Understanding Financial

Statements– A Basic Overview

Introduction to Accounting and A
Conceptual Overview
 Preamble
• I am completely new to Accounting. Will I be
able to cope up with the course?
• Some of my classmates are from commerce
background. I won’t be able to challenge them
in grades.
• Apart from the given materials and textbooks
what other things I should consult?
• Sir is discussing cases in the class. Being a
novice how do I attempt those?
 The Business Environment

All countries have three

basic forms of business
organization:
• Sole Proprietorships
• Partnerships (general and limited)
• Limited liability companies
 The Business Environment

All countries have three

basic forms of business
organization:
• Sole Proprietorships
• Partnerships (general and limited)
• Limited liability companies
 The Business Environment
Sole Proprietorship -- A business
form for which there is one owner.
This single owner has unlimited
liability for all debts of the firm.

• Oldest form of business organization.

• Business income is accounted for on the owner’s
personal income tax form.
 Summary for Sole
Proprietorship
Advantages Disadvantages

• Simplicity – Unlimited liability

• Low setup cost – Hard to raise additional
• Quick setup capital
• Single tax filing on
individual form – Transfer of ownership
difficulties
 The Business
Environment
Partnership -- A business
form in which two or more
individuals act as owners.

• Business income is accounted for on each

partner’s personal income tax form (USA).
• In India the firm is taxed flatly along with
LLP.
 Types of Partnerships
General Partnership --
All partners
have unlimited liability and are liable for all
obligations of the partnership. Maximum
Number of Partners can be 100 (India)
Limited Partnership -- Limited partners have liability
limited to their capital contribution (investors only). In
some countries like USA, at least one general partner is
required and all general partners have unlimited liability.
In some other countries, like India, all partners can have
limited liabilities. There can be unlimited partners in LLP in
India.
 Summary for Partnership
Advantages Disadvantages
• Can be simple • Unlimited liability for
• Low setup cost, higher the general partner
than sole • Difficult to raise
proprietorship additional capital, but
• Relatively quick setup easier than sole
proprietorship
• Limited liability for
• Transfer of ownership
limited partners
difficulties
 The Business
Environment
Corporation -- A business form
legally separate from its owners.

• An artificial entity that can own assets and

incur liabilities.
• Business income is accounted for on the
income tax form of the corporation.
corporation
 Summary for Corporation
Advantages Disadvantages
• Limited liability • Double taxation
• Easy transfer of • More difficult to
ownership establish
• Unlimited life • More expensive to
• Easier to raise large set up and maintain
quantities of capital
 Financial Market
Capital Market Money Market
• Securities of more than one • Securities of less than one
year maturity are traded. year maturity are traded.
• Examples are equity, long • Examples are Treasury Bills,
term bonds etc. Certificate of Deposits,
Commercial Papers.
• Regulator is SEBI. • Regulator is RBI.
• Used for long-term • Used for short-term
financing/investing of the financing/investing of the
firms. firms.
• Yields are higher. • Yields are lower.
 Money Market Instruments
• Treasury Bills
• Commercial Papers
• Certificate of Deposits
• Repurchase Agreements
• Bankers’ Acceptance
 Capital Market Securities
• Equity Shares
• Bonds/Debentures ( Secured/Unsecured, Convertible,
Zero Coupon, Secured Premium Notes, Floating Rate,
Indexed etc.)
• Preference Shares
• Equity Shares With Detachable Warrants
• Sweat Equity Shares
• ABS/MBS
• Equity Derivatives
• Participatory Notes
• ETFs- REITs and Gold ETFs
Accounting as an Information System
1-1

BUSINESS DECISION
ACTIVITIES MAKERS

Data Information

ACCOUNTING

MEASUREMENT PROCESSING Communication

Accomplished Accomplished Accomplished
by recording of by storage and by reporting
data preparation of
data
 The Users of Accounting Information
1-3

DECISION MAKERS

MANAGEMENT THOSE WITH DIRECT THOSE WITH INDIRECT

FINANCIAL INTEREST FINANCIAL INTEREST
Finance
Operations and Investors Tax Authorities
Production Creditors Regulators
Marketing Labor Unions
Human Resources Customers
Information Systems Economic Planners
Accounting
 Questions Asked by Internal
Users
• Is cash sufficient to pay bills?
• What is the cost of manufacturing each
unit of product?
• Can we afford to give employee pay
raises this year?
• What product line is most profitable?
 Questions Asked by External
Users
• Is the company earning satisfactory
income?
• How does the company compare in
size and profitability with competitors?
• Will the company be able to pay its
debts when they become due?
Business Goals, Activities, and
Performance Measures
• A business is an economic unit that aims to
sell goods and services to customers at
prices that will provide an adequate return
to its owners.
• Businesses, though different, have similar
goals and engage in similar activities.
 Business Goals and Activities
1-2

BUSINESS GOALS BUSINESS ACTIVITIES

PROFITABILITY
FINANCING OPERATING

INVESTING
LIQUIDITY
3 Types of Business Activity

• Financing
• Investing
• Operating
 Financing Activities
It
Takes

MONEY
to
Make

MONEY!
 Two Ways of Outside
Financing of a Corporation
• Borrowing money
(Outside liabilities)
• Issuing shares of
stock in exchange
for cash (Equity)
Reporting

Main Financial Statement

Each has its own

contribution to
the whole..
Reporting

Difference between Financial Year

and Calendar Year
The Calendar Year runs from January 1 to
December 1 of every year, but
a Financial/Fiscal year may start on the first
day of any month except January.
The Financial/Fiscal year is any 12
consecutive months chosen to be the official
accounting period by a business or
organization.
 What is Income Statement or Profit & Loss Statement?

Revenue- what are the various sources

of sales $xxx
- Source 1
- Source 2….anymore sources?

Then we minus
Costs of Sales:(Direct costs of generating
the sales)$(xxx)
Eg, Direct manpower? Direct utilities?
Maintenance?

Gross profit (for the period)

$xxx
What is Income Statement or Profit & Loss Statement?

Gross profit (continued)

$xxx
Add: any Other Income? (rentals, interest received) xxx

Now, we minus all the other INDIRECT costs….

Operating expenses:
Selling expenses (xxx)
General expenses (xxx)
Operating income (EBIT) $xxx Printing & stationery
Training costs
Interest charges (xxx) Salaries
EPF
Income after Interest; before Taxes $xxx
Medical costs
Communications
Compensations
Taxation (xxx) Directors fees
Income after Interest and Taxes or Net Profit Entertainment
$xxx
The Income / Profit & Loss Statement

 From the Income Statement.

Revenue $xxx
Costs of goods sold: (xxx)
Gross profit on sales $xxx
Operating expenses:
Selling expenses $xxx
General expenses xxx (xxx)
Operating income (EBIT) $xxx

Interest charges (xxx)

Income after Interest; before Taxes $xxx

Taxation (xxx)
Income after Interest and Taxes $xxx
Net income/(loss) $xxx
What are Revenues?
Finance for
Non
Financials -
What are
Revenues?
Revenues result from sale
of a
 Product or
 Service
Finance for Non Financials - Cash Basis
Accounting
Cash Basis vs Accrual Basis Accounting
Difference between title of a Balance
sheet and Income statement

The primary difference between the

Income statement and the balance sheet
involves their respective treatments of
time. The balance sheet summarizes the
financial position of a company for one
specific point in time. The Income
statement shows revenues and expenses
during a set period of time. The length of
the period of time covered in the Income
statement may vary, but common
intervals include quarterly (three months)
and annual statements
Accrual Basis of Accounting

The REVENUE RECOGNITION and MATCHING

principles are used under the accrual basis of
accounting.
Under cash-basis accounting, revenue is recorded
only when cash is received, and expenses are
recorded only when paid.

Generally accepted accounting principles (in our case.,

the Indian Accounting Standards) require accrual basis
accounting because the cash basis often causes
misleading financial statements.
The Matching Principle

The practice of expense recognition is referred to as the

matching principle.

The matching principle dictates that efforts

(expenses) be matched with accomplishments
(revenues).

Expenses
Revenues
Are offset incurred in
earned
against.... earning the
this month revenue
When to Recognize Revenue?

Now, when should the ‘Revenue’ be

recognized in your company?

This is what is meant by the Revenue

Recognition Principle…
i.e. the point of recognizing revenue in
the books of financials.
From the Income Statement

Revenue
$100m This may not
Costs of goods sold: represent the
$(70m) amount of cash
Gross profit on sales collected
from customers
$30m
Operating expenses:
Selling expenses $3m
General expenses $2m
(5m) charges
Interest
Operating
(0.5m)income (EBIT)
$25mafter Interest; before Taxes
Income $24.5m
Taxation (0.5m)

Income after Interest and Taxes

$24m
Net income/(loss)
SOME OF THESE
$24mEXPENSES MAY NOT HAVE BEEN PAID IN CASH
YET
From the Income Statement

Advance deposits
from clients / MAY?
Customers WHEN IS SERVICE
RENDERED?

MARCH? When should

REVENUE be
recognized?
Thus, the concept of Unearned Revenue

Unearned Revenues are revenues received and

recorded as liabilities before they are earned.
Unearned revenues are subsequently earned by
performing a service or providing a good to a
customer.

We shall look at this statement shortly....

What are Expenses?

Expenses are the cost of assets consumed or

services used to generate revenues
Cost of sales or Cost of goods sold (i.e. direct costs of
manufacturing products/providing services)

Other operating expenses (Eg. Manufacturing Overhead/

Professional fees , regulatory fees, communication fees)

General and administrative expenses

Interest expense
Cost of Sales / Cost of Goods Sold

These are the DIRECT COSTs

incurred in producing the
product/service which is
subsequently sold (Revenue)
DIRECT COSTS = DIRECT LABOUR+ DIRECT
MATERIALS

DIRECT MATERIALS (only usually relevant in

product industry….may NOT be relevant in service
business)

OPERATIONS OVERHEADS (Regular servicing fees,

Repairs & Maintenance, Depreciation, Utilities –
Water, Electricity, etc)
Depreciation

Depreciation is the process of

allocating the cost of an asset to
expense over its useful life in a
rational and systematic
The purchase of equipment manner .
or a building is
viewed as a long-term prepayment of
services and, therefore, is allocated in the
same manner as other prepaid expenses.
The Income / Profit & Loss Statement

Net Income / Profit is the

excess of revenues over
expenses.
Revenue $10,000
Expenses 3,000
Net income / (loss) $ 7,000
EBIT or (PBIT)

 EBIT is Earnings Before Interest and Tax

o i.e. the profit of the organization before
deducting any interest elements and taxation
(remember: tax is an expense for a company)

 What about EBITA??

What is an Amortization?

AMORTIZATION IS spreading of the expenses over the period to which it belongs to.

Example: INSURANCE PAID (in advance for 12 months)

Jan Feb Mar Apr May Jun July Aug Sep Oct Nov Dec
e t

CORRECT WAY
is......Spread it!!
If NOT amortized
Lets say or spread, it will
Insurance paid appear as
$1,200 for 12 expenses $1,200 in
months Jan Income
Statement....NOT
FAIR!
The Balance Sheet

Components of Balance Sheet Statement

Assets are resources owned by
a business.
They are things of value used in
carrying out such activities as
production, consumption and
exchange.

The common characteristics

possessed by all assets is the
capacity to provide future services or
benefits to the entities that use
them.
Current / Short Term Assets

Current assets are cash and other resources that are

reasonably expected to be realized in cash or sold or consumed
in the business within one year of the balance sheet date or
the company’s operating cycle, whichever is longer.

Current assets are listed in the order of their liquidity.

The operating cycle of a company is the average time that is

required to go from cash to cash in producing revenues.

Examples of current assets are cash, short-term

investments, receivables, Inventories and prepaid expenses
Long-Term Investment Assets

Long-term investments are resources

that can be realized in cash, but the
conversion into cash in not expected
within one year or the operating
Examples include investments
cycle, whichever is longer. in
shares and bonds of another
company or investment in land held
for resale.
Property, Plant and Equipment: Long-Term Assets

Tangible resources of a relatively permanent nature that are used in the

business and not intended for sale are classified as property, plant, and
equipment.

Examples include land, buildings, machinery, equipment, and furniture and

fixtures.
What is Depreciation?

Definition Analysis
Allocation of Asset purchase price or cost over its estimated
useful life
Depreciation is a non-cash expense and is charged to Profit
& Loss a/c each year
This lowers the value of these Long Term Assets
systematically each year
Example – Purchase of a Van

Purchase of van (50,000) at the start of

20X1.

Estimates
 To be used for 10 years (estimated
useful life)
 Annual depreciation expense =
(acquisition cost) / number of
periods
 = 50,000 / 10 years
 = 5,000 a year (or translated as
10% per year)
Example – Purchase of a Van

Taken out to each year’s Income Statement as

Expense (a non-cash flow Exp)

Continues until Year 10 when the value

becomes 0
Example – Disposal of an asset

Book value of asset Depreciation

Balance
in Balance Sheet of expense in Income
sheet date
each year Statement
Purchase 50,000 - What if
dispose
End 20x1 45,000 5,000
d off
End 20x2 40,000 5,000 after
Year 3
End 20x3 35,000 5,000 for say,
33k?
End 20x4 30,000 5,000

Book value 35k

Disposal value (33k) INCOME
STATEMENT as
Loss on disposal (2k) Expense
Intangible
Assets

Intangible assets are noncurrent resources

that do not have physical substance.

Examples include patents, copyrights, trademarks, or trade

names that give the holder exclusive right of use for a
specified period of time.
Intangible Assets

)
Intangible Assets

The goodwill am
ountsto the
excess of the
"purchase
consideration"
(the money paid
to purchase the
asset or
business) over
the total value
of the assets
and liabilities.
Liabilities / Debts / Borrowings

Liabilities are claims against assets.

They are existing debts and obligations.

Most claims of creditors attach to total enterprise assets

rather than to the specific assets provided by the creditor.
Current / Short Term Liabilities

Current liabilities are

obligations that are
reasonably expected to
be paid from existing
current assets or through
the creation of other
current liabilities within
one year or the operating
cycle, whichever is
longer.

Examples include
accounts payable, wages
payable, interest
payable, and current
maturities of long-term
debt.
Long Term Liabilities

Obligations expected to be paid

after one year are classified as
long-term liabilities.

Examples include long-term notes

payable, bonds payable, mortgages
payable, and lease liabilities.
The Concept of Provisions

 Provision is a liability of uncertain timing or

amount.

 Reported either as current or non-current liability.

 Recognized in line with ‘conservative’ concept of showing the ‘worst

case scenario’ rather than best case scenario in financial statements.

 Common types are :

 Obligations related to litigation.

 Provision for losses or write offs

 Provision for any expenses

Shareholders’ (Owners’) Equity

The content of the owner’s

equity section varies with the
form of business organization.

For a corporation, owners’ (shareholders’)

equity is divided into two accounts:

 1. Common/ordinary shares (Paid

up Capital) and
 2. Retained Earnings
The Conservative Principle

The Conservatism Principle is the

general concept of recognizing expenses
and liabilities as soon as possible when
there is uncertainty about the outcome,
but to only recognize revenues and
assets when they are assured of being
received.
ABC Ltd - Retained Earnings Statement For the Year Ended December 31, 2008

This example assumes ABC Ltd

is in 1st year of operations

Retained earnings, January 1 2008 $ 0

Add: Net Income for year (2008) 6,800

6,800
Less: Dividends ( 600)
Retained earnings, December 31 $ 6,200

This Closing balance of

Profit for 2008 becomes
Opening balance for 2009

Ending Retained Earnings is needed for the balance she

Relationship between Income Statement & Balance Sheet

1st Year
operations
Year 1999 2000 2001 2002

Income Statement for various years

Net 10,000 20,000 15,000 10,000

profit
Balance Sheet (extract) for various years
Retained
Earnings 10,000 30,000 45,000 55,000
The Complete Picture: Why Balance Sheet must balance
 The Cash Flow Statement

Statement of Cash Flows

Cash Provided by or Used in:

Operating Activities $XXX

Investing Activities XXX

Financing Activities XXX

Net Increase (Decrease) in Cash

$XXX

Cash--Beginning of Year XXX

Cash--End of Year $XXX

Operating Activities
Investing Activities

• Sale of plant
• Sale of Securities, other than trading
Cash In-
flow securities
• Collection of Principal on loans

• Purchase of plant assets

• Purchase of securities, other than
Cash Out-
flow trading securities
• Making of loans with other entities
Financing Activities
How the Statement of Cash Flows relate to the Balance Sheet?

Condensed Balance Sheet Statement of Cash Flows

As of December 31, 2002 For the Year 2002
Assets
Cash $ 4,895 Net Cash Flow from
Accounts Receivable $ 5,714 Operating Activities $1,069
Inventories $ 8,517
Building and equip. 7,154 Net Cash Flow from
Land 981 Investing Activities $(1,625)
Total assets $27,261 Net Cash Flow from
Liabilities and Owners’ Equity Financing Activities $ 400
Liabilities $16,156 Net Decrease in Cash $ (156)
Owners’ Equity Cash at Beginning of Year $5,051
Paid-in capital 2,000 Cash at End of Year $4,895
Retained earnings 9,105
Total liabilities and
owners’ equity $27,261
Capital and Revenue Expenditure

Expenditure

Increases Increases Operating

operating N useful life N Expenditure
efficiency o (extraordin o (ordinary
or adds to ary maintenance and
capacity? repairs)? repairs)

Ye Ye
s s

Capital Capital
Expenditure Expenditure
Elements of an

• Financial Statements
– Income Statement
– Statement of Retained Earnings
– Balance Sheet
– Statement of Cash Flows
• Management Discussion and Analysis
• Notes to Financial Statements
• Auditor's Report
 Management Discussion
and Analysis

Covers three aspects of a company:

– liquidity - ability to pay near-term
obligations
– capital resources - ability to fund
operations and expansions
– results of operations
 Notes to Financial Statements
• Provide additional information not
included in body of statements
• Does not have to be numeric
• Examples:
– Description of accounting policies or
explanation of uncertainties and
contingencies
– Statistics and voluminous details
 Auditor's Report
• Auditor, a professional accountant who conducts
an independent examination of the financial
accounting data presented by a company.
• Auditor gives an unqualified opinion if the
financial statements present the financial
position, results of operations, and cash flows in
accordance with GAAP.
 Relation between Business Activities and Balance Sheet and Income Statement
Goals and
Strategies

Noncurrent Current Current Noncurrent

 Land, Buildings,  Cash  Notes Payable  Bonds Payable
and Equipment  Accounts  Accounts Financing  Common Stock
Investing
 Patents Receivable Payable  Retained Earnings
 Investments  Inventories  Salaries
in Securities  Marketable Payable
Securities  Income Taxes
Payable
Assets  Sales Revenue Liabilities and
(Balance Sheet)  Cost of Goods Sold Shareholders’ Equity
 Selling Expense (Balance Sheet)
 Administrative Expenses
 Interest Expense
 Income Tax
Expense
Operating

Net Income
(Income Statement)