Understanding Financial Statements in 38 Characters

Understanding Financial Statements

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

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

Income Sched Previous Current
Sales ule Year Year
Other Income No. xxx
Expenditure xxx
Material and Other
Profit Before Tax xxx
Expenditure
Provision for Tax xxx
xxx
Profit After Tax xxx
Interest
Prior period adjustments
xxx
xxx
Depreciation
Extra Ordinary Items xxx
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 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 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

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

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

 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

 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
 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 Tax on Accounting Create Deferred
Income > Taxable Income > Tax Tax Liability
Income payable as per
Income Tax Act
Accounting Tax on Accounting Create Deferred
Income < Taxable Income < Tax Tax Asset
Income payable as per
Income Tax Act

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
(2) Interest accrued on Investments
(3) Stores and Spare parts
(4) Loose Tools
(5) Stock in Trade
(6) Work in Progress
(7) 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.

 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.

 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.

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
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

Understanding Financial Statements in 38 Characters

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