FRCC MODULE 1

Financial Reporting and Cost Control

Financial Reporting and Cost Control

COMPANIES FINAL ACCOUNTS Module 1ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN1

Chapter contentsIntroductionMeaning of companies Types of companies Characteristics of companiesUnderstanding Annual ReportsProfit and loss statement and balance sheet Off Balance sheet items Treatment of events occurring after Balance sheet

ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN2

Learning outcomesObtaining a basic understanding about company form of business organization Understanding the contents and format of P&L and Balance sheet of companies. Understanding Annual reports.


ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN4Introduction

introductionIndustrial revolution has led to the emergence of large scale business organizations. These organization require big investments and the risk involved is very high. Joint Stock Company form of business organization has become extremely popular as it provides a solution to overcome the limitations of partnership business. The giant Indian Companies may include the names like Reliance, TalcoBajaj Auto, Infosys Technologies, Hindustan Lever Ltd., Ranbaxy Laboratories Ltd.,and Larsen and Tubro etc.ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN5

Definition/meaning of companyA comprehensive and clear definition of a company is given by LordJustice Lindley, A company is meant an association of many persons who contributemoney or moneys worth to a common stock and employ it in some trade or business,and who share the profit and loss (as the case may be) arising there from. The commonstock contributed is denoted in money and is the capital of the company. The personswho contribute it, or to whom it belongs, are members. The proportion of capital towhich each member is entitled is his share. Shares are always transferable although theright to transfer them is often more or less restricted.ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN6

Types of companiesALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN7

Types of companies-by incorporationALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN8

Types of incorporated companiesALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN9

By no. of membersALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN10

By ownershipALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN11

By Country of origin or nationalityALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN12

Characteristics of companiesALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN13

Characteristics of companySeparate Legal Entity:Under Incorporation law, a company becomes a separate legal entity as compared to its members. The company is distinct and different from its members in law. It has its own seal and its own name, its assets and liabilities are separate and distinct from those of its members. It is capable of owning property, incurring debt, and borrowing money, employing people, having a bank account, entering into contracts and suing and being sued separately.


Characteristics of companyLimited Liability:The liability of the members of the company is limited to contribution to the assets of the company upto the face value of shares held by him. A member is liable to pay only the uncalled money due on shares held by him. If the assets of the firm are not sufficient to pay the liabilities of the firm, the creditors can force the partners to make good the deficit from their personal assets. This cannot be done in the case of a company once the members have paid all their dues towards the shares held by them in the company.


Characteristics of companyPerpetual Succession:A company does not cease to exist unless it is specifically wound up or the task for which it was formed has been completed. Membership of a company may keep on changing from time to time but that does not affect life of the company. Insolvency or Death of member does not affect the existence of the company.


Characteristics of companySeparate Property:A company is a distinct legal entity. The company's property is its own. A member cannot claim to be owner of the company's property during the existence of the company.Transferability of Shares:Shares in a company are freely transferable, subject to certain conditions, such that no share-holder is permanently or necessarily wedded to a company. When a member transfers his shares to another person, the transferee steps into the shoes of the transferor and acquires all the rights of the transferor in respect of those shares.


Characteristics of companyCommon Seal:A company is an artificial person and does not have a physical presence. Thus, it acts through its Board of Directors for carrying out its activities and entering into various agreements. Such contracts must be under the seal of the company. The common seal is the official signature of the company. The name of the company must be engraved on the common seal. Any document not bearing the seal of the company may not be accepted as authentic and may not have any legal force.


Characteristics of companyCapacity to sue and being sued:A company can sue or be sued in its own name as distinct from its members.Separate Management:A company is administered and managed by its managerial personnel i.e. the Board of Directors. The shareholders are simply the holders of the shares in the company and need not be necessarily the managers of the company.


Characteristics of companyOne Share-One Vote:The principle of voting in a company is one share-one vote i.e. if a person has 10 shares, he has 10 votes in the company. This is in direct distinction to the voting principle of a co-operative society where the "One Member - One Vote" principle applies i.e. irrespective of the number of shares held, one member has only one vote.


Understanding a companys annual reportALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN21

About Annual reportsAn annual report is intended to provide a snapshot of a business' performance with investors, potential investors and other stakeholders. It should provide enough information so that a potential investor understands the nature and scope of the business, its recent developments and future outlook. The main sections of an annual report typically include the financial statements and the "Management Discussion and Analysis." The former gives a summary of the financial results over the past year. For publicly traded companies, all financial results must be reported for public consumption. Privately held companies are under no such obligation, but most will share key financial information with investors.ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN22

About Annual reportsThe information contained in an annual report should give investors and other stakeholders a clear idea of how the company is performing and how it plans to grow and improve its business in coming years. Publicly traded companies mail reports to shareholders or provide a copy of the annual report on their websites. Investors who want the straight financial data can also download copies of the company's 10-K it files with the Securities & Exchange Commission.


CHAIRMANS LETTERIt is customary for the annual report to contain a letter from the chairman of the board of directors to shareholders. A small business might not have a separate board of directors, but a letter from the chairman and CEO/president is appropriate to give to investors and other stakeholders and should provide an overview of the past year's key developments. The chairman's letter should provide details about the successes as well as the challenges of the past year. It should also include the future outlook for the company, including insights about the market and growth opportunities.


MANAGEMENT DISCUSSION & ANALYSISThe Management Discussion and Analysis is a section of the annual report that discusses different aspects of the business. Topics of discussion typically include new hires or appointments, new product introductions, updates on the progress of business acquisitions, product launches and other information management believes to be important to investors. It is an overview of the previous year's developments and how the company performed over that period. It should be a good starting point for a new investor who wants to understand a business' fundamentals.


Auditors report/letterAnnual reports include a letter form the party reviewing and externally verifying the financial data, typically in the form of an auditors report or Certified Public Accountant letter. This letter provides proof of independent verification of the data presented. It is typically presented on the official letterhead of the auditing firm or individual CPA.


FINANCIAL STATEMENTSThe financial statements comprise the meat of the annual report. This is where the company provides the numbers that investors use to determine how well the company performed financially. The financial statements consist of the income or profit and loss statement, balance sheet and cash flow statement for the current year previous year and prior years so investors can compare the performance from one year to the next. Publicly traded companies are required to provide three years worth of financial statements in their annual reports. A privately held company is not bound by the same regulations. However, investors will always welcome greater transparency. A privately held business that goes above and beyond to publish prior-year financial results in its annual report increases its chances of attracting new money.


Notes to statementsAn annual reports financial statements are followed by notes that clarify various points. This may include an introductory summary of the nature of the organization and its business. This may be followed by a summary of the accounting policies applied, information regarding capital contributions, investments and stock redemptions, and other items depending on the business and events of the prior year.


Additional informationIf the company has partners or subsidiary companies, partner profiles and company data sheets may be included in the report to provide a more complete picture of the years activities. Contact information is always included and generally closes the report.


ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN30Profit & loss statements & balance sheet

SCHEDULE VI OF COMPANIES ACT(2013 AMENDMENT)Schedule VI to Indian Companies Act 1956 specifies the format of Profit & Loss account & Balance Sheet.The latest format as per 2013 amendment is attached for perusal & understanding


Format of p & l account & balance sheetBALANCE SHEET AND PROFIT AND LOSS FORMAT.xlsxALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN32

Major changes in revised schedule VIThe major changes that have been made in schedule Vi can be better understood by categorizing the changes into 3 broad headingsMajor changes in balance sheet Additional disclosures that are required in balance sheetMajor changes in P & L accountDisclosures that are not required


Major changes related to the Balance sheetThe Revised Schedule VI prescribes only the vertical format forpresentation of Financial Statements. Thus, a company will now not have an option to use horizontal format for the presentation of Financial Statements as prescribed in Old Schedule VI.Current and non-current classification has been introduced forpresentation of assets and liabilities in the Balance Sheet. The application ofthis classification will require assets and liabilities to be segregated into theircurrent and non-current portions. For instance, current maturities of a long termborrowing will have to be classified under the head Other current liabilities.


Major changes related to the Balance sheetThe Number of shares held by each shareholder holding more than 5 percent shares in the company now needs to be disclosed. In the absence of any specific indication of the date of holding, such information should be based on shares held as on the Balance Sheet date.Details pertaining to aggregate number and class of shares allotted forconsideration other than cash, bonus shares and shares bought back willneed to be disclosed only for a period of five years immediately precedingthe Balance Sheet date including the current year.


Major changes related to the Balance sheetAny debit balance in the Statement of Profit and Loss will be disclosed under the head Reserves and surplus. Earlier, any debit balance in Profit and Loss Account carried forward after deduction from uncommitted reserves was required to be shown as the last item on the Assets side of the Balance Sheet.Specific disclosures are prescribed for Share Application money. The application money not exceeding the capital offered for issuance and to the extent not refundable will be shown separately on the face of the Balance Sheet. The amount in excess of subscription or if the requirements of minimum subscription are not met will be shown under Other current liabilities.


Major changes related to the Balance sheetThe term sundry debtors has been replaced with the term trade receivables. Trade receivables are defined as dues arising only from goods sold or services rendered in the normal course of business. Hence, amounts due on account of other contractual obligations can no longer be included in the trade receivables.The Old Schedule VI required separate presentation of debtors outstanding for a period exceeding six months based on date on which the Guidance Note on the Revised Schedule VI to the Companies Act, 1956 bill/invoice was raised whereas, the Revised Schedule VI requires separate disclosure of trade receivables outstanding for a period exceeding six months from the date the bill/invoice is due for payment.


Major changes related to the Balance sheetCapital advances are specifically required to be presented separately under the head Loans & advances rather than including elsewhere.Tangible assets under lease are required to be separately specifiedunder each class of asset. In the absence of any further clarification, the term under lease should be taken to mean assets given on operating lease in the case of lessor and assets held under finance lease in the case of lessee.


Major changes related to the Balance sheetIn the Old Schedule VI, details of only capital commitments were required to be disclosed. Under the Revised Schedule VI, other commitments also need to be disclosed.The Revised Schedule VI requires disclosure of all defaults in repayment of loans and interest to be specified in each case. Earlier, no such disclosure was required in the Financial Statements. However, disclosures pertaining to defaults in repayment of dues to a financial institution, bank and debenture holders continue to be required in the report under Companies (Auditors Report) Order, 2003 (CARO).


Additional disclosures(a) Rights, preferences and restrictions attaching to each class of shares, including restrictions on the distribution of dividends and the repayment of capital;(b) Terms of repayment of long-term loans;(c) In each class of investment, details regarding names of the bodies corporate in whom investments have been made, indicating separately whether such bodies are (i) subsidiaries, (ii) associates, (iii) joint ventures, or (iv) controlled special purpose entities, and the nature and extent of the investment made in each such body corporate (showing separately partly-paid investments);


Additional disclosures-contd.(d) Aggregate provision for diminution in value of investments separately for current and long-term investments;(e) Stock-in-trade held for trading purposes, separately from other finished goods.


Major changes related to the P & l accountThe name has been changed to Statement of Profit and Loss asagainst Profit and Loss Account as contained in the Old Schedule VI. Unlike the Old Schedule VI, the Revised Schedule VI lays down aformat for the presentation of Statement of Profit and Loss. This format of Statement of Profit and Loss does not mention any appropriation item on its face.


Major changes related to the P & l account In addition to specific disclosures prescribed in the Statement of Profit and Loss, any item of income or expense which exceeds one percent of the revenue from operations or Rs. 100,000 (earlier 1 % of total revenue or Rs. 5,000), whichever is higher, needs to be disclosed separately.The Old Schedule VI required the parent company to recognizedividends declared by subsidiary companies even after the date of theBalance Sheet if they were pertaining to the period ending on or before theBalance Sheet date. Such requirement no longer exists in the RevisedSchedule VI.


Major changes related to the P & l account In respect of companies other than finance companies, revenue fromoperations need to be disclosed separately as revenue from (a) sale ofproducts, (b) sale of services and (c) other operating revenues.Net exchange gain/loss on foreign currency borrowings to the extentconsidered as an adjustment to interest cost needs to be disclosedseparately as finance cost.


Major changes related to the P & l account Break-up in terms of quantitative disclosures for significant items ofStatement of Profit and Loss, such as raw material consumption, stocks,purchases and sales have been simplified and replaced with the disclosureof broad heads only. The broad heads need to be decided based on considerations of materiality and presentation of true and fair view of the Financial Statements.


Disclosures that are not required Disclosures relating to managerial remuneration and computation of net profits for calculation of commission; Information relating to licensed capacity, installed capacity and actual production; Information on investments purchased and sold during the year; Investments, sundry debtors and loans & advances pertaining to companies under the same management;Maximum amounts due on account of loans and advances from directors or officers of the company; Commission, brokerage and non-trade discounts


OFF BALANCE SHEET ITEMSALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN47

OFF BALANCE SHEET ITEMSOff-balance sheet financing means a company does not include a liability on its balance sheet. It is an accounting term and impacts a companys level of debt and liability.ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN48

EXAMPLE OF OFF BALANCE SHEET ITEMSCommon forms of off-balance sheet financing include operating leases and partnerships. Operating leases have been widely used over the years, although the accounting rules have been tightened to lessen the use. For example, a company can rent or lease a piece of equipment and then buy the equipment at the end of the lease period for a minimal amount of money, or it can buy the equipment outright. In both cases, a company will eventually own the equipment or building. ALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN49

Analysis of example-contdThe difference is in how a company accounts for the purchase. In an operating lease, the company records only the rental expense for the equipment rather than the full cost of buying it outright. When a company buys it outright, it records the asset (the equipment) and the liability (the purchase price). So by using the operating lease, the company is recording only rental expense, which is significantly lower than booking the entire purchase price, resulting in a cleaner balance sheet.


Another examplePartnerships are another common OBS financing itemWhen a company engages in a partnership, even if the company has a controlling interest, it does not have to show the partnerships liabilities on its balance sheet, again resulting in a cleaner balance sheet.


Obs & investorsThese two examples of OBS financing arrangements depict the reason their use is attractive to many companies. The problem investors encounter when analyzing a companys financial statements is that many of these OBS financing agreements are not required to be disclosed at all, or they have partial disclosures, which are very minimal and do not provide adequate data required to fully understand a companys total debt. Even more perplexing is that these financing arrangements are allowable under current accounting rules, although some rules govern how each can be used. Because of the lack of full disclosure, investors need to determine the worthiness of the reported statements prior to investing by understanding any OBS arrangements.


Why OBS Financing is So AttractiveOBS financing is very attractive to all companies, but especially to those that are already highly levered. For a company that has high debt to equity, increasing its debt may be problematic for several reasons.First, for companies that already have high debt levels, borrowing more money is usually exceedingly more expensive than for companies that have little debt because the interest charged by the lender is high.Second, borrowing more may increase a companys leverage ratios, causing agreements (called covenants) between the borrower and lender to be violated.


Why OBS Financing is So AttractiveThird, partnerships, such as in research and development, are attractive to companies because R&D is expensive and may have a long-time horizon before completion. The accounting benefits of partnerships are many-fold. For example, accounting for an R&D partnership allows the company to add very minimal liability to its balance sheet while conducting the research. This is beneficial because during the research process, there is no high-value asset to help offset the large liability. This is particularly true in the pharmaceutical industry where R&D for new drugs takes many years to complete.Last, OBS financing can often create liquidity for a company. For example, if a company uses an operating lease, capital is not tied up in buying the equipment since only rental expense is paid out.


How OBS Financing Affects InvestorsFinancial ratios are used to analyze a companys financial standing. OBS financing affects the leverage ratios, like the debt ratio, a common ratio used to determine if the debt level is too high when compared to a company's assets. Debt-to-equity, another leverage ratio, is perhaps the most common because it looks at a company's ability to finance its operations long term using shareholder equity instead of debt. The debt-to-equity ratio does not include short-term debt used in a company's day-to-day operations to more accurately depict a companys financial strength.


How OBS Financing Affects Investors In addition to the debt ratios, other OBS financing situations include operating leases and sale-lease back impact liquidity ratios. Sale-lease back is a situation where a company sells a large asset, usually a fixed asset like a building or large capital equipment, and then leases it back from the purchaser. Sale-lease back arrangements increase liquidity because they show a large cash inflow after the sale and a small nominal cash outflow for booking a rental expense instead of a capital purchase. This reduces the cash outflow level tremendously, so the liquidity ratios are also affected. Current assets to current liabilities is a common liquidity ratio used to assess a companys ability to meet its short-term obligations. The higher the ratio, the better the ability to cover current liabilities. The cash inflow from the sale increases the current assets, making the liquidity ratio more favorable.


Events after balance sheet dateALLIANCE UNIVERSITY ABS MBA LAKSHMI NARASIMHAN57

Events after balance sheet dateEvents after the balance sheet date are significant financial events that occur after the date of the balance sheet, but prior to the date that the financial statements are issued. For example, a company's balance sheet that has the heading of December 31, 2012 might not be finalized and distributed until February 1, 2013. During January new information may arise that has financial significance. Perhaps there is an event that provides more information about the conditions actually existing on December 31. The second type of event would be a new January event that does not change the December 31 amounts, but needs to be disclosed to the readers of the December 31 financial statements.


An example..An example of the first situation might be that a customer owes Jay Company $200,000 on December 31 and Jay Company assumed that the customer was financially sound. As a result Jay Company did not provide any allowance for the customer's account being uncollectible. Then on January 28, the customer filed for bankruptcy and Jay Company learns that none of the $200,000 receivable will be collected. If the customer's financial condition on December 31 was already in bankruptcy condition, Jay Company will need to adjust its December 31 balance sheet and its income statement for the year 2012 for this $200,000 of bad debts expense.


Another example.An example of the second situation might be a loss arising from a catastrophe occurring on January 16, 2013. The amounts reported as of December 31, 2012 will not be adjusted since those amounts were correct as of December 31. However, the readers of the December 31 balance sheet and the 2012 income statement should be informed through a disclosure that something significant has occurred to the company's financial position since December 31.The events after the balance sheet date are often referred to as subsequent events or post balance sheet events.


FRCC MODULE 1

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