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Financial Reporting and GAAP

M.S.Narasimhan Indian Institute of Management Bangalore

Issues in Financial Reporting


Dispersed ownership and involvement of several stakeholders warrant the firm to report its affairs, particularly financial performance In reporting financial and other details, firms have to keep in mind
the target audience or users of the reports generally accepted accounting principles (or Accounting Standards) of the country the needs of the auditors, who are vetting the financial statements

Firms follow a set of accounting principles and in addition comply GAAP


M.S.Narasimhan, Indian Institute of Management Bangalore

Accounting Concepts and Conventions


Concepts and conventions give a general guidance on how to treat financial transactions Business is a separate entity Business has a long-life (going concern) Accounting generally restricts itself to transactions, which can be measured in monetary value Prefers an objective measure in valuation compared to values not agreed by all (cost concept) Record profits only when realised (not necessarily in cash form); losses before its realisation (conservatism)
M.S.Narasimhan, Indian Institute of Management Bangalore

Accounting Concepts and Conventions Business is a going concern but financial transactions are summarised periodically - Accounting Period
Match Expenses with revenues of the period

Accounting Standards require the firms to treat accounting items in a specified manner. Accounting Standards on various accounting items

reflects the above concepts and conventions.


M.S.Narasimhan, Indian Institute of Management Bangalore

Accounting Standards Setting Bodies International Accounting Standards Committee


a voluntary association of professional accounting organisations of several countries sets International Accounting Standards encourages members to influence standard-setting process to adopt IAS

Institute of Chartered Accountants of India


set up the Accounting Standard Board, which sets Accounting Standards (AS) in India

US: SEC has the legal authority to set standards


SEC delegated most of the responsibility to Financial Accounting Standard Board (FASB)
M.S.Narasimhan, Indian Institute of Management Bangalore

Accounting Standards in India Disclosure of Accounting Policies(AP) Accounting for


Construction Contracts, R&D, Fixed Assets, Effects of changes in foreign exchange rates, Government Grants, Contingencies and events occurring after BS date, etc.

Depreciation Accounting Prior Period, Extraordinary items and changes in AP Investments, Amalgamation, Retirement Benefits Valuation of Inventories Changes in Financial Positions
M.S.Narasimhan, Indian Institute of Management Bangalore

AS - P & L Account
Profit is determined by subtracting expenses of the period from revenue of the period Accounting Standards are pronounced on three important items of P&L Account
Revenue Recognition Inventory Valuation Depreciation

On other items, accounting concepts and conventions are used


M.S.Narasimhan, Indian Institute of Management Bangalore

Accounting Methods for Measuring Performance


Cash Basis of Accounting
Revenue and expenses are recognised only when cash is received or paid Most simple method of accounting but suffers from several defects Cash Flow Statement reflects cash basis of accounting Profit or loss of one period mingles with other periods

Accrual Basis of Accounting


Revenue is recognised when the firm sells goods Cost incurred to generate revenue are recognised
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition
Activities in Revenue Generation Process
Firm receives order and produce or produce and sell Receives advance with orders in some cases Despatch goods and raise invoice may happen simultaneously or different points of time Goods are accepted or returned by the customer Receives payment in full or part, retention money, discount availed for advancing payment, payment not received or not to be received.
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition
When to recognise the revenue?
The operating cycle explains profit is being earned over the cycle and it is realized in cash form at the end of the cycle (when cash is received) Since there is no objective way to measure profit earned at different process, profit is recognized at one single point (Objectivity principle)

M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - In Normal Cases


Seller has transferred the title of goods
Refer Sale of Goods Act

No significant uncertainty exists regarding collection of consideration Under accrual basis, revenue is recognised when a firm
has performed all or substantial portion of service it expects to provide and has received cash, a receivable or some other asset whose cash equivalent value can be measured objectively
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Special Cases 1. When transaction involves rendering of service


Completed service contract method (CSCM) or Proportionate or percentage of completion method (POCM)1

2. When transaction involves use of enterprise resources by others


Interest - accrual basis Royalties - accrual basis Dividend - when owners right to receive payment is established
1 IAS 11 prefers POCM. In UK and Netherlands, POCM alone is allowed. In

India, US, Germany, France, Japan and Canada, both methods are allowed. In Austria, CSCM alone is allowed.
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Special Cases: Examples Insurance Company


Make provision for insurance liability Completed contract method if contract is for short-term like Travel insurance, vehicle insurance

Franchisers
after the commencement of franchising operation

Real Estate Developers


Period of cancellation is expired Some predetermined percentage of cash received (10%) Land development process is over Delivery or POCM or Instalment method
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Special Cases: Examples


Hire-purchase Firms
At the time of sale (AS)1 Instalment Method Cost-Recovery-First Method At the time of full collection Interest to be shown separately

Forest Product, Plantation, Breweries, etc.


Percentage of completion or delivery
1

US GAAP too prefers this method when there is no uncertainty relating to cash collection
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Sale of Goods


Delayed Delivery - Accrual (at the time of sale) Delivery subject to conditions
installation and inspection - wait for acceptance or approval on approval - wait for acceptance guaranteed sales - recognise sale but make suitable provision consignment sale - wait until sale take place to third party

Instalment sale but delivery after the receipt of all instalments - wait for the receipt of all instalments Advance received in a special order -wait for delivery Sale and repurchase - not a sale & hence not a revenue Dealers & distributors: sale if title of goods is passed Subscriptions for publication
M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Service Installation Fee: Wait for completion of installation Advertising: Wait for publication of advertisement Insurance agency commission: Wait for commencement or renewal of policy Financial Service Commission
One-time Fee - Recognise when service is completed On-going service - Recognise over the years.

Admission Fees Tuition Fees Entrance and Membership Fees


M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition Methods - Summary


Normal Sales
Cash Basis of Accounting Accrual Basis of Accounting

Special Cases of Sales


Cash Basis of Accounting Completed Contract (or sale) Method Percentage-of-completion Method Instalment Method Cost-Recovery-First Method

M.S.Narasimhan, Indian Institute of Management Bangalore

Revenue Recognition - Comprehensive Exercise


Road Construction Division of Infrastructure Construction Corporation was awarded a contract to construct a by-pass road at an estimated value of Rs. 120 cr. The contract is expected to be completed in three years but contract value will be collected over five years. The details are given below: Period Expected Receipts Expected Cost 1 10 20 2 20 40 3 30 40 4 40 5 20 Show the revenue, expense & profit under different methods.
M.S.Narasimhan, Indian Institute of Management Bangalore

Comprehensive Exercise: Additional Questions


If the actual expenses for the three years are Rs. 20,

45 and 50 crores respectively, what is the impact on


the profit under each of the methods? At the end of second year, the company found that it has incurred Rs. 20 cr. in year 1 and Rs. 60 cr. in year 2 and expected to incur another Rs. 50 cr. in year 3. That is, the company found at the end of year 2 that the contract is going to result in a loss of Rs.10 cr. How the company should treat the estimated loss under different methods?
M.S.Narasimhan, Indian Institute of Management Bangalore

Inventory Valuation
Components of Inventory
Raw Material, Components, Merchandise Work-in-process Finished Goods Miscellaneous items (e.g. packing materials)

Components of Inventory Value


Purchase Cost Cost incurred to bring materials or goods to stores Value Addition or Conversion Cost

M.S.Narasimhan, Indian Institute of Management Bangalore

Inventory Valuation - GAAP


Cost or Market Value whichever is lower Market Value requires
Replacement cost of the material
If closing stock is X units, how much it cost to buy X units today in a normal purchase transaction

Net Realisable Value of the material


If some value addition needs to be done, realisable value after value addition less cost incurred for value addition

Cost Value requires


Choice of FIFO, LIFO, Weighted Average, etc. Allocation of conversion cost
M.S.Narasimhan, Indian Institute of Management Bangalore

Valuation of Raw Materials, Components, etc. Periodic Inventory System


Physical counting at the end of period Latest price or current market price is used

Perpetual Inventory System


records inflow and outflow of materials and track the balance in quantity Follows FIFO, LIFO, Weighted Average or Specific identification method to value outflow and closing stock Many countries including US allows use of FIFO, LIFO or WA method; AS allows FIFO and WA methods. LIFO is rarely used by the industries; FIFO and WA are prominently used by the industries
M.S.Narasimhan, Indian Institute of Management Bangalore

Impact of FIFO, LIFO, WA method of Valuation FIFO vs. LIFO In Rising Price In Falling Price FIFO More Profit Less Profit LIFO Less Profit More Profit Weighted Average method moderates the distortion in profit under different price trends LIFO price attached to the physical units may significantly differ (LIFO layers) Sometimes, LIFO affects purchasing behaviour
M.S.Narasimhan, Indian Institute of Management Bangalore

Valuation of WIP and Finished Goods Components of WIP and FG Value


Material Cost Conversion Cost (variable or direct and fixed or period or indirect cost) Excise Duty: Include if paid; Make provision and include

Material cost is traceable and valued under any of the methods used for valuation of materials Conversion cost has to be charged or allocated Total Cost or Variable/Direct Cost alone? Cost Accounting System does the computation once the choice is made
M.S.Narasimhan, Indian Institute of Management Bangalore

Valuation of Joint or By-Products


Allocation or separation of Joint Cost
Based on sale value at the split-off point Based on estimated net realisable value (NRV) method Based on gross-margin percentage NRV method Allocation of cost using physical measure-based data

If by-products are recognised at the time of production, the closing stock is recognised based on net realisable value. If by-products are recognised at the time of sale, the value of closing stock is not recognised.
M.S.Narasimhan, Indian Institute of Management Bangalore

Inventory Valuation - AS 2
Cost or Net Realisable Value, whichever is less Cost: Cost incurred to bring inventory to its present location and condition; excludes duties recoverable subsequently from taxing authority Specific cost if the cost of the item is identifiable FIFO or Weighted Average Method Storage, interest, abnormal wastage, Administration and selling & distribution costs are excluded Refer: http://www.icai.org for the recent AS 2.
M.S.Narasimhan, Indian Institute of Management Bangalore

Fixed Assets Definition


Assets used for producing or providing goods/services Not held for sale in the course of ordinary business Includes land, building, machines, vehicles, furniture, goodwill, trademarks, patents, designs, special spares, etc.

Accounting Treatment
Not treated as expense of the period but allowed to remain in the books of accounts

Method of Accounting treatment affects income statement and balance sheet


M.S.Narasimhan, Indian Institute of Management Bangalore

Fixed Assets - Valuation Components of Fixed Assets Value


Invoice Price All changes incurred to bring the assets in usable condition e.g. transport, insurance, installation, etc. Cost incurred on test runs and experimental production Interest and other charges incurred till the time assets are put into use. Expenditure incurred on assets, which increases the future benefits of the fixed assets

Principle: Expenditure incurred in the ordinary course of acquiring the assets


M.S.Narasimhan, Indian Institute of Management Bangalore

Fixed Assets Valuation - Special Cases


Self-constructed Fixed Assets Fixed Assets acquired in exchange of other assets (shares, bonds, etc) Goodwill: include only if there is a cash outflow Patents developed in-house - capitalise and write off Cost of Know-how: add with the cost of appropriate assets Revaluation of Fixed Assets
should not affect P&L account in any way
M.S.Narasimhan, Indian Institute of Management Bangalore

Depreciation
Reasons for providing depreciation
Value decline over the years or due to wear and tear; failure to provide depreciation will affect true picture Product cost has to bear the cost of using the assets Lenders and other creditors would prefer that the firm recover the capital over the years for repayment

Factors used in computation of depreciation value


Value of the asset and salvage value of the asset Useful life of the asset Usage of asset Taxation policy of the country
M.S.Narasimhan, Indian Institute of Management Bangalore

Depreciation Methods
Based on Usage of the Asset
Units-of-production method (e.g. Mould) Machine hours can also be used as a basis of charge

Based on Time Period


Straight Line Method (equal distribution) Written-down Value (WDV) or Declining Balance Method (starts with high value and the decline over the years) Sum-of-the-Years Digit Method - bit of standardisation of WDV method
e.g. 5/15, 4/15, 3/15, 2/15, 1/15 for 5 years.
M.S.Narasimhan, Indian Institute of Management Bangalore

Depreciation Accounting

Allocate depreciable value of the asset systematically over the useful life of the assets Normally, depreciation is provided as a provision in P&L account Accumulated depreciation are transferred to assets once the asset is not in existence (sold or destroyed) Loss or gain on sale of assets is treated as nonoperating income or expenses Revaluation of Fixed Assets
increases the value of asset & Capital (Revaluation) reserve a part of depreciation come from P&L a/c and balance from Revaluation Reserve
M.S.Narasimhan, Indian Institute of Management Bangalore

Liabilities Basic conditions of liability recognition


Obligation leading to sacrifice of future resources of the firm e.g. repayment of loan Firm is in a position to measure with reasonable precision the cash-equivalent value of the obligation Firm has little or no discretion to avoid the transfer Obligation may not in place but transaction or event which will cause an obligation has already occurred

Failure to recognise a liability often increase the profit Managers thus prefer to delay the recognition of obligation in the books
M.S.Narasimhan, Indian Institute of Management Bangalore

Different Forms of Liabilities Obligations with fixed payment dates and value
e.g. Repayment Schedule along with interest dues

Obligations with fixed payment but estimated payment dates


e.g. Dues payable to suppliers

Obligation with estimated payment dates & value


e.g. Obligation under warranty agreement

Obligation arising out of advances from customers Obligation under mutually unexecuted contracts
e.g. long-term supply contract or Conbon supply

Contingent Obligations
M.S.Narasimhan, Indian Institute of Management Bangalore

Recognition of Liabilities Liabilities are to be recognised when


amount and date of liability is fixed amount is fixed and date can be estimated amount & date of liability can be reasonably estimated an advance payment is received from customers obligation arising out of unexecuted contracts & agreements

Liabilities are not generally recognised when


there is an obligation under mutually unexecuted contract there is a contingent obligation

Liabilities not recognised may need to be given in notes to financial statement, if the amount is large
M.S.Narasimhan, Indian Institute of Management Bangalore

Contingent Obligation -when to recognise?


Liabilities, which are contingent require a formal recognition when
information available prior to issuance of financial statements shows the existence of liabilities and the firm can estimate the amount of loss with reasonable precision

Dividend to be declared has to be adjusted Contingent gains should not be recognised in the financial statements Refer AS 4 (www.icai.org)
M.S.Narasimhan, Indian Institute of Management Bangalore

Liability Recognition - Special Cases


Issuance of Hybrid Securities
e.g. Convertible Debentures with high or low probability of conversion or mandatory conversion

Sale of receivables with recourse Promote a subsidiary, which buys material and then sell the same to the firm Promote a subsidiary, which perform R&D Take or pay contract - power purchase agreements Derivative transactions - hedging and trading Retirement Benefit and post-retirement obligations
M.S.Narasimhan, Indian Institute of Management Bangalore

Liability Recognition - Special Cases Leased Assets and Lease Rental Obligations
Operating Lease Financial or Capital Lease

Conditions required for capital lease method


Lease extends for at least 75% of assets life or Transfer of ownership at the of lease period Lessee gets a right to purchase the asset at the end Discounted lease value is => 90% of assets value

M.S.Narasimhan, Indian Institute of Management Bangalore