Tag: Operations Management

Objective To prescribe accounting for: i. Provision ii. Contingent liabilities iii. Contingent Assets iv. Provision for restructuring cost III. Scope This standard shall may be used all entities in accounting for: i. Provisions ii. Contingent liabilities iii. Contingent Assets. Except for those covered by specific other standards like

1. Ind AS -12 Income Taxes
2. Ind AS 116-Leases
3. IndAS -19 Employee Benefits
4. IndAS -104 Insurance Contracts
5. IndAS-103 Business Combinations
6. Revenue from contracts with customers –Ind AS 115
7. Ind AS-19 Financial Instruments

Factors affecting Measurement of Provisions

1. Measured at Best Estimate of the expenditure required to settle the present legal or constructive obligation as a result of past obligating event.
2. Management should really incorporate all available information in their estimates and they must not forget about
3. Risks and uncertainties
4. Time value of money

Some probable future events

Obligating event

• A present obligation (legal or constructive) has arisen as a result of a past event (the obligating event),
• Payment is probable (‘more likely than not’), and
• The amount can be estimated reliably.

An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having no realistic alternative but to settle the obligation.

A constructive obligation arises if past practice creates a valid expectation on the part of a third party, for example, a retail store that has a long-standing policy of allowing customers to return merchandise within, say, a 30-day period.

A possible obligation (a contingent liability) is disclosed but not accrued. However, disclosure is not required if payment is remote.

In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present obligation. In those cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. A provision should be recognised for that present obligation if the other recognition criteria described above are met. If it is more likely than not that no present obligation exists, the entity should disclose a contingent liability, unless the possibility of an outflow of resources is remote.

Legal obligation

Legal Obligation is also referred to as the legal duty. Legal Obligation is generated through the contract or law. Also, it requires an individual to conform their actions to a specific standard.

A provision is recognised as contamination occurs for any legal obligations of clean up, or for constructive obligations if the company’s published policy is to clean up even if there is no legal requirement to do so (past event is the contamination and public expectation created by the company’s policy).

Constructive obligation

A provision is a liability of uncertain timing or amount. The liability may be a legal obligation or a constructive obligation. A constructive obligation arises from the entity’s actions, through which it has indicated to others that it will accept certain responsibilities, and as a result has created an expectation that it will discharge those responsibilities. Examples of provisions may include: warranty obligations; legal or constructive obligations to clean up contaminated land or restore facilities; and obligations caused by a retailer’s policy to make refunds to customers.

An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. If an outflow is not probable, the item is treated as a contingent liability.

A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. Risks and uncertainties are taken into account in measuring a provision. A provision is discounted to its present value.

Contingent Liability

No need to recognize it. Whereas, the entity should disclose in the financial statements.

A contingent Liability is

1. Possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
2. A present obligation that arises from past events but is not recognized because:
3. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation.
4. the amount of the obligation cannot be measured with sufficient reliability.

Contingent Asset

No need to recognize it. Whereas, the entity should disclose in the financial statements.

Contingent Asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of entity.

Provisions

A provision is a liability of uncertain timing or amount. The liability may be a legal obligation or a constructive obligation. A constructive obligation arises from the entity’s actions, through which it has indicated to others that it will accept certain responsibilities, and as a result has created an expectation that it will discharge those responsibilities. Examples of provisions may include: warranty obligations; legal or constructive obligations to clean up contaminated land or restore facilities; and obligations caused by a retailer’s policy to make refunds to customers.

An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. If an outflow is not probable, the item is treated as a contingent liability.

A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. Risks and uncertainties are taken into account in measuring a provision. A provision is discounted to its present value.

IAS 37 elaborates on the application of the recognition and measurement requirements for three specific cases:

• Future operating losses; a provision cannot be recognised because there is no obligation at the end of the reporting period;
• An onerous contract gives rise to a provision; and
• A provision for restructuring costs is recognised only when the entity has a constructive obligation because the main features of the detailed restructuring plan have been announced to those affected by it.

Contingent Liabilities

Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed.

Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable. Contingent liabilities do not include provisions for which it is certain that the entity has a present obligation that is more likely than not to lead to an outflow of cash or other economic resources, even though the amount or timing is uncertain.

A contingent liability is not recognised in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.

Contingent assets

Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent.

A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital.

If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.

Concepts of capital maintenance and the determination of profit

The capital maintenance concept states that the business net worth is said to have been maintained if net assets at the end of the period are equal to or more than net assets at the beginning of the accounting period keeping aside any withdrawal during the said period. In other words, it states that the company must book net income only when it has recovered its capital or the cost, i.e., an adequate amount of capital has been maintained.

Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power.

All the inflows such as the sale of stock to shareholders, the addition of capital from owners, and payment of dividends to shareholders payment of bonus to shareholders are excluded. The two measurement units of financial capital maintenance theory are constant purchasing power units and nominal monetary units.

Financial capital maintenance is affected only by the entire amount of funds available at the starting of the year and the funds available at the end of the year. Therefore, this concept is least concerned with any other capital assets transaction undertaken during the financial year.

Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

This method books profit only when the physical production capacity of the business at the end of the year is more than or equal to the physical production capacity of the business at the beginning of the year except any amount adjusted towards any amount paid to owners during the year or any amount raised by the owner. The main use of this method is for checking and maintaining the operational business capacity.

Capital Maintenance and Inflation

Inflation is the increase in any product/service cost or decrease in purchasing capacity. When the inflation rate is high, which has occurred in a short duration of time can affect the business’s ability to determine if it has achieved capital maintenance or not accurately. Due to inflation, the purchase price of assets gets increased accordingly, the value of the company’s net assets also increases. But the increase due to this inflation misrepresents the original value of the company’s assets.

Capital maintenance is distorted at the time of inflation as the pressure of inflation will increase the net assets even if their original value is unchanged. Due to this reason, at the time of inflammation, the companies must adjust the value of their assets to determine whether they have achieved capital maintenance. This is very important if the business operates in a hyperinflationary  economy.

Financial position

The financial position of an enterprise is primarily provided in a balance sheet. The main purpose of financial statements is to provide financial information to the users to assist them in their economic decisions. The financial statements basically present the financial information in such form that it is not only understandable but also useable. That is why financial statements present the financial effects of different business events that also includes business transactions.

In order to enhance the quality of information in financial statements, business transactions are grouped in different classes or categories on the basis of their economic characteristics. The broad classes or categories are called elements of financial statements.

The elements of a balance sheet or the elements that measure the financial position are as follows:

Asset: An asset is a resource:

• Controlled by the enterprise as a result of past events, and
• From which future economic benefits are expected to flow to the enterprise.

Liability: A liability is a present obligation of the enterprise arising from the past events, the settlement of which is expected to result in an outflow from the enterprise’ resources, i.e., assets.

Equity: Equity is the residual interest in the assets of the enterprise after deducting all the liabilities. Equity is also known as owner’s equity.

Financial performance

The financial performance of an enterprise is primarily provided in an income statement or profit and loss account. The elements of an income statement or the elements that measure the financial performance are as follows:

Income:

• Increases in economic benefit during an accounting period in the form of inflows or enhancements of assets, or
• Decrease of liabilities that result in increases in equity.

However, it does not include the contributions made by the equity participants, i.e., proprietor, partners and shareholders.

Expenses:

Expenses are:

• Decreases in economic benefits during an accounting period in the form of outflows, or
• Depletions of assets or incurrences of liabilities that result in decreases in equity.

Measurement of the Elements of Financial Statements

According to the Framework of IAS, the term ‘measurement’ has been defined in the following words:

“Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement.”

There are a number of measurement basis that are employed in different degrees and in varying combinations in financial statements. They are listed below:

• Historical cost: Historical cost is the most common measurement basis adopted by enterprises in preparing their financial statements. This is usually combined with other measurement basis, such as current cost basis, realisable basis, etc., which are discussed later in this section. Under historical cost measurement basis, assets are originally recorded at their costs or purchasing price or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation.
• Current cost: Under current cost basis, assets are carried at the amount of cash that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash that would be required to settle the obligations currently.
• Realisable value: Assets are carried at the amount of cash that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amount of cash expected to be paid or satisfy the liabilities in the normal course of business.
• Present value: Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the presented discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

“Recognised” means reported on, or incorporated in amounts reported on, the face of the financial statements of the entity (whether or not further disclosure of the item is made in notes thereto).

Reporting of information about assets, liabilities, equity, revenues and expenses in financial reports may be by way of recognition and/or by disclosure in notes in the financial report. An item may be recognised as an element either singly or in combination with other items. For example, a particular asset may be recognised by incorporation in the carrying amount of a class of assets reported in the statement of financial position. In addition, where assets and liabilities have been set off against each other, or where revenues and expenses have been netted off, in the presentation of those items in financial statements, those elements would nonetheless have been recognised. The manner in which recognised elements should be presented in financial statements, including the circumstances in which they may be set off or netted off, are matters of display which are beyond the scope of this Statement. Inclusion of an element only in notes in the financial report does not constitute recognition.

The main elements of financial statements are as follows:

Assets. These are items of economic benefit that are expected to yield benefits in future periods. Examples are accounts receivable, inventory, and fixed assets.

Criteria for Recognition of Assets 38 39 40 An asset should be recognised in the statement of financial position when and only when:

• It is probable that the future economic benefits embodied in the asset will eventuate.
• The asset possesses a cost or other value that can be measured reliably.

Liabilities. These are legally binding obligations payable to another entity or individual. Examples are accounts payable, taxes payable, and wages payable.

Criteria for Recognition of Liabilities 65 66 67 68 69 A liability should be recognised in the statement of financial position when and only when:

• It is probable that the future sacrifice of economic benefits will be required.
• The amount of the liability can be measured reliably.

Revenue. This is an increase in assets or decrease in liabilities caused by the provision of services or products to customers. It is a quantification of the gross activity generated by a business. Examples are product sales and service sales.

A revenue should be recognised in the operating statement, in the determination of the result for the reporting period, when and only when:

• It is probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred.
• The inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably.

Equity. This is the amount invested in a business by its owners, plus any remaining retained earnings.

Recognition of Equity Since equity is the residual interest in the assets of an entity and the amount assigned to equity will always correspond to the excess of the amounts assigned to its assets over the amounts assigned to its liabilities, the criteria for the recognition of assets and liabilities provide the criteria for the recognition of equity.

If the aggregate amount assigned to an entity’s liabilities exceeds the aggregate amount assigned to its assets there would be no amount recognised as equity.  What would be reported is a deficiency of reported assets compared with reported liabilities.  As with the reported amount of equity, the reported amount of any deficiency would depend on the bases on which the entity’s assets and liabilities are recognised and measured. It is possible for the reported liabilities of an entity to exceed its reported assets and for the ownership group or, where there is an absence of an ownership group, some other party or parties with residual rights, to have an interest of some value in the entity. For example, assets may exist but not have been recognised, or a measurement basis may have been adopted which does not report the current value of the reported assets and liabilities. Notwithstanding this, the existence of legal restrictions, for example, may inhibit the ability of an entity that reports a deficiency to make distributions to owners.

Expenses. This is the reduction in value of an asset as it is used to generate revenue. Examples are interest expense, compensation expense, and utilities expense.

An expense should be recognised in the operating statement, in the determination of the result for the reporting period, when and only when:

• It is probable that the consumption or loss of future economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred.
• The consumption or loss of future economic benefits can be measured reliably.

Customers

When a customer is considering which supplier to select for a major contract, it wants to review their financial statements first, in order to judge the financial ability of a supplier to remain in business long enough to provide the goods or services mandated in the contract.

Company Management

The management team needs to understand the profitability, liquidity, and cash flows of the organization every month, so that it can make operational and financing decisions about the business.

Competitors

Entities competing against a business will attempt to gain access to its financial statements, in order to evaluate its financial condition. The knowledge they gain could alter their competitive strategies.

Governments

A government in whose jurisdiction a company is located will request financial statements in order to determine whether the business paid the appropriate amount of taxes.

Investment Analysts

Outside analysts want to see financial statements in order to decide whether they should recommend the company’s securities to their clients.

Investors

Investors will likely require financial statements to be provided, since they are the owners of the business and want to understand the performance of their investment.

Debenture Holders

The debenture holders are interested in the short-term as well as the long-term solvency position of the company. They have to get their interest payments periodically and at the end the return of the principal amount.

Rating Agencies

A credit rating agency will need to review the financial statements in order to give a credit rating to the company as a whole or to its securities.

Employees

A company may elect to provide its financial statements to employees, along with a detailed explanation of what the documents contain. This can be used to increase the level of employee involvement in and understanding of the business.

Suppliers

Suppliers will require financial statements in order to decide whether it is safe to extend credit to a company.

Prospective Investors

Prospective Investors are interested in the future prospects and financial strength of the company.

Unions

A union needs the financial statements in order to evaluate the ability of a business to pay compensation and benefits to the union members that it represents.

Shareholders

Divorce between ownership and management and broad-based ownership of capital due to dispersal of shareholdings have made shareholders take more interest in the financial statements with a view to ascertaining the profitability and financial strength of the company.

Benefits of Accounting Standards

Accounting Standards are the ruling authority in the world of accounting. It makes sure that the information provided to potential investors is not misleading in any way. Let us take a look at the benefits of AS.

Improves Reliability of Financial Statements

There are many stakeholders of a company and they rely on the financial statements for their information. Many of these stakeholders base their decisions on the data provided by these financial statements. Then there are also potential investors who make their investment decisions based on such financial statements.

So, it is essential these statements present a true and fair picture of the financial situation of the company. The Accounting Standards (AS) ensure this. They make sure the statements are reliable and trustworthy.

Attains Uniformity in Accounting

Accounting Standards provides rules for standard treatment and recording of transactions. They even have a standard format for financial statements. These are steps in achieving uniformity in accounting methods.

Prevents Frauds and Accounting Manipulations

Accounting Standards (AS) lay down the accounting principles and methodologies that all entities must follow. One outcome of this is that the management of an entity cannot manipulate with financial data. Following these standards is not optional, it is compulsory.

As described above, there is a set format of the financial statement no one can manipulate or commit fraud in the whole accounting process. Therefore, the accounting standard has already reduced the chances of manipulation and fraud and made the accounting system more effective and reliable.

So, these standards make it difficult for the management to misrepresent any financial information. It even makes it harder for them to commit any frauds.

Comparability

This is another major objective of accounting standards. Since all entities of the country follow the same set of standards their financial accounts become comparable to some extent. The users of the financial statements can analyze and compare the financial performances of various companies before taking any decisions.

Also, two statements of the same company from different years can be compared. This will show the growth curve of the company to the users.

Assists Auditors

Now the accounting standards lay down all the accounting policies, rules, regulations, etc in a written format. These policies have to be followed. So if an auditor checks that the policies have been correctly followed he can be assured that the financial statements are true and fair.

Determining Managerial Accountability

The accounting standards help measure the performance of the management of an entity. It can help measure the management’s ability to increase profitability, maintain the solvency of the firm, and other such important financial duties of the management.

Management also must wisely choose their accounting policies. Constant changes in the accounting policies lead to confusion for the user of these financial statements. Also, the principle of consistency and comparability are lost.

Disadvantages of Accounting Standards

Compromise the standard: Sometimes, the accounting standard is compromised due to lobbying or government pressure. This is because the government or powerful authority wants to give advantages only to the big powerful companies. Therefore, standards are compromised and cannot be relied on.

Rigid or inflexible: The policies are already made and have to be followed by the entity at any cost; thus, making the financial statement is rigid no one can change it according to their convenience. The format is already set, which has to be followed. Thus, it lacks flexibility.

Cost is high for maintenance: The cost is high for maintaining the books of account according to the format set by the accounting standard. The detailed paperwork and the use of standard equipment also increase the cost of maintaining books of accounts.

Time-consuming process: The whole process of following accounting standards takes time as every note and schedule according to the format must be produced by the user and has to go through a lengthy, time-consuming process.

Scope is restricted: Accounting standard has to be framed according to the rules set presently in the nation. They cannot override the statute. Thus, the scope for providing policies gets restricted.

Difficulty in choosing the alternative: There are many methods to record the transaction in the books of account; thus, it becomes difficult to choose which method to adopt and what not to. And also, sometimes, due to restrictions on the method of choice, the entity has to forgo its best convenient method and adopt the secondary method of recording transactions.

The convergence of accounting standards refers to the goal of establishing a single set of accounting standards that will be used internationally. Convergence in some form has been taking place for several decades, and efforts today include projects that aim to reduce the differences between accounting standards.

Convergence is driven by several factors, including the belief that having a single set of accounting requirements would increase the comparability of different entities’ accounting numbers, which will contribute to the flow of international investment and benefit a variety of stakeholders. Criticisms of convergence include its cost and pace, and the idea that the link between convergence and comparability may not be strong.

Need for Convergence

• To make the financial statements reliable, comparable & transparent.
• To ensure a general understanding of best accounting practices.
• To standardize financial accounting & reporting across the globe.
• To eliminate information barriers for users of financial statements.
• To promote foreign Investment & spur Industrial growth.

Benefits of Convergence

Beneficial to Investors

Convergence is a boon for investors who wish to invest in foreign markets or economies. It makes it much easier for them to study and compare the financial statements of foreign companies. Since the financial statements are made using the same set of standards it is also easier for the investors to understand and analyze them.

Beneficial to the Economy

If the accounting standards are converged it will promote international business and increase the influx of capital into the country. This will help India’s economy grow and expand. International investing will also mean more capital for domestic companies as well.

Beneficial to the Industry

With globally accepted standards the industry can also surge ahead. So convergence is important for the industry as well. It will allow the industry to lower the cost of foreign capital. If companies are not burned by adopting two different sets of standards it will allow them easier entry into the market.

Cost Saving

Firstly it will exempt companies from maintaining separate accounting books according to separate standards. This will save a lot of work hours and money for the finance department. And also planning and executing auditing will also become easier.

It will be especially helpful for those companies that have subsidiaries in many countries. And the cost of capital will also reduce since capital would be more accessible and easily available.

More Transparency

Convergence will benefit the users of the financial statements as well. It will make it easier for them to understand the financial statements. And this will generate better transparency and raise the confidence of the investors to invest funds.

Challenges

Changes in Indian regulation: Current regulations governing the financial regulation would need a complete overhaul to implement the IFRS standards. The Companies Act 1956, SEBI act 1992, IT Act 1962 etc. will have to be amended to bring them in line with IFRS regulations. These legal hurdles is a major constraint in the path of IFRS convergence.

Training & Awareness: Many do not know the IFRS standards & lack of knowledge & awareness makes it a difficult task of implementation. Finance professionals will have to be adequately trained and then the standards can be implemented consistently and uniformly in right spirit.

Fair Value system of measurement: The IFRS considers the fair value system of asset measurement and the Indian GAAP recognizes historical system. This divergence of system would create volatility and subjectivity in financial statements. This would lead to different results for performance & earnings of the Company.

Small & Medium businesses: The SME sector in India is comparatively larger than other Countries. The cost of convergence far outweigh the advantages of convergence for these small businesses. The dearth of resource and skills in financial knowledge adds up to the problem of implementation in this sector. In addition, SME’s cannot be ignored, considering the role they play in the Indian economy.

IT systems: Financial accounting software and tools used for reporting would have to be completely changed resulting in substantial investment in IT infrastructure for Indian Companies. Indian companies are habitually reluctant when any proposal involves cost, time & effort.