Understanding Financial Statements

Sanjay Dhamija sdhamija@imi.edu sandha@hotmail.com

Why Accounting
Informational requirement of a number of stakeholders in the business
Internal Stakeholder
Owners Management Employees Government/ Tax department Investors Banks/Lenders Suppliers/Creditors NGOs/ Industry associations Researchers

External Stakeholders

Accounting is the tool for providing financial information to various stakeholders

Financial Accounting Information

Predominately used by external stakeholders though managers also use it for decision making
To ensure that the accounting information is `true & fair
Generally Accepted Accounting Principles (GAAP) Accounting Standards Unification of Accounting Standards (IFRS)

Accounting principles are not `exact

Some latitude with the management

GAAP
GAAP
Good accounting practices evolved by the profession over a period of time Most of these practices have been adopted explicitly in the Accounting Standards

Accounting Standards
Mandatory accounting/ disclosure principles prescribed by an authority In India Accounting Standards are prescribed by the Institute of Chartered Accountants of India So far 32 accounting standards have been issued by the ICAI

Please note
Financial Statement are prepared in accordance with the applicable GAAP/ Accounting Standards The format is prescribed by the Companies Act 1956 They are audited by the `external auditors The audit report is addressed to the shareholders In case of listed companies periodic disclosure (quarterly basis) is required to be made. Annual accounts are required to be presented to the shareholders for approval within six months of the close of the year

Basic Financial Statements

To answer the three basic questions
How much profit was generated by the business over a particular period? What are the assets and liabilities of the business at the end of a particular period? What were the sources and uses of cash over a particular period?

Financial Statements
Profit & Loss Account Balance Sheet Cash Flow Statement

Income Statement

Profit and Loss Account of XYZ Ltd. for the Year ended March 31st 20XX Income Sales Other Income Expenditure Material and Other Expenditure Interest Depreciation
Profit Before Tax Provision for Tax Profit After Tax Prior period adjustments Extra Ordinary Items Profit available for appropriations Appropriations Dividend Dividend Distribution Tax General Reserve Surplus carried to Balance Sheet

Schedule No.

Previous Year

Current Year xxx xxx xxx xxx xxx

xxx xxx xxx xxx xxx xxx xxx xxx xxx

Revenue Recognition
Revenue
Sales of Goods Rendering of Services Use by others of enterprise resources yielding interest, royalties and dividends

Sales of Goods
Seller has transferred property in goods to the buyer for a consideration Transfer of significant risk and rewards of ownership to the buyer

Revenue Recognition
Rendering of Services Recognise revenue when services are performed
Proportionate Completion Method Performance consists of a series of acts Revenue recognised proportionately by reference to performance of each act Completed Service Contract Method Performance consists of a single act; or Performance cant be deemed to be completed unless fully executed

Revenue Recognition
Interest
On a time proportion basis taking into account amount outstanding and the interest rate

Royalties
On an accrual basis with the terms of the relevant agreement

Dividend
When the right to receive payment is established

Impact of uncertainties
If there is uncertainty regarding the amount of the consideration at the time of sale or rendering of services
Postpone revenue recognition till it is reasonably certain

If uncertainty arises subsequently

Make a separate provision to reflect uncertainty rather than adjust the amount of revenue originally recorded

Depreciation (AS 6)
Most of the Fixed Assets have limited useful life The cost of a Fixed Assets needs to appropriated on a systematic basis over its useful life This process of appropriation is called depreciation Based upon the `Matching Principle Different Terms Depreciation
Real Assets with limited useful life

Depletion
Natural resources

Amortization
Intangible assets

Determinants of Depreciation
Amount of depreciation depends upon
Cost of Acquisition Expected Useful Life Estimated Residual Value

Expected Useful Life

Period / Production Units Physical Life Extent of use Legal / Contractual Requirements Technological Changes Obsolescence Past experience

Determinants of Depreciation
Estimated Residual Value
Amount expected to be realized on disposal If considered insignificant taken as Nil Otherwise based upon the past experience

Depreciable Value
Cost of Acquisition Estimated Residual Vale

Depreciation
Cost of Acquisition Residual Value Useful Life

Depreciation Methods
Method of allocating the cost of assets over its useful life
Straight Line Method (SLM) Written Down Value Method (WDV) Unit of Production Method Sum of Digits Method

The Management is free to use any method The method chosen must be applied consistently from period to period

Straight Line Method

Depreciable amount is amortized equally over the useful life of the asset Depreciation = Cost RV Useful Life Depreciation charge in each period remains same over the useful life of the asset Simple to operate / understand

Accelerated Methods
Written Down Value (WDV) Method
Higher depreciation in the earlier years Depreciation is calculated by applying a rate to the net book value in the beginning of the year

Sum of years digit Method

Depreciation for 1st year = n/SYD SYD = n(n+1)/2

Depreciation Rates - Schedule XIV of the Companies Act

WDV
Building - Factory Other Temporary
Plant & Machinery- Single shift Double Shift Triple Shift Electrical Fittings Vehicles (Motor Carr, Motor cycles, scooters) Buses & Lorries (other than used for hire) Furniture & Fittings Individual assets costing less than Rs.5000

SLM
3.34 1.63 100
4.75 7.42 10.4 4.75 9.50 11.31 6.33 100%

10.00 5.00 100.00

13.91 20.87 27.82 13.91 25.89 30.00 18.10 100%

Inventory
AS 2 `Valuation of Inventories issued by the ICAI in June 1981 What is inventory
Assets
Held for sale in the ordinary course of business In the process of production for such sale In the form of materials or supplies to be consumed in the production process or in the rendering of services

Importance
Profit = Sales - COGS Cost of Goods Sold = (Opening Stock + Purchases Closing Stock) Opening Stock + Purchases = Closing Stock + COGS Closing Stock (inventories) appears in the Balance Sheet as Current Assets Inventories often constitute (except in case of a Services Company) a significant portion of the total assets of a company Problem How to apportion goods available for sale between ending inventory and cost of good sold ?

Valuation of Inventory
Inventories should be valued at the lower of cost and net realisable value Valuation process
Ascertain cost Ascertain net realisable value Value at lower of cost and net realisable value

Cost of Inventories
Comprises of cost of purchase, costs of conversion and other cost incurred to bring inventories to their present location and condition Cost of Purchases
Includes purchase price, duties and taxes, freight inwards and other expenses directly attributable to the acquisition Trade discounts, rebates, duty drawbacks etc are deducted

Cost of Conversion
Cost directly related to the production Systematic allocation of fixed and variable production overheads Costs not to be considered for valuation
Interest & borrowing costs Abnormal wastages Storage costs (unless necessary in the production process before further production) Administrative overheads Selling & Distribution Overheads

Cost Formulas
For identifying the cost
Specific Identification FIFO LIFO Weighted Average Method

AS 2 permits use of Specific Identification, FIFO and Weighted Average Cost Method

Specific Identification Methods

Cost of inventories, that are not ordinarily interchangeable and can be identified or for specific project Not practical when a large number of inventory items which are interchangeable Some form of approximation is used
The formula used should reflect the fairest possible approximation to the cost incurred

Methods
First in First Out (FIFO)

Last in First Out (LIFO)

Assumes that the items of inventory purchased or produced first are consumed or sold first Items remaining in the inventory are those that were purchased or produced recently
Assumes that the items of inventory purchased or produced recently are consumed or sold first Items remaining in the inventory are those that were purchased or produced first Weighted average of the cost of similar items at the beginning of a period and cost of similar item produced or purchased during the period Either on a periodic basis or for each shipment

Weighted Average Method

Net Realisable Value

Estimated selling price in the ordinary course of business less the estimated cost of completion and estimated cost to make the sale On an item to item basis Estimate based upon the most reliable evidence that may be available at the time estimates are being made

Material are not written down below cost if the finished products in which they will be used are expected to be sold above cost.

Disclosure
Accounting policies and cost formula used Total carrying amount of inventory and its classification
Raw Material, Components, WIP, Finished Goods, Stores and Spares, Loose Tools

Prior Period Adjustments and Extra-ordinary Items

Disclose separately on the face of the Profit & Loss Statement
Result of Ordinary Activities Extra Ordinary Items Prior Period Items Impact of Change in Accounting Policies

Prior Period Adjustments and Extra-ordinary Items

Ordinary activities Activities which are undertaken as part of its business and related activities Extraordinary items Income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities Not expected to recur frequently or regularly. Prior period items Income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods

Summary
Profit & Loss A/c is an account showing income and expenses Revenue/ Income is recognised when earned Expenses are recorded when incurred Basic Concepts
Accounting Period Conservatism Accrual Matching Consistency Materiality

Show the result of ordinary activities, extra-ordinary items, prior-period items and impact of change of accounting policies separately

Balance Sheet

Schedule VI Part I
Accounts must be maintained on an accrual basis and according to double entry book keeping system (section 209) The Balance Sheet and the Profit & Loss account must be prepared for every financial year The financial statements must be laid before the Annual General Meeting of the shareholders for approval within six months of the close of the year (Section 210) The balance sheet of a company shall be either in horizontal form or vertical form The Balance Sheet must show figures for the current year and comparative figures for the previous year Information required under any head may be given in separate `Schedule

Balance Sheet of XYZ Limited as at ..

Schedule Number Figures as at the end of current financial year Figures as at the end of previous financial year

Sources of Funds
1 Shareholders Funds: (a) Capital (b) Reserve & Surplus 2. Loan Funds (a) Secured Loan (b) Unsecured Loan TOTAL

II. Application of Funds

1. Fixed Assets 2. Investments 3. Current Assets, loans and advances Less : Current Liabilities & Provisions Net Current Assets 4. a) Miscellaneous Expenditure to the extent not written off or adjusted b) Profit & Loss Account TOTAL

Sources of Funds

1. Share Capital
Authorized, Issued, Subscribed, and Called up for each class of shares Calls unpaid to be deducted from the Called up capital to arrive at Paid up Capital Add: Forfeited Shares (amount paid up) Terms of redemption/conversion of redeemable preference shares to be stated with date redemption/conversion Shares issued for consideration other than cash to be identified Shares allotted by way of bonus shares to be shown Sources from which bonus shares have been issued to be specified Calls unpaid by the Directors to be separately indicated

Type of Capital
Preference Capital
Preference for payment of dividend at a fixed rate and repayment of Capital

Equity Capital
Perpetual Last preference for dividend and repayment of capital

Type of Capital
Authorized Share Capital The maximum amount that the company may raise by issuing capital is mentioned in the Memorandum of Association Issued Share Capital Part of Authorized Share Capital that is offered by the company for subscription Subscribed Share Capital Part of the Issued Share Capital that is subscribed by the shareholders Called up Share Capital Part of the Subscribed Share Capital that has been called up by the Company Calls in Arrear call amount not paid by the shareholders Paid up Capital Called up share capital minus calls in arrear Forfeited Shares amount paid up on the shares forfeited due to non payment of call money

Share Capital - Example

Authorized Share Capital
1,00,00,000 Equity Shares of Rs.10 each

Issued Share Capital

50,00,000 Equity Shares of Rs.10 each

Subscribed Share Capital

49,90,000 Equity Shares of Rs.10 each

Called up Share Capital

49,90,000 Equity shares Rs.8 called up

Calls in Arrear
Rs.5 on 1,00,000 shares

Share Capital - Example

Called up Share Capital
49,90,000 Equity shares (Rs.8 called up) : 3,99,20,000 : 5,00,000
3,94,20,000

Less : Calls in Arrear

1,00,000 shares @ Rs.5 each

Paid up Share Capital

Share Capital - Example

If share are forfeited Paid up Share Capital
48,90,000 Equity shares of Rs. 10 each, (Rs.8 called up) : Add: Forfeited Shares (1,00,000 x 3) Total 3,91,20,000 3,00,000 3,94,20,000

Reserve & Surplus

Earnings not distributed to shareholders
II. Reserve & Surplus
Capital Reserve Share Premium Account Other Reserves Less: Debit balance in Profit & Loss Account Surplus balance in profit & loss account Sinking Funds

Reserve & Surplus

Addition and deductions since the last balance sheet to be shown under each specified head `Fund in relation to any `Reserve should be used only where such reserve is specifically represented by earmarked investments

2. Loan Funds
Secured Loans (1) Debentures (2) Loans & Advances from Banks (3) Loan & Advances from subsidiaries (4) Other Loans & Advances Loans from Directors should be shown separately Interest accrued and due on secured loans should also be included The nature of security to be specified in each case Terms of redemptions/ conversions of debentures together with the date if redemption or conversion

Loan Funds
Unsecured Loans (1) Fixed Deposits (2) Loans & Advances from subsidiaries (3) Short term loans and advances (a) From Banks (b) From Others (4) Other Loans and Advances (a) From Banks (b) From Others Loans from Directors should be shown separately Interest accrued and due on un-secured loans should also be included Short term loans will include those which are due for not more than one year from the date of the Balance Sheet

Deferred Tax Liability/Assets

Relevant Accounting Standard AS 22 Due to difference between taxable income (as per Income Tax Act) and accounting profit
Permanent Difference Dont reverse subsequently Expenses disallowed, exempt income Timing Difference Reversed in the subsequent period Expenses allowed on payment basis, depreciation

Deferred Tax Liability/Assets

Cause Effect Accounting
Create Deferred Tax Liability Accounting Tax on Accounting Income > Taxable Income > Tax Income payable as per Income Tax Act

Accounting Tax on Accounting Income < Taxable Income < Tax Income payable as per Income Tax Act

Create Deferred Tax Asset

Application of Funds

1. Fixed Assets
Show, to the extent possible, under the following headings Goodwill Land Building Leaseholds Railway Sidings Plant & Machinery Furniture & fittings Development of Property Patents, Trade Marks and Design Livestock Vehicles

Fixed Assets
Under each head show the original cost, addition and deduction during the year and total depreciation written off up to the end of the year
Original Cost Gross Block Less Accumulated Depreciation Net Block

Relevant Accounting Standards

AS 10 : Fixed Assets AS 26 : Intangible Assets AS 6 : Depreciation Accounting

Fixed Assets
Show at cost of acquisition less depreciation The cost comprise purchase price and any attributable cost of bringing the asset to its working condition for its intended use. (AS-10) Capitalize borrowing cost up-to the point the asset us ready for its intended use (AS-16) Import duties, taxes, delivery & handling costs, site preparations, installation cost, professional fees, start up & commissioning, test runs Subsequent expenditures to be added to its book value only if they increase the future benefits from the existing asset
Improvement Repairs

Fixed Assets
Intangible Assets (AS 26) Identifiable, non-monetary assets without physical substance Acquired intangible assets are recorded at their cost of acquisition Self-generated goodwill/brand value is not recognized Research cost inventing or creating a new product, method or system is not capitalized Development cost converting the result of research into a marketable product can be capitalized Expenses that provide future economic benefits but no intangible assets is created treat as expense when incurred e.g. start up costs, launching new product, training etc.

2. Investments
Distinguish between
Investment in Government Securities Investment in shares debentures and bonds Showing separately fully paid up/partly paid up Investment in Subsidiary Companies Investment in Immovable properties Investment in the capital of partnership firms

Aggregate amount of quoted investments and their market value should be shown Aggregate amount of unquoted investments to be shown

Investments
Relevant Accounting Standard : AS 13

Distinguish between Current Investments and Long Term Investments

Cost of Investment includes all the related costs Valuation (Carrying Amount)

Current Investments Intended to be held for not more than one year

Profit or Loss on disposal of investment to be shown in Profit & Loss Account Significant restriction on right of ownership, remittance of income or proceeds of disposal to be disclosed

Current Investment at Lower of Cost or Fair Value preferably on individual basis Long Term Investments at Cost subject to any nontemporary diminution

3. Current Assets, Loans & Advances

(A) (1) (2) (3) (4) (5) (6) Current Assets Interest accrued on Investments Stores and Spare parts Loose Tools Stock in Trade Work in Progress Sundry Debtors

(7A) Cash balance on hand (7B) Bank Balances (a) With Scheduled Banks (b) with others

(a) Balance outstanding for a period exceeding 6 months (b) Other Debts Less : Provisions

Current Assets, Loans & Advances

Mode of valuation of stock shall be stated Lowe of Cost or Realizable Value In respect of debtors
Debt considered good where company is fully secured Debt considered good otherwise Debt considered doubtful or bad Debt due from directors or other officers of the company or firms of private companies in which any director is a partner or a director Debt due from companies under the same management Maximum amount due from a director or other officers of the company any time during the year

Current Assets, Loans & Advances

(B) Loans & Advances
(8) Advances & loans to subsidiaries (9) Bills of Exchange (10)Advance recoverable in cash or in kind or for value to be received (11) Balances with customs, port trust etc.

Less : Current Liabilities and Provisions

Current Liabilities & Provisions

A. Current Liabilities
(1) (2) (3) (4) (5) (6) (7) Acceptance Sundry Creditors Subsidiary Companies Advance payments Unclaimed dividends Other Liabilities Interest accrued but not due on loans

Current Liabilities & Provisions

B. Provisions
(8) Provision for Taxation (9) Proposed dividends (10) For contingencies (11) For Provident Fund scheme (12) For insurance, pension and similar staff benefit schemes

Net Current Assets

4. Miscellaneous Expenditure
To the extent not written off or adjusted
(1) Preliminary Expenses (2) Expenses on Issue of Shares/ Debentures (3) Discount on Issue of Shares or Debentures (4) Interest paid out of capital during construction (5) Development expenditure (6) Other Expenditure

Profit & Loss Account (Debit Balance)

Contingent Liabilities
Contingency (Accounting Standard 4/29) A condition or situation, the ultimate outcome of which, gain or loss, will be known or determined only on the occurrence, or nonoccurrence, of one or more uncertain future events. Restricted to conditions or situations at the balance sheet date The estimates of the outcome and of the financial effect of contingencies are determined by the judgment of the management of the enterprise.

Contingent Liabilities
Accounting treatment of a contingent loss

If it is likely that a contingency will result in a loss to the enterprise, then it is prudent to provide for that loss in the financial statements. If there is conflicting or insufficient evidence for estimating the amount of a contingent loss, then disclosure is made of the existence and nature of the contingency. Provisions for contingencies are not made in respect of general or unspecified business risks since they do not relate to conditions or situations existing at the balance sheet date.

Contingent Liabilities
The following information should be provided in respect of contingent liability
the nature of the contingency the uncertainties which may affect the future outcome an estimate of the financial effect, or a statement that such an estimate cannot be made.

Contingent Liabilities
Company SPIC Hindustan Motors Essar Steel Year ended 2004 2004 2004 Contingent Liability 126.48 137.04 3108.64 Net Worth 2.15 15.09 589.01 CL as a % of NW 5882 908 528

Sakthi Sugars
HCC Gammon India Ispat Industries Esab India Skansha Cementation

2003
2004 2004 2004 2003 2003

177.19
833.97 581.58 2145.41 28.28 513.41

37.92
238.74 184.07 833.29 12.40 91.58

467
349 316 257 24 561

Cash Flow Statement

Accounting Standard - 3

Why Cash Flow Statement

To assess the ability of the business to generate cash and its utilization P&L based upon accrual concept doesnt reveal cash from operations Other sources and uses of cash impact balance sheet To have an overview of sources and uses of cash in the accounting period a Cash Flow Statement is prepared

What is Cash
Cash comprises cash on hand and deposits with banks Cash Equivalents
Short term, highly liquid investments Readily convertible into cash Insignificant risk of changes in value

Cash Flow Statement

To be prepared and presented for each period for which financial statements are prepared Cash flow should be classified into
Operating Activities Investing Activities Financing Activities

The sum of cash flow from these activities should explain change in cash balance over the accounting period

Operating Activities
Principal revenue-generating activities Generally result from the transactions and other events that enter into the determination of net profit or loss Examples
Receipts from sale of goods or rendering of services Payments to suppliers for goods and services Payment to employees Payment of income tax

Investing Activities
Acquisition and disposal of long-term assets and other investments For acquiring resources intended to generate future income and cash flow Examples
Payment to acquire fixed assets Receipts from disposal of fixed assets Payments for acquiring investments Cash advances and loans made Recovery of cash advances and loans Receipt of dividend/ interest on investments

Financing Activities
That result in changes in the size and composition of the owners capital and borrowings of the enterprises Useful to predict claim on future cash flow by the providers of funds Examples
Cash proceeds from issue of shares Cash proceeds from issuing debentures and other long term borrowings Cash repayments of amount borrowed Payment of interest / dividend

Extra-Ordinary Items
Cash flow from extra-ordinary items should be separately disclosed classified into operating, investing and financing activities

Taxes on Income
Tax paid to be classified as cash flow from operating activities unless they can be specifically identified with financing and investing activities

Non Cash Transactions

Investing and Financing Transactions that do not require use of cash Exclude from cash flow statement Disclose separately elsewhere in the financial statements

Cash From Operations

Direct Method
Major classes of receipts and payments for operating activities are considered

Indirect Method
Adjust Net profit or Loss
non-cash items changes in current assets and liabilities Items that can be classified as financing or investing cash flows

Disclosure
Components of Cash and cash equivalents Reconciliation of amounts in the Cash Flow Statement with the items reported in the Balance Sheet Amount of significant cash and cash equivalents held by the enterprise that are not available for use by it