Financial Statement Analysis Solved Papers May' 2015, Dibrugarh University B.Com 6th Sem

Financial Statements Analysis Solved Question Paper May' 2015
COMMERCE (Speciality)
Course: 602 (Financial Statement Analysis)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
 

The figures in the margin indicate full marks for the questions.

1. (a) Fill in the blanks with appropriate words:         1x5=5

(i) Financial statement analysis helps to measure ________ (Operating efficiency/Management efficiency/Employee’s efficiency)

(ii) GAAP stands for Generally Accepted Accounting Principles

(iii) Reporting to corporate governance reflects __________. (Company Management/Earning status/Socio economic status).

(iv) The institute of chartered accountants if India (ICAI) has decided to adopt IFRS in India from ____. (2011/2012/2013)

(v) According to IFRS, banking companies are to adopt _______ (Fair value accounting/Historical value accounting).

(b) State whether the following statements are true or false:                     1x3=3

(i) Financial statement analysis is an important means of assessing past performance and planning future performance. True

(ii) The new name of standards issued the ISAB is international financial reporting standards (IFRS).   True

(iii) Higher the price earnings ratio, better it is, as it indicates growth of the company.     False

2. Write short notes on any four of the following:     4x4=16

(a) Comparative statements

Ans: 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 are frequent changes in accounting policies.

(b) Significance of solvency ratio

Ans: Solvency Ratio/Debt to Total Funds Ratio: This ratio gives same indication as the debt-equity ratio as this is a variation of debt-equity ratio. This ratio is also known as solvency ratio. This is a ratio between long-term debt and total long-term funds.

Debt to Total Funds Ratio = Debt/Total Funds

Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Total Funds = Equity + Debt = Capital Employed

Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: Debt to Total Funds Ratios shows the proportion of long-term funds, which have been raised by way of loans. This ratio measures the long-term financial position and soundness of long-term financial policies. A higher proportion is not considered good and treated an indicator of risky long-term financial position of the business.

(c) Reporting of corporate governance

Ans: Report on Corporate Governance: There shall be a separate section on Corporate Governance in the Annual Reports of company, with a detailed compliance report on Corporate Governance. Non-compliance of any mandatory requirement of this clause with reasons thereof and the extent to which the non-mandatory requirements have been adopted should be specifically highlighted.

The companies shall submit a quarterly compliance report to the stock exchanges within 15 days from the close of quarter as per the format given latter. The report shall be signed either by the Compliance Officer or the Chief Executive Officer of the company.

Compliance: The company shall obtain a certificate from either the auditors or practicing company secretaries regarding compliance of conditions of corporate governance as stipulated in this clause and annex the certificate with the directors’ report, which is sent annually to all the shareholders of the company. The same certificate shall also be sent to the Stock Exchanges along with the annual report field by the company.

The non-mandatory requirements may be implemented as per the discretion of the company. However, the disclosures of the compliance with mandatory requirements and adoption (and compliance) / non-adoption of the non-mandatory requirements shall be made in the section on corporate governance of the Annual Report.

Information to be placed before Board of Directors

1.       Annual operating plans and budgets and any updates.

2.       Capital budgets and any updates.

3.       Quarterly results for the company and its operating divisions or business segments.

4.       Minutes of meetings of audit committee and other committees of the board.

5.       The information on recruitment and remuneration of senior officers just below the board level, including appointment or removal of Chief Financial Officer and the Company Secretary.

6.       Show cause, demand, prosecution notices and penalty notices which are materially important.

7.       Fatal or serious accidents, dangerous occurrences, any material effluent or pollution problems.

8.       Any material default in financial obligations to and by the company, or substantial nonpayment for goods sold by the company.

9.       Any issue, which involves possible public or product liability claims of substantial nature, including any judgement or order which, may have passed strictures on the conduct of the company or taken an adverse view regarding another enterprise that can have negative implications on the company.

10.   Details of any joint venture or collaboration agreement.

11.   Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property.

12.   Significant labour problems and their proposed solutions. Any significant development in Human Resources / Industrial Relations from like signing of wage agreement, implementation of Voluntary Retirement Scheme etc.

13.   Sale of material nature, of investments, subsidiaries, assets, which is not in normal course of business.

14.   Quarterly details of foreign exchange exposures and the steps taken by management to limit the risks of adverse exchange rate movement, if material.

15.   Non-compliance of any regulatory, statutory or listing requirements and shareholders service such as non-payment of dividend, delay in share transfer etc.

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(d) RBI guidelines regarding financial reporting of banks

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/mitigates, 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 include 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.

(e) Activity ratio

Ans: 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.

(f) Value-added statement

Ans: Value Added Statement is a financial statement that depicts wealth created by an organization and how is that wealth distributed among various stakeholders. The various stakeholders comprise of the employees, shareholders, government, creditors and the wealth that is retained in the business. As per the concept of Enterprise Theory, profit is calculated for various stakeholders by an organization. Value Added is this profit generated by the collective efforts of management, employees, capital and the utilization of its capacity that is distributed amongst its various stakeholders. Consider a manufacturing firm. A typical firm would buy raw materials from the market. Process the raw materials and assemble them to produce the finished goods. The finished goods are then sold in the market. The additional work that the firm does to the raw materials in order for it to be sold in the market is the value added by that firm. Value added can also be defined as the difference between the value that the customers are willing to pay for the finished goods and the cost of materials.

3. (a) What is meant by analysis of financial statement? How and in what way prospective investors are benefited through such analysis?    4+7=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) Discuss different types of financial statement.            11

Ans: Types of Financial statements

A set of financial statements includes (Types):

a)       Profit and loss account or Income statements

b)      Balance sheet or Position statements

c)       Cash flow statements

d)      Funds flow statements or

e)      Schedules and notes to accounts.

a) Profit and loss account or income statement: Income statement is one of the financial statements of business enterprises which shows the revenues, expenses, and profits or losses of business enterprises for a particular period of time. Its main aim to show the operating efficiency of the enterprises. Income Statement is sometime called the statement of financial performance because this statement let the users to assess and measure the financial performance of entity from period to period of the same entity or with competitors. 

b) Balance sheet or Position statement: Balance Sheet is sometime called statement of financial position. It shows the balance of assets, liabilities and equity at the end of the period of time. Balance sheet is sometime called statement of financial position since it shows the values of net worth of entity. The net worth of the entity can be obtained by deducting liabilities from total assets. It is different from income statement since balance sheet report account’s balance as on a particular date while income statement report that the account’s transactions during a particular period of time.

c) Cash flow statement: 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.

d) 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.

According to R.N. Anthony, “Fund Flow is a statement prepared to indicate the increase in cash resources and the utilization of such resources of a business during the accounting period.”

According to Smith Brown, “Fund Flow is prepared in summary form to indicate changes occurring in items of financial condition between two different balance sheet dates.”

From the above discussion, it is clear that the fund flow statement is statement summarising the significant financial change which have occurred between the beginning and the end of a company’s accounting period.

e) Schedule and notes to account: The notes to the financial statements are integral part of a company's external financial statements. They are necessary because not all relevant financial information can be communicated through the amounts shown (or not shown) on the face of the financial statements. Generally, the notes are the main method for complying with the full disclosure principle and are also referred to footnote disclosures. The first note to the financial statements is usually a summary of the company's significant accounting policies for the use of estimates, revenue recognition, inventories, property and equipment, goodwill and other intangible assets, fair value measurement, discontinued operations, foreign currency translation, recently issued accounting pronouncements, and others.

The first note is followed by many additional notes that contain the details (including schedules of amounts) for items such as inventories, accrued liabilities, income taxes, employee benefit plans, leases, business segment information, fair value measurements, derivative instruments and hedging, stock options, commitments and contingencies, and more. Each external financial statement should also include a reference (usually as footer) which states that the accompanying notes are an integral part of the financial statements.

4. (a) From the following balance sheet of Assam Co. Ltd as on 30th June, 2014, calculate the following:   3x4=12

(i) Debt to equity ratio

(ii) Current ratio

(iii) Quick ratio

(iv) Working capital turnover ratio

Balance Sheet of Assam Co. Ltd

AS on 30th June, 2014

Liabilities

Amount

Assets

Amount

Equity Share capital

Capital Reserve

12% loan

Creditors

Bank overdraft

Provision for taxation

Profit and loss account

28,000

5,600

22,400

11,200

2,800

5,600

8,400

Goodwill

Fixed Assets

Stock

Debtors

Short-term investment

Cash in hand

Underwriting commission

13,600

39,200

8,400

8,400

4,800

4,800

4,800

84,000

84,000

Additional Information: Sales Rs. 25,200

Or

(b) What are the categories under which various ratios are grouped? What purposes are served by profitability ratios? 6+6=12

Ans: CLASSIFICATION OF RATIOS

The ratios are used for different purposes, for different users and for different analysis. The ratios can be classified as under:

a)       Traditional classification

b)      Functional classification

c)       Classification from user ‘s point of view

1) Traditional classification: As per this classification, the ratios readily suggest through their names, their respective resources. From this point of view, the ratios are classified as follows.

a) Balance Sheet Ratio: This ratio is also known as financial ratios. The ratios which express relationships between two items or group of items mentioned in the balance sheet at the end of the year. Example: Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio, Proprietary ratio, etc.

b) Revenue Statement Ratio: This ratio is also known as income statement ratio which expresses the relationship between two items or two groups of items which are found in the income statement of the year. Example: Gross Profit ratio, operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover ratio, Operating Profit ratio.

c) Combined Ratio: These ratios show the relationship between two items or two groups of items, of which one is from balance sheet and another from income statement (Trading A/c and Profit & Loss A/c and Balance Sheet). Example: Return on Capital Employed, return on Proprietors' Fund ratio, return on Equity Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover ratio.

2) Functional Classification of Ratios: The accounting ratios can also be classified according their functions as follows:

a) Liquidity Ratios: These ratios show relationship between current assets and current liabilities of the business enterprise. Example: Current Ratio, Liquid Ratio.

b) Leverage Ratios: These ratios show relationship between proprietor's fund and debts used in financing the assets of the business organization. Example: Capital gearing ratio, debt-equity ratio, and proprietary ratio. This ratio measures the relationship between proprietor’s fund and borrowed funds.

c) 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.

d) Profitability Ratio: These ratios show relationship between profits and sales and profit & investments. It reflects overall efficiency of the organizations, its ability to earn reasonable return on capital employed and effectiveness of investment policies. Example: i) Profits and Sales: Operating Ratio, Gross Profit Ratio, Operating Net Profit Ratio, Expenses Ratio etc. ii) Profits and Investments: Return on Investments, Return on Equity Capital etc.

e) Coverage Ratios: These ratios show relationship between profit in hand and claims of outsiders to be paid out of profits. Example: Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage Ratio.

3) Classification from the view point of user: Ratio from the users' point of view is classified as follows:

a) Shareholders' point of view: These ratios serve the purposes of shareholders. Shareholders, generally expect the reasonable return on their capital. They are interested in the safety of shareholder’s investments and interest on it. Example: Return on proprietor's funds, return on capital, Earning per share.

b) Long term creditors: Normally leverage ratios provide useful information to the long term creditors which include debenture holders, vendors of fixed assets, etc. The creditors interested to know the ability of repayment of principal sum and periodical interest payments as and when they become due. Example: Debt equity ratio, return on capital employed, proprietary ratio.

c) Short term creditors: The short-term creditors of the company are basically interested to know the ability of repayment of short-term liabilities as and when they become due. Therefore, the creditors have important place on the liquidity aspects of the company's assets. Example: a) Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c) Stock working capital Ratio.

d) Management: Management is interested to use borrowed funds to improve the earnings. Example: Return on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.

Purpose of Profitability Ratios

There are various groups of people who are interested in analysis profitability of a company. Ratio analysis helps the various groups in the following manner:

a) To work out the profitability: Profitability ratios 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: Profitability ratios 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 Profitability ratios 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: Profitability ratios are very useful as they briefly summaries the result of detailed and complicated computations.

e) Helpful for forecasting purposes: Profitability 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.

5. (a) Define financial reporting. Discuss the qualitative characteristics which make financial reporting more useful for its users.                    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 use 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)

Qualitative Characteristics of Financial Reports

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. The Qualitative characteristics of useful financial reporting identify the types of information which are likely to be most useful to users in making decision about the reporting authority on the basis of information in its financial report. Financial information is useful when it is relevant and presented faithfully. Some of the qualitative characteristics which makes the financial reports useful to its users are given below:

a)       Relevance: Information is relevant if it would potentially affect or make a difference in users’ decisions. A related concept is that of materiality i.e. information is considered to be material if omission or misstatement of the information could influence users’ decisions.

b)      Faithful Representation: This means that the information is ideally complete, neutral, and free from error. The financial information presented reflects the underlying economic reality.

c)       Comparability: This means that the information is presented in a consistent manner over time and across entities which enables users to make comparisons easily.

d)      Materiality: Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity's financial report.

e)      Verifiability: This means that different knowledgeable and independent observers would agree that the information presented faithfully represents the economic phenomena it claims to represent.

f)        Timeliness: Timely information is available to decision makers prior to their making a decision.

g)       Understandability: This refers to clear and concise presentation of information. The information should be understandable by users who have a reasonable knowledge of business and economic activities and who are willing to study the information with diligence.

h)      Transparency: This means that users should be able to see the underlying economics of a business reflected clearly in the company’s financial statements.

i)        Comprehensiveness: A framework should encompass the full spectrum of transactions that have financial consequences.

j)       Consistency: Similar transactions should be measured and presented in a similar manner across companies and time periods regardless of industry, company size, geography or other characteristics.

Or

(b) What do you mean by ‘social benefits’ and ‘social costs’? What suggestions would you give to improve the disclosure practices in reporting of corporate social responsibility?        4+4+3=11

6. (a) Discuss the purpose underlying the issue of an accounting standard. How has global accounting standards (IFRS) affected Indian GAAP?                  7+4=11

Or

(b) What do you mean by international financial reporting standard (IFRS)? Discuss the role played by the ICAI in convergence of Indian GAAP with IFRS.                 5+6=11

7. (a) Discuss the suggestions made by RBI’s advisory group on accounting and auditing in financial reporting of banks and FIs.       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:

5.       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.

6.       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.

7.       Derivatives: Forward Rate Agreement/Interest Rates Swap: Important aspects of the disclosures would include the details relating to:

e.       The notional principal of swap agreements;

f.        Losses which would be incurred if counterparties failed to fulfill their obligations under the agreements;

g.       Collateral required by the bank upon entering into swaps;

h.       Nature and terms of the swaps including information on credit and market risk and the accounting policies adopted for recording the swaps etc.

8.       Exchange Traded Interest Rate Derivatives: As regards Exchange Traded Interest Rate Derivatives, details would include the notional principal amount undertaken:

e.       During the year (instrument-wise),

f.        Outstanding as on 31st March (instrument-wise),

g.       Outstanding and not “highly effective” (instrument-wise),

h.       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:

d.       The structure and organization for management of risk in derivatives trading,

e.       The scope and nature of risk measurement, risk reporting and risk monitoring systems,

f.        Policies for hedging and/or mitigating risk and strategies and processes for monitoring the continuing effectiveness of hedges/mitigates, 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 include 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:

g.       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.

h.       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.

i.         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.

j.         Details of financial assets sold to Securitization/Reconstruction Company for Assets Reconstruction.

k.       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.

l.         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.

Or

(b) Explain the following:                              6+5=11

(i) IFRS – 4

Ans: IFRS 4 - Insurance contracts: An insurance contract is that where one party (the insurer) accepts the insurance risk of another party (the policy holder) by agreeing to reimburse the amount of policy to the policy holder if any specified uncertain future events occur and adversely affect the policy holder. The primary objective of this IFRS for an entity is to determine the financial reporting for the issued insurance contracts (described in this IFRS as an insurer) until the Board completes the second phase of its project on insurance contracts.

(ii) Financial reporting of NBFC as per RBI’s Guidelines

Ans: RBI – GUIDELINES REGARDING FINANCIAL STATEMENTS OF NBFC’S

The issues related to accounting include Income Recognition criteria, Accounting of Investments, asset classification and provisioning requirements. These have been provided in details in the RBI Directions, namely “Non-Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015” and “Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015”.

RBI has prescribed that Income recognition should be based on recognised accounting principles, however Accounting Standards and Guidance Notes issued by the Institute of Chartered Accountants of India (referred to in these Directions as “ICAI” shall be followed in so far as they are not inconsistent with any of these Directions.

Income Recognition

1.       The income recognition of NBFCs, irrespective of their categorisation, shall be based on recognised accounting principles.

2.       Income including interest/ discount/ hire charges/ lease rentals or any other charges on NPA shall be recognised only when it is actually realised. Any such income recognised before the asset became non-performing and remaining unrealised shall be reversed.

3.       Income like interest /discount /any other charges on NPAs shall be recognised only when actually realised, RBI also requires that income recognised before asset becoming NPA should be reversed in the financial year in which such asset becomes NPA.

4.       The NBFCs are required to recognise income from dividends on shares of corporate bodies and units of mutual funds on cash basis, unless the company has declared the dividend in AGM and right of the company to receive the same has been established, in such cases, it can be recognized on accrual basis.

5.       Income from bonds and debentures of corporate bodies and from government securities/bonds may be taken into account on accrual basis provided it is paid regularly and is not in arrears.

6.       Income on securities of corporate bodies or public sector undertakings may be taken into account on accrual basis provided the payment of interest and repayment of the security has been guaranteed by Central Government.

Principles for accounting of Investments

Investing is one of the core activities of NBFCs, hence RBI requires the Board of Directors to Frame investment policy of the company and implement the same. The investments in securities shall be classified into current and long term, at the time of making each investment. The Board of the company should include in the investment policy the criteria for classification of investments into current and long-term. The investments need to be classified into current or long term at the time of making each investment. There can be no inter-class transfer of investments on ad hoc basis later on. Inter class transfer, if warranted, should be done at the beginning of half year, on April 1 or October 1, and with the approval of the Board. The investments shall be transferred scrip-wise, from current to long-term or vice-versa, at book value or market value, whichever is lower;

The depreciation, if any, in each scrip shall be fully provided for and appreciation, if any, shall be ignored.

Moreover, the depreciation in one scrip shall not be set off against appreciation in another scrip, at the time of such inter-class transfer, even in respect of the scrips of the same category.

Valuation of Investments

A) The directions also specifies various valuation guidelines in respect of Quoted and Unquoted current investments leaving the Long Term Investments to be valued as per ICAI Accounting Standards. It requires Quoted current investments to be grouped into specified categories, viz. (i) equity shares, (ii) preference shares, (iii) debentures and bonds, (iv) Government securities including treasury bills, (v) units of mutual fund, and (vi) others.

The valuation of each specified category is to be done at aggregate cost or aggregate market value whichever is lower. For this purpose, the investments in each category shall be considered scrip-wise and the cost and market value aggregated for all investments in each category. If the aggregate market value for the category is less than the aggregate cost for that category, the net depreciation shall be provided for or charged to the profit and loss account. If the aggregate market value for the category exceeds the aggregate cost for the category, the net appreciation shall be ignored. Depreciation in one category of investments shall not be set off against appreciation in another category.

B) Unquoted equity shares in the nature of current investments shall be valued at cost or break-up value, whichever is lower. However, the RBI Directions has prescribed that fair value for the break-up value of the shares may be replaced, if considered necessary.

C) Unquoted preference shares in the nature of current investments shall be valued at cost or face value, whichever is lower.

D) Investments in unquoted Government securities or Government guaranteed bonds shall be valued at carrying cost.

E) Unquoted investments in the units of mutual funds in the nature of current investments shall be valued at the net asset value declared by the mutual fund in respect of each particular scheme.

F) Commercial papers shall be valued at carrying cost.

G) A long term investment shall be valued in accordance with the Accounting Standard issued by ICAI.

Preparation of Balance Sheet and Profit and Loss Account

1.       Every non-banking financial company shall prepare its balance sheet and profit and loss account as on March 31 every year. Whenever a non-banking financial company intends to extend the date of its balance sheet as per provisions of the Companies Act, it should take prior approval of the Reserve Bank of India before approaching the Registrar of Companies for this purpose.

2.       Further, even in cases where the Bank and the Registrar of Companies grant extension of time, the nonbanking financial company shall furnish to the Bank a proforma balance sheet (unaudited) as on March 31 of the year and the statutory returns due on the said date. Every non-banking financial company shall finalise its balance sheet within a period of 3 months from the date to which it pertains.

3.       Every non-banking financial company shall append to its balance sheet prescribed under the Companies Act, 2013, the particulars in the schedule as set out in Annex I.

Disclosures in the Balance Sheet

1.       The directions specify certain disclosure requirements in the balance sheet.

2.       Disclosure of provisions created without netting them from the income or against the value of assets. The provisions shall be distinctly indicated under separate heads of account as (i) Provisions for bad and doubtful debts; and (ii) Provisions for depreciation in investments.

3.       Provisions shall not be appropriated from the general provisions and loss reserves held. Provisions shall be debited to the profit and loss account.

4.       The excess of provisions, if any, held under the heads general provisions and loss reserves may be written back without making adjustment against the provisions.

5.       Every non-banking financial company shall append to its balance sheet prescribed under the Companies Act, 2013, the particulars in the schedule as set out in Annex I.

6.       The following disclosure requirements are applicable only to systemically important (Asset Size more than Rs. 500 crores) non-deposit taking non-banking financial company:

a)       Capital to Risk Assets Ratio (CRAR);

b)      Exposure to real estate sector, both direct and indirect; and

c)       Maturity pattern of assets and liabilities.”

7. The formats for the above disclosures are also specified by RBI.

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