Understanding financial statements

Understanding Financial
Statements

Sanjay Dhamija




Why Accounting


Informational requirement of a number of stakeholders in
the business


Internal Stakeholder






External Stakeholders









Owners
Management
Employees
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
Profit Before Tax
Provision for Tax
Profit After Tax
Prior period adjustments
Extra Ordinary Items

Profit available for appropriations
Appropriations
Dividend
Dividend Distribution Tax
General Reserve
Surplus carried to Balance Sheet

Schedule
No.

Previous Year

Current Year
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx


Revenue Recognition

 Revenue
 Sales of Goods
 Rendering of Services
 Use by others of enterprise resources yielding
interest, royalties and dividends

 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

 Depreciation
Cost 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
5.00
100.00

3.34
1.63
100

Plant & Machinery- Single shift
Double Shift
Triple Shift

13.91
20.87
27.82

4.75
7.42
10.4

Electrical Fittings

13.91

4.75

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

25.89
30.00

9.50
11.31

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