FSA-IFIM

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• External users of Financial statements
• The common characteristic of External users is their general
lack of authority to PRESCRIBE the info they want from the
company
• External users are a diverse type but generally can be
classified in to 3 groups—
• 1) Credit and Equity investors
• 2) Government , regulatory bodies and tax authorities
• 3) The general public and special interest groups, labor
unions and Consumer groups
• These groups have different objectives in FSA BUT THE
EQUITY INVESTORS and CREDITORS are the PRIMARY
USERS
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• The info supplied to Equity investors and creditors is
useful to others as well; hence Accounting Standards are
“EQUITY investors and Creditors Oriented”
• The UNDERLYING OBJECTIVE of FSA is the
COMPARATIVE measurement of RISK AND RETURNS so
as to make Investment and or Credit decisions. Predictions
of the future results is by Historical extrapolations generally
though special models are covered here
• Equity investors look at Profitability and Growth whereas
Creditors especially the short term ones look at LIQUIDITY
and Solvency. Long term investors like insurance cos are
interested in long term asset growth and profitability
 Concepts in Accounting
• 1) BUSINESS ENTITY CONCEPT– Equity treatment
• 2) GOING CONCERN concept—distinguishing
CAPITAL/REVENUE. Capital expenses vs Revenue and
deferred revenue CAPITAL RECEIPTS vs REVENUE
RECEIPTS CAPITAL PROFITS vs REVERNUE PROFITS; no
dividend out of Capital profits
• 3) MATCHING CONCEPT– Deferred Revenue concept;
Provisioning concepts;
• 4) REALIZATION CONCEPT—property in the goods getting
transferred
• 5) COST CONCEPT—historical costs; capitalization of relevant
costs
 hurdles created for Analyst
• Managers-interest in Accounts
• Brazen Accounting gimmicks—deferred interest
capitalization and capital standby then!
• Window dressing- - making lower provisions,
avoiding inventory write offs
• Opposing standards that could impact the
profits
 Qualities--
• Qualities of accounting information
• 1) Relevance- time relevance especially
• 2) Reliability-reality and unbiased
• Accounting information is a trade off between
relevance and reliability; forecasts increase
Relevance but reduce Reliability
• 3) Comparability and consistency
• Important principles of Accounting
• 1) Recording at Historical costs-objectivity
0

takes the place of relevance!

• 2) Accrual basis- Cash and Accruals together
make Accounts. In accrual Revenues are
recognized when earned and expenses when
incurred regardless of cash movements
• 3) Materiality- “the magnitude of an omission
or mis- statement of information that, in the light
of surrounding circumstances, makes it
possible that the judgment of a reasonable
person relying ---
 0

• -- would be changed or influenced by the

omission or misstatement’
• 4)Conservatism and prudence
• Reporting the lowest estimate or a fairly low
estimate as compared to Optimistic ones
while reporting estimates’
• Recognize losses but not unrealized gains;
delay the good news while accepting the bad
ones immediately-wrong part of
Conservatism
• Limitations of financial statements
• 1) Timeliness? 0

• 2) frequency-infrequent?
• 3) Not Forward looking—reflects past events!
• ------------------
• Accrual system of accounting
• Are the sum of all accounting adjustments that
make net income different from net cash
flow
• Net income=Operating cash flows+ Accruals
• Accrual process involves—
• 1) Revenue recognition—when earned and realized or realizable. The
goods need to be delivered and the company should run into an asset
0

( Cash/receivables) very likely to be converted into cash

• 2) Expense matching-expenses should as far as possible be matched with
their Revenues. This applies to both product and period cost
• ---------
• -Revenue recognition
• Recognition of revenue from five types of transactions:
• A)Revenues from selling inventory are recognized at the date of sale
often interpreted as the date of delivery.
• B)Revenues from rendering services are recognized when services are
completed and billed.
• C)Revenue from permission to use company’s assets (e.g. interests for
using money, rent for using fixed assets, and royalties for using
intangible assets is recognized as time passes or as assets are used.
• D)Revenue from selling an asset other than inventory is recognized at
the point of sale when it takes place
• E)Revenue from LONG TERM contracts--% of Completion Method.
• Percentage-of-completion method says that if (1) the
contract clearly specifies the price and payment options
with transfer of ownership, (2) the buyer is expected to pay
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the whole amount and (3) the seller is expected to

complete the project, then revenues, costs, and gross profit
can be recognized each period based upon the progress of
construction (that is, percentage of completion). For example, if
during the year, 25% of the building was completed, the builder
can recognize 25% of the expected total profit on the contract.
This method is preferred. However, expected loss should be
recognized fully and immediately due to Prudence
• Completed contract method should be used only if
percentage-of-completion is not applicable or the contract
involves extremely high risks. Under this method, revenues,
costs, and gross profit are recognized only after the project is
fully completed. Thus, if a company is working only on one
project, its income statement will show $0 revenues and $0
construction-related costs until the final year. However,
expected loss should be recognized fully and immediately
due to Prudence constraint
• The relationship among Operating Cash flows,
Investing cash flows and free cash flows
0

• Investing cash flows- in Fixed Assets say--

are usually Negative until Maturity stage,
especially for growth cos. The Operating cash
flows during this period are Positive and
usually high for growth cos. Passing
maturity stage, the Operating cash flows
decline-- while because of asset
divestment-- the Investing cash flows
increase
• All cash flows are NOT treated on the same footing. A
reduction in free cash flows arising out of growth could
push up stock prices other factors not being adverse!
 4-The Financial Reporting System
• The accounting process that generates accounting information
for External users are 5 principally—
• 1) Balance sheet
• 2) Income statement
• 3) Statement of Comprehensive income
• 4) Statement of Cash Flows
• 5) Statement of Stock Holders equity
• These 5 statements along with Notes to Accounts are
interpreted to provide relevant, timely and reliable information to
make investment, credit and similar decisions. Many
transactions are reflected in more than one Statement so that it
requires a foray in to all statements before comprehensive
conclusions can be drawn
• A Tour of the Financial Statements
• We chose the financial statements of The Coca-Cola Company because
they show the basics very well and because practically everyone has heard
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of Coke. The company includes four financial statements in its annual

report, and they are shown in Exhibit 1.2. The names of the financial
statements are
• • Consolidated Statements of Income
• • Consolidated Balance Sheets
• • Consolidated Statements of Cash Flows
• • Consolidated Statements of Share-Owners’ Equity
• Notice that the balance sheet covers two years and the other statements
cover three years. All the titles listed above include the word “consolidated”
because the statements include the accounts of The Coca-Cola Company
(Coca-Cola) and all subsidiaries in which the company’s ownership interest
enables it to exert control.
• A starting point for determin-ing control is when a company owns more than
50 percent of the voting stock of another company. Coca-Cola states in its
“Management’s Discussion and Analysis” (MD&A) that “all majority-owned
entities in which our Company’s control is considered other than temporary
are consolidated.”
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• The Financial reporting System is based on data generated
from ACCOUNTING and Economic events. Financial
Statements recognize events and transactions meeting certain
criteria---Primarily Exchange transactions, passage of
time(accrual of interest), the use of services, (insurance), use
of assets ( depreciation), use of estimates ( Bad debts) and
impact of some contracts ( Financial leases)
• Accrual accounting rests on matching principle which says
Revenues are to be matched by corresponding costs and as
such have to be accounted even though cash did not change
hands.
• Transactions are measured on HISTORICAL BASIS, with
events resulting in a hike in value generally ignored
 6
• Financial statements are prepared measuring transactions at
their Historical Costs. These costs are OBJECTIVE and
VERIFIABLE. Its UTILITY however DECLINES as 1) The
Specific prices 2) General Prices, changes Hence additional
disclosures are made mandatory by Regulating authorities all
over the world
• Financial Reporting also relies on GOING CONCERN
CONCEPT; that the firm in question would continue its
operations indefinitely. This concept brings as to the difference
between Capital and Revenue– all costs and Incomes would
have to be Revenue if this concept were not in place
 6a Reporting Environ
• I) the Reporting environment
• A) The statutory reports– Income statements
and B/S
• B) Other reports
• 1) Financial statements-Quarterly
• 2) Earnings announcement
• 3) Other statutory reports
 6b
• Financial statements-these are statutory reports a
company must file with the SEC; are not publicity
oriented (unlike some annual reports) and contain
info. beyond what annual reports reflect---Form10-
k
• Form-10q—are quarterly statements filed with
the SEC. these provide LATEST info.
• While analyzing these data we need to take
cognizance of a) seasonality factors b) Year end
adjustments-which do not appear quarterly
 6c
• Year end adjustments are done in the following
areas generally
• 1) inventory-difference between actual stock
and book stocks
• 2) tax provision
• 3) Outstanding expenses—salaries etc
• 4) provision for depreciation
 6d
• Year end adjustments are done in the following
areas generally
• 1) inventory-difference between actual stock
and book stocks
• 2) tax provision
• 3) Outstanding expenses—salaries etc
• 4) provision for depreciation
 6e
• 2) Earnings announcements
• Key announcements about cos. performance quarterly
and yearly
• Cos. PRO FORMA Earnings statement give a clear a/c
of the Operational profits i.e profits from continuing
operations divested from non operational earnings and
extraordinary income/ expenses
• Pro forma earnings while reflecting operational profits
might exclude from Profits certain non operating
incomes/expenses which could provide ‘value to an
analyst’
 6f
• 3) Other statutory reports
• Form10k- filed with annual report
• Form 10 Q filed with Quarterly report
• Form 20 f Filed by Foreign Issuers
• Form 8k current report to be filed <15 days of
1) Change in Management Control
• 2) acquisition/ disposition of major assets
• 3)bankruptcy/receivership
• 4) change of auditors
• 5) Directors resignation
• Prospectus– filed along with a security issue
 7
• Financial reporting Systems
• The SEBI
• Has come out with disclosure norms for acquisitions, norms for
publishing information etc. The Annual report has the following
disclosure requirements---
• Contents
• --Business of the company
• The properties and Assets it owns
• --Management discussions and analysis
• --Auditors report including Qualifications if any
• --Financial statements and Notes to Accounts
• --Investee Financial statements ( Where applicable)
• --Parent company statements and results to the extent required
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• Schedules
• --condensed Financial information including details of Assets
Liabilities, Income and Expenses that are major
• -- major expansion/ diversification plans including on going
acquisition talks—broad details
• --Auditors statements including expression of Opinion on
Accounts
• --segment reporting
• --Corporate governance standards adopted and Issues if any
• ------
• Quarterly report
• A birds eye view of Working results for the Quarter
• The perception of the Management for the Quarters ensuing
• IAS– Indian Accounting Standards
• Fixes Standards for Accounting of Companies and other Public
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bodies. Before issuing a new Statement of Accounting
Standards, the Body holds elaborate discussions with Industry
representatives, Academicians, legal luminaries and all
important stake holders including the government. The ICA is
the Principal decision maker so far as the contents are
concerned. Views of the Ministry of Company Affairs also are
taken in to account before issuing these standards
• Qualitative character of Accounting
Information
• Analysts concern with Qualitative accounting Standards arises
from the need for Information that facilitates comparison of
firms using ALTERNATIVE REPORTING METHODS and is
useful for decision making. The characters are – RELEVANCE
and RELIABILITY, Timeliness, Neutrality, Consistency,
Comparability and Materiality
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• Relevance ‘ the capacity of information to make a difference to
a decision’ To a Technical analyst all financial data are
‘irrelevant’ To a Fundamental analyst, the RELEVANCE of
Information VARIES WITH the method of Analysis– Of Cash
flow’/ Balance sheet/ or Income statement
• Timeliness is an important aspect of relevance. Information
LOSES VALUE RAPIDLY . As time passes FUTURE becomes
the PRESENT with the PAST becoming increasingly
IRRELEVANT However past data helps Projections
• Reliability encompasses verifiability, representational
faithfulness, and neutrality
• Unfortunately Relevance and Reliability are OPPOSING
ATTRIBUTES. Auditing improves RELIABILITY but the
TIMELINESS which is a RELEVANCE attribute gets hit;
thus Quarterly results are NOT audited!!
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• Relevance and Reliability also CLASH ELSEWHERE. Market
prices may be very relevant but less reliable. Historical costs
though HIGHLY RELIABLE become LESS RELEVANT!! IT is
the OLD ARGUMENT as to whether to be ‘PRECISELY
WRONG or be APPROXIMATELY RIGHT’ ANALYSTS have
opted for ESTIMATES in SEGMENT REPORTING, off balance
sheet financing etc. whereas AUDITORS harp on RELIABILITY
and have opposed estimates in Financial Statements
• Consistency and Comparability are again equally strong
attributes of Financial Statements . CONSISTENCY in
adopting and continuing to use them is an ATTRIBUTE of good
Financial statements
• Comparability becomes an Issue when accounting policies are
changed just as much as when NEW transactions– like
SECURITIZATION—come in to the picture between 2 firms
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• Comparability becomes a PERVASIVE ISSUE as choice of
certain policies as also estimates in certain parameters make
comparability a flouted attribute. REAL DIFFERENCES – let
alone Accounting policies—make comparability a ‘tricky issue’
Ex Some Firms have INTERNATIONAL OPERATIONS while
others are ‘ Domestic’
• MATERIALITY is arguably a CRUCIAL ASPECT’ An
INFORMATION is MATERIAL when it makes a DIFFERENCE
to the VALUATION of the firm. Sometimes even SMALL
CHANGES can have a MATERIAL EFFECT on VALUATION
Ex Sales FORCED upon Customers to achieve the
PROJECTED TARGET . Realizing Capital Gains to achieve
Profit targets
• The SEC has announced that Auditors should recognize
QUALITATIVE CHANGES AS WELL. Examples
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• 1. Obscuring changes in EARNINGS TRENDS
• 2 HIDING the FAILURE to achieve PROJECTED ANALYST
FORECASTS
• 3 Converting a LOSS to INCOME and Vice versa
• 4 Obscuring CHANGES in SIGNIFICANT BUSINESS
SEGMENTS
• 5 Increasing Managerial Remuneration
• 6 Things AFFECTING COMPLIANCE with REGULATORY
REQUIREMENTS, LOAN COVENANTS or other contracts
• 8 Concealing UNLAWFUL A/CS
 14- PRINCIPAL FIN STATMENTS
• BALANCE SHEETS
• The B/s – Statement of Financial position—reports major
classes of ASSETS( Resources OWNED AND CONTROLLED
by the FIRM) LIABILITIES ( EXTERNAL CLAIMS on these
Assets) and Stock holders Equity ( Owners Capital
contributions and other INTERNALLY GENERATED FUNDS)
and their INTERRELATIONSHIPS at specific points in time
• Capital= A– L
• Assets are defined as probable future economic benefits
obtained or controlled by a particular entity as a result of
past transactions or events.
• The weakness in the definition is the lack of reference to RISK
There are transactions where Assets are transferred but the
risks of ownership still lie to some extent with the Seller--
Financial lease
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• Liabilities are defined as ‘ probable FUTURE SACRIFICES of
Economic benefits arising from PRESENT OBLIGATIONS of a
particular entity to transfer assets or provide services to other
entities in the future as a result of PAST TRANSACTIONS or
events’
• EQUITY is ‘the residual interest in the net assets of an
entity that remains AFTER DEDUCTING its LIABILITIES
• In reality some Instruments have characteristics of BOTH
equity and debt making Categorization a ‘ difficult job’—
Convertible Debentures and Preferred Stock
• THE INCOME STATEMENT
• Reports on the results of OPERATIONS and non operating
activities. It explains SOME IF NOT ALL of the changes in
Assets , Liabilities and Equities between two consecutive
Balance sheet dates
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• The use of ACCRUAL CONCEPT brings about an interrelationship between
Income Statement and balance sheet
• The preparation of the INCOME STATEMENT is governed by the
MATCHING PRINCIPLE , which states that performance can be measured
ONLY IF revenues and related costs are accounted for during the same
time period
• Elements of the Income statements
• Revenues are defined as
• Inflows…of an entity…from delivering or producing goods, rendering
services or carrying out 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 major or central
operations
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• The definitions of Revenues and Expenses SPECIFICALLY
EXCLUDE increases( decreases) in EQUITY from peripheral
or incidental transactions Thus GAINS( and LOSSES) are
NON OPERATING EVENTS. Examples would include GAINS
AND LOSSES from Sales of Assets, Law suits and changes in
Values ( including Currency values)
• While stating so may be easy, the problem centrally would
focus on GREY ISSUES like—Recurring vs Non recurring,
Operational and Non Operational costs/ revenues, and ‘
extraordinary items’
• From the Analyst’s point of view DISCLOSURE rather than
classification is important while from the Data base USER’s
end, the classification is EQUALLY IMPORTANT
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• STATEMENT OF COMPREHENSIVE INCOME
• COMPREHENSIVE INCOME is defined as
• The CHANGE in EQUITY of a Business enterprise during a
period from transactions and other events and
circumstances from non owner sources It includes all
changes to EQUITY during a period EXCEPT those
resulting from INVESTMENTS by OWNERS and
DISTRIBUTION to OWNERS
• Comprehensive income INCLUDES BOTH NET INCOME and
DIRECT EQUITY ADJUSTMENTS such as---
• --Cumulative TRANSLATION ADJUSTMENTS
• ---Minimum Pension Liabilities
• --Unrealized gains and losses on available for sale securities
• --Deferred gains and losses on cash flow hedges
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• These adjustments are COLLECTIVELY called OTHER
COMPREHENSIVE INCOME. SFAS130 requires that firms with
items of other comprehensive income report---;
• --The CLOSING BALANCES of EACH ITEM. The total is
reported as a SEPARATE COMPONENT of EQUITY called
accumulated OTHER COMPREHENSIVE INCOME
• -- the CHANGE ( either Pretax or post tax) in EACH item; the
change can be reported GROSS Or NET
• ---Reclassification adjustments to avoid DOUBLE COUNTING;
for example realized investment gains that include un-
realized gains of EARLIER YEARS must be knocked off
from COMPREHENSIVE INCOME to avoid double counting
• --Total Comprehensive in condensed financial statements
to be provided for interim periods
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• Equity means property rights and refers to stockholders’ or owners’ equity.This owners’ equity
represents the claims of owners to the assets of the business, as shown in the accounting
equation:
• Assets = Liabilities + Equity
• When the company reports net income on its income
statement, that income amount is added to the stockholders’
equity or property rights. Therefore, the components of net
income affect equity. Those components of net income are
limited to revenues, expenses, gains, and losses. All of those
components of net income are included in comprehensive
income. But there are changes in stockholders’ equity that are
comprehensive income but not net income. Some changes in
assets and liabilities go right to the stockholders’ equity section
of the balance sheet without first affecting net income and being
included in the income statement. Unrealized gains and losses
that are included in comprehensive income but are not
recognized or reported on the income statement are related to
foreign currency translation adjustments, available-for-sale
investments, and derivative financial instruments.
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• Requirement---- The FASB requires companies to report
comprehensive income, either in a separate financial
statement (as Dow Chemical Company does, shown in
Exhibit 2.3) or as part of the stockholders’ equity
statement.
• The definition of comprehensive income given earlier relates it
to the change in equity during a period, but it is also described
as the change in wealth during a period. Wealth can increase
not only from business operations but also from changes
in market values that are not related to operations. The
goal of the requirement to report comprehensive income is
to have a net income with results of business operations
and a separate comprehensive income with results of the
market’s impact on the values of assets and liabilities.
Three examples of items affecting comprehensive income are
(1) foreign currency translation adjustments, (2) unrealized
• gains and losses on available-for-sale securities, and (3)
deferred gains and losses on derivative financial instruments.
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• Foreign Currency Translation Adjustments
• When changes in the value of foreign currency
cause the assets of a company to increase in
value, the result will be an increase in the
stockholders’ equity (picture the accounting
equation increasing on the left side as well as on
the right side). Because the change in value of
the foreign currency is not related to the
company’s operations, the increase in
stockholders’ equity cannot be reported as
net income. However, the increase in
stockholders’ equity is reported as
comprehensive income.
• HTM---@Cost
• AFS---M2M
• Trading Secs—M2M
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• Unrealized Gains and Losses on Available-for- Sale Securities
• Companies that own investments in marketable securities
(bonds and stocks) will see the market values of their
investments increase and/or decrease over time. If that
investment is classified as “available for sale” (meaning that
the company does not intend to sell but could if necessary, as
contrasted with “trading” investments not intended to be held a
long time), then the investment must be included in the balance
sheet at its market value. If that market value is greater
than the cost of the investment, there is an unrealized
holding gain. But the gain in value is not related to the
company’s operations and the company is in the same
situation as for the foreign currency change discussed
above: an increase in asset value that must be balanced
with an increase in stockholders’ equity that cannot be
reported as net income. Therefore, it is comprehensive
income.
 24
Deferred Gains and Losses on Derivative
Financial Instruments
Companies may invest in derivative financial
instruments to hedge their exposure to the risk of
changing prices or rates. Such changes will
cause the value of the derivative to change, and
again, lead to unrealized gains or losses. If the
derivative instrument meets certain criteria, the
unrealized gain or loss will be reported in
comprehensive income rather than in net income.
 Minimum pension liability
Unrealized gains and losses on AVAILABLE for Sale
securities
Cumulative Translation Adjustment ( Foreign operations)
Unrealized gains and losses on Cash flow hedges
 25
• Continued next slide
26—continued-Comprehensive Income
27
 28
• Statement of cash Flows
• This Statement reports cash receipts and payments in the
period of their occurrence classified as Operating, Investing and
Financing Activities. It provides supplementary disclosures
about non cash Investing and Financing activities. Cash flow
data helps explain changes in consecutive balance sheets and
supplement information provided by Income statement
• SAFS 95 defines INVESTING ACTIVITIES CASH FLOWS as
those resulting from---
• Acquisition or Sale of property, plant and Equipment
• Acquisition or Sale of a Subsidiary or segment
• Purchase or sale of Investments in other firms
 25
• Similarly FINANCING CASH FLOWS are those resulting from—
• Issuance or retirement of Debt or Equity securities
• Dividends paid to Stock holders
• The Standard requires GROSS rather than NET reporting of
SIGNIFICANT investing and Financing activities, thereby
providing improved disclosures. For ex. Cash flows from Sales
of property CANNOT be NETTED off against Property SALES
• Enterprises with Foreign Currency transactions on Foreign
operations must report the effect of exchange rates on cash
and cash equivalents as a separate component of reconciliation
of cash and cash equivalents for the period
• Cash from OPERATIONS may be reported DIRECTLY using
MAJOR CATEGORIES of GROSS CASH RECEIPTS and
PAYMENTS; or INDIRECTLY by providing a reconciliation of
NET INCOME with Net Cash Flow from Operating activities
 26
• Both the direct and Indirect methods require a separate
disclosure of cash outflows for INCOME TAXES and
INTEREST within the Statements or Elsewhere in the
financial Statements
• STATEMENT OF STOCK HOLDERS EQUITY
• the statement reports the amounts and Sources of changes in
Equity from Capital transactions with Owners and may include
the following components—
• Preferred stock
• Common stock
• Additional paid up capital
• Retained earnings
• Treasury shares ( Repurchased equity)
• ESOPs
 27
• And as components of OTHER COMPREHENSIVE INCOME,
the following---
• Minimum pension liability
• Unrealized gains and losses on AVAILABLE for Sale securities
• Cumulative Translation Adjustment ( Foreign operations)
• Unrealized gains and losses on Cash flow hedges
• Shares issued are recorded at par in Equity and the Excess
over Par value as Share Premium a/c and as Additional capital
issued REPURCHASES or Buy backs are treated as Treasury
Stock—a Contra entry in the B/S. Retained earnings and
ESOPS are also reported
• FOOT NOTES / Notes to accounts
• Are an integral part of the financial statements and provide data
on such subjects as Business segments, the financial position
of Retirement plans and Off- balance sheet obligations
 28
• These data are required by GAAP ( FASB) or regulatory
authorities The Notes to accounts and 10K filings to the SEC
are audited. Supplementary Schedules are however un audited
Notes provide info about Accounting methods, assumptions,
and estimates used by Management to develop the data
reported in Financial statements. They are designed to allow
users to improve assessments of the amounts, timings, and
uncertainty of the estimates reported in the Financial
statements. They provide additional disclosures related to such
areas as
Fixed assets Debts- interest rates etc
Inventories Law suits and contingencies
Taxes Marketable securities and Investments
Pensions and post employment benefit plans
 29
• Marketable Securities
• Hedging and other risk management activities
• Business Segments
• Significant customers, Sales to related parties and Exports
• CONTINGENCIES
• Notes to accounts often contain disclosures relating to
‘contingent losses’ These losses get classified either as
‘provisions’ or as ‘ contingent liabilities’ depending upon
whether the loss is fairly certain or not. This part is
SUBJECTIVE and involves judgment.
• Where losses are fairly certain a Provision is created by
debiting the Profit and loss account. Where losses are ONLY
DEPENDENT on the happening of a certain event, a
Contingent liability by way of just a note in the accounts comes
in to picture
 30
• In India contingent liabilities are basically things like ---
• --Claims against the company not acknowledged as debts
• ---Arrears of cumulative Preference dividends
• --- Bills discounted
• --- Amounts yet to be called up on partly paid shares
• ---other matters for which the company is contingently liable
• MANAGEMENT DISCUSSIONS and ANALYSIS ( MDA)
• These are discussions on earnings that have been a part of the
Annual reports for Listed companies. In India they are called
Directors Report. The MDA is supposed to discuss—
• Results of Operations, including discussion of trends in Sales
and categories of expenses
• Capital resources and liquidity including discussions of cash
flow trends
• Outlook based on known trends
 31
• The discussions could involve the following---
• 1) prospective information and required discussion of Significant effects of
currently known trends, events and uncertainties– ex decline in Market
share, inventory obsolescence etc. Firms may voluntarily disclose Forward
looking data that anticipates trends or events
• 2) Liquidity and Capital resources: Firms are expected to use cash flows
statements to analyze liquidity ; provide a balanced discussion of Operating,
Investing and Financing activities and events AFTER THE DATE OF
BALANCE SHEET
• 3) Discussions on Discontinued operations, Extraordinary items and other ‘
unusual or infrequent events known as ‘ Non recurring and Extraordinary
gains/ losses
• 4) Extensive disclosures in interim financial statements in keeping with the
obligation to periodically up date MD&A discussions
• 5) Disclosure of Segment’s disproportionate need for cash flows or
contribution to revenues or Profits
 32
• The SEC in 2002 issued a statement reinforcing its views on
the importance of MDA disclosures the release reminds
registrants that disclosure ‘must be both useful and
understandable’
• Topics addressed include—
• 1) Liquidity and capital resources, including the impact of Off
Balance sheet arrangements on Liquidity and Capital resources
• 2) Disclosures about contractual obligations and commercial
commitments ( that is Off balance sheet obligations)
• 3) Disclosures about Trading Activities, including non—
Exchange traded contracts
• 4) The effects of transactions on related parties, including
persons ( like employees) who could fall outside the definition
of Related parties
 33
• Role of the Auditor
• the auditor must ensure that the financial statements conform
to GAAP/ IAS. Accounting policies must be appropriate and
estimates reasonable. The Auditor would also look into the ‘true
and fair view’ that the statements must reflect and into the
correct position of Assets and Liabilities.
 34- THE ACCRUAL CONCEPT
• In Financial Reporting, the determination of---
• Which cash flows are included in INCOME and When
• Which changes in assets and Liabilities are included in Income
• How and when the selected changes in asset and Liabilities are measured
• Are BASSED ON ACCOUNTING RULES and PRINCIPLES that make up
the generally accepted accounting principles ( GAAP). With a few
exceptions the Accounting process ONLY RECOGNIZES VALUE
CHANGES arising from ACTUAL TRANSACTIONS
• Reported income under the accrual concept provides a measure of current
Operating Performance that is NOT exactly based on ACTUAL CURRENT
Period Cash flows. Cash inflows and outflows ( past present and Future) are
recognized as ‘income’ in the appropriate ACCOUNTING PERIODS. The
selected periods ‘best’ indicates the firm’s present and continuing ability to
generate future cash flows Information about enterprise earnings based
on accrual accounting generally provides a better indication of an
enterprises ability to generate cash flows THAN in formation limited to
the FINANCIAL EFFECTS of cash receipts and Payments
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• The accrual basis of accounting thus allocates ( recognizes as
Revenue and expense) many transactions and events to
TIME PERIODS OTHER THAN those in which the Cash
flows occur. Accrual accounting Principles are,
fundamentally, the decision rules that tell preparers of
Financial Statements WHEN to recognize the revenue and
Expense consequences of Cash flows and other events
• The recognition of Revenues and expenses in periods
other than when cash is actually received or spent has a
corollary effect on the balance sheet. Both the recognition
and measurement of certain assets and liabilities are the
results of the application of the accrual concept of income.
The differences between the income recognized and actual
cash flows are accounted for as Assets or Liabilities
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• The MATCHING PRINCIPLE added on to the accrual concept
provides a better info.than does cash flows perse