JS

Financial Accounting &

Analysis

Union Bank Staff Training College

Shankar Jaganathan

March 26, 2011

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

Balance Sheet
Profit & Loss Stmt
Cash Flow Stmt.

Accounting Standards
Basis for Preparing
Financial Statements
3
 JS

A. The Need for Accounting

Standards

4
 The Birth: Hat-trick of events JS
• The hat-trick years -1967-69
• Location: Great Britain
• Setting: Takeover battles
– 1st ball: GEC –AEI
– 2nd ball: Courtaulds –International Paints
– 3rd ball: Leasco -Pergamon

5
 1st ball: GEC –AEI JS
• Industrial Reorganization Corporation established in 1966 to
promote rationalization in private sector
• Year 1967, Electrical equipments facing tough times
• Major players AEI and GEC
• Attempts at friendly consolidation between the two failed
• AEI performing below expectations
– A return of only 5% on £220 m investments
– Diversified into all segments of market
• Reports results for the first half year of 1967 in September
– £3.7 m profits lower than £6.9 m in 1966
• Poor results trigger GEC to bid for AEI
– £120 m for the business offered
– AEI Directors rejected the bid triggering a battle 6
 1st ball –GEC –AEI JS
• October 20th: AEI formally rejects the offer and announces
– Rationalization of business; sale of assets to realize £20 m
– Forecast profit of £10 m for 1967 vs. £9.2 m in 1966
– Forecast profit of £16 m in 1968 and £20 m in 1969
• October 30, GEC raised bid to £152 m
– Raises its own profit forecast to £21 m for 1967 from £19.5
– Forecasts profit of £24 m for 1968
• November 2, AEI rejects the bid
• Same day, GEC raises bid to £160 m &
– Attacks profit forecast of AEI
• This scuffle led to a proxy war
• GEC won the proxy war 7
 1st ball –GEC –AEI JS
• After GEC took over, they announced AEI results for 1967
– A loss of £4.5 million reported vs. £10 m profit forecast by AEI
• AEI directors published a rejoinder –their request for joint
meeting to analyze difference not accepted
• A Joint report of the two auditors was published
• In the report the auditors quantified the difference of £14.5 m
- £5 m as matter of fact
- £9.5 m as matter of judgment, of which £8.7 m
was lower valuation of stock & contracts
• ‘Neither the directors nor we have found it possible to judge
the extent to which the increase in this charge reflects the
difference in approach on the part of management under
new control’ Auditors note in the AEI accounts
8
2nd ball: Courtaulds –International
Paints JS
• International Paints a leading brand in UK in business from
1881
• Dufay Bitumastic made a takeover bid for International
Paints
• Before the offer expired, Courtaulds announced that they
will bid, if the Dufay bid failed
• As desired by Courtaulds, Dufay bid failed and Courtaulds
took-over International Paints
• Courtaulds was surprised by the quality of profits reported
by International Paints
• Chairman of Courtaulds wrote to the President of Institute
of Chartered Accountants of England and Wales,
complaining about multiple accounting policies and the
problem of reconciling pre-acquisition profits with post-
acquisition profits
9
3rd ball: Leasco -Pergamon JS
• Pergamon was a leading publisher of Scientific journals in UK
• Leasco Data Processing Corporation was a New York based
company
• Leasco negotiates to buy Pergamon and acquires 38% stake
for $22 million
• Pergamon’s auditors were Chalmers Impey, a respected British firm
• Leasco appointed Price Waterhouse to conduct a special audit
• The special audit reflects a loss of £60 k against a reported
profit of £1.5 m; the difference was mainly due to:
– £560 k of profit on sale to a related company (owned by Chairman)
– Not considering the loss of a associate encyclopedia company
• The acquisition was called off, leading to a lengthy legal battle

10
 ICAEW response JS
• ‘Statement of Intent on Accounting Standards’ issued in the
1970 with the objective of:
– Narrowing the areas of difference and variety in accounting
practice;
– Disclosing accounting bases;
– Disclosing departures from established accounting standards;
– Exposing major proposals on accounting standards for
consultation.
• Statement announced the formation of Accounting Standards
Steering Committee, which was subsequently called
Accounting Standards Committee.

11
Indian Accounting Standards JS
• ICAI responsible for Accounting standards in India
• Accounting Standards Board set up in 1977
• Till date 29 accounting standards issued and enforced
– Revenue 02
– Costs 04
– Assets 06
– Liabilities 03
– Generic 09
Specific 05
Total 29
AS 8: Accounting for R&D is withdrawn;
Hence we have 28 Accounting Standards today
12
Accounting Standards issued but not
Effective JS
• AS 30: Financial Instruments: Recognition and
Measurement
• AS 31: Financial Instruments: Presentation

Both these accounting standards are effective for

Financial Statements prepared from
• April 1, 2009, recommendatory

• April 1, 2011, mandatory

13
 Enterprises classified into multiple
categories JS
• Enterprises classified into three levels
– Level I
– Level II
– Level III
• Level II and III considered Small and Medium Enterprises
• Accounting Standards are of two types
– Measurement standards
– Disclosure standards
• All accounting standards applicable to Level I
• For Level II and Level III exempt from accounting standards
focused on disclosures

14
 Levels Defined
JS
LEVEL I
 Listed enterprises: debt or equity listed in stock exchange
 Enterprises planning to list their securities
 Enterprises with turnover exceeds Rs.50 crores
 Commercial, industrial or business enterprise having borrowing
including public deposits in excess of Rs.10 crores
 Subsidiary company whose parent company presents
consolidated results
 Banks
 Financial institutions
 Insurance companies
LEVEL II (Enterprises not in level I) and
 Turnover of more than Rs.40 lacs and less than Rs.50 crores
 Borrowings in excess of Rs.1 crore and less than Rs.10 crores
 Holding and subsidiary enterprises of any one of the above
LEVEL III
 Enterprises not covered in Level I and Level II

15
 AS 1: Disclosure of Accounting
Policies JS
• Objective: Promote better understanding of financial statements and
comparison between enterprises
• Fundamental Assumptions need not be disclosed
– Going concern, Consistency, Accrual basis
– Disclose only if these assumptions are not made
• Consideration in selection of accounting policies
– Prudence: profit not estimated and provision made for liabilities
– Substance over form
– Materiality: knowledge of which might influence the decision of
the user of financial statements

16
Answer to the first two cases GEC-AEI & Courtaulds –International Paints
AS 1: Disclosure of Accounting Policies
JS
• Areas in which Accounting policies differ:
1. Methods of depreciation, depletion and amortization
2. Treatment of expenditure during construction period
3. Conversion or translation of foreign currency items
4. Valuation of inventories
5. Treatment of goodwill
6. Valuation of Investments
7. Treatment of retirement benefits
8. Recognition of profit on long term contracts
9. Valuation of contingent liabilities
• Accounting policies should be disclosed in one place and form part of
financial statements
• Any change in accounting policy should be disclosed along with the
impact of such change
17
 JS

B. Recognizing Income and

Accounting for Costs

18
 Payment terms in Contracts JS
Based on payment terms
- Advance payment
- Cash on delivery
- Defined credit periods e.g. 30 days or 60 days
- Payment based on milestones
- Deferred Credit – e.g. a few years
Customer Financing
• Installment payment
• Hire purchase
Other variants
• Consignment Sales
• Sale on returnable basis
• Sale subject to Acceptance

Revenue recognition a challenge of Accrual Accounting 19

 Revenue Recognitions (AS) 9 JS
Covers
- Sale of goods
- Rendering of services
- Use by others of enterprise resources yielding interest,
royalties and dividends
Does not cover
- Revenue from Construction contracts, hire purchase, lease,
revenue from insurance contracts, government grants and
other subsidies
Revenue defined
1. The gross inflow of cash receivables or other considerations
arising in the ordinary course of business from sale of
goods, service or use by other of enterprise resources
2. Completed services contract method
3. Proportionate completion method 20
 Revenue Recognition (AS) 9 JS
General Principles
- Binding contract for sale (transfer of ownership for a consideration) in
Sale of goods
- Risk and reward should be transferred
- Recoverability of sale price
Services
- Proportionate completion method
- When more than one act is required for performance
- Revenue recognized based on contract value, associated cost, number
of acts,
- when services cover indeterminate acts over a period of time, on
straight line basis, unless otherwise specified
- Completed services contract method
- execution of a single act, or the final services are so significant that the
service is not considered concluded if the final act is not done
- Revenue recognized when the final act takes place
- Others – interest –accrues; Royalty –based on contract, Dividend –
based on right to receive 21
 Revenue Recognition (AS) 9 JS
Un-certainties on Revenue recognition
- Unreasonable to assess ultimate collection: price escalation,
penal interest on delayed payments
- After sale if uncertainty of collection arises, write off as bad
debts

Disclosure
- Disclose where revenue recognition has been postponed
pending resolution of significant un-certainties
- Basis for revenue recognition is disclosed
22
 Revenue Recognition (AS) 9 JS
Some Variants highlighted, when revenue recognized
- Delivery delayed at buyers request; risk transferred
- Delivery subject to installation; if installation is simple
- Delivery subject to approval; if accepted or period for rejection
has expired
- Guaranteed sale –giving buyer unlimited right of return; if
‘money back guarantee’ is given is given to customers
- Consignment sale- Only if the goods are sold by the consignee
- Cash on delivery –only on receipt of cash
- Sales with agreement to repurchase –not recognized as revenue
- Subscription for services –straight line basis over the period of
delivery or in line with value delivered if not proportionate
23
 Revenue Recognition (AS) 9 JS
Some Variants highlighted, when revenue recognized
- Installment sale –Revenue recognized on delivery of goods,
value recognized is value less the interest cost in the price;
interest recognized proportionate to unpaid balance
- Trade discount and volume discount should be reduced from
revenue
- Installation fee – only when equipment is installed
- Advertising and insurance agency commission –when service
is completed
- Admission fee –when the event has taken place
- Tuition fees –over the course
- Entrance and membership fee –Entrance fee is generally
capitalized, membership fee over the period of service 24
Identifying Good revenue recognition
Policy JS
• Adequate and meaningful disclosure
• Consistency –no accounting policy changes unless
mandated by statute
• No Prior period adjustments on account of Revenue
recognition (sales returns, revenue de-recognition)
• Receivables and other working capital components in line
with or better than the industry performance
• Other forms of Receivables –Unearned / Unbilled revenue
• Absence of wide fluctuations in revenue (variance in line
with industry fluctuations acceptable)

25
Receivables is the Barometer of Revenue recognition policy
 Accounting for Construction
Contracts (AS) 7 JS
• Though named Construction contracts applies to all contracts
that have the following feature:
“Date at which contract activity is entered into and
date when the activity is completed usually
falls into different accounting periods.”
• Construction contract is a contract for construction of an asset
or a combination of assets that are interrelated in terms of their
design, technology and function or their ultimate purpose
• Contract revenue is the initial amount agreed plus variations in
contract work, claims and incentive payments
• Variations, claims and incentives can be included only if they
can be reliably measured 26
Accounting for Construction Contracts
(AS) 7 JS
• Contract cost includes all direct costs and costs that are
attributable to contract activity in general and can be allocated to
the contract
– Insurance, design and technical assistance and construction
overhead
– Cost that cannot be included are General Administration cost, Selling
Cost, R&D Cost, Depreciation on idle plant
• Contract revenue and contract costs recognized by reference to the
stage of completion of activity
• Expected loss on contract should be expensed immediately on
identification 27
 Accounting for Construction
Contracts (AS) 7 JS
For Fixed Price projects the following conditions to be met:
- revenue can be reliably measured
- Economic benefits will flow to the business
- Contract cost for completion and % completion can be
reliably measured
- Actual cost can be compared with the estimate
When outcome of a Construction contract cannot be estimated:
- Revenue should be recognized only to the extent of cost
incurred, which can be recovered
- Contract cost should be recognized as an expense in the
period incurred
- Expected loss should be recognized immediately
28
 Accounting for Construction
Contracts (AS) 7 JS
Change in estimate of Contract cost or revenue

- When change identified in accounting period, cumulative

impact up to earlier period should be reported as prior

period expense and disclosed separately

Enterprise should disclose the methods used to determine

Revenue

29
 AS 6: Accounting for Depreciation JS
• Objective: Disclosure of depreciation policy necessary to appreciate
the view presented in financial statements
• Applies to all depreciable assets except
– Forests, plantations and similar regenerative natural resources
– Wasting assets like minerals, oils, natural gas and similar non-
regenerative assets
– Expenditure on R&D
– Goodwill
– Livestock
• Depreciation: wearing out, consumption or other loss of value of
depreciable asset arising from use, effluxion of time, obsolescence
through technology or market changes 30
 Computation of
Depreciation (AS 6) JS
• Depreciable assets are those that meet the following
conditions
- Expected to be used over more than one accounting period
- Have a limited useful life;
- Are held for the purpose of use in production or supply of
goods and services
• Depreciation is computed based on:
- Asset cost (historical cost)
- Estimated residual value
- Useful life
31
 Estimating useful life of an
asset JS
• Pre-determined by legal or contractual limits, e.g. lease hold
premises
• Directly governed by extraction or consumption e.g. moulds and
dies
• Extent of use, physical wear and tear e.g. plant and machinery
• Obsolescence arising from:
- Technology
- Improvement in production methods
- Change in market demand
- Legal restrictions

32
 What is Deferred Revenue expenses JS
• Event based Revenue expenses, where due to scale benefits are
expected to be realized over more than one accounting period

• Examples:

- Preliminary expenses

- Product launch expenses –Advertisement

- Expenditure on relocating or reorganizing part or all of its

enterprise for an economic benefit

• AS 26 requires all these expenses to be expensed when incurred

33
Accounting for borrowing cost (AS 16) JS
 Borrowing cost –interest and other costs incurred in connect
with borrowing of funds
• interest, amortization of discount or premium related to
borrowing, ancillary cost, finance charges, exchange
difference arising from foreign currency borrowing
• Borrowing cost directly associated with acquisition,
construction or production of asset –capitalized
- Conditions necessary:
1. expenditure incurred during construction period,
2. borrowing cost incurred, and
3. activities are necessary to prepare the asset for its intended use
34
 JS

C. Valuing Assets and

Recognizing Liabilities

35
Types of Assets JS
• Based on nature
– Physical assets, financial assets & intangible assets
• Based on intention of holder
– Current assets and long term assets
• Based on Balance Sheet classification by
Companies law
– Fixed Assets, Investments & Current Assets

36
 AS 22 Accounting for Taxes on
Income
JS
• Objective: Prescribe accounting treatment for taxes on Income

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

• Taxable Income: amount of profit or loss for the period

determined in accordance with the tax laws

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

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

• Deferred tax: effect of timing difference

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

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

• Permanent difference: difference between taxable

income and accounting income for a period that do not
reverse subsequently

38
AS 22 Accounting for Taxes on
Income JS
• Profit and loss account to consider Tax expense (i.e.
current tax + deferred tax)
• Deferred tax assets are tax benefits not availed by
the enterprise, but available to it –e.g. unabsorbed
depreciation or unabsorbed carry forward loss
• Deferred tax liability is tax benefit availed in the
Profit and Loss account, that will be reversed in
future, e.g. higher tax depreciation over book
depreciation
39
AS 22 Accounting for Taxes on
Income JS
• Disclosure:
• Deferred tax assets and deferred tax
liabilities should be reflected separately in
the balance sheet
• Break up of Deferred tax assets and Deferred
tax liabilities should be given in the Notes to
Accounts

40
Principles of Inventory Valuation (AS) 2
JS
• Inventory defined as
- held for sale in the ordinary course of business
- In the process of production for such sale; or
- In the form of materials or supplies to be consumed in the
production process or in rendering services
- Does not include spares for use in fixed assets (AS) 10
• Inventory to be valued at Cost or Net realizable value
• Cost includes
- Cost of purchase
- Cost of conversion (normal capacity, cost of goods)
- Cost excludes interest cost, abnormal wastage, storage cost,
administrative, selling and distribution costs 41
 Valuation of Inventories (AS) 2 JS
• Effective from April 1, 1999
• Applies to
- All inventories other than, specified below
• Does not apply to
- Work in progress under construction contract (AS) 7
- Work in progress in the ordinary course of business of
service providers
- Financial instruments held as stock in trade
- Producers’ inventories of livestock, agricultural and forest
products, mineral oils, ores and gases 42
Principles of Inventory Valuation JS
Basis for Inventory Valuation
Permitted by Accounting standard
- FiFo, Weighted Average
- Standard cost / Retail method permitted for convenience
(permitted for convenience if results approximate actual)
- LiFo (not permitted by Accounting Standard)
- Retail method is where cost is arrived at by reducing the gross
margin from the sale value to arrive at value of material
consumed
Inventory policies adopted should be disclosed in financial
statements
- policies adopted in measuring inventories including cost
formula
- Total carrying amount of inventories and its classification
43
AS 10 Fixed Assets JS
• Objective: this standard deals with accounting for fixed assets
under historical cost basis
• Fixed Asset: Assets held with the intention of being used for the
purpose of producing or providing goods and service and is not
held for sale in the normal course of business
• Component of cost: purchase price, site preparation, installation
cost, professional fees of architects and Engineers, expense on
start-up and commissioning of project including test runs and
experimental production
• Self constructed assets: same principle as above, except no
profit can be recognized on the same
• Cost of addition or extension to an existing asset is added to
44
existing asset
AS 10 Fixed Assets JS
• Amount substituted for historical cost:
– Value determined by competent appraisers
– Increase in value of fixed asset cannot be credited to Profit and
loss account; this amount is credit to Revaluation reserve
shown as part of Net-worth and not available for distribution as
dividend
– Revaluation of assets cannot be done selectively, it must be
undertaken for a whole class of asset within a unit
• Gross book value: Historical cost or other amounts
substituted for historical cost in the books of accounts
• Disclosure: Gross block, addition and disposal to be shown;
where revalued amount substituted for historical cost and
basis to be shown 45
How will you account for
this transaction? JS
• Your firm purchased a car on Lease finance.

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

• You have entered into a five year lease, paying an

annual rental of Rs.1.5 lacs.

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

year 5, by paying Rs.10,000

46
 Implicit Interest in Lease rental JS
Cash flows & Implicit interest working
Implicit Interest rate 15.65%  
Year Rs. Lacs  
Year 0 -5.000 $5.00  
Year 1 1.5  
Year 2 1.5  
Year 3 1.5  
Year 4 1.5  
Year 5 + RV 1.6      
Year Rental Interest Loan rpd Principal
Year 0 -5.000
Year 1 1.5000 0.783 0.718 (4.28)
Year 2 1.5000 0.670 0.830 (3.45)
Year 3 1.5000 0.540 0.960 (2.49)
Year 4 1.5000 0.390 1.110 (1.38)
Year 5 1.6000 0.216 1.384 0.00

47
AS 19 Accounting for Leases JS
• Objective: Prescribe accounting for lessee and lessors for

financial and operational lease

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

payment or a series of payment

• Finance lease: where substantially all risk and rewards of the

ownership of asset is transferred to the lessee

• Operating lease: other than a financial lease

48
AS 19 Accounting for Leases JS
• Interest rate implicit in lease: discount rate that
equals minimum lease value plus un-guaranteed
residual value to the fair value of the leased asset
at the inception of lease
• Accounting for financial lease:
– Lessee should recognize the lease as an asset and
liability, value of asset must equal fair value of he
leased asset
– Lease payment made should be apportioned
between finance charge and balance towards the
liability
– Depreciation of the asset should be accounted as
per AS 6
49
AS 19 Accounting for Leases JS
• Accounting for Operating lease:

– accounted as expense on a straight line basis

over the lease period or where more representative
over the time pattern of users benefit

– Should disclose by way of note the future minimum

lease payment under non-cancelable operating
lease
50
The Next Class:
Presentation JS
1. How will you decide if one industry is better than

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

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

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

and explain what the number reported their mean?

51