Session- 11 Accounting for Owners Equity

Objective: To understand the different concepts, components and accounting of Shareholders

fund.

Forms of organizations Sole Proprietorship, Partnership and corporation (company).

Sole Proprietorship is a type of business entity which is owned solely by an Individual and all the
transactions are done by the Individual himself.

Partnership firm is a business entity owned jointly by two or more individuals (partners). Each
Individuals are liable for all the debts of the entity and for other partners business actions.

Corporation (Company) is a legal entity authorized, recognized and governed under laws. There
are two types companys:

Private company, where the shares are held by few individuals and their family member or
investors and the shares are not traded on the securities market. Example: Paytm, Ola, OYO
Rooms etc.,

Public company, where some shares are held by the public and the shares are traded on the
securities market. Example: L&T, ICICI, Infosys etc.,

A Company finances its business in two ways: Debt and Equity.

Debt: Capital borrowed from financial Institutions or lending organizations or Individuals as

credit.

Equity: Capital Invested by Issuing stocks.

Stocks are of two types Common stocks (Equity stocks) and Preferred shares (Additional paid in
capital).

Common stock holders are the owners and have the right to vote and receive dividends on pro
rata basis.

Preferred stock holders have preferred claim to the assets and earnings, they are the investors of
the firm and hence all claims and payments are made to the preferred stock holders before the
common stock holders. They do not hold any right to vote.

Assets = Liabilities + Shareholders Equity, the Shareholders equity has components as

mentioned below

Shareholders fund (Equity) is of two components Contributed capital and Retained Earnings.
 Share Holders
Funds

Retained Earnings
Contributed
Capital (Reserves and
surplus)

Additional paid
Common Stock in Capital (
Preferred stocks)

Figure 1: Components of Shareholders Equity

Authorized stock: Maximum number of shares that are authorized to be issued.

Issued stock: Number of stocks Issued to the stockholders, may not be outstanding shares.

Outstanding stock: Number of companys stocks held by all the shareholders.

Treasury stock: Stocks that are bought back by the company (buyback of shares).

Par value: It is also known as the nominal value or the face value which is the value of the stock
that is mentioned by the Issuer.

Market value: Actual stock price that an Investor pays to purchase or get the stock transferred.

Additional paid in capital: Amount received in excess of the par value, also known as paid-in
capital in excess of par or premium on stock.

Retained Earnings: It is the cumulative net profit of the firm less the total dividends paid since
its inception.

Reserves: It is a part of the Retained earnings kept for the future specific utilization (often
expected losses) of the company.

Dividends: An amount of net profit distributed to its shareholders. They are distributed as
either cash or stocks (its own stock in lieu of cash).

Stock split: Splits the existing no. of stocks in the ratio as prescribed, but has no effect on the
amount of equity held as the par value reduces proportionately.

Example:
 Session- 12 Lease Accounting and Analysis

Objective: To understand how to lease is being accounted in the books of the lessor and the
lessee and different types of leases.

Accounting for leases in India are guided through Accounting Standard 19 (AS 19).

Lease is a contract of right to use an asset (Property or equipment) for a specified period in
exchange of cash payment. The owner is the lessor and the own who takes it on rent is the
lessee.

It can be an Acquisition or on Rental basis and the accounting varies between the lessors or
lessees financial statements.

Lessees Statements

Financial Accounting Standards board (FASB) SFAS, A lease contract that makes the lessee
the owner and transfers all the benefits and risks is called Capital leases and all other leases
are of rental and is Operational leases

Capital lease needs to meet any one of the criterias:

1. Title is transferred to the lessee by the end of the lease term

2. Lease agreement must contain an option of bargain purchase
3. The term of the least must be at least 75% design life of the property
4. The Present minimum lease payment amount is 90% or more of the fair value of the
property

Recorded initially as an asset and a liability by the lessee and the ownership is transferred.

Operational leases, Leases that do not meet the above criterions are often paid as rental. If the
rents are unequal, the rent is considered on the straight-line method.

Examples:

Lessees capital Accounting Examples

1. Purchase of Equipment for $ 5000
Debit: Inventory of Equipment $5000
Credit: Cash $5000

2. Equipment Rented for 5 years under operating lease at $500/ month

Debit: Rental Expense $6000

Credit: Cash $6000
3. For a capital leased Equipment with yearly intallments
Debit: Capital leased Equipment $100000
Credit: Equipment Lease Obligation $100000

Transaction record after yearly Payment

Debit: Interest Expense $XXX
Debit: Equipment Lease Obligation $XX
Credit: Cash $XX +$XXX

Lessors Statements:
Capital Lease is recorded in the asset side as an Investment.
Operating Lease is charged as rentals at frequent intervals neither an asset nor a liability.

1. Lessor gives the Equipment with book value $1000 on Operating Lease of $ 120 per year
with residual value $700 after 3 years.
First the Lessor purchase the Equipment and is in Inventory
Debit Inventory of Equipment $1000
Credit Cash $1000

Debit Leased Equipment $1000

Credit Inventory of Equipment $1000

Lease payment of $120 is received every year

Debit Cash $120

Credit Rental Revenue $120

Depreciation of the Equipment at 10% recorded every year

Debit Leased Equipment Depreciation $100

Credit Accumulated Depreciation $100

References
 Session: 13 Deferred Tax

Objective: To understand and accounting of Deferred Tax Asset and Liabilities Accounts.

Accounting for taxes in India are guided through Accounting Standard 22 (AS 22) and Indian
Income Tax Act 1961.

Deferred Tax arise due to the difference between Tax paid and Actual Tax incurred due to the
difference in Accounting Income and Taxable Income and is the tax effect of timing difference.

It will be an Asset If the difference is positive and a Liability If the it is negative.

The difference between Accounting Income and Taxable Income can be classified in to two:
Permeant difference, where the difference does not reverse automatically and Timing
differences, which can be reversed during the subsequent periods.

Tax Recognition: Tax expense must include the deferred tax and current period tax to find the
net profit or loss for the given period.
Effect of Deferred Tax
Instance Entry
Reporting Tax > Return Tax Credit the Balance
Reporting Tax < Report Tax Debit the Balance

Example: Case of Surfs up and Bug off. Case Referred: HBR 9-191-071

The Equipment bought for $ 1 Million is depreciated in different ways in tax filling and
Accounting, MACRS method and Straight-line method respectively. This leads to deferred tax.

The Income Statement and Deferred Tax calculations of the case are as below.

Pro forma Income Statement of Surfs up All Amounts are in $

1990 1991 1992 1993
For Filing For Filing For Filing For Filing
Tax On Book Tax On Book Tax On Book Tax On Book
Revenue 1500000 1500000 1500000 1500000 1500000 1500000 1500000 1500000
Deprecia
tion 200000 50000 320000 100000 192000 100000 115200 100000
PBT 1300000 1450000 1180000 1400000 1308000 1400000 1384800 1400000
Tax 40% 520000 580000 472000 560000 523200 560000 553920 560000
PAT 780000 870000 708000 840000 784800 840000 830880 840000
 1994 1995 1996 1997
For Filing For Filing For Filing For Filing
Tax On Book Tax On Book Tax On Book Tax On Book
1500000 1500000 1500000 1500000 1500000 1500000 1500000 1500000
115200 100000 57600 100000 0 100000 0 100000
1384800 1400000 1442400 1400000 1500000 1400000 1500000 1400000
553920 560000 576960 560000 600000 560000 600000 560000
830880 840000 865440 840000 900000 840000 900000 840000

1998 1999 2000

For Filing Tax On Book For Filing Tax On Book For Filing Tax On Book
1500000 1500000 1500000 1500000 1500000 1500000
0 100000 0 100000 0 50000
1500000 1400000 1500000 1400000 1500000 1450000
600000 560000 600000 560000 600000 580000
900000 840000 900000 840000 900000 870000

Calculation of deferred tax of Surfs up All Amounts are in $

Tax Reported Tax Return Deferred Tax Cum. Deferred Tax
1990 580000 520000 60000 Cr 60000
1991 560000 472000 88000 Cr 148000
1992 560000 523200 36800 Cr 184800
1993 560000 553920 6080 Cr 190880
1994 560000 553920 6080 Cr 196960
1995 560000 576960 -16960 Dr 180000
1996 560000 600000 -40000 Dr 140000
1997 560000 600000 -40000 Dr 100000
1998 560000 600000 -40000 Dr 60000
1999 560000 600000 -40000 Dr 20000
2000 580000 600000 -20000 Dr 0

In the case of Bug off the Refund Expense of the warranty is reported the next year due to the Tax laws
and hence creates a deferred tax and the pro forma of their Income Statement and deferred tax
calculation is as below.
Pro forma of their Income Statement All Amounts are in $
1990 1991 1992
For Filing Tax On Book For Filing Tax On Book For Filing Tax On Book
Revenue 200,000 200,000 100,000 100,000 100,000 100,000
Material
Expense 50,000 50,000 25,000 25,000 25,000 25,000
Wages
Expense 55,000 55,000 35,000 35,000 35,000 35,000
 Depreciation 5,000 5,000 5,000 5,000 5,000 5,000
Warranty
Expense 12,000 6,000 6,000 12,000 6,000 6,000
Total Expense 122,000 116,000 71,000 77,000 71,000 71,000
PBT 78,000 84,000 29,000 23,000 29,000 29,000

Tax 40% 31,200 33,600 11,600 9,200 11,600 11,600

PAT 46,800 50,400 17,400 13,800 17,400 17,400

Deferred Tax Calculation All Amounts are in $

Tax Reported Tax Return Deferred Tax Cum. Deferred Tax
1990 33,600 31,200 2400 Dr 2400
1991 9200 11600 -2400 Cr 0
1992 11600 11600 0 0

References:
1. Class Notes
2. Harvard Business Review, Taxing Situations: Two cases on Income Tax and Financial
Reporting, Inc. HBR 9-191-071
3. Harvard Business Review, A Brief Note on Deferred Taxes: An Analysis Perspective. HBR
9-107-047
4. Robert N. Anthony, Accounting: Texts and Cases.
 Session 14-15 Preparation and Analysis of Cash Flow Statement
Objective: Preparation and Interpretation of Cash Flow Statement and to understand the
different activities involved in the preparation.
Preparation of Cash Flow Statement are in accordance with Accounting Standard 3 (AS 3) and
has mandated all the organizations to prepare and report the Cash Flow Statement annually.

Cash Flow Statement has the Inflow and outflow of all Cash and Cash Equivalent transactions
and is classified into 3 activities: Operating, Investing and Financing Activities. It does not follow
the basis of accrual.

Operating Activities Investing Activities Financing Activities

Receipts form Sales or Purchase and Sale of Rasing funds by Issuing

Service rendered, fees, Assets adn other shares, bonds, loans
commissions and Investments and debentures.
premium charged.

Payments for salary, Dividends received Interest paid on

raw material, Interest, advances and dividends
Tax. paid.

Operating Activities are recorded using two methods Direct Method and Indirect Method.

Direct Method
Reports the major sources of cash Inflow and outflow
Cash Inflows are added and the payments are subtracted
Is not used often but is preferred by the FASB
Indirect method
Adjusts the Net Income with the non-cash or non-cash equivalents (Depreciation,
profit/loss made due to sale/purchase of asset)

Example: Case of Chemalite, Inc. (B) Case Reference: HBR 9-495-130

Bennette Alexander, founder of Chemalite, Inc. wondered where the cash was coming and
where it was going , since there was a question of concern to know whether the short term
debt is really required.
The Cash Flow Statement of Chemalite, Inc. has been prepare using Indirect method and is as
below.
 Cash Flow Statement of Chemalite, Inc. for 1992 using Indirect method

1 Operating Cash Flow

Net Income $ 118,995.00
Depreciation and Amortization $ 86,625.00
Deferred Tax $ 26,730.00
Accounts Receivable $ (70,030.00)
Raw Materials Inventory $ (20,450.00)
Finished Goods Inventory $ (104,680.00)
Depreciation of Inventory $ 5,000.00
Prepaid Insurance $ (65,000.00)
Decrease in Taxes Payable $ (950.00)
Gain on Sale of Machines $ (24,250.00)
Net Cash Flow from Operation Activities $ (48,010.00)

2 Investing Cash Flow

Sale Of Old Machines $ 215,500.00
Purchase of New Machines $ (520,000.00)
Purchase of New Production Facility $ (425,000.00)
Net Cash Flow from Investing Activities $ (729,500.00)

3 Financial Cash Flow

Long term debts $ 510,000.00
Short term debts $ 200,000.00
Purchase of Treasury Stocks $ (26,000.00)
Dividends Paid $ (10,000.00)
Net Cash Flow from Financing Activities $ 674,000.00

Opening Cash Balance $ 113,000.00

Net Cash Flow $ (103,510.00)
Closing Cash Balance $ 9,490.00
References:
1. Class Notes
2. Harvard Business Review, Chemalite, Inc. HBR 9-495-130
3. Harvard Business Review, A Brief Note on Deferred Taxes: An Analysis Perspective HBR
9-107-047
4. Accountancy: Company Accounts and Analysis of Financial Statements, Chapter 6 Cash
Flow Statement
5. Robert N. Anthony, Accounting: Texts and Cases.
 Session 18-19 Financial Statement Analysis
The Financial Statements consists of the Balance Sheet, Income Statement and the Cash Flow
Statement.
It is Important to learn how to analyze the Financial Statements to review the existing
condition of the firm, Identify and Implement necessary actions to boost the growth.
No Single Ratio can tell everything about a firm and hence there are set of ratios to be
Identified and Analyzed. They are broadly classified into three categories Profitability, Solvency
and Liquidity Ratios

Profitability Ratios Solvency Ratios Liquidity Ratios

Receipts form Sales or Debt- Equity Ratio Rasing funds by Issuing

Service rendered, fees,
commissions and
premium charged.
Payments for salary,
raw material, Interest,
Tax.
Debt to Asset Ratio shares, bonds, loans
Times Interest Earned and debentures.
or Interest coverage
Ratio
Capital Gearing Ratio Interest paid on
advances and dividends
paid.

1. =

2. =

3. =
+
4. =

Du Pont Analysis is a method to assess the Return of Equity of a company splitting it into 3
sections: Net Profit Margin, Asset Turnover and Equity Multiplier, which gives us the Operating
Efficiency, Asset use efficiency and Financial Leverage of the firm respectively.
=
 Asset
Trun Over
Net Profit Financial
Margin Leverage

Dupont
Analysis