essentials of fa_chapter 3

7/30/2019 Essentials of FA_Chapter 3

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Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

ESSENTIALSOF FINANCIALACCOUNTING

BY ASISH K BHATTACHARYYASecond Edition

Chapter 3


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Purpose of Balance Sheet

Balance sheet is a snap shot statement of the

financial position of a company at the end of the

accounting period.

It lists assets (economic resources) and claims

(claim of equity holders and other creditors,

including debt holders) on those assets.

Assets and liabilities are grouped under different

categories as per the generally accepted

accounting principles (GAAP).

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Information on Capital Structure

The balance sheet presents the break-up of the

sources of funds.

Information on capital structure is relevant to

assess the ability of the company to:

meet long-term commitments;

take advantages of favourable events (opportunities) in

the business environment; and

respond appropriately to unfavourable events (threats).

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Information on Capital Structure (cont.)

If the proportion of debt in the capital structure issignificantly high, the company is likely to face hugeliquidity problem when events in the businessenvironment are not favourable, say, during theeconomic down trend.

If the proportion of debt is low in the capital structure,the firm may borrow funds to take advantage ofbusiness opportunities and to tide over liquidity crisis.

A firm manages capital with reference to the businessenvironment and the risk characteristics of theunderlying assets.

Risk characteristics depend on the industry in which itoperates and its strategy.

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Information on Assets

The balance sheet also presents the components of

fixed assets, investments and working capital.

Working capital is measured at the difference

between current assets and current liabilities.

This information, when analysed in conjunction with

the information provided in the profit and loss

account, helps:

develop a perspective on the ability of the company to

utilise the infrastructure (i.e. fixed assets) productivelyand

manage working capital efficiently.

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Balance Sheet Structure

Balance sheet is presented in two segments:

sources of funds and application of funds.

The segment entitled Sources on Funds provides

information on the capital structure.

The segment entitled Application of Funds

provides information on assets and working capital.


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Hindustan Unilever Limited (HUL)



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Shareholders Fund

Shareholders Fund (also called equity or net worth)

has two components:

Capital, and Reserves and Surplus.

Capital represents the face value of shares issued,

subscribed and outstanding at the balance sheet

date.

It also includes bonus shares issued by the company.

Balance sheet presents information on authorised

capital as disclosure.



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Shareholders Fund: Bonus Share

Issue of bonus shares is a process of capitalisation of retained

profit.

It does not change the amounts of assets and liabilities in the

balance sheet and consequently the amount of shareholders

fund. The number of outstanding shares increases.

Market capitalisation increases marginally because investors

take issue of bonus shares as good news.

By issuing bonus shares, companies transfer a portion of the

retained profit, which was available for distribution to capitaland cannot be distributed to shareholders.

Therefore, issue of bonus share signals managements

confidence in the growth of the company.



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Hindustan Unilever Limited (HUL)



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Reserves and Surplus

Reserves and surplus represents the amount ofprofit retained in the company.

In the present format provided in Schedule VI to theCompanies Act, accumulated loss, being debit balance,is presented in the asset side of the balance sheet.

In the proposed revised format, accumulated loss ispresented as negative reserves and surplus.

Reserves and surplus are classified in twocategories: capital reserveand revenue reserve.

Capital reserves are not available for distribution toshareholders.

Revenue reserves are available for distribution toshareholders.



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Capital Reserve

Capital reserves are capital profits retained in the

business. Examples of capital profit are:

a. Profit prior to incorporation of the company

b. Unrealised revaluation gain on the revaluation of fixed

assets

c. Excess amount realised on sale of an item of fixed

asset over its acquisition cost.

d. Profit on issue of forfeited shares.


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Capital Redemption Reserve

The item capital redemption reserve' represents the facevalue ofpreference shares redeemed.

When a company redeems preference shares, it is requiredeither to issue fresh shares or to transfer an amount equal tothe face value of shares redeemed from free reserves to the

capital redemption reserve. The Companies Act, 1956 considers redeemable preference

share quasi-equity.

Therefore, the law requires that the face value of thepreference shares redeemed should be transferred from

reserves available for distribution to shareholders to capitalredemption reserve.

This ensures that the total contributed capital (equity sharesplus preference shares) is not reduced on redemption ofpreference shares.


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Statutory Reserves

Statutory reserves represent reserves created tocomply with requirements of various statues. Exportprofit reserveand Development allowance reserve,which are classified as revenue reserve, are

statutory reserves. Certain tax exemptions or tax credits are available

under the Income Tax Act, subject to the conditionthat the company will retain a specified amount ofprofit for a specified period.

During that specified period, the profit cannot bedistributed to shareholders.

After the expiry of that period, the retained profit isavailable for distribution to shareholders.


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General Reserve

General reserve is the amount of retained profit

which is available for distribution to shareholders.

General reserve is also called free reserve.

The credit balance in the Profit and Loss Accountrepresents retained profit not apportioned to any

specified reserve.

There is no difference in the nature of general

reserve and the credit balance in the profit and loss

account because both are available for distribution

to shareholders.


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Loan Fund

Loan fund represents the amount of borrowings

outstanding at the balance sheet date.

Loans are eithersecured loansorunsecured loans.


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Secured Loan

Secured loansare those for which the companyhas provided some collateral, usually in the form ofmortgage or hypothecation of an asset or a group

of assets.

Examples are cash credit from a bank secured by

hypothecation of inventories and other current assets,

and a term loan from a financial institution secured by

mortgage of land.

In a situation when the company fails to honour itscommitment to repay the loan or to pay the interest,

a secured creditor can force the company to sell the

collateral and settle the outstanding amount from

the sale proceeds.


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Unsecured Loan

Unsecured loansare those for which no securityother than the personal guarantee is provided.

Usually, public deposit and overdrawn bank balance are

unsecured loan.


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Short-term and Long-term Loans

Short-term and long-term loans

Usually, the amount borrowed for a period one yearor less isclassified as short-term loan.

The amount borrowed for a period longer than one year isclassified as long-term loan.

Loans repayable within twelve months Schedule VI requires disclosure of the amount of loan

(including the part of long term loan) repayable within oneyear after the balance sheet date.

IFRS require entities to classify the loan repayable within

twelve months after the balance sheet date as current liability. In Indian balance sheets, current liabilities do not include the

amount of loan payable within twelve months after the balancesheet date.


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Operating Liabilities: Current Liabilities and

Provisions

Current liabilitiesare liabilities that are expected to be settledwithin the normal operating cycle or within twelve months after

the balance sheet date.

Provisionsrepresents liabilities that are present at the balancesheet date but the amount and the timing when they will be

settled are uncertain.

They are measured at the managements best estimate.

Acceptancesrepresent the amount payable to creditors forgoods and services acknowledged by accepting a negotiable

instrument (e.g. promissory note and bill of exchange). Sundry creditorsrepresent amount due to creditors for which

no negotiable instrument is executed.


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Operating Liabilities: Current Liabilities and

Provisions (cont.)

In Indian balance sheets, current liabilities and

provisions are grouped together.

This gives an impression that all liabilities represented by

provisions are current liabilities. But this is not true.

For example, provision for retirement/post-retirementbenefits to employees is not a current liability.

IFRS require classification of provisions into current and

non-current categories.

Current liabilities are usually presented in thebalance sheet as a deduction from current assets.


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Hindustan Unilever Limited (HUL)Current Liabilities and Provisions as at 31st March 2009


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Contingent Liabilities

Contingent liabilities are those obligations, settlement

of which, according to managements estimate, will not

result in outflow of economic benefits.

Therefore, those liabilities are disclosed as footnotes

below the balance sheet and are not recognised in the

balance sheet.

Liabilities which cannot be estimated reliably are not

recognised in the balance sheet. They are disclosed

under the heading contingent liabilities.


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Fixed Assets: Presentation

The amount of gross block (acquisition cost),

accumulated depreciation and impairment loss, and

net block (also called written down valueor WDV)are shown separately.

A company has to present details of different

classes of fixed assets separately.

IFRS require companies to present property, plant

and equipment and intangible assets separately.


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Fixed Assets: Presentation (cont.)

Gross blockrepresents the acquisition cost of fixedassets that the company holds at the balance sheet

date.

Net blockrepresents the written down value of fixedassets that the company holds at the balance sheet

date.

Capital-work-in-progressrepresents fixed assetsthat are under production or construction and fixed

assets that are yet to be ready for use.


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Asset Intensity

Analysts calculate asset turnover ratio, which

indicates the total sales per Re. 1 of investment in

fixed assets.

Some analysts calculates asset intensity ratio (ratio

of asset to sales) to estimate the investment

required by a company to achieve the desired

growth.

Asset intensity differs between industries.

Asset intensity also depends on the business

model.

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Asset Intensity (cont.)

Asset intensity ratios of selected companies

(Amount in Rs., Crore; figures for the year 20082009)

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HUL

(FMCG)

Infosys

(IT)

Bharti Airtel

(Telecommunication)

Sales 20,239 20,264 34,014

Net fixed assets 2,079 4,414 27,580

Fixed asset turnover 9.73 4.59 1.23

Fixed asset intensity ratio 0.10 0.22 0.81

Net current asset (working capital)

183 12,288

6,595

Working capital turnover ratio 1.65

Working capital intensity ratio 0.61


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Deferred Tax Asset and Deferred Tax

Liability

Deferred tax asset and deferred tax liability arises

from the temporary differencesin the carryingamount of an asset or liability in the balance sheet

and the tax base.

In most situations, tax base is the carrying amountof an asset or a liability in the balance sheet

prepared (notionally) for income tax purposes.

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Nature of Deferred Tax Liability

Financial analysts consider deferred tax liability as

quasi-equity.

The amount of deferred tax liability is available for use to

create value for shareholders.

It is different from other liabilities because: it does not carry any interest,

it does not arise from operations,

it does not finance the working capital, and

it is uncertain when the liability will materialise.

When the market value of equity is used to measure

the gearing, market capitalisation should not be

adjusted for deferred tax asset/liability.

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Deferred Tax Expense

Deferred tax represents the difference between the

closing balance and opening balance of deferred

tax liability/asset.

The amount by which the deferred tax liability increases

is recognised as deferred tax expense.

The amount by which the deferred tax liability

decreases is recognised as negative deferred taxexpense.

The amount by which the deferred tax asset increasesis recognised as negative deferred tax expense.

The amount by which the deferred tax asset decreases

is recognised as deferred tax expense.

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Investment

Investment represents assets that are neither used

for production and administration nor support

working capital.

Those assets are expected to produce regular

return (e.g. interest, dividend, and rent) and/or gainfrom capital appreciation.

Some investments provide trade benefits.

Companies trade in securities is a part of treasury

function.

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Treasury Function

A typical treasury function includes cash

management, risk management, hedging and

insurance management, accounts receivable

management, accounts payable management,

bank relations and investor relations. The stock of securities in which the company trades

(called marketable securities) is included in currentasset.

However, under the Indian GAAP, those areincluded in investment.

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Current Assets

Current assets support current operation.

Current assets are:

assets that are held for trading (finished goods);

assets which are expected to be consumed within the

normal operating cycle(e.g. raw material, work-in-progress and stores and spares that are used in regular

repair and maintenance);

assets that are recoverable within the normal operating

cycle or 12 months after the balance sheet date,

whichever is longer (e.g. trade debtors);

marketable securities, and cash and cash equivalents.

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Current Assets (cont.)

Indian GAAP (extant schedule VI to the Companies

Act, 1956) does not require classification of assets

into current and non-current categories.

Therefore, some items of assets, which should be

classified as non-current assets, are included incurrent assets in the balance sheet of Indian

companies.

Examples of those items are:

deposits with the company supplying power;

non-moving items of inventories.

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Loan and Advances

Loans and advances include loans and advances to

employees, loans and advances to vendors, and

loans and advances to subsidiaries and associates.

In the balance sheet of Indian companies, the total

amount of loans and advances is included incurrent assets.

However, as per the definition of current asset that part

of the loans and advances which is expected to be

realised after 12 months after the balance sheet dateshould not be included in current assets.

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UNDER

IFRS

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IFRS: Current And Non-current Distinction

A company should present current and non-current

assets and current and non-current liabilities

separately.

Current liabilities include the amount of debt

repayable within twelve months after the balancesheet date.

When a presentation based on liquidity provides

information that is reliable and more relevant, a

company should present assets and liabilities inincreasing or decreasing order of liquidity.

For example, financial institutions present assets and

liabilities in order of liquidity.

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Current Ratio

Current assets are short-term assets. Current liabilities are short-term liabilities.

Traditionally, analysts calculate current ratio, which

is the ratio of current assets to current liabilities, to

measure the liquidity position of the company. Liquidity refers to the ability of the company to meet its

short-term commitments.

Traditional view is that a ratio of less than 1.33 indicates

stressed liquidity position of the company.

However, this conclusion is incorrect if the company has

the capacity to borrow funds to meet short-term

commitments.

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IFRS: Assets to be Recovered After Twelve

Months

Companies are required to disclose the amount of

asset to be recovered after twelve months, after the

balance sheet date.

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IFRS: Liabilities to be Settled After Twelve

Months

Companies are required to disclose the amount of

liabilities to be settled after twelve months after the

balance sheet date.

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IFRS: Information to be Provided In The

Balance Sheet

As a minimum, the balance sheet should include

line items that present the following amounts:

(a) Property, plant and equipment

(b) Investment property

(c) Intangible assets

(d) Financial assets (excluding amounts shown under (e),

(h) and (i)

(e) Investments accounted for using the equity method

(f) Biological assets (e.g. tea plantation and animals)(g) Inventories

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IFRS: Information to be Provided in The

Balance Sheet (cont.)

(h) Trade and other receivables(i) Cash and cash equivalents

(j) The total assets classified as held for sale and

assets included in disposal group classified as

held for sale(k) Trade and other payables

(l) Provisions

(m) Financial liabilities (excluding amounts shown

under (k) and (l)

(n) Liabilities and assets for current tax

(o) Deferred tax liabilities and deferred tax assets

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(p) Liabilities in disposal group classified as held

for sale

(q) Non-controlling interests, presented within

equity; and

(r) Issued capital and reserves attributable to

owners of the parent.

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The parent (also called the holding company) is required to

present consolidated financial statements, which combine thefinancial statements of the parent and those of subsidiaries.

The items listed above appear in consolidated balance sheet

only as follows:

Investments accounted for using the equity method (item (e)

above) represents investment in associates.

Non-controlling interests, presented within equity (item (q)

above) represents interest of investors other than the parent

in the net assets of the subsidiary.

The non-controlling interest is often called the minorityinterest.

Non-controlling interest is a part of equity.


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Disposal grouprefers to a group of assets to bedisposed of by sale or otherwise, together as a

group of single transaction, and liabilities directly

associated with those assets that will be transferred

in the transaction.Assets and liabilities of the disposal group should

be presented separately (items (j) and (p) above).

Those should not be classified either as current or non-

current. Deferred tax asset and deferred tax liability are

classified as non-current.


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Balance Sheet

Additional line items are included when the size,

nature or function of an item or group of similar

items are such that separate presentation is

relevant to an understanding of the companys

financial position.A company decides on the presentation of

additional line items based on the assessment of:

(a) The nature and liquidity of the asset

(b) The function of the assets within the company; and(c) The amounts, nature and timing of liabilities.


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Royal Dutch Shell PLCBalance Sheet as at 31 December 2007


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Treasury Shares

Treasury shares underequity, in the consolidatedbalance sheet, represent own equity shares boughtback by the company and held by it.

Buy-back of shares results in distribution of cash toshareholders.

It reduces cash and correspondingly reduces the equitycapital in the balance sheet.

Therefore, it is presented as a negative balance underequity capital.

A company can reissue the treasury shares.

In India, companies are allowed to buy back equityshares but are not allowed to hold it. Bought back shares are cancelled within seven days.


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Comparative Information

IFRS require every company to disclose

comparative information in respect of the previous

period for all amounts reported in the current

periods financial statements.

A company should include comparative informationfor narrative and descriptive information when it is

relevant to an understanding of the current periods

financial statements.


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Change in Accounting Policy

Companies apply accounting policy consistently

from period to period.

An accounting policy is changed only when a new

accounting standard requires such change.

It is rarely that a company changes its accounting

policy voluntarily to make the presentation more

relevant.

Usually, a new accounting standard stipulates

transition provisionwhich describes the method forfirst time application of the principles stipulated in

the new accounting standard.


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Change in Accounting Policy (cont.)

In the absence of a transitional provision or when the

company changes an accounting policy voluntarily, the new

accounting policy is applied retrospectively.

Retrospective application implies application of the policy to

transactions, events and conditions as if that policy had

always been applied.

When a new accounting policy is applied retrospectively, the

company has to present an additional balance sheet at the

beginning of the earliest comparative period presented.

The Indian GAAP requires that the cumulative effect (deficit or

surplus) should be recognised as a separate item in the profitand loss account for the current year.


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Errors and Restatement

When an entity detects a prior-period error, it has torestate the comparative information.

Error results in either omission or mis-statement ofinformation that was available or was supposed to beavailable while preparing financial statements.

Error might occur due to mathematical mistakes,mistakes in applying accounting policies, oversight ormisinterpretation of facts, and fraud.

The Indian GAAP requires presentation of the effectof correcting the error as a separate line item in thecurrent years profit and loss account as a separateline item. Usually, it is presented as prior period adjustments.


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Change in Accounting Estimates

Accounting estimate is at the central of measurement ofassets and liabilities.

At each balance sheet date, an entity reviews estimates and

revises the same based on new information or new

developments.

A change in an estimate is not a correction of error.

The effect of a change in accounting estimate is recognised

prospectively.

It is recognised in the profit or loss for the current period.

However, if the change affects the current period as well asfuture periods, the effect is recognised in profit or loss for the

current period and future periods.


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Reclassification

Companies are not allowed to change the

classification of items in the balance sheet and

profit and loss account voluntarily.

Voluntary reclassification is permitted only if it is

established that the reclassification will improve therelevance of information provided in financial

statements.

As in the case of restatement, in case of

reclassification, three balance sheets are to bepresented including the balance sheet as at the end

of the current year.


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ASSETS

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Current Assets IAS-1 stipulates that a company classifies an asset

as current asset when:

(a) it expects to realise the asset, or intends to

sell or consume it, in its normal operating

cycle;

(b) it holds the asset primarily for the purpose oftrading;

(c) it expects to realise the asset within twelve

months after the reporting period; or

(d) the asset is cash or cash equivalent unlessthe asset is restricted from being exchanged

or used to settle a liability for at least twelve

months after the reporting period.

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Operating Cycle

Operating cycle is the time between the acquisition

of assets for processing and their realisation in

cash or cash equivalents.

In the case of a firm engaged in manufacturing of

products or services, the operating cycle begins with thereceipt of raw materials and components, and ends with

the realisation of cash from customers.

When the normal operating cycle is not clearly

identifiable, it is assumed to be twelve months.

The operating cycle should be viewed as a process.

Any asset that is in the process is a current asset.

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Cash and Cash Equivalents

Cash and cash equivalents are current assets.

Cash equivalents are short-term, highly liquid investments

that are readily convertible to known amounts of cash and

which are subject to an insignificant risk of changes in

value. If there are restrictions on the short-term use of cash, it is

not classified as a current asset.

For example, cash deposited in an escrow account for

purchase of a property is not a current asset because it is

not available to support operations of the enterprise. Usually, include the cash in current asset and disclose the

restriction in footnotes.

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Monetary and Non-monetary Assets

Monetary assetsare money held and assets to bereceived in fixed or determinable amounts of

money.

Assets that cannot be classified as monetary asset

are classified as non-monetary asset. Examples of monetary assets are cash, receivables

from customers, deposits with various authorities, and

loans to be recovered in cash.

Examples of non-monetary assets fixed assets andprepaid expenses for goods or services to be received

in future (e.g. advances to vendors for goods and fixed

assets).

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Measurement of Assets: Fixed Assets

Fixed assetsare usually measured at historicalcost.

The historical cost is adjusted for accumulated

depreciation and accumulated impairment loss.

Historical costis the amount of cash or cashequivalents paid or the fair value of the

consideration given to acquire the asset at the time

of acquisition.

IFRS provide an option to measure fixed assets atfair value.

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Measurement of Assets: Inventories

Raw materials and stores and spares are measuredat historical cost.

Finished goods and work-in-progress are measured

at lower of historical cost and net realisable value

(NRV). NRV is the amount that the company expects to realise

by selling those items in the normal course of business

in the next or a subsequent period, reduced by

expected costs to sell and estimated cost to complete

the production.

Cost and NRV are compared for each class of

finished goods/work-in-progress separately.

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Measurement of Assets: Receivables

Amount due from customers and loans are financialinstruments.

They are initially measured at fair value.

If the amount due from the counter party is expected to

be collected within six month from the transaction date,the contracted amount is the fair value.

In other cases, fair value is the present value of

expected cash flows calculated at the market rate of

interest.

Subsequently, they are measured at amortised cost

using effective interest rate method.

Under the Indian GAAP, receivables and loans are

measured at the contracted amount.

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M f A R i bl


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Measurement of Assets: Receivables:

Effective Interest Rate

The effective interest rate is the rate that exactlydiscounts estimated future cash payments or

receipts through the expected life of the financial

instrument to the net carrying amount, which is the

fair value at the initial recognition, of the financialasset or financial liability.

In calculating the effective interest rate, an entity

considers promised cash flows and does not consider

future credit losses.

The calculation includes all fees and points paid or

received between parties to the contract that are

integral part of the effective interest rate.

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M t f A t R i bl


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Example

The accounting year of Antara Limited (AL) ends on31 March. On 1 January, 2010, it sold goods to a

customer for Rs. 1,000. The amount is expected to be

collected on 31 December, 2011. No interest is

charged from the customer. The market rate of

interest at which the customer could borrow for a

period of one year is 15%.

Solution

Effective interest rate is 15%. Fair value is the present

value of the cash flow discounted at the market interestrate. Sale will be recognised at Rs. 870. In 20092010,

interest income will be recognised at Rs. 32. In 2010

2011, interest income will be recognised at Rs. 98.

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Example (cont.)

Journal entries

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January 1,

2010

Receivables Dr. Rs. 870

To sales Cr. Rs. 870

March 31,2011

Receivables Dr. Rs. 32To interest income Cr. Rs. 32

December

31, 2011

Receivables Dr. Rs. 98

To interest income Cr. Rs. 98

December

31, 2011

Cash Dr. Rs. 1,000

To receivables Cr. Rs.1,000

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Measurement of Assets: Pre-paid

Expenses

Pre-paid expenses are measured at the amountpaid to the counter party.

Examples of pre-paid expenses are advance paid to a

vendor for supply of goods, services or fixed assets.

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Measurement of Assets: Investments

Investments are measured at fair value.

However, there are exceptions.

Investment in debt securities are measured at historical

cost provided the company intends to hold it till maturity.

Loans and receivables are measured at historical cost.

Entities have an option to measure investment in

property either at historical cost or at fair value.

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Fair Value Fair valueis the amount for which an asset could

be exchanged or a liability settled betweenknowledgeable, willing parties in an arms length

transaction.

Fair value is the exit price.

The phrase arms length transaction implies that theparties to the transaction are acting independently in

their self-interest and not under any pressure or duress.

In most situations, observable prices (bid price) in an

active market (e.g. capital market and commodity

exchange) are the best estimate of fair value.

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Essentials of Financial Accounting, Second Edition

ASISH K. BHATTACHARYYA

Fair Value (cont.)

In certain situations, the observable price is not thebest estimate of fair value in all situations.

For example, if the trading volume in a particular period

is much lower than the normal trading volume,

observable prices during that period are not the bestestimate of fair value.

In situations, where active market is not available or

observable prices are not the best estimates of fair

value, economic models are used to estimate the

fair value.

Economic models are used to estimate the fair

value of assets and liabilities that are not traded in

an active market.

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Active Market

An active marketis a market in which all thefollowing conditions exist:

a) the items traded within the market are homogeneous;

b) willing buyers and sellers can normally be found at any

time; andc) prices are available to the public.

Examples of active market are capital marketandcommodity exchange.

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LIABILITIES

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Liability: Definition

Liabilityis a present obligationof the companyarising from past events, the settlement of which is

expected to result in an outflow from the entity of

resources embodying economic benefits.

An obligation is a liability if, practically, the companyhas no alternative but to settle the obligation.

An obligation may arise from contract or from the

operation of law (e.g. income-tax liability).

Example of liabilities are borrowings from financialinstitutions, borrowings from public through issuance of

debentures or other types of bonds, public deposits,

interest accrued on borrowings, trade creditors, and

advance received from customers.

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Liability: Recognition

A liability is recognised in the balance sheet only ifthe management can estimate the amount of

outflow of economic benefits reliably.

If the management estimates that it is less than

probable that the liability will result in an outflowfrom the entity of resources embodying economic

benefits, it discloses the obligation below the

balance sheet under the heading Contingent

Liability. If the management is unable to estimate the

amount of the liability, it discloses the same under

the heading Contingent Liability.

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Constructive Obligation

Constructive obligation arises from a pattern of pastpractice of the entity or from a sufficiently specific

current statement issued by the management.

A pattern of past practice or a specific statement

creates a valid expectation among some individualsor other entities that the entity has undertaken an

obligation and will honour the same.

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Constructive Obligation (cont.)

A liability is recognised if, practically, the entity hasno alternative but to settle the obligation arising

from the pattern of the past practice or a specific

current statement.

A constructively obligation ultimately gets translatedinto contractual obligation.

The concept of constructive obligation results in

early recognition of a liability.

Indian GAAP does not recognise the concept ofconstructive obligation.

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Current and Non-Current Classification

A liabilityis classified as current when it satisfiesany of the following criteria:

a) It is expected to be settled in the normal operating

cycle.

b) It is held primarily for the purpose of being traded.c) It is due to be settled within twelve months after the

balance sheet date.

d) The enterprise does not have an unconditional right to

defer settlement of the liability for at least twelve

months from the balance sheet date.

A liability that cannot be classified as current

liability is classified as non-current liability.

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Operating Liabilities

Operating items such as trade creditors, overduesalaries and wages, advance from customers are

classified as current liabilities even if they are not to

be settled within twelve months after the balance

sheet date because they are part of the workingcapital.

However, those items are classified as non-current

liability if they are not expected to be settled within the

normal operating cycle or within twelve months after the

balance sheet date.

The operating cycle is the same that is used to classify

assets in current and non-current categories.

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Non-Operating Liabilities

Debts which are to be settled within twelve monthsafter the balance sheet date is classified as currentliability.

Current liability includes that part of the long- term

debt which is to be settled within twelve monthsafter the balance sheet date.

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Liabilities Held for Trading

Trading generally reflects active and frequentbuying and selling.

The fact that a liability is used to fund trading activities

does not in itself make that liability one that is held for

trading.

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Liabilities Held for Trading (cont.)

Liabilities held for trading include:a) Derivative liabilities that are not used for hedging

b) Obligations to deliver financial assets borrowed by a

short seller

c) Financial liabilities that are incurred with an intention torepurchase them in the near term.

d) Financial liabilities that are part of a portfolio of

identified financial instruments that are managed

together and for which there is evidence of a recent

pattern of short term profit taking.

It is rarely that a non-finance company holds

liabilities for trading.

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Derivative InstrumentsA derivative instrument is an instrument that is

derived from an asset.

The most common derivative instrument is option.

A call optiongives the holder a right to buy theunderlying asset (e.g. share issued by a company)

at a predetermined price on or before a specifieddate.

A put optiongives the holder a right to sell theunderlying asset at a predetermined price on or

before a specified date. The holder of an option exercises the right only if it

is favourable to him.

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Derivative Instruments (cont.)

The writer (often known as seller) of the option hasthe obligation to honour the right given under the

option.

For example, if you hold a call option that gives a right

to buy the underlying asset (usually a security) at aspecified price (say Rs. 100) at a specified date (expiry

date), you will exercise the right only if the market price

of the asset at the expiry date is above Rs. 100.

If the market price of the asset is below Rs. 100, you will

allow the right to lapse.

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Derivative Instruments (cont.)

If you are the writer of the call option, you will berequired to deliver the asset to the holder of the call

option, if he/she decides to exercise the right.

Therefore, as a writer of the call option, you have a

liability which is a liability held for trading unless you

have written the option as a part of your strategy tohedge risks.

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Short Selling

You are a short seller of a security if you are sellingthe security that you do not own.

You borrow shares from someone, sell them, and at

a later date return them to the lender by purchasing

those shares from the market. If the share price falls you make money because you

buy shares at a lower price and return the same to the

lender with interest.

If the share price increases, you lose.

Your obligation to deliver the shares borrowed by

you is a current liability.

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Bonds with Repurchase Option

An enterprise may issue bonds with a repurchaseoption (call option) which gives the enterprise theright to repurchase those bonds in a near term, say

within three months.

Alternatively, an enterprise may issue bonds with aput optionthat gives the holder of those bonds aright to sell them back to the enterprise in a near

term, say within three months.

Those bonds are classified as current liabilities(liabilities held for trading) even if the remaining

maturity period of those bonds is longer than twelve

months from the balance sheet date.

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Bonds With Re Purchase Option (cont.)

The most common money market instrument isREPO or repurchase agreement.

If a bank purchase treasury securities from a

securities dealer with an agreement that the dealer

will repurchase them at a specified price at aspecified date in a near term, say, on the expiry of

three days from the date of purchase, the

transaction is known as three-day REPO.

The dealers obligation under the REPO is a currentliability.

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Measurement of Liabilities

Financial liabilities are initially measured at fairvalue.

Subsequently, they are measured at amortised cost

using effective interest method.

If loans are arranged at commercial terms andconditions, may assume the contracted amount

represents fair value.

Therefore, liabilities are carried at the amount of

proceeds received in exchange of obligation. Insome circumstances.

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Measurement of Liability: Example

A firm operating in the SME arranged a loan of Rs.1,000 under a government scheme at an interest

rate of 10% per annum.

The interest is payable at the end of each year and

the principal amount is repayable at the end of thethird year.

The rate of interest at which the firm could borrow

from the market at the same terms is 15%.

The fair value of the loan is the present value of thecash flow discounted at 15%.

PV = 100/(1.15) + 100/(1.15)2 +1,100/(1.15)3 = Rs. 886.

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Effective Interest Rate: Example (cont.)

Effective interest is 15%.

The loan should be initially recognised at Rs. 886

and Rs. 114 should be recognised as income.

Accounting for interest expense and loan will be as

follows: Year 1: Interest exp.: 8860.15 = Rs.133; Cl. balance of

loan = 886 + (133100) = Rs. 919

Year 2: Interest exp.: 9190.15 = Rs.138; Cl. balance of

loan = 919 + (138100) = Rs. 957 Year 3: Interest exp.: 9570.15 = Rs.143; Cl. balance of

loan = 957 + (143100) = Rs. 1,000

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END

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essentials of fa_chapter 3

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