Summary notes on Session 2 - Understanding Corporate Financial Statements I

The session had a discussion on gaining deeper understanding of the various financial statements
reporting and various issues related to them. Summary notes will cover the following topics:

1. Concept of depreciation:
• Depreciation is basically reduction in value of asset due to either usage or wear & tear
or passage of time. E.g.- If you bought a car for INR 5 lacs say 4 years back do you think
it’s value will be the same? No right! So, this reduction in value is nothing but
depreciation of the asset
• Now in terms of accounting depreciation is gradual conversion of cost into expense.
What this means is that whenever an asset is acquired it is recorded on balance sheet
only. If you bought a machinery for INR 1 lac on cash than below will be the effect on
accounting equation: (A= L+OE)
✓Machinery comes in  Asset +
✓Cash goes out so in  Asset –
• This cost of INR 1 lac will be recorded on P&L account as period or annual expenditure
over the useful life of the asset. Say if the useful life is 5 years than each year INR 20k
will be recorded as expenditure on P&L account rather than recording entire INR 1 lac in
1st year itself logic being that if the asset is providing benefit for 5 years it’s cost should
be matched accordingly or else it will provide incorrect picture of profit / loss. If we
charged everything in 1st year itself that year profit will be lower or even a loss and in
subsequent years that profit will be artificially higher because we are getting benefits of
the asset but cost is being charged.
• There are certain judgements which companies must make with regards to the useful
life of asset, residual value of asset and method of depreciation to be used
• The allocation to P&L will be based on the method of depreciation being used which we
shall see in next section
2. Methods of depreciation: The method of depreciation is an approach by which costs of asset
will be recorded in P&L account. The depreciation methods can differ for purpose of financial
reporting v/s taxation calculation hence in India companies act allows both methods but Income
tax act allows only WDV method. There are 2 most used methods for depreciation:
• Straight Line Method (SLM): As per this method of depreciation the entire cost of asset
minus estimated residual value is divided by the useful life. Like we saw earlier that INR
1 lac is having useful life of 5 years with resale value as 0 than the depreciation per year
is INR 20k (1 Lac – 0) / 5 . Below is the example from the excel sheet discussed during
the class:
 ✓ Main issue with SLM method is it’s just a naïve way of allocating the depreciation
and hence It seems illogical to charge depreciation on the original cost of the asset
every year when the balance of the asset is declining year after year.
✓ This method is more suited for small sized firms or firms with large number of old
machines with very less value left.
• Written down value method (WDV): The WDV or reducing balance method is another
method of depreciation wherein the depreciation is charged at a certain rate (%) of net
book value and not the original value as was the case earlier. The main difference here
is that depreciation is not same in each year like it was the case with SLM. Below was
the example discussed during the class:
 ✓ More on WDV -> https://indiantaxstudy.com/knowledge-base/financial-
reporting/calculate-wdv-rates-depreciation/
✓ This method is more logical as depreciation charged in earlier years is more and
then as it gets older the amount of depreciation also goes down hence the term
reducing balance or declining balance method

3. Accounting standards for depreciation (AS-6): Accounting standards are issued by the ICAI or
Institute of chartered accountants of India which basically lay down the rules for reporting of
depreciation for companies in India. This will bring uniformity in financial reporting which is the
basic purpose of accounting standards. Few important points on AS 6 which now actually
covered under AS 10. (http://www.indianaccounting.in/2012/03/as-6-depreciation-
accounting.html)

✓ The useful life estimate for similar asset can be different among companies
✓ There will no depreciation expense if company uses assets past it’s useful life
✓ Companies can have different depreciation methods for financial accounting v/s taxation
 ✓ If companies revise the estimate of the useful life than it will need to restate it’s financial
statements for previous years
✓ Accelerated depreciation results in higher depreciation in earlier years than SLM method
but total depreciation is same under both methods. (Note: PPT provided seems to state
incorrectly that total depreciation under accelerated method is more v/s SLM method) –
(https://www.accountingcoach.com/terms/A/accelerated-depreciation)

4. Overview of financial statements – Balance Sheet, Profit & Loss and Cash flow statement
• Balance sheet is a snapshot of current position of the company with respect to the
Assets = Liabilities + Owner’s equity.
• Profit & Loss statement shows whether company has made profit or loss during the
period but along with that it provides lots of important information which we shall see
in detail in upcoming sections
• Cash flow statement is summary of cash inflow & outflow for various activities under
Operating, Investing & Financing Cash flows. This is different from P&L because cash
flow statement is prepared on cash basis whereas the P&L is based on accrual
accounting (which is discussed in the previous summary notes document)
5. Balance sheet under different accounting standards like IFRS, US GAAP & Indian Accounting
standards (IAS): As discussed earlier accounting standards are for purpose of brining uniformity
to the reporting in financial statements across all companies reporting within a specific country
or geography. Like US GAAP (Generally Accepted Accounting Principles) is relevant for
companies operating in US where IAS (Indian accounting standards) for India. IFRS (International
Financial reporting standards) is an attempt to merge all the country specific standards into a
global nature which will bring transparency, accountability and comparability
(http://www.ifrs.org/about-us/who-we-are/)

✓ As you would have understood by now that different accounting standards mean various
formats for balance sheet and other financial statements. The same can be seen in the slid
below from the class:

✓ In the assets & Liabilities side of balance sheet different classifications are made as under:
 oFixed Assets: They include those assets which are core assets of the business-like
Plant, machinery etc. They are important in carrying on the core operations of the
business. Also note this assets are long term in nature and cannot be converted to
cash easily
o Investments: This are also assets in which company has invested the money which is
not related to their business-like Shares, Bonds, etc.
o Current Assets: This includes those assets which are having duration less than one
year like Stock of finished goods, Debtors, Cash etc. or one may say cash and other
assets that are expected to be converted to cash within a year
o Long term loans: This category shows loans or money borrowed by companies for
longer time frame. Any loan more than one year is considered long term debt. This
can be secured meaning a collateral or security is provided against the borrowing
whereas unsecured loan is one where there is no such security provided and usually
attracts very high interest rates
o Current liabilities & provisions: This includes the liabilities which are getting due in
less than one year or during the current accounting period. E.g. short term loan of
say 6 months or long term loan coming up for repayment. A provision is an amount
set aside for the probable, but uncertain, economic obligations of an enterprise.
✓ Balance sheet under schedule 3 under has two sections:
o Sources of funds which consists of owner’s equity & liabilities
o Application of funds shows where this fund is applied split among various categories
like Fixed Assets (Net block), Capital work in progress etc.
6. Exercise for classification of items under different balance sheet heads:

✓ Salaries & wages are current liabilities as they need to be paid within current accounting
period or less than year
✓ Service revenue is part of income statement hence NA
✓ Interest payable is again current liabilities payable within current accounting period or less
than year
✓ Goodwill is excess purchase consideration paid over total value of assets & liabilities. It is
considered as intangible asset as it cannot be touched or visible
✓ Depreciation expense is recorded on income statement hence NA
✓ Mortgage payable in 3 years is Long term liability as it’s more than one year and beyond
current accounting period
✓ Investment in real estate is a property hence comes under PPE
✓ Equipment is a plant or machinery hence coming under PPE
✓ Accumulated depreciation comes under PPE as it’s deducted from the Gross block of fixed
assets
✓ Debt investment in short term is current assets
✓ Retained earnings is part of the Stockholder’s equity
✓ Unearned service revenue is cash received for service or goods which is still not sold or
provided hence it’s part of current liability
7. Balance Sheet of Victory co ltd: The below items can be first marked as B/s or P&L than classify
them under various heads of balance sheet. The below BS is based on the concepts discussed
above and it just confirms the items discussed above:

8. Recap solved:
9. Income statement / P&L – Single Step method, Multi step method
• Income statement or P&L account is used for recording the income & expenditure made
during the accounting period. The result is net income will be either positive (profit) if
revenue + gains > expenses + losses or negative (loss)
• Income statement can be prepared in two formats – Single step & Multi step
• The single step income statement provides only net income figure. It is a simple
statement showing Income minus expenses resulting in Net income figure. Apart from
this it will show profit before tax (PBT) & profit after tax (PAT)
• Single step statement is usually for companies not willing to provide more information
or transparency
• Multi step statement provides different levels of profitability. It provides great amount
of information which is useful for various stakeholders like investors, employees, govt
employees.
• Below is side by side comparison of the Income statements under both the methods:
• Key points to be noted from the above comparison:
o Under single step costs & expenses are clubbed whether they relate to core operations
or not. For e.g. Interest expense is shown under other revenues & expenses in multi
step method whereas the same is under one head in single step.
o The net income is same under both and hence it has no impact on the same.
o Under multi step income statement we start with Net sales / Revenue & deduct COGS
which is all direct costs like material, labor & expenses which will provide us with “Gross
margin”. E.g. – For a furniture making company wood will be a direct material cost and
hence fall under COGS
o Next are all “operating expenses” which are pertaining to operating expenses related to
core business in terms of administration, selling & distributions etc. which gives us
“Income from operations”. This number represents income which business is earning
from it’s core business activities
o Next we factor in the other income & expenses which are not pertaining to core of the
business. Like gains from foreign exchange or sale of an investment etc. This will provide
us with “PBIT” – profit before interest & taxes
o Next we deduct the interest cost which will lead us to “PBT” (profit before taxes). We
than proceed to deduct the income tax from PBT which gives us the final figure of PAT
or profit after tax
o The significance of multi step income statement is it shows how company is doing at
core operations which can understood from operating income number. Also next helps
us understand the impact of Fixed expenses like Interest cost, Depreciation cost & Other
income / expenses on net income number.
o When we compare them on Year on Year or Quarter on Quarter it helps us pin point the
exact reason / source from which profit is increasing or decreasing. The same can be
seen from below slides:
10. Other financial reporting statements – segment Reporting, earning per share statement,
consolidated financial statements:
o Segment reporting shows how the company is doing in a particular segment. Segment
can be a geography or product
o EPS statement shows how much company is earning per share which is helpful to
understand the valuation of the company via price to earnings ratio or P/E ratio
o Consolidated statement shows the results of the company along with it’s subsidiaries.
Subsidiaries are those companies where parent has acquired stake. So companies show
standalone & consolidated statements which will show how much original company is
earning and how much it is earning on combined basis