FA merged

SESSION 11
Financial Accounting
Term 1
Assistant Professor, Divya Aggarwal
FPM - XLRI
SESSION 11
Quick
Quick Recap recap 9
till Session
• Accounting conventions
• Accounting transaction processing – recording, classifying and summarizing

• World of debit and credit
• Journal entries to ledger to trial balance to financial statements
• Income statement – revenue recognition and COGS
• Today ---------------------------→ Inventory accounting
https://www.bseindia.com/xml-data/corpfiling/AttachHis/4e6bfc0a-8ebe-4515-944c-1e64a0d782d0.pdf
Pg 101 and 102 – Balance Sheet and Income statement (Inventories, COGS etc)
Pg 134, 151 - Note 14, 38 and 39
Pg 214, Note 3.3 Inventories
What is cost of materials consumed? What are changes in inventories of finished goods and WIP
SESSION 11
Remember
Balanceformat of balance sheet
Sheet formats
Assets:
• Inventories
• Long lived Assets
• Financial Assets
SESSION 11
LetsCurrent
look atAssets
current assets
Current Assets: when the asset is expected to be realized, sold or consumed in its normal operating
cycle or within 12 months after the reporting period
Operating cycle: time between the acquisition of assets for processing and their realization in cash.
When an enterprise’s normal operating cycle is not clearly identifiable, it is assumed to be 12
months.
Major current assets are:

• Cash & Bank balances
• Accounts Receivables
• Prepaid expenses
• Short term financial assets
• Inventories
SESSION 11
Operating
Managing cycle
operating cycle
Operating cycle involves the continual conversion of cash into inventories, then into receivables and
back into cash in the normal course of business.
The shorter the length of a firm’s operating cycle, the greater the firm’s efficiency in managing its
current assets i.e. receivables and inventories
1. Operating cycle: cash purchase and cash sale
2. Operating cycle: cash purchase and credit sale
3. Operating cycle: credit purchase and cash sale
4. Operating cycle: credit purchase and credit sale

SESSION 11
Inventories
Inventory Valuation and income measurement
Inventories: goods meant for eventual conversion into cash in the normal course of business.
Manufacturing firm will have several kinds of inventories unlike merchandizing organizations
which merely buys and sells goods
Raw Materials Consist of goods yet to be introduced into the production Steel and paint for Tata Motors
process
Work in progress In production process when some units are in the process Partly assembled cars and car parts
but are yet to be completed for Tata Motors
Finished goods Goods produced completely but remaining unsold Fully finished cars for Tata Motors
Stock in trade Goods bought for trading, main inventories for Clothes for big bazaar
merchandizing firm
Supplies Known as stores and spares, loose tools Cleaning materials, coolants etc
SESSION 11
Inventories
Inventory Valuation : Ind AS-2
and income measurement
Inventories are assets:
a) held for sale in the ordinary course of business – Finished goods
b) Process of production for such sale – WIP
c) In form of materials of supplies to be consumed – Raw materials
What constitutes inventory cost:

a) Cost of purchase (less trade discounts etc.)
b) Cost of conversion and other cost in bringing the inventory into present location and condition
Inventories are recognized at the lower of cost or net realizable value

a) There can be situation where market price of a product/good becomes lower than its
procurement price (cyclical/seasonal commodities)
b) A basic concern arises is now to value the inventory
SESSION 11
Inventories
Inventory Valuation : Ind AS-2
and income measurement
Good inventory practices would exclude the following items while computing the cost of
inventories:
a) Abnormal amounts of wasted materials, labor, other production costs

b) Storage costs
c) Administrative overhead
d) Selling and distribution cost
e) Interest and borrowing costs
SESSION 11
Matching inventory costs
COGSwith Revenue
Cost of goods sold = Cost of goods available for sale – Ending inventory
Gross Profit = Net Sales – Cost of goods sold
• Cost assigned to ending inventory directly affects the reported profit
• If ending inventory is overstated, profit increases and current assets are also overstated
• Valuing inventory affects both the income statement and the balance sheet
SESSION 11
Inventory costing methods
Inventory valuation
• Inventory valuation:
• Determine the physical inventory that belongs to the business
• Periodic Vs. Perpetual inventory valuation -------→ taking stock of ending inventory methods
• What if inventory prices fluctuate?
• Goods available for sale:

How much becomes cost of goods sold?
How much becomes ending inventory?
SESSION 11
Inventory
Widely costing methods
used methods for inventory costing
• Specific identification
• Weighted Average cost
• First-in, first-out (FIFO)
• Last-in, first out(LIFO) ----→

• Ind AS 2 and IAS 2/IFRS do not permit LIFO. US GAAP
permits LIFO
SESSION 11
1. Specific Identification Method
• Assigns specific costs to each unit sold and each unit on hand.
• Each unit sold is matched with the unit’s actual cost
• Suited to inventories of high value, low volume items e.g. jewellery and designer dresses etc. Used for:
• Big ticket items (e.g., automobile).
• Uniquely identified items (e.g., jewelry).
Pros:
• Appropriate to use when inventory items are not interchangeable and can be distinguished.
• Track purchase cost of each item and each unit in inventory is affixed with an identification
Cons:
• Does not involve any assumption about cost flow. Matches cost to the physical flow of the inventory and
eliminates the effect of cost flow assumptions on reported net profit
• May offer opportunity to manipulate costs
• Method is costly to implement
SESSION 11
2.2.Weighted
Average Cost
average cost
• Periodic method and computes an average cost for all units for the entire period
• Appropriate when the inventory units involved are homogenous or when it is difficult to make a cost flow
assumption
• Ending inventory is calculated at the cost of weighted average

• Average cost price is influenced by all the purchase prices paid during the year
Average Beginning inventory + Purchases

=
Unit Cost Units available for sale
SESSION 11
3. First-in,
3. FIFOFirst-Out
– First in(FIFO)
first out
• First units acquired are the first units sold

• Cost of units in ending inventory are the most recently purchased goods
• Ending inventory approximates current cost of goods.
• Periodic/perpetual methods produce identical results.
• Advantages of FIFO:
• More realistic for pricing products.
• More accurate balance sheet valuation
• When using cost-plus pricing, these are the units being sold, hence better matching
• During rising prices, it produces highest amount of net profit as current revenues are matched with
low purchase prices paid in the past
• Most widely and popularly used inventory costing method

SESSION 11
4. Last-in,
4. LIFOFirst-Out
– Last in(LIFO)
first out
• Last units acquired are the first units sold

• Cost of units in ending inventory are the most earliest purchased goods
• Balance sheet inventories may be dated and unrealistic as ending inventory may be costed at historical
prices
• Not permitted by IFRS and not permitted in India.
• LIFO Reserve.
• Difference between LIFO valuation and FIFO (or average cost) valuation.
• Disclosed in notes to financial statements.
• Beneficial in periods of rising prices why? During periods of price increases:

• Higher costs of goods sold.
• Lower taxable income.
• Lower income taxes.
• Higher cash flows.
SESSION 11
Accounting
Comparing Gimmicks
inventory costing methods
• FIFO inventory value is more realistic:

• closer to current cost, but it produces a net
profit unrelated to current input costs
• LIFO does a fair job of matching current selling

prices and cost of goods sold, which is closer to
current replacement costs, but often produces an
outdated inventory value
• Both LIFO and WAC allow a business to manipulate

net profit by changing the timing of additional
purchase
SESSION 11
Comparing inventory
Comparing cost
inventory formulas
costing methods
• Which method to select? Depends upon a number of factors such as:
• Effect on financial statements and income tax
Prices Ending Inventory Cost of Goods Sold Gross Profit

Increasing FIFO > WAC > LIFO LIFO > WAC > FIFO FIFO > WAC > LIFO
Constant FIFO = WAC = LIFO FIFO = WAC = LIFO FIFO = WAC = LIFO
Decreasing LIFO > WAC > FIFO FIFO > WAC > LIFO LIFO > WAC > FIFO
• For FIFO and specific identification methods, ending inventory and COGS are same whether a period or
perpetual system is used
• They can produce different values for ending inventory and COGS under LIFO and weighted average cost
methods
SESSION 11
Comparing inventory
Comparing cost
inventory formulas
costing methods
• Lets compare the workings of all the four methods of inventory costing
• Which method results in highest gross profit and which method results in lowest gross profit?
• Problem in the excel file – solving by all 4 methods

SESSION 11
Analysis of Inventory
Inventory Analysis
• Necessary to optimize inventory levels as investment in investment is like idle funds on which a business
does not earn any profit
• Inventory turnover: Measures velocity with which merchandise moves

through business.
• Cost of goods sold / Average Inventory.
• For inventory, can use period average or ending.
• Days’ inventory ----→ Inventory turnover expressed in number of days.

• Inventory ÷ (Cost of goods sold /365) or simply
• 365/Inventory turnover
• Low holding period or high inventory turnover indicates efficient

inventory management
SESSION 11
Analysis
Lets of Inventory
discuss the case
• Lets work on the case
• The credit term “2/10, n/EOM means that the company can deduct 2% from the bill amount if the
payment is made within 10 days. If the company does not make the payment within 10 days, then the
entire amount will become due at the end of the month.
• The term 2/10, n/30 is a typical credit term and means the following:
• "2" shows the discount percentage offered by the seller.
• "10" indicates the number of days (from the invoice date) within which the buyer should pay the
invoice in order to receive the discount.
• "n/30" states that if the buyer does not pay the (full) invoice amount within the 10 days to qualify
for the discount, then the net amount is due within 30 days after the sales invoice date
• Read Chapter 5 of the textbook

• Section on Inventory valuation using LCM, NRV and even Retail inventory and standard cost methods are only for reading
purposes. No question will come on it
SESSION 12
Term 1
FPM - XLRI
SESSION 10
Some websites for financial job profiles/industry you can see
Private Equity Roles

https://samaracapital.com/
Connect on Linkedin if it interests you (avoid bulk spamming)
See similar firms
Certifications
Chartered Alternative Investment Analyst (CAIA) designation
Explore their website
SESSION 10
Remember
Balanceformat of balance sheet
Sheet formats
Assets:
• Inventories
• Long lived Assets
• Financial Assets
SESSION
SESSION 1012
Asset Side : Investing Activities
Monetary
Non monetary Assets
Assets/Financial Assets
• Money or claims to receive fixed sums • Items used in future production

of money. and sales of goods and services.
• Appear on balance sheet at “value.” • Appear on balance sheet at book

• Cash value
• Accounts receivable; estimated
realizable value.
• Marketable securities; fair value.
SESSION
SESSION
1012
Financial Assets : Cash
• Cash (Note 16, CCD report, Pg 134)

• Funds available for disbursement.
• May include highly liquid short-term investments (e.g., certificate of deposit).
• Cash equivalents generally include: T-bills, certificate of deposits, commercial paper,
money market deposits, bank deposits
Analyzing Cash:
• Days’ cash.
• Cash on hand /Cash outflow per day
• Cash on hand represents company’s current cash reserve
• Cash outflow per day = Cash expenses /365
• Cash expenses = (Operating expenses – Non cash expenses eg depreciation)
• Shows how well company is managing cash : number of days that an organization can
continue to pay its operating expenses, given the amount of cash available
SESSION
SESSION
1012
Financial Assets : Receivables
• Accounts receivables: Called trade receivables for nonfinancial institutions.
• Other receivables: E.g., advances or loans to employees for travel expenses. Shown
separately (e.g., Due from Employees).
Analyzing Receivables:
• Days’ sales outstanding/Collection period:

• Average Accounts receivable/(Average credit Sales ÷ 365).
• Broad General rule: Should not exceed 133% of payment terms.
• Debtor’s aging analysis
• Note 9, Pg 131 CCD annual report

SESSION
SESSION 1012
Receivables : Provisions and Ageing Analysis
SESSION
SESSION 1012
Receivables : Problem on Ageing Analysis
Veena trading company had the following customer account balances on December 31, 20xx
Account Amount Due Date Account Amount Due Date

Anand 11,070 November 30 Hariharan 6,310 August 14
Bhowmick 3,570 June 12 Kamal 980 December 14
Chandra 9,250 January 10 (next year) Lakshman 10,720 January 27 (next year)
Dawood 5,980 October 23 Pankaj 2,310 September 3
Eknath 7,190 November 15 Uday 3,210 October 7
Goving 1,480 December 8 Wilson 1,120 December 31
Required:
• Prepare an ageing analysis of the trade receivables under the following age categories: not yet
due; 1-30 days past due; 31-60 days past due; 61-90 days past due; 91-120 days past due; over 120
days past due
SESSION
SESSION 1012
Receivables : Problem on Ageing Analysis
Solution
• Veena trading company : Ageing Schedule - on December 31, 20xx
Account Amount Not due yet 1-30 31-60 61-90 91-120 Over 120
Anand 11,070 11,070
Hariharan 6,310 6,310
Kamal 980 980
Lakshman 10,720 10,720
Pankaj 2,310 2,310
Uday 3,210 3,210
Wilson 1,120 1,120
Bhowmick 3,570 3,570
Chandra 9,250 9,250
Dawood 5,980 5,980
Eknath 7,190 7,190
Goving 1,480 1,480
Total 63,190 19,970 3,580 18,260 9,190 2,310 9,880
SESSION
SESSION
1012
Transfer of Trade Receivables
Factoring: transfer of receivables without recourse i.e. without subsequent liability on the seller
• Factor: party who buys the receivables, assumes the risk of credit loss and absorbs any bad debts
Suppose ABC company factors INR 100,000 of its receivable from XYZ company with Factors Ltd. The
factor levies a finance charge of 2% of the amount of trade receivables and retains an amount equal to
5% of trade receivables (to cover unexpected sales returns). The entry in the books of ABC company will
be as follows:
Cash A/C 93,000 (BS as cash)
Due from Factor A/C 5,000 (BS as other financial asset)
Loss on sale of TRs 2,000 (IS as loss)
Trade receivables 100,000 (Reduced from BS)
• Hypothecation: agreement for using receivables as security for a loan, similar to just like giving a
collateral for loan. No formal transfer of receivables. Only requires a disclosure.
SESSION
SESSION
1012
Financial Assets: Financial Investments
• Can be in Equity instruments or Debt instruments

Debt securities Equity securities
• Commercial Paper, ABS • Common shares
• Corporate & Govt bonds • Preferred shares
• Current investments are valued at the lower of the cost or fair value
• Companies are required to provide exhaustive information of each and every

security held in their investments
SESSION
SESSION 1012
Investments
Pg 101 – Balance Sheet : Equity accounted investees, financial assets (current & non current)
Note 8A, 8B, 9, 10, 11, 12, 15, 16, 17, 18, 19
SESSION
SESSION 1012
Financial Accounting Classification and Measurement model
1.Contractual cash flows?

Yes No
2. Business model :
Hold to collect
Yes No
2. Business model :
Hold to collect and sell
Yes
Amortized
FVTOCI FVTPL
cost
SESSION
SESSION 1012
Accounting for Financial Assets : IFRS 9
• Business model: implies objective of holding financial assets: regulatory driven (like banks),
parking surplus cash (like manufacturing companies) or for trading gains (Invt Banks, MFs etc)
• Hold to collect model : to collect contractual cash flows

• e.g. debt securities HTM
• Hold to collect and sell model: both to collect contractual cash flows and to sell financial
assets e.g. liquidity portfolios
• Contractual cash flow characteristics: the contractual terms of the financial asset give rise on specified
dates to cash flows that are solely payments of principal and interest on the principal amount outstanding
• On the basis of above two, financial assets are measured as follows:
1. Amortized cost
2. FV through other comprehensive income (FVOCI)
3. FV through profit or loss (FVTPL)
SESSION
SESSION 1012
Analyzing monetary assets
• Current ratio.
• Current assets ÷ Current liabilities.
• Measures liquidity; margin of safety.
• Need to also look at make up of assets (e.g., cash vs. inventory).
• Acid-test ratio.
• Monetary current assets ÷ Current liabilities.
• Excludes inventories and prepaid items.
FA – DEFERRED TAX ASSETS
Kingfisher Airlines Ltd
Kingfisher Airlines Ltd was one of the largest aviation companies in India. Lets look at the note of
deferred taxes in its annual report 2012.
Note 8: Deferred Tax
Particulars March 31 (INR mn)

2012 2011
DTL
On account of depreciation on fixed assets 2,121 3,183
On account of timinig differences in recognition of 202 408
expenditure
2,323 3,591
DTA
On account of timing differences in recognition of expenditire 84 94
On account of disallowance under section 40 (ia) 7,917 6,612
On account of unabsored losses and depreciation under IT Act 34,781 26,164
1961
42,782 32,869
Net DTA 40,459 29,278

Note 39:
DTA on unabsorbed depreciation and business losses has been recognized on the basis of a business
plan prepared by the management which takes into account certain future receivables arising out of
contractual obligations. The management is of the opinion that there is virtual certainty supported by
convinving evidence that sufficient future taxable income will be available against which the DTA can
be realized.
The auditor’s report contained the following observation:
Attention of the members is invited to note 39 regarding recognition of DT credit on account of

unabsorbed lossed and allowances during the year aggregating to INR 11,181 mn (year ended March
31, 2011, INR 4,934 mn). Total amount recognized upto March 31, 2012 , INR 40,459 mn. This does
not satisfy the virtual certainty test for recognition of deferred tax credit as laid down in AS 22.
A note to the company’s financial statement for the year ended March 31, 2012 stated:
Deferred tax credit earlier recognized upto March 31, 2012 , INR 40,459 mn has been derecognized
during the year by debit to surplus account (reserves and surplus) in the balance sheet.
Required:
1. Do you agree with the company’s position on deferred taxes? Explain

2. Identify possible management considerations for the position adopted. Examine to what
extent they might apply in the case.
Journal of Behavioral and Experimental Finance 25 (2020) 100258
Contents lists available at ScienceDirect
Journal of Behavioral and Experimental Finance

journal homepage: www.elsevier.com/locate/jbef
Full length article
Ambiguity attitudes and myopic loss aversion: Experimental evidence

using carnival games
∗
Divya Aggarwal a , , Uday Damodaran b
a
T A Pai Management Institute, Badagabettu Road, Manipal, Karnataka 576104, India
b
IIM Udaipur, India
article info a b s t r a c t
Article history: A series of tailor made experiments were executed on a representative Indian household sample to
Received 27 March 2019 investigate the influence of risky and ambiguous options on the choices made by the subjects. The
Received in revised form 30 November 2019 objective of the study was to understand the impact of prior results on subsequent decisions made
Accepted 7 December 2019
along with identifying role of demographic factors impacting their choices. The experiment showed
Available online 16 December 2019
that subjects displayed an escalation of commitment while playing the game in domains of losses. The
JEL classification: results show that attitude of ambiguity aversion cannot be generalized in totality and role of cultural
C93 factors needs to be explored further.
G40 © 2019 Elsevier B.V. All rights reserved.
G41
Keywords:
Ambiguity aversion
Myopic loss aversion
Status quo bias
1. Introduction prominently used by academicians (Camerer and Weber, 1992).

The paradox gave persuasive evidence on preference of peo-
The distinction between risk and uncertainty dates back to ple towards known probability distributions. The three colour
Knight (1921), but it focused only on quantifiable explicit proba- paradox consisted of an urn containing 90 balls of which 30
bilities as the differentiator between risk and uncertainty. Savage balls are known to be of red colour. The remaining 60 balls
(1962) Proposed subjected expected utility (SEU) model which are a combination of black and yellow balls, the exact number
enabled to represent individual preferences by forming proba- of black or yellow balls are unknown. One ball is to be drawn
bilities based on subjective beliefs of an individual. Economics out randomly from the urn. The decision maker is offered two
assumed that for a rational decision maker all uncertainties can pair of bets. In the first bet, the decision maker could bet either
be reduced to risk by using subjective beliefs to form probability on red having a known probability of 1/3 or on black with an
estimates. Daniel Ellsberg with his famous Ellsberg paradox (Ells- unknown probability. It was observed that majority of the partic-
ipants preferred to bet on the known probability. In the second
berg, 1961) brought a sharp turn in the theory of decision making
bet, the decision maker could bet either on the combination of
by arousing the interest to understand and model ambiguity. His
red+yellow balls, having unknown probability or black+yellow
seminal paper contested that SEU fails to hold in certain situa-
balls having a known probability of 2/3 since total black and
tions (which he termed as ambiguous) and hence there is a need
yellow balls were 60 in number. It was observed that majority
to explore alternate models of decision making. He defined the
of the participants preferred to bet on the latter leading to the
ambiguity construct in the form of characteristics of information violation of Savage’s independence axiom. Since then Ellsberg
which effects the subjective beliefs of the decision maker. Nature paradox has been widely studied in academic circle and the con-
of information with respect to its amount, reliability, type and struct of ambiguity has led to more ambiguities on how people
unanimity can influence a decision maker’s degree of confidence make choices. Scholars have developed empirical and theoretical
in forming subjective beliefs (Frisch and Baron, 1988). models for examining decision making under ambiguity. A review
Ellsberg used several colour and urns examples to represent of the same is done by Camerer and Weber (1992), Najjar et al.
ambiguity, among which the 3 colour paradox became the most (2009) and Guidolin and Rinaldi (2013).
The first study credited to build a descriptive model of de-
∗ Corresponding author. cision making under ambiguity, was by Einhorn and Hogarth
E-mail addresses: [email protected] (D. Aggarwal), (1985). Their model was based on three parameters which in-
[email protected] (U. Damodaran). fluence decision making under ambiguity, firstly anchoring on
https://doi.org/10.1016/j.jbef.2019.100258
2214-6350/© 2019 Elsevier B.V. All rights reserved.
2 D. Aggarwal and U. Damodaran / Journal of Behavioral and Experimental Finance 25 (2020) 100258
an initial probability estimate, secondly, amount of ambiguity choices of gambles have been used extensively as a research
present in the situation and thirdly, an individual’s own tolerance design to examine SEU models under risky situations, the re-
towards ambiguity. These three parameters result in an anchoring sults are inconsistent when examined under ambiguous situa-
and adjustment strategy for decision making under ambiguity. tions (Camerer and Weber, 1992). Moreover, with majority of the
The model paved way for studies in two directions, first be- experimental studies done in developed markets, it remains ques-
ing situation specific studies which analysed how an individual tionable if general conclusions can be made from their results
behaves under ambiguous and unambiguous (risky) situations. (Grou and Benjamin, 2008).
Second strand of research examined the individual characteristics Since attitudes towards risk and uncertainty are context spe-
with respect to socio-demographics and psychological personality cific, a gambling situation might give different results as com-
traits influencing decision making under ambiguity. This study is pared to investing situation (Budner, 1962). This study has used
an attempt to examine both aspects for decision making under carnival games as representation of gambling and leisure activi-
ambiguity through an experimental methodology. ties. Prospect theory (Kahneman and Tversky, 1979; Tversky and
With respect to the first path, numerous empirical studies Kahneman, 1992) is rooted in lottery choice questions and lottery
have been done since 1990s which have established that an tasks were popularized in behavioural finance literature by Holt
individual’s decision making under risky(unambiguous) situation and Laury (2002) experiments. In his book (Holt, 2007), gives
is substantially different from decision making under ambigu- several example of risky decisions by leveraging the example of
ous situation (Hogarth and Kunreuther, 1989; Ghosh and Ray, the famous reality show ‘‘Who wants to be a millionaire?’’ to
1992; Tversky and Fox, 1995; Borghans et al., 2009; Charness and support the use of lottery choices in understanding individual
Gneezy, 2010; Levati et al., 2017). Hence, attitudes towards risk preferences. It highlights that individuals attribute the outcome
are different from attitudes towards ambiguity, but whether they of their choices to pure luck in lottery choices. While competence,
are positively or negatively related is still debatable (Trautmann peer evaluation, self-evaluation and past experience heavily influ-
and Kuilen, 2014). Over time, Ellsberg paradox paved way for ence financial investing decisions, leisure activities like gambling
inter disciplinary research with a lending hand from psychol- in a city carnival are devoid of feeling of blame, regret and eval-
ogists to examine attitudes towards ambiguity with respect to uations as the outcomes are believed to be purely out of chance
the socio-demographic and behavioural traits of the decision (Curley et al., 1986). The choices under leisure activity are not of
maker. With inter disciplinary research, the SEU models started forced nature and can be used to understand ambiguity avoidance
being psychologized with an increasing focus on factors affecting as more of a general attitude, which is the objective of this study.
information processing (Slovic et al., 1977). Since ambiguity is Kahneman and Tversky (1979) made use of lottery choices and
omnipresent in real life decision making, it becomes imperative to based it on two assumptions. Firstly, individuals have no special
understand what drives and impacts ambiguity attitudes (Halevy, reason to disguise their true preference when eliciting lottery
2007; Berrger and Bosetti, 2016). Myriad empirical literature has preferences Secondly, assuming that individuals often know how
emerged which has examined the robustness of ambiguity atti- they would behave in actual situations of choice, it is difficult to
tudes by exploring the personality traits and socio-demographics attribute each individual’s preference to a common factor.
of the decision maker. The influence of socio-demographic factors Illustrative works by Ellsberg (1961) and Becker and Brownson
like gender, financial wealth and nature of employment needs (1964) and the likes only explain ambiguity leading to aversion
to be examined to bring more clarity to understand ambiguity and are devoid of psychological information by not answering
phenomena and its agents. The progress in decision making under as to ‘‘Why should an aversion or preference come?’’. Empir-
ambiguity phenomenon needs to be at par with the progress ical work in this area is sparse and inconclusive. Hence more
in decision making under risks (Dorresteijn, 2017). Scholars are studies are needed which can explain actual behaviours under
finding it difficult to interpret the conceptual vignettes emerging ambiguity so they can be generalized to the behaviour in ac-
from various studies and are struggling to develop a coherent the- tual world (Machina and Siniscalchi, 2014). Understanding the
ory of decision making under ambiguity (Machina and Siniscalchi, existing dearth of work, an experimental study is done in a city
2014). carnival event to explore general attitudes towards ambiguity
The objective of this study is to contribute to the existing lit- in an Indian context. Participants were given an initial equal
erature in three ways. Firstly, it uses an experimental approach to endowment in the form of poker chips and had to play multiple
examine choices under risky and ambiguous gambling situations games by investing a part or all of the given endowment in each
in an emerging market like India. The difference between risk game. While most of the studies have used choices as prefer-
and ambiguity attitudes has already been established in multiple ences to elicit ambiguity attitudes, few studies have also used
works, this study supplements the existing literature on this willingness to pay/bidding amount (Di Mauro and Maffioletti,
front. Secondly, antecedents of ambiguity avoidance as a general 2004) and allocation preferences among different options to elicit
attitude with respect to socio-demographic factors are examined. ambiguity attitudes (Charness and Gneezy, 2010; Weber et al.,
Factors like gender, employment type and education level are 2012). This study also uses allocation preferences to examine how
examined to understand if they play a role in moderating atti- individuals respond to risk and ambiguity. To elicit true prefer-
tude towards ambiguity. With presence of inconclusive evidence ences, incentives in the form of rewards in kind were given based
on influence of social and demographic factors on ambiguity, on maximization of the initial endowment. The winners were
this study aims to bring more clarity on this aspect. Thirdly, announced on an hourly basis by maintaining a leader board. This
impact of constant and instant feedback on subsequent choices ensured that participants had incentives to play instead of making
is also observed. Just like in a casino, a person plays multiple it a voluntary exercise without any incentives. Given the nature
games and gets instant feedback of his/her wins or loses, similarly of the experiment in a carnival, it would not have been possible
this experiment enables to observe similar behaviour by playing to reward cash prizes as it would have been treated as a lottery,
multiple games. The study aims to understand how feedback of which is subjected to regulatory approvals under Indian law.
previous decisions, influences subsequent choices, which is still The paper proceeds as follows. The next section discusses
less explored in the existing literature. the relevant literature leading to hypothesis development. Sec-
The context of the study is pure leisure activities of gambling tion 3 discusses the methodology and charts the experimental
with a focus on how individuals allocate their wealth under design. Section 4 presents the results and discussion, followed by
different games projecting situations of risk and ambiguity. While conclusion in Section 5 and future research areas in Section 6.
D. Aggarwal and U. Damodaran / Journal of Behavioral and Experimental Finance 25 (2020) 100258 3
2. Literature review and hypothesis development to analyse the impact of antecedents like demographic and eco-
nomic factors on ambiguity attitudes in context of developed
Allocation of choices under situations of risk and ambiguity countries like US and Netherlands. They examined whether low
have been examined empirically in various studies (Charness education has a positive impact on ambiguity aversion and found
and Gneezy, 2010). Modern portfolio theory only focuses on contrasting results from prior literature (Butler et al., 2014). The
risk and return relationship, it does not uses risk in conjunction aversion to ambiguity was higher among college educated par-
with ambiguity. Various studies have examined the influence of ticipants as compared to only high school educated participants.
demographic factors on financial risk taking. While it has been es- Since the empirical literature on it is sparse and inconclusive,
tablished that socio-demographic factors do influence risk taking we develop our hypothesis based on the theory of Butler et al.
appetite, but multiplicity of such factors has made it difficult to (2014). Higher education leads to high cognition levels which can
compare and determine which factor is important (Dorresteijn, enable an individual to deal with ambiguity better. This leads to
2017; Dohmen et al., 2011). The field is more fragmented with the development of third hypothesis which is:
respect to ambiguity attitude where inconclusive results prevail H3: Higher educated participants allocate a higher proportion of
on which socio demographic factors influence choices (Machina endowment as compared to others under ambiguity.
and Siniscalchi, 2014). This section examines the current liter- The next hypothesis deals with the influence of type of em-
ature with respect to the study of antecedents in the form of ployment on ambiguity attitude. While scholars have analysed
demographic profile and instant feedback on attitudes towards role of occupation on risk appetite, the literature on this front is
risk and ambiguity to form hypothesis for the study. Allocation of not very extensive and also mixed in nature (Dorresteijn, 2017).
endowments across different games is used to operationalize the Research on entrepreneurial cognition (McMullen and Shepherd,
measurement of ambiguity, which can be treated synonymously 2006), has given evidence that entrepreneurs or self-employed
as willingness to invest/bet in a particular game. individuals operate in environments characterized with ambigu-
a. Influence of risk and ambiguity on preferences ity. Hence, entrepreneurs act on vague information which leads
The risk return trade-off implies that an increase in risk should them to develop their own beliefs with assigning a high proba-
corroborate with an increase in return (Machina and Siniscalchi, bility of success to their own ventures (Knight, 1921). Whether
2014). This study leverages the same concept in designing the entrepreneurs are averse to ambiguity or have a preference for
experiment in this study. Studies have shown that ambiguity it, is still a debatable question. Empirical works on ambiguity
aversion can explain market anomalies like equity premium puz- attitudes of entrepreneurs have given inconclusive evidence as
zle (Dimmock et al., 2016a), portfolio under diversification (Uppal the attitudes of entrepreneur tend to be context driven and are
and Wang, 2003) and even non participation in stock markets marked with overconfidence and optimism. Studies including
(Boyle et al., 2012). This study aims to analyse whether presence works of Shyti and Paraschiv (2014), Shyti (2013), Schere (1982),
of ambiguity impacts the choices made under risk return trade- Holm et al. (2010) and Ng (2015) have shown that entrepreneurs
off similarly through an experimental study. Hence, the first deal with ambiguity more as compared to managers but a gen-
hypothesis for the study is: eral conclusion on their ambiguity attitudes cannot be drawn.
Hence, our next hypothesis deals with exploring ambiguity at-
H1: Amount allocated under risky situation is significantly different titudes of self-employed participants, considered as similar to
from amount allocated under ambiguous situation across high or low entrepreneurs in this study.
likelihood of events.
H4: Self-employed participants allocate a significantly higher propor-
b. Influence of demographic factors tion of endowment as compared to others under ambiguity.
Socio-demographic factors in the form of gender, age, edu- Higher the quantum of endowment gambled by self-employed
cation, wealth/level, race, occupation, culture, religion, marital will show a preference towards ambiguity since they are willing
status, dependants have been typically used in studies to assess to part a higher amount as compared to other participants.
their influence on an individual’s decision making attributes.
With respect to gender, it is typically found that males are more c. Instant Feedback of wins/loses
overconfident which makes them more risk seeking as compared Rooting our hypothesis development in prospect theory offers
to females (Lundeberg et al., 1994). Areas where males have an explanation of how people perceive losses and gains in de-
a favourable disproportionate representation such as financial cision making. Over time prospect theory has been advanced to
industry or even gambling, they tend to be more risk seek- explain attitudes under ambiguity as well (Tversky and Kahne-
ing. Various studies, to name a few, including those of Schubert man, 1992; Wakker, 2010). Key elements of prospect theory are
et al. (1999), Gervais and Terrance (2001), Barber and Terrance how individuals weigh uncertainty and how they compare losses
with gains (Kahneman and Tversky, 1979). With respect to risky
(2001) and Gysler et al. (2002), have shown males to be less
situations, it has been observed that individuals become risk seek-
risk averse as compared to females in varied contexts. Charness
ing in domain of losses and risk averse in domain of gains (Lopes,
and Gneezy (2012) had empirically examined that amount of
1987; Chakravarty and Jaideep, 2007). It has been attributed to a
allocation in risky assets by females was smaller as compared to
reflection affect bias along with the feeling of regret and blame
males since females are generally more risk averse. With respect
leading an individual to become risk averse in gains (Kahneman
to ambiguity aversion, the results are inconclusive on whether
and Tversky, 1979). Though studies regarding ambiguity attitudes
females are more ambiguity averse as compared to males (Agnew
under situations of losses are limited, the existing studies have
et al., 2008; Borghans et al., 2009; Kray and Gelfand, 2009; Yang
shown confirmatory evidence to prospect theory with losses be-
and Zhu, 2016). As the study examines ambiguity attitudes as a
ing perceived differently from gains. It has been observed that
general trait with respect to leisure activities, this leads to the
individuals become ambiguity seeking under losses and ambi-
development of second hypothesis:
guity averse under gains but the results are contingent to the
H2: Males allocate a significantly higher proportion of endowment stakes involved and the context of the situation (Bouchouicha
as compared to females under ambiguity. et al., 2017). Whether the reflection effect of prospect theory can
With respect to risk tolerance, it is generally believed that be generalized, still needs to be seen (Hershey and Schoemaker,
higher education leads to higher risk tolerance (Dohmen et al., 1980). Along with reflection effect, scholars have also attributed
2011). Recent studies by Dimmock et al. (2016b,a) have tried an escalation of commitment effect which leads to continuing on
In game one, since all 52 cards were used, the probability of

each card being drawn out could be estimated by the participant.
While group 4 offered the highest reward, it also had the highest
risk of only card ‘‘A’’ having the probability of being drawn to
be 1/13. Similarly group 1, 2 and 3 had the winning probability
of 5/13, 4/13 and 3/13 respectively. This was similar to a risky
situation as the probability of each card was known for sure. After
the participant told the experimenter of his/her decision to bet
on the cards, he/she drew out a card and immediately got the
feedback of his/her winnings or losses.
After game 1, the participant was asked by the experimenter
to randomly draw out 10 cards from the deck of cards without
seeing which cards were drawn out. The reward groups remained
the same as of game 1 (Fig. 1), but now the participant did
not know which cards had been drawn out. This resulted in
a situation of ambiguity, where due to relevant missing infor-
mation the participant could not assess the probability of each
Fig. 1. Four betting groups in the deck of cards.
card being drawn out. The participants were asked to repeat
the same exercise of betting on the cards as done in game 1.
The task of drawing out cards was given to the participant to
the same path even if it results in consecutive negative outcomes give an illusion of control. This was done to avoid the par-
(Staw, 1981). Keeping in perspective the context of gains and ticipant develop a feeling of the game being manipulated by
losses in gambling activities, the fifth hypothesis examines the the experimenter. The experiment was designed as a one group
impact of losses on betting amounts in ambiguous situations. pre-test/post-test repeated measures quasi experimental study
Hence, the hypothesis is: where all the participants took part in all the conditions. The
H5: The proportion of allocation by participants is higher under measurement variable was the allocation of betting amount on
losses as compared to gains. the card numbers under situation of risk (before ambiguity). All
The next section discusses the experimental design to test the participants were then given the treatment of ambiguity in the
hypothesis. form of missing information by randomly removing 10 cards from
the deck of cards. Consistent with the psychological perspective
3. Experimental design of ambiguity, ambiguity was conceptualized in this experimental
design in the form of missing information (Frisch and Baron,
1988; Einhorn and Hogarth, 1985). Post that, the measurement
a. Structure of the experiment: variable of allocation of betting amount on card numbers was
In the experiment, the participants had to play two card analysed. Hence, the study enabled to compare betting amount
games. The first one involved betting on cards from the full deck under risk with betting amount under ambiguity. This was done
of 52 cards. The second game involved betting on cards from an to examine whether allocations differ under situations of risk and
incomplete deck of cards. The layout of the stall design did not ambiguity. The reasons for the difference in betting amounts were
permit randomization of the two games as all the participants had examined with respect to two aspects. Firstly impact of socio
to play both the games in an orderly manner. For the first game, demographic variables and secondly experience of wins/loss on
participants were asked to bet on any or all cards as classified subsequent choices. No interaction effect was examined among
under four betting groups. Fig. 1 was displayed to the participants these two aspects as it was not the objective of the study.
which showed the cards classified into each betting group. The
participant had to decide how much to bet by specifying the card b. Execution of the experiment
numbers. Each card depending upon the group it belonged to, The experiment was done in an annual two day winter car-
guaranteed a specific amount of return on the amount betted nival event being held since last 38 years in the township city
on it. Group 1 consisted of card numbers 2, 3, 4, 5, 6; Group 2 named Jamshedpur in the state of Jharkhand, India. The exper-
consisted of card numbers 7, 8, 9, 10; Group 3 consisted of card iment was disguised in the form of simple lucky draw card
numbers J, Q, K and Group 4 consisted of card A as shown in Fig. 1, games. The participants were naïve about the purpose of the
giving returns of 2x, 3x, 4x and 5x respectively. experiment and were only asked to play the games as part of
Once the participant had decided how much to bet and on the carnival event. The set of games as part of the experiment
how many number of cards to bet on, only one card was drawn were masked under the theme of a famous Indian movie named
out from the deck of cards by the participant. Depending upon ‘‘Gangs of Wasseypur’’. The movie was chosen on the basis of
the card drawn out, the participant would be eligible to win its popularity in Indian cinema and the relation of its storyline
2x, 3x, 4x and 5x of their endowment betted on that card if it with the carnival region Jamshedpur. This was done deliberately
belonged to group 1, 2, 3 and 4 respectively. While the game so that participants can relate to the game. The experiment was
assured only gains, but since only 1 card was to be drawn out, carried with the help of university students who performed the
the participant had to forego the endowment betted on the other role of experimenters.
cards, if he/she had betted on more than one card. For e.g., if a A nominal ticket price (INR 20) was charged to play the game.
participant decided to bet INR 100 on card number ‘‘2’’ and INR The games were briefed to the participants before starting and
100 on face card ‘‘J’’, his/her total amount betted in the game an initial equal endowment (poker chips equivalent to INR 1000)
stood at INR 200. Only one card was drawn out by the participant was given to them. Before starting the game, the experimenters
from the deck of cards. If the card drawn out was 2, he/she won randomly asked the participants the count of each card in the
INR 200 (endowment increased to INR 1100); if it was J, he/she deck of cards and how many cards will remain if they remove
won INR 400 (endowment increased to INR 1300); however if a specific card from the deck. This was done to ensure that
it was any other card, he/she would lose INR 200 betted in the participants understand the game. The participants had to choose
game(endowment reduced to INR 800). the portion of the initial endowment that they wished to bet in
Table 1
Descriptive statistics.
Source: Authors estimates.
Variable Alternative Indicated N Percentage
Male 1 135 66.5%
Gender
Female 0 68 33.5%
Outside 1 97 47.8%
Employment Self 2 42 20.6%
Unemployed 0 64 31.6%
Graduate & Below 1 132 65.0%
Education level
Post graduate 0 71 35.0%
Red 1 116 57.1%
Ellsberg 2 urn – Choice 1
Black 0 87 42.9%
Red + Yellow 0 103 50.7%
Ellsberg 2 urn – Choice 2
Black + Yellow 1 100 49.3%
Followed 1 79 38.9%
Fig. 2. Stall layout of the experiment. Paradox
Not Followed 0 124 61.1%
the games. They could bet all or any amount between 0–1000
be it red or black when asked to choose among the combination of
of their endowment, the remaining chips not betted would also
red+yellow or black+yellow. A tabular frequency count of Ellsberg
be treated as their endowment only. The objective of the game
3 colour paradox are given in Table 2.
was to maximize their initial endowment by playing the card
games. A leader board was maintained and in every hour one
4.2. Hypothesis testing
lucky winner was announced and given a prize for maximizing
the endowment given. Since the footfall at the carnival repre-
sented Indian household population, it assured random selection The results of the allocations made in each game gave interest-
of participants to play the games. Participants above 17 years of ing insights. The dependent variable was taken as the proportion
age were allowed to play as it ensured that higher secondary of amount allocated among different groups in Game 1 and Game
education has been imparted to all. Moreover, since playing card 2. It was calculated based on the stake betted divided by the
games are a common Indian leisure activity, it can be assumed endowment in hand, before starting of each game. With in-
that individuals can estimate probabilities of card numbers. dependent variables being categorical in nature, paired t tests
Fig. 2 Shows the execution design of the experiment stall at with equal and unequal samples along with one way analysis of
the carnival. A stall with different layout units was set up with variance (ANOVA) measures were used to analyse the significance
the interior décor based on the movie theme. across categorical groups. Firstly, the number of groups invested
Movie props and photoshoot stalls were made at the entrance in each game were analysed. Under game 1(Risk), only 20% of
and exit of the stall to create a leisure environment and build the participants betted on all four groups; whereas under game
movie nostalgia. After purchasing the entry ticket from the desk, 2 (Ambiguity), only 12% of the participants betted on all four
participants were made to go through the profiling desk where groups. This was calculated to assess whether participants diver-
they were briefed that they will have to play card games in the sified more by betting across multiple groups under situation of
movie theme stall. They were asked to fill their name and de- risk vs ambiguity. Moreover, the average number of groups i.e. (1,
mographic questions pertaining to their age, gender, employment 2, 3 or 4) invested in both the games was compared using the
and education level in a questionnaire. They were informed that paired t test. The difference was significant at 5% level with p =
it was done so as to announce the winners in every one hour. 0.00016 (T statistic = 3.8512) with a difference of 0.266 in the
The standard Ellsberg 3 colour paradox was also asked to elicit two means. Participants betted on more number of groups under
their choices. On an average it took 7 min per participant to risk than under ambiguity.
play the games which included eliciting their profiling data and Secondly, the proportions of allocations made under both card
Ellsberg choices as well. The next section discusses the results of games were analysed using two sample for means paired t tests.
the allocations made by the participants. The difference in the average proportion of allocation in situation
of risk (game 1) and in situation of ambiguity (game 2) was 3.06%.
4. Results and discussion The result was significant at 1% level with p = 0.0014 (T statistic
= 3.0161) leading to failure of rejection of null hypothesis H1.
4.1. Descriptive analysis Hence amounts allocated under risky situation was significantly
higher than amounts allocated under ambiguous situation. A be-
The descriptive results of the data collected is shown in tween group comparison of the amounts allocated under risk and
Table 1. A total of 250 visitors played the game. Due to in- ambiguity is given in Table 3.
complete data, the final sample consisted of 203 participants, The results showed that on an average participants allocated
of which the average age was 38 years (Min = 22 years, Max a higher proportion of their endowment in all the groups under
= 78 years and SD = 13 years). Among the participants, 33.5% situation of risk as compared to ambiguity, but the results are
were females, 71.4% were married and 35% had above graduate only significant for groups 3 and 4. In situations of high risk high
level of education. Almost 48% of the participants were employed return, the stakes invested differed significantly under situations
in private and government organizations while 20% were self- of risk and ambiguity.
employed and remaining were unemployed. The Ellsberg choices The impact of demographic factors including gender, edu-
of the participants are also mentioned in Table 1. cation and employment type along with the influence of win-
In the 3 colour Ellsberg paradox, only 39% of the participants ning/losses in previous games have been analysed based on the
followed the Ellsberg paradox. The results were surprising as proportion of allocations made under both the games. The results
almost 60% of the people stuck to their original choice of colour, of Hypothesis 2 and 3 are shown in Table 4.
Table 2
Cross tabulation of ellsberg 3 colour paradox.
Variable Count % Variable Count %
Choice 1
Red ball 116 57.1 Black Ball 87 42.9
Of which: Of which:
• Red + Yellow 70 60.3% • Red + Yellow 33 38.0%
• Black + Yellow 46 39.7% • Black + Yellow 54 62.0%
Total 116 100.0% Total 87 100.0%
Table 3
Average proportion of amount betted among different groups (H1).
Groups Game 1 – Risk Game 2 - Ambiguity Difference in means T statistic P value
Group 1 (2, 3, 4, 5, 6) 5.61% 5.03% 0.58% 0.9369 0.1749
Group 2 (7, 8, 9, 10) 7.69% 7.62% 0.07% 0.0902 0.4641
Group 3 (J, Q, K) 7.41% 6.25% 1.15% 1.5485 0.0615***
Group 4 (A) 3.94% 2.68% 1.26% 1.8252 0.0347**
All groups 24.65% 21.59% 3.06% 3.0161 0.0014*
Notes: *, ** and *** show significance at 1%, 5% and 10% respectively.
Table 4
Difference in proportion of allocations based on gender education level (H2 and H3).
Game 1 – Risk Game 2 - Ambiguity Difference in means Paired T statistic P value
Gender
Female 23.75% 18.14% 5.61% 3.5135 0.0004*
Male 25.10% 23.32% 1.78% 1.3829 0.0844***
Difference in means (1.35%) (5.18%)
T-statistic (0.5413) (2.3239)
P value 0.2945 0.0105*
Education level
Graduate & Below 23.60% 19.61% 3.99% 4.1653 0.00002*
Post graduate 26.61% 25.26% 1.35% 0.5868 0.2795
Difference in means (3.01%) (5.65%)
T-statistic (1.1126) (1.9285)
P value 0.1340 0.0282**
Paired t tests were used to analyse the mean difference in With more than two groups under type of employment, one
allocations made by females and males under risk and ambiguity way analysis of variance (ANOVA) was done to examine the
respectively. Both females and males allocated a higher propor- influence of employment type on allocations made under risk and
tion of their endowments under risk with results at 1% and 10% ambiguity. The results are shown in Table 5.
significance level. A between group comparison among males and The ANOVA results of within group comparison under both
females was also done under risk and ambiguity respectively. risk and ambiguity, showed a significant difference in alloca-
In both situations, males allocated a higher proportion of their tions made by self-employed, employed outside and unemployed
endowment as compared to females. However, the results were participants. To examine which level of employment influenced
significant only in situation of ambiguity. This leads to failure of allocations under risk and ambiguity, paired t tests were used.
rejection of second hypothesis. The analysis showed that males Though everyone allocated more under risk than ambiguity, the
allocated a higher proportion of allocation than females under results were significant at 1% significance level for unemployed
ambiguity. The results are similar to gender studies under risky and outside employed participants. This leads to rejection of
situations where it has been found that generally females are hypothesis 4. Though self-employed participants allocated more
more risk averse than males (Dorresteijn, 2017). under ambiguity as compared to others, it was not significant.
With respect to education level, similar approach was adopted However, the unemployed and outside employed participants
by using paired t tests. There was a significant difference in the allocated a significantly lower amount under ambiguity as com-
average allocations made under risk and ambiguity by partici- pared to risk. Studies on influence of occupation on risk tolerance
pants who were graduates and below. In both situations, post- are limited and inconclusive (Dorresteijn, 2017). With respect
graduates allocated a higher proportion but the results were to ambiguity, it needs to be explored further whether nature of
significant under ambiguity. This leads to failure of rejection of occupation influences attitude towards ambiguity.
third hypothesis. The analysis showed that post graduates allo- The impact of wins and losses made under Game 1(Risk) was
cated a higher proportion of endowment as compared to others also analysed using paired t tests on the proportion allocated
under ambiguity. While it has been studied that higher level of under Game 2 (Ambiguity). It was observed that participants who
education enables individuals to have a higher tolerance for risk lost under Game 1 (Risk) allocated higher, on an average 23.14%,
(Dorresteijn, 2017), whether it leads to develop a higher tolerance whereas participants who won allocated on an average 20.64%
towards ambiguity is to be explored further. This study showed of their endowments. The difference in means of 2.5% did not
that post graduates were more tolerant to ambiguity as compared come out as significant (T statistic = 0.88819, p value = 0.1880).
to participants who were either graduates or below graduates. Past losses made participants more liberal by escalating their
Table 5
One way anova analysis and paired T tests of proportion of amount invested inn each sub game based on type of employment (H4).
Employment type Game 1 – Risk Game 2 - Ambiguity Difference in means Paired T statistic P value
Outside employed 26.02% 22.53% 3.50% 2.7585 0.0034*
Unemployed 20.23% 16.07% 4.16% 2.7811 0.0035*
Self employed 28.21% 27.82% 0.39% 0.1212 0.4520
F-statistic 3.3343 5.8909
P value 0.0376** 0.0032*
commitment in the game but the results did not come out as However, the study suffers from two limitations. Firstly, being
significant. Hence, hypothesis 5 was rejected. The next section a carnival game, the stall layout did not permit randomization of
discusses the conclusion of the study. the card games, leading to presence of order effects. The rationale
for using risk game first was to examine impact of wins/losses
5. Conclusion under risk on decision making under ambiguity. Secondly, the
financial/risk literacy score of the participants was not exam-
Interesting insights were obtained with respect to the Ellsberg ined. It was assumed that being acquainted with card games,
paradox where majority of the participants did not follow the participants are comfortable in dealing with probabilities related
paradox and decided to stick to their original choices. Similar to card games. The limitation was addressed by providing that
results have been obtained by Roca et al. (2006) which question experimenters explain the games to the participants and ensure
whether Ellsberg choices can be generalized. Baron (2000) has that they understand it.
given a different interpretation of exploring attitudes towards In comparison to risk vs ambiguity in the card game, a higher
ambiguity from the perspective of personal theory of probabilities proportion of allocation and diversification was done in the
which is inclined towards the psychological traits of an individual. risk game. This is consistent with the theoretical frameworks of
It argues that ambiguity attitudes are dependent more upon the Bossaerts et al. (2010) and Epstein and Schneider (2010) where
framing effects of a situation which is related to how the missing individuals diversify and invest less in situations of ambiguity as
information is perceived by the decision maker. Moreover, apart compared to situations of risk. With respect to the antecedents
from the status quo bias, the violation of the paradox could be due of ambiguity behaviour, gender, education level and employment
to the feeling of regret by changing the first choice made or lack type came as significant variables. These variables, except for
of trust on the experimenter (Frisch and Baron, 1988). Hence, the nature of occupation, have consistently come as significant in
concept of decision making under ambiguity is still ambiguous myriad studies under risk also. Under ambiguity it needs to be
with multiple perspectives by scholars. explored more in depth. The results from the study are consistent
This study contributes to the existing literature in three novel
with the theoretical framework of Langer and Weber (2005)
ways. Firstly, it explores the ‘‘why’’ aspects of ambiguity attitudes
which states that myopic view can result in increasing the at-
by examining the influence of gender, employment level and
tractiveness of subsequent gambles rather than decreasing it, but
education level on it. Secondly, this study also urges to explore
the findings are not significant in this regard. The next section
factors beyond demographic variables to elicit ambiguity prefer-
gives directions for future work.
ences which could be driven more based on recent experience of
negative or positive outcomes. Thirdly, it examines the ambiguity
6. Direction for future work
attitudes in an emerging market context like India, to highlight
the potential impact of cultural factors on decision making.
The results of the study support the growing literature chal- While the study examined choices under risk and ambiguity
lenging the assumption of ambiguity aversion being universal in the context of gambling/leisure activity, different contexts like
in nature (Kocher et al., 2018). The formal inference procedure financial investing or medical results can lead to different results.
stems from observing the behavioural differences in comparison Hence, more studies are needed in this direction to understand
to existing studies. When compared to studies by Ho et al. (2002, how ambiguity attitudes are dependent upon the situation and
2001) done with MBA participants from developed countries, amount at stake. Ambiguity attitudes cannot be generalized and
majority of them were averse to ambiguity. On the other hand, In- looked in isolation for all participants. Impact of geographical
dian participants in this study did not strictly follow the Ellsberg culture and idiosyncratic behaviours like status quo bias needs
paradox. Exploring risk preferences among four different coun- to be built in when analysing individual decision making. Indian
tries i.e. USA, Germany, Poland and China; Weber and Hsee (1998) culture is characterized as more of collectivist in nature. Role
showed that the risk preferences significantly differed from each of family commitment, status of women in the household and
other. They found that Chinese respondents were less risk averse moral values regarding persistence in belief and optimism can
as compared to American respondents. They relied on Hofstede lead to ambiguity attitudes which can differ in comparison to the
1980 study for their explanation of cross-cultural differences by developed world.
leveraging the ‘‘individualism’’ dimension. This study shows that The antecedents of the ambiguity aversion bias needs to be
the results obtained by other behavioural finance studies cannot explored further by moving beyond demographic factors. Biases
be easily obtained in other countries. It suggests that cultural of belief perseverance, status quo, regret, overconfidence and
differences and social status differences among others, should be loss aversion are also observed in support to ambiguity and
taken into consideration before making general conclusions based uncertainty attitudes (Granberg and Brown, 1995; Krauss and
on experiments. Studies have also found evidence of optimism Wang, 2003; Rostami and Dehaghani, 2015). It is these biases
leading to ambiguity seeking in loss domain and at boundary which lead to escalation of commitment and sticking to origi-
levels of probability, contingent upon the context of the deci- nal choices, without updating beliefs based on new information.
sion made. With respect to Indian sample size, cultural factors Even wealth effects need to be examined to determine ambi-
need to be explored to understand the preference for ambiguity, guity attitudes along with exploring cultural and geographical
especially in cultures where hope is an essential component. factors. Apart from just the core argument of loss aversion by
prospect theory, sensitivity to losses and aspiration level of an Guidolin, M., Rinaldi, F., 2013. Ambiguity in asset pricing and portfolio choice:
individual also needs to be examined while examining ambiguity A review of the literature. Theory and Decision 74 (2), 183–217.
Gysler, M., Kruse, J.B., Schubert, R., 2002. Ambiguity and Gender Differences
attitudes. Experience of past returns along with an aspiration
in Financial Decision Making: An Experimental Examination of Competence
level of achievement can influence decision making especially in and Confidence Effects. Swiss Federal Institute of Technology, Center for
financial contexts. This holds an interesting and promising area Economic Research.
of future research. Halevy, Y., 2007. Ellsberg revisited: An experimental study. Econometrica 75 (2),
503–536.
Acknowledgements Hershey, J.C., Schoemaker, P.J., 1980. Prospect theory’s reflection hypothesis: A
critical examination. Organ. Behav. Human Perform. 25 (3), 395–418.
Ho, J.L., Keller, R.L., Keltyka, P., 2001. Managers’ variance investigation decisions:
This research would not have possible without the support an experimental examination of probabilistic and outcome ambiguity. J.
of the management students from XLRI-Xavier School of man- Behav. Decis. Mak. 14 (4), 257–278.
agement. The students were given the role of experimenters to Ho, J.L., Keller, R.L., Keltyka, P., 2002. Effects of outcome and probabilistic
execute the experiment in the carnival. ambiguity on managerial choices. J. Risk Uncertain. 24 (1), 47–74.
Hogarth, R.M., Kunreuther, H., 1989. Risk, ambiguity and insurance. J. Risk
Uncertain. 2 (1), 5–35.
References Holm, H.J., Victor, N., Sonja, O., 2010. Entrepreneurs under uncertainty: an
economic field experiment. Working paper. Center for the Study of Economy
Agnew, J.R., Anderson, L.R., Gerlach, J.R., Szykman, L.R., 2008. Who chooses and Society Lund.
annuities? An experimental investigation of the role of gender, framing, and Holt, C.A., 2007. Markets, Games, & Strategic Behavior. Pearson Addison Wesley,
defaults. Am. Econ. Rev. 98 (2), 418–422. Boston.
Barber, B.M., Terrance, O., 2001. Boys will be boys: Gender, overconfidence, and Holt, C.A., Laury, S.K., 2002. Risk aversion and incentive effects. Am. Econ. Rev.
common stock investment. Q. J. Econ. 116 (1), 261–292. 92 (5), 1644–1655.
Baron, J., 2000. Thinking and Deciding. Cambridge University Press. Kahneman, D., Tversky, A., 1979. Prospect theory: An analysis of decision under
Becker, S.W., Brownson, F.O., 1964. What price ambiguity? Or the role of risk. Econometrica 263–291.
ambiguity in decision-making. J. Polit. Econ. 72 (1), 62–73. Knight, F.H., 1921. Risk, Uncertainty and Profit. Hart, Schaffner and Marx, New
Berrger, L., Bosetti, V., 2016. Ellsberg re-revisited: An experiment disentangling York.
model uncertainty and risk aversion. ssrn papers. Kocher, M.G., Lahno, A.M., Trautmann, S.T., 2018. Ambiguity aversion is not
Borghans, L., Heckman, J.J., Golsteyn, B.H., Meijers, H., 2009. Gender differences universal. Eur. Econom. Rev. 268–283.
in risk aversion and ambiguity aversion. J. Eur. Econom. Assoc. 7 (2–3), Krauss, S., Wang, X.T., 2003. The psychology of the Monty Hall problem:
649–658. discovering psychological mechanisms for solving a tenacious brain teaser.
Bossaerts, P., Ghirardato, P., Guarnaschelli, S., Zame, W.R., 2010. Ambiguity in J. Exp. Psychol. Gen. 132 (1).
asset markets: Theory and experiment. Rev. Financ. Stud. 23 (4), 1325–1359. Kray, L.J., Gelfand, M.J., 2009. Relief versus regret: The effect of gender and
Bouchouicha, R., Martinsson, P., Medhin, H., Vieider, F.M., 2017. Stake effects on negotiating norm ambiguity on reactions to having one’s first offer accepted.
ambiguity attitudes for gains and losses. Theory and Decision 1–17. Soc. Cogn. 27 (3), 418–436.
Boyle, P., Garlappi, L., Uppal, R., Wang, T., 2012. Keynes meets Markowitz: Langer, T., Weber, M., 2005. Myopic prospect theory vs. myopic loss aversion:
The trade-off between familiarity and diversification. Manage. Sci. 58 (2), how general is the phenomenon? J. Econ. Behav. Organ. 56 (1), 25–38.
253–272. Levati, V.M., Napel, S., Soraperra, I., 2017. Collective choices under ambiguity.
Budner, S.N., 1962. Intolerance of ambiguity as a personality variable. J. Pers. 30 Group Decis. Negot. 26 (3), 133–149.
(1), 29–50. Lopes, L.L., 1987. Between hope and fear: The psychology of risk. Adv. Exp. Soc.
Butler, J.V., Guiso, L., Jappelli, T., 2014. The role of intuition and reasoning in Psychol. 20, 255–295.
driving aversion to risk and ambiguity. Theory Decis. 77 (4), 455–484. Lundeberg, M.A., Fox, P.W., Punćcohaŕ, J., 1994. Highly confident but wrong:
Camerer, C., Weber, M., 1992. Recent developments in modeling preferences: Gender differences and similarities in confidence judgments. J. Educ. Psychol.
Uncertainty and ambiguity. J. Risk Uncertain. 5 (4), 325–370. 86 (1), 114.
Chakravarty, S., Jaideep, R., 2007. Attitudes Towards Risk and Ambiguity Across Machina, M., Siniscalchi, M., 2014. Ambiguity and ambiguity aversion. In:
Gains and Losses. Economic Science Association World Meeting, pp. 1–34. Handbook of the Economics of Risk and Uncertainty, Vol. 1. pp. 729–807.
Charness, G., Gneezy, U., 2010. Portfolio choice and risk attitudes: An experiment. McMullen, J.S., Shepherd, D.A., 2006. Entrepreneurial action and the role of
Econ. Inq. 48 (1), 133–146. uncertainty in the theory of the entrepreneur. Acad. Manage. Rev. 31 (1),
Charness, G., Gneezy, U., 2012. Strong evidence for gender differences in risk 132–152.
taking. J. Econ. Behav. Organ. 83 (1), 50–58. Najjar, A., Nabil, I., Weinstein, J., 2009. The ambiguity aversion literature: a
Curley, S.P., Yates, F.J., Abrams, R.A., 1986. Psychological sources of ambiguity critical assessment. Econ. Phil. 25 (3), 249–284.
avoidance. Organ. Behav. Human Decis. Process. 38 (2), 230–256. Ng, D., 2015. Entrepreneurial overconfidence and ambiguity aversion: dealing
Di Mauro, C., Maffioletti, A., 2004. Attitudes to risk and attitudes to uncertainty: with the devil you know, than the devil you don’t know. Technol. Anal.
experimental evidence. Appl. Econ. 36 (4), 357–372. Strateg. Manage. 27 (8), 946–959.
Dimmock, S.G., Kouwenberg, R.G., Mitchell, O.S., Peijnenburg, K., 2016a. Ambi- Roca, M., Hogarth, R.M., Maule, J.A., 2006. Ambiguity seeking as a result of the
guity aversion and household portfolio choice puzzles: Empirical evidence. status quo bias. J. Risk Uncertain. 32 (3), 175–194.
J. Financ. Econ. 119 (3), 559–577. Rostami, M., Dehaghani, Z.A., 2015. Impact of behavioral biases (overconfidence,
Dimmock, S.G., Kouwenberg, R., Wakker, P.P., 2016b. Ambiguity attitudes in a ambiguity-aversion and loss-aversion) on investment making decision in
large representative sample. Manage. Sci. 62 (5), 1363–1380. Tehran stock exchange. J. Sci. Res. Dev. 2 (4), 60–64.
Dohmen, T., Falk, A., Huffman, D., Sunde, U., Schupp, J., Wagner, G.G., Savage, L.J., 1962. The Foundations of Statistical Inference. Methuen.
2011. Individual risk attitudes: Measurement, determinants, and behavioral Schere, J.L., 1982. Tolerance of ambiguity as a discriminating variable between
consequences. J. Eur. Econom. Assoc. 9 (3), 522–550. entrepreneurs and managers. In: Academy of Management Proceedings.
Dorresteijn, F.v., 2017. Which socio-demographic factors determine risk taking Academy of Management, pp. 404–408.
of Investors? Schubert, R., Brown, M., Gysler, M., Brachinger, H.W., 1999. Financial decision-
Einhorn, H.J., Hogarth, R.M., 1985. Ambiguity and uncertainty in probabilistic making: are women really more risk-averse? Am. Econ. Rev. 89 (2),
inference. Psychol. Rev. 92 (4), 433–456. 381–385.
Ellsberg, D., 1961. Risk, ambiguity, and the Savage axioms. Q. J. Econ. 643–669. Shyti, A., 2013. Over-confidence and entrepreneurial choice under ambiguity. In:
Epstein, L.G., Schneider, M., 2010. Ambiguity and asset markets. HEC Paris Research Paper, (pp. No. SPE-2013-982). Paris.
Frisch, D., Baron, J., 1988. Ambiguity and rationality. J. Behav. Decis. Mak. 1 (3), Shyti, A., Paraschiv, C., 2014. Risk and ambiguity in evaluating a new venture: an
149–157. experimental study. In: DRUID Society Conference. Copenhagen, Denmark.
Gervais, S., Terrance, O., 2001. Learning to be overconfident. Rev. Financ. Stud. Slovic, P., Fischhoff, B., Lichtenstein, S., 1977. Behavioral decision theory. Annu.
14 (1), 1–27. Rev. Psychol. 28 (1), 1–39.
Ghosh, D., Ray, M.R., 1992. Risk attitude, ambiguity intolerance and decision Staw, B.M., 1981. The escalation of commitment to a course of action. Acad.
making: An exploratory investigation. Decis. Sci. 23 (2), 431–444. Manage. Rev. 6 (4), 577–587.
Granberg, D., Brown, T.A., 1995. The Monty Hall dilemma. Pers. Soc. Psychol. Trautmann, S.T., Kuilen, G.v., 2014. In: Keren, G., Wu, G. (Eds.), Ambiguity
Bull.. Attitudes; HandBook of Judgment and Decision Making. Blackwell, London.
Grou, B., Benjamin, T.M., 2008. Ambiguity aversion and illusion of control: Tversky, A., Fox, C.R., 1995. Weighing risk and uncertainty. Psychol. Rev. 102 (2),
Experimental evidence in an emerging market. J. Behav. Financ. 9 (1), 22–29. 269–275.
Tversky, A., Kahneman, D., 1992. Advances in prospect theory: Cumulative Weber, M., Weber, E.U., Nosic, A., 2012. Who takes risks when and why:
representation of uncertainty. J. Risk Uncertain. 5 (4), 297–323. determinants of changes in investor risk taking. Rev. Financ. 17 (3), 847–883.
Uppal, R., Wang, T., 2003. Model misspecification and underdiversification. J. Yang, X., Zhu, L., 2016. Ambiguity vs risk: An experimental study of
Finance 58 (6), 2465–2486. overconfidence, gender and trading activity. J. Behav. Exp. Financ. 9, 125–131.
Wakker, P.P., 2010. Prospect Theory: For Risk and Ambiguity. Cambridge
University Press, London.
Weber, E.U., Hsee, C., 1998. Cross cultural differences in risk perception, but
cross cultural similarities in attitudes towards perceived risk. Manage. Sci.
25–35.
SESSION 14
Term 1
FPM - XLRI
SESSION 10
Some websites for financial job profiles/industry you can see
Private Equity Roles

https://www.lcatterton.com/Aboutus.html
Connect on Linkedin if it interests you (avoid bulk spamming)
See similar firms , they have office in Mumbai
Books to read
Psychology of Money by Morgan Housel
SESSION 10
Operating
Balance liabilities
Sheet formats
Liabilities:
• Operating liabilities
• Financial liabilities
SESSION 10
Classification of liabilities
• Current Liabilities : expected to be settled in normal operating cycle or within 12 months
after reporting period. (TPs, BPs, Bank ODs, Unearned revenue, IT payables). Identify
whether they are related to? ----------→
Operating Activities • Payables etc
• ST borrowings, interest
Financing Activities
payable
• Non Current Liabilities : post retirement health care, pensions, loans, bonds issued
• Assess disclosures for all restrictions and covenants
• Operating liabilities arise from firm’s operating activities, can be settled via cash or
goods/services
• Financial liabilities arise from source of funds, can be settled by cash or through another
financial assets or conversion into equity
SESSION 10
Current liabilities
Current liabilities: Definite Vs. Estimated
• Definite: can be determined precisely e.g.: TPs, Salaries payable, interest payable, bills
payable, current portions of long term debt
• Bills payable: firm buying on credit or taking loan issues a bill payable to its supplier. It
makes the terms concrete and definite
• Current portion of LT debt
• Estimated/Provision: known liability but the amount is uncertain i.e. definite obligations
but estimates with respect to precision on timing and amount needs to be estimated. E.g.
are product warranties, income taxes, employee benefits
• Income taxes payable
• Employee benefits
SESSION 10
Liabilities
• Non Current Liabilities

• Assess disclosures for all restrictions and covenants
• Note 23, Pg 139, CDEL AR, Lets read and analyze first 2 term loans
• What are your observations on it?
• Lots of loan facilities drawn
Debentures/
Loans
Bonds
SESSION 10
Financial liabilities
• Financial liabilities – contractual obligations to pay definite amounts often over long periods
• Debentures, loans, mortgages and leases
• What are secured and unsecured liabilities?
SESSION 10
Are Bonds and Debentures the Same?
Bonds Debentures
Tenure Period Long term Short term
Risk Low High
Collateral Required Most are collateral free
Interest Lower Higher
Convertibility into shares Never Can be
Priority in case of liquidation First priority After Bondholders
Issued Mostly by govt, financial Mostly by corporates
institutions
SESSION 10
Debentures Payable
• Debenture/Bond ---→ written promise to pay a principal amount at a specified time and interest rate
• Parties : Issuer/Borrower and debenture holder/lender
• Terms: Debenture trust deed, underwriter, debenture trustee
• Google and see what all types of debentures are available:

• Secured, unsecured, bullet bonds, term, serial, convertible, callable, zero coupon, deep
discount
• What are credit rating agencies ????? What is their role in bonds/debentures
SESSION 10
Issuing debentures
• Par/Face value , coupon rate , maturity , yield
• Par value: The par (principal) value is the amount that will be paid by the issuer to the bondholders at maturity to retire
the bonds.
• Coupon rate: The coupon rate is the promised interest rate on the bond.
• Maturity date: Debt securities are issued over a wide range of maturities, from as short as one day to as long as 100 years
or more
• Yield : investor’s required interest rate for debentures of a particular risk category, think as inventor’s opportunity cost
• If yield > coupon rate --------------------→ what should be the fair value of the debenture
• It will be priced below its face value hence debenture will be issued at a discount Debentures are
• If yield < coupon rate --------------------→ what should be the fair value of the debenture
recorded at their
• It will be priced above its face value hence debenture will be issued at a premium
fair value in the
books and not at
• If yield = coupon rate --------------------→ what should be the fair value of the debenture par value
• It will be priced at its face value hence debenture will be issued at a par
SESSION 10
Understand few operating liabilities
PENSION BENEFITS
INCOME TAXES
SESSION 10
Pensions and Other Post employment Benefits
• “Search Employee benefits in CCD report”
• Lets understand it in more detail
• Pg 161, Significant accounting policies : Employee benefits – defined benefit plan

SESSION 10
Employee benefits
• In service benefits : provided during employee’s service
• Salaries, wages, bonus, paid leave, cash for unused leave, health care, cars,
housing, club membership, EPF etc.
• Most of it paid in the normal course of operations and expensed
• All are part of payroll expenses
• Post employment benefits : provided after employee’s separation
• Provident fund, gratuity, pension, health care etc.

SESSION 10
Post employment benefits – Pension plans
Type of pension plan Defined Contribution Plan (DCP)
• Company guarantees annual contribution to an investment fund (separate trust fund)
• Company has no further obligation beyond annual contribution
• Annual contribution is determined by agreement between enterprise and employees
• Employees can also contribute to the fund
• NPS and PF are examples of DCP in India
Defined Benefit Plan (DBP)

• Company guarantees money paid out later, e.g. in % on income of last 5 years before retirement
• Company has an obligation to pay out an uncertain future amount (especially for medical plans) regardless
of the funding made
• Pensions and gratuity are examples of DBP
• If the trust fund does not have sufficient assets, employer must make up the shortfall
• Sometimes appoints a fund manager (insurer or pension fund) to administer
Extent to which companies offer DC or DB varies by country (macro policies on health care benefits)
SESSION 10
Accounting Treatment
Income Statement Balance Sheet
DCP • The annual contribution charged as an expense as • No impact in BS, the company does not
part of payroll and corresponding payment or guarantee the amount of pension
liability if contribution has not been paid
• The expenses includes the annual contribution • Differences between value of pension
DBP charge, but also several other non operating fund and obligation is the basis for the
components asset or liability on the BS
• Expected return on plan assets
• Interest expense on pension obligation
• Actuarial gains or losses
SESSION 10
Defined Benefit Plan
• Most DB plans are funded through a separate legal entity, typically a pension trust,
which disburses the benefits
• Funded status of a pension plan – overfunded or underfunded – refers to whether

the amount of assets in the pension trust is greater than or less than the estimated
liability
• Determining liability under DBPs is complex ---------------------Actuaries
• Actuary is engaged to prepare a valuation of the company’s liability for pension
and other benefits
SESSION 10
Measuring a defined benefit Pension plan obligation
• Measure Pension obligation as the present value of future benefits earned by employees
for service provided to date
• PVDBO under IFRS and PBO under GAAP
• Its projecting in future, so what all assumptions are needed?
• Future compensation increases and levels
• Discount rates
• If changes in assumptions increase obligation --→ actuarial loss
• If changes in assumptions decrease obligation -→ actuarial gain
• Balance Sheet Presentation
• Report pension plan funded status on balance sheet
• Funded Status = Fair value of plan assets – PVDBO
SESSION 10
Understand few operating liabilities
PENSION BENEFITS
INCOME TAXES
SESSION 10
Types of tax rates
• Statutory tax rate : tax rate specified in the tax law -------------- Finance Act
enacted by Parliament specifies it every year
• Effective tax rate: rate at which an enterprise pays tax on its profit. Measured
as ratio of income tax expense to accounting profit ----------------------→ tax
burden
SESSION 10
Income taxes
• Separate entity convention !!!!

• Income tax Act, 1961 ----→ classifies companies as separate taxable entity which must pay
income taxes
• Tax laws determine taxable profit, accounting principles determine accounting profit
• Both are governed by different objectives, one focused on generating government
revenue, other on measuring financial performance
• The financial statements will arrive at a tax expense, but the actual tax payable will
come from the tax return.
• Current tax: amount of income tax payable in respect of taxable profit for a period
• Usually payable in installments, called advance tax, during the period in which taxable
profit is earned
• Any excess payment is a current tax asset
SESSION 10
Income taxes : Deferred taxes
What is a permanent difference in tax expense?
• Difference between financial accounting and tax accounting that is never eliminated.
• A permanent difference will cause a difference between the statutory tax rate and the
effective tax rate.
• Also, because the permanent difference will never be eliminated, this tax difference does
not generate deferred taxes, as in the case with temporary differences.
• Eg. company incurring a fine. Tax codes rarely ever allow a deduction in the event of a fine,
but fines are often deducted from income in book accounting.
A permanent difference will never be reversed, and as such, will only have an impact in the
period it occurs. Often, the only impact is that the effective tax rate on the books will be
higher or lower than the effective tax rate on the company’s tax return
SESSION 10
Income taxes : Deferred taxes
What is a temporary difference in tax expense?
• Differences between pretax book income and taxable income that will eventually reverse itself or
be eliminated
• Transactions that create temporary differences are recognized by both financial accounting and
accounting for tax purposes, but are recognized at different times hence simply called timing
differences
• Eg. Depreciation computed based on different tax base and carrying amount
A temporary difference, however, creates a more complex effect on a company’s accounting.
If a temporary difference causes pre-tax book income to be higher than actual taxable income, then a
deferred tax liability is created. This is because the company has now earned more revenue in its book
than it has recorded on its tax returns.
The company knows that this will eventually have to reverse, and the company will have higher revenues
and, thus, higher taxes on its tax returns at a future period. Transitively, having lower book income than
tax income will result in the creation of a deferred tax asset.
SESSION 10
Temporary and permanent differences
SESSION 10
Deferred tax liability/assets
• DTL : When the firm has paid less taxes than the required taxes on the accounting profit
(when you underpay authorities) i.e. more taxable income on accounting books but less
taxable income as per IT records
• DTL -----→ records the fact the company will, in the future, pay more income tax
because of a transaction that took place during the current period
• DTA: When the firm has paid more taxes than the required taxes on the accounting
profit (when you overpay authorities)
SESSION 10
GST
• GST : tax on supply of goods and services rather than the earlier central, state or local taxes levied
on the manufacture of goods and services
• Central GST and State GST : levied on intra state supply i.e. within
• Integrated GST : levied on inter state supply i.e. between
• GST : allows input tax credit
• Lets understand with an example
• Hari in Dibrugarh sells a chair for INR 1,000 plus tax to Ganesh in Guwahati. Assume a CGST of 5%,
SGST of 5% and IGST of 10%. Ganesh pays INR 1,100 consisting of product price of INR 1,000 and
GST of INR 100 in Assam. Suppose Ganesh sells the chair to Joseph, a consumer in Bengaluru for
INR 1,600 plus tax, adding a profit of INR 600. Joseph pays Ganesh INR 1,760.
• What will be the recording for it?

SESSION 10
GST journal entries
Hari’s Journal Ganesh’s Journal
Hari Sells to Ganesh Debit Credit Ganesh buys from Hari Debit Credit
Cash 1,100 Purchases 1,000
To Sales 1,000 CGST Recoverable 50
CGST Payable 50 CGST Recoverable 50
SGST Payable 50 To Cash 1,100
Ganesh Sells to Joseph Debit Credit

Hari Pays GST Debit Credit
Cash 1,760
CGST Payable 50
To Sales 1,600
CGST Payable 50
IGST Payable 160
To Cash 100
Ganesh Pays GST Debit Credit
IGST Payable 160
GST receivable and GST Payable are part of the
To Cash 60
operations and will be classified as current assets and
current liabilities CGST Recoverable 50
SGST Recoverable 50
SESSION 15
Term 1
FPM - XLRI
Financial
Balance Sheet liabilities
formats
OE: Owner’s Equity
• Shareholder’s equity consists of :

• Share capital
• Reserves and Surplus
A. Share capital
Terms you might come across for
Share: Unit in the share capital of the company
Issue price/Face value/Par value: Price at which a

company issues a share. Minimum amount that
shareholder must pay on a share.
Share/Stock price: Price at which a share is quoted on

the stock exchange on which it is listed
Companies Act allows a company to issue only two

types of shares i.e. ordinary/equity shares (common
stock) or preference shares (preferred stock).
A. Share capital
Stock & NOSH
Authorized/Registered/Nominal capital: Maximum number of shares that a corporation is

legally permitted to issue, as specified in the MoA. Companies can increase authorized
capital with its shareholder’s approval
Issued capital: Number of shares issued by the company Look at CDEL
share capital
Subscribed capital: Number of shares taken up by the public
Called up capital: Portion of subscribed capital that has been called up by the company for
payments
Paid up capital: Part of called up capital that has been paid up by the subscribers of the
share capital
NOSH: Stock currently held by investors

Companies Act guidelines on Face Value
(1) Subject to the provisions of the Companies Act, 1956, the Act and these regulations, an issuer
making an initial public offer may determine the face value of the equity shares in the following
manner:
a) if the issue price per equity share is five hundred rupees or more, the issuer shall have the option
to determine the face value at less than ten rupees per equity share:
Provided that the face value shall not be less than one rupee per equity share;
b) if the issue price per equity share is less than five hundred rupees, the face value of the equity
shares shall be ten rupees per equity share:
Provided that nothing contained in this sub-regulation shall apply to initial public offer made by any
government company, statutory authority or corporation or any special purpose vehicle set up by any
of them, which is engaged in infrastructure sector.
(2) The disclosure about the face value of equity shares (including the statement about the issue price
being “X” times of the face value) shall be made in the advertisements, offer documents
and application forms in identical font size as that of issue price or price band.
Process to Raise Share Capital
Prospectus: Regulator approved document inviting offers from the public, for the subscription or
purchase of any shares or debentures of the corporate
Receive Applications: Intending shareholders make applications for equity shares in the prescribed
form, along with the prescribed application money (Norms around minimum subscription 90% of
issue size and amount of initial application money i.e. min 5% of face value of shares)
Allotment of Shares: Acceptance of the offer of the applicant for the purchase of the shares of the
company (allotment is done on pro-rata basis in case of over subscription). After allotment, applicant
is liable to pay the full amount of the shares allotted to him
Making Calls: Installments demanded by the directors against the sum payable by the shareholders
on their shares. Company can either collect the whole amount due on such shares together or in
installments
https://www.sebi.gov.in/filings/public-issues/apr-2021/zomato-limited-drhp_49956.html Look at
DRHP
Accounting for share capital
• Par value : Companies Act require shares to have a par value i.e. amount that must be recorded as share
capital
• Securities Premium/Share premium : any amount received in excess of par value
• Accounting entry for it: Issue of share capital with par value at a premium
Assume ABC company issues 10,000 shares of INR 20 per equity share at INR 25 (including premium of INR 5)
requiring full payment. Journal entry for it will be:
Debit Credit
Shares issues at premium of INR 5 Cash 250,000
To Equity share capital 200,000
To securities premium 50,000
Shares issues at par Cash 200,000
To Equity share capital 200,000
• Sweat Equity : equity shares issued by a company to its directors or employees for providing intangible
assets such as know how. As per Company’s act a company cannot issue any shares at discount except
‘sweat equity’ shares.
• Right issue : offer of shares to the existing shareholders
Restrictions on use of Issue of Shares
Companies Act has put restrictions on the use of securities premium account:
• Issuing un-issued shares as fully paid bonus shares to the members
• Purchase of its own shares or securities
• Payment of any premium payable, on the redemption of any redeemable preference shares, or of any
debenture of the company
• Writing off any expenses of, or any commission paid or any discount allowed on any issue of shares or
debentures of the company
Companies Act has put restrictions for issue of sweat equity shares at discount:
• They are authorized by a special resolution passed by the company
• Such resolution specifies the number of shares, the current market price, considerations if any
• At least one year has elapsed since the date on which the company was entitled to commence its business
• In case the shares are listed with a recognized stock exchange the rules prescribed by SEBI needs to be
followed.
Types of Equity Shareholders
Preference Shareholders Equity Shareholders

Types of Equity Securities
• There are three features that characterize and vary among equity securities
Life Voting Rights Cash flow Rights
Types of Equity securities Life Voting Rights Cash flow rights

Common Stock Infinite Yes Yes
Preferred stock Finite Generally not Priority over CS
• Some companies may issue different classes of common stock that provide different cash flow and voting
rights. In general, an arrangement in which a company offers two classes of common stock (e.g., Class A
and Class B) typically provides one class of shareholders with superior voting and/or cash flow rights.
• Preferred stock can be

• cumulative and non cumulative;
• participating and non participating;
• Redeemable and irredeemable
• Convertible and non convertible
• Creation of Reserves
Reserves and Surplus
• Reserve: Amount taken out (or separated) from the profit for some purpose
• Each type of reserve is made based on certain regulations and has certain restrictions around it
• In the BS, reserves and surplus appear under Other Equity.
Reserves
Revenue Capital Reserve

Reserve
General Specific
Reserve Reserve
Reserves Classification
• Revenue reserves: created out of revenue profits, Arise due to operational activities
• These reserves can be distributed among the shareholders as dividends
• General reserves (a.k.a. free reserves) : Created to add financial strength, ensures funds
availability to meet future expenses or contingencies; Example: Contingency Reserve
• Specific Reserves: Created for some specific purpose; Examples: Statutory reserve, debenture
redemption reserve
• Capital reserves: created out of capital profits, Arise due to non-operational activities of any
business;
• Examples: Profit on sale of fixed assets, Premium on issues of shares/debentures, and
Revaluation of fixed assets/liabilities, foreign currency translation reserve
• Types of capital reserves : capital redemption reserve, securities premium reserve
• All appropriations and dividends appear in the retained earnings column of the statement of
changes in equity ------→ known as below the line items
Earnings per share
EPS : measure of corporate performance for shareholders and potential investors
Reported only for equity share capital. Its computation depends on a company’s capital structure
• Simple capital structure ----------------------→ Basic earnings per share (EPS),

• Complex capital structure (contains convertibles) -------------------→ Diluted earnings per share (EPS).
Net income available to common shareholders

Basic EPS =
Weighted average number of common shares outstanding
• Numerator: Net income – preferred dividends.

• Denominator: Weighted average ??????
• To account for new issues, buybacks etc during the year
Diluted EPS : Reduction in EPS under the assumption that convertible instruments are converted into equity
Owner changes : Reacquisition of shares
• Why do you think company will reacquire its own shares?
Wants to return Prevent hostile takeover Feels its overcapitalized

Wants to signal that
surplus cash to by reducing number of and dividend outgo is
stock is undervalued
shareholders shares large
• Can be done through buyback or treasury stock operation
• Buyback : Companies Act 2013, specifies rule and conditions for buyback with respect to extent of
usage of free reserves, quantum of paid up capital and free reserves to be bought back etc.
• Can be bought from existing shareholders on a proportionate basis or from the open market
• Treasury stock operation : company’s own share capital that was issued and reacquired by the
company as an investment. Currently treasury stock is not allowed in India.
Bonus Shares and Stock split
• Bonus shares : additional shares of a company’s share capital distributed to its shareholders
without payment. Permitted by the company law they can be issued out of retained earnings or
other reserves
• Will it have any cash impact?
• Does not affect the company’s assets or shareholder’s equity. Simply transfers retained earnings or
other items in reserves and surplus to share capital ---------------------------→ capitalization of
reserves
Avoid paying
Signal confidence to
dividends and cash
shareholders
outflow
• Now think what can be a stock split?

Dividends
• Dividend : distribution of cash to shareholders
• Final dividend : approved in the company’s annual general meeting, paid at end of accounting
period
• Interim dividend : approved in the company’s annual general meeting, paid during the accounting
period
• Declaration date.
• Declared by board of directors.
• Create liability (i.e., Dividends Payable).
• Date of record.
• No entry.
• Determine who is entitled to dividend.
• Payment date.
• Pay out cash, eliminate liability.
Lets look at few problems
Problem 1: The share capital of Veer Company consists of

• 10,000 equity shares of INR 10 par value
• 2000, 10% preference shares of INR 10 par value
The company declared and paid total dividends in the first four years of operation as follows:
• Year 1 : INR 800
• Year 2 : INR 1,200
• Year 3 : INR 14,000
• Year 4 : INR 17,000
Required:
1. Determine the rate of dividend on each class of share capital in Years 1 to 4, assuming that the preference
share capital is cumulative
2. Determine the rate of dividend on each class of share capital in Years 1 to 4, assuming that the preference
share capital is non-cumulative
Lets look at few problems
• Solution to Problem 1
• Cumulative pref shares

Year Total dividends Preference dividends Equity dividends Rate % pref Rate % equity
1 800 800 0 4 0
2 1,200 1,200 0 6 0
3 14,000 2,000 (arrears) 2,000 (current) 10,000 10 10
4 17,000 2,000 15,000 10 15
• Non Cumulative pref shares

Year Total dividends Preference dividends Equity dividends Rate % pref Rate % equity
1 800 800 0 4 0
2 1,200 1,200 0 6 0
3 14,000 2,000 12,000 10 12
4 17,000 2,000 15,000 10 15
Lets look at your textbook
Problem 2:
Shamsher company earned a profit after tax of INR 210,000 for the year ended December 31, 20XX. The
company had 20,000 equity shares at the beginning of the year. On October 1, 20XX, it issued 40,000 shares.
Required: Compute the company’s weighted average EPS for the year
Solution:
Number of shares Weight Weighted Number of shares

20,000 9/12 15,000
60,000 3/12 15,000
30,000
EPS = 210,000/30,000 =7
Lets look at your textbook
• Read the Chapter on Equity
• Journal entries on share application and allotment etc are not part of final exam but you can read them for
better understanding
SESSION 16
Term 1
FPM - XLRI
Lets start understanding quality of financial reports
As an analyst, ask yourself two basic questions:
• Are the financial reports GAAP-compliant and decision useful?

• Are the results (earnings) of high quality? In other words, do they provide an adequate level of return, and are they
sustainable?
Scope of Financial statement analysis
• What is financial reporting by companies?
• Then what is the role of financial statement analysis?
• From what other sources can you get company information?
• Economic, industry and company information

• Voluntary disclosures
• Information intermediaries – analysts, investment newsletters, investment
advisers, debt raters
Other important financial documents
Documents Sources Written By

Quarterly Reports Company website Company
Analyst Reports OneSource, Bloomberg, 1. Brokerage houses
Thomson 2. Investment banks
Credit rating reports Alacra, OneSource Credit rating agencies like
S&P, Moody’ & Fitch, Crisil,
ICRA
Investor Presentation Company website Company
Earnings/Conference Company website Company
transcript
Components of Business Analysis
Business Environment and Strategy Analysis
Industry Analysis Strategy Analysis
Financial Statement Analysis
Financial Analysis
Accounting Prospective
Analysis Profitability Cash Flow Risk Analysis
Analysis Analysis Analysis
Quality of financial analysis depends on the reliability and

economic content of the financial statements i.e. accounting Intrinsic
analysis
Value
Source of Information
Areas of financial analysis
Composition of Asset Base --------------→ Investing
Capital Structure ----------------→ Financing
Working Capital----------------→ Operations
Adequacy of cash flows and accruals examination -----------→ Earnings Quality
Nature of operations----------→ Discontinued & Continued
Segment Analysis
Tools for Financial Analysis
• 1. Horizontal Analysis
• 2. Vertical Analysis
• 3. Ratio analysis
• 4. Combined Ratio metrics – DuPont and Altman Z score

1. Comparative Financial Statement Analysis
• Review consecutive financial statements

from period to period
• Prime objective – TREND

• Direction, speed and extent of trend
• Trend in related items
• Also known as HORIZONTAL ANALYSIS
• Two types:
• Year to year change analysis
• Index number trend analysis
2. Common Size Financial Statement Analysis
• Understanding the internal makeup

of financial statements
• Prime objective – Composition

• Balance Sheet – sources of
financing, composition of assets
• Enable intercompany
comparisons
• Also known as VERTICAL
ANALYSIS
• Two types:
• For income statement
• For Balance Sheet
3. Ratios
Financial ratio is a mathematical It enables investors, analysts,

relationship between two or more management, suppliers & other users of
amounts reported in the financial financial statements to better understand
statements and guide the business affairs
“The truth, however, is that financial ratio’s are not

substitutes for a crystal ball. They are just a
RATIO convenient way to summarize large quantities of
ANALYSIS financial data and to compare firm’s performance.
Ratio’s help you ask the right questions; they
seldom answer them”
-----------→ Brealey and Myers

4 broad categories of ratios
Profitability Solvency
Asset Turnover Liquidity
Ratio = Numerator / Denominator
= Outputs (per year) / Inputs

How to make sense of income statement
How to make use of numbers from income statement? What can Profitability
be interpreted from the profit breakup and expense format? Margins Ratio
Gross Margin
Formula: Gross Profit/Sales We can answer how
Ability of a company to control direct costs well the company is
able to manage
costs?
Operating Margin
Formula: Operating Profit/Sales
Overall operating efficiency; accounts for all operating expenses
Net Profit Margin

Formula: Net Profit/Sales
Proportion of sales available for distribution to shareholders
Profitability - Financial Statement Ratios
Operating Performance
Gross Profit Margin (Sales – COGS)/Sales
EBITDA Margin EBITDA/Sales
Operating Profit Margin Income from operations i.e. EBIT/Sales
PBT Margin PBT/Sales
Net profit margin Net income or PAT /Sales
Earnings per share Net income/ No. of shares outstanding
Cash realization Cash generated by operations/Net income
Profitability Return Metrics
How to make use of numbers from both balance sheet and Profitability
income statement Return Ratio
Return on Equity (ROE) How much return

Formula: Net income/Average shareholder’s Equity the company is able
Return on owner’s capital to generate for its
stakeholders?
Return on Assets (ROA)

Formula: Net income/Average Total Assets
Efficiency with which assets are utilized to generate returns for
stakeholders
Profitability - Financial Statement Ratios
Return on Investment = Net income/Investment
Investment??????
Return on Investment Net income/Investment
Return on Assets (ROA) (Net income + interest expense(1-tax rate))/Avg Total assets
Return on net assets (RONA) (Net income + interest expense(1-tax rate))/Avg Net assets
Net assets = Total assets – non interest bearing liabilities

Return on capital employed (ROCE) EBIT(1-t) / Average capital employed
Return on Invested capital (ROIC) (Net income + interest expense(1-tax rate))/ Invested capital
Invested capital = (working capital + NCA) or (NCL + OE)
(Focuses on permanent capital, excludes CL)
Return on equity (ROE) Net income/ Avg shareholder’s equity
Capital employed = Total debt (both long & short) + Shareholder’s equity (Net worth)
Shareholder’s equity = Total assets – Intangible assets – Total debt – current liabilities
Why average ?
• In ratios, averaging of balance sheet items is used as:
• P&L reflects full year of firm’s operation whereas balance sheet states the position of
the firm as on a specific date
• Only when both numerator and denominator are sourced only from P&L or from BS,
then averaging is not required
Efficiency Ratios
• Asset Turnover
• How efficiently are the assets being utilized?
• How efficiently is the company managing its working capital?
• Which ratios?
• Total asset turnover, fixed asset turnover, working capital turnover,
inventory turnover
Efficiency Financial Statement Ratios
Efficiency Ratios
Total asset turnover (in times) Sales / Average Total assets
Fixed asset turnover (in times) Sales / Average Total fixed assets
PPE turnover (in times) / Capital asset intensity Sales / Average PPE
Working capital turnover (in times) Sales / Avg working capital
Equity turnover Sales/ Avg shareholder’s equity
Cash turnover (in times) Sales/Avg cash & CE
Receivable turnover (in times) Sales / Average debtors
Average collection period (in days) (Debtors velocity or Debtor days) 365 / Receivable turnover ratio
Payable turnover (in times) COGS / Average creditors
Average payables period (in days) (Creditors velocity or Creditor days) 365 / Payable turnover ratio
Inventory turnover (in times) COGS / Average inventories
Average inventories period (in days) (Stock velocity) 365 / Inventories turnover ratio
Efficiency Financial Statement Ratios
Efficiency Ratios
Day’s cash Cash / (Cash expenses / 365)
Day’s receivables (or collection period) Accounts Receivable / (Sales/365)
Day’s inventory Inventory / (Cost of sales/365)
Cash conversion cycle days inventory outstanding + days sales
outstanding - days payables outstanding.
Stock velocity in months 12/Inventory turnover ratio
Creditors velocity in months 12/Creditor turnover ratio
Debtors velocity in months 12/Debtor Turnover ratio
Risk Analysis ratios - Solvency
• Solvency
• What is the level of financial risk borne by the shareholders from
long term perspective?
• How well is the company placed to meet its interest obligations?
• Which ratios?
• Debt to equity, Debt to total capital, Interest coverage ratio, total
coverage ratio
Financial Statement Ratios
Capital Structure & Solvency
Financial leverage Assets / Shareholder’s equity
Total debt to equity Total liabilities/shareholder’s equity
Debt capitalization LT debt/ (LT debt + shareholder’s equity)
Overall gearing ratio (Long term debt + short term debt)/shareholder’s equity
Net gearing ratio (LT debt + St debt – cash & ST invt)/shareholder’s equity
Long term debt to equity Long term liabilities/ shareholder’s equity
Times interest earned/Interest Income before income taxes and interest expense/Interest expense
coverage
Coverage EBITDA/Total fixed charges
Total debt to CFO (LT debt + ST debt)/ cash flow from operations
Total debt to EBITDA (LT debt + ST debt)/EBITDA
Capital Block to current Assets Capital Block / Current Assets
Capital Block = Equity funds + Debentures/Term loans etc
Du Pont Analysis : Breaking of ROE
• Why ROE is relevant?
• DuPont analysis is an approach to analyze ROE in detail – a way to decompose ROE to evaluate
what changes are driving the changes in ROE
• ROE = Net income/ Avg shareholder’s equity
• ROE = Net income/Sales * Sales/ Avg shareholder’s equity
• ROE = Net income/Sales * Sales/ Total Assets * Total Assets/Avg shareholder’s equity
• ROE = Profitability * Operating efficiency (asset turnover) * Leverage
• Profitability = Net income/Sales = EBIT/Sales * EBT/EBIT * Net income/EBIT

• = Ebit margin*interest burden*tax burden
Risk Analysis ratios - Liquidity
• Liquidity
• How are short term financing requirements being met?
• Are there sufficient liquid assets to meet its short term
obligations?
• Which ratios?
• Current ratio, Quick ratio, Cash ratio
However, a high current or quick ratio is not necessarily indicative of a problem- free company. It may also indicate that
the company is holding too much cash and not investing in other resources necessary to create more profit.
Liquidity Ratios
Current Ratio Current Assets/Current Liabilities
Acid test/Quick Ratio (Cash & CE + Mkt securities + Acc Receivables)/ Current liabilities
(Current Assets – Inventories)/Current liabilities
Cash Ratio (Cash & CE + Mkt securities)/Current liabilities
Cash flow ratios
Cash realization ratio (i.e., quality of earnings).

• Cash generated by operations ÷ Net income.
Coverage ratios.
• Use cash flow as numerator both coverage ratios (i.e., times interest
earned, fixed charges coverage).
Source and use percentages.

• Reorganize data into sources and uses format; then show each item as
percent of total sources.
• Ratio of cash generated by operations to total debt.
Altman z score
• Altman’s Z-Score model is a numerical measurement that is used to predict the chances of a
business going bankrupt in the next two years. The model was developed by American finance
professor Edward Altman in 1968 as a measure of the financial stability of companies
• Altman’s Z-Score interpretation:
• < 1.8 = company is in financial distress and with

a high probability of going bankrupt
• Btw 1.8 and 3 = company is in a grey area and

with a moderate chance of filing for
bankruptcy
• > 3 = company is in a safe zone and is unlikely

to file for bankruptcy
Are we forgetting any other metrics?
• What about market related measures?
• PE, PB – Are these ratios?
• How to interpret them?
• Enterprise Value related measures?

Market Measures
Price to Earnings Market price per share/ Earnings per share
Earnings Yield Earnings per share/ Market price per share
Dividend Yield Cash dividends per share/ Market price per share
Dividend payout rate Cash dividends per share/ Earnings per share
Price to book Market price per share/ Book value per share
Price to sales Market price per share/Sales per share
Price to cash flow Market price per share/cash flow per share
With whom to compare the ratios with?
• There can be four types of standards with which the ratios can be compared with
• Experience
• Budget
• Historical amount
• An external benchmark – can be like industry average etc

Pros and Cons of Ratio Analysis
• Usefulness:
• Quick analysis of historical performance
• Used for financial modeling or forecasting future earnings
• Used for investment decision making process
• Used for evaluation of management’s performance
• Limitations:
• Considers on quantitative data
• Relative comparison becomes difficult due to use of different accounting treatment or
periods
• Difficult to find comparable industry ratios when analyzing companies operating in
multiple products segments or different georaphies
SESSION 17
Term 1
FPM - XLRI
Business Cycle for Saanvi’s business
Completing the cycle 1. Firm raises capital

• Dividends
• Retained earnings Financing
4a. Rewards capital 2. Invests capital in long

providers term resources
4b. Reinvests part of its
profit to generate growth Investing
Operations
Business Activities Only cash
3. Makes profit by investing efficiently • Revenue transactions !!!!
• Expenses
• Net profit (Net loss)
Purpose of cash flow statement
• Limitations of Income statement
• Period’s income bears no direct relationship to the cash flows associated with the
period’s operations (remember accrual accounting)
• Does not provide information about entity’s investing or financing activities
• Why cash flow is important?
• Cash flows associated with period’s operations, entity’s investing and financing
• Lenders need to know how interest and principal repayment comes
• It is free from managerial’s judgement and estimates -------→ not accrual

Sources and uses of Cash
• Cash flow activities can be classified in two categories:
• Sources of cash : activities that generate cash
• Uses of cash: activities that involve spending cash
Sources Uses
Operations Cash Dividends
New borrowings Repayment of borrowings
New stock issues Repurchase of stock
Sale of property, plant and Purchase of property, plant and
equipment equipment
Sale of other noncurrent assets Purchase of other non current assets
• These 10 types of sources and uses are combined into 3 major categories ------→
operating, investing and financing
1. Operating activities
• All transactions that are not investing or financing activities i.e. net cash flow generated
by the period’s operations
• It can be presented in two ways:
Direct Method Indirect Method
• Summaries of operating inflows and • Most preferred by companies
outflows are shown and then combined
to arrive at net cash flow from • Starts from net income and reconciles
operations all operating inflows and outflows
• Easy to understand, but fails to show • Harder to understand than direct

the reconciliation between net income method
and cash flow from operations
• Not practiced in industry
Note: Cash flow from operating activities will be the same under either method.
1. Operating activities ------- Indirect method – Adjustment A
• Start with net income and make three types of adjustments

1. Adjust for noncash items included in net income (i.e., adjustment of accrual
based earnings).
• Add: Depreciation and amortization (add back).
• Add: Depletion
• Add: Bad debt expense
1. Operating activities ------- Indirect method – Adjustment B & C
• Start with net income and make three types of adjustments

2. Adjust for non operating items included in net income
1. Add: loss on disposal of PP&E or investments

2. Less: gain on disposal of PP&E or investments
3. Adjust for working capital items included in net income
1. Add: Decrease in current assets like trade receivables

2. Add: Increase in current liabilities like trade payables
3. Less: Increase in current assets like trade receivables
4. Less: Decrease in current liabilities like trade payables
Different view on classification
• FASB :
• Interest received or paid: operating activity.

• Dividends received: operating activity.
• Dividends paid: financing activity
• IASB :
• Can be classified in any activity category as long as done in a consistent manner.

1. Operating activities --------→ Indirect method
• Additions to net income • Subtractions to net income

• Depreciation expense • Increases in:
• Decreases in: • Accounts receivable
• Accounts receivable • Inventories
• Inventories • Prepaid Expenses
• Prepaid Expenses • Decreases in:
• Increases in: • Accounts payable
• Accounts payable • Wages payable
• Wages payable • Interest payable
• Interest payable • Taxes payable
• Taxes payable • Deferred taxes
• Deferred taxes • Gain on disposal
• Loss on disposal
2. Investing activities
• How are the funds used apart from operating activities
• What happens to assets -------→ bought or sold
• Inflows and outflows related to a specific type of asset are shown as separate amounts
rather than as single net amount
• Will interest received be an investing activity or operating?

3. Financing activities
• How are the funds sourced apart from operating and investing activities
• What happens to equity and liability -------→ additions or repayments
• Inflows and outflows related to a specific type of liability or equity are shown as
separate amounts rather than as single net amount
• Will dividend payments to shareholders be a financing activity or operating?
• Will interest paid be a financing activity or operating?

What about noncash transactions
• Significant investing and financing activities that did not involve cash.
• E.g., conversion of a convertible bond into stock, purchase of a building with a notes
payable.
• Not reported in body of statement of cash flows; narrative statement or supplemental

disclosure.
Summary of cash flow statement
• Assuming use of indirect method:
1. Cash generated by operations by adjusting the net income as reported on IS
1. Depreciation expense
1. Decrease in deferred Net cash flow
Net 2. Increase in deferred
taxes liability from operating
income taxes liability
2. Increase in accounts activities
3. Decrease in accounts
receivable
receivable
3. Increase in inventories
4. Decrease in inventories
4. Increase in prepaid
5. Decrease in prepaid
expenses
expenses
5. Decrease in payables
6. Increase in payables
6. Gain on disposal
7. Loss on disposal
Cash flow from operating activities

+ Cash flow from investing activities
+ Cash flow from financing activities
= Increase (decrease) in cash and cash equivalents
+ Cash and cash equivalents at beginning of year
= Cash and cash equivalents at end of year
Cash flow ratios
• Operating cash margin : Net cash provided by operating activities/Net sales
• Current liability cover: Net cash provided by operating activities/ Current liabilities
• Capital expenditure cover: Net cash provided by operating activities/ capital

expenditure
• Long debt cover: Net cash provided by operating activities/ non current financial
liabilities
• Cash interest cover: Net cash provided by operating activities/ interest paid
Lets solve a question
Lori Crump owns a small trucking operation. The bookkeeper presented Crump with the following income statements and
balance sheets for 2023 and 2022
Income Statements 2023 2022
Revenues 1,91,400 1,82,600 Crump cannot understand how the company can be 17,600
Operating expenses:
Depreciation -26,400 -26,400
ahead of last year in terms of cash on hand and yet show an
Fuel -77,000 -46,200 11,000 loss for the year
Driver's salaries -44,000 -35,200
Tax and licenses -22,000 -17,600
Required: Prepare a cash flow statement (indirect method) to
Repairs -30,800 -19,800
Miscellaneous -2,200 -1,100 use in explaining this to Lori Crump
Income (Loss) -11,000 36,300
Balance Sheets 12/31/23 12/31/22

Cash 22,000 4,400
Accounts Receivable 8,800 26,400
Net fixed Assets 1,98,000 2,24,400
Total Assets 2,28,800 2,55,200
Accounts Payable 30,800 22,000

Accrued Salaries 8,800 5,500
Other accruals 3,300 1,100
Long term debt 1,00,100 1,29,800
Crump, capital 85,800 96,800
Total liabilities and capital 2,28,800 2,55,200
Textbook Questions
Chapter 13 of your textbook : Statement of Cash Flows
Go through the Review Problem
Can practice below problems:

13.1, 13.4, 13.5, 13.6, 13.8, 13.9, 13.10, 13.11, 13.12, 13.13
Decoding Finance
Term 1
FPM - XLRI
Term 1
Financial Costing & Fundamentals

Accounting Decision Making of Finance
Annual reporting of Internal operational finance Value creating

Performance understanding investments
Has Tata Motors made Which product of Tata Should Tata Motors set up
profits? What is their motors is profitable, how is another factory in
financial position the cost of the product Jamshedpur?
arrived
Term 1

Annual reporting of Internal operational finance Value creating

Performance understanding investments
Historical looking Current operational costing, Future worth, hence time

budgets value of money
Relevant Skill sets for each

• Technical Skills --------------→ Excel proficiency, Databases proficiency

• Bloomberg, Reuters
• In depth understanding and interpretation of financial statements

Interested in Finance as a career : Book Bibles
Interested in Finance as a career : God of Finance
https://pages.stern.nyu.edu/~adamodar/
Global Competitions
https://fmworldcup.com/
https://symposium.org/initiatives/global-essay-competition/
https://www.ceeman.org/competitions-awards/case-writing-competition
Aggarwal, Divya, and Uday Damodaran. "Ambiguity attitudes and myopic loss aversion: Experimental
evidence using carnival games." Journal of Behavioral and Experimental Finance 25 (2020).

FA merged

Uploaded by

Copyright:

Available Formats

FA merged

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FA merged

Uploaded by

Copyright:

Available Formats

SESSION 11

Assistant Professor, Divya Aggarwal

• Accounting transaction processing – recording, classifying and summarizing

• Income statement – revenue recognition and COGS

• Today ---------------------------→ Inventory accounting

Major current assets are:

1. Operating cycle: cash purchase and cash sale

2. Operating cycle: cash purchase and credit sale

3. Operating cycle: credit purchase and cash sale

4. Operating cycle: credit purchase and credit sale

What constitutes inventory cost:

Inventories are recognized at the lower of cost or net realizable value

a) Abnormal amounts of wasted materials, labor, other production costs

Gross Profit = Net Sales – Cost of goods sold

• Cost assigned to ending inventory directly affects the reported profit

• What if inventory prices fluctuate?

• Goods available for sale:

• Weighted Average cost

• First-in, first-out (FIFO)

• Last-in, first out(LIFO) ----→

• Ending inventory is calculated at the cost of weighted average

Average Beginning inventory + Purchases

• First units acquired are the first units sold

• Most widely and popularly used inventory costing method

• Last units acquired are the first units sold

• Beneficial in periods of rising prices why? During periods of price increases:

• FIFO inventory value is more realistic:

• LIFO does a fair job of matching current selling

• Both LIFO and WAC allow a business to manipulate

Prices Ending Inventory Cost of Goods Sold Gross Profit

• Problem in the excel file – solving by all 4 methods

• Inventory turnover: Measures velocity with which merchandise moves

• Days’ inventory ----→ Inventory turnover expressed in number of days.

• Low holding period or high inventory turnover indicates efficient

• Read Chapter 5 of the textbook

Assistant Professor, Divya Aggarwal

Private Equity Roles

• Money or claims to receive fixed sums • Items used in future production

• Appear on balance sheet at “value.” • Appear on balance sheet at book

• Cash (Note 16, CCD report, Pg 134)

• Days’ sales outstanding/Collection period:

• Debtor’s aging analysis

• Note 9, Pg 131 CCD annual report

Account Amount Due Date Account Amount Due Date

• Can be in Equity instruments or Debt instruments

• Companies are required to provide exhaustive information of each and every

1.Contractual cash flows?

• Hold to collect model : to collect contractual cash flows

• On the basis of above two, financial assets are measured as follows:

Kingfisher Airlines Ltd

Note 8: Deferred Tax

Particulars March 31 (INR mn)

Net DTA 40,459 29,278

The auditor’s report contained the following observation:

Attention of the members is invited to note 39 regarding recognition of DT credit on account of

1. Do you agree with the company’s position on deferred taxes? Explain

Contents lists available at ScienceDirect

Journal of Behavioral and Experimental Finance

Full length article

Ambiguity attitudes and myopic loss aversion: Experimental evidence

Notes: , and show significance at 1%, 5% and 10% respectively.

Notes: , and show significance at 1%, 5% and 10% respectively.

Notes: , and show significance at 1%, 5% and 10% respectively.