Understanding Financial
Statements
Sanjay Dhamija
sdhamija@imi.edu
sandha@hotmail.com
Why Accounting

Informational requirement of a number of stakeholders in
the business
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Internal Stakeholder
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External Stakeholders
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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
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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
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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)
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Last in First Out (LIFO)
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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
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
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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
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Profit & Loss A/c is an account showing income and
expenses
Revenue/ Income is recognised when earned
Expenses are recorded when incurred
Basic Concepts
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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
Number
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
Figures as at the
end of current
financial year
Figures as at
the end of
previous
financial year
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
 Paid up Share Capital
:
5,00,000
:
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) :
Add: Forfeited Shares (1,00,000 x 3)
 Total
3,91,20,000
3,00,000
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
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


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
Income > Taxable Income > Tax
Income
payable as per
Income Tax Act
Create
Deferred Tax
Liability
Accounting
Tax on Accounting
Income < Taxable Income < Tax
Income
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 nontemporary 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)
(1)
(2)
(3)
(4)
(5)
(6)
Current Assets
Interest accrued on Investments
Stores and Spare parts
Loose Tools
Stock in Trade
Work in Progress
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
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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)
(2)
(3)
(4)
(5)
(6)
(7)
Acceptance
Sundry Creditors
Subsidiary Companies
Advance payments
Unclaimed dividends
Other Liabilities
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
ended
Contingent
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

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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