ximr fa4 finterms 2010

8/8/2019 XIMR FA4 FinTerms 2010

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FA 4: Finance Terminology &

Concetps

XIMR FA4 2010

S Krishnamoorthy: [email protected], Cell:9821461488


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Assets such as buildings, factories, equipment, furniture, vehicles and

computers last over several years but not indefinitely

The initial investment made in these assets gets used up over a period

of time

The initial investment, thus seen as capital at that time, eventually

becomes an expense

It is thus only appropriate to slowly convert this capital investment to

expense gradually over the life rather than discarding it as an expense

after its life is over

Thus during each accounting period a portion of the cost of the asset isappropriated as an expense

Thus a portion of the asset gets transferred from the balance sheet to

the income statement as depreciation expense every year during the

entire life of the asset

Depreciation


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It is important to recognize that depreciation in accounting is the allocation

of the historical cost of an asset across time periods when the asset isemployed to generate revenues

It is simply the recognition that a portion of the asset's cost - the portion

that will never be recuperated through re-sale or disposal of the asset was

"used up" in the generation of revenues for that time period

The use of depreciation affects the financial statements and in some

countries the taxes of companies and individuals

The recording of depreciation will:

cause an expense to be recognized thus lowering stated profits on the

income statement

while the net value of the asset will decline on the balance sheet

Depreciation reported for accounting and tax purposes may differ

substantially

Rationale for Depreciation


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DepreciationLand is not depreciated as it lasts indefinitely

The assets which are depreciated are referred to as

Fixed Assets

Depreciable Assets

Buildings

Plant and Equipments

Motor & Other Vehicles

Computers

Furniture & Office Equipments

Loose tools

There are 2 main methods & few other methods used for depreciation

Straight Line method [SLM]

Written Down Value [WDV] method

Linear methodGeometric method

Sum of digits method

The above two main methods simply provide an alternative way of allocating the total

depreciation charge over several accounting periods

The total depreciation charge using either method will be the same over the total usefuleconomic life of the asset


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The total amount to be depreciated over the life of a fixed asset is determined

by the following calculation:

Cost of the fixed asset less residual value/ Useful economic life If the cost is Rs 110,000 , residual value Rs 10,000 and useful life 5 yrs

the amount of depreciation = 110,000 10,000 / 5 = 20,000

The period over which to depreciate a fixed asset is known as the "useful

economic life" of the asset

A depreciation method is required to allocate, in a systematic way, the total

amount to be depreciated between each accounting period of the asset's useful

economic life

The straight-line method [SLM] of depreciation is widely used and simple to

calculate. It is based on the principle that each accounting period of the asset'slife should bear an equal amount of depreciation

The reducing balance [WDV] method of depreciation provides a high annual

depreciation charge in the early years of an asset's life but the annual

depreciation charge reduces progressively as the asset ages

Computation of Depreciation


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Straight Line Method WDV Method

M F

I M

M R

M

A

A

A

"N "?? "N "

H

M


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Linear Depreciation

This method diminishes the value of an asset by a fixed amount each perioduntil the net value is zero

The depreciation is determined by dividing the cost of the asset by the

estimated useful life and applying the same across the lifetime of the asset

Geometric Depreciation

For each period the asset is depreciated by a fixed percentage of its value

the previous period

In this method the value of an asset decreases exponentially leaving a value

at the end that is larger than zero ( i.e. - a resale value).

Sum of Digits

A third method most often employed in Anglo Saxon countries is the sum of

digits methodIn this method the cost of the asset is divided by sum of digits of the useful

life and the resultant amount is applied as the depreciation rate

Other Methods of Depreciation


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In India the governing laws for depreciation are provided under the

Companies Act, 1956 [as amended]Income Tax Act, 1961 [as amended]

Any other Governing Statue

There are different streams of accounting provided under the Cos.Act & IT Act

The IT Act and the Cos.Act have independent provisions that treat depreciationdifferently

It is legally recognized that there can be several parallel streams of accounting,

each independently following its own accounting and legal parameters prescribed

by the governing statute

The Companies Act prescribes rates of depreciation which are lower than those

set by the Income-Tax rules

Laws Governing Depreciation Accounting


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For compliance with the Cos. Act corporate are required to claim

depreciation at the rates prescribed under this Act

A company will not have any option in the matter. The written-down value

will be reflected year after year in conformity with the rates of

depreciation claimed under the Cos.Act

For all obligations under the Cos. Act it is such rates of depreciation and the

resultant written-down values that would have to be recognized

Under the IT Act the depreciation schedule would reflect the depreciation

allowable as per the rates prescribed under the IT Rules and the written-down

value year after year would be determined accordingly

Both these depreciation schedules, under the Cos.Act and under the ITAct respectively run parallel each undergoing change year after year as

per its own prescribed Rules with reference to the rate of depreciation

allowable under the respective statute

Depreciation Accounting


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Amortization differs slightly from depreciation

Amortization is used for write off intangible assets or repayment of loans while

depreciation is used for write-off tangible assets

These terms are often used interchangeably, but it is incorrect technically

Amortization can be defined for two separate things:

Intangible Assets: The capital expenditure used in building up

intangible assets like patents, copyrights, goodwill etc. is

amortized over a specific period of time

Loans and Financing: Paying off a loan debt as regular

installments over a period of time

Amortization


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Amortization ofIntangible asset:

A medical firm spent Rs100 cr on developing a patented equipment

and that the equipment lasts for 20 years

The firm will thus amortize the expenditure by Rs 5 cr every year as an

expense

A firm Paid Rs 2 cr as premium on a 5yr term leasehold land

The amount will be amortized over the term of the lease

Loan Amortization:

In loan amortization usually the total money paid remains constant per

period, but the components of the payment vary between the principal

repayment and the interest paid

An individual has taken housing loan for Rs 20 Lakhs for 20 yrs @

11 interest. The repayment in Equated Monthly Installment [EMI] issay Rs 15,000 monthly

Initially the interest component is higher, but gradually as the net loan

decreases, the interest component decreases and the principal

repayment increases

Amortization: Examples


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Particulars Firm A Firm B

Profit before depreciation

& amortization 100000 100000

Depreciaiton &

amortization 30000 0Profit before taxation 70000 100000

Tax expense @ 30% 21000 30000

Tax saved by Firm A 9000

Impact of Depreciation&Amortization Claim:Rs

Impact of Depreciation Claim

Depreciation provide tax shieldThe tax shield reduces the quantum of tax expense

To that extent the firm retain the cash flow

This cash flow will help the firm to sustain and grow

Many firms ended up paying Zero tax by claiming depreciation on huge capex

incurred


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Deferred tax reporting in India is mandated by accounting standard AS 22

[Internationally by IAS 12]

Deferred tax asset [DTA] and deferred tax liability [DTL] arise due to difference

between Accounting Profit [TP] and Tax [Profit]

AP is determined based on GAAP [ Ex. Accounting Standards prescribed by

ICAI]

TP is based on Taxation Laws [Ex. Income Tax Act]

AP = Sales COGS Other & other expenses Depreciation Amortization

Interest

TP = Taxable income Allowable Expenses Allowable Deductions

AP is subject to accounting policy assumptions especially with regard to

COGS, depreciation and amortization

TP is subject to tax laws and policies

The difference between AP and TP can be classified as

Permanent difference [due to tax policies]

Temporary difference [ due to accounting policies and assumptions]

Deferred Taxation


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DTA is created by overpaying taxes during a given time period

DAT usually occurs as a result of timing differences based on how the company

depreciates its assets and or claims expensesDTA reduces the company's tax liability in the future

Example: DTA of Rs100 from the previous year could be applied to before-tax

income of Rs 250 in the current year, resulting in taxable income of Rs 150

(250 100)

DTA because they reduce the liability in the future has a value and hence shown

as an asset on the balance sheet

Deferred Tax Asset [DTA]

Y1 Y2 Y3 Y4 Total

Income* 50,000 50,000 50,000 50,000

VRS Expenses 40,000 0 0 0 40,000

Taxable Income 10,000 50,000 50,000 50,000

Tax Expense 3,000 15,000 15,000 15,000 48,000

Income* 50,000 50,000 50,000 50,000

VRS Expenses 10,000 10,000 10,000 10,000 40,000

Taxable Profit 40,000 40,000 40,000 40,000

Current Tax @ 30% 12,000 12,000 12,000 12,000 48,000

DTL[-] / DTA 9,000 (3,000) (3,000) (3,000) 0

Income Statement (Amt Rs)

Tax Statement [No Export Income] (Amt Rs)

* Income is before VRS Expenses

Example: Deferred Tax Asset


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DTL occurs when a company underpays its taxes due to a difference between how

it accounts for an asset on its books versus how it accounts for it on a tax basis

DTL occurs when company claims accelerated depreciation accelerated benefit

for expenses for tax

DTL increase the liability in the future and hence are shown as liabilities on the

balance sheet

Investors should consider when analyzing a company's financials levels of DTA and

DTL to known whether the company is too aggressive in its accrual accounting and

tax planning

DTL occurs if Tax Expense > Current Tax

DTA occurs if Tax Expense < Current Tax

Deferred Tax Liability [DTL]

Y1 Y2 Y3 Y4 Total

Income* 50,000 50,000 50,000 50,000

R&D Expenses 10,000 10,000 10,000 10,000 40,000

Taxable Income 40,000 40,000 40,000 40,000

Tax Expense 12,000 12,000 12,000 12,000 48,000

Income* 50,000 50,000 50,000 50,000

R&D Expenses 40,000 - - - 40,000

Taxable Profit 10,000 50,000 50,000 50,000

Current Tax @ 30% 3,000 15,000 15,000 15,000 48,000

DTL[-] / DTA -9,000 3,000 3,000 3,000 0

Tax Statement [No Export Income] (Amt Rs)

*Income is before R&D Expenses

Income Statement (Amt Rs)

Example: Deferred Tax Liability


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21XIMR FA4 2010

For many companies inventory represents a large (if not the largest) portion of

assets and makes up an important part of the Balance Sheet

It is therefore crucial for investors who are analyzing stocks to understand how

inventory is valued

Inventory is defined as assets that are intended for sale, are in process of being

produced for sale or are to be used in producing goods

Types of Inventory [Ex. Vehicle Manufacturer]

Raw Materials: Steel Plates, Tyres, Paints

In Process Materials: Vehicles in various stages completion

Finished Goods: Finished [road worthy] Vehicles ready for dispatch

Stores & Spares: Ball bearing, Machinery parts

Fuels: Diesel oil, Furnace Oil for running operating machineriesVehicle Spares: Tyres, Clutch Plates, etc [for after sales service]

Packing Materials: Cartons, Boxes , Plastic Sheets

Inventory and Inventory Valuation


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A company's inventory is determined as follows:

Beginning Inventory

+ et Purchases

-Consumption of Inventory [Cost of Goods Sold (COGS)]

=Ending Inventory

An important point in the examples above is that COGS appears on the

Income Statement (P&L Account), while ending inventory appears on

the Balance Sheet under Current Assets

The accounting method that a company decides to use to determine the

costs of inventory can directly impact the balance sheet, income

statement and statement of cash flow

There are three inventory-costing methods that are commonly used bythe companies:

First in First Out [FIFO]

Last in First Out [LIFO]

Average Cost Weighted Average Cost

Inventory Valuation & Accounting


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First In First Out (FIFO)

This method assumes that the first unit making its way into inventory is the

first soldEx. A bakery produces 200 loaves of bread on D1 at a cost of Rs1 each, and

200 more on D2 at Rs 1.25 each

If 200 loaves are sold on D3 then FIFO would value COGS at Rs 1 per loaf

The balance 200 loaves would be valued at Rs 1.25 each and shown as

ending inventory on the balance sheet

Last In First Out (LIFO)This method assumes that the last unit making its way into inventory is sold

first

The older inventory, therefore, is left over at the end of the accounting period

For the 200 loaves sold on D3, the value would be Rs 1.25 per loaf to COGS

The remaining 200 loaves would be valued at Rs 1 each and as inventory at

the end of the period

Average/ Weighted Average Cost

The weighted average of all units available for sale during the accounting

period is computed and that average cost is applied to value of COGS and ending

inventory

In above example the average cost for inventory would be Rs1.125 per unit [(200

x Rs 1) + (200 x Rs 1.25)] 400

Inventory Valuation


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If there were no inflation then all three of the inventory valuation methods would

produce the exact same results

When prices are stable the bakery would be able to produce all of its loafs of

bread at Rs 1 and FIFO, LIFO and average cost would give the same cost of

Rs 1 per loaf

owever over the long term, prices tend to rise, which means the choice of

accounting method can dramatically affect valuation ratios

If a company uses LIFO valuation when it files taxes, which results in lower taxes

when prices are increasing, it then must also use LIFO when it reports financial

results to shareholders. This lowers net income and earnings per share

Accounting standards stipulate that companies will have to state inventory at thelower of cost or market . This means that if inventory values were to plummet,

their valuations would represent the market value (or replacement cost) instead

of FIFO, LIFO or average cost

Why Inventory Valuation Method is Important


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Monthly Inventory Purchases

Month Units Purchased Cost/Unit:Rs Total Value:Rs

J 1 000 10 10 000

F 1 000 12 12 000

M 1 000 1 1 000

Total 3,000 37,000

Beginning Inventory = 1,000 units purchased at Rs 8 each (a total of 4,000 units)

Income Statement (simplified): January-March*

Item LIFO:Rs FIFO:Rs Average:Rs

Sales = 3,000 units @ Rs 20 each 60,000 60,000 60,000

Beginning Inventory 8,000 8,000 8,000

Purchases 37,000 37,000 37,000

Ending Inventory (appears on B/S)=+(1000+3000)-3000=1000

8,000 15,000 11,250

COGS=Op.Inv+ Net Purchase-Cl.Inv 37,000 30,000 33,750

Other Expenses 10,000 10,000 10,000

Net Income 13,000 20,000 16,250

Financial Impact ofInventory Valuation Methods


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Capital Expenditure and Revenue Expenditure


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Intangible assets are classified based on the useful life as per [IAS 38 AS 26]

Indefinite life: no foreseeable limit to the period over which the asset is expected

to generate net cash inflows for the entity

Finite life: a limited period of benefit to the entity.

Measurement Subsequent to Acquisition: Intangible Assets with Indefinite

Lives

An intangible asset with an indefinite useful life should not be amortized

Its useful life should be reviewed each reporting period to determine whether

events and circumstances continue to support an indefinite useful life assessment

for that asset

If they do not, the change in the useful life assessment from indefinite to finite

should be accounted for as a change in an accounting estimate

The asset should also be assessed for impairment in accordance IAS 36 AS 26

Treatment of Intangible Assets


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Measurement Subsequent to Acquisition: Intangible Assets with Finite

Lives

The cost less residual value of an intangible asset with a finite useful life should

be amortized on a systematic basis over that life

The amortization method should reflect the pattern of benefits

If the pattern cannot be determined reliably, amortize by the straight line method

The amortization charge is recognized in profit or loss unless another IFRS

requires that it be included in the cost of another asset

The amortization period should be reviewed at least annually

The asset should also be assessed for impairment in accordance

Treatment of Intangible Assets


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Good will in accounting is an intangible asset valued according to the

advantage or reputation a business has acquired (over and above its tangible

assets)

Goodwill is the difference between the purchase price of a company and its net

worth (assets less liabilities)

Goodwill arises when a company buys another business at a price greater than

the book value

The accounting treatment of an intangible asset such as the takeover premium

in a merger or acquisitionGoodwill is an specific accounting term treatment used to reflect the portion of

the book value of a business entity not directly attributable to its assets and

liabilities

Example:

Firm A acquired Firm B for Rs 50 lakhs. The value of the tangible assets

amounted to Rs 30 lakhs only. The excess of Rs 20 lakhs is the considerationpaid for goodwill an intangible asset

Value of goodwill is retained as such or amortized over a an estimated time

period

If for any reason the goodwill value is diminished [impaired] then the same is

written-off [reduced] from the books

Goodwill


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Initial Recognition: Research and Development Costs [IAS 38 / AS26]

Charge all research cost to expense

Development costs are capitalized only after technical and commercial

feasibility of the asset for sale or use have been established

This means that the entity must intend and be able to complete the intangible

asset and either use it or sell it and be able to demonstrate how the asset will

generate future economic benefits

If an entity cannot distinguish the research phase of an internal project to

create an intangible asset from the development phase, the entity treats theexpenditure for that project as if it were incurred in the research phase only

In-process Research and Development Acquired in a Business

Combination

A research and development project acquired in a business combination is

recognized as an asset at cost, even if a component is researchSubsequent expenditure on that project is accounted for as any other

research and development cost (expensed except to the extent that the

expenditure satisfies the criteria for recognizing such expenditure

as an intangible asset)

Treatment of Research & Development [ R & D] Costs


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Preoperative expenses is different from the preliminary expenses

Pre-operative expenses are those which are connected with actions that are

required for start up of operations [project related expenses including trail

production before commencement of commercial production]

Preliminary expenses essentially associate with activities involved in the formation

of the company [Share issue and company registration expenses]

Pre operative expenses of capital nature and or revenue nature are to be

capitalized - by apportionment allocation to assets which are the subject matter of

operation - with cost of fixed assets in relation to which they have been incurred

and depreciation claimed over the years

Whereas pre operative expenses which has not resulted in tangible assets [ or ifthe project fails] are to be charged against profits

Preliminary expenses are written off as revenue and set off when the company

generates profits and the treatment should be done according Section 35D of

income tax act 1961

Treatment of Pre-operative and Preliminary Expenses [AS 26]


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Inflation accounting is an accounting system that adjusts values for changes in

purchasing power of money

Inflation Accounting is also referred to as the Price Level Accounting

Adjusting financial statements to show a firm's real financial position in inflationary times

It aims to indicate:

ow rising prices and lower purchasing power of the currency affect a firm's cost of

refinancing its productive assets

Firms ability to maintain an adequate level of profit on the capital employed

Inflation has two components:

monetary inflation called cash inflation

non-monetary inflation called historical cost accounting inflation

Cash or monetary inflation destroys the real value or purchasing power of money and other

monetary items

Inflation Accounting


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One method is to adjust every figure in the balance sheet on the basis of a price index (such

as consumer price index) which reflects the current purchasing power of the currency

Another method suggests to revalue tangible assets at their replacement cost

In valuation of inventory inflation accounting treatment can effect the firm's taxable

income, cash position and reported earnings depending on whether the firm uses FIFOor LIFO methods

FIFO method, shows a higher profit, therefore higher tax burden and a decrease in

net cash flow

LIFO method lowers the profit and tax burden and increases the net cash flow

Inflation Accounting Methods


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In certain inflation accounting models price level costs were achieved by

employing particular indexes

The second model is the Constant Dollar Rupee Accounting. This model

helps to convert the non monetary assets and equities into current dollars

employing a general price index

The monetary assets are not taken into account during the conversion

On the income statement, depreciation is adjusted for changes in general pricelevels based on a general price index.

2001 2002 2003 Total

Revenue 33,000 36,302 39,931 109,233

Depreciation 30,000 31,500 (a) 33,000 (b) 94,500

Operating income 3,000 4,802 6,931 14,733

Purchasing power loss - 1,500 (c) 3,000 (d) 4,500

Net income 3,000 3,302 3,931 10,233

(a) 30,000 x 105/100 = 31,500(b) 30,000 x 110/100 = 33,000

(c) (30,000 x 105/100) - 30,000 = 1,500

(d) (63,000 x 110/105) - 63,000 = 3,000

Inflation Accounting Models


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Historical cost accounting model is the global basic accounting model

In most countries, primary financial statements are prepared on the historical cost basis ofaccounting without regard either to changes in the general level of prices or to increases in

specific prices of assets held, except to the extent that property, plant and equipment and

investments may be revalued

Today the stable measuring unit assumption is implemented as part of the historical cost

model only for the purpose of valuing constant real value non- monetary items in low

inflationary economies

The accounting profession has realized over the years that the stable measuring unit

assumption cannot be applied to variable real value non- monetary items

Variable real value non-monetary items are valued today, for example, at fair value, market

value, present value, net realizable value or recoverable value in terms of IASB International

Accounting and Financial Reporting Standards and US GAAPs as issued by the FASB,IFRSand Indian Accounting Standards

Examples of variable real value non-monetary items are land, buildings, property, plant,

equipment, vehicles, stock, raw materials, finished goods, marketable securities, foreign

exchange, etc.

Rationale for Inflation Accounting


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Ignoring general price level changes in financial reporting creates

distortions in financial statements such as:

Reported profits may exceed the earnings that could be distributed to

shareholders without impairing the company's ongoing operations

The asset values for inventory, equipment and plant do not reflect their

economic value to the business

Future earnings are not easily projected from historical earnings

The impact of price changes on monetary assets and liabilities is not clear

Future capital needs are difficult to forecast and may lead to increased

leverage, which increases the business's risk

When real economic performance is distorted, these distortions lead to

social and political consequences that damage businesses (examples:

poor tax policies and public misconceptions regarding corporate

behavior)

Impact of Ignoring Inflation Accounting


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AS 1 Disclosure of Accounting Policies

AS 2 Valuation of Inventories

AS 3 Cash Flow Statements

AS 4 Contingencies and Events Occurring after the Balance Sheet Date

AS 5 et Profit or Loss for the Period, Prior Period Items and Changes in

Accounting Policies

AS 6 Depreciation Accounting

AS 7 Construction Contracts

AS 8 Accounting for Research and Development (Withdrawn pursuant toAS 26 becoming mandatory)

AS 9 Revenue Recognition

AS 10 Accounting for Fixed Assets

AS 11 The Effects of Changes in Foreign Exchange Rates

AS 12 Accounting for Government Grants

AS 13 Accounting for InvestmentsAS 14 Accounting for Amalgamations

AS 15 Employee Benefits

AS 16 Borrowing Costs

AS 17 Segment Reporting

AS 18 Related Party Disclosures

Accounting Standards Issued by Institute of Chartered Accountants of India


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AS 19 Leases

AS 20 Earnings Per ShareAS 21 Consolidated Financial Statements

AS 22 Accounting for Taxes on Income

AS 23 Accounting for Investments in Associates in Consolidated Financial

Statements

AS 24 Discontinuing Operations

AS 25 Interim Financial Reporting

AS 26 Intangible Assets

AS 27 Financial Reporting of Interests in oint Ventures

AS 28 Impairment of Assets

AS 29 Provisions, Contingent Liabilities and Contingent Assets

AS 30 Financial Instruments: Recognition and Measurement

AS 31 Financial Instruments: Presentation

Accounting Standards Issued by Institute of Chartered Accountants of India

ximr fa4 finterms 2010

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