at this level. Estimating
RNOA is covered in an advanced level course on FSA.
• Work upon Franklin case in the textbook AHMP and Ranbaxy in the Assignment 2
Industry Analysis:
87
We can make choices between industries to invest in and compare with as in the chart given below.
Look at he chart given below -
In the above figure few industries are lower to the curve and few are higher. Here macroeconomic
environment may have an impact on industries. Few industries by nature have low margin while
others have low asset turnover and vice versa. You can discuss and debate about these.
We can segregate ROE into three components also –
NET INCOME SALES TOTAL ASSETS

𝑅𝑂𝐸 = ∗ ∗
OWNERS 0 𝐸𝑄𝑈𝐼𝑇𝑌 SALES TOTAL ASSETS
NET INCOME SALES TOTAL ASSETS

𝑅𝑂𝐸 = ∗ ∗
SALES TOTAL ASSETS OWNERS 0 𝐸𝑄𝑈𝐼𝑇𝑌
𝑅𝑂𝐸 = 𝑃𝑅𝑂𝐹𝐼𝑇 𝑀𝐴𝑅𝐺𝐼𝑁 ∗ 𝐴𝑆𝑆𝐸𝑇 𝑇𝑈𝑅𝑁𝑂𝑉𝐸𝑅 ∗ 𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸
88
CASE STUDY: SEARS ROEBUCK & CO. AND WALMART INC.
The above shown three way decomposition will be covered in this case. Let me just brief you about
this case.
Edward is a recent graduate from a business school and is appointed by an investment bank. His task
is to prepare a summary report (diagnostic) to find out the issues and problem in tow retail giants
Sears Roebuck and Co. and Walmart. He wants to identify which on is a good stock to pick and
further explain the problems in each of the companies.
In his diagnostic report, he trusts upon DuPont Analysis. Let’s have a look at the results Edward got
from Financial Statements:
ROE Return Asset Utilization* Leverage

on
sales*
Walmar 3526/(18503+17143)/ 3526/11795 117958/(45384+39604)/ 42494/(18503+17143)/
t 2 8 2 2
19.7% 0.03 2.78 2.38
Sears 1188/(5862+4945)/2 1188/41296 41296/(38700+36167)/2 37433.5/(5862+4945)/

2
22% 0.29 1.10 6.93
Now you should follow “drilling down” or “peeling onion approach” as I explained you desegregating
ratios” in the class.
As we discuss a limited ratios, but, you should be comfortable with this approach to deal any company
of any industry.
So my observations are as follows:
1) Return on Sales – Though both have same ROS, but if we look closely Sears has high gross margin
but loses in Administrative expense. Walmart though provide upfront discount but has less
Administrative expenses.
2) Asset Utilization – You can claim from case that Walmart’s inventory management practice is really
good. But you see, sales per square feet of both the companies is same. This contradicts to the claim
made earlier. Let’s dig further and look at cash-to-cash cycle (includes inventory A/R, A/P).
Formula Walmart Sears
89
Day Inventory 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 OPQRS
= 66.8
SVRR
= 69
TURUQ/UPS WPXPT/UPS
𝐶𝑂𝐺𝑆/365
Day receivables 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐 TXP
=3 24272
OOXTSQ/UPS = 244
𝑆𝑎𝑙𝑒𝑠/365 36371/365
Days payables 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 9126 PPUX
= 91
= 36 WPXPT/UPS
𝐶𝑂𝐺𝑆/365 93438/365
Cash-to-cash 𝐷𝑎𝑦 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 33.8 222
+ 𝑑𝑎𝑦 𝑟𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒𝑠
− 𝐷𝑎𝑦 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
Based on the ratios day inventory, day receivables and day payables you can debate about the
preference of Walmart over Sears. Few observations:
i) Both companies took almost similar time to convert raw material into finished goods - > day
inventory is same.
ii) Day receivables of Sears is very very high (222 vs. 3 days). This refers where the problem is with
Sears. You can base this story from the details given in the case. Sears has a credit division and
receivables management is poor.
iii) Sear takes more time to pay to it suppliers (91 vs. 36 days). Two possibilities – either they don’t’
have money so paying late to supplier or suppliers have more trust on Sears of which Sears is taking
advantage to balance out in cash-to-cash. Looking at the case details second option seems appropriate
because Sears is an Old Sinking Ship but may have reputation in the suppliers market.
3) Leverage –Walmart has a corporate philosophy that “Debt is Bad”. Here you can talk about interest
coverage ratio of both the companies.
Since you observed above that Sears has a credit division is relying more on debt. It Leverage ratio is
6.93 which is three times higher than Walmart!!
So, let’s see if the credit card division is the main problem of Sears?
To explore and answer this, let’s do one thing. Let’s recalculate the DuPont for Sears’ retail business
only. We will remove the credit division and can calculate the DuPont. This is given below
ROE Return Asset Utilization* Leverage

on sales*
Sears 594 36371 15073
36371 15073 5403.5
10.99% 0.016 2.41 2.80
• NI = 594 = this is half of the NI of 1188. It is given in the case that retail income
is half of the total income (exhibit 6)
90
• Average Asset can be calculated after removing accounts receivables from assets of two years.
UQXVVmOTQRUmUUOPnUPOPXmOTUVUmWWPV
= 36371
UPUXO
What you observe when compare Walmart Ratios calculated above –
i) Asset utilization of Sears is almost equal to Walmart!!

ii) Leverage ratio class is in the almost same range of Walmart!
GUYS, This is a classic observation.
SO SHOULD WE SUGGEST SEARS TO SHUT DOWN THEIR CREDIT DIVISION

BECAUSE THIS IS A ROTTEN EGG NOW!!!
WRAP UP
You can clearly see where the problem is with Sears. Walmart is doing better in this area. The main
earnings of Walmart is from core retail business. So Walmart has a clear edge over Sears. A further
look at the table on page 14 of the case tells you that per square foot sales of Walmart is also
decreasing which can be a caution for Walmart.
EQUITY ANALYSIS
From investors’ point of view, we focus primarily on the prospects of stock of a company. Two ratios
I want to discuss here –
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
1. Price to Book Ratio: P/B =
𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
2. Price-to-Earnings (PE) Ratio: P/E =
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Here estimation of MVE is crucial.
So, above calculated ratios depend upon MVE which the market price of equity now. Market price is
decided when investors buy and sell bid matches. So, price is dependent upon bids by the investors
which in turn is a function of the expectation of investors about the future prospects of the company.
Prospects can be defined in term earnings and growth in sales. So, if we can estimate the present
value of future earnings we can price the equity today. This is called an Earnings- Based model which
assumes of earning persistence.
Earnings persistence says, “What earnings was there in the past will persist in future also and you can
make projections of it through following Prospective Analysis”
91
ease in receivable or inventory turns. Analysts often prepare several projec-
amine best (worst) case scenarios in addition to the most likely case. This
analysis highlights which assumptions have the greatest impact on financial
Earnings-based model for P/B
consequently, help to identify those areas requiring greater scrutiny.
The model needs three inputs –

ationBook
of Prospective
Value of Equity atAnalysis
time t
Residual Income
Expected ResidualValuation
income E(RI),Model
the company can generate in future
Theoutset
ed at the appropriate discountprospective
of this chapter, rate (k) to discount
analysis isresidual income
central to security
The market value of equity at time t will be the Book value(t)
he residual income valuation model, for example, defines equity value at plus the present value of Residual
he sumIncome
11:32 AM
ofPage
current
(t +book
614
value nand
n), where =1,the present value of all future expected
2, 3,…
ome: i.e.
E(RIt"1) E(RIt"2 ) E(RIt"3 )
Vt ! BVt " " " "###
(1 " k )1 (1 " k )2 (1 " k )3
sFinancial
bookStatement
value Analysis
at the end of period t, RIt " n is residual income in period t " n ,
V
ost of capitalt = Market value of1).Equity
(see Chapter Residual income at time t is defined as
sive net BVincome
t = Book value
minus a of equity
charge ontoday
beginning book value, that is, RIt !
BVt $ 1k). = cost of capital (assumed value)
EARNINGS PERSISTENCE
E(RIt+1) = Expected residual Income = Net Income – Equity Cost= NIt+1 – k*BVt
e playsThis an can
thatbemany
rewritten
types ofasnonrecurring can provide information regarding
ompany valua- items often are included in income future profitability.
arch indicates from continuing operations. Exam- Recent analysis research indi-
ngs increase ples are gains and losses from asset cates that companies currently re-
a dollar-for- disposals, changes in accounting porting negative income along with
he stockWe priceknow that ROCE
estimates, t+1 = Netand
asset writedowns, Income/Equity
special items are=more
NIt+1 /BV
likely to tre-
nt sources of provisions for future losses. Analy- port special items in the following
NIt+1 = sis
and positively ROCE t+1* BVexamine
must carefully t the fi- year. These subsequent years’ special
e degree of nancial statement notes, MD&A, items are likely to be of the same
and other disclosures for the exis- sign. Profitable companies with dis-
rely solely on tence of these items. Evidence also continued operations are more likely
assifications in shows that extraordinary items and to report higher earnings in subse-
nce of a com- discontinued operations (special quent years.
earch indicates items) may be partly predictable and
By substituting the accounting-based expression for equity value in the numerator, the
PB ratio can be expressed in terms of accounting data as follows:
! " ! "
Vt (ROCEt"1 # k ) (ROCEt"2 # k ) BVt"1
!1" " $
BVt (1 " k ) (1 " k )2 BVt
! "
(ROCEt"3 # k ) BVt"2
" $ "···
3
(1 " k ) BVt
Source yields
This expression – Willd and
several Subramaniyam
important (2007)
insights. As future ROCE and/or growth in book
value increase, the PB ratio increases. Also, as the cost (risk) of equity capital, k, increases,
the PB ratio decreases. Recognize that PB ratios deviate from 1.0 when the market expects
residualObservations:
earnings (both positive and negative) in the future. If the present value of future
residual earnings is positive (negative), the PB ratio is greater (less) than 1.0.
1) Stock price is only impacted so long as ROCE ≠ k
Price-to-Earnings
2) Shareholder(PE)valueRatio
is created so long as ROCE > k
The price-to-earnings (PE) ratio is expressed as: Here ROCE/ROE is a value driver as are its components:
3) P/B depends upon ROCE/ROE.
• Net Profit MarginMarket value of equity
Net income
Ohlson and Juettner-Nauroth (2000) show that the PE ratio can be written
92 as a function
of short-term (STG) and long-term growth (LTG) of earning per share (eps) as follows:
P0 1 STG # LTG
eps1 ! k $ k # LTG
• Asset Turnover
• Financial Leverage
We have already discussed above factors importance in DuPont.
4) Shareholder value P/B depends upon k also, which we have assumed to be constant
5) Shareholder value P/B depends upon growth in Equity book value factor BVt+1/BVt
We skip one important point here - How to project NI, ROE, and BV numbers for next 4-5 years?
Basically prospective analysis helps you here
Prospective Analysis
It is projecting the Income statement and Balance sheet for next five years based on the past historical
data and some set of assumptions.
The projection process is mentioned in the slides and was explained to you in brief in the class. Refer
to my slides.
Insight –
Here an important question for you is – Why should we predict/project only for five years?
As you know ROE is a growth driver which ultimately is a function of NI, Margin etc. There was a
research study on different industries and value drivers pattern was studied. This is as given below –
Source – Willd and Subramaniyam (2007)
93
What you see here from these graphs that, all such value drivers for different companies are reverting
to mean over a period of time. This is called as Mean reversion property of Ratios. This property
refers that in a competitive environment initially there will be a clear distinction between companies,
which gradually decreases over a period of time (say 5 years) and after which lines become parallel. A
parallel line says that every company after 5 years settles in their growth ranges and two lines will
never meet because every company has it’s non-imitable resources and capabilities which restricts it
to meet. For Example – Sony vs Samsung, Apple vs. HP, McDonalds vs. Burger-King
All these brands have their unique features or keep distinguishing themselves from others through
innovation, R&D, service quality etc (non-imitable resource). You will learn more about in future
courses.
So, it makes sense to project up to for four to five years. Another reason could be shift in economic
environment and uncertainty in businesses.
CREDIT ANALYSIS
A creditor will look at the two aspects of a business

• Liquidity – Look at the ratios of dealings with customers and suppliers.
• Solvency – Look at the ratio investigating capital structure and Financial Risk (Leverage)
Guys look at those relevant ratios’ meaning and interpretation.
*****************The End*********************
Reference
1. Anthony, R. N., Hawkins, D. F., & Merchant, K. A. (1999). Accounting, text and cases. McGraw-
Hill/Irwin.
2. Penman, S. H., & Penman, S. H. (2010). Financial statement analysis and security valuation. New
York: McGraw-Hill/Irwin.
3. Wild, J. J., Subramanyam, K. R., & Halsey, R. F. (2007). Financial statement analysis.
94

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INTRODUCTION TO FINANCIAL ACCOUNTING

by Prof. Pankaj Gupta

WHY STUDY FINANCIAL ACCOUNTING

WHAT IS FINANCIAL STATEMENT

KERALA DOSA CAFÉ (KDC)

Transaction No. Transaction detail Parties involved and cash

5. August 6, 2020 During month, an additional $57500 of ingredients and boxes

9. August 10, 2020 No Cash. Customer and KDC

11. August 30, 2020 No Cash. Supplier of

FINANCIAL STATEMENTS: CAPTURING BUSINESS ACTIVITIES

From Capital market KDC From Product market

Fig. 1 - Business Activities diagram of KDC

ACTIVITY TYPE IN ACCOUNTING LANGUAGE

Task: Discuss and classify remaining transactions into these categories.

I FINANCIAL STATEMENTS USING LOGIC

KDC -Balance sheet as on August 1, 2020

Assets Liabilities & Owners’ Equity

Total 100,000_____ Total 100,000

B/S changes after another transaction on August 3, 2020

BALANCE SHEET AS ON AUGUST, 30, 2020

Table 4: Balance sheet as on August 30, 2020

Assets Liabilities & Owners’ Equity

LET US SUMMARIZE THE LEARNINGS FROM BALANCE SHEET

INCOME STATEMENT: KDC

Cash Flow Statement

Cash Flow Statement for KDC

Total cash Inflow

FINANCIAL STATEMENT USERS

Income statement during December,

Sales revenue 1,22,000

Balance sheet as on 31/12/2021

Assets Liabilities & O/E

Module I: Preparation of Financial Statements (FS)

THE ACCOUNTING RECORD SYSTEM

•Identify which two accounts involved

3. Prepare Ledger /T accounts •Ledger balance for each account

4. Identify, analyze and post •Analyze adjusting entries

Before you proceed let’s talk about few terminologies.

• Cash • Capital stock/owners’ capital

• Accounts receivable • Retained earnings

• Inventory • Sales revenue

• Prepaid insurance • Interest revenue

• Property, Plant and Equipment • Wages

• Accumulated Depreciation (contra- • Supplies expenses

• Accounts payable • Rent expenses

• Notes payable (short term) • Utilities expenses

• Wages payable • Telephone expenses

• Interest payable • Advertising expenses

• Unearned revenue • Depreciation expenses

• Loan payable • Interest expenses

• Accrued interest expenses • Income tax expenses

• Accrued utilities expenses

• IDENTIFY ACCOUNTS AS PERMANENT & TEMPORARY?

Case – KDC diary page

Transaction No. Transaction detail Step 1: Analyzing

9. August 10, 2020 Dr. Inventory (A)

12. August 30, 2020 Dr. Accounts Receivable (A)

Apart from adjusting