Financial Statements Analysis

Dr. Rachappa Shette,

Indian Institute of Management Kozhikode
rachappa.s@iimk.ac.in
Phone: 0495-2809 422
 Session 4: Synopsis
• FSA Approach: 7 Steps in FSA
• LAJ case: Application of these steps
7 steps of financial statements analysis
1. Understanding construction of financial statements
2. Understanding the measurement of items of
financial statements
3. Understanding the techniques of financial
statements analysis
4. Reviewing the accounting policies
5. Correcting the financial statements
6. Preparing the corrected financial statements
7. Analysis based on corrected financial statements
1. Understanding construction, correction and
reconstruction of financial statements
• Every economic event has two sides.
• Accountants record both sides of some
economic events as a transaction.
• Furthermore, accountants require that the
two sides of a transaction balance so that the
basic accounting equation remains in balance.
Assets = Liabilities + Owners’ Equity
 1. Understanding construction, correction and
reconstruction of financial statements
transaction assets = liab. + s.h.equity
1. Borrowings not +10,000 +10,0000
recorded for Rs 10,000.
2. Payment of salaries are recorded -1,000 -1,000
as part of capex Rs 1000 by error.
3. Obsolete inventory not
-200 -200
recorded Rs 200.
4. Provision for retirement
+300 -300
benefits was understated by Rs 300.
5. Credit sales revenue
overstated by Rs 400 -400 -400
6. Depreciation understated by
Rs 50. -50 -50
7. Investments overstated
by Rs 1000
-1,000 -1,000
 2. Understanding the measurement of items of
financial statements

• COGS and Inventory

– FIFO
– LIFO
– WA
– Specific Identification Method
• Depreciation and amortization
– Straight line method
– Diminishing Balance Method
• Measurement of Revenue
• Measurement of Non-current assets
• Measurement of liability
 3. Understanding techniques of financial
statements analysis
• Ratio Analysis
– Liquidity ratios
– Solvency ratios
– Profitability ratios
– Efficiency ratios
– Valuation ratios
• Common size analysis
• Comparative analysis
 4. Reviewing the accounting notes
Examples from Air India Company (Annual Report 2014-15):
1. Consumption of inventory not accounted for Rs 1308
Million
2. Obsolete inventory part of inventory Rs 503.7 Million
3. Instead of showing Rs 3,870.7 Million as liability, it is shown
as contingent liability.
4. Change in accounting policy for repairable spares as result
lower expenses by Rs 433.3 Million
5. No depreciation has been charged on the standby
Equipment, Machinery Spares (grouped under inventories).
6. Under-estimation of Post-retirement medical benefits of
employees.
 5. Correcting the financial statements
Correction Items Assets Liabilities Equity
= + Shareholders’
Funds
1. Consumption of inventory not
accounted for Rs 1308 Million
2. Obsolete inventory part of inventory
Rs 503.7 Million
3. Instead of showing Rs 3,870.7 Million
as liability, it is shown as contingent
liability.
4. Change in accounting policy for
repairable spares as result lower
expenses by Rs 433.3 Million
5. No depreciation has been charged on
the standby Equipment, Machinery
Spares (grouped under inventories).
6. Under-estimation of Post-retirement
medical benefits of employees.
 6. Preparing the corrected financial
statements
• Corrected Balance Sheet
• Corrected Income Statement
• Corrected Cash Flow Statement
 7. Analysis based on corrected financial
statements
• Apply the techniques of financial statement
analysis
– corrected balance sheet
– Corrected income statement
– Corrected cash flows statement
Summary of FSA framework: Off Wall Street
Consulting research report on Enron Inc.

Reported Corrections Corrected

Amount Amount
Cash and Bank 200 -1 199
A.R 550 -22 528
Inventory 350
PPE 500
Capital WIP 100
Patents 150
Total 1950
Questions?