essentials of fa_chapter 2

7/29/2019 Essentials of FA_Chapter 2

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Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

ESSENTIALSOF FINANCIAL

ACCOUNTING

BY ASISH K BHATTACHARYYASecond Edition

Chapter 2


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Debt and Liabilities

In the case of debt and other liabilities, the

company has an obligation to return the capital and

to pay a return on the capital (interest) as per the

loan covenant.

Lenders have a claim on the assets of the

company.

If the company fails to meet its commitment for

return of the capital or to pay the interest, they can

force the company to sell the assets and repay theloan and pay the outstanding interest on the capital.

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Equity Capital

Equity is the residual interest in the assets of the

company after deducting all its liabilities.

Investment in equity capital is exposed to business

risks.

In the case of equity capital, the company has no

obligation to return the capital and to pay a return

on the capital.

The Companies Act does not allow a company to

return the equity capital contributed by equity

shareholders because return of capital is

detrimental to the interest of debt holders and other

creditors.

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Equity Capital (Cont.)

Investment in the debt capital is exposed to credit

risk only if the value of assets that the company

holds is significantly higher than the amount of the

debt capital.

A company has unconditional discretion to decide

when and how much of the net profit is to be

distributed to equity shareholders.

Investment in equity capital is exposed to business

risks.

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Equity Capital (Cont.)

Equity in the balance sheet fails to reflect the

fundamental value of the equity capital invested in

the entity because:

Internally generated intangible assets (except software)

are not recognised in the balance sheet

Fixed assets and liabilities are measured at historical

costs, current assets are measured at the lower of cost

and realisable value and investments in loan are

measured at cost and other investments are measured

at fair value

Financial statements provide historical information,

while the fundamental value depends on the cash flow

stream that the company is expected to generate in

future.

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Accounting Equation

Equity = Assets Liabilities

The terms equity and net worth are used

interchangeably.

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7/45Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Asset

An asset is a resource controlled by a firm as a

result of past events and from which future

economic benefits are expected to flow to the firm.

An asset is recognised in the balance sheet only if

its cost or value can be measured reliably.

Although many companies create value by

managing intangibles, internally generated

intangibles, other than software, are not recognised

as assets in the balance sheet.

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Classification of Assets2

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Assets

Non-currentassets

Currentassets

Fixed assets Investments Others

Property,

Plant andEquipment

Intangible

assets



Fixed Assets

Fixed assets are those which are used for

production and administration.

They provide benefits for more than one accounting

period.

Fixed assets can further be classified asproperty,

plant and equipment(PPE) and intangible assets.

Examples of PPE are land, building, railway siding,

machinery, equipment, vehicle, and computer.

Fixed assets may be viewed as assets that provide

the infrastructure.

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Current Assets and Non-current Assets

Current assets support the current operation.

They are part of the working capital.

Examples of current assets are finished goods held for

sale, work-in-progress held in stock, raw materials and

stores and spares, receivables (the amount due from

customers), marketable securities (securities that can

be sold in an active market and the company intends to

hold them for a short period), cash and bank balances.

Assets that cannot be classified as current assetsare classified as non-current assets.

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Liability

Liability is a present obligation of the company

arising from past events, the settlement of which is

expected to result in an outflow from the firms

resources embodying economic benefits.

Examples of liabilities are borrowings from financial

institutions, borrowings from public through issuance of

debentures or other types of bonds, public deposits,

interest accrued on borrowings, trade creditors (amount

due to suppliers of goods and services), advance

received from customers, progress payments received

from customers, and amount due against tax liability.

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Liabilities: Classification2

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Liabilities

Non-current

liabilities

Current

liabilities


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Current and Non-current Liabilities

Liabilities that are to be settled within the normal

operating cycle or12 months after the balance

sheet date are classified as current liabilities.

Examples of current liabilities are trade creditors,

advance from customers and that part of long-termborrowings which is payable within 12 months after the

balance sheet date.

Liabilities which cannot be classified as current

liabilities are known as non-current liabilities.

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Capital Structure

The capital structure represents how a firm finances

its overall operations and growth by using different

sources of funds.

Equity and debt are components of capital

structure.

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Gearing Ratio

Gearing is the relationship between a firms debt

capital and equity capital.

It is calculated as follows:

Net debt divided by enterprise value, that is, [D/(D+E)]

Net debt is calculated as total debt less the amount of

cash and cash equivalents in the balance sheet.

Theoretically, market value of debt and equity should be

used to calculate gearing.

But, in practice, in most situations, gearing is calculatedusing the book value of debt and equity.

.

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Gearing Ratio (cont.)

Gearing ratio indicates the risk of variability in

return to equity shareholders and the risk that the

entity may go bankrupt.

There is no ideal gearing ratio.

However, in general, high gearing increases the

financial risk of the firm

Companies manage capital structure and make

adjustments to it in light of changes in economic

conditions and the risk characteristics of the

underlying assets.

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Gearing Ratio (cont.)

Gearing: Selected companies: 31 March 2009

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Company Borrowing(Rs.

crore)

Equity(Rs.

crore)

Market

cap(Rs.

crore)

Gearing(Book

value)

Gearing

(Market

cap)

ABB Ltd. (Engineering) 0.02 2118.95 9056.96 0.00% 0.00%

Crompton Greaves Ltd. (Engineering) 53.67 1241.89 4512.43 4.14% 1.18%

Larsen & Toubro Ltd. (Engineering) 6556.03 12459.69 39396.29 34.48% 14.27%

Hindustan Motors Ltd. (Automobiles) 129.03 92.28 212.26 58.30% 37.81%

Maruti Suzuki (India) Ltd. (Automobiles) 753.8 9344.9 22393.42 7.46% 3.26%

Hindustan Unilever Ltd. (FMCG) 421.94 2061.51 51924.65 16.99% 0.81%

Procter & Gamble Hygiene & HealthCare Ltd. (FMCG)

0 346.64 2439.1 0.00% 0.00%

ITC Ltd. (Diversified) 177.55 13735.08 69750.9 1.28% 0.25%

Infosys Technologies Ltd. (IT) 0 17809 75848.43 0.00% 0.00%

Tata Consultancy Services Ltd. (IT) 40.37 13446.25 52844.97 0.30% 0.08%


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Expenditure and Expense

Expenditure reduces asset or increases liabilities.

If no asset is recognised from the expenditure, the

amount of equity in the balance sheet reduces.

Expenditure, which is not recognised as an asset, isan expense for the accounting period in which it is

incurred.

An asset is recognised from expenditure if it is

probable that the expenditure will provide benefits

in future and if the cost or value of the benefit

(asset) can be measured reliably.

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Expenditure and Expense (cont.)

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Willthe

benefits fromthe expenditureflow to

subsequentperiod(s)?

If no,Recognise the expenditureas an expense in the

income statement for thecurrent period.

If yes,Whether theresulting assetmeets therecognitioncriteria?

If no,Recognise the expenditureas an expense in theincome statement for thecurrent period.

If yes,Recognise the asset in the

balance sheet.


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Probable

Probable implies more likely than not.

Management is expected to form its judgement

based on evidence available to it.

In most situations it is impossible to assert withcertainty that an asset will provide benefits in future

in a changed business environment.

Therefore, reasonable certainty is the criterion for

recognition of asset from expenditure.

The term probable implies reasonable certainty.

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Virtual Certainty

The criterion of virtual certainty is used for

recognition of a few specified assets.

Virtual certainty implies very close to certainty,

without being actually certain.

For example, the criterion is used for the recognition of

an asset from a promise to reimburse an expense by a

third party (e.g. government).

Therefore, even if a firm is reasonably certain that the

benefit from the promise will materialise, it cannotrecognise an asset until the reimbursement becomes

virtually certain.

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Income

Income measures increases in economic benefits

during the accounting period in the form of inflows

or enhancements of assets or decreases in

liabilities that result in increases in equity, other

than those relating to contributions from equityparticipants.

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Expense

Expenses measure decreases in economic benefits

during the accounting period in the form of outflows

or depletions of assets or incurrence of liabilities

that result in decreases in equity, other than those

relating to distributions to equity participants.

Expense includes that part of expenditure, which

was recognised as asset in the current year or in

any previous years, allocated to the current year.

The allocated expense is called depreciation.

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Double Entry Bookkeeping

The double entry bookkeeping flows from the

accounting equation.

The equation tells us that, if the total amount of

assets increases, either the total amount of

liabilities increases or the amount of equity

increases.

The principle of double entry bookkeeping is thatfor

every debit there is a credit.

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DebitCredit Rules

Asset: Increase is Debit; Decrease is Credit

Liability: Increase is Credit; Decrease is Debit

Equity: Increase is Credit; Decrease is Debit

Expense: Debit Income: Credit

Recognition of income and recognition of

corresponding asset (cash/receivable) or de-

recognition of a liability are simultaneous. Similarly, recognition of expenses and recognition

of liability (provision/creditor) or derecognition of

asset (e.g. cash) are simultaneous.

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Alternative Debit-Credit Rules

Personal account

Amount due to or from a natural or juridical person (e.g.

a limited liability company)

Debit the receiver and credit the giver

Real account

Assets, other than the amount due from a person

Debit: what comes in; credit: what goes out

Nominal account

Incomes and expenses

Debit expenses and credit incomes

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Accrual Accounting

Under accrual basis of accounting, the effects of

transactions and other events are recognised when

they occur(and not as cash or its equivalent is

received or paid) and they are recorded in the

accounting records and reported in the financialstatements of the periods to which they relate.

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Accrual Accounting (cont.)

Revenue

Recognise income from sales of goods or services

when the goods have been delivered or services have

been rendered and it is reasonably certain that that the

amount will be collected. Expense

Expenses should be recognised when the goods or

services are received without waiting for actual cash

outflow.

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Pre-paid expenses

An expense paid in advance is recognised as an asset

and is usually classified as a current asset. Examples

are rent paid in advance, and advance paid to suppliers

of goods. Deferred revenue

Amount received from a customer before the goods

(services) are delivered is recognised as a liability.

Revenue is recognised and liability extinguished on

delivery of the goods (services).

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Interest

Interest income and interest expense are recognised on

time proportion basis.

Depreciation and amortisation

Depreciation (of property, plant and equipment) and

amortisation (of intangible assets) represent allocation

of capitalised expenditure to different periods that

benefit from the expenditure.

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Principle of Prudence

Prudence is the inclusion of a degree of caution in

the exercise of the judgements needed in making

the estimates required under conditions of

uncertainty, such that assets or income are not

overstated and liabilities or expenses are notunderstated.

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Principle of Prudence (cont.) Inventory valuation

Inventory of finished goods and work-in-progress (WIP)

are measured at cost or net realisable value (NRV),

whichever is lower.

Onerous contract

Executory contract is a contract under execution, orwhere one or more parties have not yet performed their

duties as stipulated in the contract document.

Onerous contract is an executory contract in which the

unavoidable costs of meeting the obligations under the

contract exceed the economic benefits expected to be

received under it.

A provision (liability) should be recognised for the

estimated loss on an onerous contract.

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Principle of Prudence (cont.)

Impairment loss

Impairment loss is recognised when management

estimates that a group of assets (called cash generating

unit) will not be able to recover its carrying amount,

which is the total of WDV of assets that constitute thecash generating unit (CGU).

Intangibles

GAAP does not permit recognition of internally

generated corporate reputation, product brands,

mastheads, publishing titles, customer lists and items

similar in substance.

It does not permit recognition of human resources as an

asset.

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Substance Over Form

Transactions and other events are recorded and

presented in financial statements based on their

economic substance, which might be different from

the legal form of the transaction.

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Substance Over Form: Finance Lease

In a lease agreement the lessor, who is the owner

of the asset, conveys to the lessee the right to use

the asset for an agreed period of time and receives

lease rent from the lessee.

In a finance lease, the lessor transfers substantiallyall the risks and rewards incidental to ownership of

the asset to the lessee.

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Substance Over Form: Finance Lease

(cont.)

A finance lease, in substance, is a financing

arrangement.

The lessee recognises the asset and a

corresponding liability in his balance sheet.

He recognises depreciation on the asset in his profit and

loss account.

The lessor presents the asset in his balance sheet

as receivable.

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Substance Over Form: Redeemable

Preference Shares

Investors in preference shares issued by a limited

liability company have preferential right over

distribution of net profit and assets on liquidation of

the company.

In the case of redeemable preference shares, thecompany is underobligation to repay the capital.

IFRS require classification of redeemable

preference shares in the balance sheet as debt.

However, the Companies Act, 1956 requires thatpreference shares should be presented in the

balance sheet as a component of equity capital.

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Substance Over Form: Sale and Buy-Back

Arrangement

In sale of goods, a sale is recognised only if, among

other things, the company has transferred to the

buyer the significant risks and rewards of ownership

of the goods.

In some transactions involving sale and buy-back ofthe goods significant risks and rewards of

ownership are not transferred to the buyer.

Example: Sale includes an arrangement to buy back at

a predetermined priceAlthough the legal form of those transactions is sale

of goods, they are not presented as such in

financial statements.

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Substance Over Form: Barter Transaction

A barter transaction that involves exchange of

similar goods, where neither of the parties

recognise sale and expenses in their profit and loss

account.

This is because exchange of similar goods has nocommercial substance in the sense that the

transaction does not have any material impact on

the cash flows of the parties concerned.

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Authorised Capital and Face Value

The authorised capital of a company is themaximum amount of share capital, measured at

face value, that the company is authorised to issue

to its shareholders.

The Memorandum of Association mentions the amount

of authorised capital.

Part of the authorised capital can (and frequently does)

remain unissued.

The authorised capital of the company may be

increased by the votes of the shareholders at a generalmeeting.

Authorised capital has no economic significance.

Higher the authorised capital, higher is the registration

fees and stamp duty.

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Authorised Capital and Face Value (Cont.)

Usually, a company that has ambition to grow as a large

company signals the ambition by mentioning high

authorised capital in the Memorandum of Association.

Face value (also calledpar value) is calculated by

dividing the authorised capital by the number ofparts in which the authorised capital is divided by

the company.

It is at the discretion of the company to decide the face

value.

A company can issue shares at a premium.

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Book Value

Book value per share is calculated by dividing the

amount of equity in the balance sheet by the

number of outstanding shares.

The number of outstanding shares is the number of

shares issued and subscribed less the number ofshares bought back.

Book value, to an extent, reflects historical

performance of the company.

However, it does not capture the historicalperformance fully for two reasons:

Most intangible assets are not recognised in the balance

sheet.

Most assets and liabilities are measured at historical cost.

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Market Value and Market Capitalisation

Market value refers to the price at which the shares

are being traded in the capital market.

It reflects the market expectation about the future

performance of the company.

Market value of the equity capital is called marketcapitalisation.

Share price may be perceived as market capitalisation

divided by the number of outstanding shares.

However, in practice, share price being observable,market capitalisation is calculated as follows:

Market capitalisation = Share price Number of

outstanding shares

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Market Value and Market Capitalisation

(cont.)

Market capitalisation may not be the same as the

intrinsicorthe fundamental valueof the equity.

There can be many reasons.

For example, market may not be confident of the

outcome of the companys strategy (e.g. turnaroundstrategy of a sick company projected by its

management).

Moreover, in the short term, the share price is affected

by factors such as liquidity in the market and market

sentiment.

In the long-term market capitalisation tends to

converge to the intrinsic or fundamental value of the

equity capital.

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