Tuesday, August 30, 2011

Socrates Teaches Balance Sheet

Of late, I am trying to adapt socractic method of teaching. Here is my attempt to explain the concept of Balance Sheet using one of the most intuitive methods of teaching.

The teacher enters the class and writes on the board - Balance Sheet. Then he asks one of the most studious student in class, "Can you please define this for us?"

"A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders."

Ramesh the mathematics wizard of the batch adds:

The balance sheet is based on the following formula. Assets = Liabilities + Shareholders' Equity

The teacher thanks both and asks his next question "Could you please tell me what is the relevance of specific point in time."

Ravi who always loves to show his ability to understand concepts chips in "It is akin to standing at a particular point and looking in the future. The teacher is elated as Ravi has taken in the direction he wanted the discussion to follow.
The teacher then asks what do you mean by company's assets, liabilities and shareholders' equity . Ramesh who likes rules based approaches and has not spoken yet jumps at this chance "We assume we are standing on that particular date and we look at the future. Every item then is put through a test based on the following rules.:
1. If the item creates a benefit in the future it is known as an asset.
2. If the item creates an obligation in the future it can either be a liability or equity.
3. If the item has an obligation in the future towards the people who run the business the term owner's equity is used.
4. If the obligation is created towards outsiders the term liability is used.

The teacher then started throwing terms at the class. The class knew exactly what to do. They had to explain the term and then with reasons categorize it. As asset liability or equity. This is the list of answers he got:

1, Share capital - A future obligation to pay the amount invested to "owners", The class had also pointed out that there could be two classes of shares: equity shares and preference shares.
a. Equity Share Capital - referred to shares that had uncertain level of dividends.Investors generally invested in this class of shares to make profit out of change in profits. During wounding up of company they would be the last ones to be paid.

b. Preference Share Capital - The teacher loved to call this class of shares as quasi debt because dividends on these shares were fixed akin to interest on debts.

c.Debentures - are credit instruments that have fixed interest rates. Raj had added that to be make debentures interesting a lot of companies these days were adding a clause which made them convertible. Convertible debentures, had the feature wherein it would convert to equity shares as and when the need

c.Stock Options and Warrants - are a class of liability that the holders of the instrument have a right to exercise after a specified period of time.

d. Reserves and Surplus: The part of profit that is transferred to the balance sheet is accumulated as Reserves and Surplus in Balance Sheet. Generally, the company decides on the particular reserve in which it wants to transfer the profit.In certain sectors such as Banking the government regulates the amount to be transferred to statutory reserves to ensure the solvency of the firm.
The amounts transferred to the balance sheet is profit net of dividends paid out to the shareholders and is known as retained earnings. As the reserves and surplus is transferred technically out of net profit which is the the reward of Equity shareholders for taking risks, Hence,it is shown along with the capital as it is the obligation to be paid to the equity shareholders.

e. Current Liabilities:

Refers to the liabilities or obligations that the company needs to pay in the the short term. It includes
A. Accounts Payable/ Creditors - amount to be paid with respect to credit purchases ONLY for goods pertaining to SALES.
B. Bank Overdraft - Amount withdrawn in excess of bank balance.
C. Outstanding Expenses - Expenses which have not been paid yet.

On the asset side the class mentioned items such as :

1. Fixed Assets which consists of both tangible and intangible assets.
Tangible Fixed Assets include Plant Property and Equipment (PP&E). They also added that the tangible assets include those fixed Assets which can be seen.
Intangible assets include Goodwill and Patents.
2. Investments include investments of companies in different classes of instruments.
3. Current Assets include those assets which have a benefit of less than one year. The students could not elaborate much on current assets due to lack of time. However,it became clear the items had a benefit of not more than one year.It was also clear from the discussion that current assets included accounts receivable which shows the accumulated credit sales; cash;inventories and prepaid expenses.The teacher added that some companies prefer to show current asset as net of current liabilities.
He ended the discussion by adding the following points :

1. He told the students that fixed assets are recorded in the books on net book value (value at which it was purchased less depreciation/amortization) not at the prevailing market value.On the other hand inventories was recorded at book value or market value whichever is lower.

2. He reminded the students that liabilities are recorded in the books at book value too.

3. On the other hand equity share was recorded at face value. According to the teacher this face value was different from market value at which it was issued.

4. He ended the discussion with the caveat that list he has given is not exhaustive,and student should use the socractic method to tackle any new items he encounters.

He also asked them to refer to www.investopedia.com to look for terms that they were still confused with.

Saturday, August 27, 2011

Income Statement - A score keeper versus book keeper

We have always been blaming accounts for not being intuitive. However, the perspective at which we have been looking at an accountant is what should be blamed rather than the school of knowledge on which accounts is based.

To look at it from the right perspective,it is important to understand that the job of the accountant is akin to that of a score keeper. He needs to understand the rules of the games and make entries in the books so as to represent the financial transactions of the entity in the same way in which the score keeper records the proceedings of the games. Each game has a rule in the same way each book has its rules too.

To illustrate, I have taken PROFIT AND LOSS ACCOUNT statement:

Following are the rules of this game:
1. Expenses and Income related to a particular year are the players who participate in the game
2. Expenses are recurring (occur again and again) in nature and it does not matter wether thay are paid or outstanding
3. Income is also recurring and it does not matter wether thay are received or outstanding
4. Purchase and Sale of Assets and Liablities are not recorded in income statement.
5. However profit or Loss from sale of asset is recorded. Similarly fall in the value of fixed assets which is known as depreciation is recorded in the books as expense.
Now there are two sides to the score board we maintain: Debit and credit:
6. We debit all expenses and we credit all income gains.Profit or Loss is the final score.
7. Dividend is distibution of income and not income hence does not appear in the income statement.
So any book keeper who wants to be as efficient as a score keeper and contribute to the success of the company has to remember thes rules.
Now if you look at the book with these rules in mind; I am sure accounts will be more intuitive.