Financial Decision Making 25th Jan 2010

Topics to be covered Basic Accounting Concept - The balance sheet Basic Accounting Concept - The income statement Generally Accepted Accounting Principles (GAAP) International Financial Reporting System (IFRS) Inventory Valuation

Basic Accounting Concept - Balance sheet Balance sheet is a statement that shows company’s financial position as on particular date It is a snapshot of the company’s performance It is also called “Stock statement” because it is as of particular date

Concepts used while preparing B/S Money Measurement Concept In accounting only those events get recorded which can be measured in terms of money The Entity Concept Accounts are kept for entities, as distinguished from the persons who are associated with these entities The Going Concern Concept Unless there is good evidence to the contrary, accounting assumes that an entity is a going concern, that it will continue to operate for an indefinitely long period in the future

Concepts used while preparing B/S The Cost Concept It says that an asset is ordinarily entered initially in the accounting records at the price paid to acquire it, at the cost Dual Aspect Concept Every transaction affects two accounts Assets = Equities Assets = Liabilities + Owner’s Equity

Concepts used while preparing Income Statement Accounting Period Accounting measures activities for a specified interval of time, called the accounting period Conservatism Concept Recognize revenues only when they are reasonably certain Recognize expenses as soon as they are reasonably possible Realization Concept The amount recognized as revenue is the amount that is reasonably certain to be realized, that is customers are reasonably certain to pay

Concepts used while preparing Income statement The Matching Concept When a given event affects both revenue and expenses, the affect on each should be recognized in the same accounting period The Consistency Concept Once an entity has decided on one accounting period it should use the same method events for all subsequent events of the same character unless it has sound reason to change the method The Materiality Concept Insignificant events may be disregarded, but there must be full disclosure of all important information

Generally Accepted Accounting Principles (GAAP)

GAAP What is GAAP ? The common set of accounting principles, standards and procedures that companies use to compile their financial statements GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information GAAP is implemented through measurement principal and disclosure principals

GAAP’s Concern Basically, GAAP is concerned with: The measurement of economic activity; The time when such measurements are to be made and recorded; The disclosures surrounding this activity; and The preparation and presentation of summarized economic information in financial statements

GAAP Why GAAP? Without GAAP, companies would be free to decide for themselves what financial information to report and how to report it, making things quite difficult for investors and creditors who have a stake in that company Regulating GAAP Although it is not written in law, the U.S. Securities and Exchange Commission (SEC) require publicly traded companies and other regulated companies to follow GAAP for financial reporting Why Should I Know GAAP? If you have anything to do with the financial reporting of a company or government

Fundamentals Principals of GAAP Generally accepted accounting principles (GAAP) are varied but based on a few basic principles that must be upheld by all GAAP rules. These principles include consistency, relevance, reliability, and comparability Consistency Consistency means that all information should be gathered and presented the same across all periods. For example, a company cannot change the way they account for inventory from one period to another without noting it in the financial statements and having a valid reason for the change Relevance Relevance means that the information presented in financial statements (and other public statements) should be appropriate and assist a person evaluating the statements to make educated guesses regarding the future financial state of a company

Fundamentals Principles of GAAP Reliability Reliability means simply that the information presented in financial statements is reliable and verifiable by an independent party Basically a company must confirm that if an independent auditor were to base their reports off of the same information that they would come up with the same results Following this generally accepted accounting principle (GAAP) also means that the company is representing a clear picture of what really happened (and is happening) with their company Comparability Comparability is one of the most important GAAP categories and one of the main reasons having something similar to GAAP is necessary By ensuring comparability, a company’s financial statements and other documentation can be compared to similar businesses within its industry The importance of this principle cannot be overstated, as without comparability investors would be unable to discern differences between companies within an industry to benchmark how a company is doing compared to its peers

International Financial Reporting System (IFRS)

What is IFRS? FRS are International Financial Reporting Standards, which are issued by the International Accounting Standards Board (IASB) Nearly 100 countries use or coordinate with IFRS. These countries or groups of countries include the European Union, Australia, and South Africa. While some countries require all companies to adhere to IFRS, others merely allow it or try to coordinate their own country’s standards to be similar The IASB is working towards this goal in a partnership with some of the most influential accounting standard-setters across the globe The International Accounting Standards Board (IASB) and the International Financial Reporting Standards (IFRS) that they issue are very important for the future of accounting

Why IFRS is important? With businesses turning global, it is important that investors are able to compare companies under similar standards. Likewise, it is important for businesses operating in multiple countries to be able to create financial statements that are understandable in all of the countries they operate in Eventually, IASB and other accounting organizations hope to see a convergence of all accounting standards throughout the world This type of convergence, would allow for the best of circumstances for investors and other interested parties to be able to examine and compare companies in a transparent and equal way With the coordination of the International Financial Reporting Standards (IFRS) with other accounting standards from around the globe, this goal of convergence may not be as far-fetched as it may sound

IFRS is a reality Globalization of business and finance has led to the successful mass adoption of IFRS in more then 110 countries IASB expects that 150 countries will mandate or allow IFRS within next three years Canada, India and Japan will adopt IFRS in 2011 www.isab.org, www.ifrs.com

Reason for Global Accounting Standards Global accounting standards improve the functioning of global capital markets by providing better information to investors and other users of financial statement Decrease the cost of preparing and interpreting financial statement Decrease cost of capital

Benefits to Capital Markets Enhanced worldwide comparability for investors More efficient capital allocation Enhanced credibility of local markets to foreign investors More company-friendly US securities market for foreign listings No need to develop and maintain national standards

Benefit to Companies Lower cost of capital Supports raising capital overseas Easier consolidation (one set of books) Easier cross-border acquisitions Encourages integrated IT Systems Understand the financial statements of overseas suppliers, customers, subsidiaries

Differences between US GAAP, Indian GAAP and International Accounting Standards Simplified Summary of Significant Differences between US GAAP, Indian GAAP and International Accounting Standards Price Water House

Main Differences Particulars Indian GAAP US GAAP IFRS Revenue Recognition Revenues are recognized when all significant risks and rewards of ownership are transferred or on a percentage of completion basis. No detailed industry specific guidelines. Industry specific revenue recognition guidelines. Could be different from what I-GAAP has recognized. Revenues are recognized when all significant risks and rewards of ownership are transferred. Balance sheet Conforms to statute and captions are in the following order : --Equity and reserves --Debt --Fixed assets --Investments --Net current assets --Deferred expenditure and --Accumulated losses Required only for the current year with the prior year comparatives. Balance sheet captions are presented in order of liquidity starting with the most liquid assets, cash. Also requires disclosure of movements in stockholders’ equity, including the number of shares outstanding for all years presented. Balance sheet captions are presented in the inverse order of liquidity i.e. illiquid items appear earlier. Requires disclosure of either changes in equity or changes in equity other than those arising from capital transactions with owners and distribution of owners

Main Differences Particulars Indian GAAP US GAAP IFRS Cash Flow Statement Mandatory only for listed companies and companies meeting certain turnover conditions. Mandatory for all entities. Property, Plant and Equipment Use historical costs or revalued amounts. On revaluation, an entire class of assets is revalued, or selection of assets for revaluation is made on a systematic basis. No current restriction on frequency of valuation. Revaluations not permitted. Tested for impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. Use historical cost or revalued amounts. revalued.

Main Differences Particulars Indian GAAP US GAAP IFRS Leases Similar to US GAAP but, no quantitative thresholds defined. Leases are classified as capital and operating leases as per certain criteria. Capital leases are included under property, plant and equipment of the lessor. Lease rentals on operating leases are expensed as incurred. Quantitative thresholds have been defined. Similar to US except that the criteria for distinguishing between capital and revenue leases is different. Goodwill Goodwill is capitalized and tested for impairment annually. Except for goodwill from amalgamation, which is amortized over 3-5 years. Goodwill is not amortized but goodwill is to be tested for impairment annually. Goodwill is amortized to expense on a systematic basis over its useful life with a maximum of twenty years. The straight line method should be adopted unless the use of any other method can be justified.

Main differences Particulars Indian GAAP US GAAP IFRS Pension / Gratuity / Post Retirement Benefits Required to be mandatorily provided Based on either actuarial valuation or Contribution to a defined plan. Follows AS-15, actuarial gain/losses are recognized immediately. To be provided for and funded based on actuarial valuation. Significant disclosure requirements exist. actuarial gains/losses are amortized. To be provided for and funded based on actuarial valuation. Significant disclosure requirements exist. Actuarial gains/ losses are amortized Investment and Marketable Securities Only unrealized depreciation on AFS (Available-For-Sale) securities is recognized in the income statement. Both appreciation and depreciation (if unrealized) is recognized as other Comprehensive Income Separate standard for treatment of cost of development of computer software Similar to US GAAP. Except option to recognize gains/losses in AFS either income statement or equity. However, the selection is a one-time option. No guideline under IFRS.

Inventory Valuation Inventory Valuation

Inventory Valuation What Is Inventory? Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods The following equation expresses how a company's inventory is determined: Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory

How do we Value Inventory? The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement and statement of cash flow. There are three inventory-costing methods that are widely used by both public and private companies First-In, First-Out (FIFO) - This method assumes that the first unit making its way into inventory is the first sold. Last-In, First-Out (LIFO) - This method assumes that the last unit making its way into inventory is sold first. Average Cost - This method is quite straightforward; it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory

Why is Inventory important? If inflation was nonexistent, then all three of the inventory valuation methods would produce exactly the same results If prices are rising, each of the accounting methods produce the following results: FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay LIFO isn't a good indicator of ending inventory value because the left over inventory might be extremely old and perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher Average cost produces results that fall somewhere between FIFO and LIFO (Note: if prices are decreasing then the complete opposite of the above is true)

Finance Questions What is market efficiency? Define leverage? What is MM proposition on capital structure? What is a green shoe option? What is a Free cash flow? What is indexed bond?