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FINANCIALACCOUNTING for MANAGERS

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in.pearson.com

www.pearsoned.co.in/sanjaydhamija



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About Pearson Pearson is the world’s learning company, with presence across 70 countries worldwide. Our unique insights and world-class expertise comes from a long history of working closely with renowned teachers, authors and thought leaders, as a result of which, we have emerged as the preferred choice for millions of teachers and learners across the world. We believe learning opens up opportunities, creates fulfilling careers and hence better lives. We hence collaborate with the best of minds to deliver you class-leading products, spread across the Higher Education and K12 spectrum. Superior learning experience and improved outcomes are at the heart of everything we do. This product is the result of one such effort. Your feedback plays a critical role in the evolution of our products and you can contact us - [email protected] We look forward to it.

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FINANCIAL ACCOUNTING for Managers

Third Edition

Sanjay Dhamija

Professor Finance and Accounting Department International Management Institute, New Delhi

Dedication To my parents and teachers

Editor—Acquisitions: Varun Goenka Editor—Development: Jubi Borkakoti Sr. Editor—Production: Vipin Kumar The aim of this publication is to supply information taken from sources believed to be valid and reliable. This is not an attempt to render any type of professional advice or analysis, nor is it to be treated as such. While much care has been taken to ensure the veracity and currency of the information presented within, neither the publisher nor its authors bear any responsibility for any damage arising from inadvertent omis-sions, negligence or inaccuracies (typographical or factual) that may have found their way into this book. Copyright © 2018 Pearson India Education Services Pvt. Ltd This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out, or otherwise circulated without the publisher’s prior written consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser and without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book. No part of this eBook may be used or reproduced in any manner whatsoever without the publisher’s prior written consent. This eBook may or may not include all assets that were part of the print version. The publisher reserves the right to remove any material in this eBook at any time. ISBN 978-93-528-6833-9 eISBN 978-93-530-6189-0 First Impression Published by Pearson India Education Services Pvt. Ltd, CIN: U72200TN2005PTC057128. Head Office: 15th Floor, Tower-B, World Trade Tower, Plot No. 1, Block-C, Sector-16, Noida 201 301, Uttar Pradesh, India. Registered Office: 4th Floor, Software Block, Elnet Software City, TS-140, Block 2 & 9, Rajiv Gandhi Salai, Taramani, Chennai 600 113, Tamil Nadu, India. Fax: 080-30461003, Phone: 080-30461060 Website: in.pearson.com, Email: [email protected] Compositor: Saksham Printographics, Delhi Printed in India at

Contents 1 INTRODUCTION TO ACCOUNTING  1 1.1  What is Accounting?  1 1.2  Users of Financial Accounting Information  1 1.3  Financial Accounting Versus Management Accounting  3 1.4  Need for Accounting Principles—GAAP and Accounting Standards  3 1.5  Accounting Cycle  4 1.6 Financial Statements 5 1.7  Accounting Environment  6

2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND ACCOUNTING STANDARDS  13 2.1  2.2  2.3  2.4 

Nature of Generally Accepted Accounting Principles  13 Need for Accounting Standards  23 Accounting Standards in India  24 Globalization of Accounting Standards  26

3 ACCOUNTING CYCLE  36 3.1 Introduction 36 3.2  Accounting Process  36 3.3 Journal Entry 37 3.4 Classification 39 3.5 Summarization 41 3.6  Adjustment Entries  49 3.7 Financial Statements 52

4 FINANCIAL STATEMENTS OF COMPANIES  70 4.1 Introduction 70 4.2 Financial Statements 71 4.3  Statement of Profit and Loss  72 4.4 Balance Sheet 73 4.5  Statement of Change in Equity  74 4.6  Cash Flow Statement  74 4.7 Notes to Accounts 75

5 STATEMENT OF PROFIT AND LOSS  78 5.1 Introduction 78 5.2  Format of Statement of Profit and Loss  79 5.3 Revenue 81

vi  Contents

 5.4 Expenses 84  5.5 Exceptional Items 91   5.6  Tax Expenses  92   5.7  Profit/Loss From Discontinued Operations  93   5.8  Profit/Loss for the Period  93   5.9  Other Comprehensive Income (OCI)  93 5.10  Earnings Per Share  94 5.11  Various Measures of Profit  96 5.12  Appropriation of Profit  97

6 BALANCE SHEET  121  6.1 Introduction 121   6.2  Format of Balance Sheet  122  6.3  Assets  127  6.4 Non-Current Assets 129  6.5 Current Assets 138  6.6 Current Tax Assets (NET) 144  6.7 Other Current Assets 144   6.8  Equity and Liabilities  144  6.9 Equity 145 6.10  Statement of Change in Equity  158 6.11 Liabilities 160 6.12 Non-Current Liabilities 161 6.13 Current Liabilities 167 6.14  Contingent Liabilities and Commitments  171

7 ACCOUNTING FOR REVENUE  202 7.1 Revenue 202 7.2  Quantum of Revenue  203 7.3  Timing of Revenue Recognition  206 7.4  Impact of Uncertainty  213 7.5 Disclosures 214 7.6  Accounting for Receivables  215

8 ACCOUNTING AND VALUATION OF INVENTORY  226 8.1  Meaning of Inventory  226 8.2  Inventories and the Financial Statements  227 8.3  Methods of Inventory Accounting  229 8.4  Valuation of Inventory  229 8.5 Costing Methods 231 8.6 Disclosures 235

Contents  vii

9 ACCOUNTING FOR FIXED ASSETS AND DEPRECIATION  246 9.1 Introduction 246 9.2  Property, Plant and Equipment  248 9.3 Investment Property 265 9.4 Intangible Assets 266 9.5 Impairment of Asset 270

10 ACCOUNTING FOR INVESTMENTS  288 10.1 Introduction 288 10.2  Classification of Investments  288 10.3 Measurement 291 10.4  Investment in Subsidiaries, Associates and Joint Venture  294

11 CASH FLOW STATEMENT  299 11.1 Introduction 299 11.2  Cash Flow Statement  300 11.3  Cash Flow from Operating Activities  302 11.4  Cash Flow from Investing Activities  311 11.5  Cash Flows from Financing Activities  313 11.6 Special Points 315 11.7  Cash Flows at Different Stages of Life cycle  316

12 CONSOLIDATED FINANCIAL STATEMENTS  343 12.1 Introduction 343 12.2  Concept of Control  344 12.3  Consolidated Financial Statements  345 12.4  Consolidated Statement of Profit and Loss  345 12.5  Consolidated Balance Sheet  347 12.6  Investments in Associates and Joint Ventures  351

13 DISCLOSURES IN ANNUAL REPORTS  368 13.1 Introduction 368 13.2  Disclosures under the Companies Act, 2013  369 13.3  Disclosures under Listing Agreement  372 13.4  Disclosures under Accounting Standards  374 13.5  Voluntary Disclosures  379

14 ANALYSIS OF FINANCIAL STATEMENTS  392 14.1 Introduction 392 14.2  Common Size Statements  395 14.3  Indexed Financial Statements  397 14.4 Ratio Analysis 399 14.5  Ratios to Predict Financial Insolvency  420

viii  Contents

15 FINANCIAL SHENANIGANS  456 15.1 Introduction 456 15.2 Financial Shenanigans 458 15.3  Motivations for Financial Shenanigans  459 15.4  Opportunities for Financial Shenanigans  461 15.5 Financial Shenanigans Techniques 462 15.6 Regulatory Reactions 474 15.7  How to Detect Financial Shenanigans?  475 15.8  Prevention of Financial Shenanigans  477

Preface It gives me immense pleasure in presenting the third edition of the book. The earlier two editions received overwhelming responses from both students and teachers. The feedback received from the academic community has therefore been duly incorporated in the revised edition. Financial accounting and reporting has undergone a major shift in India with the convergence of our accounting standards with the IFRS. The Ministry of Corporate Affairs introduced a new series of accounting standards (called Ind AS) which are substantially aligned with the IFRS. The transition to the new Ind AS has begun from the financial year 2016–17. The convergence with the IFRS would substantially improve the reporting and disclosure practices by the Indian companies. The current edition has been thoroughly revised based upon the newly introduced Ind AS. This book is designed to cater to the needs of postgraduate students in the first semester for various universities and institutes. Accounting information is used by functional managers for taking various economic decisions. These managers may not be responsible for the preparation of financial statements but must possess the necessary skill of understanding the information conveyed by the financial statements. Accordingly, this book has been written keeping the users’ perspective in focus. It is expected that it will help users understand the contents of financial statements as well as the principles behind these numbers so as to enable them to take informed decisions. The book is divided into 15 chapters. The first three chapters focus on the basics of accounting, including generally accepted accounting principles, accounting standards, and accounting process leading to the preparation of the profit and loss statement and the balance sheet. The users of financial information may not know the accounting procedure in as much detail as an accountant needs to know; nevertheless, a broad understanding of the accounting cycle and underlying principle is needed to really comprehend the information conveyed by financial statements. The next seven chapters discuss two key financial statements, namely, the balance sheet and the statement of profit and loss, in detail. Four key issues, viz., revenue recognition, inventory accounting and valuation, accounting for fixed assets and depreciation and investments, have been covered in length. The next chapter focuses on a preparation and analysis of cash flow statement. The information con- tained in the earlier two statements needs to be supplemented by the information about the cash flows of the enterprise during the given a accounting period. The readers will be able to appreciate as to why some profitable enterprises suffer a cash crunch. The chapter will also help the readers to assess the cash-generating ability of an enterprise which forms the basis of a large number of economic decisions. Chapter Twelve introduces the need and process for the preparation of consolidated financial statements. As large corporations often do business through one or more subsidiaries and joint ventures, it becomes critical to assess the performance of the group as a whole and also the resources it controls. Such information is provided by the consolidated financial statements. This chapter will help the readers differentiate between stand-alone financial statements and consolidated financial statements. In addition to financial statements, the annual report of a company also contains a large number of additional disclosures. Additional information available in annual reports—both mandatory and voluntary—has been covered in Chapter Thirteen . The readers will learn to use the information contained in various reports like segment reporting, management discussion and analysis, corporate governance report, directors’ report, value-added statement and Economic Value-Added (EVA) statement, etc. The next chapter introduces the readers to the analytical tools used for dissecting financial information to

x  Preface

understand the financial performance and health of a business enterprise. The readers will learn to use tools like common size financial statements, trend analysis, and ratio analysis. The last chapter highlights the areas of earnings management whereby unscrupulous management attempt to window dress their financial results. As a number of accounting scams have surfaced in the recent past undermining the reliability of information contained in the financial statements, this chapter illustrates some of the common financial shenanigans deployed for window dressing of financial statements. This will help the readers to be vigilant while using financial statements. The chapter also focuses on ethical issues in accounting. Keeping in mind that this may be the first exposure to accounting for most of the students, a stepped up approach—from simple to difficult—has been used. A number of solved and unsolved illustrations have been provided to show the application of the concepts used. As a bridge between theory and practice, a number of relevant examples and cases from the annual reports of Indian companies have also been used.

Salient Features:

• In view of the convergences of Indian accounting standards with IFRS, accounting and report• • • • • • •

ing has been discussed based upon the applicable Ind AS. Very strong analytical perspective—how to use accounting information as a manager and as an analyst. A separate chapter on financial shenanigans make the readers understand the financial gimmicks used by unscrupulous management to mislead investors. Concepts discussed in the text have been reinforced with the help of solved illustrations both within the text and at the end of every chapter. Unsolved problems against each chapter encourage students to test their understanding. Extensive reference to examples from the annual reports of Indian companies. Case studies in each chapter to encourage out-of-the-box thinking. Most of the cases are based on information in the annual reports and real-life situations. Requirements of the Companies Act 2013 have been suitably incorporated.

FOR WHOM Financial Accounting for Managers is primarily meant to be used in postgraduate programmes of vari- ous universities and institutions. The book can be used as an introductory course on accounting. It will also be useful in courses where students already know the procedure of accounting, but need to acquire an analytical and user orientation. This book would be helpful to practicing managers—both in finance and non-finance areas—to sharpen their skills in understanding and analyzing financial and accounting information.

Sanjay Dhamija

Acknowledgements I thank all my well wishers who were kind enough to guide and assist me in this endeavour. I am grateful to all my colleagues, friends and students, who extended morale support and helped in preparing manuscript by asking probing questions. This work would not have been possible without unstinted support of my family. My thanks are due to my family members for their patience and support. I also appreciate the efforts of wonderful people at Pearson Education-editorial team for specific invaluable inputs and bringing this book out in a record time. I have picked a number of examples from the annual reports of various companies. In addition, references have been made to accounting standards and other reports issued by various institutions and organizations like the Institute of Chartered Accountants of India, the Ministry of Corporate Affairs, KPMG, the Securities Exchange Commission, etc. They have been appropriately acknowledged in the text.

Sanjay Dhamija

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About the Author Sanjay Dhamija is currently working as a Professor of Finance and Accounting and Dean—MDP and Executive Education at International Management Institute, New Delhi. A doctorate in finance (FPM) from IMI, Delhi, he completed his M.Com from Delhi School of Economics and LLB from Delhi University. He is a Fellow Member of the Institute of Cost Accountants of India (FCMA) and the Institute of Company Secretaries of India (FCS). He is also a Chartered Financial Analyst from ICFAI. He has attended management programs at Harvard Business School, Wharton Business School, and the University of Maryland. Professor Dhamija has over 32 years of experience, both in industry and academia. He worked in senior positions with ABN AMRO Asia Equities, HSBC Securities and Capital Markets, Escorts Finance Ltd., and MMTC of India Ltd. for more than 16 years. He has been in academics since 2003, worked with ICFAI Business School and with Management Development Institute (MDI), before joining IMI in 2009. At MDI, he held various positions including Chairperson of Executive Post-Graduate Diploma in Management, Chairperson of Continuing Education, and Chairperson of Finance and Accounting. He has received the ‘Excellence in Teaching’ award at MDI. He also received the ‘Best Trainer’ award at IMI. Professor Dhamija has handled number of consulting and training assignments for many private and public organizations as well as for government sectors. It includes ABB, ABN AMRO Asia Equities, Apollo Tyres, Bharat Electronics, BHEL, Central Electricity Authority, Canara Bank, Department of Telecommunication, Department of Atomic Energy, Engineers India, Ericsson India, Fortis Health Care, Fidelity India, Hindustan Coca Cola, Hindustan Coppers, Hughes Communications India Limited, IBM Daksh, IFFCO, Indian Army, Indian Oil, Jamia Handard University, LIC, NHPC, NTPC, ONGC, Power Grid, Punj Lloyd, Royal Bank of Scotland, Sapient Consulting, SBI Life Insurance, Suzlon Energy, Transition Optical, Virgin Mobiles, etc. He also regularly conducts popular programmes on ‘Finance for Non-Finance Executives’ and ‘Understanding and Analysis of Financial Statements’.

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Introduction to Accounting

1

CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand the meaning and nature of accounting. • Differentiate between financial accounting and management accounting. • Identify various users of accounting information. • Appreciate the need for generally accepted accounting principles (GAAP) and accounting standards (AS). • Understand the accounting environment and role of various regulatory institutions in India. • Get an overview of accounting cycle. • Identify the three basic financial statements and their purposes.

1.1  WHAT IS ACCOUNTING? Accounting is the language of business; it is the medium through which business organizations communicate information about their financial performance and financial position to the outside world. Financial accounting involves identifying and recording business transactions and summarizing them in rupee terms. The financial information is presented in three basic financial statements—the balance sheet, the profit and loss statement and the cash flow statement. These statements are used to communicate the financial status of the organization to various stakeholders of the business to enable them to take economic decisions. The American Accounting Association defines ‘Accounting as the process of identifying, measuring and communicating economic information, to permit informed judgments and decisions by a user of the information’. It is important to note that financial accounting deals only with those business events and transactions that can be expressed in rupee terms, other events howsoever important are not the subject matter of financial accounting.

1.2  USERS OF FINANCIAL ACCOUNTING INFORMATION The accounting information is used both by internal and external stakeholders. These stakeholders have financial interest in the business, and therefore are keen to know about the financial performance Accounting information is used both and health of the organization. Financial statements by external users as well as internal essentially attempt to meet the information needs of users. these stakeholders.

2  Chapter 1

The most predominant group of external stakeholders includes the suppliers of capital. This group consists of shareholders, lending banks and financial institutions, bond holders and other lenders—both existing and prospective. This group has a direct stake in the financial health of the organization. They use the financial information to assess the risk-return profile of the organization. The information contained in the financial statements helps them to judge the return they can expect from their investment as well as the risk they are exposed to, by investing or lending to the organization. They assess the capacity and ability of the organization to pay interest and repay the principal using financial information. Other entities that facilitate raising of capital, for example, credit rating agencies also rely on the information contained in financial statements to form a view about the financial health of the organization. ‘The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit.’1 Likewise, suppliers of goods or services to the organization especially on credit are concerned about the ability of the enterprise to pay their dues. Customers also actively watch the financial information especially when they have long-term contracts with the enterprise. The information is useful is judging the continuance of the enterprise. Tax authorities are also interested in the accounting information. As business units are liable to pay tax on their taxable income, accounting information is used to ascertain the same. However, it must be noted that taxable income is computed in accordance with the provisions of applicable tax laws and Tax accounting is a separate branch these provisions do differ from financial accounting of accounting as records are kept to principles. It forces companies to maintain separate meet the requirements of income tax accounting records for tax purposes. laws. Regulatory bodies are the other set of external users of financial information. For example, the Central Bank (Reserve Bank of India) oversees the banks as to profitability, maintenance of capital, credit concentration, asset liability mismatch, etc., using key information derived from financial statements of banks. Likewise, Insurance Regulatory and Development Authority (IRDA) uses the information contained in financial statements of insurance companies for various regulatory purposes. Even employees and trade unions actively watch the financial performance of the company to judge the soundness of the enterprise and that they are being properly rewarded. The information may also be used for wage negotiations by the trade unions. In addition academicians and researchers use financial accounting information to carry out research about the financial performance and policies of various organizations. In addition to the external stakeholders, managers also use the financial information. In fact, managers have a dual role—they have the responsibility to prepare financial statements and also they are one of the users of the information for performing their roles. Organizational goals are often set in financial terms and managerial performance is assessed against these financial targets. Managers use financial information to ensure that the actual performance is aligned to the set targets. Ability to understand and use financial information is therefore a key skill that each manager must possess. Managers, as users of financial information, may not be proficient in accounting process and preparation of financial statements (that is the role of accountants) but they must understand what these figures actually mean and how their meaning may change under different circumstances.

Introduction to Accounting  3

1.3  FINANCIAL ACCOUNTING VERSUS MANAGEMENT ACCOUNTING At this stage, it is important to draw a distinction between financial accounting and management accounting. As observed earlier, financial accounting primarily aims at meeting the informational needs of external users though insiders also make use of the information. The management accounting aims at assisting managers in their decision makFinancial accounting is primarily used ing functions. The primary focus of management by external users. accounting is internal planning, control and decision Management accounting is exclu­ making. The management accounting information sively for the internal users. is privileged one and is not available to the external users. As the financial accounting information is used by external users, the information is presented in standardized formats to ensure easy comparability. The information is prepared using accounting concepts often called generally accepted accounting principles (GAAP). Information is presented on an aggregate basis for the entity as a whole. Management accounting follows no such formats or accounting rules. The information is broken down product-wise, segment-wise and geographically to help managers in efficient decision making. The information is prepared more frequently—almost on a concurrent basis. In addition to financial information, management accountants also use non-financial data, for example, product demand, quantities of material used, labour hours, capacity utilization, etc. Management accounting is more forward looking and uses financial estimates. The information is less precise though compared to financial accounting information. Though financial accounting and management accounting are two distinct branches of accounting, they do use common inputs. An integrated accounting system would support both financial accounting and management accounting requirements.

1.4  NEED FOR ACCOUNTING PRINCIPLES—GAAP AND ACCOUNTING STANDARDS Accounting is a management discipline and not an exact science. The same accounting event is capable of being recorded on different basis by different accountants. How do we ensure the comparability of accounting information as reflected in financial statements? For example, an investor wants to make an investment in equity shares of either Infosys or Wipro. He would like to compare the performance of two companies. If these companies are preparing their financial statements using different accounting policies, performance comparison would not be possible. The need for comparability led to the evolution of GAAP. GAAP are good accounting practices evolved by the accounting profession over a period of time. Financial statements prepared using GAAP are more readily comparable. GAAP do not cover specific accounting situations, but provide Accounting principles and standards broad principles that govern the choice of specific make financial statements prepared by accounting policies. The management, as a preparer various entities comparable by reduc­ of financial statements, always has some latitude ing management’s discretion in choice in applying these principles in the given situation. of accounting treatment. It must also be understood that as the business

4  Chapter 1

e­ nvironment is getting more and more complex, accounting principles are also evolving to keep pace with the changing environment. The GAAP are further elaborated by means of accounting standards (AS). Accounting standards are mandatory requirements to be followed while preparing financial statements. In India, the Institute of Chartered Accountants (ICAI) is empowered to prescribe accounting standards. Each AS covers a specific accounting area and provides detailed guidelines to be followed for accounting and disclosure. The GAAP and accounting standards have been discussed in Chapter 2.

1.5  ACCOUNTING CYCLE The American Institute of Certified Public Accountants provided a functional definition of accounting. ‘Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof’. Viewed as a process, financial accounting is shown in Figure 1.1. The accounting cycle begins with a business transaction that can be expressed in terms of money. Every business transaction is supported by a document called ‘voucher’. Vouchers are supporting documents to prove that an accounting transaction has taken place and also for quantifying the monetary value of the transaction. For example, purchase of goods is evidenced by way of a purchase invoice, clearly indicating the value of goods purchased. On the basis of the relevant voucher, an accounting transaction is recorded in the accounting system by was of a journal entry. Journal entries are recorded in a chronological order. Transactions recorded by way of journal entries are then classified under various heads called ledger accounts. This process of classification is called ledger posting. At the end of the accounting period, these ledgers accounts are balanced to find the balancing figures. The balancing figure in each ledger is summarized by way of a trial balance. The trial balance forms the basis of preparation of the three basic financial statements, viz., the statement of profit and loss, the balance sheet and the cash flow statement. The information presented in these financial statements can be analyzed using various tools like trend analysis, common size statements and ratio analysis. Business managers need to have the skill to understand and analyze the information contained in financial statements. However, to fully appreciate financial statements, they must understand the accounting process as well. The accounting cycle has been covered in detail in Chapter 3 whereas financial analysis has been dealt with in Chapter 14. Chapter 15 deals with limitation of accounting information and earnings management.

Input

Throughput

Financial Statements

Analysis

Vouchers or Supporting Documents

Recording Classification Balancing Trial Balance

Profit & Loss Statement Balance Sheet Cashflow Statement

Trend Analysis Common Size Ratios Analysis

Figure 1.1  Accounting Process

Introduction to Accounting  5

1.6  FINANCIAL STATEMENTS Financial statements aim to answer three basic questions about a business entity:

1. How much profit was earned by the business during a particular time period? 2. What are the assets and liabilities of the business at the end of the period? 3. What were the sources and uses of cash during a particular period?

The answers to the above questions can be found in three financial statements, namely the statement ‘The objective of financial statements of profit and loss, the balance sheet and the cash is to provide information about the flow statement, respectively. financial position, performance and Statement of profit and loss also called income cash flows of an enterprise that is use­ statement or profit and loss accounts is a summary ful to a wide range of users in making of incomes and expenses of the business during a economic decisions’ period of time (called accounting period). Excess of income over expenses is called profit whereas, if ICAI—Framework for the expenses during the accounting period exceeds the preparation and presentation of financial statements income, the same is termed as a loss. All incomes earned and expenses incurred during the accounting period are aggregated and the difference is either profit or loss. Balance sheet, on the other hand, is a statement of assets and liabilities on a particular day—the last day of the accounting period. It gives a snapshot of what the business owns (assets) and what it owes (liabilities) on a particular date. Assets may be further classified into non-current and current. Liabilities of business are classified into liability to the owners (called capital or equity) and liabilities to the external parties. External liabilities can again be classified as non-current and current based upon their maturity. The statement of profit and loss, the balance sheet and related disclosures have been discussed in detail in Chapters 4 to 10. Cash flow statement provides detail about the sources and uses of cash during an accounting period. The balance sheet shows the cash balance on a particular date but it does not explain the change in the cash position since the last balance sheet date. The cash flow statement aims to explain the variation in cash position between two balance sheets by showing the sources and uses of cash. The cash flows are broken under three heads: (i) Cash flow from operating activities—sources and uses of cash arising directly from the main revenue generating activities of the organization. (ii) Cash flow from investing activities—sources and uses of cash related to investing in long-term assets including long-term investments. This also includes the income generated from these long-term investments. (iii) Cash flow from financing activities—sources and uses of cash related to funds raising activities including repayment of loans, payment of interest on borrowed funds and payments of dividends on shares. Cash flow statement helps the users in understanding the cash generating ability of the business organization. Cash flow statement has been covered in detail in Chapter 11.

6  Chapter 1

As it may not be possible to provide all the requisite details in the main body of these statements, a lot of details is provided by way of notes to accounts. The users of financial statements will do well to go through these notes for better understanding of the financial statements. Financial statements are standardized to meet the requirements of a diverse set of external users. Users, therefore, should not expect tailor made solutions to meet their informational requirements rather understand the formats and contents and reclassify the information to suit their requirements. In addition to these financial statements, many progressive companies do provide additional information purely on voluntary basis. Some such practices are discussed in Chapter 13.

1.7  ACCOUNTING ENVIRONMENT The accounting and disclosure practices are greatly influenced by the regulatory requirements prescribed by various statutes. As discussed earlier, financial statements essentially are used by the external users. To ensure comparability of information provided in financial statements suitable provisions are made in applicable acts. Some of the institutions and statutes, having bearing on the accounting and disclosure practices in India, are discussed below:

1.7.1 Ministry of Corporate Affairs The Ministry of Corporate Affairs (MCA) is primarily responsible with the administration of the Companies Act, 2013. In addition, it also supervises three professional accounting bodies, namely the Institute of Chartered Accountants of India, the Institute of Cost Accountants of India and the Institute of Company Secretaries of India. The Companies Act, 2013, governs the creation, continuation and winding up of companies. The Act also has specific provisions regarding the books of accounts to be kept by companies, format of financial statements and authentication of financial statements. It also prescribes the mechanism for notifying accounting standards formulated by the ICAI for compliance by the companies. Some of the important provisions of the act in this regards are given below.

Books of Accounts to be Kept Every company is required to keep proper books of accounts to give a true and fair view of the state of affairs of the company. The books of accounts have to be kept on accrual basis and according to The books of accounts of a company double entry book-keeping system. The accounts must be kept on accrual basis fol­ must be kept for all receipts and expenditure, sale lowing double entry book-keeping and purchase of goods and assets and liabilities. The system. books of accounts need to be preserved for a period of eight years.

Financial Statements Every company is required to prepare a balance sheet, a statement of profit and loss and a cash flow statement for each accounting year. The accounts are kept on a financial year basis, i.e., from 1st April to 31st March. These financial statements are required to be laid before the shareholders in the annual general meeting for approval within six months of the end of the accounting year.

Introduction to Accounting  7

To ensure that the information provided in finanThe format of financial statements cial statements by various companies is readily comhas been prescribed in Schedule III of parable by users, formats of the balance sheet and Companies Act, 2013. statement of profit and loss have been prescribed by the Companies Act, 2013. The balance sheet of the company at the end of the financial year should be in the format set out in Part I of Schedule III of the Act. The format of the statement of profit and loss is prescribed in Part II of Schedule III. However, Schedule III does not apply to any insurance or banking company or a company engaged in the generation or supply of electricity. Financial statements must give a true and fair view of the state of affairs of the company. They must be approved by the board of directors and signed on behalf by the Board. The signed financial statements are then submitted to auditors for their report.

Compliance with Accounting Standards Financial statements of the company shall comply with the applicable accounting standards. In case of non-compliance, the company must report the deviation from the accounting standards, the reasons for such deviations and also the financial effect arising due to such deviations.

1.7.2  Reserve Bank of India The Reserve Bank of India (RBI) is the central bank of the country. It was set up in the year 1934 to regulate the business of banking in India. The Banking Regulations Act, 1949, prescribes requirements relating to financial statements of banking Financial statements of banking comcompanies. Accordingly, every banking company panies must be prepared in the for­ incorporated in India is required to prepare a balance mat prescribed in the Third Schedule sheet and a profit and loss account for each accountof Banking Regulations Act, 1949. ing period. Banking companies incorporated outside India are also required to prepare similar statements in respect of business transacted through their branches in India. The format for financial statements has been prescribed in the Third Schedule to the Act. Financial statements need to be signed by the prescribed officers of the banking company. RBI, as a supervisor of banking companies has, from time to time, issued circulars relating to disclosures in the notes to accounts to the financial statements. These circulars were consolidated and a master circular was issued by RBI prescribing matters to be covered in the notes to accounts.2 The disclosure requirements cover key areas, like investments, quality of assets, non-performing assets, assets liability management, exposure to sensitive sectors, etc.

1.7.3  Insurance Regulatory and Development Authority (IRDA) IRDA was established in the year 1999 ‘to protect the interests of holders of insurance policies, to regulate, promote and ensure orderly growth of the insurance industry’ in India.3 The Insurance Act, 1938 authorises the IRDA to make regulations on various matters including the preparation of balancesheet, profit and loss account and a separate account of receipts and payments and revenue account. In exercise of its powers, IRDA came out with regulations4 and has prescribed the format for revenue account, profit and loss account (shareholders’ account) and the balance sheet. the regulations also

8  Chapter 1

The financial statements of insurance companies must be prepared in the format prescribed by IRDA Regulations—Schedule A for Life Insurers and Schedule B for General Insurers.

require that separate revenue account shall be prepared for fire, marine, and miscellaneous insurance business. In addition, a receipts and payments account is also required to be prepared. The regulations also prescribe the format (Schedule C) for auditors’ report on financial statements.

1.7.4  Securities and Exchange Board of India (SEBI) SEBI was established by an act of parliament in the year 1992 to ‘protect the interests of investors in securities and to promote the development of, and to regulate, the securities market.’5 The Act gives SEBI powers to specify the requirements for listing of securities. Accordingly, SEBI has prescribed the contents of listing agreement to be signed between the issuer of securities and the stock exchange where Listing agreement is signed between the securities are proposed to be listed. The purpose an issuer of securities and stock of the listing agreement is to protect the interest of exchange where the securities are investors in publically-traded securities. Some of the traded. important provisions in the listing agreement relating to disclosures of financial information are:

• A requirement to prepare and file quarterly results has been prescribed. Quarterly results are • •

required to be filed with the stock exchange and also published in newspapers in the prescribed format. Quarterly results shall either be audited or be subjected to a limited review by the auditor. If the auditor has expressed any qualification or other reservation, such qualification or other reservation and impact of the same on the profit or loss, should also be submitted.

1.7.5  Income Tax Act, 1961 As discussed earlier, financial accounting and tax accounting are two distinct branches of accounting. The taxable income is computed as per the provisions of Income Tax Act, 1961, whereas reported profit for financial accounting is determined based upon the applicable accounting standards and requirements of the Companies Act, 2013. The income tax is computed on a financial year basis (1st April to 31st March). The Companies Act, 2013 requires the companies to keep financial accounts on financial year basis, bringing uniformity in tax accounting and financial accounting.

Introduction to Accounting  9

Summary 1. Financial accounting aims at meeting the informational requirements of both external and internal stakeholders. 2. External stakeholders include shareholders, prospective investors, bond holders, banks, financial institutions and other lenders, suppliers of goods and services, credit rating agencies, tax authorities and other regulators. 3. Managers also use financial accounting information for decision making and to align organizational performance with the targets. 4. To ensure comparability of financial information provided by different organization, they must conform to the applicable GAAP and accounting standards. 5. Three financial statements—statement of profits and loss, balance sheet and cash flow statement help the users in understanding the financial results and health of the organization. 6. The statement of profit and loss contains information about revenue and expenses during an accounting period, difference being called either profit or loss. 7. Balance sheet is a summary of assets and liabilities of the organization on the last day of the accounting period. 8. Cash flow statement reports sources and uses of cash during the accounting period and helps in explaining the change in cash position between two balance sheets dates. 9. Balance sheet and statement of profit and loss of a company must be prepared in the format prescribed in Schedule III of the Companies Act, 2013. 10. Format of financial statements for banking companies has been prescribed in Third Schedule of the Banking Regulations Act, 1949. Likewise, format of financial statements for insurance companies has been laid down by IRDA Regulations, 2002. 11. Companies whose securities are traded on stock exchanges are subject to additional disclosure requirements as per the listing agreement. They also need to prepare and publish quarterly results in the prescribed format. 12. Functional managers must develop the basic skills in understanding and analysis of these financial statements to be better able to use the information available.

Assignment Questions 1. ‘Financial accounting information is primarily used by the external users whereas management accounting information is exclusively used by internal users’. Explain. 2. What are the key differences between financial accounting and management accounting? 3. Identify three primary financial statements and state their purposes. 4. The accounting and disclosure requirements are greatly influenced by the regulations. Briefly explain the accounting environment in India.

10  Chapter 1

Cases Case 1.1: Bharti Airtel Limited Bharti Airtel Limited was promoted by Mr. Sunil Mittal in the year 1995. With the opening of telecom sector in India, the company launched its mobile services under the brand name ‘Airtel’ in Delhi and Himachal Pardesh. The company now has a presence in all the 22 telecom circles in India. After having established itself as the leading telecom service provider in India, in 2009 the Company made foray in Sri Lanka through its wholly owned subsidiary Bharti Airtel Lanka (Pvt.) Ltd and is recognized as Sri Lanka’s fastest growing wireless service provider. The Company acquired 70% stake in Warid Telecom, Bangladesh (Warid) in January 2010. Warid is a leading mobile services provider across all 64 districts of Bangladesh. In March 2010, the Company acquired Zain Africa B.V. (Zain). The company is currently ranked number 3 globally in terms of the subscriber base and has presence in 20 countries with a customer base exceeding 342 million. The Company went public in the year 2002 with its maiden public issue of 18.53 crore equity shares. The issue was priced at ` 45 per share and the company mobilized ` 834 crore. The shares of the Company are listed on the Stock Exchange, Mumbai and the National Stock Exchange. As on 31st March 2016, the company has 225,685 shareholders. The shareholding pattern of the Company is given below: Shareholders’ Group

(%) Holding

Promoters   – Domestic

45.09

  – Foreign

21.60

Financial Institutions

26.75

Others

6.50

Total

100.00

The shares of the Company are actively traded. The company provides adequate disclosures to the shareholders and prospective investors through quarterly reports and also through its website. Frequent and transparent communication with investors keeps the Company closer and accessible to the investors. The Company is in constant touch with majority of analysts and research desks by providing right information to enable them to form their own informed opinion. As a responsible corporate, interaction with opinion makers is equally important as they serve the interest of investors. The Company enjoys outstanding rating from rating agencies—both domestic and international. It is rated as AA+ by CRISIL and ICRA for long-term borrowings. For short-term borrowings, it enjoys A1+ ratings from CRISIL and ICRA, respectively. The Company was rated ‘Investment Grade’ with a ‘Stable’ outlook by three international credit rating agencies—Fitch, Moody’s and S&P. The aggregate borrowings of the company, as on 31st March 2016, from banks and other lenders amounted to ` 424,001 million. As on 31st March, 2016, the Company has 24,940 employees on its payroll. In a high tech sector like telecom service, Bharti Airtel treats its people as the most valuable asset. The Company has a robust Employees Stock Option Plan (ESOP) and till 31st March 2016, the Company has approved

Introduction to Accounting  11

18,734,552 options under ESOP Scheme, 2005 and 31,680,000 options under ESOP Scheme, 2001. ‘Besides attraction of new talent, the policies also help in retention of well performing employees, who are contributing to the growth of the Company.’ The Company has adopted a business model which uses outsourcing as a strategic tool. It has partnered with global leaders for managing its IT systems and networks, thus focusing on its core competence, i.e., customer acquisition. Accordingly, the entire IT management has been outsourced to IBM whereas network management is done by Ericsson, Nokia Siemens Networks and Huawei (for Sri Lanka). Even the transmission towers are managed by Indus Towers and Bharti Infratel. Telecom sector in India is regulated by the Department of Telecom, Government of India. The Telecom Regulatory Authority of India (TRAI) has been set up by the Government of India as the nodal authority for this purpose. TRAI regulates the telecom services including fixation/revision of tariffs. With effect from 1st August, 1999, the Company pays a variable licence fee to the government, computed at the prescribed rates of revenue share. Revenue for this purpose is computed as per the respective license agreements. The cumulative contribution of the company to the exchequer in India in the last 5 years amounts to ` 995.8 billion. The company undertook various initiatives towards corporate social responsibility (CSR) in the areas of promotion of education, rural sanitation programme, higher and technical education, child welfare programmes, disaster relief initiatives, community development programmes, environmental initiatives and awareness and employability and entrepreneurship. The Company spent over ` 534.69 million towards the CSR activities during 2015–16. The brief financials of the company for the years 2014–15 and 2015–16 are set out below: From Balance Sheet

2014–15

2015–16

( ` in Million)

Shareholders’ Funds

782,729

844,468

Liabilities

481,508

774,920

1,264, 237

16,19,388

 

 

Income

606,894

340,143

Profit Before Tax

156,553

100,398

Profit After Tax

132,005

75,465

 

 

178,398

200,582

Cash Used in Investing Activities

(128,012)

(222,833)

Cash Used in Financing Activities

(51,957)

(18,885)

Total Assets

From Statement of Profit and Loss

From Cash Flow Statement Cash Flow from Operating Activities

Source: Annual Report of Bharti Airtel Limited for the year 2015–16 and official website of the company, www.airtel.in

12  Chapter 1

Questions for Discussion 1. Identify various users—both internal and external—who are interested in the financial information about Bharti Airtel Limited? 2. What kind of financial information do you think these users would need? 3. What is your assessment of the financial health of Bharti Airtel Limited?

Endnotes 1. Financial Accounting Standard Board—Statement of Financial Accounting Concept No.8: Conceptual Framework for Financial Reporting; September 2010 2. Master Circular RBI/2015–16/99 DBR.BP.BC No. 23/21.04.018/2015–16 dated 1st July, 2015 3. The Insurance Regulatory and Development Authority Act, 1999 4. The IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2000 5. The Securities and Exchange Board of India Act, 1992

Generally Accepted Accounting Principles and Accounting Standards

2

CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand the nature and purpose of GAAP. • Visualize the impact of important accounting principles on financial reporting. • Develop familiarity with key accounting principles. • Apply accounting principles to accounting events. • Appreciate requirements of Ind AS 8 relating to accounting policies. • Understand the role of the Institute of Chartered Accountants of India (ICAI) in setting of accounting standards. • Appreciate the need for having uniform global accounting standards.

2.1  NATURE OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Accounting principles or GAAP are general rules guiding recording of accounting transactions. As accounting is not an exact science, accounting practices may differ significantly from one firm to another. Accounting principles are nothing but good accounting practices evolved over a period of time. As accounting information is used by a number of users, it is important that the accounting information is relevant for making economic decisions and is objective. Often the users have conflicting objectives; accounting information must be fair to all of them without any bias. GAAP lends objectivity and relevance to accounting information. It must however be noted that GAAP do not deal with specific accounting events. To decide how a particular transaction will be recorded, the management still has a lot of latitude. Some of the key accounting principles used in preparation of accounting information have been discussed below:

2.1.1  Separate Entity To begin with, the accountant has to clearly define the business unit for which accounting is being done. The concept states that accounts are kept for the business entity which is distinct from the owner.

14  Chapter 2

The accounts must reflect the effect of a transaction on the accounting entity and not on the persons who own the entity. Therefore, the personal affairs of the owners must not be mixed with business activities. Payment of rent by a proprietorship firm for the personal residence of its proprietor will not be recorded as business expense to ascertain profit or loss of the firm, rather will be recorded as a reduction of capital. Secondly, it must be recognized that any transaction between the accounting entity, on the one hand, and any other entity on the other, is the subject matter of accounting. This helps the users in understanding the scope of financial statements clearly. Accordingly, a cash transfer from one branch of a bank to another branch must be recorded as an accounting transaction when branch accounts are being prepared. However, while preparing the financial statements of the bank as an accounting entity, such inter-branch transactions are ignored. Separate entity concept ensures that the personal affairs of the proprietor are not mixed with business transactions resulting in correct ascertainment of business results and financial position.

■  Illustration 2.1

Star International UK set up a captive BPO unit in India called StarTrek India. It invested £50 million as capital in the Indian subsidiary. Should it be recorded as an accounting transaction? Yes, Star International UK (owner) and StarTrek India are two different entities. It will appear as an investment in the books of former and as capital in the books of later. Suppose StarTrek India provided some back office services to Star International UK. Should this be recorded as an accounting transaction in the books of StarTrek India? Yes, the monetary value of services provided by Indian entity to UK entity is an accounting transaction. ■  Illustration 2.2

Ram Manohar & Sons is a proprietorship firm owned by Mr. Ram Manohar. During the year 2017, the firm bought goods worth ` 1,000,000. Goods costing ` 100,000 were consumed by Mr. Ram Manohar for personal purposes. The remaining goods were sold for ` 9,60,000. What is the profit or loss for the year? Though the total purchases are for ` 1,000,000, goods costing ` 100,000 have been consumed by the proprietor. As such goods costing ` 900,000 ( ` 1,000,000 – ` 100,000) have been sold for ` 960,000 resulting in profit of ` 60,000 ( ` 960,000 – ` 900,000) for the year.

2.1.2  Accounting Period Stakeholders want accounting information on a regular basis, therefore, financial statements are prepared periodically. The period covered by such financial statements is called the accounting period. As a matter of convention, the accounting period is a period of twelve months. In absence of a uniform accounting period, comparing results of different entities will not be possible. A period of 12 months covers all the seasonal variations. In India, financial year, i.e., from 1st April to 31st March is more popular accounting period, whereas internationally, calendar year is the preferred choice as accounting period. In certain circumstances, it may be possible to have an accounting period which is

Generally Accepted Accounting Principles and Accounting Standards  15

longer or shorter than 12 months. For example, the Accounting period is usually a period first accounting period after the commencement of of 12 months. Additionally, interim business may be shorter than 12 months. reports are prepared to meet the The Companies Act, 2013 makes it mandatory require­ment of users for more concurfor all companies to keep their accounts on finanrent information. cial year basis. Those companies that were keeping their accounts on any other basis were given a period of two years from the commencement of the Act to switch over to financial year. In addition to annual results, the users may need more frequent information. This requirement is met through interim reporting. The listed companies in India are required to report quarterly results as well, to meet the informational needs of investors. ■  Illustration 2.3

Hindustan Boiler Limited, an India subsidiary of a US company, prepares its accounts using financial year as the accounting period. The US parent company prepares its accounts on calendar year basis. What kind of problem the US Company would face to present consolidated results? As the holding and subsidiary company are following different accounting periods, it may not be possible to directly consolidate the accounts by the holding company. The Indian subsidiary will have to prepare two set of accounts—on financial year basis for local reporting and calendar year basis for reporting to the holding company.

■  Illustration 2.4

ABC Limited was keeping its books of accounts on a calendar year basis. After preparing its accounts for the year 2014, it decided to change its accounting period to financial year basis. How would the switch over happen in terms of accounting period? The accounts for the year 2015–16 will be for fifteen months i.e. from 1st January 2015 to 31st March 2016. Thereafter, regular financial year will be followed.

2.1.3  Money Measurement Money is a common unit of measurement. Only those events and transactions which can be converted or expressed in money terms are subject matter of accounting. If a business unit buys 5,000 kg of raw material @ ` 100 per kg, only the monetary value, i.e., ` 500,000 will be entered in the books of accounts and not the quantity purchased. The Money measurement concept makes it necessity of this concept is obvious. For example, possible to aggregate different types of Progress Technologies Limited owns 20 computers, assets, liabilities, revenues and expenses ` 5 million in cash, a piece of land with an office by expressing them in a common unit building thereon and few more assets. How do we of reporting. state the total assets of the company as on date

16  Chapter 2

unless we are able to express each of these assets into a common denominator? Fortunately, money provides the common denomination. This concept has other implications too. What if a business unit earns its revenue in multiple currencies? How would the total revenue of the business be ascertained? The financial statements are prepared using a uniform currency called the reporting currency. All companies in India use Indian rupee as the reporting currency. Any revenue earned or expenses incurred in any other currency is converted into the reporting currency by using the then prevailing exchange rate. This concept, though essential, has its limitations too. Firstly, we assume that money has a constant value. Change in the purchasing power of money is therefore not incorporated in the account books. A piece of land bought in the year 1990 at ` 10 million will continue to appear in the books of accounts at the same value though the value of rupee might have declined substantially in the last 20 years. This may have significant implications on the financials of the business especially in countries with high inflation rate. Secondly, events that cannot be expressed in terms of money, howsoever important, are not reflected in accounts. A major labour unrest, leading to strike in the factory or change in government regulation having adverse impact on the business, are major events but are not subject matter of accounting ■  Illustration 2.5

Progressive InfoTech Limited earned revenue of $1.5 million from exports and also ` 320 million in the domestic market during the month of July. Assuming the exchange rate of 1 $ equals to ` 65, what is the total revenue for the month of July? To ascertain the total revenue, the export income must be converted into the reporting currency by using appropriate exchange rate. The revenue from export will be recorded at ` 97.5 million ($1.5 million multiplied by ` 65) resulting in total revenue of ` 417.5 million. ■  Illustration 2.6

After the death of the promoter of E-Sport Limited, there is fierce battle between his two sons for succession. How will this be reflected in the books of accounts of the company? The above event, though very important, cannot be expressed in money terms. As such, it will not be reflected in the book of accounts of E-Sports Limited.

2.1.4  Going Concern

Going concern concept requires a longer term view to be taken for recording business transactions as if the business will continue to operate for an indefinite period of time.

For the purposes of accounting, it is assumed that the business is a going concern and would continue to operate indefinitely. There is neither the need nor the intent to discontinue operations. This concept has strong implication on the valuation of assets of the business. Assets should be valued on the basis of their intrinsic value to the entity as an ongoing business rather that at their realizable

Generally Accepted Accounting Principles and Accounting Standards  17

value. Accounting policies and estimates must reflect the financials of the business as a going concern rather being influenced by short-term considerations. However, the basis of valuation will change if the going concern assumption is violated. If there is evidence that the accounting entity or a part thereof is likely to be liquidated shortly, the assets value would reflect the liquidation value. ■  Illustration 2.7

Healthcare Pharmaceutical Limited has 3 plants located at Delhi, Mumbai and Pune. The company has decided to shut down the Pune plant and sell its assets either as a running unit or in a piecemeal manner. What is the implication of such a decision in the books of accounts of the company? In respect of Pune plant, the going concern assumption has been violated as such the assets should be shown at their liquidation value. For the other two plants, going concern continues to hold good.

2.1.5  Cost Concept Cost concepts states that the long-term assets are shown in the financial statements at their historical cost irrespective of the current realizable or liquidation value. This concept is an extension of going concern principle as discussed above. A temporary decline in the market value of an asset should be ignored as the business will continue to view the Cost concept lends objectivity to the asset at its intrinsic value as a going concern. Due financial statements as a long-term to the same reason, any appreciation in the liquiasset will continue to be shown at its dation value will also be ignored. However, if the historical cost irrespective of fluctuagoing concern assumption is violated, e.g., in case tion in the market price. However a of discontinuation of operations, cost principle will permanent fall in value is recognized. also not apply. Likewise, if decline in value of the asset is non-temporary, the asset would be shown at its liquidation value. The main advantage of cost concept is objectivity. The historical cost can be objectively measured, whereas determining the current realizable value suffers from subjectivity. It will also require lot of efforts in keeping a track of change in the liquidation value of the asset. It, however, must be noted that the cost of a long-term asset is systematically apportioned over its useful life. Such an apportionment of cost of a permanent asset over its useful life is called depreciation. ■  Illustration 2.8

Industrial Lab Limited bought a piece of land for ` 5 million in the year 1970. The company has used the land to set up an industrial unit. The current market price of the land is ` 20 million. At what value this asset should be shown in the financial statements of the company? The land will continue to appear at its historical cost, i.e., ` 5 million irrespective of its current market price following cost concept.

18  Chapter 2

2.1.6  Conservatism or Prudence The conservatism or prudence principle states that it is better to understate the financial position of the business rather that overstate. In more specific terms, gains should be recognized when they are reasonably certain, however, losses should be recogConservatism concept prefers accountnized even if they are reasonably probable. Prudence ing policies that understate rather is an important guiding principle while choosthan overstate profits; ignore probable ing accounting policies. When in doubt, choose an gains but account for probable losses. accounting policy that understate the profits rather than overstate it. ■  Illustration 2.9

Reliable Limited sells goods on credit basis. At the end of the year, it has a total outstanding of ` 120 million from its customers. The past experience shows that about 5% of the customers invariably default. How do we account for this anticipated loss? As based upon past experience 5% loss is reasonably probable, the company will make a provision for anticipated losses at ` 6 million. This will appear in the statement of profit and loss for the year as an expense. In the balance sheet, receivables will be shown at ` 114 million, i.e., net of the provisions. ■  Illustration 2.10

Pee Ltd. bought 1,000 shares of RIL at ` 1,200 per share during the year for trading. The market price per share at the end of the year is ` 1,100. At what value will the short-term investment appear in the Balance Sheet of Pee Ltd? How do we treat ` 100 fall in value per share? What would be your answer if the market price per share at the end of the year is ` 1,500? As the current market price ( ` 1,100) is lower than the cost price ( ` 1,200); there is a reasonable probability of loss of ` 100 per share. The short-term investment will appear at ` 1,100, i.e., lower of the two. At the same time, the anticipated loss of ` 100 per share will appear in the statement of profit and loss for the year. If the current market price is ` 1,500, the appreciation will be ignored as it is not certain. The short-term investment will appear at the cost price being lower of the two.

2.1.7  Materiality or Relevance The materiality principle guides the level of details required to be disclosed in financial statements. In general, any information that is relevant to the user of financial statements should be disclosed. At the same time, unnecessary details should be avoided. If all details are provided in financial statements, they will become too long and cumbersome to Materiality concept provide all inforunderstand. On the other hand, if lot of information mation that is relevant to the users is clubbed together, some vital information may be but avoid unnecessary details. lost. In case of doubt, it is better to over-disclose rather than under-disclose.

Generally Accepted Accounting Principles and Accounting Standards  19

■  Illustration 2.11

In the statement of profit and loss of Tee Ltd. about 60% of the expenses have been clubbed under the heading ‘miscellaneous expenses’, whereas Cee Ltd. has reported all heads of expenses separately including about 100 different types of expenses which together constitute only 10% of the total expenses in rupee terms. What are your views? In case of Tee Ltd. vital details are being lost as 60% of the expenses are being clubbed as ‘miscellaneous expenses’. The company should analyze its expenses under relevant heads and disclose accordingly. Cee Ltd., on the other hand, is over disclosing. It can club a number of expense heads as miscellaneous and make financial statements simpler.

2.1.8 Consistency

Consistency concept facilitates inter-

The consistency principle requires that accounting period comparison by requiring that policies once chosen must be applied consistently same accounting policies are followed period after period. When a user is trying to estabperiod after period. Change in accountlish a trend by comparing financial statements of an ing policies, if any, must be adequately entity over a period of time, say, last 10 years, it is disclosed. important that these statements have been prepared using the same accounting policies. Consistency does not, however, mean that accounting policies cannot be changed. If there is a strong reason to change, accounting policies may be altered. For example, a change in government regulation may necessitate change in accounting policies. However in such an event, the change in accounting policy must be disclosed and the impact of the change in accounting policy must be quantified and reported separately. ■  Illustration 2.12

Red Swan Auto Limited is proposing to change its accounting policy for the valuation of inventories as the management feels that it would lead to better estimation of cost of inventories. Can they do so? Yes, Red Swan Auto can change its accounting policy for better estimation of cost. However, the company needs to disclose the change in accounting policy. The impact of change also must be quantified and disclosed.

2.1.9 Matching The matching principle requires that the expenses incurred must be matched against the revenue earned to ascertain the profit or loss for the business. If the expenses are incurred in one period, whereas revenues Matching concept for correct ascer­ are earned in the next period, the expenses need to tainment of profits, expenses incurred be carried forward to the next period to ascertain the to earn revenue are matched against profit. To apply matching principle, first the revenues the revenue earned. Both revenue and are identified to a particular period. Once revenue has related expenses must be accounted been recognized, expenses incurred to earn that revfor in the same accounting period. enue is matched to ascertain profit or loss.

20  Chapter 2 ■  Illustration 2.13

During the year, Smart Trading Limited bought goods worth ` 1,350,000. It also had goods worth ` 200,000 in stock which were bought during the previous year. At the end of the year, goods costing ` 450,000 are still unsold. Remaining goods have been sold during the year for ` 1,400,000. Ascertain the cost of goods sold during the year and profit or loss for the year. The total cost of goods available for sale is made up of the goods from the previous year (opening stock) amounting to ` 200,000 and goods bought during the year amounting to ` 1,350,000. Out of this, goods costing ` 450,000 are still unsold (closing stock). The cost of goods sold can be calculated as: Opening stock + Purchases – Closing stock = ` 1,100,000. The company has earned ` 1,400,000 from sales of goods. By matching the cost of goods sold against this income, the profit for the year comes to ` 300,000.

2.1.10  Accrual Basis of Accounting There are two different methods of recording accounting transactions—cash and accrual. In cash basis of accounting, transactions are recognized only when cash is paid or received. The timing of recognizing an accounting event and the quantum depends upon exchange of cash. For example, Delhi Auto Limited made a sale of ` 500,000 on 28th February 2018 allowing three months to its customer to make the payment. The payment was finally received on due date, i.e., 31st May 2018. Assuming further that the company maintains its accounts on financial year basis, the transaction will be entered in account books only on 31st May 2018 when the cash is actually received. On 28th February, i.e., date of sale no accounting transaction was recorded. Cash basis of accounting is very simple and objective as recording of accounting transaction coincide with receipt or payment of cash. Cash basis—transactions are recorded On the other hand, in accrual basis of accounton receipt and payment of cash. ing transactions are recorded when a legally binding obligation to pay or receipt is created. Revenue is Accrual basis—revenue are recorded recorded in financial statements when goods have when earned while expense are been sold or a service has been performed, resulting recorded when incurred irrespective of in creation of a right to receive payment. Likewise, when received or paid. expenses are recorded when goods or services have been purchased and a legally binding payment obligation has been created. In the above example, the sale has been completed on 28th February 2018 creating a right to receive payment for Delhi Auto Limited. Accordingly, sales was recorded on 28th February 2018 notwithstanding the fact that the payment is actually received later. ■  Illustration 2.14

ABC Diagnostic Limited has the practice of paying the monthly salary on the 7th of next month. Accordingly, salary for the month of March 2018 was paid on 7th April 2018. If the company follows cash basis of accounting, when would the expenses be recognized? What if the company follows accrual basis of accounting?

Generally Accepted Accounting Principles and Accounting Standards  21

In cash basis of accounting, expenses are recorded upon payment only. Accordingly, the salary paid will be recorded as an expense on 7th April 2018 and will appear as an expense for the year 2018–19. If ABC Diagnostic Limited follows accrual basis of accounting, expenses will be recorded when incurred, i.e., when a legally binding obligation to pay has occurred. As the company has used the services of its employees, it has an obligation to pay. As such, salary for the month of March has already accrued by 31st March 2018. Accordingly, it will be recorded as an expense for the year 2017–18, though paid in 2018–19.

2.1.11  Dual Aspect The modern day accounting is based upon what is called double entry book keeping system. It states that the basic accounting equation, i.e., Assets = Owners’ Capital + Liabilities, will always be true. Each accounting transaction affects at least two accounts in such a way that the accounting equation will always be in balance. In fact, because of double entry book keeping system assets and liabilities side of balance sheet will always tally. The equation, Assets = Capital + Liabilities, is the foundation of modern days accounting. In this equation, assets signify what a business own, e.g., land, building, plant, machinery, cash, inventories, accounts receivables, etc. Capital means business’s obligations towards the owners. It includes not only the original contribution of the owner but also retained earnings, i.e., profit made but not withDouble entry bookkeeping – every drawn by the owners. Revenue earned results in transaction affects at least two accounts an increase of capital, whereas expenses results in in such a way that Assets = Capital + decrease in capital. Liabilities mean what the busiLiabilities. ness owes to non-owners, e.g., bank loans, accounts payables, creditors for goods and services, etc. At any point of time, the equation will always be true. ■  Illustration 2.15

Mr. Ramesh Jha started a new business on 1st April 2017 contributing ` 1,000,000 in cash as capital. The firm bought some furniture for ` 200,000 in cash and bought machinery from XYZ Limited for ` 700,000 on credit. How would these transactions affect the accounting equation? When Mr. Ramesh Jha introduced ` 1,000,000 as capital, it has a dual effect on the business. The business has acquired an asset (Cash) and also an obligation towards Mr. Jha. At this stage: Assets

= Capital   + Liabilities

Cash  ` 1,000,000  =

` 1,000,000 0

When furniture is bought for ` 200,000 and paid for in cash, one type of asset (cash) is replaced by another (furniture). The accounting equation now is: Assets

= Capital   + Liabilities

Cash  ` 800,000     = Furniture ` 200,000

` 1,000,000 0

22  Chapter 2

When the firm bought machinery on credit, it results in increase in assets (machinery) and at the same time it has incurred a liability towards XYZ Limited. Assets

= Capital   + Liabilities

Cash    ` 800,000  =

` 1,000,000

XYZ Limited  ` 700,000

Furniture    ` 200,000 Machinery  ` 700,000 All accounting transactions and procedure are based upon the above fundamental accounting equation.

2.1.12  Substance Over Form Accountants often face situations where the real intent of a transaction is totally different from the form in which the transaction is entered into. Should the accountant merely be guided by the legal form in which the transaction has been entered into or go by the substance of the transaction? As a principle, the substance of the transaction takes precedence over its legal form. The real intent behind the transaction should be explored and given effect to in accounting. ■  Illustration 2.16

On 1st May 2017, Moneywise Bank sold some securities to KM Bank for ` 100 million with an agreement to buy them back at ` 101 million after a month. The securities were delivered to KM Bank on 1st May 2017. On 1st June, Moneywise Bank paid ` 101 million and bought back the securities. How should the transactions be recorded in the books of Moneywise Bank? Prima facie the transaction appears as a sale and purchase of securities. In substance, however, Moneywise Bank has borrowed ` 100 million from KM Bank against collateral of securities in question. The loan has been repaid on 1st June 2017 with interest of ` 1 million. Looking at the substance of the transaction, it will be recorded as a borrowing and ` 1 million will be recorded as an interest expense in the books of Moneywise Bank. Ind AS 8 (Accounting policies, change in accounting estimates and errors), issued by the Institute of Chartered Accountants of India (ICAI) states that accounting policies are specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. Any transaction or event or condition that is specifically covered by an Ind AS, accounting policy shall be determined by applying the relevant Ind AS. If there is no specific Ind AS covering a particular transaction or event or condition, the management shall use its judgement in developing an accounting policy. Selection of accounting policy shall be governed by principles of relevance and reliability. The information must be relevant to the economic decision making needs of the users. The accounting policies are considered to be reliable if the financial statements:

1. represent the financial position, financial performance and cash flows of the entity in a faithful manner; 2. reflect the economic substance of transactions, other events and conditions and not merely the legal form; 3. are neutral, i.e., free from bias;

Generally Accepted Accounting Principles and Accounting Standards  23



4. are prudent; 5. are complete in all material respects.

An entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions, unless an Ind AS specifically requires or permits categorization of items for which different policies may be appropriate. Accounting policies once chosen shall be applied consistently periodically. However, an entity may change its accounting policy if the change is required by an Ind AS; or the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. In case of a change in accounting policy, the entity shall disclose the nature of change in it and how the new accounting policy provid will reliable and more relevant information. The impact of the change in accounting policy for the current period and each prior period presented shall also be quantified and presented.

2.2  NEED FOR ACCOUNTING STANDARDS As discussed earlier, accounting principles have evolved over a period of time as general rules for recording accounting transactions. They do not Accounting standards translate gencover specific situations. Accounting standards, eral accounting principles to specific on the other hands, are prescribed by a designated accounting rules and are mandatory to authority and often have backing of law. They cover be followed. specific type of accounting events and transactions. To illustrate, conservatism principle states that probable losses should be provided for, but probable gains should be ignored. Ind AS 2 applies this principle to inventory valuation by laying down specific rule that inventories should be valued at ‘lower of cost or net realizable value’. Accounting standards thus converts general accounting principles to specific rules. To that extent, they reduce management’s discretion in choosing accounting policies. Further, they also lay down disclosure requirements for better understanding of financial statements. As they have backing of law, they acquire a mandatory status. Accounting standards are formulated with a view to harmonise different accounting policies and practices in use in a country. The objective of accounting standards is, therefore, to reduce the accounting alternatives in the preparation of financial statements within the bounds of rationality, thereby ensuring comparability of financial statements of different enterprises with a view to provide meaningful information to various users of financial statements to enable them to make informed economic decisions.1 However, it must be noted that accounting standards do not completely eliminate management’s latitude in choosing accounting policies. To the extent permitted by accounting standards, management has some discretion in choosing accounting policies. For example, Ind AS 2 permits business enterprises to either use First-In-First-Out (FIFO) or weighted average method to ascertain cost of inventories. Please note that firstly, the choice of management is restricted but not eliminated as there are many more methods for inventory valuation like NIFO, HIFO, and simple average, etc. Secondly, Ind AS 2 requires disclosure to be made about the method used by the management.

24  Chapter 2

2.3  ACCOUNTING STANDARDS IN INDIA2 The Institute of Chartered Accountants of India (ICAI) was set up as a statutory body in the year 1949 by an act of parliament, chartered accountants Act, 1949, with the objective of the regulation of the profession of Chartered Accountants in ICAI currently has over 160,000 memIndia. The ICAI set up the Accounting Standards bers and is the second largest accountBoard (ASB) in 1977 and entrusted it with the role ing body in the whole world. of preparation of accounting standards. The objectives of the ASB are:

• To conceive and suggest areas in which accounting standards need to be developed. • To formulate accounting standards with a view of assisting the Council of the ICAI in evolving and establishing accounting standards in India.

• To examine how far the relevant international accounting standards can be adapted while formulating the accounting standards, and adapt the same.

• To review, at regular intervals, the accounting standards from the point of view of acceptance or changed conditions and if necessary revise the same.

• To provide from time to time, interpretation and guidance on accounting standards. To ensure a wider participation by various interest groups, the ASB has a broad-based structure. It has representations form government (Ministry of Corporate Affairs, Comptroller and Auditors General of India), regulators (RBI, SEBI, IRDA, PFRDA), industry bodies (ASSOCHAM, FICCI, CII), tax authorities (CBDT, CBEC), other professional bodies (ICWAI, ICSI), academicians and member of the ICAI.

2.3.1 Process The process adopted for laying down a new accounting standard is set out below:

• Identification of the broad areas by the ASB for formulating the accounting standards. • Constitution of the study groups by the ASB for preparing the preliminary drafts of the proposed Accounting Standards.

• Consideration of the preliminary draft prepared by the study group by the ASB and revision, if any, of the draft on the basis of deliberations at the ASB.

• Circulation of the draft, so revised, among the Council members of the ICAI and specified outside bodies such as Standing Conference of Public Enterprises (SCOPE), Indian Banks Association, Confederation of Indian Industry (CII), Securities and Exchange Board of India (SEBI), Comptroller and Auditor General of India (C & AG), and Department of Company Affairs, for comments.

• Meeting with the representatives of specified outside bodies to ascertain their views on the draft of the proposed accounting standard.

• Finalization of the exposure draft of the proposed accounting standard on the basis of comments received and discussion with the representatives of specified outside bodies.

• Issuance of the exposure draft inviting public comments.

Generally Accepted Accounting Principles and Accounting Standards  25

• Consideration of the comments received on the exposure draft and finalization of the draft accounting standard by the ASB for submission to the Council of the ICAI for its consideration and approval for issuance.

• Consideration of the draft accounting standard by the Council of the Institute, and if found necessary, modification of the draft in consultation with the ASB.

• The accounting standard, so finalized, is issued under the authority of the Council. The new accounting standards are recommendatory in nature for an initial period. The ICAI has issued 32 accounting standards. The list of accounting standards issued by ICAI is given in Table 2.1.

Table 2.1  List of Accounting Standards

Accounting Standard

Subject Matter

AS 1

Disclosure of Accounting Policies

AS 2

Inventory Valuation

AS 3

Statement of Cash Flow

AS 4

Events after Balance Sheet Date

AS 5

Net Income and Change in Policies

AS 6

Depreciation Accounting

AS 7

Construction Contracts

AS 8

Accounting for Research and Development

AS 9

Revenue Recognition

AS 10

Accounting for Fixed Assets

AS 11

The Effect of Changes in Foreign Exchange Rates

AS 12

Accounting for Government Grants

AS 13

Accounting for Investments

AS 14

Accounting for Amalgamation

AS 15

Employees Benefits

AS 16

Borrowing Costs

AS 17

Segment Reporting

AS 18

Related Party Disclosures

AS 19

Leases

As 20

Earnings Per Share

AS 21

Consolidated Financial Statements

AS 22

Taxes on Income

AS 23

Accounting for Investments in Associates in Consolidated Financial Statements

AS 24

Discontinuing Operations (continued )

26  Chapter 2 AS 25

Interim Financial Reporting

AS 26

Intangible Assets

AS 27

Financial Reporting of Interest in Joint Ventures

AS 28

Impairment of Assets

AS 29

Provisions, Contingent Liabilities and Contingent Assets

AS 30

Financial Instruments – Recognition

AS 31

Financial Instruments – Presentation

AS 32

Financial Instruments – Disclosure

2.4  GLOBALIZATION OF ACCOUNTING STANDARDS With the increased globalization of business, cross-border flow of capital has become increasingly common. A number of Indian companies have raised capital abroad by issuing instruments like american depository receipts (ADR), global depository receipts (GDR) and foreign currency convertible bonds. Indian companies have set up and acquired businesses overseas and foreign companies have their presence in India through subsidiaries or joint ventures. In a globalized environment, it is imperative that the Indian accounting standards are harmonized with international accounting standards. The Ministry of Corporate Affairs (MCA) decided to converge Indian accounting standards with iternational financial reporting standards (IFRS) issued by the International Accounting Standard Board (IASB). Such a move is necessary ‘to enable IFRS Foundation is an independent, accessibility of financial information to global non-profit organization with the priinvestors since the need for restatement of accounts mary objective of developing a single would be obviated for Indian companies seeking to set of high quality, understandable, tap international financial market’3. It is expected enforceable and globally accepted that IFRS convergence will result in improved disinternational financial reporting stanclosure by Indian companies in line with global dards (IFRSs) through its standard-setbest practices. The financial reports will enjoy betting body, the IASB. ter credibility enabling Indian companies to raise capital in overseas markets with ease. Instead of adopting the IFRS, whereby Indian accounting standards would have ceased to exist, India has opted for convergence route for transition. In this route, a new set of accounting standards are issued, which are substantially in line with IFRS. However, the IFRS are modified in light of usage and business environment prevailing in the country. The MCA issued a new series of 40 Indian accounting standards (Ind AS) which are substantially in line with IFRS. `While finalizing the Ind AS, the Indian standard setters have examined individual IFRS and modified the requirements wherever necessary, to suit Indian conditions. These modifications are routinely termed as ‘carve outs’.4 The list of 40 Ind AS is given in Table 2.2.

Generally Accepted Accounting Principles and Accounting Standards  27

Table 2.2  List of converged Ind AS

Converged Accounting Standards (Ind AS) Ind AS 101:

First time adoption of indian accounting standards

Ind AS 102:

Share based payments

Ind AS 103:

Business combinations

Ind AS 104:

Insurance contracts

Ind AS 105:

Non-current assets held for sale and discontinued operations

Ind AS 106:

Exploration and evaluation of mineral resources

Ind AS 107:

Financial instruments: Disclosures

Ind AS 108:

Operating segment

Ind AS 109:

Financial instruments

Ind AS 110:

Consolidated financial statements

Ind AS 111:

Joint Arrangements

Ind AS 112:

Disclosures of interest in other entities

Ind AS 113:

Fair value measurement

Ind AS 114:

Regulatory deferral accounts

Ind AS 1:

Presentation of financial statements

Ind AS 2:

Inventories

Ind AS 7:

Statement of cash flow

Ind AS 8:

Accounting policies, Change in accounting estimates and errors

Ind AS 10:

Events after the reporting period

Ind AS 11:

Construction contracts

Ind AS 12:

Income taxes

Ind AS 16:

Property, plant and equipment

Ind AS 17:

Leases

Ind AS 18:

Revenue

Ind AS 19:

Employee benefits

Ind AS 20:

Accounting for government grants and disclosure of government assistance

Ind AS 21:

The effects of changes in foreign exchange rates

Ind AS 23:

Borrowing costs

Ind AS 24:

Related party disclosures

Ind AS 27:

Separate financial statements

Ind AS 28:

Investments in associates and joint ventures

Ind AS 29:

Financial reporting in hyperinflationary economies

Ind AS 32:

Financial instruments: Presentation

Ind AS 33:

Earnings per share (continued )

28  Chapter 2 Ind AS 34:

Interim financial reporting

Ind AS 36:

Impairment of assets

Ind AS 37:

Provisions, contingent liabilities and contingent assets

Ind AS 38:

Intangible assets

Ind AS 40:

Investment property

Ind AS 41:

Agriculture

The Ministry of Corporate Affairs has notified a phased roadmap for transition to Ind AS commencing from 1st April, 2016. It was made compulsory for the listed companies and certain other class of companies to follows Ind AS with effect from 1st April, 2016, whereas other companies would be required to transit to Ind AS for the accounting periods beginning on or after 1st April, 2017.5 In the first phase, it was mandatory for the companies specified below to follow Ind AS for the accounting periods beginning on or after 1 April, 2016, with comparatives for the periods ending 31 March, 2016.

i) Companies whose equity and/or debt securities are listed or are in the process of listing on any stock exchange in India or outside India and having net worth of ` 500 crore or more. ii) Companies other than those covered above, having net worth of ` 500 crore or more. iii) Holding, subsidiary, joint venture or associate companies of companies covered above. In the second phase, Ind AS is mandatory for specified companies for the accounting periods beginning on or after 1 April, 2017, with comparatives for the periods ending 31 March, 2017 or thereafter. The companies specified for the second phase are:

i) Companies whose equity and/or debt securities are listed or are in the process of being listed on any stock exchange in India or outside India and having net worth of less than ` 500 crore. ii) Unlisted companies having net worth of ` 250 crore or more but less than ` 500 crore. iii) Holding, subsidiary, joint venture or associate companies of companies covered above. Once a company starts follow Ind AS, voluntarily or mandatorily, it shall be required to follow the same for all the subsequent financial statements. Companies listed or getting listed on the Small and Medium Enterprises (SME) exchanges are exempted from adoption of Ind AS. Companies not covered by the revised road map could continue to apply the existing accounting standards. In respect of insurance companies, banking companies and NBFCs, the transition to Ind AS is proposed to begin for the accounting period beginning from 1 April, 2018. As the transition to Ind AS has already begun, the subsequent discussion in this book is based upon Ind AS issued by the MCA.

Generally Accepted Accounting Principles and Accounting Standards  29

Summary

• Accounting principle provides generalized guidelines for accounting to ensure comparability • • • • • • • • • • • • • • • •



of financial information provided by various enterprises. Separate Entity: Business and the owner are distinct entities. Accounts are kept for business quite distinct from the owner. Accounting Period: The entire life of the business is divided into smaller periods for accounting and reporting purposes. An accounting period is usually a period of 12 months. Money Measurement: Only those transactions that can be expressed in terms of money are the subject matter of accounting. Financial information is presented in a reporting currency. Going Concern: The business will continue to operate for an infinite period of time; there is neither the need nor the intention to discontinue operations. Cost: Assets meant for long-term usage are normally shown at their historical cost; fluctuation in their market price is not considered. Conservatism: Ignore gains unless reasonably certain but record losses even if reasonably probable. Materiality: Information relevant to the users for making economic decisions must be provided but unnecessary details may be avoided. Consistency: Accounting policies once adopted must be followed period after period unless there is a strong reason to change them; makes inter period comparison possible. Matching: Both revenue and expenses incurred to earn those revenue must be recorded in the same period. Accrual: Income is recognized when earned, expenses are recognized when incurred irrespective of when received or paid. Dual Aspect: Every accounting transaction affects at-least two accounts in such a way that Assets = Capital + Liabilities. This basis accounting equation forms the basis of double entry book keeping system. Substance Over Form: Accounting must give effect to the real intent behind the transaction and not be guided merely by the form. As per Ind AS 8, the choice of accounting policies is guided by the relevant Ind AS and considerations of relevance and reliability. Accounting standards are more specific than GAAP and have backing of law. Accounting Standard Board of ICAI is responsible for developing accounting standards. ICAI issued 32 accounting standards covering different aspects of accounting. AS are recommendatory in initial period before they are made mandatory. While formulating new AS, ASB gives due consideration to International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) in addition to conditions and practices prevailing in India. MCA has issued 40 new Accounting Standards (Ind AS) which are substantially in line with IFRS. Transition to Ind AS has commenced in a phased manner.

30  Chapter 2

Assignment Questions 1. 2.

Explain the following accounting principles with suitable examples: a. Accounting period b. Separate entity c. Money measurement d. Substance over form e. Historical cost f. Dual aspect ‘Gains are recorded if reasonably certain, whereas losses are recorded even if reasonably p­ robable’. Explain the statement and identity the accounting principle. 3. As per consistency principle, accounting policies once chosen cannot be changed. Do you agree? 4. What is the need for accounting standards? 5. Describe the process followed by the Accounting Standard Board for laying down new accounting standards. 6. Briefly discuss the requirements of Ind AS 8 relating to accounting policies. 7. What is the rationale of convergence of Indian accounting standards with IFRS?

Problems 1. Identifying relevant accounting principle: Curewell Pharmaceutical Limited is facing a law suit wherein it may be liable to pay a fine of ` 10 million. The lawyer of the company has advised that there is a high probability of the company losing the law suit. How should the company record this transaction in the books of accounts? What accounting principle is involved? 2. Identifying relevant accounting principle: Shivam Limited borrowed a sum of ` 50 million from the State Bank of India on 1st August 2016 for a period of one year. The loan matured on 30th July 2017 and was duly repaid on due date with interest amounting to ` 5 million. The company maintains its books on financial year basis. In which accounting year the interest expenses should be recorded? Why? 3. Money measurement: Which of the following transactions are subject matter of accounting: a. Purchase of 200 kg of goods by the firm on credit for ` 100,000. b. Resignation of one of the key salesman of the firm. c. A pharmaceutical company has filed application for patent of a new drug. d. A construction company has won a major contract from the government. e. A telecom company has paid ` 200 million as a security deposit to the government. 4. Identifying relevant accounting principle: Free Flow Oil Limited, an Indian company set up an office in Sri Lanka for executing a specific contract. Due to some reasons, the Sri Lankan government put a ban on the company to operate in the country. How will it impact the valuation of assets of the Sri Lankan operations of the company?

Generally Accepted Accounting Principles and Accounting Standards  31

Solutions to Problems 1. Curewell Pharmaceutical is advised to make appropriate provision for the loss as there is a reasonable probability of company losing the case. It is based upon the principle of conservatism. 2. The interest of ` 5 million is for a period of 12 months from 1st August 2016 to 30th July 2017. Interest accrues on a day to day basis. Interest from 1st August 2016 to 31st March 2017 should be accounted for in the year 2016–17, whereas interest for the period 1st April 2017 to 30th July 2017 will be treated as an expense for the year 2017–18. Accordingly, interest of ` 5 million will be split 2/3rd: 1/3rd between the two accounting years. 3. a. Yes: ` 100,000 will be recorded as purchase but not the quantity b. No: Cannot be expressed in money terms c. No: Filing an application cannot be expressed in terms of money d. No: Winning a contract cannot be expressed in monetary terms e. Yes: Amount of security deposit is an accounting transaction 4. As there is evidence to believe that Sri Lankan operation of the company are no longer viable, these operations can no longer be viewed as going concern. Accordingly, valuation of assets of Sri Lankan operations should reflect their realizable value.

Try It Yourself 1. Cash basis vs. accrual basis of accounting: A business enterprise recorded cash sales of ` 15.5 million and credit sales of ` 7.8 million during the year 2016–17. The cash purchases during the year were ` 13 million whereas credit purchases amounted to ` 4 million. The enterprise also paid ` 3 million towards various expenses including an advance payment ` 1 million to one of the vendors. Ascertain the profit for the year using : a. Cash basis of accounting b. Accrual basis of accounting. 2. Identify the accounting principle: Alto Limited bought a building for ` 30 million in the year 2014–15 which is being used for office purposes. Due to fall in the real estate prices in the area, the company ascertains that the current market price of the same has fallen to ` 23 million. At what value the building should be shown in the books of accounts of the company? Also state the accounting principle involved. 3. Dual aspect: Complete the table: ( ` in Million) Assets

Liabilities

Capital

?

14.50

 6.85

63.25

?

22.75

43.80

12.30

?

4. Identify the accounting principle: P T Jewelers bought 1 kg of gold during the year at the rate of ` 18,000 per ten grams. At the end of the year, half of the gold is still unsold. The current market

32  Chapter 2

price of the gold is ` 21,000 per ten grams. At what value the gold inventory should be shown in the financial statements of P T Jewelers? What will be your answer if the current market price of gold is ` 17,000 per ten grams? State the principle involved. 5. Application of accounting principles: Straight Bank of India invests in debt securities issues by the Government of India. Some of these investments are long-term in nature and are expected to be ‘held till maturity’ whereas some of the investments are short-term in nature and are ‘held for trading’. The details of the investments as on 31st March 2018 are given below:

Nature of Investment

Cost of Acquisition ( ` in Crore)

Current Market Price ( ` in Crore)

Held Till Maturity

3200

3400

Held for Trading

2800

2600

i) At what value the investments should be shown in the Balance Sheet as on 31st March 2018? ii) What will be the impact on the Profit & Loss Statement for the year ended 31st March 2018? iii) What are the accounting principles involved? 6. Application of accounting principle: Pee Tee Limited so far has been following the Last-inFirst-Out (LIFO) method for valuation of inventory. The management would like to change the method of valuation of inventory and adopt First-In-First-Out (FIFO) as this better represent the flow of inventory. Is it possible to change the method of valuation of inventory? If yes what are the requirements? 7. Change of accounting period: Sit-Sat Limited followed the calendar year as the accounting period till December 2015 and changed to financial year thereafter. During the switch over period, it prepared the accounts for fifteen months from 1st January 2016 to 31st March 2017 and thereafter on financial year basis. It reported a profit after tax of ` 350 million for the financial year ended 31st March 2018 compared to ` 370 million for the period ended on 31st March 2017. The management is concerned about the decline in profit. How do you respond to the concern of the management?

Cases Case 2.1: Exotica Trading Company Mr. Smart Lal commenced his trading business in the name of Exotica Trading Company on 1st April 2017 with a capital of ` 1,000,000 and a loan from the State Bank of India amounting to ` 500,000. At the end of the first year, the summary of his business transactions recorded on cash basis are set out below:  (Amount in `)

Loan from State Bank at 10% Deposit with the land lord for the shop taken on rent Furniture purchased Rent paid for the shop Salary paid to salesman

— — — — —

500,000 200,000 500,000 90,000 225,000

Generally Accepted Accounting Principles and Accounting Standards  33

Cash paid to the supplier for goods purchased Other expenses paid Cash Sales

— 2,250,000 — 100,000 — 2,500,000

At the end of the year, he prepared the profit and loss statement and a balance sheet as given as follows: Profit and Loss Statement for the Year ended on 31st March 2018

Particulars

(Amount in `)

Sales

2,500,000

Less: Expenses Deposit with landlord

200,000

Paid for furniture

500,000

Rent paid

90,000

Salary paid

225,000

Paid for purchases of goods

2,250,000

Other expenses

100,000

Total expenses

3,365,000

Loss for the year

865,000

Balance Sheet as on 31st March 2018

Particulars

(Amount in `)

Sources of funds Capital Less: Loss

1,000,000 865,000 135,000

Loan from SBI

500,000

Total

635,000

Applications of funds Cash & Bank balance

635,000

Total

635,000

Smart Lal is very upset about the results as in the first year of operations itself, the business has incurred a loss of ` 865,000. He is concerned about the prospects of this business going forward. While reviewing the accounts, he also come across some more information kept by his accountant:

• Rent for a quarter is still to be paid at ` 10,000 per month. • Salary paid includes an advance given to the salesman amounting to ` 45,000.

34  Chapter 2

• • • • • •

Interest on bank loan for the whole year is yet to be paid. Suppliers of goods are yet to be paid for the supplies made ` 150,000. Goods purchased for ` 50,000 were consumed at the household of Smart Lal. Goods costing ` 215,000 are still unsold and lying in the stock. Sales amounting to ` 325,000 are yet to be collected from the customers. One of the customer from whom ` 45,000 is due is feared to be insolvent. It is expected that furniture would have a useful life of five years. The current market value of similar furniture is ` 600,000.

Mr. Smart Lal is not too sure as to how to incorporate the above information in the financial results. Please help him by preparing the revised statement of profit and loss and balance sheet highlighting the accounting principle involved. Case 2.2 Change of Accounting Period of Hindustan Unilever Limited6 Hindustan Unilever Limited (HUL), incorporated in 1933, is a part of the Unilever Group. The company is present in various segments including home and personal care, food and beverages, and water. The Company used to prepare and present its financial statements on a calendar year (January– December) basis. After presenting its accounts for the calendar year 2007, the company decided to change its accounting period to financial year (April–March). The change in accounting year was done ‘to avoid duplication in preparation and audit of accounts under the companies and Income Tax Acts. This change simplifies the process, thereby saving cost and time.’ As a result, the first annual accounts of the company after the change of accounting period were presented for a period of 15 months, from 1st January 2008 to 31st March 2009. The summarized profit and loss account for the two accounting period is given below: (` in Lakh) (Except EPS) Particulars

15 Months Period Ended 31st March 2009

12 Months Period Ended 31st December 2007

20239,33

13675,43

362,23

193,66

Total

20601,56

13869,09

Operating costs and expenses

(17561,37)

(11796,77)

Depreciation

(195,30)

(138,36)

Interest income (Net)

180,23

212,37

3025,12

2146,33

Net sales Other operational income

Profit before tax Taxation

(524,41)

(403,21)

Profit after tax (before exceptional items)

2500,71

1743,12

(426)

182,35

2496,45

1925,47

11.46

8.73

Exceptional items (Net of tax) Net profit Basic EPS (£)

Source: Annual Report of Hindustan Unilever Limited for the year 2008–09

Generally Accepted Accounting Principles and Accounting Standards  35

Questions for Discussion 1. How do you justify the change in accounting period by HUL? 2. The company has an exceptional year with total income increasing by 48% and PAT (before exceptional items) increasing by 43% over the previous year. Do you agree? 3. How would you make the results of current accounting year comparable with the previous accounting year? Case 2.3: Change of accounting year for ACC Limited ACC Limited has prepared its financial statements using the calendar year as its accounting period. The last financial statements were prepared for the year ended 31st December 2013. The Companies Act 2013, has now made it mandatory for the Indian companies to keep their accounts using financial year (i.e., 1st April to 31st March) as the accounting period. Companies are allowed a period of two years to switch over to the financial year. To meet the requirement of the law, ACC Limited would need to adopt the financial year for its accounts.

Questions for Discussion 1. The change in accounting period is a violation of consistency principle. Comment. 2. What should ACC Limited do to change the accounting period? 3. What accounting periods would you suggest during the transition period?

Endnotes 1. ICAI—Indian Accounting Standards: A perspective. 2. Discussion in this portion is based upon ICAI publication—Indian Accounting Standards: A Perspective. 3. Ministry of Corporate Affairs: Vision on Convergence. 4. ‘Final step towards IFRS convergence—CII IFRS Summit 2011’, KPMG, 5. Companies (Indian Accounting Standards) Rules, 2015.

3

Chapter

Accounting Cycle

CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand the accounting process leading to the preparation of the profit and loss account, and the balance sheet. • Differentiate between real accounts, p ­ ersonal accounts and nominal accounts. • Apply the rules for debiting or crediting different types of accounts. • Understand the process of ledger posting, balancing of accounts and preparation of trial balance. • Prepare the profit and loss account, and the balance sheet from a given trial balance and year-end adjustment entries.

3.1 INTRODUCTION Financial statements—the profit and loss account and the balance sheet—convey useful information about the financial health of a business enterprise. Every manager is expected to have the necessary skills to be able to read, understand and analyze the information contained in these statements. These statements are the end result of a well-structured accounting process, which is the responsibility of the accounts department of the enterprise. However, to fully appreciate the information contents of these financial statements, it is important for other functional managers also to have a basic understanding of accounting cycle. In this chapter we will discuss the process of accounting that culminates into preparation of financial statements. As discussed in Chapter 2, the modern day accounting is based upon the dual aspect concept, i.e., each transaction affects at least two accounts in such a way that the basic accounting equation, Assets = Capital + Liabilities is always true. The accounting system based upon the dual aspect concept is called double-entry book keeping system.

3.2  ACCOUNTING PROCESS Various steps in the accounting process are depicted in Figure 3.1:

• Recording: At this stage, the accounting transactions are identified on the basis of the supporting documents called vouchers. A voucher is an evidence of an accounting transaction having taken place. The transaction is analysed to decide which of the accounts are to be affected and the

Accounting Cycle  37 Recording of Transactions

Classification of Transactions

Summarization

Financial Statements

• Journal Entries

• Ledger Posting

• Balancing of Accounts • Trial Balance

• Profit and Loss Statement • Balance Sheet

Figure 3.1  Accounting Cycle



amounts involved. The transaction is then recorded by way of a journal entry. Journal entries are recorded in a chronological order. Classification: The accounting entries recorded at the first stage are then grouped under different heads called ledger accounts. The purpose of this stage is to ensure that all entries of similar nature are grouped together. It may be noted that no new accounting entry is passed at this stage; rather the journal entries recorded earlier only are classified by way of ledger posting.

• Summarization: When the enterprise wants to ascertain the results for an accounting period, it needs to first find the balance in each ledger account. Once the balance in each account has been ascertained, it is put in a statement called trial balance to ensure that the equality of debits and credits has been observed.

• Financial statements: At this stage, balances in various accounts are arranged to prepare the profit and loss account, and the balance sheet. All accounts relating to income or gains and losses or expenses are transferred to the profit and loss account, whereas accounts representing assets, capital and liabilities are arranged in the Balance Sheet. The various steps in the accounting cycle have been discussed in detail in the following sections.

3.3  JOURNAL ENTRY Journal entry—all accounting transac-

Accounting entries are recorded by a system of debtions are originally recorded by way its and credits. As a rule, every accounting transof journal entries in a chronological action affects atleast two accounts, one or more of order. which are debited and the others credited in such a way that sum of amounts debited is equal to amounts credited. This process of recording is called the journal entry.

3.3.1  Types of Accounts For this purpose, accounts are classified under three heads:

1. Real accounts: Accounts relating to assets owned by the enterprise. For example—cash, machinery, land and building, furniture and fixture, etc.



2. Personal accounts: Accounts relating to the persons—both natural as well as legal—with whom the enterprise has business transactions. They represent the amount receivable or p­ ayable by the enterprise. For example, capital account, loan from banks, receivables for goods sold on credit, payables for goods and services bought on credit, expenses outstanding, etc. 3. Nominal accounts: Accounts relating to incomes or gains and losses or expenses. For example, sales, purchase of goods, rent earned, interest earned, wages and salaries, power and electricity charges, and audit fees, etc.



38  Chapter 3

3.3.2  Rules for Debits and Credits To determine whether an account has to be debited or credited, we follow certain rules for each category of accounts. Rules for the same are described in Table 3.1. Table 3.1  Rules for Debits and Credits

Type of Accounts Real Account

Rules Debit what comes in Credit what goes out

Personal Account

Debit the receiver Credit the giver

Nominal Account

Debit all expenses/losses Credit all incomes/gains

The expressions ‘debit’ or ‘credit’ have no definitive meaning—it is just a way of recording accounting transactions.

3.3.3  Transaction Analysis Once an accounting transaction has taken place, the same is analysed to pass the necessary journal entry. The following questions need to be answered by the accountant:

1. Which accounts are getting affected?—two or more accounts will need to be identified. 2. What is the nature of these accounts—real, personal or nominal? 3. Which account or accounts are to be debited or credited and by how much—in such a way that the total of debits is equal to the total of credits?

To illustrate: On 1st April 2017, an amount of ` 5,000 was paid to the watchman in cash towards his ­salary. The transaction will be analysed and journalized as follows:

1. Accounts affected—Cash Account and Salary Account. 2. Type of accounts—Cash is an asset therefore the Cash Account is a real account whereas Salary is an expenses and therefore the Salary Account is a nominal account. 3. Debit or Credit—As cash is going out (real account) it will be credited, salary is an expense (nominal account) it will get debited. Both the accounts will be recorded at ` 5,000.

After having analysed the transaction, the following journal entry will be passed: Date

Particulars

Dr.

01-04-2017

Salary A/c

` 5,000

      To Cash A/c (Salary paid to watchman vide voucher no….)

Cr. ` 5,000

As a convention, account to be debited is shown first and a prefix ‘To’ is added before the account head to be credited. A brief narration is added along with the journal entry about the nature of the transaction.

Accounting Cycle  39

■  Illustration 3.1

Analyse the following transactions and pass the necessary journal entries:

1. Paid rent to the landlord by cash: 2. Sold goods to Ramesh on credit: 3. Cash withdrawn from the bank:

` 60,000 ` 100,000 ` 35,000

The transactions will be analysed as follows:





1. Rent Account and Cash Account are two accounts getting affected. Rent is an expense (nominal account); Cash account (real account) has decreased. Expenses are always debited whereas real accounts are credited when decreased. The journal entry accordingly will be: Rent A/c Dr. ` 60,000   To Cash A/c   ` 60,000 2. Sales account (income) and Ramesh Account (personal) will be affected. As income is increasing, Sales Account will be credited whereas Ramesh is a receiver (he has received goods) without paying for them so he will be debited. The journal entry will be: Ramesh A/c Dr. ` 100,000   To Sales A/c   ` 100,000 3. Accounts affected are Cash Account (real) and Bank Account (personal). Cash has come in, therefore will be debited whereas bank is a giver so will be credited. The journal entry will be: Cash A/c     Dr.    ` 35,000  To Bank A/c        ` 35,000

3.4 CLASSIFICATION Journal entries as aforesaid are recorded in a chronological order, i.e., as and when they occur. In an Ledger posting—is a process by accounting period, a number of transactions affectwhich a journal entry is transferred to ing the same head of account might take place. On a ledger. the basis of journal entries alone, it is not readily possible to know all the transactions that might have affected a particular account during an accounting period. Therefore, we need to classify these transactions under suitable heads called ‘ledger accounts’ or simply ‘accounts’. An account is a T-shaped statement in which the left-hand side is called the debit side and the right-hand side is called the credit side. For example, all the journal entries where Cash Account has been debited will be shown on the left-hand (Debit) side of the Cash Account and wherever cash has been credited will be shown on the right-hand (Credit) side of Cash Account. So by looking at the Cash Account, one can easily ascertain all the transactions affecting cash that have taken place in an accounting period. The process of classification is called ‘ledger posting’. It may be noted that no new entries are recorded at this stage. Transaction recorded earlier by way of journal entries only are posted in the accounts.

40  Chapter 3 ■  Illustration 3.2

Classify the transactions in Illustration 3.1 under relevant accounts. There are five different accounts to be opened—Rent Account, Cash Account, Sales Account, Ramesh’s Account and Bank Account. The entries will be posted as follows: Rent Account

Dr. Particulars

(Amount in ` )

To Cash A/c

60,000

Particulars

Cr. (Amount in ` )

Cash Account

Dr.

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

35,000

By Rent A/c

60,000

Sales Account

Dr. Particulars

(Amount in ` )

Particulars By Ramesh A/c

Dr.

(Amount in ` )

To Sales A/c

100,000

Particulars

(Amount in ` ) 100,000

Ramesh’s Account

Particulars

Dr.

Cr.

Particulars

Cr. (Amount in ` )

Bank Account (Amount in ` )

Cr.

Particulars

(Amount in ` )

By Cash A/c

35,000

The first journal entry has been posted in two accounts—debit side of Rent Account and credit side of Cash Account. While posting in the rent account, cross reference to other account affected (i.e. Cash Account) is made. Likewise, while posting in the Cash Account, cross reference to Rent Account is made. As a convention, while posting on the debit side of the account, a prefix ‘To’ is added whereas

Accounting Cycle  41

on the credit side posting, a prefix ‘By’ is added. It may also be noted that both the entries affecting cash have been posted in the same Cash Account. By looking at the Cash Account, one can observe all the transactions affecting cash and by comparing the two sides, it is also possible to ascertain the cash balance at any point of time. The classification or ledger posting is a mechanical process requiring no analysis at all. In computerized accounts this mapping is done by the accounting software using the codification system used to identify various accounts.

3.5 SUMMARIZATION Steps described above—recording and classification—are followed for all accounting transactions throughout the accounting period. At the end of the accounting period, each of these ledger accounts are summarized by ascertaining the balance in each account and putting balance in a statement called the Trial Balance.

3.5.1  Balancing of Accounts As discussed earlier, each account has a debit side and a credit side and may have entries posted on Debit balance—excess of the total of both sides. At the end of the accounting period, debit side of an account over credit side. these accounts are required to be balanced. For balancing an account, the totals of debit side and credit Credit balance—excess of the total of side are ascertained. If the sum of the entries on the credit side of an account over debit debit side is greater than the credit side, the differside. ence is posted on the credit side as the balancing figure. Such a balance representing excess of debit side over credit side is called a ‘debit balance’ though posted on the credit side of the account. If the sum of the entries on the credit side is greater than the debit side, the difference is posted on the debit side as the balancing figure. Such a balance representing excess of credit side over debit side is called a ‘credit balance’ though posted on the debit side of the account. This process is repeated for all the accounts. ■  Illustration 3.3

The Cash Account of Strong Bull Limited for the month of December 2017 is given below. You are required to ascertain the balance is cash account as on 31st December 2017. Cash Account

Dr. Particulars To Opening Balance

(Amount in ` ) 103,000

Particulars By Stationery A/c

Cr. (Amount in ` ) 75,00

To Bank A/c

85,000

By Salaries A/c

45,000

To Sales A/c

73,000

By Rent A/c

12,000

By Purchase A/c

63,500

42  Chapter 3

The total of the debit side of the Cash Account ( ` 261,000) is more than the total of the credit side ( ` 128,000) by ` 133,000 so the Cash Account has a debit balance (excess of debit over credit) of ` 133,000. The closing balance will be shown as follows: Cash Account

Dr. Particulars To Opening Balance

(Amount in ` ) 103,000

Particulars By Stationery A/c

Cr. (Amount in ` ) 75,00

To Bank A/c

85,000

By Salaries A/c

45,000

To Sales A/c

73,000

By Rent A/c

12,000

By Purchase A/c

63,500

By Balance Carried Down 261,000

133,000 261,000

The balancing figure in the Cash Account (` 133,000) is also called the closing balance. In the next accounting period, the same balance will appear on the debit side as the Opening Balance or Balance brought down.

3.5.2  Trial Balance Once balances of all accounts have been ascertained, they are placed in a Trial Balance. The Trial Balance is again a T-shaped statement with the left-hand side called the Debit side and the righthand side being called the Credit side. All accounts with debit balances are placed on the debit side of the Trial Balance with the closing balance amount. Trial balance—T-shaped statement Accounts with credit balances are placed on the separately showing all the debit and credit side of the Trial Balance. The total of the debit credit balances at the end of the side of the Trial Balance and the total of credit side accounting period. must tally, reflecting the nature of the double entry book keeping system. Because of the accounting rules discussed earlier, all real accounts (assets) and expenses and losses will necessarily have debit balances, whereas income and gains will always have credit balances. The personal accounts may have either a debit or credit balance. A personal account with debit balance represents a receivable and a personal account with credit balance represents a payable. The format of Trial Balance is given in Table 3.2. The Trial Balance serves three basic purposes. 1. It ensures that the dual aspects concept has been properly followed, i.e., for every debit there is an equal and corresponding credit. 2. It gives an overview of balances in various ledger accounts. 3. It forms the basis for the next step, i.e., preparation of financial statements.

Accounting Cycle  43

Table 3.2  Format of Trial Balance

Dr.

Trial Balance (Amount in ` )

Cr. (Amount in ` )

Nominal Accounts (Expenses)

Nominal Accounts (Income)

 Rent

  Interest earned

  Material consumed

 Sales

 Salary

  Profit on investments

 Interest

  Other incomes

  Other expenses Personal Accounts (Receivables)   Loans and advances given   Trade Receivables/Debtors

Personal Accounts (Payables)

  Expenses paid in advance

  Capital account

  Bank Acount

  Loans taken

Real Accounts (Assets)

  Trade Payables/Creditors

 Cash

  Outstanding expenses

  Land and building

  Income received in advance

  Plant and machinery   Furniture and fittings   Other assets Total

Total

■  Illustration 3.4

Satya Paul started a new business on 1st April 2017. For the first quarter, his transactions are listed below. 1. Started business with ` 1,000,000 capital in cash. 2. Opened a bank account and deposited ` 990,000 in the bank. 3. Paid towards rent ` 60,000 by cheque. 4. Bought stationary for ` 7,000 paid in cash. 5. Invested ` 100,000 in government bonds through bank account. 6. Bought machinery for ` 250,000 paid through bank account. 7. Bought furniture for ` 150,000 from M/s Furniture Mart on credit. 8. Bought goods for ` 400,000 paid by cheque. 9. Bought goods for ` 200,000 from X Limited on credit. 10. Sold goods for cash ` 550,000. 11. Made part payment to X in cash ` 150,000. 12. Sold goods to Y on credit for ` 250,000. 13. Received part payment from Y by cheque for ` 175,000, allowed him discount of ` 5,000 for prompt payment.

44  Chapter 3

14. Received interest on investment ` 1,000 by cheque. 15. Paid salary to employees by cheque ` 110,000. You are required to do the following: i) Analyze the above transactions and pass necessary journal entries. ii) Post the transactions in the Ledger Accounts. iii) Prepare a Trial Balance as on 30th June 2017. i)  Analysis and Journal Entries Analysis

Journal Entry ` Particulars

The accounts affected are Cash A/c (Real) and Owner A/c (personal). Cash has come in so will be debited whereas owner is a giver and will be credited. Owner’s account is called Capital.

Cash A/c

The accounts affected are Bank A/c (personal) and Cash A/c (real). Bank is a receiver and will be debited whereas cash has gone out so will be credited.

Bank A/c

Rent A/c (nominal) and Bank A/c (personal) are affected. Expenses are always debited. Bank is a giver so will be credited.

Rent A/c

Stationary A/c (nominal) and Cash A/c (Real) are involved. Expenses are debited. Cash is going out so will be credited.

Stationary A/c

Dr.

Cr.

1,000,000

   To Capital A/c

1,000,000

990,000

   To Cash A/c

990,000 60,000

   To Bank A/c

60,000 7,000

   To Cash A/c

7,000

The accounts involved are Investment A/c Investment A/c (real) and Bank A/c (personal). Investment    To Bank A/c are coming in (increasing) so will be debited. Bank is giver so will be credited.

100,000

Machinery A/c (real) and Bank A/c are Machinery A/c affected. Machinery is coming in so will    To Bank A/c be debited whereas bank is the giver and will be credited.

250,000

Furniture A/c (real) bought on credit Furniture A/c from M/s Furniture Mart (personal).    To M/s Furniture Mart Furniture coming in will be debited, M/s Furniture Mart as giver will be credited.

150,000

Goods bought for resale are treated Purchases A/c as expenses (nominal) and are called    To Bank A/c Purchases A/c. Bank A/c is the giver and will be credited.

400,000

100,000

250,000

150,000

400,000

(continued )

Accounting Cycle  45

Journal Entry `

Analysis

Particulars

Purchases (nominal) will be debited whereas X is a giver and will be credited.

Purchases A/c

Goods sold are treated as an income (nominal) and will be credited to Sales A/c. Cash (real) is coming in so it will be debited.

Cash A/c

X (personal) is now a receiver and will be debited whereas Cash A/c (real) is going out and will be credited.

X A/c

Y (personal) is a receiver and will be debited whereas Sales (nominal) is an income and will be credited.

Y A/c

Three accounts are involved here, Y (personal) is a giver and will be credited, Bank (personal) is a receiver and will be debited; Discount Allowed is an expense (nominal) and will be debited.

Bank A/c

Interest on Investment is an income (nominal) and will be credited whereas Bank (personal) is a receiver and will be debited.

Bank A/c

  To

Dr.

Cr.

200,000

X A/c

200,000 550,000

   To Sales A/c

550,000 150,000

   To Cash A/c

150,000 250,000

   To Sales A/c

Discount Allowed A/c

250,000 175,000 5,000

   To Y A/c

180,000

1,000

   To Interest Earned A/c

Salary paid is an expense (nominal) and Salaries A/c will be debited whereas Bank (personal)    To Bank A/c is a giver and will be credited.

1,000

110,000 110,000

ii)  Ledger Posting and Balancing of Accounts Dr. Particulars

To Balance

Capital Account (Amount in ` )

Cr.

Particulars

(Amount in ` )

By Cash A/c

1,000,000

1,000,000 1,000,000

1,000,000

46  Chapter 3 Cash Account

Dr. Particulars To Capital A/c To Sales A/c

(Amount in ` )

Particulars

1,000,000

By Bank A/c

550,000

By Stationary A/c

(Amount in ` ) 990,000 7,000

By X A/c

150,000

By Balance

403,000

1,550,000

Dr.

Cr.

1,550,000

Stationary Account

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Cash A/c

7,000

By Balance

7,000

7,000

7,000

Bank Account

Dr.

Cr.

Particulars

(Amount in ` )

Particulars

To Cash A/c

990,000

By Rent A/c

To Y A/c

175,000

By Investment A/c

100,000

1,000

By Machinery A/c

250,000

By Purchases A/c

400,000

By Salaries A/c

110,000

By Balance

246,000

To Interest Earned A/c

1,166,000

(Amount in ` ) 60,000

1,166,000

Rent Account

Dr.

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

60,000

By Balance

60,000

60,000

Dr.

60,000

Investment Account

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

100,000

By Balance

100,000

100,000

100,000

Accounting Cycle  47

Dr. Particulars To Balance

Interest Earned Account (Amount in ` )

Particulars By Bank A/c

1,000 1,000

Dr.

Cr. (Amount in ` ) 1,000 1,000

Machinery Account

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

250,000

By Balance

250,000

250,000

Dr. Particulars To Furniture Mart A/c

250,000

Furniture Account (Amount in ` )

Particulars

(Amount in ` )

150,000

By Balance

150,000

150,000

Dr.

Cr.

150,000

Purchases Account

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

400,000

By Balance

600,000

To X A/c

200,000 600,000

600,000

X Account

Dr. Particulars

(Amount in ` )

To Cash A/c

150,000

To Balance

Particulars By Purchases A/c

Cr. (Amount in ` ) 200,000

50,000 200,000

200,000

Sales Account

Dr. Particulars

(Amount in ` )

To Balance

800,000 800,000

Cr.

Particulars

(Amount in ` )

By Cash A/c

550,000

By Y A/c

250,000 800,000

48  Chapter 3 Y Account

Dr.

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Sales A/c

250,000

By Bank A/c

175,000

By Discount A/c By Balance 250,000

5,000 70,000 250,000

Discount Account

Dr. Particulars To Y A/c

Cr.

(Amount in ` )

Particulars

(Amount in ` )

5,000

By Balance

5,000

5,000

5,000

Salaries Account

Dr.

Cr.

Particulars

(Amount in ` )

Particulars

(Amount in ` )

To Bank A/c

110,000

By Balance

110,000

110,000

110,000

Furniture Mart Account

Dr. Particulars

(Amount in ` )

To Balance

150,000

Particulars By Furniture A/c

150,000

Cr. (Amount in ` ) 150,000 150,000

iii)  Trial Balance Trial Balance as on 30th June 2017

Dr. Particulars Purchases A/c Rent A/c Salaries A/c Stationary A/c Cash A/c Y A/c

Cr. (Amount in ` )

Particulars

(Amount in ` )

600,000

Capital A/c

1,000,000

60,000 110,000 7,000 403,000

X A/c Sales A/c Interest earned A/c Furniture mart A/c

50,000 800,000 1,000 150,000

70,000

Discount A/c

5,000

Furniture A/c

150,000 (continued )

Accounting Cycle  49

Particulars

(Amount in ` )

Plant and machinery A/c

250,000

Investments A/c

100,000

Bank A/c

246,000 2,001,000

3.6  ADJUSTMENT ENTRIES

Particulars

(Amount in ` )

2,001,000

Adjustment entries are passed at the end of accounting period to give effect to accrual and matching principles and for rectifying errors that might have happened earlier.

Journal entries as discussed above are recorded on a continuous basis throughout the accounting period. The trial balance prepared reflects the effect of all those accounting transactions. At the end of the accounting period, some adjustment entries may be required to be made to give effect to accrual principle and matching principle. These adjustments entries are again recorded by way of journal entries. As a result of these adjustments, balances appearing in the trial balance get altered. Some of the common adjustments that are made at the end of accounting periods are discussed below.

3.6.1  Outstanding Expenses Expenses paid during the year under various heads get recorded during the year and are reflected in the Trial Balance. If however some expense incurred during the year remains outstanding at the end of the period, the same need to be adjusted. The adjustment will lead to an increase in the expense account and recoding the outstanding amount as a liability. For example, Salary Expenses as per trial balance is ` 1,250,000. At the year-end, it is realized that salaries amounting to ` 150,000 are still to be paid. We need to increase salary expenses by the outstanding amount and also record the same as a liability. The adjustment entry to be made is: Salary A/c Dr. ` 150,000   To Salary Outstanding A/c   ` 150,000 As a result of the above adjustment, the Salary A/c will go up by ` 150,000 to ` 1,400,000 and at the same time a liability of ` 150,000 towards outstanding salary will appear in the books. Similar adjustments may be made for other heads of expenses which have been incurred but remain outstanding at the end of the accounting period.

3.6.2  Pre-paid Expenses In case a part of the expenses paid during the year actually pertain to the next accounting period, a suitable adjustment needs to be made. For example, insurance on machinery paid during the year amounted to ` 600,000. It covers a period of 12 months including three months of the next year. Accordingly, one fourth of the amount paid will be treated as pre-paid expense and the expense for the year will be reduced by the same amount. The adjustment entry will be: Pre-paid Insurance A/c Dr. ` 150,000   Insurance Expenses A/c   ` 150,000

50  Chapter 3

As a result of this entry, the insurance expense for the year will get reduced by ` 150,000 to ` 450,000 and the Pre-paid Insurance will be recorded as a receivable in the books of the company. Similar adjustment may be made for any other head of expenses which has been paid in advance.

3.6.3  Income Earned But Not Received It may be possible that an income has been earned but not received by the enterprise during the accounting period. As a result, no entry has been passed in respect of such income. To give effect to the accrual principle, such income needs to be recorded. For example, interest amounting to ` 60,000 on investments have accrued but has not been received during the accounting period. The adjustment entry for the same will be: Interest Receivable A/c Dr. ` 60,000   To Interest Earned A/c   ` 60,000 As a result of this entry, the Interest Earned will get recorded as an income in accounts and the Interest Receivable will get recorded as a receivable by ` 60,000. Similar adjustments may have to be made for other heads of incomes which have accrued but not record.

3.6.4  Income Received in Advance An enterprise might have received some income in advance, i.e., which pertains to the next accounting period. Due to accrual principle, only the income for the current year should be accounted for in the current accounting period and the advance portion will appear as a liability. For example, an enterprise received an annual fee of ` 1,200,000 towards annual maintenance contract which was credited to AMC Fees A/c as an income. The AMC covers a period of 12 months out of which 9 months fall in the next year. The following adjustment entry will be made: AMC Fees A/c Dr. ` 900,000   To AMC Fees Received in Advance A/c   ` 900,000 As a result of this entry, the income from AMC Fees to be recognized during the period will get reduced by ` 900,000 to ` 300,000. At the same time, the advance received amounting to ` 900,000 will get recorded as a liability for which services are yet to be rendered.

3.6.5 Depreciation Fixed assets of an enterprise need to be written off over their useful life by charging depreciation. Depreciation is nothing but the process of appropriating the cost of a fixed asset over its useful life. Depreciation is recorded at the end of the accounting period by suitable adjustment entry. It has two ways affect—firstly, depreciation amount gets recorded as an expense and secondly, the book value of the asset gets reduced to that extent. Accordingly, the adjustment entry for depreciation is passed as follows: Depreciation Account   To Asset Account

Dr.

Alternatively, an enterprise may like to disclose the asset at its gross value (or cost of acquisition) showing depreciation written off separately as a deduction. In that a case, we open another account as ‘Accumulated Depreciation’ or ‘Provision for Depreciation’. The adjustment entry for depreciation accordingly will be: Depreciation Account Dr.   To Accumulated Depreciation A/c

Accounting Cycle  51

The ‘Accumulated Depreciation A/c’ is a contra-asset account. While presenting the information about the asset in financial statements, the balance in this account will be shown as a deduction from the gross value of the asset as follows:

Assets—Cost of Acquisition Less: Accumulated Depreciation Book Value of Asset

3.6.6  Provisions for Doubtful Debts Following conservatism principle, the enterprise may decide to create a provision for anticipated losses due to non-recovery from its customers to whom goods or services have been provided on credit. The adjustment entry for such a provision is done on the same basis as discussed above for accumulated depreciation. The following entry is passed: Bad Debts Expenses A/c Dr.   To Provision for Bad and Doubtful Debts A/c The Bad Debts Expenses A/c will be treated as an expense in the profit and loss account of the enterprise and the provision for bad and doubtful debts account will be shown as a deduction from the gross value of debtors or trade receivables in the Balance Sheet as follows: Sundry Debtors/Accounts Receivables Less: Provision for Bad and Doubtful Debts

3.6.7  Provision for Expenses At the end of the accounting period, the enterprise may estimate that certain cost or expenses might have to be incurred in the future as a result of past events and it would like to provide for such expenses. The effect of such provisioning will be to record the same as an expense and at the same time create a liability based upon the estimated amount of the expense. For example, the enterprise may like to make a provision for warranty cost in respect of goods sold during the year. The adjustment entry will be: Warranty Cost A/c   To Provision for Warranty Cost A/c

Dr.

The Warranty Cost account will be included with other costs in the profit and loss account, whereas provision for warranty cost will be taken as a liability.

3.6.8  Closing Stock When goods are purchased, the entire cost is recorded as an expense in the purchase account. If at the end of the period some of these goods are remaining unsold, the cost of inventories need to be adjusted. The closing stock (or ending inventory) will have two affects—firstly, the cost of material consumed will go down to that extent and secondly, the inventory will be treated as an asset to be consumed in the next accounting period. The adjustment inventory for the same will be: Closing Stock A/c   To Purchases A/c

Dr.

52  Chapter 3

As a result, the Closing Stock will get recorded as an asset to be shown in the Balance Sheet and the Purchase account has been adjusted downwards to reflect cost of goods sold. After making the necessary adjustment entries, the ledger balances get adjusted and a revised trial balance is prepared. The final trial balance will form basis of financial statements.

3.7  FINANCIAL STATEMENTS The updated trial balance after passing the necessary adjustments entries forms the basis of preparing the financial statements. All nominal accounts, i.e., those pertaining to expenses, losses, income and gains are temporary accounts. They are closed Nominal accounts are temporary out at the end of the accounting period by transaccounts whereas Real accounts and ferring their respective balances to the profit personal accounts are permanent and loss account. In the next accounting period, accounts. these accounts will start with zero balances. Real accounts, i.e., those pertaining to assets and personal accounts are permanent accounts. Balances in these accounts are shown in the Balance Sheet and are carried forward to the next accounting period. In the next accounting period, these accounts will show the Opening Balance, i.e., the balance carried from the earlier period.

3.7.1  Transfer Entries Journal entries at the end of the accounting period for transferring the balances in nominal accounts to the profit and loss account are called transfer entries. As they result in closing the nominal accounts by reducing their balance to zero, they are also referred to as closing entries.

Closing Income and Gain Accounts An income or a gain account necessarily has a credit balance. The account balance can be brought to zero by debiting it by equivalent amount and crediting the same to the profit and loss account. This way an income account is ‘closed’ and the balance gets ‘transferred’ to the credit of the profit and loss account. All accounts pertaining to income and gains are closed by debiting them and crediting the same to the profit and loss account at the end of the accounting period.

Closing Expenses Accounts An expense account by nature will have a debit balance. The account can be closed by crediting it by the balance amount and simultaneously debiting the profit and loss account. All the accounts relating to expenses and losses will get closed by these entries. ■  Illustration 3.5

As per the Trial Balance of Bright Shine Limited, the Sales Account has a credit balance of ` 232.45 million and the Purchase Account has a debit balance of ` 163.02 million. Pass the necessary closing entries.

Accounting Cycle  53

The sales account will be closed by debiting it by ` 232.45 million and crediting the same amount to the profit and loss account. The purchase account will be closed by crediting it by ` 163.02 million and debiting profit and loss account by the same amount. The necessary entries will be as follows: Sales A/c Dr. ` 232.45 million   To Profit and Loss A/c   ` 232.45 million Profit and Loss A/c Dr. ` 163.02 million   To Purchases A/c   ` 163.02 million

3.7.2  Profit and Loss Account Profit and loss account is a summary By means of the transfer entries as discussed above, of all the nominal accounts for a parall nominal accounts have been closed and their ticular period. Income and gains are respective balances transferred to the profit and shown on one side and expenses and loss account. The credit side of the profit and loss losses on the other. account will have balances of all accounts pertaining to incomes and gains. The balances of expenses and losses will appear on the debit side of the profit and loss account. If the sum of credit side (incomes) is greater than the debit side (expenses), the balancing figure is profit and is shown on the debit side of the profit and loss account. On the other hand, if the sum of debit side exceeds the credit side, the balancing figure will be shown on the credit side representing the loss for the period. The profit and loss account is also a temporary account and is closed down by transferring the balance to the Capital Account. The transfer entries are given below: In case of a profit: Profit and Loss A/c Dr.   To Capital A/c (By the amount of profit) In case of a loss: Capital A/c Dr.   To Profit and Loss A/c (By the amount of loss) By this transfer entry, the owner’s capital gets adjusted by the profit or loss for the period and the profit and loss account balance is reduced to zero.

3.7.3  Balance Sheet This is the last stage in the accounting cycle. By Balance sheet is a summary of real this time, all nominal or temporary accounts have accounts (assets) and personal been closed and we are left with only real accounts ac­counts (receivables and payables) at and personal accounts. Real accounts pertain to the end of the accounting period. assets and by nature have debit balances. A Personal account may have a debit balance or a credit balance. A personal account with credit balance represents liability or payable whereas a personal account with

54  Chapter 3

debit balance represents receivable. Accordingly, permanent accounts with credit balances (capital and payables) will be shown on the Liability side of the Balance Sheet whereas accounts with debit balances (assets and receivables) will appear on the Assets side of the Balance Sheet. Because of the double-entry book keeping system, the total of both the sides of the Balance Sheet will be equal. The relationship between the different types of accounts and the financial statements is depicted in Figure 3.2. Personal Accounts

Real Accounts

Nominal Accounts

Receivables (Dr.)/ Payables (Cr.)

Assets (Dr.)

Expenses (Dr.)/ Income (Cr.)

To the Extent Not Written Off

To the Extent Written Off (Depreciation/ Amortization)

Profit & Loss Account

Balance Sheet (At the End of the Accounting Period)

(For the Period)

Assets (Dr.) + Receivables (Dr.) = Capital (Cr.) + Payables (Cr.)

Incomes (Cr.) – Expenses (Dr.) = Profit (Transferred to Balance Sheet)

Figure 3.2  Type of Accounts and Financial Statements ■  Illustration 3.6

Please refer to the Trial Balance in illustration 3.4. After preparing the Trial Balance, Satya Paul identified the following additional information:

• • • • •

Salary for one month amounting to ` 55,000 is yet to be paid. Interest on investment accrued to the extent of ` 1,500 is yet to be received. Rent paid is for a period of six months. Goods costing ` 80,000 are unsold at the end of the quarter. Depreciation to be provided @ 10% per annum on Furniture and @ 7.5% per annum on Machinery.

You are required to do the following:

• • • •

Pass necessary adjustment entries. Prepare the revised Trial Balance incorporating the above adjustments. Pass the necessary transfer entries. Prepare the profit and loss account for the quarter ended 30th June 2017 and the Balance Sheet as on that date.

Accounting Cycle  55

Adjustment Entries Dr. Salary A/c

Cr.

55,000

  To Salary Outstanding A/c

55,000

Interest Receivable A/c

1,500

  Interest Earned A/c

1,500

Prepaid Rent A/c

30,000

  To Rent A/c

30,000

Closing Stock A/c

80,000

  To Purchase A/c

80,000

Depreciation A/c

8,437

  To Provision for Depreciation A/c

8,437

As rent has been paid for six months amounting to ` 60,000, half of it will be treated as prepaid. Depreciation on Plant and Machinery ( ` 4,687) and Furniture ( ` 3,750) has been charged. After passing the above entries, the revised Trial Balance as on 30th June 2017 will appear as follows: Trial Balance as on 30th June 2017 (`)

Particulars

Dr.

Purchases

520,000

Rent Salaries Stationary Cash Y

30,000 165,000 7,000 403,000 70,000

Discount

5,000

Furniture

150,000

Plant and Machinery

250,000

Investments

100,000

Bank

246,000

Closing Stock

Particulars Capital Account X Account Sales Interest Earned Furniture Mart Salary Outstanding Provision for Depreciation

Cr. 1,000,000 50,000 800,000 2,500 150,000 55,000 8,437

80,000

Interest Receivable

1,500

Depreciation

8,437

Prepaid Rent

30,000 2,065,937

2,065,937

56  Chapter 3 Transfer Entries for Incomes

Particulars

Dr.

Sales A/c

Cr.

800,000

Interest Earned A/c

2,500

   To Profit and Loss A/c

802,500

Transfer Entries for Expenses

Particulars

Dr.

Profit and Loss A/c

Cr.

735,437

  To Purchases A/c

520,000

  To Rent A/c

30,000

  To Salaries A/c

165,000

  To Stationery A/c

7,000

  To Discount A/c

5,000

  To Depreciation A/c

8,437

Financial Statements Profit and Loss Account for the Quarter Ended 30th June 2017 (`)

Particulars

Dr.

Purchases

520,000

Rent Salaries

Particulars Sales

30,000

Interest Earned

800,000 2,500

165,000

Stationary

7,000

Discount

5,000

Depreciation

8,437

Profit (Transfer to Capital)

Cr.

 

  67,063 802,500

802,500

Accounting Cycle  57

Transfer Entry for Profit Profit and Loss A/c Dr.   ` 67,063   To Capital A/c      ` 67,063 Balance Sheet as on 30th June 2017

Particulars Capital account Add: Profit

Dr.

Particulars

1,000,000 67,063 1,067,063

X account Furniture Mart A/c Salary Outstanding A/c

50,000 150,000

Cash A/c Y A/c Furniture A/c Less: Provision for depreciation

55,000      

Cr. 403,000 70,000 150,000 3,750 146,250

Plant and Machinery A/c Less: Provision for depreciation

 

250,000 4,687 245,313

 

Investments A/c

100,000

 

Bank A/c

246,000

 

Closing Stock A/c

 

Interest Receivable A/c

 

Prepaid Rent A/c

1,322,063

80,000 1,500 30,000 1,322,063

Summary

• Understanding of accounting process helps is developing a better appreciation of the financial • • •

statements which are the end product of the accounting cycle. Accounting process begins with the vouchers. Vouchers are the supporting documents providing evidence that an accounting transaction has taken place and also the amounts involved. Accounting process is made up of recording, classification and summarization. All the transactions recoded at the first stage are later classified and summarized to prepare the financial statements. A chart of accounts shows the list of all accounts in which the accounting transactions are recorded.

58  Chapter 3

• Accounts are of three types—real, personal and nominal. Real accounts pertain to assets, • • • • • •

• • • • •





personal accounts pertain to receivables and payables and nominal accounts pertain to incomes and expenses. Accounting transactions are recorded by way of journal entries. While recording an accounting transaction, one or more accounts are debited and others are credited in such a way that the sums of debits and credits in a transaction are the same. In respect of real accounts the recording rule states ‘debit what comes in and credit what goes out’. For personal account we ‘debit the receiver and credit the giver’. For nominal accounts ‘incomes and gains are credited whereas losses and expenses are debited’. Journal entries are passed in a chronological order, i.e., in the order in which they take place. Accounting transactions recorded by way of journal entries are classified under different accounts. An account is a T-shaped statement with the left-hand side called Debit Side (Dr.) and the righthand side being Credit Side (Cr.). The process of classification is called ledger posting. At the end of the accounting period, all accounts are balanced to find the closing balances. An account where the sum of debit side is greater than the sum of credit side is said to be having a debit balance whereas an account having higher credits than debits will have a credit balance. The balance in each account are put in a T-shaped statement called the Trial Balance. The debit side of the Trial Balance will have all accounts with debit balances whereas accounts with credit balances are placed on the credit side of the Trial Balance. Because of doubleentry bookkeeping system, both the sides of the Trial Balance will be equal. At the end of the accounting period, some adjustment entries may have to be passed to give effect to the accrual and matching principles, e.g., outstanding expenses, prepaid expenses, income accrued but not received, income received in advance, depreciation, closing stock, etc. After passing necessary adjustment entries, a revised trial balance is prepared which forms the basis of the preparation of financial statements. Nominal accounts are temporary accounts. They are closed at the end of the accounting period by transferring their balances to the profit and loss account by passing transfer entries or closing entries. Nominal accounts representing incomes or gains are closed by transferring them to the credit side of the profit and loss account. Accounts relating to expenses and losses are closed by transferring their balances to the debit side of the profit and loss account. If the credit side of the profit and loss account is greater than the debit side, the difference is called profit. The profit is transferred to the Capital account of the owner by debiting profit and loss account and crediting Capital account. In case the debit side is greater, the resultant loss is transferred to the Capital account by crediting profit and loss account and debiting Capital account. Permanent accounts—real and personal—are arranged in the Balance Sheet of the enterprise at the end of the accounting period. The Liability side of the Balance Sheet will have all personal accounts with credit balances—representing either capital or liabilities. The Asset side of the Balance Sheet will have real accounts (assets) and personal accounts with debit balances representing receivables. Because of the double entry bookkeeping system, the sum of the two sides will be equal. The closing balances of real accounts and personal accounts will be carried forward to the next accounting period as opening balances.

Accounting Cycle  59

Assignment Questions 1. 2. 3. 4.

Describe various stages in accounting process. Identify different categories of accounts and the rules for debits and credits. What is the purpose of preparing Trial Balance? Explain its structure. Nominal accounts are closed out at the end of the accounting period whereas personal accounts and real accounts are carried forward to the next accounting period. Why?

Problems 1. Types of accounts: Classify the following accounts as real, personal or nominal: a. Bank Account b. Furniture Account c. Salary Account d. Cash Account e. Rent Outstanding f. Bank Overdraft g. Capital Account h. Sales i. Accounts Receivables j. Sundry Creditors 2. Transaction analysis and journal entries: Analyze the following transactions and pass necessary journal entries: a. 1st October 2016: Goods sold on credit to SM & Sons for ` 1,250,000. b. 1st December 2016: Payment received from SM & Sons by cheque ` 500,000. c. 15th January 2017: It was decided to write off the amount due from SM & Sons. d. 1st June 2017: Payment received from SM & Sons towards full and final settlement ` 300,000. 3. Preparation of trial balance: The followings balances were extracted from the books of Snow White & Co on 31st December 2017. You are required to arrange them in a Trial Balance. Particulars

Dr.

Purchases

11,250,000

Particulars Creditors

Capital

9,309,375

Discount allowed

Inventories (1st January 2017)

3,750,000

Bank balance

Sales Discount earned Debtors Freight

16,875,000 84,375 2,625,000 22,500

General expenses Bad debts Furniture Wages and salaries

Cr. 2,812,500 150,000 4,687,500 562,500 75,000 937,500 1,125,000 (continued )

60  Chapter 3 (continued )

Particulars Cash in hand Machinery

Dr. 183,750 1,875,000

Particulars

Cr.

Repair

187,500

Purchase return

187,500

Provision for depreciation

562,500

Rent received

225,000

Sales return

562,500

Interest earned

187,500

Premises

2,250,000

4. Adjustment entries and adjusted trial balance: After preparing the above trial balance, the following adjustments were identified. You are required to pass the necessary adjustment entries, prepare a revised Trial Balance and close the accounts. a. Make provision for depreciation @ 7.5% on machinery on the original cost. b. Stock in hand on 31st December 2017 amounted to ` 2,875,000. c. 3% of the trade receivables are to be provided as doubtful. d. Salaries amounting to ` 175,000 are outstanding. 5. Preparation of profit and loss account and balance sheet: Based upon the revised Trial Balance, prepare the profit and loss account of Snow White & Co for the year ended 31st December 2017 and the Balance Sheet as on that date.

Solutions to Problems 1. 2.

a. b. c. d. e. f. g. h. i. j.

Personal A/c (Receivable or payable) Real A/c (Asset) Nominal A/c (Expense) Real A/c (Asset) Personal A/c (Payable) Personal A/c (Payable) Personal A/c (Payable to the Owner) Nominal A/c (Income) Personal A/c (Receivable) Personal A/c (Payable)

Date 1st October 2016

Analysis

Sales (nominal) and SM & Sons (personal) are the two accounts getting affected. As sales is increasing, it will be credited and SM & Sons being a receiver will be debited. 1st December 2016 Bank (personal) and SM & Sons (personal) are the two accounts. The Bank A/c is a receiver and SM & Sons is a giver. The former will be debited and the later credited.

Journal Entry SM & Sons Dr. 1,250,000    To Sales A/c 1,250,000

Bank A/c Dr. 500,000    To SM & Sons 500,000

(continued )

Accounting Cycle  61

Date

Analysis

Journal Entry

15th January 2017

Bad Debt is a loss (nominal) and SM & Sons Bad Debts A/c Dr. 750,000 will be affected. Bad Debt account will be    To SM & Sons 750,000 debited for the amount of loss whereas the debit balance in the SM & Sons will be written off by crediting it with the amount due.

1st June 2017

As the amount due from SM & Sons was completely written off earlier, any recovery now will be treated as a gain. The two accounts will be bad debts recovered (nominal) and bank (personal)

Bank A/c Dr. 300,000   To Bad Debts Recovered           300,000

3. Trial Balance of Snow White & Co as on 31st December 2017 Particulars

Dr.

Purchases

11,250,000

Particulars

Dr.

Interest earned

187,500

Inventories (Opening)

3,750,000

Rent received

225,000

Debtors

2,625,000

Purchase return

187,500

Freight Cash in hand Machinery Sales return Premises Discount allowed

22,500

Creditors

183,750

2,812,500

Provision for depreciation

1,875,000

Discount earned

562,500

84,375

Sales

2,250,000

562,500 16,875,000

Capital

9,309,375

150,000

 

4,687,500

 

75,000

 

General expenses

562,500

 

Furniture

937,500

 

1,125,000

 

187,500

 

Bank balance Bad debts

Wages and salaries Repair  

30,243,750

 

30,243,750

4. Adjustment Entries Particulars Depreciation A/c

Dr. 168,750

  To Provisions for Depreciation A/c Closing Stock A/c   To Purchase A/c

Cr.

168,750 2,875,000 2,875,000 (continued )

62  Chapter 3 (continued )

Particulars

Dr.

Bad Debts A/c

Cr.

78,750

  To Provision for Doubtful Debts

78,750

Salary A/c

175,000

  To Outstanding Salary A/c

175,000

Revised Trial Balance Trial Balance of Snow White & Co as on 31st December 2017

 Particulars

Dr.

Particulars

Cr.

Purchases

8,375,000

Interest earned

187,500

Inventories (Opening)

3,750,000

Rent received

225,000

Debtors

2,625,000

Purchase return

187,500

Freight Cash in hand Machinery Sales return Premises Discount allowed Bank balance

22,500 183,750 1,875,000 562,500 2,250,000 150,000 4,687,500

Creditors Provision for depreciation Discount earned Sales Capital Salaries outstanding Provision for doubtful debts

2,812,500 731,250 84,375 16,875,000 9,309,375 175,000 78,750

Bad debts

153,750

 

General expenses

562,500

 

Furniture

937,500

 

1,300,000

 

Depreciation

168,750

 

Repair

187,500

 

Wages and salaries

Closing stock  

2,875,000 30,666,250

30,666,250

Accounting Cycle  63

Transfer Entries Only nominal accounts will be closed by transferring to profit and loss account as follows: Transferring Nominal Accounts with Credit Balances

Particulars

Dr.

Interest Earned A/c

` 187,500

Rent Received A/c

` 225,000

Purchase Return A/c

` 187,500

Discount Earned A/c

` 84,375

Sales A/c

Cr.

` 16,875,000

     To Profit and Loss A/c

` 17,559,375

Transferring Nominal Accounts with Debit Balances

Particulars

Dr.

Cr.

Opening Stock

` 3,750,000

Purchases A/c

` 8,375,000

Freight A/c

` 22,500

Sales Return A/c

` 562,500

Discount Allowed A/c

` 150,000

Bad Debts A/c

` 153,750

General Expenses A/c Wages and Salaries A/c

` 562,500 ` 1,300,000

Depreciation A/c

` 168,750

Repair A/c

` 187,500

     To Profit and Loss A/c

` 15,232,500

5.  Profit and Loss Account of Snow White & Co for the Year Ended 31st December 2017 Particulars

Dr.

Purchases

8,375,000

Less: Purchase return

187,500

 

8,187,500

Inventories (Opening)

3,750,000

Freight Discount allowed

22,500 150,000

Particulars Sales Less: Sales return

Cr. 16,875,000 562,500 16,312,500

Interest earned

187,500

Rent received

225,000

Discount earned

84,375 (continued )

64  Chapter 3 (continued )

Particulars

Dr.

Particulars

Cr.

Bad debts

153,750

 

General expenses

562,500

 

1,300,000

 

Depreciation

168,750

 

Repair

187,500

 

2,326,875

 

Wages and salaries

Profit for the year (Balancing figure)  

16,809,375

 

16,809,375

The profit for the year amount to ` 2,326,875 will be transferred to the Capital A/c by the following journal entry: Profit and Loss A/c Dr. ` 2,326,875   To Capital A/c   ` 2,326,875 Balance Sheet of Snow White as on 31st December 2017

Liabilities

Amount `

Assets

Amount `

Capital

9,309,375

Machinery

1,875,000

Add: Profit for the year

2,326,875

Premises

2,250,000

11,636,250

Furniture

937,500

Less: Provision for depreciation

731,250

  Creditors

2,812,500

Salaries outstanding

175,000

4,331,250

 

 

Debtors

 

 

Less: Provision for doubtful debts

 

 

 

 

Closing stock

2,875,000

 

 

Bank balance

4,687,500

 

 

Cash in hand

183,750

 

2,625,000 78,750 2,546,250

14,623,750  

14,623,750

Accounting Cycle  65

Try It Yourself 1. Transaction analysis and journal entries: Analyze the following transactions and pass necessary journal entries: a. Goods sold to RS & Company for ` 450,000 on credit on 10th April 2017. 50% of goods returned by them on 18th April 2017 being defective. b. SR & Company from whom an amount of ` 925,500 was due made a payment of ` 900,000 as full and final settlement. c. An asset with a book value of ` 225,000 was destroyed by fire. d. Made investment of ` 400,000 in government securities on 28th February 2017. The market value of these investments has fallen to ` 320,000 on the date of the Balance Sheet. e. Make provision towards warranty cost at ` 850,000. 2. Impact on financial for statements: Kong Fuser Ltd prepares its financial statements on financial year basis. How would the following transactions during the year 2017–18 affect the Profit and Loss Account and Balance Sheet of the company: a. Purchased computer on 1st April 2017 to be used in the office for ` 100,000. The useful life of the computer is estimated to be 3 years with zero residual value. b. Purchased stationary items for ` 20,000 during the year. At the end of the year inventory in hand amounted to ` 1,800. c. Purchased land for ` 3,000,000 on 31st October 2017 for setting up office building. d. Paid annual fire insurance premium amounting to ` 22,000 on the office car on 1st October 2017. e. Received an advance payment of ` 1,500,000 from a customer on 28th February 2017, the goods were not yet delivered to him by 31st March 2017. f. Salary paid during the year amounted to ` 2,400,000 including an advance of ` 100,000 paid to one of the employee. Salaries for the month of March 2017 amounting to ` 185,000 were paid in April 2017. 3. Preparation of financial statements: Dare Devil & Co is a small scale manufacturing unit. It procures semi-finished goods and sells them after further processing. The trial balance and additional information as on 31st March 2017 are given below. You are required to prepare the Profit and loss A/c for the year and the Balance Sheet as on that date. Trial Balance of Dare Devil & Co as on 31st March 2017

Particulars

Dr.

Advertising

326,820

Bad debts

40,852

Cash in hand Computers Debtors Discount allowed

Particulars Bank overdraft Capital

235,145

Commission

514,741

Creditors

8,824,140 43,576

Loan from bank Sales

Cr. 768,000 8,878,610 98,046 4,166,955 680,875 23,834,206 (continued )

66  Chapter 3 (continued )

Particulars

Dr.

General expenses

Particulars

208,347

Insurance

Sales tax

Cr. 510,656

54,470

Interest on overdraft

49,023

Inventories (Opening)

2,169,267

Machinery

6,040,195

Purchases

13,873,509

Power and fuel

652,716

Rent

449,377

Sales return

253,285

Wages and salaries

5,201,885

 

38,937,348

38,937,348

Additional Information a. Commission accrued to be received: ` 24,500 b. Insurance expenses include premium paid amounting to ` 15,000 on a machine covering the period from 1st October 2016 to 30th September 2017. c. Loan from the bank attracts interest @ 10%. d. Write off ` 15,000 as bad debts and make a provision for doubtful debts @ 3%. e. The stock in hand at the end of the year is valued at ` 1,387,250. f. Depreciate machinery @ 15% and computer @ 25%. g. Expenses outstanding at the year-end amounted to ` 32,150. 4. Correcting the given trial balance: Roney, a fresh management graduate has recently joined Seven Wonders & Company. He was asked by the Chief Accountant of the firm to prepare the Trial Balance for the year ended 31st March 2017. Roney extracted the balances from the ledger accounts of the company and put them in the Trial Balance. He is pleased with himself that the total of both the sides of the Trial Balance has almost tallied. The Chief Accountant however is not satisfied because the Trial Balance has to exactly match due to double-entry bookkeeping system being followed. You are requested to help Roney in recasting the Trial Balance. The Trial Balance prepared by Roney is given below: Trial Balance of Seven Wonders & Company as on 31st March 2017

Particulars

Dr.

Particulars

Cr.

Machinery

732,089

Capital

1,897,000

Furniture

332,768

Creditors

1,331,800

Bank

303,500

Building

1,700,000

Cash

56,647

Debtors

1,796,950 (continued )

Accounting Cycle  67 (continued )

Particulars

Dr.

Loan from bank Opening stock Sales

1,265,000 402,000 10,715,129

Particulars

Cr.

Provident fund deducted from salaries

33,000

Purchase

8,319,200

Bad debts

66,560

Sales returns

399,300

Insurance premium

74,420

Rent paid

199,660

Phone charges

24,657

Salaries

532,600

 

Interest charges

66,550

 

Electricity expenses

35,368

 

Commission paid  

199,660 15,240,271

15,243,587

5. Adjustment entries and financial statements: Thanks to your help Roney is able to present the re-casted and duly tallied Trial Balance to the Chief Accountant. The Chief Accountant informed him some additional transactions that need to be recorded. a. Stock in hand as on 31st March 2017: ` 988,500. b. Depreciation to be provided at the following rates:   Machinery 7.5%   Furniture 12.5%   Building 2.5% c. Loan from the bank attracts interest at 10%. The loan was outstanding for the whole year. d. There is a pending court case against the firm. It is decided to make a provision towards possible claim for ` 100,000.  Please help Roney in making the necessary adjustment entries and also in preparation of the profit and loss account for the year ended 31st March 2017 and the Balance Sheet on that date. 6. Financial statements from a trial balance: Eighth Wonder & Co is engaged in cosmetics business. The trial balance and additional information as on 31st March 2017 are given below. You are required to prepare the profit and loss account for the year and the Balance Sheet as on that date. Trial Balance of Eighth Wonder & Company as on 31st March 2017

Particulars

Dr.

Particulars

Cr.

Investments

3,500,000

Capital

9,010,325

Machinery

5,140,875

Creditors

1,841,875

Furniture

3,718,750

Loan from bank

1,443,750

Bank

87,500

Sales

Cash

32,815

Provision for doubtful debts

262,500

Discount

175,000

Debtors

1,750,000

13,212,500

(continued )

68  Chapter 3 (continued )

Particulars

Dr.

Particulars

Cr. 87,500

Opening stock

4,375,000

Salaries outstanding

Purchase

5,403,125

Interest on investments

Sales returns

345,625

59,060

 

Rent paid

109,375

 

Salaries

201,250

 

54,750

 

Interest charges Wages

1,192,200

 

Depreciation

196,875

 

Commission paid

459,375

 

Accrued interest

65,625

 

Bad debts

32,500

 

26,379,075

26,379,075

 

Additional Information: 1. Closing stock in hand as on 31st March 2017 is ` 625,000. 2. Goods costing ` 90,000 have been sold on approval basis for ` 120,000 and included in sales. The approval from the customer is yet to be received. 3. Provision for doubtful debts to be created at 2%. 7. Financial Statement from a Trial Balance: From the following Trial Balance of SSS Limited, prepare the profit and loss account for the year ended 31st March 2017 and a Balance Sheet on that date: Trial Balance of SSS Limited as on 31st March 2017

Particulars

Debit (`)

Particulars

Credit (`)

Land and building

37,321,250

Equity share capital (Face value ` 10 each)

51,125,000

Plant and machinery

68,712,000

Sundry creditors

15,337,500

Furniture and fixtures

29,141,250

Sales

Purchases

68,712,000

12% Debentures

28,630,000

Sundry debtors

18,405,000

Purchases returns

5,010,250

Sales returns

2,249,500

Discount received

Opening stock

4,908,000

Reserves and surplus

31,902,000

Bad debts

1,942,750

Bank overdraft

30,675,000

165,133,750

2,147,250

(continued )

Accounting Cycle  69

Particulars Salaries and wages Interest on bank overdraft Advertisement Annual fire insurance premium (with effect from May 01, 2016) Investments (8% p.a.)

Debit (`)

Particulars

Credit (`)

52,147,500 3,067,500 12,270,000 1,840,500

20,450,000

Discount allowed

1,227,000

General expenses

5,521,500

Cash at bank

2,045,000 329,960,750

329,960,750

Additional Information: a. Goods costing ` 5,000 were distributed as free samples during the year. Goods costing ` 45,000 were destroyed by accident and the insurance company has admitted a claim for ` 35,000. These transactions were not recorded in the accounts. b. Closing stock as physically verified on 31st March 2017 amounted to ` 50,000. c. Provide depreciation on land and building @ 2%, plant and machinery @ 20% and on furniture and fixtures @ 10% p.a. d. Make a provision for doubtful debtors @ 5%.

4

Financial Statements of Companies

CHAPTER OBJECTIVES

This chapter will help the readers to: • Get an overview of financial statements of companies. • Develop understanding of Ind AS 1 relating to presentation of information in financial statements. • Appreciate objectives and interrelationship between various financial statements.

4.1 INTRODUCTION The accounting cycle, leading to the preparation of financial statements as discussed in Chapter 3, is followed by all accounting entities. However, companies are subject to much higher requirements of disclosure. Obviously, they use vast societal resources, and therefore, many stakeholders are interested in their financial performance and health. Disclosures in financial statements of companies are guided by the requirements of the Companies Act, 2013 and the relevant accounting standards. To ensure standardized presentation for easy comparability, the format of the balance sheet and the statement of profit and loss has been prescribed in the Schedule III of the Companies Act, 2013. Additionally, Ind AS 1 lays down the basic requirements for the presentation of financial statements to ensure comparability, both with the entity’s financial statements of previous periods and with the financial statements of other entities.

4.1.1  Purpose of Financial Statements Financial statements provide information about the financial position, financial performance and cash flows of an entity which is useful to users in making economic decisions. In particular, financial statements provide information about an entity:

(a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and losses; (e) contributions by and distributions to owners in their capacity as owners; and (f) cash flows.

This information is useful for forecasting the entity’s future cash flows especially, their timing and certainty.

Financial Statements of Companies    71

4.1.2  Key Requirements for Presentation Ind AS 1 also lays down some of the key requirements to be followed for presenting information in financial statements. (i) Going Concern—Financial statements are prepared on a going concern basis. Management has to assess the entity’s ability to continue as a going concern. If financial statements are not based upon going concern basis, the reasons are to be disclosed. (ii) Accrual Basis of Accounting—Financial statements, except cash flow statement, are required to be prepared using accrual basis of accounting. (iii) Materiality—Each material class of similar items must be presented separately and same has to be followed for the items of dissimilar nature or function. If a line item is not individually material, it is aggregated with other items either in those statements or in the notes. An item, that is not sufficiently material to warrant separate presentation in those statements, may warrant separate presentation in the notes. (iv) Offsetting—Assets and liabilities or income and expenses are required to be shown on gross basis without offsetting against each other, unless required or permitted by an Ind AS. (v) Frequency of Reporting—Financial statements must be presented annually. If the entity changes, its accounting period and financial statements are prepared for a period longer or shorter than one year. The reason for using a longer or shorter period shall be disclosed with a statement that financial statements are not entirely comparable. (vi) Comparative Information—Comparative information in respect of the preceding accounting period for all amounts presented in the currents year’s financial statements shall be given for better analysis. (vii) Consistency—Presentation and classification of items in the financial statements from period to period shall be consistently followed. However, if an Ind AS requires a change in presentation or another presentation or classification is considered to be more appropriate, the classification and presentation may be changed. (viii) True and Fair—Financial statements shall present information which is relevant, reliable, comparable and understandable. It is presumed that financial statements that are compliant with the Ind AS present a true and fair view of the financial position, performance and cash flow of the entity. Any deviation from compliance with Ind AS shall be explicitly disclosed.

4.2  FINANCIAL STATEMENTS As per Ind AS 1, a complete set of financial statements comprises:

(i) A statement of profit and loss for the period.

(ii) A balance sheet at the end of the period. (iii) Statement of changes in equity for the period. (iv) A statement of cash flows for the period. (vi) Notes—comprising a summary of significant accounting policies and other explanatory information.

72  Chapter 4

To ensure uniformity in the presentation of financial statements, the formats for the statement of profit and loss and the balance sheet have been prescribed in the Schedule III of the Companies Act, 2013. The Schedule III also includes general instructions for the preparation of financial statements. Accordingly, it is mandatory to present current year figures and the comparative figures of the previous year. The figures in financial statements may be rounded off depending upon the turnover of the company. If the turnover is less than ` 100 crore, the figures may be rounded off to the nearest hundreds, thousands, lakh or millions. If, however, it is ` 100 crore or more, rounding off is permitted in the nearest lakh, millions or crore. Each entry in the balance sheet, statement of changes in equity and statement of profit and loss is required to be cross-referenced with the related information in the notes. All material items—information that individually or collectively could be relevant for decision making by users—shall be disclosed. At the same time, excessive disclosures shall be avoided. Materiality of an item should be judged in the particular circumstances considering the size or nature of the item or a combination of both. In addition, disclosures required by any law or regulation shall also be made.

4.3  STATEMENT OF PROFIT AND LOSS The statement of profit and loss (also called profit and loss account) is the primary financial statement to understand the financial performance of an enterprise during a given period. It summarizes incomes earned and expenses incurred by an enterprise during a given period. If the aggregate income earned exceeds the expenses incurred, the difference is called net income or simply net profit. If, however, the income fails to cover the expenses, the enterprise is said to have incurred a loss. The purpose of the statement of profit and loss is to provide information about different sources of income and gains and also expenses and losses incurred during an accounting period. Incomes and expenses may be arranged one after the other and such a presentation is called vertical format. The same information may also be presented in a T-shaped format wherein incomes are presented on the right-hand side and expenses are on the left-hand side, such a presentation is called horizontal format. The Schedule III prescribes the vertical format to be followed showing income first followed by expenses. The statement of profit and loss is presented in two sections:

(i) Profit or loss for the period.

(ii) Other comprehensive income (OCI) for the period. The sum of (i) and (ii) above is called total comprehensive income. It may be noted that these are not two different statements rather two sections of the same statement. Profit or loss is defined as ‘the total of income less expenses, excluding the components of other comprehensive income’. Other comprehensive income is defined as ‘comprising items of income and expense (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other Ind ASs. It may be noted that the classification of income and expense between profit or loss and OCI is not principle-based but is rule-based. Whether an item of income or expense is to be presented in profit or loss or in OCI is based upon the requirements of the relevant Ind AS. The format and contents of the statement of profit and loss have been discussed in detail in Chapter 5.

Financial Statements of Companies    73

Income represents increase in economic benefits during the accounting period. The increase in economic benefits may be in the form of inflows or enhancement of assets or decrease in liabilities. An entity may earn income by sale of goods, provision of services, or by letting others use its assets, e.g., rent, interest, royalty, etc. Income earned from its main revenue generating activities (from core operations) is called revenue from operations. Income from incidental activities is presented as other income. The sum total of revenue from operations and other income is called total income for the period. Expenses represent decrease in economic benefits during the accounting period. The decrease is evidenced by outflow or depletion of assets or increase in liabilities. Expenses are presented under various heads depending upon their nature. For example, material consumed, employee benefits, finance cost, depreciation, etc. Income and expense are recorded using accrual basis of accounting. Income is recognized if it is probable that the future benefits will flow to the enterprise and that same can be measured reliably. Expense is recognized if it is probable that the future benefits will flow from the entity and that the cost can be measured reliably.

4.4  BALANCE SHEET The balance sheet in simple terms is a statement of assets and liabilities of a business enterprise on a particular day. It is prepared on the last day of the accounting period. Unlike the statement of profit and loss which summarizes the incomes earned and expenses incurred during an accounting period, balance sheet depicts what the business own (assets) and what is owes (liabilities) on a particular day, i.e., at the end of the accounting period. Accordingly, statement of profit and loss is a flow statement, whereas balance sheet is a position statement. The format of the balance sheet has been prescribed in the Schedule III of the Companies Act, 2013. The balance sheet represents the basic accounting equation, i.e., Assets = Equity + Liabilities. The information may be presented one after the other in a vertical format. The same information may also be given in a T-shaped format. Assets are presented on the right-hand side and equity and liabilities are shown on the left-hand side. Such a presentation is called horizontal format. The Schedule III prescribes the vertical format to be followed in which details of assets are followed by equity and liabilities. An asset is a resource controlled by an entity as a result of past events from which future economic benefits are expected to flow to the entity. The future benefits may be in the form of increase in cash flow or reduction in the cash outflow. Assets are classified as current assets and non-current assets. Current assets include cash and cash equivalents and those assets that are expected to be consumed or converted into cash within 12 months or in the normal operating cycle of the business. For example cash, bank balance, inventories, trade receivables, short-term loans and advances, short-term investments, etc. Assets other than current assets, for example, land, building, plant, equipment, vehicles, long-term investments, long-term loans and advances are classified as non-current assets or fixed assets. As per the format prescribed in the Schedule III, non-current assets are presented first, followed by current assets. A liability is a present obligation of an enterprise arising from past events. The settlement of the obligation would require outflow of resources in future. Equity represents the contribution of the owner to the enterprise. It is the residual interest in the assets of the enterprise after deducting all liabilities. Liabilities are further classified as current and non-current or fixed liabilities. Current liabilities are expected to be settled within 12 months or in the normal operating cycle of the business.

74  Chapter 4

For example, short-term loans, trade payables for goods and services, outstanding expenses, advances from customers, short-term provisions, etc. All other liabilities are classified as non-current liabilities. Non-current liabilities are expected to be settled after 12 months or beyond the normal operating cycle of the enterprise. For example, term loans from banks, long-term provisions, etc. As per the format prescribed in the Schedule III, non-current liabilities are presented first, followed by current liabilities.

4.5  STATEMENT OF CHANGE IN EQUITY Schedule III requires a separate ‘statement of change in equity’ to be presented comprising equity share capital and other equity. Other equity includes all items other than equity shares that are attributable to the holders of equity instruments of an entity. The statement of change in equity represents a reconciliation of equity, shows balances in the beginning of the year, changes occurred during the year, and balances at the end of the year. Ind AS 1 requires such reconciliation for each component of equity showing separately changes resulting from: (i) profit or loss; (ii) other comprehensive income; (iii) transactions with owners in their capacity as owners, showing separately contributions by, and distributions to owners and changes in the ownership interests in subsidiaries that do not result in a loss of control; and (iv) any item recognized directly in equity. The balance sheet depicts the equity balance at the end of the accounting period. The statement of change in equity identifies the reasons for change in the various components of equity during the year. The primary reasons for change in equity are profit or loss for the year, other comprehensive income for the year, distribution of dividend to the shareholders, issue of fresh shares, buy-back of shares and any direct adjustment in the equity balances.

4.6  CASH FLOW STATEMENT Cash flow statement provides detail about the sources and uses of cash during an accounting period. The balance sheet shows the cash balance on a particular date but it does not explain the change in the cash position since the last balance sheet date. The cash flow statement aims to explain the variation in cash position between two balance sheets by showing the sources and uses of cash. The cash flows are broken under three heads: (i) Cash Flow from Operating Activities—sources and uses of cash arising directly from the main revenue generating activities of the organization. (ii) Cash Flow from Investing Activities—sources and uses of cash related to investing in long-term assets including long-term investments. This also includes the income generated from these long-term investments. (iii) Cash Flow from Financing Activities—sources and uses of cash related to funds raising activities including repayment of loans, payment of interest on borrowed funds and payments of dividends on shares.

Financial Statements of Companies    75

Cash flow statement helps the users in understanding the cash generating ability of the business organization and the needs of the entity to utilize these cash flows. Ind AS 7 deals with the presentation and disclosure of cash flow statement.

4.7  NOTES TO ACCOUNTS Notes to accounts are used to present information about the basis of preparation of the financial statements and the specific accounting policies used. It also provides information as may be required by various Ind ASs those are not presented elsewhere in the financial statements. Additional information, relevant for understanding the financial statements, is also provided in the notes to accounts. Notes to accounts shall be presented in a systematic manner. Each item in the balance sheet, the statement of profit and loss, the statements of changes in equity and cash flows statement is crossreferenced to any related information in the notes to accounts. The notes to accounts also include a statement that the relevant accounting standards have been complied with. The purpose and inter-relationship between various financial statements is depicted in Figure 4.1. Financial statements

Statement of profit and loss

Balance sheet

Income and expenses during a year

Assets, equity and liabilities at end of the accounting year

Statement of change in equity Reconciliation of various items of equity during a year

Cash flow statement

Inflow and outflow of cash during a year

Notes to accounts Accounting policies and explanation to items in other financial statements

Figure 4.1  Financial Statements of a Company

Summary

• Financial statements of companies are more structured and detailed as these are used by a large number of stakeholders.

• Financial statements of companies consist of the statement of profit and loss, the balance • •

sheet, the statement of change in equity, the cash flow statement and notes to accounts. To ensure uniformity in presentation, formats of the statement of profit and loss and the balance sheet have been prescribed in the Schedule III of the Companies Act, 2013. Cash flow statement is required to be prepared in accordance with the requirements of Ind AS 7.

76  Chapter 4

• Ind AS 1 lays down the key requirements for presenting financial statements—going concern, • • • • • •

accrual basis of accounting, materiality, consistency and accounting period are some of the basic accounting principles emphasized. Financial statements must comply with the applicable AS to give a true and fair view of the financial performance, financial health and cash flows. The statement of profit and loss provides a summary of income earned and expenses incurred during the year. It is presented in two sections—profit or loss and other comprehensive income. The sum total of the two is called other comprehensive income. The balance sheet is a statement of assets on the one side and equity and liabilities on the other. Assets and liabilities are split as current and non-current. The statement of change in equity provides reconciliation between opening balances and closing balances under the heading equity. The cash flow statement presents inflows and outflows of cash during the year. It explains the changes in cash balance during the year. It helps in assessing the cash generating ability of the enterprise and also uses of cash. Notes to accounts give an overview of significant accounting policies followed in the preparation of financial statements. It also provides details as required by Ind AS and other details that may be necessary for better understanding of information presented in the financial statements. Information presented in financial statements are cross-referenced with the relevant notes to accounts.

Assignment Questions 1. Financial statements of companies are much more detailed and structured. Why? 2. Explain the key requirements as laid down by Ind AS 1 relating to the presentation of financial statements. 3. Write a short note on various financial statements which are required to be prepared by a company. 4. The statement of profit and loss is a flow-based statement whereas the balance sheet is a static statement. Explain. 5. For better understanding of financial statements, it is important to go through the notes to accounts. Do you agree?

Problems 1. Ramesh, a fresh graduate, has recently joined his first job in a bank. His supervisor has asked him to find certain information from financial statements of a company. Please help him by suggesting which financial statement will contain the following information:

Financial Statements of Companies    77



a. b. c. d. e. f. g.

Inventory in hand at the end of the year Employee cost during the year Cash and bank balance Cash outflow on account of purchase of investments Operating income during the year Accounting policies Reasons for change in equity during the year



h. Intangible assets i. Material consumed during the year j. Details regarding non-current investments

Solution to Problem 1.

a. b. c. d. e. f. g. h. i. j.

Balance sheet Statement of profit and loss Balance sheet Cash flow statement Statement of profit and loss Notes to accounts Statement of change in equity Balance sheet Statement of profit and loss Notes to accounts

Try It Yourself 1.

Identify financial statements which include the following information: a. Shares issued during the year b. Other income earned during the year c. Trade receivables at the end of the year d. Depreciation on assets charged during the year e. Accumulated depreciation on assets f. Dividend received during the year g. Interest earned during the year h. Loan outstanding i. Loan repaid during the year j. Interest expenses during the year

Statement of Profit and Loss

5

CHAPTER OBJECTIVES This chapter will help the readers to: • Understand the contents of statement of profit and loss in depth. • Appreciate the issues involved with accrual of expenses. • Prepare the statement of profit and loss as per the requirements of the Companies Act, 2013. • Differentiate various measures of profits—gross profit, operating profit, pre-tax profit and • net profit. • Calculate and interpret basic earnings and diluted ­earnings per share. • Appreciate the requirements of applicable accounting standards—Ind AS 12 (income taxes), Ind AS 19 (employees benefits), Ind AS 23 (borrowing costs), Ind AS 33 (earnings per share), Ind AS 102 (share based payment) and Ind AS 105 (discontinuing operations).

5.1 INTRODUCTION To ensure the uniformity in the presentation of the statement of profit and loss, the format for the same has been prescribed in the Schedule III of the Companies Act, 2013. The information is presented in a vertical format—income followed by expenses. As discussed in the Chapter 4, the statement of profit and loss is divided into two sections: 1. Profit or loss for the period;

2. Other Comprehensive Income for the period.

The sum of (1) and (2) above is called total comprehensive income. Profit or loss is defined as ‘the total of income less expenses, excluding the components of other comprehensive income’. Other comprehensive income is defined as ‘comprising items of income and expense (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other Ind ASs. Other comprehensive income shall further be presented as:

1. Items that will not be reclassified to profit or loss and its related income tax effects.



2. Items that will be reclassified to profit or loss and its related income tax effects.

Reclassification adjustments are amount reclassified to profit or loss in the current period that were recognized in other comprehensive income in the current or previous periods. Total comprehensive income comprises all components of profit or loss and of ‘other comprehensive income’. The statement of profit and loss is a single statement which presents profit or loss and other comprehensive income in two sections.

Statement of Profit & Loss  79

5.1.1  GAAP Revisited Let us recall some of the relevant accounting principles having a direct bearing on the information presented in the statement of profit and loss. 1. Accounting period: The statement of profit and loss concerns only the income and expenses incurred during the given accounting period. Income and expenses pertaining to earlier or subsequent accounting period are not considered. 2. Separate entity principle: The statement of profit and loss shows the income and expenses of the business entity as a unit. Any transaction between the business entity and others—including owner—will be recorded as an accounting transaction. 3. Money measurement principle: The income, gains, expense and losses that can be expressed in terms of money only are shown in the statement of profit and loss. Income earned and expenses incurred in a currency other than the reporting currency are converted in the reporting currency for incorporating in the statement of profit and loss. 4. Accrual principle: The income is recorded when earned and expenses are recorded when incurred. The statement of profit and loss is not based on cash basis but on accrual basis. 5. Matching principle: Income is matched against the expenses incurred to earn that income to ascertain profit. 6. Conservatism principle: It is better to understate the profit rather that overstate. Accordingly, incomes and gains are recorded when reasonably certain but expenses and losses are recorded even when reasonably probable. 7. Materiality principle: In deciding the level of details to be given in the statement of profit and loss, we are guided by materiality principle. Any information relevant for the user, must be disclosed but, at the same time, irrelevant details can be avoided.

5.2  FORMAT OF STATEMENT OF PROFIT AND LOSS The Schedule III prescribes the vertical format to be followed. The format of the statement of profit and loss is shown in Table 5.1 and related instructions for preparation of the statement are given in Appendix I to this chapter. Table 5.1  Format for the Profit and Loss Statement for the Year Ended Note No.

Figures as at the End of Current ­Reporting Period

I) Revenue from operations II) Other income III) Total Revenue (I +II) IV) Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

Cost of materials consumed

 

 

 

Purchase of Stock-in-Trade

 

 

 

Particulars

Figures as at the End of Previous Reporting Period

(continued )

80  Chapter 5 (continued )

Note No.

Figures as at the End of Current ­Reporting Period

Changes in inventories of finished goods, workin-progress and stock-in-trade

 

 

 

Employee benefit expense

 

 

 

Finance costs

 

 

 

Depreciation and amortization expense

 

 

 

Other expenses

 

 

 

Total Expenses  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Particulars



V)  Profit/(Loss) before exceptional items and tax (III – IV)

VI) Exceptional Items

Figures as at the End of Previous Reporting Period

VII)  Profit/(Loss) before tax (V – VI) XVIII) Tax expense: (1) Current tax (2) Deferred tax IX)  Profit/(Loss) from the period from continuing operations (VII – VIII)

X)  Profit/(Loss) from discontinued operations

XI) Tax expense of discounted operations XII)  Profit/(Loss) from discontinuing ­operations (X – XI)

 

 

 

XIII) Profit/(Loss) for the period (IX + XII)

 

 

 

XIV) Other comprehensive income (1)  (a) Items that will not be reclassified to profit and loss   (b) Income tax relating to items that will not be reclassified to profit and loss (2)  (a) Items that will be reclassified to profit and loss   (b) Income tax relating to items that will be reclassified to profit and loss

 

 

 

XV) T  otal comprehensive income for the period (XIII + XIV) comprising profit (Loss) and other comprehensive Income for the period)

 

 

  (continued )

Statement of Profit & Loss  81 (continued )

Note No.

Figures as at the End of Current ­Reporting Period

XVI) Earnings per equity share (for ­continuing operations) (1) Basic (2) Diluted

 

 

 

XVII) Earnings per equity share (for discontinued operations) (1) Basic (2) Diluted

 

 

 

XVIII) Earnings per equity share (for discontinued and continuing operations) (1) Basic (2) Diluted

 

 

 

Particulars

Figures as at the End of Previous Reporting Period

It may be noted that the Schedule II sets out the minimum requirements for disclosure in financial statements. If any act or regulation requires specific disclosures to be made, such disclosure are required to be made in addition to the requirements of the schedule and it must be ensured that such additional disclosures are made in the notes or as additional statements. Financial Statements shall disclose all material items. Each item mentioned in statement of profit and loss is cross-referenced to any information in the notes.

5.3 REVENUE The revenue represents income earned by an enterprise by sales of goods, provision of services or by permitting others to use sources owned by the enterprise. The terms revenue or income are often used interchangeably. The revenue earned is split into two subheads—operating revenue and other income. The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income, and may or may not arise in the course of the ordinary activities of an entity, for example, those arising on the disposal of non-current assets1.

5.3.1  Revenue from Operations This heading includes the income earned by the enterprise from its main operating activities. The revenue from operations must be disclosed separately under the following headings:

1. Sale of products



2. Sale of services



3. Other operating revenues

82  Chapter 5

Companies engaged in manufacturing and trading activities derive majority of their income from sales of products. The revenue from sales of products is recognized using accrual basis of accounting when the sale is complete and the ownership of goods have been transferred to the buyer. On the other hand, companies in the service sector earn their income by providing services. The revenue in such cases is recognized upon a proportionate basis. Besides income from sales of goods and provisions of services, the enterprise may earn ‘other operating revenue’. For example, income from sale of scraps by a manufacturing organization is shown as ‘other operating income’. For entities engaged in financing activities, interest earned will be a part of operating revenue. Likewise for an investment company, trading gains are part of operating revenue. Again the revenue is recognized using accrual basis of accounting irrespective of timing of receipt. Revenue includes the gross inflow of benefits to the entity on its own account. Amount collected, if any, on behalf of third parties are therefore excluded from revenue. For example, most of the indirect taxes, e.g., Goods and Services Tax (GST). Value Added Tax (VAT), sales tax, service tax, etc., are collected from the customer on behalf of the government. The business enterprise is merely collecting the tax as an agent and passing on the same to the government, and therefore, the same should not be recorded as revenue. However, if the indirect tax is collected by the enterprise on its own account as a principal and it pays the tax to the government on its own account, the revenue will be taken on gross basis. For example, an entity pays excise duty to the government on production of goods and built in the same in the sale price. In such a case, the revenue will be shown on gross basis (inclusive of excise duty) and excise duty paid will be shown separately under expenses.

5.3.2  Other Income In addition to earning revenue from its main operating activity, a business enterprise may also earn revenue from other sources—sources incidental to its operations. Income derived from other such activities is classified as other income. The purpose of separating other income from operating income is to convey the users as to what extent the revenue is being earned from main operations of the enterprise. Other income is classified as:

1. Interest income



2. Dividend income



3. Other non-operating income (net of expenses directly attributable to such income)

Whether an income should be classified as ‘other operating income’ or ‘other income’ depends upon the source of income and to what extent it is related to the main revenue generating activity of the business. To illustrate rental income for a pharmaceutical company from letting out a part of its premises is classified as ‘other income’ whereas rental income for a real estate company engaged in construction and sale of real estate is classified as ‘other operating income’. Similarly, gain on sale of assets is better classified as ‘other income’ whereas sale of manufacturing scrap is classified as ‘other operating income’. The break-up of income earned by Maruti Suzuki India Limited for the years 2016 and 2017 is given in Table 5.2.

Statement of Profit & Loss  83

Table 5.2  Income break-up of Maruti Suzuki India Limited2 Income

(` in Million) 2017

2016

696,253

583,858

65,155

55,719

761,408

639.577

Income from services

3,917

3,428

Sale of scrap

3.830

3.564

889

776

Sale of products Vehicles Spare parts/dies and moulds/components Other operating revenue

Recovery of service charges Liabilities no longer required written back Rental income Others Revenue from operations

35

694

370

313

2,213

2,194

11,254

10,969

772,254

650,546

Other income Interest income on Bank deposits Income tax refund Receivables from dealers Advance to vendors Others

12



-

885

343

545

16

3

1

77

129

107

209



Dividend income Dividend from equity investments Other gains and losses Net gain on sale of investments in associates Net gain on sale of investments in debt mutual funds Fair value gain on investment in debt mutual funds Net foreign exchange gains Other income

612

974

21,203

12,019

273



22,798

14,610

It may be observed that the major portion of the total income of Maruti Suzuki India Limited is derived from sale of products and other operating income. The contribution of other income in the total income is proportionately small. The timing and quantum of revenue to be recognized is one of the most critical aspects in accounting. The issues relating to revenue recognition have been covered in detail in Chapter 7. Income

84  Chapter 5

received during an accounting period is adjusted to arrive at income to be recognized in the statement of profit and loss in the following manner:

Income received during the year Add: Income earned during the year but not received Add: Income received in earlier years but pertains to the current year Less: Income received in advance in the current year Less: Income earned in earlier years but received in the current year.

■  Illustration 5.1

Diamond Real Estate Limited has two office premises which are given on rent. During the year 2016– 17, it received rent of ` 4,300,000 in respect of these two premises. The following additional information is available: Premises 1 Amount of ` 200,000 towards rent was outstanding to be received as on 31st March 2016, the same was duly received in the year 2016–17. As on 31st March 2017 rent amounting to ` 300,000 is yet to be received. Premises 2 It was let out on 1st July 2016 at an annual rent of ` 2,400,000. The entire rent was paid by the tenant in advance for the period 1st July 2016 to 30th June 2017. How much will be recognized as rent income for the year 2016–17? ( `) Rent received during the year 4,300,000 Less: Outstanding rent of premises 1 for 2015–16 received during 2016–17 200,000 Less: Rent received in advance for premises 2 (April–June 2017) 600,000 Add: Rent receivable for premises 1 for 2016–17 300,000 Rent income in the statement of profit and loss 3,800,000 The sum total of revenue from operations and other income is the total income of the entity for the accounting period.

5.4 EXPENSES Expense represents the cost of inputs consumed for the purpose of generating revenue. Expenses result in either an outflow of cash or decline in asset or increase in liability. Expenses considered in the statement of profit and loss are called operating expenses or revenue expenses as distinguished from capital expenditure. Applying accrual basis of accounting, expenses are recorded when incurred and not necessarily when paid. The expenses paid during a year are adjusted for expenses incurred but not paid and expenses paid in advance. The following adjustments are required to be made:

Expenses paid during the year Add: Expenses outstanding (incurred but not paid) Less: Paid in advance (paid but not incurred) Add: Paid in earlier years but pertain to the current year Less: Expenses of earlier years (outstanding) paid in the current year

Statement of Profit & Loss  85

■  Illustration 5.2

On the basis of the following information, find the expenses to be recognized in the statement of profit and loss for the year 2016–17. Salary paid during the year: ` 5,300,000. Salary for the month of March 2017 is outstanding amounting to ` 450,000. Insurance premium paid during the year: ` 350,000. The company bought a new machine on 1st December 2016 which was insured on the same date by paying an annual premium of ` 60,000. Interest paid during the year: ` 1,000,000. The company had borrowed a sum of ` 10,000,000 from SBI on 1st October 2015 @ 10% per annum. The loan amount with interest was repaid on 30th September 2016. The expenses will be recognized as follows: The salary will be recorded at ` 5,750,000 including salary outstanding. Insurance premium will be recorded at ` 310,000. The premium paid on the new machine covers a period of 12 months including eight months of 2016–17. Accordingly, the proportionate premium paid is advance in deducted from the premium paid. Interest expense will be shown at ` 500,000. Though the interest paid is ` 1,000,000, on time proportionate basis interest for six months will be recognized in the year 2016–17. Expenses are classified under various heads based on the nature of expense. Expenses encompasses losses as well expenses that arise in the ordinary activities of the company. The level of details is decided keeping in mind the materiality of the disclosures. It is necessary to strike a balance between too much aggregation and providing too much details. The classification of expenses as given is Part II of Schedule III is discussed below.

5.4.1  Cost of Material Consumed In case of manufacturing companies, this may constitute the biggest share of expenses. For the purpose of disclosure under this heading, the followings points must be noted:

• Materials consumed would consist of raw materials and other materials, such as purchased inter• • •

mediates and components which are ‘consumed’ in the manufacturing activities of the company. These materials physically enter into the composition of the finished product. Materials, such as stores, fuel and spare parts for machinery are not shown under this heading as they do not form part of the finished product. Packing material may or may not be taken as a part of this heading. If the packing is of essential nature, it may be included under this heading whereas packing material for publicity purposes may not be so included. The amount to be disclosed relates to material consumed and not material purchased. This is consistent with the matching principle. The actual consumption of material may be compiled from the internal records of the company. Alternatively, the material consumed is derived by making suitable adjustments with respect to the opening stock and closing stock of raw material using Equation 5.1.

86  Chapter 5

Cost of material consumed = Opening stock of material + Material purchased during the year – Closing stock of material (5.1)

5.4.2  Purchase of Stock-in-Trade This heading deals with purchase of goods with the intention to resell without further processing. An enterprise which is engaged in trading activity, i.e., buying and selling of goods will disclose the goods purchased under this heading. Likewise, a manufacturing company may also be buying certain goods for reselling without further processing. Such purchases need to be distinguished from the material purchased for processing which are reported under the previous heading. If the enterprise is buying semi-finished goods to be processed further before selling, they should not be included under this heading rather treated as material consumed in the previous heading.

5.4.3 Change in Inventories of Finished Goods, Work-in-progress and Stock-in-trade At the year-end, the business may have some finished goods and stock-in-trade which are remaining unsold. The business may also have inventory of semi-finished goods at various stages of completion. Similarly, inventory of finished goods, stock-in-trade, and work in progress may be available in the beginning of the year. To give proper effect to the matching principle, suitable adjustment in respect of change in inventories is required to be made. As observed from Equation 5.1, opening stock is added and the closing stock in subtracted. If the closing stock is more that the opening stock (i.e., there is an increase in inventory of finished goods, stock-in-trade, and work-in-progress compared to the opening stock), the increase will be shown as a negative adjustment. However, if the closing stock is less than the opening stock (i.e., there is a decrease in inventory of finished goods, stock-in-trade, and work-inprogress compared to the opening stock), the decrease will be shown as a positive adjustment. Apportioning the cost of inventory available for sale between closing stock and cost of goods sold requires well thought out accounting policy and can have significant impact on the reported profits. The accounting and valuation of inventories have been covered in detail in Chapter 8. ■  Illustration 5.3

How will you show the following information relating to inventories in the statement of profit and loss for the year 2016–17. Material purchased during the year: ` 6,450,000. Stock in trade purchased during the year: ` 1,780,000.

Inventory Raw material Work in progress Stock in trade Finished goods

(Amount in `) 1st April 2016

31st March 2017

2,455,000

1,837,000

434,000

625,000

220,000

445,000

1,378,000

664,200

Statement of Profit & Loss  87

The information will be disclosed in the statement of profit and loss as follows: 1. Cost of material consumed: ` 7,068,000 (` 2,455,000 + ` 6,450,000 – ` 1,837,000 = ` 7,068,000) 2. Purchase of stock in trade: ` 1,780,000 3. Change in inventories of work in progress Stock in trade and finished goods: ` 297,800 Opening stock = ` 2,032,000 Closing stock = ` 1,734,200 Decrease in stock = ` 297,800

5.4.4  Employee Benefits Expenses This head covers cost associated with salaries and wages of the employees and other expenses incurred on employees’ welfare. For service organization, this is usually the largest head of expense. As per Ind AS 19, employees’ benefits include:

1. Short-term employee benefits—wages, salaries, social security contributions, paid annual leave, paid sick leave, profit sharing and bonuses, and non-monetary benefits for current employees;



2. Post-employment benefits—retirement benefits, e.g., pensions and lump-sum payment on retirement and other post-employment benefits, e.g., medical care and life insurance;



3. Other long-term employee benefits—long-term paid absences, jubilee or other long-service benefits and long-term disability benefits;



4. Termination benefits

Payments made as consultancy fees or advisory fees to consultants and advisors should not be included under this head and there is no employer-employee relationship with such persons. Likewise sitting fees paid to directors for attending the board meeting is also not included under this head. Recurring and regular payments, like salary, allowances, benefits in kind, etc., are expensed in the profit and loss statement as and when incurred. As per Schedule III of Companies Act, In addition to regular payroll, an employer may also 2013, the following components of contribute a fixed sum to certain funds maintained employees benefits to be disclosed for the benefits of the employees. The employer’s separately (i) salaries and wages, (ii) concontribution to defined contribution plans for the tribution to provident and other funds, benefits of employees, like provident fund, superan(iii) share-based payment to employees nuation fund, employees state insurance, labour weland (iv) staff welfare expenses. fare fund, etc., are also recognized on accrual basis. The enterprise may also provide some deferred benefits to the employee at the time of retirement or post retirement, e.g., gratuity, leave encashment, post-retirement medical facility, etc. In respect of such long-term defined benefits plans, liability is estimated using actuarial valuation considering the age of employee, remuneration, average increment, iteration rate and other such variables. The cost so arrived at, using actuarial valuation is charged to the statement of profit and loss in the current period to ensure matching of cost and benefits.

88  Chapter 5

Share-based payment to employees: In the knowledge economy, employees are the most valuable asset for any business enterprise. A number of companies are offering stock options to their employees as a part of compensation benefits. This also serves as a retention strategy since the options generally are exercisable after a deferment period. As these benefits are being given to the employees in lieu of the services rendered, the value attached to such options shall be treated as another form of employee compensation in the financial statements of the company. The option value is ascertained as the fair value using option pricing method. The option value is normally amortized over the vesting period. (Ind AS 102: Share-based Payment) ■  Illustration 5.4

On 1st April 2015, Nav Bharat Hitech Limited granted 100,000 stock options to its employees. The employees have a right to exercise the options after three years at an exercise price of ` 100 each. The market price per share at the time of granting the option is ` 160 each. The fair value of each option is ascertained to be ` 90. The company estimates that 80% of the employees will remain with the company and will exercise the options. Show the effect of ESOPs on employee cost. The fair value of each option at the time of grant is ` 90. The total value of the options granted therefore is ` 9,000,000. 80% of ` 9,000,000 will be amortized over the vesting period of three years on a straight line basis. Accordingly, each year ` 2,400,000 will be included in employees benefits expenses in the statement of profit and loss for the year 2015-16 to 2017–18.

5.4.5  Finance Cost A business enterprise may meet a part of its funding requirements from borrowings. The amount may be borrowed from a bank or other financial institution. Alternatively, the firm may issue instruments like debentures to raise funds. The cost associated with such borrowings is classified under this heading. The interest cost is charged in the accounts using accrual principle even if the interest has not been paid. In addition to interest cost, other costs that are associated with borrowing include:

a) b) c) d) e)

Interest component of assets taken under a finance lease. Commitment fees on bank loan. Amortization of cost incurred in connection with the arrangement of borrowings. Amortization of discount on issue of debentures. Net gain/loss on foreign currency transactions and translation on foreign currency borrowings to the extent they are regarded as an adjustment to interest cost.

Dividend on redeemable preference shares will also be classified as finance cost if the company has no discretion over the payment of dividend. Dividend as well as dividend distribution tax in such a case will be classified as finance cost. However, if the entity has discretion over the payment of dividend, the dividend and tax on distribution will be treated as a distribution of profit and presented in the Statement of Change in Equity. As per Ind AS 23, borrowing costs should be recognized as expenses in the period it is incurred. However, borrowing costs directly attributable to acquisition, construction or production of an asset shall be capitalized. Obviously companies that are relying more on borrowed funds for financing will have higher finance cost whereas companies with lower level of borrowed funds will incur less under this heading.

Statement of Profit & Loss  89

5.4.6  Depreciation and Amortization In addition to revenue expenses, a business enterprise also incurs capital expenditure that is expected to benefit the enterprise over a long period of time. Such an expenditure results in recognition of a noncurrent asset. Since a non-current asset is expected to be used and benefit the enterprise over a period of time, the matching principle requires that the cost of such an asset should be appropriated over its useful life. The process of apportioning the cost of a non-current asset over its useful life is called depreciation. The term depreciation is associated with tangible assets, e.g., plant and machinery, furniture, building, vehicles, etc. When the cost of an intangible asset, e.g., patent rights, software license, copy rights, etc., is apportioned over its useful life the same is called amortization. Depreciation on property plant and equipment, investment property and amortization of intangible assets is shown under this heading. Depreciation may be calculated under various assumptions. If the asset is depreciated equally over its useful life it is called a straight line method of depreciation. On the other hand, if higher depreciation is charged in the initial years and lower depreciation in the later years, this is called an accelerated method of depreciation. Ascertaining the amount of deprecation to be charged to the statement of profit and loss requires assumptions about the useful life of the asset and the residual value of asset after its useful life is over. These estimates coupled with the choice of method of depreciation can have significant effect on the reported profit as well as the book value of the asset. The basic principles relating to depreciation are the subject matter of Ind AS 16, whereas amortization of intangible assets is provided in Ind AS 38. The same have been discussed in detail in Chapter 9. It may be noted that depreciation, unlike other expenses, is a non-cash expense. It does not involve an outflow of cash. It merely represents an accounting adjustment whereby the cost of a non-current asset is written off over its useful life. Business enterprises engaged in highly capital intensive operations and therefore with large investments in non-current assets, e.g., manufacturing sector, are likely to have higher depreciation expenses. On the other hand, companies in service sector, e.g., information technology, consulting etc., are likely to have lower depreciation expense.

5.4.7  Other Expenses This heading includes a large number of operating expenses not covered in the earlier headings. Many companies break this heading into ‘Manufacturing Expenses’ ‘General and Administration Expenses’ and ‘Selling and Marketing Expenses’ to differentiate based upon the nature of expenses incurred. Any item of expenditure which exceeds one percent of the revenue from operations or ` 10,00,000, whichever is higher is required to be disclosed separately. Payments to auditors for taxation matters, for company law matters, for other services and for reimbursement of expenses are required to be disclosed separately. Amount of expenditure incurred on corporate social responsibility activities, in pursuant of Section 135 of the Companies Act 2013, is also required to be disclosed separately. Research and Development Expenses: Business enterprises engaged in R&D activities (for example pharmaceutical companies) may be spending substantial amounts under this head. As the amount involved may be significant, R&D cost may be reported separately. As a principle, cost incurred on research (searching a new product or new application of an existing product) is expensed out by charging to the statement of profit and loss of the year when such a cost is incurred. However development

90  Chapter 5

cost (cost incurred on developing the outcome of research for commercial exploitation) can be capitalized. Development cost so capitalized is amortized in a systematic manner. Expenses incurred on research which are recognized in the statement of profit and loss are included in the other expenses. Provisions: A provision may be created in respect of a liability where the timing or amount is uncertain. If the entity recognizes that there is a present obligation as a result of a past event and it will require an outflow of economic benefits to settle the obligation, a provision is required to be made based upon the estimated amount. ■  Illustration 5.5

Pee Tee Heavy Engineering Limited sells customized machines to its customers. These machines are covered by one year manufacturer warranty. The company estimates that cost of repair would be ` 1,00,000 if a minor defect is detected and it would cost ` 5,00,000 to repair in case of major defect. At the year-end, there are 200 machines sold which are covered by the warranty. The company estimates that 80% of the machines would need no repair, 15% would need minor repair and only 5% would need major repairs. Ascertain the amount of provision to be made. As there a present obligation as a result of past event, it would need outflow of economic benefits and reliable estimates can be made, the company needs to make provision towards the same. The amount of provisions would be 80% × 200 × 0 + 15% × 200 × ` 100,000 + 5% × 200 × ` 500,000 = ` 80,00,000 Ind AS 37 further provides that where the effect of the time value of money is significant, the amount of provision shall be arrived at by finding the present value of the expected expenditure. ■  Illustration 5.6

XYZ Limited is expected to incur some expenses after 2 years in pursuant of a past agreement. The expenses are estimated to be ` 20,00,000. The appropriate discount rate is 8% per annum. Determine the amount of provision to be made in the current year’s financial statements. As the effect of time value of money is significant, the amount of provision will be equivalent to the present value of expected expenditure.

Provision =

Expected Expenditure (1 + K)n

Where K = discount rate (8%) and n = time when expenditure is expected to be incurred (2 years) Accordingly the provision would be made at ` 17,14,677

Statement of Profit & Loss  91

The break-up of expenses of Maruti Suzuki India Limited for the year 2016 and 2017 is given in Table 5.3: Table 5.3  Expense break-up of Maruti Suzuki India Limited Expenses

( ` in Million) 2017

2016

Cost of material consumed

426,296

354,839

Purchase of stock-in-trade

44,821

32,066

Change in inventories of finished goods, work in progress and stock-in-trade

(3,801)

69

Excise Duty

92,314

75,165

Employee benefits expense

23,310

19,788

894

815

Depreciation and amortisation expense

26,021

28,202

Other expenses

87,228

80,377

Less: Vehicle/ Dies for own use

(1,036)

(602)

Finance costs

Maruti Suzuki India Limited has classified expenses in the nature of manufacturing, selling and general administration as other expenses with break-up being provided in the relevant notes to accounts. The company, engaged in manufacturing of cars, has significant cost of material consumed. It has also undertaken trading in a small way as evidenced by purchase of stock in trade. The business being capital intensive, depreciation and amortization is significantly high. Finance costs are relatively less indicating that the company is not using high amount of borrowed funds. It may be noted that the company has disclosed excise duty as a separate line item, though the same is not prescribed in the format of the statement of profit and loss. As the amount of excise duty is significant, the company has disclosed that separately in pursuant of the materiality principle. The company has used some of the vehicles and dies internally, therefore, the cost of such vehicles and dies has been deducted from the total expenses for the period. The total of all the expenses recognized under the above headings are deducted from the total income, to arrive at the profit before exceptional items and tax.

5.5  EXCEPTIONAL ITEMS This heading, as the term suggest, deals with those incomes and expenses which do not arise in the normal course of the business activities of the enterprise and may be non-recurring in nature. Such items need to be disclosed separately. Such a disclosure enables the readers of the financial statements to identify the impact of activities which are not likely to repeat in future. After the adjustment made for the exceptional items, we arrive at the Profit Before Tax or (PBT).

92  Chapter 5

5.6  TAX EXPENSES The profit earned by an enterprise is subject to income tax in accordance with the income tax laws. Tax is calculated on the taxable income calculated as per the provisions of the Income Tax Act. The tax expense is comprised of current tax and deferred tax. The current income tax is calculated as the tax payable in respect of the taxable profit for a period. Any excess or short payment relating to the earlier years need to be disclosed separately. Due to various provisions in the tax laws, a company may be able to reduce tax in the current year but the same will result in higher tax liability in future years. Such a temporary difference is recognized as deferred tax liability. On the other hand, an enterprise may have paid higher tax in the current year but the same may get reversed in future years and reduce tax liability in the future year. The temporary difference in such a case is called deferred tax asset. Deferred tax assets may also be recognized due to carry forward of unused tax losses and unused tax credits. There is an underlying assumption that these temporary differences will get reversed in future. Deferred tax assets and liabilities are reviewed at every balance sheet date. Such an accounting of deferred tax is mandated by Ind AS 12. The accounting entries for tax aspects are discussed below:

a) Advance payment of tax: Companies are required to pay advance tax on their estimated income. The tax is payable in four instalments as given in Table 5.4 below: Table 5.4  Due Dates for Advance Payment of Tax3

Due Date

Amount Payable

15th June

Not less than 15% of estimated tax liability

15th September

Not less than 45% of estimated tax liability

15th December

Not less than 75% of estimated tax liability

15th March

Not less than 100% of estimated tax liability

       At the end of the year, the company will estimate its taxable income and make the appropriate provision for tax—both current and deferred.   At the time of making payment of the advanced tax, the following journal entry is passed: Advance Payment of Tax Account Dr.    To Bank Account        The amount of advance tax paid during the year will appear in the trial balance as a debit ­balance. When the provision for tax is made, the following entries are made: b) To make provision for the current year tax expenses: Current Tax Account Dr.    To Provision for Tax Account c) To recognize deferred tax liability: Deferred Tax Account Dr.    To Deferred Tax Liability Account

Statement of Profit & Loss  93

d) To recognize deferred tax assets: Deferred Tax Assets Account    To Deferred Tax Account

Dr.

The current tax account and deferred tax account will appear in the statement of profit and loss as a deduction from the profit before tax. The provision for tax account, advance payment of tax account, deferred tax assets account and deferred tax liabilities account are carried to the balance sheet. Profit before tax minus tax expenses (current tax and deferred tax) is presented as the profit or loss for the period from continuing operations.

5.7  PROFIT/LOSS FROM DISCONTINUED OPERATIONS Ind AS 105 requires that the profit or loss from discontinued operations should be disclosed separately in the statement of profit and loss. Discontinued operations includes non-current assets that have been disposed of or are being held for sale. Profit or loss from discontinued operation include profit or loss of discontinued operations and gain or loss recognized on the measurement of fair value less cost to sell or on the disposal of assets constituting the discontinued operations. Profit/Loss from discontinued operations is adjusted for the tax expenses or tax credits in respect of such operations to arrive at the post-tax profit/loss from discontinued operations.

5.8  PROFIT/LOSS FOR THE PERIOD Post-tax profit/loss from continuing operations plus post-tax profit/loss from discontinued operations are added to arrive at the profit/loss for the period.

5.9  OTHER COMPREHENSIVE INCOME (OCI) This heading presents items of incomes and expenses (including reclassification adjustments) that are not recognized in profit or loss as required or permitted by other Ind ASs. It may be noted that classification of items between profit or loss and OCI is rule based rather than principle based. Whether an item of income or expense would be classified in profit and loss or in OCI is provided in the relevant Ind AS. If an item is required to be recognized in OCI, it should be so classified. Generally, items in OCI arise out of revaluation or re-measurement of various assets or liabilities especially financial assets and liabilities. Some of the items of OCI are subsequently reclassified to profit or loss as per the relevant Ind AS. Accordingly, OCI is classified into (a) items that will not be reclassified to profit or loss and its related income tax effects; and (b) items that will be reclassified to profit or loss and its related income tax effects. The classification is rules based rather that principles based and is dictated by the relevant Ind ASs.

5.9.1 Items that will Not be Reclassified to Profit or Loss and Its Related Income Tax Effects This heading includes:

1. Changes in revaluation surplus. 2. Re-measurements of the defined benefit plans.

94  Chapter 5



3. Fair value changes on equity instruments through other comprehensive income. 4. Fair value changes relating to own credit risk of financial liabilities designated at fair value through profit or loss. 5. Share of other comprehensive income in associates and joint ventures, to the extent not to be classified into profit or loss. 6. Gains and losses on hedging instruments that hedge investments in equity instruments measured through OCI. 7. Others (specify nature).

5.9.2 Items that will be Reclassified to Profit or Loss and Its Related Income Tax Effects This heading includes:



1. 2. 3. 4.

Exchange differences in translating the financial statements of a foreign operation. Fair value changes in debt instruments through other comprehensive income. The effective portion of gain and loss on hedging instruments in a cash flow hedge. Share of other comprehensive income in associates and joint ventures, to the extent to be classified into profit or loss. 5. Changes in time value of options when separating the intrinsic value and time value of an option contract and designating only intrinsic value changes as the hedging instrument. 6. Changes in the value of the forward elements of forward contracts when separating the forward element and spot element of a forward contract and designating only spot element changes as hedging instrument. 7. Changes in the value of the foreign currency basis spread of a financial instrument when excluding it from the designation of that financial instrument as the hedging instrument. 8. Others (specify nature).

The aggregate of the profit/loss for the period and other comprehensive income is presented as the Total Comprehensive Income for the Period.

5.10  EARNINGS PER SHARE Earnings Per Share (EPS) is one of the most widely used indicators of profitability of a business enterprise from shareholders’ perspective. As per Ind AS 33, an enterprise is required to present both basic and diluted earnings per share on the face of the statement of profit and loss. Such a disclosure will ‘improve performance comparison between different entities for the same reporting period and between different accounting periods for the same entity.’4

5.10.1 Basic EPS The basic EPS is calculated by dividing the profits attributable to ordinary equity shareholders by the number of equity shares outstanding. Basic EPS may be calculated by using Eq. 5.2. Basic EPS =

(Profit After Tax – Dividend on Preference Shares – Tax on Dividend on Preference Shares) (5.2) Number of Equity Shares

Statement of Profit & Loss  95

If the number of equity share has undergone a change during the year; for example, because of fresh issue of capital, buy-back of shares, conversion of debenture into equity, etc., the denominator will be taken as weighted average number of equity shares outstanding during the year. For the purpose of calculating the weighted average, the number of days for which the shares have been outstanding will be considered. However, if the number of shares have increased due to issue of bonus shares or due to stock split (i.e., where no new resources are availed by the enterprise), the denominator will be number of shares outstanding at the year-end irrespective of the timing of bonus issue or stock split.

5.10.2  Diluted EPS In addition to basic EPS, companies are also required to report diluted EPS. An enterprise might have issued financial instruments that may get converted into equity shares in future. For example, an enterprise may have an employee stock option plan (ESOP) which entitles the holders of stock option to get certain number of equity shares in future. Likewise, convertible debentures may get converted into equity in future. In such cases, the EPS needs to be adjusted for the effects of all dilutive potential equity shares. For calculation, both the numerator and denominator may need to be adjusted. The difference between the basic EPS and diluted EPS will indicate the presence of potential equity shares that may arise on conversion of existing instruments in future. ■  Illustration 5.7

High Profile Software Limited reported a profit after tax of ` 56 million for the year 2016–17. The capital structure of the company as on 31st March 2017 is given as follows: (Amount in `)





5,000,000 equity shares of ` 10 each

50,000,000



1,000,000, 10 per cent preference shares

10,000,000

The company also has 50,000 stock options outstanding. Assume dividends attract a distribution tax at the rate of 15 per cent of dividends paid.

a. Calculate the basic and diluted EPS for the company. b. Assuming that out of the above, 2,000,000 equity shares were issued on 1st January 2017 for cash. Calculate the basic EPS. c. What will be the basic EPS if 2,000,000 equity shares were issued as bonus shares on 1st January 2017 rather than for cash?

Solution: a. Basic EPS= ( ` 56,000,000 − ` 1,000,000 − ` 150,000)/5,000,000 = ` 10.97 Diluted EPS = ( ` 56,000,000 − ` 1,000,000 − ` 150,000)/5,050,000 = ` 10.86

b. Weighted average number of shares: As the number of shares outstanding stood at 3,000,000 for nine months and 5,000,000 for the next three months, the weighted average will be calculated as follows: = 3,000,000 × 9/12 + 5,000,000 × 3/12 = 3,500,000 Basic EPS = ` 54,850,000/3,500,000 = ` 15.67

96  Chapter 5



c. As the change in equity is because of bonus shares, the year end equity will be considered in denominator. The basic EPS will still be ` 10.97 per share.

The basic and diluted EPS for Bicon Limited is given in Table 5.5. Table 5.5  EPS Calculations for Biocon Limited5

Particulars

March 31, 2017

March 31, 2016

5,193

3,686

200,000,000

200,000,000

(3,702,196)

(3,697,436)

196,297,804

196,302,564

1,376,484

167,870

197,674,291

196,470,434

  Basic (` )

26.45

18.78

  Diluted (` )

26.27

18.76

Profit for the year (` million) Shares Less: Weighted average shares held with the   ESOP Trust Weighted average shares used for computing   basic EPS Add: Effect of dilutive options granted Weighted average shares used for computing   diluted EPS Earnings Per Share

*Diluted effect on weighted average number of equity shares and profit attributable is on account of Foreign Currency Convertible Bonds and Employee Stock Option Plan (ESOP)

Schedule III requires earnings per equity share to be reported separately in respect of continuing operations, for discontinued operations and combined for continuing and discontinued operations.

5.11  VARIOUS MEASURES OF PROFIT After heaving discussed different heads of income and expenses, we can now look at the concept of profit as well. Some of commonly used expressions are discussed below:

• Gross Profit: The excess of operating income over cost of goods sold or services provided is •

• •

called gross profit. This represents the inherent profitability of an enterprise before charging other operating and non-operating expenses. Cash Operating Profit: Earnings before interest, tax, depreciation and amortization (EBITDA) is often called the cash operating profit. As depreciation and amortization are non-cash expenses and tax and interest are non-operating expenses, profit before charging these four heads of expenses is called cash operating profit. Operating Profit: Earnings before interest and tax (EBIT) is a measure of operating profit. Depreciation and amortization (non-cash expenses) are deducted from EBITDA to arrive at EBIT or operating profit. Pre-Tax Profit: This is also called profit before tax (PBT) and is arrived at by deducting Interest and finance expenses from EBIT. This indicates the profitability of the enterprise after charging all cost and expenses other than tax.

Statement of Profit & Loss  97

• Net Profit: The net profit or profit after tax (PAT) is the most popular measure of profit of a business enterprise. From PBT we deduct the net tax expenses to arrive at the PAT. It is popularly called the bottom line. A business enterprise may or may not disclose all of the above measures on the face the profit and loss statement. However, it is possible to arrive at these measures of profitability by working backwards in the following manner:

PAT + Tax expense = Profit before tax

(5.3)



PBT + Interest and finance expenses = Earnings before interest and tax

(5.4)



EBIT+ Depreciation and amortization = EBITDA

(5.5)

■  Illustration 5.8

The summary of the profit and loss statement of Rishabh Limited for the year ended 31st March is given below: Particulars

( ` in Crore)

Total revenue

364.54

Cost of goods sold

120.47

Other operating expenses

60.26

Depreciation and amortization

53.25

Finance and interest cost

42.20

Tax on income

19.84

Profit after tax

68.52

Please calculate the gross profit, cash operating profit (EBITDA), operating profit (EBIT) and pre-tax profit for Rishabh Limited. Solution: Pre-tax profit = PAT + Tax expense = ` 68.52 + ` 19.84 = ` 88.36 crore Operating profit (EBIT) = Pre-tax profit + Finance and interest cost = ` 88.36 + ` 42.20 = ` 130.56 crore Cash operating profit (EBITDA) = EBIT + Depreciation and amortization = ` 130.56 + ` 53.25 = ` 183.81 crore Gross profit = EBITDA + Other operating expenses = ` 183.81 + ` 60.26 = ` 244.07 crore

5.12  APPROPRIATION OF PROFIT After determining the PAT of the enterprise the same needs to be appropriated. The balance carried forward from the earlier year is added to the current year profit to ascertain the profit available for appropriation. The appropriation is usually done under the following heads:

98  Chapter 5

5.12.1 Dividend A part of the profit available for distribution is given out to the shareholders as dividend. Dividend represents a fraction of profit of the enterprise that is paid to the shareholders. Dividend may be paid on the preference capital or equity capital. A company might have paid an interim dividend, i.e., dividend declared and paid during the year. The final dividend is proposed by the directors and paid to the shareholders after obtaining their approval in the general meeting of the shareholders. Both interim and final dividend represents appropriation of profit. The accounting entries in respect of dividends are discussed below:

• Payment of interim dividend: Interim Dividend Account Dr.    To Bank Account The interim dividend account appears in the trial balance as a debit balance and is transferred to the profit and loss appropriation at the end of the year.

• Proposed dividend: Dividend Account Dr.    To Proposed Dividend Account The dividend account is closed by transferring it to the statement of profit and loss. The proposed dividend account is in the nature of a provision and is carried to the balance sheet as a current liability.

5.12.2  Dividend Distribution Tax The payment of dividend attracts a tax called corporate dividend tax or dividend distribution tax at the prescribed rate. It may be noted that this tax is in addition to the tax paid by the company on its income. Since the distribution tax is incidental to the payment of dividend, this is also treated as an appropriation of profit. As interim dividend has already been paid during the year, no provision is required to be made in respect thereof. Whereas at the time of preparing profit and loss statement, the proposed dividend is in the nature of a liability for which appropriate provision is required to be made. It may be noted that as per Ind AS 10 if the dividends are declared after the reporting period but before the financial statements are approved, then the dividends are not recognized as a liability. In such a case, dividends are only disclosed in the notes as no obligation exists at the date of the financial statements.

5.12.3  Transfer to Reserves A part of the profits may be transferred to various reserves, e.g., general reserve. Transfer to reserve is also an appropriation of profit. The amount transferred to reserves is added to the shareholders’ funds in the balance sheet. The journal entry for transfer to reserve is given below: Profit and Loss Appropriation   Dr.    To General Reserve Account Here, it is pertinent to make a distinction between reserve and provision. A provision is a charge on profit, and for all practical purposes is treated as a part of operating expenses. A provision is created for

Statement of Profit & Loss  99

meeting an anticipated fall in the value of asset or for an uncertain but probable liability. For example, a business enterprise selling goods on credit may decide to create a provision for doubtful debts to meet likely defaults in collection. Likewise, provision may be created for fall in the market value of investments. Such provisions are included in other expenses. Reserves, on the other hand, are general purpose retention of profits and are created after ascertaining profits. Any balance left in the profit and loss statement after all the appropriations is also taken to the shareholders’ funds in the balance sheet. In case of a loss the same is carried to the balance sheet and adjusted from reserves and surplus from the earlier years. As per the Schedule III of the Companies Act, 2013, the appropriation of profit is not shown in the statement of profit and loss rather the total comprehensive income for the period is taken to the statement of change in equity and added to the carried forward balance of the profit from earlier years. Necessary appropriations are disclosed in the statement of change in equity alongwith other items that have an impact of equity.

Summary

• The statement of profit and loss or the income statement is the primary statement for knowing • • • •



• • •

about the profitability of an enterprise. It provides a summary of revenue earned from different sources and expenses incurred on various heads. Statement of profit and loss is based on various accounting principles notably accounting period, separate entity, money measurement, accrual, matching, conservatism and materiality. To ensure uniformity and comparability, the format of the statement of profit and loss has been prescribed by Schedule III of the Companies Act, 2013. It is mandatory to disclose previous year’s figures against current number figures as well. The statement of profit and loss is presented in two sections—profit or loss and other comprehensive income. The total of profit or loss and other comprehensive income is called the total comprehensive income. Revenue earned during a year is broken in operating income and other income. The former represent income earned from the main operating activities of the business enterprise. The later includes incomes earned from sources incidental to the main business. The income is accounted for using accrual basis of accounting. Expenses incurred during an accounting period are broken into various heads using materiality principle. Material consumed, stock-in-trade purchased, change in inventory, employee cost, finance expenses, depreciation and amortization and other expenses are the prescribed classification. Cost of material consumed shows the cost of raw material and components consumed in the manufacturing process. Material purchased during the year is adjusted for the change in inventory. Purchase of stock-in-trade represents the goods purchased for the purpose of reselling without further processing. Change in inventory is the adjustment required due to increase or decrease in inventories of work in progress, stock-in-trade or finished goods compared to the beginning of the year. If the closing inventory of work in progress, stock-in-trade or finished goods is greater than the opening, the increase is deducted and vise versa.

100  Chapter 5

• Employee cost includes the regular payments to employees towards salaries and allowances, •

company’s contribution to defined contribution plans and also cost towards defined benefits plans. The cost of defined benefits plan is ascertained using actuarial valuation. Interest and finance cost represents the cost of borrowed funds. The cost is ascertained using accrual basis of accounting considering the amount of borrowing, period of use and the rate of interest. Interest incurred on borrowing for acquisition or construction of a fixed asset is capitalized till the asset is ready for its intended use.

• Depreciation and amortization are non-cash expenses. The cost of tangible asset when appropriated over its useful life, the same is called depreciation. Amortization refers to apportionment of cost of an intangible asset like software license, patents, etc.

• Other expenses includes a number of expenses incurred for day to day running of the business. Expenses are accounted for using accrual basis of accounting and using matching principle. The expenses under this head may be further classified as manufacturing, selling, general and administration expenses.

• Business enterprises engaged in research and development activities may disclose these costs separately. The research costs are expensed as and when incurred, whereas development costs are capitalized and amortized systematically.

• The profit earned by a business enterprise is subject to income tax. The income tax is broken in current tax and deferred tax. The current tax is the tax on current year’s taxable income as per the provisions of the income tax act. Deferred tax represents the impact of timing difference between taxable income and reported profit. The tax expenses are deducted from the PBT to arrive at the net profit or net income or simply the profit after tax (PAT). This is also referred to as the bottom line.

• Other comprehensive income for the period is added to the profit or loss to arrive at the total comprehensive income

• Whether an item of income or expenses shall be classified as profit and loss or OCI is as required by the relevant Ind AS.

• The PAT along with any balance of profit carried from the previous year is available for appropriation. A part of it gets distributed to the shareholders as dividends and another is transferred to various reserves. The balance available after appropriations is carried to the Balance Sheet under the heading reserves and surplus.

• Earnings Per Share (EPS) is an important measure of profitability for equity shareholders. On the face of the statement of profit and loss, basic EPS and diluted EPS are reported. Basic EPS is calculated by dividing profits available for equity shareholders by number of equity shares outstanding. Whereas diluted EPS takes into account the effect of potential equity shares that may be issued against financial instruments already issued by the company, e.g., convertible bonds, ESOP, etc.

• EPS is reported separately in respect of continuing operations, discontinued operations and combined for continuing and discontinued operations.

Statement of Profit & Loss  101

Assignment Questions 1. Identify the main accounting principles having a bearing on the preparation of the statement of profit and loss. 2. ‘Interest paid is an expense whereas dividend paid is an appropriation of profit’. Explain. 3. Explain the accounting for different types of employees’ cost. 4. Differentiate between basic earnings per share and diluted earnings per share. 5. ‘Deferred tax assets and deferred tax liabilities arise due to timing difference between taxable income and reported income’. Explain the statement with suitable examples. 6. Explain the different measures of profit. 7. What is the basic principle behind accounting for research and development expenses?

Problems 1. Accrual of Expenses: In each of the following cases ascertain the amount to be charged as expenses in the statement of profit and loss for the year 2016–17: a. Premises taken on rent on 1st August 2016 by paying a deposit of ` 10 million. Quarterly rent of ` 300,000 paid on 1st August and 1st November each. Rent due on 1st February not paid till 31st March 2017. b. Paid towards salaries to employees ` 60.30 million. It includes a sum of ` 4.85 million as advance to employees against salary. c. Debtors outstanding as on 31st March 2017 amounted to ` 305 million. Based upon the past trend the company estimates that 2% of the debtors will default on payment. d. Goods bought during the year 2015–16 amounting to ` 12.23 million were actually paid for in the year 2016–17. e. Special goods were ordered on 15th December 2015 with advance payment of ` 3 million. The same were received and consumed during 2016–17. 2. Preparation of statement of profit and loss: The details of income and expenses of SDTV Limited for the year 2017 is given below: Particulars Advertising revenue Equipment hire revenue

( ` in Crore) 173.25 17.26

Interest on fixed deposits

8.48

Rental income

1.32

Production expenses

54.63

Salary, wages and other benefits

38.03

Rent expenses

11.89

Provision for doubtful debts Other expenses

3.34 17.22 (continued )

102  Chapter 5 (continued )

Particulars

( ` in Crore)

Depreciation on equipments

5.53

Amortization of software licenses

6.73

Interest on bank loans

14.34

Other finance charges

0.33

Current tax on income

10.14

Deferred tax

3.87

You are required to prepare the statement of profit and loss for the company using suitable heads for income and expenses. Also, indicate the cash operating profit, operating profit and pre-tax profit separately. 3. Preparation of statement of profit and loss from a given trial balance: Based upon the given Trial Balance and the additional information, prepare the statement of profit and loss of Shivam Industries Limited for the year ended 31st March 2017: Trial Balance of Shivam Industries Limited as on 31st March 2017

 Particulars

( Amounts in ` ) Dr.

Cr.

Share capital

 

1,200,000

(1,20,000 equity shares of ` 10 each)

 

 

General reserve

 

500,000

100,000

 

Unclaimed dividends

 

13,052

Trade Payables

 

173,716

Calls in arrear (20,000 shares at ` 5 each)

Buildings (at cost)

300,000

 

1,001,806

 

 

2,167,894

718,000

 

53,628

 

General expenses

62,156

 

Machinery (at cost)

400,000

 

Motor vehicles (at cost)

60,000

 

Furniture (at cost)

10,000

 

Opening stock

344,116

 

Trade Receivables

446,760

 

Investments

577,900

 

Purchases Sales Manufacturing expenses Salaries

(continued )

Statement of Profit & Loss  103 (continued )

 Particulars

( Amounts in ` ) Dr.

Cr.

Provision for depreciation (1.4.2016)

 

 

  Machinery

 

110,000

  Building

 

50,000

  Motor vehicles

 

30,000

  Furniture

 

4,000

Advance income tax (2016–17)

125,000

 

Cash at bank

144,480

 

3,600

 

Interest on investment

 

17,088

Balance in Statement of Profit and loss

 

92,000

Directors fees

Other Comprehensive Income Tax on OCI Total

80,000 22,000  4,527,700

4,527,700

Additional Information 1. Stock in hand on 31st March 2017 ` 297,360 2. Provide depreciation on the fixed assets at original cost at the following rates: Plant and machinery 10% Motor vehicles 20% Furniture 10% Buildings 2% 3. Interest accrued on investments ` 5,500 4. Provision for doubtful debts to be made 2% 5. Provision for tax for the current year to be made ` 120,000 6. Salary for the month of March 2017 is outstanding ` 4,800 7. General expenses include insurance paid amounting to ` 8,000 for the period from 1st January 2017 to 31st December 2017. 4. Calculation of basic and diluted EPS: Mahaveer Limited earned a PAT of ` 33.80 million for the year 2017. The share capital of the company is made up of eight million equity shares of ` 2 each and one million preference shares of ` 100 each carrying dividend at the rate of 10%. The company had six million equity shares outstanding in the beginning of the year and issued three million additional shares on 1st April 2017. It bought back one million shares on 1st December 2017 from the market for cancellation. a. Calculate the weighted average number of equity shares outstanding. b. What is the basic EPS of the company for the year? c. Assuming that each preference share is convertible into two equity shares in the future, calculate the diluted EPS?

104  Chapter 5

Solutions to Problems 1. a. The deposit of ` 10 million is not an expense and hence will not appear in the profit and loss account. The rent for the period of eight months (from August 2016 to 31st March 2017) amounting to ` 800,000 will be shown in the profit and loss statement on accrual basis. b. Advance salaries are not to be expensed during the year 2016–17. Accordingly, an amount of ` 55.45 million (` 60.30 less ` 4.85 million) will appear in the profit and loss statement. c. Provision for doubtful debts will be created at ` 6.10 million (2% of ` 305 million) and the same will appear in the profit and loss account as an expense. d. Purchases of ` 12.23 million will be included in the profit and loss statement of 2015–16 even if paid in the next year using the accrual basis of accounting. e. Purchase of ` 3 million will be included in the profit and loss statement of 2016–17 even if paid in advance in the previous year. 2. The profit and loss account of SDTV Limited for the year ended 31st December 2017 Particulars

( ` in Crore)

Operating income Advertising revenue Equipment hire revenue

173.25 17.26

190.51

Other income Interest on fixed deposits

8.48

Rental income

1.32

Total income

9.80 200.31

Expenses Salary, wages and other benefits

38.03

Production expenses

54.63

Rent expenses

11.89

Provision for doubtful debts Other expenses

3.34 17.22

Profit before depreciation, amortization, interest and taxes

125.11 75. 20

Less: Depreciation and amortization Depreciation on equipments

5.53

Amortization of software licenses

6.73

12.26 (continued )

Statement of Profit & Loss  105 (continued )

Particulars

( ` in Crore)

Profit before interest and tax

62.94

Less: Interest and finance charges Interest on bank loans

14.34

Other finance charges

0.33

14.67

Profit before tax

48.27

Tax Current tax on income Deferred tax

10.14 3.87

14.01

Profit after tax

34.26

3. The profit and loss statement of Shivam Industries Limited for the year ended 31st March 2017 Income

( Amount in ` )

Revenue from operations Sales

2,167,894

Other income Interest on investments

17,088

Add: Accrued interest

5,500

22,588 2,190,482

Expenditure expenses Raw material consumed Opening stock Add: Purchases Less: Closing stock

344,116 1,001,806 297,360

1,048,562

Employee benefit expenses Salaries Add: Outstanding salaries

53,628 4,800

58,428

Depreciation and amortisation Plant and machinery

40,000

Motor vehicles

12,000

Furniture

1,000

Building

6,000

59,000

(continued )

106  Chapter 5 (continued )

Income

( Amount in ` )

Other expenses Manufacturing expenses

718,000

Directors’ fees

3,600

Provision for doubtful debts

8936

General expenses

62,100

Less: Prepaid insurance

–6,000

786,636 1,952,604

Total expenses Profit before tax

237,896

Provision for tax

120,000

Profit after tax

117,896

Other comprehensive income

80,000

Less : Tax on OCI

22,000 58,000

Total comprehensive income for the year

175,896

4. a. Weighted average number of equity shares I

II

No. of Months

Share Outstanding

3

6

18

8

9

72

1

8

8

12

III = I × II

98

Weighted average = 98/12 = 8.17 million shares b. Basic EPS = (PAT − Dividend on preference shares)/Weighted average number of equity shares outstanding = (` 33.80 − ` 10)/8.17 = ` 2.91 per share



c. Diluted EPS: The preference shares outstanding are convertible into two million equity shares in the future. Upon conversion, they will not be entitled to get dividend at the fixed rate of 10%. Accordingly, both the denominator and numerator need to be adjusted to calculate the diluted EPS as follows: Diluted EPS = PAT/(Number of equity shares outstanding + Dilutive shares) (` 33.80)/(8.17 + 2) = ` 3.32 per share

Statement of Profit & Loss  107

Try It Yourself 1. Expense recognition in the statement of profit and loss: Ascertain the impact of the following transaction on the profit and loss statement for the financial year 2016–17: a. The company borrowed ` 100 crore from the State Bank of India the rate of 12% per annum on 1st July 2016. The interest is payable quarterly on the first day of October, January, April and July respectively. The interest due on 1st October 2016 was duly paid but the interest due on 1st January 2017 has not been paid till date of the balance sheet. b. During the year, the company spent ` 13 million towards buying various stationary items. As on 31st March 2017, the store department still has stationary items costing ` 1.8 million with it whereas stationary items in hand on 1st April 2016 amounted to ` 2.3 million. c. The company paid employee cost of ` 134.75 million during the year including an advance of ` 2 million to one of the employees. Salaries for the month of March 2017 amounting to ` 15.35 million were paid on 5th April 2017. The company would also like to create a provision of ` 2.35 million towards retirement benefits for the employees. 2. Nature of income: Classify the following incomes into operating income, other income, exceptional income or extra-ordinary income: a. Interest earned by a bank. b. Interest earned by a manufacturing company on the fixed deposits it kept with the bank. c. Sale of scrap arising out of manufacturing process. d. Fees earned by the manufacturer of computer by providing annual maintenance services to its customers. e. Profit on sale of machine. f. Profit on sale of shares in a subsidiary company. g. Premium received on the issue of new shares. h. Amount received on one time settlement of a court case. i. Provisions no longer required written back. j. Rent received by a trading company by letting out its premises. 3. Classification of expenses: Classify the following expenses under various heads of statement of profit and loss as per Schedule III of the Companies Act, 2013: a. Staff welfare expenses b. Interest paid c. Payment to contract labour d. Goods purchased for trading e. Auditors’ fees f. Depreciation on property, plant and equipment g. Bank charges in relation to obtaining loan h. Contribution to provident fund i. Raw material purchased j. Directors’ fees k. Income tax l. Consumable stores purchased 4. Various measures of profits: Tech Mahindra Limited made a profit of ` 743 crore for the year 2009–10 after making a provision of ` 131 crore towards taxes and ` 130 crore towards deprecia-

108  Chapter 5

tion and amortization. The company also incurred ` 160 crore as interest and finance charges. Calculate the pre-tax profit, operating profit and cash operating profit for the company. 5. Preparation of the profit and loss account: On the basis of the following information, prepare the profit and loss account for the Jack Paints Limited for the year 2016–17. Show EBITDA, EBIT and PBT separately. Particulars

( ` in Crore )

Gross sales

5,528.82

Excise duty

403.74

Interest earned

131.30

Dividend received

1.85

Profit on sales of fixed assets

10.70

Exceptional Income

25.46

Material consumed

2,840.24

Employee cost

280.84

Manufacturing expenses

718.73

Administrative and marketing expenses

295.27

Depreciation and amortization

60.74

Interest on borrowed funds

13.76

Provision for tax for the current year

336.46

Provision for tax of earlier year written back

6.29

6. Computing earnings per share: The share capital of the Jack Paints Limited consists of 96 million equity shares of the face value ` 10 each. In addition, the company also has given stock options to its employees which can be converted into 5.80 million equity shares on exercise. Based upon the profits arrived in Problem 5 above, calculate the basic earnings per share and diluted earnings per share for the company. 6. Preparing of statement of profit and loss from a trial balance: From the following balance extracted from the books of accounts of Solid Steels Limited as on 31st March 2017, prepare the statement of profit and loss. Particulars

( ` in Crore)

Particulars

( ` in Crore)

Amortisation

12

Provisions and write off

17

Bank charges

14

Raw material purchased

8332 1120

Contribution to employees funds

212

Salary and wages

Depreciation on tangible assets

331

Sale of scrap

235

23

Sale of steel

13120

Dividend received Exceptional expenses

6

Stock in trade purchased

233

Freight outwards

356

Stores and spare parts

518

Handling cost

130

Tax expenses

258 (continued )

Statement of Profit & Loss  109 (continued )

Particulars

( ` in Crore)

Particulars

Interest earned

180

Training and development cost

Interest paid

191

Opening stock

Loss on sales of asset

12

Other expenses

809

Other comprehensive income— Items that will be classified to profit and loss (credit) Other comprehensive income— Items that will not be classified to profit and loss (debit)

( ` in Crore) 34

– Raw material

557

– Work in progress – Finished goods

328 205

80

Tax on OC—Items that will be classified to profit and loss (Dr)

20

Tax on OCI—Items that will not be classified to profit and loss (Cr)

Power and fuel

462

Repair and maintenance

168

22

6

The closing stock as on 31st March 2017: – Raw material 662 – Work-in-progress 432 – Finished goods 156 8. Preparation of the profit and loss statement from a trial balance: Star Limited has an authorized capital of ` 600 million divided into 60 million equity shares of ` 10 each. The trial balance of the company for the year ended 31st March 2017 is as follows: Trial Balance of Star Limited as on 31st March 2017

Particulars

Dr. ( ` in Million)

Particulars

Cr. ( ` in Million)

Premises

274.00

Share capital

Machinery

445.25

Trade payables

85.24

9.32

Loan from bank

68.50

Furniture Bank

132.70

Sales

Investments

119.19

Interest

Cash

26.74

General reserves (1–4–2016)

548.00

1,602.76 8.56 102.75

Trade receivables

144.40

Profit and loss A/c (1–4–2016)

60.81

Opening stock

255.40

Purchase return

13.50

Purchase

983.95

Accumulated depreciation

Salesreturns General expenses Salaries Interest charges

17.37 34.58 24.48 6.17

 Premises  Machinery  Furniture

49.03 252.22 2.47   (continued )

110  Chapter 5 (continued )

Particulars

Dr. ( ` in Million)

Particulars

Cr. ( ` in Million)

Wages

150.34

 

Freight

6.73

 

Auditors fees

11.78

 

Directors fees

35.96

 

115.48

 

Advance payment of tax  

2,793.84

2,793.84

Additional Information ( ` in Million) a. b. c. d. e. f. g.

Outstanding wages: 2.59 Outstanding salaries: 1.64 Interest accrued on investments: 3.43 Closing stock: 171.03 Provide depreciation at original cost on: i) Premises 2% ii) Machinery 7.5% iii) Furniture 10% Make provision for income tax at 30% The board of directors of companies has proposed a dividend of 7.5% after transferring 5% of the profits to general reserves. The dividend attracts a distribution tax at 15% of the dividends.

You are required to prepare the profit and loss statement for the year ended 31st March 2017. Hint: Not all the balances appearing in the trial balance are relevant for the purposes of the profit and loss statement.

Cases Case 5.1: Preparation of the Statement of Profit and Loss for Asian Paints Limited6 Asian Paints was set up in the year 1942 and is India’s leading paint company with a group turnover of ` 170.85 billion. The group has an enviable reputation in the corporate world for professionalism, fast track growth, and building shareholder equity. Asian Paints operates in 16 countries and has 24 paint manufacturing facilities in the world servicing consumers in over 65 countries. Besides Asian Paints, the group operates around the world through its subsidiaries Berger International Limited, Apco Coatings, SCIB Paints, Taubmans and Kadisco. Asian Paints manufactures wide range of paints for decorative and industrial use.    

Statement of Profit & Loss  111

Based upon the following particulars prepare the statement of profit and loss of the company for the year 2016–17. Particulars Advertisement expenses Amortisation of intangible assets Closing stock—raw material Closing stock—packing material Closing stock—finished goods

Dr. ( ` in Crore) 517 26 598 36 1233

Particulars Opening stock—raw material Opening stock—packing material Opening stock—finished goods Opening stock—work in progress Opening stock—stock in trade

Cr. ( ` in Crore) 534 40 778 65 135

75

Other comprehensive income —items that will be classified to profit and loss (credit)

3

Closing stock—stock in trade

185

Other comprehensive income— items that will not be classified to profit and loss (credit)

139

Consumption of stores, spares and consumables

43

Other non-operating income

185

Training and recruitment

46

Information technology expenses

45

Contribution to provident and other funds

40

Power and fuel

88

Closing stock—work in progress

Current income tax Deferred tax Depreciation on property, plant and equipment

817 42 270

Purchase of raw material

5630

Purchase of packing material

1168

Purchase of stock in trade

647 196

Dividend income

77

Rent paid

Exchange difference (credit)

17

Repair and maintenance

Freight and handling charges Interest income

1713 829

Salaries and wages Sale of products

Interest expense on loans

22

Processing and service income

Interest on lncome tax

18

Scrap sales

Tax credit for earlier year Legal and professional expenses Miscellaneous expenses

1

Subsidy from state government

86 642 14154 53 9 137

37

Sale of service

8

331

CSR expenses

48

Staff welfare expenses

60 (continued )

112  Chapter 5 (continued )

Particulars

Travelling Expenses

Dr. ( ` in Crore)

101

Particulars Tax on OCI—items that will not be classified to profit and loss (credit)

Cr. ( ` in Crore)

3

Case 5.2: Preparation of the Statement of Profit and Loss for HCL Tech Limited7 HCL Technologies Limited is a leading IT solution provider company with operations is 32 countries and 116,000 employees. The global revenue of the company exceeded USD 7.2 billion. HCL Technologies provides solutions built around digital, IoT, cloud, automation, cybersecurity, analytics, infrastructure management and engineering services. Using the following particulars, prepare the statement of profit and loss of the company for the year 2016–17. Particulars

Bank charges

Closing stock of stock-in-trade

Dr. ( ` in Crore

Particulars

5

Other comprehensive income —items that will be classified to profit and loss (credit)

521

90

Other comprehensive income— items that will not be classified to profit and loss (debit)

7

Communication costs

131

Outsourcing costs

Contribution to employee funds

245

Power and fuel

Current income tax

Cr. ( ` in Crore)

1,537

Profit on sale of property

2,219 234 2

Deferred tax (credit)

134

Purchase of stock-in-trade

123

Depreciation and amortisation

479

Rent paid

217

26

Repair and maintenance

261

57

Salaries, wages and bonus

Dividend from subsidiary companies Exchange difference (credit) Interest income Interest expense on loans Investment income Legal and professional fees

Miscellaneous expenses

Miscellaneous income Opening stock of stock in trade

788

Sale of hardware and software

51

Sale of service

46

Software licence fees incurred

132

Staff welfare expenses

300

Tax on OCI—items that will be classified to profit and loss (debit)

37 129

Tax on OCI—items that will not be classified to profit and loss (credit) Travel and conveyance

6,545 168 19,150 224 53

110

1 740

Statement of Profit & Loss  113

Case 5.3: Preparation of the Statement of Profit and Loss for Cipla Limited8 from the Trial Balance Cipla  is a leading global pharmaceutical company, dedicated to high-quality, branded and generic medicines. We are trusted by healthcare professionals and patients across geographies. Cipla was founded in the year 1935 and has presence in 80 countries. The company has over 23,000 employees and a global revenue exceeding USD 2.2 billion. From the following trial balance and the additional information for the company, you are required to prepare the statement of profit and loss for the company for the year ended 31st March 2017. Particulars Bank balance—other than cash and cash equivalents Capital work-in-progress Cash and cash equivalents

Amount

Particulars

Amount

14

Accumulated amortisation

27

540

Accumulated depreciation

389

Current borrowings from banks

324

45

Commission on sales

234

Deferred tax credit

Contractual services expenses

164

General reserve

99 3,142

Contribution to pf and other funds

71

OCI—will not be classified to profit and loss

Csr expenditure

28

Other current financial liabilities

456

638

Other current liabilities

230

Current investments Current loans

10

Other financial liabilities - non current

Current tax expenses

311

Other income

Current tax assets

192

Other non-current liabilities

11

45 130 80

Deferred tax assets

60

Other operating income

Employee stock option expense

22

Outstanding employee stock options

59

Freight and forwarding

158

Provision for doubtful trade receivables

97

Impairment of investment

251

Provisions—current

248

Provisions—non current

126

Income tax on oci Intangible assets

4 202

Retained earnings

Intangible assets under development

15

Revenue from sales of products

Interest expense

39

Securities premium

Manufacturing expenses

443

Non-current investments

3,648

Non-current loans Opening stock—raw material and packing material

216 1,303

Share capital Trade payables

337

6,951 10,637 1,505 161 1,298     (continued )

114  Chapter 5 (continued )

Particulars

Amount

Particulars

Amount

Opening stock—finished goods

602

 

Opening stock—stock-in-trade

199

 

Opening stock— work -in-progress

762

 

Other current assets

840

 

Other current financial assets

207

 

Miscellaneous expenses

654

 

Other non-current assets

298

 

57

 

Power and fuel

206

 

Professional fees

395

 

Other non-current financial assets

Property, plant and equipment

4,949

Purchase of raw material

2,765

Purchase of stock in trade

1,129

Repair and maintenance

132

Research costs—clinical trials

280

Salaries and wages

1,540

Sales promotion expenses

231

Staff gratuity

39

Staff welfare expenses

57

Stores and spares

94

Trade receivables

2,069

Travelling and conveyance  Total

 

239 26,352

Additional Information 1. Closing inventories as on 31st March 2017 consists of: ( ` in Crore) a. Raw material and packing material 1,112 b. Work in progress 545 c. Finished goods 680 d. Stock-in-trade 282 e. Consumable Stores 34 2. Provide depreciation on property, plant and equipment: ` 465 crore 3. Amortise intangible assets: ` 35 crore. 4. Make provision for doubtful trade receivables : ` 33 crore

26,352

Statement of Profit & Loss  115

Case 5.4: Preparation of the Statement of Profit and Loss for Hindustan Unilever Limited9 from the Trial Balance Hindustan Unilever Limited (HUL) is India’s largest Fast Moving Consumer Goods company. HUL has over 35 brands spanning 20 distinct categories such as soaps, detergents, shampoos, skin care, toothpastes, deodorants, cosmetics, tea, coffee, packaged foods, ice cream, and water purifiers. The Company has about 18,000 employees. From the following Trial Balance of the company and additional information, you are required to prepare the Statement Profit and Loss for the company for the year ended 31st March 2017. Particulars Advertising and promotion Assets held for sale Bank balance—other than cash   and cash equivalents Capital work-in-progress Carriage and freight Cash and cash equivalents Contribution to pf and other  funds Csr expenditure

Amount

Particulars

3470

Amount  

72

Accumulated amortisation

11

1,099

Accumulated depreciation

281

203 1,457 572 81 104

Capital redemption reserve

6

Capital reserve

4

Dividend income Employee stock options  outstanding Exceptional item

178 30 241

Current investments

3,519

General reserve

Current tax expenses

1,865

Income for services rendered

513

Interest income

262

Deferred tax assets

160

Deferred tax charge

41

Miscellaneous other income

Defined benefits plan expenses

18

Non-current tax liabilities

Dividend distribution tax paid

693

Other comprehensive income—will   be reclassified to profit and loss

2,187

86 296 1

Dividend paid

3,571

Other current financial liabilities

181

Excise duty

2,597

Other current liabilities

628

Other non-current liabilities

207

Excise duty in closing inventory of   finished goods

15

Intangible assets

393

Interest expense

22

Investments in subsidiaries,   associates and joint ventures Miscellaneous expenses Non-current investments Non-current loans

254 1,266 6 198

Other non-current financial liabilities

71

Other operating income

79

Other reserves Provision for doubtful trade  receivables

9 31

Provisions—current

387

Provisions—non current

485 (continued )

116  Chapter 5 Particulars

Amount

Non-current tax assets Opening stock-stores and spares Opening stock—  work-in-progress

Opening stock—raw material and   packing material Other comprehensive income—   will not be classified to profit   and loss

Amount

311

Retained earnings

3,716

61

Sales of products

33,895

354

Opening stock - finished goods   and stock-in-trade

Particulars

1,206 907

32

Securities premium

116

Share capital

216

Tax credit on OCI—will not be   classified to profit and loss

Trade payables

11

6,006

Other current assets

553

 

Other current financial assets

306

 

70

 

Other non-current financial assets

114

 

Power, fuel, light and water

257

 

Processing charges

290

 

Property, plant and equipment

4,319

 

Purchase of stock in trade

4,166

 

116

 

11,335

 

Rent

241

 

Repair and maintenance

120

 

Royalty expenses

1,044

 

Salaries and wages

1,330

 

94

 

Trade receivables

959

 

Travelling and conveyance

176

 

Workmen and staff welfare  expenses

97

 

50,134

50,134

Other non-current assets

Rates and taxes Raw material and packing   material purchased

Share based payments to  employees

 Total

Statement of Profit & Loss  117

Additional Information 1. Closing inventories as on 31st March 2017 consists of: ( ` in Crore) a. Raw material and packing material 879 b. Work in progress 205 c. Finished goods and stock-in-trade 1,214 d. Stores and spares 64 2. Provide depreciation on property, plant and equipment: ` 384 crore. 3. Amortise intangible assets: ` 12 crore. Case 5.5: Comparison of the Statement of Profit and Loss of Hero Honda Motors Limited and Tech Mahindra Limited for the year 2016–17 Hero MotoCorp Ltd. (Formerly Hero Honda Motors Ltd.) is the world’s largest manufacturer of twowheelers, based in India. In 2001, the company had achieved the coveted position of being the largest two-wheeler manufacturing company in India and also, the ‘World No.1’ two-wheeler company in terms of unit volume sales in a calendar year. Hero MotoCorp Ltd. continues to maintain this position till date.It derives its income from manufacturing and sale of motorcycles. Tech Mahindra Limited is engaged in the IT solutions and services, business process services and IT platforms. The company is present in 90 countries with over 115,000 associates. The statements of profit and loss of two companies for the year ended 31st March 2017 are reproduced below: Particulars I. Revenue from operations II. Other income III. Total income (I +II)

Hero Motocop

Tech Mahindra

30,847

23,165

522

893

31,369

24,058

18,949

0

0

0

63

0

IV. Expenses: Cost of materials consumed Purchase of stock-in-trade Changes in inventories of finished goods,  work-in-progress Excise duty on sales of goods

2,371

0

Employee benefit expense

1,396

7,745

0

8,757

Subcontracting expenses Finance costs Depreciation and amortization expense Other expenses Total expenses (IV)

6

64

493

622

3,432

2,992

26,710

20,180 (continued )

118  Chapter 5 (continued )

Particulars V. Profit/(loss) before exceptional items and   tax (III-IV) VI. Exceptional items

Hero Motocop 4,659

Tech Mahindra 3,878

0

0

4,659

3,878

1,082

723

199

108

3,378

3,047

X. Profit/(loss) from discontinued operations

0

0

XI. Tax expense of discounted operations

0

0

VII Profit/(loss) before tax (V – VI) VIII. Tax expense:   (1) Current tax   (2) Deferred tax IX. Profit/(loss) from the period from continuing operations (VII - VIII)

XII. Profit/(loss) from discontinued operations (X – XI) XIII. Profit/(loss) for the period (IX + XII)

0

0

3,378

3,047

XIV. Other comprehensive income A (i) Items that will not be reclassified to profit and loss

-22

-6

(ii) Income tax relating to items that will not be reclassified to profit and loss

7

0

B (i) Items that will be reclassified to profit and loss

0

531

0

-252

3,363

3,320

(ii) Income tax relating to items that will be reclassified to profit and loss XV. Total comprehensive income for the period (XIII + XIV) comprising profit (loss) and other comprehensive income for the period)

Questions for Discussion 1. Comment upon the key differences in the composition of expenses for the two companies. 2. Hero Motocop has reported excise duty as a separate line item. Likewise, Tech Mahindra reported subcontracting expense as a separate line item rather than clubbing them with other expenses. What accounting principle in involved?

Appendix I: General Instructions for the Preparation of the Statement of Profit and Loss 1. The provisions of this part shall apply to the income and expenditure account, in like manner as they apply to a statement of profit and loss.

Statement of Profit & Loss  119

2.

The statement of profit and loss shall include: (a) Profit or loss for the period (b) Other comprehensive income for the period The sum of (a) and (b) above is total comprehensive income.

3. Revenue from operations shall disclose separately in the notes (a) sale of products (including excise duty) (b) sale of services (c) other operating revenues. 4. Finance costs: finance costs shall be classified as (a) interest (b) dividend on redeemable preference shares (c) exchange differences regarded as an adjustment to borrowing costs; and (d) other borrowing costs (specify nature). 5 Other income: other income shall be classified as (a) interest Income (b) dividend Income (c) other non-operating income (net of expenses directly attributable to such income). 6. Other comprehensive income shall be classified into (A) Items that will not be reclassified to profit or loss (i) Changes in revaluation surplus (ii) Remeasurements of the defined benefit plans (iii) Equity instruments through other comprehensive income (iv) Fair value changes relating to own credit risk of financial liabilities designated at fair value through profit or loss (v) Share of other comprehensive income in associates and joint ventures, to the extent not to be classified into profit or loss (vi) Others (specify nature). (B) Items that will be reclassified to profit or loss (i) Exchange differences in translating the financial statements of a foreign operation (ii) Debt instruments through other comprehensive income (iii) The effective portion of gains and loss on hedging instruments in a cash flow hedge (iv) Share of other comprehensive income in associates and joint ventures, to the extent to be classified into profit or loss (v) Others (specify nature). 7. Additional information:  A Company shall disclose by way of notes, additional information regarding aggregate expenditure and income on the following items: (a) employee Benefits expense [showing separately (i) salaries and wages, (ii) contribution to provident and other funds, (iii) share based payments to employees, (iv) staff welfare expenses] (b) depreciation and amortisation expense (c) any item of income or expenditure which exceeds one per cent of the revenue from operations or ` 10,00,000, whichever is higher, in addition to the consideration of ‘materiality’ (d) interest Income

120  Chapter 5



(e) interest Expense (f) dividend income (g) net gain or loss on sale of investments (h) net gain or loss on foreign currency transaction and translation (other than considered as finance cost) (i) payments to the auditor as (a) auditor, (b) for taxation matters, (c) for company law matters, (d) for other services, (e) for reimbursement of expenses (j) in case of companies covered under section 135, amount of expenditure incurred on corporate social responsibility activities (k) details of items of exceptional nature. 8. Changes in regulatory deferral account balances shall be presented in the statement of profit and loss in accordance with the relevant indian accounting standards.

Endnotes 1. ICAI: Exposure Draft—Framework for the Preparation and Presentation of Financial Statements, 2010. 2. Annual Report of Maruti Suzuki India Limited for the year 2017. 3. Section 209 of Income Tax Act 1961. 4. ICAI: Ind AS 33 ‘Earnings Per Share’ 5. Annual Report of Biocon Limited for 2016–17 6. Annual Report of Asian Paints Limited for the year 2016–17 and the official website of the company https://www.asianpaints.com/more/about-us.html 7. Annual Report of HCL Technologies Limited for the year 2016–17 and the official website of the company https://www.hcltech.com/about-us 8. Annual Report of Cipla Limited for the year 2016–17 and the official website of the company http://www.cipla.com/en/corporate-information/at-a-glance.html 9. Annual Report of Hindustan Unilever Limited for the year 2016–17 and the official website of the company https://www.hul.co.in/about/who-we-are/introduction-to-hindustan-unilever/ 10. Annual Reports of Hero Motocop Limited and Tech Mahindra Limited for the year 2016–17; the official websites of the companies; http://www.heromotocorp.com/en-in/about-us.php; and https://www.techmahindra.com/company/default.aspx

Balance Sheet

6 CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand the contents of balance sheet in depth. • Differentiate between equity and liabilities, current liabilities and non-current liabilities, current assets and non-­current assets. • Appreciate the issues involved in valuation of assets and liabilities in the balance sheet. • Appreciate the impact of relevant accounting standards on the balance sheet—Ind AS 40 (Investment Property), Ind AS 2 (Inventories), Ind AS 109 (Financial Instruments) Ind AS 7 (Statement of Cash Flow) and Ind AS 113 (Fair Value Measurement).

6.1 INTRODUCTION To ensure uniformity in the presentation of the balBalance sheet depicts the financial ance sheet, the format for the same has been preposition of the enterprise on a particuscribed in the Schedule III of the Companies Act, lar day. 2013. The information is presented in a vertical format—assets followed by equities and liabilities. The balance sheet, in simple terms, is a statement of assets and liabilities of a business enterprise on the last day of the accounting period. The balance sheet may also be viewed as a statement of sources and uses of funds. A business enterprise raises funds either from the owners (called capital) or from creditors or lenders (called liabilities). These funds are then used to acquire various types of assets to be used in the business. The total funds raised by the business (capital + liabilities) therefore are always equal to the assets. To that extent the balance sheet represents the financial position of the business enterprise at the end of the accounting period.

6.1.1  GAAP Revisited The relevant accounting principles, discussed earlier in Chapter 2, having a direct bearing on the balance sheets are summarized as follows: 1. Separate entity principle: For the purpose of the balance sheet, owner and business are treated separately. Owners’ contribution to the business is called capital, and is shown on the liabilities side or sources side of the balance sheet.

122  Chapter 6

2. Money measurement principle: All the assets and liabilities are shown in the reporting currency as a common unit of measurement. Assets held or obligations in a currency other than the reporting currency are converted in the reporting currency for incorporating in the balance sheet. 3. Going concern principle: It is assumed than the business will continue to operate indefinitely. There is neither the need nor the intent to liquidate the assets in the near future. 4. Cost concepts: The non-current assets are usually shown at their cost of acquisition less accumulated depreciation. However, if there is a fall in the value of the assets which is non-­ temporary, the assets value is impaired. 5. Conservatism: It is preferable to understate the assets rather that overstating them. Likewise in case of doubt, it is better to overstate the obligations rather than understate them. 6. Dual aspect: Every accounting transaction affects atleast two accounts in such a way that the fundamental accounting equation, i.e., Assets = Owners’ Capital + Liabilities, is always true. The equation suggests that the funds for acquiring assets have either been raised from the owners (called capital) or from creditors (called liabilities). Thus, at any point of time the total of what an enterprise owns will be equal to the claims of various suppliers of funds, i.e., owners and creditors. Due to the dual aspect concept, both sides of the balance sheet will always be equal.

6.1.2  Fair Value Measurement An asset or liability may be recognized either at its historical cost or at its fair value. Ind AS 113 states that ‘fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement value.’ The fair value may be determined by using:

1. Market approach—using prices and other relevant information from market transactions involving comparable assets or liabilities. 2. Cost approach—amount that would be needed to replace an asset. 3. Income approach—finding the present value of future cash flows of income and expenses.

When an asset or liability is measured at its fair value, the difference between the carrying amount and its fair value is recorded in profit or loss, or other comprehensive income. Ind AS 113 does not stipulate when fair value should be used. It addresses how to measure the fair value and requires the following disclosures to be made:

1. The extent of usage of fair value in valuation of assets and liabilities. 2. Valuation techniques, inputs and assumptions used in measuring fair value. 3. The impact of fair value measurements on profit and loss or other comprehensive income.

6.2  FORMAT OF BALANCE SHEET Format of the Balance Sheet has been prescribed in Schedule III of the Companies Act, 2013 to ensure comparability.

The format for the balance sheet has been prescribed in the schedule III of the Companies Act, 2013. The format of the balance sheet is reproduced in Table 6.1 and related disclosures have been given in Appendix-I to the chapter.

Balance Sheet  123

Table 6.1  Format of Balance Sheet

Note No.

Particulars

Figures as at the End of Current Reporting Period

Figures as at the End of Previous Reporting Period

I. Assets (1) Non-current assets (a) Property, plant and equipment (b) Capital work-in-progress (c) Investment property (d) Goodwill (e) Other intangible assets (f) Intangible assets under development (g) Biological assets other than bearer plants (h) Financial assets (i) Investments (j) Trade receivables (k) Loans (l) Deferred tax assets (net) (m) Other non-current assets (2) Current assets (a) Inventories (b) Financial assets (i) Investments (ii) Trade receivables (iii) Cash and cash equivalents (iv) Bank balances other than (iii) above  (v) Loans (vi) Others (to be specified) (c) Current tax assets (net) (d) Other current assets Total II. Equity and liabilities (1) Equity (a) Equity share capital (b) Other equity (continued )

124  Chapter 6 (continued )

Particulars

Note No.

Figures as at the End of Current Reporting Period

Figures as at the End of Previous Reporting Period

III. Liabilities (1) Non-current liabilities (a) Financial liabilities  (i) Borrowings (ii) Trade payables (iii) Other financial liabilities (other than those specified in item (b), to be specified) (b) Provisions (c) Deferred tax liabilities (Net) (d) Other non-current liabilities (2) Current liabilities (a) Financial liabilities  (i) Borrowings (ii) Trade payables (iii) Other financial liabilities (other than those specified in item (c) (b) Other current liabilities (c) Provisions (d) Current tax liabilities (Net) Total equity and liabilities

A brief snapshot of the information given in the balance sheet of Biocon Limited as on 31st March 2017 is given below in Table 6.2: Table 6.2  Balance Sheet of Biocon Limited as on 31st March 2017

Particulars

Note No.

( ` in Million) 31st March 2017

31st March 2016

Property, plant and equipment

8,649

8,596

Capital work-in-progress

2,408

1,723

439

439

Assets Non-current assets

Investment property

(continued )

Balance Sheet  125 (continued )

Particulars Intangible assets

Note No.

( ` in Million) 31st March 2017

31st March 2016

292

342

33,635

32,106

1,923

1,584

243

670

414

428

Financial assets  (i) Investments (ii) Loans (iii) Other financial assets Income tax assets Deferred tax assets (Net)

1,054

-

Other non-current assets

1,847

1,382

50,904

47,270

5,396

5,046

 (i) Investments

5,247

5,983

(ii) Trade receivables

7,982

5,038

(iii) Cash and cash equivalents

Total Non-current assets Current assets Inventories Financial assets

3,416

2,903

(iv) Bank balances other than (iii) above

413

3,527

(v) Others (to be specified)

983

990

Other current assets Total current assets Total Assets

348

224

23,785

23,711

74,689

70,981

1,000

1,000

64,411

58,966

65,411

59,966

1,324

1,365

2

7

133

95



9

Equity and liabilities Equity Equity share capital Other equity Liabilities Non-current liabilities Financial Liabilities  (i) Borrowings (iii) Other financial liabilities Provisions Deferred tax liabilities (Net) Other non-current liabilities Total Non-current liabilities

767

913

2,226

2,389 (continued )

126  Chapter 6 (continued )

Particulars

Note No.

( ` in Million) 31st March 2017

31st March 2016

Current liabilities Financial Liabilities  (i) Borrowings



2,255

4,505

3,944

663

910

Other current liabilities

787

503

Provisions

320

285

Current tax liabilities (Net)

777

729

(ii) Trade payables (iii) Other financial liabilities

Total current liabilities

7,052

8,626

Total equity and liabilities

74,689

70,981

Source: Based upon Annual Report of Biocon Limited for the year 2016–17.

Before the contents of the balance sheet are discussed in detail, some quick observations can be made. The above balance sheet represents the financial position of Biocon Limited, the reporting entity at the end of the accounting period, i.e., 31st March 2017 compared with the previous year. This represents the cumulative assets and liabilities on that particular date since inception of the company. The reporting currency is Indian Rupee and the figures have been presented in rupees million. The balance sheet has two sides—on one side, all the assets (uses of funds) are presented and, on the other side, the equity and liabilities (sources of funds) are shown. Because of the dual aspect concept, the totals of both the sides are equal. The assets side represents the resources owned by the enterprise, whereas the equities and liabilities represent the funds supplied by owners and creditors, respectively and their respective claims on the assets of the business. The asset side represents resources owned by the enterprise at the end of the accounting period. The assets owned are classified into current and non-current based upon their intended use. Cash and assets which are intended to be converted into cash shortly, i.e., usually within 12 months are classified as current assets. The current assets include cash in hand, bank balance, inventories, debtors, short–term loans and advances and current investments. On the other hand, assets intended to be used over a long period of time are called non-current assets (or fixed assets). This category includes assets like plant and machinery, land and building, furniture, computer system, etc. Non-current assets without any physical substance are also included in this category. Such assets are called intangible assets and include copyrights, patents, software licenses and similar rights controlled by the enterprise. Investments which are meant to be held over a long period of time are also classified as non-current. The liabilities side has three major headings—shareholders’ funds, non-current liabilities and current liabilities. The shareholders’ funds (also called equity) represent the funds supplied by the owners of the business. Liabilities, on the other hand, represent the obligation of the enterprise to external parties, i.e., amount it owes to supplier of goods and services, banks and financial institutions, debenture holders, employees, etc. Liabilities which are expected to be met shortly (usually within 12 months) are called current liabilities whereas other obligations (maturing after 12 months) are classified as non-current liabilities.

Balance Sheet  127

A quick look at the balance sheet of Biocon Limited reveals that as on 31st March 2017, the company owns total assets amounting to ` 74,689 million out of which ` 23,785 million are current assets and the balance ` 50,904 million are non-current assets. On the liabilities sides, the equity (shareholders’ funds) amount to ` 65,411 million whereas claims of external parties amounted to ` 9,278 million out of which ` 7,052 million is expected to mature shortly (current liabilities) and liabilities amounting to ` 2,226 million are of long–term nature (non-current liabilities). Both sides of the balance sheet, of course are, equal as per double entry book keeping system. Various components of the balance sheet are depicted in Figure 6.1. Balance Sheet Financial Position at the end of the accounting period

Assets Resources controlled as a result of past events that would bring future benefits

=

Liabilities

Equity

Present obligations due to past events that would lead to future outflow

Residual interest in assets after deducting liabilities

+

Figure 6.1.  Components of the Balance Sheet

6.3 ASSETS Assets—resources controlled by an The expression ‘asset’ generally denotes someenterprise as a result of past events thing which the enterprise own. The funds raised from which future economic benefits by an enterprise through shareholders’ funds and are expected to the entity borrowed funds are used to acquire various assets needed for the operations of the business. Though ownership is often viewed as a criterion for recognizing an asset, it may not always be a necessary condition. The expression asset may be defined as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.’1 Accordingly, for an asset to be recognized the following conditions must be satisfied:





1. It must represent a resource from which future economic benefits are expected—The future benefit from an asset may be derived in a number of possible ways. For example, it may be used in production of goods and services by the enterprise or for settling a liability or for simply acquiring any other asset. The asset may be in the form of cash or cash equivalent or has the potential to contribute to the cash flow of the enterprise in future. 2. It must be controlled by the enterprise—The control normally is associated with the ownership but it may not always be true. For example, a machine obtained on a finance lease basis where the lease period covers almost the entire useful life of the machine will be recognized as an asset in the books of the lessee. Though the legal ownership of the asset is with the lessor, the lessee has the control over it.

128  Chapter 6



3. The control is because of past event—The assets are acquired as a result of transaction that has already taken place. Assets which are expected to be controlled in future are not recognized.

An asset may or may not have a physical form or existence. Assets in physical form, e.g., machinery, furniture, vehicle, etc., are called tangible assets. Assets representing certain rights from which future economic benefits can be derived but not having a physical form, e.g., patent rights, copyrights, software licenses, etc., are called intangible assets. Assets controlled by an entity are classified as current assets and non-current assets based upon their liquidity. Assets which are intended to be converted into cash in short period of time, usually 12 months or in the normal operating cycle of the business are classified as current assets. Cash and cash equivalents, inventories held by the enterprise, trade receivables, etc., are examples of current assets. Current assets are short-term assets, i.e., assets which are in the form of cash or are intended to be converted into cash in the normal operating cycle of the business. The Schedule III of the Companies Act, 2013, provides that ‘an asset shall be classified as current when it satisfies any of the following criteria: 1. It is expected to be realized in, or is intended for sale or consumption in, the company’s normal operating cycle. 2. It is held primarily for the purpose of being traded. 3. It is expected to be realized within twelve months after the reporting date; or 4. It is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date. Usually a cut-off of 12 months is used to distinguish current assets from non-current assets, however, in businesses where operating cycle is longer than 12 months a current asset may have conversion period exceeding 12 months. For example, for an enterprise engaged in construction business, the operating cycle may well exceed 12 months due to long time period needed to complete the project. The operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. The operating cycle of a business is presented in Figure 6.2. Raw Materials, Components and Stores

Cash and Bank Balance

Operating Cycle Work-inProgress

Accounts Receivables

Finished Goods

Figure 6.2  Operating Cycle of a Business

Balance Sheet  129

A business enterprise needs to maintain sufficient cash and bank balance to fund its day-to-day operations. These funds are used to procure raw material, components and other consumable stores to be used for producing goods and services. It must keep sufficient quantities of these items to ensure continuous and uninterrupted supply for the production purposes. Raw material and other supplies are injected in the production cycle where other expenses are incurred at the work-in-progress stage. Once the production cycle is over, the enterprise obtains finished goods. To meet the requirements of its customers, sufficient quantities of finished goods are kept in the store to be sold in the ordinary course of business. These finished goods when sold on credit get converted into debtors or receivables. Upon collection the operating cycle is complete and the enterprise again has access to cash. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve months. When an entity is engaged in multiple businesses with different operating cycles, the classificaNon-current assets are intended to tion of assets into current and non-current would be be held for long period in the busidone depending upon the operating cycles of respecness and not for the purpose of contive businesses. sumption or sale All other assets (other than current assets) will be classified as non-current. Assets intended to be used within the business over a long period of time, exceeding 12 months, are classified as non-current assets. Plant and machinery, furniture, vehicles, patent rights are some of the examples of non-current assets.

6.4  NON-CURRENT ASSETS Any asset that is intended to be used in the business over a long period of time (exceeding 12 months or the normal operating cycle of the business) is classified as a non-current asset. Such assets have been acquired by the enterprise to be used for production of goods and services and not for the purpose of resale in the ordinary course of its business. It is not the nature of asset but its intended use that determine whether it is a current asset or a non-current asset. For example, furniture purchased for the purpose of resale and lying in inventory is a current asset, but the same furniture if purchased for the purpose of use in the office will be shown as a non-current asset. The non-current asset are required to be classified into the following sub-headings 1. Property, plant and equipment 2. Capital work-in-progress 3. Investment property 4. Goodwill 5. Other intangible assets 6. Intangible assets under development 7. Biological assets other than bearer plants 8. Financial assets (a) Investments (b)  Trade receivables (c) Loans (d) Other 9. Deferred tax assets (net) 10. Other non-current assets

130  Chapter 6

6.4.1  Property, Plant and Equipment These are the assets acquired or controlled by an enterprise to be used for the production of goods and services over a long period of time. As these assets are expected to benefit the entity over a long period of time, the cost of acquisition of these assets is appropriated over their useful life by charging depreciation. The depreciated value of property, plant and equipment (PPE) is depicted in the balance sheet. Schedule III of the companies act requires these assets to be classified as:

1. Land 2. Buildings 3. Plant and equipment 4. Furniture and fixtures 5. Vehicles 6. Office equipment 7. Bearer plants 8. Others (specify nature)

Assets under lease are required to be disclosed separately under each category. Assets given on an operating lease (short-term lease) are shown in the balance sheet of the lessor, whereas assets taken on a finance lease (long-term lease) are shown in the balance sheet of the lessee. In either case, these assets are required to be shown separately. A reconciliation of the gross and net carrying amounts of each class of assets—at the beginning and end of the reporting period—showing additions, disposals, acquisitions through business combinations and other adjustments and the related depreciation and impairment losses/reversals are required to be disclosed separately. PPE are disclosed in the balance sheet at their depreciated value. The reconciliation as aforesaid is given in the notes to accounts. PPE are initially recognized at cost. Subsequently, an entity may present the PPE as cost less accumulated depreciation and impairment losses or alternatively at revalued amount less the accumulated depreciation and accumulated impairment loss. Accounting, depreciation and valuation of PPE have been discussed in detail in Chapter 9. The details of property, plant and equipment as appearing in the balance sheet of Biocon Limited are given in Table 6.3. The balance sheet shows the PPE at ` 8,649 million. The reconciliation for the same is provided in the notes to account. The break-up amount property, plant and equipment of ` 8,649 million as on 31 March 2017 is presented below: (` in Million)

Gross carrying amount

20,116



Accumulated depreciation

11,467



Net carrying amount

8,649

From Table 6.3, it can be observed that the gross carrying amount of PPE has gone up from ` 18,674 million to ` 20,116 million. Major portion of the PPE is blocked in plant and equipment followed by building. The accumulated depreciation accounts for about 55% of the gross carrying amount implying that 55% of the cost of the assets being used has already been depreciated.



Disposals

– – – – – –

Depreciation for the year

Disposals

At March31, 2016

Depreciation for the year

Disposals

At March 31, 2017 346 476 564

At April 1, 2015

At March 31, 2016

At March 31, 2017

Net Carrying Amount



At April 1, 2015

Accumulated Depreciation

564

88

At March 31, 2017

476



Disposals

Additions

130

Additions

At March31, 2016

346

At April 1, 2015

Gross Carrying Amount

Land

2,723

2,793

2,561

1,186



158

1,028



149

879

3,909

(1)

89

3,821



381

3,440

5

5

5

1





1





1

6





6





6

4,850

4,796

5,007

9,032

(9)

1,109

7,932

(74)

1,040

6,966

13,882

(10)

1,164

12,728

(77)

832

11,973

Leasehold Plant & Building Improvements Equipment

320

332

403

909



78

831



86

745

1,229



66

1,163



15

1,148

Research and Development Equipment

Table 6.3  Property, Plant and Equipment (PPE) of Biocon Limited as on 31st March 2017 



236

248

178

317

(2)

54

265

50

215

553

(2)

42

513

77

43

393

Furniture and Fixtures

28

23

27

22

(5)

6

21

(2)

6

17

50

(5)

11

44

(6)

6

44

Vehicle

8,649

8,596

8,527

11,467

(16)

1,405

10,078

(76)

1,331

8,823

20,116

(18)

1,460

18,674

(83)

1,407

17,350

Total

( ` in Million)

Balance Sheet  131

132  Chapter 6

6.4.2  Capital Work-in-Progress The capital work-in-progress represents the expenditure incurred on acquiring or constructing tangible assets which are not yet ready for intended use. It may be noted that advances given to the supplier for acquisition of fixed assets are not included under this heading. Once the asset is ready for its intended use, the amount accumulated under this head is transferred to the carrying amount of the PPE.

6.4.3  Investment Property Ind AS 40 defines investment property as land or building or both which is held to earn rentals or capital appreciation or both. If the property is being held for use in production or supply of goods or services or for administrative purposes or for sale in the ordinary course of business, it will not be classified as investment property. Initial recognition of investment property is at cost, i.e., purchase price plus transaction cost and any other directly attributable expenditure. Investment property is carried in the balance sheet at cost less accumulated depreciation and any impairment losses. A reconciliation of the gross and net carrying amounts of each class of property needs to be presented at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments and the related depreciation and impairment losses or reversals.

6.4.4 Goodwill Goodwill is required to be presented as a separate line item on the face of the balance sheet apart from ‘Other Intangible Assets’. Like PPE, a reconciliation of the gross and net carrying amount of goodwill at the beginning and end of the reporting period showing additions, impairments, disposals and other adjustments is also required to be given in the notes to accounts.

6.4.5  Other Intangible Assets Intangible assets are generally in the nature of rights. The following break up of intangible assets is required to be disclosed:

1. 2. 3. 4. 5. 6. 7. 8.

Brands /trademarks Computer software Mastheads and publishing titles Mining rights Copyrights, patents and other intellectual property rights, services and operating rights Recipes, formulae, models, designs and prototypes Licenses and franchise Others (specify nature)

As these intangible assets are expected to generate economic benefits over a period of time, the cost of acquiring or developing these assets is apportioned over their useful lives. Apportioning the cost of an intangible asset over its useful life is called amrotization. Intangible assets are initially recognized at cost. They are carried in the balance sheet at cost less accumulated amortization and any impairment losses. Alternatively, they may be carried in the balance sheet at the revalued amount less accumulated amortization and subsequent accumulated impairment losses.

Balance Sheet  133

A reconciliation of the gross and net carrying amounts of each class of asset needs to be presented at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments and the related amortization and impairment losses or reversals.

6.4.6  Intangible Assets Under Development Expenditure incurred on development of intangible assets which are yet to be finished are accumulated and reported separately under this heading. Once the development of an intangible asset is completed, the amount accumulated under this head is transferred to gross carrying amount of the relevant intangible asset. The details of intangible assets as appearing in the balance sheet of Biocon Limited are given in Table 6.4. (` Million)

Table 6.4:  Intangible Assets of Biocon Limited as on 31st March 2017

Intellectual Property Rights

Computer Software

Marketing and Manufacturing Rights

Customerrelated Intangibles

Total

Gross Carrying Amount At April 1, 2015

81

163

193



437



54

101

77

232

81

218

294

77

669



31





31

81

249

294

77

700

81

59

141



281



27

12

8

46

81

86

153

8

327



39

27

15

81

81

125

180

23

408

At April 1, 2015



104

52



156

At March31, 2016



132

141

69

342

At March 31, 2017



124

114

54

292

Additions At March 31, 2016 Additions At March 31, 2017 Accumulated Amortization At April 1, 2015 Amortization for the year At March 31, 2016 Amortization for the year At March 31, 2017 Net Carrying Amount

The recognition and valuation of tangible assets (plant, property and equipment) and intangible assets can have a significant impact on the financial position of the enterprise depicted in the balance sheet. The principles governing initial recognition of these assets, their depreciation and amortization and subsequent revaluation has been covered in detail in Chapter 9.

134  Chapter 6

6.4.7  Biological Assets Other than Bearer Plants A biological asset is defined in Ind AS 41 as a living animal or plant. Examples of biological assets, as given in Ind AS 41, include sheep, trees in a timber plantation, dairy cattle, cotton plants, sugar cane, tea bushes, oil palms, fruit trees, rubber trees, etc. Some plants, for example, cotton plants, tea bushes, oil palms, fruit trees, grape vines, usually meet the definition of a bearer plant, and therefore, are excluded from this heading. However, the produce growing on bearer plants, viz., cotton, tea leaves, oil palm fruit, fruits, grapes, etc., are biological assets. A reconciliation of changes in the carrying amount of biological assets between the beginning and the end of the current period is required to be presented in the notes to accounts.

6.4.8 Financial Assets Financial assets generally mean cash, financial instruments of another entity (equity instruments, debt instruments) and a contractual right to receive cash or other financial assets. Accordingly, this heading includes:

i. ii. iii. iv.

Non-current investments Non-current trade receivables Non-current loans Other non-current financial assets

Non-current Investments A business enterprise may invest its resources in acquiring the securities issued by another enterprise. Such an investment may be made either for controlling the other enterprise or simply for making a return either as periodical returns or by capital gains. Where the intention is to hold such investments for a long period of time (usually exceeding 12 months), they are classified as non-current investments. Investments are required to be classified as: (a) Investments in equity instruments (b) Investment in preference shares (c) Investments in government or trust securities (d) Investments in debentures or bonds (e) Investments in mutual funds (f) Investments in partnership firms (g) Other investments (specify nature) Under each classification, names of the bodies corporate that are subsidiaries, associates, joint ventures, or structured entities, in which investments have been made are required to be disclosed. The nature and extent of the investment so made in each such body corporate showing separately investments which are partly-paid is also required to be disclosed in the notes to accounts. Investments in partnership firms showing names of the firms, their partners, total capital and the shares of each partner is required to be disclosed separately. In addition, aggregate amount of quoted investments and market value thereof, aggregate amount of unquoted investments and aggregate amount of impairment in value of investments is required to be disclosed.

Balance Sheet  135

The details of non-current investments of Biocon Limited as on 31st March 2017 are given in Table 6.5. Table 6.5:  Long-term Investments of Biocon Limited as on 31st March 2017

Particulars

( ` in Million) 31st March 2017 31st March 2016

Non-current investments I. Quoted equity Instruments In Subsidiary company at cost Syngene International Limited

27,591

27,591

27,591

27,591

Biocon Research Limited

1

1

Biocon SA Switzerland

4

4

Biocon FZ LLC, UAE

3

3

121

51

4,453

4,453

1

1

2

2

Total quoted non-current investments II. Unquoted equity instruments In subsidiary company at cost

Biocon Pharma Limited Biocon Biologics Limited Biocon Academy In joint venture compnay NeoBiocom FZ LLC, UAE In other: Energon KN Wind Power Private Limited

1



Less: Provision for decline, other than temporary, in the value of non-current investments

(1)



4,585

4,515

IARRICa Inc USA

139

139

Less: Provision for decline, other than temporary, in the value of non-current investments

(139)

(139)

Total unquoted investments in equity instruments III. Unquoted preference shares in associate company





Vaccinex Inc USA, B1 preferred convertible stock

186

186

Vaccinex Inc USA, B2 preferred convertible stock

32

32

Total unquoted investments in preference share in associate company Others:

(continued )

136  Chapter 6 (continued )

Particulars Less: Provision for decline, other than temporary, in the value of non-current investments

( ` in Million) 31st March 2017 31st March 2016 (218)

(218)

Energon KN Wind Power Private Limited–Compulsory Convertible Preference Shares

1



Less: Provision for decline, other than temporary, in the value of non-current investments

(1)







LIC Housing Finance Co Ltd

701



HDFC Limited

758



1,459



Total unquoted investments in preference shares IV. Quoted debentures or bonds Others:

Total unquoted investments in debentures or bonds Total non-current Investments

33,635

32,106

Aggregate book-value of quoted investments

27,591

27,591

Aggregate market value of quoted investments

75,622

55,800

6,403

4,872

359

357

Aggregate value of unquoted investments Aggregate amount of impairment in value of investments

The non-current investments of the company have increased from ` 32,106 million to ` 33,635 million as on 31st March 2017. Majority of these investments are strategic in nature—in joint ventures, associate and subsidiary companies. The company has recognized impairment loss to the extent of ` 359 towards decline in the value of these investments which is non-temporary in nature. The quoted investments have been recognized in the books at ` 27,591 million as against the market value of these investments is ` 75,622 million. Investments are initially recognized at cost. The cost includes acquisition charges, like brokerage and fees & taxes duties. The subsequent measurement may be either at historical cost (amortized cost) or at fair value. The impact of fair value measurement may be recognized either through profit or loss (fair value through profit or loss) or through other comprehensive income (fair value through other comprehensive income). The requirements of Ind AS 109 in this regards have been discussed in detail in Chapter 10.

Non-current Trade Receivables Amount outstanding to be received from the customers on the balance sheet date towards goods sold or services rendered is classified as trade receivables. Trade receivables which are expected to be realized after 12 months from the balance sheet date are classifies as non-current. It needs to be classified as: (a) Secured—considered good (b) Unsecured—considered good (c) Doubtful

Balance Sheet  137

Provision made towards bad and doubtful debts shall be disclosed under the relevant heads separately. Amounts due by directors or other officers of the company or any of them either severally or jointly with any other person or debts due by firms or private companies respectively in which any director is a partner or a director or a member is separately stated.

Non-current Loans Loans represent the money extended by an enterprise to another as loan which is repayable in future. Loans expected to be realized after 12 months are classified as non-current loans. This also includes security deposits given by the enterprise for various purposes during the ordinary course of business. Loans to related parties are required to be disclosed separately. Loans are accordingly classified as: (a) Security deposits (b) Loans to related parties (giving details thereof) (c) Other loans (specify nature) Likewise a loan or an advance may be secured against some collateral given by the borrower or unsecured. Accordingly the aggregate value of loans and advances is broken down in three sub-headings: (a) Secured—considered good (b) Unsecured—considered good (c) Doubtful The loans and advances are shown at their gross value less provision for bad and doubtful loans made. The above breakup is provided in the relevant notes to the balance sheet.

Other Non-current Financial Assets Non-current financial assets other than investments, trade receivables and loans are classified under this heading. Any financial asset which is non-current is nature and has not been classified in the earlier sub-headings will get disclosed under this heading. For example, amounts due under contractual rights, dues in respect of insurance claims, receivables on account of sale of property, plant and equipment, contractually reimbursable expenses, etc. are classified as other non-current financial assets if they are realizable after 12 months. Likewise, bank deposits with more than 12 months maturity and non-current portion of finance lease receivables are also classified under this heading.

6.4.9  Deferred Tax Assets Deferred tax assets are recognized due to timing differences between the taxable income and the reported income. If due to such timing difference an enterprise has paid higher taxes in the current accounting period which will get reversed and result in lowering of tax liability in the future accounting period, the same is recognized as deferred tax asset. If the aggregate of deferred tax asset on the balance sheet date exceeds the aggregate of deferred tax liabilities, the net amount is shown under noncurrent assets as deferred tax asset (net). The deferred tax asset usually arises when certain expenses or provisions are recognized for the purpose of reported profit on accrual basis but for tax computation, the same are permitted as deduction on payment basis. For example, provision for doubtful debts reduces the reported profit for the period when the provision is made but the same is allowable for tax computation only when the bad debts are actually written off.

138  Chapter 6

6.4.10  Other Non-current Assets This is the residual category for non-current asset. Any asset which is non-current and non-finance is nature and has not been classified in the above sub-headings will get disclosed under this heading. Capital advances and other advances which are not in the nature of loans are classified here. Other non-current assets are classified as:

1. Capital advances 2. Advances other than capital advances 3. Others (specify nature) Advances other than capital advances are further classified as



1. Security deposits 2. Advances to related parties (giving details thereof) 3. Other advances (specify nature).

Advances to directors or other officers of the company or any of them either severally or jointly with any other persons or advances to firms or private companies respectively in which any director is a partner or a director or a member are separately stated.

6.5  CURRENT ASSETS As discussed earlier, current assets include cash, cash equivalents, assets intended for sale or consumption or expected to be realized in cash within 12 months or in the company’s normal operating cycle and held primarily for the purpose of being traded. Current assets are more liquid than the non-current assets. Current asset are required to be classified into the following sub-headings: 1. Inventories 2. Financial assets (a) Investments (b)  Trade receivables (c)  Cash and cash equivalents (d)  Bank balances other than (iii) above (e) Loans (f)  Others (to be specified) 3. Current tax assets (net) 4. Other current assets

Current assets are intended to be converted into cash within 12 months or normal operating cycle of the company.

6.5.1 Inventories The expression ‘inventories’ include goods held by an enterprise for the purpose of consumption in the production process or which are currently in the production cycle or are being held for sale in the ordinary course of business. Inventories are classified as:

1. Raw materials 2. Work-in-progress 3. Finished goods 4. Stock-in-trade

Balance Sheet  139



5. Stores and spares 6. Loose tools 7. Others (specify nature)

Goods in transit are disclosed under the relevant heading of inventories. Inventories are initially recognized at cost. The cost for this purpose includes the cost of acquiring the inventory and appropriate conversion cost. After initial recognition at cost, inventories are carried in the balance sheet at ‘the lower of cost or net realizable value’ following conservatism principle. The valuation of inventories can have a significant impact on the balance sheet as well as the statement of profit and loss. The inventory valuation is the subject matter of Ind AS 2 and has been covered in detail in Chapter 8. Appropriate disclosure regarding the mode of valuation used should be made. The details of inventories held by Biocon Limited are depicted in Table 6.6. Table 6.6:  Inventories held by Biocon Limited as on 31st March 2017

Particulars

(` in Million) 31st March 2017

31st March 2016

Raw Material including goods in bonds*

988

1,166

Packing materials

386

323

Work-in-progress

2,494

1,569

Finished goods

1,305

1,726

Traded goods

223

262

5,396

5,046

* includes goods in-transit ` Nil (March 31, 2016–` 151). Write-down of inventories to net realisable value amounted to ` 3 (March 31, 2016–` 3). These were recognized as an expense during the year and included in ‘changes in inventories of traded goods, finished goods and work-in-progress’ in statement of profit and loss.

As on 31st March 2017, total inventories held by Biocon Limited were ` 5,396 million (previous year ` 5,046 million). Major portion of inventories is represented by work-in-progress followed by finished goods. The inventories have been valued at ‘lower of cost and net realizable value’ and the resultant loss has been charged to the statement of profit and loss.

6.5.2  Current Financial Assets As discussed earlier, financial assets generally mean cash, financial instruments of another entity (equity instruments, debt instruments) and a contractual right to receive cash or other financial assets. Financial assets of current nature are included under this heading. Accordingly, this heading includes:

i. ii. iii. iv.

Current investments Current trade receivables Current loans Other current financial assets

140  Chapter 6

Current Investments An enterprise instead of keeping its short-term cash surpluses in bank accounts may invest the same in financial instruments to generate higher returns. Such investments are usually made in instruments which are highly liquid and convertible into cash quickly. Current investments are intended by the company to be sold within twelve months or within the company’s operating cycle. They also include investments which have a remaining maturity of less than twelve months or within the company’s operating cycle. Current Investments are required to be classified as: (a) Investments in equity instruments (b) Investment in preference shares (c) Investments in government or trust securities (d) Investments in debentures or bonds (e) Investments in mutual Funds (f) Investments in partnership firms; or (g) Other investments (specify nature) Under each classification, names of the bodies corporate that are subsidiaries, associates, joint ventures, or structured entities, in which investments have been made are required to be disclosed. The nature and extent of the investment so made in each such body corporate, showing separately investments which are partly-paid, is also required to be disclosed in the notes to accounts. Investments in partnership firms, showing names of the firms, their partners, total capital and the shares of each partner, are required to be disclosed separately. In addition, aggregate amount of quoted investments and market value thereof, aggregate amount of unquoted investments and aggregate amount of impairment in value of investments is required to be disclosed. Investments are initially recognized at cost. The cost includes acquisition charges, like brokerage and fees taxes and duties. The subsequent measurement may be either at historical cost (amortized cost) or at fair value. The impact of fair value measurement may be recognized either through profit or loss (fair value through profit or loss) or through other comprehensive income (fair value through other comprehensive income). The requirements of Ind AS 109 in this regards have been discussed in detail in Chapter 10. The details of current investments of Biocon Limited as on 31st March 2017 are given in Table 6.7. Table 6.7:  Current Investments of Biocon Limited as on 31st March 2017

Particulars

(` Million) 31st March 2017 31st March 2016

Investments in mutual funds Birla Sun Life Short Tem Fund—Growth DHFL Premerica Banking and PSU Debt Fund Edelweiss Banking and PSU Fund—Regular Plan Growth

907



93



276

DWS Banking and PSU Debt Fund—Regular Plan Growth



724

HDFC Medium Term Opportunities Funds—Regular Plan

503

– (continued )

Balance Sheet  141

Particulars HDFC Short-term Opportunities Fund—Regular Plan Growth

(` Million) 31st March 2017 31st March 2016 405



JP Morgan Banking and PSU Debt Fund—Weekly Dividend Reinvestment Option



258

Reliance Banking and PSU Debt Fund—Weekly Dividend Reinvestment Option Plan



465

851



SBI Premier Liquid Fund—Regular Plan



74

UTI—Treasury Advantage Fund—Institutional Plan

92

42

3,127

1,563

2,120

4,420

5,247

5,983

5,247

5,983

Reliance Banking and PSU Debt Fund—Growth

In Others Inter corporate deposits with financial institutions

Aggregate value of unquoted investments

The current investments of Biocon Limited have declined from ` 5,983 million in the previous year to ` 5,247 million as on 31st March 2017. The company is keeping its short-term surplus cash in mutual funds and inter-corporate deposits, which are highly liquid and have low risk.

Current Trade Receivables Trade receivables which are expected to be realized within 12 months from the balance sheet date or within the normal operating cycle are classifies as current trade receivables. The amount of receivables needs to be classified as: (a) Secured—considered good (b) Unsecured—considered good (c) Doubtful Provision made towards bad and doubtful debts shall be disclosed under the relevant heads separately. Amounts due by directors or other officers of the company or any of them either severally or jointly with any other person or debts due by firms or private companies respectively in which any director is a partner or a director or a member is separately stated. The accounting for receivables and doubtful debts has been discussed at length in Chapter 7. The details of trade receivables of Biocon Limited as on 31st March 2017 are given in Table 6.8.

142  Chapter 6 Table 6.8:  Current Trade Receivables of Biocon Limited as on 31st March 2017

Particulars Unsecured, considered good Doubtful Allowance for credit loss Traded Goods The above includes due from Narayna Hrudayalaya Limited in which a director of the company is a member of board of directors

(` Million) 31st March 2017 31st March 2016 7,982

5,038

58

42

8,040

5,080

(58)

(42)

7,982

5,038

4

8

The trade receivables for Biocon Limited has gone up to ` 7,982 million as on 31st March 2017 compared to ` 5,038 million in the previous year. The company has a provision of ` 58 million (previous year ` 42 million) towards credit loss expected on account of non-recovery of receivables.

Cash and Bank Balances Cash and bank balances are classified into two sub-heading: (a) Cash and cash equivalents (b) Bank balances other than cash and cash equivalents As per Ind AS-7, cash and cash equivalents include cash in hand and demand deposits with banks. Cash equivalents are defined as short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. An investment would normally qualify as a cash equivalent only when it has a short maturity of three months or less from the date of acquisition. This would include term deposits with banks that have an original maturity of three months or less. Cash and equivalents are further classified as: (a) Balances with banks (of the nature of cash and cash equivalents) (b) Cheques and drafts on hand (c) Cash on hand (d) Others (specify nature) Bank balances, other than cash and cash equivalents as above, are required to be disclosed below cash and cash equivalents on the face of the balance sheet. The following additional disclosures are required to be made with regard to cash and bank balances: (a) Earmarked balances with banks (for example, for unpaid dividend). (b) Balances with banks to the extent held as margin money or security against the borrowings, guarantees, other commitments, etc. (c) Repatriation restrictions, if any, in respect of cash and bank balances. It may be noted that deposits with maturity period exceeding twelve months should not be shown under this heading rather is should be shown under other non-current financial assets.

Balance Sheet  143

The cash and bank balances of Biocon Limited as on 31st March 2017 is shown in Table 6.9: Table 6.9:  Cash and Bank Balances of Biocon Limited as on 31st March 2017

Particulars

(` Million) 31st March 2017 31st March 2016

Cash and Cash Equivalents Balances with Banks On current accounts

3,410

2,653

6

10

On unpaid dividend account Deposits with original maturity of less than 3 months Total cash and cash equivalents



240

3,416

2,903

410

3,524

3

3

Other bank balances Deposits with maturity of less than 12 months Margin money deposits Total other bank balances (a) M  argin money deposits are subject to first charge against bank guarantees obtained.

413

3,527

3,829

6,430

3

3

(b) T  he Company has cash on hand which are not disclosed above since amounts are rounded off to Rupees million.

As on 31st March 2017, total cash and bank balance of the company stood at ` 3,829 million (previous year ` 6,430 million). The major portion (` 3,416 million) is represented by cash and cash equivalents. It may be noted that bank deposits exceeding 12 months maturity are not included under this heading.

Current Loans Loans expected to be realized within 12 months of the date of the balance sheet are classified as current loans. This also includes security deposits given by the enterprise for various purposes during the ordinary course of business. Loans to related parties are required to be disclosed separately. Accordingly, loans are classified as: (a) Security deposits (b) Loans to related parties (giving details thereof) (c) Other loans (specify nature) Likewise, a loan or an advance may be secured against some collateral given by the borrower or unsecured. Accordingly, the aggregate value of loans and advances is broken down in three sub-headings: (a) Secured; considered good (b) Unsecured; considered good (c) Doubtful The loans and advances are shown at their gross value less provision for bad and doubtful loans made. The above breakup is provided in the relevant notes to the balance sheet.

144  Chapter 6

6.6  CURRENT TAX ASSETS (NET) Companies are required to pay advance tax on the estimated taxable income for the year. It may happen that the amount of tax already paid in respect of current and prior periods exceeds the amount of tax due for those periods. The excess tax so paid is recognized as an asset. The excess tax paid is computed for each assessment period separately.

6.7  OTHER CURRENT ASSETS This is the residual category for the current asset. Any asset which is current is nature and has not been classified in the above sub-headings will get disclosed under this heading. Other current assets are further classified as advances other than capital advances and others. Advances other than capital advances are further broken into security deposits, advances to related parties (giving details thereof) and other advances. Advances to directors or other officers of the company or any of them either severally or jointly with any other persons or advances to firms or private companies respectively in which any director is a partner or a director or a member should be separately stated. Other current assets will also include prepaid expenses and income received in advance.

6.7.1  Pre-paid Expenses An enterprise may incur certain expenses in one accounting period a portion of which pertains to the next accounting period. The unexpired portion of expenses incurred in an accounting period is referred to as prepaid expense and is shown as a current asset. To illustrate annual maintenance charges paid amounting to ` 600,000 for a period covering 12 months out of which say 3 months fall in the next accounting period. Three-fourth of the expenses incurred (for 9 months) will be expensed in the current accounting period whereas the unexpired portion (for three months) amounting to ` 150,000 will be shown in the balance sheet as prepaid expenses. Similarly, other expenses incurred are analysed to ensure proper matching of expenses.

6.7.2  Income Earned but not Received An enterprise might earn certain income in one accounting period which is actually received in the subsequent accounting period. The income is recognized following accrual principle in the period when earned and at the same time it is recorded as a current asset. To illustrate, an enterprise placed a fixed deposit of ` 10 million for one year on 1st December 2016. The deposit earns interest @ 12% per annum and will mature on 30th November 2017. Interest for the period of 4 months (from 1st December 2016 to 31st March 2017) amounting to ` 400,000 will be recognized as an income in the statement of profit and loss for the period ended 31st March 2017. At the same time, interest earned but not received for the same amount will be recorded in the Balance Sheet as on 31st March 2017 as other current asset.

6.8  EQUITY AND LIABILITIES The second part of the balance sheet—Equity and Liabilities—reflects what the company owes to the providers of capital. Liabilities are the present obligations of the entity arising from the past events which is expected to result in outflow on settlement. Equity represents the claim of the owners i.e. the residual interest in the assets of the entity after settlement of all liabilities.

Balance Sheet  145

6.9 EQUITY Equity represents the claim of the shareholders over the assets owned by the company. As the shareholders are the owner of the business their ‘claim’ is not of the same nature as that of external suppliers of funds. They are perpetual in nature and are not expected to be repaid except in case of liquidation of the company and that too after paying all other obligations. Equity, therefore, ‘is the residual interest in the assets of the entity after deducting all its liabilities’. To that extent, the accounting equation may be represented as Equity = Assets – Liabilities. The equity is further broken down in two sub-headings— share capital and other equity. Schedule III requires a separate ‘statement of change in equity’ to be presented comprising equity share capital and other equity. Other equity includes all items other than equity shares that are attributable to the holders of equity instruments of an entity. The statement of change in equity provides a reconciliation of equity, showing balances in the beginning of the year, changes during the year and balances at the end of the year.

6.9.1  Share Capital The total capital of a company is divided into small units called shares. Each share has a ‘face value’ or ‘par value’. The share capital represents the amount raised by the company by issuance of shares at the stated face value. A company being an artificial person is managed in accordance with its constitution called memorandum of association. The memorandum of association amongst other things also define the maximum amount that the company is authorized to raise by way of issue of shares. The upper limit so defined is called the authorized share capital. Each share represents a part ownership of the company. The shares issued by the company may be either preference shares or equity shares. As the rights associated with the preference shares capital and equity shares capital are different, they are shown separately in the balance sheet.

Preference Shares Preference shares carry a fixed rate of dividend and have a preference over equity in the payment of dividend as well as repayment of principle in case of liquidation of the company. Preference shares have a face value and a stated rate of dividend. For example, 10% preference share of ` 100 each means Preference shares are entitled to a that the face value per share is ` 100 on which divifixed rate of dividend and have prefdend at a fixed rate of 10% will be paid. Though they erence over equity in payment of are entitled to a fixed rate of dividend, it is payable d ­ ividend and repayment of capital in only if the company has adequate profits. In case the case of winding up of the company. company is unable to pay dividend on the preference shares due to inadequacy of profit, the same gets accumulated and has to be paid once the company starts making profits provided that the preference shares were cumulative in nature. In case of non-cumulative preference shares, the dividend once skipped does not accumulate. They normally do not have any voting rights. However, in case of non-payment of dividend they do get limited voting rights. Preference shares further may be redeemable or irredeemable. Redeemable preference shares are issued for a fixed maturity. On maturity the shares are redeemed, that is, the principal amount is repaid to the holders. Irredeemable preference shares, on the other hand, are perpetual in nature. The Companies Act, 2013, permits issuance of only redeemable preference shares with maturity not e­ xceeding 20 years.2 The preference shares may also be convertible into equity shares. Preference shares with convertibility clause are called convertible preference shares.

146  Chapter 6

Equity Shares Equity shares also called common shares or ordinary shares represent the ownership of the comEquity shares represent the ownership pany. They have the last preference in getting of a company as they enjoy voting dividend and repayment of principle. The dividend rights. in not fixed—it is declared at the discretion of the board of directors of the company. Dividend, if any, on equity shares is paid only after paying the dividend on preference shares. Similarly, in case of liquidation of the company they have the last claim over the assets of the company. Equity shares are issued with a par value also called the face value per share. When a company raises funds by issue of equity shares its bank balance increases and at the same time the share capital representing claim of the owners also goes up. The following entry is passed: Bank Account Dr.    To Equity Share Capital Account

Share Premium An existing and profit-making company may issue its equity shares to new shareholders at a price higher than the face value of the shares. The excess of the issue price over and above the face value of share is called premium. The amount of securities premium is not included in the share capital but is shown separately as securities premium account. It may be noted that securities premium is in the nature of a capital profit and therefore not taken to the profit and loss statement. It is credited to the ­securities premium account which is an example of capital reserve and is included in other equity. Securities premium account cannot be used to pay dividends to the shareholders but is permitted to be used for issuing fully paid up bonus shares.4 ■  Illustration 6.1

Blue Bell Limited issued 20 million equity shares of the face value of ` 10 each at an issue price of ` 50 each for cash. How will this transaction be recorded? The issue price of ` 50 per share is made up of two components—` 10 towards face value and ` 40 towards premium. Accordingly, the transaction will be recorded as follows: Bank Account   Dr.  ` 1,000 million (20 million × ` 50 per share) To Equity Share Capital Account ` 200 million (20 million × ` 10 per share) To Securities Premium Account ` 800 million (20 million × ` 40 per share) Only the amount of ` 200 million will be shown as share capital. The securities premium account at ` 800 million will appear as a separate heading under other equity.

Issued, Subscribed and Paid-up Capital The authorized share capital is the maximum amount that the company may raise by the issue of shares. This is also called the nominal capital because this amount has not actually been raised by

Balance Sheet  147

the company. A part of the authorized capital that Share Application Money is shown is actually offered by the company for subscription separately as a part of shareholders’ to investors is called the issued capital. The issued funds till allotment is made capital cannot exceed the authorized capital. The part of issued capital that is actually taken up and allotted to the investors is called the subscribed capital. The subscribed capital cannot exceed the issued capital. The issuing company may not call the entire face value per share in one go rather decide to call the amount in instalments. The part of subscribed capital in respect of which calls have been made on the shareholders by the company for payment is known as the called-up capital. If the shareholders fail to pay a part of the amount called up, the same is termed as calls in arrear. The calls in arrear amount is deducted from the called up capital to arrive at the paid up capital. The paid up capital is the real capital of the company which is taken in the amount column in the balance sheet. ■  Illustration 6.2

Kay Kay Limited has an authorized capital of 60 million equity shares of the face value ` 10 each and one million preference shares of the face value ` 100 each carrying dividend at 10%. The company offered 20 million equity shares at par for subscription and on which ` 8 has been called up. All ­shareholders paid the amount called except holder of 500,000 shares who failed to pay call amount of ` 4 each. How will this information appear in the balance sheet of the company? The information will be shown as follows:   Balance Sheet of Kay Kay Limited as on………….

Particulars

( ` in Million)

Equity Share capital Authorized Equity shares capital (60 million equity shares of ` 10 each)

600

Preference share capital (1 million, 10% preference shares of ` 100 each)

100 700

Issued and subscribed Equity share capital (20 million equity shares of ` 10 each) Called up

  200  

20 million equity shares of ` 10 each, ` 8 called up

160

Less: Calls in arrear

  2

(500,000 equity shares at ` 4 each) Paid up capital 

  158

The paid up capital of ` 158 million will be shown in the balance sheet as the share capital. All other details are provided in the schedule to the balance sheet. Usually the issued, subscribed, called up and paid up capital is the same for most of the companies.

148  Chapter 6

Share Application Money The issue of share capital may be a three step process—the company invites the prospective investors to apply for the shares of the company, the investors apply for the shares paying application money with the application and the company accepts the application by way of making an allotment. It may be noted that the share capital comes into existence only when the company accepts the application by way of making the allotment. Accordingly, money received on application is shown separately till the allotment is made. Upon allotment, the application money is transferred to share capital.

■  Illustration 6.3

Readwell Book Store Limited, with an authorized share capital of ` 40 million (four million equity shares of ` 10 each), has a paid up capital of ` 10 million (one million shares of ` 10 each). It further offered two million equity shares of ` 10 each at par for subscription on 28th February 2017. The company received ­applications for three million equity shares with application money amounted to ` 30 million. The c­ ompany made allotment of two million shares and refunded the excess application money on 25th April 2017. How will the necessary entries be passed? How will it appear in the balance sheet as on 31st March 2017? The necessary journal entries will be as follows: On receiving the application money: Bank Account Dr. ` 30 million    To Share Application Money Account    ` 30 million At the time of allotment: Share Application Money Account Dr. ` 20 million    To Equity Share Capital Account    ` 20 million For making the refund: Share Application Money Account Dr. ` 10 million   To Bank Account   ` 10 million As on 31st March 2017, the allotment is yet to be made, the application money received will not be included in the equity share capital. The application money in respect of the two million shares will be shown funds separately. The excess application money to be refunded shortly will be shown in the current liabilities. The share capital in the balance sheet as on 31st March 2017 will appear as follows:           Balance Sheet of Readwell Book Stores Limited as on 31st March 2017

Particulars

31st March 2017

Share capital Authorized 4 million equity shares of ` 10 each

( ` in Million)   40 (continued )

Balance Sheet  149 (continued )

Particulars

31st March 2017

Issued and subscribed 40

4 million equity shares of ` 10 each

 

Issued and subscribed

30

3 million equity shares of ` 10 each Called up and paid up 1 million equity shares of ` 10 each

10

Share application money

20 30

Current liabilities Share application money (to be refunded)

10

Share Forfeiture Account If the shareholder to whom the shares have been allotted fails to pay the amount due on call, the company by giving due notice to the defaulting shareholder has a right to forfeit the shares issued. The forfeiture involves forfeiting the amount already paid, writing-off the calls in arrear and reducing the paid up capital to that extent. The amount forfeited is shown separately in the balance sheet. The shares forfeited for nonpayment can be subsequently reissued by the company. At that stage, the balance available in the share forfeiture account is transferred to capital reserves and shown in the reserves and surplus. ■  Illustration 6.4

Assume that Kay Kay Limited (Illustration 6.2) decides to forfeit the 500,000 equity shares on which the call money has not been paid after giving due notice to the defaulting shareholders. What will be the accounting entry for the forfeiture? How will it be shown in the balance sheet? In respect of 500,000 equity shares, ` 8 per share has been called up. Out of which, ` 4 per share has been paid up and the balance ` 4 is call in arrears. The following entry will be passed to record the forfeiture: Equity Share Capital Account   ` 4,000,000 (500,000 shares at ` 8 each called up) To Share Forfeited Account ` 2,000,000 (500,000 shares at ` 4 each paid) To Calls in Arrear Account ` 2,000,000 (500,000 shares at ` 4 each in arrear) After forfeiture the paid up capital will be shown in the balance sheet as follows:

19.5 million equity shares of ` 10 each, ` 8 called up

( ` in Million) 156

Add: Share Forfeited Account   2

  158

150  Chapter 6

Issue of Warrants A warrant is an instrument that gives the holder a right to buy the specified number of shares at a Warrant gives the holders a right to predetermined price. It may be noted that issue of apply for a fixed number of shares warrants by a company does not lead to an increase of the company at a predetermined in the share capital. The warrant holder has a right price in future to apply for and purchase equity shares of the company at a predetermined price some time in future. At the time when the warrant is ­exercised, the holder will pay the agreed price and the company will issue the new shares. The necessary entries for issue of share capital will be passed when the warrant is exercised. If the company has received some amount from the warrant holders as a precondition for issue of warrant, the same will be shown separately in the balance sheet and will be adjusted when shares are issued in lieu of the warrants.

Stock Splits A company may decide to split its shares into share of lower face value. Stock split essentially involves substituting equity shares with larger face value by equity shares of smaller face value in such a way that the total paid up capital of the company and the proportionate ownership of the company remain unaltered. As a result of stock split, the number of shares goes up but with proportionately lowers face value. Consequently, the share capital of the company remains unaffected.

■  Illustration 6.5

The paid up capital of the company consists of 25 million equity shares of ` 10 each and the management decides to split each share into five shares of face value ` 2 each. How will the share capital appear before and after the split? Before the split the share capital of the company will appear as follows:    Equity share capital (25 million shares of ` 10 each) ` 250 million After split of five for one the share capital will be shown as follows:    Equity share capital (125 million shares of ` 2 each) ` 250 million It may be observed that the paid up capital of the company has remained unaltered though the number of equity shares outstanding have gone up five times due to five for one split.

Bonus Share Bonus refers to the issue of new shares to the existing shareholders in proportion of their existing shareholding without consideration. A company may decide to issue new shares to its existing shareholders without any consideration. Such an issue of shares is called bonus shares or stock dividend. As the shares are issued without consideration there is no change in the cash position of the company. The paid up share capital of the company though go up by the face value

Balance Sheet  151

of the new shares, there is no change in the shareholders’ funds. The bonus shares are issued by capitalization of reserves. The reserves and surplus of the company is reduced to the extent of the face value of the new shares issued. Consequent upon the issue of bonus shares, the paid up capital of the company increases proportionately though the shareholders’ funds remain unaltered.

■  Illustration 6.6

The shareholders’ funds of Dee Jay Limited as on 31st March 2017 are given as follows: (` in Million) Equity Share Capital (30 million shares of ` 10 each)

300

General Reserves Account

900

Securities Premium Account

  450

    Total

1,650

The company decided to issue bonus shares to its shareholders in the ratio of 2:1 (i.e., two new equity shares for each share held). For this purpose, it decided to capitalize securities premium account and general reserves account. Pass the necessary accounting entries and show how the equity will be shown in the balance sheet after the bonus issue. Journal Entry Securities Premium Account   Dr. ` 450 million General Reserves Account   Dr. ` 150 million To Equity Share Capital Account       ` 600 million Equity after the Bonus Issue:

Equity Share Capital (90 million shares of ` 10 each)

( ` in Million) 900

General Reserves Account

  750

Total

1,650

Share Buy-back Share buy-back in Indian context essentially means buying the shares from the market and cancelling them. If the management feels that the company is overcapitalized and has surplus cash, it may decide to buy-back the shares for the purpose of cancellation. This is also called share repurchase. The Companies Act, 2013, lays down the necessary conditions for the buy-back of shares.3 Share buy-back is exactly opposite of issue of shares. In case of buy-back, the paid up share capital of the company goes down due to cancellation of shares repurchased. At the same time, the surplus cash of the company gets utilized towards payment to the shareholders. If the shares are bought back

152  Chapter 6

at a price higher than the face value of the share, the excess is adjusted from the accumulated reserves of the company. ■  Illustration 6.7

The current share capital of the company is 50 million equity shares of ` 5 each and the company has reserves and surplus of ` 800 million. The company decides to repurchase five million shares from the existing shareholders for cancellation at ` 60 each. The excess will be adjusted from the general reserve of the company. Pass the necessary journal entry. How will the transaction affect the balance sheet of the company? The following journal entry will be passed: Equity Share Capital Account Dr. ` 25 million (5 million × ` 5 face value) General Reserves Account Dr. ` 275 million (5 million × ( ` 60 – ` 5))    To Bank Account   ` 300 million (5 million × ` 60) As a consequence of the buy-back, the number of shares outstanding will go down by five million. The paid up capital post buy-back will stand at ` 225 million with reserves and surplus at ` 525 million. At the same time, the cash balance will also be reduced by ` 300 million.

Employee Stock Option Plan (ESOP) As discussed in Chapter 5, a number of companies are offering stock options to their ­employees. An option is like a warrant that gives the holder a right to buy a certain number of shares at a predetermined price (called the strike price) after a defined period of time (vesting period). The shares are issued only when the option is exercised and therefore share capital does not increase at the time when the options are issued. The value attached to such options is treated as another form of employee ­compensation in the financial statements of the company. The option value is taken as the fair value using option pricing method. The option value is amortized over the vesting period. ■  Illustration 6.8

On 1st April 2015, Nav Bharat Hitech Limited granted 100,000 stock options to its employees. The employees have a right to exercise the options after three years at an exercise price of ` 100 each. The fair value per option at the time of granting the option is ` 60. On 31st March 2018, all the options are exercised by the employees. Pass the necessary journal entries and show the impact on the balance sheet. The total fair value of the options granted is ` 6,000,000. The fair value will be treated as a deferred expense with simultaneous credit to employee stock option account. The deferred expenses will be amortized over the vesting period of three years on a straight line basis. Accordingly, each year ` 2,000,000 will be included in employees cost in the statement of profit and loss. The amount standing to the credit of employee stock option account will be adjusted at the time of exercise of the option. The following entries will be passed:

Balance Sheet  153

1st April 2015 ESOP Deferred Expenses Account       Dr. ` 6,000,000 To Employee Stock Option Outstanding Account    ` 6,000,000 31st March 2016 Employee Cost Account    Dr. ` 2,000,000 (1/3rd of ` 6,000,000) To ESOP Deferred Expenses Account    ` 2,000,000 The same entry will be repeated on 31st March 2017 and 31st March 2018 as well. The option value of ` 6,000,000 will get amortized over the vesting period. 31st March 2018 At the time of exercise the employee have to make payment for the shares @ ` 100 per share, i.e., the exercise price, and they will be allotted shares. The allotment price will be taken at ` 160 per share. The following entry will be passed Bank Account       Dr. ` 10,000,000 Employee Stock Option Outstanding Account Dr.   ` 6,000,000 To Equity Share Capital Account     ` 1,000,000 To Equity Share Premium Account    ` 15,000,000 In the balance sheet of the company, the employee stock option account − ESOP deferred expenses account will be shown separately under reserves and surplus.

Disclosure as per Schedule III The following disclosures are required to be made relating to the share capital of the company. As noted earlier, in the main body of the balance sheet only the paid up capital is shown, the related disclosures are made in the relevant schedule to the balance sheet which constitutes an integral part of the same. A company shall disclose the following in the notes to accounts for each class of share capital (different classes of preference shares to be treated separately):

• • • • • • • •

The number and amount of shares authorized. The number of shares issued, subscribed and fully paid, and subscribed but not fully paid. Per value per share. A reconciliation of the number of shares outstanding at the beginning and at the end of the reporting period. The rights, preferences and restrictions attached to each class of shares including restrictions on the distribution of dividends and the repayment of capital. Shares in respect of each class in the company held by its holding company or its ultimate holding company including shares held by or by subsidiaries or associates of the holding company or the ultimate holding company in aggregate. Shares in the company held by each shareholder holding more than 5% shares specifying the number of shares held. Shares reserved for issue under options and contracts/commitments for the sale of shares/disinvestment, including the terms and amounts.

154  Chapter 6

• For the period of five years immediately preceding the date as at which the balance sheet is

• •

prepared: –– Aggregate number and class of shares allotted as fully paid up pursuant to contract(s) without payment being received in cash. –– Aggregate number and class of shares allotted as fully paid up by way of bonus shares. –– Aggregate number and class of shares bought back. Terms of any securities convertible into equity/preference shares issued along with the earliest date of conversion in descending order starting from the farthest such date. Calls unpaid (showing aggregate value of calls unpaid by directors and officers)

The information as required by the Schedule III is given in the notes to the balance sheet and is useful in understanding the composition and changes in the share capital of the company during the year. The details of share capital of Biocon Limited are given in Table 6.10. The paid up capital of the Biocon Limited has remained unchanged at ` 1,000 million against authorized capital of ` 1,100 million signifying the fact that no new shares have been issued during the year. The face value per share is ` 5 each. Table 6.10  Share Capital of Biocon Limited as on 31st March 2017

Particulars

( ` in Million) 31 March 2017

31 March 2016

1,100

1,100

1,000

1,000

Share Capital Authorized 220,000,000 (31st March 2016: 220,000,000) Equity shares of ` 5 each (31st March 2016: ` 5 each) Issued, subscribed and paid-up 200,000,000 (21st March 2016: 200,000,000) Equity shares of ` 5 each (31st March 2016: ` 5 each) Annual Report of Biocon Limited for the year 2016–17.

The paid up capital of the Biocon Limited has remained unchanged at ` 1,000 million against authorized capital of ` 1,100 million signifying the fact that no new shares have been issued during the year. The face value per share is ` 5 each. The company further stated that it has only one class of equity shares having a par value of ` 5 per share. Each holder of equity shares is entitled to one vote per share. The company declares and pays dividends in Indian rupees. The dividend proposed by the board of directors is subject to the approval of the shareholders in the ensuing annual general meeting. In the event of liquidation of the company, the holders of equity shares will be entitled to receive remaining assets of the company, after distribution of all preferential amounts, if any. The distribution will be in proportion to the number of equity shares held by the shareholders. There were two shareholders with holding in excess of 5% each. Kiran Mazumdar-Shaw held 79,287,564 equity shares (39.64%) and Glentec International Limited held 39,535,194 equity shares (19.77%)

Balance Sheet  155

6.9.2  Other Equity Other equity includes all items other than equity shares that are attributable to the holders of equity instruments of an entity. The followings are disclosed as other equity:

• • • • • • • • • •

Share application money pending allotment Equity component of compound financial instrument Reserves and surplus Debt instruments through other comprehensive income Equity instruments through other comprehensive income Effective portion of cash flow hedges Revaluation surplus Exchange difference on translating the financial statements of a foreign corporation Other items of other comprehensive income Money received against share warrants

Share Application Money Pending Allotment Application money received from the applicants is a part of other equity as a separate line item. It may be noted that only share application money, to the extent of not refundable, shall be shown in this line item. Share application money, to the extent of refundable, is separately shown under ‘other financial liabilities’.

Equity Component of Compound Financial Instruments An entity might have issued instruments that have both, equity as well as liability component. Such compound instruments are required to be split into two components—debt and equity. The ‘equity component of compound financial instrument’ is required to be presented as a part of ‘other equity’. The ‘liability component of compound financial instrument’ is required to be presented as a part of ‘borrowings’. For example, convertible debentures issued by the company would be split as ‘other equity’ and borrowings.

Reserves and Surplus Reserves and surplus is an important component of shareholders’ funds. In respect of profit making companies with long existence, this heading may be much larger than the share capital. These shall be further bifurcated as:

• • • •

Capital reserves Securities premium reserve Other reserves (specify nature) Retained earnings

Capital Reserves:  A capital reserve is defined as a reserve of an enterprise which is not available for distribution as dividend. These reserves are not created out of the profits earned in the usual course

156  Chapter 6

of business. For example, profit on reissue of forfeited shares is in the nature of capital reserve and therefore is required to be disclosed separately. Securities Premium Reserve:  As discussed in the earlier paragraphs, the Securities premium reserve representing excess of issues price over the face value of the securities issues is shown separately as a part of reserves and surplus. Other Reserves:  Any other reserve not covered above is shown under this heading. Nature, purpose and amount of each of such reserve are required to be stated separately.

Retained Earnings As discussed earlier, dividend on equity shares is a discretionary payment—based upon the profits made and future funds requirements of the enterprise, the board of directors recommends the dividend to be paid. Conversely, part of profit is retained within the business and ploughed back in the business. The retained earnings of the business since inception, i.e., profits made since beginning less the dividends paid both of preference shares and equity shares are accumulated in the reserves and surplus. After providing for dividend and transferring profits to specific reserves, any balance left in the profit and loss statement is called ‘surplus’ and is a part of retained earnings. As retained earnings keep on accumulating year after year, companies with long track record of profitability will have large amounts in reserves and surplus. The retained earnings are also dependent upon the dividend policy being pursued by the company. A company distributing large part of its profits as dividends will be adding lower amounts to retained earnings, whereas a company with lower dividend payments will be retaining more and therefore will have larger reserves and surplus. The credit balance of retained earnings is shown separately under the heading reserves and surplus. If the net balance in the statement of profit and loss is a loss (or a debit balance), the same is shown as a negative balance. A company with huge accumulated losses may have a negative figure in retained earnings.

Debt Instruments through Other Comprehensive Income Any fair value gain or loss on debt instruments which are measured at fair value through other comprehensive income (FVOCI) is presented as a part of other equity. Ind AS 109 requires subsequent measurement of investments at FVOCI based on the company’s business model for managing the portfolio of debt instruments and contractual cash flow characteristics.

Equity Instruments through Other Comprehensive Income As per Ind AS 109, companies have an option to designate investments in equity instruments to be measured at FVOCI. For such instruments, the cumulative fair value gain or loss is presented as a part of other equity under this heading.

Effective Portion of Cash Flow Hedges For all qualifying cash flow hedges, this component of other equity associated with the hedged item (i.e., cash flow hedge reserve) is adjusted to the lower of the cumulative change in the fair value of the

Balance Sheet  157

hedging instrument and the cumulative change in the fair value of the hedged item attributable to the hedged risk. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (i.e., the portion that is offset by the change in the cash flow hedge reserve) is recognized in other comprehensive income. Also, Ind AS 109 requires that exchange differences on monetary items that qualify as hedging instruments in a cash flow hedge are recognized initially in other comprehensive income to the extent that the hedge is effective.

Revaluation Surplus An enterprise may decide to revalue its assets to show them at their current realizable value. Reserves created out of the gain on revaluation of assets are called revaluation reserves. When the carrying amount of an asset is increased, the increase is recognized in the other comprehensive income and is accumulated as revaluation surplus under ‘Other Equity’.

Exchange Differences on Translating the Financial Statements of a Foreign Operation An entity with foreign operations is required to translate the financial statements of foreign operations to the presentation currency. As per Ind AS 21 ‘The effects of changes in foreign exchange rates requires that the exchange differences arising on translation of the financial statements of foreign operation from functional currency to presentation currency should be recognized in the OCI. The accumulated amount of the exchange difference is presented in other equity.

Other Items of Other Comprehensive Income (specify nature) Any other items that need to be presented in OCI as per the relevant Ind AS shall be included under other equity.

Money Received Against Share Warrants An entity may issue warrants which give the holders a right to acquire equity shares of the entity sometime in future. The holder of the warrant is required to pay money as a consideration. The money paid against warrants would be finally adjusted when the shares are issued against warrants in future. Since shares are yet to be allotted against the same, these are not reflected as part of share capital but as a separate line item—money received against share warrants. It may be noted that a balance in the reserves and surplus does not mean that the amount is lying with the company in cash. However, if the amount standing to the credit of a reserve is represented by specific earmarked investments, it should be separately disclosed. For example, an entity may decide to create a reserve for the repayment of a loan by transferring a certain amount from the statement of profit and loss annually. The amount transferred to the reserve account is simultaneously invested in identified investments to generate sufficient cash for the repayment of loan on maturity. The fact that the reserve is backed by earmarked investments shall be disclosed. The addition and deduction since last balance sheet is also required to be disclosed under each of the specified heads. The details of other equity of Biocon Limited are given in Table 6.11.

158  Chapter 6 Table 6.11  Other Equity of Biocon Limited as on 31st March 2017

( ` in Million) Securities premium reserve Revaluation reserve General reserve Retained earnings SEZ reinvestment reserve Share based payment reserve Treasury shares Cash flow hedging reserves Other Items of OCI Total other equity

31st March 2017

31st March 2016

2,908

2,788

9

9

3,458

3,458

58,244

52,858

0

0

440

435

–727

–577

102

0

–23

–5

64,411

58,966

On 31st March 2017, the other equity of the company stood at ` 64,411 million which is largely made up of balance in the retained earnings at ` 58,244 million, securities premium of ` 2,908 million and general reserves of ` 3,458 million.

6.10  STATEMENT OF CHANGE IN EQUITY In addition to the presentation of balance sheet at the end of the accounting period, an entity is also required to separately present a statement of change in equity. The statement of change in equity essentially provides a reconciliation of equity share capital and all items of other equity. The statement is broken into two parts. The part of equity share capital provides details regarding balance at the beginning of the period, changes in equity shares capital during the year and balance at the end of the reporting period. Likewise, the part for Other Equity provides a reconciliation during a particular reporting period, as a part of one single statement, of all items other than equity share capital, that are attributable to the holders of equity instruments of an entity. The statement is prepared in columnar form with the following details:

• Share application money pending allotment • Equity component of compound financial instruments • Reserves and surplus –– Capital reserve –– Securities premium reserve –– Other reserves (specify nature) –– Retained earnings • Debt instruments at fair value through other comprehensive income • Equity instruments at fair value through other comprehensive income • Effective portion of cash flow hedges • Revaluation surplus

Balance Sheet  159

• Exchange differences on translating the financial statements of a foreign operation • Other items of other comprehensive income (specify nature) • Money received against share warrants The statement of change in equity provides a comprehensive view of changes in equity during the accounting period. The statement of change in Equity of Biocon Limited for the year ended 31st March 2017 is given in Table 6.12 Table 6.12  Statement of Change in Equity of Biocon Limited as on 31st March 2017

( ` in Million) 31st March 17

31st March 16

A. Equity Share Capital Opening Balance Changes in equity share capital Closing Balance

1,000

1,000





1,000

1,000

B. Other Equity

Particulars Balance at March 31, 2016

ShareSecurities SEZ based Cash flow Other Total Premium Revaluation General Retained Reinvestment Payment Treasury Hedging Items of Other Reserve Reserve Reserve Earnings Reserve Reserve Shares Reserves OCI Equity 2,788

9

3,458

52,858

0

435

–577

0

–5

58,966

Profit for the year

0

0

0

5,193

0

0

0

0

0

5,193

OCI, net of tax

0

0

0

0

0

0

0

102

–18

84

Share based payment

0

0

0

0

0

125

0

0

0

125

Purchase of Treasury shares

0

0

0

0

0

0

–150

0

0

–150

Transfer to SEZ reinvestment reserve

0

0

0

–162

162

0

0

0

0

0

Transfer from SEZ reinvestment reserve on utilisation

0

0

0

162

–162

0

0

0

0

0

Exercise of share options

120

0

0

193

0

–120

0

0

0

193

2,908

9

3,458

58,244

0

440

-727

102

–23

64,411

Transactions recorded directly in equity

Balance at March 31, 2017

160  Chapter 6

6.11 LIABILITIES The equity represent the obligation of the business to the owner of the business. The expression liability, on the other hand, refers to the obligation to external parties. ‘A liability is a ­present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’.4 The obligation to an external party arising due to past event may be in the form of making payment or transfer some other assets or perform certain services. For example, the obligation to maintain the goods sold consequent upon a warranty given by the seller also gives rise to a liability. A liability is measured as the amount that will be needed to satisfy the obligation to a third party. In certain cases, the amount of liability may not be readily ascertainable and have to be estimated. Such liabilities are referred to as provisions. A provision satisfies the other conditions, for example, present obligation due to past event but the amount needs to be estimated. For example, an enterprise has an obligation to pay certain retirement benefits to its employees. There is an obligation due to past events but the amount of obligation needs to be estimated. The enterprise will have to make a provision towards retirement benefits. The liabilities are classified and reported as non-current and current liabilities. Non-current liabilities are long-term in nature usually maturing after 12 months whereas current liabilities are short-term Liabilities represent present obligations of the enterprise to external ­parties due to past events.

Financial Liabilities Provisions Non-current

Deferred Tax Liabilities Other Noncurrent Liabilities

Liabilites Financial Liabilities

Current

Other Current Liabilities Provisions

Current Tax Liabilities

Figure 6.3  Classification of Liabilities

Balance Sheet  161

in nature. Schedule III of the Companies Act, 2013 provides that ‘a liability shall be classified as current when it satisfies any of the following criteria:

• • • •

It is expected to be settled in the company’s normal operating cycle. It is held primarily for the purpose of being traded. It is due to be settled within 12 months after the reporting date. The company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification.’

Liabilities or obligations that are not classified as current are called non-current liabilities or ­long-term debts. The classification of liabilities in the balance sheet have been depicted in Figure 6.3.

6.12  NON-CURRENT LIABILITIES As already discussed, liabilities other than the current liabilities are classified as non-current liabilities. These liabilities are expected to be settled after 12 months from the date of the balance sheet. Noncurrent liabilities are classified under the following headings:

1. 2. 3. 4.

Non-current financial liabilities Non-current provisions Deferred tax liabilities Other non-current liabilities

6.12.1  Non-current Financial Liabilities As per Ind AS 32, the expression financial liabilities include:

• Contractual obligation to deliver cash or another financial asset to an entity. • Exchange of assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity. • A contract which will be settled with entity’s own equity instruments and is –– a derivative that will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments; or –– a non-derivative for which the entity is or may be obliged to receive a variable number of its own equity instruments. In general, financial liabilities would include contractual obligations to pay, e.g., loans, deposits, borrowings, trade payables and finance lease obligations, etc. Payables which are not in the nature of contractual obligations—statutory dues, tax payable—are not included in the financial liabilities. Non-current financial liabilities are further classified as:

• Borrowings • Trade Payables • Other Financial Liabilities

162  Chapter 6

Non-current Borrowings A business enterprise may borrow from banks and financial institutions for acquiring long-term assets or for financing its day-to-day operations. Borrowings usually means taking money from someone which is repaid in future with interest. The non-current borrowings are further sub-classified as:

• Bonds or debentures • Term loans –– from banks –– from other parties • Deferred payment liabilities • Deposits • Loans from related parties • Long-term maturities of finance lease obligations • Liability component of compound financial instruments • Other loans (specify nature) Bonds or Debentures A debenture or a bond is a financial instrument which carries a fixed rate of interest, a fix maturity and a promise by the issuer to repay the principle on maturity. A company, instead of taking a loan from a bank or financial institution, may decide to issue debentures in the market. The amount borrowed is represented by smaller units, each unit being called a debenture. The debentures have a face value, carry a fixed rate of interest called coupon rate and have a fixed maturity. Such debentures are called coupon bearing bonds or debentures. On the other hand, an enterprise may decide to issue bonds carrying no coupon rate of interest. In such cases, the instrument is issued at a discount to the face value and is redeemed at par. The return for the holder (therefore the cost for the issuer) is implicit in the difference between issue price and the redemption price. Such bonds are called zero-coupon bond. The debentures may be issued with convertibility clause, i.e., they are issued as debentures but have an inbuilt option to convert them into equity at a predetermined price and time. If the debentures can be partially converted into equity, it is called a partially convertible debenture. If, however, the entire face value of the debenture can be converted into equity, it is called a fully convertible debenture. In India, the terms bonds and debentures are used interchangeably. Debentures may be secured or unsecured depending upon the creation or otherwise of collateral in favour of debenture holders. As such instruments are usually repayable over a long period of time; they are classified as long-term borrowings. At the time of issuance of the debentures, the debenture account is credited by the face value of the debentures issued. The debenture account will appear in the balance sheet as a borrowing till redemption. On redemption, the debenture account is debited to extinguish the liability. ■  Illustration 6.9

Ultra Securities Limited issued one million debentures with a face value of ` 100 each carrying interest at 10%. The debentures will be redeemed after seven years. Show the necessary journal entries for the issue and redemption of debentures.

Balance Sheet  163

At the time of issue: Bank Account ` 100 million    To 10% Debentures Account    ` 100 million At the time of redemption: 10% Debentures Account ` 100 million   To Bank Account   ` 100 million The debentures will continue to appear on the liability side under long-term borrowings. However, when the time to maturity comes down to less than 12 months, they will be shown under current liabilities. Bonds/debentures (along with the rate of interest and particulars of redemption or conversion, as the case may be) shall be stated in descending order of maturity or conversion, starting from farthest redemption or conversion date, as the case may be. Where bonds/debentures are redeemable by installments, the date of maturity for this purpose must be reckoned as the date on which the first installment becomes due.

Term Loans Loans taken for the purpose of acquiring long-term assets are referred to as term loans and are classified as non-current borrowings. The term loans are repayable over a period of time as per the schedule agreed upon with the lender. Terms of repayment of term loans and other loans is also required to be stated. Term loans are from banks and from other parties are required to be disclosed separately.

Deferred Payment Liability An enterprise may acquire certain capital assets from its vendor where the consideration is payable on a deferred basis, i.e., over a period of time exceeding more than a year. For example, an airline may buy aircrafts for which the purchase consideration is to be paid over say next 3–4 years’ time. Deferred payment liabilities of such nature are also part of the non-current liabilities of the enterprise. The liability initially shall be recorded at the fair value of the asset being acquired rather than the invoice value. The difference between invoice value and fair value shall be recognized as interest expense over the payment period in a systematic manner.

Deposits A company may accept deposits from public or from its employees or other entities to meet its funds requirements. Such deposits are for a fixed duration and carry a fixed rate of interest. The duration may be short (less than 12 months) or long. The difference between a debenture and deposit is that the former is a transferrable instrument, whereas the latter is not. Such deposits are generally unsecured. They may be classified as long-term borrowing or short-term borrowing depending upon the maturity.

Loans from Related Parties Loans from related parties are required to be disclosed separately with all the relevant disclosures.

164  Chapter 6

Long-term Maturities of Finance Lease obligation As discussed in Chapter 5, in a finance lease the lease period covers substantially the entire useful Finance Leases are capitalized in the life of the asset taken on lease. The periodical lease balance sheet of the lessee though the rental is towards the principal (cost of the asset) and legal ownership is with the lessor. interest thereupon. Though the lessor is the legal owner, the asset is capitalized in the books of the lessee as the beneficial owner. A finance lease transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. At the commencement of lease period, the asset is capitalized in the books of the lessee at the fair value of the asset or at the present value of the lease installments over the lease period. At the same time, an equivalent amount is recorded as the lease obligation. The payments made towards lease installment are broken into two parts—interest and principal. The interest component is treated as an expense for the period and is taken to the profit and loss s­ tatement. The principal component is deducted from the lease obligation recognized at the commencement. The lease obligation outstanding after adjusting the principal repayment is taken to the balance sheet under long-term borrowings. ■  Illustration 6.10

Critical Chemicals Company Limited obtained a machine on a finance lease basis from a non-banking finance company (NBFC). The cash down list price of the machine is ` 50 million. The company will pay three annual instalments of ` 20.82 million each at the end of the next three years. The breakup of the instalments between principal and interest is given as follows: ( ` in Million) Instalment No.

Instalment Amount

Principal

Interest

1.

20.82

14.82

6.00

2.

20.82

16.60

4.22

3.

20.82

18.58

2.24

Pass the necessary journal entries for the above transaction. At the time of taking the asset of lease: Machinery on Lease Account Dr. ` 50 million    To Finance Lease Obligation Account    ` 50 million At the end of the first year: Interest on Finance Lease Account Dr. ` 6.00 million Finance Lease Obligation Account Dr. ` 14.82 million   To NBFC Account   ` 20.82 million NBFC Account Dr. ` 20.82 million   To Bank Account   ` 20.82 million

Balance Sheet  165

At the end of the second year: Interest on Finance Lease Account Dr. ` 4.22 million Finance Lease Obligation Account Dr. ` 16.60 million   To NBFC Account   ` 20.82 million NBFC Account Dr. ` 20.82 million   To Bank Account   ` 20.82 million At the end of the third year: Interest on Finance Lease Account Dr. ` 2.24 million Finance Lease Obligation Account Dr. ` 18.58 million   To NBFC Account   ` 20.82 million NBFC Account Dr. ` 20.82 million   To Bank Account   ` 20.82 million The finance lease obligation account will be initially recorded at the fair value of the asset at the inception of the lease. With each instalment, the liability will get reduced.

Liability Component of Compound Financial Instruments As discussed earlier, compound instruments issued by an entity are required to be split into two components—debt and equity. The liability component of compound financial instrument is disclosed as a part of borrowings. For example, convertible debentures issued by the company would be split as other equity and borrowings. All the borrowings are further classified as secured or unsecured and the nature of security shall be specified separately in each case. If the loan is backed up by some specified assets of the borrower as collateral, the loan will be classified as secured loan. If no such collateral has been created to secure the loan amount, it will be called an unsecured loan. Term loans are usually secured by creating mortgage on the immoveable assets of the company, e.g., land, building, plant and machinery. Working capital loans are usually secured by way of hypothecation or pledge of moveable assets. In case of hypothecation, the asset in question remains in the possession of the borrower whereas in case of pledge, the possession of the assets being offered as collateral is given to the lender. The nature of security should also cover the type of asset given as security, e.g., inventories, plant and machinery, land and building, etc. When promoters, other shareholders or any third party have given any personal security for any borrowing, such as shares or other assets held by them, disclosure should be made thereof, though such security does not result in the classification of such borrowing as secured. Disclosure is also required to be made regarding the repayment terms including the period of maturity with respect to the balance sheet date, number and amount of instalments due, the applicable rate of interest and other significant relevant terms, if any.

Non-current Trade Payables Trade payables are dues in respect of goods and services purchased in the normal course of business. An enterprise buying goods and services from its vendors often gets a specified period for making the

166  Chapter 6

payment. The amount outstanding to the suppliers of goods and services is referred to as trade payables or accounts payable or sundry creditors. Following accrual basis of accounting, the liability is recognized when the goods are supplied or services are rendered by the vendor. For example, at the time of buying goods on credit the following entry will be passed: Purchases Account Dr.    To Vendor Account It may be noted that amounts due to vendors of goods and services only are included under this heading. Payables of any other nature (statutory dues, payables for purchase of capital goods, etc.) are not included under this heading. Trade payables which are non-current in nature are disclosed under this heading.

Non-current Other Financial Liabilities Any other non-current liability which is in the nature of a financial liability is required to be disclosed under this heading.

6.12.2  Non-current Provisions A provision is the books of accounts is made whenever there is an existing obligation due to past events but the amount of liability is uncertain and has to be estimated. For example, warranty extended by a seller of certain equipment to the buyer give rise to a contractual obligation, however, the quantum of obligation needs to be estimated. The seller will make a provision towards warranty cost based upon his past experience. The provision again may be short-term (current) or long-term (non-current) and need to be classified accordingly. Non-current provisions are further classified into ‘provision for employee benefits’ and ‘others’ specifying the nature. Provision for employee benefits, mainly unfunded, are defined as post-employment benefits. All non-current provisions, other than those related to employee benefits, are disclosed separately based on their nature.

6.12.3  Deferred Tax Liabilities As discussed in the Chapter 5, deferred tax liabilities and assets are recognized due to timing difference between the taxable income and reported income. A timing difference is one that is likely to be reversed in future. If due to timing difference an enterprise has paid lower taxes in the current year which will result in increased tax liability in the future years, the same is recorded as deferred tax liability. On the other hand, if higher taxes have been paid in the current year which will get reversed in future resulting in lowering of taxes, the same is recorded as deferred tax asset. The deferred tax assets and liabilities are ascertained on each balance sheet date in respect of timing differences. If the deferred tax liabilities exceed the deferred tax assets, the net amount is reported on the liabilities side of the balance sheet as a non-current liability. On the other hand, if the deferred tax assets are more than the deferred tax liabilities, the excess will be shown on the asset side of the balance sheet as a non–current asset.

6.12.4  Other non-current Liabilities This is the residual category of non-current liabilities. Other non-current liabilities are further classified as ‘advances’ and ‘others’, specifying the nature. Amounts received against goods to be sold or ser-

Balance Sheet  167

vices to be provided, security deposits from customers or vendors, statutory dues payable, legal claims outstanding, interest payable on unpaid amount to supplier, etc., are classified under this heading. The details of non-current liabilities of Biocon Limited as on 31st March 2017 are given in Table 6.13. Table 6.13  Non-current liabilities of Biocon Limited as on 31st March 2017

( ` in Million) 31st March 2017

31st March 2016

Long-term borrowings Deferred sales tax liability (unsecured) Term loans from banks



1,326

39

49

Other loans and advances Less: current maturities of long-term borrowings

65

1,296 (11)

(75)

1,324

1,365

Other non-current financial liabilities Fair value of hedging instruments Interest accrued but not due



4 2

3

2

7

133

95

569

558

Gross deferred tax assets

1,623

549

Net deferred tax liability/(asset)

(1,054)

9

767

913

2,226

2,389

Non-current provisions Provision for employee benefits–gratuity Deferred tax liability/assets (Net) Gross deferred tax liability

Other non-current liability Deferred revenues Total non-current liabilities

From the above-mentioned details, it can be observed that Biocon Limited does not have much noncurrent liabilities especially borrowed funds. The total non-current liabilities as on 31st March 2017 stood at ` 2,226 million (previous year ` 2,389 million). These in comparison to equity at ` 65,411 million (previous year ` 59,966 million) are relatively small. The company is relying more on shareholders’ funds (equity) to meet its long-term financing requirements rather than borrowings.

6.13  CURRENT LIABILITIES As already discussed, current liabilities are expected to be paid within 12 months from the date of the balance sheet or within the normal operating cycle of the entity. Current liabilities are classified under the following headings:

1. Current financial liabilities

168  Chapter 6



2. Other current liabilities 3. Current provisions 4. Current tax liabilities It may be noted that current liabilities have almost similar classification as non-current liabilities.

6.13.1  Current Financial Liabilities Current financial liabilities are further classified into:

• Current borrowings • Current trade payables • Other current financial liabilities Current Borrowings Current borrowings are further classified into:

• Loans repayable on demand –– from banks –– from other parties • Loans from related parties • Deposits • Other loans (specify nature) Borrowings are further sub-classified as secured and unsecured specifying the nature of security in each case. Where loans have been guaranteed by directors or others, the aggregate amount of such loans under each head is required to be disclosed. If the entity has defaulted in repayment of borrowings and interest, the period and amount of default as on the balance sheet date is required to be specified separately in each case. Current borrowings will include all loans payable within a period of 12 months from the date of the loan. Loans payable on demand should be treated as part of current borrowings.

Current Trade Payables Trade payable due for payment within 12 months from the date of the balance sheet or within the normal operating cycle of the entity are classified here. As discussed earlier, trade payables are towards goods and services purchased by the enterprise on credit terms.

Other Current Financial Liabilities The amounts shall be classified as:

• • • •

Current maturities of long-term debt Current maturities of finance lease obligations Interest accrued Unpaid dividends

Balance Sheet  169

• Application money received for allotment of securities to the extent of refundable and interest • • •

accrued thereon Unpaid matured deposits and interest accrued thereon Unpaid matured debentures and interest accrued thereon Others (specify nature)

The portion of non-current borrowings/lease obligations, which is due for payments within twelve months of the reporting date is required to be classified under other current financial liabilities, while the balance amount should be classified under non-current borrowings. Likewise, current maturities of long-term debt are also classified as other financial liabilities. Interest accrued on financial liabilities shall form a part of its carrying amount whether it is at amortized cost (i.e., as per effective interest method) or at fair value. Accordingly, an entity may not present interest accrued separately from the related financial liability. Unpaid dividend on shares—equity as well as preference is also classified as other current financial liabilities. Application money received for allotment of securities to the extent of refundable and interest accrued thereon is classified as other current financial liabilities. It may be noted that application money received for allotment of shares, which would be adjusted on allotment, would be classified as other equity. Unpaid matured deposits and debentures, and interest accrued thereon would also be classified under this heading.

6.13.2  Other Current Liabilities The amounts shall be classified as:

• Revenue received in advance • Other advances (specify nature) • Others (specify nature) Others should include items, like statutory dues payable, legal claims outstanding, security deposits, etc., are classified under this heading.

6.13.3  Current Provisions The amounts shall be classified as:

• Provision for employee benefits • Others (specify nature) Others would include all provisions other than provisions for employee benefits such as provision for warranties, provision for decommissioning liabilities, etc.

6.13.4  Current Tax Liabilities Current tax liabilities are towards expected tax payable on the taxable income for the year using applicable tax rates at the balance sheet date. This also includes any adjustment to taxes in respect of pre-

170  Chapter 6

vious years. Interest income/expenses and penalties, if any, related to income tax. Current tax assets (advance tax paid) may be off set against the current tax liabilities to present either as current tax asset or current tax liabilities. The details of current liabilities of Biocon Limited as on 31st March 2017 are given in Table 6.14 below: Table 6.14  Current liabilities of Biocon Limited as on 31st March 2017

( ` in Million) 31st March 2017

31st March 2016

Current financial liabilities Current borrowings



2,255

4,505

3,944

11

75

6

10

Payable for capital goods

646

748

Fair value of hedging instruments



Trade payables Other financial liabilities Current maturities of long-term debt Unpaid dividends

77

5,168

7,109

Provision for employee benefits–gratuity

88

73

Provision for employee benefits–   compensated absence

96

82

136

130

320

285

777

729

113

116

82

58

501

252

91

77

787

503

7,052

8,626

Current provisions

Provisions for sales returns Income tax liability (Net) Other current liabilities Deferred revenue Advances from customers Book overdraft Statutory taxes and dues payable Net deferred tax liability/(asset) Total non-current liabilities

From the above details, it can be observed that the total current liabilities as on 31st March 2017 stood at ` 7,052 million (previous year ` 8,626 million). The biggest component of current liabilities for Biocon Limited is trade payable (` 4,505 million) followed by payable for capital goods (` 646 million). In the previous year, the company had ` 2,255 million as short-term borrowings, which had been completely repaid during the year.

Balance Sheet  171

6.14  CONTINGENT LIABILITIES AND COMMITMENTS A liability which is contingent upon happening or non-happening of certain future event is called a contingent liability. A distinction need to be drawn between a liability, provision and contingent liability. A present obligation of an enterprise which has already been crystallized due to past events and the Contingent liability is often referred amount is readily ascertainable is called a liability. to as off-balance sheet exposure as On the other hand, an existing liability in respect the same does not appear in the balof which amount is not readily ascertainable but is ance sheet but is reported in notes required to be estimated is called a provision. A conto accounts tingent liability is a possible future obligation due to past events which may or may not arise contingent upon certain future events not in the control of the enterprise. A present obligation may also be treated as a contingent liability if its occurrence is not probable or a reliable estimate of amount of obligation cannot be made. All liabilities and provisions as aforesaid are recognized in the balance sheet; however, contingent liabilities are disclosed in notes to accounts. The expression commitment has not been defined. Commitment generally means contractual obligations in respect of capital expenditure or in respect of contracts for purchase of raw material, employee contracts, etc. ■  Illustration 6.11

Moon Limited, a subsidiary of Sun Limited, took a loan of ` 500 million from Sound and Safe Bank Limited. The bank insisted for a guarantee from Sun Limited as a security. How will this transaction appear in the books of Moon Limited and Sun Limited?

In the books of Moon Limited, the transaction will appear in the balance sheet as borrowed funds because it is primarily responsible for repayment of the amount borrowed. The liability of Sun Limited is secondary; it may be required to pay if Moon Limited fails to meet its obligation. As such, it has a contingent liability. This probable obligation will be disclosed in the ‘otes to accounts’ of Sun Limited. The contingent liabilities are generally categorized as:

• Claims against the company not acknowledged as debt, For example, disputed amounts of • •

income tax or sales tax claims against the company. Guarantees: Where the company has stood as a guarantor on behalf of another entity. The liability of the company is contingent upon the default by the other entity. Other money for which the company is contingently liable.

Likewise, commitments shall be classified as follows:

• Estimated amount of contracts remaining to be executed on capital account and not provided for. • Uncalled liability on shares and other investments partly paid. • Other commitments.

172  Chapter 6

The above disclosures are made in notes to accounts. The contingent liabilities reported by Biocon Limited in its annual report for the year 2016–17 are shown in Table 6.15. Table 6.15  Contingent Liabilities reported by Biocon Limited as on 31st March 2017

(` million) 31st March 2017

31st March 2016

1. Contingent liabilities (A) Claims against company not acknowledged as debt

2,893

2,041

148

148

13,626

12,122

18

18

401

1,114

Committed lease rental not later than one year

19

15

Committed lease rental later than one year not later than five years

22

26

(B) Guarantees (I) In favour of central excise in respect of obligations of subsidiaries (Ii) In favour of bank towards loans obtained by subsidiaries/ step-down subsidiaries (Iii) By banks on behalf of the company for contractual obligations of the company 2. Commitments: (A) Estimated amount of contracts remaining to be executed on capital accounts and not provided for, net of advances (B) Operating lease commitments where company is a lessee:

(C) Other commitments—the company has committed to provide financial support to a subsidiary with regard to the operations of such company.

The contingent liabilities of Biocon Limited largely relate to the guarantees given by the company in respect of obligations of subsidiary/associate companies. There are contingent liabilities in respect of taxation matters which are under appeal and certain other claims against the company which are not considered probable and hence not acknowledged as debts. These liabilities may or may not arise but it does give information to the readers about the potential liability, however remote, that the company has on the date of the balance sheet.

Balance Sheet  173

Summary

• The balance sheet is a statement of financial position of a business enterprise at the end of • • •

• • •



• •



the accounting period. It summarizes the assets and liabilities of the enterprise at the end of the accounting period. Due to dual aspect principle and basic accounting equation, that is, Assets = Capital + ­Liabilities, both sides of the balance sheet are always equal. Some of the key accounting principles having a direct bearing on the balance sheet are separate entity principle, money measurement, going concern, historical cost principle and conservatism. Assets are resources controlled by an enterprise due to past events from which future economic benefits are expected. Liabilities are the claims of the external parties over the resources owned by the enterprise. Equity is the residual interest in the assets of the enterprise after the claims of external parties have been met. Balance sheet is divided into two sides: equities and liabilities (sources of funds) and assets (uses of funds). The sources side of balance sheet is broken into three broad headings: equity, non-current liabilities and current liabilities. Equity represent the owners’ contribution to the business. They are further subdivided into share capital and other equity. The amount actually paid up by the equity towards the face value of shares is called the paid up capital and represents the share capital of the company. Other equity is made up of share premium account, retained earnings and capital reserves. Non-current liabilities are obligations towards external parties maturing after 12 months. This category includes long-term borrowings, deferred tax liabilities, deferred credits payments, finance lease obligations, long-term provisions and other non-current liabilities. Portion of long-term borrowings maturing within the next 12 months is deducted from non-current ­liabilities and classified as current liabilities. Current liabilities are obligations which are expected to be paid within the next 12 months. This includes short-term borrowings, trade creditors, current provisions and other short-term liabilities. The assets of the enterprise are divided into non-current assets and current assets. Assets which are intended to be converted into cash in the normal operating cycle of the business usually within the next 12 months are called current assets. Assets other than current assets are classified as non-current assets. Non-current assets include property, plant and equipment, deferred tax assets, non-current investments and long-term loans and advances given. They are held for the purpose of using in the normal business operations of the enterprise over a long period of time or for generating return either as regular income or capital appreciation. Non-current assets are usually shown at their historical cost less accumulated depreciation unless there is a permanent diminution in the value of the asset. In such a case, suitable provision towards diminution in value is made.

174  Chapter 6

• Current assets include cash and bank balance, inventories, trade receivables, short-term loans



and advances given and other current assets. Current assets are shown at the ‘lower of cost or realizable value’. Accordingly, suitable provisions towards doubtful debtors and loans and advances are made. In addition to balance sheet liabilities and provisions, suitable disclosures are made towards contingent liabilities and commitments. A contingent liability is a future obligation that is contingent upon happening or non-happening of future uncertain events which are not in the control of the enterprise. It may also arise where the liability is not probable or the amount cannot be estimated. Contingent liabilities are disclosed in notes to accounts.

Assignment Questions 1. ‘The balance sheet represents the financial position of an enterprise on a particular date’. Explain. 2. Define the terms asset, liability and equity. 3. How do you differentiate current liabilities from non-current liabilities? 4. How does the valuation of current assets differ from that of non-current assets? 5. Differentiate between a liability, provision and contingent liability.

Problems 1. Issue of shares at a premium: The authorized share capital of Super Growth Limited consisted of 10 million equity shares of the face value ` 10 each and one million 10% preference shares of the face value ` 100 each. Out of this, the company allotted one million equity shares at par to the promoters for cash. The company also issued five million equity shares to other investors for cash at a premium of ` 10 each. Pass the necessary journal entries for the above. How will the equity appear in the balance sheet of the company? 2. Call in arrears and forfeiture of shares: Pee Ess Limited with an authorized share capital of ` 50 million divided into five million equity shares of ` 10 each made a public issue of two million equity shares at par. The company called the full face value of the shares in three instalments. All the shareholders paid the amount due except the holders of 200,000 shares who failed to pay ` 3 per share. a. Show the share capital in the balance sheet of the company. b. The company decided to forfeit the shares on which the calls are unpaid. How will the forfeiture affect the balance sheet of the company?

Balance Sheet  175

3. Issue of bonus shares: In the balance sheet of High Tech Tools Limited on 31st March 2017, the equity appeared as follows: Particulars

(  ` in Crore)

Share capital Authorized share capital (3 crore equity shares of ` 10 each)

30

Issued, subscribed and paid up capital (2 crore equity shares of ` 10 each)

20

Other equity General reserves

125

Securities premium account

80

Profit and loss account

42 247

The company decided to issue bonus shares to the existing shareholders in the ratio of 5:1 by capitalizing the securities premium account and a part of the general reserves. For this purpose, it was also decided to increase the authorized share capital to ` 150 crore divided into 15 crore equity share of ` 10 each.   a.   Pass necessary journal entries for the issuance of bonus shares.   b.   Show the equity after the bonus issue. 4. Non-current loans: As on 31st December 2011, All Stars Limited has a loan outstanding from the State Bank of India amounted to ` 250 million. The loan is secured against mortgage of the land, building, plant and machinery owned by the company. The loan attracts interest at 12% per annum payable half yearly on 1st April and 1st October, respectively. The company paid the interest due on 1st April 2011 but is in default towards interest due on 1st October 2011. Out of the principle outstanding, an amount of ` 25 million is due for repayment within next 12 months. How will the loan and interest outstanding appear in the balance sheet of the company as at 31st December 2011? 5. Current assets and liabilities: In each of the following cases how will the transaction affect the balance sheet as on 31st March 2017: a. Premises taken on rent on 1st August 2016 by paying a deposit of ` 10 million. Quarterly rent of ` 300,000 paid on 1st August and 1st November each. Rent due on 1st February not paid till 31st March 2017. b. Salaries paid to employees during the year amounted to ` 60.30 million. It includes a sum of ` 4.85 million as advance to employees against salary. c. Debtors outstanding as on 31st March 2017 amounted to ` 305 million. Based upon the past trend, the company estimates that 2% of the debtors will default on payment. d. Goods bought during the year 2016–17 amounting to ` 12.23 million were actually paid for in the year 2017–18. e. Special goods were ordered on 15th December 2016 with advance payment of ` 3 million. The same were received and consumed during 2017–18.

176  Chapter 6

6. Preparation of balance sheet: From the followings balances extracted from the books of SDTV Limited and additional information prepare the balance sheet of the company for the year ended 31st March 2017: Particulars

(  ` in Lakhs)

Accumulated depreciation

10,683.91

Advances from customers

4,040.93

Bank balance

340.24

Capital work-in-progress

161.82

Cash in hand

18.34

Deferred tax assets

1,123.92

Employee stock option outstanding

1,380.00

Fixed assets (Cost of acquisition) General reserve Inventories

31,220.96 527.02 36.47

Investments

5,338.02

Loans and advances

6,432.65

Other current liabilities Profit and loss account (Dr. balance) Provisions for gratuity and employee benefits

904.43 5,741.32 955.52

Revaluation reserve

2,296.39

Secured loan-term loan

3,350.43

Secured loan—working capital

8,057.47

Securities premium account

16,017.01

Share capital (61,713,092 equity shares of ` 4 each)

2,508.52

Sundry creditors

6,286.06

Sundry debtors

12,913.14

Unsecured loan—working capital

4,767.83

Additional Information a. All the investments are long-term in nature. The management estimates that there is a diminution in the value of investments to the extent of ` 395.65 lakh which is permanent in nature. b. Loans and advances are long-term. Loans amounting to ` 400 lakh are doubtful and need to be provided for. c. Out of secured term, loans outstanding an amount of ` 794.15 lakh is falling due for repayment within the next 12 months. d. Make a provision of ` 755.71 lakh towards doubtful debts on sundry debtors. The above adjustments are to be considered only for the balance sheet and the affect to the profit & loss statement has already been taken. 7. Preparation of balance sheet: Based upon the trial balance given in Problem 3 of Chapter 5 (profit and loss statement) prepare the balance sheet of Shivam Industries Limited as on 31st March 2017.

Balance Sheet  177

Solutions to Problems 1. Journal Entries Allotment of shares to the promoters: Bank Account Dr. ` 10,000,000 To Equity Share Capital Account    ` 10,000,000 Allotment of shares to investors: Bank Account Dr. ` 100,000,000 To Equity Share Capital Account    ` 50,000,000 To Securities Premium Account    ` 50,000,000 Balance Sheet of Super Growth Limited as at………

Particulars

(  ` in Million)

Share capital  

Authorized 10 million equity shares of ` 10 each

100

1 million 10% preference shares of ` 100 each

100 200  

Issued, subscribed and paid up

 60

6 million equity shares of ` 10 each Reserves and surplus Securities premium account

 50

2. a. The balance sheet of Pee Ess Limited will appear as follows: Pee Ess Limited Balance Sheet as on …..

Particulars

(  ` in Million)

Share capital Authorized 5 million equity shares of ` 10 each Issued and called up 2 million equity shares of ` 10 each Less: Calls in arrear (200,000 equity shares at ` 3 each) Paid up capital

  50.0

  20.0 0.6   19.4

178  Chapter 6



b. The forfeiture will result in cancellation of 600,000 shares on which calls are in arrears. The call in arrears will be cancelled (200,000 × ` 3 per shares) and the amount already paid in respect of these shares (200,000 × ` 7 per share) will be forfeited. The balance sheet after forfeiture will appear as follows: Particulars

(  ` in Million)

Share capital  

Authorized

50.0

5 million equity shares of ` 10 each Issued and called up

18.0

1.80 million equity shares of ` 10 each Add: Share forfeiture account

1.4

(200,000 equity shares at ` 7 each) 19.4

3. a. The bonus issue in the ratio of 5:1 (5 new shares for 1 existing) will result in issuance of 10 crore new shares with a combined face value of ` 100 crore. For this purpose, the securities premium account (` 80 crore) and general reserves (` 20 crore) will be capitalized. The necessary journal entry will be as follows: Securities Premium Account Dr. ` 80 crore General Reserves Dr. ` 20 crore    To Equity Share Capital    ` 100 crore

b. The equity after the bonus issue will appear as follows: Particulars

(  ` in Crore)

I)  Share capital Authorized

 

 

 

150

 

 

 

120

 

 

125

 

Less: Used for bonus issue

20

105

Securities premium account

80

 

Less: Used for bonus Issue

80

0

 

42

 

 

147

Total Equity (A + B)

 

267

15 crore equity shares of ` 10 each Issued, subscribed and paid up 12 crore equity shares of ` 10 each II)  Other equity General reserves

Retained earnings

Balance Sheet  179

4. The loan outstanding from the State Bank of India amounting to ` 250 million is a secured loan and will be classified under non-current liabilities. However, the principle becoming due for repayment within the next 12 months amounting to ` 25 will be deducted and shown in the current liabilities.   The company has paid interest for three months but has failed to pay interest at 12% per annum for the next six months. Interest accrued and due for six months for the period 1st April 2011 to 30th September amounting to ` 15 million will be shown under current liabilities. In addition, interest for the period 1st October to 31st December has also accrued though not due. Interest accrued but not due amounting to ` 7.5 million will also be shown separately under current liabilities. 5. a. The deposits in respect of premises taken on rent on amounting to ` 10 million will be classified as long-term loans and advances under non-current asset. Rent outstanding for five months for the period 1st November 2016 to 31st March 2017 amounting to ` 500,000 will be shown under current liabilities. b. Advance of salaries paid amounting to ` 4.85 million will be shown as short-term loan and advances under current assets. c. Trade Receiveables outstanding as on 31st March 2017 amounted to ` 305 million will be shown under current assets deducting ` 6.10 million towards provisions for doubtful debts. d. The liability towards goods bought amounting to ` 12.23 million will be shown as trades payables under current liabilities. e. The advance payment of ` 3 million will be shown as short-term loans and advances under current assets. 6. The balance sheet of SDTV Limited as on 31st March 2017 is given as follows: Particulars

( ` in Lakhs)

I)  Equity and liabilities  

Equity Share Capital (61,713,092 equity share of 4 each) Employee stock option outstanding Reserves and surplus (Note 1)

2,508.52

 

1,380.00

 

13,099.10

16,987.62  

Non-current liabilities Secured loan—term loan

3,350.43

 

Less: Due within 12 months

794.15

 

Non-current provisions for gratuity & employee benefits

955.52

3,511.80  

Current liabilities Secured loans—working capital

8,057.47

 

Unsecured loans—working capital

4,767.83

 

Term loans—due within 12 months

794.15

 

Sundry creditors

6,286.06

 

Advances from customers

4,040.93

 

Other current liabilities

904.43 Total

24,850.87 45,350.29

180  Chapter 6 Particulars

( ` in Lakhs)  

II) Assets

 

Non-current assets Fixed assets (gross block)

31,220.96

 

Less: Accumulated depreciation

10,683.91

 

Net block

20,537.05

 

Capital work-in-progress

161.82

20,698.87

Long-term Investments (Note 2)

4,942.37

Deferred tax assets

1,123.92  

Current assets Cash in hand

18.34

Balance with banks

340.24

Inventories

36.47

Sundry debtors (Note 3)

12,157.43

Loans and advances (Note 4)

 6,032.65 Total

45,350.29

Notes

(  ` in Lakhs)

1 Reserves and surplus General reserves Revaluation reserve

527.02 2,296.39

Securities premium account

16,017.01

Less: Profit and loss account (Dr. Balance)

(5,741.32)

13,099.10

2 Long-term investments Investment as cost Less: Provision for diminution in value

5,338.02 395.65

4,942.37

3 Sundry debtors Gross receivables Less: Doubtful debts

12,913.14 755.71

12,157.43

4 Loans and advances Gross amount Less: Provisions for doubtful advances

6,432.65 400.00

6,032.65

Balance Sheet  181

7. The balance sheet of Shivam Industries Limited as on 31st March 2017 is given as follows: Balance Sheet of Shivam Industries Limited as at 31st March 2017

Particulars

( Amount in ` )

I)  Equity and liabilities Equity

 

Share capital (120,000 equity shares of ` 10 each) Less: Calls in arrear

1,200,000 100,000

1,100,000

Reserve and surplus

 

General reserve

 

Opening balance Addition during the year

500,000

 

50,000

550,000

Surplus in P&L account

 

Opening balance

91,696

 

Addition during the year

27,801

119,497 –

Non-current liabilities

 

Current liabilities Sundry creditors

173,716

Current provisions

 

Proposed dividend

40,000

Provision for income tax (1.4.2016) Provision for income tax (Current year)

90,000

 

120,000

250,000

Other current liabilities Salary outstanding Unclaimed dividend

 

  4,800

 

13,052

17,852

Total

2,211,065

II) Assets Non-current assets Fixed assets Gross block

770,000

Less: Accumulated depreciation

194,000

Less: Current year depreciation

59,000

Investments

517,000 577,900

Current assets Trade receivables Less: Provision for doubtful debts

446,760 8,935

437,825 (continued )

182  Chapter 6 (continued )

Particulars

( Amount in ` )

Cash at bank

144,480

Closing stock

297,360

Current loans and advances Advance income tax (1.4.2016)

100,000

Advance income tax (2016–17)

125,000

225,000

Other current assets Accrued interest

5,500

Prepaid insurance

6,000 Total

11,500 2,211,065

Notes: a. Gross block, accumulated depreciation and depreciation for the current year consist of machinery, building, motor vehicles and furniture. b.  Investments are assumed to be long-term.

Try It Yourself 1. Issue of shares: Easy Going Financial Services Limited with an authorized share capital of ` 100 million (10 million equity shares of ` 10 each) issued seven million equity shares for subscription at par. Applications were received for 6.9 million shares with application at the rate of ` 5 each and the company made allotment in full. The company asked for the balance money at the time of allotment. All the shareholders duly paid the allotment money except holders of 50,000 shares. a. How will the share capital of the company appear in the balance sheet at this stage? b. The management decided to forfeit the shares on which amounts are in arrears. How will the share capital appear after the forfeiture? 2. Classification in the balance sheet: How will you classify the following items in the balance sheet of a company: a. Goodwill b. Sundry creditors c. Provisions for doubtful debts d. Instalments of long-term loans due for repayment within the next 12 months e. Securities premium account f. Deferred tax assets (Net) g. Current investments h. Revaluation reserves i. Profit and loss account (Dr. Balance) j. Investment property k. Provisions for gratuity and employees benefits (long-term) l. Contingent liabilities

Balance Sheet  183

3. Disclosures in the Balance Sheet: How would the following transactions be disclosed in the balance sheet:: a. The company has incurred ` 320 Crore on the construction of a building that is yet to be completed. b. An advance of ` 10 Crore has been given to the material supplier for which the goods are yet to be received. c. The Company has acquired a brand by paying a consideration of ` 150 Crore. d. A deposit of ` 280 Crore has been placed with the Super Bank for a period of five years. e. The company has a foreign currency loan of $300 million repayable after five year. The exchange rate of the date of taking the loan was ` 52 whereas on the date of balance sheet, the exchange rate prevailing is ` 55. f. The company issued 10 million equity shares of the face value ` 10 each at an issue price of ` 50 each. g. The total fixed assets of the company as on the date of the balance sheet amounted to ` 2520 Crore. The accumulated depreciation amounted to ` 980 Crore. h. The company has paid ` 200 Crore to a film star for endorsement of its products covering a period of five years. 4. Composition of shareholders’ funds: The equity of Sooper Staar Limited as per the last two balance sheets are given as follows:

( ` in Million) Particulars

31st March 2017

31st March 2016

Share capital 120

120 million shares (previous year 50 million share of ` 1 each)

50

Reserves and surplus General reserves As per last balance sheet

90

67

Addition during the year

32

23

Used for the issue of bonus shares

–50

72

 0

90

80

80

0

96

65

248

155

368

205

Securities premium account Addition during the year Balance in profit & loss account

Total equity



Based upon the above information identify the reasons for changes in the share capital and reserves and surplus of the company during the year 2016–17.

184  Chapter 6

5. Classification of borrowed funds: As on 31st March 2017, the break-up of borrowed funds of Sabse Taza Retails Limited is as follows: Particulars

( ` in Crore)

Term loan (interest at 10% per annum)

225.00

Working capital loan (interest at 12% per annum)

200.00

Public deposits (interest at10% per annum)

120.00



The term loan is secured against the mortgage of company’s fixed assets, whereas the working capital loan is secured by way of hypothecation of its current assets. Public deposits are unsecured and are repayable on demand. The first instalment for repayment of term loan amounting to ` 25 crore is due within the next 12 months. Interest on term loan and working capital loan has accrued (but not due) for one quarter. Interest on public deposits amounting to ` 6 crore is due but not paid. How will the above information appear in the balance sheet of the company on 31st March 2017? 6. Valuation of investments: The details of investments of High Power Electricity Limited as on 31st March 2017 are given as follows: ( ` in Million)

Particulars

Cost

Market Price

Equity shares Regular electricity supply company limited (Unquoted)



500



British softskills limited

42

37

Mutual funds (Unquoted)

120



Government securities

85

88

Bonds of XYZ limited

24

20

The Regular Electrical Supply Limited is a subsidiary of the company. All other investments are current is nature. The current repurchase price of the mutual funds units is ` 122 million. How will you show the investments in the balance sheet of High Power Electricity Limited as on 31st March 2017?

7. Current asset/Current liabilities: Muscle Power Builder Limited is engaged in the construction business. It follows proportionate completion method for booking revenue and accordingly revenue is booked according to the stage of completion. The details of the payments received from customer and the revenue booked based upon proportionate completion method in respect of two of its projects for the year 2016–17 are given as follows: Project



( ` in Million) Revenue Booked

Payment Received

Project X

 50.20

67.00

Project XX

120.00

98.00

In respect of Project XX, though the revenue has been booked for ` 120 million invoice has been raised only for ` 110 million.   How will the above transaction appear in the balance sheet of the company as on 31st March 2017?

Balance Sheet  185

8. Preparation of balance sheet: The extracts from the books of account of Victoria Limited as on 31st March 2017 are given as follows. Prepare the balance sheet of the company as on 31st March 2017. Make suitable assumptions as required. Particulars

( ` in Crore)

Accumulated depreciation Advance income tax

2,893 667

Advance received from clients Capital reserve Capital work-in-progress Cash and bank

Particulars

( ` in Crore)

Outstanding salaries and bonus

649

Prepaid expenses

431

82

Profit and loss statement

54

Proposed dividend

409 10,556

Provision for diminution on long-term Investments

14,371 861 3

Provision for tax

724

Deferred tax assets

432

Provision for tax on dividend

143

Deferred tax liabilities

232

Provision for Un-availed Leave

302

Deposits—Electricity/Rental

99

Provision for warranty

Deposits with financial institutions

1,892

Provisions for doubtful debts

Property, plant and equipment—

7,839

Salary advances

General reserves

5,311

Securities premium account

Investments—Current

3,708

Share capital

Investments—Long-term Loans and advances—Others Loans to employees—Housing

7 146 38

82 102 73 3,027 286

Sundry creditors Sundry debtors Unbilled revenue

Other current liabilities

424

Unclaimed dividend

Outstanding expenses

645

Unearned revenue

10 3,596 841 2 531

What are your key observations based upon the balance sheet relating to compositions of the equity and liabilities and assets of the company. 9. Preparation of balance sheet from the trial balance and additional information: Based upon the trial balance of Star Limited as given in the problem 8 of Chapter 5, prepare the balance sheet of the company as on 31st March 2017. Make suitable assumptions as necessary. 10. Preparation of Balance Sheet: High Growth Fertilizers Limited is engaged in the manufacture and distribution of fertilizers in India. During the year 2016–17, the company made a profit of ` 693.27 Crore. The Board proposed a dividend @ 300% on the Equity Shares. The dividend attracts distribution tax @ 15% of the amount distributed. The Board also proposed transfer of ` 400 Crore to general reserves. Other balances as extracted from the books of accounts of the company are given below: Particulars

( ` in Crore)

Accumulated depreciation – Land and building

102.45

– Plant and machinery

445.35 (continued )

186  Chapter 6 (continued )

Particulars

( ` in Crore)

– Other tangible assets

58.76

Capital work-in-progress

133.13

Cash and cash equivalents

595.85

Deferred tax assets

23.89

Deferred tax liability

91.34

Finished goods

1266.27

General reserves

1300.2

Investments in mutual funds

322.04

Investments in subsidiary companies

627.9

Land and building (At cost)

435.01

Liabilities towards Expenses

48.37

Loans and advances—Long-term

51.4

Loans and advances—Short-term

2013.38

Other current assets Other current liabilities Other long-term liabilities

4.8 176.14 33.99

Other short-term borrowings

421.25

Other tangible assets (At cost)

158.87

Plant and machinery (At cost)

819.78

Prepaid expenses Profit and loss balance (1st April 2016) Provisions for warranties (Long-term)

7.8 446.96 5.33

Provisions for taxation

34.84

Provisions for employees benefits (Long-term)

10.96

Raw material Share capital (Face value ` 10 each) Term loan from banks Trade payables

345.56 28.26 272.79 2042.72

Trade receivables

887.02

Work-in-progress

243.78

Working capital loans from banks

1723.5

You are required to prepare the balance sheet of High Growth Fertilizer Limited as on 31st March 2017.

Balance Sheet  187

Cases Case 6.1: Preparation of Balance Sheet of Asian Paints Limited In continuation of Case 5.1 given in Chapter 5, you are required to prepare the balance sheet of Asian Paints Limited for the year ended 31st March 2017. The relevant information extracted from the books of accounts of the company are stated below: Particulars

( ` in Crore) Particulars

( ` in Crore)

Accumulated amortization

50

Non-current loans given

70

Accumulated depreciation

479

Non-current borrowings

10

Advances received from customers

10

Advances to employees

6

Other current financial assets

474

Assets held for sale

1

Other current financial liabilities

880

Non-current provision for other post—retirement benefits

4

Balances with government authorities

107

Other current liabilities

206

Bank balance—other than cash and cash equivalents

144

Other Intangible assets—gross

107

Borrowings current Capital advances—non current Capital redemption reserve Capital work in progress Cash and cash equivalents Current advances

27

Other non-current advances

27

173

Other non-current financial assets

198

1

Other non-current financial liabilities

2

220

Other non-current liabilities

4

61 102

Packing material Property, plant and equipment (gross)

36 2,991

Current loans given

14

Provision for compensated absence—current

13

Current tax liabilities

55

Provision for doubtful trade receivables

12

Current tax assets

37 Provisions for excise and sales tax—current

22

Provisions for pension—current

1 2

Current trade receivables Debt Instruments through OCI

1,007 4

Deferred tax liabilities

261

Provisions for pension— non-current

Equity Instruments through OCI

111

Provisions for compensated absence—non current

104 (continued )

188  Chapter 6 (continued )

Particulars Equity share capital

( ` in Crore) Particulars 96

Raw material

( ` in Crore) 598

Finished goods

1,233

Retained earnings

General Reserve

4,167

Statutory payables—current

196

Stock-in-trade

186

Goodwill

36

Investment—non-current

1,455

Stores, spares and consumables

Investments—current

1,315

Trade payables—current

Miscellaneous current assets

17

Work-in-progress

2,573

66 1,671 75

Source: Annual Report of Asian Paints Limited for the year 2016–17

Case 6.2: Preparation of Balance Sheet of HCL Technology Limited In continuation of Case 5.2 given in Chapter 5, you are required to prepare the balance sheet of HCL Technologies Limited for the year ended 31st March 2017. The relevant information extracted from the books of accounts of the company are stated below: Particulars

( ` in Crore)

Accumulated amortization

633

Accumulated depreciation

2,660

Advances received from customers Bank balance—other than cash and cash equivalents

23 7,610

Particulars

( ` in Crore)

Other current financial assets

1,518

Other current financial liabilities

4,004

Other intangible assets—gross

4,943

Other non-current assets

647

Capital reserve

120

Other non-current financial assets

187

Capital work in progress

411

Other non-current financial liabilities

7

Cash and cash equivalents

352

Other non-current liabilities

35

Cash flow hedging reserve

445

Property, plant and equipment (gross)

Current loans given Current tax liabilities

2,543 430

Provision for doubtful trade receivables

5,786 120

Provision for leave benefits—current

61 50

Current trade receivables

4,538

Provisions for gratuity—current

Deferred tax assets

1,211

Provisions for gratuity— non-current

277

Equity share capital

285

Provisions for leave benefits— non current

134 (continued )

Balance Sheet  189 (continued )

Particulars

( ` in Crore)

Foreign currency translation reserve General reserve Goodwill Inventories Investment in mutual funds—current Investment in subsidiary companies—non-current Other current assets

(49) 2,639 553 90 914 3,810 671

Particulars

( ` in Crore)

Retained earnings

19,268

Revenue received in advance

697

Securities premium reserves

3,244

Share based payment reserve

20

Term loan from banks

31

Trade payables—current

485

Withholding and other tax taxes payable

165

Case 6.3: Preparation of Balance Sheet of Cipla Limited Based Upon the Trial Balance and Additional Information Use the trial balance and additional information given in Case 5.3 in Chapter 5, and prepare the balance sheet of Cipla Limited as on 31st March 2017. Case 6.4: Preparation of Balance Sheet of HUL Limited Based Upon the Trial Balance and Additional Information Use the trial balance and additional information given in Case 5.4 in Chapter 5 and prepare the balance sheet of HUL Limited as on 31st March 2017. Case 6.5: Comparison of the Balance Sheets of Hero Honda Motors Limited and Tech Mahindra Limited as on 31st March 20178 In continuation of Case 5.5 given in Chapter 5, the summarized balance sheets of Hero Honda Motors Limited and Tech Mahindra Limited for the year ended 31st March 2017 are given below: Particulars

( ` in Crore) Hero Motocorp Limited

Tech Mahindra Limited

ASSETS Non-current assets Property, plant and equipment

4,311

2,428

Capital work-in-progress

271

362

Investment property



Intangible assets Intangible assets under development

85 194

45 25 –

Financial assets  (i) Investments (ii) Loans

1,349

5,748

23

74

190  Chapter 6 (continued )

( ` in Crore)

Particulars

Hero Motocorp Limited

(iii) Other financial assets

Tech Mahindra Limited

25

427

Income tax assets

332

982

Deferred tax assets (net)



Other non-current assets

651

488

Total non-current assets

7,241

10,604

25

Current assets Inventories

656



Financial assets  (i) Investments

4,541

1,969

(ii) Trade receivables

1,562

4,572

16

972

(iii) Cash and cash equivalents (iv) Bank balances other than (iii) above

121

1,112

 (v) Loans

22

517

  (v) Others (to be specified)

24

2,175

Other current assets

511

1,786

Total current assets

7,453

13,103 26

Assets held for sale Total Assets

14,694

23,733

40

487

10,071

16,403

10,111

16,890

EQUITY AND LIABILITIES Equity Equity share capital Other equity LIABILITIES Non-current liabilities Financial liabilities  (i) Borrowings



174

(ii) Trade payables





(iii) Other financial liabilities



359

Provisions Deferred tax liabilities (Net)

75 415

384 –

Other non-current liabilities





Total non-current liabilities

490

917 (continued )

Balance Sheet  191 (continued )

Particulars

( ` in Crore) Hero Motocorp Limited

Tech Mahindra Limited





3,247

2,471

(iii) Other financial liabilities

353

269

Other current liabilities

454

1,092

39

236

Current liabilities Financial liabilities (i) Borrowings  (ii) Trade payables

Provisions Current tax liabilities (Net) Total current liabilities

– 4,093

4,695 1,231

Suspense account (Net) Total equity and liabilities

627

14,694

23,733

Source: Annual reports of Hero Honda Motors Limited and Tech Mahindra Limited for the year 2016–17

Questions for Discussion 1. Compare the composition of assets and liabilities of the two companies and identify the key differences. 2. Which of the two companies have higher level of liquidity? 3. Which of the two companies is likely to have higher level of depreciation? Why? 4. Tech Mahindra Limited has large non-current investments whereas Hero Honda Motors Limited has large current investments. What does it indicate? 5. Justify the difference between the level of trade receivables and inventories of the two companies. Case 6.6: Engineers India Limited: Impact of Bonus Shares and Stock Split on the Shareholders’ Funds in the Balance Sheet9 Engineers India Limited (EIL) was set up in 1965 to provide engineering and related technical services for petroleum refineries and other industrial projects. Its range of services include project management consultancy (PMC), project implementation services (PMS), engineering, procurement and construction (EPC) and lump sum turnkey (LSTK) contracts. The company has an enviable track record of profitability. For the year 2009–10, EIL posted a profit after tax of ` 43,557 lakh on a total income of ` 217,747 lakh. EIL does not have any borrowed funds on its balance sheet and has been rewarding its shareholders with regular cash dividends. After paying dividends any surplus in the profit and loss

192  Chapter 6

account is transferred to the general reserves. The share capital and reserves and surplus of EIL as on 31st March 2010 are given as follows: Particulars

As on 31st March 2010 ( ` in Lakhs)

I)  Share capital

 

Authorized

 

100,000,000 equity shares of ` 10 each Issued 56,196,600 equity shares of ` 10 each Subscribed and paid up 56,156,100 Equity shares of ` 10 each Add: Forfeited shares: Amount originally paid up on 1,300 equity shares of ` 10 each

10,000.00   5,619.66   5,615.61   0.01 5,615.62

II)  Reserves and surplus a. General reserve b. Share premium account c. Capital reserve Capital grant received from Oil Industry Development Board for R&D Centre

  104,724.86 920.10   200.00 105,844.96

Source: Annual reports of Engineers India Limited for the year 2009–10 and 2010–11

During the year 2010–11, EIL decided to make a bonus issue to the existing shareholders in the ration of 2:1 (2 new shares for 1 held). For this purpose, it decided to utilize the entire balance available in the share premium account and the necessary amounts from the general reserves as well. At the same time it was also decided to split the shares in the ratio of 2 for 1. Accordingly, each share of face value of ` 10 was split into two shares of face value ` 5 each. The company increased the authorized share capital to ` 30,000 lakh divided in 6,000 lakh equity share of ` 5 each. During the year 2010–11, EIL earned a profit after tax of ` 52,251.94 lakh and paid an interim dividend of ` 3,367.37 lakh. The board of directors of the company also proposed a final dividend of ` 13,477.46 lakh. The dividend distribution tax of ` 2,663.72 lakh was also paid. After these appropriations the balance amount was transferred to the general reserve account. Required a. How will the shareholders’ funds appear in the balance sheet of Engineers India Limited as on 31st March 2011? b. What is the impact of bonus issue and stock split on share capital, shareholders’ funds and promoters’ stake in the company? c. How do stock split and bonus issue affect the assets of the company?

Balance Sheet  193

Appendix I: General Instructions for Preparation of Balance Sheet 1. An entity shall classify an asset as current when: (a) It expects to realize the asset, or intends to sell or consume it, in its normal operating cycle. (b) It holds the asset primarily for the purpose of trading. (c) It expects to realize the asset within 12 months after the reporting period. (d) The asset is cash or a cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. An entity shall classify all other assets as non-current. 2. The operating cycle of an entity is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve months. 3. An entity shall classify a liability as current when: (a) It expects to settle the liability in its normal operating cycle. (b) It holds the liability primarily for the purpose of trading. (c) The liability is due to be settled within 12 months after the reporting period. (d) It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. An entity shall classify all other liabilities as non-current. 4. A receivable shall be classified as a ‘trade receivable’ if it is in respect of the amount due on account of goods sold or services rendered in the normal course of business. 5. A payable shall be classified as a ‘trade payable’ if it is in respect of the amount due on account of goods purchased or services received in the normal course of business. 6. A company shall disclose the following in the notes to accounts A. Non-Current Assets 1. Property, plant and equipment: (a) Classification shall be given as: (i)  Land (ii)  Buildings  (iii)  Plant and equipment  (iv)  Furniture and fixtures  (v)  Vehicles (vi)  Office equipment (vii)  Bearer Plants (viii)  Others (specify nature) (b) Assets under lease shall be separately specified under each class of assets. (c) A reconciliation of the gross and net carrying amounts of each class of assets at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments and the related depreciation and impairment losses or reversals shall be disclosed separately. 2. Investment property: A reconciliation of the gross and net carrying amounts of each class of property at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments and the related depreciation and impairment losses or reversals shall be disclosed separately.

194  Chapter 6

3. Goodwill: A reconciliation of the gross and net carrying amount of goodwill at the beginning and end of the reporting period showing additions, impairments, disposals and other adjustments. 4. Other intangible assets: (a) Classification shall be given as: (i) Brands or trademarks (ii) Computer software (iii) Mastheads and publishing titles (iv) Mining rights (v) Copyrights, patents, other intellectual property rights, services and operating rights (vi) Recipes, formulae, models, designs and prototypes (vii) Licenses and franchises (viii) Others (specify nature) (b) A reconciliation of the gross and net carrying amounts of each class of assets at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments and the related amortization and impairment losses or reversals shall be disclosed separately. 5. Biological assets other than bearer plants: A reconciliation of the carrying amounts of each class of assets at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations and other adjustments shall be disclosed separately. 6. Investments: (a) Investments shall be classified as: (i) Investments in equity instruments (iii) Investments in preference shares (iv) Investments in government or trust securities (v) Investments in debentures or bonds (vi) Investments in mutual funds (vii) Investments in partnership firms (viii) Other investments (specify nature) Under each classification, details shall be given of names of the bodies corporate that are: (i) Subsidiaries (ii) Associates (iii) Joint ventures (iv) Structured entities In whom investments have been made and the nature and extent of the investment so made in each such body corporate (showing separately investments which are partly-paid). Investments in partnership firms alongwith names of the firms, their partners, total capital and the shares of each partner shall be disclosed separately. (b) The following shall also be disclosed: (i) Aggregate amount of quoted investments and market value thereof (ii) Aggregate amount of unquoted investments (iii) Aggregate amount of impairment in value of investments 7. Trade Receivables: (a) Trade receivables shall be sub-classified as: (i) Secured, considered good

Balance Sheet  195

(ii) Unsecured considered good (iii) Doubtful (b) Allowance for bad and doubtful debts shall be disclosed under the relevant heads separately. (c) Debts due by directors or other officers of the company or any of them either severally or jointly with any other person or debts due by firms or private companies, respectively, in which any director is a partner or a director or a member should be separately stated. 8. Loans: (a) Loans shall be classified as: (i) Security deposits (ii) Loans to related parties (giving details thereof) (iii) Other loans (specify nature) (b) The above shall also be separately sub-classified as: (i) Secured, considered good (ii) Unsecured, considered good (iii) Doubtful (c) Allowance for bad and doubtful loans shall be disclosed under the relevant heads separately. (d) Loans due by directors or other officers of the company or any of them either severally or jointly with any other persons or amounts due by firms or private companies, respectively, in which any director is a partner or a director or a member should be separately stated. 9. Bank deposits with more than 12 months maturity shall be disclosed under other financial assets 10. Other non-current assets: Other non-current assets shall be classified as: (a) Capital advances (b) Advances other than capital advances: (i) Advances other than capital advances shall be classified as: (a)  Security Deposits (b)  Advances to related parties (giving details thereof) (c)  Other advances (specify nature) (ii) Advances to directors or other officers of the company or any of them either severally or jointly with any other persons or advances to firms or private companies, respectively, in which any director is a partner or a director or a member should be separately stated. In case advances are of the nature of a financial asset as per relevant Ind AS, these are to be disclosed under other financial assets separately. (c) Others (specify nature).

B. Current Assets 1. Inventories: (a) Inventories shall be classified as: (i) Raw materials (ii) Work-in-progress (iii) Finished goods (iv) Stock-in-trade (in respect of goods acquired for trading) (v) Stores and spares (vi) Loose tools (vii) Others (specify nature) (b) Goods-in-transit shall be disclosed under the relevant sub-head of inventories. (c) Mode of valuation shall be stated.

196  Chapter 6

2. Investments: (a) Investments shall be classified as: (i) Investments in equity instruments (ii) Investment in preference shares (iii) Investments in government or trust securities (iv) Investments in debentures or bonds (v) Investments in mutual funds (vi) Investments in partnership firms (vii) Other investments (specify nature) Under each classification, details shall be given of ames of the bodies corporate that are: (i) Subsidiaries (ii) Associates (iii) Joint ventures (iv) Structured entities In whom investments have been made and the nature and extent of the investment so made in each such body corporate (showing separately investments which are partly-paid). (b) The following shall also be disclosed: (i) Aggregate amount of quoted investments and market value thereof (ii) Aggregate amount of unquoted investments (iii) Aggregate amount of impairment in value of investments 3. Trade Receivables: (a) Trade receivables shall be sub-classified as: (i) Secured, considered good (ii) Unsecured considered good (iii) Doubtful (b) Allowance for bad and doubtful debts shall be disclosed under the relevant heads separately. (c) Debts due by directors or other officers of the company or any of them either severally or jointly with any other person or debts due by firms or private companies, respectively, in which any director is a partner or a director or a member should be separately stated. 4. Cash and cash equivalents: Cash and cash equivalents shall be classified as: (a) Balances with banks (of the nature of cash and cash equivalents) (c) Cheques, drafts on hand (d) Cash on hand Others (specify nature) 5. Loans: (a) Loans shall be classified as: (i) Security deposits (ii) Loans to related parties (giving details thereof) (iii) Others (specify nature) (b) The above shall also be sub-classified as: (i) Secured, considered good (ii) Unsecured, considered good (iii) Doubtful (c) Allowance for bad and doubtful loans shall be disclosed under the relevant heads separately.

Balance Sheet  197



(d) Loans due by directors or other officers of the company or any of them either severally or jointly with any other person or amounts due by firms or private companies, respectively, in which any director is a partner or a director or a member shall be separately stated. 6. Other current assets (specify nature): This is an all-inclusive heading, which incorporates current assets that do not fit into any other asset categories. Other current assets shall be classified as (a) Advances other than capital advances (i) Advances other than capital advances shall be classified as: (I)  Security deposits (II) Advances to related parties (giving details thereof) (III)  Other advances (specify nature) (b) Advances to directors or other officers of the company or any of them either severally or jointly with any other persons or advances to firms or private companies, respectively, in which any director is a partner or a director or a member should be separately stated. (b) Others (specify nature)

C. Cash and Bank Balances The following disclosures with regard to cash and bank balances shall be made: 1. Earmarked balances with banks (for example, for unpaid dividend) shall be separately stated. 2 Balances with banks to the extent held as margin money or security against the borrowings, guarantees, other commitments shall be disclosed separately. 3. Repatriation restrictions, if any, in respect of cash and bank balances shall be separately stated.

D. Equity 1.



Equity Share Capital: For each class of equity share capital: (a) The number and amount of shares authorized. (b) The number of shares issued, subscribed and fully paid, and subscribed but not fully paid. (c) Par value per share. (d) A reconciliation of the number of shares outstanding at the beginning and at the end of the period. (e) The rights, preferences and restrictions attaching to each class of shares including restrictions on the distribution of dividends and the repayment of capital. (f) Shares in respect of each class in the company held by its holding company or its ultimate holding company including shares held by subsidiaries or associates of the holding company or the ultimate holding company in aggregate. (g) Shares in the company held by each shareholder holding more than five per cent shares specifying the number of shares held. (h) Shares reserved for issue under options and contracts or commitments for the sale of shares or disinvestment, including the terms and amounts. (i) For the period of five years immediately preceding the date at which the Balance Sheet is prepared: • Aggregate number and class of shares allotted as fully paid up pursuant to contract without payment being received in cash. • Aggregate number and class of shares allotted as fully paid up by way of bonus shares. • Aggregate number and class of shares bought back.

198  Chapter 6



(j) Terms of any securities convertible into equity shares issued along with the earliest date of conversion in descending order starting from the farthest such date. (k) Calls unpaid (showing aggregate value of calls unpaid by directors and officers). (l) Forfeited shares (amount originally paid up). 2. Other equity: (a) Other reserves shall be classified in the notes as: (i) Capital redemption reserve (ii) Debenture redemption reserve (iii) Share options outstanding account (iv) Others—(specify the nature and purpose of each reserve and the amount in respect thereof) (Additions and deductions since last balance sheet to be shown under each of the specified heads) (b) Retained earnings represents surplus, i.e., balance of the relevant column in the statement of changes in equity. (c) A reserve specifically represented by earmarked investments shall disclose the fact that it is so represented. (d) Debit balance of statement of profit and loss shall be shown as a negative figure under the head retained earnings. Similarly, the balance of other equity, after adjusting negative balance of retained earnings, if any, shall be shown under the head other equity even if the resulting figure is in the negative. (e) Under the sub-head other equity, disclosure shall be made for the nature and amount of each item.

E. Non-Current Liabilities 1. Borrowings: (a) borrowings shall be classified as: (i) Bonds or debentures (ii) Term loans (I)  from banks (II)  from other parties (iii) Deferred payment liabilities (iv) Deposits (v) Loans from related parties (vi) Long-term maturities of finance lease obligations (vii) Liability component of compound financial instruments (viii) Other loans (specify nature) (b) Borrowings shall further be sub-classified as secured and unsecured. Nature of security shall be specified separately in each case. (c) Where loans have been guaranteed by directors or others, the aggregate amount of such loans under each head shall be disclosed. (d) Bonds or debentures (along with the rate of interest, and particulars of redemption or conversion, as the case may be) shall be stated in descending order of maturity or conversion, starting from the farthest redemption or conversion date, as the case may be. Where bonds/ debentures are redeemable by installments, the date of maturity for this purpose must be reckoned as the date on which the first installment becomes due.

Balance Sheet  199



(e) Particulars of any redeemed bonds or debentures which the company has power to reissue shall be disclosed. (f) Terms of repayment of term loans and other loans shall be stated. (g) Period and amount of default as on the balance sheet date in repayment of borrowings and interest shall be specified separately in each case. 3. Provisions: The amounts shall be classified as: (a) Provision for employee benefits (b) Others (specify nature). 4. Other non-current liabilities: (a) Advances (b) Others (specify nature).

F. Current Liabilities 1. Borrowings: (a) Borrowings shall be classified as: (i) Loans repayable on demand (I)  from banks (II)  from other parties (ii) Loans from related parties (iii) Deposits (vi) Other loans (specify nature); (b) Borrowings shall further be sub-classified as secured and unsecured. Nature of security shall be specified separately in each case. (c) Where loans have been guaranteed by directors or others, the aggregate amount of such loans under each head shall be disclosed. (d) Period and amount of default as on the balance sheet date in repayment of borrowings and interest, shall be specified separately in each case. 2. Other financial liabilities: Other financial liabilities shall be classified as: (a) Current maturities of long-term debt. (b) Current maturities of finance lease obligations. (c) Interest accrued. (d) Unpaid dividends. (e) Application money received for allotment of securities to the extent refundable and interest accrued thereon. (f) Unpaid matured deposits and interest accrued thereon. (g) Unpaid matured debentures and interest accrued thereon. (h) Others (specify nature). Long-term debt is a borrowing having a period of more than twelve months at the time of origination. 3. Other current liabilities: The amounts shall be classified as: (a) Revenue received in advance. (b) Other advances (specify nature). (c) Others (specify nature).

200  Chapter 6

4. G.

Provisions: The amounts shall be classified as: (a) Provision for employee benefits. (b) Others (specify nature). The presentation of liabilities associated with group of assets classified as held for sale and noncurrent assets classified as held for sale shall be in accordance with the relevant Indian accounting standards (Ind ASs).

H. Contingent Liabilities and Commitments 1. 2.

(to the extent not provided for) Contingent liabilities shall be classified as: (a) Claims against the company not acknowledged as debt. (b) Guarantees excluding financial guarantees. (c) Other money for which the company is contingently liable. Commitments shall be classified as: (a) Estimated amount of contracts remaining to be executed on capital account and not provided for. (b) Uncalled liability on shares and other investments partly paid. (c) Other commitments (specify nature).

I. The amount of dividends proposed to be distributed to equity and preference shareholders for the period and the related amount per share shall be disclosed separately. Arrears of fixed cumulative dividends on irredeemable preference shares shall also be disclosed separately. J. Where in respect of an issue of securities made for a specific purpose the whole or part of amount has not been used for the specific purpose at the balance sheet date, there shall be indicated by way of note how such unutilized amounts have been used or invested. 7. When a company applies an accounting policy retrospectively or makes a restatement of items in the financial statements or when it reclassifies items in its financial statements, the company shall attach to the balance sheet, a balance sheet as at the beginning of the earliest comparative period presented. 8. Share application money pending allotment shall be classified into equity or liability in accordance with relevant Indian accounting standards. Share application money to the extent of not refundable shall be shown under the head equity and share application money to the extent of refundable shall be separately shown under other financial liabilities. 9. Preference shares including premium received on issue, shall be classified and presented as equity or liability in accordance with the requirements of the relevant Indian accounting standards. Accordingly, the disclosure and presentation requirements in this regard applicable to the relevant class of equity or liability shall be applicable mutatis mutandis to the preference shares. For instance, redeemable preference shares shall be classified and presented under non-current liabilities as borrowings and the disclosure requirements in this regard applicable to such borrowings shall be applicable mutatis mutandis to redeemable preference shares. 10. Compound financial instruments such as convertible debentures, where split into equity and liability components as per the requirements of the relevant Indian accounting standards, shall be classified and presented under the relevant heads in equity and liabilities. 11. Regulatory deferral account balances shall be presented in the balance sheet in accordance with the relevant Indian accounting standards.

Balance Sheet  201

Endnotes 1. Framework for, preparation and presentation of financial statements, 2011, ICAI 2. Section 55, Companies Act, 2013 3. Section 68 of the Companies Act 2013 4. Exposure draft ‘Framework for the preparation and presentation of financial statements’, ICAI, 2011 5. Ind AS 37 provisions, contingent liabilities and contingent assets

Accounting for Revenue

7

CHAPTER OBJECTIVES This chapter will help the readers to: • Identify issues involved in revenue recognition from sales of goods, provisions of services and also long-term contracts. • Apply accrual principle on revenue recognition. • Analyze the impact of uncertainty on revenue recognition. • Get familiarity with the key requirement of Ind AS 18 ‘Revenue’, Ind AS 11 ‘Construction Contracts’, and Ind AS 21 ‘The effects of changes in Foreign Exchange Rates’ as applicable to revenue recognition.

7.1 REVENUE The expression ‘revenue’ means the consideration earned by an enterprise by sale of goods or provision of services in the ordinary course of business. Revenue may also be earned by an enterprise by letting others use resources owned by it. For example, interest is earned on moneys lent by an enterprise. Revenue earned by an entity is known by a variety of different terms including sales, fees, interest, dividends and royalties. Accounting for revenue requires answer to two related questions, firstly, how much revenue to be recognized and secondly, when should it be recognized. Revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. As per Ind AS 18, ‘Revenue is the gross inflow of economic benefits during the period arising in the course of ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants’. Ind AS 18 deals with revenue recognition from:

• Sales of goods. • Rendering of services. • The use by others of entity’s assets yielding interest, royalities and dividends. Revenue recognition from construction contracts is the subject matter of Ind AS 11.

Accounting for Revenue  203

7.2  QUANTUM OF REVENUE Revenue is measured at the fair value of the consideration received or receivable. Fair value is the amount for which an asset could be exchanged or a liability settled, between knowledgeable and willing parties in an arm’s length transaction. The amount of revenue earned is usually determined with reference to the agreement with the customer. In most cases, the consideration is in the form of cash or cash equivalents and the amount of revenue is in the form of cash or cash equivalents received or receivable.

7.2.1 Discount An enterprise may offer quantity discount or a trade discount to its customers. The quantity discount is often offered to customers for buying in bulk, whereas a trade discount may be offered to certain ­categories of customers. In both the cases, the amount of discount is known at the time of sale. In such cases, revenue should be recorded at the net sales value, that is, after deducting trade discount and quantity discount. In case of credit sale, an enterprise may also offer a cash discount. Cash discount is offered for inducing prompt payment from the customer. For example, an enterprise may sell goods on terms Trade discount and quantity discount 1/15 net 60. This expression indicate that the cusare not shown separately but are taken tomers is being allowed a credit period of 60 days as reduction of revenue. Cash discount but if he pays within 15 days he will be given a is shown separately as an expense. cash discount of 1% of the invoice value. As at the time of sale there is no certainty as to whether the customer will avail the cash discount or not, it is better to record revenue at the gross value without deducting the cash discount. Subsequently, if the customer pays early and earns cash discount, the same will be recognized as an expense. This may cause a problem where sales is recorded in one accounting period but the cash discount is availed in the next accounting period. Recording sale in one accounting period and cash discount in the next goes against the matching principle. If the incidence of cash discount is large, an enterprise may make provisions for cash discount and record estimated cash discount as an expense of the period. If cash discount is not availed by the customer, the same will get reversed in the next accounting period. ■  Illustration 7.1

Quick Fox Trading Limited usually sells its goods at the invoice value. In case of bulk orders (exceeding 1,000 units), it offers a quantity discount of 2% on the invoice value. The customers are allowed 45 days credit period however, if the payment is made within 15 days, an additional discount of 1% is given. The company received an order for supply of 1,500 units at an invoice price of `  2,000 per unit. The customer paid on the 15th day and availed cash discount. How will the transaction be recorded? The amount expected to be realized at the time of sale is ` 3,000,000 less 2% quantity discount. The sale will be recorded accordingly at ` 2,940,000. The following entry will be passed: Customer (Trade Receivables) Account  Dr. ` 2,940,000   To Sales   ` 2,940,000

204  Chapter 7

As the customer has availed cash discount of 1% by paying on the 15th day, the net receipt from the customer is ` 2,910,600. At the time of receipt will be: Bank Account Dr. ` 2,910,600 Cash Discount Dr.  ` 29,400   To Customer Account   ` 2,940,000 If a customer is not satisfied about the quality of goods bought by him, he may be permitted by the enterprise to return the goods. As a consequence of the return, the revenue earlier recorded declines with a corresponding reduction in the receivables from the customer. In the profit and loss statement, the revenue from sales will appear net of sales return. On sales return, the following accounting entry will be passed: Sales Return A/c    To Customer Account

Dr.

7.2.2  Agency Relationship In an agency relationship, the agent collects the economic benefits on behalf of the principal. The agent is merely entitled to receive commission for the services rendered. The amount, collected on behalf of the principal, does not result in increase in equity for the agent. Only the amount of commission will be treated as revenue. Entity engaged in agency business, e.g., real estate agents, insurance brokers, stock brokers, etc., would record amount of commission as revenue and not the entire amount of the transaction. ■  Illustration 7.2

Small Bull Brokers Limited is a stock broking firm. It bought shares on behalf of one of his clients for ` 50 million charging 1% brokerage. It paid ` 50 million to the stock exchange and collected ` 50.5 million (including brokerage) from its client. What amount should be recorded as revenue? As Small Bull Brokers Limited is acting in the capacity of a broker, only the amount of commission, i.e., ` 0.50 million will be recognized as revenue representing the increase in equity.

7.2.3  Indirect Taxes Indirect taxes, by nature, are paid to the government by one entity, but it is collected from the consumer as part of the price of a good or service. For example, sales tax, value-added tax, goods and services tax, etc., are levied on an entity but are borne by someone else. Revenue should include only the gross inflows of economic benefits received and receivable by the entity on its own account. As indirect taxes are collected on behalf of government, they are excluded from the definition of revenue. However, if the indirect tax is collected by the enterprise on its own account as a principal and it pays the tax to the government on its own account, the revenue will be taken on gross basis. Indirect taxes–Excise duty, service tax, sales tax and value added tax are called indirect taxes as the incidence of tax is shifted to the customer.

7.2.4  Deferred Revenue Revenue is generally recognized as the amount of cash or cash equivalent received or receivable. However, where good are sold or services provided on a deferred credit basis, i.e., revenue is r­ eceivable

Accounting for Revenue  205

after the lapse of significant time period, the fair value of the consideration may be less than the nominal amount of cash received or receivable. In such a case, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest. The difference between the fair value and the nominal amount of the consideration is recognized as interest revenue. ■  Illustration 7.3

HH Engineering Limited sold some machinery to a client on a deferred credit basis. The sale price of ` 20 million is receivable after 2 years. What amount should be recorded as revenue in the following circumstances?

1. HHEL sells similar machinery to its clients for ` 16 million if the payment is made immediately; or 2. HHEL sells machinery only on deferred credit basis and the prevalent rate of interest is 10%.

As HHEL is permitting its client 2 years to make the payment, the nominal value cannot be taken as the fair value of the goods sold. In case (1) above, the fair value of goods sold would be taken as ` 16 million and ` 4 million would be recognized as interest revenue over 2 years. In case (2), the fair value would be determined by discounting the amount of consideration by 10% per annum. 20 million Fair Value = (1 + .10)2 = ` 16.53 million Revenue from sale of machinery would be recognized at ` 16.53 million and the balance ` 3.47 million would be recognized as interest income spread over the period of 2 years.

7.2.5  Barter Transactions In case of barter transactions, good or services are exchanged or swapped. Either the entire value of transaction is settled by swap or a part of the consideration is paid in cash. If goods or services being swapped are of similar nature, no revenue would be recognized. For example, two suppliers of commodities like oil or milk agree to exchange inventories in various locations to fulfil demand on a timely basis in a particular location. On the other hand, exchange of goods or services which are dissimilar in nature is regarded as a transaction which generates revenue. In such a case, revenue is measured at the fair value of the goods or services received. When the fair value of the goods or services received cannot be measured reliably, the revenue is measured at the fair value of the goods or services given up. The revenue recognized would be adjusted with the amount of cash or cash equivalent transferred.

7.2.6  Revenue Earned in Foreign Currency Revenue earned by an enterprise in foreign currency is converted into the reporting currency by applying the appropriate exchange rate between the foreign currency and the reporting currency on the date of the transaction. An enterprise may instead of using the actual rate decide to use an approximate rate.1 For example, an average rate for a week may be used for all transactions in foreign currency during the week. However, where exchange rate fluctuations are heavy, it is preferable not to use average rate.

206  Chapter 7

Once revenue has been recorded, any subsequent change in foreign exchange rate will not alter the amount of revenue recognized, but will be recorded either as a gain or loss on account of foreign exchange difference. ■  Illustration 7.4

XYZ Limited exported goods invoiced at $700,000. On the date of the sale the prevailing exchange rate was $1 = ` 64. The customer was allowed 30 days to make the payment. The payment was duly received from the customer on due date. The exchange rate on the date of receipt was $1 = ` 63.50. What will be the impact of the above sale in the profit and loss account of the company? On the date of sale, the invoice value will be converted into Indian rupee by applying the then prevailing exchange rate, i.e., ` 64. Accordingly, sale will be recorded at ` 44,800,000 by passing the following entry: Customer (Debtor) Account Dr. ` 30,800,000   To Sales Account   ` 30,800,000 As the amount realized is at ` 63.50, there is an exchange loss of ` 0.50 per dollar. The following entry will be passed upon receipt of money from the customer: Bank Account Dr. ` 44,450,000 Exchange Loss Account Dr. ` 350,000   To Customer Account   ` 44,800,000 In the profit and loss statement revenue from sales will appear at ` 44,800,000. Loss on account of exchange difference will appear along with other expenses.

7.3  TIMING OF REVENUE RECOGNITION In cash basis of accounting, revenue is recognized only upon receipt of consideration from the customer. No accounting entries are passed at the time of sale of goods or provision of services. In accrual basis of accounting, revenue is recognized when earned and not when cash is received. In the following section, we discuss the revenue recognition from sales of goods, rendering of services and from execution of construction contracts.

7.3.1  Sale of Goods In case of sales of goods, the revenue normally will be recognized when the seller has performed his part of obligation as per the agreement with the buyer. Goods include goods produced by the entity for the purpose of sale and goods purchased for resale, such as merchandise purchased by a retailer or land and other property held for resale. Ind AS 18 lays down the following conditions to ascertain that the performance has been achieved:2

• The entity has transferred the significant risks and rewards of ownership of the goods to the •

buyer. The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold.

Accounting for Revenue  207

• The amount of revenue can be measured reliably. • It is probable that the economic benefits associated with the transaction will flow to the entity. • The costs incurred or to be incurred in respect of the transaction can be measured reliably. The transfer of the legal title or passing of possession to the buyer is often taken as an evidence of the transfer of the risks and rewards of ownership. In some cases, however, the transfer of risks and rewards of ownership may occur at a different time from the transfer of legal title or the passing of possession. If significant risk of ownership is retained by the entity, revenue is not recognized. Examples of situations in which the entity may retain the significant risks and rewards of ownership are:

• When the entity retains an obligation for unsatisfactory performance not covered by normal • • •

warranty provisions. When the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods. When the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity. When the buyer has the right to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return.

If, however, the risk of ownership retained by the entity is insignificant, the transaction is a sale and revenue is recognized. For example, an entity may be offering refund if the customer is not satisfied. The entity would recognize revenue at the time of sale. The seller would estimate future returns based on previous experience and other relevant factors and recognizes a liability for returns. Revenue is recognized only when it is probable that the economic benefits associated with the transaction will flow to the entity. If there is uncertainty existing at the time of sale regarding receipt of consideration, revenue should not be recognized until the consideration is received or the uncertainty is removed. In some cases, an uncertainty may arise subsequent to revenue recognition about the collectability of the amount. In such cases, the amount of revenue already booked is not reversed rather suitable provision for probable loss on account of non-recovery would be made. When the expenses cannot be measured reliably, revenue cannot be recognized. The matching principle requires matching of cost with revenue. Therefore, when it is not possible to measure expenses reliably, any consideration already received for the sale of the goods is recognized as a liability. Once a sales transaction meets the above conditions, revenue is deemed to have been earned. The timing of receipt has no bearing on revenue recognition. The above describes the general rules for revenue recognition. Some specific situations regarding timing of revenue recognition are discussed below:

• Installation and inspection: Revenue is normally recognized when the buyer accepts delivery, • •

and installation and inspection are complete. Consignment sales: Goods are sent by the consignor to the consignee and the later undertakes to sell the goods on behalf of the consignor. Revenue will be recognized only when goods are sold by the consignee to a third party. Cash on delivery Sales: Sale is deemed to be completed only upon receipt of cash from the customer. As such revenue will be recognized only when cash is received.

208  Chapter 7 Box 7.1  Accounting Policies Relating to Revenue Recognition from Sale of Goods Asian Paints Limited • Revenue is recognized when it is probable that economic benefits associated with a transaction flows to the company in the ordinary course of its activities and the amount of revenue can be measured reliably. Revenue is measured at the fair value of the consideration received or receivable, net of returns, trade discounts and volume rebates allowed by the company. • Revenue includes only the gross inflows of economic benefits, including excise duty, received and receivable by the company, on its own account. Amounts collected on behalf of third parties, such as sales tax and value added tax are excluded from revenue. • Revenue from sale of products is recognized when the company transfers all significant risks and rewards of ownership to the buyer, while the company retains neither continuing managerial involvement nor effective control over the products sold. ITC Limited • Revenue is measured at the fair value of the consideration received or receivable for goods supplied and services rendered, net of returns and discounts to customers. Revenue from the sale of goods includes excise and other duties which the company pays as a principal but excludes amounts collected on behalf of third parties, such as sales tax and value added tax. • Revenue from the sale of goods is recognized when significant risks and rewards of ownership have been transferred to the customer, which is mainly upon delivery, the amount of revenue can be measured reliably and recovery of the consideration is probable. Source: Annual report of Asian Paints Limited and ITC Limited for the year 2016–17

• Sale on approval basis: The seller gives the buyer an option to return the goods within a specified period of time. Sale is considered to be complete when goods are explicitly approved by the buyer or on lapse of the time allowed. • Installment Sales: In case the sales consideration is payable in installments, revenue is recognized on the date of sale by the normal selling price of the goods. Interest component in installments is recognized separately. • Delivery delayed at the request of the buyer: If the goods are identified and ready for delivery but delivery is delayed at buyer’s request, revenue is recognized immediately so long there is expectation that delivery will be made. • Internal sale: Goods sold by one unit of the enterprise to another is not recognized as revenue. As there is no transfer of ownership, no sale can be recorded. Accounting policies of some companies relating to revenue recognition from sales are given in Box 7.1.

7.3.2 Revenue from Services Revenue from rendering of services is recognized when the agreed services have been rendered. If the service consists of a single act, revenue can be easily recognized upon performance of that act. However, when service consists of a series of acts, revenue is recognized with reference to the stage of completion of the transaction. Recognizing revenue with reference to the stage of completion is called percentage of completion method. Revenue from service is recognized if it is possible to esti-

Accounting for Revenue  209

mate the outcome of the transaction reliably. The following conditions need to be satisfied for revenue recognition:

• The amount of revenue can be measured reliably. • It is probable that the economic benefits associated with the transaction will flow to the entity. • The stage of completion of the transaction at the end of the reporting period can be measured •

reliably. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

It is possible to make reliable estimates of revenue to be earned based upon the agreement with the customer. The agreement usually provides for enforceable rights of each party to the transaction, the consideration to be exchanged and the manner and terms of settlement. In addition, internal budgeting and reporting system is helpful in making the estimates. To ascertain the stage of completion, an entity may use a variety of methods. Some of the methods that could be used for this purpose include surveys of work performed, service performed as a percentage of total services to be performed, cost incurred as a percentage of the total estimated cost. It may be noted that progress payments and advances received from customers may not be indicative of the stage of completion. In cases where services consist of an indeterminate number of acts over a specified period of time, revenue is recognized on a straight-line basis over the specified period. For example, in case of annual maintenance contract, the revenue may be recognized over the period of the AMC. However, when a specific act is much more significant than any other acts, the recognition of revenue is postponed until the significant act is executed. When the outcome of the transaction involving the rendering of services cannot be estimated reliably, it would not be correct to recognize any profit. In such a case, revenue is recognized only to the extent of the expenses that are recoverable. Likewise, when the transaction is at early stage of execution, and therefore, it is not possible to estimate the outcome of the transaction reliably, revenue would be recognized only to the extent of cost incurred. When the outcome of a transaction cannot be estimated reliably and it is not probable that the costs incurred will be recovered, no revenue is recognized and the cost incurred is recorded as an expense. The accounting policy of Infosys Limited relating to revenue recognition from services is given in Box 7.2. Box 7.2  Accounting Policy Relating to Revenue Recognition from Services Infosys Limited Revenue Recognition • The company uses the percentage-of-completion method in accounting for its fixed-price contracts. • The use of the percentage-of-completion methods require the company to estimate the efforts or costs expensed to date as a proportion of the total efforts or costs to be expended. Efforts or costs expended have been used to measure progress towards completion as there is a direct relationship between input and productivity. • Provisions for estimated losses, if any, on uncompleted contracts are recorded in the period in which such losses become probable based upon the expected contract estimates at the reporting date. Source: Annual report of Infosys Limited, 2016–17

210  Chapter 7

7.3.3  Income from Construction Contracts2 Revenue recognition in case of construction contracts poses a peculiar problem. A construction contract may take a long time for execution; as a result the construction activity may commence in one accounting period and is completed in another accounting period. Revenue from contracts in such cases will have to be recognized in a systematic manner over the period of time taken for execution. Revenue and expenses associated with the contract are recognized with reference to the stage of completion of the contract activity in a particular accounting period. However, no revenue is recognized unless some reasonable progress has been made in the contract. Contract revenue shall comprise initial amount of revenue agreed in the contract as well as the variations in contract work, claims and incentive payments. However, the latter is recognized only to the extent that it is probable that they will result in revenue and they are capable of being reliably measured. A construction contract may be negotiated either on a fixed price basis or on a cost plus basis. In a fixed price contract, the contractor agrees to a fixed contract price, or a fixed rate per unit of output. The price or rate may be subject to cost escalation clauses. In case of a cost plus contract, the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee. In case of a fixed price contract, it is possible to reliably estimate the outcome of a construction contract when the following conditions are satisfied:

• Total contract revenue can be measured reliably. • It is probable that the economic benefits associated with the contract will flow to the entity. • Both the contract costs to complete the contract and the stage of contract completion at the end •

of the reporting period can be measured reliably. The contract costs attributable to the contract can be clearly identified and measured reliably so that actual contract costs incurred can be compared with prior estimates.

In the case of a cost plus contract, the following conditions must be satisfied to recognize revenue:

• It is probable that the economic benefits associated with the contract will flow to the entity. • The contract costs attributable to the contract, whether or not specifically reimbursable, can be clearly identified and measured reliably. Accounting policies of Punj Lloyd Limited relating to revenue recognition are given in Box 7.3.

Box 7.3  Accounting Policy Relating to Revenue Recognition from Construction Contracts Punj Lloyd Limited • Contract revenue associated with long-term construction contracts is recognized as revenue by reference to the stage of completion of the contract at the balance sheet date. • The stage of completion of project is determined by the proportion that contracts costs incurred for the work performed up to the balance sheet date bear to the estimated total contract costs. However, profit is not recognized unless there is reasonable progress on the contract. • If total cost of a contract, based on technical and other estimates, is estimated to exceed the total contract revenue, the foreseeable loss is provided for.

Accounting for Revenue  211

• The effect of any adjustment arising from revisions to estimates is included in the statement of profit and loss of the year in which revisions are made. • Contract revenue earned in excess of billing is classified as ‘unbilled revenue (work-in-progress)’ and billing in excess of contract revenue is classified under ‘other liabilities’ in the financial statements. • Claims on construction contracts are included based on management’s estimate of the probability that they will result in additional revenue, they are capable of being reliably measured, there is a reasonable basis to support the claim and that such claims would be admitted either wholly or in part. • The company assesses the carrying value of various claims periodically, and makes adjustments for any unrecoverable amount arising from the legal and arbitration proceedings that they may be involved in from time-to-time. Insurance claims are accounted for on acceptance/settlement with insurers. Source: Annual report of Punj Lloyd Limited for the year 2016–17

In case, the cost already incurred plus the estimated cost to completion is likely to exceed the contract revenue, appropriate provision for the resultant expected loss is made in the accounts. ■  Illustration 7.5

A construction contractor has a fixed price contract for ` 9,000 million to build a bridge. The c­ ontractor’s initial estimate of contract costs is ` 8,000 million. It will take three years to build the bridge. By the end of year one, the contractor’s estimate of contract costs has increased to ` 8,050 million. The contractor determines the stage of completion of the contract by calculating the proportion that contract costs incurred for work performed upto the reporting date bear to the latest estimated total contract costs. A summary of the financial data during the construction period is as follows: ( ` in Million) Year 1

Year 2

Year 3

  I)  Amount of revenue agreed in contract

9,000

9,000

9,000

 II)  Contract costs incurred upto the reporting date

2,093

5,957

8,050

 III)  Contract costs to complete

5,957

2,093

——

 IV)  Total estimated contract costs (II+III)

8,050

8,050

8,050

  V)  Estimated profit (I–IV)

950

950

950

VI)  Stage of completion (II/ IV)

26%

74%

100%

212  Chapter 7

The amounts of revenue, expenses and profit recognized in the statement of profit and loss in the three years are as follows:

Particulars

I

II

(III = I – II)

Upto the Reporting Date

Recognized in Prior Year

Recognized in Current Year

Year 1 Revenue (9,000 × 0.26)

2,340



2,340

Expenses (8,050 × 0.26)

2,093



2,093

Profit

247

247

Year 2 Revenue (9,000 × 0.74)

6,660

2,340

4,320

Expenses (8,050 × 0.74)

5,957

2,093

3,864

703

247

456

Revenue (9,000 × 1.00)

9,000

6,660

2,340

Expenses

8,050

5,957

2,093

950

703

247

Profit Year 3

Profit

Note: Based upon the illustration provided in Ind AS 11

7.3.4  Revenue from Use of Entity’s Assets by Others In addition to revenue from sales of goods and rendering of services, an enterprise may earn income by letting others use some of its assets. Revenue is recognized when it is probable that the economic benefits associated with the transaction will flow to the entity and the amount of the revenue can be measured reliably.

Interest Interest accrues on a day-to-day basis on the amount outstanding at the effective rate of interest. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument. To calculate the effective interest rate, future cash flows are estimated considering the contractual terms. Cash flows would consider all fees, transaction costs and premium or discounts. The discount rate that equates the discounted value of inflows and outflows is called effective rate of interest. Interest is accrued using the effective rate of interest so computed. ■  Illustration 7.6

XYZ Limited invested ` 75 million in zero coupon bonds with a maturity period of 3 years. The company paid ` 1 million to the broker. The maturity value of the bond is ` 100 million. Calculate the effective interest rate. How would the interest accrue over next 3 years.

Accounting for Revenue  213

The company has incurred ` 76 million (including brokerage) and would receive ` 100 million after 3 years. The effective interest rate would be calculated as the discount rate that equates the discounted value of ` 100 million (inflow) with ` 76 million (outflow). 100 76 = (1 + k)3 Solving for k as the discount rate, k = 9.58%. Interest would accrue using the effective interest rate. Year

Amount outstanding— Beginning of Year

Interest Accrued @ 9.58%

Amount Outstanding— End of Year

1

76.00

7.28

83.28

2

83.28

7.98

91.26

3

91.26

8.74

100.00

Royalty Royalties accrue in accordance with the terms of the relevant agreement and are usually recognized on that basis unless, having regard to the substance of the transactions, it is more appropriate to recognize revenue on some other systematic and rational basis.

Dividend Dividend on shares is recorded, when the right to Record date is the date fixed by a receive dividend is established. Dividend is reccompany to ascertain the eligibility ommended by the board of directors of the comto receive dividend or any other such pany and after approval of the shareholders is paid benefit. to those shareholders whose name appears in the register of members of the company on the record date. It may be noted that unlike interest, dividend does not accrue on time basis and hence cannot be recognized on time proportionate basis.

7.4  IMPACT OF UNCERTAINTY For recognition of revenue the enterprise must be reasonably certain about its ultimate collection. If this condition is not met, revenue recognition may have to be postponed till the uncertainty is resolved. Such an uncertainty may be present at the time of raising a claim for sales of goods or rendering of services or may arise subsequently.

Uncertainty Prevailing at the Time of Raising Claim In such a case, recognition of revenue is postponed till the uncertainty is removed and the enterprise is reasonably certain that the collection will be made. For example, extra billing to the customer due to escalation clause may be recorded only when confirmed by the customer rather that at the time of raising the invoice. Likewise, if income earned from foreign countries is subject to permission from authorities under foreign exchange regulations which makes remittance uncertain, revenue recognition may be postponed. Thus, the revenue may get recognized in the period when the uncertainty is removed.

214  Chapter 7

Uncertainty Arising Subsequently In such a case, the revenue recognized earlier is not altered but the impact of uncertainty is accounted for separately by making a provision for doubtful recoveries. As a result, the revenue may get recorded in one accounting period but the loss due to non-recovery may be recognized in a subsequent period. ■  Illustration 7.7

IMI Limited sold goods at an invoice price of ` 50 million on 28th February 2017 giving 90 days credit to the customer. On the due date of payment, i.e., 28th May 2017, the customer was declared insolvent and the amount due had to be written-off. How will this transaction affect the profit and loss statement for the year 2016–17 and 2017–18 assuming the financial year as the accounting period?

2016–17 As there is no uncertainty regarding collection, the revenue of ` 50 million will be recorded on accrual basis on 28th February 2017 by passing the following entry: Customer Account Dr. ` 50 million   To Sales Account   ` 50 million The same will reflect in the profit and loss statement for the year 2016–17. 2017–18 Once the customer is declared insolvent, loss due to non-recovery will be recorded by passing the following entry: Bad Debts Account (Loss) Dr. ` 50 million   To Customer Account   ` 50 million The loss on account of bad debts will appear in the profit and loss statement for the year 2017–18

7.5 DISCLOSURES The following disclosures are required to be made in the annual report:

1. The accounting policies adopted for the recognition of revenue including the methods adopted to determine the stage of completion of transactions involving the rendering of services. 2. The amount of each significant category of revenue recognized during the period, including revenue arising from: (a) The sale of goods (b) The rendering of services (c) Interest (d) Royalties (e) Dividends 3. The amount of revenue arising from exchanges of goods or services included in each significant category of revenue.

Accounting for Revenue  215

7.6  ACCOUNTING FOR RECEIVABLES Whenever goods are sold or services are provided on credit basis, the income gets recognized based upon the principles discussed earlier. The amount outstanding is debited to the customer’s account by passing the following entry: Customer Account Dr.    To Sales/Income from Services Account On due date when the payment is received, the following entry is passed: Bank Account   Dr.    To Customer Account

Amount Outstanding at the End of the Cccounting Period The amount outstanding to be received at the year-end is shown in the balance sheet as a current asset under the heading ‘Trade Receivables’.

Provision for Doubtful Debts At the end of the accounting period an enterprise anticipates that some of the customers may not pay up the amount due from them. In such a case following conservatism principle, it may decide to create a provision for such an anticipated loss by passing the following entry: Bad Debt Expenses Account Dr.    To Provision for Doubtful Debts At the year end, the bad debt expenses account will be transferred to the statement of profit and loss and accordingly the profit for the period will get reduced. In the balance sheet, the provision for doubtful debts is shown as a deduction from the trade receivables. ■  Illustration 7.8

Strong Plastics Limited usually provides a credit period of 90 days to its customers. During the year 2017–18, the total sales of the company amounted to ` 325 million. Out of this, amounts aggregating to ` 220 million were collected from the customers. Based upon the past experience, the company ­estimates that about 5% of the amount outstanding will not be recovered and may have to be writtenoff. How will this information appear in the profit and loss statement for the year ending on 31st March 2018 and the balance sheet as on that date? Statement of Profit and Loss Income Sales Expenses Provision for Doubtful Debts Balance Sheet Current Assets Trade Receivables Less: Provision for Doubtful Debts Net

( ` in Million) 325.00 5.25 (5% of ` 105 million)

105.00 ( ` 325 million less ` 220 million) 5.25 99.75

216  Chapter 7

Summary

• Revenue recognition requires answers to two interrelated questions—quantum (how much) • • •

• •



and timing (when) to recognize revenue. Amount of revenue is usually determined with reference to the agreement with the customer and is net of quantity discount, trade discount, sales return and indirect taxes (sales tax, VAT, etc.). Revenue from sales of goods is recorded when the ownership in goods has been transferred to the buyer and there is no significant uncertainty about the amount of consideration or its ultimate collection. Revenue from services can be recorded either on completed contract method or proportion completion method. Completed contract method is most suitable when the contract consists of a single act or the final act is so critical that without it the contract cannot be deemed to have been completed. Revenue from construction contract is recognized with reference to stage of completion of the contract. Interest income is recognized taking into account the amount lent, rate of interest and time period. Interest accrues on day-to-day basis. Income for royalties is recognized based upon the relevant contract with the user. Dividend income is recorded when the right to receive dividend is established. If at the time of sales of goods or provision of services there is uncertainty regarding ultimate collection of revenue, revenue recognition is postponed till the uncertainty is resolved. If uncertainty arises subsequently, a separate provision for loss is made.

Assignment Questions 1. 2. 3. 4.

‘Revenue is recognized when earned and not necessarily when received’. Explain. Discuss the principles of revenue recognition from sales of goods. How is the treatment of cash discount different from that of trade discount or quantity discount? How are the indirect taxes (excise duty, sales tax, value added tax, service tax) treated while recording revenue? 5. Explain method of revenue recognition from services using proportionate completion method. 6. What is the impact of uncertainty on revenue recognition?

Accounting for Revenue  217

Problems 1. Amount of sales to be recorded: During the year 2017–18, the invoice value of goods sold by Avon Corporation amounted to ` 325 million. The company offered trade discount aggregating to ` 10 million. In addition, Goods and Services Tax (GST) @ 18% of the invoice price was collected by the company and paid to the government. The company normally sells goods on credit of 60 days and offers a cash discount of 1% if payment is made by the customer within 10 days of sales. How will the revenue from sales be shown in the statement of profit and loss for the year 2017–18? 2. Revenue earned in foreign exchange: Fair White Limited is a FMCG company largely catering to domestic markets. During the year 2016–17, it received its maiden export order for $ 2 million for supply of fairness cream to USA. The order was duly executed on 1st November 2016. The supplier was allowed a credit period of 90 days for making payment. The rate of exchange on 1st November 2016 was ` 65, whereas by the payments was received on 30th January 2017 at ` 65.30. How will the above transaction appear in the statement of profit and loss for the year 2016–17? 3. Revenue from construction contract: Strong Structure Limited was awarded a contract for construction of a fly-over by the Government of Delhi on 1st October 2014. The contact consideration was fixed at ` 280 crore. The fly-over was competed on 31st December 2016 with the following details: ( ` in Crore)

Particulars Cost incurred during the year Estimated cost of work yet to be completed Payment received from the client

2014–15

2015–16

2016–17

25 212 Nil

150 70 170

65 Nil 110

The company uses the percentage of completion method for recording revenue. The stage of completion of project is determined by the proportion that contracts costs incurred for work performed up to the balance sheet date bear to the estimated total contract costs. Show the revenue, cost and profit to be recorded from this contract. 4. Provision for doubtful debts: Ram Bharose Limited, a steel trader follows a very liberal credit policy of allowing 120 days to its customer to pay against their purchases. This policy has helped the company in attracting new customers but at the same time results in a high incidence of bad debts. As on 31st March 2017, the company has total debtors of ` 15 million. The company ­classifies its customers in three categories A, B and C based upon their credit worthiness. The break-up of ` 15 million of sundry debtors is given as follows: Category

Amount ( ` in Million)

A B C

8.00 5.50 1.50

218  Chapter 7

Based upon the past experience, it is estimated that 2% of Category A, 3% of Category B and 5% of Category C may not pay when due and have to be provided for.   What will be the impact of the above in the profit and loss statement for the year and balance sheet as on 31st March 2017. 5. Sales on instalment basis: Satyam Machines Limited is a manufacturer of high tech fabrication machines. Each machine is sold on cash down price of ` 3 million. The company also offers the same machine on instalment payment basis. The customers buying on instalment basis can pay the amount in three equated annual instalments of ` 1.3 million each at the end of next three years. The company sold a machine on 1st April 2017. a. When will the revenue from sales be recorded and by how much? b. How will you treat the difference between the cash down price ( ` 3 million) and instalment price ( ` 3.9 million) 6. Accounting for accrued interest: RS Finance Limited is a non-banking finance company in the business of providing loans. On 1st October 2016, it gave a loan of ` 1,000,000 to Mr. Ram at 10% per annum to be repaid after three years. Interest is to be paid quarterly. Mr. Ram duly paid interest on 31st December 2016. However, it failed to pay interest due for the next two quarters. On 1st July 2017, the company classified the account as delinquent and decided to create a provision for the same. How will this transaction appear in the profit and loss statement for the year 2016–17 and 2017–18 and balance sheet on 31st March 2017 and 31st March 2018?

Solutions to Problems 1. Revenue to be recorded:

Sales at Invoice Price Less: Trade Discount

(` in Million) 325   10 315

GST collected by the company @18% will not be a part of revenue as this is collected by the company for onward payment to the government. Cash discount if and when availed by the customer by making prompt payment will be shown separately as an expense. 2. Profit and loss statement for the year 2016–17 ( ` in Million) Sales ($2 million at ` 65) 130.00 Gain on account of foreign exchange difference 0.60 ($2 million × ( ` 65.30 – ` 65.00) Sales will be recorded using the exchange rate prevailing at the time of sales. Subsequent exchange fluctuation will be recorded as a gain or loss without altering the revenue recorded earlier.

Accounting for Revenue  219

3. ( ` in Crore)

Particulars

2015

Cost incurred during the year Cost incurred till date

2016

2017

25

150

65 240

25

175

Estimated cost of work yet to be completed

212

70

Total estimated cost

237

245

Nil 240

(Cost incurred till date plus cost of work yet to be completed) % Completion (Cost incurred/ Total estimated cost)

10.55%

71.43%

100%

Revenue recognized till date

29.54

200.00

280.00

Cost recorded till date (% Completion × Total estimated cost)

25.00

175.00

240.00

Revenue for the year

29.54

170.46

80.00

25.00

150.00

65.00

4.54

20.46

15.00

(Revenue till date less revenue already recognized) Cost for the year (Cost till date less cost already recognized) Profit for the year

4. Provision for doubtful debts to be made 2% of ` 8 million + 3% of ` 5.5 million + 5% of ` 1.5 million = ` 0.40 million The necessary journal entry will be: Bad Debts Expenses A/c Dr.    ` 0.40 million    To Provision for Doubtful Debts      ` 0.40 million    In the profit and loss statement for the year, bad debts expenses account will appear with other expenses at ` 0.40 million. In the balance sheet the trade receivables will appear as follows: Trade Receivables Less: Provision for Doubtful Debts

(` in Million) 15.00   0.40 14.60

5. The revenue for Satyam Machines Limited is arising from two different sources—sale of machine and interest earned on instalment sales. The sale of machine will be recorded on 1st April 2017 at the normal cash down price of ` 3 million.   The difference between cash down price ( ` 3 million) and instalment price ( ` 3.9 million) is the interest earned. As the instalments are being paid annually, interest earned ( ` 0.9 million) can be apportioned over three years in the ratio of 3:2:1. Accordingly, interest income will be recognized at ` 0.45 million, ` 0.30 million and ` 0.15 million, respectively in 2017–18, 2018–19 and 2019–20, respectively.

220  Chapter 7

6. In profit and loss statement for the year 2016–17, interest income for two quarters will be recorded as income based upon accrual basis of accounting. Accordingly, ` 50,000 will appear as interest income. In the balance sheet the loan amount of ` 1,000,000 plus accrued interest for the quarter ended on 31st March 2017 will appear on the assets side as loans and advances as follows: Loan amount Add: Interest accrued but not received

(Amount in `) 1,000,000    25,000 1,025,000

The interest for quarter ended 30th June 2017 will accrue in the normal course and will be ­recognized as income. On 1st July 2017 once the company has decided to treat the account as doubtful, further accrual of interest will cease and a provision for doubtful debts will be created in respect of loan amount and the interest accrued till 30th June 2017. Profit and loss statement for the year 2017–18   (Amount in `) Income Interest 25,000 Expense Provision for bad loans

1,050,000

Balance Sheet as on 31st March 2018 Assets Loan to customer Less: Provision for bad loans

1,050,000 1,050,000 NIL

Try It Yourself 1. Internal revenue: Mahalaxmi Industries Limited is engaged in the business of industrial chemicals. It has two divisions. The products of Division A are entirely sold to Division B on a cost plus basis. Division B further processes the goods procured from Division A and sells them in the market. During the year, Division A incurred a total expenditure of ` 380 million and the goods were sold to Division B for ` 437 million. Division B incurred further costs of ` 235 ­million and sold the goods in the market for ` 930 million. While preparing the profit and loss statement of the company for the year, the accountant aggregated the results of both the divisions as follows: ( ` in Million) Particulars

Division A

Division B

Mahalaxmi Industries Limited

Sales

437

930

1,367

Cost of goods sold

380

672

1,052

Profit

 57

258

 315

Accounting for Revenue  221

  Accordingly, the company reported sales of ` 1,367 million and profit of ` 315 million. You are requested to comment upon the accounting policy of Mahalaxmi Industries Limited and if necessary redraw the profit and loss statement of the company. 2. Quantum of sales: Desire Limited is in the business of manufacturing high fashion accessories. The company sold certain goods with an invoice price of ` 25 million to one of its customer offering him a discount of 2% on the invoice price. The customer is allowed three months credit; however; a discount of 1% is offered if payment is made within 30 days. The customer in this case made the payment within the discount period and availed cash discount. How will the above transaction appear in the profit and loss statement of the company? 3. Timing of revenue recognition: In which financial year, will revenue be recognized in each of the following cases: a. Advance received from a customer on 31st December 2016. The goods are manufactured and invoiced on 1st April 2017. b. Goods sent to a commission agent on 15th January 2017. Goods sold by the commission agent on 28th April 2017. c. Loan of ` 10 million given to another company at 10% per annum on 1st March 2017 for a period of one year. The interest amount of ` 1 million deducted upfront from the loan amount. The loan is repaid in full on 1st March 2018. d. A Limited sold some of its investments to B Limited for ` 15 Million on 30th November 2016 with an agreement to buy them back on 31st May 2017 at ` 16 million. 4. Revenue from services: Shine Info Limited is engaged in software development business. It received a contract for developing and implementing software for credit risk management for a leading bank on 1st January 2016. The contact consideration was fixed at ` 130 million. The work was completed on 15th February 2018 with the following details: ( ` in Million) Particulars

31st March 2016

31st March 2017

15th February 2018

Cost incurred during the year

20

45

35

Estimated cost of work yet to be completed

70

30

Nil

Payment received from the client

40

40

50

The company uses the percentage of completion method for recording revenue. The stage of completion of project is determined by the proportion that contracts costs incurred for work performed upto the balance sheet date bear to the estimated total contract costs. Show the revenue, cost and profit to be recorded from this contract in the financial year 2016, 2017 and 2018, respectively. 5. Uncertainty in revenue: Reliable Construction Limited is a real estate sub-contractor. It completed some work for a large construction company for a consideration of ` 8 million. In addition to the work scope defined in the beginning, the company also did some extra work at the request of the client. The cost of the extra work came to ` 400,000. The company wants to add a margin of 25% on cost and invoice the client accordingly. However, the consideration for the extra work was never discussed with the client. The company is debating between the following accounting treatments: a. Recognize revenue now at ` 8.5 million (including ` 500,000 towards extra work). If the client does not accept the invoice for the extra work the same can be recorded as bad debts subsequently.

222  Chapter 7



b. Recognize revenue now at ` 8 million, that is, the agreed consideration. Revenue of ` 500,000 for extra work will be recognized once the client accepts the claim for the extra work. c. Postpone the entire revenue recognition of ` 8.5 million to a future date till a confirmation from the client is received. Please advice.

Cases Case 7.1: Asian Computer Limited—Accounting Policy for Revenue Recognition Asia Computers Limited is a newly established company in the information technology sector. The company has plans to gradually enter BPO and software development activities. In the initial phases, the company plans to concentrate on the following revenue generating activities: 1 Sale of computers: The company buys computers of reputed brands and sells them for personal and office uses. To retail customers, computers are sold on cash basis, whereas commercial customers are given 60 days credit. 2. Maintenance services: The company provides maintenance services for computers either on call basis or by entering annual maintenance contracts with its customers. In the former case, the customer pays every time maintenance service is provided. The cost of spares in such cases is also charged to the customer. In case of AMC, fee is charged yearly in advance. The AMC fee covers the service charges as well as the cost of parts that may have to be replaced. 3. The surplus funds are kept either in fixed deposits with banks or invested in units of mutual funds. Please help the company is framing suitable accounting policies for revenue recognition for the above mentioned activities. Case 7.2: Internet Railway Ticketing Company Limited—Revenue from Sales versus Commission4 Super Fast Internet Railway Ticketing Company Limited provides service of booking railway tickets through the Internet. The company made investment for setting up of infrastructure for providing such services including computers, servers, printers, manpower, etc. The company has been given access to the ‘Passenger Reservation System’ (PRS) of railways for advance reservation. Any customer requiring booking of a railway ticket is required to register himself/herself with the company at its web site and thereafter the customer can send his request for booking of the ticket through the Internet. The company collects cost of the tickets and its service charges from the customer through credit card or direct debit to the customer’s bank account through its payment gateways. Tickets issued to the customers are either hand-delivered from its office or sent by courier at the address given by the customer. The company maintains an advance deposit with the Railways. Payment to Indian Railways for the tickets booked by the company is made by way of adjustment against the amount being maintained as ‘Advance Deposit’ with the Railways. Statement for the cost of the tickets booked by the company is generated every day and the amount against those tickets is charged by the Railways from the deposit maintained with it. The company levies service charges on its customers and the same is recovered in addition to the cost of the tickets. No fees or other remuneration is paid by the railways. The quantum of the service charge is exclusively decided by the company. Indian Railways does not interfere in any manner to decide the service charges made by the company from the customers.

Accounting for Revenue  223

In case of default, repudiation of transaction or non-recovery of cost of ticket, etc., the company is responsible for the same and not the Railways. In case of cancellation of tickets also, refund is allowed only by the company. Refund on the cancelled ticket is received by the customer from the company by way of direct credit into his credit card account/bank account. In short, while the company is responsible to Indian Railways for payment of the cost of tickets, it has to recover the cost of the tickets from the customers and also to pay refunds to the customers. The accounting policy of the company for revenue recognition and expenses is given as follows:

• Income from Internet-ticketing: Income from Internet-ticketing is recognized on the basis •

of value of the tickets sold through the corporation’s web-enabled payment gateway including service charges. Expenditure on Internet-ticketing: The cost of tickets booked through the Passenger Reservation System of Indian Railways is recognized as expenditure on accrual basis.

Questions for Discussion 1. Based upon the facts given, suggest appropriate accounting policy for the company for revenue and expenses recognition? Case 7.3: Asian Paints Limited—Change in Accounting Policy Relating to Captive Consumption Asian Paints is India’s largest and Asia’s third largest paint company. It manufactures a wide range of paints for decorative and industrial use. For the year 2003–04, the company reported a total income of ` 17,641.39 million and a net profit of ` 1,477.87 million. The breakup of the income as reported in the profit and loss account is given as follows: Particulars Sales and operating income (Net of discounts) Less: Excise Sales and operating income (Net of discounts and excise)

( ` in Million) 20,070.93 2,646.31 17,424.62

Other income

216.77

Total income

17,641.39

The sales and operating income includes a sum of ` 539.01 million as inter-division transfers. The accounting policy of the company states that ‘Inter-division transfers of finished goods for captive consumption are valued at market price. The value of such inter-division transfers is included in the materials consumption of the consuming divisions. The year-end stock of such transferred goods is valued at cost.’ The next year (2004–05) the company decided to change its accounting policy. The revised accounting policy of the company stated that ‘sale of products is recognized when the risks and rewards of ownership are passed on to the customers, which is on dispatch of goods. Sales are stated exclusive of sales tax. Processing income is recognized upon rendition of the services.’ The company further states that ‘Hitherto, the company has been recognizing inter-division transfers of Phthalic Anhydride and Pentaerythritol to paint plants for captive consumption as revenue and the same was disclosed separately in “Sales & Operating Income”. The value of such inter-division transfers was included in material consumption of the consuming divisions. With effect from

224  Chapter 7

the financial year ended 31st March 2005, the company has discontinued the method of recognizing interdivision transfers as sales as well as material consumption. The previous year’s figures have been restated accordingly. The above change in the method of revenue recognition has resulted in a reduction in net sales and operating income by ` 600.28 million (previous year ` 458.16 million) with a corresponding reduction in material consumption and has no impact on the profits of the company’. As a consequence of the change, the company recasted the figures for the year 2003–04 as well. The recasted income details are given as follows: Particulars Sales and operating income (Net of discounts) Less: Excise Sales and operating income (Net of discounts and excise)

( ` in Million) 19,531.92 2,565.46 16,966.46

Other income

216.77

Total income

17,183.23

Though the company reported a lower total income there was no impact on the profit after tax.

Questions for Discussion 1. Sales and operating Income are shown net of discounts and excise duty. Why? 2. Is inclusion of inter-division transfers in the income consistent with the requirements of AS 18? 3. What is the impact of such inclusion on the total income and net profit of the company? Case 7.4: MMTC Limited: Revenue Recognition for back-to-back Transactions MMTC Limited was established in the year 1963. It is a leading international trading company in India. It was awarded the status of ‘five star export house’ by the government of India for its contribution to exports. For the year 2004–05, the auditors of the company issued a qualified report raising questions about the accounting policy regarding purchase and sale. The audit qualification in this regards is stated below: ‘In terms of Accounting Policy No. 1(b) regarding accounting of certain transactions as sales/purchases where letters of credit in the name of the company are assigned in favour of Business Associates and Accounting Policy No. 1(f) where purchases of some commodities are booked based on sales value less service charges, the company has treated sales of ` 27,896,466 thousand and purchases of ` 27,246,587 thousand (to the extent details made available and including canalized items) during the year as its own, as per past practice. On examination of the facts, circumstances and the manner of effecting these transactions, we are of the opinion that the sales and purchases booked by the company are not its own and as such, the above, accounting policy is not in conformity with Accounting Standard 9 “Revenue Recognition” issued by the Institute of Chartered Accountants of India and the guidelines issued by the Department of Public Enterprises. As a result of this policy, sales and purchases have been overstated by ` 27,896,466 thousand and ` 27,246,587 thousand, respectively. However, this policy has no effect on the profit of the company for the year. (Refer Note No.7.1 & 7.2)’.

Accounting for Revenue  225

The accounting policies and notes to account referred to by the auditors as aforesaid are reproduced as follows: Accounting Policies:

1. Purchase and sales b) Purchase/Sales include transactions/shipments where L/C (Letter of Credit) in the name of MMTC, are assigned in favour of the business associates. f) In respect of some commodities, purchases are booked based on sale value less service charges.

Notes to Accounts 7.1 Purchases and sales include ` 2,924,538 thousand (P.Y. ` 945,000 thousand) and ` 2,932,176 thousand (P.Y. ` 952,730 thousand), respectively, transactions/shipments where LCs in the name of MMTC has been assigned in favour of associates. The above includes canalized sales amounting to ` 1629,115 thousand (P.Y. ` 583,500 thousand and corresponding purchase of ` 622,824 thousand (P.Y. ` 576,300 thousand). 7.2 Sales amounting to ` 24,964,290 thousand (P.Y. ` 13,848,820 thousand) and corresponding purchases of ` 24,322,049 thousand (P.Y. ` 13,463,360 thousand) have been booked on the basis of invoice value reduced by the amount of service charges. The above includes canalized sales amounting to ` 15,894,621 thousand (P.Y. ` 6,203,680 thousand) and corresponding purchase of ` 5,488,915 ­thousand (P.Y. ` 6,048,070 thousand). The company reported a total sale of ` 151,237,206 thousand for the year 2004–05 (P.Y. ` 90,991,892 thousand).

Questions for Discussion 1. Critically evaluate the accounting policy of MMTC Limited regarding booking of purchases and sales? 2. What is the impact of the above accounting policy on the financial performance of the company? 3. How will you justify the accounting policy of MMTC Limited to the auditors in view of the qualification made by them?

Endnotes 1. 2. 3. 4.

ICAI: Ind AS 21, ‘The effects of changes in foreign exchange rates’. ICAI: Ind AS 18 ‘Revenue’ ICAI: Ind AS 11, ‘Construction Contracts’ Based upon the query 10 in Compendium of Opinions of ICAI, Volume 24

Accounting and Valuation of Inventory

8

CHAPTER OBJECTIVES This chapter will help the readers to: • Understand the meaning of the term ‘inventory’ and identify various components of inventory. • Quantify the impact of inventory on the statement of profit and loss and on the balance sheet. • Differentiate between periodic inventory system and perpetual inventory system. • Compute the cost of goods sold and ending inventory using different methods of inventory, viz., FIFO, LIFO, weighted average and specific identification. • Appreciate the application of conservatism principles while valuing inventory using `lower of cost or net realizable value’. • Appreciate the requirements of Ind AS 2 on accounting and valuation of inventory.

8.1  MEANING OF INVENTORY In the ordinary course of business an enterprise buys various types of raw materials, consumables and components to be used in production or simply for the purpose of resale. To ensure continuous availability of such items, sufficient quantities are maintained in the store. These materials and components are then put to the production line for processing. Once the production process is over they are stored in the finished form before they are finally sold out. Thus ‘inventory’ is made up of material in various forms as discussed above. Based upon the state of completion, inventories may be classified as under: 1. Raw material: Goods which are meant to be consumed in the course of production or for rendering of services. They ultimately form part of the finished goods. For example, rubber used for production of tyres, steel used for producing machines or limestone used in manufacturing cement. Components and parts that would be finally used in the finished product are also treated as raw material. 2. Consumable stores: They are also used in the production process but do not form part of the finished products. For example, lubricating oil or spare parts to be used for maintenance of machines.

Accounting and Valuation of Inventory  227

3. Work-in-progress: Goods on the production line. They have been injected in the production process but are yet to be finished. In addition to the cost of material and consumables, other manufacturing expenses are also incurred at this stage and hence constitute the cost of workin-progress inventory. 4. Finished goods: Goods kept for sale in the ordinary course of business. The manufacturing process is complete; goods are ready for sale but are yet to be sold. 5. Stock-in-trade: Inventory of goods bought by the firm for the purpose of resale without further processing is classified as stock-in-trade. Ind AS 2, defines the expression ‘inventories’ as assets:

• Held for sale in the ordinary course of business. • In the process of production for such sale. • In the form of materials or supplies to be consumed in the production process or in the rendering of services. The composition of inventories will vary from business to business. A trading organization engaged in buying and selling will not have raw material or WIP inventory, whereas a manufacturing organization’s inventory will have all the above components. An enterprise with long production cycle will have higher work in progress inventory, whereas an enterprise with seasonal availability of raw material may have higher amount blocked at that stage. A service organization may not have any inventory at all.

8.2  INVENTORIES AND THE FINANCIAL STATEMENTS Let us recall the matching principle discussed in Chapter 2 earlier. As per the matching principle, revenue earned by an enterprise is matched against the cost incurred to generate that revenue to ascertain profit. How does matching principle affect accounting for inventory? It may be possible that an enterprise purchases or produces goods in one accounting period which ultimately get sold in the next accounting period, or goods from the previous accounting period get sold in the current accounting period. In these situations inventory cost has been incurred in one accounting period but the revenue is generated in another. The proper matching of revenue and cost is essential to correctly ascertain profit and to depict assets in the balance sheet. Let us consider an example of Superior Electronics Limited—a dealer in television sets. As on 1st April 2017, it had 100 sets costing ` 2,800,000 in the showroom which were purchased in the previous year. During the year 2017–18, it purchased 1,500 sets for ` 45,000,000 and it was able to sell 1,300 sets for ` 45,500,000. As on 31st March 2018, it has 300 sets still unsold costing ` 8,700,000. How will these details be shown in the profit and loss statement for the year 2017–18 and balance sheet as at 31st March 2018? As the company has sold 1,300 sets during the year, and revenue of ` 45,500,000 has been recognized, cost of only 1,300 sets should be matched against this revenue to ascertain profit. The company has a total of 1,600 (100 from previous year and 1,500 purchased during the year) sets available for sale costing ` 47,800,000 (` 2,800,000 + ` 45,000,000). Out of these, 300 sets costing ` 8,700,000 are still unsold. Accordingly cost of 1,300 sets sold during the year is ` 39,100,000 (` 47,800,000 − ` 8,700,000). The sets unsold will appear as current asset in the balance sheet at ` 8,700,000.

228  Chapter 8

The information will be shown in the profit and loss account and balance sheet as follows: Profit and Loss Statement (Amount in `) Sales 45,500,000 Less: Cost of goods sold Opening stock 2,800,000 Add: Purchases 45,000,000 Less: Closing stock 8,700,000 39,100,000   Gross profit 6,400,000

Balance Sheet Current assets Closing stock of inventory

8,700,000

From the above example, we can generalize a simple relationship for cost of goods sold as given in Equation 8.1.

Cost of goods sold = Opening stock + Purchases during the year − Closing stock

(8.1)

It is obvious that the apportionment of the cost of goods available for sale over closing stock and cost of goods sold can have significant impact on both the financial statements. In the above ­example, if the sets unsold at the close are valued at say ` 9,000,000 instead of ` 8,700,000, the cost of goods sold will come down to ` 38,900,000 resulting in a higher reported profit of ` 86,700,000. Similarly, if the closing stock is undervalued, it will result in higher reported cost of goods sold and therefore lower reported profit. One of the key challenges in inventory accounting is determining the value of closing stock which in turn impacts the cost of goods sold and reported profits. The relationship between inventory and financial statements in case of a trading organization is depicted in Figure 8.1. In case of a manufacturing organization inventory will pass through various stages. The inventory flow for such an organization is depicted in Figure 8.2. As discussed earlier, the cost of goods sold will appear in the profit and loss statement whereas ­closing stock of raw material, work-in-progress and finished goods will form part of the balance sheet. It may also be noted that cost of raw material inventory is at the purchase price whereas cost of WIP and finished goods include appropriate conversion cost as well. Inventory Flow Opening Stock

Financial Statement From Previous Balance Sheet

+ Goods Purchased During the Year – Closing Stock

To Balance Sheet

= Cost of Goods Sold

To Profit and Loss Statement

Figure 8.1  Trading Organization—Inventory and Financial Statements

Accounting and Valuation of Inventory  229 Raw Material

Work-in-Progress

Opening Stock

Finished Goods

Opening Stock

Opening Stock

+ Material Consumed

+ Goods Completed

+ Conversion Cost

+ Goods Purchased

+ Purchases – Closing Stock of Raw Material = Material Consumed

– Closing Stock of WIP

– Closing Stock of Finished Goods

= Goods Completed = Cost of Goods Sold

Figure 8.2  Manufacturing Organization—Inventory Flow

8.3  METHODS OF INVENTORY ACCOUNTING Inventory records may be kept on a periodic basis or perpetual basis. In periodic inventory system, detailed records are kept for the goods purchased. At the end of the accounting period, physical count of the goods unsold is taken and value of goods at hand is ascertained. The value of the closing stock so computed is deducted from the value of inventory available for sale, (i.e., opening stock + purchases during the period) to arrive at the cost of goods sold. No separate record is kept every time goods are sold or consumed. On the other hand in perpetual inventory system, detailed records of not only goods purchased but also of goods sold or issued to production are kept. At any point of time, the enterprise will be aware of the goods purchased and goods sold to ascertain the goods in hand. At the end of the period, physical count of inventory is compared with the balance as per books. Difference, if any, is analysed and accounted for separately. Periodic inventory system though simple to operate has its limitations. Firstly, every time the enterprise wants to prepare its financial statements (say monthly or quarterly) physical count of inventory has to be taken, which for a large enterprise is an enormous task. Whereas in perpetual inventory system, financial statements can be prepared on the basis of inventory records without taking a physical count. Secondly, no control over loss of goods due to normal reasons, (e.g., shrinkage, leakage, etc.) or abnormal reasons, (e.g., theft, accidents, etc.) can be exercised in periodic inventory system as the difference between goods available and closing stock is assumed to have been consumed.

8.4  VALUATION OF INVENTORY One of the main challenges in inventory accounting relates to the valuation of ending inventory or closing stock. Ending inventory so ascertained is deducted from the inventory available for sale to find the cost of goods consumed or goods sold. Following conservatism principle, Ind AS 2, requires

230  Chapter 8

inventories to be measured at the lower of cost and net realizable value. Accordingly, following steps are taken for inventory valuation:





1. Ascertain the quantity of ending inventory: This is often done by a physical count of the inventory at the end of the accounting period which is reconciled with the perpetual inventory records. 2. Ascertain the stage of completion and cost to be included in inventory cost: Depending upon the stage of completion, inventory cost comprises costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition is ascertained. 3. Allocate the cost of inventory available between ending inventory and cost of goods sold: Out of the total inventory available for sale (opening inventory + purchased/produced ­during the year) sometimes it may be possible to specifically identify the item remaining unsold and forming part of ending inventory. Alternatively, such an apportionment is made using methods like LIFO, FIFO, and average cost, etc., which are discussed in the subsequent section. 4. Compare the cost of ending inventory with its net realizable value: The ending inventory will be valued at the lower of the cost as ascertained in Step 3 above and the net realizable value of ending inventory.

8.4.1  Cost of Purchase The costs of purchase of inventories includes the purchase price, import duties and other taxes, transport, handling and other costs directly attributable to the acquisition. Taxes and duties which are subsequently recoverable from the tax authorities are excluded from the cost. Any trade discount, quantity discount and rebate given by the supplier of the goods are deducted from the cost of purchase.

8.4.2  Cost of Conversion The cost of conversion of inventories includes both direct cost and overheads. Costs directly related to production, e.g., direct labour and direct production expenses are included. Fixed and variable production overheads that are incurred in converting materials into finished goods are also systematically allocated to arrive at the cost of inventories.

8.4.3  Other Costs Other costs, incurred in bringing the inventories to their present location and condition, are also included in the cost of inventories. However, costs like abnormal amounts of wasted materials, labour, storage costs, administrative overheads and selling costs are excluded from the cost of inventories as they do not contribute to bringing inventories to their present location and condition.

8.4.4  Borrowing Cost If an inventory item necessarily takes a substantial period of time to get ready for its sale, borrowing costs that are directly attributable are also included in the cost of inventories. If, however, inventories are purchased on a deferred credit basis, the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of deferred credit.

Accounting and Valuation of Inventory  231

8.5  COSTING METHODS As discussed in the previous section, inventory available needs to be divided between closing stock and cost of goods sold. There are various methods for such an apportionment. The enterprise may choose any of the permitted method for the valuation of closing inventory. Inventory method once chosen must be followed consistently period after period. Some of the methods used for this purpose are:

• • • •

Specific Identification First In First Out (FIFO) Last in First Out (LIFO) Average Cost

• S pecific identification method: In this method an attempt is made to ascertain the actual cost of the items in the inventory. Application of this method will require tracking actual movement of various inventory items to identify items that have been sold and that are still in inventory. Some of the situation where this method can be used are:

Ind AS 2: The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.

–– Inventory items segregated for a specific project –– Goods in transit –– High value items like jewelry which are not interchangeable and hence can be specifically







identified However, where the enterprise deals with a large number of items which are interchangeable, this method may not be feasible. In such cases, other methods involving approximation can be used. First-in-first-out (FIFO) method: In this method, we assume that inventory items purchased first are sold or consumed first. With this assumption, the ending inventory will be made up of the most recent purchases whereas the oldest purchases will be appropriated towards cost of goods sold. Last-in-first-out (LIFO) method: In LIFO, as the name suggests, the most recent purchases are assumed to have been consumed first. Accordingly, the cost of goods sold will be made up of cost of most recent acquisition whereas the ending inventory will be valued at the price applicable to the oldest purchase. It may be noted that FIFO and LIFO are merely assumptions for the purpose of ending inventory valuation; the actual flow of material may or may not follow the same flow as suggested by the methods’ names. Weighted average cost method: In this method, the ending inventory as well as goods sold is valued at the weighted average cost of goods available. Unlike FIFO and LIFO, where valuation of ending inventory and units sold is at different price, in this method same average price is applied.

232  Chapter 8

The above methods can be used both with periodic inventory system as well as perpetual inventory system. In the former, the assumptions of LIFO, FIFO or average will be applied only at the end of the period. However in perpetual inventory system, the assumption (LIFO, FIFO, etc.) will be applied every time goods are sold or consumed. Likewise in average cost method, new average cost will be computed whenever fresh acquisitions are made and the new average cost is applied to all the units sold till further acquisition.

Comparison of the Methods Ind AS 2: The cost of inventories should be assigned by using the first-in, first out (FIFO), or weighted average cost formula.

In case of an inflationary economy, FIFO will result is higher ending inventory and therefore lower cost of goods sold and higher profits compared to LIFO. The numbers as per average cost method will be somewhere in between FIFO and LIFO. Ind AS 2 does not permit use of LIFO and accordingly ‘the cost of inventories should be assigned by using the first-in-first-out (FIFO), or weighted average cost formula’.1 An entity shall use the same cost formula for all inventories which have similar nature and use to the entity. However, it is permitted to use different cost formulas for inventories which are of different nature or use to the entity. ■  Illustration 8.1

Based upon the following information ascertain the value of ending inventory using FIFO, LIFO and average cost method: Opening stock Purchases during the year Available for sale Sold during the year Closing stock

Number of Units

Unit Cost (`) Total Cost (`)

700 1,200 3,300 1,300 4,000 2,900 1,100

840,000 4,290,000 5,130,000

FIFO Method: Assuming that the ending inventory is made up of most recent purchases.

Number of Units

Unit Cost ( `) Total Cost ( `)

Cost of goods sold From opening stock From purchases Total

700 1,200 840,000 2,200 1,300 2,860,000 2,900 3,700,000

Ending inventory From purchases

1,100

1,300

1,430,000

LIFO Method: Assuming that the most recent purchases have been sold first. Cost of goods sold From purchases Total

Number of Units

Unit Cost ( `) Total Cost ( `)

2,900 1,300 3,770,000 2,900 3,770.000

Accounting and Valuation of Inventory  233

Ending inventory From opening stock From purchases Total

700 1,200 400 1,300 1,100

840,000 520,000 1,360,000

Average Cost Method: Average cost per unit is found by diving the total cost of inventory available for sale (opening stock + purchases) by the total number of units. The closing stock and cost of goods sold is ascertained by applying the average cost per unit. Average Cost Per Unit = ` 5,130,000/4,000 = ` 1282.50 Cost of goods sold Ending inventory

Number of Units

Unit Cost ( `) Total Cost ( `)

2,900 1,100

1,282.50 1,282.50

3,719,250 1,410,750



FIFO ( `)

LIFO ( `)

Average cost ( `)

Cost of goods sold Ending inventory

3,700,000 1,430,000

3,770,000 1,360,000

3,719,250 1,410,750

Comparison

8.5.1  Net Realizable Value The methods described above help in measuring the cost of ending inventory. Normally inventory is stated in the balance sheet at its cost. However, there may be situations where the realizable value of the ending inventory may be lower than the cost so calculated. For example, an inventory item is damaged or has become obsolete or the market price of Ind AS 2: Inventories should be valfinished goods has declined substantially. If there is ued at the lower of the cost and net any evidence to suggest that the realizable value of realizable value an inventory item has fallen, e.g., due to damage, obsolescence or a sharp decline in the market price of raw material or finished goods, the carrying amount of the inventory in the balance sheet may have to be written down. The conservatism principle states that inventory should be shown in the balance sheet at the lower of the cost or realizable value of ending inventory. According to Ind AS 2, the net realizable value is ascertained on item by item basis rather than as a group. Such an exercise is required to be done at each balance sheet date. To ascertain the net realizable value, we start by looking at the amount that the inventory is expected to be sold in the ordinary course of business. From the estimated selling price, costs estimated to be incurred towards selling expenses and towards completion of the inventory are deducted to arrive at the net realizable value (NRV). Accordingly, the NRV can be expressed as follows: NRV = Estimated selling price − Estimated cost of completion – Estimated cost to make the sale (8.2) The NRV so computed is compared with the cost of inventory and the lower of the two is taken as the carrying amount in the balance sheet.

234  Chapter 8

Materials and other supplies to be used in production are not written down below cost if the finished good in which they will be incorporated are expected to be sold at or above cost. However, when there has been a decline in the price of materials and it is estimated that the cost of the finished products will exceed net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials is taken as their net realizable value. ■  Illustration 8.2

Based upon the following information for the inventory items, ascertain the value at which ending inventory should be shown: ( Amount in `) Item

Cost Incurred

Selling Price

Cost to Complete

1

7,200

9,000

800

2

5,400

6,000

700

3

9,100

10,500

2,000

Item 1: Net realizable value = ` 9,000 − ` 800 = ` 8,200. As NRV is greater than the cost incurred, it will be shown at the cost price. Item 2: Net realizable value = ` 6,000 − ` 700 = ` 5,300. As NRV is less than the cost incurred, it will be shown at the NRV. Item 3: Net realizable value = ` 10,500 − ` 2,000 = ` 8,500. As NRV is less than the cost incurred, it will be shown at the NRV. The inventory accounting policy of some companies is given in Box 8.1

Box 8.1  Inventory Accounting Policy of Indian Companies Ultratech Cements Limited Inventories are valued as follows: • Raw materials, fuel, stores and spare parts and packing materials: Valued at lower of cost and net realisable value (NRV). However, these items are considered to be realisable at cost, if the finished products, in which they will be used, are expected to be sold at or above cost. Cost is determined on weighted average basis. • Work-in-progress (WIP), finished goods, stock-in-trade and trial run inventories: Valued at lower of cost and NRV. Cost of Finished goods and WIP includes cost of raw materials, cost of conversion and other costs incurred in bringing the inventories to their present location and condition. Cost of inventories is computed on weighted average basis. • Waste/Scrap: Waste/Scrap inventory is valued at NRV. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

Accounting and Valuation of Inventory  235

Bajaj Auto Limited Cost of inventories have been computed to include all costs of purchases (including materials), cost of conversion and other costs incurred, as the case may be, in bringing the inventories to their present location and condition. • Finished stocks of vehicles and auto spare parts and stocks of work-in-progress are valued at cost of manufacturing or net realisable value whichever is lower. Cost is calculated on a weighted average basis. Cost of finished stocks of vehicles lying in the factory premises, branches, depots are valued inclusive of excise duty. • Stores, packing material and tools are valued at cost arrived at on weighted average basis or net realisable value, whichever is lower. • Raw materials and components are valued at cost arrived at on weighted average basis or net realisable value, whichever is lower, as circumstances demand. However, obsolete and slow moving items are valued at cost or estimated realisable value whichever is lower. • Inventory of machinery spares and maintenance materials not being material are expensed in the year of purchase. However, machinery spares forming key components specific to a machinery and held as insurance spares are capitalised along with the cost of the asset. • Goods in transit are stated at actual cost incurred up to the date of Balance Sheet. Source: Annual Reports of Ultratech Cements Limited and Bajaj Auto Limited for the year 2016–17

8.6 DISCLOSURES The following disclosures are required to be made in financial statements:

• The accounting policies adopted in measuring inventories, including the cost formula used. • The total carrying amount of inventories and the carrying amount in classifications appropriate • • • • • •

to the entity. The carrying amount of inventories carried at fair value less costs to sell. The amount of inventories recognised as an expense during the period. The amount of any write-down of inventories recognised as an expense in the period. The amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognized as expense in the period. The circumstances or events that led to the reversal of a write-down of inventories. The carrying amount of inventories pledged as security for liabilities.

236  Chapter 8

Summary

• Inventory constitutes a big component in the balance sheet as well as in profit and loss • • • • • • • •

account. As such valuation of ending inventory is a key issue in accounting. Inventory includes material to be used in production (raw material), on the production line (work in progress) and goods held for sale in the ordinary course of business (finished goods). Beginning inventory plus inventory acquired during the period makes the total inventory available for sale. Cost of goods sold is ascertained by deducting ending inventory from this. Accordingly, COGS = Beginning inventory + Purchases during the year − Ending inventory. In periodic inventory system details records of goods consumed or sold are not kept. The ending inventory is ascertained by taking a physical count and value of the same is deducted from the inventory available to arrive at the cost of goods sold. In perpetual inventory system, detailed records are kept in respect of inventory consumed or sold as well. The ending inventory as per the records is matched against the physical count. The carrying amount of ending inventory is taken at the lower of cost or net realizable value. As per Ind AS 2, the cost of ending inventory can be ascertained either by using specific identification method or FIFO or weighted average method. The net realizable value of an inventory item is equal to the estimated selling price in the ordinary course of business less cost to complete the product and cost of making sale. The NRV is compared with the cost and the lower of the two is taken as the value of ending inventory.

Assignment Questions 1. What are the different types of inventories? 2. ‘Valuation of closing stock affects both the Balance Sheet and the Profit and Loss Statement’. Do you agree with the above statement? 3. Differentiate between periodic and perpetual method of keeping inventory records? 4. How is conservatism principle applied while valuing closing stock? 5. Explain different steps in inventory valuation? 6. Compare the impact on LIFO, FIFO and average cost method on the financial statements in case of an inflationary economy.

Accounting and Valuation of Inventory  237

Problems 1. Finding the missing numbers: Please complete the income statement for the year 2016–17 based upon the information given: ( ` in Thousands)

Particulars

Ram Limited

Sales

Shiv Limited

Vishnu Limited

5,500

??

10,200

??

700

1,250

1,500

??

4,750

??

9,250

3,450

Opening stock Purchases

Shyam Limited

Closing stock

850

900

??

775

Cost of goods sold

??

6,600

8,175

3,975

Gross profit

??

2,150

??

300

??

1,200

??

??

500

??

225

(500)

Operating expenses Profit/loss before Tax

2. Error in inventory valuation: The profit and loss account of Innovative Products Limited for the years 2016 and 2017 is given below: ( ` in Thousands)

Particulars Sales Closing stock Total

2016

2017

19,720

21,500

2,800

3,200

22,520

24,700

Expenses Opening stock Purchases Manufacturing and other expenses Total expenses Profit before tax

1,500

2,800

13,700

14,400

4,400

5,600

19,600

22,800

2,920

1,900

The management was surprised to note that though the sales have increased by 9%, the profit before tax has actually declined almost by 35%. While reviewing the numbers it was revealed that the closing stock for the year 2016 was overstated by ` 1,000,000. You are required to restate the Profit and loss statement for both the years. 3. Periodic inventory system: Sharda Limited uses periodic inventory system for accounting. The following data pertains to quarter ended 30th June 2017: Particulars

Quantity

Cost per Unit ( `)

Beginning inventory

 700

1,200

Purchases

2,000

1,260

238  Chapter 8

The sales of the company during the quarter amounted to ` 2,700,000. The physical verification at the quarter end revealed 1,200 units in hands. Using LIFO, FIFO and average cost method calculate: a. Cost of goods available for sale b. Value of closing inventory c. Cost of goods sold d. Gross profits 4. Perpetual inventory system: Assuming that Sharda Limited uses a perpetual inventory system and keeps detailed record of purchase and sales. The datewise break up of purchase and sales during the quarter is given below: Date

Quantity

Unit Price ( `)

10th April

800

1,240

5th May

500

1,250

15th June

700

1,290

7th April

400

1,800

10th May

800

1,800

12th June

300

1,800

Purchases

Sales

Using LIFO, FIFO and average cost method, calculate: a. Value of closing inventory b. Cost of goods sold c. Gross profits 5. Lower of cost or net realizable value: Precision Limited deals in highly sophisticated engineering items. It imports these items in semi finished form. These items are processed further to meet the precise requirement of the customers. There has been a substantial decline in the selling price of some of the finished items as well the import price of these items. As on 31st March, the details of inventory is given below:



Item

Cost Incurred

Additional Cost to be Incurred

Estimated Selling Price

101

720,000

80,000

1,050,000

102

550,300

45,000

525,000

103

335,000

50,000

400,000

104

570,000

60,000

650,000

105

425,000

30,000

390,000

a. For each inventory item, ascertain the value at which it should be included in the ending inventory, assuming each inventory item is treated separately? b. What will be the impact of applying ‘lower of cost or net realizable value’ principle on the profit of the company in the current year? c. What will be the impact in the next year? d. If all the above items are taken together for inventory valuation, what will be the inventory valuation and impact on profit?

Accounting and Valuation of Inventory  239

Solutions to Problems 1. ( ` in Thousands)

Particulars

Ram Limited

Shyam Limited

Shiv Limited

Vishnu Limited

5,500

8,750

10,200

4,275

Sales Opening stock Purchases

700

1,250

1,500

1,300

4,750

6,250

9,250

3,450

850

900

2,575

775

Closing stock Cost of goods sold

4,600

6,600

8,175

3,975

Gross profit

900

2,150

2,025

300

Operating expenses

400

1,200

1,800

800

Profit and loss before tax

500

950

225

(500)

2. Corrected profit and loss statement Particulars Sales Closing stock Total

( ` in Thousands) 2016

2017

19,720

21,500

1,800

3,200

21,520

24,700

1,500

1,800

13,700

14,400

4,400

5,600

19,600

21,800

1,920

2,900

Expenses Opening stock Purchases Manufacturing and other expenses Total expenses Profit before tax

3. a. Cost of goods available for sale = Opening stock + Purchases = ` 840,000 + ` 2,520,000 = ` 3,360,000 b. Closing inventory FIFO − 1,200 units at ` 1,260 = ` 1,512,000 LIFO − 700 units at ` 1,200 + 500 units at ` 1,260 = ` 1,470,000 Average cost method − 1,200 units at ` 1,244.44 = ` 1,493,333 c. Cost of goods sold = Goods available for sale − Closing stock FIFO = ` 3,360,000 − ` 1,512,000 = ` 1,848,000 LIFO = ` 3,360,000 − ` 1,470,000 = ` 1,890,000 Average cost = ` 3,360,000 − ` 1,493,333 = ` 1,866,667 d. Gross profit = Sales − Cost of goods sold FIFO = ` 2,700,000 − ` 1,848,000 = ` 852,000 LIFO = ` 3,360,000 − ` 1,890,000 = ` 810,000 Average Cost = ` 3,360,000 − ` 1,866,667 = ` 833,333

240  Chapter 8

4. FIFO method Receipts Date  Quantity  

  1-Apr-11

700

7-Apr-11

 

10-Apr-11  

800

Issues

Unit Price (Amount Unit Price (Amount Unit Price (Amount ( `) in `) Quantity ( `) in `) Quantity ( `) in `)         1,200

840,000  

1,240

500

1,250

  400

1,200

480,000

700

1,200

840,000

300

1,200

360,000

992,000

 

300

1,200

360,000

 

 

800

1,240

992,000

625,000

 

300

1,200

360,000

 

5-May-11

Balance

 

 

 

 

800

1,240

992,000

 

 

 

 

500

1,250

625,000

10-May-11

 

 

300

1,200

360,000

 

 

 

 

500

1,240

620,000

300

1,240

372,000

 

 

 

500

1,250

625,000

12-Jun-11

 

 

500

1,250

625,000

15-Jun-11

700

625,000

 

1,290

2,700

 

300

1,240

372,000

903,000

 

500

1,250

 

 

700

1,290

903,000

1,200

 

1,528,000

 

Total

 

3,360,000

1,500

 

1,832,000

Goods available for sale: ` 3,360,000 Cost of goods sold: ` 1,832,000 Closing inventory: ` 1,528,000 Gross profit: ` 868,000 LIFO method  Date

Quantity 1-April-11 700

Unit Price (Amount Unit Price (Amount Unit Price (Amount ( `) in `) Quantity ( `) in `) Quantity ( `) in `) 1,200 840,000 700 1,200 840,000

7-April-11 10-Apr-11

5-May-11

400 800

500

1,240

1,250

12-Jun-11

Total

700

2,700

1,290

48,0000

625,000

10-May-11

15-Jun-11

1,200

992,000

500

1,250

62,5000

300

1,240

37,2000

300

1,240

37,2000

903,000

33,60,000

1500

18,49,000

300

1,200

360,000

300

1,200

360,000

800

1,240

992,000

300

1,200

360,000

800

1,240

992,000

500

1,250

625,000

300

1,200

360,000

500

1,240

620,000

300

1,200

360,000

200

1,240

248,000

300

1,200

360,000

200

1,240

248,000

700

1,290

1,200

903,000 1,511,000

Accounting and Valuation of Inventory  241

Goods available for sale: ` 3,360,000 Cost of goods sold: ` 1,849,000 Closing inventory: ` 1,511,000 Gross profit: ` 851,000 Average cost method Receipts Date

Quantity

1-Apr-11

700

7-Apr-11

Issues

Unit Price (Amount Unit Price Quantity ( `) in `) ( `) 1,200

840,000

 

Balance (Amount in `)

Quantity

  400

1,200

700 480,000

300

Unit Price ( `)

(Amount in `)

1,200

840,000

1,200

360,000

10-Apr-11

800

1,240

992,000

1,100

1,229.09 1,352,000

5-May-11

500

1,250

625,000

1,600

1,235.63 1,977,000

10-May-11

 

12-Jun-11

 

15-Jun-11

700

Total

2,700

1,290  

800

1,235.63

988,500

300

1,235.63

370,687.5

903,000 3,360,000

800

1,235.63

988,500

500

1,235.63

617,812.5

1,200 1,500

1,839,187.5

6,200

1,267.34 1,520,812.5  

1,520,812.5

Goods available for sale: ` 3,360,000 Cost of goods sold: ` 1,839,187.50 Closing inventory: ` 1,520,812.50 Gross profit: ` 860,812.50 5. Item

Cost Incurred I

Additional Cost to be Incurred II

Estimated Selling Price III

Net Realizable Value IV = III–II

101 102 103 104 105

720,000 550,300 335,000 570,000 425,000

80,000 45,000 50,000 60,000 30,000

1,050,000 525,000 400,000 650,000 390,000

970,000 480,000 350,000 590,000 360,000

a. Ending inventory 101 – ` 720,000 102 – ` 480,000 103 – ` 335,000 104 – ` 570,000 105 – ` 360,000 b. The application of ‘lower of cost or net realizable value’ will result in the closing inventory values at ` 2,465,000 as against ` 2,600,300 cost incurred. As a result, the cost of goods sold will be higher by ` 135,300 and profit lower by the same amount.

242  Chapter 8



c. In the next year due to lower opening stock, the cost of goods sold will be lower by ` 135,300 and therefore the profit will be higher by the amount. d. If all the above items are taken together rather than item by item, the NRV comes to ` 2,750,000 which is higher than the cost incurred at ` 2,600,300. The inventory accordingly will be valued at the lower of the two, i.e. ` 2,600,300.

Try It Yourself 1. Finding the missing numbers: Please complete the income statement for the year 2016–17 based upon the information given: Particulars

( ` in Thousands) P Limited

Sales

Q Limited

R Limited

12,200

??

45,100

Opening stock

1,700

2,340

8,300

Purchases

7,280

??

37,180

Closing stock

1,700

4,720

??

Cost of goods sold

??

13,400

38,240

Gross profit

??

(2,150)

??

Operating expenses

??

4,200

??

3,200

??

(1,250)

Profit and loss before tax

2. Impact of inventory costing method: Super Star Trading Limited is evaluating the effect of various inventory costing methods (FIFO, LIFO, Average Cost) on the financial statements of the company. The company expects moderate to high inflation in the coming years in respect of its inventory items. Which of the method will: a. result in highest closing inventory. b. result in highest cost of goods sold. c. result in highest profit. d. result in most stable profit over a period of time. 3. Error in inventory valuation: The profit and loss statement of Ace Trading Limited for the years 2016 and 2017 is given below: Particulars

( ` in Thousands) 2016

2017

54,320

64,100

Opening stock

11,230

14,400

+ Purchases

37,310

32,250

Less: Closing stock

14,400

15,780

Manufacturing and other expenses

18,700

21,360

Total expenses

52,840

52,230

1,480

11,870

Sales Expenses

Profit before tax

Accounting and Valuation of Inventory  243

While reviewing the numbers, it was revealed that the closing stock for the year 2016 was understated by ` 2,300,000. You are required to restate the profit and loss statement for both the years incorporating the revised value of closing stock. 4. Periodic inventory system: STU Electronics Limited is a trader in electronic items and maintains its inventory using periodic inventory system. The following data pertains to quarter ended 31st December 2017 for one of its high selling products: Particulars

Quantity

Cost per Unit ( `)

Beginning inventory

230

12,000

Purchases

900

12,800

The sales of the company during the quarter amounted to ` 14,400,000. The physical verification at the quarter end revealed 170 units in hands. Using LIFO, FIFO and average cost method, calculate: a. Cost of goods available for sale b. Value of closing inventory c. Cost of goods sold d. Gross profits 5. Lower of cost or net realizable value: Due to the introduction of the new model, STU Limited estimates that the remaining 170 units could be sold only at ` 12,200 per unit. The company also estimates that it will have to pay ` 500 per unit as salesman commission. Based upon this additional information, work out the value of closing inventory, cost of goods sold and the gross profit for the quarter ended on 31st December 2017. 6. Lower of cost or net realizable value: Using the following information, determine the closing inventory to be shown in the financial statements: Number of units in stock

Cost Per Unit (`)

Market Price per unit (`)

Additional per unit estimated cost to be incurred before sale (`)

A

20

 80

120

10

B

12

120

100

20

C

10

150

200

40

D

22

 60

70

20

Item

7. FIFO with Perpetual Inventory System: High Power Instruments Limited uses FIFO method for issue of components from its stores department. The details of purchases and issues in respect of a component HT-1 during the quarter ended 31st December 2017 are given below. Based upon the information available calculate the cost of material consumed and value of closing stock. Date 1st October (Opening balance) 7th October

Purchase (No. of Units)

Cost Per Unit (`)

500

450

Issued (No. of Units)

Balance (No. of Units 500

250

250 (continued )

244  Chapter 8 (continued )

Purchase (No. of Units)

Cost Per Unit (`)

25th October

300

460

4th November

200

440

Date

Issued (No. of Units)

Balance (No. of Units 550 750

15th November

300

450

23rd November

200

250

4th December

400

480

650

16th December

340

310

20th December

120

190

24th December Total

300 1,700

500

490 1210

490

8. LIFO and Weighted Average with Perpetual Inventory System: If High Power Instruments Limited uses LIFO or Weighted Average Method for valuation of inventory what will be the impact on the cost of material consumed and value of closing stock.

Cases Case 8.1: Drink Well Beer Limited—Accounting for Empty Bottles The Drink Well Beer Limited runs a number of outlets for selling beer. Some of the bottles sold at these outlets are carried by the customers and are consumed later. In other cases, the beer is consumed by the customer in the bar operated by the company near the beer outlets. In such cases the empty bottles are left behind by the customers and the company takes the possession of the empty bottles. The company keeps proper records of these bottles and sells them by inviting tenders. While preparing the accounts for the year 2016–17, the company estimated that the stock of empty bottles in hand has a realizable value of about ` 12 million. The accounts team is debating about the possible treatment of these empty bottles in the accounts for the year 2016–17. The following options were discussed:



a. Mention the realizable value by way of notes to accounts only. The stock will not be brought into accounts at all. As the company is not the legal owner of these bottles (having been sold to the customers) it cannot be shown as an asset in the balance sheet. b. Include the stock of empty bottles in the balance sheet under current assets under a separate heading at the current realizable value of ` 12 million. c. Include the stock of empty bottles in the balance sheet under current assets as inventory. Inventory is required to be valued at lower of the cost of net realizable value. As the cost of these empty bottles in NIL, the stock may be included in the balance sheet at a nominal value (say ` 1).

Questions for Discussion 1. Which of the above three alternatives will you prefer? 2. What will be the impact of the above alternatives on the profit and loss account of the company?

Accounting and Valuation of Inventory  245

Case 8.2: The Bombay Dyeing and Manufacturing Company Limited—Valuation of Inventories on Lower of Cost or Realizable Value The Bombay Dyeing and Manufacturing Company Limited was established in the year 1879. It is a leading player offering products like stylish linens, towels, home furnishings, leisure clothing and kids wear, etc. As per the accounting policy of the company, the inventories are valued at lower of cost and net realizable value. During the month of March 2003, the company entered into a firm purchase contract for import of raw material viz. paraxylene at an aggregate cost of ` 27.82 crore. Paraxylene is an important input for manufacturing dimethyl terephthalate (DMT), one of the main products of the company. The company ‘expected that the net realizable value, estimated at ` 14.96 crore, will be substantially lower than the cost, compared with reference to the estimated selling price of DMT’2. Accordingly a provision for this loss, estimated at ` 12.86 crore was made in the accounts for the year 2002–03. However, the company decided to reverse this provision during the year 2003–04. Accordingly, the provision for the loss was reversed during the year 2003–04 by adjusting the same from the cost of raw material consumed. The cost of inventory consumed as shown in the schedule to accounts is shown below: Manufacturing and Other Expenses 1. Raw material consumed Less: Reversal of provision for contingent loss on   a firm purchase contract   2. Contracted production   3. Provision for contingent loss on a firm purchase contract

( ` in Crore) 2003–04

2002–03

535.66

472.32

12.86



522.8

472.32

23.87

23.74

546.67

496.06



12.86

The profit before tax for the company for the year 2002–03 and 2003–04 stood at ` 33.53 crore and ` 72.56 crore respectively.

Questions for Discussion 1. How to ascertain the realizable value of the raw material? Should the company have considered the replacement cost of the raw material? 2. What is the impact of above provisioning and reversal on the profit of the company? What would have been the profit before tax for the two years in question if no provisioning was done for the contingent loss? 3. What is the impact of the above transaction on the balance sheet of the company for the two years in question?

Endnotes 1 Ibid., 1. 2 Annual Report of Bombay Dyeing and Manufacturing Company Limited for the year 2002–03.

Accounting for Fixed Assets and Depreciation

9

CHAPTER OBJECTIVES This chapter will help the readers to: • Differentiate between operating expenses and capital expenditure. • Indentify tangible assets and intangible assets. • Understand the principles involved in ascertaining the cost of acquired assets and selfgenerated assets. • Appreciate the treatment of expenditure on improvement, repair and maintenance. • Understand the concept of depreciation, depletion and amortization. • Apply different methods for calculating depreciation. • Understand the accounting of sale, exchange and discarding of fixed assets. • Understand the impact of change in method of depreciation and impairment of assets on the financial statements of a company. • Identify the issues involved in accounting of intangible assets particularly brands, goodwill, research and development cost. • Apply the key requirements of Ind AS 16, Ind AS 17, Ind AS 20, Ind AS 23, Ind AS 36, Ind AS 38 and Ind AS 40 on accounting for non-current assets.

9.1 INTRODUCTION As discussed in Chapter 6, assets of an entity are required to be classified as current assets and noncurrent assets. Non-current assets are intended to be used by the entity over a long period of time, whereas current assets are intended to be used or converted into cash within the next 12 months or normal operating cycle of the entity. In this chapter, the initial recognition and subsequent measurement of tangible non-current assets (property, plant and equipment and investment property) and intangible non-current assets (goodwill and other intangible assets) have been discussed.

9.1.1  Operating Expenses versus Capital Expenses Expenses incurred for day-to-day running of the business are often called operating expenses (or OPEX in short) or revenue expenses. As these expenses benefit a particular accounting period, they are charged to the profit and loss statement of that period using accrual basis of account-

Accounting for Fixed Assets and Depreciation  247

ing. On the other hand, expenses that are expected to provide benefit over a long period of time are called capital expenditure (or simply CAPEX). Capital expenditure results in creation or acquisition of non-current assets or fixed assets as they are popularly called. As these assets are expected to generate benefits over more than one accounting period, it is fair to match the cost of these assets against the benefits. Accordingly, capital expenditure is appropriated over the useful lives of these assets. It may be noted that it is not the nature of asset but its intended use that determine whether to treat the same as operating expenses or capitalize the same. If the intention is to use it over a long period of time, it is capitalized.

■  Illustration 9.1

Fast-track Limited is a dealer of commercial vehicles and spare parts. It bought 10 trucks at a cost of ` 1.5 million each. Seven of these trucks are intended to be sold in the ordinary course of business, whereas other three are meant to be used within the business for carrying goods from one godown to another. How should the consideration amount of ` 15 million be accounted for? As seven trucks are intended to be resold, their cost will be treated as operating expense. Accordingly, ` 10.50 million will be charged to profit and loss statement of the year. The other three trucks are intended to be used over a period of time; hence their cost will be capitalized. Accordingly, ` 4.50 million will be capitalized and will be amortized over the useful life of these trucks.

9.1.2  Type of Fixed Assets Fixed assets may be classified as tangible and intangible. Tangible assets have physical existence and one can see, touch and feel the same. Examples will include plant and machinery, furniture and fixtures, land and building, and vehicles. Intangible assets, on the other hand, have no physical existence but they do represent some valuable rights. For example, patents right acquired by a pharmaceutical company to manufacture a drug is a valuable right and hence an intangible asset. Intangible assets may not have physical substance Tangible assets have physical subbut they are not worthless. In fact, in a knowledge stance. Intangible assets are without economy they often are more valuable than tangible physical substance. assets. Examples include patent rights, copyrights, software license, etc. In this chapter, firstly the accounting of tangible assets is covered and in the later part intangible assets are covered. Assets may further be classified as acquired assets and self-constructed assets. In case of acquired assets, identifying the cost of acquisition of the asset may be relatively straight forward, whereas for self-constructed assets identifying relevant costs attributable to the asset may require extra efforts. Further, an entity may be holding land or building or both, not for use in the production or supply of goods or services or for administrative purposes or sale in the ordinary course of business but to earn rentals or for capital appreciation or both. Such assets are called investment property.

248  Chapter 9

9.2  PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are tangible items because they are used in the production or supply of goods or services, for rental to others, or for administrative purposes. These assets are expected to be used during more than one accounting period. Property, plant and equipment (PPE) includes a wide variety of tangible assets, viz., land, building, plant and machinery, furniture and fixtures, Ind AS 16 defines property, plant and vehicles, computers, etc. These assets are tangible equipment as tangible items held for in nature and have been acquired by the entity with use in the production or supply of the intention to use during more than one period. goods or services, for rental to othAn item of property, plant and equipment shall be ers or for administrative purpose and recognized as an asset only if it is probable that to be used during more than one future economic benefits associated with the item period. will flow to the entity and the cost of the item can be measured reliably. Recognition criteria are depicted in Figure 9.1.

PPE Recognized

Future Economic Benefits will Flow to the Entity

Cost can be Measured Reliably

Figure 9.1  Recognition Criteria for PPE

9.2.1  Initial Cost An item of property, plant and equipment is initially recognized at its cost. When an asset is acquired, besides the purchase price, a number of other expenses may be incurred before the asset is ready for its intended use. As a guiding principle, all costs that are necessary to be incurred to bring the assets to its intended use are capitalized. Besides the purchase price, other costs include import duties, freight to bring the asset to the site, installation cost, professional cost of architects etc,. Classification of expenses incurred as capital expenditure or operating expense will have significant impact on the value of the asset in the balance sheet as well as profit or loss as shown in the statement of profit and loss. The initial cost of an asset will include the purchase price paid after adjusting for trade discounts and rebates. Taxes and import duties are also included in the initial cost, however, if any of the taxes paid is refundable the same is excluded. In addition, costs directly attributable for bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management are also included. Costs incurred on site preparation, initial delivery, installation and

Accounting for Fixed Assets and Depreciation  249

assembly, costs of testing, professional fees and employee benefits are also capitalized. If any item produced during the testing or trial run is sold, the net proceeds from sale are deducted from the cost. An entity may have obligations to dismantle, remove and restore the site on which the asset is located. Such obligation may arise when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. Estimated cost of dismantling and removing the items and restoring of site are also included in the initial cost of PPE. ■  Illustration 9.2

During 2016–17, New Age Fashion Limited bought a machine at a cost of ` 6.5 million. Additionally it paid ` 80,000 towards freight charges and ` 25,000 towards insurance during transportation. Cost of installation and test run came to ` 120,000. Inventories costing ` 30,000 were consumed during the trial run. Items produced during the test run were sold for ` 45,000. At what value the machine will be capitalized? All expenses (purchase price, freight, insurance and installation, test run and inventories used) are necessary to bring the machine to its intended use and will be capitalized. Proceeds from sale of products will be deducted. As such, the initial cost will be recorded at `6,710,000 million.

Assets Acquired in Exchange A new fixed asset may be acquired in exchange of an existing asset. In such a case, the cost of acquisition will be the fair market value of either the asset given up or the fair market value of the asset acquired, whichever is more evident. As an alternative, the asset may be recorded at the book value of the asset given up, especially when the assets being exchanged are similar. If a part consideration is met in cash, the same also is adjusted to arrive at the cost of acquisition. Similarly, the consideration of an asset may be paid by issue of securities. In such a case, again the asset will be recorded either at the fair market value of the asset being acquired or at the fair market value of the securities being issued whichever is more evident.

■  Illustration 9.3

Peerless Chemical Limited is acquiring a new machine in exchange of an old one. The book value of the old machine is ` 200,000. The consideration for the new machine will be met by a cash payment of ` 2.7 million and the old machine. At what value the new machine should be recorded in each of the following situations:

a. The fair market price of old machine is difficult to determine but the fair price of the new machine is ` 3 million.



b. The fair market price of the old machine is ` 400,000.



c. As the machines are highly specialized ascertaining the fair market value of either of them is difficult.

250  Chapter 9



a. As the fair value of the new machine is evident at ` 3 million, it will be recorded at the same. It will be assumed that the old machine is being taken over at ` 300,000, i.e., ` 3 million less ` 2.7 million.



b. The new machine will be recorded at ` 3.1 million, i.e., cash payment of ` 2.7 million plus fair value of old machine at ` 400,000.



c. As the fair market value of either machine is difficult to determine, the new machine will be recorded at the cash consideration plus the book value of old machine. Accordingly, the cost of acquisition will be taken at ` 2.9 million.

Self-constructed Asset The principles applicable for acquired assets also apply to self-constructed assets. In addition to cost of construction directly incurred for the specific asset, a fair share of cost incurred on construction activity in general will also form part of the cost of the asset. If similar assets are made by the entity for sale in the normal course of business, internal profits, if any, shall be eliminated to arrive at the cost.Accordingly, the cost of the self-constructed assets would be same as cost of constructing an asset for sale. Cost of abnormal wastages—material, labour or other resources—is also excluded from cost. ■  Illustration 9.4

Bharat Construction Material Limited is engaged in trading of construction material. It constructed a new warehouse building during 2016–17. The cost incurred specifically on this building came to ` 6.8 million. This include construction material consumed from own stock valued at ` 2.8 million at selling price. The cost of this material to the company was ` 2.2 million only. The company also has a project division which supervised the construction of building besides other projects. The annual cost of the project division during 2016–17 was ` 20 million. It is estimated that the project division spent about 10% of its time on supervising the building in question. What is the cost of construction of this building? The capitalized vale of the building will be calculated as follows:



( ` in Million)

Specific cost of construction:

6.8

Less: Internal profit eliminated:

0.6

Add: 10% allocated cost of project division

2.0

Total cost of construction

8.2

Asset Acquired on Deferred Payment An asset may be acquired by an entity on deferred credit terms, i.e., the purchase price is paid beyond the normal credit terms of the vendor. In such a case, the asset will be capitalized at the cash price equivalent on the recognition date. The difference between the cash price equivalent and the total payment will be recognized as interest over the period of credit.

Accounting for Fixed Assets and Depreciation  251

Capitalization of Interest The principle that expenses incurred to bring the asset to its intended use are capitalized is extended to interest on borrowed funds as well. Borrowing costs are normally treated as expenses in the period in which they are incurred, however, if the funds have been borrowed for the acquisition, construction or production of an asset, the same will be capitalized as part of that asset. If the borrowed funds have been temporarily invested pending their deployment, the income earned should be deducted from the borrowing costs. Once the asset is ready for its intended use, interest in the subsequent period will be charged to the statement of profit and loss as an expense.

Ind AS 23: To the extent that funds are borrowed specifically for the purposeof obtaining a qualifying asset, the amount of borrowing costs eligible for capitalization on that asset should be determined as the actualborrowing costs incurred on that borrowing during the period less anyincome on the temporary investment of those borrowings.

Subsequent Expenditure Once the asset has been capitalized and put to use, any subsequent expenditure incurred for day-to-day servicing of an asset are in the nature of repair and maintenance. Such costs are treated as operating expenses and are transferred to the statement of profit and loss for the period and not included in the carrying amount of the asset. However, cost of replacements is capitalized if it meets the recognition criteria, i.e., future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably. Once the new parts are recognized, the old parts are derecognized and removed from the balance sheet. If an item of PPE is subject to major periodical inspection and overhaul, the cost of inspection and overhauling expenses are also capitalized and added to the carrying amount of the asset. The treatment of subsequent expenditure is depicted in Figure 9.2.

Subsequent Expenditure

Day-to-day Maintenance– Charged to the Statement of Profit and Loss

Cost of Replacement, Major Inspection and Overhaul–Capitalize and Add to the Carrying Amount of the Asset

Figure 9.2  Treatment of Subsequent Expenditure

252  Chapter 9

9.2.2  Subsequent Measurement After initial recognition at cost, an entity has a choice between cost model and revaluation model for subsequent measurement. The accounting policy in this regard shall apply to the entire class of plant, property and equipment. In the cost model, the asset is carried in the books at its costs less accumulated depreciation and impairment losses, if any. Whereas in revaluation model, the asset is revalued at sufficient frequency at its fair value and it is carried at the revalued amount less accumulated depreciation and impairment losses, post revaluation. A class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. For example, the following may be treated as separate classes:

• • • • • • • • •

Land Land and buildings Machinery Ships Aircraft Motor vehicles Furniture and fixtures Office equipment Bearer plants

Revaluation Model Revaluation model can be used only where the fair value of an asset is reliably measurable. In such a case, revaluations shall be made with sufficient regularity to ensure that the carrying amount of the assets is close to the fair value at the end of the reporting period. The frequency of revaluation is determined keeping in the mind the fluctuation in the fair value of the item of property, plant and equipment. An annual revaluation may be needed in case of items which experience volatile changes in the fair value. For other items, revaluation once every three to five years may be sufficient. However, if an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued An increase in an asset’s carrying amount, as a result of a revaluation, is recognized in other comprehensive income and accumulated in equity under the heading of revaluation surplus.There may be a situation where the carrying amount of an asset decreases in one accounting period and increases subsequently. In such a situation, the increase is recognized in the profit or loss to the extent is reverses a revaluation decrease of the same asset which was previously recognized in profit or loss. Any decrease in the carrying amount, as a result of revaluation, is recognized in profit and loss. However, the decrease is recognized in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease reduces the amount accumulated in equity under the heading of revaluation surplus.Upon de-recognition of an item of property, plant and equipment, the revaluation surplus may be transferred directly to retained earnings.

Accounting for Fixed Assets and Depreciation  253

■  Illustration 9.5

As per the accounting policy of XXX Limited, items of property, plant and equipment (PPE) are carried at their revalued amount. Each item of PPE is annually revalued. What would be the impact of the following revaluation on the financial statements of the company? Fair Value Initial Recognition

Year 1

Year 2

Year 3

Item A

1,000,000

1,200,000

1,300,000

1,150,000

Item B

3,000,000

2,700,000

2,900,000

2,400,000

Item A In 1st year, the increase in carrying amount will be recognized in the other comprehensive income at ` 2,00,000 and the same would appear as revaluation surplus under other equity in the balance sheet. In 2nd year, further increase in the carrying amount will be recognized in the other comprehensive income at ` 1,00,000 and the same would be added to the revaluation surplus. In 3rd year, the decrease in the carrying amount will be recognized in the other comprehensive income and adjusted against the balance in the revaluation surplus. As a result, the revaluation surplus will be reduced by ` 150,000. Item B In 1st year, the decrease in carrying amount will be recognized in the profit and loss at ` 3,00,000. In 2nd year, increase in the carrying amount (` 2,00,000) will be recognized in the profit and loss as it represents a reversal of revaluation decrease. In 3rd year, the decrease in the carrying amount will be recognized in the profit and loss.

Property, Plant and Equipment

Initial Measurement

At Cost

Subsequent Measurement

Cost Model

Cost less Depreciation and Impairment

Revaluation Model Revaluated Amount Less Subsequent Depreciation and Impairment

Figure 9.3  Measurement of Property, Plant and Equipment

254  Chapter 9

Cost Model In the cost model, assets are carried in the books at its costs less accumulated depreciation and impairment losses, if any. If an entity choses cost model for a class of property, plant and equipment, the assets of that particular class will be carried in the books at their initial cost less depreciation and impairment loss. It would obviate the need for periodic revaluation of assets. The measurement principle for items of property, plant and equipment as per Ind AS 16 are depicted in Figure 9.3.

9.2.3 Depreciation The concept of depreciation is based upon matching concept. An asset that is expected to benefit more than one accounting period, the cost of such asset should be apportioned over its useful life in a systematic manner to match cost against the benefits derived. Apportioning the cost of an asset over its useful life in a systematic manner is called depreciation. By charging depreciation, a part of the capitalized cost of an asset is converted in operating expense and charged to the statement of profit and loss of each of the period in which the asset has been used. As the asset is likely to have some residual value after its useful life, the depreciable value of an asset is determined after deducting its estimated value. Please note that the depreciation amount merely represents apportionment of the cost of the asset over its useful life, it has no relation with the change in market value of the asset. In fact there are various terms being used in this regard. Depreciation is generally associated with tanTangible assets are depreciated, gible assets, like plant and machinery, furniture and intangible assets are amortized and vehicles, etc. These assets have a limited useful life, natural resources are depleted. Land are expected to be used during more than one accountis a non-depreciable asset. ing period and are not intended for resale. As land does not have a limited useful life, no depreciation is charged on land. However, if the land has been taken on leasehold basis for a defined period of time, it will also be subject to depreciation. Apportionment of the cost of intangible assets, like software licenses, goodwill, etc., is called amortization. Whereas when a non-current asset consists of natural resources, the apportionment of cost is referred to as depletion. Ind AS 16 requires that each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. For example, the airframe and engines of an aircraft may be depreciated separately as they may have different useful lives. However, various parts having same useful life and depreciation method may be grouped together for calculating depreciation. The depreciation amount is recognized in profit or loss in each year over the useful life of the asset. Depreciation of an asset begins when it is available for use. It ceases when the asset is derecognized or is classified as held for sale, whichever is earlier. Depreciation does not cease even if the asset is idle or is retired from active use till it is derecognized, classified as held for sale or is fully depreciated. To assess the amount of depreciation, the following estimates need to be made: Ind AS-16: The depreciable amount of an asset should be allocated on a systematic basis over its useful life.

• Cost of the asset • Expected useful life of the asset

Accounting for Fixed Assets and Depreciation  255

• Estimated residual value of the asset at the end of the useful life • Method of depreciation The depreciation amount to be charged can be determined by the following formula: Depreciation =

Cost − Residual value Useful life

Cost of the asset has been covered in the earlier part. The other three variables have been discussed below:

Useful Life of the Asset Estimation of expected useful life is a matter of managerial judgment. It is often shorter than the physical life of the asset as the enterprise may like to dispose of the asset before it becomes obsolete. The past experience with similar type of assets is often useful. The expected usage of the asset and related wear and tear would have an impact on the useful life. Likewise, technological changes resulting in the asset becoming obsolete need to be factored in. If there are significant contractual restrictions, for example, assets taken on lease basis for a fixed period, the useful life of the asset will get adjusted accordingly. If the asset in question is based upon a new technology about which the management has no past experience, the estimation becomes that much more difficult to make. In case of natural resources, the assessment of the embedded quantity of resources and the rate of extraction will guide the estimate about the useful life of the asset.

Residual Value Residual value of a depreciable asset means its realizable value after the useful life. As the useful life is often shorter than the physical life, the asset is expected to have some disposal value. As a guide, the past experience with similar type of assets may be used. Generally, the residual value is expected to be insignificant, and is therefore immaterial in calculation of depreciation. However, if the residual value is expected to be significant, it needs to be estimated. The residual value should be taken net of cost of disposal of the asset.

Methods of Depreciation Given the above estimates, the depreciation charge may be computed in a variety of ways called methods of depreciation. The most popular methods being straight line method, diminishing balance method and unit-of-production method, though other methods like sum-of-digits method can also be used. The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Method of depreciation, once chosen, is applied consistently period after period. If there is a change in the expected pattern of consumption of future economic benefits, depreciation method may be changed.

Straight Line Method (SLM) As the name suggests, this method assumes that the asset provides similar economic benefits period after period over its useful life, and hence, the same amount of depreciation is charged to each period.

256  Chapter 9

For example, depreciation for a machine costing ` 10 million,with an estimated residual value of ` 1 million and a useful life of 10 years will be calculated as follows: Depreciation =

` 10 million − ` 1 million

10 years

.

Thus, depreciation for the first year will be ` 900,000. The depreciation amount will remain same period after year. The reciprocal of useful life (1/10th or 10% in this case) provides the depreciation rate on a SLM basis. Thus, the 10% of the depreciable amount (Cost − residual value) will be charged as depreciation every year.

Diminishing Balance Method

Depreciation rate in reducing balance method is always higher that the straight line method

The underlying assumption under diminishing balance method (also called reducing balance method) is that the asset provides higher economic benefits in the initial years and therefore should be subjected to higher depreciation. In the later years, asset’s operational efficiency goes down and so should the depreciation charged. Lower depreciation in later years also compensate for higher repair and maintenance costs that are incurred. This method is also called Written Down Value Method (WDV method). Assuming that a machine costing ` 10 million is depreciated at 20% on reducing balance method over its useful life of seven years. The depreciation for the first year will be 20% of cost or ` 2 million. The carrying amount of the asset after the first year comes down to ` 8 million. The depreciation for the second year will be calculated at the given rate (20%) on the carrying amount (` 8 million). Accordingly, the depreciation expense for the second year comes to ` 1.6 million. This process will continue over the useful life of the asset. The depreciation schedule over the useful life of the asset is given below:

Year

WDV in the Beginning of the Year

Depreciation at 20% of WDV

WDV at the End of the Year

1

10,000,000

2,000,000

8,000,000

2

8,000,000

1,600,000

6,400,000

3

6,400,000

1,280,000

5,120,000

4

5,120,000

1,024,000

4,096,000

5

4,096,000

819,200

3,276,800

6

3,276,800

655,360

2,621,440

7

2,621,449

524,288

2,097,152

Similar effect can also be achieved by following sum-of-year digits method. Let us assume an asset costing ` 10 million with useful life of seven years. First, we find the sum of number 1, 2, 3, 4, 5, 6 and 7. The sum comes to 28. The sum can also be found by the following formula for an asset with useful life on n years: SOYD = η

 ( n + 1)   (7 + 1)  =7 = 28  2   2 

Accounting for Fixed Assets and Depreciation  257

The depreciation for the first year will be 7/28 of cost where the numerator is n. For the second year numerator will be n–1; for the third year n–2 and so on. The denominator in each case will be SOYD. Depreciation for the first year comes to 7/28 of ` 10 million, reducing to 6/28 of ` 10 million for the second year and so on. The depreciation schedule as per SOYD method is given below: Year

Depreciation Calculations

Depreciation

1

7/28 × 10,000,000

2,500,000

2

6/28 × 10,000,000

2,142,857

3

5/28 × 10,000,000

1,785,714

4

4/28 × 10,000,000

1,428,571

5

3/28 × 10,000,000

1,071,429

6

2/28 × 10,000,000

714,286

7

1/28 × 10,000,000

357,143

Reducing balance method and sum-of-year digits method are called accelerated methods as higher depreciation is charged in the initial years. The accelerated methods are more conservative as higher depreciation is written-off in the initial years.

Unit-of-Production Method In this method, the life of an asset is defined not in terms of number of years but in terms of number of units it is expected to produce over its useful life. Depreciation per unit is then calculated by dividing the cost of the asset by number of units. The total depreciation for a period is calculated by number of units produced during the period multiplied by the depreciation expense per unit. For example, a machine costing ` 10 million is expected to produce 200,000 units before it will become obsolete. In the first year, 30,000 units were produced. The depreciation expense per unit comes to ` 50 (` 10 million divided by 200,000 units). Depreciation charges for the year comes to ` 1.5 million (30,000 units multiplied by ` 50). Similarly, depreciation charges for other years will be calculated based upon the number of units produced using this machine in each of the years.

■  Illustration 9.6

Curewell Hospitals Limited bought a MRI machine at a cost of ` 60 million. Though the physical life of the machine is 10 years, the company feels that due to technological changes it will have to replace the machine after five years. At the end of fifth year, the machine is expected to be taken back by the manufacturer at a value of ` 20 million. Calculate the depreciation expenses for the first two years in each of the following cases

a. Company follows SLM for charging depreciation.



b. Company decides to charge depreciation at the rate of 30% on reducing balance method. c. Company follows sum-of-years-digits method for calculating depreciation.

258  Chapter 9



d. Company estimates that the machine is good for 20,000 scans. In the first two years, 4,500 and 3,700 scans were performed, respectively.

a. Depreciation = ( ` 60 million − ` 20 million)/5 = ` 8 million. Depreciation will be charged at ` 8 million every year. b. Depreciation for the first year will be 30% of ` 60 million = ` 18 million. The book value after the first year will be ` 60 million less ` 18 million or ` 42 million. Depreciation for the second year will be 30% of ` 42 million = ` 12.6 million. c. SOYD = 5 (5 + 1)/2 = 15 Depreciation for the first year = 5/15 of ` 40 million = ` 13.33 million Depreciation for the second year = 4/15 × ` 40 million = ` 10.67 million d. Depreciation expense per scan = ` 40 million/20,000 = ` 2,000 Depreciation for the first year = 4,500 × 2,000 = ` 9 million Depreciation for the first year = 3,700 × 2,000 = ` 7.4 million

Depreciation as per Companies Act, 2013 Schedule II of the Companies Act, 2013 prescribes the useful lives for various categories of assets and residual value for calculating depreciation. The useful life of an asset shall not be longer than the useful life as prescribed in the schedule. The residual value shall not be more than 5% of the original cost of the asset. If a company uses a useful life or residual value of an asset different from what is prescribed, justification for the difference needs to be provided in the financial statements. The useful lives prescribed by Schedule II of Companies Act, 2013 for certain categories of assets are given in Table 9.1. Table 9.1  Useful lives of Assets as per Schedule II of Companies Act, 2013

Type of Assets Building—Factory Fence, wells, tube wells Others (Including temporary structure) Plant and machinery—Other than continuous process plant Continuous process plant Special Plant and Machinery (as prescribed)

Useful Life (Years) 30 5 3 15 25 8—40

Electrical installations and equipments

10

Vehicles (Motor car, motor cycles, scooters) Buses and lorries (Other than used for hire) Buses and lorries (Used for hire)

10 8 6

Furniture and fittings (General)

10

Computers and data processing units Servers and networks End user devices, such as desktops, laptops, etc.

6 3

Accounting for Fixed Assets and Depreciation  259

In respect of assets added or discarded during the year, depreciation is to be calculated on a proportionate basis for the period for which the asset was used. The useful life as mentioned above is based upon single shift working. If the asset is used for double shift, the depreciation would increase by 50% and in case of triple shift working depreciation would increase by 100% for the period for which the asset was so used.

Depreciation as per Income Tax Act, 1961 For computation of tax liability under Income Tax Act, 1961, depreciation is allowed to be charged at the prescribed rates on the written-down value of the asset. For this purpose, assets are classified in various blocks based upon the depreciation rate that they are subjected to. Assets used for less than 180 days in a year are entitled to half the normal depreciation allowance. As the Income Tax Act, 1961, permits use of WDV method for computing depreciation, enterprises are able to postpone their tax liability by charging higher depreciation in the earlier years. Rates of depreciation on certain categories given in Table 9.2.

For financial accounting, companies usually charge depreciation on SLM basis at the rates prescribed in the Companies Act. For tax accounting, depreciation is charged on WDV basis at the rates prescribed under Income Tax Act.

of assets as per Income Tax Act, 1961, are

Table 9.2  Depreciation Rates as per Income Tax Act, 1961

Type of Asset Buildings—Residential buildings other than hotels and boarding houses Buildings—Office, factory, godowns or buildings not mainly used for residential purposes Buildings—Temporary erections

Rate of Depreciation (%) 5 10 100

Plant and machinery—General rate

25

Plant and machinery—Motor cars

20

Plant and machinery—Computers, books owned by professionals

60

Plant and machinery—Energy saving devices, plants used in field operations by mineral oil concerns

80

Plant and machinery—Pollution control equipments Patents, copyrights, trade marks, licenses, other rights

100 25

As depreciation method and rates used for financial reporting and tax accounting are different, it is a major source of difference between reported profit as per profit and loss statement and taxable income.

260  Chapter 9

9.2.4  Special Situations Small Value Items By definition, any expenditure that is likely to benefit an enterprise over a long period of time and results in creation of a fixed asset is capitalized and is depreciated over its useful life. However, an enterprise may be incurring expenditure on small value items which by definition are capital assets but have insignificant value. In such cases, an enterprise may decide to treat such capital expenditure as revenue expense by charging 100% depreciation. This treatment is based upon the concept of materiality. For example, a calculator purchased for ` 1,000 with a useful life of three years; if capitalized will be depreciated at the rate of ` 333 per annum. As the amount involved is insignificant, the enterprise may decide to treat the cost of the calculator as a revenue expense, and thus saving on efforts in maintaining detailed records of asset and depreciation over the next three years. The accounting policy of some Indian companies in this regard is given in Box 9.1.

Assets Taken on Lease An enterprise may acquire an asset on a lease basis rather than on outright purchase basis. In a lease agreement, the acquirer (lessee) agrees to make a periodic payment (lease rent) to the vendor (lessor) to obtain a right to use the asset. A lease agreement may be in the nature of operating lease or finance lease. In a finance lease, the lease period covers substantially the entire useful life of the asset, and risk and rewards relating to the asset are transferred to the lessee. Operating leases are generally for a shorter period compared to the useful life of the asset. If the agreement is in the nature of operating lease the asset is capitalized in the books of the lessor. However in case of a finance lease, the asset is recorded in the books of the lessee. The asset should normally be recorded at the fair value of the asset at the inception of the lease. However, if the fair value of the asset exceeds the present value of the minimum lease rentals, then the asset will be recorded at the present value of the lease rentals. The discount rate to be used for calculating the present value is the interest rate implicit in the lease or the incremental borrowing rate of the lessee if the former is difficult to determine. Once the asset has been capitalized in the books of the lessee, it will be depreciated over its useful life. Therefore, the asset given out on a finance lease can’t be capitalized and depreciated in the books of the lessor. Ind AS 17–A finance lease is a lease that transfers substantially all the risks and rewards incident to the ownership of an asset. A lease other than finance lease is operating lease.

Box 9.1  Accounting for Small Value Items • Assets individually costing less than or equal to 10,000 are fully depreciated in the year of purchase. Ultra Tech Cements Limited. • Assets costing ` 5,000 or less are fully depreciated in the year of purchase—Hindustan Unilever Limited. Source: Annual Reports of the Companies for the year 2016–17

Accounting for Fixed Assets and Depreciation  261

Government Grants An asset may be entirely or partially funded out of government grants. Grants related to assets are government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held. In such a situation, what value the asset will be capitalized? Ind AS 20 requires that government grants related to assets, including non-monetary grants at fair value, shall be presented in the balance sheet by setting up the grant as deferred income. Accordingly, the asset is initially recognized at its normal cost of acquisition and the grant is treated as deferred income. The asset will be depreciated over its useful life and at the same time the grant would be apportioned from the deferred income account to the statement of profit and loss. The asset will appear on the asset side of the balance sheet at the depreciated value and at the same time, the balance left in the deferred income account will appear on the liabilities side of the balance sheet as a separate heading. The net impact on the statement of profit and loss will be equal to the deprecation charge less the amount transferred from the deferred income account.

Asset Acquired in Foreign Exchange An enterprise may acquire an asset where the payment is settled in foreign currency. In such a case, the acquisition cost is recorded in the functional currency by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.

Revising Estimated Useful Life and Residual Value Ind AS 16 requires that the residual value and the useful life of an asset shall be reviewed at least at the end of each financial year. For example, due to a major overhaul the useful life of an asset may get extended. Likewise, due to new technological developments or due to wear and tear the estimated useful life may have to be shortened. In either case, the change in carried out prospectively. The carrying amount of the related asset is adjusted in the period of the change. The effect of change is applied prospectively by including it in the profit or loss in the period of change and future periods.1

■  Illustration 9.7

A machine was purchased at a cost of ` 10,00,000 with an estimated useful life of 8 years and residual value of ` 2,00,000. The company uses straight line method of depreciation. After using the machine for 3 years, the company revised the remaining useful life to be three years and the residual value at ` 1,00,000. How would the change in estimate be reflected in the financial statements? Initially, the annual depreciation works out to be ` 1,00,000. After three years, the carrying amount of the asset is ` 7,00,000. With the revised estimated residual value of ` 1,00,000, the depreciable value comes to ` 6,00,000, which would be depreciated over the remaining useful life of three years. The annual depreciation from fourth to sixth year accordingly comes to ` 2,00,000.

262  Chapter 9

Change in the Method of Depreciation Normally depreciation method once chosen is applied over the useful life of the asset. This is based on the fundamental accounting assumption of consistency. Ind AS 16 requires that the depreciation method applied to an asset shall be reviewed at least at the end of each financial year. In case there has been a significant change in the expected pattern of consumption of the future economic benefits, the method shall be changed to reflect the changed pattern. Any change in the depreciation method is treated as a change in an accounting estimate and is recognized prospectively. The nature and amount of a change in accounting estimates (useful life, residual value, method of depreciation etc.), its impact on the current period and future periods need to be disclosed in the financial statements. AS 16–Change in the method of depreciation is treated as a change in an accounting estimate.

9.2.5  De-recognition of Assets An asset is derecognized either on disposal or when no further economic benefits are expected from its use or disposal. Once an asset is derecognized, its carrying amount is eliminated from the financial statements. Any gain or loss arising on de-recognition of an item of property, plant and equipment is recognized in the profit or loss when the item is derecognized. The gain or loss is computed as a difference between the net disposal proceeds and the carrying amount of the item. Accounting policy of Colgate Palmolive (India) Limited related to depreciation is given in Box 9.2. Box 9.2: Depreciation Accounting Policy of Colgate Palmolive (India) Limited • The useful lives of the assets are based on technical estimates approved by the management, and are lower than or same as the useful lives prescribed under schedule II to the companies Act, 2013 in order to reflect the period over which depreciable assets are expected to be used by the company. • Depreciation is calculated on a pro-rata basis as per the straight line method so as to writedown the cost of property, plant and equipment to its residual value systematically over its estimated useful life based on useful life of the assets as prescribed under Part C of Schedule II to the Companies Act, 2013 except in case of following assets, wherein based on internal assessment and independent technical evaluation, a different useful life has been determined. Assets class

Useful Lives

Residential and office building

40 Years

Factory building

20 Years

Plant and machinery

7 Years to 15 Years

Dies and moulds

3 Years

Furniture and fixtures

5 Years

Office equipment

5 Years

• Estimated useful lives, residual values and depreciation methods are reviewed annually, taking into account commercial and technological obsolescence as well as normal wear and tear and adjusted prospectively, if appropriate. Source: Annual Report of Colgate Palmolive (India) Limited for the year 2016–17

Accounting for Fixed Assets and Depreciation  263

9.2.6  Accounting for Depreciation Items of property, plant and equipment are initially recognized at their cost of acquisition. In subsequent periods, they are presented in the balance sheet at their carrying cost (initial cost less accumulated depreciation). Depreciation expense for the year is charged to the statement of profit and loss of the respective year. The following entries will be passed: At the time of buying the asset Asset Account Dr.    To Bank Account If the asset is bought on credit, instead of crediting bank account, the vendor account will be credited. At the end of the year, depreciation amount is ascertained and the following entries are passed: For charging depreciation: Depreciation Account Dr.    To Accumulated Depreciation/Provision for Depreciation Account The asset account is maintained at its gross value. Instead of reducing the balance in the asset account, the amount of depreciation is credited to a contra-asset account, namely, accumulated depreciation account or provision for depreciation account. For transferring depreciation to statement of profit and loss Statement of Profit and Loss Dr.    To Depreciation Account As a result of this entry, the depreciation expense for the year is transferred to the profit and loss statement. This entry is repeated each year end over the life of the asset. The balance sheet of each year will show the asset account at its gross value less accumulated depreciation account to arrive at the net book value. At the time of de-recognition of the asset: Once the useful life of the asset is over and the asset is derecognized, the asset account and accumulated depreciation account are closed. The gain or loss on disposal of the asset is ascertained and transferred to the statement of profit and loss of the year. The following entries are passed: Bank Account Dr. (by the amount of consideration) Accumulated Depreciation Account Dr. (by the balance amount in the account) Loss on Disposal of Asset Dr. (by the loss amount)    To Asset Account (by the cost of the asset) If the asset is sold for a consideration higher than the net book value, the resultant gain will be credited to gain on disposal of asset account. The loss or gain on disposal will be transferred to the profit and loss statement. ■  Illustration 9.8

On 1st April 2014, Super Technologies Limited bought three computers at a total cost of ` 300,000. The estimated useful life of computers is three years with a residual value of ` 60,000. The company follows SLM for charging depreciation. On 31st March 2017, these were sold for ` 70,000. Pass the

264  Chapter 9

necessary journal entries in the books of Super Technologies Limited. How will the asset and depreciation appear in the financial statements of the company? 1st April 2014: For buying the computers Computer Account Dr. ` 300,000    To Bank Account    ` 300,000 31st March 2015/2016 and 2017: As the company is following SLM, same depreciation will be charged every year and the following entries will be passed at the end of each year: Depreciation Account Dr.   ` 80,000    To Accumulated Depreciation Account    ` 80,000 Profit and Loss Statement Dr.   ` 80,000   To Depreciation Account   ` 80,000 31st March 2017: For disposal of asset Bank Account Dr.   ` 70,000 Accumulated Depreciation Account Dr. ` 240,000   To Computers Account   ` 300,000    To Gain on Sale of Assets    ` 10,000 Gain on Sale of Assets Account Dr.   ` 10,000    To Profit and Loss Statement    ` 10,000 The statement of profit and loss will show the following information Particulars Expenses  Depreciation

2014–15

2015–16

2016–17

80,000

80,000

80,000

Other income   Gain on sale of asset

10,000

The balance sheet will appear as follows: Particulars

31st March 2015

31st March 2016

31st March 2017

Assets Gross block

300,000

300,000

Nil

Less: Accumulated depreciation

 80,000

160,000

Nil

Net block

220,000

140,000

Nil

Accounting for Fixed Assets and Depreciation  265

9.2.7 Disclosures For each class of property, plant and equipment, the following disclosures are required to be made in the financial statements:

• • • •

The measurement bases used for determining the gross carrying amount. The depreciation methods used. The useful lives or the depreciation rates used. The gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period. • A reconciliation of the carrying amount at the beginning and end of the period showing: –– Additions. –– Assets classified as held for sale or included in a disposal group classified as held for sale and other disposals. –– Acquisitions through business combinations. –– Increase or decrease resulting from revaluations and from impairment losses recognized or reversed in other comprehensive income. –– Impairment losses recognized in profit or loss. –– Impairment losses reversed in profit or loss. –– Depreciation. –– The net exchange differences arising on the translation of the financial statements from the functional currency into a different presentation currency, including the translation of a foreign operation into the presentation currency of the reporting entity. –– Other changes. The financial statements shall also disclose: • The existence and amounts of restrictions on title, and property, plant and equipment pledged as security for liabilities. • The amount of expenditures recognized in the carrying amount of an item of property, plant and equipment in the course of its construction. • The amount of contractual commitments for the acquisition of property, plant and equipment. • If it is not disclosed separately in the statement of profit and loss, the amount of compensation from third parties for items of property, plant and equipment that were impaired, lost or given up that is included in profit or loss.

9.3  INVESTMENT PROPERTY As discussed, Ind AS 40 defines investment property as property (land or a building—or part of a building—or both) held to earn rentals or for capital appreciation or both, rather than for use in the production or supply of goods or services or for administrative purposes or sale in the ordinary course of business. Investment property is initially measured at cost. Transactions costs, if any, are also included in the cost. Subsequently, investment property is measured using the cost model as discussed in para 9.2.2 above.

266  Chapter 9 Box 9.3: Accounting Policy of Colgate Palmolive (India) Limited Relating to Investment Property • Property that is held for long-term rental yields or for capital appreciation or both, and that is not occupied by the company, is classified as investment property. • Investment property is measured initially at its cost, including related transaction costs and where applicable borrowing costs. • Subsequent expenditure is capitalized to the asset’s carrying amount only when it is probable that future economic benefits associated with the expenditure will flow to the company and the cost of the item can be measured reliably. • All other repairs and maintenance costs are expensed when incurred. • Investment properties are depreciated using the straight line method over their estimated useful lives, which is 40 years.

Upon de-recognition, an investment property is eliminated from the balance sheet. De-recognition of an investment property happens on disposal or when the investment property is permanently withdrawn from use and no future economic benefits are expected from its disposal. Gain or loss from the retirement or disposal of investment property is determined as the difference between the net disposal proceeds and the carrying amount of the asset. Gain or loss upon de-recognition is taken to the profit or loss. Accounting policy of Colgate Palmolive (India) Limited relating to investment property has been mentioned in Box 9.3.

9.4  INTANGIBLE ASSETS Ind AS 38 defines an intangible asset as ‘an identifiable non-monetary asset, without physical substance’. An entity may spend considerable amount of resources to acquire or internally develop intangible assets, like computer software, patents, copyrights, mortgage servicing rights, licences, etc. An intangible asset should be recognized only if it is identifiable, the entity has control over it, the entity would derive future economic benefits and cost of the asset can be measured reliably. An asset is considered to be identifiable if it can be separated or is capable of being separated or divided from the identity and can be sold or licenced or rented or exchanged. It may also arise from contractual or legal rights, whether transferable or separable or not. The entity also needs to have power to obtain future benefits from the asset to the exclusion of others. The control over the future economic benefits is normally derived from legal rights that are enforceable in a court of law, e.g., patent rights, copyrights, etc. The future economic benefits may flow to the entity by way of revenue from the sale of products or services or cost savings or other benefits.

9.4.1  Initial Measurement Intangible assets are measured initially at cost. Cost for this purpose includes purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates and all expenses necessary to make the asset ready for its intended use. For example, professional fees for legal services are also capitalized. In respect of the asset acquired in business combination (e.g., merger and amalgamation), initial measurement shall be at the fair value on the acquisition date.

Accounting for Fixed Assets and Depreciation  267

9.4.2  Subsequent Measurement For subsequent measurement, an entity may choose either cost model or revaluation model. In the cost model, an intangible asset is carried at its cost less accumulated amortization and accumulated impairment loss, if any. In revaluation model, an intangible asset is carried at a revalued amount (fair value) less amortization and impairment loss subsequent to revaluation. If an intangible asset is accounted for using revaluation model, all other assets in the same class are also required to be accounted for using the same model. If the carrying amount of an intangible asset increases as a result of revaluation, the same is recognized in other comprehensive income and accumulated under other equity as revaluation surplus. If, however, the increase is reversing an earlier revaluation decrease, it would be recognized in the profit or loss. If the carrying amount of an intangible asset decreases as a result of revaluation, the same is recognized in profit or loss. If however, the decrease is reversing an earlier revaluation increase, it would be recognized in the other comprehensive income and adjusted against the revaluation surplus in other equity.

9.4.3  Amortization of Intangible Assets The depreciable amount of an intangible asset should be systematically amortized over its estimated useful life. The depreciable amount is the cost of an asset less its estimated residual value.

Estimated Useful Life An intangible asset may have a finite life or an infinite life. If it is assessed that there is no foreseeable limit to the period over which the asset is expected to generate net cash inflow for the entity, the useful life of the asset will be taken as infinite. An intangible asset with infinite life will not be amortized. However, it would be tested for impairment annually and whenever there is an indication that the asset has been impaired. While arriving at the estimated useful life, various factors like expected usage of the asset, product cycle, technological and commercial obsolescence, expected actions by competitors, level of maintenance expenditure, stability of the industry, period of control over the asset, legal restriction, etc., must be considered.

Residual Value The residual value of an intangible asset is normally assumed to be zero. However, if the enterprise already has a commitment from a third party to buy the asset at the end of the useful life or if there is an active market for the asset and the residual value can be reasonably estimated, in such cases the estimated residual value can be taken.

Amortization Method Amortization method should reflect the pattern in which the economic benefits from the assets are expected to be derived by the entity. If, however, such pattern cannot be determined reliably, the assets will be amortized using straight line method. The amortization period and method shall be reviewed at least at the end of each financial year. The principles for measurement of intangible assets as per Ind AS 38 are depicted in Figure 9.4.

268  Chapter 9 Intangible Assets

Initial Measurement

At Cost

Subsequent Measurement

Revaluation Model

Cost Model

Finite Life–Cost Less Amortisation and Impairment

Infinite Life– Test for Impairment

Revaluated Amount Less Subsequent Amortization and Impairment

Figure 9.4  Measurement of Intangible Assets

9.4.4 Brand Brands, if acquired, by an enterprise can be recognized as an intangible asset at the acquisition price and all related expenses. However, internally generated brands can’t be recognized. As the cost of developing a brand is not distinguishable from the cost of doing business in general, it should not be recognized as an intangible asset. As per Ind AS 38, ‘Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance should not be recognized as intangible assets’. Expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognized as intangible assets. For example, advertising expenses incurred may lead to improved brand image of the company, however, it may not be possible to distinguish the same from the normal cost of doing business. As such these expenses are not to be capitalized.

9.4.5 Goodwill Internally generated goodwill is not allowed to be recognized. It is not considered to be an identifiable resource controlled by the enterprise that can be measured reliably at cost. However, acquired value of the goodwill is recognized at cost. As it is not possible to separately acquire goodwill, it gets recognized only at the time of acquisition of a business. Goodwill is measured as the excess of the consideration paid over net assets acquired. Consideration paid and net assets acquired are measured at their fair value. Net assets for this purpose are taken as the assets less liabilities taken over. Goodwill is not amortized rather tested for impairment annually even if there is no indication for impairment.

Accounting for Fixed Assets and Depreciation  269

■  Illustration 9.9

Wolf Limited acquired Lamb Limited for a purchase consideration of ` 1,200,000. The fair value of assets and liabilities of Lamb Limited were ` 1,800,000 and ` 700,000, respectively. What is the value of goodwill to be recorded in the books of Wolf Limited? Acquisition cost of goodwill will be calculated as follows: Fair value of assets taken over Less: Fair value of liabilities taken over Net Assets taken over

` 1,800,000 ` 700,000 ` 1,100,000

Excess of purchase consideration ( ` 1,200,000) over the net assets ( ` 1,100,000) will be taken as the acquisition cost of goodwill ( ` 100,000). Goodwill so recognized will be tested for impairment annually, even if there is no indication of impairment.

9.4.6  Research and Development Expenses In the knowledge economy of today, business enterprises spend significant sum of money on research and development. Such activities are expected to result in development of new products, designs, processes or newer application of exiting products, etc., and are expected to bring substantial economic benefits to the enterprise. The strategic advantage of a pharmaceutical business may be dependent on the new drugs it is able to develop and commercially launch. These efforts, if successful, will be a source of significant economic benefits to the enterprise in future, however at the time when these expenses are incurred it is difficult to assess whether they will generate probable future benefits. The key question that arises is whether these expenses can be capitalized as assets or should they be expensed away by charging to the statement of profit and loss. To answer this question, R&D activities are divided into two parts: 1. Research Phase: Activities are directed towards acquiring new knowledge but it is still not possible to demonstrate that an intangible asset exists capable of providing probable future benefits. 2. Development Phase: Activities are directed towards commercial development of findings of research phase; it is now possible to identity an economic asset with probable future economic benefits. Expenditure incurred on research phase should not be capitalized but expensed as period costs, as and when incurred. The development costs can be capitalized as Intangible assets if the following conditions are met2:

• • • • • •

It is technically feasible to complete the asset. There is intention to complete the asset for the purpose of sale or use. The enterprise has the ability to use or sell the asset. The asset will generate probable economic benefits. The enterprise has adequate technical, financial and other resources to compete the development and to use or sell the asset. Expenditure during development phase attributable to the asset can be measured reliably.

270  Chapter 9 Box 9.4  Research and Developments Costs • Management monitors progress of internal research and development projects by using a project management system. Significant judgement is required in distinguishing research from the development phase. Development costs are recognised as an asset when all the criteria are met, whereas research costs are expensed as incurred. • Management also monitors whether the recognition requirements for development costs continue to be met. This is necessary due to inherent uncertainty in the economic success of any product development. Source: Annual report of Cipla Limited (2016–17)

The asset so recognized will be capitalized by the expenditure incurred from the time when the asset first met the recognition criteria. Costs that have already been expenses in the past should not be added to the cost of the asset. Accounting policies being followed by CIPLA Limited relating to research and development costs are given in Box 9.4.

9.4.7  Web Site Costs Similar consideration also applies to costs incurred for developing own web site. Expenses incurred at panning stage—undertaking feasibility studies, defining objectives and specifications, evaluating alternatives and selecting preferences—are treated as research expenses and are charged to the statement of profit and loss. At this stage, it is not possible for an enterprise to identify an asset with probable economic benefits. Expenses incurred at the development stage can be capitalized as internally generated asset provided it meets the recognition criteria.

9.5  IMPAIRMENT OF ASSET Non-current assets are normally carried in the financial statements at cost less depreciation and amortization following the cost principle. If the carrying amount of the asset exceeds its recoverable amount, it is said to be impaired. Ind AS 36 requires an entity to assess whether there is any indication that an asset may be impaired. Such an assessment must be made at the end of each reporting period. If any such indication exists, the entity shall estimate the recoverable amount of the asset and provide for the impairment loss. The recoverable amount of an asset is determined with reference to its net selling price or its value in use. The carrying amount of the asset is such a case should be reduced to its recoverable amount.The impairment loss is charged as an expense in the profit and loss statement. However, if the asset has been revalued earlier, the impairment loss will be adjusted against the revaluation reserve so created. The following procedure should be followed to account for impairment of assets:

• On every balance sheet date, look for indication that an asset may be impaired. • Indications of impairment may be external (e.g., fall in the market value of the asset, adverse technical, economic or legal developments, change in interest rate) or internal (obsolescence or

Accounting for Fixed Assets and Depreciation  271

physical damage to the asset, decline in physical performance of asset, plans to discontinue or restructure the operation). • If there are indications that an asset may be impaired, measure the recoverable amount. The recoverable amount is measured with reference to its fair value less cost to sell or its value in use. • Fair value, less costs of disposal, is the amount obtainable from the sale of an asset or cashgenerating unit in an arm’s length transaction between knowledgeable and willing parties, less the costs of disposal. • The value in use is the present (discounted) value of the future cash flow that the asset is expected to generate both during its useful active life and on disposal. • If the recoverable amount is lower than the carrying amount of the asset, the difference is recognized as impairment loss in the statement of profit and loss. • After the recognition of an impairment loss, the depreciation (amortization) charge for the asset shall be adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a systematic basis over its remaining useful life. • The impairment loss is reviewed on every subsequent balance sheet date. An impairment loss is reversed if there is an increase in the recoverable amount of the asset. In such a case, the carrying amount of the asset shall be increased to its recoverable amount. The increase is also the reversal of earlier impairment loss. However, the increased carrying amount cannot exceed the carrying amount that would have been determined had no impairment loss been recognized for the asset in prior years. The key features for impairment accounting are depicted in Figure 9.5.

Impairment

Mandatory Testing

Goodwill

Intangible Assets with Infinite Life

Impairment Indicators

Internal

External

Recoverable Amount

Fair Value Less Cost of Disposal

Figure 9.5  Impairment of Asset

Value in Use

Impairment Loss

Statement of Profit and Loss

272  Chapter 9

Summary

• Expenses incurred for day-to-day operations are called operating expenses and are charged to the profit and loss statement, whereas expenses which are expected to benefit the enterprise over more than one accounting period are capitalized. Fixed assets are expected to provide benefit over long period of time.

• Assets having physical substance are called tangible assets; assets without physical substance are called intangible assets. Fixed assets may either be acquired or self-constructed.

• Acquired assets are capitalized at the sum of all costs that are necessary to be incurred to bring the asset to its intended use. Even the interest on borrowed funds upto the date of putting the asset to its intended use is capitalized.

• Self-constructed assets are capitalized at the cost directly attributable to the specific asset plus a fair share of construction activities in general. Internal profits are eliminated.

• Cost of a fixed asset is systematically apportioned over its useful life. Such an apportionment is called depreciation for tangible assets, amortization for intangible assets and depletion for natural resources.

• Depreciation charges depend upon cost of a fixed asset, estimated useful life, estimated residual value and method of depreciation.

• In the straight line method, depreciation charges remain same period after period, whereas in accelerated methods higher depreciation is charged in the initial years. Written down value method and sum-of-years-digits method are accelerated methods.

• Companies Act, 2013, prescribes the maximum useful life and residual value for different categories os assets. For tax computation only WDV method is permitted at prescribed rates for different blocks of assets.

• Small value items are charged off to profit and loss statement in the year of purchase. • Any change in method of depreciation is treated as change in accounting policy. The impact of the change needs to be quantified and disclosed separately. The change is affected prospectively

• Impairment in the value of the asset, that is, recoverable amount falling below the ­carrying amount is charged as an impairment loss in the profit and loss statement, and the carrying amount of the asset is reduced.

• Depreciation charges are transferred to the profit and loss statement. In the balance sheet the gross book value, accumulated depreciation and net book value are disclosed.

• Assets without physical substance are recorded as intangible assets if the cost can be measured reliably and the enterprise will enjoy the future economic benefits.

• Self-generated goodwill and brands are not recognized. However, acquired goodwill and brands are recorded at their cost of acquisition.

• Intangible assets are amortized over their useful life. Intangible assets with infinite life are not amortized but are tested for impairment annually.

Accounting for Fixed Assets and Depreciation  273

• Goodwill is recorded only in amalgamation as the excess of purchase consideration over the •

net assets taken over. Expenses incurred during research phase are charged to the statement of profit and loss, whereas expense during development phase can be capitalized. If it is not possible to distinguish research phase from the development phase, expenses incurred will be treated as having incurred on research and charged to the statement of profit and loss. Similar treatment is given to website cost as well.

Assignment Questions 1. ‘All expenses necessary to be incurred to bring the asset to its intended use are capitalized’. Explain with suitable examples. 2. Differentiate between: a. Operating expenses and capital expenses b. Tangible and intangible assets c. Depreciation, depletion and amortization d. Repair and improvement e. Finance lease and operating lease 3. Do you agree with the following statements? Give reasons. a. A company may follow different methods and rates of depreciation for financial accounting and tax accounting. b. Fixed assets are normally shown at their historical cost less accumulated depreciation. c. Depreciation is a source of cash for replacement of assets. 4. How is straight line method different from written down value method? 5. How is the cost model different from revaluation model for the subsequent measurement of PPE? 6. Briefly explain the accounting for revaluation of an item of PPE. 7. How is impairment different from depreciation? 8. ‘Depreciation is a non-cash expense’. Explain. 9. How are self-generated intangible assets—brand and goodwill—accounted for? 10. What is the treatment of expenditure incurred on property, plant and equipment subsequent to its initial capitalization?

Problems 1. Ascertaining the cost of an asset and capital work-in-progress: High Fashions Limited is a recognized export house. In the month of January 2017, it imported a highly sophisticated embroidery machine from US at a cost of $ 200,000. At the time of import, the prevailing exchange rate was $ = ` 65. The company incurred an amount of ` 100,000 towards freight and insurance during transit. The import attracted import duty at the rate of 20%. The machine was transported to the factory building at an additional cost of ` 20,000 towards local transportation. Expenses towards installation came to ` 30,000. The installation was completed on 31st March 2017. The test runs

274  Chapter 9

were conducted during April 2017. During the test run company spent a further sum of ` 25,000. After successful test run the machine was put to commercial use. a. How would the amounts spent upto 31st March 2017 impact the balance sheet as on that date and the statement of profit and loss for the year ended on that date? b. When and at what value the machine should be capitalized? 2. Straight line method of depreciation: Satluj Cements Limited purchased a machine costing ` 15 million. As per suppliers warranty, the physical life of the machine is estimated to be eight years. However, the management would like to replace the machine after five years. At that time, the machine is expected to fetch a residual value of ` 5 million. a. What will be the annual depreciation if the company follows the straight line method of charging depreciation? b. How will the asset and depreciation appear in the second year’s balance sheet and profit and loss statement of Satluj Cements Limited after acquisition of the machine? 3. Written down value method: Assume that Satluj Cements Limited charges depreciation on the written down value method basis and the rate of depreciation being 20% per annum. a. Prepare the depreciation schedule for the above machine over its useful life. b. Pass the necessary journal entries in the books of Satluj Cements Limited. c. How will the machine appear in the balance sheet after three years of acquisition? 4. SOYD method: Prepare the depreciation schedule for Satluj Limited using SOYD method. a. Compare the depreciation schedule of SOYD with WDV and SLM. b. Why are WDV and SOYD methods called accelerated methods of depreciation? 5. Exchange of assets: Fast Track Limited is a provider of cab services in New Delhi. The company purchased a new car with a list price of ` 800,000 in exchange of an old car and cash consideration of ` 680,000. The old car was purchased four years back at a cost of ` 500,000 and the accumulated depreciation of the same is ` 400,000. The company recently received a bid for the old car at ` 90,000. At what value should the new car be capitalized? 6. Financial accounting versus tax accounting: Aar Dee Limited bought a machine for ` 600,000. The management estimates a useful life of 10 years for the machine after which it can be sold for ` 30,000. For accounting purposes, the company charges depreciation on SLM basis. Whereas for tax purposes the machine is eligible for depreciation at 25% on WDV basis. a. Prepare the depreciation schedule for financial accounting as well as tax accounting? b. How would the depreciation charge cause difference between taxable income and reported profit in each of these years? 7. Disposal of assets: A-One Industries follows financial year as its accounting period. On 1st December 2013, the company bought five computers for a total consideration of ` 500,000. The company estimates the useful life of the computers to be four years with negligible residual value. The company charges depreciation on a SLM basis. In the year of acquisition and disposal proportionate depreciation is charged.   On 15th January 2015, the hard disk of one of the computer became corrupted beyond repairs and accordingly the computer was disposed of for ` 30,000. The company sold two of the computers on 31st July 2016 for ` 80,000. The other two computers are still in working condition. a. Prepare the depreciation schedule for the years 2013–14 to 2016–17 b. Pass the necessary journal entries in the books of A-One Industries. c. How would the remaining two computers appear in the balance sheet of the company on 31st March 2017?

Accounting for Fixed Assets and Depreciation  275

8. Asset partially funded by government grant: Pure Copper Limited bought pollution control equipments costing ` 30 million. As per the scheme of the government, to promote use of pollution control devices, 40% of the cost of the equipment is given as a grant. The equipment is estimated to have a useful life of three years will nil residual value. The company follows straight line method of charging depreciation. a. How will the acquisition be initially recorded? b. How will the equipment and grant appear in the first balance sheet after acquiring the equipment? c. What will be the impact of government grant in the profit and loss account? 9. Revision of estimated useful life: Clarity Printers Limited bought a printing press on 1st April 2008 at a cost of ` 3 million. The management estimated the useful life of the press to be 10 years with a residual value of ` 200,000. The machine was depreciated using SLM till 2016–17. On 1st April 2017, based upon a technical review of the press, the management incurred a cost of ` 500,000 for overhauling the press. It is estimated that after overhauling, the press, will be useful for another five years and will have a residual value of ` 100,000. a. How will the cost of overhauling be treated? b. What will be the revised annual depreciation? 10. Change in method of depreciation: Please refer to the Problem 2 above. After depreciating the machine for three years using SLM, in the fourth year Satluj Cements decided to change the method of depreciation to WDV at 20% per annum. How will the change affect the profit and loss statement and balance sheet of the company? 11. Recognition of goodwill on amalgamation: Italian Ceramics Limited acquired Sonia Tiles Limited for a purchase consideration of ` 20 million. The fair value of assets and liabilities taken over are as follows: Particulars

( ` in Million)

Assets Land and building

8.5

Plant and machinery

7.9

Other assets

6.0

Liabilities Trade payables



4.5

a. Ascertain the value of goodwill to be recorded in the above transaction. b. How will the goodwill amount be treated in the books of Italian Ceramics Limited?

Solutions to Problems 1. a. As the machine is not ready for use by 31st March 2017, the amount spent will be shown as capital work-in-progress in the balance sheet under the heading fixed assets. There will be no impact in the profit and loss statement for the year ended 31st March 2017, as depreciation will commence only after the machine is ready for its intended use. b. As all the expenses incurred were necessary to be incurred to bring the machine to its intended use, all of them will be added to find the capitalized value of the machine.

276  Chapter 9



Accordingly, the machine will be capitalized at ` 14,975,000 as follows: Particulars

(Amount in ` )

Purchase price ($200,000 × 65) Freight and insurance Import duty at 20% Local transport Installation expenses Test run

13,000,000 100,000 1,800,000 20,000 30,000 25,000 14,975,000

2. Cost of the machine (Cost) ` 15 million Estimated useful life (Life) 5 years Estimated residual value (RV) ` 5 million Annual depreciation Cost − RV ` 2 million Life In the second year profit and loss account, depreciation of ` 5 million will appear as an expense. In the balance sheet the machine will appear on the asset side as follows: Particulars

( ` in Million)

Fixed assets Property, plant and equipment Less: Accumulated depreciation Net block

15 4 11

3. a. Cost ` 15 million Rate of depreciation 20% Depreciation Schedule

Year 1 2 3 4 5

( ` in Million) Depreciation

Book Value after Depreciation

3.0000 2.4000 1.9200 1.5360 1.2288

12.0000 9.6000 7.6800 6.1440 4.9152

c. In the third year profit and loss statement, depreciation of ` 1.92 million will appear as an expense. In the balance sheet, the machine will appear on the asset side as follows: Particulars

( ` in Million)

Fixed assets Property, plant and equipment

15.00

Less: Accumulated depreciation

 7.32

Net block

 7.68

Accounting for Fixed Assets and Depreciation  277

4. SOYD Depreciable Amount

N × (N + 1)/2 Cost − RV

15 ` 10 million

Depreciation Schedule Using SOYD

( ` in Million)

Year

Depreciation for the Year

1

5/15 × 10 = 3.33

2

4/15 × 10 = 2.67

3

3/15 × 10 = 2.00

4

2/15 × 10 = 1.33

5

1/15 × 10 = 0.67

5. The capitalized value of the new car will be as follows: Cash consideration Fair market value of old car given up

` 680,000   ` 90,000

Total

` 770,000

6. The new car will be capitalized at ` 770,000 Cost of the machine ` 600,000 Residual value   ` 30,000 Useful life 10 years Depreciation for income tax 25% WDV Year

Depreciation on SLM

Depreciation on WDV at 25%

 1

57,000

150,000

 2

57,000

112,500

 3

57,000

84,375

 4

57,000

63,281

 5

57,000

47,461

 6

57,000

35,596

 7

57,000

26,697

 8

57,000

20,023

 9

57,000

15,017

10

57,000

11,263

In the first four years, depreciation for income tax purposes on WDV is higher as compared to depreciation for financial accounting purposes on SLM. Accordingly, the taxable income in the first four years will be lower than the reported profit. In subsequent years, the taxable income will be higher than the reported profit. 7. a. Cost ` 500,000 Useful life 4 years Annual depreciation per machine ` 25,000

278  Chapter 9 Computer Sold on 15th Jan 2015

Computers Sold on 31st July 2016

Remaining Computers

Total Depreciation

2013–14

8,333

16,667

16,667

41,667

2014–15

19,792

50,000

50,000

119,792

2015–16



50,000

50,000

100,000

2016–17



16,667

50,000

66,667

Year

Sale price 30,000 80,000 Book value at the time of disposal 71,875 66,667 Gain/(Loss) on disposal (41,875) 13,333 In the balance sheet as on 31st March 2017, only the remaining two computers will appear on the asset side with a gross value of ` 200,000 and accumulated depreciation of ` 166,667 as follows: Tangible Assets (Amount in `)   Property, plant and equipment 200,000 Less: Accumulated depreciation 166,667   Net block 33,333 8. a. The equipment will be capitalized at ` 30 million and at the same time the grant of ` 12 million will be recorded as a deferred income to be apportioned over the life of the asset. b. Property, plant and equipment   Pollution control equipment ` 30 million Less: Accumulated depreciation ` 10 million   Net Block ` 20 million Liabilities side   Government grant Less: Transferred to profit and loss statement

` 12 million ` 4 million ` 8 million

c. Statement of Profit and loss Depreciation (1/3rd of ` 30 million) Less: Transferred from deferred income

` 10 million ` 4 million ` 6 million

9. a. The cost of overhauling is resulting in extending the useful life of the asset and hence will be capitalized by adding to the net book value.

b. Annual depreciation from 2008–09 till 2016–17 = (` 3,000,000 − ` 200,000)/10 = ` 280,000 Accumulated depreciation as on 31st March 2017 = ` 280,000 × 9 = ` 2,520,000 Net book value of the press on 31st March 2017 = ` 3,000,000 − ` 2,520,000 = ` 480,000 Add: Overhauling cost capitalized = ` 500,000 Revised book value = ` 980,000 Revised estimated remaining life = five years Revised annual depreciation = (` 980,000 − ` 100,000)/5 = ` 176,000

Accounting for Fixed Assets and Depreciation  279

10. The change in method of depreciation would be recognized prospectively. The carried amount of the machinery will be depreciated as per the new method. At the end of the third year, the carried amount of the machine is ` 9 million (` 15 million less depreciation for three years @ ` 2 million per annum on straight line basis). From the fourth year onwards, the machine will be depreciated @ 20% on WDV basis. In the fourth year, the statement of profit and loss will be charged by ` 1.8 million being 20% of ` 9 million. In the balance sheet at the end of the fourth year, the machinery will be included in the property, plant and equipment at ` 7.2 million (Gross amount ` 15 million less accumulated depreciation ` 7.8 million). 11. a. Fair value of assets ` 22.4 million Fair value of liabilities   ` 4.5 million Net assets ` 17.9 million Goodwill = Purchase consideration − Net assets Goodwill = ` 20 million − ` 17.9 million = ` 2.1 million

b. The goodwill amount will appear in the balance sheet under the heading non-current assets. It will be annually tested for impairment.

Try It Yourself 1. Capital expenses versus operating expenses: Sam Limited incurred the following expenditure during the year 2016–17. Please state whether each of them should be treated as operating expenses for the year or capitalized as an asset.

a. A calculator was purchased for office use for ` 400. b. Incurred ` 50,000 towards repair of a machine which had a major breakdown. c. Incurred ` 675,000 for overhauling a second hand machine recently purchased. d. A FMCG company sponsored a cricket series incurring ` 50 million towards the sponsorship fees. It is expected that it will enhance the brand value of the company. e. Paid ` 1 million to an author for buying the copyrights of his new book. f. Paid ` 100,000 towards insurance of a new machine while it was being transported to the factory premises for installation. g. Incurred ` 700,000 for replacing a major part that has become faulty. It is expected that the new part will also result in increasing the capacity of the machine by 20%. h. Expenses incurred by a pharmaceutical company on research activities. 2. Acquisition cost of an asset: King Kong Limited acquired a piece of land for setting up a factory for ` 50 million on 1st October 2016. It took a loan of ` 30 million from the State Bank of India at 10% for this purpose, the balance being met from internal resources. It also incurred 1% of the cost of land towards commission to the real estate agent and 5% towards the registration fees. The earlier owner has defaulted on payment of property tax and the same was also paid by the company amounting to ` 50,000. It incurred ` 1 million towards clearing and fencing of the land. The construction of factory premises commenced on 1st January 2017 and completed on 31st December 2017. The company repaid the loan to the State Bank of India on 31st March 2018. You are required to determine the cost at which the land will be capitalized in the books of King Kong Limited.

280  Chapter 9

3. Different methods of depreciation: M P Precision Limited bought equipment for ` 14.50 million. The company estimates that the useful life of the equipment is 10 years with a residual value of ` 2.5 million. a. Prepare the depreciation schedule of the equipment using straight line method (SLM) of depreciation. b. Assuming that the equipment is eligible for claiming depreciation at 40% per annum on written down value (WDV) basis. Calculate depreciation for tax accounting purposes. c. What will be the impact of reported profit vis-à-vis taxable income? 4. Change in estimated useful life: Hind Alloy Limited follows straight line method of depreciation for plant and machinery. The company charges proportionate depreciation in the year of acquisition. It bought a machine for ` 5 million on 1st October 2015. The machine was expected to have a useful life of eight years with residual value of ` 500,000. Due to the technological changes, on 1st April 2017 the company decided to revise the remaining useful life to four years. You are required to compute depreciation charges for the financial years 2016, 2017 and 2018. 5. Goodwill on acquisition: Sona Software Limited acquired Mona Hardware Limited for a cash consideration of ` 300 million. The fair value of assets and liabilities taken over are as follows: Particulars Assets Cash and bank balance Land and building Plant and machinery Trade receivables Other assets Liabilities Trade payables Other liabilities

a. b.

( ` in Million) 11.10 97.25 105.20 66.45 26.50 44.25 12.85

Ascertain the value of goodwill to be recorded in the above transaction. How will the goodwill amount be treated in the books of Sona Software Limited?

Cases Case 9.1: HCL Technologies Limited—Accounting Policy relating to Property, Plant and Equipment HCL Technologies Limited is a leading IT solution provider company with operations is 32 countries and 116,000 employees. The global revenue of the company exceeded USD 7.2 billion. HCL Technologies provides solutions built around digital, IoT, cloud, automation, cybersecurity, analytics, infrastructure management and engineering services. The carrying amount of property, plant and equipment (PPE) increased from ` 2,762.90 crore as on 31st March 2016 to ` 3,126.45 crore as on 31st March 2017. During the same period, the capital work-in-progress declined from ` 582.12 crore to ` 410.53 crore.

Accounting for Fixed Assets and Depreciation  281

Details of the PPE as provided in Note 3 to the balance sheet are reproduced below:

Gross block as at 1 April 2016 Additions Acquisitions through bussiness combinations Disposals Translation exchange differences Gross block as at 31 March 2017 Accumulated depreciation as at 1 April 2016 charge for the year Acquisitions through business combinations Deduction / other adjutments Transalations exchange differences Accumulated depreciation as at 31 March 2017 Net block as at 31 March 2017

Vehicles Paint and Office Furniture Computers Equipment Equipment and Fixures Owned Leases

Freehold Land

Building

48.34

2,090.92

1,080.31

194.05

1,129.37

472.29

101.03

2.56



372.00

107.40

16.86

166.64

19.41

30.19



712.32



28.12

5.97

2.88

0.23

2.45





39.65





20.85

3.90

11.33

21.45

23.63

2.30

83.46





(0.11)

(0.11)

(0.73)

(0.27)





(1.22)

2,491.04

1,172.72

209.78

1,284.00

472.43

107.59

0.26

5,786.16



377.66

598.14

152.25

826.99

351.24

49.12

0.57

2,355.97



115.63

75.59

16.60

118.28

27.73

20.71



74.54

48.34

Total 5,118.87





















0.09

15.53

3.86

10.38

19.43

20.48

0.38

70.15





(0.02)

(0.03)

(0.44)

(0.16)





(0.65)

493.20

658.18

164.96

934.475

359.38

49.35

0.19

2,659.71

1,997.84

514.54

44.82

349.55

113.05

58.24

0.07

3,126.45

– 48.34

Some of key accounting policies relating to accounting for property, plant and equipment of the company are: • Property, plant and equipment are stated at cost less accumulated depreciation and impairment losses, if any. Cost comprises the purchase price and directly attributable cost of ­bringing the asset to its working condition for its intended use. Any trade discounts and rebates are deducted in arriving at the purchase price. The company identifies and determines separate useful lives for each major component of the property, plant and equipment if they have a useful life that is materially different from that of the asset as a whole. • Subsequent expenditure related to an item of property, plant and equipment is added to its book value only if it increases the future benefits from the existing asset beyond its previously assessed standard or period of performance. All other expenses on existing property, plant and equipment, including day-to-day repairs, maintenance expenditure and cost of replacing parts, are charged to the statement of profit and loss for the year during which such expenses are incurred. • Gains or losses arising from de-recognition of assets are measured as the difference between the net disposal proceeds and the carrying amount of the asset and are recognized in the statement of profit and loss when the asset is derecognized.

282  Chapter 9

• Property, plant and equipment under construction and cost of assets not ready for use at the year-end are disclosed as capital work-in-progress.

• Depreciation on property, plant and equipment is provided on the straight line method over •

their estimated useful lives, as determined by the management. Depreciation is charged on a pro-rata basis for assets purchased/sold during the year. The management’s estimates of the useful lives of various assets for computing depreciation are as follows: Asset description Asset life (in years) Buildings 20 Plant and equipment    (including air conditioners and electrical installations) 10 Office equipment’s 5 Computers 4–5 Furniture and fixtures 7 Vehicles—owned 5 Vehicles–leased Over the period of lease or 5 years, whichever is lower. Leasehold–improvements Over the lease period or useful life of the asset, whichever is lower.

• The useful lives as given above best represent the period over which the management expects

• • •

to use these assets, based on technical assessment. The estimated useful lives for these assets are therefore different from the useful lives prescribed under Part C of Schedule II of the Companies Act, 2013. The residual values, useful lives and methods of depreciation of property, plant and equipment are reviewed at the end of each financial year and adjusted prospectively, if appropriate. Borrowing costs directly attributable to the acquisition, construction or production of an asset that necessarily takes a substantial period of time to get ready for its intended use or sale are capitalized as part of the cost of the asset. Intangible assets and property, plant and equipment are evaluated for recoverability whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. If such assets are considered to be impaired, the impairment to be recognized in the statement of profit and loss is measured by the amount by which the carrying value of the asset exceeds the estimated recoverable amount of the asset.

Questions for Discussion 1. Explain the expression capital work-in-progress. Why is there a decline in the carrying amount of the same? 2. The company is using cost model for the subsequent measurement of PPE. How is it different from the revaluation model? 3. State the principle for the initial measurement of PPE. What costs are included in the initial measurement? 4. What is the treatment of subsequent expenditure on property, plant and equipment? 5. How is depreciation different from impairment? 6. Why are the borrowing costs capitalized?

Accounting for Fixed Assets and Depreciation  283

Case 9.2: Biocon Limited—Accounting Policy relating to Intangible Assets Biocon Limited is India’s largest and fully-integrated biopharmaceutical company that develops, manufactures and supplies advanced, life-saving biopharmaceuticals for diabetes, cancer and autoimmune conditions at price points that make them affordable and thus accessible. The company has built world-class R&D competence and capability on the back of robust infrastructure and a talent pool that has extensive global product development experience. R&D’s core strategy is based on integrated discovery, stage-gated approach to development, core disease area expertise (autoimmune and inflammation, oncology and diabetes), and a first-rate scientific advisory board.3 Research and Development • Expenditure on research activities is recognized in statement of profit and loss as incurred. • Development expenditure is capitalized as part of the cost of the resulting intangible asset only if the expenditure can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable, and the company intends to and have sufficient resources to complete development and to use or sell the asset. Otherwise, it is recognized in statement of profit and loss as incurred. Subsequent to initial recognition, the asset is measured at cost less accumulated amortization and any accumulated impairment losses. Others • Other intangible assets are initially measured at cost. Subsequently, such intangible assets are measured at cost less accumulated amortization and any accumulated impairment losses. Subsequent Expenditure • Subsequent expenditure is capitalized only when it increases the future economic benefits embodied in the specific asset to which it relates. All other expenditure, including expenditure on internally generated goodwill and brands, is recognized in statement of profit and loss as incurred. Amortisation • Goodwill is not amortized and is tested for impairment annually. • Other intangible assets are amortized on a straight line basis over the estimated useful life as follows: –– Computer software 3–5 years –– Marketing and manufacturing rights 5–10 years –– Customer related intangibles 5 years • Amortization method, useful lives and residual values are reviewed at the end of each financial year and adjusted, if appropriate.

Questions for Discussion 1. Biocon Limited is not capitalizing expenditure on research but development expenditure is capitalized. Explain the reasons. 2. Briefly explain the accounting policy of Biocon relating to the initial and subsequent measurement of intangible assets. 3. How is the amortization of goodwill by Biocon Limited different from amortization of other intangible assets?

284  Chapter 9

Case 9.3: GE Shipping Limited—Accounting for Impairment4 GE Shipping is the largest shipping company in private sector in India. As on 31st March 2009, it had 39 ships in its fleet with a total tonnage of 2,881,624. The company reviews the carrying amounts of tangible and intangible assets each balance sheet date to determine whether there is any indication of impairment. If any such indication exists, the assets’ recoverable amounts are estimated in order to determine the extent of impairment loss, if any. An impairment loss is recognized whenever the carrying amount of an asset exceeds its recoverable amount. The impairment loss, if any, is recognized in the statement of profit and loss in the period in which impairment takes place. Where an impairment loss subsequently reverses, the carrying amount of the asset is increased to the revised estimate of its recoverable amount, however, subject to the increased carrying amount not exceeding the carrying amount that would have been determined (net of amortization of depreciation) had no impairment loss been recognized for the asset in prior accounting periods. During the year 2008–09, the company recognized an impairment of ` 70 crore in respect of one dry bulk carrier in accordance with Accounting Standard (AS) 28 consequent to a sharp fall in the recoverable value of the said asset. In the opinion of the management, the book value of this asset, after correcting for the impairment recognized is aligned closer to the current market price and also broadly reflected the earnings expectations from it. For the year 2008–09, the company charged depreciation of ` 348.48 crore and in addition impairment loss of ` 70 crore as aforesaid was provided for.

Questions for Discussion 1. What is the purpose behind impairment of assets? How is impairment different from depreciation? 2. What are factors GE Shipping Limited might have considered to arrive at the figure of impairment loss? 3. What is the impact of impairment loss on the profit and loss statement and balance sheet of the company? 4. Assume that on the next balance sheet date the management estimates that the carrying amount of the vessel in question has increased by ` 60 crore. What will be the impact of such reassessment? Case 9.4: Patni Computers Limited—Goodwill on Acquisition Patni Computers Limited, a leading company in IT sector in India, is engaged in consulting, software development and business process outsourcing. It has grown organically and also through acquisition route. It acquired business and assets of LOI, a European telecommunications consulting services company on 2nd July 2007. The company believes that through this acquisition it will strengthen its presence in communication and media practice through consultancy services on IT initiatives. The purchase price of ` 349,099 (including direct expenses of ` 34,419) was paid in cash. The company allocated the purchase price to the acquired assets as per management’s estimates and independent valuation of fair values as follows: (` in Thousands) Intangible assets   Customer contracts and non-contractual customer relationships 55,625   Intellectual property rights 32,075 Total 87,700 Goodwill 261,399 Total purchase price 349,099

Accounting for Fixed Assets and Depreciation  285

The company made another acquisition on 23rd July 2007. Patni USA acquired 100% equity in Tatatec Development Corporation. Tatatec is a leading consulting company in the life sciences industry providing integrated business, information technology and regulatory compliance products and services. The acquisition is expected to enhance Patni’s market specific services and provide additional capability to support the growing and diverse requirements of the life sciences market. The purchase price of ` 638,342 (including direct acquisition related expenses of ` 17,331), was paid in cash. The company allocated the purchase price net of cash acquired of ` 115,770 to the acquired assets and assumed liabilities as follows: (` in Thousands) Net current assets 102,953 Deferred tax asset 37,478 Property, plant and equipment 3,442 Goodwill 378,699 Total purchase price 522,572

Questions for Discussion 1. Can a company capitalize self-generated goodwill? 2. What does ‘goodwill’ represent on acquisition? 3. A large part of the purchase consideration in the above cases has been allocated towards ‘goodwill’. How do you ensure that these allocations are objectively done? 4. What will be the impact of these transactions in the financial statements of Patni Computers Limited? Case 9.5: Pantaloon Retail (India) Limited—Self-generated Brand Pantaloon Retail (India) Limited is the leading retailer of India operating through multiple retail formats. The company was incorporated in the year 1987 and went public during 1992 through its maiden initial public offer (IPO). Over a period of time, the company has established itself in Indian retail market both in value segment and in lifestyle segment. The company closes its accounts on 30th June every year. During the year 1999–2000, the company carried out an exercise for valuation of its brand. In the notes to accounts the company stated that ‘the company based on the valuation report by an independent valuer has valued its brands at ` 11,770.0 lakh as at 30th June 2000. Accordingly, the brands have been shown in the fixed assets and credited the capital reserve. Since the expenditure in the earlier year and current year has been incurred towards brand building shown under the head deferred revenue expenditure, the balance amount of ` 11,71.25 lakh has been adjusted against capital reserve account.’ The summarized balance sheets as on 30th June 1999 and 2000 are given as follows:  Particulars Share capital Reserve and surplus

( ` in Lakhs) June 2000 1,251.94

926.44

13,076.70

1,048.21

Share application money Loans funds

June 1999

400.00 3,434.30

2,877.36 (continued )

286  Chapter 9 (continued )

 Particulars

( ` in Lakhs) June 2000

June 1999

 

17,762.94

5,252.01

Fixed assets

13,532.95

1,065.97

984.77

833.82

6.53

7.82

3,150.02

2,408.20

88.67

936.20  

17,762.94

5,252.01

Capital work-in-progress Investments Net current assets Miscellaneous expenditures (To the extent not written off or adjusted)  

The ICAI issued AS 26 ‘Intangible Assets’ with effect from 1st April 2003. AS 26 inter-alia provided that ‘Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance should not be recognized as intangible assets’. Ind AS 38 also prohibits capitalization of internally generated brands, etc. The company it its accounts for the year 2003–04 stated that ‘in terms of AS-26 “Accounting for Intangible Assets” issued by the Institute of Chartered Accountants of India, self-generated brands cannot be capitalized. Accordingly, in compliance with AS-26 the brands of ` 11,770.00 lakh have been eliminated with a corresponding debit of ` 10,598.75 lakh to the capital reserves and ` 11,71.25 lakh to the balance of Revenue Reserves’. The impact of the above on the summarized balance sheets as on 30th June 2003 and 2004 is given as follows:  Particulars

( ` in Lakhs) 2004

2003

Share capital

1,913.74

1,818.44

Reserve and surplus

7,575.29

16,719.95

23,664.90

14,554.95

603.01

292.13

 

33,756.94

33,385.47

Fixed assets

16,038.79

22,500.98

1,444.14

332.37

Loans funds Deferred tax liability

Capital work-in-progress Investments Net current assets Miscellaneous expenditures (To the extent not written off or adjusted)  

526.23

526.12

15,707.77

9,972.78

40.01

53.22

33,756.94

33,385.47

Accounting for Fixed Assets and Depreciation  287

Questions for Discussion 1. Identify the impact of recognizing the brand value on the balance sheet as on 30th June 2000. 2. Identify the impact of writing-off the brand value on the balance sheet as on 30th June 2004. 3. How do you justify the AS 26 and Ind AS 38 prohibiting recognition of internally generated brands? 4. How is accounting for internally generated brands different from acquired brand?

Endnotes 1. 2. 3. 4.

Ind AS 8, ‘Accounting Policies, Accounting Estimates and Errors’. ICAI: Ind AS 38—Intangible Assets Official website of the company www.biocon.com Annual Report of GE Shipping Limited for the year 2008–09

Accounting for Investments

10 CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand issues involved in accounting and reporting of investments. • Classify investments into different categories. • Account for fair value changes in different categories of investments. • Understand the impact of investment accounting on financial statements of an entity. • Appreciate the requirements of Ind AS 109 and Ind AS 28 relating to investments.

10.1 INTRODUCTION An entity may invest in the financial instruments (e.g., shares and debentures) issued by another entity. These investments are not made for the purpose of manufacturing, administrative or marketing activities of the investors. Investment may be made with the intention to earn periodic income (dividend or interest) and/or to benefit from the appreciation in the value of these investments. Alternatively, these investments are for further business objectives, for example, investment made in a subsidiary or in joint venture. As we would discuss, the initial and subsequent measurement of investment is dependent upon the intended purpose for which it has been made.

10.2  CLASSIFICATION OF INVESTMENTS As discussed in the Chapter 6, investments are classified as current and non-current based upon the intended time horizon. Current investments are intended by the company to be sold within twelve months or within the company’s operating cycle. This also includes investments which have a remaining maturity of less than twelve months or within the company’s operating cycle. All other investments are classified as non-current. Investments (both current and non-current) are required to be further classified as:

• • • •

Investments in equity instruments Investment in preference shares Investments in government or trust securities Investments in debentures or bonds

Accounting for Investments  289

• Investments in mutual funds • Investments in partnership firms • Other investments (specify nature) Under each of the above-mentioned category, investments made in subsidiaries, associates, joint ventures, or structured entities are separately identified. The aggregate amount of quoted investments (with market value) and unquoted investments are also required to be disclosed. For subsequent measurement, investments are required to be classified based upon the entity’s business model for managing the investment and the contractual cash flow characteristics of the investment. As per Ind AS 109, investments are classified as:

• Subsequently measured at amortized cost (AC). • Subsequently measured at fair value through other comprehensive income (FVTOCI). • Subsequently measured at fair value through profit or loss (FVTPL). The business model test considers the intention behind the investment—to collect contractual cash flows till maturity or to sell prior to maturity or both. The cash flow characteristics test considers the type of the instrument—certain interest and repayment of principal or not. The above classification does not apply to the interest in associates and joint ventures that are accounted for using the equity method discussed later in this chapter.

10.2.1  Measured at Amortized Cost For an investment to be classified in this category, the following conditions need to be satisfied:

1. Investment are held within a business model whose objective is to collect contractual cash flows. 2. Contractual terms of the financial asset give rise on (specified dates) to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Investment in debt instruments which give rise to certain cash flows on specified dates, with the intention to hold them till maturity, will be classified in this category.

10.2.2  Measured at Fair Value Through Other Comprehensive Income For an investment to be classified as FVTOCI, the following conditions need to be satisfied:

1. Investment are held within a business model whose objective is to collect contractual cash flows and sell financial assets. 2. Contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Investment in debt instruments which give rise to certain cash flows on specified dates with the intention to collect contractual cash flows and sell them before maturity to meet certain cash flow requirements will be classified as FVTOCI.

10.2.3  Measured at Fair Value ThroughProfit or Loss (FVTPL) An investments which is neither classified as AC nor FVTOCI as aforesaid will be classified as measured at fair value through profit or loss (FVTPL). Investment in equity instruments will get classified under this category as it fails to meet the cash flow characteristics test.

290  Chapter 10 Debt Instruments

Fair Value through OCl

Amrotized Cost

To collect Contractual Cash Flows

Cash Flows by Way of Interest and Principal on Specific Dates

To Collect Contractual Cash Flows and by Selling Investment

Fair Value through Profit or Loss

Cash Flows by Way of Interest and Principal on Specific Dates

Other Debt Instruments

Irrevocable Election at Initial Recognition to Measure through Profit or Loss

Figure 10.1  Classification of Debt Instruments

An entity may make an irrevocable election at initial recognition for particular investments in equity instruments that would otherwise be measured at fair value through profit or loss to present subsequent changes in fair value in other comprehensive income. Likewise, an entity may make an irrevocable election at initial recognition to designate a particular investment as ‘measured at fair value through profit or loss.’ Such option is irrevocable and can be made if doing so eliminates or significantly reduces a measurement or recognition inconsistency. The classification of debt instruments based upon the above discussion is presented in Figure 10.1. In general, debt instruments that are intended to be held till maturity to collect contractual cash flows will be classified as ‘to be measured at amortized cost’. Debt instruments that are held for collecting contractual cash flows and by selling them before maturity will be classified as ‘to be measured at fair value through other comprehensive income’. Other debt instruments (which are held for trading or are irrevocably designated as such) will be classified as ‘to be measured through profit or loss’. The classification of equity instruments is presented in Figure 10.2. Equity Instruments

Fair Value through OCl

Fair Value through Profit or Loss

Irrecovable Election at Initial Recognition to Measure through OCl

Other Equity Intruments

Figure 10.2  Classification of Equity Instruments

Accounting for Investments  291

Equity does not generate contractual cash flows, and hence, fail the cash flow characteristics test. Therefore, equity instruments are classified as ‘to be measured through profit or loss’. However, at the time of the initial recognition, an entity may decide irrevocably to designate such investments as FVTOCI. Once the option to treat equity investments as FVTOCI is taken, it cannot be subsequently changed. Equity investment held for trading are not allowed to be designated as FVTOCI, and therefore, they would always be treated as FVTPL. ■  Illustration 10.1

Classify the following investments as ‘to be measured at amortized cost’, ‘to be measured at fair value through OCI’ or ‘to be measured at fair value through profit or loss’.

1. Investment made in 1,000 equity shares of an unlisted company. 2. Investment made in government securities with the intention to collect contractual cash flows. 3. Investment made in the equity shares of a listed company. The shares are regularly traded, but the company has no intention of trading. 4. Investment made in corporate debentures which are unlisted. 5. Investments made in a 10 years bond. The company intends to sell these bonds after three years to raise money for replacement of a machine. 6. Investments made in a 10 years bond to be held till maturity. However, the company may sell them if there is a significant decline in the market interest rate. 7. Investment made in listed corporate debentures with the intention to trade.

Solution:

1. To be measured at fair value through profit or loss, unless the company makes an irrevocable election to classify them as at fair value through OCI. 2. To be measured at the amortized cost as the intention is to collect contractual cash flows. 3. To be measured at fair value through profit or loss, unless the company makes an irrevocable election to classify them as at fair value through OCI. 4. To be measured at the amortized cost as the intention is to collect contractual cash flows. 5. To be measured at the fair value through OCI as the intention is to collect the contractual cash flows and selling the debentures. 6. To be measured at the amortized cost as the intention is to collect contractual cash flows. 7. To be measured at the fair value through profit or loss as the objective is trading.

10.3 MEASUREMENT In this section, we will discuss the initial and subsequent measurement of investments classified as above.

10.3.1  Initial Measurement Investments are initially measured at their fair value plus direct acquisition costs. Transactions costs that are directly attributable to the acquisition of investments are included. For example, registration and other regulatory fees, advisory fees to legal, accounting and other professionals, printing costs and stamp duties. Transaction costs are, however, not considered in the case of FVTPL investments.

292  Chapter 10

10.3.2  Subsequent Measurement Investments, after initial recognition, are measured based upon their classification. Investments that are classified as ‘measured at amortized cost’ are tested for impairment. The gain or loss on fair value measurement is recognized either in OCI or profit and loss, depending upon its classification. Table 10.1 summarizes rules for subsequent measurement. Table 10.1  Subsequent Measurement of Investments

Subsequent Measurement

Impairment Testing

At amortized cost

Amortized cost less impairment, if any

Yes

Impairment loss through profit or loss

Fair value through OCI

At fair value

No

Through OCI

Fair value through profit At fair value or loss

No

Through profit or loss

Classification

Value Change

10.3.3 Reclassification An entity may subsequently reclassify investments from one category to another. Such a reclassification is permitted only if there is a change in the business model for managing its investments. For example, a portfolio which was earlier intended to be held till maturity (and hence measured at amortized cost) may be converted to trading portfolio (and hence measured at fair value through profit or loss). If there is a change in the business model, all the affected investments shall be reclassified. Reclassification will apply prospectively from the reclassification date, and therefore, previously recognized gains or losses (including impairment) will not be restated. Table 10.2 summarizes the impact of reclassification. Table 10.2  Impact of Reclassification of Investments

Reclassification

Measurement

Treatment of Difference Arising Due to Reclassification

Amortized cost to FVTPL

FV at reclassification Difference between amortized cost and fair value date recognized through profit or loss

FVTPL to amortized cost

FV at reclassification date to be the new carrying amount

Amortized cost to FVTOCI

FV at reclassification Difference between amortized cost and fair value date recognized through OCI



(Continued)

Accounting for Investments  293

Reclassification

Measurement

Treatment of Difference Arising Due to Reclassification

FVTOCI to amortized cost

FV at reclassification Cumulative gain or loss previously recognized date to be the new through OCI is removed from other equity and carrying amount adjusted against the fair value of investment. As a result, the financial asset is measured at there classification date as if it had always been measured at amortized cost.

FVTPL to FVTOCI

No change— continue at FV

FVTOCI to FVTPL

No change— continue at FV

– Cumulative gain or loss previously recognized through OCI is removed from other equity and recognized in profit or loss as a reclassification adjustment

■  Illustration 10.2

How would you treat the following reclassification of investments consequent upon change in the business model of an entity?

1. Investment at amortized cost (`30 million) to be reclassified as FVTPL. The fair value on the date of reclassification is `32 million. 2. Investment at FVTPL (`35 million) to be reclassified as amortized cost. 3. Investment at amortized cost (`30 million) to be reclassified as FVTOCI. The fair value on the date of reclassification is `28 million. 4. Investment at FVTOCI (`35 million) to be reclassified as amortized cost. Accumulated gain, previously recognized in OCI as a part of other equity, amounts to `4 million. 5. Investment at FVTPL (`35 million) to be reclassified as FVTOCI. 6. Investment at FVTOCI (`35 million) to be reclassified as FVTPL. Accumulated loss, previously recognized in OCI as a part of other equity, amounts to `6 million

Solution



1. Investment will be shown at `32 million, i.e., the fair value on the date of reclassification. The gain of `2 million will be recognized in profit or loss. 2. The fair value on the reclassification date, i.e., `35 million will be the new carrying amount of the investment. 3. Investment will be shown at `28 million, i.e., the fair value on the date of reclassification. The loss of `2 million will be recognized in OCI. 4. The fair value on the reclassification date, i.e., `35 million will be the new carrying amount of the investment. Accumulated gain in other equity (`4 million) will be adjusted from the fair value, as a result, the investment will be measured at there classification date at `31 million, as if it had always been measured at amortized cost. 5. No change. The investment will continue to appear at the fair value, i.e., `35 million. 6. No change. The investment will continue to appear at the fair value, i.e., `35 million. Accumulated loss of `6 million will be reclassified from other equity to profit or loss as a reclassification adjustment.

294  Chapter 10

10.3.4 Derecognition An investment is derecognized when the contractual rights to the cash flows from the investment expire or the rights to receive the contractual cash flows are transferred. On derecognition of an investment, the difference between the carrying amount and consideration received will be recognized in profit or loss. When an investment measured at FVTOCI is derecognized, the cumulative gain or loss previously recognized in OCI is reclassified from other equity to profit or loss as a reclassification adjustment.

10.4 INVESTMENT IN SUBSIDIARIES, ASSOCIATES AND JOINT VENTURE Ind AS 28 defines an associate as an entity over which the investor has significant influence. The power to participate in the financial and operating policy decisions of the investee is indication of significant influence. Control or joint control over these policies is not a requisite condition for being an associate. In case of a joint venture, parties have joint control over the investee. Decisions about the relevant activities require the unanimous consent of the parties sharing control. The parties having joint control also have rights to the net assets of the arrangement. Subsidiary is an entity that is controlled by another entity due to voting rights, contractual rights, etc. (see Chapter 13 for details). In the separate financial statements, Ind AS, 27 permits investments in subsidiaries, joint ventures and associates to be either accounted for at cost or in accordance with the classification prescribed under Ind AS, 109. The entity shall apply the same accounting for each category of investments.

Summary

• Investments are classified in the balance sheet as current and non-current. • Ind AS 109 requires investments to be classified as ‘measured at cost’, ‘measured at fair value through other comprehensive income’ or ‘measured at fair value through profit or loss’.

• The classification is based upon the business model and cash flow characteristics of the investment.

• Investments are initially recognized at their fair value plus transaction cost. In case of FVTPL transactions costs are not considered.

• Investments measured at amortized cost are tested for impairment if there are indications for the same.

• Investments may be reclassified from one class to another only if there is a change in the business model.

• Upon derecognition, the difference between the carrying amount and consideration received will be recognized in profit or loss.

• In the separate financial statements, investment in subsidiaries, associates and joint ventures is either accounted at cost or as per Ind AS 109.

Accounting for Investments  295

Assignment Questions 1. Briefly explain the classification of investments as per Ind AS, 109. 2. What is the impact of subsequent measurement of investments on the financial statements of a company. 3. Is it possible to reclassify an investment from one class to another? What would be the impact of such reclassification on carrying amount and profit or loss.

Problems 1. Investment classification: PQR Limited invested `10 million in government bonds with coupon rate of 8% and maturity of 10 years. After one year, the fair value of the bonds has increased to `10.5 million. How would you classify the bonds and treat the increase in fair value if: a. The bonds are intended to be held for trading. b. The bond will be held till maturity. c. The company intends to sell the bonds only if the bond price significantly appreciates. d. The company intends to sell the bonds after three years to raise cash for replacement of a machine. 2. Treatment of fair value changes: ABC Limited invested `2 million in the equity shares of another company. The current market price of the investment is `1.7 million due to a fall in market. What are the options available to ABC Limited to classify these investments? How would you treat the fall in the market price under these alternatives. 3. Reclassification: Finvest Limited investments in corporate bonds amounting to `12 million. These investments were classified as FVTOCI in line with the business model of the company. With the change in the business model, the company would like to reclassify these investments. The carrying amount of this investment is `11 million and accumulated loss previously recognized in OCI as a part of other equity amounts to `1 million. What would be the impact of such reclassification in the following cases: a. Reclassify to ‘measured at amortized cost’. b. Reclassify to FVTPL.

Solutions to Problems 1. The classification of investments and treatment of fair value gain will be decided by the business model test and cash flow characteristics test as provided in Ind AS 109. Accordingly: a. Investment would be classified as FVTPL. The fair value gain would be recognized in profit or loss. b. Investments would be classified as ‘measured at amortized cost’. The fair value gain would be ignored. c. Investments would be classified as ‘measured at amortized cost’. The fair value gain would be ignored. d. Investment would be classified as FVTOCI. The fair value gain would be recognized in OCI.

296  Chapter 10

2. ABL Limited has two alternatives to classify equity investments: a. FVTPL b. FVTOCI—For this option, the company has to irrevocably designate these investments in this category. If the investment is for trading, this option is not available. If ABC Limited irrevocably decides to classify these investments as FVTOCI, the fair value loss of `0.3 million will be recognized in OCI and accumulate in other equity. If ABC Limited does not use this option, investment will be classified as FVTPL and the fair value loss of `0.3 million will be recognized in profit or loss. 3. The reclassification is permitted if there is a change in the business model. The impact of the reclassification would be: a. The accumulated loss of `1 million will be adjusted against the carrying amount of the investment and the carrying amount will increase to 12 million, as if these investments had always been measured at amortized cost. b. No change. The investment will continue to appear at the fair value, i.e., `11 million. Accumulated loss of `1 million will be reclassified from other equity to profit or loss as a reclassification adjustment.

Try It Yourself 1. Investment classification: Super Invest Limited invested `15 million in government bonds with coupon rate of 8% and maturity of five years. After one year, the fair value of the bonds has declined to `1 million. How would you classify the bonds and treat the increase in fair value if: a. The bonds are intended to be held for trading. b. The bond will be held till maturity. c. The company intends to sell the bonds only if the bond price significantly appreciates. d. The company intends to sell the bonds after three years to raise cash for expansion project. 2. Classification of equity investment: Starfin Limited invested `1 million in the equity shares in the stock market. The management wants this investment to be measured at amortized cost as this is intended to be held for long-term. Please advise options available to the company for classification. 3. Reclassification: XXX Investment Limited invested `10 million in corporate bonds. These investments were classified as FVTPL in line with the business model of the company. With the change in the business model, the company would like to reclassify these investments. The carrying amount of these bonds currently is `11 million. What would be the impact of such reclassification in the following cases: a. Reclassify to ‘measured at amortized cost’. b. Reclassify to FVTOCI. 4. Reclassification of investments: YYY Investment Limited invested `6 million in corporate bonds. These investments were initially classified as ‘measured at the amortized cost’ in line with the business model of the company. With the change in the business model, the company would like to reclassify these investments. The fair value these bonds is `6.4 million. What would be the impact of such reclassification in the following cases: a. Reclassify to FVTPL. b. Reclassify to FVTOCI.

Accounting for Investments  297

5. Derecognition of investments: Pee Cee Limited sold some of its investments for a consideration of `40,00,000. These investments were purchased at `32,00,000 and initially were classified as FVTOCI. The carrying amount of this investment is `38,00,000 million and the cumulative gain previously recognized in the OCI amounted to `6,00,000. What would be the impact of this sale on financial statements of the company?

Case Case 10.1: Investment Classification by Hero Moto Corp Limited Hero Moto Corp Ltd. (Formerly Hero Honda Motors Ltd.) is the world’s largest manufacturer of two-wheelers, based in India. In 2001, the company had achieved the coveted position of being the largest two-wheeler manufacturing company in India and also the ‘World No.1’ two-wheeler company in terms of unit volume sales in a calendar year. Hero Moto Corp Ltd. continues to maintain this position till date. It derives its income from manufacturing and sale of motorcycles. The company invests its surplus cash primarily in mutual funds and bonds & debentures. The company has invested in subsidiaries and associate companies for business purposes. As on 31st March 2017, the carrying amounts of current and non-current investments was reported at 4,540.85 crore and 1,349.00 crore, respectively. The break-up of these investments is given below: Current Investment in subsidiaries and associates (at cost)   – Subsidiaries   – Associates Carried at fair value through profit or loss (FVTPL) Unquoted   – Investment in equity instruments   – Investment in preference shares   – Investment in mutual funds Quoted   – Investment in equity instruments Carried at amortized cost Quoted   – Investments in debentures/bonds TOTAL



–– 4,419.80 –

(` Crore) Non-current 213.58 638.48

– 10.00 212.33 13.73

121.05

260.88

4,540.85

1,349.00

During the year 2016–17, the other income relating to investments, recognized by the company in the statement of profit and loss, included:

298  Chapter 10

Other Income Interest income on financial assets carried at amortized cost   – Tax free bonds and other instruments classified as debt Dividend Income   – Dividend received on investments carried at fair value through profit or loss   – Dividend income from trade investment in an associate company

(` Crore) 2016–17

36.48

37.98 13.83

Profit on sale of investments (after adjusting loss on sale of current investments aggregating to 0.05 crore)

260.88

Gain on investments carried at fair value through profit or loss

179.25

Questions for Discussion 1. How are current investments different from non-current investments? 2. Hero Motocorp Limited has classified its investments in bonds and debentures as ‘measured at amortized cost’, whereas investment in mutual funds is classified as ‘measured at fair value through profit or loss’. What are the conditions to be met for such classification? 3. Why is the investment in subsidiaries and associates carried at cost? How would you treat impairment in their value, if any? 4. The company has carried its equity investment at fair value through profit or loss. Is it possible to classify equity investments as FVTOCI? 5. Is it possible for the company to reclassify its investment in bonds/debentures to FVTPL? If yes, how would it impact the financial statements of the company?

Cash Flow Statement

11

CHAPTER OBJECTIVES This chapter will help the readers to: • Appreciate the need and objectives for cash flow statement. • Differentiate between cash flow from operating activities, financing activities and investing activities. • Prepare cash flow statement from the given information. • Analyze the information conveyed by the cash flow statement of companies. • Identify and apply key requirements of Ind AS 7 relating to cash flow statements.

11.1 INTRODUCTION The balance sheet and the profit and loss statement provide useful information about the financial health of a business enterprise. The former provides us information about the sources (liabilities) and application (assets) of funds at the end of the accounting year, whereas the latter is a summary of income earned and expenses incurred during the accounting year. As the profit and loss statement is based upon the accrual principle and matching principle, it does not tell us about the cash generated by the enterprise during the year. Likewise, the balance sheet is a summary of assets and liabilities at the end of the year. It does not inform the user about the sources and uses of cash during the accounting year. Cash is generated and used by an enterprise through operating activities, investing activities as well as financing activities. The purpose of cash flow statement is to provide information about inflows and outflows of cash from operating activities, investing activities and financing activities during the year at one place. Cash flow statement, when read with the other two financial statements, helps the users in better Ind AS 7: Objective of Cash Flow assessment of financial health of an organization by Statement: Information about the cash highlighting the ability of the enterprise to generate flow of an enterprise is useful in providcash. ‘Historical cash flow information is often used ing users of financial statements with a as an indicator of the amount, timing and certainty of 1 basis to assess the ability of the enterfuture cash flows.’ As cash flows are not dependent prise to generate cash and cash equivaupon the accounting methods and estimates used, lents and the needs of the enterprise to the position depicted by cash flow statement is often utilize those cash flows. seen as more objective. As a number of economic decisions like lending and investing are taken on the

300  Chapter 11

basis of cash flow estimates, cash flow statement provides a better basis to estimate the future cash flows of an enterprise.

11.1.1  What is Cash? For the purpose of preparing cash flow statement the expression, cash, is used in a wider sense. Cash flows are inflows and outflows of cash and equivalents. Cash includes cash in hand and demand deposits. Cash equivalents are short-term investments that can be quickly converted into cash without any significant risk of change in value. Cash equivalents are held as a substitute to cash and not as investments. For example, deposits held with banks for short duration, investment in money market instruments, like treasury bills, debt mutual funds, etc., will qualify as cash equivalents. However, investment in equity shares or equity mutual fund though highly liquid is not considered as cash equivalents since there is significant risk of change in value even in short-term. Investment in preference shares which are maturing shortly (generally within the next three months) for a known amount of cash would qualify as cash equivalents. Bank over drafts which are repayable on demand form integral part of an entity’s cash management, bank over drafts are included as a component of cash and cash equivalents. It is important to note that short-term investments that are classified as cash equivalents are excluded from cash flows. Therefore, investment of surplus cash in long-term investments will be shown as a cash flow on account of investing activities, however investment in short-term instruments (considered as cash equivalents) will be treated as an integral part of cash management rather that as an investing activity. Ind AS 7: Cash Equivalents are shortterm, highly liquid investments that are readily convertible into known amount of cash and which are subject to an insignificant risk of change in value.

■  Illustration 11.1

Which of the following will be treated as cash and cash equivalents?

a. b. c. d. e.

Balance in the current account with State Bank of India. Investment in the shares of a subsidiary company. Investment in 10 year government bonds maturing after two months. Investment in equity mutual funds. Fixed deposits with Canara Bank maturing after one year.

Out of the above only (a) and (c) will be classified as cash and cash equivalents as they are readily convertible into cash without any significant risk of change in value. Investment in shares of a subsidiary company (b) and fixed deposit (e) above are long-term investments and hence are not treated as cash equivalents. Whereas investment in equity mutual fund (d) above though can readily be converted into cash, but it carries significant risk of change in value and hence is not treated as cash equivalents.

11.2  CASH FLOW STATEMENT The balance sheet contains a summary of the assets and liabilities held by a business enterprise at the end of the accounting period. Cash and cash equivalents are also shown as a part of the assets. By comparing the cash and cash equivalents as shown in the current year’s balance sheet with the immediately

Cash Flow Statement  301

previous year’s balance sheet, we can ascertain the net increase or decrease in cash. The increase or decrease in cash between two balance sheets is the combined result of various activities carried on by the enterprise during the year. The cash flow statement aims at explaining the reasons for increase or decrease in the cash and cash equivalents between two Balance Sheet dates. For a better understanding of the sources and uses of cash, they are classified into three headings as follows: 1. Cash flow from operating activities: Sources and uses of cash from the main revenue generating activities of the business. Conversely, any cash flow that is not occurring on account of investing activities or financing activities will be shown under this head. 2. Cash flow from investing activities: Sources and uses of cash for acquiring or disposing off long-term assets and investments. This will also include the reward generated from financial investments like dividend or interest received. 3. Cash flow from financing activities: Sources and uses of cash relating to means of financing. Cash flows arising from raising funds as well as repayments are included in this heading. Cash flow towards servicing of various sources of funds; for example, interest or dividend paid are also considered financing cash flows. The net cash flows from (1) to (3) above is equal to the change in cash or cash equivalents between the two balance sheets. The relationship is depicted in Figure 11.1. Thus, while preparing the cash flow statement, we start by comparing the cash and cash equivalents in the two successive balance sheets to obtain the net increase or decrease. The net increase or decrease is then explained under the three categories of activities as described earlier. To illustrate, the summary of cash flows in respect of Torrent Power Limited in given in Table 11.1. The net increase or decrease in cash between the two balance sheet dates is fully explained with reference to the cash flows under the three categories. During the year 2015–16, Torrent Power Limited generated ` 2,501.60 crore from its operating activities but used ` 913.15 crore in the

Cash and Cash Equivalents in the Previous Year’s Balance Sheet

Cash Flow During the Year From +

• • •

Operating Activities Investing Activities Financing Activities

=

Cash and Cash Equivalents in the Current Year’s Balance Sheet

Figure 11.1  Relationship Between Cash Flow and Cash Balance in the Balance Sheet

Table 11.1  Summarized Cash Flow Statement of Torrent Power Limited

Particulars Increase or decrease in cash Cash and cash equivalent at the end of the year Less: cash and cash equivalent at the beginning of the year Increase or (decrease) in cash

( ` in Crore) 2017 812.21 1,025.40 (213.19)

2016 1,025.40 1,562.71 (537.31) (continued )

302  Chapter 11 (continued )

Particulars Cash flow during the year i) Operating activities ii) Investing activities iii) Financing activities Net cash flow (i + ii + iii)

( ` in Crore) 2010 2,370.37 (1,941.11) (642.45) (213.19)

2009 2,501.60 (913.15) (2,125.76) (537.31)

Source: Annual report of Torrent Power Limited for the year 2016–17

i­nvesting activities. It also used a net amount of ` 2,125.76 crore in financing activities resulting in a net decrease in cash balance by ` 537.31 crore. Similarly, during 2016–17, the company generated cash flow of ` 2,370.37 crore from its operating activities and utilized ` 1,941.11 crore in investing activities and ` 642.45 crore in financing activities resulting in a net decline in cash balance by ` 213.19 crore. ■  Illustration 11.2

As on 31st March 2017, the cash and cash equivalents of Muscles Power Limited stood at ` 945 million as compared to ` 1,014 million in the previous year’s balance sheet. During the year, the company generated a net cash flow of ` 844 million from its operating activities and used a net amount of ` 1,235 million towards investing activities. What are the net cash flows from financing activities? Change in cash and cash equivalents ( ` in Million) Balance at the end of the year 945 Less: Balance in the beginning of the year 1014 Net decrease in cash and cash equivalents (69) The sum of cash flow under three heading should be equal to ` 69 million. Cash flow from (Operating activities + Investing activities + Financing activities) = Net change in cash and cash equivalents ` 844 − ` 1235 + Financing activities = −` 69 million −` 391 + Financing activities = −` 69 million; solving the equation Cash flow from financing activities = ` 322 million. The company raised a net cash flow of ` 322 million from financing activities during the year. The three categories of cash flows are discussed in detail in the subsequent paragraphs.

11.3  CASH FLOW FROM OPERATING ACTIVITIES Operating activities are the main revenue generating activities of a business. The cash generated by a business enterprise from operating activities is a key indicator of its ability to meet its cash requirements for various purposes. If the enterprise generates strong cash flows under this head, it will have sufficient resources to pay dividend, acquire assets and reduce dependence on external sources of finance.

Cash Flow Statement  303

This category includes receipts arising from cash sales, collection from customers and also payments Ind AS 7: Operating activities are the to the suppliers of goods and services, payment of principal revenue-producing activities various expenses like salaries to employee, rent and of the enterprise and other activities other operating expenses. Cash receipts and paythat are not investing or financing ments towards premiums and claims, annuities and activities. other policy benefits by an insurance company and cash receipts and payments from contracts held for dealing or trading purposes would also be treated as cash flow from operating activities. Primarily this information is derived from the profit and loss statement. However, as the profit and loss statement is based upon accrual basis, suitable adjustments are made to convert those numbers to cash flows. For example, if sales during the year amounted to ` 150 million out of which ` 30 million are yet to be collected from the customers, the profit and loss statement will show ` 150 million as income using accrual principle, whereas in cash flow statement, we will show only ` 120 million as cash flow. As the profit and loss statement also relates to operation of the enterprise during an accounting period, the key information regarding cash flow from operating activities can be obtained from the profit and loss statement for the year. However, there are key differences between the two as detailed below:

• Profit and loss statement is prepared using accrual principle, both for revenue as well as expenses. •



Hence, revenue or expenses once accrued are recorded irrespective whether received or paid or not. In cash flow statement actual inflow or outflow is recorded. Due to matching concept followed in preparing profit and loss statement a number of non-cash expenses are recorded. For example, depreciation and amortization of assets, provisions for retirement benefits, etc. As there is no cash outflow involved, these non-cash expenses are not considered while arriving at cash flow from operating activities. Likewise, in the profit and loss statement we consider material consumed as a part of the expense, after adjusting for change in stock, whereas for cash flow from operating activities material purchased may be more relevant. Profit and loss statement also includes income and expenses which are not of operating nature but are either result of financing activities or investing activities. For example, interest or dividends received on investments are included in the profit and loss statement as other income but the same being in the nature of investing activities are not included in the cash flow from operating activities. Likewise, interest paid on loans though included in the profit and loss statement as an expense, is not considered in cash flow from operating activities being related to financing activities.

There are two alternative methods for ascertaining cash flow from operating activities—direct method and indirect method. In the direct method, major classes of gross cash receipts and gross cash payments are disclosed. In the indirect method, profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. Ind AS 7 permits use of either of the methods. However, enterprises are encouraged to use direct method as it provides information which may be useful in estimating future cash flows and which is not available under the indirect method.

304  Chapter 11 Table 11.2  Cash Flow from Operating Activities—Direct Method

Particulars

Amount

Inflow Cash sales Collection from customers for credit sales Other operating receipts Total inflow (A) Outflow Cash purchases Payment to suppliers for credit purchases Salaries Paid Other operating expenses paid Income tax paid Total outflow (B) Cash flow from operating activities (A – B)

11.3.1  Direct Method In this approach, gross receipts and payments on account of operating activities are presented. The difference between receipts and payments is taken as the net cash from operating activities. Under this method, the cash flow from operating activities may be presented as given in Table 11.2. The direct method excludes non-cash expenses, non-operating expenses (interest paid) and nonoperating income (interest or dividends received, profit on sale of assets or investments). It also removes the effect of accrual basis of accounting by only considering actual receipts and payments rather that income accrued and expenses incurred. The direct method is easier to understand for the reader but may require more efforts for the business enterprise to prepare it. ■  Illustration 11.3

From the given profit and loss statement and additional information from the balance sheet, ascertain the cash flow from operating activities for Samurai Toys Limited for the year 2016–17 using the direct method. Profit and Loss Statement for the Year Ended 31st March 2017

Income Sale revenue Interest earned Total income

( ` in Crore) 168.75 22.43 191.18

Less: Expenses Material consumed

67.47

Employees cost

23.34 (continued )

Cash Flow Statement  305 (continued )

Income

( ` in Crore)

Administrative and marketing expenses

37.89

Depreciation and amortization

18.56

Interest and finance charges

13.45

Profit before tax

30.47

Provision for tax

10.00

Profit after tax

20.47

Additional Information The company paid ` 8 crore towards taxes during the year. The following details were extracted from the balance sheet of the company. Particulars

31st March 2016

31st March 2017

Inventories

43.24

55.15

Trade receivables

39.77

30.43

Trade payables

26.89

20.45

7.75

11.34

Other current liabilities

Solution Cash Flow from Operating Activities

Crore

Cash sales and collection from customers

178.09

Paid for material

(85.82)

Employee cost

(23.34)

Administrative and marketing expenses

(34.30)

Cash flow from operating activities before taxes

34.63

Tax paid

(8.00)

Cash flow from operating activities

26.63

Notes

1. Interest earned and interest & finance charges are ignored as they are non-operating income and non-operating expense, respectively. 2. Depreciation and amrortization has been ignored being non-cash expense. 3. Sale revenue has been adjusted for trade receivables (` 168.75 – ` 30.43 + ` 39.77). 4. Material consumed has been adjusted for inventory and trade payables (` 67.47 + ` 55.15 + `  43.24 – ` 20.45 + ` 26.89). 5. Administrative and marketing expenses has been adjusted for outstanding expenses (` 37.89 – ` 11.34 + ` 7.75) assuming that other current liabilities are towards outstanding expenses. 6. Tax paid during the year has been taken as the outflow.

306  Chapter 11

11.3.2  Indirect Method In this method, we start with the profit or loss figure from the profit and loss statement and make suitable adjustments to arrive at the cash flow from operating activities. The adjustments are made to remove the effect of: • Non-cash expenses: Depreciation, amortization and provisions. • Non-operating income and expenses: Interest expenses, profit or loss on sale of assets or investments, interest or dividend earned.

• Accrual basis of accounting: Increase or decrease in trade receivables, prepaid expenses, inventories, trade payables, outstanding expenses, etc. To illustrate the cash flow from operating activities for Maruti Suzuki Limited2 for the year 2016–17 and 2015–16 is presented in Table 11.3. Table 11.3  Cash Flow from Operating Activities for Maruti Suzuki Limited

Particulars

(` in Million) 2016–17

A.  Net profit before tax

2015–16

99,413

74,437

B.  Non-cash expenses/income Depreciation and amortisation

26,021

28,202

Fair value gain on investments in debt mutual funds

(21,203)

(12,019)

Liabilities no longer required written back Unrealized foreign exchange gain/loss C.  Non-operating income/expenses Finance cost Interest income Dividend income Loss on sale/discarding of property, plant and equipment Net gain on sale of in investments in associates Net gain on sale of investments in debt mutual funds

(35) (320)

(694) 4,463

(190)

894 (372) (129)

815 (1,510) (107)

632

1,353

(209) (612)

15,299

– 204

(974)

(423)

D.  Effect of accrual principle (Increase)/decrease in non-current loans (Increase)/decrease in other non-current financial assets (Increase)/decrease in other non-current financial assets

1

2

(7)

376

(320)

66

(Increase)/decrease in Inventories

(1,301)

(4,462)

Increase) /decrease in trade receivables

1,237

(2,053) (continued )

Cash Flow Statement  307 (continued )

Particulars (Increase)/decrease in current loans (Increase)/decrease in other current financial assets (Increase)/decrease in other current assets Increase/(decrease) in non-current provisions

(` in Million) 2016–17

2015–16

6

(10)

635

258

1,049

(3,200)

71

(55)

Increase/(decrease) in other non-current liabilities

2,975

1,827

Increase/(decrease) in trade payables

9,785

17,916

Increase/(decrease) in other current financial liabilities

686

2,078

Increase/(decrease) in current provisions

501

(100)

Increase/(decrease) in other liabilities

6,622

21,940

1,988

14,631

E.  Taxes Paid

(23,173)

(19,099)

Net Cash from operating activities (A +B + C + D + E)

102,847

84,845

The above adjustments have been discussed in detail as follows:

Non-cash Expenses and Incomes Non-cash expenses like depreciation and amortization, provisions for doubtful debts, provisions for Non-cash expenses and losses are retirement benefits, unrealized foreign exchange added back to profit whereas nonlosses are added back to the profits. As they do not cash incomes and gains are subinvolve cash outflow. Likewise, incomes and gains tracted to arrive at cash flow from included in the profit and loss statement which are operating activities. not earned in cash, for example, provisions no longer required, unrealized gains on foreign exchange are deducted from the profit to arrive at the cash flow from operating activities. Since they have been considered while arriving at the profits, their effect is removed by deducting them from the profit figures.

Non-operating Income or Expenses Any income and gain or expense and loss considered in profit or loss statement arising from activities which are either financing or investing in nature need to be eliminated. Accordingly, non-operating incomes, for example, interest earned, dividend income, profit on sale of assets or investments

Non-operating expenses and losses are added back to profit whereas non-operating incomes and gains are subtracted to arrive at cash flow from operating activities.

308  Chapter 11

are deducted from profits to arrive at cash flow from operating activities. Likewise, non-operating expenses or losses, for example, interest expense, loss on sale of assets or investments are added back to profit to ascertain cash flow from operating activities.

Increase or Decrease in Trade Receivables In the profit and loss statement revenue is recorded on accrual basis irrespective whether received or not, whereas in cash flow statement the focus is on actual cash received from customers. The cash received from customers during a year may also include collection in respect of credit sales of the previous year. Similarly collection in respect of current year’s sale may actually take place in the next period. Accordingly, cash collected from customers during an accounting period may be given by Equation 11.1: Cash collection = Sales during the year + Trade receivables in the beginning of the year – Trade receivables at the end of the year

(11.1)

By rearranging Equation 11.1, we can arrive at Equation 11.2: Cash collection = Sales during the year − Trade Receivables (or + Decrease in Trade receivables)

(11.2)

Any increase in trade receivables represents blockage of funds and the same in deducted from profits to arrive at cash flows, whereas decease in trade receivables results in release of funds and hence in added to profits to arrive at cash flow from operating activities. To illustrate, the sales of a business enterprise for the year is ` 230 million. The trade receivables in the beginning of the year (last year’s balance sheet) were ` 83 million, whereas trade receivables outstanding at the end of the year (current year’s balance sheet) are ` 97 million. There is an increase in Trade receivables by ` 14 million. Though in the profit and loss statement, sales has been taken at ` 230 million the actual collection from customers is only ` 216 million ( ` 83 million + ` 230 million − ` 97 million). While arriving at cash flow from operating activities, an amount of ` 14 million will be deducted as increase in trade receivables. However, if the trade receivables at the end of the year amounted to ` 60 million only, that is, a decrease in trade receivables by ` 23 million, the actual collection from customers is ` 253 million ( ` 83 million + ` 230 million – ` 60 million). While arriving at cash flow from operating activities an amount of ` 23 million will be added as decrease in trade receivables.

Increase or Decrease in Inventories As discussed in the Chapter 8, the cost of goods sold is arrived at by using Equation 11.3: Cost of goods sold = Opening stock + Purchases – Closing stock

(11.3)

This may also be represented in Equation 11.4. Cost of goods sold = Purchase – Increase in stock or (+ Decrease in stock)

(11.4)

In the profit and loss statement, we consider the cost of goods sold by making adjustments for change in inventories. However for cash flow purposes, the effect of inventory adjustment needs to be eliminated. Accordingly, any increase in inventories between two balance sheets (representing

Cash Flow Statement  309

a­ dditional blockage of cash) is deducted, whereas any decrease in inventories is added to profits to Increase in inventories is deducted arrive at cash flow from operating activities. whereas decrease in inventories is To illustrate, the goods purchased during the added to profit to arrive at cash flow year amounted to ` 430 million, out of which from operating activities. goods ­costing ` 138 million are unsold at the end of the year (current year balance sheet) compared to `­  89 million of opening stock (last year’s balance sheet). Though the company has spent ` 430 towards purchases, the profit and loss statement will show only ` 381 million ( ` 89 million + ` 430 million – ` 138 million) as cost of goods sold. To negate the effect of increase in inventory, an amount of ` 49 million will be deducted from profit to arrive at cash flow from operating activities. However, if the ending inventory amounted to ` 53 million (i.e., a decrease of  ` 36 million compared to the beginning inventory) the decrease will be added to profits to arrive at cash flow from operating activities.

Increase or Decrease in Current Liabilities While accounting for expenses in the profit and loss statement, we follow accrual principle, that is, Increase in current liabilities is expenses are recorded when incurred irrespective added whereas decrease in current when paid. Whereas for cash flow statement we are liabilities isdeducted from profit to concerned about actual cash flow. Accordingly, the arrive at cash flow from operating effect of accrual on expense accounting needs to be activities. eliminated. To illustrate, the profit and loss statement shows employee cost of ` 879 million. In the beginning of the year (last year’s balance sheet) ` 34 million was outstanding towards salaries and at the end of the current year (current year’s balance sheet) salaries of ` 45 million are yet to be paid. The actual payment during the year towards employee cost amounts to ` 868 million ( ` 34 + ` 879 − ` 45). Accordingly, while arriving at cash flow from operating activities, a sum of ` 11 million ­( ` 45  million − ` 34 million) will be added towards increase in current liabilities. Assuming if the current outstanding is only ` 15 million, the actual outflow towards employee cost is ` 898 million ( ` 34 + ` 879 − ` 15). In such a case, ` 19 million will be deducted from profits towards decrease in current liabilities.

Taxes on Income Any cash flow towards taxes on income is usually considered as operating cash flow and is required to be disclosed separately as operating activities. However, if the cash flow can be specifically identified with investing or financing activities, it needs to be classified under suitable head. By default, tax on income is considered as a part of operating activities. Based upon the above discussion cash flow from operating activities using indirect method may be presented as given in Table 11.4.

310  Chapter 11 Table 11.4  Cash Flow from Operating Activities—Indirect Method

Particulars Profit before tax Add: Depreciation and amortization Any other non-cash expense Interest expense Loss on sale of investments Loss on sales of assets Less: Interest income Dividend income Profit on sale of assets Profit on sale of investments Provisions no longer required Any other non-cash/non-operating income

Amount –

Profits before working capital changes Add: Decrease in trade receivables Decrease in inventories Decrease in prepaid expenses Decrease in other current assets Increase in trade payables Increase in other current liabilities Less: Increase in trade receivables Increase in inventories Increase in prepaid expenses Increase in other current assets Decrease in trade payables Decrease in other current liabilities Profit after working capital changes Less: Taxes paid Cash flow from operating activities

■  Illustration 11.4

From the information given in Illustration 11.3, ascertain the cash flow from operating activities for Samurai Toys Limited for the year 2016–17 using indirect method.

Cash Flow Statement  311

Cash Flow from Operating Activities of Samurai Limited for 2016–17

Particulars

Amount ( ` in Crore)

Profit before tax Add: Depreciation and amortization Interest & finance charges Less: Interest earned Profits before working capital changes Add: Decrease in trade receivables Increase in other current liabilities Less: Increase in inventories Decrease in trade payables Profit after working capital changes Less: Taxes paid Cash flow from operating activities

30.47 18.56 13.45 (22.43)

9.34 3.59 (11.91) (6.44) 34.63 (8.00) 26.63

11.4  CASH FLOW FROM INVESTING ACTIVITIES This category includes cash inflows and outflows relating to acquisition and disposal of fixed assets and investments. As discussed earlier, short-term investments which are included in cash equivalents are not considered as a part of investing activities. While reporting cash flow under this head focus is on cash inflows and outflows. Thus, assets acquired Ind AS 7: Investing activities are for non-cash considerations are not included in the the acquisition and disposal of longcash flows. In respect of assets or investments disterm assets and other investments posed off, it is the gross consideration received that not included in cash equivalents. is included in the cash inflow rather that gain or loss on disposal of the asset. By comparing the gross fixed assets, capital work in progress and investments (other than cash equivalents) in the current year’s balance sheet with the previous year, basic information about investing activities can be obtained. The following cash flows are usually reported under this category:

• Outflows: Payments for acquiring fixed assets—tangible and intangible, payments for acquiring



shares, debentures and other financial instruments (excluding those classified as cash equivalents), loans and advances given to third parties, capitalized development costs and self-constructed property, plant and equipment. Inflows: Receipts from disposal of fixed assets and sale of share, bonds, debentures and other financial instruments and receipts on account of repayment of loans and advances. Interest and dividends received are also reported as cash inflows from investing activities.

312  Chapter 11

It may, however, be noted that an entity which is primarily engaged in purchase and sale or otherwise dealing in securities, these cash flows constitute its operating activities. In such a case, cash flows from such transactions will be reported as cash flow from operating activities. Likewise, a finance company engaged in the business of giving loans and advances and other form of lending will classify such cash outflows as operating activities and not as investing activities. Cash flow from Investing Activities for Maruti Suzuki Limited for the year 2016–17 and 2015–16 is given in Table 11.5. Table 11.5  Cash flow from Investing Activities for Maruti Suzuki Limited

Particulars

( ` in Million) 2016–17

2015–16

(32,498)

(24,663)

(1,388)

(1,787)

(177,155)

(120,050)

Proceeds from sale of property, plant and equipment

163

123

Proceeds from sale of investment in associate company

219



A.  Cash Outflows Payment for purchase of property, plant and equipment and capital work in progress Payment for purchase of intangible assets Payment for purchase of debt mutual funds B.  Cash Inflows

Proceeds from sale of debt mutual funds

118,359

73,335

Interest received

356

661

Dividend received

129

107

(91,815)

(72,274)

Net cash used/from investing activities Source: Annual Report of Maruti Suzuki Limited for the year 2016–17

■  Illustration 11.5

How will the following transactions be recorded while presenting cash flow from investing activities?

a. Asset with an original cost of  ` 12 million and accumulated depreciation of  ` 9.5 million is sold for ` 1 million in cash. b. Amount spent on construction of a factory building during the year is ` 30 million. c. Machinery bought for ` 10 million. Consideration paid by issuing one million equity shares of  ` 10 each. d. Investment made in short-term investments (considered as cash equivalents) amounting to ` 2 million. e. Loans given by ABC Finance Limited engaged in the business of lending amounting to ` 120 million. Interest received on these loans amounted to ` 13.5 million.

Cash Flow Statement  313

Solution:

a. Sale consideration of  ` 1 million will be included as a cash inflow from investing activities. b. Amount spent on construction of a factory building during the year amounting to ` 30 million will be shown as an outflow towards investing activities. c. As no cash flow in involved, it will not appear in the cash flow from investing activities. It will appear elsewhere as a footnote. d. As the investment made has been included in cash equivalents, it will not be shown in the cash flow from investing activities. e. As giving loans is the principal revenue generating activity of ABC Finance Limited, cash flows towards giving loans and interest received on such loans will be shown under operating activities and not under investing activities.

11.5  CASH FLOWS FROM FINANCING ACTIVITIES Financing activities relate to the sources of financing used by a business enterprise, both share capital as well as borrowings. The sources of funds raised also need to be serviced by payment of interest, dividends and also by repayment of principal. By comparing the shareholders’ funds and borrowed funds in the current year’s balance sheet with the previous Ind AS 7: Financing activities are the year, basic idea about the movement in sources of activities that result in the change funds can be obtained. However, if the change has in size and composition of owners’ happened without involving cash, the same will capital (Including preference share not be a subject matter of cash flow statement. For capital in case of a company) and example, if some assets have been acquired by issue borrowings of the enterprise. of shares, increase in capital will not be reported as a financing activity. Likewise, conversion of convertible debentures into equity will change the composition of sources of funds in the balance sheet but will have no cash flow effect. The following cash flows are usually reported under this category:

• Inflows: Proceeds from issue of shares (equity as well as preference), bonds, debentures and •

other similar instruments and long- and short-term borrowings. If these instruments have been issued at a premium, the premium received is also a part of the cash inflows. Outflows: Repayment of loans, payment towards redemption of bonds, debentures, preference shares and other similar instruments. Payments made towards interest on loans and debentures, dividends paid (both equity and preference shares) as well as dividend distribution tax paid during the year will also be reported as cash outflow from financing activities. However, in case of a financial enterprise (e.g., bank) interest paid will be classified as an operating activity. Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease will also be classified under this head.

The financing activities are often supplementary to the operating and investing activities. If the enterprise on a net basis has used cash for operating activities and investing activities, i.e., net cash flow from operating and investing activities is negative, it may have to raise funds either through equity or borrowings. In such a case, net cash flow from financing activities will be positive (net inflow). If,

314  Chapter 11

h­ owever, cash flow from operating activities is positive and is large enough to meet the funds requirements for investing activities, there is no need to resort to financing and in such a cash flow from financing activities will be negative representing servicing of sources of funds. Cash flow from financing activities for Maruti Suzuki Limited for the year 2016–17 and 2015–16 is given in Table 11.6. Table 11.6  Cash Flow from Financing Activities for Maruti Suzuki Limited

Particulars

( ` in Million) 2016–17

2015–16

4,836

774

Repayment of Short-term borrowings

(774)

(354)

Repayment of Long-term borrowings

(1,535)

(2,773)

Finance cost paid

(1,095)

(921)

(10,573)

(7,552)

(2,152)

(1,538)

(11,293)

(12,364)

A.  Cash Outflows Proceeds from short-term borrowings B.  Cash Inflows

Payment of dividend paid on equity shares Related income tax Net Cash from Financing Activities Source: Annual report of Maruti Suzuki Limited for the year 2016–17

■  Illustration 11.6

How will the following transactions be recorded while presenting cash flow from financing activities?



a. Issue of 10 million equity shares of the face value ` 10 each at a premium of  ` 40 each. Issue expenses amounted to ` 10 million. b. Debentures issued five years back with a face value of  ` 100 crore are converted into one crore equity shares of the face value ` 10 each at a conversion price of  ` 100 each during the year. c. Fresh loan taken during the year from SBI amounting to ` 430 million. Earlier loan of ` 280 million repaid during the year. The net increase in loan from SBI amounts to ` 150 million. d. Debentures of face value ` 50 crore redeemed during the year at a premium of 10%. e. Company bought back two million shares from the market at ` 120 per share. f. 10 million equity shares of  ` 10 each issued as bonus shares to existing shareholders.

Solution:

a. The issue proceeds of  ` 500 million (including premium) will be shown as cash inflows, whereas issue expenses of  ` 10 million will be cash outflow under financing activities. b. Conversion of debentures into equity has no cash flow implications. It will not appear in the cash flow statement rather will be mentioned as notes to accounts.

Cash Flow Statement  315





c. Fresh loan taken during the year from SBI amounting to ` 430 million will be shown as a cash inflow and repayment of earlier loan of  ` 280 million as an outflow under cash flow from financing activities. The inflows and outflows are shown on gross basis rather than on net basis. d. Redemption amount paid ( ` 50 crore plus premium ` 5 crore) will appear as cash outflow from financing activities. e. Amount paid towards buy-back of shares aggregating to ` 240 million is cash outflow from financing activities. f. As bonus shares are issued without consideration, it will not appear in the cash flow statement.

11.6  SPECIAL POINTS In this section, we will discuss certain special situations with reference to cash flow statement.

11.6.1  Non-cash Transactions A number of investing and financing activities may not involve any cash inflow or outflow. Such transactions do have an impact on the composition and values of assets and liabilities in the balance sheet but do not have any cash effect. As no cash flow in involved they are not included in cash flow statement. However, such non-cash transactions are reported separately in the annual report. Some of the non-cash transactions are stated as follows:

1. 2. 3. 4. 5.

Conversion of debentures or preference shares into equity Issue of bonus shares Splitting shares of higher face value to lower face value Acquisition of assets by issuing debentures Acquisition of another enterprise by issue of shares

11.6.2  Foreign Currency Cash Flows Cash flows in foreign currency are reported by converting the same in the reporting currency by applying the appropriate exchange rate prevailing on the date of the transaction. Cash and cash equivalents held in foreign currency are also converted in the reporting currency. Any unrealized gain or loss due to changes in the foreign exchange rates do not involve any cash flow and hence not reported in the cash flow statement. However, the effect of changes in exchange rates on cash and cash equivalents held in a foreign currency is reported separately in order to reconcile cash and cash equivalents at the beginning and end of the period.

11.6.3  Change In Ownership Interest Cash flows arising from obtaining or losing control of subsidiaries or other businesses shall be presented separately and classified a sinvesting activities.

11.6.4  Reporting Cash Flows On Net Basis Major classes of cash receipts and cash payments arising from investing and financing activities are generally reported on gross basis. For example, an entity might have taken a fresh long-term

316  Chapter 11

loan of ` 100 million and repaid another long-term loan of ` 60 million during the year with a net addition of ` 40 million to long-term loan. This will be presented as inflow of ` 100 million and outflow of ` 60 million under cash flow from financing activities rather than a net cash inflow of ` 40 million. However, certain cash flows arising from operating, investing or financing activities may be reported on a net basis. For example, cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity and cash receipts and payments for items in which the turnover is quick, the amounts are large and the maturities are short. In case of a financial institution, the following cash flows may be reported on a net basis:

1. Cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date.



2. The placement of deposits with and withdrawal of deposits from other financial in stitutions.



3. Cash advances and loans made to customers and the repayment of those advances and loans.

11.7  CASH FLOWS AT DIFFERENT STAGES OF LIFE CYCLE The composition of cash flow for enterprises at different stages of life cycle may differ significantly.

• Start-up and initial stage: A start-up will have negative or low cash flow from operating activi-







ties as the operations have just commenced. As the enterprise is in the process of creating or acquiring non-current assets and facilities, cash flow from investing activities is likely to be significantly negative. To meet the cash needs of operating and investing activities, the enterprise has to resort to raising funds and resultant positive cash flows from financing activities. After some time once operations stabilize, cash flow from operating activities may turn positive, requirement of funds for investing activities also slows down and therefore financing activities will also come down significantly. Maturity stage: Once operating activities of the enterprise start generating significant cash flows, it will use these positive cash flows to meet its limited requirements for investing activities. The enterprise will use the surplus cash flow to pay interest on borrowed funds, dividend on equity and also for repayment of principal. At this stage, cash flow from financing activities will be negative. Expansion stage: If the enterprise decides to undertake a major expansion (by expanding capacities, modernization of facilities or by acquisition), cash flow from investing activities will turn negative. Cash flow from operating activities though positive may not be sufficient to meet the cash needed for investing activities. The enterprise has to go for another round of funding either by borrowings or issuance of shares, bonds, debentures or similar instrument resulting is a positive cash flow from financing activities. Cash rich: In case cash flows from operating activities far exceed the cash needed for investing activities, the enterprise may decide to use the excess cash for rewarding the shareholders by paying special dividends, repaying its loans to acquire zero debt status and also for buyback of shares. The cash flow from financing activities in such a case will be significantly negative.

Cash Flow Statement  317

■  Illustration 11.7

On the basis of information given fill the missing entries: Particulars

( ` in Crore) Start-up Ltd.

Mature Ltd.

Expand Ltd. Cash Rich Ltd.

Increase or decrease in cash

 

 

 

 

Cash & cash equivalent

 

 

 

 

42.34

235.27

?

?

At the end of the year At the beginning of the year

3.28

Increase or (decrease) in cash

?

Cash flow during the year

 

i) Operating activities

ii) Investing activities

? 51.78

–5.78 ?

Net cash flow (i + ii + iii)

−100.69

 

–102.47

iii) Financing activities

235.67

39.06

  ?

–104.73

? 349.09

51.78

?  

334.89

–276.38

256.17

?

580.79 –221.12 ? 177.49

The completed table is shown as follows. Particulars

( ` in Crore) Start-up Ltd. Mature Ltd.

Expand Ltd.

Cash Rich Ltd.

Increase or decrease in cash

 

 

 

 

Cash & cash equivalent

 

 

 

 

42.34

235.27

134.98

433.66

3.28

183.49

235.67

256.17

39.06

51.78

–100.69

177.49

Cash flow during the year

 

 

 

 

i) Operating activities

–5.78

432.89

334.89

580.79

ii) Investing activities

–102.47

–276.38

–784.67

–221.12

iii) Financing activities

147.31

–104.73

349.09

–182.18

Net cash flow (i + ii + iii)

39.06

51.78

–100.69

177.49

At the end of the year At the beginning of the year Increase or (decrease) in cash

318  Chapter 11

Summary

• Cash flow statement depicts the inflows and outflows of cash during an accounting period. It • • • •

• • •

reconciles the opening balance of cash and cash equivalents with closing balance of cash and cash equivalents. Cash and cash equivalents include cash in hand, cash in banks and short-term investments that are readily convertible into cash without any significant risk of change in value. Ind AS 7 requires bank overdraft to be shown as a part of cash and cash equivalents. Cash flows are required to be broken into three categories: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Operating activities are the primary revenue generating activities of the business enterprise. Cash flow from operating activities may be ascertained either by following direct method or indirect method. In direct method, gross inflow and outflows are ascertained by eliminating the affect of accrual and matching principles. In indirect method, the profit figure is adjusted for non-cash expenses, non-operating expenses and incomes and also by changes in current assets and current liabilities. Taxes on income are usually considered as outflow from operating activities. However, if it could be identified with either financing or investing activities, it will be so classified. Non-cash transactions—not involving any inflow or outflow—are excluded from the cash flow statement. Cash flow statement is a useful tool is explaining the reasons for change in cash position as well as predicting the ability of a business enterprise to generate cash in future.

Assignment Questions 1. What is the purpose of preparing cash flow statement? 2. ‘The expression ‘‘cash’’ is used in a wider sense to include ‘‘cash equivalents’’ as well while preparing the cash flow statement’. What kinds of items are included in ‘cash equivalents’? 3. Explain the three broad headings under which cash inflows and cash outflows are reported while preparing cash flow statement? 4. Identify the main reasons for difference between cash flow from operating activities and reported profit for the year. 5. Differentiate between direct and indirect method of calculating cash flow from operating activities. 6. How do we treat the income tax paid in the cash flow statement? 7. What are non-cash transactions? Give three examples.

Cash Flow Statement  319

Problems 1. Cash flow from operating activities: Calculate the cash flow from operating activities on the basis of the following information using direct method and indirect method: Profit and Loss Statement for the Year Ended 31st December 2017

Particulars

( ` in Million)

Sales

487.23

 

58.45

 

Total income

545.68

 

Material consumed

246.45

 

Other expenses

133.18

 

Loss on sale of asset

33.45

 

Depreciation

93.34

 

Interest & finance charges

82.11

 

– 42.85

 

0

 

– 42.85

 

Interest earned

Profit before tax Provision for income tax Profit after tax

31st December 2017

31st December 2016

Inventories

67.33

45.30

Trade receivables

96.56

112.65

Trade payables

84.78

94.33

Balance sheet excerpts as on

Provision for tax

0

4.80

2. Finding out the figure of loan taken and repaid: The balance sheet of Axon Limited for the year 2017 and 2016 showed the following amounts under the heading borrowed funds: Particulars

( ` in Million) 2017

2016

Long-term loans

733.47

654.57

Working capital loans

614.23

823.44

Borrowed funds

The company took fresh long-term loans during the year amounting to ` 250 million. Working capital loans repaid during the year amounted to ` 300 million.

a. Based upon the above information, ascertain the amount repaid towards long-term loans and fresh working capital loans taken during the year. b. How will you show the above cash flows under cash flow from financing activities?

320  Chapter 11

3. Finding the figure of property, plant and equipment purchased: The balance sheet of Axon Limited for the year 2017 and 2016 showed the following amounts under the heading property, plant and equipment: Particulars

( ` in Million) 2017

2016

Gross block

872.24

734.15

Less: Accumulated depreciation

261.32

189.34

Net block

610.92

544.81

Property, plant and equipment

During the year, the company sold an item of PPE with original cost of ` 87 million and accumulated depreciation of ` 69.45 million for ` 21.50 million.

a. Based upon the above information, ascertain the depreciation charged for the current year and also profit or loss on sale of PPE. b. Ascertain the cost of PPE purchased during the year. c. How will the depreciation and profit/loss on sale of PPE be treated while calculating cash flow from operating activities (using indirect method)? d. How will you show the above transactions under cash flow from investing activities?

4. Inferring balance sheet changes from cash flow statement: The cash flow from operating activities (indirect method) in respect of A-One Batteries for the year 2017 is give as follows: Particulars Profit before tax

( ` in Million) 230.76

Add: Depreciation

97.79

Add: Non-operating expenses

13.45

Less: Non-operating income

(6.10)

Operating profit before working capital changes

335.90

Changes in current assets and liabilities Trade receivables

48.23

Inventories

(14.67)

Trade payables

(23.44)

Outstanding expenses

7.09

Operating cash flow before tax payment

353.11

Tax paid

103.42

Net cash flow from operating activities

249.69

Cash Flow Statement  321

On the basis of the information in the cash flow statement as above, please ascertain the changes that have taken place in inventories, trade receivables, trade payables and other liabilities between the last year’s balance sheet and current year’s balance sheet. 5. Based upon the following balance sheets, prepare the cash flow statement for the year 2016–17: ( ` ) Particulars

2016

2017

Property, plant and equipment (gross block)

405,000

787,500

Less: Provision for depreciation

141,750

171,000

Net block

263,250

616,500

Long-term investments

123,750

153,000

101,250

56,250

56,250

157,500

Inventories

337,500

463,500

Trade receivables

157,500

72,000

40,500

27,000

1,080,000

1,545,750

Share capital

450,000

562,500

Other equity

225,000

438,750

112,500

180,000

247,500

337,500

45,000

27,000

1,080,000

1,545,750

Assets Non-current assets

Current assets Cash and bank Current investments

Other current assets Total Equity and liabilities Equity

Non-current liabilities Long-term borrowings Current liabilities Trades payables Other current liabilities Total

322  Chapter 11

6. Preparing cash flow statement: On the basis of the profit and loss statement for the year ended 31st March 2017, balance sheets as on 31st March 2017 and 2016 respectively, and the additional information, prepare the cash flow statement for the year 2016–17.

Balance Sheet as on 31st March Particulars

( ` )

2017

2016

Assets Non-current assets Property, plant & equipment Gross block Less: Acc. depreciation

109,000

95,500

74,000

53,000

Net block Long-term investments

35,000

42,500

125,000

125,000

Current assets Short-term investments

35,000

6,750

Cash on hand

10,000

1,250

105,000

75,000

20,000

15,000

5,000



Trade receivables Less: Provision Interest receivables Inventories

45,000

Total

180,000

97,500

340,000

165,500 333,000

Equity and liabilities Equity Share capital

75,000

62,500

Other equity

170,500

69,000 245,500

131,500

55,500

52,000

Non-current liabilities Long-term debt Current liabilities Trade payables

7,500

94,500

Interest outstanding

11,500

5,000

Income taxes payable

20,000

Total

39,000 340,000

50,000

149,500 333,000

Cash Flow Statement  323

( ` ) Profit and loss statement for the period ended 31st March 2017 Sales

1,532,500

Interest income

15,000

Dividend income

10,000 1,557,500

Cost of goods sold

1,295,000

Depreciation

22,500

Provision for doubtful debts

5000

Administration and selling expenses

45,500

Loss on sale of PPE

2000

Interest expense

20,000 1,390,000

Profit before tax and exceptional items

167,500

Insurance receipts (exceptional) Provision for income tax Profit after tax

9000 15,000 161,500

Additional Information:

a. Dividend paid during the year amounted to ` 60,000. b. Fresh loans taken during the year: ` 12,500. c. During the year a machine with an original cost of ` 4,000 and accumulated depreciation of ` 1,500 was sold for ` 500.



Solutions to Problems

1. Cash Flow from Operating Activities—Direct Method

Particulars

( ` in Million)

Cash sales and collection from customers Sales

487.23

Less: Trade receivable at the end of the year

–96.56

Add: Trade receivables in the beginning of the year

112.65

503.32

Paid for material Material consumed Less: Inventories at the end of the year Add: Inventories at the beginning of the year

–246.45 –67.33 45.3 (continued )

324  Chapter 11 (continued )

Particulars

( ` in Million)

Add: Trade payable at the end of the year Less: Trade payable at the beginning of the year Other expenses Tax paid Provision for tax Add: Provision at the end of the year Less: Provision for tax in the beginning of the year Cash flow from operating activities

84.78 –94.33

–278.03 –133.18

0 0 –4.8

–4.8 87.31

Cash Flow from Operating Activities—Indirect Method

Particulars

( ` in Million)

Profit before tax

–42.85

Add: Depreciation Add: Interest and finance charges Add: Loss on sale of asset Less: Interest earned Operating profit before working capital changes Less: Increase in inventories Add: Decrease in trade receivables Less: Decrease in trade payables

93.34 82.11 33.45 –58.45 107.6 –22.03 16.09 –9.55 92.11 –4.8 87.31

Less: Income tax paid Cash flow from operating activities

2. a.  By using the relation; opening balance of loans + fresh loan taken – loan repaid = closing balance of loan; we can ascertain the fresh loan taken or repaid during the year. Particulars Long-term loans Opening balance Add: Fresh loan taken during the year Less: Closing balance Loan repaid during the year Working capital loans Opening balance Less: Loan repaid during the year Less: Closing balance Loan taken during the year

( ` in Million) 654.57 250.00 904.57 733.47 171.10 823.44 300.00 523.44 614.23 90.79

Cash Flow Statement  325



b. Cash Flow from financing activities Particulars

( ` in Million)

Proceeds from long-term loans

250.00

Repayment of long-term loans

(171.10)

Proceeds from working capital loans

90.79

Repayment of long-term loans

(300.00)

3. a. Depreciation charged during the year can be calculated by using the following relationship: Opening balance of provision + Provision for depreciation for the year—provision on the PPE sold during the year = Closing balance of provision for depreciation ` 189.34 + Current year depreciation – ` 69.45 = ` 261.32 million

Current year depreciation = ` 261.32 – ` 119.89 = ` 141.43 million



Book value of the PPE sold = Original cost – Accumulated depreciation



` 87.00 – ` 69.45 = ` 17.55 million

Profit on sale of PPE = Sale price – Book value

` 21.50 – ` 17.55 = ` 3.95 million b. PPE acquired during the year can be ascertained by using the following relationship; Gross Block in the beginning + PPE acquired during the year – Cost price of PPE sold = Gross Block at the end of the year. Accordingly, ` 734.15 + PPE acquired – ` 87 = ` 872.24 PPE acquired during the year = ` 872.24 – ` 674.15 = ` 225.09



c. While calculating cash flow from operating activities (using indirect method) current year’s depreciation will be added back to profits being a non-cash expenses and profit on sales of PPE will be subtracted being a non-operating activity as follows: Cash flow from operating activities Profit before tax



Add: Depreciation for the year

141.43

Less: Profit on sale of PPE



3.95

d.      Cash flow from investing activities Sale of PPE Acquisition of PPE

21.50 (225.09)

4. Trade receivables have decreased by ` 48.23 million whereas inventories have increased by ` 14.67 million between the two balance sheet dates. Trade payables have shown a decline of  ` 23.44 million whereas outstanding expenses have gone up by ` 7.09 million in the same period.

326  Chapter 11

5. Cash Flow Statement for the year 2016–17 Profit for the year Other equity as on 31st March 2017

438,750

Less: Other equity on 31st March 2016

225,000

213,750

Add: Depreciation for the year Depreciation as on 31st March 2017

171,000

Less: Depreciation on 31st March 2016

141,750

29,250 243,000

Working capital changes Add: Decrease in trade receivables

85,500

Increase in trade payables

90,000

Decrease in other current assets

13,500

Less: Increase in inventories

(126,000)

Decrease in other current liabilities Cash flow from operating activities

(18,000) A

288,000

Cash flow from investing activities Increase in PPE

(382,500)

Increase in long-term investments Cash used in investing activities

(29,250) B

(411,750)

Cash flow from financing activities Increase in share capital

112,500

Increase in long-term borrowings

67,500

Cash generated from financing activities

C

Net increase in cash and cash equivalents

A+B+C

180,000 56,250

Reconciliation Cash in bank as on 31st March 2017 Current investments as on 31st March 2017

56,250 157,500

213,750

Less: Cash in bank as on 31st March 2016 Current investments as on 31st March 2016 Net increase in cash and cash equivalents

101,250 56,250

157,500 56,250

It is assumed that the current investments are short-term in nature and are part of cash equivalents.

Cash Flow Statement  327

6. Cash Flow Statement for the Year Ended 31st March 2017 Particulars

( Amount in `)

A Cash flow from operating activities

 

Net profit before taxation and extraordinary items

167,500

Add: Non-cash expenses  Depreciation   Provision for doubtful debts

  22,500

 

5,000

27,500

Add: Non-operating expenses   Interest expense

  20,000

 

2,000

22,000

  Interest income

–15,000

 

  Dividend income

–10,000

  Loss on sale of PPE Less: Non-operating income

 

Operating profit before working capital changes Add: Decrease in inventories

–25,000 192,000

52,500

 

Less: Increase in trade receivables

–30,000

 

Less: Decrease in trade payables

–87,000

–64,500

 

127,500

Less: Income tax paid

–45,000

Cash flow before exceptional items

82,500

Add: Insurance claim receipts

9,000

Net cash from operating activities

91,500

Cash flow from investing activities

 

Purchase of PPE

–17,500

Proceeds from sale of old machinery

500

Interest received

10,000

Dividend received

10,000

Net cash from investing activities

3,000

Cash flow from financing activities

 

  Issue of share capital

12,500

  Long-term borrowings

12,500

  Repayment of loan

–9,000

Interest paid

–13,500

Dividends paid

–60,000

Net cash from financing activities Net increase in cash or cash equivalents (A+B+C) Cash & cash equivalents at the beginning Cash & cash equivalents at the end

–57,500 37,000

 

8,000

 

45,000

328  Chapter 11 Working notes

Particulars

( Amount in `)

Income tax paid

 

 

  Payable in the beginning

50,000

 

 Add: For the year

15,000

 

 Less: Payable at the end

20,000

45,000

Purchase of PPE

 

Closing gross block

109,000

 

 

Opening gross block Less: sold during the year

95,500

 

4,000

91,500

 

 

Purchased during the year

17,500

Interest received

 

Interest earned

15,000

 

Less: Interest receivable

 5,000

10,000

Repayment of loan

 

  Opening balance of loan

52,000

 

 Add: Fresh loan

12,500

 

  Less: Closing balance

55,500

 9,000

 

 

Interest paid

 

  Expense for the year

20,000

 

 Less: Outstanding at the end

11,500

 

5,000

13,500

 Add: Outstanding in the beginning

Try It Yourself 1. On the basis of information given fill the missing entries: Particulars Increase or decrease in cash

Zip Ltd.  

Zap Ltd.  

Zoom Ltd.  

 

 

 

  At the end of the year

43.88

107.87

?

  At the beginning of the year

69.00

  Cash & cash equivalent

?

230.45 (continued )

Cash Flow Statement  329 (continued )

Particulars   Increase or (decrease) in cash

Zip Ltd.

Zap Ltd.

Zoom Ltd.

?

18.65

68.33

23.32

312.55

?

–163.48

Cash flow during the year

i)  Operating activities

–76.11



ii)  Investing activities

–10.77



iii)  Financing activities

Net cash flow (i + ii + iii)

?

93.45

?

?

?

?

Comment upon the cash flows of the respective companies. 2. Finding the amount of tax paid: Avon Limited made a provision of  ` 103 million towards income tax for the year 2016–17. The provision for income tax in the current year balance sheet is ` 108 million compared to ` 97 million in the last year balance sheet. Ascertain the income tax paid during the year. 3. Cash flow from operating activities: Calculate the cash flow from operating activities on the basis of the following information using indirect method: Profit and loss account for the year ended 31st December 2017

Particulars

( ` in Million)

Sales

228.35

Interest earned

 27.43

Total income

255.78

Material consumed

96.68

Other expenses

54.24

Depreciation

32.29

Interest & finance charges

21.77

Profit before tax

50.80

Provision for income tax

17.46

Profit after tax

33.34

Balance sheet excerpts as on

31st December 2017

31st December 2016

Inventories

37.88

25.12

Trade receivables

64.63

32.17

Trade payables

16.66

11.45

Provision for tax

17.46

14.48

330  Chapter 11



4. From the following balance sheets of XYZ Limited, prepare the cash flow statement for the year ended 31st March 2018 and explain the reasons for the decline in the cash and cash equivalents: Balance Sheet of XYZ Limited as on 31st March ( ` in Crore) Particulars 2017 2018 A. Assets 1.  Non-current assets  Property, plant & equipment 13,689 15,718  Intangible assets 1,370 1,410  Capital work in progress 22,075 28,049 37,134 45,177  Non-current investments 684 685  Long-term loans and advances 1,691 2,003  Other non-current assets 30 41 39,539 47,906 2. Current assets  Current investments  Inventories 11,303 13,742  Trade receivables 4,130 4,761  Cash & cash equivalents 17,480 6,416  Short-term loans and advances 1,246 1,386   Other current assets 2,385 2,126 36,544 28,431 Total 76,083 76,337 B. Equity & liabilities 1. Equity  Share capital 4,130 4,130  Other equity 32,939 35,681 37,069 39,811 2. Non-current liabilities  Long-term borrowings 9,053 11,587  Deferred tax liabilities 1,491 1,644  Other long-term liabilities 1,096 1,090  Long-term provisions 3,192 3,513 14,832 17,834 3.  Current liabilities  Short-term borrowings 10,003 4,511  Trade payables 3,187 3,191  Other current liabilities 8,308 8,681  Short-term provisions 2,684 2,309 24,182 18,692 Total

76,083

76,337

Cash Flow Statement  331

5. From the following Balance Sheets and Profit and Loss Statement prepare the Cash Flow Statement for the year 2016–17 Balance Sheet as at 31st March ( Amount in ` )

2016

2017

1,700,000

2,635,000

106,250

51,000

85,000

144,500

Inventories

1,117,750

1,394,000

Trade receivables

1,317,500

1,479,000

127,500

85,000

4,454,000

5,788,500

Share capital

2,125,000

2,550,000

Other equity

510,000

1,275,000

637,500

510,000

A. Assets Non-current assets Property, plant & equipment Current assets Cash and bank Current investments

Other current assets Total B. Equity & liabilities Equity

Non-current liabilities Long-term borrowings Current liabilities Bank overdraft Provision for tax Outstanding expenses Trades payables Total

55,250 127,500

187,000

34,000

42,500

1,020,000

1,168,750

4,454,000

5,788,500

Profit and loss statement for the year ended 31st March 2017 ( Amount in ` ) Particulars Income Sales Interest income Total revenue

2017 14,237,500 1,062,500 15,300,000 (continued )

332  Chapter 11 (continued )

Profit and loss statement for the year ended 31st March 2017 ( Amount in ` ) Particulars

2017

Expenditure Material consumed Other operating expenses Finance cost Depreciation Total expenses Profit before tax Provision for tax Profit for the year

12,027,500 1,891,250 106,250 340,000 14,365,000 935,000 170,000 765,000

6. The profit and loss statement for the year ended 31st March 2017 and the balance sheets as on 31st March 2016 and 2017 are given below. You are required to prepare the cash flow statement for the year ended 31st March 2017 and explain the main reasons for the decline in cash and cash equivalents. Balance sheet as on 31st March ( ` in Crore) Particulars

2016

2017

Property, plant and equipment

37,224

47,663

Capital work-in-progress

23,713

28,184

60,937

75,847

1,214

1,101

329

1,317

3,616

5,614

66,096

83,879

Current investments

184

183

Inventories

382

440

Trade receivables

1,114

2,316

Cash and cash equivalents

3,680

2,336

Short-term loans and advances

2,037

2,434

Other current assets

2,229

628

9,626

8,337

75,722

92,216

A. Assets 1. Non-current assets

Non-current investments Long-term loans and advances Other non-current assets 2. Current Assets

Total

(continued )

Cash Flow Statement  333 (continued )

Balance sheet as on 31st March ( ` in Crore) Particulars B. Equity and liabilities 1. Shareholders' funds Share capital Other equity 2. Non-current liabilities Long-term borrowings Deferred tax liabilities Other long-term liabilities Long-term provisions 3. Current liabilities Short-term borrowings Trade payables Other current liabilities Short-term provisions Total

2016

2017

4,630 16,737 21,367

4,630 18,858 23,488

37,216 1,147 5,162 317 43,842

49,119 1,601 4,209 421 55,350

1,450 197 6,307 2,559 10,513 75,722

1,650 203 8,461 3,064 13,378 92,216

Profit and loss statement for the year ended 31st March 2017 ( ` in Crore) Particulars

2017

Income Revenue from operations Interest income Total income

10,035 750 10,785

Expenditure Employees benefit expenses

843

Finance cost

1943

Depreciation

2573

Other expenses

829

Total expenses

6188

Profit before tax

4597

Tax expenses—Current  —Deferred Profit for the year

889 454 3254

334  Chapter 11 Other Information:

a. The board of directors of the company has proposed dividend @ 20% amounting to ` 926 crore on which dividend distribution tax of ` 207 crore is payable. b. During the year similar dividend and distribution tax pertaining to the previous year was actually paid. c. Income tax actually paid during the year amounted to ` 889 crore. 7. Preparation of cash flow statement: On the basis of the following information, prepare the cash flow statement for Seven Wonders Limited for the year 2016–17. Balance Sheet as on 31st March ( ` in Million) Particulars A. Assets Non-current assets Property, plant and equipment Gross block Less: Accumulated depreciation Net block Long-term investments Current assets Short-term investments Cash in hand Trade receivables Less: Provision Interest receivables Inventories Total B. Equity and liabilities Shareholders' funds Share capital Share premium Reserves

2017

10,278 4,106

672 304 2,174 (26) 48 2,077

5,249 12,941

970 2,000 3,860

3,104 9,55 2,087 446 1,805 (16) 22 1,481

1,922 87 435 65

Provision for income tax

478

5,825 9,884

435 0 3,760 6,830 2,910 214

Dividend distribution tax Total

7,735 4,631 6,172 1,520

Long-term debt Deferred tax liability Current liabilities and provisions Trade payables Interest outstanding Proposed dividend

2016

4,195 3,870 180 882 15 435 74

2,987 12,941

233

1,639 9,884

Cash Flow Statement  335

Profit and loss statement for the period ended 31st March 2017 ( ` in Million) Sales Interest income Gain on sale of asset Dividend income Cost of goods sold Depreciation Provision for doubtful debts Loss on sale of long-term investments Administration and selling expenses Interest expense Profit before tax and extra-ordinary items Extra ordinary loss Profit before tax Provision for income tax Current tax Deferred tax Total tax Profit after tax Appropriation Proposed dividend Dividend distribution tax Balance carried to balance sheet

7557 212 95 89 7953 4250 675 10 45 634 438 6052 1901 342 1559 490 34 524 1035 435 65 535

Additional Information:

a. Short-term investments represent investment of short-term cash surplus in highly liquid and risk free instruments. b. The company issued bonus shares during the year with face value of `435 million to the existing shareholders. c. During the year the company acquired PPE for `4250 million. d. Long-term loan repaid during the year amounted to `1750 million. e. Fresh long-term investment made during the year amounted to `765 million. f. A dividend of ` 435 million was proposed during the year on which dividend distribution tax of ` 65 million is payable.

336  Chapter 11

Cases Case 11.1: ‘Where has the Cash Gone’?: Cash Flow Statement of New Age Limited Mr. Know-It-All is the chairman and managing director (CMD) for New Age Limited that completed its first year of operations on 31st March 2018. Mr. Kuber is the chief financial officer (CFO) of the company. They are reviewing the financial results of the company (balance sheet and profit and loss statement attached). The following conversation took place between them: CMD: I am happy to note that the company has made a profit of over ` 8 lakh in its first year of operations. Let us consider declaring a maiden dividend at 10% on equity shares. CFO: Yes sir. It had been a good first year but I am afraid that it may not be possible to declare any dividend. CMD: Why not? A 10% dividend on the equity capital of  ` 4,400,000 would require only ` 440,000. We can easily afford to pay this amount out of the PAT of  ` 875,262. CFO: Sir, I agree that we have adequate profits to pay the dividend but there is not enough cash to pay this dividend. Our cash balance is just ` 37,850. CMD: I do not understand your accounting jargons. If the profits earned is ` 875,262 then Where has the cash gone? Mr. Kuber wants your help in explaining the cash position to the CMD with the help of a cash flow statement clearly indicating cash flow from operating activities, investing activities and financing activities. Profit and loss statement of New Age Limited for the year ended 31st March 2018 Income Sales Expenses Raw material consumed

  4,325,000   1,525,000

General expenses

731,800

Salaries and wages

68,350

Directors’ fees

40,000

Provision for doubtful debts

73,500

EBITDA Less: Provision for depreciation EBIT Interest on debentures Profit before tax (PBT) Provision for taxation Profit after tax (PAT) Transfer to general reserve Surplus carried to balance sheet

1,886,350 495,000 1,391,350 250,000 1,141,350 266,088 875,262 400,000 475,262

Cash Flow Statement  337

Balance sheet of New Age Limited as on 31st March 2018 A. Assets Non-current assets Property, plant and equipment Gross block Less: depreciation

7,322,000 495,000

Net block

6,827,000

Current assets Inventories Trade receivables Less: Provisions

625,000 1,097,000 73,500

1,023,500

Cash and bank

37,850

Salary advance

48,000

Advance income tax

275,000

Total

8,836,350

Equity and liabilities Shareholders' funds Share capital

4,400,000

Other equity

875,262

5,275,262

Non-current liabilities 10% debentures

2,500,000

Current liabilities Interest on debentures accrued but not paid

125,000

Trade payables

670,000

Provision for income tax Total

266,088 8,836,350

Case 11.2: Analysis of Cash Flow Statement—Container Corporation of India Limited Container Corporation of India Ltd. (CONCOR) commenced operation from November 1989. It is now an undisputed market leader having the largest network of 68 inland containers depots (ICDs). In addition to providing inland transport by rail for containers, it has also expanded to cover management of ports, air cargo complexes and establishing cold-chain. Out of total 68 terminals, 13 are exportimport container depots and 17 exclusive domestic container depots and as many as 37 terminals perform the combined role of domestic as well as international terminals. The company reported profit before tax (PBT) of ` 1,180.61 crore and ` 1,307.95 crore for the year 2016–17 and 2015–16, respectively. However, the cash and cash equivalents have declined from ` 2,587.93 crore as on 1st April 2015 to ` 4,14.45 crore as on 31st March 2017.

338  Chapter 11

The statement of cash flow of the company for the year 2016–17 with comparative figures for the previous year is presented below: Statement of Cash Flow for the Year Ended 31st March 31 2017

Particulars

( ` in Crore) 2017

2016

A. Cash flow from operating activities: Net profit before tax

1,180.61

1,307.95

Depreciation and amortization

351.82

347.76

Amortization of leasehold land

13.17

14.97

Adjustments for:

Amortization of registration fees

2.58

2.58

(255.01)

(291.57)

Dividend income

(8.60)

(8.18)

Profit on sale of property, plant and equipment

(1.57)

(0.21)

Guarantee Income

(0.11)

(0.05)

Interest expenses

3.66

0.15

Loss on sale of property, plant and equipment

0.35

0.92

Interest income

Provision for fraud, doubtful debts and obsolete stores

0.44

2.21

1,287.34

1,376.53

– Increase/(decrease) in trade payables

54.76

(14.80)

– Increase other financial liabilities

31.37

32.48

– Increase/(decrease) in short-term provisions

4.86

(8.05)

– Increase in long-term provisions

8.22

5.93

– Increase/(decrease) in other current liabilities

2.12

(1.26)

– Increase in other non-current liabilities

1.20

1.30

(19.70)

22.39

Operating Profit before working capital changes Adjustments for changes in working capital:

– Increase/(decrease) other non-current financial liabilities – Decrease in trade receivables

6.46

3.71

– (Increase) in inventories

(4.96)

(1.04)

– (Increase)/decrease in long-term loans

(7.12)

2.97

– (Increase)/decrease in short-term loans

4.45

(4.06)

– Decrease in other current financial assets

1.27

(0.74)

(241.15)

(263.47)

(39.62)

(1,627.73)

(113.68)

(250.26)

– (Increase) in other current assets – Increase/(decrease) other non-current financial assets – (Increase) in other non-current assets

(continued )

Cash Flow Statement  339 (continued )

Particulars

( ` in Crore) 2017

2016

Cash generated from operating activities

975.82

(726.10)

Income taxes paid

(386.75)

(319.22)

Net cash from operating activities

589.07

(1,045.32)

B. Cash flow from investing activities: (925.97)

(364.65)

Acquisition of Intangible assets

Payment made for property, plant and equipment

(0.91)

(8.12)

Addition in capital work in progress

6.15

(218.64)

Proceeds from sale of property, plant and equipment

6.45

1.48

Purchase of financial assets

(16.13)

(200.42)

Interest received

294.77

342.58

8.60

8.18

Dividend received Loans repaid by related parties Net cash from Investing activities

10.55

11.45

(616.49)

(428.14)

(294.38)

(261.29)

C. Cash flow from financing activities: Dividend paid Interest paid Corporate dividend tax paid

(3.66)

(0.15)

(59.94)

(53.18)

Net cash from financing activities

(357.98)

(314.62)

Net (Decrease) in cash & cash equivalents (A+B+C)

(385.40)

(1,788.08)

Cash and cash equivalents as at 1st April (opening balance)

799.85

2,587.93

Cash and cash equivalents as at 31st March (closing balance)

414.45

799.85

Questions for Discussion 1. Identify the main reasons for the decline in cash and cash equivalents in the last two years despite strong profit before tax. 2. For the year 2015–16, the company reported profit before tax (PBT) of ` 1,307.95 crore. However, cash flow from operating activities was (` 1,045.32) crore. Identify the main reasons for the negative cash flow from operating activities during the year. 3. In 2016–17, the company deducted interest income while calculating cash flow from operating activities and added interest received in cash flow from investing activities. Explain the reason for this treatment. 4. For 2016–17, the company had positive adjustment in respect of trade receivables and trade payables and negative adjustment in respect of inventories in the cash flow from operating activities. Explain reasons for the same. 5. The company has negative net cash flow from investing activities in both the years. What does it indicate? 6. There is no cash flows (inflows or outflows) relating to borrowings or equity in the cash flow from financing activities. What does it indicate?

340  Chapter 11

Case 11.3: Analysis of Cash Flow Statement: Suzlon Energy Limited Suzlon Energy Limited, founded in the year 1995, is a leading wind power company. It has presence in 21 countries in the continents of America, Asia, Australia and Europe. It has emerged as the third largest wind power supplier. The year 2009–10 proved to be a disappointing year for Suzlon as it suffered its first full year loss. The economic downturn had a significant impact on lowering demand—and therefore the relative price—of energy. During these difficult times, the company’s management of cash is depicted in the cash flow statements for the year 2008–09 and 2009–10 as follows. Cash Flow Statement for the Year Ended 31st March

Particulars Cash flow from operating activities

( ` in Crore) 2010

2009

 

 

(799.67)

432.96

 

 

Depreciation/amortization

126.27

99.16

Interest income

(222.79)

(122.43)

Interest expenses

653.59

380.12

99.58

143.05

119.25

281.79

Provision for liquidated damages

54.48

155.65

Exchange differences, net

41.55

0.63

11.02   83.28

(15.56)   1,355.37

Profit/(loss) before tax and exceptional items Adjustments for:

Provision for operation, maintenance and warranty Provision for performance guarantee

Other adjustments   Operating profit before working capital changes Movements in working capital (Increase)/decrease in sundry debtors (Increase)/decrease in inventories

  1,760.80

  (1,443.93)

585.82

99.60

(Increase)/decrease in loans and advances

55.53

(220.25)

(Increase)/decrease in margin money deposit

11.55

(45.18)

Increase/(decrease) in current liabilities and provision

(65.61)

449.30

Cash generated from operations

2,431.37

194.91

Direct taxes paid (net of refunds)

(7.75)

(64.41)

2,423.62

130.50

Net cash generated from operating activities before exceptional items Exceptional items paid Net cash (used in)/generated from operating activities

  2,423.62

(521.67) (391.17)

(continued )

Cash Flow Statement  341 (continued )

Particulars Cash flow from investing activities Purchase of fixed assets Proceeds from sale of fixed assets Investments in subsidiaries Sale/Redemption of Investments in subsidiaries Inter-corporate deposits repaid/(granted) Loans granted to subsidiaries Repayments received from subsidiaries Interest received Dividend received Net cash used in investing activities

( ` in Crore) 2010

2009

 

 

(219.96)

(288.67)

1.68

1.40

(990.24)

(2,678.71)

 

389.53

34.21

(35.78)

(3,491.98)

(2,373.27)

1837.60

1,273.83

220.76

123.13

11.40 (2,596.53)

5.36 (3,583.18)

 

 

Share application money received/refunded

(94.96)

95.00

Proceeds from issuance of global depository receipts

522.97

Cash flow from financing activities

Proceeds from issuance of share capital including premium Debenture, zero coupon convertible bond and share issue expenses Proceeds from issuance of debentures Proceeds from long-term borrowings

 

0.12

6.94

(16.38)

(5.05)

  2,781.42

300.00 590.00

Proceeds from issuance of zero coupon convertible bonds

452.64

 

Payment towards buy-back of FCCB

(200.13)

 

Expenses incurred towards buy-back/extinguishment of FCCB

(104.88)

 

Repayment of long-term borrowings Proceeds from short-term borrowings, net Interest paid Dividend paid Tax on dividend paid Net cash generated from financing activities Effect of exchange difference on cash and cash equivalents Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year

(99.36)

(41.96)

(2,023.57)

2,861.02

(646.02)

(365.89)

 

(149.83)

 

(24.39)

571.85

3,265.84

(0.57)

0.23

398.37

(708.28)

70.95

779.23

469.32

70.95

342  Chapter 11

Questions for Discussion 1. For the year 2009, the company earned a profit before tax of ` 432.96 crore but its cash flow from operating activities was negative (−` 391.17 crore). In the next year, the company suffered a loss (−` 799.67 crore) but the cash flow from operating activities was positive ( ` 2,423.62 crore). Identify the main reasons for the same. 2. What has happened to debtors’ position in the year 2009 and 2010? 3. Indentify and analyse major uses of cash towards investing activities. 4. Analyse the major financing activities of Suzlon during 2009 and 2010.

Endnotes 1. ICAI : Ind AS 7, statement of cash flows. 2. Annual report of Maruti Suzuki Limited for the year 2016-17

Consolidated Financial Statements

12

CHAPTER OBJECTIVES This chapter will help the readers to: • Appreciate the rationale behind preparation of consolidated financial statements. • Understand the basic principles and procedures in preparation of consolidated financial statements. • Understand the concept of ‘minority interest’ in consolidated financial statements. • Prepare consolidated financial statements. • Get familiarity with the accounting and disclosure requirements under Ind AS 110 ‘Consolidated Financial Statements’ and Ind AS 28 ‘Investments in Associates and Joint Ventures’.

12.1 INTRODUCTION A company having one or more subsidiaries is required to prepare a consolidated financial statement as per the provisions of the companies act 2013. For such companies, the annual report will have two sets of financial statements—one on a ‘standalone’ basis and the other on ‘consolidated’ basis. The need to present two set of accounts arises from the fact that these enterprises carry out a number of activities through their subsidiary companies. As Ind AS 110: These (consolidated) the enterprise and its subsidiaries are separate entistatements are prepared by combinties, each of them prepares and presentsits financial ing the financial statements of all the statements on a standalone basis. Such financial group entities, with a view to deterstatements reflect the results and financial position mine the financial status of the group of each such entity individually. If one wants to as if it was one single entity. understand the financial results of the group (consisting of the parent enterprise and its subsidiaries) or the assets and liabilities of the group, these individual statements are not very helpful. To better appreciate the financial performance of the group as a whole for the period and its assets and liabilities at the end of the accounting period, there is a need to consolidate all these standalone financial statements. Such consolidated financial statements will show the profit or loss of the group as a single

344  Chapter 12

entity, assets owned by the group as well as the liabilities it owes as a group. Ind AS 110 lays down principles and procedures for preparation and presentation of consolidated financial statements.

12.1.1  Scope of Consolidation The users of financial statements are interested not only in the financial results of an enterprise but also of the group. The group for this purpose includes a parent company and its subsidiaries. The enterprise, being Ind AS 110: Group is a parent with the parent company, needs to present its own financial all its subsidiaries. Parent is an entity statements on a standalone basis and also the financial that controls one or more subsidiarstatements of the group as a whole, aggregating the ies. Subsidiary is an entity that is confinancials of the parent and its subsidiaries. The controlled by another entity. solidated statements are in addition and not a substitute to the separate financial statements of the parent. For the purpose of consolidation, a parent is an enterprise that has one or more subsidiaries. All subsidiaries—both domestic and foreign—need to be consolidated with the parent to arrive at the group’s financial performance and position.

12.2  CONCEPT OF CONTROL The parent–subsidiary relationship exists when the latter is controlled by the former. The obligation is upon the investor to determine whether it is a parent by assessing whether it controls the investee. An investor (parent) controls an investee (subsidiary) if all the following conditions are met:

• Investor has power over the investee. • Investor is exposed to or has right to variable returns from the investee. • Investor has the ability to use its power over the investee to affect the amount of the investor’s returns. The conditions to be met to determine control of investor over investee are presented in Figure 12.1.

Control

Power Over the Investee

Exposure to Variable Return from the Investee

Ability to Use the Power to Affect the Amount of Return from the Investee

Figure 12.1  Concept of Control

12.2.1 Power Power arises from rights—voting rights, contractual right, etc. An investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities. Relevant activities are activities that significantly affect the investee’s returns. Power arising from

Consolidated Financial Statements  345

v­ oting rights from shareholdings may be straightforward. Assessing power from other sources, e.g., contractual rights may be more complex.

12.2.2 Returns If the returns to the investor have the potential to vary as a result of the investee’s performance, the investor is said to be exposed to variable returns from its involvement with the investee. The investor’s returns can be only positive, only negative or both positive and negative.

12.2.3  Link between Powers and Returns An investor controls an investee if it also has the ability to use its power to affect the investor’s returns from its involvement with the investee.

12.3  CONSOLIDATED FINANCIAL STATEMENTS As discussed earlier, the parent company in addition to its separate financial statements also needs to provide consolidated financial statements. The consolidated statements include:

• • • •

Consolidated statement of profit and loss Consolidated balance sheet Consolidated cash flow statement Explanatory notes and statements forming integral part of the above statements

These statements must be presented to the extent possible in the same format as used by the parent company for its separate statements. Consolidated financial statements are prepared using uniform accounting policies. If accounting policies followed by the different entities in the group are different from those used in the consolidated statements, suitable adjustments are required to be made in the financial statements while they are used for consolidation. Likewise, financial periods of the parent and subsidiaries used in the consolidated financial statements shall be the same. If the accounting period used by the subsidiary and parent is different, suitable adjustments need to be made for the effects of significant transactions and events that occur between the reporting dates of subsidiary and parent. The difference in reporting dates cannot be more than three months. If the gap is more than three months, the subsidiary has to prepare full financial statements at the parent’s year-end date. The consolidation of parent and subsidiary companies is done on a line to line basis. The similar items of income, expenses, assets and liabilities are added together to arrive at the consolidated figures. However, intra-group transactions and intra-groups balances need to be eliminated during consolidation so that the consolidated numbers represent the group as a single economic entity.

12.4  CONSOLIDATED STATEMENT OF PROFIT AND LOSS The consolidated statement of profit and loss depicts the performance of the group as a single economic entity. It is prepared by aggregating various incomes and expenses on a line to line basis. Similar items of incomes and expenses are added together. However, two important adjustments need to be made while consolidating—firstly, intra-group transactions like sales, expenses and dividends are eliminated and secondly, the share of non-controlling shareholders in the profit of the subsidiary needs to be deducted from the consolidated profit or loss to arrive at parent’s share in subsidiary’s profit.

346  Chapter 12

12.4.1  Intra-group Transactions It may be possible, some transactions affecting the income or expenses have taken place between different members of a group. An item of income of one group member will become an expense for the other. While consolidating these incomes and expenses, such intra-group transactions need to be eliminated. After this adjustment, incomes and expenses will represent only transactions that have taken place between the ‘group’ on the one hand and external entities (non-group) on the other. ■  Illustration 12.1

The interest income and interest expenses of Fast Track Motors Limited and its subsidiary company Fast Track Components Limited for the year 2016–17 are given as follows: Particulars

( ` in Million) Fast Track Motors Limited

Fast Track Components Limited

Interest earned

132.45

12.08

Interest expenses

311.67

76.89

During the year Fast Track Component paid a sum of ` 45 million to Fast Track Motors Limited towards interest on the amount borrowed from the parent company. How will interest earned and interest expenses be shown in the consolidated profit and loss statement? While preparing consolidated profit and loss statement, intra-day transaction will be eliminated as follows: Particulars Interest earned

Consolidated Profit and Loss Statement 132.45 + 12.08 = Less: Intra-group transaction

( ` in Million) 144.53 45.00 99.53

Interest expenses

311.67 + 76.89 = Less: Intra-group transaction

388.56 45.00 343.56

12.4.2  Non-Controlling Interest In case of a wholly owned subsidiary (where 100% ownership is held by the parent), the entire consolidated profit belongs to the group. In such a case, the profit figure of parent and subsidiary company will be added together. However, if part ownership of the subsidiary which is being consolidated is with external shareholders (called non-controlling interest), the entire profit or loss of the subsidiary does not belong to the group. In such cases, non-controlling interest (NCI) in the profit or loss of the subsidiary company needs to be quantified and adjusted from the consolidated profit to arrive at the profit belonging to the group.

Consolidated Financial Statements  347

■  Illustration 12.2

Let us assume that the Fast Track Motors Limited has 60% ownership of Fast Track Components Limited, the balance 40% being held by minority shareholders. The net profit earned by the two companies for the year amounted to ` 408.44 million and ` 132.65 million, respectively. Ascertain the consolidated profit. The profit figures of the two companies will be added together and then adjusted for the minority ­interest as follows: (  ` in Million) Consolidated Profit ( ` 408.44 + ` 132.65) 541.09 Less: Minority Interest (40% of  ` 132.65) 53.06 Profit after Minority Interest 448.03 The net profit of  ` 448.03 million represents the profit attributable to the owners of the parent c­ ompany.

12.5  CONSOLIDATED BALANCE SHEET While preparing the consolidated balance sheet, various items of assets and liabilities are added on a line to line basis. The consolidated balance sheet so prepared, shows the economic resources controlled by the group and the obligations of the group. However, certain adjustments relating to intra-group balances and non-controlling interest in the net assets of the consolidated subsidiaries need to be made. These adjustments are discussed in detail.

12.5.1  Cost of Investment By investing in the shares of a subsidiary, the parent acquires a proportionate share in the equity of the subsidiary. The amount invested by the parent, appears as an investment on the assets side in its separate balance sheet. In the subsidiary’s balance sheet, the amount of equity appears on the liability side of the balance sheet. Equity for this purpose means the net assets of the subsidiary after deducting all its liabilities. The following situations are possible:

• The cost of investment made by the parent is exactly equal to parent’s portion in the equity of the



subsidiary at the time of making the investments. In this case, in the consolidated balance sheet, the investment made and parent’s portion in the equity of the subsidiary will exactly offset each other and will be eliminated. The cost of investment made by the parent Goodwill: Excess of the cost of is more than parent’s portion in the equity investment made by the parent over of the subsidiary at the time of making the parent’s share in the equity of the the investments. In this case, in the consubsidiary at the time of making the solidated balance sheet, the investment investment. made and parent’s portion in the equity of the subsidiary will be eliminated and the excess will be recorded as goodwill on the asset side.

• The cost of investment made by the parent is less than parent’s portion in the equity of the subsidiary at the time of making the investments. In this case, in the consolidated balance sheet,

348  Chapter 12

the investment made and parent’s portion in the equity of the subsidiary will be eliminated and the difference will be recorded as capital reserve on the liabilities side.

Capital Reserve: Excess of the parent’s share in the equity of the subsidiary at the time of making the investment over the cost of investment made by the parent.

■  Illustration 12.3

Bright Gold Limited has three subsidiary companies. Based upon the information given in the following, ascertain how will the cost of investment be treated in the consolidated balance sheet.

Particulars

( ` in Million) Hira Limited

Panna Limited

Sona Limited

200.00

126.00

120.00

60%

70%

75%

Assets at the time of investment

625.40

314.84

443.75

Liabilities at the time of investment

260.44

134.84

329.55

Investment made Per cent of shares owned

The amount of goodwill or capital reserve will be calculated as follows: Particulars I) Investment made II) % of shares owned

( ` in Million) Hira Limited Panna Limited Sona Limited 200.00 60%

126.00 70%

120.00 75%

III)

Assets at the time of investment

625.40

314.84

443.75

IV)

Liabilities at the time of investment

260.44

134.84

329.55

V)

Net assets at the time of investment (III-IV)

364.96

180.00

114.20

VI)

Parent’s share in the net assets (V × II)

218.98

126.00

85.65

VII)

Excess or deficit of investment over share in the net assets (I-VI)

–18.98

0.00

34.35

The cost of investment made by Bright Gold Limited and its proportionate share in the equity (net asset) of the subsidiary companies will be eliminated from the consolidated balance sheet. In respect of its investment in the Hira Limited ` 18.98 million will be recognized as capital reserve in the consolidated balance sheet, whereas in respect of Sona Limited goodwill amounting to ` 34.34 million will be recorded in the consolidated balance sheet. No goodwill or capital reserve will be recognized in respect of investments made in Panna Limited as the cost of investments is exactly offsetting the parent’s share in the net assets of the subsidiary.

Consolidated Financial Statements  349

12.5.2  Non-Controlling Interest IND

AS

110:

Non-Controlling

In case of a wholly owned subsidiary (where 100% Interest—Equity in a subsidiary not ownership is held by the parent) the entire equity attributable, directly or indirectly, to of the subsidiary belongs to the group. In such a a parent. case, the equity of parent and subsidiary company can be added together on a line to line basis for the purposes of consolidation. However, if part ownership of the subsidiary which is being consolidated is with external shareholders (non-controlling interest), the entire equity of the subsidiary does not belong to the group. In such cases, non-controlling interest in the equity of subsidiary company needs to be quantified and shown in consolidated balance sheet separately from liabilities and the equity of the parent’s shareholders. While consolidating the balance sheet, the equity of the subsidiary is broken onto three parts:

1. Non-controlling interest 2. Parent’s share in the equity of the subsidiary at the time of making the investment 3. Parent’s share in the equity of the subsidiary after the date of investment

The non-controlling interest (1 above) is shown separately in the consolidated balance sheet. Parent’s share in the equity of the subsidiary at the time of making the investment (2 above) is offset against the cost of investment and is eliminated from the consolidated balance sheet. The parent’s share in the equity of the subsidiary after the date of investment (3 above) is aggregated in the consolidated balance sheet.

12.5.3  Intra-group Balances While preparing the consolidated balance sheet, intra-group balances are identified and eliminated. For example, if the parent company has lent money to the subsidiary company, the same will be appearing on the asset side of parent company as loans and advances and on the liability side of the balance sheet of the subsidiary company as borrowed funds. In the consolidated balance sheet, both these balances will be eliminated to present the group as one economic unit. ■  Illustration 12.4

On the basis of the separate balance sheets of H Limited and S Limited and additional information, prepare the consolidated balance sheet as on 31st December 2017:  Particulars Investments in S Ltd Loan to S Ltd

( ` in Million) H Limited

S Limited

280 420

Other assets

4,940

1,270

 

5,640

1,270

Share capital

500

200

Other equity

1,890

430 

Borrowed funds  

3,250 5,640

640 1,270

350  Chapter 12

Additional Information a. H Limited acquired 70% equity share of S Limited on 1st April 2016. b. At the time of making the investments, the other equity balance in the books of S Limited stood at ` 250 million. Working Capital Reserves Equity of S limited at the time of making investments

( ` in Million)

Share capital Other equity Total equity H Limited’s share in the equity of S Ltd at the time of making the investment (70% of ` 450) Less: Cost of investment

200 250 450 315 280

Capital reserve to be recognized

35

Non-Controlling Interest 30% of equity as on 31st March 2017 = 30% of   ` 630 million = ` 189 million Other Equity Addition to other equity of S Limited since acquisition = ` 430 million – ` 250 million = ` 180 million 70% of increase in other equity H’s share = ` 180 million × 70% = ` 126 million. Consolidated other equity = ` 1,890 million + ` 126 million = ` 2,016 million. Intra-group Balances Loan to S Limited in H Limited balance sheet will be offset against the borrowed funds in the balance sheet of S Limited. Borrowed funds in the consolidated balance sheet will be equal to ` 3,250 + ` 640 – ` 420 = ` 3,470 million. Loan to S Limited will not appear in the consolidated balance sheet.          Consolidated Balance Sheet as on 31st March 2017

Particulars I)  Equity and liabilities Shareholder’s funds Share capital Other equity (Including capital reserve `35)

( ` in Million)

500

     

2,051

 

2,551 189 3,470 6,210

II) Assets Other assets  

  6,210 6,210

Non-Controlling interest Borrowed funds

Consolidated Financial Statements  351

12.5.4  Unrealized Profit on Intra-group Transactions As discussed in the earlier paragraphs, intra-group transactions and balances are eliminated in full. Some of these intra-group transactions may result in unrealized gain or losses which are included in the balance amount of assets, e.g., inventory or fixed asset. Such unrealized profits or losses are identified and eliminated from the consolidated profit and loss statement as well as balance sheet. ■  Illustration 12.5

S Limited is a subsidiary of H Limited which own 60% of the equity shares of S Limited. During the year 2016–17, S Limited sold goods costing ` 120 million to H Limited for ` 180 million. Out of these, 1/3 of goods are still in stock of H Limited on the date of the balance sheet. How will the above transaction be consolidated? Sale of ` 180 million by S Limited has been recorded as purchase by H Limited for the same amount. Both these transactions will be eliminated from the consolidated profit and loss statement. S Limited sold these goods a margin of 50% on cost recognizing a profit of  ` 60 million. As 1/3rd of the goods are still in stock of H Limited, 1/3rd of these profits, i.e., ` 20 million, are unrealized. Out of these unrealized profits, 60%, i.e., ` 12 million, belongs to the group and needs to be eliminated. In the consolidated profit and loss statement, a deduction of ` 12 million will be made towards unrealized profit. The amount of inventories in the consolidated balance sheet will also be reduced by the same amount.

12.6  INVESTMENTS IN ASSOCIATES AND JOINT VENTURES Ind AS 28 defines an associate as an entity over which the investor has significant influence. The power to participate in the financial and operating policy decisions of the investee is indication of significant influence. Control or joint control over these policies is not a requisite condition for being an associate. In case of a joint venture, parties have joint control over the investee. Decisions about the relevant activities require the unanimous consent of the parties sharing control. The parties having joint control also have rights to the net assets of the arrangement.

12.6.1  Initial Measurement Investment in an associate or a joint venture should be accounted using the equity method. Investment is initially recognized at cost, i.e., purchase price and any directly attributable expenditures necessary to acquire that investment. The difference between the cost of investment and entity’s share of the net fair value of the investee’s identifiable assets and liabilities is accounted either as goodwill or capital reserve. If the cost of investment is greater than the entity’s shares of net fair value of the investee’s identifiable assets and liabilities, the difference in recorded as goodwill. If, however, the entity’s share of net fair value of the investee’s identifiable assets and liabilities is greater than the cost of investment, the difference is recorded as capital reserve.

12.6.2  Subsequent Measurement The investment in an associate or joint venture is to be tested for impairment as single asset by comparing its recoverable amount with its carrying amount, if there are impairment indicators. Goodwill so recognized is not eligible for amortization and is not tested for impairment separately. The consoli-

352  Chapter 12 Box 12.1  Accounting policy of Biocon Limited Regarding Basis of Consolidation. Subsidiaries Subsidiaries are entities controlled by the Group. The Group controls an entity when it is exposed to, or has rights to, variable returns from its involvement with the entity and has the ability to affect those returns through its power over the entity. The financial statements of subsidiaries are included in the consolidated financial statements from the date on which control commences until the date on which control ceases.

The financial statements of the Group are consolidated on line-by-line basis. Intra-group transactions, balances and any unrealized gains arising from intra-group transactions are eliminated. Unrealised losses are eliminated, but only to the extent that there is no evidence of impairment. All temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions are recognized as per Ind AS 12, Income Taxes. For the purpose of preparing these consolidated financial statements, the accounting policies of subsidiaries have been changed where necessary to align them with the policies adopted by the Company. Annual report of Biocon Limited for the year 2016–17

dated statement of profit and loss would include the Group’s share of profit or loss and other comprehensive income. Biocon Limited presented consolidated financial statements in its annual report for the year 2016–17 by consolidating the financials of 10 subsidiary companies and one joint venture. The accounting policy of the company relating to consolidation principles is given in Box 12.1.

Non-controlling Interests (NCI) NCI are measured at their proportionate share of the acquiree’s net identifiable assets at the date of acquisition. Changes in the Group’s equity interest in a subsidiary that do not result in a loss of control are accounted for as equity transactions.

Loss of Control When the Group loses control over a subsidiary, it derecognizes the assets and liabilities of the subsidiary, and any related NCI and other components of equity. Any interest retained in the former subsidiary is measured at fair value at the date the control is lost. Any resulting gain or loss is recognized in statement of profit and loss.

Associates and Joint Arrangements (Equity Accounted Investees) An associate is an entity in which the Group has significant influence, but not control or joint control, over the financial and operating policies. A joint venture is an arrangement in which the Group has joint control and has rights to the net assets of the arrangement rather than rights to its assets and obligations for its liabilities. Interests in associates and joint ventures are accounted for using the equity method. They are initially recognized at cost which includes transaction costs. Subsequent to initial recognition, the ­consolidated financial statements include the Group’s share of profit or loss and OCI of equity-accounted investees until the date on which significant influence or joint control ceases.

Consolidated Financial Statements  353

Summary

• Consolidated financial statements are needed to understand the financial performance and • • • • •

• •

position of a group. A group consists of a parent and its subsidiaries. An enterprise in which more than 50% voting power is held by another or its composition of board of directors is controlled by the other entity is called the subsidiary of the other enterprise (called parent). The parent needs to present consolidated financial statements in addition to its own separate financial statements. To the extent practical, while preparing the consolidated statements, the accounting policies used should be uniform and the financial statements used should be drawn up to the same reporting date. Consolidation is done by adding the financial statements of the parent and subsidiaries on a line-by-line basis. Intra-group transactions and intra-group balances are eliminated. The cost of investment made by the parent is set off against its proportionate share in the equity of the subsidiary. The difference between cost of investment and its share in equity, if positive, is recorded as goodwill and, if negative, is recorded as capital reserve in the consolidated balance sheet. Non-controlling interest in the net income of the subsidiaries is quantified and deducted from the combined profits. NCI in the net assets of the subsidiaries is identified and reported separately in the consolidated balance sheet. Interest in jointly controlled entities is reported in the consolidated financial statements using proportionate consolidation. In addition to subsidiary companies and joint ventures, financial statements of associates also need to be consolidated. An associate is an enterprise in which the investor has a significant influence and which is not a subsidiary or a joint venture of the investor.

Assignment Questions 1. What is the purpose behind preparation of consolidated financial statements? 2. How do we define the expression ‘group’ for the purpose of consolidation? 3. ‘Intra-group transactions and intra-group transactions need be eliminated while consolidating’. Explain the statement with suitable examples. 4. How is the cost of investment in the subsidiary company treated? 5. Define the expression ‘minority interest’. How is minority interest disclosed in the consolidated financial statements?

Problems 1. Goodwill or capital reserve on consolidation: Big Bull Limited acquired 70% of equity shares of Small Cow Limited for a total consideration of ` 435.45 million. At the time of acquisition the equity share capital of Small Cow Limited stood at 20 million equity shares of ` 10 each and the other equity balance at ` 320 million.

354  Chapter 12



a. Compute the amount at which the goodwill or capital reserve will be recognized in the consolidated balance sheet. b. What will be the goodwill or capital reserve if the consideration was ` 235.45 million? c. How will the investment appear in the consolidated balance sheet in the above two situations? 2. Intra-group transactions: S Limited, a 100% subsidiary company of H Limited, sold goods costing ` 120 million to H Limited for ` 160 million during the year. Out of these, 40% of the goods are still unsold and are included in the balance sheet of H Limited at cost to it. How will the above transaction be treated in the consolidated financial statements? 3. Preparing consolidated balance sheet: From the following balance sheets of H Limited and S Limited and additional information prepare the consolidated balance sheet of H Limited. Particulars

( ` in Million) H Limited

S Limited

Share capital

174.50

87.30

Other equity

69.80

26.17

Trade payables

26.17

17.45

 

270.47

130.92

Assets

169.50

112.17

Trade receivables

22.45

18.75

Investments

78.52

0.00

270.47

130.92

 

Additional Information a. The face value of shares of both companies is ` 10. b. H Limited holds 60% share in S Limited at a cost of ` 78.52 million. c. At the time of acquisition, the other equity of S Limited stood at ` 9.60 million. d. Trade payables of S Limited includes a sum of ` 7.5 million due to H Limited. 4. Preparing consolidated balance sheet: Hero Limited acquired the entire equity share capital of Zero Limited on 1st January 2017 for a consideration of ` 600 million. At the time of acquisition the share capital of Zero Limited consisted on 20 million equity shares of ` 10 each. The company had other equity amounting to ` 560 million. The balance sheets of the two companies as on 31st March 2017, are given below:  Particulars

( ` in Million) Hero Limited

Zero Limited

Share capital

500

200

Other equity

2,540

750

Loan funds

3,200

1,400

Trade payables

1,650

680

 

7,890

3,030 (continued )

Consolidated Financial Statements  355 (continued )

 Particulars

( ` in Million) Hero Limited

Zero Limited

Fixed assets Investments Inventories Trade receivables

1,430 650 630 2,580

925 100 320 560

Loans and advances Other assets  

1,260 1,340 7,890

165 960 3,030

Additional Information a. Zero Limited borrowed ` 1,000 million from Hero Limited on 1st January 2011 at 10% per annum. The loan amount and interest thereon is due to be paid. b. Hero Limited bought goods from Zero Limited for ` 200 million during the year. Zero Limited charged a margin of 25% on cost. Out of these goods, 1/4th are still unsold. c. The debtors for Zero Limited include an amount of ` 140 million receivable from Hero Limited.

Solutions to Problems 1. a. Equity of Small Cow Limited at the Time of Acquisition Particulars Share capital Other equity   Cost of acquisition Less: Big bull limited’s share in the equity of small cow limited (70% of ` 435.45 million) Goodwill on consolidation



( ` in Million) 200.00 320.00 520.00 435.45 364.00 71.45

b. As the consideration of ` 235.45 million is less than the Big Bull Limited’s share in the equity of the Small Cow Limited, the difference, ` 128.55 million, will be recognized as capital reserve. c. In either case, the investment amount will not appear in the consolidated balance sheet.

2. Elimination for intra-group transactions: The transaction is appearing as ‘sale’ in the books of S Limited and as ‘purchase’ in the books of H Limited at ` 160 million. While consolidating, both the legs of the transaction will be eliminated. Consequently, both income and expenses will come down by the same amount with no impact on profit. Elimination of unrealized profit: The goods were sold by S Limited to H Limited at a profit of ` 40 million. Out of these goods 40% are still unsold resulting in an unrealized profit of ` 16 million (40% of  ` 40 million). The carrying cost of inventory in the consolidated balance sheet will be reduced by ` 16 million and at the same time the consolidated profit will be reduced by the same amount.

356  Chapter 12

3. Capital reserve Equity of S Limited at the time of making investments

( ` in Million)

Share capital

87.30

Other equity

9.60

Total equity

96.90

H Limited’s share in the equity of S Ltd at the time of making the investment (60% of ` 96.90 million)

58.14

Cost of investment

78.52

Goodwill on consolidation

20.38

Minority interest Equity of S limited

( ` in Million)

Share capital

87.30

Other equity

26.17

Total

113.47

Minority interest (40% of equity) = ` 45.39 million

Other equity Particulars

( ` in Million)

Other equity H limited Other equity S limited Less: Other equity at the time of acquisition Addition to other equity

69.80 26.17 9.60 16.57 9.94

H Limited’s share (60% of ` 16.57 million) Total

79.74

Intra-group balances Particulars

( ` in Million)

Trade receivables H Limited + S limited Less: Intra-group balance Balance

41.20 7.50 33.70

Trade payables H Limited + S limited Less: Intra-group balance Balance

43.62 7.50 36.12

Consolidated Financial Statements  357

Consolidated balance sheet H Limited

( ` in Million)

Share capital

174.50

Other equity

79.74

Minority interest

45.39

Trade Payables

36.12

 

335.75

Assets

281.67

Goodwill

20.38

Trade Receivables

33.70

 

335.75

4. The consolidated balance sheet as on 31st March 2017 is given as follows: Hero Limited

( ` in Million)

Share capital

500

Other equity

2,720

Capital reserves on consolidation

160

Loan funds

3,575

Trade payables

2,190

 

9,145

Fixed assets

2,355

Investments

150

Inventories

940

Trade receivables Loans and advances

3,000 400

Other assets

2,300

 

9,145

Working Capital Reserves:

( ` in Million)

Capital of Zero Limited at the time of acquisition Share capital

200

Other equity

560 (continued )

358  Chapter 12 760 Less: Purchase consideration

600

Capital reserve on consolidation

160

Unrealized gain Goods unsold (1/4th of ` 200 million)

50

Unrealized gain (25% of cost or 20% of invoice price)

10

Other equity Combined other equity Less: Unrealized gain on inventory Less: Other equity of Zero Ltd on the date of acquisition

3,290 10 560 2,720

Loan funds Combined loan funds

4,600

Less: Loan from Hero Ltd to Zero Ltd with interest

1,025 3,575

Trade payables Combined trade payables Less: Due from Hero Ltd to Zero Ltd

2,330 140 2,190

Investments Combined investments

750

Less: Investment by Hero Ltd to Zero Ltd

600 150

Inventories Combined inventories Less: Unrealized gain on inventory

950 10 940

Trade receivables Combined trade receivables Less: Due from Hero Ltd to Zero Ltd

3,140 140 3,000

Loans and advances Combined loans and advances

1,425

Less: Loan from Hero Ltd to Zero Ltd with interest

1,025 400

Consolidated Financial Statements  359

Try It Yourself 1. Goodwill or capital reserve on acquisition: The equity share capital of Black Pearl Limited as on 31st December 2017 stood at ` 250 million. The company has been in losses for the last few years and the accumulated losses in the balance sheet stood at ` 165 million. The promoters holding 60% stake in the company are not very hopeful about the future prospects of the company and decided to sell their entire stake to White Gold Limited for ` 45 million. a. Ascertain the amount at which goodwill or capital reserve will be recognized on consolidation. b. What will be the goodwill or capital reserve if the consideration is at ` 60 million? 2. Intra-group transactions: HR Limited holds 100% equity of SR Limited. At the year end, in addition to presenting their separate financial statements, HR Limited presents consolidated financial statements as well. During the year the following transaction took place between these two companies: a. HR Limited sold goods to SR Limited at an invoice price of ` 40 million. The cost of these goods to HR Limited was ` 25 million. At the end of the year goods with invoice price of ` 15 million are still unsold. b. The entire invoice price of ` 40 million is outstanding to be received on the date of the balance sheet. c. HR Limited gave a short term loan of ` 80 million to SR Limited. The loan was repaid by SR Limited during the year with interest amounting to ` 4 million. How will the above transactions be treated in the consolidated financial statements? 3. Preparation of consolidated balance sheet: Satya Limited acquired 80% of equity capital of Sundra Limited on 1st April 2016 for ` 575 million in an all-cash deal. The balance sheets of the two companies immediately before the transaction are given in the following:

 Particulars

( ` in Million) Satya Ltd

Sundra Ltd

Share capital

280

60

Other equity

5,995

804

Loan funds

6,230

460

Trade payables

4,420

640

16,925

1,964

8,376

412

870

85

  Fixed assets Cash Inventories Trade receivables Loans and advances Other assets  

855

471

3,380

432

874

28

2,570

536

16,925

1,964

360  Chapter 12

You are required to prepare the consolidated balance sheet of Satya Limited immediately after acquisition. 4. Preparation of consolidated financial statements: After one year of acquisition both the companies presented their respective balance sheets as on 31st March 2017 as follows:

 Particulars

( ` in Million) Satya Ltd

Sundra Ltd

Share capital

280

60

Other equity

7,465

986

Loan funds

5,680

1,850

Trade payables

5,870

880

19,295

3,776

8,005

940

180

150

  Fixed assets Cash Investments

620

 

Inventories

1,040

554

Trade receivables

4,320

948

Loans and advances

2,050

158

Other assets

3,080

1,026

19,295

3,776

 

Additional Information a. During the year Sundra Limited sold goods costing ` 660 million to Satya Limited for ` 800 million which in turn sold it to its customers for ` 920 million. b. The trade receivables of Sundra Limited include a sum of ` 430 million receivable from Satya Limited. c. Satya Limited gave a loan of ` 1,000 million to Sundra Limited on 1st October 2016 at 10%. The principal and interest thereon is outstanding on the date of the balance sheet. You are required to prepare the consolidated balance sheet on 31st March 2017.

Cases Case 12.1: Preparation of Consolidated Financial Statement: GlaxoSmithKline Pharmaceuticals Limited1 Glaxo has a wholly owned subsidiary—Biddie Sawyer Limited (Biddie). Both the companies follow financial year as their accounting year. The summary of separate balance sheets of both the companies as on 31st December 2017 and the statement of profit and loss statement for the year ended on that date are given below:

Consolidated Financial Statements  361

Standalone Balance Sheet as on 31st March 2017

Particulars

( ` in Lakhs) Glaxo

Biddie

Property, plant and equipment

25,271



Capital work-in-progress

57,322



ASSETS Non-current assets

Investment properties

532

2

Intangible assets under development

3,225



Investments subsidiary

4,761



6



Financial assets  (i) Investments   (ii) Loans (iii) Other financial assets Income tax assets

1,328 243

40 –

14,799

448

Deferred tax assets (net)

9,131

32

Other non-current assets

20,513

68

Total non-current assets

137,131

590

42,548

32

Current assets Inventories Financial assets   (i) Investments





  (ii) Trade receivables

17,080

73

(iii) Cash and cash equivalents

13,929

163

(iv) Bank balances other than (iii) above

77,469

1,651

6,873







(v) Loans (v) Others (to be specified) Other current assets Total current assets Assets classified as held for sale Total assets

6,922

594

164,822

2,513

163 302,115

– 3,103

EQUITY AND LIABILITIES Equity Equity share capital Other equity

8,470

96

194,351

2,530

202,821

2,626 (continued )

362  Chapter 12 (continued )

Particulars

( ` in Lakhs) Glaxo

Biddie

LIABILITIES Non-current liabilities Financial liabilities  (i) Borrowings (iii) Other financial liabilities Provisions

99



349

1

27,100

125

Deferred tax liabilities (Net)





Other non-current liabilities





Total Non-current liabilities

27,548

127

Current liabilities Financial liabilities –



 (ii) Trade payables

(i) Borrowings

27,592

301

(iii) Other financial liabilities

35,991



Other current liabilities

3,127

Provisions

4,825

Current tax liabilities (net) Total current liabilities Total equity and liabilities

211

3 47 –

71,746

351

302,115

3,103

Standalone Statement of Profit and Loss for the Year Ended 31st March 2017 Particulars Revenue from operations Other income

( ` in Lakhs) Glaxo

Biddie

299,451

572

7,176

106

306,627

678

Cost of materials consumed

52,358

10

Purchase of stock-in-trade

79,070

0

7,949

388

48,301

0

Total income Expenses:

Changes in inventories of finished goods, work-in-progress and stock-in-trade Employee benefit expense

(continued )

Consolidated Financial Statements  363 (continued )

Particulars Finance costs Depreciation and amortization expense

( ` in Lakhs) Glaxo

Biddie

0

0

2,635

0

Other expenses

69,779

269

Total expenses

260,092

667

46,535

11

Profit/(loss) before exceptional items and tax Exceptional items

4,573

0

51,108

11

16,297

5

1,133

2

33,678

4

(531)

0

184

0

0

0

0

0

(347)

0

33,331

4

(1) Basic

39.8

0.4

(2) Diluted

39.8

0.4

Profit/(loss) before tax Tax expense: (1) Current tax (2) Deferred tax Profit /(Loss) from the period from continuing operations Other comprehensive income A (i) Items that will not be reclassified to profit and loss  (ii) Income tax relating to items that will not be reclassified to profit and loss B (i) Items that will be reclassified to profit and loss  (ii) Income tax relating to items that will be reclassified to profit and loss Total other comprehensive income Total comprehensive Income for the period comprising profit (loss) and other comprehensive income for the period) Earnings per equity share (for continuing operations)

Additional Information a. The entire share capital of Biddie Sawyer Limited is held by GlaxoSmithKline Limited which was acquired at a cost of ` 4,761 lakh. The pre-acquisition reserves and surplus of Biddie stood at ` 4,665 lakh. b. The net receivables by Biddie from Glaxo from on the date of the balance sheet stood at `73 lakhs included in trade receivables of Biddie and other current financial liabilities of Glaxo. c. The revenue from operations of Glaxo include `24 lakhs earned from Biddie. The same amount has been included in other expenses of Biddie. Based upon the above information, you are required to prepare the consolidated balance sheet for Glaxo Smith Kline Limited as on 31st December 2017 and the consolidated statement of profit and loss for the year ended 31st December 2017.

364  Chapter 12

Case 12.2: Consolidated performance of Sun Pharmaceutical Limited2 Sun Pharmaceutical Limited is a leading pharmaceutical company of India engaged in research and manufacturing of drugs. It has over over 40 state-of-the-art manufacturing sites spanning 6 continents. These manufacturing units are located in India, the US, Brazil, Canada, Egypt, Hungary, Israel, Bangladesh, Mexico, Romania, Ireland, Morocco, Nigeria, South Africa and Malaysia. The company has around 2000 research scientists working in multiple R&D centres equipped with cutting-edge enabling technologies for research. The company presents its financials both on standalone basis and on a consolidated basis. The consolidated financial statements for the year ended 31st March 2017 have been prepared taking into account the financials of the parent company and 134 subsidiary companies, partnership firms, joint venture and associate companies. The summarized financial statements of the company for the year ended 31st March 2017 are given below, both on standalone basis and on consolidated basis. A.  Balance Sheet as on 31st March 2017:

Particulars

( ` in Million) Standalone

Consolidated

ASSETS Non-current assets Property, plant and equipment

38,319

84,953

Capital work-in-progress

10,533

15,648

Goodwill



55,362

Other Intangible assets

485

36,437

Intangible assets under development

454

12,366

Investments in the nature of equity in subsidiaries

192,442



Investment in associates



4,605

Investment in joint ventures



430

Financial assets   (i) Investments (ii) Loans

1,068

4,575

49

698

990

6,452

17,826

31,250

Deferred tax assets (net)

7,517

24,928

Other non-current assets

4,101

6,862

273,784

284,566

22,866

68,328

(iii) Other financial assets Income tax assets

Total non-current assets Current assets Inventories

(continued )

Consolidated Financial Statements  365 (continued )

Particulars

( ` in Million) Standalone

Consolidated

400

2,309

27,257

72,026

1,508

86,628

(iv) Bank balances other than (iii) above

130

64,780

(v) Loans

138

10,191

Financial assets (i) Investments   (ii) Trade receivables (iii) Cash and cash equivalents

(vi) Others (to be specified)

672

2,259

Other current assets

10,728

22,950

Total current assets

63,699

329,471

337,482

614,102

Assets classified as held for sale Total assets

66

EQUITY AND LIABILITIES Equity Equity share capital Other equity Non-controlling interest

2,399

2,399

206,316

363,997



37,909

208,715

404,305

7,606

14,361

7

1,048

11,328

12,111

LIABILITIES Non-current liabilities Financial liabilities (i) Borrowings   (ii) Other financial liabilities Provisions Deferred tax liabilities (Net) Other non-current liabilities Total non-current liabilities

– –

3,148 259

18,942

30,927

Current liabilities Financial liabilities (i) Borrowings

40,540

66,549

(ii) Trade payables

20,942

43,954

(iii) Other financial liabilities

28,135

22,116

Other current liabilities Provisions Current tax liabilities (Net)

1,738

4,621

18,470

40,159



1,471

Total current liabilities

109,826

178,870

Total equity and liabilities

337,482

614,102

366  Chapter 12 B.  Statement of Profit and Loss for the Year Ended 31st March 2017

Particulars Revenue from operations Other income Total income Expenses: Cost of materials consumed Purchase of stock-in-trade Changes in inventories of finished goods, work-inprogress and stock-in-trade Employee benefit expense Finance costs Depreciation and amortization expense Other expenses Total expenses Profit/(loss) before exceptional items and tax Exceptional Items Profit/(loss) before tax Tax expense: (1) Current tax (2) Deferred tax Profit /(Loss) from the period from continuing operations Share of profit/(loss) of associates Share of profit/loss of joint ventures Profit/(Loss) for the period Non-controlling interest Profit for the year attributable to owners of the company Other comprehensive income A (i) Items that will not be reclassified to profit & loss (ii) Income tax relating to items that will not be reclassified to profit & loss B  (i) Items that will be reclassified to profit & loss (ii) Income tax relating to items that will be reclassified to profit & loss Total other comprehensive income Total OCI attributable to– Owners of the company – Non-controlling interest

( ` in Million) Standalone

Consolidated

78,067 5,144 83,211

315,784 6,232 322,016

22,845 12,365

51,246 32,778

(1,628) 14,862 2,236 4,186 28,670 83,536 (324) 0 (324)

(2,716) 49,023 3,998 12,648 84,561 231,537 90,479 0 90,479

25 0

4,046 8,069

(349)

78,363 300 (200) 78,462 8,819 69,644

(607)

(4,508)

0 (27)

57 (10,420)

0 (634)

0 (14,872) (13,338) (1,534) (continued )

Consolidated Financial Statements  367 (continued )

( ` in Million)

Particulars

Standalone

Consolidated

(983)

63,590

Total comprehensive Income for the period comprising Profit (Loss) and other comprehensive Income for the period) Total comprehensive Income attributable to – Owners of the company – Non-controlling interest Earnings per equity share (for continuing operations) (1) Basic (2) Diluted

56,306 7,284 (–0.10) (–0.10)

29.0 29.0

C.  Cash Flow Statement for the year ended 31st March 2017

( ` in Million)  Particulars Standalone

Consolidated

Cash flow from operating activities

(16,240)

70,822

Cash flow from investing activities

23,847

(42,216)

Cash flow from financing activities

(7,530)

(22,854)

78

5,752

Increase or decrease in cash

Questions for Discussion 1. To understand the financial performance and status of the Sun Pharmaceutical Limited, which of financial statements would you prefer? 2. The company has reported a loss on standalone basis and profit on consolidated basis. What does it indicate? 3. The expression ‘non-controlling interest’ is appearing in the profit and loss statement as well as in the balance sheet. What does it indicate? 4. Why is goodwill appearing in the consolidated balance sheet but not in standalone balance sheet? 5. ‘Investment in the nature of equity in subsidiaries’ is appearing the standalone balance sheet but not in the consolidated balance sheet. Why? 6. Comment upon the cash flow under various activities on standalone basis as compared to consolidated basis.

Endnotes 1. Based upon the Annual Report of Glaxo SmithKline Limited for the year 2017. 2. Annual Report of Sun Pharmaceutical Limited for the year 2016–17.

Disclosures in Annual Reports

13

CHAPTER OBJECTIVES This chapter will help the readers to: • Develop understanding about the disclosure requirements under the Companies Act. • Differentiate between a qualified audit report and a clean report. • Appreciate the disclosure requirements as per the listing agreement. • Get familiar with the disclosure requirements under accounting standards relating to ­segment reporting (Ind AS 108), related party transactions (Ind AS 24), interest in other entities (Ind AS 112) and financial instruments disclosures (Ind AS 107). • Understand the voluntary disclosure practices relating to value added statement, e ­ conomic value added, human resource accounting and brand valuation.

13.1 INTRODUCTION In addition to the financial statements discussed in the earlier chapters, the annual report of a company contains a number of other useful reports. These reports give further insight into the financial performance and position of the company. Some of these reports are mandatory in nature, whereas some are purely voluntary. Management of progressive companies uses their annual reports to communicate with various stakeholders on voluntary basis. The information contained in the annual report may be classified under four categories: 1. Disclosure required under the Companies Act, 2013: The companies registered in India are regulated in terms of the provisions of the Companies Act, 2013. The Act requires a number of disclosures to be incorporated in the annual report of the company. These disclosures are applicable to all companies and are mandatory in nature. 2. Disclosure required under the listing agreement: A company that has raised money by inviting public to subscribe for its shares is required to sign a listing agreement with the stock exchange where it wants its shares to be traded. The listing agreement imposes a number of disclosure requirements on such publicly held companies. As these requirements are originating from the listing agreement, they apply only to listed companies.

Disclosures in Annual Reports  369

Table 13.1  Other Disclosures in Annual Reports

Companies Act

Listing Agreement

• Auditors’ report • Management • Directors’ report discussion and • Details regarding analysis subsidiary companies • Corporate governance report • Business responsibility report

Accounting Standards

Voluntary Disclosures

• Segment reporting • Related party disclosure • Disclosure of interest in other entities • Financial instruments: Disclosures

• Value added statement • Economic value added • Human resource accounting • Brand valuation

3. Disclosures required under the relevant accounting standards: Most of the accounting standards, in addition to providing guidance for accounting, also impose certain disclosure requirements. These disclosures are in addition to the requirements under the provisions of the Companies Act, 2013. 4. Voluntary disclosures: To ensure transparency, companies are making additional disclosures in their annual reports which go beyond the mandatory requirements as aforesaid. As these disclosures are voluntary in nature, there is no uniformity in the type of reports or content of reports across various companies. A brief overview of the above disclosure is given in Table 13.1.

13.2  DISCLOSURES UNDER THE COMPANIES ACT, 2013 13.2.1  Auditor’s Report The accounts of the company are required to be audited by an external auditor. Such an audit is Auditor Report is addressed to the called a statutory audit or an independent audit or an members (shareholders) of the comexternal audit. The statutory audit is performed by pany and is required to be read out a Chartered Account holding a certificate of practhe Annual General Meeting of the tice issued by the Institute of Chartered Accountants shareholders. of India. Based upon their audit, the auditors are required to make a report to the shareholders of the company. In accordance with the provisions of Section 143 (2) of the Companies Act, the auditors are required to state in their report their opinion on the accounts audited by them. The auditors’ report states the following:

• • • •

They have sought and obtained all the information and explanation necessary for the audit work. Proper books of accounts as required by law have been kept by the company. Financial statements are in compliance with the applicable accounting standards. The balance sheet gives a true and fair view of the state of affairs of the company at the end of the financial year and the profit and loss statement gives a true and fair view of the profit or loss of its financial year.

370  Chapter 13

• Report on the accounts of branch office of the company audited by a person other than the company’s auditor has been sent to him. • Observations or comments on financial transactions or matters having any adverse effect on the functioning of the company. • Any qualification, reservation or adverse remarks relating to maintenance of accounts and other matters connected thereto. • Adequacy of internal financial control system and operating effectiveness of such controls. • Any other specified matter. If auditors’ opinion on all of the above is affirmative, the auditors’ report is said to be a clean report. In an extreme case, if on the basis of the information available the auditors are not able to form an opinion, they may issue a disclaimer. However, such instances are rare. If the auditors are of the opinion that the financial statements do not represent a ‘true & fair view’, they may issue an adverse opinion. Again such instances are really rare. If the auditors have any reservation but such reservations do not warrant a disclaimer or an adverse opinion being given, a qualified report may be given by the auditor. In a qualified report the auditors state that the financial statements present a true and fair view but subject to certain reservations or qualifications stated in the audit report. It may be noted that auditors’ report is merely an opinion and not a certificate. For forming their opinion the auditors perform such audit test as may be appropriate with the size and complexity of the business. The audit is usually based upon sample testing and therefore a clean report does not ensure that the accounts are error free. However, while analyzing the financial statements of a company, qualifications in the audit report must be considered. Repeated qualified reports by the auditors also diminish the reliability of the numbers presented in the financial statements. Some examples of qualification in the auditors’ report are given in Box 13.1. Box 13.1  Auditors’ Qualifications ‘No provision has been made for interest relating to earlier years aggregating to ` 74.71 million on the outstanding inter-corporate deposit of ` 50.0 million. Had the impact of same been considered, the net profit (after tax) for the year ended 31st March 2011 would have been ` 951.73 million instead of the reported profit of ` 1,011.55 million and the accumulated losses as at 31st March 2011 would have been ` 7,272.02 million instead of the reported accumulated loss of ` 7,212.20 million. The audit report of the preceding auditors for the year ended 31st March 2010 was also qualified in respect of the above matter’.* —Spicejet Limited ‘During the year, the company received a demand notice for income tax and interest thereon aggregating ` 405,614,101 in relation to an earlier year. The matter pertains to short deduction of tax at source on certain payments and interest thereon for delayed period. The Company has disputed the above-said demand and has filed an appeal against the same with the tax authorities. The Company, based on a legal view obtained in the matter, has not made any provision in the financial statements and has not assessed the impact of the above position on the subsequent years. Pending final conclusion, we are unable to comment on the matter and its consequent impact on the Profit and Loss Account for the year and debit balance in the Profit and Loss Account at the end of the year’.** —Dish TV Limited Source: *Audit Report of Spicejet Limited for the year 2010–11 **Audit Report of Dish TV India Limited for the year 2010–11

Disclosures in Annual Reports  371

13.2.2  Directors’ Report In pursuant of Section 134 of the Companies Act, 2013, every year a report by the Board of Directors of the company is required to be attached to the financial statements. It is the formal communication from the board of directors to the shareholders. The board’s report carries out a review of the company’s affairs for the year gone by and also covers any significant developments that might have happened between the end of the financial year and the date of the report. Some of the important particulars to be included in the Directors’ Report are stated below:

• Directors’ Responsibility Statement stating that they had laid down internal financial controls

• • •

• • • • • • • • •

to be followed by the Company and that such internal financial controls are adequate and were operating effectively. The statement also confirms that the proper systems to ensure compliance with the provisions of all applicable laws are in place and are adequate and operating effectively. A statement on declaration given by independent directors that they meet the criteria of independence. Company’s policy on directors’ appointment and remuneration including criteria for determining qualifications, positive attributes, independence of a director, etc. Explanations or comments by the board on every qualification, reservation or adverse remark or disclaimer made— –– By the auditor in his report. –– By the company secretary in practice in his secretarial audit report. Particulars of contracts or arrangements with related parties. The state of the company’s affairs highlighting business performance and financial overview. The amounts which it proposes to carry to any reserves. The amount which it recommends should be paid by way of dividend. Material changes and commitments affecting the financial position of the company which have occurred between the end of the financial year of the company to which the financial statements relate and the date of the report. The conservation of energy, technology absorption and foreign exchange earnings and outgo. A statement indicating development and implementation of a risk management policy for the company including identification therein of elements of risk which in the opinion of the Board may threaten the existence of the company. The details about the policy developed and implemented by the company on corporate social responsibility initiatives taken during the year. A statement indicating the manner in which formal annual evaluation has been made by the Board of its own performance and that of its committees and individual directors.

13.2.3  Details Regarding Subsidiary Companies As per Section 129 of the Companies Act, 2013, a statement containing the salient features of the financial statements of subsidiary or subsidiaries is required to be attached with the financial statements of the folding company. This is, in addition, to the requirement of preparing and presenting consolidated financial statements.

372  Chapter 13

13.3  DISCLOSURES UNDER LISTING AGREEMENT The key disclosures under this category are discussed below. These disclosure requirements are applicable only to listed companies.

13.3.1  Management Discussion and Analysis Clause 34 of the Listing Agreement requires that a management discussion and analysis report should form part of the annual report to the shareholders. This report may either be given separately or may be included in the directors’ report as discussed earlier. In this segment, the management (Board of Directors) discusses the following:

• • • • • • • •

Industry structure and developments Opportunities and threats Segment-wise or product-wise performance Outlook Risks and concerns Internal control systems and their adequacy Financial performance with respect to operational performance Material developments in human resources/industrial relations front, including number of people employed.

MDA and directors’ report are useful to get an insider’s view on the performance of the company.

13.3.2  Corporate Governance Report The listing agreement prescribes certain mandatory and non-mandatory requirements under Clause 34. A separate report in the annual report of the company covering the mandatory requirements is required to be included. The corporate governance report dwells upon matters relating to composition of board of directors, functioning of various committees of the board of directors like remuneration committee, audit committee, etc. The company is also required to obtain a certificate regarding compliance with the corporate governance requirements from a chartered accountant or a company secretary. Some of the mandatory requirements for corporate governance report are discussed below:

• A brief statement on company’s philosophy on code of governance • Details of the board of directors and committees thereof • Specific disclosures –– Disclosures on materially–significant related party transactions that may have potential con–– ––

flict with the interests of company at large. Details of non-compliance by the company, penalties and strictures imposed on the company by Stock Exchange or SEBI or any statutory authority, on any matter related to capital markets, during the last three years. Whistle-blower policy and affirmation that no personnel has been denied access to the audit committee.

Disclosures in Annual Reports  373

Table 13.2  Shareholding Pattern of Mahindra & Mahindra Limited

1st April 2016

31st March 2017

Category of Shareholders

Number of Shares

Promoters and promoter group

157,989,015 25.44

156,967,795 25.27

Institutions

344,534,932 55.47

339,152,513 54.61

Non-Institutions

84,037,854 13.53

92,092,225 14.83

Custodians for GDRs and ADRs

34,530,583

5.56

32,879,851

5.29

621,092,384

100

621,092,384

100

Total

%

Number of Shares

%

Source: Annual Reports of Mahindra & Mahindra Limited for the year 2016–17.

–– Market price data: High, low during each month in last financial year, performance in com–– ––

parison to broad-based indices such as BSE Sensex, CRISIL index, etc. Distribution of shareholding. Outstanding GDRs/ADRs/warrants or any convertible instruments, conversion date and likely impact on equity.

These details coupled with financial data as disclosed in the financial statements can help an analyst in forming a view about the company. Composition of board of directors, their qualification and experience, frequency of meetings of board and its subcommittees are important qualitative variables that cannot be ignored. Likewise, an increase or decrease in the promoters’ holding in the company as disclosed in the shareholding distribution may indicate promoters’ confidence in the company. In case the promoters have pledged their shares for raising loans, in a declining market there is a real possibility of the lender selling these shares to recover their loans. An investors needs to look at these aspects closely to understand the motives behind increase or decrease in promoters’ holding. The shareholding pattern of Mahindra & Mahindra Limited is given in Table 13.2. It could be seen from the above that there is a marginal decline in the percentage shareholding of promoters, institutional investors and custodians for GDRs and ADRs. The shareholding of noninstitutional investors has increased by 1.30% during the year.

13.3.3  Business Responsibility Report Large corporations use a vast amount of societal resources, and therefore, they are accountable not merely to their shareholders but also to the larger society which is also its stakeholder. To fulfil their obligations to the larger body of stakeholders, they must adopt responsible business practices. The Ministry of Corporate Affairs, Government of India, laid down the ‘national voluntary guidelines on social, environmental and economic responsibilities of business’. These guidelines contain comprehensive principles to be adopted by companies as part of their business practices. In order to ensure a structured Business Responsibility Reporting (BRR), the listing agreement was amended by SEBI. Listed companies accordingly are required to disclose a structured BRR in their annual reports. The

374  Chapter 13

report demonstrates the steps taken by the company to implement the nine principles enumerated in the guidelines. The principles are: P1 Businesses should conduct and govern themselves with ethics, transparency and accountability. P2 Businesses should provide goods and services that are safe and contribute to sustainability throughout their life cycle. P3 Businesses should promote the well-being of all employees. P4 Businesses should respect the interests of, and be responsive towards all stakeholders, especially those who are disadvantaged, vulnerable and marginalized. P5 Businesses should respect and promote human rights. P6 Businesses should respect, protect, and make efforts to restore the environment. P7 Businesses, when engaged in influencing public and regulatory policy, should do so in a responsible manner. P8 Businesses should support inclusive growth and equitable development. P9 Businesses should engage with and provide value to their customers and consumers in a responsible manner.

13.4  DISCLOSURES UNDER ACCOUNTING STANDARDS In addition to the disclosures discussed in the earlier chapters which directly relate to specific area of accounting, there are certain other disclosures mandated by accounting standards. These disclosures are usually included in the notes to accounts.

13.4.1  Segment Reporting (Ind AS 108) The financial statements are prepared using entity concept, and accordingly they represent the results and financial position of the enterprise as a whole. A large enterprise usually operates in multiple business segments and in various geographies. The statement of profit and loss does not reveal the performance of different business or geographical segments. Likewise, the balance sheet also does not provide the detail of funds deployed in different segments. To better appreciate the performance of the business enterprise and the risk associated, information about segment-wise performance is essential. Information about significant components of an entity in contrast to its financial statements for the entity as a whole is very important to the users of financial statements, specifically, where an entity is engaged in different business activities or operates in different economic environments. An operating segment is defined as a component of an entity: Ind AS 108: An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates

• That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity).

• Whose operating results are reviewed regularly by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance.

• For which discrete financial information is available.

Disclosures in Annual Reports  375

Ind AS 108 lays down the basic principles for reporting financial information about various operating segments. The approach under Ind AS 108 is to align business reporting with internal reporting. Accordingly, the segments identified for reporting purposes are based on the structure of an entity’s internal organization and segment-wise reports are prepared on the same basis as are reported for internal purposes. Reportable segments are identified based upon the business activities in which it engages and economic environments in which it operates. The factors to be considered for business activities may include the nature of product and services, nature of customers, method of distribution, regulatory environment, etc. Economic environment consist of a number of factors that may have an impact on the working of any business, for example, geography, political and economic macro-systems, trade cycles, economic resources, statutory environment, income levels, currency risk and industrial growth rates, etc. An operating segment is identified on the basis or revenue, profit or assets. Accordingly, separate information about an operating segment needs to be provided if any of following quantitative criteria is met:



1. It contributes more than 10% of the combined revenue (both external and internal) of the enterprise. 2. Its profit or loss constitutes more then 10% of the combined reported profit of all operating segments that did not report loss or 10% of the combined reported loss of all operating segments that reported a loss. 3. It deploys assets exceeding 10% of the total assets of all operating segments identified as a reportable segment.

An operating segment that does not meet any of the quantitative thresholds may still be reportable and separately disclosed if management believes that information about the segment would be useful to users of financial statement. Two segments can be combined to produce operating segments only if the operating segments have similar economic characteristics and share a majority of the aggregation criteria listed above. If the total external revenue reported by operating segments constitutes less than 75 per cent of the entity’s revenue, additional operating segments need to be identified as reportable segments until at least 75 per cent of the entity’s revenue is included in reportable segments. Information about other business activities and operating segments, that are not reportable, is combined and disclosed in ‘all other segments’category. An enterprise should disclose the following for each reportable segment:

• General information about factors used to identify reportable segments and the types of products •



and services from which each reportable segment derives its revenues. Information about –– The reported segment profit or loss, including specified revenues and expenses included in reported segment profit or loss reviewed by the chief operating decision maker or otherwise regularly provided to chief operating decision maker even if not included in segment profit or loss. –– Segment assets and segment liabilities, if such amounts are regularly reported or provided to the chief operating decision maker. –– The basis of measurement. Reconciliations of the totals of segment revenues, reported segment profit or loss, segment assets, segment liabilities and any other material items to corresponding items in the entity’s financial statements.

376  Chapter 13 Table 13.3  Segment Reporting by TCS Limited

Business Segments

2016-17

( ` in Crore) Banking, Retail and Financial Communication, Consumer Services Manufacturing Media and Others Packaged and Technology Goods Insurance

Total

Revenue

35,836

8,447

16,679

16,327

15,404

92,693

Segment results

10,482

2,733

4,694

4,696

4,484

27,089

Unallocable expenses

1,591

Operating income

25,498

Other income (net)

4,568

Profit before tax

30,066

Tax expense

6,413

Profit for the year Segment assets

23,653 6,793

1,940

3,432

3,808

5,423

Unallocable assets

21,396 68,362 89,758

Segment liabilities

1,175

92

317

392

488

Unallocable liabilities

2,464 9,272 11,736

2015–16 Revenue

33,475

7,410

15,771

15,262

13,946

85,864

Segment results

10,971

2,475

4,579

4,583

4,446

27,054

Unallocable expenses

1,472

Operating lncome

25,582

Other Income (net)

3,757

Profit before tax

29,339

Tax expense

6,264

Profit for the year Segment assets

23,075 7,131

1,938

3,737

4,137

5,443

Unallocable assets

22,386 55,031 77,417

Segment liabilities

1,123

127

Unallocable liabilities

213

402

374

2,239 10,165 12,404

Annual Report of TCS Limited for the year 2016–17

Disclosures in Annual Reports  377

Geographical Segments

Segments Revenue ( ` in Crore) Americas

Europe

India

Others

Total

2016–17

53,848

22,728

7,031

9,086

92,693

2015–16

49,249

22,409

6,182

8,024

85,864

If a financial report contains both the consolidated financial statements of a parent, that is, within the scope of this Indian Accounting Standard as well as the parent’s separate financial statements, segment information is required only in the consolidated financial statements. Excerpts from segment reporting by Tata Consultancy Services Limited (TCS) for the year 2016–17 are given in Table 13.3. One can observe that banking, financial services and insurance is the largest business segment for TCS contributing over 40% of the total revenue and profits. Geographically, TCS generates the largest shares from America followed by Europe. Obviously, such kinds of observations are not possible by simply looking at the statement of profit and loss.

13.4.2  Related Party Disclosure (Ind AS 24) A business enterprise may enter into commercial transactions with its related parties. For example, an The objective of Ind AS 24 is to ensure enterprise may sell or purchase goods to or from a that an entity’s financial statements subsidiary company or lend money to a joint vencontain the disclosures necessary to ture, etc. In normal business transactions, there is draw attention to the possibility that a presumption that commercial transactions are its financial position and profit or loss entered on an arm’s length basis and the terms and may have been affected by the exisconditions have been determined on commercial tence of related parties and by transconsiderations. In a related party transaction, such actions and outstanding balances, a presumption is violated. Related party disclosure including commitments, with such aims at identifying and reporting such transactions. parties. Armed with such details, the user of the financial statement is in a better position to understand and sometime question the genuineness of such transactions and also their impact on the financial results and financial position of an enterprise. Ind AS 24 requires that an enterprise must identify and disclose its related parties. The definition of related parties is quite wide and includes key managerial personnel and their relatives, holding company, subsidiary company, joint ventures, associate company, fellow subsidiary company, etc. If any transaction has taken place between the related parties during the reporting period, appropriate disclosure need to be made in the annual report. Such a disclosure is usually made in the ‘notes to accounts’ segment of the annual report. The following disclosure regarding related party transactions is required to be made under Ind AS 241:

• The name of the transacting related party and a description of the relationship between the • •

parties. A description of the nature of transactions. The amount of transactions.

378  Chapter 13

• The amount of outstanding balances including commitments; their terms and conditions, includ• •

ing whether they are secured, and the nature of the consideration to be provided in settlement and details of any guarantees given or received. The amount of provisions for doubtful debts due from such parties at that date and amounts written off or written back in the period in respect of debts due from or to related parties. Any other elements of the related party transactions necessary for an understanding of the financial statements.

13.4.3  Interest in Other Entities Ind AS 112 requires an entity to disclose information that enables users of its financial statements to evaluate the nature of, and risks associated with, its interests in other entities; and also the effects of those interests on its financial position, financial performance and cash flows. The prescribed information is required to be disclosed regarding subsidiaries, joint arrangements, associates and structured entities that are not controlled by the entity.

13.4.4  Disclosure Regarding Financial Instrument Ind AS 107 requires an entity to make adequate disclosures in their financial statements that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance and the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. Disclosures relating to the nature and extent of risks arising from financial instruments include: 1. Qualitative Disclosures—relating to each type of risk arising from financial instruments: (a) The exposures to risk and how they arise. (b) Its objectives, policies and processes for managing the risk and the methods used to measure the risk. (c) Any changes in (a) or (b) from the previous period. 2. Quantitative Disclosures—relating to each type of risk arising from financial instruments: (a) Summary quantitative data about its exposure to that risk at the end of the reporting period. (b) Disclosures about credit risk, liquidity risk and market risk. (c) Concentration of risk, if not apparent from the disclosures made in accordance with (a) and (b). 3. Credit Risk (a) Maximum exposure to credit risk at the end of the reporting period without taking account of any collateral held or other credit enhancements. (b) A description of collateral held as security and other credit enhancements and their financial effect. (c) Information about the credit quality of financial assets that are neither past due nor impaired. (d) An analysis of the age of financial assets that are past due as at the end of the reporting period but not impaired.

Disclosures in Annual Reports  379

(e) An analysis of financial assets that are individually determined to be impaired as at the end of the reporting period, including the factors the entity considered in determining that they are impaired. (f) When an entity obtains financial or non-financial assets during the period by taking possession of collateral it holds as security or calling on other credit enhancements, disclosures regarding the nature and carrying amount of the assets and when the assets are not readily convertible into cash, its policies for disposing of such assets or for using them in its operations. 4. Liquidity Risk (a) Maturity analysis for financial liabilities that shows the remaining contractual maturities. (b) A description of how it manages the liquidity risk. 5. Market Risk (a) Sensitivity analysis for each type of market risk to which the entity is exposed at the end of the reporting period, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date. (b) The methods and assumptions used in preparing the sensitivity analysis. (c) Changes from the previous period in the methods and assumptions used, and the reasons for such changes.

13.5  VOLUNTARY DISCLOSURES 13.5.1  Value Added Statement The profit and loss statement essentially has a shareholders’ focus. The profit after tax (PAT) or net profit depicts the reward for the shareholders after all other stakeholders have been paid out. The value added statement, on the other hand, has a stakeholders’ focus. Value added is defined as the value of output produced minus cost of inputs. After ascertaining the value added, the distribution of the value added to various stakeholders is disclosed. By observing the value added statement over a period of time the reader can see the trends in value added as well as how the value added is being distributed amongst the various stakeholders. The value added statement of Steel Authority of India Limited (SAIL) is given in the Table 13.4. Table 13.4  Value Added Statement of Steel Authority of India Limited

( ` in Crore)

Particulars Value of own production Other revenues Less: Cost of raw materials

2016–17

2015–16

49,598 1080

43,323 50,678

1,145

21,126

17,155

Stores and spares

2,835

2,889

Power and fuel

5,234

5,334

Excise duty

5,314

4,823

Freight outward

1,162

Other operating cost

5,702

Total value added

44,468

1,131 41,373 9,305

5,726

37,058 7,410 (continued )

380  Chapter 13 (continued )

( ` in Crore)

Particulars

2016–17

2015–16

Establishment cost

8,948

9,715

Financing cost

2,528

2,300

(2,018)

(2,986)

Corporate income tax Dividend paid



103

Dividend tax



21

Income retained in business  Depreciation   Retained in business

2,680 (2,833)

Total value applied

2,489 (153) 9,305

(4,232)

(1,743) 7,410

Source: Annual Report of Steel Authority of India Limited for the year 2016–17

It could be observed that the total value added by SAIL during the year 2016–17 amounted to ` 9,305 crore which was almost entirely consumed by the establishment cost (` 8,948 crore). After meeting financing cost, there was nothing left to be given as tax to government or dividends to shareholders.

13.5.2  Human Resource Accounting In the knowledge economy, one of the most valuable assets of any enterprise is its human resources. However, human resources do not appear in the conventional financial statements prepared using cost principle. Assets are usually recognized in the balance sheet based upon the ownership criteria— assets owned by an enterprise through purchase or grant are recognized at the cost of acquisition. Accordingly, human resources are not recorded as assets as being not owned by the enterprise. To overcome this limitation, many companies are providing information about their human resources in the annual report. The information may include number of employees, age profile, revenue, profit or value added per employee, etc. Many companies try to put value to their human resources by using various models. The valuation of human resources is usually done at the present value of future earnings of the employees. Though there is no uniformity in the valuation or disclosure about human resources, such information does give an insight about the employee cost and productivity. Human resources accounting reported by Hindustan Petroleum Corporation Limited (HPCL) in their annual report is given in Box 13.2.

13.5.3  Economic Value Added While arriving at the profit after tax all costs including cost of borrowed funds is deducted. However, no cost is imputed towards cost of shareholders’ funds. It may be possible that the cost of shareholders’ funds may far exceed the profits earned by the enterprise in an accounting period. Economic

Disclosures in Annual Reports  381

Box 13.2  Human Resource Accounting by HPCL HPCL considers human dimension as the key to organization’s success. Several initiatives for deployment of human resources to meet new challenges in the competitive business environment have gained momentum. HPCL recognizes the value of its human assets who are committed to achieve excellence in all spheres. The Human resource profile given below shows that HPCL has a mix of energetic youth and experienced seniors who harmonize the efforts to achieve the Corporation’s goals.

No. of employees Management Non management Average age (Years)

Age 21–30

31–40

41–50

Above 50

Total

2,096 1,988 108

1,564 1,263 301

2,307 1,117 1,190

4,455 1,490 2,965

10,422 5,858 4,564 46

Accounting for Human Resource Assets The Lev & Schwartz model is being used by our company to compute the value of human resource assets. The evaluation as on 31st March 2017 is based on the present value of future earnings of the employees on the following assumptions. • Employees’ compensation represented by direct and indirect benefits earned by them on cost to company basis. • Earnings up to the age of superannuation are considered on incremental basis taking the corporation’s policies into consideration. • Such future earnings are discounted at 7.26%.

( ` in Crore)

Particulars Value of human resources Management employees Non-management employees Human assets vis-à-vis total assets Value of human assets Net assets Investments Employee cost Net profit before tax (PBT) Ratio (in %) Employee cost to human resources Human resources to total resource PBT to human resource Source: Annual Report of HPCL for the year 2016–17

2016–17

2015–16

27,003 7,878 34,881

17,975 7,367 25,342

34,881 40,076 10,919 85,876

25,242 32,880 10,579 68,701

2,946 9,021

2,321 5,777

8.45 40.62 25.86

9.2 36.74 22.89

 

382  Chapter 13

value added or EVA®2 is a measure of the profitability of an enterprise after meeting the cost of capital employed. The EVA may be represented by the following equations: EVA = Net Operating Profit After Tax (NOPAT) – Cost of Capital Employed (COCE)

(13.1)

NOPAT = Earnings Before Interest & Tax (EBIT) × (1-Tax rate)

(13.2)

COCE = Capital Employed × Weighted Average Cost of Capital (WACC)

(13.3)

Debt Total Capital Employed Equity (13.4) + Cost of Equity × Total Capital Employed

WACC = Cost of Debt ×



Thus, if the NOPAT for an enterprise is greater that the COCE, it is said to have created economic value and if the COCE is more that the NOPAT the enterprise has destroyed value. It is possible that a business enterprise has declared positive profits but the EVA is still negative because the COCE is higher than the profits earned. EVA to that extent reflects the efficiency in capital utilization. Capital employed for this purpose includes both borrowed funds and shareholders’ funds. Additionally many companies report another measure called market value added or MVA. MVA is the excess of market capitalization of the company over the shareholders’ funds and can be calculated as follows: MVA = Market capitalization – Shareholders’ funds

(13.5)

or MVA = (Market price per share – Book value per share) × Number of shares

(13.6)

The EVA statement of Marico Limited is given in Table 13.5 From the above description, it is clear that an enterprise may enhance its EVA by improving NOPAT or bringing down WACC or by reducing the average capital employed by more efficient utilization of Table 13.5  Economic Value Added reporting by Marico Limited

Particulars Average capital employed

( ` in Crore) 2011

2012

2013

2014

2015

2016

2017

1,411

1,852

2,421

2,395

2,180

2,330

2,493

Average debt/total capital (%)

43.2

42.0

34.2

30.9

25.4

16.3

11.4

Weighted average cost of capital (%)

8.90%

8.70%

8.90%

8.70%

8.30% 10.10% 10.40%

Profit after current tax (excluding extraordinary items) 269.1

324.8

456.7

496.6

572.0

711.5

798.6

31.8

34.1

42.7

25.0

16.3

14.5

11.7

Net operating profit after tax

300.9

358.9

499.4

521.6

588.3

726.0

810.3

Less: Cost of capital

126.1

160.2

216.0

208.3

180.9

235.1

258.6

Economic value added

174.8

198.7

283.4

313.3

407.4

490.9

551.7

Add: Interest post tax

Source: Annual Report of Marico Limited for the year 2016–17

Disclosures in Annual Reports  383

Box 13.3  Brand Valuation by Infosys Limited The methodology followed by Infosys Limited to value their corporate brand ‘Infosys’ is as follows: •  Determine brand profits by eliminating the non-brand profits from the total profits •  Restate the historical profits at present-day values • Provide for the remuneration of capital to be used for purposes other than promotion of the brand •  Adjust for taxes •  Determine the brand strength or brand-earnings multiple Brand Valuation

  Particulars

( ` in Crore) 2011

2010

2009

Profit before interest and tax

9,313

7,900

6,894

Less: Non-brand income

1,090

891

426

Adjusted profit before tax (1–2)

8,223

7,009

6,468

1

1.103

1.217

8,223

7732

7871

3

2

1

Inflation factor Present value of brand profits (3 × 4) Weightage factor Weighted average profit

8,001

 

Remuneration of capital

1,284

 

Brand-related profit (7–8)

6,717

 

Tax

2,231

 

Brand earnings (9–10)

4,486

 

9.03

 

Brand multiple Brand value (11 × 12)

40,509

 

 

Ratios

 Particulars 

( ` in Crore) 2011

2010

2009

40,509

36,907

32,345

186,100

150,110

75,837

Brand value as a % of market capitalization (%)

21.8

24.6

42.7

Brand value/revenue (times)

1.47

1.62

1.49

Brand value Market capitalization

Source: Annual Report of Infosys Limited for the year 2010–11

384  Chapter 13

resources. In case of Marico, the EVA has improved from ` 174.8 crore in 2010–11 to `551.7 crore in 2016–17. The NOPAT of the company has increased from ` 300.9 crore to ` 810.3 crore during the same period. The company has been able to increase its NOPAT with less than proportionate increase in capital employed, resulting in substantial improvement in EVA. However, the weighted average cost of capital from the company has increased from 8.90% to 10.40%.

13.5.4  Brand Valuation A business enterprise over a period of time develops a brand equity whereby it is recognized by its customers, employees, suppliers and other stakeholders. The brand equity so developed indeed is a valuable asset for the company in question. Brand names like Amul, Bata, Microsoft, Apple, Infosys, Tata, etc., are household names. However, the relevant accounting standard (Ind AS 38) does not permit recognition of self-generated brands in the accounting records. A strong brand does help the business enterprise in getting a better price for its goods and services and thereby in generating ‘super profit’ or excess profit compared to the peer group without such brand equity. As the formal financial statements do not recognize self-generated brands, many companies value and report their brands and report the same in the annual reports. The brand valuation is based upon the existence of ‘excess profit’, that is, profit over and above the remuneration for capital and the brand strength. The brand strength is denoted by a multiple–stronger the brand, higher the multiple to be used. The brand valuation reported by Infosys Limited is set out in Box 13.3

Summary

• Besides the financial statements—balance sheet, profit and loss statement and cash flow state• • • • •

ment—the annual report of a company includes a number of other reports which are useful for analysing the affairs of the company. Additional disclosures may be grouped under four headings—mandatory under Companies Act, 2013, required under listing agreement for publicly traded companies, required under the relevant accounting standards and voluntary disclosures. Auditor’s report expresses the opinion of the ‘independent auditors’ on the financial statements audited by them. Any reservations or observations that the auditors may have are stated as ‘qualifications’ in the audit report. Directors’ report gives an analysis of the affairs of the business and also includes the proposal by the board for amounts to be transferred to reserves and to be distributed as profits. Explanation to any reservations in the audit report is also provided in the directors’ report. In respect of listed companies, directors’ report is further supplemented by management discussion and analysis which contains a detailed SWOT analysis of the company. The listing agreement also mandates a separate corporate governance report detaining the corporate governance philosophy and governance structure of the company including functioning of various committees of the board.

Disclosures in Annual Reports  385

• The business responsibility report demonstrates the steps taken by the company to implement • • • •

the nine principles laid down by the ‘national voluntary guidelines on social, environmental and economic responsibilities of business’. Ind AS 108 requires segment reporting based the business activities in which the company engages and economic environments in which it operates. Ind AS 24 mandate related party disclosures to be made in the annual reports. Likewise, Ind AS 112 prescribes information to be disclosed regarding subsidiaries, joint arrangements, associates and structured entities that are not controlled by the entity. Ind AS 107 disclosures regarding the nature and extent of risks arising from financial instruments to which the entity is exposed and how the entity manages those risks. In addition to the mandatory disclosures, many companies are making additional disclosures on voluntary basis. These disclosures enhance transparency and are being used by management to communicate with their stakeholders. Some of the popular voluntary disclosures include value added statement, economic value added, human resources accounting and brand valuation.

Assignment Questions 1. What are the different sources of disclosures in the annual reports of companies? 2. What are the different types of audit reports? 3. How is ‘segment reporting’ helpful in understanding the financial performance of a company? 4. How is Economic Value Added different from the reported profit? 5. ‘Value added statement has a stakeholders’ focus rather than stock holders’ focus’. Do you agree? 6. Human resources are the most valuable assets for a knowledge based business, still they are not treated as assets in the balance sheet. Why?

Problems 1. Ascertaining EVA and MVA: Based upon the following information calculate the economic value added (EVA) and market value added (MVA) for Hot & Spice Limited.

Profit and loss statement for the year ended 31st March 2017 Earnings before interest and tax (EBIT) Less: Interest expenses Profit before tax (PBT) Less: Provision for tax Profit after tax (PAT)

(` in Crore) 465.23 120.20 345.03 103.51 241.52

386  Chapter 13

The detail of capital employed by the company in the last two years is given as follows: (` in Crore) 2016 2017 Shareholders’ funds 680.55 470.65 Borrowed funds 902.68 786.44 The company estimates that the pre-tax cost of borrowed funds is 10%, whereas cost of equity is estimated to be 14%. Tax rate applicable to the company is 30%. The current market capitalization of the company is ` 2,304.80 crore.

Solutions to Problems ( ` in Crore)

Capital Employed

2016

2017

Shareholders’ funds

680.55

470.65

575.6

Borrowed funds

902.68

786.44

844.56

1583.23

1257.09

1420.16

Total capital employed

Average

( ` in Crore) Weighted Average Cost of Capital

Amount

Proportion

Post Tax Cost of Funds

Cost of Capital

Average shareholders’ funds

575.60

0.41

14%

5.67%

Average borrowed funds

844.56

0.59

7%

4.16%

1420.16

1.00

Economic Value Profit after tax Add: Interest × (1-Tax rate)

9.84%

( ` in Crore)

241.52 84.14

Net operating profit after tax (NOPAT)

325.66

Less: Capital charge Average capital employed WACC

1420.16 9.84%

Average capital employed × WACC

139.70

Economic value added

185.96

Disclosures in Annual Reports  387

Market value added = Market capitalization – Shareholders’ funds = ` (2304.80 – 680.55) crore = ` 1624.25 crore Notes: 1. NOPAT can be calculated as NOPAT = PAT + Interest × (1 – Tax rate) or NOPAT = EBIT × (1 – Tax rate) 2. Post tax cost of borrowed funds = Interest rate × (1 – Tax rate)

Try It Yourself 1. EVA Comparison: On the basis of the following information and assumption, determine which of the two companies have a higher economic value added: Particulars Earnings before interest and tax (EBIT)

2016–17 ( ` in Crore) SM Limited MS Limited 673.58

875.49

88.86

172.56

Profit before tax (PBT)

584.72

702.93

Tax

175.42

210.89

Profit after tax (PAT)

409.30

492.04

Interest expenses

Capital Employed Shareholders’ funds

2016–17

2015–16

SM Limited MS Limited SM Limited MS Limited 1,952.11

2,706.44

1,700.45

2,300.80

956.43

2,645.43

900.88

2,800.79

2,908.54

5,351.87

2,601.33

5,101.59

Borrowed funds

12%

14%

Shareholders’ funds

15%

16%

Borrowed funds

Cost of capital

The applicable tax rate is 30%.

388  Chapter 13

Cases Case 13.1: Segment Reporting of Engineers India Limited3 Engineers India Limited was set up in 1965 to provide engineering and related technical services for petroleum refineries and other industrial projects. Its range of services includes project management consultancy (PMC), project implementation services (PMS), engineering, procurement and construction (EPC) and lump sum turnkey (LSTK) contracts. The company has experienced a decline in revenue as well as profits in the last 5 years. For the purpose of ‘segment reporting’ under Ind AS, the company has segmented its activities into two segments—consultancy and engineering projects and lump sum turnkey projects—taking into account the organizational structure and internal reporting system as well as different risk and rewards of these segment. Segment revenue and results are set out below: Particulars

( ` in Lakhs) 2013

2014

2015

2016

2017

Consultancy & engineering

123,424

110,907

94,797

100,746

116,507

Turnkey projects

127,173

71,452

76,503

50,356

28,358

Total

250,597

182,359

171,300

151,101

144,864

Consultancy & engineering

52,705

49,197

22,791

26,456

35,920

Turnkey projects

11,048

4,033

5,602

1,218

10,355

Total

63,752

53,230

28,393

27,674

46,275

Segment revenue

Segment profit

Questions for Discussion 1. Which segment is more profitable? 2. Using the segment information, comment upon the decline in the revenue and profit of EIL. To what extent the segment reporting is helpful in analyzing the past performance of EIL? 3. How will the segment reporting be useful is making projections about the future? Case 13.2: EVA Reporting by Hindustan Unilever Limited4 What is EVA? Traditional approaches to measuring ‘Shareholder’s Value Creation’ have used parameters such as earnings capitalization, market capitalization and present value of estimated future cash flows. Extensive equity research has established that it is not earnings per se, but value that is important. A measure called ‘Economic Value Added’ (EVA) is increasingly being applied to understand and evaluate financial performance.

Disclosures in Annual Reports  389

*EVA = Net Operating Profit after taxes (NOPAT) − Cost of Capital Employed (COCE), where, NOPAT = Profits after depreciation and taxes but before interest costs. NOPAT thus represents the total pool of profits available on an ungeared basis to provide a return to lenders and shareholders, and COCE = Weighted Average Cost of Capital (WACC) × Average Capital Employed *Cost of debt is taken at the effective rate of interest applicable to an ‘AAA’ rated company like HUL for a short-term debt, net of taxes. We have considered a pre tax rate of 7.42% for 2016–17 (8.22% for 2015–16). *Cost of equity is the return expected by the investors to compensate them for the variability in returns caused by fluctuating earnings and share prices. Cost of Equity = Risk free return equivalent to yield on long-term government bonds (taken at 6.68% for 2016–17) (+) Market risk premium (taken at 8.69%) (x) Beta variant for the company, (taken at 0.710) where Beta is a relative measure of risk associated with the company’s shares as against the market as a whole. Thus HUL’s cost of equity = 6.68% + 8.69% (x) 0.710 = 12.85% What does EVA show? EVA is residual income after charging the company for the cost of capital provided by lenders and shareholders. It represents the value added to the shareholders by generating operating profits in excess of the cost of capital employed in the business. When will EVA increase? EVA will increase if: 1. Operating profits are made to grow without employing more capital, that is, greater efficiency. 2. Additional capital is invested in projects that return more than the cost of obtaining new capital, that is, profitable growth. 3. Capital is curtailed in activities that do not cover the cost of capital, that is, liquidate unproductive capital. EVA in practice at Hindustan Unilever Limited In Hindustan Unilever Limited, the goal of sustainable long-term value creation for our shareholders is well understood by all the business groups. Measures to evaluate business performance and to set targets take into account this concept of value creation. EVA Tends: 2007–2017 (Unaudited)

( ` in Crore) Particulars

2007 2008–09 2009–10 2010–11 2011–12 2012–13 2013–14 2014–15 2015–16 2016–17

Cost of Capital Employed (COCE) 1. Average debt 2. Average equity

382

342

119

2













2,402

1,928

2,497

3,118

3,462

4,018

3,715

4,338

5,664

5,831

(continued )

390  Chapter 13 (continued )

( ` in Crore) Particulars

2007 2008–09 2009–10 2010–11 2011–12 2012–13 2013–14 2014–15 2015–16 2016–17

3. Average capital employed: (1) + (2)

2,784

2,270

2,616

3,120

3,462

4,018

3,715

4,338

5,664

3.91

3.95

5.36

6.20

6.02

6.36

5.56

5.43

4.90

5. Cost of equity %

17.59

14.47

12.51

12.93

10.10

10.07

11.62

10.91

11.98

12.85

6. WACC %

16.03

12.88

12.12

12.92

10.10

10.07

11.62

10.91

11.98

12.85

446

365

317

403

350

405

432

474

679

749

1,743

2,501

2,103

2,153

2,599

3,314

3,555

3,843

4,116

4,247

17

17

5



1

17

24

11





1,760

2,518

2,108

2,153

2,600

3,331

3,579

3,854

4,117

4,247

446

365

317

403

350

405

432

474

679

749

12. EVA (10)–(11) 1,314

2,153

1,791

1,750

2,250

2,926

3,147

3,380

3,438

3,498

4 Cost of debt, post-tax %6.24

7. COCE: (3) x (6)

5,831

Economic Value Added (EVA)

9. Add: Interest, after taxes 10. NOPAT 11. COCE, as per (7) above

hel

Economic Value Added (EVA) ( ` in Crore) 3500

3000

2500

2000 crore

8. Profit after tax, before exceptional items

1500

1000

500

0 2007

2008–09 2009–10 2010-11

2011-12

2012-13

2013-14

2014-15

2015-16

2016-17

Disclosures in Annual Reports  391

Questions for Discussion 1. How is EVA different from the conventional profit after tax (PAT)? 2. HUL’s EVA has increased over the years. Identify the main contributory factors towards improvement in EVA of the company? 3. How do you relate profitability, asset turnover and financial leverage with EVA?

Endnotes 1. 2. 3. 4.

Ind AS 24, Related Party Disclosures. EVA is the registered trade mark of Stern Stewarts & Co. Annual Reports of Engineers India Limited for the year 2012–13 to 2016–17. Annual Report of Hindustan Unilever Limited for the year 2016–17.

Analysis of Financial Statements

14 CHAPTER OBJECTIVES

This chapter will help the readers to: • Understand the nature and limitations of financial analysis. • Differentiate between inter-period and inter-firm comparison. • Prepare and analyse common size financial statements and indexed financial statements. • Compute and interpret various financial ratios. • Understand applications of ratio analysis using DuPont analysis and Z score. • Carry out detailed analysis of financial statements of companies.

14.1 INTRODUCTION The focus of the book so far, has been on understanding the accounting process and contents of the financial statements—the balance sheet, the profit and loss statement, and the cash flow statement. This chapter will focus on the tools to analyse the information conveyed by these statements. By a ­meaningful analysis, the performance and financial health of an enterprise can be dissected. The ­information conveyed can also be used for making estimates about the future. Before discussing the tools and techniques of financial statement analysis, let us understand some of the basic c­ aveats. Firstly, the focus of analysis will depend upon the purpose for which analysis is being carried out. For example, a supplier of goods on credit will be more concerned about the ability of the firm to pay his dues. His focus of analysis will be on short-term liquidity position of the e­ nterprise. A lender of term loans will focus more on the ability of the firm to honour its obligation over a long-term, therefore, focusing on the composition of enterprise’s sources of funds. A prospective investor in the equity shares of the enterprise will be keener to analyse the profitability and growth aspects of the enterprise. Secondly, the depth of analysis will depend upon the data availability. An outsider will rely solely on the information contained in the financial statements, whereas insiders (managers) will have access to more information. The latter will be able to carry more detailed analysis compared to the former. The depth and complexity of the analysis increases as more and more data becomes available. Obviously, the quality of the analysis will also depend upon the quality of the financial ­statements. Whatever limitations the financial statement have (errors or frauds), the same will get into the analy-

Analysis of Financial Statements  393

sis as well. Thirdly, analysing the financial stateInter-period comparison—comparing ments of an entity for a ­particular period may not balance sheet and profit and loss be sufficient. The changes that might have occurred account numbers over a period of time. in the financials of the enterprise over a period of time will be particularly useful. Analysing the finanInter-firm comparison—comparing balcials of an enterprise over a period of time to idenance sheet and profit and loss account tify and understand the trends is called inter-period numbers of one an enterprise with ­comparison. Likewise, comparing the financials of other similar enterprises. the enterprise with other similar firms in the industry or c­ omparing with industry aggregates will also be useful. While attempting an inter-firm comparison, it must be ensured that the other enterprises chosen for comparison are similar to the enterprise being analysed to the extent possible. Lastly, analysis as a management tool is very flexible. The financial statements are prepared using fixed formats (prescribed by the law) and rigid principles (contained in accounting standards). There are no such formats or rules as far as analysis is concerned. Anything that helps in better understanding of the financials, as depicted by the financial statements, is acceptable.

Table 14.1  Profit and Loss Statement of Excel Industries Limited for the Year Ended 31st March

Particulars

( ` in Million) 2017

2016

2015

2014

13,888

14,002

12,546

10,643

434

233

107

87

14,322

14,235

12,653

10,730

Material consumed

6,434

7,745

6,218

5,512

Other manufacturing expenses

1,650

1,623

1,531

1,455

Cost of goods sold

8,084

9,368

7,749

6,967

Administrative expenses

628

681

584

542

Marketing expenses

915

892

723

668

Depreciation and amortization

513

405

277

321

1,158

756

611

433

Sale of products and services Interest earned  

Interest Total expenses

11,298

12,102

9,944

8,931

Profit before tax

3,024

2,133

2,709

1,799

Tax expenses

1,008

712

907

598

Profit after tax

2,016

1,421

1,802

1,201

150

75

75

75

23

11

11

11

1,844

1,335

1,716

1,115

Dividend Dividend distribution tax Retained earnings

394  Chapter 14

In the following paragraphs, some of the tools for the financial analysis are discussed. The financial statements of Excel Industries Limited for the years 2014–2017 given in Tables 14.1 and 14.2, respectively will be analysed using these tools. Table 14.2  Balance Sheet of Excel Industries Limited as on 31st December

Particulars

( ` in Million) 2017

2016

2015

2014

14,976

12,633

10,545

9,744

4,305

3,792

3,664

3,387

10,671

8,841

6,881

6,357

4,608

2,290

1,569

1,078

15,279

11,131

8,450

7,435

1,299

1,522

1,487

1,021

921

533

838

832

ASSETS Non-current assets Property, plant & equipment (gross) Less: Accumulated depreciation Non-current investments Current assets Inventories Cash & bank Balance Short-term investments Trade receivables Other current assets TOTAL ASSETS

732

341

300

85

5,004

4,786

3,449

1,785

785

458

332

276

8,741

7,640

6,406

3,999

24,020

18,771

14,856

11,434

1,000

750

750

750

10,924

8,081

6,746

5,030

11,924

8,831

7,496

5,780

5,987

4,312

2,980

2,014

EQUITY AND LIABILITIES Share capital (face value `10 each) Other equity Non-current liabilities Long-term borrowings Deferred tax liabilities

768

554

423

303

6,755

4,866

3,403

2,317

Short-term borrowings

3,287

3,034

2,165

1,832

Trade payable

1,587

1,615

1,447

1,225

467

425

345

280

Current liabilities

Other current liabilities TOTAL EQUITY AND LIABILITIES

5,341

5,074

3,957

3,337

24,020

18,771

14,856

11,434

Analysis of Financial Statements  395

14.2  COMMON SIZE STATEMENTS For the purpose of analysis, preparing a common size statements is often a good starting point. In a Common size statements—expresscommon size statement, all the figures are expressed ing various components of the balance as a percentage of a base value. For example, in sheet as a percentage of total of balcommon size profit and loss statement, each item in ance sheet and various components of the profit and loss statement can be expressed as a profit and loss account as a percentage percentage of total sales. Likewise, in common size of sales. balance sheet, the total of the balance sheet may be taken as a common denominator. These common size statements give the relative importance of various items and help to establish a broad trend. The common size profit and loss statement for Excel Industries Limited is given in Table 14.3. Table 14.3  Common Size Profit and Loss Statement of Excel Industries Limited

Particulars Sale of products and services

2017

2016

2015

2014

% 100.0

100.0

100.0

100.0

3.1

1.7

0.9

0.8

103.1

101.7

100.9

100.8

Material consumed

46.3

55.3

49.6

51.8

Other manufacturing expenses

11.9

11.6

12.2

13.7

Cost of goods sold

58.2

66.9

61.8

65.5

Administrative expenses

4.5

4.9

4.7

5.1

Marketing expenses

6.6

6.4

5.8

6.3

Depreciation and amortization

3.7

2.9

2.2

3.0

Interest earned  

Interest

8.3

5.4

4.9

4.1

 Total expenses

81.4

86.4

79.3

83.9

Profit before tax

21.8

15.2

21.6

16.9

Tax expenses

7.3

5.1

7.2

5.6

Profit after tax

14.5

10.1

14.4

11.3

Dividend

1.1

0.5

0.6

0.7

Dividend distribution tax

0.2

0.1

0.1

0.1

13.3

9.5

13.7

10.5

Retained earnings

By looking at Table 14.3, one can observe the broad trends in various items in the profit and loss statement. The profit after tax as a percentage of sales has fluctuated from 10.1% to 14.5% in the last four years. The interest earned and interest expenses have i