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Transcript of XIMR FA4 FinTerms 2010
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FA 4: Finance Terminology &
Concetps
XIMR FA4 2010
S Krishnamoorthy: [email protected], Cell:9821461488
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Assets such as buildings, factories, equipment, furniture, vehicles and
computers last over several years but not indefinitely
The initial investment made in these assets gets used up over a period
of time
The initial investment, thus seen as capital at that time, eventually
becomes an expense
It is thus only appropriate to slowly convert this capital investment to
expense gradually over the life rather than discarding it as an expense
after its life is over
Thus during each accounting period a portion of the cost of the asset isappropriated as an expense
Thus a portion of the asset gets transferred from the balance sheet to
the income statement as depreciation expense every year during the
entire life of the asset
Depreciation
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It is important to recognize that depreciation in accounting is the allocation
of the historical cost of an asset across time periods when the asset isemployed to generate revenues
It is simply the recognition that a portion of the asset's cost - the portion
that will never be recuperated through re-sale or disposal of the asset was
"used up" in the generation of revenues for that time period
The use of depreciation affects the financial statements and in some
countries the taxes of companies and individuals
The recording of depreciation will:
cause an expense to be recognized thus lowering stated profits on the
income statement
while the net value of the asset will decline on the balance sheet
Depreciation reported for accounting and tax purposes may differ
substantially
Rationale for Depreciation
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DepreciationLand is not depreciated as it lasts indefinitely
The assets which are depreciated are referred to as
Fixed Assets
Depreciable Assets
Buildings
Plant and Equipments
Motor & Other Vehicles
Computers
Furniture & Office Equipments
Loose tools
There are 2 main methods & few other methods used for depreciation
Straight Line method [SLM]
Written Down Value [WDV] method
Linear methodGeometric method
Sum of digits method
The above two main methods simply provide an alternative way of allocating the total
depreciation charge over several accounting periods
The total depreciation charge using either method will be the same over the total usefuleconomic life of the asset
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The total amount to be depreciated over the life of a fixed asset is determined
by the following calculation:
Cost of the fixed asset less residual value/ Useful economic life If the cost is Rs 110,000 , residual value Rs 10,000 and useful life 5 yrs
the amount of depreciation = 110,000 10,000 / 5 = 20,000
The period over which to depreciate a fixed asset is known as the "useful
economic life" of the asset
A depreciation method is required to allocate, in a systematic way, the total
amount to be depreciated between each accounting period of the asset's useful
economic life
The straight-line method [SLM] of depreciation is widely used and simple to
calculate. It is based on the principle that each accounting period of the asset'slife should bear an equal amount of depreciation
The reducing balance [WDV] method of depreciation provides a high annual
depreciation charge in the early years of an asset's life but the annual
depreciation charge reduces progressively as the asset ages
Computation of Depreciation
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Straight Line Method WDV Method
M F
I M
M R
M
A
A
A
"N "?? "N "
H
M
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Linear Depreciation
This method diminishes the value of an asset by a fixed amount each perioduntil the net value is zero
The depreciation is determined by dividing the cost of the asset by the
estimated useful life and applying the same across the lifetime of the asset
Geometric Depreciation
For each period the asset is depreciated by a fixed percentage of its value
the previous period
In this method the value of an asset decreases exponentially leaving a value
at the end that is larger than zero ( i.e. - a resale value).
Sum of Digits
A third method most often employed in Anglo Saxon countries is the sum of
digits methodIn this method the cost of the asset is divided by sum of digits of the useful
life and the resultant amount is applied as the depreciation rate
Other Methods of Depreciation
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In India the governing laws for depreciation are provided under the
Companies Act, 1956 [as amended]Income Tax Act, 1961 [as amended]
Any other Governing Statue
There are different streams of accounting provided under the Cos.Act & IT Act
The IT Act and the Cos.Act have independent provisions that treat depreciationdifferently
It is legally recognized that there can be several parallel streams of accounting,
each independently following its own accounting and legal parameters prescribed
by the governing statute
The Companies Act prescribes rates of depreciation which are lower than those
set by the Income-Tax rules
Laws Governing Depreciation Accounting
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For compliance with the Cos. Act corporate are required to claim
depreciation at the rates prescribed under this Act
A company will not have any option in the matter. The written-down value
will be reflected year after year in conformity with the rates of
depreciation claimed under the Cos.Act
For all obligations under the Cos. Act it is such rates of depreciation and the
resultant written-down values that would have to be recognized
Under the IT Act the depreciation schedule would reflect the depreciation
allowable as per the rates prescribed under the IT Rules and the written-down
value year after year would be determined accordingly
Both these depreciation schedules, under the Cos.Act and under the ITAct respectively run parallel each undergoing change year after year as
per its own prescribed Rules with reference to the rate of depreciation
allowable under the respective statute
Depreciation Accounting
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Amortization differs slightly from depreciation
Amortization is used for write off intangible assets or repayment of loans while
depreciation is used for write-off tangible assets
These terms are often used interchangeably, but it is incorrect technically
Amortization can be defined for two separate things:
Intangible Assets: The capital expenditure used in building up
intangible assets like patents, copyrights, goodwill etc. is
amortized over a specific period of time
Loans and Financing: Paying off a loan debt as regular
installments over a period of time
Amortization
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Amortization ofIntangible asset:
A medical firm spent Rs100 cr on developing a patented equipment
and that the equipment lasts for 20 years
The firm will thus amortize the expenditure by Rs 5 cr every year as an
expense
A firm Paid Rs 2 cr as premium on a 5yr term leasehold land
The amount will be amortized over the term of the lease
Loan Amortization:
In loan amortization usually the total money paid remains constant per
period, but the components of the payment vary between the principal
repayment and the interest paid
An individual has taken housing loan for Rs 20 Lakhs for 20 yrs @
11 interest. The repayment in Equated Monthly Installment [EMI] issay Rs 15,000 monthly
Initially the interest component is higher, but gradually as the net loan
decreases, the interest component decreases and the principal
repayment increases
Amortization: Examples
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Particulars Firm A Firm B
Profit before depreciation
& amortization 100000 100000
Depreciaiton &
amortization 30000 0Profit before taxation 70000 100000
Tax expense @ 30% 21000 30000
Tax saved by Firm A 9000
Impact of Depreciation&Amortization Claim:Rs
Impact of Depreciation Claim
Depreciation provide tax shieldThe tax shield reduces the quantum of tax expense
To that extent the firm retain the cash flow
This cash flow will help the firm to sustain and grow
Many firms ended up paying Zero tax by claiming depreciation on huge capex
incurred
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Deferred tax reporting in India is mandated by accounting standard AS 22
[Internationally by IAS 12]
Deferred tax asset [DTA] and deferred tax liability [DTL] arise due to difference
between Accounting Profit [TP] and Tax [Profit]
AP is determined based on GAAP [ Ex. Accounting Standards prescribed by
ICAI]
TP is based on Taxation Laws [Ex. Income Tax Act]
AP = Sales COGS Other & other expenses Depreciation Amortization
Interest
TP = Taxable income Allowable Expenses Allowable Deductions
AP is subject to accounting policy assumptions especially with regard to
COGS, depreciation and amortization
TP is subject to tax laws and policies
The difference between AP and TP can be classified as
Permanent difference [due to tax policies]
Temporary difference [ due to accounting policies and assumptions]
Deferred Taxation
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DTA is created by overpaying taxes during a given time period
DAT usually occurs as a result of timing differences based on how the company
depreciates its assets and or claims expensesDTA reduces the company's tax liability in the future
Example: DTA of Rs100 from the previous year could be applied to before-tax
income of Rs 250 in the current year, resulting in taxable income of Rs 150
(250 100)
DTA because they reduce the liability in the future has a value and hence shown
as an asset on the balance sheet
Deferred Tax Asset [DTA]
Y1 Y2 Y3 Y4 Total
Income* 50,000 50,000 50,000 50,000
VRS Expenses 40,000 0 0 0 40,000
Taxable Income 10,000 50,000 50,000 50,000
Tax Expense 3,000 15,000 15,000 15,000 48,000
Income* 50,000 50,000 50,000 50,000
VRS Expenses 10,000 10,000 10,000 10,000 40,000
Taxable Profit 40,000 40,000 40,000 40,000
Current Tax @ 30% 12,000 12,000 12,000 12,000 48,000
DTL[-] / DTA 9,000 (3,000) (3,000) (3,000) 0
Income Statement (Amt Rs)
Tax Statement [No Export Income] (Amt Rs)
* Income is before VRS Expenses
Example: Deferred Tax Asset
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DTL occurs when a company underpays its taxes due to a difference between how
it accounts for an asset on its books versus how it accounts for it on a tax basis
DTL occurs when company claims accelerated depreciation accelerated benefit
for expenses for tax
DTL increase the liability in the future and hence are shown as liabilities on the
balance sheet
Investors should consider when analyzing a company's financials levels of DTA and
DTL to known whether the company is too aggressive in its accrual accounting and
tax planning
DTL occurs if Tax Expense > Current Tax
DTA occurs if Tax Expense < Current Tax
Deferred Tax Liability [DTL]
Y1 Y2 Y3 Y4 Total
Income* 50,000 50,000 50,000 50,000
R&D Expenses 10,000 10,000 10,000 10,000 40,000
Taxable Income 40,000 40,000 40,000 40,000
Tax Expense 12,000 12,000 12,000 12,000 48,000
Income* 50,000 50,000 50,000 50,000
R&D Expenses 40,000 - - - 40,000
Taxable Profit 10,000 50,000 50,000 50,000
Current Tax @ 30% 3,000 15,000 15,000 15,000 48,000
DTL[-] / DTA -9,000 3,000 3,000 3,000 0
Tax Statement [No Export Income] (Amt Rs)
*Income is before R&D Expenses
Income Statement (Amt Rs)
Example: Deferred Tax Liability
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For many companies inventory represents a large (if not the largest) portion of
assets and makes up an important part of the Balance Sheet
It is therefore crucial for investors who are analyzing stocks to understand how
inventory is valued
Inventory is defined as assets that are intended for sale, are in process of being
produced for sale or are to be used in producing goods
Types of Inventory [Ex. Vehicle Manufacturer]
Raw Materials: Steel Plates, Tyres, Paints
In Process Materials: Vehicles in various stages completion
Finished Goods: Finished [road worthy] Vehicles ready for dispatch
Stores & Spares: Ball bearing, Machinery parts
Fuels: Diesel oil, Furnace Oil for running operating machineriesVehicle Spares: Tyres, Clutch Plates, etc [for after sales service]
Packing Materials: Cartons, Boxes , Plastic Sheets
Inventory and Inventory Valuation
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A company's inventory is determined as follows:
Beginning Inventory
+ et Purchases
-Consumption of Inventory [Cost of Goods Sold (COGS)]
=Ending Inventory
An important point in the examples above is that COGS appears on the
Income Statement (P&L Account), while ending inventory appears on
the Balance Sheet under Current Assets
The accounting method that a company decides to use to determine the
costs of inventory can directly impact the balance sheet, income
statement and statement of cash flow
There are three inventory-costing methods that are commonly used bythe companies:
First in First Out [FIFO]
Last in First Out [LIFO]
Average Cost Weighted Average Cost
Inventory Valuation & Accounting
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First In First Out (FIFO)
This method assumes that the first unit making its way into inventory is the
first soldEx. A bakery produces 200 loaves of bread on D1 at a cost of Rs1 each, and
200 more on D2 at Rs 1.25 each
If 200 loaves are sold on D3 then FIFO would value COGS at Rs 1 per loaf
The balance 200 loaves would be valued at Rs 1.25 each and shown as
ending inventory on the balance sheet
Last In First Out (LIFO)This method assumes that the last unit making its way into inventory is sold
first
The older inventory, therefore, is left over at the end of the accounting period
For the 200 loaves sold on D3, the value would be Rs 1.25 per loaf to COGS
The remaining 200 loaves would be valued at Rs 1 each and as inventory at
the end of the period
Average/ Weighted Average Cost
The weighted average of all units available for sale during the accounting
period is computed and that average cost is applied to value of COGS and ending
inventory
In above example the average cost for inventory would be Rs1.125 per unit [(200
x Rs 1) + (200 x Rs 1.25)] 400
Inventory Valuation
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If there were no inflation then all three of the inventory valuation methods would
produce the exact same results
When prices are stable the bakery would be able to produce all of its loafs of
bread at Rs 1 and FIFO, LIFO and average cost would give the same cost of
Rs 1 per loaf
owever over the long term, prices tend to rise, which means the choice of
accounting method can dramatically affect valuation ratios
If a company uses LIFO valuation when it files taxes, which results in lower taxes
when prices are increasing, it then must also use LIFO when it reports financial
results to shareholders. This lowers net income and earnings per share
Accounting standards stipulate that companies will have to state inventory at thelower of cost or market . This means that if inventory values were to plummet,
their valuations would represent the market value (or replacement cost) instead
of FIFO, LIFO or average cost
Why Inventory Valuation Method is Important
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Monthly Inventory Purchases
Month Units Purchased Cost/Unit:Rs Total Value:Rs
J 1 000 10 10 000
F 1 000 12 12 000
M 1 000 1 1 000
Total 3,000 37,000
Beginning Inventory = 1,000 units purchased at Rs 8 each (a total of 4,000 units)
Income Statement (simplified): January-March*
Item LIFO:Rs FIFO:Rs Average:Rs
Sales = 3,000 units @ Rs 20 each 60,000 60,000 60,000
Beginning Inventory 8,000 8,000 8,000
Purchases 37,000 37,000 37,000
Ending Inventory (appears on B/S)=+(1000+3000)-3000=1000
8,000 15,000 11,250
COGS=Op.Inv+ Net Purchase-Cl.Inv 37,000 30,000 33,750
Other Expenses 10,000 10,000 10,000
Net Income 13,000 20,000 16,250
Financial Impact ofInventory Valuation Methods
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Capital Expenditure and Revenue Expenditure
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Intangible assets are classified based on the useful life as per [IAS 38 AS 26]
Indefinite life: no foreseeable limit to the period over which the asset is expected
to generate net cash inflows for the entity
Finite life: a limited period of benefit to the entity.
Measurement Subsequent to Acquisition: Intangible Assets with Indefinite
Lives
An intangible asset with an indefinite useful life should not be amortized
Its useful life should be reviewed each reporting period to determine whether
events and circumstances continue to support an indefinite useful life assessment
for that asset
If they do not, the change in the useful life assessment from indefinite to finite
should be accounted for as a change in an accounting estimate
The asset should also be assessed for impairment in accordance IAS 36 AS 26
Treatment of Intangible Assets
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Measurement Subsequent to Acquisition: Intangible Assets with Finite
Lives
The cost less residual value of an intangible asset with a finite useful life should
be amortized on a systematic basis over that life
The amortization method should reflect the pattern of benefits
If the pattern cannot be determined reliably, amortize by the straight line method
The amortization charge is recognized in profit or loss unless another IFRS
requires that it be included in the cost of another asset
The amortization period should be reviewed at least annually
The asset should also be assessed for impairment in accordance
Treatment of Intangible Assets
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Good will in accounting is an intangible asset valued according to the
advantage or reputation a business has acquired (over and above its tangible
assets)
Goodwill is the difference between the purchase price of a company and its net
worth (assets less liabilities)
Goodwill arises when a company buys another business at a price greater than
the book value
The accounting treatment of an intangible asset such as the takeover premium
in a merger or acquisitionGoodwill is an specific accounting term treatment used to reflect the portion of
the book value of a business entity not directly attributable to its assets and
liabilities
Example:
Firm A acquired Firm B for Rs 50 lakhs. The value of the tangible assets
amounted to Rs 30 lakhs only. The excess of Rs 20 lakhs is the considerationpaid for goodwill an intangible asset
Value of goodwill is retained as such or amortized over a an estimated time
period
If for any reason the goodwill value is diminished [impaired] then the same is
written-off [reduced] from the books
Goodwill
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Initial Recognition: Research and Development Costs [IAS 38 / AS26]
Charge all research cost to expense
Development costs are capitalized only after technical and commercial
feasibility of the asset for sale or use have been established
This means that the entity must intend and be able to complete the intangible
asset and either use it or sell it and be able to demonstrate how the asset will
generate future economic benefits
If an entity cannot distinguish the research phase of an internal project to
create an intangible asset from the development phase, the entity treats theexpenditure for that project as if it were incurred in the research phase only
In-process Research and Development Acquired in a Business
Combination
A research and development project acquired in a business combination is
recognized as an asset at cost, even if a component is researchSubsequent expenditure on that project is accounted for as any other
research and development cost (expensed except to the extent that the
expenditure satisfies the criteria for recognizing such expenditure
as an intangible asset)
Treatment of Research & Development [ R & D] Costs
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Preoperative expenses is different from the preliminary expenses
Pre-operative expenses are those which are connected with actions that are
required for start up of operations [project related expenses including trail
production before commencement of commercial production]
Preliminary expenses essentially associate with activities involved in the formation
of the company [Share issue and company registration expenses]
Pre operative expenses of capital nature and or revenue nature are to be
capitalized - by apportionment allocation to assets which are the subject matter of
operation - with cost of fixed assets in relation to which they have been incurred
and depreciation claimed over the years
Whereas pre operative expenses which has not resulted in tangible assets [ or ifthe project fails] are to be charged against profits
Preliminary expenses are written off as revenue and set off when the company
generates profits and the treatment should be done according Section 35D of
income tax act 1961
Treatment of Pre-operative and Preliminary Expenses [AS 26]
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Inflation accounting is an accounting system that adjusts values for changes in
purchasing power of money
Inflation Accounting is also referred to as the Price Level Accounting
Adjusting financial statements to show a firm's real financial position in inflationary times
It aims to indicate:
ow rising prices and lower purchasing power of the currency affect a firm's cost of
refinancing its productive assets
Firms ability to maintain an adequate level of profit on the capital employed
Inflation has two components:
monetary inflation called cash inflation
non-monetary inflation called historical cost accounting inflation
Cash or monetary inflation destroys the real value or purchasing power of money and other
monetary items
Inflation Accounting
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One method is to adjust every figure in the balance sheet on the basis of a price index (such
as consumer price index) which reflects the current purchasing power of the currency
Another method suggests to revalue tangible assets at their replacement cost
In valuation of inventory inflation accounting treatment can effect the firm's taxable
income, cash position and reported earnings depending on whether the firm uses FIFOor LIFO methods
FIFO method, shows a higher profit, therefore higher tax burden and a decrease in
net cash flow
LIFO method lowers the profit and tax burden and increases the net cash flow
Inflation Accounting Methods
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In certain inflation accounting models price level costs were achieved by
employing particular indexes
The second model is the Constant Dollar Rupee Accounting. This model
helps to convert the non monetary assets and equities into current dollars
employing a general price index
The monetary assets are not taken into account during the conversion
On the income statement, depreciation is adjusted for changes in general pricelevels based on a general price index.
2001 2002 2003 Total
Revenue 33,000 36,302 39,931 109,233
Depreciation 30,000 31,500 (a) 33,000 (b) 94,500
Operating income 3,000 4,802 6,931 14,733
Purchasing power loss - 1,500 (c) 3,000 (d) 4,500
Net income 3,000 3,302 3,931 10,233
(a) 30,000 x 105/100 = 31,500(b) 30,000 x 110/100 = 33,000
(c) (30,000 x 105/100) - 30,000 = 1,500
(d) (63,000 x 110/105) - 63,000 = 3,000
Inflation Accounting Models
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Historical cost accounting model is the global basic accounting model
In most countries, primary financial statements are prepared on the historical cost basis ofaccounting without regard either to changes in the general level of prices or to increases in
specific prices of assets held, except to the extent that property, plant and equipment and
investments may be revalued
Today the stable measuring unit assumption is implemented as part of the historical cost
model only for the purpose of valuing constant real value non- monetary items in low
inflationary economies
The accounting profession has realized over the years that the stable measuring unit
assumption cannot be applied to variable real value non- monetary items
Variable real value non-monetary items are valued today, for example, at fair value, market
value, present value, net realizable value or recoverable value in terms of IASB International
Accounting and Financial Reporting Standards and US GAAPs as issued by the FASB,IFRSand Indian Accounting Standards
Examples of variable real value non-monetary items are land, buildings, property, plant,
equipment, vehicles, stock, raw materials, finished goods, marketable securities, foreign
exchange, etc.
Rationale for Inflation Accounting
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Ignoring general price level changes in financial reporting creates
distortions in financial statements such as:
Reported profits may exceed the earnings that could be distributed to
shareholders without impairing the company's ongoing operations
The asset values for inventory, equipment and plant do not reflect their
economic value to the business
Future earnings are not easily projected from historical earnings
The impact of price changes on monetary assets and liabilities is not clear
Future capital needs are difficult to forecast and may lead to increased
leverage, which increases the business's risk
When real economic performance is distorted, these distortions lead to
social and political consequences that damage businesses (examples:
poor tax policies and public misconceptions regarding corporate
behavior)
Impact of Ignoring Inflation Accounting
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AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 et Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts
AS 8 Accounting for Research and Development (Withdrawn pursuant toAS 26 becoming mandatory)
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for InvestmentsAS 14 Accounting for Amalgamations
AS 15 Employee Benefits
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
Accounting Standards Issued by Institute of Chartered Accountants of India
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AS 19 Leases
AS 20 Earnings Per ShareAS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in oint Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent Liabilities and Contingent Assets
AS 30 Financial Instruments: Recognition and Measurement
AS 31 Financial Instruments: Presentation
Accounting Standards Issued by Institute of Chartered Accountants of India