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Friday, April 15, 2011

The marriage of corporate finance and accounting in IFRS/GAAP

Few people will be caught dead admitting to a liking for an accounting class. But those same people may like a finance class. This post explains how some corporate finance principles are used successfully to achieve a true and fair picture in the books of accounts. So next time you open those accounting rules(hopefully you would not need to!), try looking for more such examples

  1. While accounting for financial instruments either as assets/liabilities, entities generally need to use the effective interest rate method, which is nothing more than a glorified version of IRR. And to make the resemblance more, the initial IRR itself is used for income/expense recognition throughout, like in capital budgeting problems.
  2. Pension accounting uses the concept of risk free rate to forecast the return on pension assets, while like in financial modelling, assumptions need to be taken about the growth in salaries etc
  3. In lease accounting, IRR is again used to allocate rentals between revenue and capital
  4. While testing whether fixed assets have lost value('impairment'), a two stage DCF model is used to value the assets(singly or in blocks) to decide whether to book a charge.
  5. And of course while recording, measuring, valuing or transferring financial instruments(again), a hogmash of principles are used.
  6. While recording assets acquired in a M&A('business combination'), accounting rules need you to value each asset separately, which is more work again for the accountants/valuers.
I am not stating that accounting is always consistent with finance principles-often they are not. But a keen reader of accounting standards will find several such examples of applying finance in practice, and this I hope, will encourage more people to do the former when they need to(like CA Final exams). 

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