2. Corporate Objective
Every organisation has broad corporate Objective
which they plan to achieve over a period of time.
The objective is in terms of Vision and Mission
statement of the organisation.
Methodology for analyzing Corporate Objective
Agree objectives of each process
Plan for all aspects of the business
Align strategic goals with operational budgets
Assign responsibilities to goals
3. Corporate Objective
Report at levels that achieve objectives
Record assumptions on business environment
Communicate goals, objectives and timetable
Give access to relevant information
Use statistical techniques to predict future
performance
Provide a feedback loop
Budget a range of scenarios
Create an analysis methodology
4. Finance & Accounts
Definition
The process of identifying, measuring, recording and
communicating the economic events of an organisation to
interested users of information.
Economic Events
A happening of consequence to a business entity.
Identification
Determining what to record - Activities that are considered to
be evidence of economic activity.
5. Finance & Accounts
Measurement
Qualification in financial terms.
Recording
A chronological design of these measured events in an
orderly and systematic manner.
Communication
The recorded events are to be communicated to
management / others some form - most common report PL
A/c & B/S.
6. Finance & Accounts
Organisation
Business or a non-business entity.
Users of accounting information
Internal users
Persons who manage the organisation
External users
Direct interest - investors, creditors
Indirect interest - Tax authority, regulatory agency, labour
union etc.
7. Finance & Accounts
Book Keeping & Accounting
Book Keeping only recording of economic events. A part of
accounting.
Objective of Accounting
Calculate profit or loss.
Depiction of financial position.
To make available information to interested groups
To maintain record of business
8. Basic Accounting Terms
Assets
Economic resources of an enterprise that can be usefully
expressed on monetary terms.
• Fixed assets - assets held on long term basis
• Current assets - assets held on short term basis.
• Liquid Assets - Current Assets which are already in the cash
form or can be readily converted into cash.
• Intangible Assets - Fixed assets which cannot be seen or
touched.
• Fictitious Assets - Valueless assets or expenses treated as
assets.
9. Basic Accounting Terms
Liabilities
• Obligations or debts that the enterprises must pay in money
services at some time in the future.
• Short term liabilities - payable within one year.
Capital
• Involvement by the owner = assets - outside liability
Expenses
• Cost incurred by a business in the process of earning revenue.
10. Basic Accounting Terms
Stock
Stock (inventory) is a measure of something on hand - goods,
spares and other items in business.
Debtor
Who owes to an enterprise an amount for receiving goods
and services on credit.
Creditor
Who have to be paid by the enterprise an amount for
providing the enterprise goods and services on credit.
11. Generally Accepted Accounting Principles (GAAP)
Rules are set for preparing the financial statements. These rules are
usually called GAAP. Operating guidelines in the matter can be
classified as under:
Operating Guidelines
Assumptions Principles Modifying Principles
1. Accounting entity
2. Monetary Unit
3. Periodicity
4. Going Concern
1. Revenue recognition
2. Historical Cost
3. Historical Cost
4. Full disclosure
5. Objectivity
1. Cost benefits
2. Materiality
3. Conservatism
4. Consistency
Operating Guidelines
Assumptions Principles Modifying Principles
1. Accounting entity
2. Monetary Unit
3. Periodicity
4. Going Concern
1. Revenue recognition
2. Historical Cost
3. Historical Cost
4. Full disclosure
5. Objectivity
1. Cost benefits
2. Materiality
3. Conservatism
4. Consistency
12. Basic Accounting Assumptions
Accounting entity assumption
For accounting purposes, a business is treated as a separate
entity that is distinct from its owner /s and all other economic
entity.
Monetary Unit Assumptions / money measurement
Only those transactions that are capable of being expressed
in terms of money are included in the accounting records of
the enterprise.
Accounting Period / Periodicity Assumption
The economic life of an enterprise is divided into arbitrary
periods for preparing for financial statement. Enterprise usually
have cut off period covering twelve months for reporting the
results of the economic activities.
13. Basic Accounting Assumptions
Going Concern Assumption / Continuity assumption
A business will have an indefinite life unless it is likely to be sold
or liquidated in the near future.
Revenue recognition
Revenue should be recognised in the period in which the
sales / services are deemed to have occurred / rendered.
However, in some circumstances revenue recognition is
postponed until cash have been received.
Historical Cost Principles
All transactions should be recorded at their monetary cost of
acquisition. This is carried from year to year at acquisition cost
irrespective of any subsequent increase or decrease.
14. Basic Accounting Assumptions
Matching Principles
Expenses should be recognized in the same period as
associated revenues.
Full Disclosures Principles
All facts necessary to make financial statement not
misleading, must be disclosed.
Objectivity Principles
Accounting data should be verifiable and bias free. Therefore
historical cost accounting which is verifiable is preferred by
professional accountants to other accounting systems based
on value.
15. Basic Accounting Assumptions
Modifying Principles
The financial information should possess the qualitative
characteristic of usefulness. Information will be regarded as
useful when it is relevant and reliable.
To make the information useful, principles have been
modified from time to time keeping in view the following.
Materiality Principle
'Material' refers to the relative importance of an item or event.
This principle is an exception to the full disclosure principle. It is
due to this reason that items or events having an insignificant
economic effect or not being relevant to the user, need not
be disclosed.
16. Basic Accounting Assumptions
Consistency Principle
Unless otherwise disclosed, accounting statements should be
prepared on the same basis as that of the preceding period.
Conservatism Principle
The principle states that transactions should be recorded in such
a manner that profits are not overstated. All anticipated losses to
be recorded but all unrealized gains should be ignored.
Conservatism is now being replaced with prudent, according to
which, profits are not anticipated but recognized only when
realized.
Timeliness
To be relevant, the information must be published timely.
17. Recording of Transactions
Source of Document
Documents on the basis of which entries / transactions are
recorded in the books of account are known as source of
documents. Various business documents such as vouchers,
invoices, bill, cash memos, receipts constitute source
documents. The source document is the origin of transaction.
Accounting Equation
Accounting equation is a statement of equality between
debits and credits. It signifies that the assets of business are
always equal to total liabilities and capital.
Thus, A = L+C, or A-L = C, or A - C = L
18. Recording of Transactions
Transaction
An external event that affects assets, liabilities or capital is
called a transaction.
Rules of debit and credit
The recording of business transaction in the light of
accounting equation requires the understanding of the rules
of debit and credit through account.
Account
An account is a formal record of all transactions relating to
changes in a particular item. Through it, items of similar nature
are brought together at one place in a book called the
19. Rules of debit and credit
The recording of business transaction in the light of accounting equation requires the
understanding of the rules of debit and credit through account.
Rules
Rules of debit and credit depend upon the nature of account. For this purpose, all the
accounts are classified into be the following 5 categories. (i)Assets (ii) liabilities (iii)
owner’s equity (iv) revenue and (v) expenses.
Rules of debit and credit in respect of the various categories of accounts can be shown
as below : -
Nature of account Dr. Cr.
i. Assets Increase Decrease
ii. Liabilities Decrease Increase
iii. Owner’s equity -do- -do-
iv. Revenues -do- -do-
v. Expenses Increase Decrease
OR
20. Rules of debit and credit
Personal
Impersonal
• Real
• Nominal or Fictitious
Double entry Principle
It refers to a system of accounting in which every transaction
affects at least two accounts.
21. Golden Rules of Accounts
Personal account
Debit the receiver
Credit the giver
Real Account
Debit what comes in
Credit what goes out
Nominal Account
Debit all expenses and loss
Credit all income and profit
22. Books of original entry
These are the books of account in which a transaction is
recorded for the first time from a source document. Later,
transactions from these books are transferred to a ledger.
Following are the main books or original entry
1.) Journal 2.) Cash book 3.) Other Day Book
Journal
This is the basic book of original entry. In this book,
transactions are recorded in a chronological order, as and
when they take place. After words, transactions from this
book are posted to the ledger.
23. Books of original entry
Sub-division of the journal (Day books)
For a business with large number of transactions, it may be very
cumbersome to journalise each transaction. As many of the
transactions are repetitive in nature, they can be easily recorded on
special journals, each meant for recording all the transactions of a
similar nature. These special journals are called Day books. These
journals prove economical and make division of labour possible on
accounting work. Apart from Cash Book, the other Day Books are:
Purchase Day Book Sales Day Book Return Inward Book Return
Outward Book
Bills Receivable Book Bills Payable Book
Ledger
Ledger is the main book of accounting system. It contains, at one
place, all the transactions to a particular account, in order of their
occurrence. One can easily know the position of an account at any
point of time from the account. Posting from journal, cash book and
day books. The process of recording entries in the ledger is called
posting.
24. Trial balance
The trial balance is a statement showing the balances or total of debits and
credits of all the accounts in the ledger with a view to verifying the
equality of debits and credits posted to the ledger account. If the totals
of debit and credit amount columns of the trial balance are equal, it is
presumed that the posting to the ledger in terms of debit and credit
amounts is accurate.
A trial balance can be prepared any time.
Limitations of Trial Balance
Tallying of trial balance is not conclusive proof of the accuracy of the
ledger accounts. There may still be a number of errors. It is possible that
posting of correct amount might have been made to the wrong account
or an entry might have been omitted in journal or subsidiary book.
Compensating errors committed in such a way that the net effect of
these errors on the debits and credits of accounts is ‘nil’ also do not
reflect in the Trial Balance.
25. Preparation of Profit & Loss Account and Balance Sheet
After having satisfied himself of the accuracy of the postings of
the business transactions in the Books of accounts through
preparation of Trial Balance, The businessman gets interested in
knowing as to whether he has earned profits or incurred losses
and what is the state of affairs of his business at the end of the
accounting period. For this purpose he prepares Financial
Statements.
There are two types of Financial Statements viz.
i.Income Statement
ii.Balance Sheet
The Income Statement is split into two parts.
i.The Trading Account
ii.Profit & Loss Account.
26. Trading Account
Trading Account:
The Trading Account is designed to show the gross profit on sale
of goods. All direct expenses which relate to either purchase of
raw materials or production or manufacturing are charged to
Trading Account. The excess of sale proceeds over the direct
expenses is known as Gross Profit.
In the beginning of the year the businessman has stock of goods
left from the last year. It is called Opening Stock. The goods
remaining unsold at the end of the year are called Closing Stock.
While preparing Trading Account opening stock is added to the
Purchases and Closing Stock is added to Sales to arrive at the
Gross Profit or Loss of the business.
With the help of the Trading Account the Businessmen compare
the Purchases, Sales and Stock position of the Current Year with
those of the previous years and any variation which has affected
the volume of business and the profit is analysed. He can also find
out the ratio of Gross Profit to Sales and thus controls his business
expenses.
27. Trading Account
Purpose for preparation of Trading Account:
It provides information about gross profit. The current figure
can be compared with earlier ones and reasons found for
variation. Accordingly, future course of action for growth of
the business may be implemented.
Ratio of gross profit to sales help the trader to improve his
business administration.
Ratio of direct expenses to sales would help the trader to
control and rationalise the expenses.
Ratio of cost of goods sold to total sales proceeds could help
the trader in fixing the prices of his products.
Precautionary measures can be taken to avoid possible
losses by analysing the items of direct expenses.
28. Profit & Loss Account
Profit & Loss Account:
After preparation of Trading Account, the businessman is more
interested in knowing his net income or net profit which
increases the owner’s equity.
Net profit represents the excess of gross profit plus other revenue
gains over all indirect revenue expenses. It may be noted that
any expenditure or income of capital nature are not reflected
in the Trading Account and Profit & Loss Account.
In other words, all nominal accounts are reflected either in the
Trading Account or Profit & Loss Account and all real and
personal accounts are normally find place in the Balance
Sheet. It must be remembered that expenses relating to
owners are not accounted for in the Profit & Loss Account.
Since they are personal expenses such expenses are
transferred to Drawing A/c.
29. Profit & Loss Account
Objectives of preparing Profit & Loss Account:
Provides information about the net earning or profit/ loss of the business.
Comparison of current year’s income with previous years’ can be made
and important business decisions can be taken.
Appropriate steps may be taken to increase the profit in future through
analysis of various expenses.
Indicates the basis for earmarking the funds for various types of reserves
and provisions.
Closing entries
The preparation of P / L account requires that the balances of accounts of
all concerned items are transferred to it for its compilation. Accounts of
various items of expenses and losses are transferred to the debit side of
P / L account by debit to P / L account and credit to each item of
expenses account. Similarly, balances of the accounts of items of
income and gain will be transferred to the credit side of P / L account by
debiting each item of income and gain account.
30. Balance Sheet
Balance Sheet:
After ascertaining the profit or loss of the business, the
businessman wants to know the financial position of the
business. For this purpose, he prepares a statement of Assets
and Liabilities position which is called Balance Sheet. The
totals of Assets and Liabilities should be equal. Balance Sheet
shows the summarised position of Assets and Liabilities as at
the end of the year.
Characteristics of Balance Sheet:
It is a Statement and not an account
It shows the position of assets and liabilities as on a particular
date and not for a period
It shows Liabilities on the left side and Assets on the right side
The totals of Assets and liabilities should always be equal.
31. Balance Sheet
Preparation
All the permanent accounts i.e. Accounts of assets, liabilities and
owners equity are shown in the balance sheet. Liabilities are
shown in the left hand side and assets in the right hand side.
Valuation of assets
A balance sheet is prepared to show the financial position of
the business as a going concern. It does not show the
realisable value of the assets. Fixed assets are usually valued
at cost less estimated depreciation, current assets valued at
the cost or market price.
32. Difference between Trial Balance and Balance Sheet
Rationale of
adjustment
Final account with adjustment Point of difference Trial Balance
Balance Sheet
Object The object is to test the accuracy
of ledger Posting
The object is to know the financial
position of the business
Period Prepared on monthly, quarterly,
half-yearly or yearly basis according
to the need of the Organisation
Generally prepared at the end of the
accounting period
Profitability
position
It does not reflect the profitability
position of the business
It reflects the profitability position of
the business
Closing Stock Closing Stock position does not
appear
It shows the Closing Stock on the
Assets side
Accounts All types of accounts appear are
included
Only Real and Personal Accounts are
Included
Compulsory It is not compulsory to prepare Trial
Balance
It is compulsory to prepare Balance
Sheet as per statute.
33. Capital expenditure
Expenditure which results in the acquisition of assets to be held on a long term
basis. Further, any expenditure which adds to the productivity or earning capacity
of the asset is regarded as capital expenditure.
Revenue expenditure
Expenditure incurred in the administration of the business or in making sales is
termed as revenue expenditure.
Capital receipts
Owner’s contribution as capital, amount received by way of loan, sale proceeds of
fixed assets, etc. are regarded as capital receipts. However, loss or profit on the
realisation of fixed assets is treated as a revenue item.
Revenue receipts
Income earned in the course of business is treated as revenue receipt.
34. Adjustment of final account
Adjustment of final account
Some of the adjustments that are usually necessary in the light of
accrual basis accounting, at the end of the accounting period
for the preparation of trading & P/L account are generally as
follows :
Outstanding expenses
Prepaid expenses
Income earned but not received
Income received in advance
Depreciation
Provision for bad and doubtful debts.
Entries which are passed to incorporate these adjustments into
final accounts are called ‘Adjusting entries.
35. Limitations of balance sheet
B/S reflects the position of an enterprise as on a date.
The quality of management, expertise of staff, work culture, motivation
level of staff etc. are not reflected on the B/S.
The financial statement data depends upto the accounting principles or
practices followed. It will give different picture depending upon the
accounting principles followed.
Data contained in the financial statement are, in many instances,
derived by approximation e.g. Provision for bad and doubtful debt.
Financial statements relate to a period, and not necessarily show true
representations of the period.
Financial statements are historical and analysis of financial statements
would only relate to the past and would not necessarily reflect the future.
Assets and other transactions normally are recorded on the concepts of
historical cost and accordingly statements reflect values in terms of
historical costs. Analysis of the financial statement would not portray the
effect of price level changes over the period
36. Analysis of financial Statement of Business Units through Ratios
Financial statements contain a wealth of information. If properly
analysed and interpreted, they can provide valuable insight into the
firm's performance.
Analysis of financial statements of vital interest to the lenders (short term
as well as long-term), investors, security analysts, managers and others.
The relationships between various items in the financial statements are
expressed by means of ratios.
Ratio analysis is useful in locating symptoms of weakness and strengths.
Types of Financial Ratio
Liquidity Ratios
Leverage ratios or solvency Ratios
Turn ratios or activity ratios
Profitability Ratios
37. Understanding Balance sheet : Ratio Analysis & Funds Flow Analysis
Liquidity Ratios : measure the firm’s ability in short-term commitments out of its liquid
assets. Assets are ‘liquid’ if they are either cash or relatively easy to convert into cash.
Current Ratio : Current Assets
Current Liabilities
Current Assets are relatively liquid (i.e. they can be converted into cash in a relatively
short time period) and Current Liabilities are those liabilities which are due within one
year.
Quick Ratio or Acid Test Ratio : Current Assets-Inventory
Current Liabilities
The quick ratio or the quick assets ratio or the acid-test ratio - is a liquidity indicator that
further refines the current ratio by measuring the amount of the most liquid current
assets there are to cover current liabilities
Cash Ratio : Cash+Cash equivalent+Invested Funds
Current liabilities
The cash ratio is an indicator of a company's liquidity that further refines both the
current ratio and the quick ratio by measuring the amount of cash, cash equivalents or
invested funds there are in current assets to cover current liabilities
38. Ratios
Leverage Ratios/ Debt Ratios measure the extent of the firm’s total debt burden.
Debt to Total Assets Ratio : Total External Liabilities
Total Assets
Debt Equity Ratio : Long Term Debt
Shareholders’ Funds
The Debt Equity Ratio measures the extent of borrowing by the firm as a proportion
of the investment of its owners.
Interest Coverage Ratio : Cash Profit
Interest Expense
The Interest Coverage Ratio reflects the firm’s ability to pay interest out of its
earnings.
Capitalization Ratio : Long Term debt
Long Term debt + Shareholders’ Equity
The capitalization ratio measures the debt component of a company's capital
structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders'
equity) to support a company's operations and growth..
39. Contd…
Cash Flow To Debt Ratio : Operating cash Flow
Total debt
This coverage ratio compares a company's operating cash flow to its
total debt, which, for purposes of this ratio, is defined as the sum of short-
term borrowings, the current portion of long-term debt and long-term
debt. This ratio provides an indication of a company's ability to cover
total debt with its yearly cash flow from operations. The higher the
percentage ratio, the better the company's ability to carry its total debt.
40. Ratios : Activity
Activity Ratios show the intensity with which the firm uses its assets in generating
sales. These ratios indicate whether the firm’s investments in current and long-
term assets are too small or too large.
Inventory Turnover : Cost of Goods Sold
Average Inventory
The Inventory Turnover Ratio shows the speed with which the firm is able to
sell its output.
Average Collection Period : Sundry Debtors x 12
Credit Sales
The Average Collection Period indicates the firm’s efficiency in collecting
receivables. A longer collection period will lead to an increase in the interest
burden on the firm
• Fixed Assets Turnover : Sales
Fixed Assets
This ratio indicates how intensively the fixed assets of the firm are being utilised. A
low fixed assets turnover ratio means that the value of the goods produced
by the firm is low when compared to the investment made for producing
those goods.
Total Assets Turnover: Sales
Total Assets
Total Assets Turnover reflects how well all the firm’s assets
41. Ratios : Profitability
Profitability Ratios measure the success of the firm in earning a net return on sales or on
investment. Since profit is the ultimate objective of the firm, poor performance here
indicates a basic failure that, if not corrected, would probably result in the firm’s going
out of business.
Gross Margin : Sales - Cost of Goods Sold
Sales
The Gross Margin reflects the effectiveness of pricing policy and of production
efficiency.
Net Operating Margin : Operating Profit
Sales
The Net Operating Margin indicates the profitability of sales before taxes and interest.
Non-operating revenues and expenses are excluded when calculating this ratio.
• Net Margin : Net Profit
Sales
The Net Margin is simply the net profit earned by the firm expressed as a proportion of
sales. It is similar to the Net Operating Margin, but is slightly distorted as non-operating
income and expenditure can impact it substantially.
42. Contd….
Return on Total Assets : Net Profit + Interest Expense
Total Assets
The Return on Total Assets is the return earned by the firm for all investors (i.e.
shareholders and lenders). It reflects the ability of the firm to earn profits
without considering the financing pattern.
• Return on Equity : Net Profit-Preference Dividend
Net Worth-Preference Share Capital
The Management’s objective is to maximise returns on shareholders’
investment in the firm. Return on Equity is the best indicator of the
Management’s effectiveness in achieving this objective.
43. Investment Valuation Ratios looks at a wide array of ratios that can be used by
investors to estimate the attractiveness of a potential or existing investment and
get an idea of its valuation.
• Price/Book Value Ratio : Stock Price Per share
Shareholder’s equity Per Share
The price/book value ratio, often expressed simply as "price-to-book", provides
investors a way to compare the market value, or what they are paying for each
share, to a conservative measure of the value of the firm.
Price/Cash Flow Ratio : Stock Price Per Share
Operating cash Flow per Share
The price/cash flow ratio is used by investors to evaluate the investment attractiveness,
from a value standpoint, of a company's stock. This metric compares the stock's
market price to the amount of cash flow the company generates on a per-share
basis.
44. • Price/Earnings Ratio : Stock Price Per share
Earning per Share
The price/earnings ratio (P/E) is the best known of the investment
valuation indicators. The P/E ratio has its imperfections, but it is
nevertheless the most widely reported and used valuation by investment
professionals and the investing public. The financial reporting of both
companies and investment research services use a basic earnings per
share (EPS) figure divided into the current stock price to calculate the
P/E multiple (i.e. how many times a stock is trading (its price) per each
dollar of EPS).
• Price/Earnings To Growth Ratio : P/E
EPS
The price/earnings to growth ratio, commonly referred to as the PEG
ratio, is obviously closely related to the P/E ratio. PEG gives investor
insight into the degree of overpricing or underpricing of a stock's current
valuation, as indicated by the traditional P/E ratio.
45. • Price/Sales Ratio : Sales Price per Share
Net Sales
The P/S ratio measures the price of a company's stock against its annual sales,
instead of earnings. The P/S reflects how many times investors are paying for
every dollar of a company's sales
Dividend Yield : Annual Dividend Per share
Stock Price per share
A stock's dividend yield is expressed as an annual percentage and is calculated as
the company's annual cash dividend per share divided by the current price of
the stock.
Enterprise Value Multiple: Enterprise Value
EBIDTA
This valuation metric is calculated by dividing a company's "enterprise value" by
its earnings before interest expense, taxes, depreciation and amortization(EBITDA).
Overall, this measurement allows investors to assess a company on the same
basis as that of an acquirer.
46. Applicable Accounting Standards in Inida
AS 1 : Disclosure of Accounting policies
AS 2 : Valuation of Inventories
AS 3 : Cash Flow Statement
AS 4 : Contingencies & Events occurring after Balance sheet Dates
AS 5 : Net Profit / Loss for the period ,Prior period and changes in Accounting policies
AS 6 : Depreciation Accounting
AS 7 : Constructions contracts
AS 8 : Accounting for Research & Development
AS 9 : Revenue Recognition
AS 10 : Accounting for Fixed Assets
AS 11 : The effects of changes in Foreign Exchange Rates.
AS 12 : Accounting for Government Grants
AS 13 : Accounting for Investments
AS 14 : Accounting for Amalgamation
AS 15 : Employee Benefits
47. Applicable Accounting Standards in India
AS 16 : Borrowing Costs
AS 17 : Segment Reporting
AS 18 : Related Party Disclosure
AS 19 : Leases
AS 20 : Earning per Share
AS 21 : Consolidated Financial Statement
AS 22 : Accounting for Taxes on Income
AS 23 : Accounting for Investments in Associates in consolidated Financial statements
AS 24 : Discontinuing Operations
AS 25 : Interim Financial Reporting
AS 26 : Intangible Assets
AS 27 : Financial reporting of Interest in Joint Venture
AS 28 : Impairment of Assets
AS 29 : Provision, Contingent Liabilities & Contingent Assets
AS 30 : Financial Instruments : Recognition & Measurement
AS 31 : Financial Instruments : Presentation
49. Salient Features : AS 7 on Construction Contracts
Spread over at least two Accounting periods
The Revenues (Inflows) : based on the contractual Terms May or May
not aligned with the cost incurred.
The Difficulties in Determining the Contract Revenue for the Accounting
Period
Till the revision of the Accounting Standards following Two Methods
were adopted for recognizing revenues from the Contracts
Percentage Completion Method
On completion of the Contract
After revision of the Accounting Standard only Percentage completion
method for recognizing revenue is adopted.
50. Rationale behind the revision
Accounting concept of Accrual :
Customer & the Contractor obtain enforceable rights.
The Customer -Legal Owner-to Work In Progress
Most Long Term Contract has right to require the customer to make
Progressive Payments during the Construction period.
Continuous sale occurs as the works progress from point of view of
Contractor
51. As per AS 7 , Construction Contract is a specifically negotiated for construction of an
asset or combination of Assets closely interrelated or independent.
It also includes :
Contract for rendering Services which are directly related construction of an asset, e.g.
Services of Architect , Engineering services etc..
Contract for destruction or restoration of asset and the restoration of the environment
following the demolition of asset
Types of Construction Contract
Fixed Price Contract
Cost Plus Contracts
Or Mix of Both
Contract may provide for construction of additional asset at the option of the
Customer, then said should be treated as different contract if
Asset differ significantly as compared to original Contract
Price to the contract is independent of Original Contract.
52. • To prescribe the accounting treatment of revenue and costs associated with
construction contracts because the Commencement date and the
Completion date fall in different accounting periods.
• Therefore, the primary issue is the allocation of contract revenue and
contract costs to the accounting periods in which construction work is
performed.
Objective of the Standard :
53. Objective &
Scope
• This statement uses the recognition criteria established in the Preparation
and Presentation of Financial Statements to determine when contract
revenue and contract costs should be recognised.
• It applies to the accounting for construction contracts only.
54. Definitions
• CONSTRUCTION CONTRACT
is a contract specifically negotiated
for the
construction of an asset or
combination of assets
that are closely interrelated or
interdependent
in terms of their design,
technology and function or their
ultimate purpose or use.
55. Definitions
• Fixed Price Contract
Is a construction
contract in which
the contractor agrees to
a fixed contract price or
fixed rate per unit of
output, which
in some cases is
subject to cost
escalation.
56. Definitions
• Cost plus Contract
is a construction contract in which
the contractor is reimbursed for allowable or otherwise defined costs,
plus percentage of these costs or a fixed rate.
57. Construction Contracts
• It includes contracts for rendering
of Services
which are directly related to the
• Construction of the asset
• Destruction or restoration of assets
• Restoration of the environment
following demolition of assets.
58. Contract Revenue
It Comprises:
Initial amount agreed
Variations in the contract work, claims
and incentive payments to the extent it is
probable that they will result in revenue
and can be measured.
A variation is an instruction by the customer
for a change in the scope of the work to be
performed under the contract.
A claim is an amount that the contractor
seeks to collect from the customer or
another party as reimbursement for costs
not included in the contract price.
An Incentive payments are additional
amounts payable to the contractor, if
specified performance standards are met
or exceeded
59. Contract Costs
It comprises of :
• Direct Costs
• Attributable Costs
• Specifically chargeable costs as per the terms of the contract.
60. Recognition of Revenue and Expenses
• To be recognised when the outcome can be estimated reliably
• Contract Revenue and Costs should be recognised as revenue and
expenses
• with reference to the stage of completion of the contract activity at
the reporting date.
• Expected Loss to be recognised immediately
61. Conditions for reliable estimate
In case of Fixed Price Contracts:
• Economic benefits will flow to
the enterprise
• Contract costs to complete and
the stage of completion can be
measured at the reporting date
• Contract costs attributable to the
contract can be identified and
measured
62. Conditions for reliable estimate
In case of Cost Plus Contracts:
• Economic benefits will flow to
the enterprise
• Contract costs attributable to
the contract can be identified
and measured
63. Stage of completion
• Proportion of costs to the
estimated total cost
• Surveys of work performed
• Physical proportion of contract
work
64. Expected Loss
• Expected Loss be recognised immediately when the total costs
are likely to exceed the total revenue.
• Loss is to be recognised
• even if no work has commenced on the project.
• Irrespective of the stage of completion
• Irrespective of the profits accruing on other contracts.
65. Disclosure
• Amount of Contract Revenue
recognised
• Method used to determine the
contract revenue
• Method used to determine the stage
of completion
• Amount of advances received
• Amount of retentions
• Gross amount due from and due to
customers
• For contracts in progress, it should
also disclose:
Aggregate amount of costs
incurred and recognised profits
66. Calculation construction Profit and loss account
To determine we need
Contract Revenue
Estimated Contract Cost (Incurred cost + Future cost)
Profit = Contract Revenue – Estimated Contract Cost
Cost to Cost Method :
The percentage of completion would be estimated by comparing total cost
incurred to date with total cost expected to the entire contract. The
mathematical presentation
Percentage of Completion = Cost to Date X 100 %
Incurred Cost +Future Cost to Completion
Current revenue from Contract : [Contract Price X Percentage Completion ] –
Revenue previously recognized
Exclusions from the Cumulative Cost :
Material Supplied but not applied in the Construction
Advance Payments Made to vendors
67. Illustration
YEAR I YEAR II YEAR III
Initial amount of revenue agreed in
contract
9000 9000 9000
Variation 200 200
Total Contract Revenue 9000 9200 9200
Contract Costs incurred up to the
reporting date
2093 6068 8200
Contract costs to complete 5957 2132 0
Total Estimated costs 8050 8200 8200
Rs. In Lacs
Estimated Profit 950 1000 1000
Stage of Completion 26% 74% 100%
71. Components of Contract Revenue and Cost
Contract Revenue will consist of :
Price as agreed
Revenue arising out of escalation
Claims : various reimbursements
Increase in revenue due to increased scope
Incentive payments
Decrease in Contract Revenue due to LDs Penalties etc.
Measurement of contract revenue
Associated Contract Revenue and Contract Cost should be
recognized as revenue and expenses respectively with
reference to stage of completion of work (% completion
method).
72. Contract Cost to Include:
Site Labour
Cost of Material
Depreciation on Plant and Machinery, Equipments used on the Contract.
Cost of Moving plant ,equipments, material
Cost of hiring plant
Cost of Design and technical Assistance
Estimated cost-Rectification, Guarantee ,Warranty
Claims from Third Parties
Pre Contract Cost, if it is probable that the contract would be awarded.
Lees: Incidental Income if any
Other Cost which should be included:
Insurance
Cost of Design ,technical assistance- not directly related to a specific Contract
Construction overheads
Following specific expenses
Some Administration cost for which reimbursement is specified
Development Cost
Reimbursement of Any other cost
73. Basic Principle
Revenue and expenses are recognized in the period in which work performed
Conditions for recognizing the contract Revenue
Total Contract Revenue :
• Total Contract Revenue can be measured reliably
• It is probable that the economic benefit associated with contract will flow to the
enterprises.
• Total Contract Cost and cost up to stage of completion is measured reliably.
• Contract Cost attributable to contract can be clearly identified
• Where there is uncertainty in collection of amounts already included in Contract such
uncollectible amount to be recognized as expenses.
• Irrespective of the Commencement of the Contract or Stage of Completion , when it
is probable that the Contract cost Will exceed Contract Revenue , the expected
Losses should be recognised.
75. Project Budgeting and Construction Contract
Particulars Year 1 Year 2 Year 3
Contract Revenue 1200 1200 1200
Contract Cost Estimate 1000 1100 1050
Projected Profit 200 100 150
Cost Incurred 700 1000 1100
% Completion 70% 90.90% 100%
Profit Recognised 140 91 100
WIP 840 1091 1200
Revenue 840 251 109
Cost 700 300 100
Profit 140 -49 9
Tax 42 0 0Opportunity Lost
Due to Working
Capital Blockage
with tax Payments
76. Particulars SITUATION I SITUATION II SITUATION III
Year I Year II Year III Year I Year II Year III Year I Year II Year III
Contract Value 1200 1200 1200 1200 1200 1200 1200 1200 1200
Eastimated Cost 1000 1100 1050 1050 1050 1050 1100 1100 1100
Estimated Profit 200 100 150 150 150 150 100 100 100
Incurred Cost 700 1000 1100 700 1000 1100 700 1000 1100
% Completion 70% 91% 100% 67% 95% 100% 64% 91% 100%
Recognised Profit 140 91 150 100 143 150 64 91 100
WIP 840 1,091 1,200 800 1,143 1,200 764 1,091 1,200
Revenue for
Period 840 251 109 800 343 57 764 327 109
Cost 700 300 100 700 300 100 700 300 100
Profit 140 (49) 9 100 43 (43) 64 27 9
Tax 42 30 12 19.2 8.1 2.7
Analysis
77. Establishment : Fixed
Assest
Working Cap :
Bank Loans &
Other Loans
START
( Capital
Introduction )l
Pay Tax and
Balance is Profit
Pay Dividend or
R M Stocks
WIP
Creditors
Final Product
Commence
Buy
Raw material,
Labour &
Incur other
expenditure
Finance
Charges
and
Corporate
Overheads
Sales
Receivables
Selling &
Distributio
n ,
Marketing
etc.
Sales
Cost of Production
Employee OH
Other OH
Depreciation
Interest and
Fin Charges
Tax
Net Profit /
(Loss )
SOURCES
Capital
Reserves
Loans
APPLICATION
Fixed Assets
Investment
Net Current Assets :
{(Current Assets
Stocks ,Debtors
Cash and Bank ) –
( Current Liabilities :
Creditors , other
Payables and Provisions }
Profit & Loss A/c Balance Sheet
Editor's Notes
Complex ways in which business is conducted.
44 Paragraphs + appendix. Bold Paragraph are 12.
Revised in 2002 applicable from 1st April 2003.
Applies only to contractors and not to the contractees.
Now only one method i.e. Proportional method permitted.
Standard – It facilitates comparability, reduces number of options.
What about service contracts ?
Contracts are of two types 1. Fixed Price Contracts and Cost plus contract.
What about costs incurred prior to award of the contract ? Para 20 of the AS
Direct Costs to be reduced by incidental income.
Attributable Costs: Insurance, costs of designs and technical assistance, overheads.
Costs which cannot be allocated:
General Administrative Expenses
Selling Costs
Research & Development
Depreciation of idle plants.
The standard also provides 4 parameters for determination as to when the outcome can be reliably estimated.
Three methods prescribed for determining the stage of completion.
As a prudent policy, the standard requires for provision of loss at the first instance irrespective of the stage of contract. It may so happen that in the first year, there may be profit and in second year it may turn out to be loss affair and in the subsequent year, it may again turn around.
