FADM 1, Class 2

FADM 1 - Professor Ramana

Class 2

Questions to be asked, while looking at the balance sheet:

v How the business is financing itself?

v If it is from equity, how much reserves are contributing to the financing of assets (In TCS in 2010, equity contributed 74%, out of which reserves contributed 98%).

v Is the company declaring dividend?

Google has a policy not to give dividend. Then why it is good from shareholder’s perspective?

Reason for good: If a shareholder receives dividend, he is going to invest the money & use only a part of it. As per assumption in finance, a company is a better investor than an individual. Hence, it is good that company invests on behalf of investor / shareholder & not declare dividend. This news makes the price of the share go up. This change in share price is higher than dividend supposed to be declared. (Signaling theory of dividend / financing decision – Company is hungry for growth, they do not want to keep their cash idle)

Can equity be negative – YES, as loss has eaten away my capital, called CAPITAL EROSION (Heavy reduction in market price of asset may result in complete erosion of my equity; (-)Retained profit > Capital). The company will be called a SICK company. Hence, equity is an indicator of health of a company.

Focus on E+L means focus on financing decisions (Financing from equity or liability)

v Business Decisions – Financing decisions (from Equity / Liability), Investment (in assets), Operations (to run day to day operations)

v Income (IS), Expense (IS), Asset (BS), Liability (BS), Equity (BS) – Financial Items

v Financial Statements – BS, CFS, IS

v Process is called Financial Accounting governed by GAAP (Generally accepted accounting principle) & is understood by accounting equation (A = E + L)

Process governed by GAAP

v Concepts & Conventions

o Dual Aspect Concept – That every business decision will affect Source (S) only, Asset (A) only for S & A such that S=A (where, Source = Equity + Liability)

§ Purchase of Plant for Cash – Plant (Asset) goes up & Cash (Current Asset) goes down. Hence, only assets are affected

§ Sell Plant for Cash – Plant (Asset) goes down, Cash (CA) goes up as well as there is profit. Hence, both A & S is affected

§ Declaring cash dividend – Retained earnings (Equity) goes down & Cash goes down (Current Asset). Hence, both Asset & Source is affected

§ When one company acquire other (like TATA steel acquiring CORUS, it can be either through issuing new shares (Capital goes up), taking debt (debt goes up), payment from retained profit (Retained earnings goes down))

v Accounting Period – Accounting is a continuous activity. Accounting period is the period for which the profit is determined.

§ Statutory accounting period - which is by default annual or quarter

§ Managerial Accounting Period – Can be anything (even weekly)

§ Balance the BS after the end of the accounting period

v Accrual Concept

o It is used for recording the transaction.

o Transaction is recorded in books at the time of happening (of the transaction) & not at the time of actual realization / payment. Example: If company buys a good on credit, creditor goes up & goods come on asset side of the same amount. Hence, BS is balanced. Still, I need to record this in Income Statement as per accrual concept (It is not in cash flow statement, as there is no cash transaction)

o Governments do not follow accrual concept. If they follow it, they might become bankrupt tomorrow

v Matching Concept

o It is used for determining the profit

o Profit is excess of revenue over the corresponding expenses

§ Profit = Revenue for the period – Expenses for the period

§ Asset = Unexpired Benefit, irrespective payment has been done or not. Ex – Excess rent paid is an unexpired benefit, hence, referred as an asset. Also, excess rent paid means I can keep the plant with me for extra time to generate future cash flows, which is what an asset does; Expense = Benefit has expired within the accounting period. Rent accrued in the accounting period is an Expense.

v Accounting Standards (IFRS)

v Laws

Limitation of Accounting Equation (E+L = A)

One can’t directly look & tell how much money has been paid for expense / income (though accounting equation captures all the transactions)

Balance Sheet (Working Definition)

It is (a reflection of) an accounting equation on a particular date. Hence, BS shows sources & assets of a particular company on a specific date. (Accounting equation changes with every transaction)

Profit & Cash are changing in Accounting Equation (all other items are more or less constant), for which management is answerable. Hence, Income Statement & Cash flow statement is necessary. Hence, statutory financial statements are BS, IS, CFS.

From Business Decisions to Financial Statements

v Financial statements

o Governed by IAS – 1 (International Accounting Standard)

§ BS: Shows financial position of a company as on a particular date

· A(Assets)=E(Equity)+L(Liability)

§ IS: Financial performance for the accounting period (over a period of time)

· P(Profit)=I(Income)-E(Expense)

§ CFS: Changes in the cash flows (Answers why the cash is changing)

· C(Cash) = R(Receipt)-P(Payment)

o Why is the profit not same as cash?

§ Receipts Vs Income – All receipts are not Income (Loan is a liability – A receipt, but not an Income). Cash Sales is a receipt as well as an income.

· A receipt can be an income, a liability or sale of an asset

§ Payment Vs Expense – All payments are not expense. One pays money (Payment) towards an expense, to acquire an asset or to reduce the liability.

§ Hence, managing profit (Income & Expense – Role of Operations Manager) is not same as that of cash (Postponing / proponing the payments – Role of Treasury).

o Managing Profit / bottom line is not same as managing Revenue / Sales / business / top line / market share?

§ Maximization of revenue might eat away the profit (More ads, more hiring of employees). Instead, maximizing profit may mean reducing revenue / business to focus on key customers.

§ Telecom companies Top line has come down (low pricing resulted in decrease in revenue), but profits has gone up (Due to volumes, efficient process management, cost-cutting)

All items of an Income statement (netted off) hit the retained profit only….and liability is not recorded in any income statement/different from income statement

Buying goods is an asset, but not an income / expense as the benefit has not expired. But when the goods are sold, the benefit to me expires. Hence, at that time, needs to be captured in the income statement.

v COGS is an expense (benefit expired / already sold it), Goods / Stock is an Asset.

v Advanced Salary / Unexpired benefit (4,000) = Total Benefit / Total Salary Paid (6,000) – Salary for the month / Expired Benefit (2,000)

v For loan interest, in case I don’t pay cash, Create Interest payable as liability

v Profit can be distributed or retained (as Source – Retained Profit)

v Advance Salary, Advance Rent, CIH are all Current Liability

v Why Profit is not equal to cash

o If I pay interest of loan or do not pay, I need to recognize it in IS as expense. But, in CFS it only comes if it is paid, else it comes as liability