# Financial System Analysis

## 6th Semester

1. (a)Fill in the blanks with appropriate word(s): 1X 5=5

(1)Comparative Statement analysis is also known as Horizontal analysis (vertical analysis\ static analysis\ horizontal analysis).

(2)The Board of directors of a company has primary responsibility for the corporation is external financial reporting functions(management\members\board of directors).

(3) All present ASB of ICAI formulates the AS based on IAS (GAAP/IFRS/IAS)

(4)Ratio of net profit before interest and taxes to sales is operating profit ratio (net profit/profit/operating profit).

(b) State whether the following statement are true and false: 1 X 3=3

(1)Analysis of financial statement ignores the issues of price level change.

Ans: True

(2) Capital gearing is a term used to express the relationship between ordinary share capital and fixed interest bearing securities of a company .

Ans: True

(3) The IRDA was incorporated as statutory body in April 1999.

Ans: False

2. Write short note on the following (any four): 4 X 4=16

(a)Common Size Statement:

Ans: Common Size Financial Statement are the statement in which amount of individual items of Balance Sheet and Profit and Loss Account (or Income Statement) for two or more years and written . These amount are further converted into Percentages to the same common base . This types of analysis is called vertical Analysis since each accounting variable is analyzed vertically. Common size Financial Statements usually involve the Balance Sheet and the Income Statement.

Common Size Income Statement is an income Statement in which each amount is expressed as a percentage of value of sales. There are two objectives of Common Size Income Statement are as follow:-

1. To analyze the changes in individual item of Income Statement and Comparison of each individual item in terms of total sales.
2. To study the trend relating to different items of Income and Express.

Common Size Balance Sheet presents not only the Standard information contained in a balance as a percentage of the total assets or as a percentage of total liabilities and shareholders’ equity. The objectives of Common Size Balance Sheet are-

1) To study the changes in individual item of Balance Sheet.

2) To highlight the trends in different items of assets and liabilities.

3) To judge the financial soundness and understanding financial strategy of different firms in the same industrial.

(b) Trend Analysis

Ans: It is a analysis of financial data over time to a establish a trend which facilitates comparison of results. The Trend Analysis is also called the ‘Trend Percentage Analysis’. The “Trend Percentage” are also referred to as ‘Trend Ratios’. Trend Analysis determines the direction, upwards or down wards. This process involves computation of percentage relationship that each item bears to the item in relation to the base year. This method of analysis is adopted to ascertain the direction upward or download .It helps an analyst of financial statements to form an option as to whether favorable of unfavorable tendencies have developed . Trend Analysis is used as a tool for forecasting .

Steps for preparing Trend Percentage Analysis Statement:-

1)Selection of a base year-

Generally, the earliest year involved in comparison is taken as the base year. However, there is no hard and fast rule regarding this because any year may be taken as the ‘base year’ .

2)Calculation of Percentage Relationship-

That each item of each year bears to the same item in the base year. Formulation for calculation of Trend Percent=

Percent Year Value/Base Year Value*100

3)Format of Preparation-

The Trend Percentage Analysis Statement may be prepared in the Horizontal From or Vertical From.

(c)Acid Test Ratio-

It is the ratio between the liquid assets and current /liquid liabilities. The acid-test, or quite ratio, compares a company’s most short-term assets to its most short-term liabilities to see if a company has enough cash to pay its immediate liabilities, such as short-term debt. The acid-test ratio disregards current assets that are difficult to liquidate quickly such as inventor.

Formula =

Liquid/ quick/ acid test ratio=liquid/quick assets

Current / liquid/quick liabilities

= Current assets-stock-prepaid expenses

Current liabilities- bank overdraft

Some Advantages of Acid Test Ratio are as follows:-

1. The Acid Test Ratio removes the inventory from the calculation, which may not always be considered liquid, there by giving a more appropriate picture of the company’s liquidity position.
2. Valuation of inventory can be tricky ant it may not always be at marketable value.
3. Inventory can be very seasonal in nature and may vary in quantity over a yearly period.

Some Disadvantages of Acid Test Ratio are as follows:-

1. Using this ratio on a standalone basis may not be sufficient to analyses the liquidity position of the company.
2. This ratio may not be a good indicator for all the business models for showing short-term solvency because if companies with usually higher inventory, like supermarkets exclude inventory to arrive at liquidity position, it may not be essentially correct to do so.
3. The acid test ratio ignores the level and the timing of the cash flows which actually would be a major parameter determining the company’s ability to pay liabilities when they become due.

(d) Financial Accounting Standard Board(FASB):-

The Financial Accounting Standard Board is a private, non-profit organization standards setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP) within the United States in the Public’s interest. The securities and Exchanges Commission (SEC) designated the FASB as the organization responsible for setting accounting Standards for Public setting accounting standards for Public companies in the US. The FASB replaced the American Institutions of Certified Public Account’s (AICPA) Accounting Principles Board (APB) on july1, 1973.

The FASB pronouncements are a set of rules and general guidelines that help to facilitate the reporting of financial information. The pronouncements are part of the accounting framework known as generally accepted accounting principles (GAAP).

The FASB pronouncements are statement of financial accounting standards, Statements of financial accounting concepts, FASB Technical Bulletins, EITF. Abstracts, since September 15, 2009, authoritative announcements are contained in the codification itself.

Major FASB standards are as follows:-

1. Revenue recognition
2. Credit Losses
3. Variable Interest entities
4. Pension
5. Stock options
6. Leases(balance sheet)
7. Derivative Accounting.

(e) Sustainability Reporting:-

A sustainability report is an organization report that gives information about economic, environmental Social and Government Performance.

Sustainability Reporting is not just report generation from collected data, instead it is a method to internalize and improve an organization commitment to sustainable development in a way that can be demonstrated to both internal and external stakeholders.

There are some merits of sustainability reporting are as follows:-

1. Sustainability reporting is about process, not just product-

The process of developing a sustainability report involves strategic thinking about how sustainability issues affect a company, as well as how a company affects sustainability.

1. It’s a unique opportunity to spotlight a company’s management values, strategies and acumen-

Amid financial reporting strictures and media mayhem, it can be difficult for a company to tell it own story. Management can use sustainability reporting to elucidate its strategic approach, internally and externally. Reporting is also a platform to showcase long-term thinking.

In increasingly complex and siloed organizations, the sustainability reporting term might ne the only group that engages all aspects of the business. This generates powerful opportunities for internal communication, developing corporate culture, and sharing best practices.

1. Sustainability reporting is there for you through thick and thin-

When a company is under pressure, a candid sustainability report can help engage critics, respond to crises, and communicate values.

1. Sustainability reporting allows for vulnerability and that’s okay-

Companies rarely communicate problems; they communicate solutions. Yet in sustainability reporting, admitting uncertainties and works in progress is okay. Even an excellent sustainability report might acknowledge, “ We don’t track those data yet, but we’re looking into it, or, “We are not sure, but we are partnering with NGOs to figure it out, “Even without all the answers, there is inherent value in transparency and the reporting process.

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 statements are formal records of financial condition in both short and long- term. Financial statements are record the performance of the business and helps identifying the strength and weakness of the business. These statements are prepared on the basis of accounting records. For this reason financial statements are considered as the final product of the accounting process.

The objectives of the financial information to the parties are as follows:

1. To provide financial information to the parties interested in financial statements.
2. To provide information for financial forecasting, utilization of scarce resources.
3. To provide necessary information to the management for internal reporting and assessing the efficiency of a farm
4. Provide necessary information to the government and its authorities for taking decisions relating to levy taxes, price control etc.
5. Provide information for legal decision making.

The criticism of financial statements are as follows:

1. Historical in nature:

Financial statement are prepared on the historical records. Therefore it may not give the actual picture of the position of the concern.

1. Ignores the price level changes:

Financial statements do not consider the effect of price level changes. Since, price index in one year is differ from other year, misleading picture may be obtained while comparing year figure with past year figures.

Financial Statements are based on the personal judgments of the accounting. For example, provision for depreciation, valuation of stocks can be followed depend upon the personal judgment of the accountant.

1. Cannot fulfill the interest of all parties

Financial statement are prepared considering the interest of the owner and it cannot fulfill the need of all parties interested in them.

1. Use of diverse accounting practices-

Financial statements can be drawn up on the basis of diverse accounting practice, such as for charging depreciation, either straight line or written down method can be taken.

There are some of the significances of Financial Statement Analysis are as follow-

1. To assess the earning capacity or profitability of the firm.
2. To assess the operational efficiency and managerial effectiveness.
3. To assess the short term as well as long term solvency position of the firm
4. To identify the reasons for change in profitability and financial position of the firm.
5. To make inter firm comparison.
6. To make forecasts about future prospects of the firm.
7. To assess the progress of the firm over a period of time.
8. To help in decision making and control.
9. To guide or determine the dividend action .
10. To provide important information for granting credit.

OR

(b) Critically examine the merits and demerits of various techniques used for interpreting of various techniques used for interpreting Financing Statements. What are the limitations of such tools? 6+5=11

Ans: Financial Statement Analysis is basically a study of the relationship amount various facts and figures as started in a set of financial Statements.

The various techniques used for interpreting Financial Statement are as follows-

1. Comparative Statements – Comparative Statements are the statements which are prepared in order to compare the data as shown in the financial statements.

Merits:

(a)Comparison-

The Comparative Statements shown the figures of various firms or number of years side by side i.e. both for inter-firm comparison and intra-firm comparison.

(b)Horizontal analysis-

The variables are arranged horizontally for the purpose of analysis and interpretations of data taken taken from financial statements for assessing profitability, overall efficiency and financial position of a firm.

(c) Trend Analysis-

The comparative financial statement helps to ascertain the ‘Trend’ relating to sales, cost of goods sold, operating expiation etc.

(c)Evaluation:

The comparative financial statement helps the analyst to compare performance the performance of one firm with that of other similar firm in the industry and also compare the performance of the competitors in the line.

(d) Measuring financial-

Comparative Financial Statements help to measure important Distress financial ratios which are used for predicting financial distress and predicting corporate failure with the help of Multivariate Model.

1. Inter-firm comparison will only be effective if both the firms follow the same accounting principles, method of valuations of stocks, assets etc.
2. Comparative financial statements do not recognize the change in prices level and, as such, it will be of no use.
3. It is very difficult to ascertain the correct trend if there is a structural changes in a firm which are frequently happened.

2.Common Size Statement-

Merits-

1. Common Size Statement helps to users of financial statement to make clear about the ratio or percentage of each individual item to total assets/ liabilities of a firm.
2. A common size statement helps an analyst to find out a trend relating to percentage share of each asset in total assets and percentage share of each liability in total liabilities.
3. A common size statement helps the analyst to ascertain the structure relations of various components of cost /expenses/ assets/ liabilities etc. to the required total of assets/ liabilities and capital.

1. Common Size Statement does not help to take decisions since there is no standard ratio/ percentage regarding the change of percentage in the various component of assets ,liberties, sales etc.
2. If consistency in the accounting principle, concepts , conventions is not maintained then common size statement become useless.
3. Effect of window dressing in financial statements cannot be ignored and common size statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects of window dressing appearing in the financial statements.

3.Trend Analysis

Merits

1. Trend analysis helps the analyst to make a proper comparison between the two or more firms over a period of time.
2. Trend Analysis is found to be more effective in comparison with the absolutes figures/ data on the basis of which the management can take the decisions.
3. Trend Analysis is very useful for comparative analysis of data in order to measure the financial performances of firm over a period of time and which help the management to take decision for the future i.e. it help to predict the future.

Demerits

1. It is not so easy to select the base year.
2. It is also very difficult to follow a consistent accounting principle and policy particularly when the trends of business accounting are constantly changing.
3. Analysis of trend percentage is useless at the time of price change.

4.Ritio Analysis

Merits

1. Accounting ratio help in simplifying the comprehensive accounting figures and make them understandable to its users.
2. Ratio analysis is effective tool to assess the operating efficiency of a business concern.

Demerits

1. Ratio analysis is based on the information which has been recorded in the financial statements.
2. In ratio analysis, a single ratio may itself be meaningless.
3. If different accounting principles and policies are followed by different firms, then comparison will be of no use.

5.Cash flow Statement

Merits

1. Cash flow statement helps the management to ascertain the liquidity and profitability position of a firm.
2. It helps also to ascertain the optirnum cash balance of a firm.
3. Proper management of cash is possible if cash flow statement is properly prepared

Demerits

1. Cash flow statement actually fails to present the net income of a firm for a period since it does not consider non-cash items which can easily be ascertained by an Income Statement.
2. Cash flow statement is neither a substitutes of funds flow statement nor a substitute of income statement.
3. Cash flow from operation does not help to assess profitability of a firm since it neither considers the costs nor revenue.

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: Ratio analysis is one such tool that would aid us to interpret the financial statements in terms of the operating performance and financial position of a firm. It involves comparing the ratio with similar firms in the industry or analyzing the trend in the same company over a period of time. This analysis is one very important and most basic part of fundamental analysis process.

The word ‘Ratio’ means a ratio communicates the relationship between one accounting outcome and another, which provides a valuable comparison.

There are some category of ratio analysis and its ratios are as follows-

1.Liquidity ratios-

These are the ratios that quantity if the company would be able to meet its short term debt commitments/ current liabilities and pay them off which they are due. If the value of the ratio is greater than 1 it shows that the ratio analysis of the company is liquid and in good financial health but if it is less than one it shows failure to meet obligations.

The following ratio would help in determining the liquidity of a company-

i. Current ratio

(a) This measures the short term solvency of the company using the ratio analysis in balance sheet. Also known as the working Capital ratio.

(b) Possible creditors could use it to deciding whether or not to given short-term loans.

Formula-

Current ratio = current assets/current liabilities

ii. Quick ratio/ acid test ratio-

1. It measures the current short term solvency of the company.
2. It considers if the very liquid assets are available to meet the obligations.

Formula

Quick ratio = Quick assets (CA-Inventory)/Current liabilities.

iii. Cash ratio

Cash ratio further refines the current ratio and quick ratio.

Formula

Cash ratio= cash and cash equivalents/ current liabilities.

2.Profitability Ratios

Profitability ratio measure firms operating competence i.e. how well it utilized the available resources in order to generate profit, including its ability to generate income and hence cash flow.

Profitability ratio can be further divided into two types-

Profitability Ratio In Relations To Sales

1. Gross profitability/ ratio

It is measure to show by how much gross profit exceed production costs.

Formula –

GPM= Gross profit/Net sales * 100

1. Net Profit ratio

It shows the amount of revenue left after all the expenses have been paid off.

Formula-

NOR =Earnings (after tax)/ Net sales *100

1. Operating Profit

This ratio specifies how much profit a firm makes after paying for variable costs of production such as wages, raw materials, etc but before interest and tax.

Formula-

Operating Profit margin= EBIT/ Net sales* 100

Profitability Ratio In Relation To Investments:

1. Return On Investment (ROI)

ROI is a performance measure which evaluates the efficiency of an investments.

Formula :

ROI = net profit after interested tax / Total assets.

1. Return on equity (ROE)

ROE discloses the amount of Profit a firm made compared to the total of shareholders equity.

1. Returns on capital employed (ROCE)

This ratio measures the returns a firm gets out of the total capital employed by them.

Formula :

ROCE= EBIT/ (total assets – current liabilities)

3.Turnover Ratio

The standard of this ratio is industry specific and depends upon the requirement of assets. The following turnover ratios can be used to analyze the effectiveness of asset use.

(1)Inventory turnover

This ratio is a metric that indicates the number of times inventory has been converts into sales in a particular period of time and hence can be an effective tool for inventory management.

Formula

ITOR= Cost of good sold/ Average Inventory

ITO Days= 365/ Inventory turnover

(2)Debtor Turnover Ratio

It determines if the firm is having problems in converting their credit sales into cash.

Formula

DTR =Net Receivable Sales/Average Debtors

Average collection Period= 365/ Debtors TR

(3)Credit turnover ratio

It can help the firm in analyzing how it has been handling its payments.

Formula

CTR= Total purchases/Average creditors.

4.Debt Ratios

i. Debit to equity ratio

The debt to equity ratio in dictates the relative portion of entity’s equity and debt used to fund of the company.

Formula-

Debt to equity ratio= liabilities/Assets

ii. Debit ratio

This ratio indicates the amount of debt to the total amount of assets .

Formula-

Debt ratio = liabilities/Assets

iii.Debt service coverage ratio

This is a ratio considered to be the most important one from the lending institutions.

5.Other ratios

i. Earnings per share

This ratio helps in measuring the profit that is available to the equity shareholders on a per share basis.

Formula-

Earnings per share= Earnings after tax – Preferred divided

Equity shares outs tending

ii. Dividend per share

It is the dividends that have been paid to the shareholders on a per share basis.

Formula-

Dividend per share= earnings paid to the ordinary shareholders

No. of ordinary share outstanding

iii. Dividends payout ratio

It accounts for the relationship between the earning’s belonging to the equity shareholders and the dividends paid to them.

Formula-

Dividends payout ratio= Dividend per share

Earnings per share

(iv)Price earnings ratio or p/e ratio

Formula-

P/E ratio= Market price of share

Earnings per share

OR

b) The following is the balance sheet of Jagjeevan Industries LTD. as on 31st march,2016:

3*4=12

Particulars Figures as at the end of current period (in RS)

1. Equity and liabilities:

Equity share capital 22,50,000

Reserve and surplus 9,00.000

Non current liabilities:

10% debentures 7,50,000

Current liabilities:

Bank overdraft 3,00,000

Sundry creditors 18,00,000

Total 60,00,000

1. Assets:

Non-current assets:

Fixed assets 24,75,000

Current assets:

Investments (short term) 2,40,000

Sundry Debtors 18,60,000

Cash 60,000

Total 60,00,000

1. Other information:

Sales -> Rs. 1,11,60,000

Gross Profit -> Rs. 11,16,000

You are required to calculated the following ratios :

1. Debt –equity ratio.
2. Proprietary ratio.
3. Debtors’ turnover ratio.
4. Stock turnover ratio.

Ans: a) Debt-equity ratio = long term debt

Shareholders fund

= 7,50,000

31,50,000

=0.24:1

b) Proprietary Ratio= proprietors fund

totals assets

=31,50,000

60,00,000

=0.53:1

c)Debtors’ turnover ratio= Debtors /sales *365

= 18,60,000 / 1,11,60,000*365

1. days.

d)Stock turnover ratio= cost of goods sold

Average stock

Cost of goods sold=sales-G.P.

=1,11,60,000-11,16,000

=1,00,44,000

Therefore, STR=1,00,44,000

13,65,000

=7.36 Times.

5/(a) Write a short note on Corporate Social Reporting. What are the essentials of a perfect corporate Social responsibility report? 5+6=7

Ans: Corporate Social Reporting defined as the process of communication the Social and environmental effects of organizations economic actions to particular interest groups with society and to Society at large (Grey al,1987:9) has become widespread .

The essentials of a perfect corporate social responsibility report are as follows:-

1. Internal assessment-

Before designing a CSR strategy it is often helpful to assess your current CSR activities, looking at the whole picture what CSR policies, programs, and structure are already in place and where the “gaps” are.

1. Put it in writing

Ensure that your company creates a separate CSR statement or embeds its CSR commitment within the company’s mission or values statement code of conduct or other appropriate company policy.

1. Embed CSR into the company planning and budget processes

The unlimited goal of creating a CSR management system is to ensure that CSR considerations are a part of all business decisions.

1. Develop processes for employees to raise CSR issues and concerns to appropriate decision makes and advocates

An open environment is one of the easiest ways to solicit valuable feedback on CSR issues and problems.

1. Communication CSR performance visibly and frequently to all employees

Whether through newsletters, annual reports, internet communication, meetings, training or other informal mechanisms, make sure your employees know CSR is a company priority.

1. Put CSR on the agenda of meetings at all levels of the company

This includes the board, executive and senior management, company wide meetings and departmental communications.

1. Provide training for employees directly involved in CSR activities

This is an ongoing commitment since training needs will change as the company’s CSR issues change and evolve.

1. Create CSR accountability at all employee levels

Build CSR responsibilities into the job descriptions and performance evaluations of employees at all levels.

1. Measures and communicate your performance

Whether you choose to engage in an internally managed assessment of your CSR performance or contract out a formal external assessment of your CSR performance, find an honest and appropriate way to share the results with internal and external stakeholders.

OR

(b) Define Financial Reporting . What are the benefits derived derived from Financial Reporting?

Ans:Financial Reporting is the disclosure of financial results and related information to management and external stakeholders (e.g. investors, customers, regulators) about how a company is performing over a specific period of time. Financial reports are usually issued on a quarterly and annual basis and include the following-

1)Balance sheet or statement of financial position.

2)Income statement or profit and loss report

3)Statement of changes in equity or statement of Retained Earnings.

4)Cash flow statement.

Financial reporting for private and public companies must be performed in accordance with generally accepted accounting principles (GAAP) there are some benefit derive from financial reporting are as follows:

1. Economic decisions making:

The unlimited goal of any company is to maximize the social welfare for which an efficient allocation of resources is required. This goal is of particular significant in developing economic where resources are not plentiful.

1. Cost of capital:

Adequate disclosure in annual reports is expected, in the long run to enhance market price of company’s’ shares in the investment market highest price of company share resulting from the full discloser will have a favorable impact on the company’s cost of capital.

1. Equilibrium in share capital:

Adequate discloser will tend to minimize the fluctuations in company’s share prices. Fluctuations in share prices occur because of the ignorance prevailing in the investment market. Fluctuations show an element of uncertainty in investments decisions.

1. Employee decisions:

Employee decisions may be based on perceptions of a company’s economic status acquired through financial statements. In particular , prospective and present employees may use the financial reports to assess risk and growth potential of a company and therefore, job security and future promotional possibilities.

1. Customer decisions:

The data presented in financial statements may affect the decision of a company’s customers and hence have economic consecutives.

1. Manager’s Decisions:

The accounting data published in financial reports may have economic effects through its impact on the behavior if the managers of corporate enterprise.

6(a) Discuss the important provisions need to be considered for financial reporting of Banking Companies and Insurance Companies. 6+5=11

Ans: A banking company is defined as a company which transacts the business of banking in India. Section 5(b) of The Banking Regulation Act, 1949 defines the term banking as “accepting for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheque draft, order or otherwise.

Section-7 of this Act makes it essential for every company carrying on the business of banking in India to use as part of its name at least one of the words- bank, banker, banking or banking company . section 49A of the Act prohibits any institution other than banking companies to accept deposit money from public withdraw able by cheque. The essence of banking business is the function of accepting deposits from public with the facility of withdrawn of money by cheque. In other words, the combination of the functions of acceptance of public deposits and withdrawal of the money by cheque by any institution cannot be performed without the approval of Reserve Bank.

Some of the specific disclosure requirements in Bank’s financial statement are given below:

1. Presentation: Summary of significant Accounting policies’ and ‘Notes to Accounts’ may be shown under schedule 17 and Schedule 18 respectively, to maintain uniformity.
2. 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 the of Minimum disclosures, banks are also encouraged to make more comprehensive disclosures to assist in understanding of the financial position and performance of the bank.
3. Summary of Significant Accounting Policies: Banks should disclose the accounting polices regarding key areas of operations at one place 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
4. Disclosure Requirements: In order to encourage market discipline, Reserve Bank has over the years developed a set of discloser 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 discloser framework that enhances comparability. Banks are also required to comply with the accounting slandered 1(AS 1) on discloser of accounting policies issued by the institute of chartered accountant of India (ICAJ). The enhanced disclosures have been achieved through revision of Balance Sheet and profit and loss account on bank and enlarging the scope of disclosures to be made in “Notes to Accounts”
5. 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”.

Financial Reporting 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).

1. All companies will separately disclose if there is any departure from the accounting policies with reasons for such departure.
2. Disclosure of investments made in accordance with statutory requirements separately together with its amount, nature, security and any special rights in and outside India.
3. Disclosure of performing and non-performing investments separately.
4. Disclosure of assets to the extent required to be deposited under local laws for otherwise encumbered in or outside India.
5. All the companies are required to show sector-wise percentage of their business.
6. To include a summary of financial statements for the last five years in their annual report to be prepared as prescribed by the IRDA.
7. Disclose the basis of allocation of investments and income thereon between policyholders’ account and shareholders’ account.
8. 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:

• Contingent Liabilities.
• Actuarial assumptions for valuation of liabilities for life policies in force.
• Encumbrance’s to assets of the company in and outside India.
• Commitments made and outstanding for loans, investments and fixed assets.
• Basis of amortization of debt securities.
• Claims settled and remaining unpaid for a period of more than six months as on the balance sheet date.
• Value of contracts in relation to investments, for purchases where deliveries are pending and sales where payments are overdue.
• Operating expenses relating to insurance business and basis of allocation of expenditure to various segments of business.
• Computation of managerial remuneration.
• Historical costs of those investments valued on fair value basis.
• 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 NBFC’s 6+5=11

Ans: The Insurance regulator, IRDA is November 2010 allowed insurance companies to sell universal life plans on the basis of new guidelines. The new guidelines mentions that insurers would have to offer a guarantied return if the policy terms do not entitle the insured to receive a bonus. The guidelines laid down by IRDA are as follow-

1. The new guidelines specified that universal life plans have to be called ‘variable’ insurance policies. The regulator with regards to life ULIP’s imposed a cap on charges as well as the minimum surrender value that the insured is entitled to.
2. Accounting to guidelines, if a policy is surrendered in the first three years, the policy holder is entitled to receive the balance in the policy account as on the data of the surrender which will be paid out after the lock-in-period. The policy holder is eligible for 98% of the policy balance available in his or her account in the case of policy is surrendered in the fourth or fifth policy year. If the policy is surrendered after the fifty year the balance in the policy account has to be paid out immediately.
3. The maximum expenses that can be charged to the premium paid by the policy holder in the first year were capped at 27.5% of the first year premium. For the second and third year premium, the cap is 7.5% and 5% on subsequent years.
4. If the policy holder decides to increase his contribution through a one-time top-up, the insurance company can deduct at most 3% from the top-up by way of charges.

The RBI’s guidelines on the Financial Reporting of NBFC’s-

1. Rejected NBFCs- Requirement of conversion to Non-financial activities and disposal of financial assets-

The extant RBI Regulation require all the rejected NBFC’s holding public deposits to submit a monthly return in form NBS-4 furnishing there in the information on repayment of public deposits and other aspects of their activities.

1. Companies Amendment Act,2000-

Applicability of requirement of reporting to CIB about non -repayment of matured public deposits by defaulting NBFCs within 60 days of default.

RBI has examined the applicability of the above requirement to the NBFCs. The requirement under section 58AA of the Companies Act is also applicable to the NBFCs.

1. Acceptance of public deposits by private limited NBFC’s

It is advised that the NBE’s which were hitherto private Limited companies and were intending to take or holding public deposits are now public limited companies under the companies Act, 1956. It is presumed that they have done the needful as required of them under the companies Act, they may approach RBI for change in the certificate of registration to reflect the new name as a Public Limited Co

1. New Financial Leases Accounting Standard 19 of ICAI Applicability of Provisioning Norms

The implacability of the above as for the NBFCs in the matter of applicability of prudential norms prescribed by RBI would be that all the fresh leases (financial leases)

Written on or after April 1,2001 would now be accounted like hire purchase transactions.

1. Paragraph 9A of the NBFC directions on Prudential Norms Section 292A of the companies Act,1956 constitution of Audit Committee for NBFCs

In order to ensure that RBI regulations should be in alignment with the provision of companies Act, 1956 it has been decided to prescribe requirement of constitution of Audit Committee by each NBFC having either paid up capital of not less than Rs.5 crores or assets of Rs. 50 crores and above as per its last audited balance Sheet.

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+7=11

Ans: Accounting Standards are basic policy documents. Their main aim is to ensure transparency, reliability, consistency and comparability of the financial Statements. These Accounting Standards (AS) are issued by an accounting body or a regulatory board or sometimes by the government directly. In India, the Indian Accounting Standards are issued by the Institute of chartered Accountants of India (ICAI).

Accounting Standards mainly deal with four major issues of accounting, namely:-

1. Recognition of financial events.
2. Measurement of Financial Transactions.
3. Presentation of financial statements.
4. Disclosure requirement of companies to ensure stakeholders are not misinformed.

There are some objectives of the Accounting Slandered are as follows:-

1. The main is to improve the reliability of financial statements.
2. Then there is comparability. Following there standards will allow for inter-firm and intre-firm comparisons. This allows us to check the progress of the firm and its position in the market.
3. It also looks to provide one set of accounting policies that include the necessary disclosure requirements and the valuation methods of various financial transactions.

There are Benefits of the Accounting Standards are as follows:-

1. Attains Uniformity in Accounting –

Accounting Standards provides rules for standard treatment and recording of transactions. They even have a standard format for financial statements. These are steps in achieving uniformity in accounting methods.

1. Improves Reliability of Financial Statements-

Many of stakeholder base their decisions on the data provided by these financial statement. Then there are also potential investors who make their investment decisions based on such financial statements.

So it is essential these statements present a time and fair picture of the financial situation of the company. They make sure the statements are reliable and trustworthy.

1. Prevents frauds and Accounting Manipulations-

As lay down the accounting principle and methodologies that all entities must follow. One outcome of this is the management of an entity must follow. One outcome of this is the management of an entity cannot manipulate with financial data.

So these standards make it difficult for the management to misrepresent any financial information. It even makes it harder for then to commit any frauds.

1. Assists auditors-

Now the accounting standards lay down all the accounting policies, rules, regulation etc in a written format. These policies have to be followed. so if an auditor checks that the policies have been correctly followed can be assured that the financial statements are true and fair.

1. Comparability-

This is another major objective of accounting standards. The users of the financial statements can analyze and compare the financial performances of various companies before taking any decisions.

1. Determining Managerial Accountability-

The accounting standards help measures the performance of the management of an entity. It can help measure the management’s ability to increase profitability, maintain the solvency of the firm, and other sure important financial duties of the managements.

Management also must wisely chose their accounting policies. Constant changes in the accounting policies lead to confusion for the user of these financial Statements. Also, the principle of consistency and comparability are lost.

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

Ans: International Financial Reporting Standards (IFRS) is a set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board(IASB). The goal of IFRS is to provide a global frame work for how public companies prepare and disclose their financial statements.

The needs of IFRS, are as follows-

IFRS has gained momentum all over the world. As the capital markets become increasingly global in nature, more and more investors see the need for a common set of accounting standards. The IFRS will lower the cost of raising funds, reduce accountants fees and enable faster access to all major capital markets.

Furthermore, convergence to IFRS, by various group entries, will enable management to bring all components of the group in to a single financial reporting platform. This will eliminate the need for multiple reports and significant adjustment for preparing consolidated financial statements or filing financial statements in different stock exchanges.

The differences between IFRS and AS are as follows:-

 Basis IFRS AS Principle vs. Rule based standards Principle based Economic substance of the transactions is the prime evaluation factor. Generally rule based Companies Act and rules dominate and guide as to how a transactions is recorded Standard VS local Laws Accounting Standards take precedence over local laws Laws regulations usually take precedence while preparing financial statements. Whenever there is between law standards, the law prevails. Presentations of financial statements Primarily, no prescribed format. Assets and liabilities need to be divided into current and non-current. Companies Act and other industry regulations have defined prescribed formats. Deprecation on fixed assets Depreciation is an annual charge on the basis of estimated life of assets. Useful lives have been prescribed in Schedule II of the Indian companies Act. Cash flow statements Mandatory any of the direct or indirect method can be used. Mandatory for some. Direct method for Insurance Companies and Indirect Method for other listed companies. Valuations Provides Specify guidance and standards to deal with mergers, acquisitions, take over amalgamations etc. specifically as regards to valuation. Positions taken under IAS are debatable.

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