Understanding Financial

Statements

Sanjay Dhamija
sdhamija@imi.edu
sandha@hotmail.com
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 Schedule Previous Year Current Year
Sales No. xxx
Other Income xxx
Expenditure
Material and Other Expenditure xxx
Interest xxx
Depreciation xxx
Profit Before Tax xxx
Provision for Tax xxx
Profit After Tax xxx
Prior period adjustments xxx
Extra Ordinary Items xxx
Profit available for appropriations xxx
Appropriations
Dividend xxx
Dividend Distribution Tax xxx
General Reserve xxx
Surplus carried to Balance Sheet
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 cant 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 10.00 3.34
Other 5.00 1.63
Temporary 100.00 100
Plant & Machinery- Single shift 13.91 4.75
Double Shift 20.87 7.42
Triple Shift 27.82 10.4
Electrical Fittings 13.91 4.75
Vehicles (Motor Carr, Motor cycles, scooters) 25.89 9.50
Buses & Lorries (other than used for hire) 30.00 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
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
 Balance Sheet of XYZ Limited as at ..
Schedule Figures as at the Figures as at
Number end of current the end of
financial year 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
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) : 3,91,20,000
Add: 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
Dont 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 Tax on Accounting Create
Income > Taxable Income > Tax Deferred Tax
Income payable as per Liability
Income Tax Act
Accounting Tax on Accounting Create
Income < Taxable Income < Tax Deferred Tax
Income payable as per Asset
Income Tax Act
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 Liabilities
Company Year Contingent Net Worth CL as a %
ended Liability 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 2003 513.41 91.58 561
Cementation
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
doesnt 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