Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand thisRead more
Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand this concept in detail.
What is Creative accounting?
Creative accounting is a method of accounting in which the management manipulates the books of accounts by finding loopholes to showcase a better image of the business.
It is a practice of using accounting loopholes to make a company’s financial position look better than it really is. It is not exactly illegal but it is more of a gray area.
For example, a business may delay reporting expenses to increase the profits to present a better short-term position.
The goal of creative accounting is to impress the shareholders, investors, get loans or boost stock prices.
However, this can also be very risky and have serious consequences. It can reduce the trust of the investors and customers. In some cases, like Enron and WorldCom the world has seen how creative accounting lead to legal consequences.
Common Techniques of Creative Accounting
Some of the common techniques used by the business to manipulate the financial position are as follows:
Revenue Recognition: Techniques such as recognizing revenue before it is actually earned is a method of creative accounting.
Expense manipulation: Delaying the recognition of expenses to show a better position of the business in a short-term.
Undervaluing liabilities: Undervaluing the liabilities of the business by not recognizing any future costs such as insurance or warranty etc.
Asset Valuation: Overstating the value of asses or high amount of depreciation can be some ways of manipulating the value of assets.
Tax avoidance: This is a way of reducing the tax liability by manipulating the financial statements to lower the profits.
Cookie jar accounting: This is a method in which profits in the good years are saved in excess to use in the years of difficulty.
Ethical implications of Creative Accounting
There are several ethical implications with respect to creative accounting. Some of these are discussed below:
Misleading Stakeholders: Creative accounting is a method to mislead the stakeholders including the investors, creditors, government, etc. This can lead to loss of trust.
Loss of trust: The shareholders will lose trust over the company if the manipulation is discovered. Creative accounting breaches the fundamental of honesty.
Non – compliance: Creative accounting leads to the non-compliance of the rules and regulations of the country which requires the businesses to follow certain accounting and reporting standards.
Unfair competition: Creative accounting can make a company look more profitable and stable than it actually is, misleading investors and customers. This can leave honest businesses, who follow the rules, at a disadvantage.
Moral responsibility: Management and business has the moral responsibility of working in the best interest of the society and the stakeholders.
Conclusion
The key takeaways from the above discussion are as follows:
Creative accounting is the practice of using accounting loopholes to make a company’s financial position look better than it really is.
The goal of creative accounting is to impress the shareholders, and investors, get loans, or boost stock prices.
Revenue recognition, expense manipulation, and asset valuation are some of the common techniques of Creative accounting.
The ethical implications of creative accounting include misleading stakeholders, eroding trust, compromising regulatory compliance, promoting unfair competition, neglecting moral responsibility, etc.
Assets can be classified as Financial or Non-financial assets. One might wonder why this is necessary. Let us dive into this concept, beginning with understanding what financial and non-financial assets are and why they are classified as such. What are Assets? Assets are things that have a monetaryRead more
Assets can be classified as Financial or Non-financial assets. One might wonder why this is necessary. Let us dive into this concept, beginning with understanding what financial and non-financial assets are and why they are classified as such.
What are Assets?
Assets are things that have a monetary value and are beneficial for a business. Assets are commonly classified as tangible, intangible, current, fixed, financial, non-financial, etc.
Plant and machinery, land, buildings, cash, bank balance, patents, etc are some of the examples of assets that a business has.
What are Financial Assets?
Financial assets are the things of value that are held by a person for their underlying value. They are intangible and do not have a physical form. For example – Stocks, bonds, debentures, options, futures, etc.
The value of these assets may change over time depending upon the market conditions, changes in government policies, fluctuations in interest rates, etc.
In comparison to non-financial or physical assets, financial assets are more liquid as they can be traded and can be converted into cash.
What are Non-financial assets?
Non-financial assets are tangible or intangible assets that have a value but cannot be easily converted into cash. They are not as liquid and generally not traded.
Examples of such assets are buildings, plant and machinery, patents, trademarks, etc.
Difference between Financial and Non – Financial Asset
From the above discussion, it is clear that financial and non-financial assets are very different. The following are several important reasons why it is important to segregate the same:
It helps in the proper classification of assets on the Financial Statements.
The terms outstanding expenses and accrued expenses are two accounting terms which are often used interchangeably. However, these two terms are not the same and have different meanings. The difference between these two terms is given below: What are Outstanding expenses? As the name suggests, outstaRead more
The terms outstanding expenses and accrued expenses are two accounting terms which are often used interchangeably. However, these two terms are not the same and have different meanings. The difference between these two terms is given below:
What are Outstanding expenses?
As the name suggests, outstanding expenses are the expenses that are due but have not been paid yet. It means that the business is supposed to pay the amount due but it has not paid the same at the end of the accounting period.
Outstanding expenses are recognized as a current liability because the business is liable to pay such expenses. These expenses are recorded in the books of accounts but the payment is still pending.
Some examples of outstanding expenses are:
The electricity bill is due for the month of January but has not yet been paid on 31st January.
Salaries of employees of 50,000 is due for the month of March but have not been paid yet by the business.
What are Accrued expenses?
Accrued expenses are the expenses that a business has incurred during the accounting period but they have not yet been recorded in the books of accounts because the bill has not yet been received or the payment is not due yet.
The concept of Accrued expenses helps in complying with the accrual basis of accounting which says that the expense shall be recognised at the time it occurs regardless of the fact that payment is received or not.
Examples of accrued expenses are:
The electricity bill for December is received in the month of January. However, it shall be recognised as an expense in the month of December.
The salaries of the employees for the month of April are paid in May. However, this expense shall be recognized in April.
Key differences between outstanding expenses and accrued expenses
To summarise the above discussion, the key differences between outstanding expenses and accrued expenses are given in the table below:
To understand the difference in Revenue recognition under IFRS and GAAP , it is important to understand what are IFRS and GAAP. Both of these are accounting standards accepted globally. These are discussed below: What is IFRS? IFRS is a set of accounting standards developed by the International AccRead more
To understand the difference in Revenue recognition under IFRS and GAAP , it is important to understand what are IFRS and GAAP. Both of these are accounting standards accepted globally. These are discussed below:
What is IFRS?
IFRS is a set of accounting standards developed by the International Accounting Standards Board. These standards are globally accepted accounting standards.
They were developed and implemented with the objective of providing a consistent, transparent and reliable framework for the presentation and reporting of financial statements.
IFRS ensure uniformity and this helps in comparability of financial statements across the companies of different countries.
Some examples of IFRS Standards are : IFRS 2 – Share based payments, IFRS 9 – Financial Instruments, IFRS 16 – Leases, etc.
What is GAAP?
GAAP stands for Generally Accepted Accounting Principles. GAAP is primarily used in the USA. These are a set of accounting principles, rules and procedures which are crucial for providing consistency and transparency in the presentation and reporting of financial statements.
Some examples of GAAP Standards are: ASC 606: Revenue Recognition, ASC 842: Leases, ASC 740: Income Taxes, etc.
Difference in Revenue Recognition under IFRS and GAAP
Though both of these standards have the main goal of promoting consistency and uniformity, there are certain differences in the Revenue Recognition under IFRS and GAAP.
This is because of the fact that the nature of IFRS and GAAP is different as IFRS is more principle- based and GAAP is rule based.
Revenue and income are two accounting terms that are often used interchangeably. However, it is important to understand that these two terms are different. Let us know the difference between the two through the discussion below: What is Revenue? Revenue is the total amount of a business's sales. ItRead more
Revenue and income are two accounting terms that are often used interchangeably. However, it is important to understand that these two terms are different. Let us know the difference between the two through the discussion below:
What is Revenue?
Revenue is the total amount of a business’s sales. It is the total amount earned by a business before deducting any expenses. Revenue is recognized in accounting as soon as a sale happens, even if the payment hasn’t been received yet.
For example, XYZ Ltd sold 100 pens at a selling price of 10 per pen. The total revenue of the business is hence 1,000.
What is Income?
Income is the amount earned by a business after deducting any direct or indirect expenses. It is the amount that
What is Inventory? Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers. What is the Inventory Turnover Ratio? Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventoryRead more
What is Inventory?
Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers.
What is the Inventory Turnover Ratio?
Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventory. It shows how well a business manages its inventory.
Inventory Turnover ratio is calculated as follows:
Inventory Turnover Ratio = Cost of goods sold / Average Inventory
where Average Inventory = (Inventory at the beginning of the year + Inventory at the end of the year) / 2
If inventory turnover is high, it means products are selling quickly. But if it’s too high, the company might not have enough stock, leading to fewer sales.
If turnover is low, there are slow sales or too much stock. That can lead to higher storage costs and obsolete products. It is important to find the right balance between the two.
Why is the Cost of Goods Sold taken as a numerator instead of revenue while calculating the Inventory Turnover Ratio?
The cost of goods sold is the sum of all the direct costs involved in the production of goods. On the other hand, Revenue is the total amount of money earned through the sale of goods and services.
The cost of goods sold (COGS) includes materials, labor, and overhead costs. Inventory consists of these costs and hence, it is better to take (COGS) as the numerator.
Revenue, however, considers things like markups, discounts, and other adjustments that don’t directly relate to the actual cost of inventory.
Let us understand it better with the help of an example:
Suppose the opening inventory is 20,000 and the closing inventory is 10,000. Average inventory can be calculated as (20,000 + 10,000)/2 = 15,000.
If the cost of goods sold is 45,000 the Inventory turnover ratio comes out to be 45,000/15,000 = 3.
On the other hand, if the revenue of 60,000 is taken as the numerator, the Inventory turnover ratio comes out to be 60,000/15,000 = 4
A high inventory turnover ratio shows that the inventory is moving faster than it is which is misleading for the stakeholders.
Hence, the Cost of goods sold is taken as the numerator for the calculation of the Inventory turnover ratio.
Every business requires research and development to create innovative products for consumers. More innovative and creative products and services are more popular among customers, leading to increased revenue and profits for the business. Creating new products or designing changes and testing existinRead more
Every business requires research and development to create innovative products for consumers. More innovative and creative products and services are more popular among customers, leading to increased revenue and profits for the business.
Creating new products or designing changes and testing existing products also forms a part of research and development.
Examples of Research and Development costs are –
Salaries of employees
Cost of making prototypes
Cost of raw material
Overhead expenses
Let us now understand how research and development costs are treated in Financial Statements.
Research and Development Costs are generally shown as an expense in the Income Statement.
IAS-38
IAS-38 majorly governs the accounting of research and development costs. There are two phases in R&D:
Research: During this phase, costs are incurred for understanding or designing the product. These costs are expensed as incurred costs as there is an uncertainty of a future benefit.
Development: Economic value can be ascertained during this phase and hence, the costs incurred can be capitalized as Intangible assets. To be recognised as intangible assets, the following conditions shall be satisfied:
1. it is developed with the intention of putting it to use in the future
2. the asset shall hold an economic value
3. the costs can be measured reliably
Treatment of R&D costs in the Financial statements:
Income statement: Research costs are shown as expenses in the income statement. However, development costs if capitalized as intangible assets can be amortised over time.
Balance Sheet: Capitalised development costs are shown as intangible assets under the Assets head of the Balance Sheet.
Conclusion
The above discussion can be summarised as follows:
Research and development is essential for creating innovative and creative products and services.
Accounting standard IAS-38 governs the accounting for Research and Development.
Research costs are usually shown as an expense in the Income statement of the business.
Development costs when capitalised can be shown as Intangible assets in the Balance Sheet.
To understand the accounting treatment of fixed assets under IFRS let us first understand what fixed assets are. What are Fixed Assets? Fixed assets are the assets that are purchased for long-term use by a business and not for resale. Some examples of fixed assets are land, buildings, machinery, furRead more
To understand the accounting treatment of fixed assets under IFRS let us first understand what fixed assets are.
What are Fixed Assets?
Fixed assets are the assets that are purchased for long-term use by a business and not for resale. Some examples of fixed assets are land, buildings, machinery, furniture and fixtures, etc.
Fixed assets are essential for the smooth operations of the business. It often shows the value of the business. The value of fixed assets usually decreases with time, obsolescence, damage, etc.
As per IAS-16 Property, Plant and Equipment, an asset is identified as a fixed asset if it satisfies the following conditions:
the future economic benefits associated with the asset will probably flow to the entity, and
the cost of the asset can be measured reliably.
What is IFRS?
IFRS stands for International Financial Reporting Standards. It provides a set of standards to be followed globally by all companies to ensure transparency, comparability, and consistency.
What is the accounting treatment of fixed assets under IFRS?
Under IFRS, the first step is to measure the value of the fixed assets on cost. The cost of the fixed assets includes the following:
purchase price
any direct cost related to the asset (such as transportation, installation, etc.)
duties/taxes
After this step, the entity may choose any one of the following two primary methods:
Cost Model: According to this model the value is first recognized on a cost basis. This includes the purchase price and direct costs attributable to the asset. Subsequently, depreciation is calculated on the cost of the asset. Depreciation spreads the cost of an asset over its useful life. Impairment checks are conducted to ensure the asset’s value on the books doesn’t exceed what it’s worth.
For example, a company bought a piece of machinery for 60,000. 5,000 were spent on its installation. It has a useful life of 10 years. The machinery would be depreciated over its useful life of 10 years based on its cost which is 65,000.
2. Revaluation model: As per this model, the fixed assets are valued on their fair value, as on the revaluation date. The amount of depreciation and impairment losses is subtracted from the fair value.
If the value of an asset increases, the gain goes to equity (revaluation surplus) unless it can be set off with a past loss recorded in profit or loss.
On the other hand, if the value decreases, the loss goes to profit or loss unless it offsets a past surplus in equity.
For example, a building was purchased for 100,000. On the revaluation date, the fair value of this building was 150,000. Hence, there is a revaluation surplus of 50,000 which shall be credited to the revaluation surplus account.
Impact on Financial Statements
Fixed assets are shown on the Assets side of the Balance Sheet.
Conclusion
From the above discussion, it may be concluded that:
Fixed assets are the assets that are purchased for long-term use by a business and not for resale.
Some examples of fixed assets are land, buildings, machinery, furniture and fixtures, etc.
IFRS provides a set of standards to be followed globally by all companies to ensure transparency, comparability, and consistency.
Under IFRS, the first step is to measure the value of the fixed assets on cost.
After this step, the entity may choose any one of the two primary methods which are cost model and the revaluation model.
Fixed assets are shown on the Assets side of the Balance Sheet.
To understand why we do not record self-generated goodwill in accounting, let us first understand what goodwill is and its accounting treatment. What is Goodwill? Goodwill is an intangible asset of a business. It represents the reputation and brand value of a business built over time. It is a valueRead more
To understand why we do not record self-generated goodwill in accounting, let us first understand what goodwill is and its accounting treatment.
What is Goodwill?
Goodwill is an intangible asset of a business. It represents the reputation and brand value of a business built over time. It is a value over and above the tangible assets of the business.
Goodwill often arises when a business purchases another business and pays a premium, which means a price higher than the fair value of the business.
Characteristics of Goodwill
Goodwill has the following characteristics:
It is an Intangible asset, meaning it has no physical existence and cannot be seen or touched.
It is generally recognized during transactions in mergers and acquisitions.
It is the value attributed to the brand value and reputation of the business.
It adds value to a business beyond its tangible assets.
Example of Goodwill
Let us take an example to understand the concept of goodwill better.
Suppose there is a company ABC Ltd. It is planning to acquire XYZ Ltd. The fair value of the assets of XYZ is calculated to be 600,000. However, ABC has agreed to pay a sum of 650,000 to acquire the company. This difference of 50,000 is goodwill.
Impact on Financial Statements
Goodwill is shown under the assets side of the Balance Sheet.
What is self-generated goodwill?
Self-generated goodwill in simple words means the positive reputation or trust that a business earns over time through their own hard work and decisions. It’s not something bought or inherited but something built from scratch internally, like a brand’s reputation, loyal customers, strong relationships, or unique ideas.
For example, a small business that goes the extra mile to offer great customer service or always delivers high-quality products over the years will naturally build goodwill.
It is also known as internally generated goodwill.
Why do we not record sef-generated goodwill?
Self-generated goodwill is not recorded in the financial statements because of the following reasons:
Measurement may not be reliable: The measurement of self-generated goodwill is majorly based on the judgment of the managers. It is based on the value creation because of a good reputation or consumer base of the business, which might not be measured accurately.
Conservatism principle: As per the conservatism principle, a business shall not overstate its assets or liabilities. However, self-generated goodwill might be overstated.
Lack of market transaction: There is a lack of a market transaction that ensures verification of the value of goodwill as in the case of purchased goodwill.
Manipulation: There are higher chances of manipulation of financial statements through self-generated goodwill.
Conclusion
On a concluding note, self-generated goodwill is something that adds real value to a business, but it’s not something that can easily be measured or captured in financial statements. Accounting is all about providing clear, reliable information, and including goodwill would make things murky and open to manipulation. Even though it doesn’t show up on the books, you can still see its effects in a company’s reputation and success. Maybe in the future, businesses will find a way to highlight it better, but for now, leaving it out helps keep financial reports honest and straightforward.
What is creative accounting? What are its ethical implications?
Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand thisRead more
Everyone must have heard about the term “cooking the books”. This term is generally associated with Creative accounting. In simple words, Creative accounting is a method of accounting in which the management tries to show a better picture of the business than the reality. Let us now understand this concept in detail.
What is Creative accounting?
Creative accounting is a method of accounting in which the management manipulates the books of accounts by finding loopholes to showcase a better image of the business.
It is a practice of using accounting loopholes to make a company’s financial position look better than it really is. It is not exactly illegal but it is more of a gray area.
For example, a business may delay reporting expenses to increase the profits to present a better short-term position.
The goal of creative accounting is to impress the shareholders, investors, get loans or boost stock prices.
However, this can also be very risky and have serious consequences. It can reduce the trust of the investors and customers. In some cases, like Enron and WorldCom the world has seen how creative accounting lead to legal consequences.
Common Techniques of Creative Accounting
Some of the common techniques used by the business to manipulate the financial position are as follows:
Ethical implications of Creative Accounting
There are several ethical implications with respect to creative accounting. Some of these are discussed below:
Conclusion
The key takeaways from the above discussion are as follows:
See lessWhy do we segregate assets into financial and non-financial assets?
Assets can be classified as Financial or Non-financial assets. One might wonder why this is necessary. Let us dive into this concept, beginning with understanding what financial and non-financial assets are and why they are classified as such. What are Assets? Assets are things that have a monetaryRead more
Assets can be classified as Financial or Non-financial assets. One might wonder why this is necessary. Let us dive into this concept, beginning with understanding what financial and non-financial assets are and why they are classified as such.
What are Assets?
Assets are things that have a monetary value and are beneficial for a business. Assets are commonly classified as tangible, intangible, current, fixed, financial, non-financial, etc.
Plant and machinery, land, buildings, cash, bank balance, patents, etc are some of the examples of assets that a business has.
What are Financial Assets?
Financial assets are the things of value that are held by a person for their underlying value. They are intangible and do not have a physical form. For example – Stocks, bonds, debentures, options, futures, etc.
The value of these assets may change over time depending upon the market conditions, changes in government policies, fluctuations in interest rates, etc.
In comparison to non-financial or physical assets, financial assets are more liquid as they can be traded and can be converted into cash.
What are Non-financial assets?
Non-financial assets are tangible or intangible assets that have a value but cannot be easily converted into cash. They are not as liquid and generally not traded.
Examples of such assets are buildings, plant and machinery, patents, trademarks, etc.
Difference between Financial and Non – Financial Asset
From the above discussion, it is clear that financial and non-financial assets are very different. The following are several important reasons why it is important to segregate the same:
See lessWhat is the difference between outstanding expenses and accrued expenses?
The terms outstanding expenses and accrued expenses are two accounting terms which are often used interchangeably. However, these two terms are not the same and have different meanings. The difference between these two terms is given below: What are Outstanding expenses? As the name suggests, outstaRead more
The terms outstanding expenses and accrued expenses are two accounting terms which are often used interchangeably. However, these two terms are not the same and have different meanings. The difference between these two terms is given below:
What are Outstanding expenses?
As the name suggests, outstanding expenses are the expenses that are due but have not been paid yet. It means that the business is supposed to pay the amount due but it has not paid the same at the end of the accounting period.
Outstanding expenses are recognized as a current liability because the business is liable to pay such expenses. These expenses are recorded in the books of accounts but the payment is still pending.
Some examples of outstanding expenses are:
What are Accrued expenses?
Accrued expenses are the expenses that a business has incurred during the accounting period but they have not yet been recorded in the books of accounts because the bill has not yet been received or the payment is not due yet.
The concept of Accrued expenses helps in complying with the accrual basis of accounting which says that the expense shall be recognised at the time it occurs regardless of the fact that payment is received or not.
Examples of accrued expenses are:
Key differences between outstanding expenses and accrued expenses
To summarise the above discussion, the key differences between outstanding expenses and accrued expenses are given in the table below:
See lessHow does revenue recognition differ under various accounting standards (e.g. , IFRS vs. GAAP)?
To understand the difference in Revenue recognition under IFRS and GAAP , it is important to understand what are IFRS and GAAP. Both of these are accounting standards accepted globally. These are discussed below: What is IFRS? IFRS is a set of accounting standards developed by the International AccRead more
To understand the difference in Revenue recognition under IFRS and GAAP , it is important to understand what are IFRS and GAAP. Both of these are accounting standards accepted globally. These are discussed below:
What is IFRS?
IFRS is a set of accounting standards developed by the International Accounting Standards Board. These standards are globally accepted accounting standards.
They were developed and implemented with the objective of providing a consistent, transparent and reliable framework for the presentation and reporting of financial statements.
IFRS ensure uniformity and this helps in comparability of financial statements across the companies of different countries.
Some examples of IFRS Standards are : IFRS 2 – Share based payments, IFRS 9 – Financial Instruments, IFRS 16 – Leases, etc.
What is GAAP?
GAAP stands for Generally Accepted Accounting Principles. GAAP is primarily used in the USA. These are a set of accounting principles, rules and procedures which are crucial for providing consistency and transparency in the presentation and reporting of financial statements.
Some examples of GAAP Standards are: ASC 606: Revenue Recognition, ASC 842: Leases, ASC 740: Income Taxes, etc.
Difference in Revenue Recognition under IFRS and GAAP
Though both of these standards have the main goal of promoting consistency and uniformity, there are certain differences in the Revenue Recognition under IFRS and GAAP.
This is because of the fact that the nature of IFRS and GAAP is different as IFRS is more principle- based and GAAP is rule based.
See lessWhich is a broader term between the two- Income or Revenue?
Revenue and income are two accounting terms that are often used interchangeably. However, it is important to understand that these two terms are different. Let us know the difference between the two through the discussion below: What is Revenue? Revenue is the total amount of a business's sales. ItRead more
Revenue and income are two accounting terms that are often used interchangeably. However, it is important to understand that these two terms are different. Let us know the difference between the two through the discussion below:
What is Revenue?
Revenue is the total amount of a business’s sales. It is the total amount earned by a business before deducting any expenses. Revenue is recognized in accounting as soon as a sale happens, even if the payment hasn’t been received yet.
For example, XYZ Ltd sold 100 pens at a selling price of 10 per pen. The total revenue of the business is hence 1,000.
What is Income?
Income is the amount earned by a business after deducting any direct or indirect expenses. It is the amount that
See lessWhy is Cost of Goods Sold taken as numerator instead of revenue while calculating the Inventory Turnover Ratio?
What is Inventory? Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers. What is the Inventory Turnover Ratio? Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventoryRead more
What is Inventory?
Inventory refers to the stock of goods or raw materials a business uses to produce the final goods sold to the customers.
What is the Inventory Turnover Ratio?
Inventory Turnover Ratio is the financial ratio that shows how efficiently a business sells and replenishes its inventory. It shows how well a business manages its inventory.
Inventory Turnover ratio is calculated as follows:
Inventory Turnover Ratio = Cost of goods sold / Average Inventory
where Average Inventory = (Inventory at the beginning of the year + Inventory at the end of the year) / 2
If inventory turnover is high, it means products are selling quickly. But if it’s too high, the company might not have enough stock, leading to fewer sales.
If turnover is low, there are slow sales or too much stock. That can lead to higher storage costs and obsolete products. It is important to find the right balance between the two.
Why is the Cost of Goods Sold taken as a numerator instead of revenue while calculating the Inventory Turnover Ratio?
The cost of goods sold is the sum of all the direct costs involved in the production of goods. On the other hand, Revenue is the total amount of money earned through the sale of goods and services.
The cost of goods sold (COGS) includes materials, labor, and overhead costs. Inventory consists of these costs and hence, it is better to take (COGS) as the numerator.
Revenue, however, considers things like markups, discounts, and other adjustments that don’t directly relate to the actual cost of inventory.
Let us understand it better with the help of an example:
Suppose the opening inventory is 20,000 and the closing inventory is 10,000. Average inventory can be calculated as (20,000 + 10,000)/2 = 15,000.
If the cost of goods sold is 45,000 the Inventory turnover ratio comes out to be 45,000/15,000 = 3.
On the other hand, if the revenue of 60,000 is taken as the numerator, the Inventory turnover ratio comes out to be 60,000/15,000 = 4
A high inventory turnover ratio shows that the inventory is moving faster than it is which is misleading for the stakeholders.
Hence, the Cost of goods sold is taken as the numerator for the calculation of the Inventory turnover ratio.
See lessHow are Research & Development costs treated in financial statements?
Every business requires research and development to create innovative products for consumers. More innovative and creative products and services are more popular among customers, leading to increased revenue and profits for the business. Creating new products or designing changes and testing existinRead more
Every business requires research and development to create innovative products for consumers. More innovative and creative products and services are more popular among customers, leading to increased revenue and profits for the business.
Creating new products or designing changes and testing existing products also forms a part of research and development.
Examples of Research and Development costs are –
Let us now understand how research and development costs are treated in Financial Statements.
Research and Development Costs are generally shown as an expense in the Income Statement.
IAS-38
IAS-38 majorly governs the accounting of research and development costs. There are two phases in R&D:
1. it is developed with the intention of putting it to use in the future
2. the asset shall hold an economic value
3. the costs can be measured reliably
Treatment of R&D costs in the Financial statements:
Conclusion
The above discussion can be summarised as follows:
- Research and development is essential for creating innovative and creative products and services.
- Accounting standard IAS-38 governs the accounting for Research and Development.
- Research costs are usually shown as an expense in the Income statement of the business.
- Development costs when capitalised can be shown as Intangible assets in the Balance Sheet.
See lessWhat are the different methods of accounting for fixed assets according to IFRS?
To understand the accounting treatment of fixed assets under IFRS let us first understand what fixed assets are. What are Fixed Assets? Fixed assets are the assets that are purchased for long-term use by a business and not for resale. Some examples of fixed assets are land, buildings, machinery, furRead more
To understand the accounting treatment of fixed assets under IFRS let us first understand what fixed assets are.
What are Fixed Assets?
Fixed assets are the assets that are purchased for long-term use by a business and not for resale. Some examples of fixed assets are land, buildings, machinery, furniture and fixtures, etc.
Fixed assets are essential for the smooth operations of the business. It often shows the value of the business. The value of fixed assets usually decreases with time, obsolescence, damage, etc.
As per IAS-16 Property, Plant and Equipment, an asset is identified as a fixed asset if it satisfies the following conditions:
What is IFRS?
IFRS stands for International Financial Reporting Standards. It provides a set of standards to be followed globally by all companies to ensure transparency, comparability, and consistency.
What is the accounting treatment of fixed assets under IFRS?
Under IFRS, the first step is to measure the value of the fixed assets on cost. The cost of the fixed assets includes the following:
After this step, the entity may choose any one of the following two primary methods:
For example, a company bought a piece of machinery for 60,000. 5,000 were spent on its installation. It has a useful life of 10 years. The machinery would be depreciated over its useful life of 10 years based on its cost which is 65,000.
2. Revaluation model: As per this model, the fixed assets are valued on their fair value, as on the revaluation date. The amount of depreciation and impairment losses is subtracted from the fair value.
If the value of an asset increases, the gain goes to equity (revaluation surplus) unless it can be set off with a past loss recorded in profit or loss.
On the other hand, if the value decreases, the loss goes to profit or loss unless it offsets a past surplus in equity.
For example, a building was purchased for 100,000. On the revaluation date, the fair value of this building was 150,000. Hence, there is a revaluation surplus of 50,000 which shall be credited to the revaluation surplus account.
Impact on Financial Statements
Fixed assets are shown on the Assets side of the Balance Sheet.
Conclusion
From the above discussion, it may be concluded that:
See lessWhy don’t we record self-generated goodwill in accounting?
To understand why we do not record self-generated goodwill in accounting, let us first understand what goodwill is and its accounting treatment. What is Goodwill? Goodwill is an intangible asset of a business. It represents the reputation and brand value of a business built over time. It is a valueRead more
To understand why we do not record self-generated goodwill in accounting, let us first understand what goodwill is and its accounting treatment.
What is Goodwill?
Goodwill is an intangible asset of a business. It represents the reputation and brand value of a business built over time. It is a value over and above the tangible assets of the business.
Goodwill often arises when a business purchases another business and pays a premium, which means a price higher than the fair value of the business.
Characteristics of Goodwill
Goodwill has the following characteristics:
Example of Goodwill
Let us take an example to understand the concept of goodwill better.
Suppose there is a company ABC Ltd. It is planning to acquire XYZ Ltd. The fair value of the assets of XYZ is calculated to be 600,000. However, ABC has agreed to pay a sum of 650,000 to acquire the company. This difference of 50,000 is goodwill.
Impact on Financial Statements
Goodwill is shown under the assets side of the Balance Sheet.
What is self-generated goodwill?
Self-generated goodwill in simple words means the positive reputation or trust that a business earns over time through their own hard work and decisions. It’s not something bought or inherited but something built from scratch internally, like a brand’s reputation, loyal customers, strong relationships, or unique ideas.
For example, a small business that goes the extra mile to offer great customer service or always delivers high-quality products over the years will naturally build goodwill.
It is also known as internally generated goodwill.
Why do we not record sef-generated goodwill?
Self-generated goodwill is not recorded in the financial statements because of the following reasons:
Conclusion
On a concluding note, self-generated goodwill is something that adds real value to a business, but it’s not something that can easily be measured or captured in financial statements. Accounting is all about providing clear, reliable information, and including goodwill would make things murky and open to manipulation. Even though it doesn’t show up on the books, you can still see its effects in a company’s reputation and success. Maybe in the future, businesses will find a way to highlight it better, but for now, leaving it out helps keep financial reports honest and straightforward.
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