Understanding Financial Statements

Why Accounting Informational requirement of a number of stakeholders in

the business Internal Stakeholder

Owners Management Employees

External Stakeholders Government/ Tax department Investors Banks/Lenders Suppliers/Creditors NGOs/ Industry associations Researchers

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 IncomeExpenditure Material and Other Expenditure Interest Depreciation

Schedule No.

Previous Year

Current Year xxx xxx

xxx xxx xxx

Profit Before Tax Provision for TaxProfit After Tax Prior period adjustments Extra Ordinary ItemsProfit available for appropriationsAppropriations Dividend Dividend Distribution Tax General ReserveSurplus carried to Balance Sheet

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 can’t 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

DepreciationCost 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 SLMBuilding - Factory Other Temporary

10.00 5.00100.00

3.341.63100

Plant & Machinery- Single shift Double Shift Triple Shift

13.9120.8727.82

4.757.4210.4

Electrical Fittings 13.91 4.75Vehicles (Motor Carr, Motor cycles, scooters)Buses & Lorries (other than used for hire)

25.8930.00

9.5011.31

Furniture & Fittings 18.10 6.33Individual assets costing less than Rs.5000 100% 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

Last in First Out (LIFO) 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 Method 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

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’

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

TOTALII. 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

Balance Sheet of XYZ Limited as at …………..

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

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) : 3,91,20,000Add: 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

Don’t 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 Accounting Income > Taxable Income

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

Create Deferred Tax Liability

Accounting Income < Taxable Income

Tax on Accounting Income < Tax 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 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) Balance outstanding for a period exceeding 6 months(b) 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 LiabilitiesCompany Year

endedContingent Liability

Net Worth CL as a % of NW

SPIC 2004 126.48 2.15 5882Hindustan Motors 2004 137.04 15.09 908Essar Steel 2004 3108.64 589.01 528Sakthi Sugars 2003 177.19 37.92 467HCC 2004 833.97 238.74 349Gammon India 2004 581.58 184.07 316Ispat Industries 2004 2145.41 833.29 257Esab India 2003 28.28 12.40 24Skansha Cementation

2003 513.41 91.58 561

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

doesn’t 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