ACAD-EDGE

EDITION 1
Financial Accounting
Table of Contents
Financial Accounting ................................................................................................................................... 3
Purpose of the Financial Statements .......................................................................................................... 3
Regulatory Framework ............................................................................................................................... 3
Different Types of Firms ............................................................................................................................. 4
Sole Proprietorship ................................................................................................................................. 4
Partnership ............................................................................................................................................. 4
Limited Liability Partnership ................................................................................................................... 4
Private Limited Company ........................................................................................................................ 4
Public Limited Company ......................................................................................................................... 5
Basic Accounting Principles ........................................................................................................................ 5
Financial Statements................................................................................................................................... 7
Income Statement ...................................................................................................................................... 8
Balance Sheet ........................................................................................................................................... 11
Cash Flow Statement ................................................................................................................................ 14
Interlinkages between Financial Statements............................................................................................ 16
Depreciation ............................................................................................................................................. 18
Inventory Valuation .................................................................................................................................. 19
Inventory Valuation Methods ................................................................................................................... 20
Goodwill .................................................................................................................................................... 22
Main Components of Goodwill ............................................................................................................. 23

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 Financial Accounting
Financial accounting is a specialized branch of accounting that keeps track of a company's
financial transactions. Using standardized guidelines, the transactions are recorded,
summarized, and presented in a financial report or financial statements such as an income
statement or a balance sheet. Companies issue financial statements on a routine schedule. The
statements are considered external because they are given to people outside of the company,
with the primary recipients being owners/stockholders, as well as certain lenders. If a
corporation's stock is publicly traded, however, its financial statements (and other financial
reporting) tend to be widely circulated, and information will likely reach secondary recipients
such as competitors, customers, employees, labor organizations, and investment analysts. It's
important to point out that the purpose of financial accounting is not to report the value of a
company. Rather, it’s the purpose is to provide enough information for others to assess the
value of a company for themselves.

Purpose of the Financial Statements

Financial Statements act as the source for financial information which may be required by the
different stakeholders of any firm -
Internal Stakeholders
 Owners- To understand the financial health of their company and design strategies so as to
improve and sustain the condition of the firm
 Management- To understand the present financial position of the company and make short-
and long-term decisions to ensure stability and optimum growth
 Employees- They can use it to evaluate the performance of the company and accordingly gauge
their own remuneration and future at the company
External Stakeholders
 Investors- To assess the viability of investing in a given company and take a call on the long-
term goals of the company
 Bankers/Lenders- To decide whether to grant funds to a company or not on the basis of its
performance in the previous years and its expected future performance
 Suppliers/Creditors- To decide whether to continue doing business with the company and the
rates to be charged based on risk of default
 Government- They can use financial statements to determine if the tax returns filed by the
company are correct. By assessing the financial statements of all companies, they can track the
performance of the economy.

Regulatory Framework

To ensure that accounting information is presented in a fair manner and is comparable across
industries, companies are expected to follow certain accounting principles. Following are 3
accounting guidelines which are extensively followed in India and other countries –

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 US GAAP - US Generally Accepted Accounting Principles are the ones adopted by the US
Securities and Exchange Commission and is to be followed by companies registered in the US.
 IFRS - International Finance Reporting Standards are a globally accepted set of accounting
standards so that companies across different geographies can be compared easily.
 Indian GAAP/ Ind-AS – Indian GAAP are the accounting standards used in India up to FY 16.
However, from FY 17 onwards, companies with net worth of Rs. 500 crore or more are required
to switch to Indian Accounting Standards, while the remaining are required to do so from FY
18. The move is to make the Indian accounting standards as per the norms set by the
international standards such as IFRS.

Different Types of Firms

One Person Company

The One Person Company (commonly known as OPC) is the type of entity which is owned by a
single person. It allows a sole person to own and also manage the entire business operations.
The OPC as a business structure is recently introduced in India through Companies Act, 2013 to
administer the proprietorship businesses and promote in an organised way. This is the structure
which provides the benefits of corporate structure to those who wants no partition to business
ownership. Therefore, it is compared to sole proprietorship firm due to ownership and control
aspects. However, more often it is compared to Private Companies owing to its registration
process, business structure and characteristics. The OPC is also a type of Private Limited
Company, but with little distinctness. Similar to Private Limited Company, OPC
Registration and its operations are governed by the Indian Companies Act, 2013.

Sole Proprietorship
This is the easiest business entity to establish in India. It doesn’t need its own Permanent
Account Number (PAN) and the PAN of the owner (Proprietor) acts as the PAN for the Sole
Proprietorship firm. Registrations with various government departments are required only on a
need basis. For example, if the business provides services and service tax is applicable, then
registration with the service tax department is required. It is not possible to transfer the
ownership of a Sole Proprietorship from one person to another.

Partnership
Two or morepeoplecanformaPartnershipsubjecttomaximumof20 partners. A partnership deed is
prepared that details the amount of capital each partner will contribute to the partnership. It also
details how much profit/loss each partner will share. Working partners of the partnership are
also allowed to draw a salary. A partnership is also allowed to purchase assets in its name.
However, the owners of such assets are the partners of the firm. A partnership may/may not be
dissolved in case of death of a partner. Partners of the firm have unlimited business liabilities
which means their personal assets can be attached to meet business liability claims of the
partnership firm. Also, losses incurred due to act of one partner are liable for payment from
every partner of the partnership firm.

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 Limited Liability Partnership
LLP allows members to retain flexibility of ownership (similar to Partnership Firm) but
provides a liability protection. The maximum liability of each partner in an LLP is limited to the
extent of his/her investment in the firm.

Private Limited Company

Private Limited Company allows owners to subscribe to its shares by paying a share capital
fees. On subscribing to shares, the owners/members become shareholders on the company. A
Private Limited Company is a separate legal entity both in terms of taxation as well as liability.
The personal liability of the shareholders is limited to their share capital. Private Limited
Company can have between 2 to 50 members with minimum share capital of Rs 1,00,000 (one
lac). To look after the day to day activities of the company, Directors are appointed by the
Shareholders. Minimum two Directors must be appointed to look after the daily affairs of the
company. A Private Limited Company has more compliance burden when compared to a
Partnership and LLP. One the positive side, Shareholders of a Private Limited Company can
change without affecting the operational or legal standing of the company. Generally, Venture
Capital investors prefer to invest in businesses that are Private Limited Company since it allows
great degree of separation between ownership and operations. It also allows investors to exit the
company by selling shares without being liable for company affairs.

Public Limited Company

Public Limited Company is similar to Private Limited Company with the difference being that
number of shareholders of a Public Limited Company can be unlimited with a minimum seven
members. It is generally very difficult to establish a public limited company. A Public Limited
Company can be either listed in a stock exchange or remain unlisted. A Listed Public Limited
Company allows shareholders of the company to trade its shares freely on the stock exchange. A
Public Limited Company requires more public disclosures and compliance from the
government as well as market regular SEBI (Securities and Exchange Board of India) including
appointment of independent directors on the board, public disclosure of books of accounts, cap of
salaries of Directors and CEO. Like a Private Limited Company, a Public Limited Company is
also an independent legal person; its existence is not affected by the death, retirement or
insolvency of any of its shareholders.

Basic Accounting Principles

Before we go on to discuss the financial statements, let us have a look at the basic accounting
principles that govern these statements –

Economic Entity Assumption- This assumption implies that the company is a separate entity
and the accounts of the company are treated separately from those running it. By doing so, there
is no intermingling of personal and business transactions in a company's financial statements.

Going Concern Assumption- This assumption implies that the entity will be in existence for
an indefinitely long period in the future. Under this assumption, revenue and expense

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recognition may be deferred to a future period, when the company is still operating. Otherwise,
all expense recognition, in particular, would be accelerated into the current period.

Accounting Period- The time between two successive presentations of financial statements for
which transactions are recorded.

Matching Principle- This principle means that the revenues and expenses for a given period
must be matched. For e.g. sales commission must be recognized as an expense in the period
where corresponding sale is made and not when payment for it is received. By doing this, there
is no deferral of expense recognition into later reporting periods, so that someone viewing a
company's financial statements can be assured that all aspects of a transaction have been
recorded at the same time.

Accrual Concept- According to this concept, income and expenses need to be recognized when
the transaction occurs and not when actual cash is received/given out. Revenues are recognized
when earned, and expenses are recognized when assets are consumed. This concept means that
a business may recognize sales, profits and losses in amounts that vary from what would be
recognized based on the cash received from customers or when cash is paid to suppliers and
employees. Auditors will only certify the financial statements of a business that have been
prepared under the accruals concept.

The Accounting Equation and the Dual Aspect Concept - The dual aspect concept states that
every business transaction requires recordation in two different accounts. This concept is the
basis of double entry accounting, which is required by all accounting frameworks in equation,
which states that: 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝐸𝑞𝑢𝑖𝑡𝑦.

Conservatism concept- Revenues are only recognised when there is a reasonable certainty that
they will be realised, whereas expenses are recognised sooner when there is a reasonable
possibility that they will be incurred. This concept tends to result in more conservative financial
statements. If a situation arises where there are two acceptable alternatives for reporting an
item, conservatism directs the accountant to choose the alternative that will result in less net
income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not
direct accountants to be conservative. Accountants are expected to be unbiased and objective.
The basic accounting principle of conservatism leads accountants to anticipate or disclose
losses, but it does not allow a similar action for gains.

Consistency concept- Once a business chooses to use a specific accounting method, it should
continue using it on a go-forward basis. By doing so, the financial statements prepared in
multiple periods can be reliably compared.

Materiality concept -Transactions should be recorded when not doing so might alter the
decisions made by a reader of a company's financial statements. This tends to result in relatively
small-size transactions being recorded, so that the financial statements comprehensively
represent the financial results, financial position, and cash flows of a business.

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Monetary Unit Assumption- Economic activity is measured in Indian rupees, and only
transactions that can be expressed in Indian rupees are recorded. Only those transactions which
have a monetary value will be recorded in the financial statements.

Cost Principle- From an accountant's point of view, the term "cost" refers to the amount spent
(cash or the cash equivalent) when an item was originally obtained, whether that purchase
happened last year or thirty years ago. For this reason, the amounts shown on financial
statements are referred to as historical cost amounts. Because of this accounting principle asset
amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not
adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the
amount of money a company would receive if it were to sell the asset at today's market value.
(An exception is certain investments in stocks and bonds that are actively traded on a stock
exchange.)
Full Disclosure Principle- If certain information is important to an investor or lender using the
financial statements, that information should be disclosed within the statement or in the notes to
the statement. It is because of this basic accounting principle that numerous pages of
"footnotes" are often attached to financial statements.

Materiality- Because of this basic accounting principle or guideline, an accountant might be

allowed to violate another accounting principle if an amount is insignificant. Professional
judgement is needed to decide whether an amount is insignificant or immaterial. Because of
materiality, financial statements usually show amounts rounded to the nearest dollar, to the
nearest thousand, or to the nearest million dollars depending on the size of the company

Financial Statements

Financial accounting generates the following general-purpose, external, financial statements:

 Income statement (also referred to as "earnings statement" or "profit and loss
statement")
The income statement reports a company's profitability during a specified period of
time. The period of time could be one year, one month, three months, 13 weeks, or any
other time interval chosen by the company.
The main components of the income statement are revenues, expenses, gains, and
losses. Revenues include such things as sales, service revenues, and interest revenue.
Expenses include the cost of goods sold, operating expenses (such as salaries, rent,
utilities, advertising), and non-operating expenses (such as interest expense). If a
corporation's stock is publicly traded, the earnings per share of its common stock are
reported on the income statement.

 Balance sheet (sometimes referred to as "statement of financial position") The balance

sheet is organised into three parts:
1) Assets 2) Liabilities
3) Stockholders' Equity at a specified date (typically, last day of an accounting period)

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 The first section of the balance sheet reports the company's assets and includes such
things as cash, accounts receivable, inventory, prepaid insurance, buildings, and
equipment. The next section reports the company's liabilities; these are obligations that
are due at the date of the balance sheet and often include the word "payable" in their
title (Notes Payable, Accounts Payable, Wages Payable, and Interest Payable). The
final section is stockholders' equity, defined as the difference between the amount of
assets and a number of liabilities.

 Statement of cash flows (sometimes referred to as "cash flow statement")

The statement of cash flows explains the change in a company's cash (and cash
equivalents) during the time interval indicated in the heading of the statement. The
change is divided into three parts:
(1) operating activities, (2) investing activities and (3) financing activities
The operating activities section explains how a company's cash (and cash equivalents)
have changed due to operations. Investing activities refer to amounts spent or received
in transactions involving long-term assets. The financing activities section reports such
things cash received from the issuance of long-term debt, the issuance of stock, or
money spent to retire long-term liabilities.
 Statement of stockholders' equity
The statement of stockholders' (or shareholders') equity lists the changes in
stockholders' equity for the same period as the income statement and the cash flow
statement. The changes will include items such as net income, other comprehensive
income, dividends, the repurchase of common stock, and the exercise of stock options.

Income Statement
The income statement summarizes a firm's financial transactions over a defined period of time
(notice the difference between a balance sheet and an income statement here), whether it's a
quarter or a whole year. The income statement shows how the money is coming in (revenues,
also known as sales) and the expenses that are tied to generating those revenues. The difference
between the expenses and revenues is the profit that the company earns.
The basic equation underlying the income statement is: -

𝑅𝑒𝑣𝑒𝑛𝑢𝑒 - 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

The income statement is also known as a "profit & loss statement", or a "P&L". Revenue is also
known as “top line”. Net income is also known as "earnings" and "profit," in addition to being
called "the bottom line".

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Figure 1: Sample Income Statement

Let us start by understanding some of the most important things to look for in an income
statement-

Total Revenue: This is the total money that a company earns over a defined period of time. A
company needs to sell its product in order to stay in business, and this is where you can see that
process in action. The main sources of revenue for a company include-
 Sale of Goods
 Rendering of Services
 Income from Investments (Interest, Dividends etc.)
 Royalty

Cost of Goods Sold (COGS): The costs that are directly attributable to each unit of output
produced come under this category. For e.g. while selling a mobile phone, only the costs of the
parts that go into it will come under COGS, while the marketing and shipping costs will go into
operating expenses explained later. It consists of the following three components-

COGS= Cost of Materials Consumed + Purchase of Stock in Trade + Beginning inventory –

Closing Inventory

Cost of Materials Consumed- This is the cost of the items that are required for

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 manufacturing all the finished goods in the financial year, not just those which have
been sold.
Purchase of Stock-in-Trade- This includes some of the finished goods that the company
may decide to directly purchase rather than manufacture on its own. For e.g. retail stores
simply purchase and sell various staples, grocery etc.

Purchase of Stock-in-Trade- This includes some of the finished goods that the
company may decide to directly purchase rather than manufacture on its own. For e.g.
retail stores simply purchase and sell various staples, grocery etc.

Changes in Inventory- In order to only take into account, the cost of materials that
have been sold in the period, the portion of Cost of Materials Consumed, that doesn’t
get sold gets subtracted through this line item. It is the difference between Beginning
and ending inventory

Gross profit: Gross profit is the difference between sales price and the cost of producing the
products. Thus, it is the difference between total revenues and cost of goods sold. Cost of the
goods sold is the cost of the raw materials that are used in making the finished items that the
company sells to generate revenues. If this is negative, the company is in real trouble.

Operating Expenses: Operating expenses are costs that a company must pay in the normal
course of business. This can be classified as
Selling, General and Administrative Expenses- This involves all the direct and
indirect selling expenses such as sales commissions, advertising, promotional materials,
as well as administrative expenses such as compensation of the company's officers as
well as the marketing, sales, finance and office staffs, and other general expenses such
as the rent, utilities, supplies, computers, etc
Depreciation & Amortization- As per the ‘matching principle’, expenses must be
matched to the revenues in a period. Hence for all large, onetime expenses such as
building of a plant, purchase of machinery, furniture, computers, or promotion of a new
product, the expense is spread over time. That is, a portion of the expense is recorded
each year. This expense is called Depreciation or Amortization. The logic behind using
such a technique is that although a machine is bought in a given year, its benefits are
reaped over the next few years. So, it makes sense to distribute the expense incurred in
purchasing the machinery over a span of the machine’s working life. The term
‘Depreciation’ is used when physical assets are purchased, whereas the term
‘amortization’ is used when intangible assets are purchased, or for reasons such as the
one mentioned above – one-time promotion/advertising expenses for the launch of a
new product. Amortization is also used for land. The various methods of depreciation
and its details are covered later.

Operating Profit: Operating Profit = Gross Profit – Operating Expenses. Operating profits are
earned from a company's everyday core business operations. Operating profits also are called
"Earnings Before Interest and Taxes (EBIT).

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Finance Cost: Financing costs includes the interest payments that the company has made for
the loans that it has taken, both short- and long-term ones.

Net Income: Always found towards the bottom of the income statement (hence, also called the
bottom line), it is the most-watched number in a P&L. Net income is, in theory, the amount of
sales that are left over to be distributed to shareholders.

The layout of an income statement can be summarized as follows –

Particulars Amount
Sales (Top Line) XXX
COGS (XXX)
Gross Profit XXX
Operating Expenses (XXX)
Operating Profit (If we add depreciation and XXX
amortization, we will get EBITDA)
Interest (XXX)
Profit Before Tax XXX
Taxes (XXX)
Net Income (Bottom Line/ PAT) XXX

Balance Sheet

A statement of the assets, liabilities, and capital of a business or other organization at a

particular point in time, detailing the balance of income and expenditure over the preceding
period. The balance sheet gives the financial position of the firm at a specified moment in time.
Listed companies require disclosing their financial position at the end of every quarter (3
months) or every year (12 months).

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The structure of a Balance sheet is as follows-

Figure 2: Balance Sheet Structure

Share capital
Shareholders funds
Reserves and
Surplus
Sources
Current
Liabilities
Non-Current
Position of Funds
at a Date
Current
Assets
Non-Current
Applications
Current
Investments
Non-Current

Figure 3 gives a sample balance sheet. It has the following 3 components.

Shareholder’s Funds- This constitutes the owners share in the entity. The total shareholder’s
funds in a company can be broken down into 2 parts –
 Share capital- The initial amount that shareholders have invested in the firm
 Reserves and Surplus- It is the profits that the company has generated over the years
but has not distributed to the shareholders in the form of dividends

Liabilities- Liabilities can be of two types-

Non-Current (Long Term) Liabilities - Long term liabilities are those which have to
be repaid more than one year into the future. These can be in the form of-
Long term Borrowings- They are the principles associated with loans that the
company has taken and whose repayment doesn’t need to be done in the next
one year.
Current (Short Term) Liabilities- These are the items which need to be paid within
the accounting period of one year. It includes-
Short-term Borrowings - Loans that the company may take for raising short

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 term capital, and whose maturity is within the accounting period.
Amount/trade payables – This accounts for any good or service that the
company has used in the current accounting period but payment for the same has
not been made in the same accounting period
Accrued Expenses – Expenses that have been incurred, but not yet paid for such
as salaries, wages, and utility charges (water, electricity)
Current portion of long-term debt - The principle portion of a long-term debt
that the company needs to pay in the current accounting period.
Other current liabilities – Any liability not covered by the above-mentioned
line items

Figure 3: Sample Balance Sheet

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Application of Funds (Assets)- An asset is anything that the company owns and is likely to
provide benefits to the company for a period beyond the time at which the balance sheet has
been prepared. Assets can also be classified into two –
Non-Current Assets- A long term asset is one that will not turn into cash or be
consumed in the next one year.
Property Plant & Equipment (Tangible Assets) – PP&E is often the largest
line item on a firm's balance sheet. That makes sense, considering that many
companies make huge investments in things like factories, computer equipment
and machinery.
Intangible Assets – An intangible asset is something without a physical
substance. Examples include trademarks, copyrights and patents.
Goodwill – Goodwill is an accounting construct to balance the excess amount
(over fair value) a company pays when it acquires another company. It can't be
bought/sold, and is gradually amortized to income over its useful life (which
cannot exceed 5 years in India)

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 Current Assets- These are assets, which can be converted into cash within the
accounting period. These include-
Trade (Accounts) Receivables – The amount to be received for the goods/
services that the company has rendered but hasn’t got paid yet (for e.g. - from
customers who have taken products on credit)
Inventories - The raw materials, work-in-process goods and completely finished
goods that are considered to be the portion of a business's assets those are ready
or will be ready for sale.
Prepaid Expenses – This is opposite to Accrued expenses. These include future
expenses that have been paid in advance but have not yet been incurred. For e.g.
– Insurance premium, advance rent etc. As and when the benefits are realized,
these are reflected as expenses in income statement.
Cash and cash equivalents - Cash equivalents are extremely safe assets, like
government bonds, that can be easily transformed into cash.
Investments- An investment that is not a part of the core business that the
company has made and is expected to turn into cash within the end of the
accounting period

Cash Flow Statement

The cash flow statement is probably the most misunderstood, but most important of the
financial reports filed by companies. As they say, "Cash Is King?" Many value investors base
all of their decisions on how well a company can generate cash. The cash flow statement reports
a company's cash receipts and cash payments over a particular period of time. It leaves out
transactions that don't directly affect cash receipts and payments.

The cash flow statement divides up sources and uses of cash into these three areas:
 Cash Flow from Operations (CFO): CFO is the cash generated by the company's core
business activities. You want a company to generate cash from the business it operates.
It sounds obvious, but there are a ton of companies that don't generate cash from
operations and eventually fail.
 Cash Flow from Investing (CFI): Remember the Property Plant & Equipment line
from the balance sheet? When a company invests in these long-lived assets (or sells
them), the cash they spend buying the asset or the cash they generate from selling the
asset is recorded here. If a company is growing, CFI will almost always be negative.
That's a good thing, because it means the company is investing in assets that will create
profits for shareholders.
 Cash Flow from Financing (CFF): CFF is the cash that is provided by or repaid to
outside investors. If a company borrows $1 million that is $1 million dollars that flows
into the company, and CFF is positive. When the company repays the $1 million, that is
a $1 million outflow of cash, and CFF is negative.

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 Figure 4 - Sample cash flow statement

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 Interlinkages between Financial Statements
The connection between the balance sheet and the income statement arises due to the use of
double-entry accounting (mentioned in Basic Accounting Principles).

The interlinkage between the balance sheet and the income statement are as follows-
The profit for the year from the income statement that is retained by the company is added back
in the reserves and surplus at the end of the year. This amount belongs to the shareholders but is
kept by the company for certain strategic requirements.
The depreciation and amortization that the assets of a company goes through during the course
of operation in the period are recognised as an expense in the income statement. This amount is
deducted from the total of tangible and intangible assets from the balance sheet, at the end of
the period.
According to the accrual concept, even though revenues need to be recognised when a
transaction occurs, the actual payment could be received later. Hence, the entire revenue from
sales is recognised in the income statement once the sale occurs, but the part of the sale for
which the customer is yet to pay for goes into the accounts (trade) receivable line item of the
balance sheet.
Similar to point 3, in case of expenses, if the company uses a good or a service in the
accounting period, the entire cost for it is mentioned in the income statement. The portion of
this that the company is yet to pay its suppliers is mentioned in the Balance sheet under
accounts (trade) payables.

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To better understand linkages, let’s consider an example.

The business starts with an opening balance sheet with a cash and retained earnings balance.
The opening retained earnings balance is the starting position for the statement of retained
earnings (1).

The business trades during the year generating a net income which is shown in the income
statement and transferred to the statement of retained earnings (2).
Part of the retained earnings is distributed to investors by way of dividend, and the ending
balance is transferred to the closing balance sheet (3).

The cash balance from the opening balance sheet is the start of the cash flow statement (4).
The net income from the income statement forms the basis for calculating the cash flow from
operating activities (5).
Information from the closing balance sheet is used to complete the cash flow statement and
the cash balance in the closing balance sheet is agreed to the ending cash balance on
the cash flow statement (6).
So, if I buy a piece of equipment, initially, there is no impact on income statement; cash goes
down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash
flow statement) given that it was bought on cash.
Over the life of the asset: depreciation reduces net income (income statement); PP&E goes
down by depreciation, while retained earnings go down (balance sheet); and depreciation is
added back (because it is a non-cash expense that reduced net income) in the “cash flow from

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operations” section (cash flow statement).

Depreciation
Depreciation is defined as the measure of the wearing out, consumption or other reduction in
the useful economic life of a fixed asset, whether arising from
 Efflux(passage) of time or
 Obsolescence through technological or market changes.

Depreciation adjustments are not attempts to reflect the value of fixed assets in the balance
sheet. The purpose is to charge the purchase price of the company’s fixed assets in the profit
and loss in a systematic way. The following are the major methods of calculating D&A-

Straight Line Method- In this method of depreciation calculation, a fixed lifetime of the asset
is assumed and the cost of the asset is allocated evenly across the time periods.

Depreciation to be charged = (Purchase Price – Salvage Value) / (Life of the Asset)

Declining Balance Method- In this method of depreciation calculation a fixed depreciation

percentage is assumed. This percentage is applied to the remaining value of the asset to
calculate the depreciation for the period. For e.g. a $1000 asset being depreciated at 10% would
show depreciation of (0.1*1000) = $100 for the 1st year and (.1*(1000-100)) = $90 for the
second year and so on.

Sum of the Years’ Digits Method- This method is best explained through an example. Let us
say a $1500 asset has a useful life of 5 years. In this case we add up the numbers from one to
the life of the asset (5 in this case) i.e. 1+2+3+4+5=15. For the 1st year the depreciation
expense will be the value of the asset multiplied by the number of remaining years divided by
the sum of years’ digits i.e. 1500*(5/15) = $300. For the 2nd year it will be 1500*(4/15) =
$400 and so on.

Depreciation Based on level of Activity- In this method the depreciation is calculated on the
basis of the total number of output units a machine can produce. For e.g. if a machine can
produce 1,00,000 units in its life and its initial price is $1000, and its scrap value is $100, and if
the machine produces 10,000 units in this fiscal year, then the depreciation is given by (1000-
100) *10000/100000= $90.
BASIS FOR STRAIGHT WRITTEN
COMPARISON LINE METHOD DOWN VALUE

Meaning A method of depreciation in A method of

which the cost of the asset
is spread uniformly over the
life years by writing off a
fixed amount every year.
depreciation in which a
fixed rate of
depreciation is charged
on the book value of the
asset, over its useful life.

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 Calculation of depreciation On the original cost On the written down
value of the asset.

Annual depreciation charge Remains fixed during Reduces every year

the useful life.

Value of asset Completely written off Not completely written

off

Amount of depreciation Initially lower Initially higher

Impact of repairs and Increasing trend Remains constant

depreciation on P&L A/c

Appropriate for Assets with negligible Assets whose repairs

repairs increase, as they get
and maintenance like leases, older like machinery,
copyright. vehicles

WDV method is better method to calculate depreciation. In initial years cost of product reduced
more and WDL record depreciation higher in initial years

Inventory Valuation

Inventory valuation is the cost associated with an entity's inventory at the end of a reporting
period. It forms a key part of the cost of goods sold calculation, and can also be used as
collateral for loans. This valuation appears as a current asset on the entity's balance sheet. The
inventory valuation is based on the costs incurred by the entity to acquire the inventory, convert
it into a condition that makes it ready for sale, and have it transported into the proper place for
sale. You are not allowed to add any administrative or selling costs to the cost of inventory. The
costs that can be included in an inventory valuation are:

Direct labor Freight

Direct materials Handling
Factory overhead Import duties

It is also possible under the lower of cost or market rule that you may be required to reduce the
inventory valuation to the market value of the inventory, if it is lower than the recorded cost of
the inventory.

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 Inventory Valuation Methods

When assigning costs to inventory, one should adopt and consistently use a cost-flow
assumption regarding how inventory flows through the entity. Examples of cost-flow are:
 The Specific Identification method, where you track the specific cost of individual items
of inventory
 The First In, First Out method, where you assume that the first items to enter the
inventory are the first ones to be used
 The Last in, first out method, where you assume that the last items to enter the inventory
are the first ones to be used
 The Weighted Average method, where an average of the costs in the inventory is used in
the cost of goods sold
Whichever method you choose will affect the inventory valuation recorded at the end of the
reporting period.

As per AS2, valuation of inventory can be based on FIFO or Weighted Average Cost (WAC)
method. The use of appropriate method depends on the business type and the nature of products
sold. FIFO method is generally used for Fast moving goods like perishables while WAC is used
where goods are stacked up together in a way which makes it difficult to identify one from
another.

FIFO (First-in, first-out) method is based on the perception that the first inventories purchased
are the first ones to be sold. It is a cost flow assumption for most companies. Since the theory
perfectly matches to the actual flow of goods, therefore it is considered as the right way to value
inventory. Also, it is more logical approach, as oldest goods get sold first, thereby reducing the
risk of getting obsolete.

The LIFO (Last-in, first-out) process is mainly used to place an accounting value on
inventories. It is based on the theory that the last inventory item purchased is the first one to be
sold. LIFO method is like any store where the clerks stock the last item from front and
customers purchase items from front itself. This means that inventory located at the back is
never bought and therefore remains in the store. Presently, LIFO is hardly practiced by
businesses since inventories are rarely sold, therefore they become old and gradually lose their
value. This brings significant loss to company’s business.

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 Table - Difference between FIFO and LIFO
Particulars FIFO
In most businesses, the actual
Materials flow of materials follows
flow FIFO, which makes this a
logical choice.
If costs are increasing, the first
items sold are the least
Inflation expensive, so your cost of
goods sold decreases, you
report more profits, and
therefore pay a larger amount
of income taxes in near term.
There are no GAAP or IFRS
Financial restrictions on the use of FIFO
reporting in reporting financial results.
There are usually fewer
inventory layers to track in a
Record
FIFO system, since the oldest
keeping
layers are continually used up.
This reduces record keeping.
Since there are few inventory
layers, and those layers reflect
Reporting recent pricing, there are rarely
fluctuations any unusual spikes or drops in
the cost of goods sold that are
caused by accessing old
inventory layers.
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LIFO
There are few businesses
where the oldest items are kept
in stock while newer items are
sold first.
If costs are increasing, the last
items sold are the most
expensive, so your cost of goods
sold increases, you report fewer
profits, and therefore pay a
smaller amount of income taxes
in the near term.
IFRS does not all the use of the
LIFO method at all. The IRS
allows the use of LIFO, but if
you use it for any subsidiary,
you must use it for all parts of
the reporting entity.
There are usually more
inventory layers to track in a
LIFO system, since the oldest
layers can potentially remain in
the system for years. This
increases record keeping
There may be many inventory
layers, some with costs from a
number of years ago. If one of
these layers is accessed, it can
result in a dramatic increase or
decrease in the reported amount
of cost of goods sold.
 Goodwill

Goodwill may be described as the aggregate of those intangible attributes of a business which
contribute to its superior earning capacity over a normal return on investment. It may arise from
such attributes of a business as good reception, a favorable location, the ability and skill of its
employees and management, nature of its products, etc.
Goodwill is an intangible asset. The real value is indeterminable for a non-purchased goodwill
and based on arbitrary measurement. The valuation of goodwill is often based on the customs of
the trade and generally calculated as number of year’s purchase of average profits.

Valuation of purchased goodwill:

Average profit method: Under this method average profit is calculated on the basis of the past
few year’s profits. At the time of calculating average profit abnormal profit or loss will be
ignored. After calculating average profit, it is multiplied by a number (3 to 5 years), as agreed.
The product will be the value of the goodwill.
Goodwill = Average Profit × No. of year purchase
(The number of years of purchase is determined with reference to the probability of new
business to catch up with an existing business. It will differ from industry to industry and from
firm to firm. Normally the number of years ranges between 3 to 5.)

Weighted average profit method: To obtain the average profit, the profit of the year must be
multiplied by its weightage and the grand total should be divided by the aggregate number of
weights. After calculating average profit, it is multiplied by a number (3 or 5), as agreed. The
product will be the value of the goodwill.
Goodwill = Weighted average Profit × No. of year purchase

Super-profit method: Super profit is the excess of actual profit over the normal profit. Under
this method, super profits are taken as the basis for calculating goodwill in place of average
profit.

Goodwill is calculated as follows:

Step 1 - Calculate Capital Employed
Step 2 - Calculate Normal Return = Capital employed × Rate of normal return
Step 3 - Calculate Future Maintainable Profit
Step 4 - Calculate Super Profit
Future Maintainable Profit xxxx
Less: Normal Return (xxx)
Super Profit xxxx
Step 5 - Goodwill = Super profit × No. of years purchases

Annuity method: Under this method super profits should be discounted using appropriate
discount factor. When uniform annual super profit is expected, annuity factor can be used for
discounting the future values for converting into the present value.

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 Goodwill = Super Profit × Annuity factor
Capitalization of future maintainable method: Under this method, the firm is valued by
applying the following formula:
Goodwill = [(Future maintainable profit/ Normal rate return) *100] – Capital employed

Capitalization of super profits method: Under this method, goodwill is calculated by

capitalizing super-profits at agreed rate. The goodwill is calculated directly by applying the
following formula:
Goodwill = (Super profit/Capitalization rate) *100

Main Components of Goodwill

Profitability
The profitability is the most important factor in valuation of Goodwill. The main emphasis is on
future profits of the concern. Whether concern will able to increase in its profit in future. Since
the profit earned in past provides a base for the concern’s future profit. The process of
assessment, whether a concern will maintain its profits in the future is otherwise called “Future
Maintenance Profit”. Following factors are to be considered, while estimating the “Future
Maintenance Profit”:
 All normal working expenses should be included
 Any appreciation in the fixed assets should be excluded
 Any appreciation in the value of Current Assets should be included
 Provision for taxes should be included
 Income from non-trading assets should not be taken into account
 Transfer to General Reserve should be excluded
 Dividend to Preference Shareholders should be excluded
 Non –recurring expenses should be included
 Average profits of past years should be considered.

Normal Rate of Return

Every person investing his/her/its funds in companies needs a fair return; this is referred as
“Rate of Earnings”. The rate return is depend on the nature of industry and other factors such as
bank rate, risk, type of management, etc., it consists of following elements:
 Return at Zero Risk Level - In this case the risk to the investor is nil or zero, the concern
in which it has invested, do not has any risk in its activities. But at the same time the
return will be lower than expected. Like investment in Government securities, Bonds,
NSCs etc.
 Premium for Business Risk - It refers to risky investment. If a concern faces more risk in
its business transactions, then the rate of return or earning will be high. The profit will
vary in proportion to risk covered in the industry. The more is risk, higher is the
Premium.
 Premium for Financial Risk - It refers to risk connected with the Capital Structure. A
concern having higher debt/equity ratio is considered riskier.

There are other factors that affects the Rate of Returns are:

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 A) The bank rate C) Risk (due to nature of business)
B) Period of investment D) Economic and Political scenario, etc.

Capital Employed
The quantum of profits earned with respect to the capital used is an important basis for
valuation of goodwill. The Capital Employed represents Fixed Assets + Net Working Capital.
This represents Equity Holders fund plus long terms borrowings. Following items to be
included in determining capital employed:
 All Fixed Assets Less Depreciation written off
 Trade Investments
 All Current Assets
Following items should be excluded:
 Long term liabilities
 All current liabilities
 Intangible Assets including goodwill
 Non-Trading Assets
 Fictitious Assets
Generally, “Average Capital Employed” is used instead of “Capital Employed. Since profit
earning is a continuous process during the year.

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