Financial Statements Analysis Solved Question Paper May' 2016
COMMERCE (Speciality)
Course: 602 (Financial Statement Analysis)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
1. (a) Fill in the blanks with appropriate word(s): 1x5=5
a) Comparative statement analysis is also known as ____ (vertical analysis/static analysis/horizontal analysis)
b) The ____ of a company has primary responsibility for the corporation’s external financial reporting functions (management/members/board of directors).
c) At present ASB of ICAI formulates the AS based on ____ (GAAP/IFRS/IAS).
d) Ratio of net profit before interest and taxes to sales is ____ ratio (net profit/profit/operative profit)
(b) State whether the following statements are true or false: 1x3=3
a) Analysis of financial statements ignores the issue of price level changes. True
b) Capital gearing is a term used to express the relationship between ordinary share capital and fixed interest bearing securities of a company. True
c) The IRDA was incorporated as statutory body in April 1999. False, April 2000
2. Write short notes on the following (any four): 4x4=16
1) Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.
Merits of Common Size Statements:
a) A common size statement facilitates both types of analysis, horizontal as well as vertical. It allows both comparisons across the years and also each individual item as shown in financial statements.
b) Comparison of the performance and financial condition in respect of different units of the same industry can also be done.
c) These statements help the management in making forecasts for the future.
Demerits of Common Size Statements:
a) If there is no identical head of accounts, then inter-firm comparison will be difficult.
b) Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
c) Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
2) Trend Analysis: It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.
Merits of Trend analysis:
a) Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period.
b) Trend analysis will exhibit the direction to which the concern is proceeding.
c) The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern.
Demerits of Common Size Statements:
a) These are calculated only for major items instead of calculating for all items in the financial statements.
b) Trend values will also be misleading if there is frequent changes in accounting policies.
3) Acid Test Ratio/Liquid Ratio: Liquid ratio shows short-term solvency of a business. It is also called acid-test ratio and quick ratio. It is calculated in order to know whether or not current liabilities can be paid with the help of quick assets quickly. Quick assets mean those assets, which are quickly convertible into cash.
Liquid Ratio = Liquid Assets/Current Liabilities
Liquid assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.
Current liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Liquid ratio is calculated to work out the liquidity of a business. This ratio measures the ability of the business to pay its current liabilities in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very weak short-term financial position and in case, it is more than 1:1, it shows a better short-term financial position.
4) Financial Accounting Standard Board (FASB): Financial Accounting Standard Board is an independent not-for profit organisation which is responsible for financial accounting and reporting standards for public and private companies and NPOs in USA. It was established in 1973 with the aim to establish and interpret generally accepted accounting principles (GAAP). The FASB uses GAAP as the foundation for its comprehensive set of accounting method and practices.
5) SUSTAINABILITY REPORTING: A sustainability report is an organizational report that gives information about economic, environmental, social and governance performance. For companies and organizations, sustainability – the capacity to endure, or be maintained – is based on performance in these four key areas. An increasing number of companies and organizations want to make their operations sustainable. Establishing a sustainability reporting process helps them to set goals, measure performance, and manage change. A sustainability report is the key platform for communicating positive and negative sustainability impacts.
Sustainability reporting is therefore a vital step for managing change towards a sustainable global economy. Sustainability reporting can be considered as synonymous with other terms for non-financial reporting; Triple Bottom Line Reporting, Corporate Social Responsibility (CSR) Reporting, and more. It is also an intrinsic element of integrated reporting; a recent development that combines the analysis of financial and non-financial performance. A sustainability report enables companies and organizations to report sustainability information in a way that is similar to financial reporting. Systematic sustainability reporting gives comparable data, with agreed disclosures and metrics.
Major providers of sustainability reporting guidance include: The Global Reporting Initiative (The GRI Sustainability Reporting Framework and Guidelines), Organization for Economic Cooperation and Development (OECD Guidelines for Multinational Enterprises), The United Nations Global Compact (the Communication on Progress) International Organization for Standardization (ISO 26000, International Standard for social responsibility) etc.
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Financial Statements Analysis Solved Question Paper 2014
3. (a) Explain the concept of interpretation and criticism of Financial Statement. What are the significances of Financial Statement Analysis? 5+6=11
Ans: Financial Statement Analysis: We know business is mainly concerned with the financial activities. In order to ascertain the financial status of the business every enterprise prepares certain statements, known as financial statements. Financial statements are mainly prepared for decision making purposes. But the information as is provided in the financial statements is not adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis and interpretation of financial statements is required.
Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting and financial statements. The analysis is done by properly establishing the relationship between the items of balance sheet and profit and loss account.
In the words of Myer “Financial Statement analysis is largely a study of relationship among the various financial factors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements.”
In simple words, analysis of financial statement is a process of division, establishing relationship between various items of financial statements and interpreting the result thereof to understand the working and financial position of a business.
Objectives (Purposes) and significance of Financial Statement analysis:
Financial analysis serves the following purposes and that brings out the significance of such analysis:
a) To judge the financial health of the company: The main objective of the financial analysis is to determine the financial health of the company. It is done by properly establishing the relationship between the items of balance sheet and profit and loss account.
b) To judge the earnings performance of the company: Potential investors are primarily interested in earning efficiency of the company and its dividend paying capacity. The analysis and interpretation is done with a view to ascertain the company’s position in this regard.
c) To judge the Managerial efficiency: The financial analysis helps to pinpoint the areas wherein the managers have shown better efficiency and the areas of inefficiency. Any favourable and unfavourable variations can be identified and reasons thereof can be ascertained to pinpoint weak areas.
d) To judge the Short-term and Long-term solvency of the undertaking: On the basis of financial analysis, Long-term as well as short-term solvency of the concern can be judged. Trade creditors or suppliers are mainly interested in assessing the liquidity position for which they look into the following:
Ø Whether the current assets are sufficient to pay off the current liabilities.
Ø The proportion of liquid assets to current assets.
e) Indicating the trend of Achievements: Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be envisaged.
f) Inter-firm Comparison: Inter-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others.
g) Understandable: Financial analysis helps the users of the financial statement to understand the complicated matter in simplified manner.
h) Assessing the growth potential of the business: The trend and other analysis of the business provide sufficient information indicating the growth potential of the business.
Or
(b) Critically examine the merits and demerits of various techniques used for interpreting Financial Statements. What are the limitations of such tools? 6+5=11
Ans: Tools of Analysis of Financial Statements
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. If this is not the case, the deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.
Merits of Comparative Financial Statements:
a) Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.
b) These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise.
c) These statements help the management in making forecasts for the future.
Demerits of Comparative Financial Statements:
a) Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
b) Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
2. Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.
Merits of Common Size Statements:
d) A common size statement facilitates both types of analysis, horizontal as well as vertical. It allows both comparisons across the years and also each individual item as shown in financial statements.
e) Comparison of the performance and financial condition in respect of different units of the same industry can also be done.
f) These statements help the management in making forecasts for the future.
Demerits of Common Size Statements:
d) If there is no identical head of accounts, then inter-firm comparison will be difficult.
e) Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
f) Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
3. Trend Analysis: It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.
Merits of Trend analysis:
d) Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period.
e) Trend analysis will exhibit the direction to which the concern is proceeding.
f) The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern.
Demerits of Common Size Statements:
c) These are calculated only for major items instead of calculating for all items in the financial statements.
d) Trend values will also be misleading if there is frequent changes in accounting policies.
4. Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratio analysis.
5. Funds flow statement: The financial statement of the business indicates assets, liabilities and capital on a particular date and also the profit or loss during a period. But it is possible that there is enough profit in the business and the financial position is also good and still there may be deficiency of cash or of working capital in business. Financial statements are not helpful in analysing such situation. Therefore, a statement of the sources and applications of funds is prepared which indicates the utilisation of working capital during an accounting period. This statement is called Funds Flow statement.
6. Cash Flow Analysis: A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only sources and applications of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored. A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash. Simply, Cash Flow is a statement which analyses the reasons for changes in balance of cash in hand and at bank between two accounting period. It shows the inflows and outflows of cash.
Limitations of various tools of financial analysis
Tools of Financial analysis suffers from various limitations which are given below:
a) Historical Analysis: Financial analysis analysed what has happened till date but it does not reflect the future. Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future.
b) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. A change in the price level makes the financial analysis of different accounting years invalid because accounting records ignores change in value of money.
c) Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while carrying out the analysis of financial statements.
d) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.
e) Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies. Therefore, financial are not free from bias.
f) Variation is accounting practices: Different firms follow different accounting practices. Therefore, a meaningful comparison of their financial statements is not possible.
4. (a) Discuss ratio analysis as a tool and technique of financial management. State the ratios which may be very useful for studying efficiency of a manufacturing concern and also explain how these will be used. 6+6=12
Ans: Meaning of Ratio Analysis: A ratio is one figure expressed in terms of another figure. It is mathematical yardstick of measuring relationship of two figures or items or group of items, which are related, is each other and mutually inter-dependent. It is simply the quotient of two numbers. It can be expressed in fraction or in decimal point or in pure number. Accounting ratio is an expression relating to two figures or two accounts or two set accounting heads or group of items stated in financial statement.
Ratio analysis is the method or process of expressing relationship between items or group of items in the financial statement are computed, determined and presented. It is an attempt to draw quantitative measures or guides concerning the financial health and profitability of an enterprise. It can be used in trend and static analysis. It is the process of comparison of one figure or item or group of items with another, which make a ratio, and the appraisal of the ratios to make proper analysis of the strengths and weakness of the operations of an enterprise.
According to Myers, “Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."
Objectives of Ratio analysis
a) To know the area of the business which need more attention.
b) To know about the potential areas which can be improved with the effort in the desired direction.
c) To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
d) To provide information for decision making.
e) To Judge Operational efficiency
f) Structural analysis of the company
g) Proper Utilization of resources and
h) Leverage or external financing
Advantages and Uses of Ratio Analysis
There are various groups of people who are interested in analysis of financial position of a company used the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner:
a) To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern.
b) Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.
c) Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them.
d) To simplify the accounting information: Accounting ratios are very useful as they briefly summaries the result of detailed and complicated computations.
e) To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources.
f) To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it.
g) Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years’ ratios, estimates for future can be made.
Activity Ratio
This ratio is also known as turnover ratio or productivity ratio or efficiency and performance ratio. These ratios show relationship between the sales and the assets. These are designed to indicate the effectiveness of the firm in using funds, degree of efficiency, and its standard of performance of the organization. Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio, Stock working capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover Ratio, Capital turnover ratio.
Capital Turnover Ratio: Capital turnover ratio establishes a relationship between net sales and capital employed. The ratio indicates the times by which the capital employed is used to generate sales. It is calculated as follows:
Capital Turnover Ratio = Net Sales/Capital Employed
Where Net Sales = Sales – Sales Return
Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets.
Objective and Significance: The objective of capital turnover ratio is to calculate how efficiently the capital invested in the business is being used and how many times the capital is turned into sales. Higher the ratio, better the efficiency of utilisation of capital and it would lead to higher profitability.
Fixed Assets Turnover Ratio: Fixed assets turnover ratio establishes a relationship between net sales and net fixed assets. This ratio indicates how well the fixed assets are being utilised.
Fixed Assets Turnover Ratio = Net Sales/Net Fixed Assets
In case Net Sales are not given in the question cost of goods sold may also be used in place of net sales. Net fixed assets are considered cost less depreciation.
Objective and Significance: This ratio expresses the number to times the fixed assets are being turned over in a stated period. It measures the efficiency with which fixed assets are employed. A high ratio means a high rate of efficiency of utilisation of fixed asset and low ratio means improper use of the assets.
Working Capital Turnover Ratio: Working capital turnover ratio establishes a relationship between net sales and working capital. This ratio measures the efficiency of utilisation of working capital.
Working Capital Turnover Ratio = Net Sales or Cost of Goods Sold/Net Working Capital
Where Net Working Capital = Current Assets – Current Liabilities
Objective and Significance: This ratio indicates the number of times the utilisation of working capital in the process of doing business. The higher is the ratio, the lower is the investment in working capital and the greater are the profits. However, a very high turnover indicates a sign of over-trading and puts the firm in financial difficulties. A low working capital turnover ratio indicates that the working capital has not been used efficiently.
Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods Sold/Average Stock
Where Average Stock = [Opening Stock + Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.
Debtors’ Turnover Ratio: Debtors turnover ratio indicates the relation between net credit sales and average accounts receivables of the year. This ratio is also known as Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivables
Where Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash Sales-Return Inward
Objective and Significance: This ratio indicates the efficiency of the concern to collect the amount due from debtors. It determines the efficiency with which the trade debtors are managed. Higher the ratio, better it is as it proves that the debts are being collected very quickly.
Or
(b) The following is the Balance Sheet of Jagjeevan Industries Ltd. as on 31st March, 2016:
Particulars | Amount (in Rs.) |
I. Equity and Liabilities: a) Shareholder’s Fund Equity Share Capital Reserve and Surplus b) Non Current Liabilities: 10% Debentures c) Current Liabilities: Bank Overdraft Sundry Creditors | 22,50,000 9,00,000 7,50,000 3,00,000 18,00,000 |
60,00,000 | |
II. Assets: a) Non-Current Assets: Fixed Assets b) Current Assets: Investments (short term) Stock-in-Trade Sundry Debtors Cash | 24,75,000 2,40,000 13,65,000 18,60,000 60,000 |
60,00,000 |
Other Information: Sales – Rs. 1, 11, 60,000; Gross Profit – Rs. 11, 16,000
You are required to calculate the following ratios: 3x4=12
a) Debt-Equity Ratio.
b) Proprietary Ratio.
c) Debtors’ Turnover Ratio.
d) Stock Turnover Ratio.
5. (a) Write a note on Corporate Social Reporting. What are the essentials of a perfect corporate social responsibility report? 5+6=11
Ans: Corporate social responsibility (CSR) is a business approach that contributes to sustainable development by delivering economic, social and environmental benefits for all stakeholders. CSR is a concept with many definitions and practices. Corporate social responsibility (CSR) promotes a vision of business accountability to a wide range of stakeholders, besides shareholders and investors. Key areas of concern are environmental protection and the wellbeing of employees, the community and civil society in general, both now and in the future.
The concept of CSR is underpinned by the idea that corporations can no longer act as isolated economic entities operating in detachment from broader society. Traditional views about competitiveness, survival and profitability are being swept away.
A corporation practicing CSR strives to comply with the laws and regulations, make a profit, be ethical and provide social accountability. It is responsible for the wider impact on society and not just the return of investments to stakeholders alone. Changing business practices and internal operations is considered vital for those organizations practicing CSR. In 1998 John Eklington coined the term “Triple Bottom Line” which is a coincident approach to that of CSR and an integrated concept under the umbrella of Social Responsibility. The “Triple Bottom Line (TBL)” approach is a means for corporations to achieve the adequate level of Corporate Social Responsibility which is necessary in the age of sustainable development for future generations.
There is no single, universally accepted definition of TBL reporting. In its broadest sense, TBL reporting is defined as corporate communication with stakeholders that describes the company’s approach to managing one or more of the economic, environmental and / or social dimensions of its activities and through providing information on these dimensions. Consideration of these three dimensions of company management and performance is sometimes referred to as sustainability or sustainable development. In its purest sense, the concept of TBL reporting refers to the publication of economic, environmental and social information in an integrated manner that reflects activities and outcomes across these three dimensions of a company’s performance.
QUALITIES AND CHARACTEISTICS OF INFORMATION IN TBL REPORTS
TBL reports usually contain both qualitative and quantitative information. In order for all reported information to be credible, it should possess the following characteristics: -
a) Reliability: Information should be accurate, and provide a true reflection of the activities and performance of the company.
b) Usefulness: The information must be relevant to both internal and external stakeholders, and be relevant to their decision-making processes.
c) Consistency of presentation: Throughout the report there should be consistency of presentation of data and information. This includes consistency in aspects such as format, timeframes, graphics etc.
d) Full disclosure: Reported information should provide an open explanation of specific actions undertaken and performance outcomes.
e) Reproducible: Information is likely to be published on an ongoing basis, and companies must ensure that they have the capacity to reproduce data and information in future reporting periods.
f) Audit ability: All statements and data within the report are able to be readily authenticated.
Or
(b) Define Financial Reporting. What are the benefits derived from Financial Reporting? 4+7=11
Ans: Basically, financial reporting is the process of preparing, presenting and circulating the financial information in various forms to the users which helps in making vigilant planning and decision making by users. The core objective of financial reporting is to present financial information of the business entity which will help in decision making about the resources provided to the reporting entity and in assessing whether the management and the governing board of that entity have made efficient and effective use of the resources provided. Financial reporting is of two types – Internal reporting and external reporting. The financial report made to the management is generally known as internal reporting and the financial report made to the shareholders and creditors is generally known as external reporting. The internal reporting is a part of management information system and they uses MIS reporting for the purpose of analysis and as an aid in decision making process.
The components of financial reporting are:
a) The financial statements – Balance Sheet, Profit & loss account, Cash flow statement & Statement of changes in stock holder’s equity
b) The notes to financial statements
c) Quarterly & Annual reports (in case of listed companies)
d) Prospectus (In case of companies going for IPOs)
e) Management Discussion & Analysis (In case of public companies)
Objectives and significance of Financial Reporting
The following points sum up the objectives & purposes of financial reporting:
a) Providing information to management of an organization which is used for the purpose of planning, analysis, benchmarking and decision making.
b) Providing information to investors, promoters, debt provider and creditors which is used to enable them to male rational and prudent decisions regarding investment, credit etc.
c) Providing information to shareholders & public at large in case of listed companies about various aspects of an organization.
d) Providing information about the economic resources of an organization, claims to those resources (liabilities & owner’s equity) and how these resources and claims have undergone change over a period of time.
e) Providing information as to how an organization is procuring & using various resources.
f) Providing information to various stakeholders regarding performance of management of an organization as to how diligently & ethically they are discharging their fiduciary duties & responsibilities.
g) Providing information to the statutory auditors which in turn facilitates audit.
h) Enhancing social welfare by looking into the interest of employees, trade union & Government.
6. (a) Discuss the important provisions need to be considered for financial reporting of Banking Companies and Insurance Companies. 6+5=11
Ans: DISCLOSURE OF ACCOUNTS AND BALANCE SHEETS OF BANKS (RBI Guidelines)
There are various types of users of the financial statements of banks who need information about the financial position and performance of the banks. The financial statements are required to provide the information about the financial position and performance of the bank in making economic decisions by the users. The important information sought by these users are, about bank’s Liquidity and solvency and the risks related to the assets and liabilities recognized on its balance sheet and to its off balance sheet items. This useful information can be provided by way of ‘Notes’ to the financial statements, hence notes become an integral part of the financial statements of banks. The users can make use of these notes and supplementary information to arrive at a meaningful decision. Some of the specific disclosure requirements in Bank’s financial statement are given below:
a) Presentation: Summary of Significant Accounting Policies’ and ‘Notes to Accounts’ may be shown under Schedule 17 and Schedule 18 respectively, to maintain uniformity.
b) Minimum Disclosures: While complying with the requirements of Minimum disclosures, banks should ensure to furnish all the required information in ‘Notes to Accounts’. In addition to the minimum disclosures, banks are also encouraged to make more comprehensive disclosures to assist in understanding of the financial position and performance of the bank.
c) Summary of Significant Accounting Policies: Banks should disclose the accounting policies regarding key areas of operations at one place (under Schedule 17) along with Notes to Accounts in their financial statements. The list includes – Basis of Accounting, Transactions involving Foreign Exchange, Investments – Classification, Valuation etc, Advances and Provisions thereon, Fixed Assets and Depreciation, Revenue Recognition, Employee Benefits, Provision for Taxation, Net Profit, etc.
d) Disclosure Requirements: In order to encourage market discipline, Reserve Bank has over the years developed a set of disclosure requirements which allow the market participants to assess key pieces of information on capital adequacy, risk exposures, risk assessment processes and key business parameters which provide a consistent and understandable disclosure framework that enhances comparability. Banks are also required to comply with the Accounting Standard 1 (AS 1) on Disclosure of Accounting Policies issued by the Institute of Chartered Accountants of India (ICAI). The enhanced disclosures have been achieved through revision of Balance Sheet and Profit & Loss Account of banks and enlarging the scope of disclosures to be made in “Notes to Accounts”.
e) Additional/Supplementary Information: In addition to the 16 detailed prescribed schedules to the balance sheet, banks are required to furnish the following information in the “Notes to Accounts”. Such furnished (information should cover the current year and the previous year). “Notes to Accounts” may contain the supplementary information such as:
1. Capital (Current & Previous Year) with breakup including CRAR – Tier I/II capital (%), % of shareholding of GOI, amount of subordinated debt raised as Tier II capital. Also it should show the total amount of subordinated debt through borrowings from Head Office for inclusion in Tier II capital etc.
2. Investments: Total amount should be mentioned in crores, with the total amount of investments, showing the gross value and net value of investments in India and Abroad. The details should also cover the movement of provisions held towards depreciation on investments.
3. Derivatives: Forward Rate Agreement/Interest Rates Swap: Important aspects of the disclosures would include the details relating to:
a. The notional principal of swap agreements;
b. Losses which would be incurred if counterparties failed to fulfill their obligations under the agreements;
c. Collateral required by the bank upon entering into swaps;
d. Nature and terms of the swaps including information on credit and market risk and the accounting policies adopted for recording the swaps etc.
4. Exchange Traded Interest Rate Derivatives: As regards Exchange Traded Interest Rate Derivatives, details would include the notional principal amount undertaken:
a. During the year (instrument-wise),
b. Outstanding as on 31st March (instrument-wise),
c. Outstanding and not “highly effective” (instrument-wise),
d. Mark-to-market value of exchange traded interest rate derivatives outstanding and not “highly effective” (instrument-wise).
f) Qualitative Disclosure: Banks should discuss their risk management policies pertaining to derivatives with a specific reference to the extent to which derivatives are used, the associated risks and business purposes served. This also includes:
a. The structure and organization for management of risk in derivatives trading,
b. The scope and nature of risk measurement, risk reporting and risk monitoring systems,
c. Policies for hedging and/or mitigating risk and strategies and processes for monitoring the continuing effectiveness of hedges/mitigants, and accounting policy for recording hedge and non-hedge transactions; recognition of income, premiums and discounts; valuation of outstanding contracts; provisioning, collateral and credit risk mitigation.
g) Quantitative Disclosures: Apart from qualitative disclosures, banks should also included the quantitative disclosures. The details are both Currency Derivatives and Interest rate derivatives.
h) Asset Quality: Banks’ performances are considered good based on the quality of assets held by banks. With the changing scenario and due to number of risks associated with banks like Credit, Market and Operational risks, banks are concentrating to ensure better quality assets are held by them. Hence, the disclosure needs to cover various aspects of asset quality consisting of:
a. Non-Performing Assets, covering various details like Net NPAs, movement of NPAs (Gross)/(Net) and relevant details provisioning to different types of NPAs including Write off/write-back of excess provisions, etc., Details of Non-Performing financial assets purchased, sold, are also required to be furnished.
b. Particulars of Accounts Restructured: The details under different types of assets such as (i) Standard advances (ii) Sub-standard advances restructured (iii) Doubtful advances restructured (iv) TOTAL with details number of borrowers, amount outstanding, sacrifice.
c. Banks disclose the total amount outstanding in all the accounts/facilities of borrowers whose accounts have been restructured along with the restructured part or facility. This means even if only one of the facilities/accounts of a borrower has been restructured, the bank should also disclose the entire outstanding amount pertaining to all the facilities/accounts of that particular borrower.
d. Details of financial assets sold to Securitization/Reconstruction Company for Assets Reconstruction.
e. Provisions on Standard Assets: Provisions towards Standard Assets need not be netted from gross advances but shown separately as ‘Provisions against Standard Assets’, under ‘Other Liabilities and Provisions – Others’ in Schedule No. 5 of the balance sheet.
f. Other Details: Business Ratios: (i) Interest Income as a percentage to Working Funds (ii) Non-interest income as a percentage to Working Funds (iii) Operating Profit as a percentage to Working Funds (iv) Return on Assets (v) Business (Deposits plus advances) per employee (vi) Profit per employee.
i) Assets Liability Management: As part of Assets Liability Management, the maturity pattern of certain items of assets and liabilities such as deposits, advances, investments, borrowings, foreign current assets, and foreign currency liabilities. Banks are required to disclose the information based on the maturity patterns covering daily, monthly and yearly basis.
j) Break up Exposures: Banks should also furnish details of exposures to certain sectors like Real Estate Sector.
Exposure to Capital Market: Capital Market exposure details should be disclosed for the current and previous year in crores. The details would include direct investment in equity shares, convertible bonds, convertible debentures and units of equity-oriented mutual funds the corpus of which is not exclusively invested in corporate debt and also loan raised against such securities. A bank must also disclose the risk associated with such investments. The risks are to be categorized as Insignificant, Low, Moderate, High, Very high, Restricted and Off-credit.
Apart from the above category of exposures, banks are required to disclose details relating to Single Borrower Limit (SGL)/Group Borrower Limit (GBL) exceeded by the bank, and Unsecured Advances are to be furnished. Miscellaneous items would include Amount of Provisions made for Income Tax during the year, and Disclosure of Penalties imposed by RBI, etc.
Financial Reporting Requirements of Insurance Companies in India
To protect the interests of policyholders and to increase transparency and credibility of insurance companies there is a need to have an effective regulatory system for financial reporting of insurance companies. Reporting requirements of insurance companies are different from that of other companies, because of the concept of policyholders and shareholders’ fund, segment reporting in respect of all the funds maintained by the company, complexity of insurance contracts and insurance itself is an intangible product.
Earlier the accounts of insurance companies were governed by Insurance Act 1938, but passing of Insurance Regulatory Development Authority Act (IRDA Act) in 1999 opened a new chapter for disclosure norms of insurance companies. In the year 2002, the IRDA came up with regulations for the preparation of the financial statements of insurance companies. According to the Insurance (Amendment) Act, 2002, the first, second and third schedules prescribed for balance sheet, profit and loss account and revenue account respectively as given in Insurance Act, 1938 have been omitted. Now revenue account, profit and loss account and balance sheet are to be prepared as per the formats prescribed by IRDA. However, the statutes governing financial reporting practices of insurance companies in India are: Insurance Act 1938, IRDA Act, 1999 (including IRDA Regulations), Companies Act and Institute of Chartered Accountants of India (ICAI).
IRDA Act 1999 (Including IRDA Regulations)
Insurance Regulatory Development Authority (IRDA) has prescribed various regulations from time to time. Preparation of Financial Statements and Auditor’s Report of Insurance Companies Regulations, 2002 are one of them. These regulations are related to the financial reporting practices of insurance companies. These regulations are important constituents of the Indian regulatory regime. According to the regulations made by the authority in consultation with the Insurance Advisory Committee, accounts of insurance companies are prepared according to the prescribed formats given by the authority. Details are given as under:
a) Preparation of Financial Statements: After the commencement of Insurance Regulatory Development Authority, Regulations, 2002, all the life insurance companies shall comply with the requirements of Schedule A and general insurance companies with Schedule B of these regulations while preparing their financial statements. The auditor’s report on the financial statements of all insurance companies shall be in conformity with the requirements of Schedule C. IRDA given the list of items to be disclosed in the financial statements of insurance companies under Part II of Schedule A (for life insurance companies) and Schedule B (for general insurance companies) of the (Preparation of Financial Statements and auditor’s report of Insurance Companies) Regulations, 2002. According to these regulations, following disclosure will form part of financial statements of insurance companies:
1. Every insurance company will disclose all significant accounting policies and accounting standards followed by them in the manner required under Accounting Standard I issued by the Institute of Chartered Accountants of India. (ICAI).
2. All companies will separately disclose if there is any departure from the accounting policies with reasons for such departure.
3. Disclosure of investments made in accordance with statutory requirements separately together with its amount, nature, security and any special rights in and outside India.
4. Disclosure of performing and non-performing investments separately.
5. Disclosure of assets to the extent required to be deposited under local laws for otherwise encumbered in or outside India.
6. All the companies are required to show sector-wise percentage of their business.
7. To include a summary of financial statements for the last five years in their annual report to be prepared as prescribed by the IRDA.
8. Disclose the basis of allocation of investments and income thereon between policyholders’ account and shareholders’ account.
9. To disclose accounting ratios as prescribed by the Insurance Regulatory and Development Authority.
Disclosure of following items is made by way of notes to balance sheet:
1. Contingent Liabilities.
2. Actuarial assumptions for valuation of liabilities for life policies in force.
3. Encumbrance’s to assets of the company in and outside India.
4. Commitments made and outstanding for loans, investments and fixed assets.
5. Basis of amortization of debt securities.
6. Claims settled and remaining unpaid for a period of more than six months as on the balance sheet date.
7. Value of contracts in relation to investments, for purchases where deliveries are pending and sales where payments are overdue.
8. Operating expenses relating to insurance business and basis of allocation of expenditure to various segments of business.
9. Computation of managerial remuneration.
10. Historical costs of those investments valued on fair value basis.
11. Basis of revaluation of investment property.
Or
(b) Discuss the guidelines of IRDA regarding disclosure of financial statements of Insurance Companies. Explain the RBI’s guidelines on the Financial Reporting of NBFCs. 6+5=11
Ans: IRDA Guidelines: Insurance Regulatory Development Authority (IRDA) has prescribed various regulations from time to time. Preparation of Financial Statements and Auditor’s Report of Insurance Companies Regulations, 2002 are one of them. These regulations are related to the financial reporting practices of insurance companies. These regulations are important constituents of the Indian regulatory regime. According to the regulations made by the authority in consultation with the Insurance Advisory Committee, accounts of insurance companies are prepared according to the prescribed formats given by the authority. Details are given as under:
a) Preparation of Financial Statements: After the commencement of Insurance Regulatory Development Authority, Regulations, 2002, all the life insurance companies shall comply with the requirements of Schedule A and general insurance companies with Schedule B of these regulations while preparing their financial statements. The auditor’s report on the financial statements of all insurance companies shall be in conformity with the requirements of Schedule C. IRDA given the list of items to be disclosed in the financial statements of insurance companies under Part II of Schedule A (for life insurance companies) and Schedule B (for general insurance companies) of the (Preparation of Financial Statements and auditor’s report of Insurance Companies) Regulations, 2002. According to these regulations, following disclosure will form part of financial statements of insurance companies:
10. Every insurance company will disclose all significant accounting policies and accounting standards followed by them in the manner required under Accounting Standard I issued by the Institute of Chartered Accountants of India. (ICAI).
11. All companies will separately disclose if there is any departure from the accounting policies with reasons for such departure.
12. Disclosure of investments made in accordance with statutory requirements separately together with its amount, nature, security and any special rights in and outside India.
13. Disclosure of performing and non-performing investments separately.
14. Disclosure of assets to the extent required to be deposited under local laws for otherwise encumbered in or outside India.
15. All the companies are required to show sector-wise percentage of their business.
16. To include a summary of financial statements for the last five years in their annual report to be prepared as prescribed by the IRDA.
17. Disclose the basis of allocation of investments and income thereon between policyholders’ account and shareholders’ account.
18. To disclose accounting ratios as prescribed by the Insurance Regulatory and Development Authority.
Disclosure of following items is made by way of notes to balance sheet:
12. Contingent Liabilities.
13. Actuarial assumptions for valuation of liabilities for life policies in force.
14. Encumbrance’s to assets of the company in and outside India.
15. Commitments made and outstanding for loans, investments and fixed assets.
16. Basis of amortization of debt securities.
17. Claims settled and remaining unpaid for a period of more than six months as on the balance sheet date.
18. Value of contracts in relation to investments, for purchases where deliveries are pending and sales where payments are overdue.
19. Operating expenses relating to insurance business and basis of allocation of expenditure to various segments of business.
20. Computation of managerial remuneration.
21. Historical costs of those investments valued on fair value basis.
22. Basis of revaluation of investment property.
b) Management Report: According to the IRDA Regulations 2002, all the insurance companies are required to attach a management report to their financial statements. The contents of the management report are given under PART IV (Schedule A and Schedule B) of these regulations and reproduced below:
1. Confirmation regarding the continued validity of the registration granted by the IRDA.
2. Certification that all the dues payable to the statutory authorities has been duly paid.
3. Confirmation to the effect that the shareholding patterns and the transfer of shares during the year are in accordance with the statutory or regulatory requirements.
4. Declaration that the management has not directly or indirectly invested outside India the funds of the policyholders.
5. Confirmation regarding required solvency margins.
6. Certification to the effect that no part of the life insurance fund has been directly or indirectly applied in contravention of the provisions of the Insurance Act, 1938 (4 of 1938) relating to the application and investment of the life insurance funds.
7. Disclosure with regard to the overall risk exposure and strategy adopted to mitigate the same.
8. Operations in other countries, if any, with a separate statement giving the management’s estimate of country risk and exposure risk and the hedging strategy adopted.
9. Ageing of claims indicating the trends in average claim settlement time during the preceding five years.
10. Certification to the effect as to how the values, as shown in the balance sheet, of the investments and stocks and shares have been arrived at, and how the market value thereof has been ascertained for the purpose of comparison with the values so shown.
11. Review of assets quality and performance of investment in terms of portfolio, i.e. separately in terms of real estate, loans, investments. Etc.
12. A schedule payments, which have been made to individuals, firms, companies and organizations in which directors of the insurance company are interested.
13) A responsibility statement indicating therein that:
Ø In the preparation of financial statements, the applicable amounting standards, principles and policies have been followed along with proper explanations relating to material departures, if any;
Ø The management has adopted accounting policies and applied them consistently and made judgements and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs of the company at the end of the financial year and of the operating profit or loss and of the profit or loss of the company for the year;
Ø The management has taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the applicable provisions of the Insurance Act, 1938 and Companies Act 1956 for safeguarding the assets of the company and for preventing and detecting fraud and other irregularities;
Ø The management has prepared the financial statements on a going concern basis;
Ø The management has ensured that an internal audit system commensurate with the size and nature of the business exists and is operating effectively.
Non-Banking Financial Company
A Non-Banking Financial Company (NBFC) is a company engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issue by Government or local authority or other marketable securities of a like nature, leasing, hire purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in instalments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).
Section 451 (c) of the RBI defines “financial institution”, A non-banking company carrying business of financial institution will be an NBFC. NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as:
a) NBFC cannot accept demand deposits;
b) NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself.
c) Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.
DISCLOSURES IN FINANCIAL STATEMENTS (RBI – GUIDELINES)
a) NBFCs with assets of Rs. 100 crore and above were required to make additional disclosures in their balance sheet from the year ending March 31, 2009 relating to CRAR, exposure to real estate sector (both direct and indirect), and maturity patterns of assets and liabilities respectively. The above disclosures are now applicable for NBFCs-ND-SI (as redefined) and for all NBFCs-D. However, other NBFCs already disclosing the above are encouraged to continue to do so, in line with prudent practice.
b) All NBFCs-D shall additionally disclose the following in their Annual Financial Statements, with effect from March 31, 2015:
1. Registration/license/authorization obtained from other financial sector regulators;
2. Ratings assigned by credit rating agencies and migration of rating during the year;
3. Penalties, if any, levied by any regulator;
4. Information viz., area, country of operation and joint venture partners with regard to Joint Ventures and Overseas Subsidiaries; and
5. Asset liability profile, extent of financing of parent company products, NPAs and movement of NPAs, details of all off-balance sheet exposures, structured products issued by them as also securitization/assignment transactions and other disclosures.
7. (a) “Accounting Standards aim to protect the users of financial reports in providing reliable and comparable accounting information.” Explain how these Accounting Standards do help accountants and auditors. 6+5=11
Or
(b) Discuss the need of International Financial Reporting Standards (IFRS). What are the differences between International Financial Reporting Standards and Accounting Standards? 5+6=11
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