Financial Statement & Analysis Dr. Prakash Singh Finance & Accounting Area IIM, Lucknow

Why Financial Statements In any markets, the participants need to value the assets to facilitate buy and sell Price discovery is possible only if we have information about the asset (full, reliable and consistent) Companies report their performance in a structured format to the markets Markets analyze the information and “discover” the fair value

Two Main Parts Accounting Statements: Construction and Analysis –The Balance Sheet –The Profit & Loss Account –The Cash Flow Statement Accounting Policies: Standards, practices and the impact on the statements

Financial Statement Users Managerial accounting Financial accounting Internal UsersExternal Users Managers Executives Lenders Investors

The Basic Accounting Elements Asset –Has future benefit to the entity Liability –Obligation to transfer assets in the future Owners’ Equity –Owners’ interest in the company Revenue –Increase in economic resources resulting from normal operations of the company Expense –Decrease in economic resources resulting from normal operations of the company

Diamond Chapter 26 The Balance Sheet Presents the financial position of a company at a particular point in time. Three categories: –Assets –Liabilities –Owners’ Equity

Balance Sheet Format: Sources of Funds  Shareholders Funds  Loan Funds  Application of Funds  Net Block (Gross Block – Accumulated Depn.)  Investments  Net Current Assets (Current Assets, Loans and Advances – Current Liabilities & Provisions)  Misc. Expenditure (to the extent not yet written off)

Income Statement Reports the economic results of a company over a time period. It shows the derivation of earnings or losses. + Revenues - Cost of Revenue (product cost or COGS) = Gross Margin - Sales and Marketing - General and Administrative - Research & Development - Depreciation and Amortization = Operating Income (EBIT) + Interest Income(expense) net = Net Income before Taxes - Income Tax Provision - Extraordinary Items = Net Income Income Statement of XXX Corp. – year 2000 $ % Rev.

Diamond Chapter 29 Classifies individual cash flows according to three main activities: –Operating activities –Investing activities –Financing activities The Statement of Cash Flows

Contentious Issues Recognition issue Valuation issue Classification issue These issues underlie almost every major decision in financial accounting. Measurement issues are controversial.

Recognition Recognition means the recording of a transaction. Refers to the difficulty of deciding when a business transaction occurred. Point of recognition is important because it affects the financial statements.

Classification Classification is the process of assigning transactions to the appropriate accounts Proper classification depends on –Correctly analyzing the effect of each transaction on the business –Maintaining a system of accounts that reflects that effect

Valuation Focuses on assigning a monetary value to a transaction. Most controversial issue in accounting. According to GAAP, use original cost –Also called historical cost. Practice of recording transactions at cost follows the cost principle.

How Does It All Add Up IncomeExpenses AssetsLiabilities When you buy something… When you get paid for a product or service… The value of anything you own… The value of anything you borrow… Assets often generate income Liabilities often generate expenses

Contemporary Issues IFRS/Accounting Standards (GAAP) / Companies Act e.g. AS 28 Interpretation of Accounting Policies: Fair Value / Income Recognition Contingent Liabilities: The Bottom line in the Sub prime Mortgage Crisis (report and relax) Recapitalization/ Write offs/ Selective Bailouts: Why Lehman was not saved ? Role of the Auditors: The Satyam fiasco Role of Independent Directors Corporate Governance: Disclosure is the buzz word Compensation to the Directors and other top management professionals: Obscene bonuses