Key takeaways of the course

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1. Introduction
• FINANCIAL ACCOUNTING Primarily meets needs of external users: investors, lenders,
prospective buyers etc.

• Communicates information through periodically issued financial statements:

• Income statement – captures performance during a period of time.
• Revenue – expenses= Net income
• Balance sheet – captures a company’s resources and claims on a given point of time
• Assets are resources that a company owns and will use to generate future benefits
• Liabilities are claims against assets by outsiders
• Shareholders’ equity is owners claims against assets
• A = L + SE
• Statement of cash flows
• It divided in 3 components – operating, investing and financing sections
• Cash flow from operations can be arrived in two ways – direct and indirect methods
• In the indirect method depreciation / amortization is added back to net income
because it is a non-cash expense, NOT because it is a source of cash
• The sign and magnitude of CFO, CFI and CFF conveys information about life cycle
of a company

• These numbers are subject to specified accounting rules Ind AS / US GAAP / IFRS

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2. Accrual accounting
Under accrual basis of accounting
• CASH INFLOW ≠ INCOME
• CASH OUTFLOW ≠ EXPENSE

• Revenue recognition principle is applied to determine income and Matching principle is

applied to determine expenses

MECHANICS
• The accounting equation is A = L + SE

Assets = Liabilities + Shareholders' Equity

Common stock Retaine d Earnings AOCI

Income - Expe nse s - Dividends

• Increase in LHS or decrease in RHS means Debit

• Increase in RHS or decrease in LHS means Credit
• DEAD CLEAR
• Journal entries=> T accounts => Trial balance => Income statement and balance sheet
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3. Revenue recognition principle and AR

Revenue is recognized when it is

• Earned - the company has completed a substantial portion of the its effort for sale
• Realized (or realizable) - when cash or claims to cash are received

• If the company has NOT finished what it is supposed to do in order to “earn” the revenue, the
revenue is not recognized. If cash is received and the it is recorded as deferred revenue.

• If the company has finished what it is supposed to do in order to “earn” the revenue, but the cash is
not received it can still record revenue. The cash to be collected from customers is recorded as
gross accounts receivables.

• It a company is not sure about the collections from customers then they have to create an
allowance for doubtful debts. Gross AR – allowance = Net AR

• Write off of receivables ≠ bad debt expense

• Companies often tend to inflate income by

• Recording income before it is earned
• Not providing sufficient allowance for doubtful debts

• Increase in receivable days is an indicator for deteriorating quality of receivables or fictitious

sales (assuming credit terms have not been changed)
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4. Inventory & COGS

Expenses are recognized in the same period that the associated revenue is recognized
• If the benefits of a cost are expected to accrue in the same period when the cost is incurred, then the
cost is expensed in that period.
• If the benefits of a cost are expected to accrue in future periods to when the cost is incurred, then the
cost is capitalized in that period.

INVENTORY & COGS

• When inventory is purchased or produced, it is capitalized and carried on the balance sheet as an
asset until it is sold. When the inventory item is sold, its cost is transferred to cost of goods sold on
the income statement. Opening inventory + purchases = COGS + Ending inventory
• SALES – COGS = GROSS PROFIT

• To allocate cost between ending inventory and COGS some common cost flow assumptions are –
LIFO, FIFO, Average cost, specific identification. These assumptions DO NOT relate to actual
physical flow of inventory.

• When the value of inventory is lower than its cost, Companies have to “write down” the inventory
to its market value in the period in which the price decline occurs.
• Increase in inventory holding days might indicates the a company is not able to sell its inventory
and in some cases might indicate delay in recording write downs
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5. PP&E

As the benefits PP&E are expected to extend beyond one year, the acquisition cost is capitalized when
the PP&E is bought.

Capitalized costs are eventually charged as an expense to income through different processes:
 Depreciation / Amortization – to capture decline in value due to use / passage of time
 Impairment – to capture permanent decline in value due change in business conditions
 Gains / losses on disposal of assets

• Common methods for depreciation are straight line method (SLM) and accelerated depreciation
methods.

• Depreciation is not directly deducted from PP&E. It is cumulated over time under Accumulated
depreciation (CA). Gross PP&E – Accumulated depreciation = Net PP&E

• Companies can choose and change assumptions underlying depreciation methods. They can
extending the assumed value of useful life thereby reducing depreciation expense and inflating the
net income.

• Decline in fixed asset turnover ratio indicates that the company is not productively using its fixed
assets and in some cases prolonged decline suggests delay in recording impairment

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6. Intangibles

• Intangibles lack physical existence and are difficult to value

• Only identifiable intangibles are recorded. These intangibles (i) arise out of contractual or other legal
rights; and (ii) are separable from a company and can be sold

• Acquired intangibles are recorded on the balance sheet but internally developed intangibles are not. For
e.g., balance sheet typically only puts filing and legal costs of patents, not the cost of the science to
develop the patent

• Internally generated intangibles, R&D (in the US) and research costs (in IFRS and Indian GAAP) is
not recorded as an assets because of uncertainties relating to future economic benefits that these assets
can generate.

• True economic intangibles like brand name, exceptional management, desirable location, good
customer relations, skilled employees, high-quality of products, are not recorded as intangible assets.

• When a business is purchased the cost of the purchase typically exceeds the fair value of the
identifiable net assets (assets less liabilities) purchased. The difference is recorded as goodwill which
captures the above mentioned unidentifiable intangibles.

• Finite life intangibles are amortized and all intangibles are tested for impairment (highly subjective)
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6. Intangibles

• Intangibles lack physical existence and are difficult to value

• Only identifiable intangibles are recorded. These intangibles (i) arise out of contractual or other legal
rights; and (ii) are separable from a company and can be sold

• Acquired intangibles are recorded on the balance sheet but internally developed intangibles are not. For
e.g., balance sheet typically only puts filing and legal costs of patents, not the cost of the science to
develop the patent

• Internally generated intangibles, R&D (in the US) and research costs (in IFRS and Indian GAAP) is
not recorded as an assets because of uncertainties relating to future economic benefits that these assets
can generate.

• True economic intangibles like brand name, exceptional management, desirable location, good
customer relations, skilled employees, high-quality of products, are not recorded as intangible assets.

• When a business is purchased the cost of the purchase typically exceeds the fair value of the
identifiable net assets (assets less liabilities) purchased. The difference is recorded as goodwill which
captures the above mentioned unidentifiable intangibles.

• Finite life intangibles are amortized and all intangibles are tested for impairment (highly subjective)
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7. Investments

Equity Ownership: < 20% 20-50% > 50%

Influence: “passive” (little or no “significant influence” “controlling”

influence) (Parent & subsidiary)

Valuation Method Fair Value Equity Method. Consolidation

Investment increases by P’s Rather than showing a single
share in net income of S and line “investment”, all assets
decreases by P’s share in and liabilities of S added to
dividend paid by S those of P. An adjustment
for NCI is made later.
Unrealized holding Available Trading Not recognized Not recognized
gains or losses for Sale: Securities:
OCI (in IFRS Net Income
and Ind AS)

Recording Income: Dividends declared; gains Proportionate share of “Consolidate” subsidiary’s

or losses from sale investees’ income in net
income
Look out for Equity method income is
“NON CASH”
net income with those of
parent; account for non-
controlling interest (NCI)
Companies might avoid
consolidation to show more
profitability and less risk

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8. Liabilities
• Companies borrow from general public by issuing corporate bonds

• Time value of money techniques are applied as cash flows occur at various times

• Basic demand and supply economics determines bond proceeds. Bonds are sold for cash and are
issued at:
Par if coupon rate = market rate [expected rate of return]
Premium if coupon rate > market rate
Discount if coupon rate < market rate

• Effective interest rate method is used to account for bonds that spreads the discount / premium over
the life of the bond

• We assess the ability of the firm to repay the borrowings in the long term as well as in the short
term using ratios such as
• Total Liabilities / Total Assets
• Current assets / Current Liabilities
• Cash / Current Liabilities
• Interest coverage ratio
• Debt service coverage ratio

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9. Shareholders’ equity
 The system of shares is the foundation for a corporation.

 Typically, shareholders have following rights

• To share proportionately in profits and losses.
• To share proportionately in management (the right to vote for directors).
• To share proportionately in assets upon liquidation.
• To share proportionately in any new issues of shares of the same class [preemptive right]

• Major components of shareholders equity include – common stock, preferred stock, treasury
stock, retained earnings, AOCI, NCI

• Major transactions that affect SE are – issue of share, treasury stock transactions, dividend (cash
as well as stock), stock splits

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10. FSA

• Return on Equity (ROE) = Net Income / Shareholders’ Equity

How much profit do the shareholders generate for each $ they invested in equity?

𝑵𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

ROE =
𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑬𝒒𝒖𝒊𝒕𝒚

• Profit margin: Measures a firm’s ability to generate income from a particular level of sales.
• Asset turnover: Measures a firm’s ability to generate sales from a particular investment in assets.
• Leverage: equity multiplier

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