ub-fa-2011- 4
TRANSCRIPT
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Financial Accounting &Analysis
Union Bank Staff Training College
Shankar Jaganathan
March 26, 2011
Accounting Standards: The Need and their Content
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JSFinancial Accounting & Analysis-Topics
2
1. Introduction (March 6) Course structure, methodology and evaluation A brief history of accountancy
2. Accounting concepts, conventions & Double entry (March 12) Accounting concepts, Conventions, Double entry accounting
3. Financial Statements (March 19) Balance Sheet, Profit and Loss Account & Cash Flow Statements4. Important Accounting Standards (March 26)
Need for Accounting Standards and key standards
5. Ratio Analysis or Comparative view (April 2) Intra-industry, Inter-industry and Specific purpose analysis
6. Accounting for Internal decision making (April 9) Cost accounting and management accounting systems7. Accounting for Equity Markets (April 13)
Share premium, EPS, Book value, Bonus issue, Stock split, USGAAP and IFRS
8. Project Presentation (April 24)
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JSAccountancy: The
Sequence
3
Bookkeeping FinancialStatements
Financial
Analysis &
Interpretation
Balance Sheet
Profit & Loss Stmt
Cash Flow Stmt.
Accounting Standards
Basis for Preparing
Financial Statements
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A. The Need for AccountingStandards
4
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JSThe Birth: Hat-trick of events
The hat-trick years -1967-69
Location: Great Britain
Setting: Takeover battles
1st ball: GEC AEI
2nd ball: Courtaulds International Paints
3rd ball: Leasco -Pergamon
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JS1st ball: GEC AEI Industrial Reorganization Corporation established in 1966 to
promote rationalization in private sector
Year 1967, Electrical equipments facing tough times
Major players AEI and GEC
Attempts at friendly consolidation between the two failed
AEI performing below expectations
A return of only 5% on 220 m investments
Diversified into all segments of market
Reports results for the first half year of 1967 in September 3.7 m profits lower than 6.9 m in 1966
Poor results trigger GEC to bid for AEI
120 m for the business offered
AEI Directors rejected the bid triggering a battle6
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JS1st ball GEC AEI October 20th: AEI formally rejects the offer and announces
Rationalization of business; sale of assets to realize 20 m
Forecast profit of 10 m for1967 vs. 9.2 m in 1966
Forecast profit of 16 m in 1968 and 20 m in 1969
October 30, GEC raised bid to 152 m
Raises its own profit forecast to 21 m for1967 from 19.5
Forecasts profit of 24 m for1968
November 2, AEI rejects the bid
Same day, GEC raises bid to 160 m &
Attacks profit forecast of AEI
This scuffle led to a proxy war
GEC won the proxy war 7
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JS1st ball GEC AEI After GEC took over, they announced AEI results for 1967
A loss of 4.5 million reported vs. 10 m profit forecast by
AEI
AEI directors published a rejoinder their request for jointmeeting to analyze difference not accepted
A Joint report of the two auditors was published
In the report the auditors quantified the difference of 14.5 m- 5 m as matter of fact
- 9.5 m as matter of judgment, of which 8.7 mwas lower valuation of stock & contracts
Neither the directors nor we have found it possible to judgethe extent to which the increase in this charge reflects thedifference in approach on the part of management under new
control Auditors note in the AEI accounts
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JS2nd ball: Courtaulds InternationalPaints
International Paints a leading brand in UK in business from1881
Dufay Bitumastic made a takeover bid for InternationalPaints
Before the offer expired, Courtaulds announced that theywill bid, if the Dufay bid failed
As desired by Courtaulds, Dufay bid failed and Courtauldstook-over International Paints
Courtaulds was surprised by the quality of profits reportedby International Paints
Chairman of Courtaulds wrote to the President of Instituteof Chartered Accountants of England and Wales,complaining about multiple accounting policies and theproblem of reconciling pre-acquisition profits with post-acquisition profits
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JS3rd ball: Leasco -Pergamon Pergamon was a leading publisher of Scientific journals in UK
Leasco Data Processing Corporation was a New York based
company
Leasco negotiates to buy Pergamon and acquires 38% stake for
$22 million Pergamons auditors were Chalmers Impey, a respected British firm
Leasco appointed Price Waterhouse to conduct a special audit
The special audit reflects a loss of60 k against a reported
profit of1.5 m; the difference was mainly due to:
560 k of profit on sale to a related company (owned by Chairman)
Not considering the loss of a associate encyclopedia company
The acquisition was called off, leading to a lengthy legal battle
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JSICAEW response Statement of Intent on Accounting Standards issued in the
1970 with the objective of:
Narrowing the areas of difference and variety in accounting
practice;
Disclosing accounting bases;
Disclosing departures from established accounting standards;
Exposing major proposals on accounting standards for
consultation.
Statement announced the formation of Accounting Standards
Steering Committee, which was subsequently called
Accounting Standards Committee.
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JSIndian Accounting Standards ICAI responsible for Accounting standards in India
Accounting Standards Board set up in 1977
Till date 29 accounting standards issued and enforced
Revenue 02
Costs 04
Assets 06
Liabilities 03
Generic 09
Specific 05
Total 29
AS 8: Accounting forR&D is withdrawn;
Hence we have 28 Accounting Standards today
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JSAccounting Standards issued but notEffective
AS 30: Financial Instruments: Recognition and
Measurement
AS 31: Financial Instruments: Presentation
Both these accounting standards are effective for
Financial Statements prepared from
April 1, 2009, recommendatory
April 1, 2011, mandatory
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JSEnterprises classified into multiplecategories
Enterprises classified into three levels
Level I
Level II
Level III
Level II and III considered Small and Medium Enterprises
Accounting Standards are of two types
Measurement standards
Disclosure standards
All accounting standards applicable to Level I
For Level II and Level III exempt from accounting standardsfocused on disclosures
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JSLevels DefinedLEVEL I Listed enterprises: debt or equity listed in stock exchange Enterprises planning to list their securities Enterprises with turnover exceeds Rs.50 crores Commercial, industrial or business enterprise having borrowing
including public deposits in excess of Rs.10 crores
Subsidiary company whose parent company presentsconsolidated results
Banks Financial institutions Insurance companiesLEVEL II (Enterprises not in level I) and
Turnover of more than Rs.40 lacs and less than Rs.50 crores Borrowings in excess of Rs.1 crore and less than Rs.10 crores Holding and subsidiary enterprises of any one of the aboveLEVEL III Enterprises not covered in Level I and Level II
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JSAS 1: Disclosure of AccountingPolicies
Objective: Promote better understanding of financial statements and
comparison between enterprises
Fundamental Assumptions need not be disclosed
Going concern, Consistency, Accrual basis
Disclose only if these assumptions are not made
Consideration in selection of accounting policies
Prudence: profit not estimated and provision made for liabilities
Substance over form
Materiality: knowledge of which might influence the decision of
the user of financial statements
16Answer to the first two cases GEC-AEI & Courtaulds International Paints
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JSAS 1: Disclosure of Accounting Policies Areas in which Accounting policies differ:
1. Methods of depreciation, depletion and amortization
2. Treatment of expenditure during construction period
3. Conversion or translation of foreign currency items
4. Valuation of inventories
5. Treatment of goodwill
6. Valuation of Investments
7. Treatment of retirement benefits
8. Recognition of profit on long term contracts
9. Valuation of contingent liabilities Accounting policies should be disclosed in one place and form part of
financial statements
Any change in accounting policy should be disclosed along with the
impact of such change
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B. Recognizing Income andAccounting for Costs
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JSPayment terms in Contracts
Based on payment terms
- Advance payment
- Cash on delivery
- Defined credit periods e.g. 30 days or 60 days
- Payment based on milestones- Deferred Credit e.g. a few years
Customer Financing
Installment payment
Hire purchase
Other variants Consignment Sales
Sale on returnable basis
Sale subject to Acceptance
19Revenue recognition a challenge of Accrual Accounting
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JSRevenue Recognitions (AS) 9Covers
- Sale of goods
- Rendering of services
- Use by others of enterprise resources yielding interest,royalties and dividends
Does not cover
- Revenue from Construction contracts, hire purchase, lease,revenue from insurance contracts, government grants andother subsidies
Revenue defined1. The gross inflow of cash receivables or other considerations
arising in the ordinary course of business from sale ofgoods, service or use by other of enterprise resources
2. Completed services contract method
3. Proportionate completion method20
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JSRevenue Recognition (AS) 9
General Principles- Binding contract for sale (transfer of ownership for a consideration) in
Sale of goods- Risk and reward should be transferred
- Recoverability of sale priceServices- Proportionate completion method
- When more than one act is required for performance
- Revenue recognized based on contract value, associated cost, numberof acts,
- when services cover indeterminate acts over a period of time, on
straight line basis, unless otherwise specified- Completed services contract method
- execution of a single act, or the final services are so significant that theservice is not considered concluded if the final act is not done
- Revenue recognized when the final act takes place
- Others interest accrues; Royalty based on contract, Dividend based on right to receive 21
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JSRevenue Recognition (AS) 9
Un-certainties on Revenue recognition
- Unreasonable to assess ultimate collection: price escalation,
penal interest on delayed payments
- After sale if uncertainty of collection arises, write off as bad
debts
Disclosure- Disclose where revenue recognition has been postponed
pending resolution of significant un-certainties
- Basis for revenue recognition is disclosed
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JSRevenue Recognition (AS) 9
Some Variants highlighted, when revenue recognized
- Delivery delayed at buyers request; risk transferred
- Delivery subject to installation; if installation is simple
- Delivery subject to approval; if accepted or period for rejection
has expired
- Guaranteed sale giving buyer unlimited right of return; if
money back guarantee is given is given to customers
- Consignment sale-O
nly if the goods are sold by the consignee- Cash on delivery only on receipt of cash
- Sales with agreement to repurchase not recognized as
revenue
- Subscription for services straight line basis over the period of
delivery or in line with value delivered if not proportionate2
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JSRevenue Recognition (AS) 9Some Variants highlighted, when revenue recognized
- Installment sale Revenue recognized on delivery of goods,
value recognized is value less the interest cost in the price;
interest recognized proportionate to unpaid balance
- Trade discount and volume discount should be reduced from
revenue
- Installation fee only when equipment is installed
- Advertising and insurance agency commission when service
is completed- Admission fee when the event has taken place
- Tuition fees over the course
- Entrance and membership fee Entrance fee is generally
capitalized, membership fee over the period of service24
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JSIdentifying Good revenue recognitionPolicy Adequate and meaningful disclosure
Consistency no accounting policy changes unless
mandated by statute
No Prior period adjustments on account of Revenue
recognition (sales returns, revenue de-recognition)
Receivables and other working capital components in line
with or better than the industry performance
Other forms of Receivables Unearned / Unbilled revenue
Absence of wide fluctuations in revenue (variance in line
with industry fluctuations acceptable)
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Receivables is the Barometer of Revenue recognition policy
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JSAccounting for ConstructionContracts (AS) 7 Though named Construction contracts applies to all contracts
that have the following feature:
Date at which contract activity is entered into and
date when the activity is completed usuallyfalls into different accounting periods.
Construction contract is a contract for construction of an asset
or a combination of assets that are interrelated in terms of their
design, technology and function or their ultimate purpose Contract revenue is the initial amount agreed plus variations in
contract work, claims and incentive payments
Variations, claims and incentives can be included only if they
can be reliably measured26
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JSAccounting for Construction Contracts(AS) 7 Contract cost includes all direct costs and costs that are
attributable to contract activity in general and can be allocated
to the contract
Insurance, design and technical assistance and construction
overhead
Cost that cannot be included are General Administration cost,
Selling Cost, R&D Cost, Depreciation on idle plant
Contract revenue and contract costs recognized by reference
to the stage of completion of activity
Expected loss on contract should be expensed immediately on
identification27
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JSAccounting for ConstructionContracts (AS) 7
For Fixed Price projects the following conditions to be met:
- revenue can be reliably measured
- Economic benefits will flow to the business
- Contract cost for completion and % completion can bereliably measured
- Actual cost can be compared with the estimate
When outcome of a Construction contract cannot be estimated:
- Revenue should be recognized only to the extent of cost
incurred, which can be recovered
- Contract cost should be recognized as an expense in the
period incurred
- Expected loss should be recognized immediately28
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JSAccounting for ConstructionContracts (AS) 7
Change in estimate of Contract cost or revenue
- When change identified in accounting period, cumulative
impact up to earlier period should be reported as prior
period expense and disclosed separately
Enterprise should disclose the methods used to determine
Revenue
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JSAS 6: Accounting for Depreciation Objective: Disclosure of depreciation policy necessary to appreciate
the view presented in financial statements
Applies to all depreciable assets except
Forests, plantations and similar regenerative natural resources
Wasting assets like minerals, oils, natural gas and similar non-
regenerative assets
Expenditure on R&D
Goodwill Livestock
Depreciation: wearing out, consumption or other loss of value of
depreciable asset arising from use, effluxion of time, obsolescence
through technology or market changes 30
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JSComputation of
Depreciation (AS 6) Depreciable assets are those that meet the following
conditions
- Expected to be used over more than one accounting period
- Have a limited useful life;
- Are held for the purpose of use in production or supply of
goods and services
Depreciation is computed based on:
- Asset cost (historical cost)
- Estimated residual value
- Useful life 31
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JSEstimating useful life of an
asset Pre-determined by legal or contractual limits, e.g. lease holdpremises
Directly governed by extraction or consumption e.g. moulds anddies
Extent of use, physical wear and tear e.g. plant and machinery Obsolescence arising from:
- Technology
- Improvement in production methods
- Change in market demand
- Legal restrictions
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JSWhat is Deferred Revenue expenses
Event based Revenue expenses, where due to scale benefits are
expected to be realized over more than one accounting period
Examples:
- Preliminary expenses
- Product launch expenses Advertisement
- Expenditure on relocating or reorganizing part or all of itsenterprise for an economic benefit
AS 26 requires all these expenses to be expensed when incurred
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JSAccounting for borrowing cost (AS 16) Borrowing cost interest and other costs incurred in connect
with borrowing of funds
interest, amortization of discount or premium related to
borrowing, ancillary cost, finance charges, exchangedifference arising from foreign currency borrowing
Borrowing cost directly associated with acquisition,
construction or production of asset capitalized
- Conditions necessary:
1. expenditure incurred during construction period,
2. borrowing cost incurred, and
3. activities are necessary to prepare the asset for its intended use34
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C. Valuing Assets andRecognizing Liabilities
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JSTypes of Assets
Based on nature
Physical assets, financial assets & intangible assets
Based on intention of holder Current assets and long term assets
Based on Balance Sheet classification byCompanies law
Fixed Assets, Investments & Current Assets
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JSAS 22 Accounting for Taxes onIncome
Objective: Prescribe accounting treatment for taxes on Income
Accounting Income: profit before tax in the profit and loss stmt.
Taxable Income: amount of profit or loss for the period
determined in accordance with the tax laws
Current tax: income tax payable for the period based on tax law
Tax expense: total of current tax and deferred tax for the period
Deferred tax: effect of timing difference
37The boom in the leasing industry in 1980s and 1990s
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JSAS 22 Accounting for Taxes onIncome
Timing difference: difference between taxable
income and accounting income in one period
capable of reversal in another, e.g. provision for
doubtful debts, difference in depreciation rates
between Accounts & Tax
Permanent difference: difference between taxable
income and accounting income for a period that do
not reverse subsequently 38
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JSAS 22 Accounting for Taxes onIncome
Profit and loss account to consider Tax expense (i.e.
current tax + deferred tax)
Deferred tax assets are tax benefits not availed by
the enterprise, but available to it e.g. unabsorbed
depreciation or unabsorbed carry forward loss
Deferred tax liability is tax benefit availed in the
Profit and Loss account, that will be reversed in
future, e.g. higher tax depreciation over book
depreciation
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JSAS 22 Accounting for Taxes onIncome
Disclosure:
Deferred tax assets and deferred tax
liabilities should be reflected separately inthe balance sheet
Break up of Deferred tax assets and Deferred
tax liabilities should be given in the Notes toAccounts
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JSPrinciples of Inventory Valuation (AS) 2 Inventory defined as
- held for sale in the ordinary course of business
- In the process of production for such sale; or
- In the form of materials or supplies to be consumed in the
production process or in rendering services
- Does not include spares for use in fixed assets (AS) 10
Inventory to be valued at Cost or Net realizable value
Cost includes
- Cost of purchase
- Cost of conversion (normal capacity, cost of goods)
- Cost excludes interest cost, abnormal wastage, storage cost,
administrative, selling and distribution costs41
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JSValuation of Inventories (AS) 2 Effective from April 1, 1999
Applies to
- All inventories other than, specified below
Does not apply to
- Work in progress under construction contract (AS) 7
- Work in progress in the ordinary course of business of
service providers
- Financial instruments held as stock in trade
- Producers inventories of livestock, agricultural and forest
products, mineral oils, ores and gases42
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JSPrinciples of Inventory ValuationBasis for Inventory Valuation
Permitted by Accounting standard
- FiFo, Weighted Average
- Standard cost / Retail method permitted for convenience
(permitted for convenience if results approximate actual)- LiFo (not permitted by Accounting Standard)
- Retail method is where cost is arrived at by reducing the
gross margin from the sale value to arrive at value of
material consumed
Inventory policies adopted should be disclosed in financial
statements
- policies adopted in measuring inventories including cost
formula
- Total carrying amount of inventories and its classification43
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JSAS 10 Fixed Assets Objective: this standard deals with accounting for fixed assets
under historical cost basis
Fixed Asset: Assets held with the intention of being used for the
purpose of producing or providing goods and service and is notheld for sale in the normal course of business
Component of cost: purchase price, site preparation,
installation cost, professional fees of architects and Engineers,
expense on start-up and commissioning of project including
test runs and experimental production
Self constructed assets: same principle as above, except no
profit can be recognized on the same
Cost of addition or extension to an existing asset is added to
existing asset44
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JSAS 10 Fixed Assets Amount substituted for historical cost:
Value determined by competent appraisers
Increase in value of fixed asset cannot be credited to Profit and
loss account; this amount is credit toR
evaluation reserveshown as part ofNet-worth and not available for distribution as
dividend
Revaluation of assets cannot be done selectively, it must be
undertaken for a whole class of asset within a unit
Gross book value: Historical cost or other amountssubstituted for historical cost in the books of accounts
Disclosure: Gross block, addition and disposal to be shown;
where revalued amount substituted for historical cost and
basis to be shown45
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JSHow will you account forthis transaction?
Your firm purchased a car on Lease finance.
The car is available in the market for Rs.5 lacs
You have entered into a five year lease, paying an
annual rental of Rs.1.5 lacs.
You have the right to buy the car back at the end of
year 5, by paying Rs.10,000
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JSImplicit Interest in Lease rentalCash flows & Implicit interest working
Implicit Interest rate 15.65%
Year Rs. Lacs
Year 0 -5.000 $5.00
Year 1 1.5
Year 2 1.5Year 3 1.5
Year 4 1.5Year 5 + RV 1.6Year Rental Interest Loan rpd Principal
Year 0 -5.000Year 1 1.5000 0.783 0.718 (4.28)Year 2 1.5000 0.670 0.830 (3.45)Year 3 1.5000 0.540 0.960 (2.49)Year 4 1.5000 0.390 1.110 (1.38)Year 5 1.6000 0.216 1.384 0.00
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JSAS 19 Accounting for Leases
Objective: Prescribe accounting for lessee and lessors for
financial and operational lease
Lease: right to use an asset for an agreed period of time for a
payment or a series of payment
Finance lease: where substantially all risk and rewards of the
ownership of asset is transferred to the lessee
Operating lease: other than a financial lease
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JSAS 19 Accounting for Leases Interest rate implicit in lease: discount rate that
equals minimum lease value plus un-guaranteedresidual value to the fair value of the leased assetat the inception of lease
Accounting for financial lease: Lessee should recognize the lease as an asset and
liability, value of asset must equal fair value of heleased asset
Lease payment made should be apportioned
between finance charge and balance towards theliability
Depreciation of the asset should be accounted asper AS 6
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JSAS 19 Accounting for Leases
Accounting forOperating lease:
accounted as expense on a straight line basis
over the lease period or where more representative
over the time pattern of users benefit
Should disclose by way of note the future minimum
lease payment under non-cancelable operating
lease
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JSThe Next Class:Presentation
1. How will you decide if one industry is better than
another? Explain w.r.t. Dupont Ratio Analysis.
2. What is Altmans score? How can a banker use it?
3. Look at the stock exchange pages of ET or Businessline
and explain what the number reported their mean?
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