Make Analytical Adjustments to Financial Statements

Analytical Adjustments
Introduction
Classification of Business Activities
Main Contents::
1 Operating vs. Non-Operating Activities
Sales and Impairments , Interest and Dividend , Foreign Currency Transactions
The Hinduja Case: Reported Case
Analysis
Reclassification
2 Depreciation and Revaluation Reserve
3 Goodwill and Other Intangible Assets
4 Off Balance Sheet Items
Objective of this Module

The Financial Analysis process necessitates making certain Analytical
Adjustments to Financial Statements. To arrive at measures, there are more
reflective of Creditors' Risks, Rights, and Benefits.

Source:::https://www.crisil.com/Ratings/Brochureware/RR_ASSES/Analytic
al-adjustments-to-financial-statements.pdf

When companies prepare their Financial Statements, they are governed by many factors
such as a particular Accounting Standard, the Management’s Discretion on certain
issues, the Accounting Culture, Regulatory Norms and so on.
Analysts frequently make adjustments to a company’s reported financial statements
when comparing those statements to those of another company that uses different
accounting methods, estimates, or assumptions. Adjustments include those that are
related to Investments; inventory; property, plant and equipment; goodwill; and off-
balance-sheet financing.
Management’s Discretion
Regulatory Norms

A surface level reading of the Financial Statements of some companies would lead,
one to conclude;
 Improved Profitability: was due to Better Control on Costs, that the reduction
in receivable days was due to an improvement in collection efficiency
 Reduction in Interest Cost: was due to better pricing negotiation with lenders.

Example of Three Companies

Why is it necessary to make analytical adjustments?
Analysts make adjustments to financial statements in order to;
• Reflect a true and fair view;
Financial statement analysis forms an integral part of credit analysis. Going only by
reported numbers can lead to incorrect conclusions, particularly in a scenario
where accounting treatments differ widely across companies.
• Compare a company’s standing with its peers;
An analysis of audited Financial Statements begins with a review of accounting
quality to determine whether RATIOS derived from Financial Statements can be used
accurately to measure the company’s performance and position relative to its peer
group and to a larger universe of other companies in the same industry. Making
adjustments thus ensures comparability.

Here is an illustration of how facts reported in Financial Statements could take on a different
meaning after analytical adjustments are made.
Reported Fact Prima Facie Conclusion
Conclusion after Analytical
Adjustment
Improving profitability
Inherent improvement in the
business risk
Write-offs directly through reserves
Reduction in receivable
days
Better working capital management
from earlier times
A high proportion of off-balance
sheet financing by using bills
discounting
Substantial reduction in
exposure to group
companies
Relaxed financial position of the
parent, availability of large
proportion of funds for use
Loans replaced by irrevocable
corporate guarantees
Reduction in interest cost
Better pricing negotiation by the
company with lenders
A high proportion of foreign
currency loans with no forward

The Purpose and Value of Analytical Adjustment

Companies typically have two sets of business activities; Operating Activities that
relate to their core business operations and other Non-operating Activities.
All these activities contribute to the overall profitability of the company.
But all these activities do not bear equal weight while considering the future
performance and profitability of the company.

 This operating revenue and expenses determine the company’s EBITDA (Earning Before
Interest, Taxes, Depreciation & Amortization), which is the efficiency of generating profits
through a company’s core business activities.
 The sale of property on the other hand is a one-time activity that is not sustainable in the
long-term.
 This, as well as other non-operating and non-recurring income and expenses, should therefore
be excluded while analysing the company’s profitability to make historical financial ratios
more indicative of future performance.
 Let’s consider two types of income. A widget manufacturing company reported a certain
amount from the sale of widgets. The company also reported a large amount from the sale of
property. The sale of widgets is core to the company’s business operations and is therefore
likely to continue in the future.

How interest and dividend are treated for non-financial entities?
There can be grey areas while classifying incomes as operating or non operating
Interest on delay of subsidy received or interest on FD's where it is a business need
to keep funds under FD, can be classified as operating income.
The classification of interest and dividend as operating or non-operating activities
will depend on whether the company is a financial or non-financial institution.
Interest and Dividend

Interest and Dividend Received;
The interest charged for a leased property or equipment and the interest and dividend received for investments made in
other ventures are classified as investing activities in a cash flow statement. These are secondary sources of income for a
non-financial entity and should therefore be excluded when calculating EBITDA and operating revenue.
Though in some cases interest and dividends received may be classified as operating cash flows if they enter into the
determination of profit or loss. For example interest income received from FD (Fixed Deposit)in case of government
contractors as this FD is required for Earnest Money deposit/ security deposit purpose.
Interest and Dividend Paid;
Similarly, the interest paid to the lenders of capital and the dividend distributed to shareholders are classified as financing
activities in a cash flow statement and are not directly linked to the core business of a non-financial entity. They are thus a
part of non-operating expenses and should not be deducted as a cost to EBITDA.
Other examples of non-operating incomes and expenses can be- rental income received from an apartment owned by a
proprietorship where core business is trading of goods, balances w/off (creditors w/off), one time subsidy received &
interest income earned on that subsidy, interest income earned on idle money invested in a term deposit etc
Interest and Dividend

Foreign currency transaction gains or losses arise from transactions denominated in a
currency other than a company's functional currency (generally the currency in which it
transacts most of its business).
Classification is the key Examples of foreign currency transactions include selling goods or rendering services at
prices denominated in a foreign currency, borrowing or lending in a foreign currency, or other contractual
obligations denominated in a foreign currency and are to be recognised under operating activities.
On the other hand, gains or losses resulting from the issuance of foreign-currency-denominated debt is to be
recognised under non-operating activities.
When do adjustments have to be made?
The gains or losses arising from foreign currency transactions are to be evaluated on the basis of whether it is an
operating or non-operating activity. Adjustments should be made when non-operating activities are found to be
included in operating profit and similarly, when operating activities have been included under non-operating
profit.
Foreign Currency Transactions

From the above given Statistics;
• Let’s now find out the impact of the reduction on the profitability of the company.
• Operating profit is calculated by subtracting operating expenses from ‘revenue from operations’.
• Let’s calculate the adjusted and reported operating profit.
• The adjusted operating profit is a small fraction of the reported operating profit.
• Let’s also see the actual or adjusted operating profit margin versus the reported operating profit
margin.
• The adjusted operating profit margin is now about 39 times less than the reported profit margin.
Thus we find that the company, Hinduja Ventures Limited, which seemed very profitable at first, is
actually struggling to sustain itself.

Now that we understand how to classify operating and non-operating activities,
we move on to look at two more important items—depreciation and revaluation
reserve.
Depreciation and Revaluation Reserve

Methods of Expressing Depreciation

How should depreciation be adjusted?
The depreciation and asset impairment policies of a company should
be scrutinized in relation to normal accounting practices and
standard industry norms to study its impact on the company’s
financials. Any discrepancies found should be accordingly adjusted.
Depreciation, despite being a non-cash expense, has a significant
impact on the financial status of a company.
Depreciation and Revaluation Reserve.

Depreciation and amortization cannot be routed through the balance sheet
as a deduction to reserves. It needs to be expensed through the Profit and
Loss account.
Besides this, the Institute of Chartered Accounts of India (ICAI) has
prescribed that listed companies should recognize an impairment loss in
order to ensure that its assets are carried at no more than their recoverable
amount. However, a company may charge lower asset impairment than
what is deemed adequate.

Let’s look at a case to understand the impact of
depreciation on the profitability of the company.
The Godrej Case
Godrej Consumer Products Ltd. reported Profit After
Tax (PAT) of Rs. 73,972 lakhs for the financial year
2015 - 2016. After adjustments, the PAT was listed as
Rs.68,697 lakhs.
What caused the difference of Rs. 5,275 lakhs?
The company reported amortization for the year on brands worth Rs. 5,275 lakhs as a
deduction from general reserves. This amount was adjusted as depreciation for the year in the
Profit and Loss statement, to arrive at the adjusted PAT of Rs. 68,697 lakhs.

What is revaluation reserve?
When fixed assets are revalued to bring their reporting values on par with market values,
the corresponding entry on the liabilities side, equal to the change in the asset value,
is added to the net worth and is reflected as ‘revaluation reserve’.
Important points to consider
• Revaluation reserve is only a book entry, based on the perception of the asset’s value. In reality however,
it is unrealized profit not available for distribution among the shareholders. Moreover, the valuation
could be subjective and dependent on market conditions.
• If a company revaluates its assets, the revaluation distorts the comparability of the entity’s financial
statements as against the financial statements of other entities since it does not represent a realized gain
and is not a result of an arm’s length transaction.
Remember!
Since revaluation reserve is only a book adjustment and since the earning capacity of the assets remains the same before
and after revaluation, it should be deducted from the net worth and the assets are to be considered at book value only.
While analyzing the credit worthiness of a company, revaluation reserve is to be deducted from the net worth.

Goodwill and Other Intangible Assets

Goodwill is the difference between a company’s market value and its book value.
What is goodwill?
Whenever a business is acquired for a price in cash or in shares, at a price that is in excess of the
value of the net assets of the business, the excess is termed as ‘goodwill’. Goodwill arises from
trade name, reputation or from other intangible benefits enjoyed by a company.
Goodwill represents the difference between the purchase consideration and the total value of the
company’s readily identifiable net assets. At its core, goodwill represents the ability of the
company’s collective assets to earn cash flows in the future.

Goodwill is treated in the following ways:
 Goodwill may be treated as an asset to be amortized through the P&L account on
a systematic basis over a reasonable period of time, in cases where a genuine
third party transaction is established.
 Some companies, however, do not write off goodwill and retain it as a perpetual
asset. In such instances, the goodwill may be amortized over a reasonable period
of time (usually five years) in its adjusted financial statements.
Goodwill is recorded in the books only when some consideration has been paid for it.

What Are Intangible Assets?
Intangible assets are identifiable non-monetary assets without physical substance. They are a
resource that is controlled by a company because of past events from which future economic
benefits are expected.
Intangible assets include:
 Corporate intellectual property including items such as patents, trademarks, copyrights and
business methodologies
 Goodwill and brand recognition
 Licenses and contracts
 Special user rights
Non-physical assets such as
patents, trademarks and
copyrights are called intangible
assets.

How Are Intangible Assets Adjusted?
Intangible assets can be recorded only if they meet certain conditions given in Indian Accounting Standard 38. They need to be
adjusted against net worth or amortized depending on whether their intrinsic value is established. Intangible assets can be
categorized into internally generated intangible assets and acquired intangible assets.
Internally generated intangible assets
In such cases, the intangible assets are often adjusted against net worth to determine the tangible net worth of a company. This is
primarily because comparisons become distorted as companies cannot record their own valuable business intangibles. It is thus
necessary to reduce the value of intangible assets from the company’s net worth.
Acquired intangible assets
In cases of acquired intangible assets such as licenses, patents and trademarks, whose intrinsic worth is established through a
market-based transaction with a third party and a reasonable revenue generation capability is ascertained, the intangible assets may
be amortised over a reasonable period of time.
Remember!
The worth and validity of any asset needs to be justified before it is recognised in the company’s books. Reported intangible items need to
be evaluated to determine their validity because they may be due for impairment change or created only due to its book entries.
Intangible assets, also known as invisible assets,
primarily affect the net worth of a company.

We have seen how intangible assets and goodwill should be adjusted. Now let’s find out how off
balance sheet items need to be adjusted.
Off Balance Sheet Items
What Are Off Balance Sheet Items?
Items which may become assets or liabilities in the future and for which no present cash outflow or inflow has
taken place up to the date of preparation of the balance sheet are called ‘Off balance sheet’ items.
Though they are not disclosed on the balance sheet, these items are mentioned in the notes to accounts in a
company’s annual report.
Off balance sheet items have the potential of getting converted into hidden liabilities and so should be carefully
scrutinized while assessing a company’s financial health.
Liabilities are discussed in detail in the module ‘Cash Flow Analysis and Financial Statement Fraud’.
Some items are not recorded on the balance sheet. Let us learn more about them.
One of the most common off balance sheet items is Operating Lease. Many other contingent liabilities which are still not
legally binding on the company are kept off the balance sheet.

What Is a Lease?
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments
the right to use an asset for an agreed period.
There are two basic types of leases. The classification of leases is based on the extent to which risks and
rewards incidental to ownership of a leased asset lie with the lessor or the lessee.
Lease Transactions
Operating Lease Financial Lease
Operating Lease::
A lease in which the lease agreement does not
substantially transfer all the risks and rewards
associated with the ownership of the asset to the lessee
Financial Lease::
A lease in which the lease agreement substantially
transfers all the risks and rewards associated with the
ownership of the asset to the lessee.
The title, however, may or may not be eventually transferred.

We’re now aware that there are two types of lease—financial lease and operating lease. We’re also aware that
in a financial lease, a substantial part of the risks and rewards associated with the ownership of an asset is
transferred to the lessee and that the opposite is true in an operating lease.
But how can we determine whether a lease is a financial or operating lease?
Let’s start by looking at the characteristics of a financial lease.
A financial lease transfers the ownership or title of the asset to the lessee at the end of the lease term.
The lessee has an option to purchase the asset.
The lease term is for the major part of the useful life of the asset.
At the inception of the lease, the present value of minimum lease payments forms a substantial part of the fair
value of the leased asset.
If none of these criteria apply, then the lease should be classified as an operating lease.
Thus, the substance of the lease agreement, rather than the form, will determine whether a lease is an
operating or financial lease.
Off Balance Sheet Items Lease contd…

Financial leases are adjusted in both the balance sheet and the ‘Profit and Loss’ account.
Treating Financial Leases:
In the case of a financial lease, the lessee should treat the leased asset in the following manner. Indian Accounting
Standard 17 is applicable to lease.
Balance Sheet
At the commencement of the lease term, an amount equal to the fair value of the leased property, or if
lower, the present value of the minimum lease payments, is to be entered in the balance sheet under ‘Assets’
and ‘Liabilities’.
Profit and Loss Account
Depreciation and finance cost need to be debited to the P&L account.
Lease contd…

In the case of an operating lease, the lessee should treat the leased asset as follows:
1. The leased asset should be completely kept off the balance sheet. However, the rental
payments should appear as an expense in the Profit and Loss account.
2. The total lease liability of the asset should appear in the notes.
3. Also, a key disclosure about the total future minimum lease payments to be paid under non-
cancellable operating leases must be included for the following periods:
a. Not later than one year
b. Later than one year and not later than five years
c. Later than five years
How should operating leases be treated?
Lease contd…

Adjusting Lease:
When are lease adjustments required?
• Companies sometimes inappropriately classify a financial lease as an operating lease. Misclassifying
a financial lease as an operating lease means that neither an asset nor a liability is recorded on the
company’s balance sheet. This means reduced assets and liabilities, which helps the company to gain
a higher Return On Assets (ROA) along with better solvency ratios including the debt to equity ratio.
• In cases when a financial lease is incorrectly classified as an operating lease, an asset and a liability of
the same amount needs to be recorded in the balance sheet. This will increase debt in the company’s
books, deteriorating its solvency ratios, and will also increase assets in the company’s books, lowering
its ROA.
• The lease assets that are of a specialized nature such that only the lessee can use them without major
modifications being made shall be classified under a financial lease.
Lease contd…

Treating Contingent Liabilities
Here are a few contingent liabilities found in the annual report of a company that require some scrutiny
• Disputed liabilities not paid
Disputed liabilities can be at different stages of appeal. Depending on the probability of the liability
materializing in the future, an appropriate adjustment needs to be made. Refer to the auditor report to
find out the status of this disputed liability.
• Foreign exchange exposure not hedged
Here, the company may not have hedged the foreign currency borrowing or receivables and payables.
This should be analyzed and a covenant put in defining that the total unhedged exposure should not be
more than a particular percentage of net worth.
• Future commitments
Future commitments, like a commitment on the capital account, would generally be mentioned in the
annual report. These commitments should be factored as an outflow while preparing the future cash flow
statement.

Here’s a recap of the key learning points in this Session
• Need for analytical adjustments
• Classification of business activities
• Depreciation and revaluation reserve
• Intangible assets and goodwill
• Off balance sheet items
RECAP OF THE SESSION

Analytical adjustments are required to provide a true and fair view about the company’s financial health and to
determine whether ratios derived from financial statements can be used accurately to measure a company’s
performance and position.
When analyzing a company’s profitability, its reported operating income and cash flows should be adjusted to exclude non-
operating and non-recurring items to make historical financial ratios more indicative of future performance. These could include:
 The sale of property plant and equipment
 The sale of a subsidiary
 Asset impairments/write-downs
 Interest and dividends received and paid
 Foreign currency transaction gains and losses
Need for analytical adjustments
Classification of business activities

Depreciation, though a non-cash expense, has a significant impact on the reported profitability of the company and
hence, the way assets are depreciated must be scrutinized. Similarly, revaluation of fixed assets is only a book entry
and does not affect the earning capacity of the asset in any way. Therefore, it should be deducted from a company’s
net worth.
Intangible assets like patents, copyrights and trademarks have intrinsic value to bring in future economic benefits.
These items need to be scrutinized and adjusted against net worth to determine the tangible net worth of a company.
Intangible assets that have worth established through a market-based transaction with a third party may be amortized
through the P&L account over a reasonable period of time.
Transactions representing a possible future profit or loss to the company are included as off the balance sheet items.
They are considered as contingent liabilities and require a thorough assessment before rating the credit worthiness of a
company. The most common off balance sheet item is an operating lease. Operating leases are kept off the balance
sheet whereas financial leases require a thorough treatment in the balance sheet and P&L account.
Depreciation and revaluation reserve
Intangible assets and goodwill
Off balance sheet items

Make Analytical Adjustments to Financial Statements

Recommended

Recommended

More Related Content

Similar to Make Analytical Adjustments to Financial Statements

Similar to Make Analytical Adjustments to Financial Statements (20)

Recently uploaded

Recently uploaded (20)

Make Analytical Adjustments to Financial Statements