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

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 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

Depletion

Real Assets with limited useful life

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

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
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

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) :
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
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. (AS10)
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)
(b)

Balance outstanding for a period exceeding 6 months

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
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 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