Tag: Equity

Management Notes

Credit and Debit notes (Sec 34)

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(1) Where one or more tax invoices have been issued for supply of any goods or services or both and the taxable value or tax charged in that tax invoice is found to exceed the taxable value or tax payable in respect of such supply, or where the goods supplied are returned by the recipient, or where goods or services or both supplied are found to be deficient, the registered person, who has supplied such goods or services or both, may issue to the recipient one or more credit notes for supplies made in a financial year containing such particulars as may be prescribed.

(2) Any registered person who issues a credit note in relation to a supply of goods or services or both shall declare the details of such credit note in the return for the month during which such credit note has been issued but not later than September following the end of the financial year in which such supply was made, or the date of furnishing of the relevant annual return, whichever is earlier, and the tax liability shall be adjusted in such manner as may be prescribed:

Provided that no reduction in output tax liability of the supplier shall be permitted, if the incidence of tax and interest on such supply has been passed on to any other person.

Conditions on issue of credit note:

  1. The supplier may issue one or more credit notes for supplies made in a financial year through one or more tax invoices which have been issued by him earlier.
  2. The credit note cannot be issued at any time after either of the following 2 events.
  • Annual return has been filed for the FY in which the original tax invoice was issued.
  • September of the FY immediately succeeding the FY in which the original tax invoice was issued.

(3) Where one or more tax invoices have been issued for supply of any goods or services or both and the taxable value or tax charged in that tax invoice is found to be less than the taxable value or tax payable in respect of such supply, the registered person, who has supplied such goods or services or both, shall issue to the recipient one or more debit notes for supplies made in a financial year containing such particulars as may be prescribed

(4) Any registered person who issues a debit note in relation to a supply of goods or services or both shall declare the details of such debit note in the return for the month during which such debit note has been issued and the tax liability shall be adjusted such manner as may be prescribed.

The GST Law mandates that a registered supplier may issue one or more debit notes for supplies made in a financial year through one or more tax invoices which has been issued by him earlier under the following circumstances:

  1. Actual value of supply is higher than that stated in the original tax invoice.
  2. Tax charged in the original tax invoice is lower than that applicable on the supply.
  3. The debit note needs to be linked to the original tax invoice(s).
  4. The debit note contains all the applicable particulars as specified in Rule 53(1A) of the CGST Rules, 2017.
  5. A debit note issued under Section 74, 129 or 130 would not entitle the recipient to avail credit in respect thereof, and the supplier shall specify prominently, on such debit note the words “INPUT TAX CREDIT NOT ADMISSIBLE”; as provided in Rule 53(3).
  6. It may also be noted that no time limit has been prescribed for issuing debit notes. Meaning, a debit note may be raised and uploaded subsequently, with no restriction as to the time period for doing so.
Management Notes

Ind AS-28: Investments in Associate and Joint Ventures

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IAS 28 Investments in Associates and Joint Ventures (as amended in 2011) outlines how to apply, with certain limited exceptions, the equity method to investments in associates and joint ventures. The standard also defines an associate by reference to the concept of “Significant Influence“, which requires power to participate in financial and operating policy decisions of an investee (but not joint control or control of those polices).

Objective of IAS 28

The objective of IAS 28 (as amended in 2011) is to prescribe the accounting for investments in associates and to set out the requirements for the application of the equity method when accounting for investments in associates and joint ventures. [IAS 28(2011).1]

Scope of IAS 28

IAS 28 applies to all entities that are investors with joint control of, or significant influence over, an investee (associate or joint venture). [IAS 28(2011).2]

Important Definition:

Significant influence: The power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies.

Associate: An entity over which the investor has significant influence.

Joint arrangement: An arrangement of which two or more parties have joint control.

Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement.

Joint ventures: A party to a joint venture that has joint control of that joint venture.

Equity method: A method of accounting whereby the investment is initially recognised at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the investee’s net assets. The investor’s profit or loss includes its share of the investee’s profit or loss and the investor’s other comprehensive income includes its share of the investee’s other comprehensive income.

Joint control: The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control.

Significant influence

Where an entity holds 20% or more of the voting power (directly or through subsidiaries) on an investee, it will be presumed the investor has significant influence unless it can be clearly demonstrated that this is not the case. If the holding is less than 20%, the entity will be presumed not to have significant influence unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an entity from having significant influence. [IAS 28(2011).5]

The existence of significant influence by an entity is usually evidenced in one or more of the following ways: [IAS 28(2011).6]

  • Participation in the policy-making process, including participation in decisions about dividends or other distributions.
  • Representation on the board of directors or equivalent governing body of the investee.
  • Material transactions between the entity and the investee.
  • Provision of essential technical information.
  • Interchange of managerial personnel.

The equity method of accounting

Distributions and other adjustments to carrying amount. The investor’s share of the investee’s profit or loss is recognised in the investor’s profit or loss. Distributions received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s other comprehensive income (e.g. to account for changes arising from revaluations of property, plant and equipment and foreign currency translations.) [IAS 28(2011).10]

Basic principle. Under the equity method, on initial recognition the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. [IAS 28(2011).10]

Potential voting rights. An entity’s interest in an associate or a joint venture is determined solely on the basis of existing ownership interests and, generally, does not reflect the possible exercise or conversion of potential voting rights and other derivative instruments. [IAS 28(2011).12]

Classification as non-current asset. An investment in an associate or a joint venture is generally classified as non-current asset, unless it is classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. [IAS 28(2011).15]

Interaction with IFRS 9. IFRS 9 Financial Instruments does not apply to interests in associates and joint ventures that are accounted for using the equity method. An entity applies IFRS 9, including its impairment requirements, to long-term interests in an associate or joint venture that form part of the net investment in the associate or joint venture but to which the equity method is not applied. Instruments containing potential voting rights in an associate or a joint venture are accounted for in accordance with IFRS 9, unless they currently give access to the returns associated with an ownership interest in an associate or a joint venture. [IAS 28(2011).14-14A]

Application of the equity method of accounting

Basic principle. In its consolidated financial statements, an investor uses the equity method of accounting for investments in associates and joint ventures. [IAS 28(2011).16] Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in IFRS 10. Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture. [IAS 28. (2011).26]

Exemptions from applying the equity method. An entity is exempt from applying the equity method if the investment meets one of the following conditions:

The entity is a parent that is exempt from preparing consolidated financial statements under IFRS 10 Consolidated Financial Statements or if all of the following four conditions are met (in which case the entity need not apply the equity method): [IAS 28(2011).17]

  • The entity is a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the investor not applying the equity method
  • The investor or joint venturer’s debt or equity instruments are not traded in a public market
  • The entity did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market
  • The ultimate or any intermediate parent of the parent produces financial statements available for public use that comply with ifrss, in which subsidiaries are consolidated or are measured at fair value through profit or loss in accordance with ifrs 10.

Classification as held for sale. When the investment, or portion of an investment, meets the criteria to be classified as held for sale, the portion so classified is accounted for in accordance with IFRS 5. Any remaining portion is accounted for using the equity method until the time of disposal, at which time the retained investment is accounted under IFRS 9, unless the retained interest continues to be an associate or joint venture. [IAS 28(2011).20]

Management Notes

Ind AS-16: Property, Plant and Equipment

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Ind AS 16 Property Plant Equipment is applicable to all Property and P&E (Plant & Equipment) unless and until any other accounting standard asks for a different treatment. Ind AS 16 Property Plant Equipment is not applicable in the following cases:

  • Biological assets which are related to agricultural activities except bearer plants.
  • Property and P&E (Plant & Equipment) which are classified as held for sale as per Ind AS 105.
  • Mineral rights and reserves like oil, natural gas and other such non-regenerative resources.
  • The measurement and recognition of exploration and evaluation assets.

Constituents of cost

The cost of the item of PPE includes:

(a) Costs which are directly attributable to bringing assets to the condition and location essential for it to operate in a manner as intended by the management.

(b) The purchase price, which includes the import duties and any non-refundable taxes on such purchase, after deducting rebates and trade discounts.

(c) Initial estimate of costs of removing and dismantling an item and restoring a site where it is located.

Recognition

Recognition simply means incorporation of item in the business’s accounts, in this case as a non-current asset. The recognition of property, plant & equipment depends on two criteria:

a) It is probable that future economic benefits associated with these assets will flow to the entity.

b) Cost can be measured reliable.

Initial Measurement

The cost of items of Property, plant & equipment compromises:

  • Purchase price, including import duties, non-refundable purchase taxes, less trade discount & rebate.
  • Initial estimates of cost of dismantling/decommissioning removing, & site restoration at present value if the entity has an obligation that it incurs on acquisition of the asset or as a result of using the asset other than to produce inventories.
  • Cost directly attributable to bringing the asset to the location & condition necessary for it to be used in a manner intended by management.

Measurement subsequent to initial recognition

The standard offers two possible treatments here, essentially a choice between keeping an asset recorded at cost model or revaluation model. However, the same policy must be applied to each entire class of property, plant and equipment.

Cost Model carry the asset at its cost less depreciation and any accumulated impairment losses.

Revaluation Model carry the assets at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses.  The revised IAS 16 makes clear that the revaluation model is available only if the fair value of the item can be measured reliably.

Revaluation Model

The market value of Land & Buildings usually represents the fair value, assuming existing use and line of business. Such valuations are usually undertaken by professionally qualified valuers.

In case of plant & equipment, fair value is usually market value. If the market value is not available, fair value is estimated using depreciated replacement cost.

The frequency of valuation depends on the volatility of the fair values of the individual items of property, plant and equipment. The more volatile the fair value, the more frequently revaluations should be carried out. Where the current fair value is very different from the carrying amount then a revaluation should be carried out. Most importantly, when an item of property, plant & equipment is revalued, the whole class of assets to which it belongs should be revalued.

All the items within a class should be revalued at the same time, to prevent selective revaluation of the certain assets and to avoid disclosing a mixture of costs and values from different dates in the financial statements. Items within a class may be revalued on a rolling basis within short period of time provided revaluation are kept upto date.

Accounting for a revaluation

How should any increase in value to be treated when a revaluation takes place? The debit will be the increase in value in the statement of financial position, but what about the credit? IAS 16 required the increase to be credited to other comprehensive income and accumulated in a revaluation surplus (part of owner’s equity).

Debit: Assets Value (Statement of financial position)

Credit: Other comprehensive income (revaluation surplus)

Retirement & Disposals

When the assets are permanently withdrawn from the use, or sold or scrapped, and no future economic benefits are expected from its use or disposal, it should be withdrawn from the financial position. Gains or losses are the difference between the net disposal proceeds and the carrying amount of the asset. They should be recognized as income or expense in profit or loss.

Derecognition

Any entity is required to derecognize the carrying amount of an item of property, plant or equipment that it disposes of on the date the criteria for the sale in IFRS 15 would be met. This also applies to part of assets. An entity cannot classify as revenue a gain which it realizes on the disposal of an item of property, plant & equipment.

Depreciation

IAS 16 requires the depreciable amount of a depreciable asset to be allocated on a systematic basis to each accounting period during the useful life of the asset. Every part of an item of property, plant & equipment with a cost that is significant in relation to the total cost of the item must be depreciated separately.

There are situations where, over a period, an asset has increased in value, i.e. its current value is greater than the carrying amount in the financial statements. You might think that in such situation it would not be necessary to depreciate the asset. The standard states, however, that this is irrelevant, and that depreciation should still be charged to each accounting period, based on the depreciable amount, irrespective of a rise in value.

An entity is required to begin depreciating an item of property, plant and equipment when it is available for use and to continue depreciating it until it is derecognized even if it is idle during the period.

The following factors should be considered when estimating the useful life of a depreciable asset:

  • Expected physical wear and tear.
  • Legal or other limits on the use of the assets.

Disclosure Requirement

  • Depreciation method used.
  • Measurement bases used for determining gross carrying amount.
  • Useful lives or the depreciation rate used.
  • Reconciliation of carrying amount at the beginning and end of period.
  • Property, plant and equipment pledged as security for liabilities.
  • Amount of compensation from third parties for items of property, plant and equipment.
  • Amount of expenditure recognized in the course of construction
  • Contractual commitments for the acquisition of property, plant and equipment.
  • Gross carrying amount and accumulated depreciation at beginning and end of the period. Accumulated impairment losses are aggregated with accumulated depreciation.

Disclosure for revalued assets:

  • Whether an independent valuer was involved.
  • Effective date of revaluation.
  • Revaluation surplus, including movement and any restrictions on distribution of balance to shareholders.
  • Carrying amount of each class of revalued property, plant and equipment if the cost model had been applied.
Management Notes

Ind AS-17: Leases

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Ind AS-17: Leases Lessee Accounting:

Initial recognition:

  • A Lessee is required to recognise a right of use asset representing its right to use the underlying leased asset and a lease liability representing its obligations to make lease payments.
  • A Lessee will recognise assets and liabilities for all leases for a term of more than 12 months, unless the underlying asset is of low value.
  • A lessee will measure right-of-use assets similarly to other non-financial assets (such as property, plant and equipment) and lease liabilities similarly to other financial liabilities.
  • Lease liability = Present value of lease rentals + present value of expected payments at the end of lease. The lease liability will be amortised using the effective interest rate method.
  • Lease term = non-cancellable period + renewable period if lessee reasonably certain to exercise.
  • Right to use asset = Lease liability + lease payments (advance)-lease incentives to be received if any initial + initial direct costs + cost of dismantling/ restoring etc. The asset will be depreciated as per IND AS 16 Property plant and equipment.
  • A lessee recognises depreciation of the right-of-use asset and interest on the lease liability (as per IND AS 17 the same was classified as rent in case of operating lease on a straight-line basis)

Presentation:

A lessee shall either present in the balance sheet, or disclose in the notes:

  • Lease liabilities separately from other liabilities.
  • Right-of-use assets separately from other assets.

Lessor Accounting:

  • A lessor shall classify each of its leases as either an operating lease or a finance lease.
  • A lease is classified as a finance lease if it transfers substantially all the risks and rewards, incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.
  • For operating leases, lessors continue to recognize the underlying asset.
  • For finance leases, lessors derecognize the underlying asset and recognize a net investment in the lease.
  • Any selling profit or loss is recognized at lease commencement.

Classification of leases

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease. [IAS 17.4]

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following: [IAS 17.10]

  • The lease transfers ownership of the asset to the lessee by the end of the lease term.
  • The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised.
  • The lease term is for the major part of the economic life of the asset, even if title is not transferred at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
  • The lease assets are of a specialised nature such that only the lessee can use them without major modifications being made.

Other situations that might also lead to classification as a finance lease are: [IAS 17.11]

  • If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
  • Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments).
  • The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent.

Accounting by lessees

The following principles should be applied in the financial statements of lessees:

  • Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability) [IAS 17.25]
  • At commencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity’s incremental borrowing rate) [IAS 17.20]
  • For operating leases, the lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user’s benefit [IAS 17.33]
  • The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease the asset should be depreciated over the shorter of the lease term or the life of the asset [IAS 17.27]

Accounting by lessors

The following principles should be applied in the financial statements of lessors:

  • At commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease [IAS 17.36] the lessor should recognise finance income based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment outstanding in respect of the finance lease [IAS 17.39]
  • Assets held for operating leases should be presented in the balance sheet of the lessor according to the nature of the asset. [IAS 17.49] Lease income should be recognised over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern in which use benefit is derived from the leased asset is diminished [IAS 17.50]

Sale and leaseback transactions

For a sale and leaseback transaction that results in a finance lease, any excess of proceeds over the carrying amount is deferred and amortised over the lease term. [IAS 17.59]

For a transaction that results in an operating lease: [IAS 17.61]

  • If the sale price is below fair value: Profit or loss should be recognised immediately, except if a loss is compensated for by future rentals at below market price, the loss should be amortised over the period of use.
  • If the transaction is clearly carried out at fair value: The profit or loss should be recognised immediately.
  • If the fair value at the time of the transaction is less than the carrying amount a loss equal to the difference should be recognised immediately [IAS 17.63]
  • If the sale price is above fair value: The excess over fair value should be deferred and amortised over the period of use.
Management Notes

Ind AS-24: Related Party Disclosures

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The objective of Ind AS 24 is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties.

A related party transaction is a transfer of resources, services or obligations between RE (reported entity) and related party regardless of whether a price is charged or not.

Entity is related to another entity if:

  • Entity and RE are members of same group (i.e., Parent, Subsidiary, fellow subsidiary) A Group is a parent and all its subsidiaries.
  • Associate or JV of the entity covered under (i) (i.e., associate or JV of member of group)
  • Both entities are JV of same third party
  • JV and Associate of the same third party
  • Entity is post-employment benefit plan of either the RE or an entity related to RE. If RE is itself such a plan, the sponsoring employers are also related to RE.
  • Entity is controlled / jointly controlled by Person identified under a)
  • Person identified in a(i) has significant influence over the entity; or Person is a member of KMP of the entity or parent of the entity
  • Entity (or any member of the group of entity is part) provides KMP services to RE or parent of RE.

Related party disclosure requirements as laid down in this Standard do not apply in circumstances where providing such disclosures would conflict with the reporting entity’s duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

In case a statute or a regulator or a similar competent authority governing an entity prohibits the entity to disclose certain information which is required to be disclosed as per this Standard, disclosure of such information is not warranted. For example, banks are obliged by law to  maintain confidentiality  in respect of their customers’ transactions and this Standard would not override the obligation to preserve the confidentiality of customers’ dealings.

This standard shall be applied to:

  • Identifying outstanding balance and commitments between the reporting entity and related parties.
  • Identifying related parties and transactions with them.
  • Determine the disclosures to be made.
  • Recognising the circumstances in which disclosures will be required in the above-stated situations.

Related Party Transactions: A transaction of transfer of resources, services or obligations between a reporting entity and a related party regardless of whether a price is charged Government: Government, government agencies and similar bodies whether local, national or international Government-related entity is controlled, jointly controlled or significantly influenced by a government 5. The following are not related parties two entities because they have director or other member of key management personnel in common two joint venturers simply because they share joint control providers of finance trade unions public utilities departments and agencies of government that does not control, jointly control or significantly influence the reportiing entity a customer supplier franchisor distributor general agent 6. Following disclosures are to be made Relationships between a parent and its subsidiaries should be disclosed irrespective of whether there have been transactions between them An entity shall disclose key management personnel compensation in total and for each of the following categories:

  • Post-employment benefits
  • Short-term employee benefits
  • Other long-term benefits
  • Termination benefits and
  • Share based payment.
  • If key management personnel services are obtained from another entity, the above requirements need not be disclosed.
  • If an entity has had related party transactions during the periods covered by financial statements, it shall disclose the nature of the related party relationship as well as information about those transactions (i.e amount, terms and conditions, provisions, expense) and outstanding balances, including commitments.
  • The disclosures required above shall be made separately for each of the parent, entities with joint control or significant influence over the entity, subsidiaries, associates, joint ventures, key management personnel, other related parties
  • Amounts incurred by the entity for the provision of key management personnel services that are provided by a separate management entity.

Some of the examples of transactions to be disclosed if done with related party;

Purchases or sales of goods or assets, rendering or receiving services, leases, transfer of research and development and so on

Disclosures to be made

  • An entity must report the compensation to the key management personnel in total and each of the categories such as short term employee benefits, post-employment benefits, termination benefits, share-based payment, and other long-term benefits.
  • Relationships between parent and subsidiaries should be disclosed irrespective of whether there have been any transactions or not. If the entity’s parent or the ultimate controlling party does not produce consolidated financial statements, then the next senior parent must be named in the consolidated financial statements for public use.
  • If key management services are obtained from another entity, then only the amounts incurred for the provision of such services shall be disclosed.
  • The above disclosures will be made separately in respect of a parent, subsidiaries, associate, entities with joint control or significant influence over the other entity, joint ventures in which the entity is the venturer, and key management personnel of the entity or parent and other related parties.
  • If the entity has transactions with the related party during the financial year, then it shall disclose the nature of such transactions, and also all the details such as amount, outstanding balances including commitments, provision for doubtful debts, and the expense recognised in respect of bad and doubtful debts.

Government related entities Reporting entity is exempt from the disclosures requirements in relation to related party transactions and outstanding balances including commitments with government who has control or joint control or significant influence over the reporting entity and another entity that is related party because the same government has control or joint control of or significant influence over both the reporting and other entity If the above exemption is applied by the reporting entity then it shall disclose the following about the transactions and related outstanding balances.

  • Name of the government and nature of its relationship
  • The nature and amount of each individually significant transaction and for other transactions that are collectively but not individually significant a qualitative or quantitative indication of their extent.
Management Notes

General Accounting System controls

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Accounting controls consists of the methods and procedures that are implemented by a firm to help ensure the validity and accuracy of its financial statements. The accounting controls do not ensure compliance with laws and regulations, but rather are designed to help a company operate in the best possible manner for all stakeholders.

Accounting Controls are the measures and controls adopted by an organization that leads to increased efficiency and compliance across the organization and ensures that financial statements are accurate when presented to auditors, bankers, investors, and other stakeholders.

The purpose of implementing accounting controls in a firm is to ensure that all areas in an organization avoid fraud and other issues, improve efficiency, accuracy, and compliance. Every firm will have different accounting controls in place, depending on their type of business, however, there are three traditional areas that are the most common when it comes to accounting controls: detective controls, preventive controls, and corrective controls.

Corrective Controls

As the name suggests, corrective controls are put in place to fix any issues found through detective controls. These can also include remedying any issues made on accounting books after the audit process has been completed by an accountant.

Preventive Controls

Preventive controls are simply the controls that have been put in place by an organization to avoid any inaccuracies or incorrect practices. These are the policies and procedures that all employees must follow.

An example of a preventive control would be limiting management’s involvement in the preparation of financial statements. Sometimes it’s helpful for management to be involved since they generally know the company better than anyone. But final say on numbers should be in the hands of an accountant, because management may have the incentive to distort numbers to inflate the company’s performance.

Detective Controls

The controls in this category are meant to seek out any current practices that don’t align with the policies and procedures in place. The goal here is to find any areas that are not functioning as they ought to, if employees are accidentally or purposefully practicing incorrect or illegal actions, or detecting any errors in systems or accounting practices. Examples of detective controls would include inventory checks and internal audits.

Advantages of Accounting Internal Controls

  • Accuracy of financial statements and funds application.
  • The action log identifies the person responsible for any error.
  • Efficient use of the resources for the intended purpose.
  • A strong foundation for a more significant growth.
  • Helpful in audit facilitation.
  • Saving of cost and resources.
  • Identification and rectification of any discrepancy identified.

Disadvantages:

  • The high cost of maintaining controls and standards.
  • Sometimes irritating and time-consuming for employees.
  • Duplication of work.
  • Overdependent for financial statements and audit.

Procedures:

Approval Authority Requirements

Requiring specific managers to authorize certain types of transactions can add a layer of responsibility to accounting records by proving that transactions have been seen, analyzed and approved by appropriate authorities. Requiring approval for large payments and expenses can prevent unscrupulous employees from making large fraudulent transactions with company funds, for example.

Daily or Weekly Trial Balances

Using a double-entry accounting system adds reliability by ensuring that the books are always balanced. Even so, it is still possible for errors to bring a double-entry system out of balance at any given time. Calculating daily or weekly trial balances can provide regular insight into the state of the system, allowing you to discover and investigate discrepancies as early as possible.

Physical Audits of Assets

Physical audits include hand-counting cash and any physical assets tracked in the accounting system, such as inventory, materials and tools. Physical counting can reveal well-hidden discrepancies in account balances by bypassing electronic records altogether. Counting cash in sales outlets can be done daily or even several times per day. Larger projects, such as hand counting inventory, should be performed less frequently, perhaps on an annual or quarterly basis.

Separation of Duties

Separation of duties involves splitting responsibility for bookkeeping, deposits, reporting and auditing. The further duties are separated, the less chance any single employee has of committing fraudulent acts. For small businesses with only a few accounting employees, sharing responsibilities between two or more people or requiring critical tasks to be reviewed by co-workers can serve the same purpose.

Periodic Reconciliations in Accounting Systems

Occasional accounting reconciliations can ensure that balances in your accounting system match up with balances in accounts held by other entities, including banks, suppliers and credit customers. For example, a bank reconciliation involves comparing cash balances and records of deposits and receipts between your accounting system and bank statements. Differences between these types of complementary accounts can reveal errors or discrepancies in your own accounts, or the errors may originate with the other entities.

Standardized Financial Documentation

Standardizing documents used for financial transactions, such as invoices, internal materials requests, inventory receipts and travel expense reports, can help to maintain consistency in record keeping over time. Using standard document formats can make it easier to review past records when searching for the source of a discrepancy in the system. A lack of standardization can cause items to be overlooked or misinterpreted in such a review.

Accounting System Access Controls

Controlling access to different parts of an accounting system via passwords, lockouts and electronic access logs can keep unauthorized users out of the system while providing a way to audit the usage of the system to identify the source of errors or discrepancies. Robust access tracking can also serve to deter attempts at fraudulent access in the first place.

Management Notes

Accounting and economic concepts of value and income

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Accounting income is an income resulting from business transactions arising from the cash-to-cash cycle of business operations. It is derived from a periodic matching of revenue (sales) with associated costs. Accounting income is an expost measure that is, measured ‘after the event.’

The accounting income recognises income only when they have been realised. On the other hand, the economic income, because it is based on valuations of all anticipated future benefits, recognises these flows well before they are realised. This means that, at the point of original investment, economic capital will exceed accounting capital by an amount equivalent to the difference between the present value of all the anticipated benefit flows and the value of those resources transacted and accounted for at that time.

The difference represents an unrealized gain which will, over time, be recognised and accounted for in computing income as the previously anticipated benefit flows are realised.

Accounting income and economic income basically differ in terms of the measurement used.

As Boulding observes:

“Accountants measure capital in terms of actualities, as the primary by-product of the accounting income measurement process; and that economist in terms of potentialities, in order to measure economic income.”

The accountant uses market prices (either past or current) in measuring income based upon recorded transactions which may be verified. Current values, if used in accounting income, utilise the historic cost transactions base before updating the data concerned into contemporary value terms.

The economist, on the other hand, uses predictions of future flows stemming from the resources which have the subject of past transactions. The accountant basically adopts a totally backward-looking or expost approach, and consequently ignores potential capital value changes.

The economist, on the other hand, is forward looking in his model and bases his capital value on future events. Under accounting income, the accountant aims to achieve objectivity maximization while measuring income for reporting purposes. The economist is free of such a constraint and is quite content in his model which may have large-scale subjectivity.

As a result, the two income concepts appear to be poles apart in concept and measurement certainly the accountant would find the economic model almost impossible to put into practice in financial reporting, despite its great theoretical qualities. On the other hand, the economist would not find the accounting model relevant as a guide to prudent personal conduct.

Conventional accounting income possess a limited utility for decision-making purposes because of the historical cost and realisation principle which govern the measurement of accounting income. Changes in value are not reported as they occur. Economic concept of income places emphasis on value and value changes rather than historical costs. Economic income stresses the limitations of accounting income for financial reporting and decision-making purposes.

Similarities:

  • Both involve measurement and valuation procedures.
  • Both use the transactions for income measurement.
  • Capital is an essential ingredient in income determination.
  • In a world of certainty and with perfect knowledge, accounting income and economic income as measures of better-offness would be readily determinable and would be identical. With such knowledge, earnings for a period would be the change in the present value of the future cash flows, discounted at an appropriate rate for the cost of money.
  • Under current cost accounting, the reported income equals economic income in a perfectly competitive market system. During periods of temporary disequilibrium and imperfect market conditions, current cost income may or may not approximate economic income.
Management Notes

Basis of Accounting, Cash basis and Accrual Basis

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Basis of Accounting refers to the method by which financial transactions are recorded and recognized in the accounting system. There are two primary types: Accrual Basis and Cash Basis. Under the accrual basis, revenues and expenses are recognized when they are earned or incurred, regardless of cash flow. The cash basis, on the other hand, records transactions only when cash is received or paid. The choice of accounting basis affects how financial performance and position are reported and can impact decision-making and analysis.

Cash basis

Cash Basis Accounting is a simple method where revenues and expenses are recorded only when cash is actually received or paid. In this system, income is recognized when cash is collected, and expenses are recognized when payments are made, regardless of when the transaction occurred. It is commonly used by small businesses and individuals due to its simplicity and focus on actual cash flow. However, it may not provide a complete picture of a business’s financial health, as it ignores receivables, payables, and other non-cash transactions.

Functions of Cash basis:

  • Simple and Easy to Use:

One of the main functions of cash basis accounting is its simplicity. It requires no complex financial tracking or extensive knowledge of accounting principles. Businesses record income when cash is received and expenses when payments are made. This ease of use makes it particularly attractive for small businesses, freelancers, and sole proprietors with limited accounting resources.

  • Focuses on Cash Flow:

Cash basis accounting emphasizes actual cash flow, helping businesses closely monitor their available cash. Since it records only when cash is received or spent, businesses can easily see how much cash they have on hand. This is critical for small businesses or startups that rely on maintaining positive cash flow for their day-to-day operations and short-term decision-making.

  • Immediate Recognition of Transactions:

In cash basis accounting, transactions are recognized immediately upon receipt or payment of cash. This function simplifies financial record-keeping, as there is no need to track receivables, payables, or adjust for accruals. As a result, business owners can directly link their bank statements to their accounting records, creating a clear and straightforward financial picture.

  • Lower Administrative Costs:

Cash basis accounting typically requires less administrative effort and fewer resources than accrual accounting. It eliminates the need for tracking accounts receivable, accounts payable, and making complex adjustments. This function reduces bookkeeping time and costs, making it an affordable option for small businesses without the need for extensive accounting departments.

  • Tax Benefits:

In many tax systems, cash basis accounting can offer potential tax benefits. Since income is recognized only when cash is received, businesses may be able to defer income tax liability if payments from customers are delayed until the next tax year. This can help manage tax obligations and smooth out cash flow, especially for businesses with fluctuating income.

  • Provides a Clear Picture of Immediate Liquidity:

Cash basis accounting gives an accurate view of a company’s current liquidity. Since it only records cash transactions, it shows exactly how much cash is available at any given time. This function is particularly useful for businesses needing to make short-term decisions based on available resources.

  • Reduces Complexity in Financial Reporting:

With cash basis accounting, there are no complex financial reports to prepare. There are no accruals, prepayments, or provisions to account for, reducing the complexity of financial statements. For smaller businesses, this function means less reliance on professional accountants or financial experts, simplifying reporting and compliance.

  • Better for Small or Cash-Based Businesses:

Cash basis accounting functions well for businesses that operate primarily on a cash basis, such as retail stores, food service providers, and small service-oriented businesses. Since these businesses receive payments immediately and have minimal credit sales or long-term receivables, cash basis accounting aligns well with their operations, making financial management straightforward and efficient.

Cash basis Book entry:

Date Transaction Debit Credit Description
YYYY-MM-DD Cash Sale Cash Sales Revenue Cash received from sales.
YYYY-MM-DD Cash Purchase Purchases Cash Cash paid for inventory or supplies.
YYYY-MM-DD Cash Received from Customer Cash Accounts Receivable Cash received for previously sold goods.
YYYY-MM-DD Cash Payment to Supplier Accounts Payable Cash Payment made to supplier for outstanding bills.
YYYY-MM-DD Cash Expense Payment Expenses Cash Cash paid for operating expenses (e.g., rent).
YYYY-MM-DD Owner’s Capital Contribution Cash Owner’s Equity Cash invested into the business by the owner.
YYYY-MM-DD Cash Withdrawal for Personal Use Owner’s Equity Cash Cash withdrawn by the owner for personal use.
YYYY-MM-DD Loan Received Cash Loan Payable Cash received from a loan.
YYYY-MM-DD Loan Payment Loan Payable Cash Cash payment made towards loan repayment.
YYYY-MM-DD Cash Dividend Distribution Retained Earnings Cash Cash dividends paid to shareholders.

Accrual Basis:

Accrual Basis Accounting is a method where revenues and expenses are recorded when they are earned or incurred, regardless of when cash is actually received or paid. Under this system, revenue is recognized when goods or services are delivered, and expenses are recorded when obligations arise. This method provides a more accurate picture of a company’s financial performance by matching revenues with related expenses within the same accounting period. While more complex than cash basis accounting, it is widely used by larger businesses and follows generally accepted accounting principles (GAAP).

Functions of Accrual basis:

  • Matching Principle:

One of the primary functions of accrual basis accounting is the matching principle, which states that revenues should be matched with the expenses incurred to generate them within the same accounting period. This function allows businesses to accurately assess profitability by linking income with its associated costs, providing a clearer picture of financial performance.

  • Comprehensive Financial Reporting:

Accrual accounting enhances financial reporting by providing a complete view of a company’s financial activities. It includes not only cash transactions but also accounts receivable and payable, ensuring all financial obligations and rights are recognized. This comprehensive reporting is crucial for stakeholders who need to evaluate a company’s performance over time.

  • Improved Financial Forecasting:

By recognizing revenue and expenses when they occur, accrual basis accounting allows for better financial forecasting and planning. Businesses can analyze trends and patterns based on actual performance rather than cash flow timing. This function is particularly beneficial for long-term strategic planning and investment decisions.

  • Enhanced Creditworthiness:

Companies using accrual accounting can present a more accurate picture of their financial health, improving their creditworthiness. Lenders and investors often prefer accrual basis financial statements because they reflect all obligations and income, not just cash transactions. This transparency can lead to better financing options and terms.

  • Facilitates Compliance with Standards:

Accrual basis accounting complies with generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). Many public companies are required to use this method for financial reporting. This function ensures that businesses meet regulatory standards and enhances the reliability and comparability of financial statements.

  • Management of Receivables and Payables:

Accrual accounting requires businesses to track accounts receivable and accounts payable, providing insights into outstanding debts and future cash inflows. This function helps businesses manage cash flow more effectively, ensuring they can meet their obligations while maximizing revenue collection.

  • Historical Financial Analysis:

Accrual basis accounting enables more effective historical financial analysis by providing a consistent view of revenues and expenses over time. Businesses can analyze trends, assess long-term performance, and make informed decisions based on historical data, leading to more strategic growth initiatives.

  • Supports Investment Decisions:

Investors rely on accrual basis financial statements for making informed investment decisions. The recognition of revenue and expenses at the time they are earned or incurred provides a more accurate representation of a company’s operational performance. This function helps investors assess potential risks and returns effectively.

Accrual basis Book entry:

Date Transaction Debit Credit Description
YYYY-MM-DD Sale on Credit Accounts Receivable Sales Revenue Revenue recognized when goods/services are delivered.
YYYY-MM-DD Purchase on Credit Purchases Accounts Payable Expense recognized when goods/services are received.
YYYY-MM-DD Payment Received for Accounts Receivable Cash Accounts Receivable Cash received for previously recognized revenue.
YYYY-MM-DD Payment Made to Supplier Accounts Payable Cash Payment for previously recognized expense.
YYYY-MM-DD Accrued Salaries Salary Expense Accrued Salaries Payable Salary expense recognized before payment.
YYYY-MM-DD Accrued Interest Expense Interest Expense Accrued Interest Payable Interest expense recognized as incurred.
YYYY-MM-DD Depreciation Expense Depreciation Expense Accumulated Depreciation Depreciation recognized for the accounting period.
YYYY-MM-DD Unearned Revenue Cash Unearned Revenue Cash received in advance; revenue recognized later.
YYYY-MM-DD Expense Prepaid Prepaid Expense Cash Expense paid in advance; recognized over time.
YYYY-MM-DD Adjusting Entry for Accruals Various Expenses Various Payables Adjustments made for accrued or deferred items.

Key differences between Cash basis and Accrual Basis

Aspect Cash Basis Accrual Basis
Revenue Recognition Cash Received Earned
Expense Recognition Cash Paid Incurred
Complexity Simple Complex
Financial Reporting Limited Comprehensive
Matching Principle Not Applicable Applicable
Cash Flow Focus Yes No
Tax Implications Immediate Deferred
Usage Small Businesses Larger Businesses
Accounts Receivable Not Recorded Recorded
Accounts Payable Not Recorded Recorded
Timeframe Current Future/Current
Regulatory Compliance Limited Required
Financial Insights Short-term Long-term
Investment Analysis Limited Enhanced

 

Management Notes

Changes in accounting estimate

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When accounting for business transactions, there will be times when an estimate must be used. In some cases, those estimates prove to be incorrect, in which case a change in accounting estimate is warranted. A change in estimate is needed when there is a change that:

  • Alters the subsequent accounting for existing or future assets or liabilities.
  • Affects the carrying amount of an existing asset or liability.

Changes in estimate are a normal and expected part of the ongoing process of reviewing the current status and future benefits and obligations related to assets and liabilities. A change in estimate arises from the appearance of new information that alters the existing situation. Conversely, there can be no change in estimate in the absence of new information.

Applying changes in accounting policies

(i) An entity shall account for a change in accounting policy resulting from the initial application of an Ind AS in accordance with the specific transitional provisions, if any, in that Ind AS; and

(ii) when an entity changes an accounting policy upon initial application of an Ind AS that does not include specific transitional provisions applying to that change, or changes an accounting policy voluntarily, it shall apply the change retrospectively.

Examples of Changes in Accounting Estimate

All of the following are situations where there is likely to be a change in accounting estimate:

  • Reserve for obsolete inventory
  • Allowance for doubtful accounts
  • Changes in the useful life of depreciable assets
  • Changes in the amount of expected warranty obligations
  • Changes in the salvage values of depreciable assets

Changes in accounting estimates

As a result of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision but can only be estimated. Estimation involves judgements based on the latest available, reliable information. For example, estimates may be required of:

(a) Bad debts

B) Inventory obsolescence

(c) The fair value of financial assets or financial liabilities

(d) The useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets

 (e) Warranty obligations.

When there is a change in estimate, account for it in the period of change. If the change affects future periods, then the change will likely have an accounting impact in those periods, as well. A change in accounting estimate does not require the restatement of earlier financial statements, nor the retrospective adjustment of account balances.

If the effect of a change in estimate is immaterial (as is usually the case for changes in reserves and allowances), do not disclose the alteration. However, disclose the change in estimate if the amount is material. Also, if the change affects several future periods, note the effect on income from continuing operations, net income, and per share amounts.

Management Notes

Derivatives and Hedge Accounting

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Derivatives Accounting

A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. There are two key concepts in the accounting for derivatives. The first is that ongoing changes in the fair value of derivatives not used in hedging arrangements are generally recognized in earnings at once. The second is that ongoing changes in the fair value of derivatives and the hedged items with which they are paired may be parked in other comprehensive income for a period of time, thereby removing them from the basic earnings reported by a business.

The essential accounting for a derivative instrument is outlined in the following bullet points:

  • Initial recognition. When it is first acquired, recognize a derivative instrument in the balance sheet as an asset or liability at its fair value.
  • Subsequent recognition (hedging relationship). Recognize all subsequent changes in the fair value of the derivative (known as marked to market). If the instrument has been paired with a hedged item, then recognize these fair value changes in other comprehensive income.
  • Subsequent recognition (ineffective portion). Recognize all subsequent changes in the fair value of the derivative. If the instrument has been paired with a hedged item but the hedge is not effective, then recognize these fair value changes in earnings.
  • Subsequent recognition (speculation). Recognize in earnings all subsequent changes in the fair value of the derivative. Speculative activities imply that a derivative has not been paired with a hedged item.

The following additional rules apply to the accounting for derivative instruments when specific types of investments are being hedged:

  • Trading securities. This can be either a debt or equity security, for which there is an intent to sell in the short term for a profit. When this investment is being hedged, recognize any changes in the fair value of the paired forward contract or purchased option in earnings.
  • Held-to-maturity investments. This is a debt instrument for which there is a commitment to hold the investment until its maturity date. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value.
  • Available-for-sale securities. This can be either a debt or equity security that does not fall into the held-to-maturity or trading classifications. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value. If the change is temporary, record it in other comprehensive income.

Rules for Accounting Derivatives

Accounting of derivatives is based upon the purpose for which it is used as it can be used for speculation, i.e. to earn profit from derivatives transactions and hedging, i.e. to control the risk of future contracts. Suppose there is speculation loss that is to be recognized immediately in the accounts.

Some of the rules for Accounting of derivatives are as under:

  • Initially, derivatives are to be recorded at fair value.
  • Re-measurement of fair value is to be done at the end of the financial year or at the end of the contract period, whichever falls earlier.
  • The purpose of the derivative is to be determined at the time of entering so as to decide whether it is speculation or hedging.
  • Any transaction cost for entering into derivatives is to be charged to the profit and loss account immediately.
  • If the derivative is of speculation in nature, the loss or profit is to be immediately recognized in the profit and loss account.
  • If the derivative is non-speculative, the loss or gain is to be transferred to a comprehensive income account.
  • Journal entries of accounting for derivatives are:
Date Particulars Debit ($) Credit ($)
On entering into a transaction for an underlying derivative asset:
Forward Asset A/c                 Dr. XXX
                      To Bank/ Creditor A/c XXX
(Being underlying asset purchased by entering into a derivative contract)
Increase in fair value of forward asset resulting in a gain
Forward Asset A/c                      Dr. XXX
                      To Forward value gain A/c XXX
(Being increase in the value of forward asset results in gain)
Decrease in fair value of asset resulting in loss
Fair Value Loss A/c                         Dr. XXX
               To Forward Asset A/c XXX
(Being Decrease in value of asset resulted loss in forward contract)
Settlement of Forward contract
Creditor/ Bank A/c                             Dr. XXX
                     To Forward Asset A/c XX
                     To Profit and Loss A/c XX
(Being Forward contract settled and net gain or loss is transferred to profit and loss A/c)  

Hedge Accounting

Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. There are two types of hedge recognized. For a fair value hedge, the offset is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cash flow hedge, some of the derivative volatility is placed into a separate component of the entity’s equity called the cash flow hedge reserve. Where a hedge relationship is effective (meets the 80%–125% rule), most of the mark-to-market derivative volatility will be offset in the profit and loss account. Hedge accounting entails much compliance involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.

Under IAS 39, derivatives must be recorded on a mark-to-market basis. Thus, if a profit is taken on a derivative one day, the profit must be recorded when the profit is taken. The same holds if there is a loss on the derivative.

If that derivative is used as a hedging tool, the same treatment is required under IAS 39. However, this could bring plenty of volatility in profits and losses on, at times, a daily basis. Yet, hedge accounting under IAS 39 can help decrease the hedging tool’s volatility. However, the treatment of hedge accounting for hedging tools under IAS 39 is exclusive to derivative instruments.

A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges:

  • A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.
  • A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.
  • A net investment hedge may be designated for the net investment in a foreign operation.

There are three main asset categories that companies use hedge accounting for:

Foreign currency exposures: For transaction exposures, such as forecasted purchases, revenues and expenses in foreign currencies, as well as foreign-currency-denominated assets and liabilities.

Interest rate exposures: Such as forecasted fixed-rate borrowing, variable-rate assets and liabilities, as well as fixed-rate assets and debt.

Commodity exposures: These include forecasted purchases, sales and inventory.

Accounting standards enable hedge accounting for three different designated categories:

Cash flow hedge: Designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognised asset or liability, or a forecasted intercompany transaction.

Fair value hedge: Designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.

Net investment hedge: Designated for the net investment in a foreign operation.

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