LOS E and F requires us to:
e. describe different types of assets and liabilities and the measurement bases of each;
and
f. describe the components of shareholders’ equity.
1. Current Assets
As discussed the current assets are those assets that can be converted easily into cash or could be expected to be used up within one year or within an operating cycle. Following are some of the important current assets generally found on the balance sheet.
1.1. Cash and Cash Equivalents
a. These are:
i. short-term investments (usually less than 90 days) nearing maturity;
ii. highly liquid investments; which are
iii. readily convertible into cash
iv. having almost zero or insignificant interest rate risk.
b. The examples of cash and cash equivalents are: cash in hand, cash with bank, treasury bills, commercial papers, money market funds, etc.
c. These are financial assets and are generally reported at amortized cost or fair value. The amortized cost is the cost that has been reduced by the value of depreciation or amortization over the assets. And the fair value is the price of exit that would be realized if the asset was sold at the valuing date. Both the valuing bases result in the same value for cash and cash equivalents.
1.2. Marketable Securities
a. These are the:
i. financial assets,
ii. having maturity of less than one year;
iii. traded in a public market;
iv. and whose value can easily be determined.
b. The reporting entity does not have significant interest over the marketable securities; because if there was a significant influence, it would have been termed as interest or subsidiary.
c. The examples of marketable securities are: equity stocks, debentures, bonds, treasury bills, etc.
d. These securities could be reported at the total value in the current assets section of the balance sheet and details of the same can be disclosed in the financial footnotes.
1.3. Trade or Accounts Receivable
a. Trade or accounts receivable are the amounts owed by others to the company as a result of sales of goods and services made by it in the ordinary course of the business.
b. Trade receivables are financial assets that reported by the company at the net realizable value in the balance sheet.
c. The reporting entities may use a contra account like ‘allowance for bad debts accounts’ to control the reportable value of this account. Thus the reporting entity is required to make an estimate for the allowance to be provided.
d. The reporting entities are required to report the concentration of credit risk. This can be done by reporting the customers accounting for more than 10 percent of the accounts receivable.
e. Allowance for doubtful debt can be created by estimating the percentage of receivables considered as uncollectible (which is nothing but the allowance for bad debts divided by the gross accounts receivable). These estimates are affected by changes in the credit quality of the customers, credit policies, risk management policies, etc.
1.4. Inventory
a. Inventory is the stock of goods, raw material, and work-in-progress that is either ready for sale or would be ready anytime soon.
b. The cost of inventory includes all the cost of purchase, cost of conversion, and cost to bring the goods to any particular location.
c. As per IFRS, inventory is listed at:
i. cost, or
ii. net realizable value
whichever is less.
d. As per U.S. GAAP, inventory should be listed at:
i. cost, or
ii. market value
whichever is less.
e. The cost of inventory may be estimated using any of the methods such as LIFO, FIFO, weighted average cost, etc. It may also be calculated using any other allowable method such as standard costing or retail method (where the cost is calculated by reducing the sales value by the gross margin) etc.
f. The net realizable value is calculated as follows:
i. As per the IFRS, it is estimated by reducing the sales price with the cost of sales; and
ii. As per U.S. GAAP, it should be listed at the current replacement cost.
g, If the net realizable value is less than the carrying amount, the value of inventory shall be written down.
h. If however after writing down the value of inventory there is an increase in the net realizable value, IFRS allows for the revaluation (upwards) of inventory. However, U.S. GAAP does not allow for revaluation.
i. Inventory once sold becomes a part of the cost of goods sold.
1.5. Other Current Assets
a. All the other current assets not discussed above are a part of other current assets.
b. These are usually listed at an aggregated value on the balance sheet. For example, prepaid expenses are a part of other current assets. And all the prepaid expenses would be aggregated into one line item.
c. However, if it is material and significant for the understanding of the users; any single item can also have a separate line item.
2. Current Liabilities
Current liabilities are the obligations of the company in form of debt or other obligations that will be due for repayment in the next year.
Some of the common current liabilities that need to be reported on the balance sheet are:
2.1. Trade / Accounts Payables
It is the amount owed by the reporting entity to the vendors for the number of goods or services purchased on credit.
2.2. Notes Payable and Current Portion of Long-Term Debt
a. These are the formal loan agreements for a short-term basis in form of promissory notes etc. These obligations are owed to the creditors or lenders. If however, these notes payable are due for payment after a period greater than one year then it should be classified as a non-current liability.
b. And, that portion of the long-term debt that is payable within one year shall also be classified as a current liability.
2.3. Accrued Liabilities / Expenses
a. These are the expenses that have been incurred during the reporting period but not yet paid till the reporting/balance sheet date. These are the expenses that have been realized in the income statement, but as per the contract, their payment is yet not due.
b. For example, the insurance premium becomes due by March-end next year and is payable at the end of the period, but we have already taken the insurance services for the nine months then these would be recognized as insurance expenses (for nine months) in the income statement for the period ending December 31st. The liability for the same amount will accrue in the balance sheet on the reporting date (i.e. December 31st).
2.4. Unearned / Deferred Income
a. These are those revenues against which the payments have been received during the reporting period, but they have not become due. In other words, the goods and services against which the payments were received were not yet delivered or provided by the entity to its customers.
b. Thus, all the payments received in advance for the goods or services to be provided in the next reporting period would be termed as unearned income.
c. Unearned/deferred income should not be considered as a real liability and should not be given weight while calculating the liquidity or solvency ratios. It should be considered as an accounting liability created to adhere to the matching principle of accounting.
3. Non-Current Assets
Non-current assets are all the other assets that have a useful life of more than one year. These are long-term assets.
3.1. Property, Plant, and Equipment
a. These are tangible, long-lived assets used for the production of goods and services of the business.
b. The examples of property, plant, and equipment are: land, building, machinery, furniture, fixtures, etc.
c. Under IFRS, these are reported using either the cost model or the revaluation model.
d. Under U.S. GAAP only the cost model is allowed.
e. Under the cost model, the historical cost (which includes the purchase price, delivery charges, installation charges, and all the other charges to bring the asset to use) is reduced by the amount of accumulated depreciation or depletion and the impairment losses (which is an unanticipated decline in value).
Thus,
Reportable Value = |
Historical cost |
Less: accumulated depreciation |
|
Less: impairment losses |
f. Under the revaluation model, the asset is listed at the fair value as reduced by the accumulated depreciation.
g. The value of assets should be tested for impairment under the cost model. If the carrying value of an asset exceeds its recoverable value materially then the asset is impaired (or written down) to reflect its recoverable value. The loss of impairment is reflected in the income statements of the entity.
h. The revaluation and loss recovery of the impaired asset is allowed under IFRS but not under U.S. GAAP.
3.2. Investment Property
a. Investment property is the long-term real estate property that is purchased with an intention to either earn rentals or appreciation in the value of the property and ultimate resale of the same.
b. Under, IFRS the investment property is recorded at fair value or amortized cost.
c. As per the fair value model any increase or decrease in fair value is recognized in the income statement.
d. U.S. GAAP does not specify the treatment for investment property.
3.3. Intangible Assets
a. Intangibles are the identifiable, non-monetary assets that exist without physical substance; for example patents, copyrights, licenses, etc.
b. As per IFRS, the intangibles should be recognized only if:
i. the future economic benefit is expected and
ii. the cost of the asset can be measured reliably.
c. The cost of an asset can only be measured reliably if it can be purchased in the market or are a result of rights or privileges conveyed to the owner as a result of formal licensing etc.
d. Under IFRS cost both cost or revaluation models can be used for the listing intangibles. The reevaluation model can only be used if there is an active market for intangible assets.
e. Under U.S. GAAP only a cost model is allowed.
f. The cost of the asset includes the cost of purchase for the purchased assets and for the internally generated assets, it includes the cost incurred at the development stage of the asset. The cost incurred at the research stage is expensed and not capitalized.
g. If the assets have finite useful lives, the assets should be amortized or impaired annually. However, assets with indefinite lives should be tested annually for impairment.
3.4. Goodwill
a. Goodwill is the excess amount paid over the value of identifiable net assets at the time of acquisition of another entity. The buyer usually pays a higher amount for acquisition due to certain advantages with the acquired entity such as customer loyalty, reputation, etc.
b. Since this goodwill is created as a result of the difference in value only, it should be considered as an accounting asset only and not an economic one. Thus while calculating ratios during ratio analysis the value of goodwill should be eliminated.
c. The goodwill is not usually amortized or depreciated. It is tested for impairment annually.
d. The internally generated goodwill is not listed on the balance sheet; it is usually expensed as incurred.
3.5. Financial Assets
a. Financial assets, as per IFRS, are the financial instruments that give rise to both a financial asset for one entity and a financial liability or equity instrument for the other.
b. The examples of financial assets are equity stocks, debt instruments, bonds, etc.
c. Financial assets are usually measured at historical cost, fair value, or amortized cost.
d. The ‘fair value’ of an asset, according to U.S. GAAP is “the price received for an asset or paid to transfer a liability”. And according to IFRS, fair value is “an arms-length transaction value to transfer an asset or settle a liability between knowledgeable and willing parties”. Both the definitions have more or less the same meaning. The value is the exit price required to get off the asset.
e. The amortized cost is the original recognition price as reduced by the principal repayments (against the payment of loans or debt instruments), the amortization of premium (the amortization of discount is added), and reduction for impairment.
f. There are different categories of financial assets. They are:
i. Held -to-maturity securities. These are those securities (primarily the debt instruments) that are intended to be held till maturity. These securities should be listed at amortized cost, ignoring any changes in the market value.
ii. Trading Securities. These are the securities that are acquired for the purpose of selling them in the near term. These are usually listed at mark-to-market or fair value. The unrealized changes in the value of such securities due to listing them at fair value could either be transferred to the income statement or to the statement of other comprehensive income. All the realized gains on such securities go to the income statement.
iii. The available-for-sale securities. These are the securities that are purchased to be held for some time but maybe sold or made available for sale if there is enough profit realizable. These securities should be listed at fair value. All the unrealized gains or losses on such securities should be transferred to the statement of other comprehensive income. And all the realized gains and losses on such securities are transferred to the income statement.
4. Non-Current Liability
All the liabilities that become due for repayment after one year are called non-current liability. Some of the important non-current liabilities are:
4.1. Long Term Financial Liabilities
a. Like financial assets, financial liabilities are also the instrument that creates liabilities for the entity issuing the debt and asset for the entity purchasing the same.
b. Financial liabilities include bank loans, notes payable, bonds payable, derivatives, etc.
c. Financial liabilities are typically amortized for the value of discount and premium.
4.2. Deferred Tax Liabilities
a. Deferred tax liabilities are the temporary timing differences between tax expenses recognized in the books of accounts and actual income tax payable as per the income tax laws.
b. When the tax expense recognizable as per the books is higher than the income tax payable deferred tax liability is created and vice-a-versa for the tax assets.
c. This usually occurs when the expenses or losses become tax-deductible before being recognized in the books of accounts.
d. For example, say as per the tax laws for a non-current asset the depreciation can be levied at an accelerated rate in the initial years whereas, in the books of accounts the depreciation is chargeable at a lower rate. This would result in lower depreciation expense being recognized in the books of accounts in comparison to the amount of tax-deductible expense. And this leads to a timing difference that requires the creation of deferred tax liability.
5. Shareholder’s Equity
Anything that is left after deducting the liabilities from the assets, and which is attributable to the owners or the shareholders of the company is called shareholder’s equity. It is the residual interest in the assets of the company. The typical components of shareholder’s equity are:
5.1. Capital Contributed by the Owners
a. It is the amount contributed by the owners to acquire the shares from the company. It is the amount paid at the time of initial public offerings and does not include the secondary market transaction price for the transfer of shares.
b. Capital contributed by the owners is also called the common stock. It has two components mainly: the par value and the paid-in capital.
c. Par value is the face value of the share and the paid-in capital is the amount paid in excess of the par value at the time of IPO. It is the stated or legal value of the shares.
d. The number of shares that form a part of capital contributed is of three types they are: authorized shares, issued shares, and outstanding shares.
e. The authorized shares are the total number of shares that the company is authorized to issue. It is the number of shares that may be sold under the firm’s articles of incorporation.
f. The issued and outstanding shares are usually the same except if the company holds the treasury shares. Issued shares are the number of shares that have actually been sold to the shareholders. The outstanding share is issued shares less treasury shares.
5.2. Preferred Shares
a. Preferred stock is the stock that has certain rights and privileges that are not typically conferred upon the common stockholders. In the event of liquidation, the owners of preferred shares have priority over the claims of common shareholders.
b. Preferred stock may be classified as equity or liability depending upon its characteristics. They would be classified as equity only if they are perpetual and non-redeemable. However, if the stock has mandatory redemption at a fixed amount at a future date.
5.3. Non-Controlling Interest
Non-controlling interest or minority interest is the minority shareholder’s pro-rata share of net assets or equity of a subsidiary that is not wholly-owned by the parent.
5.4. Treasury Stock
a. Treasury stocks are the shares that have been repurchased by the company but not yet canceled.
b. The shares are repurchased:
i. when the shares are undervalued;
ii. when the options need to be fulfilled; and
iii. dilution needs to be limited.
c. The stocks held in the treasury do not carry voting rights or any dividend rights.
d. The treasury stocks may also be resold but no gains or losses need to be recorded.
e. Repurchase of shares reduces the shareholder’s equity by the amount of acquisition cost and the number of shares outstanding.
f. Treasury stock can be considered as a contra equity account.
5.5. Retained Earnings
Retained earnings are the cumulative amount of earnings that have been earned over the years but have not been distributed to the shareholders.
5.6. Accumulated Other Comprehensive Income
This includes all the changes in shareholder’s equity other than the transaction recognized in the income statement and transactions with the shareholders such as issuing stocks, paying dividends, etc.
6. Statement of Changes in Equity
a. The statement of changes in shareholder’s equity summarizes all the transactions that affect (increases or decreases) the equity account of a company during the reporting period.
b. The statement typically includes:
i. Details of total comprehensive income,
ii. Retrospective effects of all policy change,
iii. Details of all capital transactions and distribution to owners,
iv. Component carrying amounts reconciliation, etc.
c. The format of a typical statement of changes in equity are:
STATEMENT OF CHANGES IN EQUITY AND STATEMENT OF RETAINED EARNINGS |
||||
Share Capital |
Share Premium |
Retained Earnings |
Total Equity (attributable to the owners of the company) |
|
Opening balance of the previous period |
xxx |
xxx |
xxx |
xxx |
Corrections for prior period errors |
– |
– |
(xxx) |
(xxx) |
Restated opening balance of the previous period |
xxx |
xxx |
xxx |
xxx |
Changes in equity for the previous reporting period |
||||
Total comprehensive income for the year |
– |
– |
xxx |
xxx |
Profit for the year |
– |
– |
xxx |
xxx |
Extraordinary gains / (losses) |
– |
– |
xxx |
xxx |
Closing Balance of previous reporting period |
xxx |
xxx |
xxx |
xxx |
Changes in equity for the current reporting period |
||||
Total comprehensive income for the year |
– |
– |
xxx |
xxx |
Profit for the year |
– |
– |
xxx |
xxx |
Extraordinary gains / (losses) |
– |
– |
xxx |
xxx |
Issue of shares |
xxx |
xxx |
– |
– |
Dividends |
– |
– |
(xxx) |
(xxx) |
Closing Balance of current period |
xxx |
xxx |
xxx |
xxx |