Financial Statement Analysis: Introduction

Accounting and its limitations

• Recording the material impact of transaction and events on the financial position of a
company.

• Involves judgement guided by fundamental principles.

• While accounting principles are governed by standards, the complexity of business

transactions and events make it impossible to adopt a uniform set of accounting rules for
all companies and all time periods.

• Most accounting standards evolve as part of a political process to satisfy the needs of
diverse individuals and their sometimes conflicting interests
 Effect of Accounting limitations

• Affect the usefulness of financial statements in two ways:

• Lack of uniformity in accounting leads to comparability problems i.e. when different

companies adopt different accounting for similar transactions.

• Also discretion and imprecision in accounting can distort financial statement

information
 Accounting Distortions..

Deviations of accounting information from the underlying economics. These distortions

occur in at least three forms:

1. Managerial estimates can be subject to honest errors or omissions. This estimation

error is a major cause of accounting distortions.

a. Inventory and depreciation method and estimates could be different for different
companies, affecting earnings differently.

b. Provisioning estimates for bad debts, warranty, obsolescence could differ from
company to company.
 ..Accounting Distortions..

2. Managers might use their discretion in accounting to manipulate or window dress

financial statements. This earnings management can cause accounting distortions.

a. Channel stuffing by automobile companies

b. Capitalize selling expenses to reduce expense and inflate income.
c. Inflate expense and liabilities in good years and write them back in bad years
 ..Accounting Distortions

3. Accounting standards can give rise to accounting distortions from a failure to capture
economic reality.

a. DLF Ltd in early 2000 purchased huge land banks. Land prices shot to
unprecedented level in 2007, but it was still carried at cost in DLF balance sheet.

b. Engineering & Procurement Companies (EPC) agree to build the asset by some
time, failing which, they are entitled to pay damages to the clients. Highly probable
contingent liabilities may not be reflected in the statements.

c. Operating leases by companies, though a fixed commitment, is not reflected as

liability thus understating the leverage position of the company
 What do we do in this course?
Accounting analysis

• Studying a company’s transactions and events,

• Assessing the effects of its accounting policies on financial statements and

• Adjusting the statements to both better reflect the underlying economics and make
them more amenable to analysis.

Financial Analysis

• Profitability

• Cash flow &

• Risk Analysis
 Course Overview..

Module 1: Introduction

• Accounting theory and framework

• Indian Accounting Standards (Ind AS and Indian GAAP), US Standards,
International financial reporting Standards (IFRS)
• Ratio Analysis
 ..Course Overview..
Module 2: Issues in Financial reporting for single entities….

• Earnings Management
• PPE
• Tangible
• Intangible
• Impairment
• Borrowing Cost
• Analysis of Tax
• Leases
• Employee benefits
 ..Course Overview.

Module 3:
• Inter-corporate Investments
• Financial Instruments
• Adjustment to assets, Adjustment to liabilities
Financial Reporting System: Conceptual Framework
 Objective of Financial Reporting System

• Provide information about the entity’s economic resources and the claims against it.
(Statement of Financial position)

• Information about the effect of transactions and other events that change a entity’s
economic resources and claims (Statement of Financial Performance)
Conceptual Framework & Measurement Rules

Conceptual Framework Measurement Rules

1. Relevance (faithful 1. Accrual Accounting
representation) Vs Reliability 2. Matching principle
2. Consistency and Comparability 3. Historical Cost convention
3. Understandability 4. Going Concern
4. Materiality
 Accounting Principles

• Relevance Vs Reliability:
• Carrying assets at acquisition price provides reliability but is it relevant?
• Off-balance sheet liability is not reliable but very relevant.

• Comparability
• The statements should be comparable across time and also with other companies.
• Change in accounting method or estimate make statements non-comparable
• Sales being reported on net basis rather than gross basis.
 Measurement Rules

• Accrual accounting: Revenues are recognized when earned and expenses

when incurred, regardless of the receipt or payment of cash

• Cash Accounting: Revenues and expenses are recognized only when cash is
received and paid respectively.

• Why use accrual accounting?

• The objective of financial reporting is to get an understanding of financial
position and financial performance.
• If you manufacture 100 units and are able to sell only 50, using cash
accounting you may show a loss even when the cost per unit is less than
price per unit.
• Provides the assessment of the business by the management about the
possible direction that the business can take.
 Measurement Rules

Matching Principle:

• Expenses booked should relate to the revenues that have been booked.

Historical cost convention:

• The assets are recorded at the cost of acquisition rather than the market
value of the asset.
 Principal Financial Statements…

• Standalone Vs Consolidated
• Balance sheet
• Income Statement and other comprehensive Income
• Cash flow Statement
• Statement of change in Shareholder’s equity
 Standalone Vs Consolidated Financial Statments

• Standalone financial statements show the financial statements of the company

only .

• Consolidated financial statements assumes that the company as well as its

controlled subsidiaries to be a single entity.
• Usually all companies in which a company has more than 50% stake are
considered when consolidation is done.

• Which one to use?

• It makes sense to analyze the consolidated financial statement to get the
complete picture.
• A parent company may earn income through its subsidiaries. Not including
subsidiaries would not provide complete information about the
sustainability of income.
 Standalone Vs Consolidated Financial Statments

• Then is there any use of standalone financials?

• Analyzing standalone would bring out any issue at the subsidiary level.
• For example you may find lower receivables at consolidated level while higher at
standalone level.
• Reason could be that some subsidiaries which are customers of the parent are not
paying in time (maybe lender’s to the subsidiary are blocking the payment).
 Balance sheet

• Reflects the sources and uses of funds and shows the financial resources under control
of a company at a given point in time.

Elements of balance sheet

• Assets: probable future benefits obtained or controlled by a particular entity as a result of
past transactions or events.

• So if there is any reason to believe that benefits will not flow then they should not be
recognized as assets.

• What could be an example of controlling the future benefits and so it is an asset? Contract
to use a facility for long term. So it would be classified as asset.
What are intangible assets?
What is “Right-of-use assets?
What is the distinction between assets and financial assets?
 Balance sheet
Elements of balance sheet

• Liabilities: probable future sacrifices of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entities in future as a
result of past transactions or events.

• Equity is therefore the residual interest in the net assets of an entity that remains after
deducting its liabilities. Are there financial instruments that have characteristics of both
equity and debt? Convertible debt
 Statement of Profit and Loss

• Reports on the performance of the firm. It explains some but not all changes in the assets,
liabilities and equity of the firm. What is that it does not explain? Share issue, debt raised.

• Use of the accrual concept means that income and balance sheet are related.

• Governed by matching principle.

 Statement of Profit and Loss

Revenues are defined as:

• Inflows of an entity from delivering or producing goods, rendering services or other

activities that constitute the entity’s ongoing major or central operations.

Expenses are defined as

• Outflows from delivering or producing goods, rendering services or carrying out other
activities that constitute the entity’s ongoing major or central operations.

These exclude gains (and losses), defined as

• Increase (decrease) in equity from peripheral or incidental transactions.

 Other Comprehensive Income

• Comprehensive Income=Net Income+ Other Comprehensive Income

• Comprehensive Income includes all changes to equity except those resulting from
Investment by owners and distribution to owners.
• Mainly includes
• Actuarial gains and losses on defined benefit plan
• Foreign currency translation adjustment
• Gains and losses on re-measuring equity instruments designated at FVTOCI
• Debt instruments measured at FVTOCI
• Gains/losses on hedging [cash flow hedge]
• Reduces income volatility enabling assessment of income durability
• Is separately shown as a component of equity
3. Statement of Stock Holders equity:
• Reports the amounts and sources of changes in equity from capital transactions with
owners and components of other comprehensive income.

4. Statement of Cash Flows

a. Operating
b. Investing
c. Financial
 Other Sources of Financial Information

5. Management Discussion & Analysis

6. Auditors report
7. Notes to account
8. Contingencies
 Auditor’s Report

• Usually offers “unqualified” Opinion meaning that the company’s

financial statements are fairly presented.

• In some cases they offer “Qualified” opinion i.e. the company has
used accounting procedure which does not present the true and
fair picture of the financials.
4) Refer to note no. 2.11 regarding providing of deferred tax assets
amounting to Rs. 9740.00 lakhs on carry forward loss and
unabsorbed depreciation without virtual certainty of profit in future
years.
Financial Reporting Environment in India
 Regulatory Environment: India

• Ministry of Corporate Affairs (MCA) is concerned with administration of wide range of

statues for corporate sector, like:

• Companies Act 2013 and Companies Act 1956

• Limited liability Partnership Act 2008 and
• Insolvency & Bankruptcy code 2016
• Other Allied Acts and rules & regulations governing corporate sector
• Competition Act 2002
• National Financial Reporting Authority (NFRA)
• Supervision over ICAI (Chartered Accountant), ICSI, ICAI (Cost Accountants)
 Regulatory Environment: India

• National Advisory Committee on Accounting Standards (NACAS) advices central

Government on the formulation and setting of accounting standards in the country

• Accounting Standard Board (ASB) of ICAI issues accounting standards in India. ICAI is
governed under a statute administered by MCA.

• Apart from ASB, accounting related requirements are also issued by SEBI (for listed
companies), RBI (for banks) and IRDA (for insurance companies)
 About NFRA

• Independent Audit regulator from October 2018.

• In line with practice in other countries
• Up-till then audit profession was being regulated as a self regulatory organization by
ICAI.
• Increase in audit lapses a major reason for creation of this body.
• Audit regulator for all listed companies and all unlisted companies with paid up
capital above Rs.500 cr or sales turnover above Rs.1000 cr.
• The remaining unlisted companies would still be under regulation of ICAI.
 Status in India

Source: KPMG, IFRS notes

• As per Ministry of Corporate Affairs, Scheduled commercial banks,
insurers/insurance companies and non-banking financial companies are required to
prepare IND-AS based financial statements for the accounting period beginning
from April’2018 onwards with comparatives for the period beginning April’2017.

• However RBI had deferred the implementation of IND AS for banks by one year to
April-2019. This has been again deferred till further notice by RBI in Mar-2019.

• IRDA had deferred for Insurance companies to April-2020 but now is has been
postponed indefinitely.
Other Accounting Standards
 US GAAP
• Accounting standards given by Financial Accounting Standard
Board (FASB) for all companies issuing audited financial
statements.

• All FASB announcements are considered authoritative by AICPA

and SEC.

• Securities Exchange Commission (SEC) governs the form and

content of financial statements of companies whose securities
are publicly traded.
 IFRS
• Framed by International Accounting Standard Board (IASB).

• Origin of IASB.
• IASC (Australia, Canada, France, Germany, Japan, Mexico,
Netherlands, U.K. and Ireland and U.S.A.)
• Need for comparable financial information on account of
increasing international trade.

• IFRS has been adopted in 110 jurisdictions for all the listed
companies.

• Major economies like China, India, Russia and the U.S.A. had at
least some form of IFRS convergence project in operation.
 Need for Common Set of Standards

• Better understanding of foreign firms.

• Promote financing from global sources.

• Simplify reconciliation work (for multinationals operating in

nations with different accounting rules)

• Provide global talent pool of accountants.

• Cut costs by centralizing accounting function.

• Learn from best practices

 Which Standard to Choose?

• One which is more flexible to accommodate and thus offers

flexibility and at the same time does not comprise the objective
of presenting true and fair view.
 IFRS

• Principle based rather than rule based.

• While deciding whether a lease is operating or capital IFRS

uses terms like major part instead 75% of the useful life as
specified by US GAAP. Terms like “substantially all” instead of
90% in present value test while determining whether a lease is
operating or capital

• Depreciation based on useful life of asset rather than some

statutory minimum depreciation that need to be charged as
per IGAAP (Depreciation on asset is charged at either rates
based on asset’s useful life or on statutory depreciation rate as
per the companies Act prescribed, whichever is higher)
 ..IFRS..

• Use of Fair value accounting rather than historical cost method.

• Valuing the company based on its current value rather than historical value. Why?

• So that financial statements reflect economic reality.

• Applicable to financial instruments like equity, bond, derivatives, etc

• The changes in value in many cases has to be marked to market and the gain/loss has
to be recorded through the income statement.

• Could create lot of volatility in Income statement of companies.

 Comparison

Historical Cost Fair Value

• Asset and liability values • Determined by current
largely determined by value using market
actual transactions. assumptions.
• Income determined by • Income determined by net
matching cost to revenues. change in fair value of
assets and liabilities
A company makes use of debt and equity of 50,000 each to purchase
a commercial complex. The complex is purchased at a price of
100,000. In year 1 the company earns a rental of 12000. The life of
the complex is assumed to be 50 years and its salvage value is 75000.
In year 1 the complex has a market value of 125000 while debt has
market value of 48000. Year 2 the complex earns a rental of 12500
and the market value of complex is 1,10,000 while debt is valued at
50500. Debt is borrowed @ 6% per annum.

Prepare the balance sheet and income statement of the company

using historical cost concept as well as fair value concept.
Year 0 balance sheet Year 1 Balance sheet
  Historical Fair Value Historical Fair Value
Cash - - 9,000.00 9,000.00
Building 1,00,000.00 1,00,000.00
Assets 1,00,000.00 1,00,000.00 99,500.00 1,25,000.00
Debt 50,000.00 50,000.00 1,08,500.00 1,34,000.00
Equity 50,000.00 50,000.00 50,000.00 48,000.00
TL & Equity 1,00,000.00 1,00,000.00 58,500.00 86,000.00
1,08,500.00 1,34,000.00

Year 1 Income statement

  Historical Fair Value
Revenue 12,000.00 12,000.00
Dep -500.00  
Interest -3,000.00 -3,000.00
Unrealized gain
on complex   25,000.00
Unrealized gain
on debt   2,000.00
Net Income 8,500.00 36,000.00
 Balance sheet
  Historical Fair Value Historical Fair Value Historical Fair Value
- -
Cash 9,000.00 9,000.00 18,500.00 18,500.00

Building 1,00,000.00 1,00,000.00 99,500.00 1,25,000.00 99,000.00 1,10,000.00

Assets 1,00,000.00 1,00,000.00 1,08,500.00 1,34,000.00 1,17,500.00 1,28,500.00

Debt 50,000.00 50,000.00 50,000.00 48,000.00 50,000.00 50,500.00

Equity 50,000.00 50,000.00 58,500.00 86,000.00 67,500.00 78,000.00

TL & Equity 1,00,000.00 1,00,000.00 1,08,500.00 1,34,000.00 1,17,500.00 1,28,500.00

Income Statement
  Historical Fair Value Historical Fair Value
Revenue 12,000.00 12,000.00 12,500.00 12,500.00
Dep -500.00   -500.00  
Interest -3,000.00 -3,000.00 -3,000.00 -3,000.00
Unrealized
gain on
complex   25,000.00   -15,000.00
Unrealized
gain on debt   2,000.00   -2,500.00
Net Income 8,500.00 36,000.00 9,000.00 -8,000.00
 ..IFRS..

• No role of any other body in deciding the accounting treatment

except the conceptual framework.

• In India while accounting for acquisitions, court could dictate

the accounting rules that a merged entity must follow (like
writing off expenditures against various reserves).

• RBI dictates the rules for banks to keep the accounting

conservative.

• True and Fair view requirement can over-ride the standard in some
cases.