Financial Reporting and Analysis

Coverage- FSA: An Introduction

1. Role of Financial reporting and Financial Statement Analysis (FSA)

2. System of Double Entry

3. Steps in FSA framework

4. Audit of financial statements

5. Internal Controls in an organisation

6. Basic Accounting Principles

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Basic Definitions

1. Accounts
 Records which contain history of transactions under taken for business
 Sequence – Journal (date-wise)>> General Ledger (account-wise) >> Trial Balance
 Chart of accounts is the list of all the accounts used for accounting in the company
2. Accounting
“Accounting is the art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events, which are, in part at least , of a financial character
and interpreting the results thereof.”

3. Accountancy
 Principles / techniques / rules which are used in The US UK India
accounting are collectively called as Accountancy
Technical FASB IASB ICAI
 These rules are necessary to be followed to promote
standardization Regulatory SEC FSA SEBI

 Formed by technical organizations but enforced by

regulatory body
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 Basic Definitions (Contd.)

4. Financial Reporting
 The process of placing different ledger balances from Trial balance into different formats

5. Financial Statements
 Are the different formats which have been prescribed by the law (accountancy) to be used for the
purpose of financial reporting.
 Each format communicates a separate aspect of the business
 Different Financial Statements are:
1. Income Statements
2. Balance Sheet
3. Cash Flow
4. Statement of change in owner’s equity

6. Financial Statement Analysis (or Reporting Analysis)

 Is the process of making use of the information derived from the financial statement
 Done by any stakeholders (shareholder,employee,govt,banker,suppliers,customers,society, etc.)
 To make some economic decision
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Sequence of actions in business and its reporting

1 Business Transaction

2 Recording for future reference Accounting

(Journals, Ledgers, Memo)

3 Proper presentation Financial Reporting

(Balance sheet, P/L, Cash Flow St)

4 Use of information by stakeholder Financial

Statement Analysis

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Roles of Financial reporting and Financial Statement Analysis

 Financial reporting: It is the way companies show their performance to outside world

 International Accounting Standards Board (IASB) has described the role of financial reporting in its
Framework for the Preparation & Presentation of Financial Statements as:

“ The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of users in
making economic decisions ”

 Financial Statement Analysis (FSA): The role of FSA is to use the company’s financial statements &
other relevant information to make economic decisions

a) FSA is used to
1. Evaluate company’s past performance and current financial position
2. Project company’s ability to earn profits and future cash flows

b) So that economic decisions like the following can be taken:

1. Whether to invest in the company's securities
2. Whether to extend bank credit to the company

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Flow of information in an accounting system

1 Journal entries
(record every transaction chronologically)

2 General ledger
(sorts the entries in the general journal by accounts)

3
Trial balance
(initial trial balance & adjusted trial balance)

4
Financial statement
(Grouping into various financial line items)

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Basic Accounting Principles

Basic Accounting Assumptions

1. Going Concern: Business is expected to continue forever
2. Accrual : Records transaction when these are done rather than when cash flow associated
take place

3. The Entity Concept: The business is separate from its owners.

Other Principles
1. Materiality: accounts to be prepared keeping materiality in mind
2. Conservatism: Recognize all expenses and losses immediately but don’t account for
profits and gains unless they actually accrue.
3. Matching: Cost should be set out against that revenue in the period during which it is
recognised as earned.
4. Dual Aspect

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Double entry accounting Imp

 Each transaction is recorded atleast at two (double) accounts and in a way that balances both the
sides of the balance sheet

 For example:
A) An increase in an asset account must be balanced by either:
 Increase in a liability or owners' equity account
 Decrease in another asset account

B) An expenses incurred (causing reduced earning leading to low retained earning to low equity
hence lower liability) must be balanced by either:
 Reduction in cash (if expenses is incurred in cash)
 Increase in liability (if expenses is incurred on credit)

Account 1 Account 2 Example

Asset ↑ Asset ↓ Purchase inventory with cash

Asset ↑ Liability ↑ Purchase inventory on credit
Asset ↓ Equity ↓ Company pays out Salary

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Examples on Double entry accounting

1. Purchase furniture for $1,000 cash

 Furniture (an asset) increases by $1,000
 Cash (an asset) decreases by $1,000.
 Both assets and liabilities are balanced
 Both assets and liabilities are balanced

2. Purchase furniture for $1,000 through raising $1,000 notes

 Furniture (an asset) increases by $1,000
 Notes (liability) increases by $1,000
 Both assets and liabilities are balanced

3. Pay $1000 for salary in cash

 Salary (expenses) reduces net income, leading to low equity and lower liabilities by $1000
 Cash reduces by $1000
 Both assets and liabilities are balanced

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The Magical Accounting Equation

Assets = Liabilities + Owner’s equity

Long Lived Long term Loans Common stock Capital

Current Assets Short term Loans Reserves and Surplus
Investments Current Liabilities Preferred Stock Capital

This equation will always balance for

1. All the transactions done by the business
2. At ALL points in TIME during the life of the company

 This equation is a substitute of rules of Debit and Credit which are not necessary for an analyst

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Practice – Basic Accounting Equation

Identify the classification of the activity from point of view of both the entities involved:

1. SBI gave a loan to Maruti for $100 Mn

2. Maruti used that amount to buy a land from Ansals for constructing a factory $80 Mn

3. An investor opened a time deposit account with SBI for $1Mn

4. An investor got share in SBI’s IPO for $1Mn

5. Ansals sold a commercial space of $1M to an investor for $1.6 M

6. Ansals purchased a piece of land from Farmers (cost $ 0.5M) near Bhiwadi for $2M

7. Maruti sold scrap generated during the production process for $ 15M

8. Bharti made investments into mutual funds to park surplus funds for $10M

9. Ranbaxy made investments into mutual funds to earn some extra return for $10M

10. Reliance paid $1.1M as fees to the GOI for allocation of an oil exploration site in India

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Structure of FSA

1. Determine
2. Gather
the Objective
Data
and Context

6. Update the 3. Process

Analysis the Data

5. Report the
4. Analyze
Conclusions or
and interpret
Recommendati
the data
ons

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Stating the context or objective of Analysis

Stakeholder Objective

► Lender ► Credit worthiness

► Investor ► Returns from the investment

► Supplier ► Liquidity Position

► Customer ► Sustainability of operations

► Capital Markets ► Corporate Governance

► Government ► Revenue generation ability

► Employees ► Impact on wages/salaries

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Sources of information for an analyst

1. Financial statements

2. Supplementary information

3. Footnotes

4. Management Disclosure and Analysis

5. SEC filings

6. Proxy Statements

7. Other Sources

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1. Financial Statements

 Are the different formats which have been prescribed by the law (accountancy) to be used for
the purpose of financial reporting.

 Each format communicates a separate aspect of the business

 Different Financial Statements are:

1. Income Statements

2. Balance Sheet

3. Cash Flow

4. Statement of change in owner’s equity

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2. Supplementary schedules

 These schedules detail out different consolidated figures given in financial statements

 These are more or less voluntary disclosures by the company

 Supplementary schedules contains additional information like:

1. Operating income or sales by region or business segment

2. Reserves for an oil and gas company

3. Information about hedging activities and financial instruments

 Supplementary schedules are not required to be audited

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3. Financial Statement Notes

 Also known as FOOTNOTES:

 Provides information about accounting methods, assumptions & estimates used in preparing financial
statements

 Provide additional information on business segment, related party transactions, acquisitions / disposals,
contingencies, significant customers

 Allows users to improve their assessment of amount, timing & uncertainty of estimates reported in
financial statements

 All footnotes are required to be audited

Company A Company B

Revenue 100 600

Revenue through related party 500 0
Total Revenue 600 600

Since Company A has many related party transactions, company B’s revenues are more reliable

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4. Management's Discussion and Analysis (MD&A)

 Management's Discussion and Analysis (MD&A) provides assessment of the financial performance of
a firm from management’s perspective

1. In their annual reports, public companies are required to disclose following information in MD&A
a) Result from operations with trends in sales and expense
b) General business overview based on known trends
c) Capital resources and liquidity along with trends in cash flows
d) Discussion on significant events & uncertainties

2. Additional information, not compulsorily required to be disclosed, under MD&A:

a) Effects of known trends on business
b) Accounting policies requiring significant judgment
c) Issues related to capital structure and liquidity
d) Information on unusual or infrequent items and extraordinary items etc.

► Qualitative business performance

► Significant effects of currently known trends, events
► Risks facing the organizations
► Outlook

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6. Proxy Statements

 It is a form to be used for voting in the absence of shareholder from the AGM

 Issued to shareholders along with the notice of AGM highlighting the decisions that need
shareholder’s approval like:

a) Appointment of a director

b) Appointment of an auditor

c) Any M&A to be done

 Good source of information about the election of (and qualifications of) board members.
compensation, management qualifications, and the issuance of stock options
 and sales of company securities by corporate insiders

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7. Other Sources of Information

a) Corporate Reports

b) Press Releases

c) Trade Journals

d) Statistical Reporting Services and Govt. Agencies

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Audit of Financial Statements

 Auditor: an accounting expert appointed by shareholders to independently review the FS prepared by

the management
 Every country’s regulatory body prescribes the minimum qualification that is required for an auditors
 Attestation function – signing and certification that the FS are free from material errors

 Objective of Audit
 To get an independent opinion on fairness and reliability of financial statements
 To check whether generally accepted accounting policies (GAAP) were followed
 To examine efficiency of accounting & internal control system
 To determine financial statements contain no material errors

 Audit reports to the shareholders and NOT to the management

 Audit report is addressed to the shareholders and NOT to the management

 Auditor is not a BLOODHOUND. He is just a WATCH DOG.

 He has responsibility to reasonably assure the stakeholders about the fairness of FS
 Different accounting fraud has led to a debate on the role and responsibility of the auditor

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Audit Reports – Types of Scenarios

On the basis of his analysis, an auditor can issue one of the following 4 reports:

1. Unqualified opinion
 FS are free from material omissions and errors
 FS reflect the true and fair picture of the business

2. Qualified Opinion
 Except for few material issues, FS reflect the true and fair picture of the business
 Above material issues do not change the overall message communicated by the FS
 Auditors must explain these exceptions in the audit report

3. Adverse Opinion
 Statements DO NOT represent the true and fair picture
 There are material omissions / errors

4. Disclaimer of Opinion
 Due to some circumstances, an audit is unable to express any opinion on the FS, he issues a disclaimer
 Disclaimer DOES NOT mean that FS are incorrectly prepared by the management.
 Disclaimer is Inability of expression

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www.edupristine.com
Conceptual framework for financial reporting 2010

Fundamental Characteristics
1. Relevance

2. Faithful Representation

Four characteristics that enhances fundamental characteristics

1. Comparability

2. Verifiability

3. Timeliness

4. Understandability

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Core principle for FS preparation

International Accounting Standards No.1 - Principles

1. Fair presentation: no malafide intention while preparing the accounts

2. Going concern: The existence the legal company will continue forever

3. Accrual basis: Accounting when the actual transaction take place rather than when
corresponding Cash flow occur.

4. Consistency: Stick to one policy after making a choice from various options available

5. Materiality: cost of collecting the information should always be less than the benefit of
using that information

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 Question Set 2

1 Which of the following statements regarding footnotes to the financial statements is FALSE?
A) Footnotes provide information about policies, assumptions, estimates used by management.
B) Footnotes may disclose what types of accounting methods are being used.
C) Some supplementary schedules are audited whereas footnotes are not audited.

2 Which of the following is an independent auditor least likely to do with respect to a company’s
financial statements?
A) Provide an opinion concerning their fairness and reliability.
B) Prepare and accept responsibility for them.
C) Confirm assets and liabilities contained in them.

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 Question Set 2 (Contd.)

3 Which of the following statements represents information at a specific point in time?

A) The income statement.
B) The statement of cash flows.
C) The balance sheet.

4 Which of the following items is least likely a financing activity?

A) Dividends paid to shareholders.
B) Purchase of treasury stock.
C) Gain on sale of stock of a subsidiary.

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Financial Reporting Mechanics
Why FRA is important for an analyst

1. Credit Evaluation of borrower by the lender and assigning a rating

2. Evaluating a subsidiary division of the parent company

3. Managing Investment – identifying companies that are mis-priced

 Certain criterion are fixed for stock selection out of a big group

 Back testing: using historical data to check the efficiency of criterion selected

4. Facilitate analyst’s adjustment for making justified comparisons between companies

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Basic Definitions (Contd.)

All entities can be divided into 5 basic categories

Liability
Assets

Income Expense

Owner’s Equity

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 Balance Sheet (includes Assets, Liabilities and Equity)

Assets Liabilities and Equity

1.Property, Plant & Equipment 1.Owner equity
Long Term
Risk Long Term
2.Intangible Assets 2.Reserves Capital finances
Non-
operational 3.Investments 3.Long term loan
4.Prepaid expenses 4.Short term loan

Borrowed capital
5.Inventory (Stocks) 5.Accounts payable
Short Term
Short Term 6.Accounts Receivables 6.Advanced received finances
7.Marketable Securities 7.Unearned revenue
8.Cash & Bank 8.Accrued expenses

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Income Statement (includes Incomes and Expenses)

Profit and Loss Account Profit and Loss Appropriation Account

Particulars Particulars
Sales PAT
(Less) COGS (All direct expenses) (Less) Preference Dividend
Gross Profit Earning Attributable to Common
stockholders
(Less) Selling & Distribution Exp
(Less) Common Dividends
(Less) Administrative Exp
Retained Earnings
(Less) General Exp
EBITDA
(Less) Depreciation
EBIT
(Less) Interest
EBT
(Less) Income Tax Expense
PAT
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Link Between financial Management and Accountancy

Broad rules for effective Financial Management (Actual may be different for
different industries):

1. Short term liabilities should be used to finance the Short term assets & Long term
liabilities be used to finance the long term assets

2. At any point in time, amount of risk capital should not fall below one half of the
borrowed capital

3. Repayment of Liability can be from :

a) Cash generated by operations (Primary sources)
b) By liquidating an asset (Secondary sources)

4. Intangible assets are the most abused form of application of funds

To execute these principles, we need to know the value of financial parameters

which are derived from Accounts

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Any Value outflow can take three forms

Value outflow
Value does not mean only cash. It can also be effort, time, energy. For the purpose of accounting,
we will have to convert all qualitative parameters into monetary terms

Asset Expenditure Loss

Future benefit Current benefit No Benefit

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Classification of Activities

 All the activities of ANY business can be divided into three categories

 These three categories are:

1. MUTUALLY EXCLUSIVE and
2. EXHAUSITIVE

1. Operating activity: transactions that involve the firm’s primary activities.

1. This includes the main route by which any company intends to make profits
2. It includes the day to day business functions of a company

2. Investing activity: activities associated with the acquisition and disposal of long term
assets.

3. Financing activity: activities related to obtaining or repaying capital to be used in the

business.

The same transaction can be classified differently by both the entities

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Practice - Classification of Activities

Identify the classification of the activity from point of view of both the entities involved:

1. SBI gave a loan to Maruti for $100 Mn

2. Maruti used that amount to buy a land from Ansals for constructing a factory $80 Mn

3. An investor opened a time deposit account with SBI for $1Mn

4. An investor got share in SBI’s IPO for $1Mn

5. Ansals sold a commercial space to an investor for his office

6. Ansals purchased a piece of land from Farmers near Bhiwadi

7. Maruti sold scrap generated during the production process

8. Bharti made investments into mutual funds to park surplus funds

9. Ranbaxy made investments into mutual funds to earn some extra return

10. Reliance paid the fees to the GOI for allocation of an oil exploration site in India

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Financial Reporting Standards
Reporting standards

 If reporting standards didn’t exist then financial statements can take any form because of possible
assumptions & estimates

 Reporting standards
1. Makes financial statements much more comparable

2. Fixes a range on management estimates which otherwise could have substantially varied

3. Makes Financial statements useful to a wide range of users including security analysts

4. For e.g.: Depreciation methods, inventory valuation methods, representation of assets at book value etc
are made standardized by reporting standards

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Barriers to develop a universal accounting standard

 Accounting standards differ across countries:

 Depending upon the economic structure of a nation and prevalent conditions in a particular country

 Treatment of a particular item or issue is different in different countries

 This is a major barrier for setting up universal accounting standards

 Other reasons are:

 Political pressures from business groups who will be affected by changes in reporting standards

 Pressure from others who will be affected by changes in reporting standards

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IFRS – Financial Statement’s Objectives
 Ideas on which IASB bases its standards are expressed in the IFRS “Framework for Preparation &
Presentation of Financial Statements”

 According to IFRS, objective of financial statements are:

 To provide information on financial position, performance and changes in the financial position of an
entity

 Provide information that is useful to a wide variety of users for taking economic decisions

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IFRS – Financial Statement Characteristics Imp

Fundamental Characteristics
1. Relevance

2. Faithful Representation

Four characteristics that enhances fundamental characteristics

1. Comparability

2. Verifiability

3. Timeliness

4. Understandability

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IFRS Description – Financial Statement’s Elements

 IFRS describes the financial statement elements as:

1. Assets: Resources which are expected to accrue economic benefits in future periods

2. Liabilities: Obligations which are expected to accrue economic costs in future periods

3. Equity: Residual interest equal to Assets – Liabilities

4. Income: Includes revenue and gains; result of past transaction which accrued economic benefits either
by way of increasing assets or decreasing liabilities

5. Expenses: Includes expenses and losses; result of past transaction which accrued economic costs
either by way of decreasing assets or increasing liabilities

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IFRS – Financial Statement’s Constraints and assumptions

 Constraints:

1. FSs can directly present only quantitative information but not the non-quantifiable information like brand
loyalty, capacity for innovation, etc.

2. Strike a balance between reliability (free of errors) v/s timeliness

3. Strike a balance between cost of preparing FSs v/s benefits to users through FSs

 Assumptions

1. Accrual basis: financial statements should reflect transactions at the time they actually occur, not
necessarily when cash is paid

2. Going concern: entity is expected to continue its operations in foreseeable future

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IAS – An overview

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General requirements for financial statements Imp

 International Accounting Standard (IAS) No. 1 states that:

 Financial statements required are:
1. Balance sheet
2. Statement of comprehensive income
3. Cash flow statement
4. Statement of changes in owner’s equity
5. explanatory notes, including a summary of accounting policies

 Fundamental principles while preparing financial statements are:

1. Fair presentation
2. Going concern basis
3. Accrual basis of accounting
4. Consistency
5. Materiality (no omissions and misstatements)

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General requirements for financial statements (Cont…)

 Fundamental principles while presenting financial statements are

 No offsetting of assets against liabilities unless specific standard permits it

 Aggregation of similar items
 Should present a classified balance sheet showing current & non-current assets & liablities
 Minimum information on the face supported by detailed information in footnotes
 Comparative information with information on prior periods

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