Financial Statements

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
FOFA: Accounting Part
Topic: Financial Statements

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 1
The Accounting Equation
The accounting equation shows the relationship between the economic
resources of a business and the claims against those resources.
At all times, the following relationship holds:
Economic resources = Claims
Economic resources are assets. The claims consist of creditors’ claims, or liabilities, and
owners’ claims, or equity.
➢ Assets = Liabilities + Equity
➢ Assets: “own”
➢ Liabilities: “owe”
➢ Equity: “residual interest”

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The Accounting Equation
We can analyze any business transaction, regardless of its size and complexity, in terms of
its effect on the accounting equation.
The balance sheet shows the position of assets, liabilities and equity.
Assets
An asset is a resource that gives benefits to its owner. An enterprise should
consider a resource its asset if
(a) it controls the resource, and
(b) the resource is expected to give benefits.
Therefore, we can say that asset is expected to generate cash, directly or indirectly.
Assets can be
1) Tangible (e.g plant and machinery and inventories, have physical form)
2) Intangible (e.g patents and trademarks confer exclusive legal rights but have no physical form)
Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 3
The Accounting Equation
Liabilities
✓ A liabilities is an obligation that requires to settled by giving up assets.
✓ A liability is the mirror image of an asset.
✓ Usually, it requires payment of cash.
Equity
✓ Equity is net assets, i.e. the difference between an enterprise’s assets and its liabilities.
✓ The equity of a business enterprise increases through investments by owners and profits from
operations and decreases through distributions to owners and losses from operations.
Think of equity as the residual.
The equity of a company is called shareholders’ equity.
Its components include share capital, securities premium, and retained earnings.

✓ Dividends are distributions to shareholders.

✓ Profits increase equity; losses, dividends and share buybacks decrease equity.

✓ Retained earnings represent the profit kept in the business.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 4
Effects of Transactions
Assets: Increase, decrease, no effect
Liabilities: Increase, decrease, no effect
Equity: Increase, decrease, no effect

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 5
Owners Investment
On March 1, 20XX, Mr. FOFA sets up FOFA Chips Ltd and invests 50,000 in cash.
The first balance sheet of the new business will show cash of 50,000 and equity of 50,000.

The Indian convention is to show liabilities and equity on the left side and assets on the right side.

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Takes a loan
On March 2, Mr. FOFA takes an interest-free loan of 20,000 from his friend, DRM for FOFA Chips Ltd.
This transaction increases both assets (cash) and liabilities (loan payable).

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Buys equipment for cash
On March 3, FOFA Chips Ltd pays 58,000 for a chips making equipment.
This transaction decreases one asset (cash) and increases another asset (equipment).

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 8
Buys supplies on credit
On March 6, FOFA Chips Ltd purchases supplies for 6,000 on credit.
The effect is that both assets (supplies) and liabilities (trade payables) increase.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 9
Sells for cash
On March 9, FOFA Chips Ltd sells its first Chips Bundle to a retail store and receives 12,000.
Revenue increases the owner’s claim on the business.
So the cash sale increases both assets (cash 12000 + 12000 = 24000) and equity

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 10
Pays supplier
On March 12, FOFA Chips pays on account for the supplies bought on credit on March 6, 2,000.
As a result, both assets (cash) and liabilities (trade payables (6000-2000=4000) decrease.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 11
Takes supplies home
✓ On March 17, Mr. FOFA takes supplies costing 1,000 for personal use.
✓ The reporting entity assumption requires separation of personal and business activities.
✓ So we should treat this use as a withdrawal of capital by the owner, and not as a business expense.
✓ As a result, both assets (supplies) and equity decrease.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 12
Returns supplies
On March 23, FOFA Chips ltd returned supplies costing 1,900 and received full refund.
As a result, one asset (cash) increases and another asset (supplies 5000-1900=3100) decreases.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 13
Pays expense
On March 26, FOFA Chips Ltd pays employees’ salaries of 4,000 and office rent of 1,200.
Expenses reduce the owner’s claim on the business, the opposite of the effect of revenue.
This transaction decreases both assets (cash) and equity.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 14
Sells on credit
On March 29, FOFA Chips Ltd shipped the chips on credit for 8000.
The customer will pay the agreed fee of 8,000 a week later.
In this case, FOFA Chips Ltd has done the work but has not received the fee.

The effect of this transaction is that both assets (trade receivables) and equity increase.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 15
Withdraws cash
✓ On March 30, Mr. FOFA withdraws 3,500 for personal use.
✓ The reporting entity assumption requires separation of personal and business activities.
✓ So we should treat this payment as a withdrawal of capital by the owner, and not as a business expense.
✓ This transaction decreases both assets (cash) and equity.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 16
Uses supplies
On March 31, FOFA Chips Ltd uses supplies costing 1,000. This is an expense.
Expenses reduce the owner’s claim on the business.
This transaction decreases both assets (supplies) and equity.

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 17
Financial Statements
Balance sheet
Statement of profit and loss
Statement of changes in equity
Statement of cash flows
How are the financial statements interrelated?

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 18
Financial Statement Analysis: The Basics

➢ Profit margin
➢ Return on assets, or return on investment
➢ Asset turnover
➢ Collection efficiency
➢ Payment to suppliers
➢ Return on equity
➢ “Skin in the game”

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 19
Form and Content of Company Financial Statements
Balance sheet
➢ Assets
❑ Non-current assets
❖ Tangible assets
❖ Intangible assets
❖ Financial assets
❖ Deferred tax assets
❑ Current assets
❖ Inventories
❖ Financial assets
➢ Equity
❖ Equity share capital
❖ Other equity

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 20
Form and Content of Company Financial Statements
Balance sheet
➢ Liabilities
❑ Non-current liabilities
❖ Financial liabilities
❖ Provisions
❖ Deferred tax liabilities
❑ Current liabilities
❖ Financial liabilities
❖ Provisions
❖ Current tax liabilities

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 21
Form and Content of Company Financial Statements
Statement of profit and loss
➢ Income
➢ Expenses
➢ Tax expense
➢ Profit for the period
➢ Other comprehensive income
➢ Comprehensive income

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 22
Form and Content of Company Financial Statements
Statement of changes in equity
➢ Equity share capital
➢ Retained earnings
➢ Other comprehensive income

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 23
Form and Content of Company Financial Statements
Statement of cash flows
➢ Operating activities
➢ Investing activities
➢ Financing activities

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting First Sem 2023-24 24
Smelling Fraud
➢ Qualified audit report
➢ Auditor, audit committee chair, independence director or CFO resignation
➢ Contravention of the law
➢ Promise of excessively high profitability
➢ Payment problems
➢ High performance pressure and huge financial incentives

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