Understanding Financial Statements

1. Understanding Financial Statements Sanjay Dhamija sdhamija@imi.edu sandha@hotmail.com

2. 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

3. 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

4. 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

5. 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

6. 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

7. Income Statement

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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Determinants of Depreciation • Estimated Residual Value • Amount expected to be realized on disposal • If considered insignificant – taken as Nil • Otherwise based upon the past experience • Depreciable Value • Cost of Acquisition – Estimated Residual Vale • Depreciation Cost of Acquisition – Residual Value Useful Life

16. 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

17. 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

18. 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

19. Depreciation Rates - Schedule XIV of the Companies Act

20. 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

21. 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 ?

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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.

29. 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

30. 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

31. 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

32. 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

33. Balance Sheet

34. Schedule VI – Part I • Accounts must be maintained on an accrual basis and according to double entry bookkeeping 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’

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

36. Sources of Funds

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. Deferred Tax Liability/Assets

49. Application of Funds

50. 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