16 Jun 2015 14:48 IST

Reading between the lines

A thorough reading of accounting policies is critical to making sense of numbers in financial statements

Reading financial statements can be an uphill task. It has never been an easy exercise for stakeholders, leave alone lay persons. The way various disclosures in the financial statements are worded usually leave the readers more confused than informed on a company’s financial position because they are laden with jargon.

Financial Statements

Financial statements usually consist of a balance sheet, also known as a ‘statement of financial position’, detailing a company’s assets, liabilities and owners’ equity or net worth.

The balance sheet, together with the income statement — showing profit and loss — and cash-flow statement, are the cornerstone of any company’s financial statements. A list of significant accounting policies and notes to the financial statements are added to provide clarity.

Financial statements should comply with the Companies Act, 2013 (the Act) in form and content, with additional disclosures as required by the accounting standards specified by the Companies (Accounting Standards) Rules, 2006 notified by the government.

Financial statements enable viewers to get a precise picture of the items included within, particularly those that have the potential to impact results. They also act a barometer for gauging the company’s health.

Let’s take a simple example of depreciation being charged by the company. The Act requires companies to follow the useful lives of assets as given in Schedule II. However, companies can follow a different ‘useful life’ basis to compute depreciation if it is justified by a technical evaluation.

Although the pattern of usage of fixed assets may remain the same for both, while one company may choose to adopt the ‘useful life’ as prescribed by the Act, another may decide to carry out a technical revaluation of its fixed assets and provide for depreciation based on the higher/ lower useful life of the assets. This would result in the latter having a lower/ higher profit as compared to the first company, all other factors remaining the same.

Further, as part of the transition provisions, Schedule II provides that the carrying amounts of assets whose remaining useful life is nil, can be recognised either in the statement of profit and loss or against the opening balance of retained earnings — that is, surplus in the profit and loss account.

Writing off assets

To illustrate, if a company has an asset that is being depreciated over a period of 10 years, of which eight have already elapsed, whereas the useful life of the asset is only eight years as per Schedule II, the carrying amount of the asset as at the date of transition, can be written off in the statement of profit and loss, or in the balance sheet against the surplus in profit and loss (P&L) account.

Certain companies applying these transitional provisions may prefer writing off such assets against the retained earnings so that the annual profitability would not be impacted on this count, while others may prefer routing such amounts through the P&L statement to show the impact on their profitability.

A third facet of depreciation is its computation based on the components contained in the fixed asset, rather than on the fixed asset as a whole. This concept, hitherto mentioned in Accounting Standard (AS) 10, and AS 6, Depreciation Accounting has now been made part of Schedule II itself, and requires companies to evaluate if it is likely that the useful life of a part (component) of an asset is longer/ shorter than that of the asset as a whole and it retains a separate identity of its own.

In such cases, the company should make an estimate of the useful life of such part (component) and depreciate it over its useful life, which may be longer/ shorter than the useful life of the asset.

Most companies have intangible assets, either internally developed or purchased, which may also include goodwill arising on an amalgamation in the nature of purchase.

Such goodwill represents a payment in anticipation of future income, and should be amortised over its useful life, on a systematic basis. However, it is often difficult to estimate its useful life with reasonable certainty. Accounting Standard (AS 14), requires companies to amortise goodwill over a period not exceeding five years, unless a longer period can be justified.

The estimation of the period of amortisation, which is made on a prudent basis may be considered differently by each company. The estimate made by a company is important as it directly impacts the profitability of the company on a year-on-year basis.

In some instances, the financial statements may reveal that the company has entered into a scheme of arrangement during the year. The accounting treatment prescribed in the scheme could include those not presently envisaged under the Accounting Standards, for example, setting off carried forward losses against the securities premium account.

On approval of the scheme by regulatory authorities, the accounting treatment contained therein overrides the accounting treatment given in the accounting standards, and the company would be required to follow the scheme-prescribed treatment. This could result in its financials reflecting a position different from that of another company for which this accounting treatment is not prescribed.

The examples given above clearly demonstrate the importance of AS 1, which deals with disclosure of accounting policies, which require companies to disclose all their significant accounting policies in the financial statements. Reading of these accounting policies is therefore critical to understand the numbers given in the financial statements and the rationale for adopting certain accounting treatment.

(With inputs from Madhumathi L, Associate Director)

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