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ADMINISTRATION (MBA)
III YEAR (FINANCE)
PAPER III
CORPORATE FINANCIAL
ACCOUNTING
WRITTEN BY
SEHBA HUSSAIN
EDITTED BY
MASTER OF BUSINESS
ADMINISTRATION (MBA)
III YEAR (FINANCE)
PAPER III
CORPORATE FINANCIAL
ACCOUNTING
BLOCK 1
INTRODUCTION TO CORPORATE
FINANCIAL ACCONTING
PAPER III
CORPORATE FINANCIAL ACCOUNTING
BLOCK 1
INTRODUCTION TO CORPORATE FINANCIAL
ACCOUNTING
CONTENTS
Page number
28
65
UNIT 1
FUNDAMENTALS OF CORPORATE FINANCIAL
ACCOUNTING
Objectives
After studying this unit, you should be able to understand and appreciate:
Structure
1.1 Introduction to corporate finance
1.2 Corporate financial accounting
1.3 Accounting theory, postulates and conventions
1.4 Accounting equations
1.5 Accounting of price level changes
1.6 Significance and limitations of price level accounting
1.7 Techniques and models of price level accounting
1.8 Summary
1.9 Further readings
to pay dividends to shareholders. On the other hand, the short term decisions can be
grouped under the heading "Working capital management". This subject deals with the
short-term balance of current assets and current liabilities; the focus here is on managing
cash, inventories, and short-term borrowing and lending (such as the terms on credit
extended to customers).
The terms corporate finance and corporate financier are also associated with investment
banking. The typical role of an investment bank is to evaluate the company's financial
needs and raise the appropriate type of capital that best fits those needs.
capital (WACC) to reflect the financing mix selected. (A common error in choosing a
discount rate for a project is to apply a WACC that applies to the entire firm. Such an
approach may not be appropriate where the risk of a particular project differs markedly
from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection
criteria in corporate finance. These are visible from the DCF and include discounted
payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
Alternatives (complements) to NPV include MVA / EVA (Stern Stewart & Co) and APV
(Stewart Myers). See list of valuation topics.
b. Valuing flexibility
In many cases, for example R&D projects, a project may open (or close) paths of action
to the company, but this reality will not typically be captured in a strict NPV approach
Management will therefore (sometimes) employ tools which place an explicit value on
these options. So, whereas in a DCF valuation the most likely or average or scenario
specific cash flows are discounted, here the flexibile and staged nature of the
investment is modelled, and hence "all" potential payoffs are considered. The difference
between the two valuations is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real options analysis
(ROA); they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent
management decisions. (For example, a company would build a factory given that
demand for its product exceeded a certain level during the pilot-phase, and
outsource production otherwise. In turn, given further demand, it would similarly
expand the factory, and maintain it otherwise. In a DCF model, by contrast, there
is no "branching" - each scenario must be modelled separately.) In the decision
tree, each management decision in response to an "event" generates a "branch" or
"path" which the company could follow; the probabilities of each event are
determined or specified by management. Once the tree is constructed: (1) "all"
possible events and their resultant paths are visible to management; (2) given this
knowledge of the events that could follow, management chooses the actions
corresponding to the highest value path probability weighted; (3) then, assuming
rational decision making, this path is taken as representative of project value. See
Decision theory: Choice under uncertainty.
ROA is usually used when the value of a project is contingent on the value of
some other asset or underlying variable. (For example, the viability of a mining
project is contingent on the price of gold; if the price is too low, management will
abandon the mining rights, if sufficiently high, management will develop the ore
body. Again, a DCF valuation would capture only one of these outcomes.) Here:
(1) using financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option; (2) an
histogram provides information not visible from the static DCF: for example, it allows for
an estimate of the probability that a project has a net present value greater than zero (or
any other value).
Continuing the above example: instead of assigning three discrete values to revenue
growth, and to the other relevant variables, the analyst would assign an appropriate
probability distribution to each variable (commonly triangular or beta), and, where
possible, specify the observed or supposed correlation between the variables. These
distributions would then be "sampled" repeatedly - incorporating this correlation - so as
to generate several thousand scenarios, with corresponding valuations, which are then
used to generate the NPV histogram. The resultant statistics (average NPV and standard
deviation of NPV) will be a more accurate mirror of the project's "randomness" than the
variance observed under the scenario based approach.
firms look for the cheaper type of financing regardless of their current levels of internal
resources, debt and equity.
assets of the firm such as trademarks, patents, talented managers and loyal customers are
not included in the balance sheet. Hence we can say that the balance sheet method is
simple
but
is
not
accurate.
Determining the future flow of cash is another way to measure the value of the firm. A
model to evaluate the firm is designed on cash flow giving a better picture of the
effectiveness
of
the
financial
decisions.
Other ways of calculating the value of firm are:
Cash cycle
Assets
Revenue, Inventory and Expenses
Financial Ratios
Bank Loans
Sustainable Growth
Uses and Sources of Cash
Firm Value, Debt Value and Equity Value
Capital Structure
Cost of Capital
Risk Premiums
The examples of descriptive accounting theories used before 1955 are based on
observations and what is used in accounting a particular economic event mostly is adopted
as a method for that transaction in a particular field. For example if depreciation is used
in practice applying a certain method then that is accepted as a method of accounting if it
is widely used. That is, descriptive accounting theories guide accounting methods,
principles and conventions.
After 1956, the normative accounting theories governed to prescribe what should be
done. For example, after 1956 norms of best practice was developed by the incorporation
of usefulness of accounting information. This not necessarily based on observation. Due
to Normative accounting theories decision usefulness theories were developed and also
measurement issues and income concepts became important. As well, the normative
accounting theories gave birth to conceptual frame works projects.
After 1975 on wards because of dissatisfaction with normative theories positive
accounting theories became important. For example these theories enable the accounting
profession to explain and predict that what should be done based not necessarily based on
observation. That is the positive accounting theories are basically a specific scientific
method of inquiry in to specific accounting issues. The in accounting the important
positive accounting theories are capital market based research, contracting theory,
behavioral research.
13
14
there are two or more accounts affected by every transaction, the accounting system is
referred to as double entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the
companys general ledger. Each account in the general ledger is designated as to its type:
asset, liability, owners equity, revenue, expense, gain, or loss account.
Example
A student buys a computer for Rs.945. This student borrowed Rs.500 from his best friend
and saved another Rs.445 from his part-time job. Now his assets are worth Rs.945,
liabilities are Rs.500, and equity Rs.445.
The formula can be rewritten:
Assets - Liabilities = (Shareholders or Owners equity)
Now it shows owner's interest is equal to property (assets) minus debts (liabilities). Since
in a company owners are shareholders, owner's interest is called shareholder's equity.
Every accounting transaction affects at least one element of the equation, but always
balances. Simplest transactions also include:
Transaction
Shareholder's
Assets Liabilities
Explanation
Number
Equity
1
+ 6,000
+ 6,000
Issuing stocks for cash or other assets
Buying assets by borrowing money
2
+ 10,000 + 10,000
(taking a loan from a bank or simply
buying on credit)
Selling assets for cash to pay off
3
900
900
liabilities: both assets and liabilities are
reduced
Buying assets by paying cash by
4
+ 1,000 + 400
+ 600
shareholder's money (600) and by
borrowing money (400)
5
+ 700
+ 700
Earning revenues
Paying expenses (e.g. rent or
6
200
200
professional fees) or dividends
Recording expenses, but not paying
7
+ 100
100
them at the moment
8
500
500
Paying a debt that you owe
Receiving cash for sale of an asset: one
9
0
0
0
asset is exchanged for another; no
change in assets or liabilities
16
Price changes have pervasive effects on financial statements, and good analysis must
recognize those effects and incorporate them into valuation decisions. It is wellunderstood that in an inflationary environment, conventional historical cost accounting
results in an understatement of operating assets and a mismatching of allocated costs and
revenues. The mismatching occurs because revenues reflect current general price levels
and conventional depreciation reflects past price levels. Business managers, investors and
government officials closely watch corporate profits. The trend of these profits plays a
significant role in the levels of employment, and in the national economic policy.
However, a strong argument may be made that much of the corporate profit reported
today is an illusion.
Accounting for changing price levels is of great interest. Where inflation (or deflation) is
an issue the relevance and reliability of traditional financial statements prepared on a
historical cost basis is called into question. But making price level adjustments is not
straightforward. There are competing conceptual approaches, an understanding of which
will help students to understand both the benefits and the limitations of the more popular
accounting models--typically, historical cost with adjustments for fair value in certain
circumstances.
1.5.1 Inflation
Since we started understanding things around us, we all used to listen from our
Grandparents about the things and articles especially Gold & Ghee being cheaper in their
times.
That time we used to think that why the things were cheaper in our Grandparents' time
and why had they started becoming costlier. So this question would keep us puzzled.
But now as we have grown in our knowledge and understanding, we have come to know
about the phenomenon of Inflation which in layman's language is known as the state of
rising pricing or the falling value of money was the greatest reason behind this.
Now emerges the question that what exactly is the Inflation?
Inflation is a global phenomenon in present day times. There is hardly any country in the
capitalist world today which is not afflicted by the spectre of inflation.
Different economists have defined inflation in different words like Prof. Crowther has
defined inflation "as a state in which the value of money is falling, i.e., prices are rising."
In the words of Prof. Paul Einzig, "Inflation is that state of disequilibrium in which an
expansion of purchasing power tends to cause or is the effect of an increase of the price
level." Both the definition have emphasized on the rising prices of the goods.
The basic factors behind the inflation are either the rising demand or the shortening of
supply due to any reason.
17
18
a building purchased in 1970 for Rs.20,000 is sold in 2006 for Rs.200,000 when its
replacement cost is Rs.300,000, the apparent gain of Rs.180,000 is illusory..
reported profits may exceed the earnings that could be distributed to shareholders
without impairing the company's ongoing operations
the asset values for inventory, equipment and plant do not reflect their economic
value to the business
future earnings are not easily projected from historical earnings
the impact of price changes on monetary assets and liabilities is not clear
future capital needs are difficult to forecast and may lead to increased leverage,
which increases the business's risk
when real economic performance is distorted, these distortions lead to social and
political consequences that damage businesses (examples: poor tax policies and
public misconceptions regarding corporate behavior)
19
1. Historical accounts do not consider the unrealised holding gains arising from the rise in
the monetary value of the assets due to inflation.
2. The objective of charging depreciation is to spread the cost of the asset over its useful
life and make reserve for its replacement in the future. But it does not take into account
the impact of inflation over the replacement cost which may result into the inadequate
charge of depreciation.
3. Under historical accounting, inventories acquired at old prices are matched against
revenues expressed at current prices. In the period of inflation, this may lead to the
overstatement of profits due mixing up of holding gains and operating gains.
4. Future earnings are not easily projected from historical earnings.
In the last few years, price level accounting has been adopted as a supplementary
financial statement in the United States and the United Kingdom. This comes after more
than 50 years of debate about methods of adjusting financial accounts for inflation.
Accountants in the United Kingdom and the United States have discussed the effect of
inflation on financial statements since the early 1900s, beginning with index number
theory and purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money
was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting,
which was about Constant Purchasing Power Accounting. This model by Sweeney was
used by The American Institute of Certified Public Accountants for their 1963 research
study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by
the Accounting Principles Board (USA), the Financial Standards Board (USA), and the
Accounting Standards Steering Committee (UK). Sweeney advocated using a price index
that covers everything in the gross national product. In March 1979, the Financial
Accounting Standards Board (FASB) wrote Constant Dollar Accounting, which
advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust
accounts
because
it
is
calculated
every
month.
During the Great Depression, some corporations restated their financial statements to
reflect inflation. At times during the past 50 years standard-setting organizations have
encouraged companies to supplement cost-based financial statements with price-level
adjusted statements. During a period of high inflation in the 1970s, the FASB was
reviewing a draft proposal for price-level adjusted statements when the Securities and
Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of
the largest US corporations to provide supplemental information based on replacement
cost. The FASB withdrew the draft proposal.
Though Inflation Accounting is more practical approach for the true reflection of
financial status of the company, there are certain limitations which are not allowing this
to be a popular system of accounting. Following are the limitations:
1. Change in the price level is a continuous process.
2. This system makes the calculations a tedious task because of too many conversions
and calculations.
3. This system has not been given preference by tax authorities.
21
b.
c.
22
Edwards and Bell adopt a physical capital maintenance approach to income recognition.
In this approach, which determines valuations on the basis of replacement cost, operating
income represents realized revenues, less the replacement cost of the assets in question.
Edwards and Bell believe operating profit is best calculated by using replacement costs as
the approach to profit calculation operating profit is derived after ensuring that the
operating capacity of the organization is maintained intact. (Page 103 Chapter 4)
The current cost operating profit before holding gains and losses, and the realised holdig
gains, are both tied to the notion of realization, and hence the sum of two equates to
historical cost profit. Holding gains are deemed to be different to trading income as they
are due to market-wide movements, most of which are beyond the control of
Management.
Some of the criticism relates to its reliance (CCA) on replacement costs but what is the
rationale for replacement cost?
3. Business profits Concept
2 components of current cost accounting are
1. Current operating profit (COP) and
2. Realizable cost savings (RCS).
COP is the excess of the current value of the output sold over the current cost of the
related inputs.
RCS are the increase in the current cost of the assets held by the firm in the current
period.
The term we use for realizable cost saving is holding gains /losses which can be
realized or unrealized. (IAS Investment property holding gain of revaluation surplus is
unrealized but is treated as business profit in income statement).
For example two companies with different set up years Company A 10 years earlier
than others. The operating profit of A will be larger because of lower depreciation
expenses, thus giving the impression that A is more efficient than the others.
In fact, the larger profit of Company A is not due to the efficiency of the managers in
operating the firm in the current years. Rather, it reflects the efficiency of the manager of
10 years ago in starting the business and purchasing the assets at that time.
4. Exit price accounting
MacNeals argument He contended that conventional accounting principles do not
23
serve the decision-oriented investor well; they provide financial statements that may be
misleading or false. Accountant should report all profits and losses and values as
determined in competitive markets. MacNeal suggested that
a.
b.
c.
d.
Using exit price (the opportunity cost), however, does not provide the relevant
data to match against revenues to measure the relevant success or failure, this is,
the performance of the firm. Accounting must measure past events, those that
actually happened, rather than those that might happen if a firm does something
other than what was planned.
24
Weston concluded that the exit price accounting does not supply useful profit
information.
25
Revenue
Depreciation
Operating income
Purchasing power loss
Net income
2001 2002
2003
Total
33,000 36,302
39,931
109,233
30,000 31,500 (a) 33,000 (b) 94,500
3,000 4,802
6,931
14,733
1,500 (c) 3,000 (d) 4,500
3,000 3,302
3,931
10,233
26
1.8 SUMMARY
This unit focuses on concepts related to corporate finance and corporate financial
accounting. It has been explained that the primary goal of corporate finance is to
maximize corporate value while managing the firm's financial risks. Although it is in
principle different from managerial finance which studies the financial decisions of all
firms, rather than corporations alone, the main concepts in the study of corporate finance
are applicable to the financial problems of all kinds of firms. Later in the unit, accounting
theory, postulates and conventions were described followed by discussion on accounting
equations. Another important area of concern of the unit was accounting of price level
changes. Significance and limitations of price level accounting and techniques and
models of price level accounting were discussed in the final sections.
Copeland, T.E. and J.F Weston. Financial theory and corporate policy, 2nd edition
Addison Wesley, 1983
UNIT 2
27
Structure
2.1 Introduction
2.2 Accounting approaches to investment decisions
2.3 Social accounting
2.4 Purpose and scope of social accounting
2.5 Social accounting case
2.6 Social auditing
2.7 Summary
2.8 Further readings
2.1 INTRODUCTION
Not all investments are made with the goal of turning a quick profit. Many investments
are acquired with the intent of holding them for an extended period of time. The
appropriate accounting methodology depends on obtaining a deeper understanding of the
nature/intent of the particular investment. You have already seen the accounting for
"trading securities" where the intent was near future resale for profit. But, many
investments are acquired with longer-term goals in mind.
For example, one company may acquire a majority (more than 50%) of the stock of
another. In this case, the acquirer (known as the parent) must consolidate the accounts of
the subsidiary. At the end of this chapter we will briefly illustrate the accounting for such
"control" scenarios.
Sometimes, one company may acquire a substantial amount of the stock of another
without obtaining control. This situation generally arises when the ownership level rises
above 20%, but stays below the 50% level that will trigger consolidation. In these cases,
the investor is deemed to have the ability to significantly influence the investee
company. Accounting rules specify the "equity method" of accounting for such
investments. This, too, will be illustrated within this unit.
28
Not all investments are in stock. Sometimes a company may invest in a "bond" (you
have no doubt heard the term "stocks and bonds"). A bond payable is a mere "promise"
(i.e., bond) to "pay" (i.e., payable). Thus, the issuer of a bond payable receives money
today from an investor in exchange for the issuer's promise to repay the money in the
future (as you would expect, repayments will include not only amounts borrowed, but
will also have added interest).
Although investors may acquire bonds for "trading purposes," they are more apt to be
obtained for the long-pull. In the latter case, the bond investment would be said to be
acquired with the intent of holding it to maturity (its final payment date) -- thus, earning
the name "held-to-maturity" investments. Held-to-maturity investments are afforded a
special treatment, which is generally known as the amortized cost approach.
By default, the final category for an investment is known as the "available for sale"
category. When an investment is not trading, not held-to-maturity, not involving
consolidation, and not involving the equity method, by default, it is considered to be an
"available for sale" investment. Even though this is a default category, do not assume it
to be unimportant. Massive amounts of investments are so classified within typical
corporate accounting records. We will begin our look at long-term investments by
examining this important category of investments.
29
The Financial Accounting Standards Board recently issued a new standard, "The Fair
Value Option for Financial Assets and Financial Liabilities." Companies may now elect
to measure certain financial assets at fair value. This new ruling essentially allows many
"available for sale" and "held to maturity" investments to instead be measured at fair
value (with unrealized gains and losses reported in earnings), similar to the approach
previously limited to trading securities. It is difficult to predict how many companies
will select this new accounting option, but it is indicative of a continuing evolution
toward valued-based accounting in lieu of traditional historical cost-based approaches.
2. AVAILABLE
SECURITIES
FOR
SALE
SECURITIES;
SIMILAR
TO
TRADING
The accounting for "available for sale" securities will look quite similar to the accounting
for trading securities. In both cases, the investment asset account will be reflected at fair
value. If you do not recall the accounting for trading securities, it may be helpful to
review that material via the indicated link.
To be sure, there is one big difference between the accounting for trading securities and
available-for-sale securities. This difference pertains to the recognition of the changes in
value. For trading securities, the changes in value were recorded in operating income.
However, such is not the case for available-for-sale securities. Here, the changes in value
go into a special account. We will call this account Unrealized Gain/Loss- OCI, where
"OCI" will represent "Other Comprehensive Income."
3. OTHER COMPREHENSIVE INCOME
This notion of other comprehensive income is somewhat unique and requires special
discussion at this time. There is a long history of accounting evolution that explains how
the accounting rule makers eventually came to develop the concept of OCI. To make a
long story short, most transactions and events make their way through the income
statement. As a result, it can be said that the income statement is "all-inclusive." Once
upon a time, this was not the case; only operational items were included in the income
statement. Nonrecurring or nonoperating related transactions and events were charged or
credited directly to equity, bypassing the income statement entirely (a "current operating"
concept of income).
Importantly, you must take note that the accounting profession now embraces the allinclusive approach to measuring income. In fact, a deeper study of accounting will reveal
that the income statement structure can grow in complexity to capture various types of
unique transactions and events (e.g., extraordinary gains and losses, etc.) -- but, the
income statement does capture those transactions and events, however odd they may
appear.
There are a few areas where accounting rules have evolved to provide for special
circumstances/"exceptions." And, OCI is intended to capture those exceptions. One
exception is the Unrealized Gain/Loss - OCI on available-for-sale securities. As you will
30
soon see, the changes in value on such securities are recognized, not in operating income
as with trading securities, but instead in this unique account. The OCI gain/loss is
generally charged or credited directly to an equity account (Accumulated OCI), thereby
bypassing the income statement ( there are a variety of reporting options for OCI, and the
most popular is described here).
Illustration
Assume that Webster Company acquired an investment in Merriam Corporation. The
intent was not for trading purposes, control, or to exert significant influence. The
following entry was needed on March 3, 20X6, the day Webster bought stock of
Merriam:
3-3-X6
50,000
Cash
To record the purchase of 5,000
shares of Merriam stock at Rs.10 per
share
50,000
Next, assume that financial statements were being prepared on March 31. By that date,
Merriam's stock declined to Rs.9 per share. Accounting rules require that the investment
"be written down" to current value, with a corresponding charge against OCI. The charge
is recorded as follows:
3-31-X6
5,000
5,000
This charge against OCI will reduce stockholders' equity (the balance sheet remains in
balance with both assets and equity being decreased by like amounts). But, net income is
31
not reduced, as there is no charge to a "normal" income statement account. The rationale
here, whether you agree or disagree, is that the net income is not affected by temporary
fluctuations in market value -- since the intent is to hold the investment for a longer term
period.
During April, the stock of Merriam bounced up Rs.3 per share to Rs.12. Webster now
needs to prepare this adjustment:
4-30-X6
15,000
15,000
Notice that the three journal entries now have the available for sale securities valued at
Rs.60,000 (Rs.50,000 - Rs.5,000 + Rs.15,000). This is equal to their market value (Rs.12
X 5,000 = Rs.60,000). The OCI has been adjusted for a total of Rs.10,000 credit
(Rs.5,000 debit and Rs.15,000 credit). This cumulative credit corresponds to the total
increase in value of the original Rs.50,000 investment.
The preceding illustration assumed a single investment. However, the treatment would
be the same even if the available for sale securities consisted of a portfolio of many
investments. That is, each and every investment would be adjusted to fair value.
4. ALTERNATIVE -- A VALUATION ADJUSTMENTS ACCOUNT
As an alternative to directly adjusting the Available for Sale Securities account, some
companies may maintain a separate Valuation Adjustments account that is added to or
subtracted from the Available for Sale Securities account. The results are the same; the
reasons for using the alternative approach are to provide additional information that may
be needed for more complex accounting and tax purposes.
Dividends and interests
Dividends or interest received on available for sale securities is reported as income and
included in the income statement:
32
9-15-X5
Cash
Dividend Income
To record receipt of dividend on
available for sale security investment
75
75
33
34
In reviewing this illustration, note that Available for Sale Securities are customarily
classified in the Long-term Investments section of the balance sheet. And, take note the
OCI adjustment is merely appended to stockholders' equity.
5. HELD TO MATURITY SECURITIES
INVESTMENTS IN BONDS
It was noted earlier that certain types of financial instruments have a fixed maturity date;
the most typical of such instruments are "bonds." The held to maturity securities are to
be accounted for by the amortized cost method.
35
36
1-1-X3
Investment in Bonds
5,000
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at par -interest payable semiannually
5,000
The above entry reflects a bond purchase as described, while the following entry reflects
the correct accounting for the receipt of the first interest payment after 6 months.
6-30-X3
Cash
125
Interest Income
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest
X 6/12 months)
125
Now, the entry that is recorded on June 30 would be repeated with each subsequent
interest payment -- continuing through the final interest payment on December 31, 20X5.
In addition, at maturity, when the bond principal is repaid, the investor would make this
final accounting entry:
12-31-X5
Cash
5,000
37
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
1-1-X3
Investment in Bonds
5,300
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at 106 -interest payable semiannually
5,300
The above entry assumes the investor paid 106% of par (Rs.5,000 X 106% = Rs.5,300).
However, remember that only Rs.5,000 will be repaid at maturity. Thus, the investor will
be "out" Rs.300 over the life of the bond. Thus, accrual accounting dictates that this
Rs.300 "cost" be amortized ("recognized over the life of the bond") as a reduction of the
interest income:
6-30-X3
Cash
125
38
Interest Income
75
Investment in Bonds
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest
X 6/12 months = Rs.125; Rs.300
premium X 6 months/36 months =
Rs.50 amortization)
50
The preceding entry is undoubtedly one of the more confusing entries in accounting, and
bears additional explanation. Even though Rs.125 was received, only Rs.75 is being
recorded as interest income. The other Rs.50 is treated as a return of the initial
investment; it corresponds to the premium amortization (Rs.300 premium allocated
evenly over the life of the bond -- Rs.300 X (6 months/36 months)) and is credited
against the Investment in Bonds account.
This process of premium amortization (and the above entry) would be repeated with each
interest payment date. Therefore, after three years, the Investment in Bonds account
would be reduced to Rs.5,000 (Rs.5,300 - (Rs.50 amortization X 6 semiannual interest
recordings)).
This method of tracking amortized cost is called the straight-line method. There is
another conceptually superior approach to amortization, called the effective-interest
method, that will be revealed in later chapters. However, it is a bit more complex and the
straight-line method presented here is acceptable so long as its results are not materially
different than would result under the effective-interest method.
In addition, at maturity, when the bond principal is repaid, the investor would make this
final accounting entry:
12-31-X5
Cash
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
5,000
39
In an attempt to make sense of the above, perhaps it is helpful to reflect on just the "cash
out" and the "cash in." How much cash did the investor pay out? It was Rs.5,300; the
amount of the initial investment. How much cash did the investor get back? It was
Rs.5,750; Rs.125 every 6 months for 3 years and Rs.5,000 at maturity.
What is the difference? It is Rs.450 (Rs.5,750 - Rs.5,300) -- which is equal to the income
recognized above (Rs.75 every 6 months, for 3 years). At its very essence, accounting
measures the change in money as income. Bond accounting is no exception, although it
is sometimes illusive to see. The following "amortization" table reveals certain facts
about the bond investment accounting, and is worth studying to be sure you understand
each amount in the table. Be sure to "tie" the amounts in the table to the entries above:
Sometimes, complex topics like this are easier to understand when you think about the
balance sheet impact of a transaction. For example, on 12-31-X4, Cash is increased
Rs.125, but the Investment in Bond account is decreased by Rs.50 (dropping from
Rs.5,150 to Rs.5,100). Thus, total assets increased by a net of Rs.75. The balance sheet
remains in balance because the corresponding Rs.75 of interest income causes a
corresponding increase in retained earnings.
Illustration of bonds purchased at a discount
The discount scenario is very similar to the premium scenario, but "in reverse." When
bonds are purchased at a discount, the investor pays less than the face value up front.
40
However, the bond's maturity value is unchanged; thus, the amount due at maturity is
more than the initial issue price! This may seem like a bargain, but consider that the
investor is likely getting lower annual interest receipts than is available on other bonds -that is why the discount existed in the first place.
Assume the same facts as for the previous bond illustration, except imagine that the
market rate of interest was something more than 5%. Now, the 5% bonds would not be
very attractive, and investors would only be willing to buy them at a discount:
1-1-X3
Investment in Bonds
4,850
Cash
To record the purchase of five
Rs.1,000, 5%, 3-year bonds at 97 -interest payable semiannually
4,850
The above entry assumes the investor paid 97% of par (Rs.5,000 X 97% = Rs.4,850).
However, remember that a full Rs.5,000 will be repaid at maturity. Thus, the investor
will get an additional Rs.150 over the life of the bond. Accrual accounting dictates that
this Rs.150 "benefit" be recognized over the life of the bond as an increase in interest
income:
6-30-X3
Cash
125
Investment in Bonds
25
Interest Income
To record the receipt of an interest
payment (Rs.5,000 par X .05 interest
X 6/12 months = Rs.125; Rs.150
discount X 6 months/36 months =
Rs.25 amortization)
150
41
The preceding entry would be repeated at each interest payment date. Again, further
explanation may prove helpful. In addition to the Rs.125 received, another Rs.25 of
interest income is recorded. The other Rs.25 is added to the Investment in Bonds
account; as it corresponds to the discount amortization (Rs.150 discount allocated evenly
over the life of the bond -- Rs.150 X (6 months/36 months)).
This process of discount amortization would be repeated with each interest payment.
Therefore, after three years, the Investment in Bonds account would be increased to
Rs.5,000 (Rs.4,850 + (Rs.25 amortization X 6 semiannual interest recordings)). This is
another example of the straight-line method of amortization since the amount of interest
is the same each period.
When the bond principal is repaid at maturity, the investor would also make this final
accounting entry:
12-31-X5
Cash
Investment in Bonds
To record the redemption of bond
investment at maturity
5,000
5,000
Let's consider the "cash out" and the "cash in." How much cash did the investor pay out?
It was Rs.4,850; the amount of the initial investment. How much cash did the investor
get back? It is the same as it was in the preceding illustration -- Rs.5,750; Rs.125 every
6 months for 3 years and Rs.5,000 at maturity. What is the difference? It is Rs.900
(Rs.5,750 - Rs.4,850) -- which is equal to the income recognized above (Rs.150 every 6
months, for 3 years). Be sure to "tie" the amounts in the following amortization table to
the related entries:
42
Can you picture the balance sheet impact on 6-30-X5? Cash increased by Rs.125, and
the Investment in Bond account increased Rs.25. Thus, total assets increased by Rs.150.
The balance sheet remains in balance because the corresponding Rs.150 of interest
income causes a corresponding increase in retained earnings.
6. THE EQUITY METHOD OF ACCOUNTING
THE EQUITY METHOD
On occasion, an investor may acquire enough ownership in the stock of another company
to permit the exercise of "significant influence" over the investee company. For example,
the investor has some direction over corporate policy, and can sway the election of the
board of directors and other matters of corporate governance and decision making.
Generally, this is deemed to occur when one company owns more than 20% of the stock
of the other -- although the ultimate decision about the existence of "significant
influence" remains a matter of judgment based on an assessment of all facts and
circumstances.
Once significant influence is present, generally accepted accounting principles require
that the investment be accounted for under the "equity method" (rather than the methods
previously discussed, such as those applicable to trading securities or available for sale
securities).
With the equity method, the accounting for an investment is set to track the "equity" of
the investee. That is, when the investee makes money (and experiences a corresponding
43
increase in equity), the investor will similarly record its share of that profit (and viceversa for a loss). The initial accounting commences by recording the investment at cost:
4-1-X3
Investment
50,000
Cash
To record the purchase of 5,000
shares of Legg stock at Rs.10 per
share. Legg has 20,000 shares
outstanding, and the investment in
25% of Legg (5,000/20,000 = 25%) is
sufficient to give the investor
significant influence
50,000
Next, assume that Legg reports income for the three-month period ending June 30, 20X3,
in the amount of Rs.10,000. The investor would simultaneously record its "share" of this
reported income as follows:
6-30-X3
Investment
Investment Income
To record investor's share of Legg's
reported income (25% X Rs.10,000)
2,500
2,500
Importantly, this entry causes the Investment account to increase by the investor's share
of the investee's increase in its own equity (i.e., Legg's equity increased Rs.10,000, and
the entry causes the investor's Investment account to increase by Rs.2,500), thus the name
"equity method." Notice, too, that the credit causes the investor to recognize income of
Rs.2,500, again corresponding to its share of Legg's reported income for the period. Of
course, a loss would be reported in just the opposite fashion.
When Legg pays out dividends (and decreases its equity), the investor will need to reduce
its Investment account:
44
7-01-X3
Cash
Investment
To record the receipt of Rs.1,000 in
dividends from Legg -- Legg declared
and paid a total of Rs.4,000 (Rs.4,000
X 25% = Rs.1,000)
1,000
1,000
The above entry is based on the assumption that Legg declared and paid a Rs.4,000
dividend on July 1. This treats dividends as a return of the investment (not income,
because the income is recorded as it is earned rather than when distributed). In the case
of dividends, notice that the investee's equity reduction is met with a corresponding
proportionate reduction of the Investment account on the books of the investor.
Note that market-value adjustments are usually not utilized when the equity method is
employed. Essentially, the Investment account tracks the equity of the investee,
increasing as the investee reports income and decreasing as the investee distributes
dividends.
7. INVESTMENTS REQUIRING CONSOLIDATION
CONCEPT OF CONTROL
You only need to casually review the pages of most any business press before you will
notice a story about one business buying another. Such acquisitions are common and
number in the thousands annually. Typically, such transactions are effected rather
simply, by the acquirer simply buying a majority of the stock of the target company. This
majority position enables the purchaser to exercise control over the other company;
electing a majority of the board of directors, which in turn sets the direction for the
company. Control is ordinarily established once ownership jumps over the 50% mark,
but management contracts and other similar arrangements may allow control to occur at
other levels.
ECONOMIC ENTITY CONCEPT AND CONTROL
The acquired company may continue to operate, and maintain its own legal existence. In
other words, assume Premier Tools Company bought 100% of the stock of Sledge
Hammer Company. Sledge (now a "subsidiary" of Premier the "parent") will continue to
operate and maintain its own legal existence. It will merely be under new ownership.
45
46
This excess is quite common, and is often called "purchase differential" (the difference
between the price paid for another company, and the net book value of its assets and
liabilities). Why would Premier pay such a premium? Remember that assets and
liabilities are not necessarily reported at fair value.
For example, the land held by Sledge is reported at its cost, and its current value may
differ (let's assume Sledge's land is really worth Rs.110,000, or Rs.35,000 more than its
carrying value of Rs.75,000). That would explain part of the purchase differential. Let
us assume that all other identifiable assets and liabilities are carried at their fair values.
But what about the other Rs.65,000 of purchase differential (Rs.100,000 total differential
minus the Rs.35,000 attributable to specifically identified assets or liabilities)?
47
GOODWILL
Whenever one business buys another, and pays more than the fair value of all the
identifiable pieces, the excess is termed "goodwill." This has always struck me as an odd
term -- but I suppose it is easier to attach this odd name, in lieu of using a more
descriptive account title like: Excess of Purchase Price Over Fair Value of Identifiable
Assets Acquired in a Purchase Business Combination. So, when you see Goodwill in the
corporate accounts, you now know what it means. It only arises from the purchase of one
business by another. Many companies may have implicit goodwill, but it is not recorded
until it arises from an actual acquisition (that is, it is bought and paid for in a arm's-length
transaction).
Perhaps we should consider why someone would be willing to pay such a premium.
There are many possible scenarios, but suffice it to say that many businesses are worth
more than than their identifiable pieces. A movie rental store, with its business location
and established customer base, is perhaps worth more than the movies, display
equipment, and check-out stands it holds. A law firm is hopefully worth more than its
48
desks, books, and computers. An oil company is likely far more valuable than its drilling
and pumping gear. Consider the value of a brand name that may not be on the books but
has instead been established by years of marketing. And, let's not forget that a business
combination may eliminate some amount of competition; some businesses will pay a lot
to be rid of a competitor.
THE CONSOLIDATED BALANCE SHEET
No matter how goodwill arises, the accountant's challenge is to measure and report it in
the consolidated statements -- along with all the other assets and liabilities of the parent
and sub. Study the following consolidated balance sheet for Premier and Sledge, clicking
on the account title links to see how the related dollar amounts are calculated:
Premier Tools Company and Consolidated Subsidiaries
Balance Sheet
March 31, 20X3
Assets
Liabilities
Current
Liabilities
Current Assets
Cash
Trading
securities
Rs.150,000
Accounts
payable
Rs.160,000
70,000
Salaries
payable
30,000
Accounts
receivable
110,000
Inventories
Property, Plant
& Equip.
Land
220,000
Note payable
Rs.135,000
Building and
equipment
375,000
(net)
Intangible
Assets
Patent
Goodwill
Rs.550,000
Interest
10,000
payable
Long-term
Liabilities
Mortgage
liability
510,000
Rs.240,000
110,000
Total
liabilities
350,000
Rs.550,000
Stockholders'
equity
Rs.225,000
65,000
Rs.200,000
Retained
500,000
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earnings
Total
stockholders'
equity
Total assets
Rs.1,350,000
Total
Liabilities
and equity
800,000
Rs.1,350,000
In the above illustration, take note of several important points. First, the Investment in
Sledge account is absent because it has effectively been replaced with the individual
assets and liabilities of Sledge. Second, the assets acquired from Sledge, including
goodwill, have been pulled into the consolidated balance sheet at the price paid for them
(for example, take special note of the calculations relating to the Land account).
Finally, note the consolidated stockholders' equity amounts are the same as from
Premier's separate balance sheet. This result is expected since Premier's separate
accounts include the ownership of Sledge via the Investment in Sledge account (which
has now been replaced by the actual assets and liabilities of Sledge).
It may appear a bit mysterious as to how the above balance sheet "balances" -- there is an
orderly worksheet process that can be shown to explain how this consolidated balance
sheet comes together, and that is best reserved for advanced accounting classes -- for now
simply understand that the consolidated balance sheet encompasses the assets (excluding
the investment account), liabilities, and equity of the parent at their dollar amounts
reflected on the parent's books, along with the assets (including goodwill) and liabilities
of the sub adjusted to their values based on the price paid by the parent for its ownership
in the sub.
THE CONSOLIDATED INCOME STATEMENT
Although it will not be illustrated here, it is important to know that the income statements
of the parent and sub will be consolidated post-acquisition. That is, in future months,
quarters, and years, the consolidated income statement will reflect the revenues and
expenses of both the parent and sub added together. This process is ordinarily
straightforward. But, an occasional wrinkle will arise.
For instance, if the parent paid a premium in the acquisition for depreciable assets and/or
inventory, the amount of consolidated depreciation expense and/or cost of goods sold
may need to be tweaked to reflect alternative amounts from those reported in the separate
statements. And, if the parent and sub have done business with one another, adjustments
will be needed to avoid reporting intercompany transactions. We never want to report
internal transactions between affiliates as actual sales. To do so can easily and rather
obviously open the door to manipulated financial results.
50
It points to the fact that companies influence their external environment (both positively
and negatively) through their actions and should therefore account for these effects as
51
part of their standard accounting practices. Social accounting is in this sense closely
related to the economic concept of externality.
Social accounting offers an alternative account of significant economic entities. It has the
"potential to expose the tension between pursuing economic profit and the pursuit of
social
and
environmental
objectives".
The purpose of social accounting can be approached from two different angles, namely
for management control purposes or accountability purposes.
2.4.1 Accountability
Social accounting for accountability purposes is designed to support and facilitate the
pursuit of society's objectives. These objectives can be manifold but can typically be
described in terms of social and environmental desirability and sustainability. In order to
make informed choices on these objectives, the flow of information in society in general,
and in accounting in particular, needs to cater for democratic decision-making. In
democratic systems, Gray argues, there must then be flows of information in which those
controlling the resources provide accounts to society of their use of those resources: a
system of corporate accountability.
Society is seen to profit from implementing a social and environmental approach to
accounting in a number of ways, e.g.:
52
Maintaining legitimacy.
2.4.3 Scope
1. Formal accountability
In social accounting the focus tends to be on larger organisations such as multinational
corporations (MNCs), and their visible, external accounts rather than informally produced
accounts or accounts for internal use. The need for formality in making MNCs
accountability is given by the spatial, financial and cultural distance of these
organisations to those who are affecting and affected by it.
Social accounting also questions the reduction of all meaningful information to financial
form. Financial data is seen as only one element of the accounting language.
53
encouragement. External social audits thus also attempt to blur the boundaries between
organisations and society and to establish social accounting as a fluid two-way
communication process. Companies are sought to be held accountable regardless of their
approval. It is in this sense that external audits part with attempts to establish social
accounting as an intrinsic feature of organisational behaviour. The reports of Social Audit
Ltd in the 1970s on e.g. Tube Investments, Avon Rubber and Coalite and Chemical, laid
the foundations for much of the later work on social audits.
3. Reporting areas
Unlike in financial accounting, the matter of interest is by definition less clear-cut in
social accounting; this is due to an aspired all-encompassing approach to corporate
activity. It is generally agreed that social accounting will cover an organisations
relationship with the natural environment, its employees, and ethical issues concentrating
upon consumers and products, as well as local and international communities. Other
issues include corporate action on questions of ethnicity and gender.
4. Audience
Social accounting supersedes the traditional audit audience, which is mainly composed of
a company's shareholders and the financial community, by providing information to all of
the organisation's stakeholders. A stakeholder of an organisation is anyone who can
influence or is influenced by the organisation. This often includes, but is not limited to,
suppliers of inputs, employees and trade unions, consumers, members of local
communities, society at large and governments. Different stakeholders have different
rights of information. These rights can be stipulated by law, but also by non-legal codes,
corporate values, mission statements and moral rights. The rights of information are thus
determined by "society, the organisation and its stakeholders".
54
separate (including online) environmental reports. Such reports may account for pollution
emissions, resources used, or wildlife habitat damaged or re-established.
In their reports, large companies commonly place primary emphasis on eco-efficiency,
referring to the reduction of resource and energy use and waste production per unit of
product or service. A complete picture which accounts for all inputs, outputs and wastes
of the organisation, must not necessarily emerge. Whilst companies can often
demonstrate great success in eco-efficiency, their ecological footprint, that is an estimate
of total environmental impact, may move independently following changes in output.
Legislation for compulsory environmental reporting exists in some form e.g. in Denmark,
Netherlands, Australia and Korea. The United Nations has been highly involved in the
adoption of environmental accounting practices, most notably in the United Nations
Division for Sustainable Development publication Environmental Management
Accounting Procedures and Principles (2002).
In short, the object is to account for economic effects of all environmental activities of
the firm to promote quality of life. Accordingly, accounting is used in a broader sense to
include financial, cost and management accounting issues including control functions like
internal and external audits. Some of relevant issues are:
Are the amount incurred, if any, for taking necessary environmental measures
during the period sub-divided into suitable heads, such as:
o Liquids effluent treatment;
o Waste gas and air treatment;
o Solid waste treatment;
o Analysis, control and compliance;
o Remediation;
o Recycling;
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Is the capital expenditure decision making process suitably adjusted for justifying
green technology?
Does the existing system of recording and reporting companys liabilities and
provisions take into consideration environmental issues?
How does the company treat additional expenditure incurred for training of
employees to enhance their environmental awareness?
Does the product innovation decision take care of environment friendless? Does it
involve additional cost?
What are environmental benefits? Can these benefits be identified, measured and
disclosed under suitable classification, such as
o Process benefits;
o Product benefits;
o Fiscal benefits, and
o Overall other benefits
What is the impact on profitability of the company for getting ISO 14000
accreditation and for following ISO 14001 standards? Can ISO 14001 increase net
operating profit of the company?
IASB issue any such standard? How can ICAI cooperate with other notable
international accounting standard-setters to formulate a suitable accounting
standard to capture identification, measurement and disclosure of environment
costs and benefits of a firm in India?
Has the company introduced a separate environmental audit system? If yes, who
forms part of the audit team employees or external persons? What is the
composition of the team?
Does the environmental audit report form part of the statutory audit report or
separate environmental report? l What is the level of social responsibility
reporting in the annual report of the company? Does the reporting of a
environmental activities form part of social responsibility and shown separately?
Or, is it shown only as a part of Directors Report?
Does the company show expenses on environmental activities in the annual report
under a separate head or are they clubbed with items of operating expenses?
The above and many other similar issues become pertinent for discussion in the context
of accounting for corporate environmental management. It would be impossible to
delineate here all of them for the constraint of volume. Accordingly, only a few of them
are discussed here briefly.
Accounting Policies
Accounting policies form the basis of measurement and reporting of economic activities
of the firm and are critical for understanding its accounting numbers contained in the
annual reports. The environmental awareness of the firm, translation of the awareness
into environmental measures leading to some economic actives and treatment of
environment-related expenses can be captured well only when accounting policies of the
firm make a suitable disclosure of them in appropriate places of the financial statements.
In India, Accounting Standard (AS) 1, Disclosure of Accounting Policies, deals with the
disclosure of significant accounting policies to be followed for preparation and
presentation of financial statements. The purpose of this standard is to promote better
understanding of financial statements by making the disclosure of significant accounting
policies in the financial statements and the manner of doing so. Such disclosure facilitates
a more meaningful inter-period and inter-firm comparison.
57
guidelines and regulatory provisions. In this context, issues concerning sustainability are
generally raised.
Sustainable economic development encompasses economic, environmental and social
performances of the company. The Royal Dutch/Shell Group of Companies considers
sustainable development reporting in an interesting way as shown in Figure 1.
Therefore, from the standpoint of sustainability, reporting may assume a different
dimension. Accordingly, the reporting principles and contents rooted in the premise of
sustainability are briefly discussed below.
Reporting Principles
The Global Reporting Initiative (GRI) Guidelines (June, 2000) presented a first version
of the principles that are essential to produce a balanced and reasonable report on an
organisations economic, environmental and social performance. GRI (2002) presents a
revised set of principles with the benefit of time and learning through application of the
June 2000 Guidelines. These principles are designed with the long term in mind and are
expected to create an enduring foundation upon which performance measurement will
continue to evolve on new knowledge and learning.
58
Figure 1
Positive or negative
59
Traidcraft plc, the fair trade organisation, claims to be the first public limited company to
publish audited social accounts in the UK, starting in 1993.
60
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2.4.6 Format
Companies and other organisations (such as NGOs) may publish annual corporate
responsibility reports, in print or online. The reporting format can also include summary
or overview documents for certain stakeholders, a corporate responsibility or
sustainability section on its corporate website, or integrate social accounting into its
annual report and accounts.
Companies may seek to adopt a social accounting format that is audience specific and
appropriate. For example, H&M, asks stakeholders how they would like to receive
reports on its website; Vodafone publishes separate reports for 11 of its operating
companies as well as publishing an internal report in 2005; Weyerhaeuser produced a
tabloid-size, four-page mini-report in addition to its full sustainability report
Source: The Challenge of Corporate Social Responsibility, Sir Adrian Cadbury, CIPD Conference 2003, Business in the
Community
In other words, Sir Adrian is in no doubt that a company should live by its own values
and if CSR is not at the top of its list of corporate values then, providing it is living within
the law, it cannot be criticised. Sir Adrian was reported in the Daily Telegraph, however,
as follows:
"...in many cases society would be better off if such companies ignored the campaigners
and concentrated on making a profit."
Source: Don't give in to pressure groups, by Richard Tyler, The Daily Telegraph, 7 October 2004
Whilst not everyone will agree with Sir Adrian's position on CSR, the Telegraph
portrayal of that position was less than favourable and a full reading of both the speech
and the article will reap its own reward.
63
performances
in
relation
to
the
chosen
social
objectives.
Eight specific key principles have been identified from Social Auditing practices around
the world. They are:
1. Multi Perspective/Polyvocal.
Aims to reflect the views (voices) of all those people (stakeholders) involved with or affe
cted by the organisation/department/programme.
2. Comprehensive
Aims to (eventually) report on all aspects of the organisations work and
performance.
3. Participatory
Encourages participation of stakeholders and sharing of their values
4. Multidirectional
Stakeholders share and give feedback on multiple aspects.
5. Regular
Aims to produce social accounts on a regular basis so that the concept and the
practice become embedded in the culture of the organisation covering all the activities.
6. Comparative
Provides a means, whereby, the organisation can compare its own
performance each year and against appropriate external norms or benchmarks; and provid
e for comparisons with organisations doing similar work and reporting in similar fashion.
7. Verification
Ensures that the social accounts are audited by a suitably experienced person or agency w
ith no vested interests in the organisation.
8. Disclosure
Ensures that the audited accounts are disclosed to stakeholders
wider community in the interests of accountability and transparency.
and
the
So how does a company put all of its social accounting and reporting together? Well, first
of all it has to start with a social audit. That is, someone has to verify that when
64
Manchester United, for example, say that they are aiming at curbing racism in football
that they actually did something to achieve that aim.
Here are some definitions of social audit that might be helpful:
'Social Audit is a method for organisations to plan, manage and measure non-financial
activities and to monitor both the internal and external consequences of the
organisation's social and commercial operations.'
Source: Social Audit Toolkit (1997) Freer Spreckley, Social Enterprise Partnership
'Social Auditing is a process which, enables organisations and agencies to assess and
demonstrate their social, community and environmental benefits and limitations. It is a
way to measure the extent to which an organisation lives up to the shared values and
objectives it has committed itself to promote.'
Source: Social Economy Agency for Northern Ireland
'Social auditing is the process whereby an organisation can account for its social
performance, report on and improve that performance. It assesses the social impact and
ethical behaviour of an organisation in relation to its aims and those of its stakeholders.'
Source: New Economics Foundation
It should be clear from everything we have said that before a social audit can take place
you have to be clear about:
Indicators - how you will measure and record the extent to which you are doing it
When these are in place, it is easy to design simple procedures to log what is going on
from day to day (social bookkeeping), to tally up the indicators every now and again
(social accounting) and make sure that you are on target, or to do something about it if
you are not!
and you will see that this is true. However, for other, perhaps smaller, organisations it is
not necessarily vital that a fully qualified auditor or accountant takes the job on.
The key characteristic of a social auditor must be independence and remoteness. That is,
the social audit must be carried out by someone who does not work for the organisation
that s/he is auditing and it is helpful if the auditor is not, for example, a shareholder in the
organisation. It might even be helpful for the auditor to know nothing about the products
and processes of the organisation when they first begin their audit so that they start their
work completely cleanly!
The social auditing process requires an intermittent but clear time commitment from a
key person within the organisation. This social auditor liases with others in the
organisation and designs, co-ordinates, analyses and documents the information collected
during the process.
Social auditing information is collected through research methods that include social
bookkeeping, surveys and case studies. The objectives of the organisation are the starting
point from which indicators of impact are determined, stakeholders identified and
research tools designed in detail.
The collection of information is an on-going process, often done in 12-month cycles and
resulting in the organisation establishing social bookkeeping and the preparation of an
annual social audit document/report.
Experience has shown that it is important to provide training to the social auditor as well
as mentoring during the first few years. If well facilitated, social auditors from different
organisations can become self-supporting for subsequent years.
Activity 2
1. Discuss various accounting approaches to investment decisions. What do you
understand by valuation adjustment account?
2. Write an essay on social accounting.
3. Discuss the need of social auditing in todays scenario.
4. Write short note on environment accounting.
2.7 SUMMARY
This unit highlighted various approaches of accounting relevant to investment decisions.
Unit also throws light on social account concepts. In earlier sections unit introduces main
approaches of accounting to investment decisions. Social accounting was explained as a
process of communicating the social and environmental effects of organizations'
66
economic actions to particular interest groups within society and to society at large.
Purpose and scope of social accounting was described in next sections followed by
discussion
on
social
auditing
which
was
explained
as
a tool with which government departments can plan, manage and measure non financial
activities and monitor both internal and external consequences of the
department/organisation's social and commercial operations.
R.H. Gray, 'Thirty Years of Social Accounting, Reporting and Auditing: what (if
anything) have we learnt?', Business Ethics: A European View 10(1) 2001.
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UNIT 3
HUMAN RESOURCE AND VALUE ADDED ACCOUNTING
Objectives
After studying this unit you should be able to:
Structure
3.1 Introduction
3.2 Conceptual frame and HRA scenario
3.3 The need for human resource accounting
3.4 Information management in HRA
3.5 Approaches to analyse human resource
3.6 Measures for assessing individual value
3.7 Human resource practices in India
3.8 Value added accounting
3.9 Summary
3.10 Further readings
3.1 INTRODUCTION
Human resource accounting is not a new issue in the field of finance.
Economists consider human capital as a production factor, and they
explore different ways of measuring its investment in education,
health, and other areas. Accountants have recognized the value of
human assets for at least 70 years. Research into true human resource
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69
70
71
Figure 1
It is one of the most important 'M' associated, which is considered while taken care of
4M's associated with any organization and they are money machines, materials and men.
But the most interesting thing is that the first three are recognized and find a place in the
assets side of the Balance sheet of the organization. But in case of fourth one ambiguity
prevails among the accountant. In spite of its usefulness has been acclaimed is various
literature over the decades but its application still remain a suspectable issue, the IASB
and the ASB in different countries have not been able to formulate any specific
accounting standard for measurement & reporting of such valuable elements.
It is a popular phenomenon among the Indian corporate world is to disclose information
relating to human resource in annual statements. In this context, it is necessary to conduct
a study to assess the disclosure pattern of HRA information in Indian corporate World.
It first promulgated by BHEL (Bharat Heavy Electrical Ltd), a leading public enterprise,
during the financial year 1972-73. Later it was also adopted by other leading public and
private sector Organization in the subsequent years. Some of them are Hindustan
Machine Tools Ltd.(HMTL). Oil and Natural Gas Corporation Ltd.(ONGC), NTPC,
Cochin Refineries Ltd. (CRL), Madras Refineries Ltd.,(MRL), Associated Cement
Company Ltd.(ACC) and Infosys Technologies Ltd.(ITL).
However, adaptability of various model (mainly Lev and Schwartz model, Flamholtz
model and Jaggi and Lev model) and discount rate fixation and disclosure pattern ie.
either age wise, skill wise etc in BHEL, SAIL, MMTC (Minerals & Metals Trading
Corporation Of India Ltd.) HMTL, NTP make it clear, that there has been no uniformity
among Indian enterprises regarding HRA disclosure.
HRA introduce
in the year
Model
Discount
rate (in%)
72
BHEL
SAIL
1973 74
1983 84
12
14
MMTC
1982 83
12
ONGC
1981 82
12.25
NTPC
1984 85
12
1999
12.96
2006-07
14.97
INFOSYS
Source: Secondary
Terminology used:
1) PBT-Profit Before Tax
2) HR- Human Resource
3) TA-Total Assets
4) Turn-Turnover ( or Sales)
5) FA-Fixed Assets
6) VA- Value Added
73
74
75
Organisations can actually find out how much they can earn from an individual, as the
intellectual assets of a company are often worth three or four times the tangible book
value. Human capital also provides expert services such as consulting, financial planning
and assurance services, which are valuable, and very much in demand.
Realising this, many companies world-over are making HRA as a necessary element on
their balance sheets. One of the best examples is of the Denmark Government. The
Danish Ministry of Business and Industry has issued a directive that with effect from the
trading year 2005, all companies registered in Denmark will be required to include in
their annual reports information on customers, processes and human capital. A minimum
of five measures for each is required, and comparison with the previous two years must
be shown. Figures for investment in intellectual capital must be shown and compared
with the previous two years. A narrative should accompany each set of figures.
Information for investors about intellectual capital, both current and future, should
occupy at least one third of the report. Where relevant, information must also be provided
regarding care for the environment.
In India, there are very few companies like BHEL, Infosys and Reliance Industries,
which have implemented HRA and some are working on it. Infosys, which started
showing human resource as an asset in its balance sheet, has been reaping high market
valuations. NIIT has been following a similar method called Economic Value Addition
(EVA), which also helps in assessing the real value that an employee can fetch for the
company.
Experts point out that companies can derive many benefits by going in for HRA. Not
only can they measure the return on capital employed on total organisational assets
(including the human assets), but the resources can also be planned accordingly. Once
organisations realise the actual benefit and take it as a growth process, it will only help
them in increasing their shareholders value. When a company is able to assess an
individuals worth, it helps in increasing its own worth, says Ajay Sharma, senior HR
manager of Cadence Systems.
Basically HRA can be tracked through two methodscost-based analysis and valuebased analysis. The cost-based approach focuses on the cost parameters, which may
relate to historical cost, replacement cost, or opportunity cost. The value-based approach
suggests that the value of human resources depends upon their capacity to generate
revenue. This approach can be further sub-divided into two broad categories: nonmonetary and monetary.
The disposition of resources can also be examined by allocating relative human asset
values to different job grades. HRA also helps in examining expenditure on personnel
and in re-appraisal of expenditure on services and training. It can also serve as a key
factor in case of mergers and takeover decisions, where the human asset value becomes a
relevant factor. Another very significant role, which HRA can help in creating, is
goodwill for a company. The company can project itself in having best practices with
76
superior policies in place. Experts believe that this may help the organisation attract more
investments.
77
78
competitive strategy training. Therefore, creative training comes from the firm's planning
process and makes personnel capable of doing their job. On the contrary, competitive
strategic training maintains the firm's competitive level. Inside creative training, three
different actions can be distinguished that will incur some expenses.
Those training expenses are related to jobs and profession evolution, improvements in
global services, and innovation or change in projects. In any case, expenses derived from
creative training are considered long-term because they increase the firm's added value.
In other words, with creative training, the firm becomes more competitive and increases
its income. Expenses derived from competitive strategic training will be considered as
current expenses since they appear as a consequence of short-term actions that maintain
the firm's competitive level, even though its absence may lead to a decrease in the
employee's qualifications.
Treatment from a Financial Accounting Perspective
Following the definitions already explained, as long as future benefits are expected to
come from these training costs, they can be treated as assets. However, this does not hold
true in reality. As Cea Garca [1990] states:
"There is a clear absence of correspondence between the real assets in the present firms
and those recognised in the balance sheet... In fact, assets are too related to its juridical
conception (that is, owned by the firm...), in front of a pure economic approach where
asset is every instrument or way that can be used in the production-distribution firm's
process or, in general, every category of economic value which can be transformed into
goods or service or any instrument at the service of the firm or that the firm uses,
regardless [of] its juridical state...and also all those goods and rights that the firm does not
own now but used to own or will own later on, by virtue of collateral contracts or
agreements which may induce it."
So, a diagnosis is reached about the predominant asset concept. This situation can be
explained by two important problems that are met when referring to intangibles: Identify
the assets cost and estimate the period in which the asset should be amortized.
In international accounting, besides clearly recognizing some items as assets (cash, stock,
machinery, and so on) there is great debate whether certain other items are considered
capitalization. These are known as deferred charges in English accounting literature. It
can be said then that not only are the limits unclear between intangible, fixed assets and
deferred charges, but also which elements are considered assets and which elements are
considered expenses.
Treatment from a Managerial Accounting Perspective
Personnel working for a determined enterprise are actually participating in a valuecreation process. That is, any economic activity makes the firm incur costs. One
traditional classification takes into account the cost categories of raw materials, industrial
79
plants, and personnel. When adding income flow to an organization's market goods and
services, if it is superior to the cost flow, it becomes added value. This value is a
consequence of the interaction between material and human resources in production.
Because it is difficult to know and measure value, accounting has used substituted
measures such as acquisition cost, substitution cost, and even opportunity cost .
80
From the management accounting point of view, an accurate estimation of the learning
factor is essential to obtain a good prediction of the product cost and is also important in
the labor force. On the other hand, the enterprise can make decisions about its human
resource investments if it knows which benefits will be reported. In this sense, the
learning factor or experience curve provides information for decision-making and
resolution of problems regarding the rising costs of the labor force where new fabrication
processes or specialized jobs are important. In both cases, the cost will decrease as long
as employees get to know their jobs better.
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because future events in this particular issue are unknown. The provision entry must not
be recorded for the entire staff because this would be acting against the accrual, register,
and prudent accounting principles. When is the best moment for recording a staff
indemnity provision? An indemnity provision must be recorded only when the enterprise
has decided to put an end to the existing contracts and has already estimated (based upon
the prevailing law) the quantity accrued. Recording the provision beforehand would not
be correct because the firm's decision is still needed, not just personal opinions.
Do any restrictive factors exist for recording it? Not only is this not trivial, but it poses an
important problem. It is obvious that if a firm cannot financially afford the indemnities
because it does not have enough cash, then the provision must not be recorded. Since the
firm is not able to pay it, the liability does not exist.
Referring to the indemnities accrued or paid to the staff when finishing their contracts,
two questions arise that are heavily discussed in accounting literature. Must the
indemnities be classified in the profit and loss account as operating or extraordinary
expenses? Can indemnities be considered an asset? At this point, two different situations
can be distinguished. There are those firms that because of their size, activity, or other
factors, have a high personnel turnover; therefore, indemnities are a frequent issue. In this
case, it seems reasonable that its accounting treatment must be inside operating expenses
because, here, indemnities become something quite usual.
However, there are those firms that need to cancel contracts for the firm to survive. In
this case, indemnities must be classified as extraordinary expenses because they comply
with certain conditions. They do not form part of the typical and ordinary activities of the
firm and they are not supposed to happen frequently. If the extraordinary expense
definition holds true, then, no doubt, indemnity expenses can be considered
extraordinary.
It can be concluded that personnel indemnities are a necessary expense for the firm, so
they should never be considered an asset. The reason is obvious. As a general rule, an
asset is a good or a right that the firm owns in a determined moment. Other elements are
also considered assets such as prepayment adjustments or capitalized expenses, which are
neither a good nor an expense but are considered assets for other reasons. Indemnities,
because of their nature, cannot be included in any of the previous concepts. However, it
could be argued that the concept is greater than these definitions, therefore, something is
lacking. Obviously, this possibility could be considered, but logic and common sense
says that when a firm pays an indemnity to an employee, it has an expense and is not
buying or creating an asset.
Some authors argue that if accrued indemnities make it possible for a firm to increase its
profits by means of decreasing the firm's expenses, then these indemnities should
logically be registered as assets and considered as deferred expenses, strictly following
the principle of income and expense correlation. Real situations are considered above
accounting principles, whether generally accepted or not. An asset is an asset and by no
means can an element be recorded as an asset only to justify an accounting principle.
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2. Performance evaluation measures used in HRA include ratings, and rankings. Ratings
reflect a persons performance in relation to a set of scales. They are scores assigned to
characteristics possessed by the individual. These characteristics include skills, judgment,
knowledge, interpersonal skills, intelligence etc. Ranking is an ordinal form of rating in
which the superiors rank their subordinates on one or more dimensions, mentioned above.
3. Assessment of potential determines a persons capacity for promotion and
development. It usually employs a trait approach in which the traits essential for a
position are identified. The extent to which the person possesses these traits is then
assessed.
4. Attitude measurements are used to assess employees attitudes towards their job, pay,
working conditions, etc., in order to determine their job satisfaction and dissatisfaction
b)
Measurement of the investments in human resources will help to evaluate the charges in
human resource investment over a period of time. The information generated by the
analysis of investment in human resources has many applications for managerial
purposes. The organizational human performance can be evaluated with the help of such
an analysis. It also helps in guiding the management to frame policies for human
resource management. The present performance result will act as input for future
86
planning and the present planning will have its impact on future result. The same
relationship is also applicable to the areas of managerial applications in relation to the
human resource planning and control. Investment in human resources can be highlighted
under two heads, namely,
2)
Cost of selection
3)
Training cost
4)
5)
Subsistence allowance
6)
7)
8)
Medical expenses
9)
Ex-gratia payments
10)
All these items influence directly or indirectly the human resources and the productivity
of the organization.
significantly to the building of shareholder value. The critical success factor for any
knowledge-based company was its highly skilled and intellectual workforce. Soon after,
the manufacturing industry also seemed to realize the importance of people and started
perceiving its employees as strategic assets.
For instance, if two manufacturing companies had similar capital and used similar
technology, then it was only their employees who were the major differentiating factor.
Due to the above development, the need for valuing human assets besides traditional
accounting of tangible assets was increasingly experienced.
88
Rolta quality standards are benchmarked to world class levels, with top quality
certifications such as ISO 9001:2000, BS 7799, and SEI CMM level 5. The British
Standards Institution (BSI) has awarded Rolta the BS15000 certification for its entire
range of IT service management processes. This unique accreditation has been bestowed
on less than 25 companies globally.
Measuring the intangibles
A companys balance sheet discloses the financial position or rather health of the
company. The financial position of an enterprise is influenced by the economic resources,
financial structure, liquidity, solvency and its capacity to adapt to changes in the
environment. However, it is becoming increasingly clear that intangible assets have a
significant role in defining the growth of a company. So often, the search for the added
value invariably leads us to calculating and evaluating the intangible assets of the
business.
A Concept of Economic Value Added (EVA)
Economic Value Added (EVA) is the financial performance measure that aims to capture
the true economic profit of an enterprise. EVA is developed to be a measure more
directly linked to creation shareholder wealth over time. Hence, it focuses on maximizing
the shareholders wealth and helps company management to create value for shareholders.
EVA refers to the net operating profits of the company which is opportunity cost.
EVA is calculated as Net operating Profit after tax (NOPAT) (Capital*Cost of Capital)
Generally, all intangible assets are being measured in terms of economic value added by
those particular intangible assets.
HUMAN RESOURCE VALUATION
Human resource or human capital valuation refers to identifying and measuring the value
of human resources of a company. Employees are the most valuable resources of
companies in the services sector more so in knowledge based sectors. Like all other
resources, employees possess value because they provide future services resulting in
future earnings. There are various approaches/models that help in valuation of Human
resources in a company like Historical cost method, Replacement cost method,
Opportunity cost method. Rolta bases its calculation on Economic Approach Model.
According to this model, an estimate of the future earnings during the remaining life in
the organization of the employee has to be forecasted.
Secondly, we have to arrive at the present value by discounting the estimated earnings at
the employees cost of capital which includes all direct and indirect benefits earned both
in India and abroad. This will be called the Total Human Resource Value. A note of
caution has to be maintained here. In order to estimate future earnings from total labor
force, any organization can not go on a haphazard way.
89
It can divide the human resources into homogenous groups such as skilled, semiskilled,
technical, managerial staff etc. And in accordance with different classes and age groups,
average earning stream for different classes and age groups are prepared separately for
each groups or classes. Then the discounted present value for human capital is computed.
The aggregate present value of different groups represents the capitalized future earnings
of the firm as a whole which will be called as Total Value of Human Resources.
As a Third step, Total revenues will be divided by Total Human Resource Value. Here,
an observer will find the per employee portion of revenue upon its value.
Finally, the Revenues per employee will be divided by per employee portion of revenue
of its value. The derived value will be the value of human resource per employee.
Table 5
90
Source: A report on Case Study on Measuring Intangible Assets Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
Human resource value of Rolta India Pvt. Ltd. over the years has found northwards
movement. In FY 2002, the HR Value was Rs. 10.96 Million which grew at the rate of
16.78 % in 2003 and reached to the value of Rs. 12.8 Million. The growth in HR value
found quantum jump of 23.59 % in the FY 2004 as compared to FY 2003 where total
human resource value was Rs. 12.8 million which reached to Rs. 15.82 million in 2004.
The compounded growth rate of maximization of Human resources value is around 13 %
over the last three years under review.
Source: A report on Case Study on Measuring Intangible Assets Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
2. INFOSYS
Infosys Technologies Ltd. provides consulting and IT services to clients globally - as
partners to conceptualize and realize technology driven business transformation
initiatives. With over 58,000 employees worldwide, they use a low-risk Global Delivery
Model (GDM) to accelerate schedules with a high degree of time and cost predictability.
As one of the pioneers in strategic offshore outsourcing of software services, Infosys has
leveraged the global trend of offshore outsourcing. Even as many software outsourcing
companies were blamed for diverting global jobs to cheaper offshore outsourcing
destinations like India and China, Infosys was recently applauded by Wired magazine for
its unique offshore outsourcing strategy it singled out Infosys for turning the
outsourcing myth around and bringing jobs back to the US.
Infosys provides end-to-end business solutions that leverage technology. They provide
solutions for a dynamic environment where business and technology strategies converge.
92
Their approach focuses on new ways of business combining IT innovation and adoption
while also leveraging an organization's current IT assets. They work with large global
corporations and new generation technology companies - to build new products or
services and to implement prudent business and technology strategies in today's dynamic
digital environment.
Infosys' Vision
"To be a globally respected corporation that provides best-of-breed business solutions,
leveraging technology, delivered by best-in-class people."
Infosys' Mission Statement:
"To achieve our objectives in an environment of fairness, honesty, and courtesy towards
our clients, employees, vendors and society at large."
The values that drive them: C-LIFE
Customer Delight: A commitment to surpassing our customer expectations.
Leadership by Example: A commitment to set standards in our business and transactions
and be an exemplar for the industry and our own teams.
Integrity and Transparency: A commitment to be ethical, sincere and open in our
dealings.
Fairness: A commitment to be objective and transaction-oriented, thereby earning trust
and respect.
Pursuit of Excellence: A commitment to strive relentlessly, to constantly improve
ourselves, our teams, our services and products so as to become the best.
93
In the financial year 1995-96, Infosys Technologies (Infosys) became the first software
company to value its human resources in India. The company used the Lev & Schwartz
Model (Refer Exhibit I) and valued its human resources assets at Rs 1.86 billion. Infosys
had always given utmost importance to the role of employees in contributing to the
company's success. Analysts felt that human resources accounting (HRA) was a step
further in Infosys' focus on its employees. Narayana Murthy (Murthy), the then chairman
and managing director of Infosys, said: "Comparing this figure over the years will tell us
whether the value of our human resources is appreciating or not. For a knowledge
intensive company like ours, that is vital information."
The concept of HRA was not new in India. HRA was pioneered by public sector
companies like Bharat Heavy Electronics Ltd. (BHEL) and Steel Authority of India Ltd.
(SAIL) way back in the 1970s. However, the concept did not gain much popularity and
acceptance during that time.
It was only in the mid-1990s, after Infosys started valuing its employees, that the concept
gained popularity in India. By 2002, HR accounting had been introduced by leading
software companies like Satyam Computers and DSQ Software, as well as leading
manufacturing
firms
like
Reliance
Industries.
HR managers were quick to respond on the above developments by stating that more and
more organizations had now started to realize the importance of skilled workforce. They
felt that to be successful in highly competitive markets, companies require to
continuously improve the level of performance of their workforce.
HRA enabled companies to understand whether the skill sets of their human capital was
appreciating or not. R. Krishnaswamy, an actuarial accountant, said, "The value can be
used internally by an organization to make comparisons from unit to unit, from year to
year, as well as within its industry."
Stock market analysts felt that the 'comprehensive disclosure policy' was becoming a
differentiating factor among companies in various industries. Yezdi H. Malegam,
managing director, S.B. Billimoria & Company commented, "In the last few years,
people are realizing that their intangible assets are worth much more than their tangible
ones. Now an attempt is being made to put a value to these intangibles, and to bring these
hidden
values
to
book."
Analysts felt that HRA was an investor-friendly disclosure, and assured stakeholders that
the company had the right human capital to meet its future business requirements
The assets of an organization could be broadly classified into tangible and intangible
assets. Tangible assets referred to all the physical assets which could be presented in the
balance sheet including plant and machinery, investments in securities, inventories, cash,
cash equivalents and bank balance, marketable securities, accounts and notes receivables,
finance receivables, equipment on operating leases, etc.
94
Intangible assets included the goodwill, brand value and human assets of a company. The
human assets involved the capabilities, knowledge, skills and talents of employees in an
organization.
In the past, less importance was given by organizations to value their human assets.
Moreover, it was also considered difficult to value them since there were no defined
parameters of valuation. Companies did not value human resources as these were never
treated as an asset in the past. All investments related to employees, including salary as
well as recruitment and training costs were considered as expenditures.
In addition, accountants also felt that the stakeholders2 of a company may not accept the
concept
of
placing
a
monetary
value
on
human
resources.
The importance and value of human assets started to be recognized in the early 1990s
when there was a major increase in employment in firms in service, technology and other
knowledge-based sectors3. In the firms in these sectors, the intangible assets, especially
human resources, contributed significantly to the building of shareholder value. The
critical success factor for any knowledge-based company was its skilled and intellectual
workforce.
HRA in Practice at Infosys
Infosys' HRA model was based on the present value of the employees' future earnings
with the following assumptions:
An employee's salary package included all benefits, whether direct or otherwise, earned
both in India and in a foreign nation.
The additional earnings on the basis of age and group were also taken into account.
To calculate the value of its human assets in 1995-96, all the 1,172 employees of Infosys
were divided into five groups, based on their average age. Each group's average
compensation was calculated. Infosys also calculated the compensation of each employee
at retirement by using an average rate of increment.
95
Source: A report on Case Study on Measuring Intangible Assets Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
96
insights into the organization and its future potential. Proper valuation of human
resources helped organizations to eliminate the negative effects of redundant labor.
This, in turn, helped them to channelize the available skills, talents, knowledge and
experience of their employees more efficiently. By adopting and implementing HRA in
an organization, the following important information could be obtained:
Cost per employee
Human capital investment ratio
The amount of wealth created by each employee
The profit created by each employee
The ratio of salary paid to the total revenue generated
Average salary of each employee
Employee absenteeism rates
Employee turnover rate and retention rate
97
Source: A report on Case Study on Measuring Intangible Assets Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
The future earnings have been discounted at 17.01%, being the weighted Average Cost of
Capital (WACC) for the past five years. The Associate cost for the year 2005-06 at Rs.
2700.67 crores, was 11.56% of the Human Resource Value.
Figure: 3 Human Resource Value for Satyam
98
Source: A report on Case Study on Measuring Intangible Assets Indian Experience Indian Institute of Planning and
Management (IIPM) Ahmedabad
99
So value added can - comparable to accounting income - also be regarded as a net figure.
It expresses the value an economic entity (such as a person, a company, an industry, or an
entire national economy) adds to the goods and services it received (purchased) from
other entities through its own economic (productive, creative) activities.
Due to the fact that all the created wealth is also appropriated in some way the value
added can also be computed by the so-called additive or direct method which represents
the sum of appropriated parts of the created wealth. Those parts represent primarily the
remuneration of the productive factors which have led to the wealth creation. So, for
example, in relation to a company the additive method (direct method) of value added
calculation is shown as follows:
These two formulas reveal the characteristic content of the value added concept which
can be split up into a performance and a social aspect. The performance aspect is
expressed by the indirect method and the social aspect by the direct one.
It is said that value added puts the economic activity of a company in a social context
because it makes obvious that economic transactions have social implications in the use
made of productive capacity which is furnished by other economic sources, segments of
society, and in remunerating them with parts of the wealth created through its economic
operations. In terms of a company the productive factors are represented by the different
stakeholder-groups.
Thus, value added is a much broader performance measure than net income, because it is
not focused on and biased by the viewpoint of the equity-capital provider but it reveals
the "income of the entity" which belongs to, and has to be distributed to, all stakeholders.
Therefore the underlying "concept of the firm" is a coalition of various stakeholders.
Looking at the broad definition it can be easily understood that the extent of value added
depends on the classification of specific items as output or input and how the
remunerations of the different productive factors are defined. The numerous value added
concepts which can be found in literature and practice in different organisations and/or
for different purposes vary in the light of the specific classifications and definitions
adopted for the various items of the value added calculation. The major differences are
related to the following areas and questions:
100
Definition of output
Are only sales or total production the basis of the calculation?
Are intangible items included or not?
Are only operating revenues relevant or also income from other activities, such as rent,
and investments?
Definition of input
Is depreciation treated as input?
Are duties for public services treated as input?
Limits to inclusions
Extraordinary items?
Indirect taxes and subsidies?
Definition of the shares of value added appropriation
What are the components of the employees' share?
What are the components of the government's share?
What are the components of the capital providers' share?
Should there be a share "retained in business"?
Measurement
Is historical cost or current cost the basis?
Is there a nominal or a real valuation?
Are different purchasing powers taken into account?
The actual and potential applications show clearly the double-sided nature of the value
added concept, that is to say, the performance measurement and the social aspect. Due to
its characteristic of wealth creation measurement the value added concept has been
discussed as a mean to estimate the productivity of economic entities, through their
efficiency in the use of productive factors, such as work-force and capital. Efficiency is
the crucial objective of economic behaviour because it relates the amount of output to the
respective input. For this purpose value added is often used as the relevant output figure.
101
Related to this productivity measurement function value added can be used - in the place
of income or in combination with income - as a basis for employees incentive schemes
for their participation in an appropriate and fair manner in the results of productivity
increases and at the same time to motivate them to improve their efficiency
The amount of added value related to the total output of an economic unit indicates the
structure of the business activities of this entity. Vertical integration illustrates how much
an entity has created value by its own through its operating activities
In considering the social aspect of the value added concept it has been discussed as a
basis for computing a Company's contributions to the social security system.
Additionally, corporate reporting of added value during a period and its calculation in the
annual report has been regarded as useful information for the employees in particular and
is therefore an instrument of social reporting.
It has to be noted that not only value added by itself but more particularly ratios which
put value added in relation to other items are regarded as useful indicators and analytical
instruments. The appropriation of value added is usually represented in the following
way, which is particularly characterized by its differenciation between "added costs" and
"income".
Added value is not a management objective in the same sense as production levels are,
but it is an analysis tool. As such it holds a privileged place in the measurements,
balances and ratios which are at the root of all financial analysis
All revenues (other than income from investments and interests) are regarded as
value added from operations;
Depreciation is regarded as input; that means that a net value added is calculated;
Value added from operating activities, from non-operating activities and from
extraordinary events are separated;
There are no adjustments for indirect taxes, subsidies, leases and costs of external
personnel;
Share to employees
Governments share
Creditors' share
Investors' share
103
The general aim of the value added calculation by external analysts is to build up
appropriate ratios and to investigate their development over the years or compare them
with other companies. The most common ratios are related to the performance,
productivity and structural analysis, and to the analysis of the distribution (appropriation)
of value added.
External analysts are not alone in using the value added figure for analytical purposes,
companies also do so in comparing their ratios with the ratios of their major competitors.
This corporate analytical interest, called "benchmarking", has become increasingly
popular during the last few years. Among the key benchmarking criteria are the different
productivity levels of the companies. Since value added based productivity ratios are
regarded as the most useful, companies try to estimate the value added of their
competitors.
Activity 3
1. Discuss the need for human resource accounting. Throw light on human resource
accounting practices in India.
2. Write a brief note on information management in HRA.
3. List various measures for assessing individual value.
4. What do you understand by value added accounting? Discuss financial statement
analysis in value added concept.
3.9 SUMMARY
This unit considerably discusses Human resource accounting and value added
accounting. In knowledge based sectors where human resources are considered to be the
key elements for monitoring the business activities to attend their goals successfully, may
not overlooked this side. Hence, considering the great significance of HRA proper
initiation should be taken by the government along with that other professional &
accounting bodies both at the national & international levels for the measurement &
reporting of such valuable assets. After discussing the need of HRA, unit moves on
explaining information management in human resource accounting. The next area of
consideration was discussion on approaches to analyze human resources.
Measures to assess individual value were described in detail and human resource
practices in India were revealed. Cases of Indian companies which are using human
resource accounting as an unbeatable tool were discussed. Finally concept of value added
accounting was focused with suitable illustrations.
104
Blau, Gary E. Human Resource Accounting, 1st ed. Scarsdale, N.Y.: Work in
America Institute, 1978.
105