lec 3 financial statements

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Lecture 3

Brief Introduction toAccounting

Introduction to Financial Management

11th Jan 2012



What is accounting?

• Accounting is the activity of analyzing, recording,

summarizing, reporting, reviewing, and interpreting

financial information.

• Accounting is about ACCOUNTABILTY• Most organizations are externally accountable in

some way for their actions and activities.

•

Accounting is the language of business



What Accountants Do

Accounting consists of these functions:

• Recording

•

Classifying• Summarizing

• Reporting and evaluating the financial

activities of a business



Use of Accounting

Accounting is essentially an "information process" that ensures the

accountability of the business to its stakeholders.

• Provides a record of assets owned, amounts owed to others and

monies invested

• Provides reports showing the financial position of an organization

and the profitability of its operations

• Helps stakeholders monitor an organization’s activities and

performance

• Enables potential investors or funders to evaluate an organization

and make decisions

• Helps management actually manage the organization

• Helps the government evaluate the tax liability



Accounting as an Aid to

Decision Making

Fundamental relationships in the decision-

making process:

Event

(Transaction)

Accountant’s

analysis &

recording

Financial

Statements

Users



Types of Accounting Information

There are two broad types of accounting information

• Financial Accounts: focuses on the specific needs of decisionmakers external to the organization, such as stockholders,

suppliers, banks, and government agencies

• Management Accounts: serves internal users, such as topexecutives, management, and administrators within organizations.

Although there is a difference in the type of information presented infinancial and management accounts, the underlying objective is thesame - to satisfy the information needs of the user.



Accounting Concepts

Financial accounting relies on several underlying concepts thathave a significant impact on the practice of accounting.

Assumptions

•Separate entity assumption - the business is an entity that isseparate and distinct from its owners, so that the finances of

the firm are not co-mingled with the finances of the owners.

• Going concern assumption - the business is going to be

operating for the foreseeable future.• Stable monetary unit assumption

• Fixed time period assumption - information prepared and

reported periodically (quarterly, annually, etc.)



Principles of Accounting

• Duality concept: All transactions have two dimensions, debit and

credit.

• Historical cost principle - assets are reported and presented at their

original cost and no adjustment is made for changes in market value.

• Matching principle - matching of revenues and expenses in the period

earned and incurred.• Revenue recognition principle - revenue is realized (reported on the

books as earned) when everything that is necessary to earn the

revenue has been completed.

• Full disclosure principle - all of the information about the business

entity that is needed by users is disclosed in understandable form.

• Conservatism principle – when in doubt err on the side of caution.

• Materiality principle - a company must strictly state accounts and

transactions that are significant to the organization's operations.



Some Definitions

• An Account is a separate record for each type of asset,

liability, equity, revenue, and expense used to show the

beginning balance and to record the increases and decreases

for a period and the resulting ending balance at the end of a

period.

• Transaction-Any event or condition that must be recorded in

the books of a business because of its effect on the financial

condition of the business, such as buying and selling. Abusiness deal or agreement.



Fundamental Accounting Equation

Assets = Liabilities + Owner’s Equity

Owner’s Equity = Assets – Liabilities

= what the business owns – what the business owes

• Assets - The properties used in the operation or investmentactivities of a business.

– Tangible (buildings, machinery, raw materials)

– Intangible (brand value, R&D knowhow, accounts receivable )

• Liabilities - Claims by creditors to the property (assets) of abusiness until they are paid.

• Owner’s Equity - The owner's rights to the property (assets) of thebusiness; also called proprietorship and net worth.



Other Accounts

• Revenue (Income) - The gross increase in owner's equity

(capital) resulting from the operations and other activities of

the business.

• Expense (Cost) - Decrease in owner's equity (capital) resulting

from the cost of goods, fixed assets, and services and supplies

consumed in the operations of a business.

• Owner's Investments- Increase in owner's equity (capital)

resulting from additional investments of cash and/or other

property made by the owner.

• Owner's Drawing - Decrease in owner's equity (capital)

resulting from withdrawals made by the owner.



Journal Entry

• Chronological recording of financial data (taken usually from a

journal voucher) pertaining to business transactions in a

journal such that the debits equal credits.

• Journal entries provide an audit trail and a means of analyzing

the effects of the transactions on an organization's financial

position.

• Types of journals:

• general journal

• specialised journals



General journal



Cash payments journal



General Ledger

• All general ledger accounts should be thought of as specially formattedrecords shaped as a big “T”.

• The importance of the “T” structure is that it distinguishes between theleft and right side of each general ledger account.

• Instead of saying “left side” and “right side” accountants use the terms“debit” and “credit”. “Debit” simply means the left side of the “T”

account, and “credit” refers to the right side of the “T” account.• The general ledger is a collection of the group of accounts that supports

the value items shown in the major financial statements.

– It is built up by posting transactions recorded in the sales daybook,purchases daybook, cash book and general journals daybook.

–

There are five (seven) basic categories in which all accounts aregrouped: Assets, Liability, Owner's equity, Revenue, Expense, (Gains),(Loss)

– The main categories of the general ledger may be further subdividedinto subledgers to include additional details of such accounts as cash,accounts receivable, accounts payable, etc.



Ledgers

• T ̵ Account



Difference Between Ledger and Journal

• The journal is the book of first entry (original entry); the ledger is thebook of second entry. It is the goal where all the entries in the journal find their ultimate destination.

• The journal is the book of chronological record; the ledger is the

book for the analytical record.

• The journal, as a book of source entry, ordinarily has greater weightas legal evidence than the ledger.

• The unit of classification of data within the journal is the transaction;

the unit of classification of data within the ledger is the account.

• The process of recording in the journal is called journalising; theprocess of recording in the ledger is called posting.



Trial Balance

• Trial balance may be defined as an informal accounting

schedule or statement that lists the ledger account balances

at a point in time compares the total of debit balance with the

total of credit balance.



Debit and credit rules



Expanded Version of Accounting

Equation

Assets = Liabilities + Beginning Owner's Equity(Capital)

+ Additional Owner Investments + Revenues

- Expenses - Draws

This can also be written as:

Assets + Expenses + Draws = Liabilities + Beginning Owner's Equity(Capital)

+ Additional Owner Investments + Revenues

Any increase on the left hand side is treated as a debit

Any increase on the right hand side is treated as a credit



Accounting Cycle

Business transactions occur

Business documents prepared as evidence

Journal used to record transactions

Ledger accounts used to summarize transactions

Trial Balance

Prepare the statements of financial performance

(Profit and Loss Account)

Prepare the statements of financial position

(Balance Sheet)



Example

Mr and Mrs Crane run a small graphic design business trading

under the name of Samples Limited. Mr Crane buys some

stationery from Mr Smith's Stationers for £100. Mr Crane must

make two equal and opposite entries somewhere is the

Company's accounting ledgers to record this transaction.

This example has been taken from

http://www.securetransact.net/infosheets/accounting/intro_to_book-

keeping.html



Recording the first cash transaction

Date Description Analysis Code Debit (£) Credit (£)

05 May Paid Mr. Smith for

supply of stationery

Stationery 100

05 May Paid Mr. Smith for

supply of stationery

Bank 100

If we follow through on the payment of £100, then the

Company's general journal will be completed in the following

way:



After a day's trading at Samples Ltd, the same journal may look something like this:

Date Description Account Debit (£) Credit (£)05 May Paid Mr. Smith for supply of stationery Stationery 100

05 May Paid Mr. Smith for supply of stationery Bank 100

05 May Sold a widget to Parkins and Co Sales 250

05 May Shop till funds re sale to Parkins Cash 250

05 May Sold 2 widgets to Mr. Jones Sales 500

05 May Shop till funds re sale to Mr. Jones Cash 500

05 May Cost of week’s milk supply Milk 10

05 May Paid milkman for milk supply Bank 10

860 860

Although the Cranes's have only enacted four transactions, it has taken

eight entries in the ledger to reflect the day's business.



Date Description Customer Code Debit (£) Credit (£)

05 May Sold 1 widget Parkins 250

05 May Sold 2 widgets Jones 500

05 May Cash received in till 750

Sales Ledger



Lecture 4

Financial Statements



Financial Statements

• Financial statements provide information

about the financial activities and position of

a firm.

• Important financial statements are:

– Balance sheet

– Profit & Loss statement

– Cash flow statement



Important Questions

• What is the financial position of the firm at a

given point of time?

•

How has the firm performed financially over agiven period of time?

• What have been the sources and uses of cash

over a period of time?



BALANCE SHEET



BALANCE SHEET

Vertical (or Report) FormI. Sources of Funds

(1) Shareholders’ funds:(a) Capital

(b) Reserves and Surplus

(2) Loan funds:

(a) Secured loans

(b) Unsecured loans

II. Application of funds

(1) Fixed assets

(2) Investments

(3) Current assets, loans and advancesLess: Current liabilities and provisions:

Net current assets

(4) Miscellaneous expenditures and losses



Capital, Reserves and Surplus

• Share Capital – Equity Share Capital

– Preference Share Capital

• Equity Share Capital – Authorized: Issued: Subscribed: Called up: Paid up capital

• Reserves and Surplus – Capital Reserve

– Specific Reserves

– General Reserve

– P&L A/c Credit Balance

• Reserves can broadly be classified as Capital or Revenue innature

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31 20



BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20

X 1

A. Account Form Rs.in crore

Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0

Share capital 15.00 15.00 Fixed assets 33.00 32.20

Equity 15.00 15.00 Investments 1.00 1.00

Preference – – Current assets, loans

Reserve & surplus 11.20 10.60 and advances 23.40 15.60

Secured loans 14.30 13.10 Miscellaneous

Unsecured loans 6.90 2.50 expenditures and losses 0.50 0.50

Current liabilities

and provisions 10.50 8.10

57.90 49.30 57.90 49.30

Centre for Financial Management , Bangalore

BALANCE SHEET OF HORIZON LIMITED AS ON



BALANCE SHEET OF HORIZON LIMITED AS ONMARCH 31, 20 X 1

Rs.in crores

20 x 1 20 x 0

I. Sources of Funds(1) Shareholders’ funds: 26.20 25.60

(a) Share Capital 15.00

(b) Reserves and surplus 11.20

(2) Loan funds: 21.20 15.60

(a) Secured loans 14.30

(b) Unsecured loans 6.9047.40 41.20

II. Application of Funds

(1) Fixed assets 33.00 32.20

(2) Investments 1.00 1.00

(3) Current assets, loans and advances 23.40 15.60

Less: Current liabilities and provisions: 10.50 8.10

Net current assets 12.90 7.50

(4) Miscellaneous expenditures and losses 0.50 0.50

47.40 41.20



LIABILITIES

• Share Capital

• Reserves & Surplus

• Secured Loans

• Unsecured Loans

• Current Liabilities and Provisions




ASSETS

• Fixed Assets

• Investments

• Current Assets, Loans, & Advances

• Miscellaneous Expenditure & Losses


PROFIT & LOSS ACCOUNT OF HORIZON LTD FOR THE YEAR



PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR

ENDING ON MARCH 31, 20 X 1

(Rs.in crore)

Income

Sales 70.1

Other income (loss) –

70.1

Expenditure

Material and other expenditure 58.2

Interest 2.1

Depreciation 3.0

Profit before tax 6.8

Provision for tax 3.4

Profit after tax 3.4

Prior period adjustments 0.8

Profit available for appropriations 4.2

Appropriations 3.5

Balance carried forward 0.7


PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR



PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEARENDING ON MARCH 31, 20 X 1

(Rs. in crore)

20 x 1 20 x 0Net sales 70.1 62.3

Cost of goods sold 55.2 47.5Stocks 42.1Wages and salaries 6.8Other manufacturing expenses 6.3

Gross profit 14.9 14.8Operating expenses 6.0 4.9

Depreciation 3.0

General administration 1.2Selling 1.8Operating profit 8.9 9.9Non-operating surplus/deficit – 0.6Profit before interest and tax 8.9 10.5Interest 2.1 2.2Profit before tax 6.8 8.3Provision for tax 3.4 4.1

Current tax 2.1 2.9Deferred tax 1.3 1.2

Profit after tax 3.4 4.2Prior period adjustments 0.8 0.7Amount available for appropriation 4.2 4.9Appropriations 3.5 4.0Balance carried forward 0.7 0.9


PROFIT AND LOSS ACCOUNT ITEMS



PROFIT AND LOSS ACCOUNT ITEMS

Net Sales

Cost of Goods Sold

Gross Profit

Operating Expenses

Operating Profit

Non-operating Gains and Losses

Profit Before Interest and Taxes Interest

Profit before Tax

Income Tax Provision

Profit After Tax

Prior Period Adjustments

Amount Available for Appropriation

Appropriations

Balance Carried Forward


BALANCE SHEET AND FINANCE TOPICS



BALANCE SHEET AND FINANCE TOPICS• Share capital

• Equity

• Preference

• Reserves and surplus

• Secured loans• Debentures

• Loans and advances

• Unsecured loans

• Current liabilities and provisions

• Trade creditors

• Provisions

• Fixed assets (net)

• Gross block

• Less: depreciation

• Investments

• Current assets, loans and advances

• Cash and bank

• Receivables

• Inventories

• Miscellaneous expenditure and losses

Capital structure

and cost of capital

Working capital

financing policy

Capital budgeting

Portfolio management

Cash management

Credit management

Inventory management

PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS



PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS

• Net sales

• Cost of goods sold

• Stocks

• Wages and salaries• Other manufacturing expenses

• Gross profit

• Operating expenses

• Selling and administration expenses

• Depreciation

• Operating profit

• Non-operating surplus/deficit

• Earnings before income and tax

• Interest

• Profit before tax

• Tax

• Profit after tax

• Dividends

• Retained earnings

Revenue risk

Gross profit margin

Depreciation policy

Business risk

Financial risk

Tax planning

Return on equity

Dividend policy

NET CASH FLOW



NET CASH FLOW

When we looked at the profit and loss account, the emphasis was on

profit after tax (also called the bottom line). In finance, however, the

focus is on cash flow.

A firm’s cash flow generally differs from its profit after tax because

some of the revenues/expenses shown on its profit and loss account

may not have received /paid in cash during the year. The relationship

between net cash flow and profit after tax is as follows:

Net cash flow = Profit after tax – Non cash revenues

+ Non cash expenses


NET CASH FLOW



NET CASH FLOW

An example of non cash revenue is accrued interest income that has not yet been received. It

increases the bottom line but is not matched by a cash inflow during the accounting period –

the cash inflow would occur in a subsequent period. An example of a non cash expense is

depreciation.

In practice, analysts defined the net cash flow as:

Net cash flow = Profit after tax + Depreciation + Amortisation

However, note that the above expression will not reflect net cash flow accurately if there are

significant noncash items beyond depreciation and amortisation.


ACCOUNTING INCOME VERSUS ECONOMIC INCOME



ACCOUNTING INCOME VERSUS ECONOMIC INCOME

Accounting income diverges from economic income due to the

following reasons:

• Use of the accrual principle

• Omission of changes in value

• Depreciation

• Treatment of R & D and advertising expenditures

• Inflation

• Creative accounting


COMPONENTS OF CASH FLOWS



COMPONENTS OF CASH FLOWS

Cash inflows

from operations

Cash inflows

from investing

activities

Cash inflows

from financing

activities

Cash outflows

from investing

activities

Cash flow

from investing

activities

Cash outflows

from financing

activities

Cash flow

from financing

activities

Operating

Investing

Financing

–

–

=

=

=

+ –

+ –

=

–

Cash outflows

from operations

Cash flow

from operations

Net cash flow

for the period


CASH FLOW STATEMENT



CASH FLOW STATEMENT

LIABILITIES ASSETS

CAPITAL FIXED ASSETS

RESERVES & SURPLUS

INVESTMENTS

LOANS

INVENTORIES

CURRENT LIABILITIES DEBTORS

AND PROVISIONS

CASH


SOURCES USES



• FINANCING CAPITAL CAPITAL

• OPERATING RES. & SURPLUS RES. & SURPLUS

• FINANCING LOANS LOANS

• OPERATING CURRENT LIABILITIES CURRENT LIABILITIES

& PROVISIONS & PROVISIONS

• INVESTMENT FIXED ASSETS FIXED ASSETS

• INVESTMENT INVESTMENTS INVESTMENTS

• OPERATING INVENTORIES INVENTORIES

• OPERATING DEBTORS DEBTORS


CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD



,

1.4.20X0 TO 31.3.20X1

(Rs. in crore)

(A) Cash Flow from Operating Activities

Net profit before tax and extraordinary items 6.8

Adjustments for

Interest paid 2.1

Depreciation 3.0

Operating profit before working capital changes 11.9

Adjustments

Debtors (4.6)Inventories (3.3)

Advances 0.5

Trade credit 1.5

Advances 0.7

Provisions 0.2

Cash generated from operations 6.9

Income tax paid (3.4)Cash flow before extraordinary items 3.5

Extraordinary item –

Net cash flow from operating activities 3.5

(Contd.)


(Contd.)



(Rs.in crore)

(B) Cash Flow from Investing Activities

Purchase of fixed assets (3.8)

Net cash flow from investing activities (3.8)

(C) Cash Flow from Financing Activities

Proceeds from term loans 1.2

Proceeds from inter-corporate deposits 4.4

Interest paid (2.1)Dividend paid (2.8)

Net cash flow from financing activities 0.7

(D) Net Increase in Cash and Cash Equivalents 0.4

Cash and cash equivalents as on 1.04.20x0 0.6

Cash and cash equivalents as on 31.03.20x1 1.0


MANIPULATION OF THE BOTTOM LINE



1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE

FOLLOWING YEAR

2. ALTER THE ‘OTHER INCOME’ FIGURE BY PLAYING WITH NON-OPERATIONAL IETMS

3. FIDDLE WITH THE METHOD & RATE OF DEPRECIATION

4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.

5. MAKE INADEQUATE PROVISIONS . . LIABILITIES

6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS

7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.

8. REVALUE ASSETS . . CREATE . . IMPR’N . . RESERVES

9. LENGTHEN … ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.

WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEP’N . . COMPETENT MGT

INCREASE MGRL COMPEN’N

QUALITY PROMPTNESS

OF CANDOUR IN ANALYSING PAST PERFORMANCE

REPORTING MEANINGFUL DISCUSSION . . PROSPECTS


TAXES



TAXES

• Taxes may be divided into two broad categories : direct

taxes and indirect taxes.

• A tax is a direct tax if the impact and incidence of the tax

is on the same person. Example : Income tax

• A tax is an indirect tax if the impact is on one person but

through the process of shifting, the incidence is onanother. Example : Excise duty


CORPORATE INCOME TAX




• A company’s taxable income is determined by taking into

account its revenues, expenses, and deductions on accountof various incentives and reliefs. The taxable income is

subject to a tax rate of 30 percent for domestic companies

and 40 percent for foreign companies.

• While computing the taxable income, among other things,

bear in mind the provisions relating to the following -

depreciation, interest expense, dividend payment, dividend

income, unabsorbed business loss and depreciation,exemptions and deductions, minimum alternate tax, and

advance tax.






• A variety of exemptions and deductions are granted

under the Income Tax Act.

• If the income tax payable on the total income of a

company, as computed under the Income Tax Act,is less than 10.0 percent of its book profit, the tax

payable shall be deemed to be 10.0 percent of such book

profit.

• Advance tax is payable on the current income of the

company in four installments during the financial year.






1. Depreciation is charged on blocks of assets which

represent a group of assets within the broad class of

assets such as buildings, plant, machinery, and furniture,

for which a common rate of depreciation is applicable.

2. While interest on borrowings is a tax-deductible expense,

dividend on share capital is not.

3. Unabsorbed business loss of any year can be carried

forward and set off against income under the head of

business of subsequent years.


INDIRECT TAXES



INDIRECT TAXES

The three most important indirect taxes are the excise duty,

the sales tax, and the customs duty.

• The excise duty is a levy on the goods manufactured in

the country.

• Sales tax is a levy on “sale of goods.”

• Customs duty is a levy on the import of goods into India

or the export of goods out of India.


FREE CASH FLOW



FREE CASH FLOW

Free cash flow is the cash flow available for

distribution to investors (lenders and shareholders)

after the firm has made investments in fixed assets

and working capital to support its operations.


CASH FLOW SUMMARY



A. The cash flow identity

Cash flow from assets = Cash flow to lenders + Cash flow toshareholders

B. Cash flow from assets

Cash flow from assets = Operating cash flow – Net capital spending –

Change in net working capitalwhere

Operating cash flow = PBIT – Taxes + DepreciationCapital spending = Ending net fixed assets – Beginning

net fixed assets + Depreciation

Change in net working capital = Ending net working capital –

Beginning net working capital

C. Cash flow to lendersCash flow to lenders = Interest paid – Net new borrowing

D. Cash flow to shareholders

Cash flow to shareholders = Dividends paid – Net new share capital

raised


SUMMING UP



• The balance sheet shows the financial position (or condition) of a firm at a given

point of time. It provides a snapshot and may be regarded as a static picture.

The income statement (referred to in India as the profit and loss account) reflects

the performance of a firm over a period of time. The cash flow statement

portrays the flow of cash through the business during a given accounting period.

• Assets are classified into following categories : (i) fixed assets, (ii) investments,

(iii) current assets, loans and advances, and (iv) miscellaneous expenditures and

losses. Liabilities are classified into the following categories : (i) share capital,(ii) reserves and surplus, (iii) secured loans, (iv) unsecured loans, and (v) current

liabilities and provisions.

• The important items in the profit and loss account are: (i) net sales, (ii) cost of

goods sold, (iii) gross profit, (iv) operating expenses, (v) operating profit, (vi)non-operating surplus/deficit, (vii) profit before interest and tax, (viii) interest,

(ix) profit before tax, (x) tax and (xi) profit after tax.

• The important topics in finance can be keyed to the balance sheet and the profit

and loss account.


• From a financial point of view, a firm basically generates cash and spends cash.



p , y g p

The activities that generate cash are called sources of cash and the activities that

absorb cash are called uses of cash. Increase in owners' equity and liabilities and

decrease in assets represent sources of cash. Decrease in owners’ equity and

liabilities and increase in assets, on the other hand represent uses of cash.

• To understand how cash flows have been influenced by various decisions, it is

helpful to classify cash flows into three categories: cash flows from operating

activities, cash flows from investing activities, and cash flows from financing

activities.

• Corporate managements have discretion in influencing the occurrence,

measurement and reporting of revenue, expenses, assets and liabilities. They

may use this latitude to manage the bottom line.

• Taxes can be one of the major cash outflows for a firm. The magnitude of the tax

burden is determined by the tax code, which is subject to change.


• Taxes may be divided into two broad categories: direct taxes and indirect taxes.

A t i f d t di t t if th i t d i id f th t i th



A tax is referred to as a direct tax if the impact and incidence of the tax is on the

same person. Income tax, wealth tax, and gift tax are examples of direct taxes.

A tax is regarded as an indirect tax if the impact and incidence of the tax is on

different persons. Excise duty, sales tax, and customs duty are the three

important indirect taxes.

• We have a balance sheet identity which says that the value of a firm's assets is

equal to the value of its liabilities plus the value of its equity. In the same

manner we have a cash flow identity which says that :

Cash flow from assets = Cash flow to lenders + Cash flow to shareholders

lec 3 financial statements

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