Essentials of FA - Chapter 3

ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA
Second Edition Chapter 3
Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA
Purpose of Balance Sheet

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Balance sheet is a snap shot statement of the financial position of a company at the end of the accounting period. It lists assets (economic resources) and claims (claim of equity holders and other creditors, including debt holders) on those assets. Assets and liabilities are grouped under different categories as per the generally accepted accounting principles (GAAP).
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Information on Capital Structure

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The balance sheet presents the break-up of the sources of funds. Information on capital structure is relevant to assess the ability of the company to:
meet long-term commitments; take advantages of favourable events (opportunities) in the business environment; and respond appropriately to unfavourable events (threats).
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Information on Capital Structure (cont.)

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If the proportion of debt in the capital structure is significantly high, the company is likely to face huge liquidity problem when events in the business environment are not favourable, say, during the economic down trend. If the proportion of debt is low in the capital structure, the firm may borrow funds to take advantage of business opportunities and to tide over liquidity crisis. A firm manages capital with reference to the business environment and the risk characteristics of the underlying assets. Risk characteristics depend on the industry in which it operates and its strategy.
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Information on Assets
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The balance sheet also presents the components of fixed assets, investments and working capital. Working capital is measured at the difference between current assets and current liabilities. This information, when analysed in conjunction with the information provided in the profit and loss account, helps:
develop a perspective on the ability of the company to utilise the infrastructure (i.e. fixed assets) productively and manage working capital efficiently.
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Balance Sheet Structure

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Balance sheet is presented in two segments: sources of funds and application of funds. The segment entitled Sources on Funds provides information on the capital structure. The segment entitled Application of Funds provides information on assets and working capital.
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Hindustan Unilever Limited (HUL)

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Shareholders Fund
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Shareholders Fund (also called equity or net worth) has two components:
Capital, and Reserves and Surplus.
Capital represents the face value of shares issued, subscribed and outstanding at the balance sheet date.
It also includes bonus shares issued by the company.
Balance sheet presents information on authorised capital as disclosure.
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Shareholders Fund: Bonus Share

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Issue of bonus shares is a process of capitalisation of retained profit. It does not change the amounts of assets and liabilities in the balance sheet and consequently the amount of shareholders fund. The number of outstanding shares increases. Market capitalisation increases marginally because investors take issue of bonus shares as good news. By issuing bonus shares, companies transfer a portion of the retained profit, which was available for distribution to capital and cannot be distributed to shareholders. Therefore, issue of bonus share signals managements confidence in the growth of the company.
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Reserves and Surplus

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Reserves and surplus represents the amount of profit retained in the company.
In the present format provided in Schedule VI to the Companies Act, accumulated loss, being debit balance, is presented in the asset side of the balance sheet. In the proposed revised format, accumulated loss is presented as negative reserves and surplus.
Reserves and surplus are classified in two categories: capital reserve and revenue reserve. Capital reserves are not available for distribution to shareholders. Revenue reserves are available for distribution to shareholders.
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Capital Reserve
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Capital reserves are capital profits retained in the business. Examples of capital profit are:
Profit prior to incorporation of the company b. Unrealised revaluation gain on the revaluation of fixed assets c. Excess amount realised on sale of an item of fixed asset over its acquisition cost. d. Profit on issue of forfeited shares.
a.
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Capital Redemption Reserve

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The item capital redemption reserve' represents the face value of preference shares redeemed. When a company redeems preference shares, it is required either to issue fresh shares or to transfer an amount equal to the face value of shares redeemed from free reserves to the capital redemption reserve. The Companies Act, 1956 considers redeemable preference share quasi-equity. Therefore, the law requires that the face value of the preference shares redeemed should be transferred from reserves available for distribution to shareholders to capital redemption reserve. This ensures that the total contributed capital (equity shares plus preference shares) is not reduced on redemption of preference shares.
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Statutory Reserves
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Statutory reserves represent reserves created to comply with requirements of various statues. Export profit reserve and Development allowance reserve, which are classified as revenue reserve, are statutory reserves. Certain tax exemptions or tax credits are available under the Income Tax Act, subject to the condition that the company will retain a specified amount of profit for a specified period. During that specified period, the profit cannot be distributed to shareholders. After the expiry of that period, the retained profit is available for distribution to shareholders.
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General Reserve
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General reserve is the amount of retained profit which is available for distribution to shareholders. General reserve is also called free reserve. The credit balance in the Profit and Loss Account represents retained profit not apportioned to any specified reserve. There is no difference in the nature of general reserve and the credit balance in the profit and loss account because both are available for distribution to shareholders.
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Loan Fund
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Loan fund represents the amount of borrowings outstanding at the balance sheet date. Loans are either secured loans or unsecured loans.
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Secured Loan
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Secured loans are those for which the company has provided some collateral, usually in the form of mortgage or hypothecation of an asset or a group of assets.
Examples are cash credit from a bank secured by hypothecation of inventories and other current assets, and a term loan from a financial institution secured by mortgage of land.
In a situation when the company fails to honour its commitment to repay the loan or to pay the interest, a secured creditor can force the company to sell the collateral and settle the outstanding amount from the sale proceeds.
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Unsecured Loan
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Unsecured loans are those for which no security other than the personal guarantee is provided.
Usually, public deposit and overdrawn bank balance are unsecured loan.
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Short-term and Long-term Loans

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Short-term and long-term loans

Usually, the amount borrowed for a period one year or less is classified as short-term loan. The amount borrowed for a period longer than one year is classified as long-term loan.
Loans repayable within twelve months Schedule VI requires disclosure of the amount of loan (including the part of long term loan) repayable within one year after the balance sheet date. IFRS require entities to classify the loan repayable within twelve months after the balance sheet date as current liability. In Indian balance sheets, current liabilities do not include the amount of loan payable within twelve months after the balance sheet date.
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Operating Liabilities: Current Liabilities and Provisions

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Current liabilities are liabilities that are expected to be settled within the normal operating cycle or within twelve months after the balance sheet date. Provisions represents liabilities that are present at the balance sheet date but the amount and the timing when they will be settled are uncertain.
They are measured at the managements best estimate.
Acceptances represent the amount payable to creditors for goods and services acknowledged by accepting a negotiable instrument (e.g. promissory note and bill of exchange). Sundry creditors represent amount due to creditors for which no negotiable instrument is executed.
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Operating Liabilities: Current Liabilities and Provisions (cont.)

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In Indian balance sheets, current liabilities and provisions are grouped together.
This gives an impression that all liabilities represented by provisions are current liabilities. But this is not true. For example, provision for retirement/post-retirement benefits to employees is not a current liability. IFRS require classification of provisions into current and non-current categories.
Current liabilities are usually presented in the balance sheet as a deduction from current assets.
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Current Liabilities and Provisions as at 31st March 2009
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Contingent Liabilities
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Contingent liabilities are those obligations, settlement of which, according to managements estimate, will not result in outflow of economic benefits. Therefore, those liabilities are disclosed as footnotes below the balance sheet and are not recognised in the balance sheet. Liabilities which cannot be estimated reliably are not recognised in the balance sheet. They are disclosed under the heading contingent liabilities.
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Fixed Assets: Presentation

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The amount of gross block (acquisition cost), accumulated depreciation and impairment loss, and net block (also called written down value or WDV) are shown separately. A company has to present details of different classes of fixed assets separately. IFRS require companies to present property, plant and equipment and intangible assets separately.
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Fixed Assets: Presentation (cont.)

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Gross block represents the acquisition cost of fixed assets that the company holds at the balance sheet date. Net block represents the written down value of fixed assets that the company holds at the balance sheet date. Capital-work-in-progress represents fixed assets that are under production or construction and fixed assets that are yet to be ready for use.
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Asset Intensity
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Analysts calculate asset turnover ratio, which indicates the total sales per Re. 1 of investment in fixed assets. Some analysts calculates asset intensity ratio (ratio of asset to sales) to estimate the investment required by a company to achieve the desired growth. Asset intensity differs between industries. Asset intensity also depends on the business model.
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Asset Intensity (cont.)

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Asset intensity ratios of selected companies

(Amount in Rs., Crore; figures for the year 20082009)
HUL
(FMCG)
Infosys
(IT) 20,264 4,414 4.59 0.22 12,288 1.65 0.61
Bharti Airt el
(Telecommunication) 34,014 27,580 1.23 0.81 6,59 5 138
Sales Net fixed assets Fixed asset turnover Fixed asset intensity ratio Net current asset (working capital) Working capital turnover ratio Working capital intensity ratio
20,239 2,079 9.73 0.10 183
Deferred Tax Asset and Deferred Tax Liability

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Deferred tax asset and deferred tax liability arises from the temporary differences in the carrying amount of an asset or liability in the balance sheet and the tax base. In most situations, tax base is the carrying amount of an asset or a liability in the balance sheet prepared (notionally) for income tax purposes.
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Nature of Deferred Tax Liability

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Financial analysts consider deferred tax liability as quasi-equity.
The amount of deferred tax liability is available for use to create value for shareholders.
It is different from other liabilities because:
it does not carry any interest, it does not arise from operations, it does not finance the working capital, and it is uncertain when the liability will materialise.
When the market value of equity is used to measure the gearing, market capitalisation should not be adjusted for deferred tax asset/liability.
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Deferred Tax Expense

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Deferred tax represents the difference between the closing balance and opening balance of deferred tax liability/asset.
The amount by which the deferred tax liability increases is recognised as deferred tax expense. The amount by which the deferred tax liability decreases is recognised as negative deferred tax expense. The amount by which the deferred tax asset increases is recognised as negative deferred tax expense. The amount by which the deferred tax asset decreases is recognised as deferred tax expense.
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Investment
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Investment represents assets that are neither used for production and administration nor support working capital. Those assets are expected to produce regular return (e.g. interest, dividend, and rent) and/or gain from capital appreciation. Some investments provide trade benefits. Companies trade in securities is a part of treasury function.
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Treasury Function
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A typical treasury function includes cash management, risk management, hedging and insurance management, accounts receivable management, accounts payable management, bank relations and investor relations. The stock of securities in which the company trades (called marketable securities) is included in current asset. However, under the Indian GAAP, those are included in investment.
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Current Assets
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Current assets support current operation. Current assets are:
assets that are held for trading (finished goods); assets which are expected to be consumed within the normal operating cycle (e.g. raw material, work-inprogress and stores and spares that are used in regular repair and maintenance); assets that are recoverable within the normal operating cycle or 12 months after the balance sheet date, whichever is longer (e.g. trade debtors); marketable securities, and cash and cash equivalents.
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Current Assets (cont.)

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Indian GAAP (extant schedule VI to the Companies Act, 1956) does not require classification of assets into current and non-current categories. Therefore, some items of assets, which should be classified as non-current assets, are included in current assets in the balance sheet of Indian companies. Examples of those items are:
deposits with the company supplying power; non-moving items of inventories.
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Loan and Advances

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Loans and advances include loans and advances to employees, loans and advances to vendors, and loans and advances to subsidiaries and associates. In the balance sheet of Indian companies, the total amount of loans and advances is included in current assets.

However, as per the definition of current asset that part of the loans and advances which is expected to be realised after 12 months after the balance sheet date should not be included in current assets.
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PRESENTATION UNDER IFRS

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IFRS: Current And Non-current Distinction

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A company should present current and non-current assets and current and non-current liabilities separately. Current liabilities include the amount of debt repayable within twelve months after the balance sheet date. When a presentation based on liquidity provides information that is reliable and more relevant, a company should present assets and liabilities in increasing or decreasing order of liquidity.

For example, financial institutions present assets and liabilities in order of liquidity.
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Current Ratio
Current assets are short-term assets. Current liabilities are short-term liabilities. Traditionally, analysts calculate current ratio, which is the ratio of current assets to current liabilities, to measure the liquidity position of the company.
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Liquidity refers to the ability of the company to meet its short-term commitments. Traditional view is that a ratio of less than 1.33 indicates stressed liquidity position of the company. However, this conclusion is incorrect if the company has the capacity to borrow funds to meet short-term commitments.
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IFRS: Assets to be Recovered After Twelve Months

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Companies are required to disclose the amount of asset to be recovered after twelve months, after the balance sheet date.
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IFRS: Liabilities to be Settled After Twelve Months

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Companies are required to disclose the amount of liabilities to be settled after twelve months after the balance sheet date.
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IFRS: Information to be Provided In The Balance Sheet

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As a minimum, the balance sheet should include line items that present the following amounts:
(a) Property, plant and equipment (b) Investment property (c) Intangible assets (d) Financial assets (excluding amounts shown under (e), (h) and (i) (e) Investments accounted for using the equity method (f) Biological assets (e.g. tea plantation and animals) (g) Inventories
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IFRS: Information to be Provided in The Balance Sheet (cont.)

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(h) Trade and other receivables (i) Cash and cash equivalents (j) The total assets classified as held for sale and assets included in disposal group classified as held for sale (k) Trade and other payables (l) Provisions (m) Financial liabilities (excluding amounts shown under (k) and (l) (n) Liabilities and assets for current tax (o) Deferred tax liabilities and deferred tax assets
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(p) Liabilities in disposal group classified as held for sale (q) Non-controlling interests, presented within equity; and (r) Issued capital and reserves attributable to owners of the parent.
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The parent (also called the holding company) is required to present consolidated financial statements, which combine the financial statements of the parent and those of subsidiaries. The items listed above appear in consolidated balance sheet only as follows:
Investments accounted for using the equity method (item (e) above) represents investment in associates. Non-controlling interests, presented within equity (item (q) above) represents interest of investors other than the parent in the net assets of the subsidiary. The non-controlling interest is often called the minority interest. Non-controlling interest is a part of equity.
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Disposal group refers to a group of assets to be disposed of by sale or otherwise, together as a group of single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. Assets and liabilities of the disposal group should be presented separately (items (j) and (p) above).

Those should not be classified either as current or noncurrent.
Deferred tax asset and deferred tax liability are classified as non-current.
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IFRS: Information to be Provided in The Balance Sheet

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Additional line items are included when the size, nature or function of an item or group of similar items are such that separate presentation is relevant to an understanding of the companys financial position. A company decides on the presentation of additional line items based on the assessment of:
(a) The nature and liquidity of the asset (b) The function of the assets within the company; and (c) The amounts, nature and timing of liabilities.
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Royal Dutch Shell PLC

Balance Sheet as at 31 December 2007
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Treasury Shares
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Treasury shares under equity, in the consolidated balance sheet, represent own equity shares bought back by the company and held by it.
Buy-back of shares results in distribution of cash to shareholders. It reduces cash and correspondingly reduces the equity capital in the balance sheet. Therefore, it is presented as a negative balance under equity capital. A company can reissue the treasury shares.
In India, companies are allowed to buy back equity shares but are not allowed to hold it.
Bought back shares are cancelled within seven days.

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Comparative Information
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IFRS require every company to disclose comparative information in respect of the previous period for all amounts reported in the current periods financial statements. A company should include comparative information for narrative and descriptive information when it is relevant to an understanding of the current periods financial statements.
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Change in Accounting Policy

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Companies apply accounting policy consistently from period to period. An accounting policy is changed only when a new accounting standard requires such change. It is rarely that a company changes its accounting policy voluntarily to make the presentation more relevant. Usually, a new accounting standard stipulates transition provision which describes the method for first time application of the principles stipulated in the new accounting standard.
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Change in Accounting Policy (cont.)

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In the absence of a transitional provision or when the company changes an accounting policy voluntarily, the new accounting policy is applied retrospectively.
Retrospective application implies application of the policy to transactions, events and conditions as if that policy had always been applied. When a new accounting policy is applied retrospectively, the company has to present an additional balance sheet at the beginning of the earliest comparative period presented.
The Indian GAAP requires that the cumulative effect (deficit or surplus) should be recognised as a separate item in the profit and loss account for the current year.
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Errors and Restatement

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When an entity detects a prior-period error, it has to restate the comparative information.
Error results in either omission or mis-statement of information that was available or was supposed to be available while preparing financial statements. Error might occur due to mathematical mistakes, mistakes in applying accounting policies, oversight or misinterpretation of facts, and fraud.
The Indian GAAP requires presentation of the effect of correcting the error as a separate line item in the current years profit and loss account as a separate line item.
Usually, it is presented as prior period adjustments.

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Change in Accounting Estimates

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Accounting estimate is at the central of measurement of assets and liabilities. At each balance sheet date, an entity reviews estimates and revises the same based on new information or new developments. A change in an estimate is not a correction of error. The effect of a change in accounting estimate is recognised prospectively.
It is recognised in the profit or loss for the current period. However, if the change affects the current period as well as future periods, the effect is recognised in profit or loss for the current period and future periods.
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Reclassification
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Companies are not allowed to change the classification of items in the balance sheet and profit and loss account voluntarily. Voluntary reclassification is permitted only if it is established that the reclassification will improve the relevance of information provided in financial statements. As in the case of restatement, in case of reclassification, three balance sheets are to be presented including the balance sheet as at the end of the current year.
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ASSETS
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Current Assets
IAS-1 stipulates that a company classifies an asset as current asset when: (a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realise the asset within twelve months after the reporting period; or (d) the asset is cash or cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.
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Operating Cycle
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Operating cycle is the time between the acquisition of assets for processing and their realisation in cash or cash equivalents.
In the case of a firm engaged in manufacturing of products or services, the operating cycle begins with the receipt of raw materials and components, and ends with the realisation of cash from customers.
When the normal operating cycle is not clearly identifiable, it is assumed to be twelve months. The operating cycle should be viewed as a process. Any asset that is in the process is a current asset.
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Cash and Cash Equivalents

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Cash and cash equivalents are current assets.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. If there are restrictions on the short-term use of cash, it is not classified as a current asset. For example, cash deposited in an escrow account for purchase of a property is not a current asset because it is not available to support operations of the enterprise. Usually, include the cash in current asset and disclose the restriction in footnotes.
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Monetary and Non-monetary Assets

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Monetary assets are money held and assets to be received in fixed or determinable amounts of money. Assets that cannot be classified as monetary asset are classified as non-monetary asset.
Examples of monetary assets are cash, receivables from customers, deposits with various authorities, and loans to be recovered in cash. Examples of non-monetary assets fixed assets and prepaid expenses for goods or services to be received in future (e.g. advances to vendors for goods and fixed assets).
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Measurement of Assets: Fixed Assets

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Fixed assets are usually measured at historical cost.
The historical cost is adjusted for accumulated depreciation and accumulated impairment loss.
Historical cost is the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire the asset at the time of acquisition. IFRS provide an option to measure fixed assets at fair value.
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Measurement of Assets: Inventories

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Raw materials and stores and spares are measured at historical cost. Finished goods and work-in-progress are measured at lower of historical cost and net realisable value (NRV).
NRV is the amount that the company expects to realise by selling those items in the normal course of business in the next or a subsequent period, reduced by expected costs to sell and estimated cost to complete the production.
Cost and NRV are compared for each class of finished goods/work-in-progress separately.
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Measurement of Assets: Receivables

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Amount due from customers and loans are financial instruments. They are initially measured at fair value.
If the amount due from the counter party is expected to be collected within six month from the transaction date, the contracted amount is the fair value. In other cases, fair value is the present value of expected cash flows calculated at the market rate of interest.
Subsequently, they are measured at amortised cost using effective interest rate method. Under the Indian GAAP, receivables and loans are measured at the contracted amount.
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Measurement of Assets: Receivables: Effective Interest Rate

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The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount, which is the fair value at the initial recognition, of the financial asset or financial liability.
In calculating the effective interest rate, an entity considers promised cash flows and does not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are integral part of the effective interest rate.
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Measurement of Assets: Receivables: Example

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The accounting year of Antara Limited (AL) ends on 31 March. On 1 January, 2010, it sold goods to a customer for Rs. 1,000. The amount is expected to be collected on 31 December, 2011. No interest is charged from the customer. The market rate of interest at which the customer could borrow for a period of one year is 15%. Solution

Effective interest rate is 15%. Fair value is the present value of the cash flow discounted at the market interest rate. Sale will be recognised at Rs. 870. In 20092010, interest income will be recognised at Rs. 32. In 2010 2011, interest income will be recognised at Rs. 98.
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Measurement of Assets: Receivables: Example (cont.)

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Journal entries
January 1, 2010 March 31 , 2011 December 31, 2011 December 31, 2011 Receivables To sales Receivables To interes t income Receivables To interes t income Cash To receivables Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Rs. 1,000 Rs. 1,000 Rs. 98 Rs. 98 Rs. 32 Rs. 32 Rs. 870 Rs. 870
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Measurement of Assets: Pre-paid Expenses

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Pre-paid expenses are measured at the amount paid to the counter party.
Examples of pre-paid expenses are advance paid to a vendor for supply of goods, services or fixed assets.
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Measurement of Assets: Investments

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Investments are measured at fair value. However, there are exceptions.
Investment in debt securities are measured at historical cost provided the company intends to hold it till maturity. Loans and receivables are measured at historical cost. Entities have an option to measure investment in property either at historical cost or at fair value.
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Fair Value
Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction.
Fair value is the exit price. The phrase arms length transaction implies that the parties to the transaction are acting independently in their self-interest and not under any pressure or duress. In most situations, observable prices (bid price) in an active market (e.g. capital market and commodity exchange) are the best estimate of fair value.
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Fair Value (cont.)

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In certain situations, the observable price is not the best estimate of fair value in all situations.
For example, if the trading volume in a particular period is much lower than the normal trading volume, observable prices during that period are not the best estimate of fair value.
In situations, where active market is not available or observable prices are not the best estimates of fair value, economic models are used to estimate the fair value. Economic models are used to estimate the fair value of assets and liabilities that are not traded in an active market.
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Active Market
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An active market is a market in which all the following conditions exist:

the items traded within the market are homogeneous; b) willing buyers and sellers can normally be found at any time; and c) prices are available to the public.
a)
Examples of active market are capital market and commodity exchange.
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LIABILITIES
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Liability: Definition
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Liability is a present obligation of the company arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. An obligation is a liability if, practically, the company has no alternative but to settle the obligation. An obligation may arise from contract or from the operation of law (e.g. income-tax liability).

Example of liabilities are borrowings from financial institutions, borrowings from public through issuance of debentures or other types of bonds, public deposits, interest accrued on borrowings, trade creditors, and advance received from customers.
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Liability: Recognition
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A liability is recognised in the balance sheet only if the management can estimate the amount of outflow of economic benefits reliably. If the management estimates that it is less than probable that the liability will result in an outflow from the entity of resources embodying economic benefits, it discloses the obligation below the balance sheet under the heading Contingent Liability. If the management is unable to estimate the amount of the liability, it discloses the same under the heading Contingent Liability.
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Constructive Obligation
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Constructive obligation arises from a pattern of past practice of the entity or from a sufficiently specific current statement issued by the management. A pattern of past practice or a specific statement creates a valid expectation among some individuals or other entities that the entity has undertaken an obligation and will honour the same.
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Constructive Obligation (cont.)

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A liability is recognised if, practically, the entity has no alternative but to settle the obligation arising from the pattern of the past practice or a specific current statement. A constructively obligation ultimately gets translated into contractual obligation. The concept of constructive obligation results in early recognition of a liability. Indian GAAP does not recognise the concept of constructive obligation.
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Current and Non-Current Classification

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A liability is classified as current when it satisfies any of the following criteria:

It is expected to be settled in the normal operating cycle. b) It is held primarily for the purpose of being traded. c) It is due to be settled within twelve months after the balance sheet date. d) The enterprise does not have an unconditional right to defer settlement of the liability for at least twelve months from the balance sheet date.
a)
A liability that cannot be classified as current liability is classified as non-current liability.

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Operating Liabilities
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Operating items such as trade creditors, overdue salaries and wages, advance from customers are classified as current liabilities even if they are not to be settled within twelve months after the balance sheet date because they are part of the working capital.
However, those items are classified as non-current liability if they are not expected to be settled within the normal operating cycle or within twelve months after the balance sheet date. The operating cycle is the same that is used to classify assets in current and non-current categories.
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Non-Operating Liabilities
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Debts which are to be settled within twelve months after the balance sheet date is classified as current liability. Current liability includes that part of the long- term debt which is to be settled within twelve months after the balance sheet date.
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Liabilities Held for Trading

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Trading generally reflects active and frequent buying and selling.
The fact that a liability is used to fund trading activities does not in itself make that liability one that is held for trading.
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Liabilities Held for Trading (cont.)

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Liabilities held for trading include:

a)
b) c) d)
Derivative liabilities that are not used for hedging Obligations to deliver financial assets borrowed by a short seller Financial liabilities that are incurred with an intention to repurchase them in the near term. Financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short term profit taking.
It is rarely that a non-finance company holds liabilities for trading.

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Derivative Instruments
A derivative instrument is an instrument that is derived from an asset. The most common derivative instrument is option. A call option gives the holder a right to buy the underlying asset (e.g. share issued by a company) at a predetermined price on or before a specified date. A put option gives the holder a right to sell the underlying asset at a predetermined price on or before a specified date. The holder of an option exercises the right only if it is favourable to him.
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Derivative Instruments (cont.)

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The writer (often known as seller) of the option has the obligation to honour the right given under the option.
For example, if you hold a call option that gives a right to buy the underlying asset (usually a security) at a specified price (say Rs. 100) at a specified date (expiry date), you will exercise the right only if the market price of the asset at the expiry date is above Rs. 100. If the market price of the asset is below Rs. 100, you will allow the right to lapse.
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Derivative Instruments (cont.)

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If you are the writer of the call option, you will be required to deliver the asset to the holder of the call option, if he/she decides to exercise the right. Therefore, as a writer of the call option, you have a liability which is a liability held for trading unless you have written the option as a part of your strategy to hedge risks.
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Short Selling
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You are a short seller of a security if you are selling the security that you do not own. You borrow shares from someone, sell them, and at a later date return them to the lender by purchasing those shares from the market.
If the share price falls you make money because you buy shares at a lower price and return the same to the lender with interest. If the share price increases, you lose.
Your obligation to deliver the shares borrowed by you is a current liability.

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Bonds with Repurchase Option

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An enterprise may issue bonds with a repurchase option (call option) which gives the enterprise the right to repurchase those bonds in a near term, say within three months. Alternatively, an enterprise may issue bonds with a put option that gives the holder of those bonds a right to sell them back to the enterprise in a near term, say within three months. Those bonds are classified as current liabilities (liabilities held for trading) even if the remaining maturity period of those bonds is longer than twelve months from the balance sheet date.
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Bonds With Re Purchase Option (cont.)

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The most common money market instrument is REPO or repurchase agreement. If a bank purchase treasury securities from a securities dealer with an agreement that the dealer will repurchase them at a specified price at a specified date in a near term, say, on the expiry of three days from the date of purchase, the transaction is known as three-day REPO. The dealers obligation under the REPO is a current liability.
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Measurement of Liabilities
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Financial liabilities are initially measured at fair value. Subsequently, they are measured at amortised cost using effective interest method. If loans are arranged at commercial terms and conditions, may assume the contracted amount represents fair value. Therefore, liabilities are carried at the amount of proceeds received in exchange of obligation. In some circumstances.
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Measurement of Liability: Example

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A firm operating in the SME arranged a loan of Rs. 1,000 under a government scheme at an interest rate of 10% per annum. The interest is payable at the end of each year and the principal amount is repayable at the end of the third year. The rate of interest at which the firm could borrow from the market at the same terms is 15%.
The fair value of the loan is the present value of the cash flow discounted at 15%. PV = 100/(1.15) + 100/(1.15)2 +1,100/(1.15)3 = Rs. 886.
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Effective Interest Rate: Example (cont.)

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Effective interest is 15%. The loan should be initially recognised at Rs. 886 and Rs. 114 should be recognised as income. Accounting for interest expense and loan will be as follows:
Year 1: Interest exp.: 8860.15 = Rs.133; Cl. balance of loan = 886 + (133 100) = Rs. 919 Year 2: Interest exp.: 9190.15 = Rs.138; Cl. balance of loan = 919 + (138 100) = Rs. 957 Year 3: Interest exp.: 9570.15 = Rs.143; Cl. balance of loan = 957 + (143 100) = Rs. 1,000
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END
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Essentials of FA - Chapter 3

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ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA

Second Edition Chapter 3

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Purpose of Balance Sheet

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Information on Capital Structure

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Information on Capital Structure (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Balance Sheet Structure

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Hindustan Unilever Limited (HUL)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Capital, and Reserves and Surplus.

It also includes bonus shares issued by the company.

Balance sheet presents information on authorised capital as disclosure.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Shareholders Fund: Bonus Share

Hindustan Unilever Limited (HUL)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Reserves and Surplus

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Capital Redemption Reserve

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Short-term and Long-term Loans

Short-term and long-term loans

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Operating Liabilities: Current Liabilities and Provisions

They are measured at the managements best estimate.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Operating Liabilities: Current Liabilities and Provisions (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Hindustan Unilever Limited (HUL)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Fixed Assets: Presentation

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Fixed Assets: Presentation (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Asset Intensity (cont.)

Asset intensity ratios of selected companies

20,239 2,079 9.73 0.10 183

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Deferred Tax Asset and Deferred Tax Liability

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Nature of Deferred Tax Liability

Financial analysts consider deferred tax liability as quasi-equity.

It is different from other liabilities because:

Deferred Tax Expense

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Current assets support current operation. Current assets are: