Tag: Depreciation

Measurement

A financial asset or financial liability is measured initially at fair value. Subsequent measurement depends on the category of financial instrument. Some categories are measured at amortised cost, and some at fair value. In limited circumstances other measurement bases apply, for example, certain financial guarantee contracts.

The following are measured at amortised cost:

• Held to maturity investments—non-derivative financial assets that the entity has the positive intention and ability to hold to maturity;
• loans and receivables—non-derivative financial assets with fixed or determinable payments that are not quoted in an active market; and
• Financial liabilities that are not carried at fair value through profit or loss or otherwise required to be measured in accordance with another measurement basis.

The following are measured at fair value:

• Financial assets and financial liabilities held for trading—this category includes derivatives not designated as hedging instruments and financial assets and financial liabilities that the entity has designated for measurement at fair value. All changes in fair value are reported in profit or loss.
• Available for sale financial assets—all financial assets that do not fall within one of the other categories. These are measured at fair value. Unrealised changes in fair value are reported in other comprehensive income. Realised changes in fair value (from sale or impairment) are reported in profit or loss at the time of realisation.

Initial measurement

Initially, financial assets and liabilities should be measured at fair value (including transaction costs, for assets and liabilities not measured at fair value through profit or loss). [IAS 39.43]

Measurement subsequent to initial recognition

Subsequently, financial assets and liabilities (including derivatives) should be measured at fair value, with the following exceptions: [IAS 39.46-47]

• Loans and receivables, held-to-maturity investments, and non-derivative financial liabilities should be measured at amortised cost using the effective interest method.
• Investments in equity instruments with no reliable fair value measurement (and derivatives indexed to such equity instruments) should be measured at cost.
• Financial assets and liabilities that are designated as a hedged item or hedging instrument are subject to measurement under the hedge accounting requirements of the IAS 39.
• Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or that are accounted for using the continuing-involvement method, are subject to particular measurement requirements.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. [IAS 39.9] IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix A, paragraphs AG69-82]

• Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument.
• If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes recent arm’s length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments.
• If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be made reliably, then an entity must measure the equity instrument at cost less impairment.

Amortised cost is calculated using the effective interest method. 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 the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss is subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used.

IAS 39 fair value option

IAS 39 permits entities to designate, at the time of acquisition or issuance, any financial asset or financial liability to be measured at fair value, with value changes recognised in profit or loss. This option is available even if the financial asset or financial liability would ordinarily, by its nature, be measured at amortised cost but only if fair value can be reliably measured.

In June 2005 the IASB issued its amendment to IAS 39 to restrict the use of the option to designate any financial asset or any financial liability to be measured at fair value through profit and loss (the fair value option). The revisions limit the use of the option to those financial instruments that meet certain conditions: [IAS 39.9]

• The fair value option designation eliminates or significantly reduces an accounting mismatch, or
• A group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis by entity’s management.

IAS 39 available for sale option for loans and receivables

IAS 39 permits entities to designate, at the time of acquisition, any loan or receivable as available for sale, in which case it is measured at fair value with changes in fair value recognised in equity.

Impairment

A financial asset or group of assets is impaired, and impairment losses are recognised, only if there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset. An entity is required to assess at each balance sheet date whether there is any objective evidence of impairment. If any such evidence exists, the entity is required to do a detailed impairment calculation to determine whether an impairment loss should be recognised. [IAS 39.58] The amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated cash flows discounted at the financial asset’s original effective interest rate. [IAS 39.63]

Assets that are individually assessed and for which no impairment exists are grouped with financial assets with similar credit risk statistics and collectively assessed for impairment. [IAS 39.64]

If, in a subsequent period, the amount of the impairment loss relating to a financial asset carried at amortised cost or a debt instrument carried as available-for-sale decreases due to an event occurring after the impairment was originally recognised, the previously recognised impairment loss is reversed through profit or loss. Impairments relating to investments in available-for-sale equity instruments are not reversed through profit or loss. [IAS 39.65]

Scope

This Standard shall be applied in accounting for all leases other than:

(a) Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources; and

(b) Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

However, this Standard shall not be applied as the basis of measurement for:

(a) Property held by lessees that is accounted for as investment property (see Ind AS 40 Investment Property);

(b) Investment property provided by lessors under operating leases (see Ind AS 40 Investment Property);

(c) Biological assets held by lessees under finance leases (see Ind AS 41 Agriculture1); or

(d) Biological assets provided by lessors under operating leases (see AS 41 Agriculture).

This Standard applies to agreements that transfer the right to use assets even though substantial services by the lessor may be called for in connection with the operation or maintenance of such assets. This Standard does not apply to agreements that are contracts for services that do not transfer the right to use assets from one contracting party to the other.

A non-cancellable lease is a lease that is cancellable only:

(a) Upon the occurrence of some remote contingency;

(b) With the permission of the lessor;

(c) If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or

(d) Upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.

The inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date:

(a) A lease is classified as either an operating or a finance lease; and

(b) In the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined.

The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (ie the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate).

The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.

Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:

(a) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee;

(b) For a lessor, any residual value guaranteed to the lessor by:

(i) The lessee;

(ii) A party related to the lessee; or

(iii) A third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Economic life is either:

(a) The period over which an asset is expected to be economically usable by one or more users; or

(b) The number of production or similar units expected to be obtained from the asset by one or more users.

Useful life is the estimated remaining period, from the commencement of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.

Guaranteed residual value is:

(a) for a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable); and

(b) For a lessor, that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Unguaranteed residual value is that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.

Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors.

Gross investment in the lease is the aggregate of:

(a) The minimum lease payments receivable by the lessor under a finance lease, and

(b) Any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease.

Unearned finance income is the difference between:

(a) The gross investment in the lease, and

(b) The net investment in the lease.

The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.

The lessees incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.

Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (eg percentage of future sales, amount of future use, future price indices, and future market rates of interest).

A lease agreement or commitment may include a provision to adjust the lease payments for changes in the construction or acquisition cost of the leased property or for changes in some other measure of cost or value, such as general price levels, or in the lessors costs of financing the lease, during the period between the inception of the lease and the commencement of the lease term. If so, the effect of any such changes shall be deemed to have taken place at the inception of the lease for the purposes of this Standard.

The definition of a lease includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. These contracts are sometimes known as hire purchase contracts.

Termination benefits arise when an employee is terminated by the employer or when an employee accepts the employer’s offer of benefits in exchange of termination of employment. This is different to post-employment benefits. Classic example of termination benefits is retrenchment compensation where the employee has no option to accept the termination. Voluntary Retirement Scheme is also an example of termination benefits where the employees are due a compensation and in return accept early retirement.

Termination Benefits are to be recognised on the earlier date of when the company can no longer withdraw the offer of the termination benefits, or when the company recognises costs for restructuring which involves the payment of termination benefits. For instance, a company may face debt restructuring and accordingly, several employees would have to be laid off, and the termination benefits would be recognised.

Termination benefits are employee benefits provided in exchange for the termination of an employee’s employment as a result of either:

• An entity’s decision to terminate an employee’s employment before the normal retirement date; or
• An employee’s decision to accept an offer of benefits in exchange for

An entity shall recognize a liability and expense for termination benefits at the earlier of the following dates: The termination of

• When the entity can no longer withdraw the offer of those benefits; and
• When the entity recognises costs for a restructuring that is within the scope of Ind AS 37 and involves the payment of termination benefits

It does not cover an employee’s voluntary termination or mandatory retirement. It is generally a lump sum payment and also includes:

• Enhancement of post-employment benefits (through benefit plan).
• Salary to be paid until the end of a specified notice period.

Recognition

An employer should recognize termination benefits as a liability and as an expense at the earlier of the following dates:

• The employer can no longer withdraw the offer for those benefits. The employer recognizes restructuring cost per Ind AS 37 and involves payment of termination benefits

Measurement

Termination Benefits are measured based on the criteria considering if they are an enhancement to post-employment benefits. If they are an enhancement to post-employment benefits (for instance payable after retirement), then they are accounted as per Defined Contribution Plan or Defined Benefit Plan, as the case maybe. If they are not an enhancement to post-employment benefits, based on whether the termination benefits are expected to be settled within 12months they are accounted as either Short Term Employee Benefits (for cases when the settlement is within 12 months) or Other Long Term Employee Benefits (for other cases).

• Measure the termination benefits on initial recognition and recognize subsequent changes with the nature of employee benefit.
• Analyze if the benefits are an enhancement of post-employment benefits or short-term employee benefits or long-term employee benefits.

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification of financial data by methodical classification of the data given in the financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the data so simplified.’

Objectives

• Assessing the current position & operational efficiency: Examining the current profitability & operational efficiency of the enterprise so that the financial health of the company can be determined. For long-term decision making, assets & liabilities of the company are reviewed. Analysis helps in finding out the earning capacity & operating performance of the company.
• Reviewing the performance of a company over the past periods: To predict the future prospects of the company, past performance is analyzed. Past performance is analyzed by reviewing the trend of past sales, profitability, cash flows, return on investment, debt-equity structure and operating expenses, etc.
• Predicting growth & profitability prospects: The top management is concerned with future prospects of the company. Financial analysis helps them in reviewing the investment alternatives for judging the earning potential of the enterprise. With the help of financial statement analysis, assessment and prediction of the bankruptcy and probability of business failure can be done.
• Loan Decision by Financial Institutions and Banks: Financial analysis helps the financial institutions, loan agencies & banks to decide whether a loan can be given to the company or not. It helps them in determining the credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, and maturity date etc.

Nature:

(i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

Scope

• Analyze financial ratios to assess profitability, solvency, working capital management, liquidity, and operating effectiveness.
• Compare current performance with historical conditions using trend analysis.
• Compare with peer companies or industry averages to find out how well companies are performing.

Advantages

The Ability to Detect Patterns

Financial statements reveal how much a company earns per year in sales. The sales may fluctuate, but financial planners should be able to identify a pattern over years of sales figures. For example, the company may have a pattern of increased sales when a new product is released. The sales may drop after a year or so of being on the market. This is beneficial, as it shows potential and sales patterns so executives know to expect a drop in sales.

A Chance to Budget Outline

Another advantage of using financial statements for future planning and decision making is that they show the company’s budgets. The budgets reveal how much wiggle room the company has to spend on launching products, developing marketing campaigns or expanding the current office size. Knowing how much money is available for planning and decision making ensures that the company does not spend more than expected.

Limitation

Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a firm. But, the analysis is based on the information available in the financial statements. Thus, the financial analysis suffers from serious inherent limitations of financial statements.

The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgment, etc.

Some of the important limitations of financial analysis are, however, summed up as below:

(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-monetary factors are ignored.

(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis.

(v) Changes in accounting procedure by a firm may often make financial analysis misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways.

Stages of financial statement analysis

Determine the purpose of the analysis. You need to determine what questions you want to answer through the study. The objective identifies the approach, tools, data sources, and format that you use to present the results.

• Collecting data. You then gather the necessary information. For example, to analyze a company’s historical performance, you might only need to use financial statements. When you want to examine more comprehensively, for example, valuing the company’s stock price, you need data such as economic and industry reports.
• Processing data. You need to convert financial data into useful statistics such as financial ratios or growth percentages. The more in-depth analysis may require not only descriptive statistics but also inferential statistics such as regression.
• Interpret statistics. To conclude, you might not only analyze historically but also compare with peer companies or industry averages.

Investment account is an account opened for the purpose of the investment. Further, if the number of investment is large, a separate account for each investment should be opened.

Accounting entry on the purchase of any investments are given as hereunder:

The basic objective of Accounting is the preparation of financial statements is a way that they give a true and fair view of the operating results and the financial position or the business to its various users, namely investors, creditors, management Government, trade unions, research institutions etc. These financial statements are prepared based on certain accounting concepts and conventions. The money measurement concept is a basic attribute of accounting. The money measurement concept states that only those business transactions that are capable of being expressed in terms of money can be recovered in the books of account. It also assumes that the monetary unit used for recording the transaction is stable in nature.

Inflation accounting is a term describing a range of accounting models designed to correct problems arising from historical cost accounting in the presence of high inflation and hyperinflation. Inflation accounting may be described as an attempt to portray financial performance of business enterprises on the basis of current prices. Special accounting techniques, which can be used during periods of high inflation. Inflation accounting requires statements to be adjusted according to price indexes, rather than rely solely on a cost accounting basis. Companies operating in countries experiencing hyperinflation may be required to update their statements periodically, in order to make them relevant to current economic and financial conditions.

Role

• Facilitates reasonable comparison: It facilitates a fair inter-period comparison of business profits by bringing all expenses and income to current value. All financial statements such as Balance sheet and Profit and loss account shows present values in place of historical values which makes comparison a reasonable task.
• Presents true condition: Inflation accounting presents true condition of company by adjusting all price level changes taking place in its financial statements. It depicts fair view of company’s financial position by reflecting all changes as per the current price index.
• Remove distortions: This branch of accounting helps in removing all distortions arising due to historical data. It makes accounting records reliable by updating all the data and matching current revenues with current expenses.
• Check on Mis-leading deeds: Inflation accounting keep an eye over the misleading deeds of Historical cost concepts depicting higher profits and higher taxes, thereby resulting in more wages being demanded by workers seeing the high profits. When all adjustments as per the price level accounting is made, these kind of demand will not arise.
• Improve decision making: It is an efficient tool with management which assist in efficient decision making. Inflation accounting provides reliable from of data that is adjusted to current price level. After adjustments, balance sheet exhibits fair position which helps managers in taking right decisions.
• Inbuilt automatic mechanism: Inflation accounting has an inbuilt and automatic mechanism for making adjustments as per the price level changes in company’s book of accounts. It compares revenues and expenses at current cost for reflecting realistic position.

Importance & Objectives

• Exhibits true position: Inflation accounting exhibits true financial status of company by reflecting all books of accounts at current price. It adjusts all record in accordance with current price index for determining real profitability.
• Avoids profit overstatement: This branch of accounting keeps a check on financial statements of companies for avoiding any overstatements of profits. All expenses and income are mentioned at current values which prevents overstatement of business income.
• Calculate right depreciation: Inflation accounting charges correct amount of depreciation by calculating it on present value instead of historical value. Charging right depreciation facilitates business in easy replacement of assets.
• Easy profit comparison: It enables firms in easy comparison of their inter-periods performance for determining their profitability. Inflation accounting adjust effects of prices changes on all expenses and incomes listed in financial statements that avoids distortion of historical data.
• Provides correct information: Inflation accounting provides correct information to shareholders and workers based on present price level. There may be a chance of higher dividend and higher wages being demanded by these people in absence of such information.

Need

Inflation, especially when it is prolonged and high, reduces considerably the meaningfulness and use of the corporate accounts because the various amounts in current rupee values may not signify proportionate real amounts, as the real worth of the rupee varies in different years. Moreover, arithmetical operations involving different amounts in rupees having different real worth become quite misleading. To make the accounts more meaningful, all items should be expressed in values relating to common year. This is attempted through inflation accounting, the following reasons usually being advanced in its favor.

• It helps to correct the usually distorted picture of the financial operations and condition of a company presented by the conventional system of accounts.
• It facilitates inter-company comparisons since inflation hits different firms in different degrees.
• It also facilitates inter-period comparisons of the performance of firm.
• Correct measurement of income is possible only with inflation accounting.
• When some nominal value in the accounts forms the basis of government action, e.g., taxation based on profits, MRTP Act measures based on nominal value acting as proxy for relevant variables, determination of controlled price on the basis of nominal profits and so on, inflation may cause unfair decisions by the government, unless the relevant nominal value is adjusted for inflation.

Merits

• Basis of depreciation. The correct amount of depreciation is when it is charged on the current values (inflated values), and thus the replacement of assets will be more reasonable.
• Realistic view. Inflation accounting enables the company to present a realistic view of its profitability as current revenues are matched to current costs.
• Check on payment of dividends out of capital. Inflation accounting enables companies to maintain capital by checking payment of dividends and taxes out of capital (due to inflated profit calculated based on historical cost accounting).
• Reasonable comparison of profitability. When financial statements consider inflation accounting, the profitability of two plants purchased on two dates can be known concretely. This is because they are calculated based on current value and not on historical cost.
• True and fair balance sheet. The company’s financial position, as shown by the balance sheet, will be true and fair if it keeps a meaningful balance of various effects of inflation accounting in mind.
• Check on misleading deeds. In inflation accounting, higher wage and salary demand is less likely to arise, more and more prospective entrepreneurs will not come to open their units, and unwanted competition will be checked.
• Wrong matching concepts. Assets purchased in the past are depreciated at the original cost or historical cost concept, while all other revenues and expenses are shown on current prices against matching accounting concept.
• Safety of owner’s equity. Inflation accounting records fixed asset values according to their current values. Hence, the owner’s capital valuation will show its correct value.

Demerits

Complicated process

Inflation accounting is a very complicated technique as it involves a lots of adjustments to be done in financial statements. Too many calculations and unwanted adjustments are to be made which becomes a difficult task for a common man.

Never ending process

Major limitation with inflation accounting is that the price changing is a never ending process and continues for infinity. Adjusting of financial statement at every point of time whenever inflation or deflation occurs becomes a tedious task.

Theoretical concept

Inflation accounting is merely a theoretical concept as under it window dressing of accounting concepts is done as per the suitability of individuals.

Situation in Deflation

During deflationary periods, it may lead to an overstatement of business profits which is harmful. Prices fall suddenly at the times of deflation, making adjustments to the price level at this time will lead to lesser depreciation being charged by the company thereby causing an exaggeration of profits.

Expensive technique

This accounting process is a very expensive technique. Small businesses cannot afford to implement it in their process.