Week 1: Assignment

A report on what has been learnt by us over the week 1.

The first weekly lesson started with the video on difference between Calendar year and Fiscal
year. We get to know that Calendar year consists of 12 months starting from January to
December. However, the fiscal year is any 12-month period which can start from any
month except January, e.g., Feb’2019 to Jan’2020 can be considered as a fiscal year.

Fiscal Year provides flexibility for businesses like seasonal business as preparing the final
accounts and filing the return under calendar year system could split the seasons in two
different years. Thus, making fiscal year to be more efficient to compare two seasons if
recorded under two different years.

It is not mandatory for any government or company to follow a specific year accounting
system. They can choose from any of the above according to their business cycle or
seasonality associated with their products.

Like, Google, Colgate and Chinese Government follow calendar year system while US Govt.
choose fiscal year (October to July).

YEAR (12 months)

FISCAL YEAR
CALENDAR YEAR
(Any 12 months other than
(January - December)
calendar year)
Then we learnt about the FORMAT of INCOME STATEMENT which contained items
recurring in nature. We also learnt some jargons like Topline (Gross Sales) and Bottomline
(Profit after Tax) and its uses. We get to know few non-Recurring items and its components
and their above/below the line position in the Income Statement.

Under non-recurring items, only Unusual or Infrequent items was placed above the line
before the EBT. Discontinued Operations, Extraordinary Items and Changes in accounting
principle or estimates were placed below the line after the recurring-PAT. After all the
calculating all the figures of recurring and non-recurring items we will get the final PAT.

In the following lesson we are taught how to make changes in income statement in case of
below the line non-recurring items. In case of discontinued operations, we will restate the
historical figures of that specific statement. If there are changes in accounting principles
(Changes in inventory valuation, changes in depreciation method, etc.) we present the
cumulative effect of the accounting changes in the current accounting year. As for the
Estimates, the changes are made in current and future years.

We learnt about 4 important ‘margins’ from the income statement. A margin is a profit figure
which is expressed as percentage of the company’s sales revenue. The 4 margins were:

1. Gross Margin (Gross Profit/Gross Sales)

2. EBITDA Margin (EBITDA/Gross Sales)
3. EBIT Margin (EBIT/Gross Sales)
4. PAT Margin (PAT/Gross Sales)
5.

After the Income Statement, we learnt about the ‘Revenue Recognition’ principle, when
should the revenue be realised and what are its implications provided by Financial
Accounting Standards Board (FASB). Under the accrual system, the revenue is recognized
only when it is earned and not earned or due – not necessarily when cash is received. Also,
expenses are recognised when they are incurred.

FASB has provided 2 conditions as so when the revenue could be realised:

1. Revenue must be realised or realisable

2. Revenue must be earned
In addition, SEC also provides 4 criteria for revenue recognition:

1. Arrangement between buyer and seller

2. Goods and services have been delivered.
3. Price must be determined.
4. Reasonably sure about collection of money.

In the same video lesson, we discussed how Long-Term Contracts are recognised:

1. Percentage Completion Method

2. Completed Contract Method

Furthermore, we learnt about the Instalment Sales and Cost Recovery method in detail.

In the Instalment Sales method, all cost is incurred/calculated at once while revenues are
earned over a period of time. For example, firm A has purchased has purchased material from
firm B. Due to shortage of cash, both the parties agreed upon instalment payment over a
period of time. From the point of view of firm B, it has incurred all the costs at the time of
sale but is expecting revenue over the period of time. To calculate the revenue, he must have
used Instalment Sales method of recognising revenue.

However, if the collection of revenue from sales is questionable, we use Cost Recovery
method. In cost recovery method, the amount of sales and gross profit are not recognised
until the cost of goods are fully recovered.
Next, we learnt about the Depreciation policies followed by various companies. Common
depreciation method used by companies:

a. Straight Line Method – Company assumes that each year a machine is used equally
and hence its depreciation should be calculated equally across its useful years of life.

Cost−Residual Value
It is calculated as: Depreciation= :
Number of years

b. Accelerated Method – Assets depreciate at a faster rate during the beginning of their
lifetime and slow down near the end of the asset’s life.
The most popular accelerated method is Double Declining Method (DDB).

2∗Cost − Accumulated Depr .

It is calculated as (using DDB): Depreciation=
Useful Life

Till now we have understood about Income Statement and its format. Then, we learnt about
its application by taking a case study on Colgate. We will discuss about the key formats of
Income Statement and convert the given income statement format to Analyst friendly format.

Analyst Friendly format should contain Gross Profits, EBITDA, EBIT, PAT.
According to industry standards, the Hard Coded numbers (Gross Sales, COGS) are
formatted in blue colour. Hard coded numbers are the facts that are already provided by the
company. Whereas, the Formula numbers (Gross profit, EBIT) are formatted in black colour.

The given statement does not bifurcate recurring and non-recurring items in the income
statement. We learnt about how we can bifurcate these items to perform our calculations
more accurately.
Balance Sheet provides us the financial position of a company at a specific point of time.
Balance sheet has 2 segments: Assets & Liability. Assets are equal to the sum of Liability and
Shareholders’ Equity.

Current
Assets
Assets
Long Term
Assets
Balance
Sheet Current
Liability

Long Term
Liability
Liability

Shareholder'
Equity

1. Assets
a. Current Assets
These are expected to be used, sold or converted into cash withing a year
or an operating cycle.
 Cash and Cash Equivalents: required to run day to day
services. E.g. – Cash, bank deposits, securities, etc.
 Accounts Receivables: services are rendered but payment
has not been received.
 Inventories: goods or material held by business. E.g., raw
material, work-in-progress, finished goods.
 Prepaid Expenses: future expenses that are paid in advance.
They are intangible expenses.
 Other Current Assets: marketable securities, deferred
income tax, advances to employees, etc.
 b. Long Term Assets: Stocks, bonds, real estate, machinery, investment,etc.

2. Liability
a. Current Liability
Those obligations which are needed to be paid within a year.
 Accounts Payable: bought goods/services from supplier but
not paid them.
 Unearned revenue: advanced received from customers but
goods are not delivered.
 Short term debt: a short loan which is needed to be paid
within a year.
 Current maturities of long-term debt: A portion of debt
which is required to paid in the accounting period.
 Other current liabilities: can be related to unpaid liabilities
like wages, taxes, interest.
b. Long Term Liability: Long term loans, capital leases, mortgage,
debentures, etc.
c. Shareholders’ Equity: equity shares, preference shares, retained earnings

Under Inventories segment, we learned how we can deal with the situation when inventory
prices are increasing or decreasing and how to adjust them in the balance sheet and income
statement. To tackle such kind of situation where the inventory price might change
(increase/decrease), we use LCM (Lower of the Cost or Market) method.

LCM states that balance sheet will state the amount whichever is less, i.e., Cost price or
Market price. For example, CP is ₹1000 and MRP is ₹1500, the balance sheet will show the
state the price of CP for inventory. If CP is ₹1000 and MRP is ₹500, the balance sheet will
show the price of MRP for inventory.

In case the price decreases than the amount of price stated in the balance sheet, the amount
difference is written off from balance sheet from inventories in asset side. There would be a
corresponding decrease in the liability side, which we would get from income statement.
The difference in the price will be shown as loss in the income statement which would impact
the PAT. The PAT comes under Equity section under Liabilities in the balance sheet. Thus,
the difference will be deducted both from the assets and liabilities.

In case the price increases than the amount of price stated in the balance sheet, the vice versa
would be done.

The decrease in price is treated as loss while increase in price is treated as profit. But this loss
is not a cash loss and hence it will not affect the cash flow statement.

In the inventories segment, we also learnt about the Inventory Accounting method. There are
3 kinds of inventory accounting method:

1. FIFO
2. LIFO
3. Weighted Average

We were taught about a very important equation in inventory accounting known as BASE
equation.

B A S E

Beginning inventory Additions/Purchase Subtract/Sold Ending balance

0 20 5 15

From the above data, we can say that the equation B + A = S + E

Now let us take a look on how the above inventory accounting method will perform based on
a common situation. A firm purchases inventory at different period of time and at different
prices. Although the selling price must be the same as the amount of goods sold, but the
amount of inventory changes based on what inventory accounting method a firm chooses as
its policy.

We will now understand the same situation under different inventory accounting method.

1. FIFO (First In First Out): In this method the inventory which comes first would be
sent first as a sale.
2. LIFO (Last In First Out): In this method the inventory which comes last would be
issued first for the sale.
 3. Weighted Average: In this method we will find the weighted average price (dividing
total sum of price of inventory by total number of units) and calculate the price of
inventory by multiplying it with average price.

We noticed the trend that if the prices of inventory are rising, inventory valuation will be
highest in FIFO method and COGS will be highest in the LIFO method.

Whereas, if the prices of inventory are decreasing, valuation of inventory will be highest in
LIFO method and COGS will be highest in FIFO method.

According to US GAAP, all the inventory accounting methods are allowed whereas
according to IFRS only FIFO and Weighted Average method are allowed.

Thus, while comparing two companies we have to check if they are following the same
inventory accounting method or not or else, we will have to do few adjustments.

Finally, we learnt about the financial statements and why it is necessary to prepare them. The
main reasons are:

 Standard of comparison
 Minimum disclosure to compare
 Useful to many users like investors

There are some entities who help users to ensure the standards of comparison. These entities
are:

1. Standard Setting Body: It is a pool of accountants and auditors. They help in making
the financial reporting standards.
Example, in US there FASB (Financial Accounting Standards Board) while
internationally there is IASB (International Accounting Standards Board) as a
standard setting body. Whereas, for reporting standards, in US there is US GAAP
while internationally there is IFRS.
2. Regulatory Authorities: they have legal authorities to ensure the compliance of above
standards.
Example, in US SEC (Securities and Exchange Commission), in UK FSA (Financial
Service Authority).

These authorities regulate the accounting and reporting standards within their region.
They mandate some forms that needs to be filled by a firm for a minimum disclosure.
Some of the important forms from the point of analysis (US SEC Forms):
 S-1: registration statement under securities act of 1933
 8-K: Discloses material events; acquisition, disposal, change in management
 10-K: Annual filing including info about business and financial statements
 10-Q: Quarterly filings; not audited
 20-F: Annual filings by any foreign issuer
 40-F: Annual filings by Canadian companies