Week 2: Assignment

A report on what has been learnt by us over the week 2.

We started this week’s learning with learning about:

1. Tangible assets
2. Intangible assets
3. Goodwill
4. Goodwill accounting
5. Long term investments

Last week, we left off the course by leaning about Current Assets and Current Liability. In
this week we will learn about the terms that were left off.

Long-Term Assets: Long-term assets are those held on a company's balance sheet for many
years. They are of three types:

1. Tangible Assets – An asset that has a monetary value and has a physical form.
Depreciation is charged as an expense. E.g., Machinery, Fixtures, Plant, etc.
2. Intangible Assets – An asset that does not possess any physical form. Amortisation is
charged as an expense. E.g., Patent, trademarks, copyrights, etc.
3. Natural Resources – Those resources which we can capitalize and generate revenue.
Depletion is charged as an expense. E.g., Oil, Gas, Gold, mines, etc.

Long Term
Assets

Tangible Intangible Natural

Assets Assets Resources
Tangible Assets

Tangible assets are actively used in operations for the expected benefit for future periods. We
also call them Property, Plant and Equipment (PPE).

Costs that come under PPE:

1. Bought for use

a. Broking
b. Search
c. Legal
d. Transport
2. Under Construction (say, oil field or refinery)
a. Manpower
b. Electricity supply
c. Legal
d. Transportation
e. Interest on loan

Intangible Assets

Intangible assets are those assets without physical substance, acquired for operational use. It
provides exclusive right of privileges which does not have any pre-determined useful life of
years.
A major intangible asset we learned about this week is Goodwill.

Goodwill

It is an intangible asset. General meaning of goodwill as a layman:

1. It’s brand value

2. It represents reputation
3. Establish customer loyalty

But the above meaning does not represent a monetary goodwill value that can be shown in
the balance sheet.
Goodwill Accounting

Accounting goodwill is said to be formed when a company is purchased/acquired by another.

It can be done by two ways:

1. Pooling method – no goodwill is formed

2. Purchase method – goodwill is formed

Pooling Method: It refers to a technique of recording a merger where assets and liabilities of
two companies are summed together. Example, a company A has 2000 assets & liabilities
and company B has 1500 in assets & liabilities, then after the merger the company will have
3500 in assets & liabilities. In this technique goodwill is not formed.

Purchase Method: It refers to a technique of reporting the purchase of company which

targets the acquired firm as an investment in the balance sheet of buyer. Instead of pooling of
resources, the assets of the target firm are added to the balance sheet of acquirer at a fair
market value.
The amount paid by acquirer over the net value of targets asset & liabilities is considered as
goodwill which is shown in the balance sheet.

Goodwill is not amortised as an expense, rather an impairment test is done every financial
year. Goodwill impairment means an amount/charge when company’s goodwill on financial
statements exceeds its fair value. If there is a goodwill impairment, amount of goodwill is
assets side of balance sheet will reduce with the amount of impairment and the impairment
amount will be charged as expense in the income statement which will further reduce the
shareholders equity.

Long-Term Investment

These are categorised under long term assets and defined as those investments which
company intends to hold for more than one year. E.g., stock, bonds, real estate, machinery,
etc.

These investments are needed to report at either the book value or market value, whichever is
lower, in the balance sheet.
Financial Instruments

These are those assets which can be traded or may be traded. For example, stock, bonds, note
payable, derivative, etc. Financial instruments are classified in three categories:

 Held till maturity: these instruments are intended to keep till the maturity. Example, a
bond which has maturity of 5 years will be kept till the maturity and will be sold off
after the maturity period.
 Trading securities: they are intended to buy and sell to gain profits in the near-term or
daily basis.
 Available for sale: they are not held till maturity and are not intended to be sold in the
near term.

In the balance sheet, held till maturity category is recorded at book value or historical cost
whereas trading securities and available for sale category are recorded at fair value.

Long-term Liabilities

They are categorised into three types:

1. Known long term liabilities

2. Estimated long term liabilities
3. Contingent long-term liabilities

Long Term
Liabilties

Known Estimated Contingent

employee benfits, litigation, debt

known warranties, guarantees,
obligations defered income enviormental
tax assessments
Various types of Bonds are available in the market. They are:
1. Secured Bonds: They have some kind of collateral (property, vehicle, mortgage)
attached to it. The bondholders can seize the assets in case of default of repayment.
2. Unsecured Bonds: They don’t have any kind of any collateral attached to it.
3. Callable Bonds: They provide a right to redeem prior to its mature date. It is priced
lower than rest of the bonds. A company may call their bond if market rates are lower,
allowing them to re-borrow at more profitable rate.
4. Convertible Bonds: They provide a right to convert a bond into common share at a
predetermined form. At the conversion of bond, it gave them features of equity
securities. If the bond is not converted, it is characterised as fixed income securities.

Shareholders’ Equity

The balance is divided into two segments: Assets and Liabilities. Assets are termed as
‘resources’ of the firm which help to generate revenue, whereas liabilities are termed as a
way these resources are ‘funded’.

These funding of sources comes from Debt and Equity. In case of debt, we take loans from
others and have to repay the principal with the interest. They do not own any ownership is the
firm.

In case of equity, they get ownership in the firm of the amount invested. They receive
dividends.

The shareholder equity is an amount which shows how much is invested in the company by
the owners. On the balance, it is broken into four categories:

1. Common stock: It is the legal/par value of the share. It shows the face value of the
share.
2. Additional paid in capital: It refers to the amount paid in excess of par value or
premium paid by investors in exchange for the share issued to them.
3. Treasury stock: It is amount expensed by the firm to buy back its share. It reduces the
value of shareholders equity as the amount is taken from it to buy back the shares.
4. Retained earnings: It refers to the net profit which is retained by the firm and decided
not to distribute among the shareholders.
Dividends are paid to the owners of the firm. The amount of dividend pay-out varies from
owner to owner on the basis of the amount invested by him.

Dividends are classified into 3 types:

1. Cash dividend: they are paid in cash taken from the retained earnings.
2. Property dividend: they are paid in kind of assets like marketable securities.
3. Stock dividend: they are paid in the shares of the firm. Example, 1 share for 1 share
owner. This do not change any ownership pattern as they receive the share in
proportion of their ownership.

Dividends are not paid on the Treasure Share.

Cash Flow

Cash flow statement is a financial statement that indicates the net inflows and outflows of
cash and cash equivalents of the firm. As an analyst, cash flow helps in:

 If a business is generating enough revenue from its core business.

 If a business has enough cash to pay off its debts.
 If a business can deal with unexpected obligations like contingent liabilities.
 If a business has enough cash for business growth.

Cash Flow is bifurcated into 3 parts:

1. Cash flow from Operation: Cash generated from core activities of business. E.g., sales
2. Cash flow from Investing: Cash flow from investments in long term fixed assets.
3. Cash flow from Finance: Cash flow from external sources like debt & equity,
debentures, repayment of loan, etc.

Cash flow from Operations can be calculated by 2 ways:

1. Direct method
2. Indirect method
Direct Method: This method uses actual cash inflows and outflows instead of modifying the
operating section from accrual accounting to cash basis. Format:
1. Cash receipts from customers
2. Cash payments to suppliers
3. Cash payment from operating expenses
4. Cash payment for interest expenses
5. Cash payment for income tax
The simplest format of direct method looks like:
Cash flow from Revenue – Cash payment for Expenses = Income before taxes – Cash
payment for income tax = Net cash flow from Operating Activities.
Few formulas we learnt:

 Cash Receipts (Sales) = Sales (IS) + Change in accounts receivable (cash impact-BS)
 Cash Payments (COGS)=COGS(IS) + Change in inventory & accounts payable (BS)

Indirect Method: The indirect method presents the statement of cash flows beginning with net
income or loss, with subsequent additions to or deductions from that amount for non-cash
revenue and expense items, resulting in cash flow from operating activities. Steps:

1. Begin with net income from the income statement.

2. Add back noncash expenses, such as depreciation, amortization, and depletion.
3. Remove the effect of gains and/or losses from disposal of long-term assets, as cash
from the disposal of long-term assets is shown under investing cash flows.
4. Adjust for changes in current assets and liabilities to remove accruals from operating
activities.