Understanding Financial Statements

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) Some latitude with the management

Accounting principles are not `exact



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 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

Accounting Standards
  

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? Profit & Loss Account Balance Sheet Cash Flow Statement

 Financial Statements
  

Income Statement

Profit and Loss Account of XYZ Ltd. for the Year ended March 31st 20XX

Income Sales Other Income Expenditure Material and Other Profit Before Tax Expenditure Provision for Tax Profit After Tax Interest Prior period adjustments Extra Ordinary Items Depreciation
Profit available for appropriations Appropriations Dividend Dividend Distribution Tax General Reserve Surplus carried to Balance Sheet

Sched Previous Current ule Year Year No. 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 Seller has transferred property in goods to the buyer for a consideration Transfer of significant risk and rewards of ownership to the buyer

 Sales of Goods
 

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 Natural resources Intangible assets

 

Depletion
 

Amortization

Determinants of Depreciation
 Amount of depreciation depends upon
    Cost of Acquisition Expected Useful Life Estimated Residual Value Period / Production Units  Physical Life  Extent of use  Legal / Contractual Requirements  Technological Changes Obsolescence  Past experience

 Expected Useful Life

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 Cost of Acquisition Estimated Residual Vale Cost of Acquisition Residual Value Useful Life

 Depreciable Value  Depreciation

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 10.00 5.00 100.00 13.91 20.87 27.82 13.91 25.89 30.00 18.10 100%

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

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)
  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

Last in First Out (LIFO)

 

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 50,00,000 Equity Shares of Rs.10 each 49,90,000 Equity Shares of Rs.10 each 49,90,000 Equity shares Rs.8 called up Rs.5 on 1,00,000 shares

 Issued Share Capital  Subscribed Share Capital  Called up Share Capital  Calls in Arrear

Share Capital - Example

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

 Less : Calls in Arrear

 1,00,000 shares @ Rs.5 each : 5,00,000

 Paid up Share Capital

: 3,94,20,000

Share Capital - Example

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

Effect
Tax on Accounting Income > Tax payable as per Income Tax Act Tax on Accounting Income < Tax payable as per Income Tax Act

Accounting
Create Deferred Tax Liability

Accounting Income < Taxable Income

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

 Relevant Accounting Standards

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. (AS10)  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
 Current Investments Intended to be held for not more than one year

Cost of Investment includes all the related costs Valuation (Carrying Amount)
  Current Investment at Lower of Cost or Fair Value preferably on individual basis Long Term Investments at Cost subject to any non-temporary diminution

 

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

3. Current Assets, Loans & Advances

(A) Current Assets (1) Interest accrued on Investments (2) Stores and Spare parts (3) Loose Tools (4) Stock in Trade (5) Work in Progress (6) Sundry Debtors
(a) (b) Balance outstanding for a period exceeding 6 months Other Debts Less : Provisions

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

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) Acceptance (2) Sundry Creditors (3) Subsidiary Companies (4) Advance payments (5) Unclaimed dividends (6) Other Liabilities (7) 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 Sakthi Sugars HCC Gammon India Ispat Industries Esab India Skansha Cementation Year ended 2004 2004 2004 2003 2004 2004 2004 2003 2003 Contingent Liability 126.48 137.04 3108.64 177.19 833.97 581.58 2145.41 28.28 513.41 Net Worth 2.15 15.09 589.01 37.92 238.74 184.07 833.29 12.40 91.58 CL as a % of NW 5882 908 528 467 349 316 257 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