Class 7-A

Class 7 - A

(FADM-1; Dr. Ramana)

Question: What influences the Financing decision?

Answer: The cost will decide the financing decision - (How I am going to finance my business; which is the cheapest source from where I can obtain money for the business / company). Hence, source side of balance sheet tells us the COST of funds.

SOURCE of FUND
Financing Decision	Equity	Cost
	LTL
	CL

Question: What influences the Investment Decision?

Answer: Investments that are made by a business have returns (Ex- I Invest in a Fixed Deposit keeping in mind return on it). Hence, the asset side of a business tells us the RETURN generated on the funds.

USE of FUND
Investment Decision	Fixed Assets	Return
	Investments
	Current Assets

Fixed Assets

· Fixed Assets - FA (Indian) / Plant, Property and Equipment – PPE (US)

· IAS-16 (International accounting Standards 16) governs FA accounting. AS-10 is related Indian Accounting Standard.

· PPE helps to do the business, though it might not be the purpose of business.

Accounting Issues related to FA

1) Recognition of Assets

a. Initial Recognition – Measurement: Cost of acquisition (How to recognize fixed assets in books of accounts at what price / How to measure FA of a business/ How much to pay to acquire FA for a business).

b. Subsequent Recognition – The assets will not be consumed (destroyed) immediately after purchase, but would continue to exist even after many years. Hence, recognizing the value of asset after ‘N’ years is called subsequent recognition.

2) De-recognition of Assets – When to remove the assets from the balance sheet.

Acquisition of PPE / FA

1) Cash Purchase – In Uses side of Balance Sheet (BS), PPE increases, Cash decreases by equal amount.

2) Credit Purchase – In Uses side of BS, PPE Increases; In Source side of BS, liability is created.

3) Lease

4) Exchange (acquire asset in exchange of something) – Asset exchanged with shares of my company. Hence, Capital (share capital) goes up in source side (as company has issued new shares to acquire asset) and in uses side of BS, FA goes up.

5) Gift

Hence, as seen above, acquisition of an asset results in

· Creation of a liability (Credit Purchase)

· Decrease of Cash (Cash Purchase) or other assets

Initial Recognition

Cost of Acquisition (COA) = Purchase Price + Capitalized Incidental expenses required to bring the asset into working condition.

· The process of including the expenses in the cost of acquisition is called Capitalization of Expenses (Converting expense into assets; where expense’s benefit expires in accounting period whereas assets benefit continues after that). (Capitalization of Profit is a Bonus Issue – Converting the profit into bonus issues / Capital)

Example – Case 1 = 100% capitalization (Fully Capitalized), Case 2 (Partially Capitalized) = 60% capitalization, Case 3 (No Capitalization) = 0% Capitalization. Purchase price being fixed, COA is determined by extent of capitalization of Incidental Expenses, which is decided by management.

	Case 1	Case 2	Case 3
Purchase Price	50000	50000	50000
Incidental Expenses	30000 (100%)	18000 (60%)	0 (0%)
Cost of Acquisition	80000	68000	50000

Hence, expense in Case-1 is zero (30,000-30,000), in Case-2, it is 12,000 (30,000-18,000) and in Case-3, it is 30,000 (30,000-0).

Hence, company can increase / decrease the cost of the asset by using the principle of capitalization.

All other things remaining same, Profit in Case 1 will be highest as all expenses are converted to asset. So, zero expense meaning profit is maximum.

Hence, profit can be managed by managing the accounting assumption (like capitalization of expenses). If one can prove / defend that the expense is required to bring the asset in working condition, then the expense can be made as asset. Bottom line is proving, defending, explaining that why company has made that expense as an asset under capitalization of expenses.

Flexibility in Accounting is used to capture the complexity of the business. But the flexibility is misused – Dr Ramana DV.

World-com scam – The company showed expense as assets by the above method. With expense decreasing, profit of the company went up (way against the actual).

However, following expenses are not allowed to be capitalized.

· Exclusive Admin expenses

· Interest on loan after asset is put into operation (only interest on loan during construction period can be capitalized. After construction, the interest is treated as expense)

Subsequent Recognition

There are 2 options available -

1) Cost Model – Asset will be shown at COA less accumulated depreciation (AD).

a. AD depends on methods of depreciation

b. Subsequent Year: BS show COA – AD = BV of Asset (Book Value)

2) Revaluation Model – Asset will be shown at the fair value to reflect the market reality.

a. MV > BV = If revaluation leads to higher value, show the asset at the fair value (Market Value), but show an additional corresponding source known as REVALUATION RESERVE.

Example – Here, Market Value after revaluation is 100,000.

	1st April
	Before Revaluation	After Revaluation
Capital	100000	100000
Revaluation Reserve	0	50000
Loan	200000	200000
Total Source	300000	350000
Plant (BV)	50000	100000
Shares of other company	250000	250000
Total Asset	300000	350000

Revaluation Reserve (RR) is a BOOK PROFIT and not actual as company assumes that MV of the asset has gone up. Company is NOT ALLOWED to distribute it as a dividend. Hence, it is not a part of retained profit (not shown / routed through Income Statement), but a separate item on Balance Sheet (BS). RR only strengthens the BS.

b. MV < BV: If Market Value is less than Book Value (COA), show the loss as IMPAIRMENT LOSS. The impairment loss needs to be shown in the Income Statement (unlike RR, which is NOT shown in IS in order to stop distribution of dividend because profit has increased due to RR). Normally, no company wants impairment loss, but then every company has to go through impairment test to certify that they do not have any impairment loss.

Question - What is difference between Depreciation and Impairment?

Answer - Depreciation is allocation of cost over useful life of an asset. But impairment is comparison of MV with BV. Impairment is the change in the market value, depreciation is an allocation of cost. Depreciation does not compare to the market value.Depreciation is actual but impairment cost is speculative.

Revaluation is done because when you depreciate over a period, the asset becomes zero. But asset is still there. Hence we revaluate it.

What is a FAIR Value?

· It can be market price, if there is an active market to trade the product.

· If there is no active market, company defends the Fair value calculation by using a model, which will surrogate (act as replacement) for market. Hence, it is called M to M accounting (M to M = Mark to Market / Mark to Model). Value of an asset is not what one paid, but what one will receive in future (See top, where return is shown on Asset side)

Question - The following question shows the effect of RR / Impairment. Look at the opening balance sheet. The following transactions were done during the year.

· Purchase goods on credit = 100,000

· Sales of goods on Credit = 150,000

· Depreciation (reducing balance) = 20% of COA of PPE

· MV of Plant now is 50,000

· Interest on loan is 6% is paid in cash

Balance Sheet
	Opening	Closing
Capital	100000	100000
Retained Profit		18000
Loan	200000	200000
Creditors / Payable		100000
Total Source	300000	418000
Plant (BV)	70000	50000
Cash	230000	218000
Debtors / Receivable		150000
Stock of Goods		0
Total Asset	300000	418000

Income Statement			CFS
Sales	150000		Opening Cash	230000
Total Income	150000		Total Receipt	230000
COGS	100000
Depreciation	14000
Impairment Loss	6000
Interest on loan	12000		Interest on loan	12000
Total Expense	132000		Total Payment	12000
Profit (Retained)	18000		CIH	218000