Essentials of FA - Chapter 2

ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA
Second Edition Chapter 2
Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA
Debt and Liabilities

1/22/2014
In the case of debt and other liabilities, the company has an obligation to return the capital and to pay a return on the capital (interest) as per the loan covenant. Lenders have a claim on the assets of the company. If the company fails to meet its commitment for return of the capital or to pay the interest, they can force the company to sell the assets and repay the loan and pay the outstanding interest on the capital.
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Equity Capital
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Equity is the residual interest in the assets of the company after deducting all its liabilities. Investment in equity capital is exposed to business risks. In the case of equity capital, the company has no obligation to return the capital and to pay a return on the capital. The Companies Act does not allow a company to return the equity capital contributed by equity shareholders because return of capital is detrimental to the interest of debt holders and other creditors.
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Equity Capital (Cont.)

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Investment in the debt capital is exposed to credit risk only if the value of assets that the company holds is significantly higher than the amount of the debt capital. A company has unconditional discretion to decide when and how much of the net profit is to be distributed to equity shareholders. Investment in equity capital is exposed to business risks.
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Equity Capital (Cont.)

1/22/2014
Equity in the balance sheet fails to reflect the fundamental value of the equity capital invested in the entity because:
Internally generated intangible assets (except software) are not recognised in the balance sheet Fixed assets and liabilities are measured at historical costs, current assets are measured at the lower of cost and realisable value and investments in loan are measured at cost and other investments are measured at fair value Financial statements provide historical information, while the fundamental value depends on the cash flow stream that the company is expected to generate in future.
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Accounting Equation
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Equity = Assets Liabilities The terms equity and net worth are used interchangeably.
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Asset
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An asset is a resource controlled by a firm as a result of past events and from which future economic benefits are expected to flow to the firm. An asset is recognised in the balance sheet only if its cost or value can be measured reliably. Although many companies create value by managing intangibles, internally generated intangibles, other than software, are not recognised as assets in the balance sheet.
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Classification of Assets
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Assets
Noncurrent assets
Current assets
Fixed assets
Investments
Others
Property, Plant and Equipment
Intangible assets
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Fixed Assets
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Fixed assets are those which are used for production and administration. They provide benefits for more than one accounting period. Fixed assets can further be classified as property, plant and equipment (PPE) and intangible assets.

Examples of PPE are land, building, railway siding, machinery, equipment, vehicle, and computer.
Fixed assets may be viewed as assets that provide the infrastructure.

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Current Assets and Non-current Assets

1/22/2014
Current assets support the current operation. They are part of the working capital.

Examples of current assets are finished goods held for sale, work-in-progress held in stock, raw materials and stores and spares, receivables (the amount due from customers), marketable securities (securities that can be sold in an active market and the company intends to hold them for a short period), cash and bank balances.
Assets that cannot be classified as current assets are classified as non-current assets.
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Liability
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Liability is a present obligation of the company arising from past events, the settlement of which is expected to result in an outflow from the firms resources embodying economic benefits.
Examples of liabilities are borrowings from financial institutions, borrowings from public through issuance of debentures or other types of bonds, public deposits, interest accrued on borrowings, trade creditors (amount due to suppliers of goods and services), advance received from customers, progress payments received from customers, and amount due against tax liability.
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Liabilities: Classification
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Liabilities
Non-current liabilities
Current liabilities
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Current and Non-current Liabilities

1/22/2014
Liabilities that are to be settled within the normal operating cycle or 12 months after the balance sheet date are classified as current liabilities.
Examples of current liabilities are trade creditors, advance from customers and that part of long-term borrowings which is payable within 12 months after the balance sheet date.
Liabilities which cannot be classified as current liabilities are known as non-current liabilities.
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Capital Structure
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The capital structure represents how a firm finances its overall operations and growth by using different sources of funds. Equity and debt are components of capital structure.
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Gearing Ratio
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Gearing is the relationship between a firms debt capital and equity capital. It is calculated as follows:
Net debt divided by enterprise value, that is, [D/(D+E)] Net debt is calculated as total debt less the amount of cash and cash equivalents in the balance sheet. Theoretically, market value of debt and equity should be used to calculate gearing. But, in practice, in most situations, gearing is calculated using the book value of debt and equity.
.
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Gearing Ratio (cont.)

1/22/2014
Gearing ratio indicates the risk of variability in return to equity shareholders and the risk that the entity may go bankrupt. There is no ideal gearing ratio. However, in general, high gearing increases the financial risk of the firm Companies manage capital structure and make adjustments to it in light of changes in economic conditions and the risk characteristics of the underlying assets.
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Gearing Ratio (cont.)

1/22/2014
Gearing: Selected companies: 31 March 2009

Company Borrowing (Rs. crore)
0.02
Equity (Rs. crore)

2118.95
Market cap (Rs. crore)

9056.96
Gearing (Book value)

0.00%
Gearing (Market cap)

0.00%
ABB Ltd. (Engineering)
Crompton Greaves Ltd. (Engineering)

Larsen & Toubro Ltd. (Engineering) Hindustan Motors Ltd. (Automobiles) Maruti Suzuki (India) Ltd. (Automobiles) Hindustan Unilever Ltd. (FMCG) Procter & Gamble Hygiene & Health Care Ltd. (FMCG) ITC Ltd. (Diversified) Infosys Technologies Ltd. (IT) Tata Consultancy Services Ltd. (IT)
53.67
6556.03 129.03 753.8 421.94 0
1241.89
12459.69 92.28 9344.9 2061.51 346.64
4512.43
39396.29 212.26 22393.42 51924.65 2439.1
4.14%
34.48% 58.30% 7.46% 16.99% 0.00%
1.18%
14.27% 37.81% 3.26% 0.81% 0.00%
177.55 0 40.37
13735.08 17809 13446.25
69750.9 75848.43 52844.97
1.28% 0.00% 0.30%
0.25% 0.00% 0.08%
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Expenditure and Expense

1/22/2014
Expenditure reduces asset or increases liabilities. If no asset is recognised from the expenditure, the amount of equity in the balance sheet reduces. Expenditure, which is not recognised as an asset, is an expense for the accounting period in which it is incurred. An asset is recognised from expenditure if it is probable that the expenditure will provide benefits in future and if the cost or value of the benefit (asset) can be measured reliably.
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Expenditure and Expense (cont.)

Will the benefits from the expenditure flow to If no, Recognise the expenditure as an expense in the income statement for the current period.
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subsequent period(s) ?
If yes, Whether the resulting asset meets the recognition criteria?
If no, Recognise the expenditure as an expense in the income statement for the current period.
If yes, Recognise the asset in the balance sheet.
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Probable
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Probable implies more likely than not. Management is expected to form its judgement based on evidence available to it. In most situations it is impossible to assert with certainty that an asset will provide benefits in future in a changed business environment. Therefore, reasonable certainty is the criterion for recognition of asset from expenditure. The term probable implies reasonable certainty.
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Virtual Certainty
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The criterion of virtual certainty is used for recognition of a few specified assets. Virtual certainty implies very close to certainty, without being actually certain.
For example, the criterion is used for the recognition of an asset from a promise to reimburse an expense by a third party (e.g. government). Therefore, even if a firm is reasonably certain that the benefit from the promise will materialise, it cannot recognise an asset until the reimbursement becomes virtually certain.
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Income
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Income measures increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.
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Expense
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Expenses measure decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Expense includes that part of expenditure, which was recognised as asset in the current year or in any previous years, allocated to the current year.

The allocated expense is called depreciation.
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Double Entry Bookkeeping

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The double entry bookkeeping flows from the accounting equation. The equation tells us that, if the total amount of assets increases, either the total amount of liabilities increases or the amount of equity increases. The principle of double entry bookkeeping is that for every debit there is a credit.
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DebitCredit Rules
1/22/2014
Asset: Increase is Debit; Decrease is Credit Liability: Increase is Credit; Decrease is Debit Equity: Increase is Credit; Decrease is Debit Expense: Debit Income: Credit Recognition of income and recognition of corresponding asset (cash/receivable) or derecognition of a liability are simultaneous. Similarly, recognition of expenses and recognition of liability (provision/creditor) or derecognition of asset (e.g. cash) are simultaneous.
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Alternative Debit-Credit Rules

1/22/2014
Personal account
Amount due to or from a natural or juridical person (e.g. a limited liability company) Debit the receiver and credit the giver Assets, other than the amount due from a person Debit: what comes in; credit: what goes out
Real account
Nominal account
Incomes and expenses Debit expenses and credit incomes
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Accrual Accounting
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Under accrual basis of accounting, the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.
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Accrual Accounting (cont.)

1/22/2014
Revenue
Recognise income from sales of goods or services when the goods have been delivered or services have been rendered and it is reasonably certain that that the amount will be collected.
Expenses should be recognised when the goods or services are received without waiting for actual cash outflow.
Expense
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Pre-paid expenses
An expense paid in advance is recognised as an asset and is usually classified as a current asset. Examples are rent paid in advance, and advance paid to suppliers of goods.
Amount received from a customer before the goods (services) are delivered is recognised as a liability. Revenue is recognised and liability extinguished on delivery of the goods (services).
Deferred revenue
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Interest
Interest income and interest expense are recognised on time proportion basis.
Depreciation (of property, plant and equipment) and amortisation (of intangible assets) represent allocation of capitalised expenditure to different periods that benefit from the expenditure.
Depreciation and amortisation
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Principle of Prudence
1/22/2014
Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.
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Principle of Prudence (cont.)
Inventory valuation
1/22/2014
Inventory of finished goods and work-in-progress (WIP) are measured at cost or net realisable value (NRV), whichever is lower.
Onerous contract
Executory contract is a contract under execution, or where one or more parties have not yet performed their duties as stipulated in the contract document. Onerous contract is an executory contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. A provision (liability) should be recognised for the estimated loss on an onerous contract.
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Principle of Prudence (cont.)

1/22/2014
Impairment loss
Impairment loss is recognised when management estimates that a group of assets (called cash generating unit) will not be able to recover its carrying amount, which is the total of WDV of assets that constitute the cash generating unit (CGU).
Intangibles
GAAP does not permit recognition of internally generated corporate reputation, product brands, mastheads, publishing titles, customer lists and items similar in substance. It does not permit recognition of human resources as an asset.
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Substance Over Form

1/22/2014
Transactions and other events are recorded and presented in financial statements based on their economic substance, which might be different from the legal form of the transaction.
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Substance Over Form: Finance Lease

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In a lease agreement the lessor, who is the owner of the asset, conveys to the lessee the right to use the asset for an agreed period of time and receives lease rent from the lessee. In a finance lease, the lessor transfers substantially all the risks and rewards incidental to ownership of the asset to the lessee.
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Substance Over Form: Finance Lease (cont.)

1/22/2014
A finance lease, in substance, is a financing arrangement. The lessee recognises the asset and a corresponding liability in his balance sheet.

He recognises depreciation on the asset in his profit and loss account.
The lessor presents the asset in his balance sheet as receivable.
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Substance Over Form: Redeemable Preference Shares

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Investors in preference shares issued by a limited liability company have preferential right over distribution of net profit and assets on liquidation of the company. In the case of redeemable preference shares, the company is under obligation to repay the capital. IFRS require classification of redeemable preference shares in the balance sheet as debt. However, the Companies Act, 1956 requires that preference shares should be presented in the balance sheet as a component of equity capital.
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Substance Over Form: Sale and Buy-Back Arrangement

1/22/2014
In sale of goods, a sale is recognised only if, among other things, the company has transferred to the buyer the significant risks and rewards of ownership of the goods. In some transactions involving sale and buy-back of the goods significant risks and rewards of ownership are not transferred to the buyer.

Example: Sale includes an arrangement to buy back at a predetermined price
Although the legal form of those transactions is sale of goods, they are not presented as such in financial statements.
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Substance Over Form: Barter Transaction

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A barter transaction that involves exchange of similar goods, where neither of the parties recognise sale and expenses in their profit and loss account. This is because exchange of similar goods has no commercial substance in the sense that the transaction does not have any material impact on the cash flows of the parties concerned.
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Authorised Capital and Face Value
The authorised capital of a company is the maximum amount of share capital, measured at face value, that the company is authorised to issue to its shareholders.

1/22/2014
The Memorandum of Association mentions the amount of authorised capital. Part of the authorised capital can (and frequently does) remain unissued. The authorised capital of the company may be increased by the votes of the shareholders at a general meeting. Authorised capital has no economic significance. Higher the authorised capital, higher is the registration fees and stamp duty.
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Authorised Capital and Face Value (Cont.)

1/22/2014
Usually, a company that has ambition to grow as a large company signals the ambition by mentioning high authorised capital in the Memorandum of Association.
Face value (also called par value) is calculated by dividing the authorised capital by the number of parts in which the authorised capital is divided by the company.
It is at the discretion of the company to decide the face value.
A company can issue shares at a premium.

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Book Value
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Book value per share is calculated by dividing the amount of equity in the balance sheet by the number of outstanding shares.
The number of outstanding shares is the number of shares issued and subscribed less the number of shares bought back.
Book value, to an extent, reflects historical performance of the company. However, it does not capture the historical performance fully for two reasons:
Most intangible assets are not recognised in the balance sheet. Most assets and liabilities are measured at historical cost.
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Market Value and Market Capitalisation

1/22/2014
Market value refers to the price at which the shares are being traded in the capital market.
It reflects the market expectation about the future performance of the company.
Market value of the equity capital is called market capitalisation.

Share price may be perceived as market capitalisation divided by the number of outstanding shares. However, in practice, share price being observable, market capitalisation is calculated as follows: Market capitalisation = Share price Number of outstanding shares
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Market Value and Market Capitalisation (cont.)

1/22/2014
Market capitalisation may not be the same as the intrinsic or the fundamental value of the equity. There can be many reasons.
For example, market may not be confident of the outcome of the companys strategy (e.g. turnaround strategy of a sick company projected by its management). Moreover, in the short term, the share price is affected by factors such as liquidity in the market and market sentiment.
In the long-term market capitalisation tends to converge to the intrinsic or fundamental value of the equity capital.
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END
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Essentials of FA - Chapter 2

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ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA

Second Edition Chapter 2

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Debt and Liabilities

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Equity Capital (Cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Equity Capital (Cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Property, Plant and Equipment

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Fixed assets may be viewed as assets that provide the infrastructure.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Current Assets and Non-current Assets

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Current and Non-current Liabilities

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Gearing Ratio (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Gearing Ratio (cont.)

Gearing: Selected companies: 31 March 2009

Equity (Rs. crore)

Market cap (Rs. crore)

Gearing (Book value)

Gearing (Market cap)

ABB Ltd. (Engineering)

Crompton Greaves Ltd. (Engineering)

13735.08 17809 13446.25

69750.9 75848.43 52844.97

1.28% 0.00% 0.30%

0.25% 0.00% 0.08%

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Expenditure and Expense

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Expenditure and Expense (cont.)

If yes, Whether the resulting asset meets the recognition criteria?

If yes, Recognise the asset in the balance sheet.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

The allocated expense is called depreciation.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Double Entry Bookkeeping

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Alternative Debit-Credit Rules

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Accrual Accounting (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Accrual Accounting (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Accrual Accounting (cont.)

Depreciation and amortisation

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA