understanding financial statements sanjay dhamija [email protected] [email protected]
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Understanding Financial Statements
Sanjay Dhamija
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 Income
Expenditure
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 SLM
Building - 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 4.75
Vehicles (Motor Carr, Motor cycles, scooters)Buses & Lorries (other than used for hire)
25.8930.00
9.5011.31
Furniture & Fittings 18.10 6.33
Individual 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
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
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 5882
Hindustan Motors 2004 137.04 15.09 908
Essar Steel 2004 3108.64 589.01 528
Sakthi Sugars 2003 177.19 37.92 467
HCC 2004 833.97 238.74 349
Gammon India 2004 581.58 184.07 316
Ispat Industries 2004 2145.41 833.29 257
Esab India 2003 28.28 12.40 24
Skansha 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