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Accounting has been called the language of business. As such, the
purpose of accounting is to formalize data and numbers in such a manner
that it aids in financial planning and decision making. While book
keeping refers to just the manner of organizing and keeping records
i.e. books of accounts, accounting goes a step further in that it is
used to analyze the data or information. And the purpose of this
analysis is to make inferences or plans based on trends or assumptions.
The result of the book-keeping process are three main financial
statements, the Income Statement, the Balance Sheet and the Cash Flow
or Funds Flow Statement. The income statement shows whether the
business operations have been successful or not i.e. whether they have
resulted in a Profit or Loss. If we look at these carefully and try to
analyze our total revenues, costs and expenses we can learn a lot. Once
we have worked on these three determinants i.e. revenues, costs and
expenses, we then have an idea of the role each plays in the
determination of our profits. Our goal would be to increase Profits
either by increasing Revenues or controlling and decreasing Costs and
Expenses. In a similar manner, the Balance Sheet is a picture of the
Assets, Liabilities and Owners Equity of a business on a particular
date, being the end of the accounting year for that firm. Assets are
the resources used by the firm while Liabilities and Owner’s Equity are
both sources of funds; they show whether the resources used by the
business belong to the owners themselves (Owners Equity) or are
borrowed from other sources (Liabilities). By analyzing the breakup of
total assets, liabilities and owners equity, we can determine whether
the business is solvent, debt-heavy etc. The cash flow statement shows
how cash was generated and how it was spent in the business. The
collective information from all three statements in tandem will
definitely aid in decision making. Using ratio analysis, trend analysis
and other measures, we can set the tone for future business goals.
(Source:Robert Meigs: Accounting: The Basis For Business Decisions. (Irwin/McGraw-Hill [11th ed.]).
Financial Leverage
Financial leverage refers to the degree to which a business is
utilizing borrowed money. Companies that are highly leveraged may run
the risk of being bankrupt if they are unable to make the necessary
principal and interest installments on their debt. Being defaulters,
they are regarded a credit risk and may also be unable to find new
lenders in the future.
Financial leverage is not always bad, however. One may invest and do
business with borrowed funds, earn a profit on the same and out of
these, make interest payments to the bondholders and dividend payments
to the shareholders. Other than this, interest being a fixed cost is
also tax deductible- therefore there is a tax advantage of using debt
rather than equity to finance the business. However the capital
structure of the firm must be carefully decided- the total value of the
firm at any point is the sum of the value of debt plus equity in the
capital structure. The capacity of the firm to absorb debt and meet the
debtors fixed obligations will have to be determined, before launching
a bond flotation. A firm having a strong equity base will be regarded
more favorably by the prospective bondholder- as he is sure that there
are enough assets and profits to cover interest and principal
repayments. These bonds will be rated as first class debt securities
and may even be offered at a premium. Conversely, if a business is
already debt heavy, its bonds will have to be floated at a discount to
face value, thereby increasing its yield and making it favorable for
the bondholder. This is the principle behind deep discount bonds. Other
factors that may influence the value of the bonds are the availability
of credit in the economy, the short and long term structure of interest
rates, the number of issues already in the market, the firm’s business
plans and its value in the eyes of the stakeholders.
(Source: www.investorwords.com/1952/financial_leverage.html and Ramesh Rao (1992) Financial Management: Concepts and Applications, 2nd edition, Macmillan)
Off Balance Sheet Lliabilities
Off balance sheet liabilities or contingent liabilities refer to
debts that may occur or become due based upon the happening or
non-occurrence of some specific event in the future. The principle of
adequate disclosure in financial reporting requires that all contingent
assets and liabilities also be reported on the Balance Sheet. This
helps a potential stakeholder form a more complete and lucid opinion on
the company. The effect on the company’s financial stature must also be
included; this is usually reported in the Notes to the Accounts section
of the Company’s annual reports. The potential of partial or total loss
from a particular venture or event must be noted and accounted for.
Often, the non-reporting of such items can have serious consequences. A
recent example is the Enron scandal. In the wake of this, Section
401(a) of the Sarbanes-Oxley Act requires the reporting of "all
material off-balance sheet transactions, arrangements, obligations
(including contingent obligations), and other relationships of the
issuer with unconsolidated entities or other persons, that may have a
material current or future effect on financial condition, changes in
financial condition, results of operations, liquidity, capital
expenditures, capital resources, or significant components of revenues
or expenses." In this context, the following are some examples of
contingent or off balance sheet liabilities:
i) Any obligation under a direct or indirect guarantee. ii) A
retained or contingent interest in liabilities transferred to an
unconsolidated entity. iii) Derivatives, to the extent that the fair
value thereof is not fully reflected as a liability in the financial
statements.
In some instances where a liability is probable, a company can
reasonably estimate a range of losses. A company may determine that one
amount within the range is more probable than any other amount within
the range. In that situation, a company should accrue its best estimate
within the range and disclose in the notes to the financial statements
the additional exposure to loss if there is at least a reasonable
possibility of loss in excess of the amount accrued.
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