1.1. Nature and Definition of Auditing Different scholars have defined auditing in different ways. For example, Auditing is a process of collection and evaluation of evidence for the purpose of reporting on economic transaction. The other definition of auditing given by the Institute of Chartered Accountants of India, in its publication titled, General Guidelines on Internal Auditing has defined auditing as ‘ a systematic and independent evaluation of data, statements, records, operations and performances ( financial or otherwise) of an enterprise for stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his/her judgment which is communicated through audit report. As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing as the process by which a complete, independent person accumulates and evaluates evidence about quantifiable information related to specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. To sum up, Auditing is the process of verifying the assertions produced by accounting, as to whether they present a true and fair view of the entity's financial position in accordance with accounting standards and GAAP. In other words, auditing seeks to verify whether or not financial records have been properly prepared. Study Note  The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them Auditing is as old as accounting.  It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.  The original objective of auditing was to detect and prevent errors and frauds and most recently objective of audit shifted to ascertain whether the accounts were true and fair rather than detection of errors and frauds.  Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the growth of the joint stock companies the ownership and management became separate.  The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees. 1.2. Historical Development of Auditing The development of auditing is closely linked to the development of accounting. In the early stage of civilization, the number of transaction was usually so small that able to record the transactions himself. However, with the growth of civilization and consequential growth in volume and complexity of transactions, it becomes necessary to entrust the job of recording the transactions to other persons. The trend started with maintenance of accounts to empires by public officials

1. FINANCIAL MANAGEMENT
Course Code: 501
Dr. Subir Sen – Faculty Member, IBS
E-Mail: subir@ibsindia.org - 9830697368
Ref: 1) Financial Management – James Van Horne
2) Financial Management – Prasanna Chandra
3) Financial Management – I. M. Pandey
4) Financial Management – Khan & Jain
5) Indian Financial System – Bharati V Pathak

2. 2
INTRODUCTION
Finance is the life blood of an organization – Warren Buffet

3. What is Finance?
 Suppose you want to start up a business. No matter what
the nature of the proposed business is, its size or how it
will be registered, you will have to address some
fundamental questions:
 How much investment is required to set up the business? It
includes preliminary expenditure, land and building, plant
and machinery, and furniture and fixture.
 How will you raise the money? It includes long term
sources like equity and debt.
 How will you finance your day-to-day activities? It includes
your inventory, giving credit to customers, and some cash
to take care of daily operations.
 All this involves finance.
3

4. What is Financial Management?
 While these are not the only areas of financial decision
making, they are certainly the important ones.
 Financial Management refers to the efficient and effective
utilization of finance (referred to as funds) in such a
manner so as to accomplish the objectives of the
organization.
 It broadly involves two aspects - managing inflow and
outflow of funds.
 As a financial manager you broadly try to pre-pone your
inflows and post-pone your outflows.
 As a finance manager you also need to make a risk –
return trade off in every financial decision because of
agency problems. 4

5. What is Financial Accounting?
 Financial accounting is basically the backbone of any
financial management system.
 Without proper financial accounting records, finance
managers will not be in a position to take financial
management decisions.
 Financial accounting is basically a process in which
financial transactions are condensed and classified and
recorded and summarized in the books of accounts based
on certain established principles to prepare the Income
statement and Balance sheet.
 Management accounting uses this output to prepare
certain advanced MIS reports (e.g. fund flow statement,
ratio analyses) to aid in financial decision making. 5

6. 6
Why do we need financial accounting?
 It assists in financial decision making.
 It enables the organization to keep systematic records and
track the assets and liabilities of the organization.
 It prevents chances of error or fraud in the form of
revenue and cost leakages.
 It enables the assessment of liabilities towards direct
(Income tax) and indirect taxes (Excise duty and Sales
tax) and facilitates the filing of returns to tax authorities.
 It ensures transparency to major stakeholders.
 It enables the management to assess the periodical health
of the organization.
 It helps prevent asset liability mismatch (ALM).

7. 7
 Users of Information : External – Internal
 Type of Analysis : Whole – Part
 Data Used : Raw Data – Semi finished Data
 Nature of Analysis : Historical – Futuristic
 Unit of Measurement : Quantitative – Qualitative
 Frequency : Medium to Long Term – Short Term
 Nature : Objective – Subjective
 Precision : Very High – Low to Medium
 Legal Compulsion : Very High – Low
 Nature of Content : Low to Medium – Very High
 Level of Management : Low – Medium to High
Financial Accounting Vs Financial Management

8. Economics Vs Financial Management
 The macro economic environment defines the setting
within which a firm operates, and undermines the
conceptual underpinnings for financial decision making.
 The key macro economic variables that influences a firms
objectives are – inflation and interest rates.
 A firms top-lines, bottom-lines, including share prices are
largely influenced by these two factors.
 Other key macro economic factors that influences a firm
are – economic growth rate, tax environment, currency
stability, money supply, supply of skilled man power, govt
policy on land acquisition, etc.
 Without understanding of economics, financial decisions
become irrelevant redundant. 8

9. Important areas of financial decisions
 Capital Budgeting – The process of analyzing, appraising
and taking decisions with regards to investments in new
projects or businesses or scaling up existing businesses in
the form of increasing existing capacities.
 Working Capital Management – It involves the assessment
of requirement of funds for carrying on the day to day
activities of the businesses, followed by effective
monitoring and control.
 Investment Management – It involves the systematic
allocation of working capital rendered surplus during off
seasons and ploughing back of the same during peak
seasons based on established principles of risk and return
and diversification. 9

10. Important areas of financial decisions (contd)
 Capital Structure – It involves decisions regarding the
composition or mix of raising of long term funds from
equity shares – preference shares – debentures.
 Dividend Policy – It refers to establishing patterns in
dividend payment decisions of a firm to its equity
shareholders based on its goals and objectives.
10

11. Evolution of financial management
 The treatise of ‘Arthashashtra’ propounded by Chanakya
around circa 300 BC forms the basic back bone of
modern economics and finance.
 Even today it is the basis of good governance and
prudent financial decision making.
 Earliest evidences of modern double entry booking
keeping system dates back to around circa 16th century.
 Development of some of the earliest theories in finance
on valuation, capital structure, and dividend policy began
in the US in the 1960s.
 In the 1990s onwards with the availability advanced
computing systems and e-databases, has made possible a
lot of research on risk analysis and its mitigation. 11

12. Objectives of financial management
 Profit Maximization – The most traditional school of
thought in finance argues that a business entity exists for
the sole purpose of making profits and not charity.
Therefore profit maximization is the main objective of
finance.
 Critique: Profit generally implies the surplus of revenue
over cash. However, profits can also be earned by selling
of fixed assets like land, investments held by a firm or
through other sources like interests and dividends on
investments or commissions.
 Such non-orthodox sources of generating profit does not in
any way enhance the health of the organization as they
are not regular sources nor primary to its business.
 Profit is also not well defined and vague.
12

13. Objectives of financial management (contd)
 Shareholder Wealth Maximization – According to this
school of thought since the equity shareholders provide
seed capital and are the ultimate risk bearers of the firm,
therefore financial decisions should be taken in a manner
that enhances equity share prices as the profits ultimately
belongs to the shareholders.
 Critique: The capital market skeptics argue that the stock
market displays myopic tendencies and are often
incorrectly priced.
 Some argue that other important stakeholders are ignored
like employees, suppliers, customers, etc.
 Most importantly, it ignores the society at large, as a firm
cannot exist in vacuum. 13

14. Objectives of financial management (end)
 Stakeholder Wealth Maximization – According to this
modern school of thought financial decisions should be
taken in a way to ensure not only the equity shareholders,
but all relevant stakeholders are benefitted from it. The
logic is while shareholders provide only the risk capital,
other stakeholders also contribute largely to the success
of any firm.
 Critique: Balancing the interests of all the relevant
stakeholders is not practical. There is no way to determine
the right balance and will be left to individual discretion.
 Further, if a firms social objectives supersedes its business
objectives, it will fail to rival its competitors and ultimately
become sick. 14

15. What then is the right objective?
 Growth – It primarily refers to the extent the firm has
created or enhanced value over a period of time. Growth
can be measured in terms of sales, profits, earnings per
share, market capitalization, etc. Modern organizations link
growth with market leadership and sustainability.
 The broad objective is to grow at pace that outsmarts its
competitors.
 Growth based on one measure is extremely susceptible to
risk.
 Growth will not only ensure healthy profits but will also
maximize returns to shareholders and also contribute to
the society as a whole through CSR.
 Growth therefore reins supreme over all objectives. 15

16. How to choose organization form?
 An organization is an artificial person. Therefore, choosing
the type of organizational form is important as it has
serious financial implications, especially from the point of
view of finance, taxation and control.
 Sole Proprietorship – It is a business entity owned by a
single person and is subject to minimal government
regulations. It is simple, very easy to set up and set up
costs are nominal. The owner bears all the profits and
losses of the firm. Owners liabilities are unlimited.
 Such firms have limited ability to raise capital and attract
talent.
 It is relatively easy to transfer the assets and or sell of the
firm. 16

17. Partnership firm
 Partnership – A partnership firm requires a minimum of 2
(two) members to be set up and can have at the most 20
members (except in the case of NBFCs 10 members).
 It is governed by the Indian Partnership Act, 1932.
Government regulations are slightly more complex and set
up costs are on the incremental side.
 The partners share all the profits and losses of the firm.
Partners liabilities are unlimited individually and
collectively.
 Partnership firms have somewhat greater ability to raise
capital, however attracting talent remains status quo.
 It is the firm which owns the assets therefore, It is
relatively difficult to transfer the assets or sell of the firm.
17

18. A Company
 Company – It is registered under the Indian Companies
Act, 1956 (as revised 2013). A private company can at the
most have 50 shareholders, while for public company
there is no limit to the no. of shareholders.
 Government regulations are very complex and set up
costs are also very high.
 Public ltd Cos are regulated by SEBI.
 The shareholders share all the profits and losses of the
firm however, their liabilities are limited.
 A company has unlimited potential to raise capital, and
can also attract the brightest talent in the industry.
 It is the firm which owns the assets therefore, It is very
difficult to transfer the assets and or sell of the firm.
 Stakeholders can also sue for winding up. 18

19. Other issues in selecting organizational form
 Decision Making – In proprietorship firms decision making
is the fastest. In a partnership firm the consent of all the
partners is essential (except for sleeping partners).
Therefore, decision making process slows down. In a
company, since superiors need to ratify decisions, often at
multiple levels; decision making is the slowest.
 Confidentiality – In a proprietorship firm information is
shared with no one, therefore confidentiality is very high.
In case of a partnership firm, confidentiality comes down.
Since company’s need to file their financial details with
RoC and stock exchanges, a lot of information is there in
the public domain.
 Succession Planning – It is the smoothest in case of a
company.
19

20. Agency problem
 In proprietorship or partnership it is the owners or partners
who also manages the activities of the business entity.
 However, in case of a company there is complete divorce
between ownership (or principal) and management.
 Professional managers are usually appointed to manage
the day to day affairs of the business. There is an implicit
relationship of trust.
 It is expected that the decisions taken by the managers (or
agents) should be well aligned with the dictum of the
owners. However, often there is a conflict between the
two. This is known as agency problem.
 Agency problem needs to minimized through a holistic and
360 degree appraisal of their performance and rewards.20

21. The finance vertical (contd)
 Entry Level (0 – 5 yrs) : In industry, entry level finance
functions typically involves around managing working
capital, which includes inventory, debtors and cash. In a
bank it could include: credit appraisal, credit monitoring
and control. In an IT or consulting positions it could
include financial or investment analysis.
 Mid Level (5 – 15 yrs): In industry, mid level finance
functions typically involves investment or treasury
management or may be heading a particular division or
even SBU. In such cases projects appraisal or capital
budgeting, including raising long term finance (advisory
capacity) becomes an important function. In a bank it
could include an operations or branch head. In IT industry
it could be a Sr Consultant.
21

22. The finance vertical (end)
 Senior Level (15 – above yrs) : In industry, senior level
finance functions (CFO) typically involves designing of
capital structure and dividend policy. As the CFO is
primarily responsible for RoI he also is final approving
authority for new projects or scaling up existing
businesses.
 In a bank it could include senior positions at regional –
zonal – head office levels, where decisions are taken with
regards to exposures in different industries, base rate
across different lending products and opening of new
branches or ATMs.
 In IT / Consulting industry it could be of Country or
Functional heads, directly reporting to the BoD. 22

23. End
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