GAAP Dr Manish Dadhich Topics Definition of GAAP

GAAP Dr. Manish Dadhich

Topics • Definition of GAAP • Why GAAP is Important? • Similarities & Differences between Indian GAAP, IFRS and US GAAP - Financial Statements - Revenue Recognition - Foreign Currency Translation

Definition • GAAP is the abbreviation of Generally Accepted Accounting Principle. • GAAP are the common set of accounting principles, standards and procedures that companies use to compile their financial statements. • GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.

Related Information • In India, GAAP standards are set by the Institute of Chartered Accountants of India (ICAI). ICAI continually updates GAAP as new accounting issues and concerns arise. • In USA, GAAP standard are set by Financial Accounting Standards Board (FASB). • Outside the US, the equivalent of GAAP is IAS - International Accounting Standards - which is maintained by the International Accounting Standards Board (IASB). • Financial statements submitted to the SEBI by publicly traded companies are required to meet GAAP standards.

Why GAAP? • GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. • GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. • Companies are expected to follow GAAP rules when reporting their financial data via financial statements. • If a financial statement is not prepared using GAAP principles, be very wary!

Important points • When comparing financial statements from different years, it is important to note any changes in GAAP over the intervening period. • Since GAAP is only a set of guidelines, it cannot guarantee financial statements are not fraudulent. So, even when a company uses GAAP, we still need to scrutinize its financial statements. • If company management provides the auditing firm with incorrect data, the resulting financial statements may be GAAP compliant yet still incorrect.

Contents of GAAP • ACCOUNTING FRAMEWORK • FINANCIAL STATEMENTS • CONSOLIDATED FINAL STATEMENTS • OTHER ACCOUNTING & REPORTING TOPICS -FOREIGN CURRENCY TRANSLATION -EARNING PER SHARE -RELATED-PARTY TRANSACTION • BUSINESS COMBINATIONS -SEGMENT REPORTING • REVENUE RECOGNITION -DISCONTINUED OPERATIONS • EXPENSE RECOGNITION -POST BALANCE SHEET EVENTS • ASSETS • LIABILITIES • EQUITY • DERIVATIVES & HEDGING -INTERIM REPORTING

Similarities & Differences between Indian GAAP, US GAAP & IFRS

Financial Statements

General Requirements • Compliance Indian company should comply with Indian GAAP, the Companies Act and Industry specific regulatory requirements. Additionally listed companies should comply with the rules and regulations and financial interpretations of SEBI. The law requires entities to disclose whether the financial statements comply with applicable accounting standards and to give details of non compliances. There is a presumption that compliance with accounting standards is necessary to give a “ True and Fair View”.

General Requirements contd. . • Comparatives: One year of comparatives is required for all numerical information in the financial statements with limited exceptions and disclosures. • Preparation and Presentation: Financial Statements are presented on a single entity parent company (stand alone) basis. It is not mandatory to prepare consolidated financial statements but must use the consolidation standards if prepared. Pursuant to the listing agreements with stock exchanges, Public listed companies present consolidated financial statements along with standalone financial statements.

Components of Financial Statements Components Indian GAAP US GAAP IFRS Balance Sheet Required Income Statements Required Statement of changes in shareholder’s equity Required Fund flow Statement Required Accounting Policy Required Notes to the Financial Statements Required

Balance Sheet • INDIAN GAAP: Accounting Standard do not prescribe any format of balance sheet. The Companies Act prescribes a format and requires presentation of the following items on the face of balance sheet: Sources of Funds: - Share Capital, Reserves and Surplus, Secured Loans, Unsecured Loans, Minority Interest. Application of Funds: - Fixed assets, Investments, Current Assets, Loans and Advances (Inventories, Sundry debtors, Cash and Bank balances, Other Current Assets) less Current Liabilities and Provisions, Miscellaneous expenditure. • US GAAP: Presented as total assets balancing to total liabilities and shareholder’s equity. Items are presented in decreasing order of liquidity. Public entities should follow specific SEC guidance.

Balance Sheet contd. . • IFRS: Current and non-current assets, and current and non-current liabilities are to be presented separately except when a liquidity presentation provides more relevant and reliable information. Assets: PPE, investment property, intangible assets, financial assets, investment accounted for using equity method, biological assets, inventories, trade and other receivables, tax assets, and cash equivalents. Equity and liabilities: issued share capital and other components of shareholder’s equity, financial liabilities, provisions, tax liabilities, trade and other payables, and minority interests (presented within equity).

Income Statement • INDIAN GAAP: Accounting standards and the Companies Act prescribe disclosure norms for certain income and expenditure items. Expenses are presented by either function or nature. Other industry regulations prescribe industryspecific format of income statement. • US GAAP: Presented either as A single-step format where all expenses are classified by function and are deducted from total income to give income before tax : or A multi-step format where cost of sales is deducted from sales to show gross profit, and other income and expenses are then presented to give income before tax.

Income Statement contd. . • IFRS: Expenses presented by either function or nature. Portion of profit and loss attributable to the minority interest and to the parent entity is separately disclosed. Disclosure of expenses by nature is required in footnotes if functional presentation is used on income statement. Items presented are revenue, finance costs, share of after-tax results of associates and joint ventures accounted for using equity method, tax expenses, post-tax gain or loss attributable to the results and remeasurement of discontinued operations and net profit or loss for the period.

Statement of changes in Shareholder’s Equity • INDIAN GAAP: No separate statement is required. Changes in shareholder’s equity are disclosed in separate schedules of ‘Share capital’ and ‘Reserves and surplus’ • US GAAP: Same to IFRS, except that US GAAP does not have a Statement of Recognized Income and Expense (So. RIE), and SEC rules require further disclosure of certain items in notes. • IFRS: It is presented as a primary statement unless a So. RIE is presented. Supplemental equity information is presented in notes when So. RIE is presented. It should show capital transactions with owners, the movement in accumulated profit and a reconciliation of all other components of equity. Certain items are permitted to be disclosed in notes rather than in primary statement.

Fund Flow Statement • INDIAN GAAP : Inflow & outflow of ”cash & Cash equivalent” are reported in fund flow statement. It can be prepared by two ways: Direct or indirect method. Direct method (Cash flow is derived from aggregating cash receipts & payments associated with operating activities) , Indirect method (Cash flow is derived from adjusting net income from transaction of non cash in nature such as depreciation ). However only indirect method is prescribed for listed enterprises & direct for insurance companies. It is required for all enterprises whose turnover exceeds Rs 500 Million or having borrowing over Rs. 100 million at any point of time during accounting period.

Fund Flow Statement contd. . • US GAAP : Cash flow statement provides relevant information about “cash receipts & cash payments”. A reconciliation of net income to cash flows from operating activities is disclosed. There are limited exemption for certain investment entities. • IFRS : It is similar to Indian GAAP. However, Indirect is more common in IFRS. The cash flow from operating, investing & financing activities are classified separately.

Accounting Policy • INDIAN GAAP : The cumulative amount of change is recognized & disclosed in the income statement in the period of change. Certain new standards require adjustment of the cumulative amount of the change for opening retained earnings. Impact of change in depreciation method is determined under the new method & is recorded in the period of change, whereas on revision of asset life, the unamortized depreciable amount is charged over the revised remaining life. • US GAAP : The cumulative amount of change is recognized & changed in the income statement of period of change. Retrospective adjustment are required in some of the cases like : method of accounting for inventory valuation, depreciation in rail industry , construction contracts & adoption of full cost method in extractive industry.

Accounting Policy contd. . • IFRS : Comparative information is restated, & the amount of the readjustment relating to prior period is adjusted against the opening balance of retained earnings of the earlier year presented. Policy changes made by adoption of new standard are accounted for in accordance with standard Transition provisions. For correction of errors & accounting estimates accounting policy method & income statement are required.

References for Details. . • INDIAN GAAP : Companies Act, AS 1, AS 3, AS 5, AS 6, AS 10, AS 11 • US GAAP : CON 1 -, FAS 16, FAS 52, FAS 95, FAS 130, FAS 141, FAS 154, APB 20, APB 29, APB 30, ARB 43, SEC Regulation S-X, FIN 39 • IFRS : IAS 1, IAS 7, IAS 8, IAS 19, IAS 21, IAS 29, IAS 32, SIC 30

Revenue Recognition

Definition of Revenue Gross inflow of consideration ( Cash / receivables / others ) arising in the course of ordinary activities from • Sale of Goods • Rendering of Services • Use of enterprise resources yielding interest, royalties and dividends.

Definition contd. . Consideration: • Flow of economic benefits • Inflows resulting in an increase in equity (Other than increase through the contribution from equity holders) Ordinary Activities: • Activities undertaken as part of business • Related activities engaged in - Furtherance of - Incidental to - Arising from these activities.

Criteria for Revenue Recognition CONDITION Can the revenue be recognized TIMING When will we record revenues? MEASUREMENT How much will we record? CRITERIA FOR REVENUE RECOGNITION

Criteria for Revenue Recognition : Goods Property in goods transferred to buyer for a price Or All significant risks and rewards of ownership transferred to buyer & seller retains no effective control over goods No significant uncertainty regarding consideration PERFORMANCE UNCERTAINTY

Criteria for Revenue Recognition : Services RECOGNITION OF REVENUE INCOME COMPLETED SERVICE METHOD Recognize revenue when the sole or final act takes place and the service becomes chargeable PROPORTIONATE SERVICE METHOD Recognize revenue by reference to performance of each act – on the basis of contract value / associate cost / no. of acts No Uncertainty

Service Income - Examples • Advertising (Media/Production) commissions: - Upon completion of service • Insurance agency commissions: - On effective commencement of renewal dates of the related policies • Installation fees: - When equipment is installed and accepted by customers. • Financial service commissions: - Driven by i) nature of service ii) incidence of costs related to service iii) when the payment of the service will be received

Criteria for Revenue Recognition : Others • Interest: - Time proportion basis taking into account a) Amount outstanding b) Rate applicable • Royalties: - Accrual basis in accordance with terms of agreement • Dividends: - When owner’s right to receive payment is established

Uncertainties in Revenue Recognition • Measurability: - Consideration should be reasonably determinable - If not determinable then postpone • Collectibility: - Ability to asses ultimate collection - With reasonable certainty at time of collection - But not if uncertainty arises after sale • Disclosure: - Of circumstances under which revenue recognition is postponed

International Financial Reporting Standards (IFRS) • Significant risks and rewards of ownership transferred • Seller retains neither continuing managerial involvement usually associated with ownership nor effective control • The amount of revenue can be measured • Likely that economic benefits of transaction will flow to the seller • The cost incurred or to be incurred in respect of the transaction can be measured reliably

US GAAP • Persuasive evidence of an arrangement exists • Delivery has occurred • Fee is fixed or determinable • Collectibility is reasonably assured

Alternate Standards: A Comparison Indian GAAP / IFRS US GAAP Probable that economic benefit will flow to entity Collectibity is reasonably assured Revenue and costs (including future costs) can be measured reliably Vendor’s price is fixed or determinable Seller retains neither management Delivery has occurred or services nor control, and transfer of have been rendered risks and rewards of ownership to buyer Stage of completion of transaction Vendor’s price fixed or can be measured determinable

Commonalities and differences Examples • Warranty and Product maintenance contracts: - When price includes a component for subsequent servicing, the latter is deferred and recognized over the warranty period • Software Revenue Recognition: - IFRS/Indian GAAP: No guidelines. Usually by the stage of completion - US GAAP: Value for element based on Vendor Specific Objective Evidence (VSOE). Revenue recognized as element is delivered • Barter Transactions (Advertising): - IFRS/Indian GAAP: At fair value of goods/services received or given - US GAAP: Similar non barter deals of the entity in past six months

Key Issues • Risk factor which influence • Indicators of Potential improper Revenue Recognition: Accounting Misstatements: - Management characteristics and influence over the control environment - Absence of an agreement - Industry condition - Lack of delivery - Operating characteristics and financial stability - Incomplete earning process misstatements - Lack of Internal controls/audit

CIF vs. FOB Sales • Cost, Insurance and Freight ( CIF ): • Free on Board ( FOB ): - Sale price includes cost, insurance and freight - Sale price does not include any insurance or freight - Paid by the seller - All insurance, freight etc. would be borne by the buyer - Transfer of ownership takes place on receipt of goods by the buyer - Recognize revenue on receipt of bill of lading /acknowledged lorry receipt - Recognize revenues at the time of dispatch

References for Details. . • INDIAN GAAP : AS 7 (REVISED 2002), AS 9 • US GAAP : CON 5, SAB 104, SOP 81 -1, SOP 97 -2, EITF 99 -17, EITF 00 -21, FTB 90 -1 • IFRS : IAS 11, IAS 18

Foreign Currency Translation

Functional Currency • INDIAN GAAP: Does not define or require determination of functional currency. Assumes an entity normally uses the currency of the country in which it is domiciled in recording its transaction. • US GAAP: Emphasizes the primary economic environment in determining an entity’s functional currency. It has no hierarchy of indicators. There is greater focus on the cash flows rather than the currency that influences the pricing. • IFRS: Currency of the primary economic environment in which entity operates. Management should use judgment to determine functional currency if indicators are not obvious.

TRANSLATION – The Individual Entity • INDIAN GAAP, US GAAP & IFRS have similar requirements regarding the translation of transactions by an individual entity, as follows: - Translation is at exchange rate in operation on date of transaction. - Monetary assets and liabilities denominated in foreign currency are translated at the closing rate. - Non-monetary foreign currency assets and liabilities are translated at the appropriate historical rate.

TRANSLATION – The Individual Entity contd. . - Non-monetary items denominated in a foreign currency and carried at fair value are reported using the exchange rate that existed when the fair value was determined - Income statement accounts are translated using historical rates of exchange at the date of transaction or an average rate as a practical alternative, provided the exchange rate does not fluctuate significantly. - Exchange gains and losses arising from an entity’s own foreign currency transaction are reported as part of the profit or loss for the year.

TRANSLATION – Consolidated Financial Statements When translating financial statements into a different presentation currency IFRS, US GAAP and INDIAN GAAP require the assets and liabilities to be translated using the closing rate. Amounts in the income statements are translated using the average rate for the accounting period if the exchange rates do not fluctuate significantly. IFRS and INDIAN GAAP are silent on the translation of equity accounts historical rates are used under US GAAP.

Tracking of Translation Differences in Equity • INDIAN GAAP: Translation differences in equity are separately tracked and the cumulative amounts disclosed. The appropriate amount of cumulative translation difference relating to the entity is transferred to the income statement on disposal of a foreign operation and included in the gain or loss on sale. The cumulative translation difference may be released through income statement, for a partial disposal on a pro rata basis relative to the portion disposed. The proportionate share of the related cumulative translation difference is included in the gain or loss. The payment of dividend out of pre-acquisition profits constitutes a return of the investment and is regarded as a partial disposal.

Tracking of Translation Differences in Equity contd. . • US GAAP: Similar to Indian GAAP, however, gains and losses are transferred to the income statement only upon sale or complete or substantially complete liquidation of the investment. • IFRS: Similar to Indian GAAP.

Presentation Currency • INDIAN GAAP: It assumes an entity normally uses the currency of the country in which it is domiciled in presenting its financial statements. If a different currency is used, requires disclosure of the reason for using a different currency. • IFRS: Assets and liabilities are translated at the exchange rate at the balance sheet date when financial statements are presented in a currency other than the functional currency. Income statement items are translated ate the exchange rate at the date of the transaction or are permitted to use average rates if the exchange rates do not fluctuate significantly. • US GAAP: Similar to IFRS; historical rates are used in equity.

Foreign Currency Translation – Hyperinflationary Economy • INDIAN GAAP: No specific guidance foreign currency translation • IFRS: Hyperinflation is indicated by characteristic of the economic environment of a country. These characteristic include a) general population’s attitude towards local currency b) prices linked to a price index c) cumulative inflation rate over three years is approaching or exceeds 100% • US GAAP: Similar to IFRS

Functional Currency Translation – Hyperinflationary Economy • INDIAN GAAP: No specific guidance for functional currency translation • IFRS: Functional currency use that currency for measurement of transactions. Financial statement for current & prior period are remeasured at the measurement unit current at the balance sheet date in order to present current purchasing power • US GAAP: Does not generally permit inflation - adjusted financial statements. The use of reporting currency ( US dollar ) as the functional currency is required

Presentation Currency Translation – Hyperinflationary Economy • INDIAN GAAP: No specific guidance for presentation currency translation • IFRS: Results & financial position of those entities whose functional currency is the currency of a hyper inflationary economy are translated into a different presentation currency using following procedure: - All item including comparatives are translated at the date of most recent balance sheet - When amount are translated into currency of a non inflationary economy, comparative amounts are those that were presented as current year amounts in the relevant prior - year financial statement • US GAAP: Not applicable, because the currency of a hyperinflationary economy is not used for measuring its transactions in the hyperinflationary economy

References for Details. . • INDIAN GAAP : AS 11 (REVISED 2003) • US GAAP : FAS 52, FIN 37 • IFRS : Framework, IAS 21, IAS 29

References 1) Http: //www. icai 2) Similarities & Differences : A comparison of IFRS, US GAAP and INDIAN GAAP – by Price Water House Coopers: November 2006

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