Financial Performance of BOC Bangladesh Limited

E X E C U T I V E   S U M M A R Y

This report “The Overall Evaluation of Financial Statements of BOC” is prepared to fulfill the partial requirement of BUS 800 program of Business Administration Program of Southeast University, Bangladesh. The topic of dissertation was selected upon consultation with course adviser of respective department.

The main aim of this report is to know the financial situation of the company through financial statement analysis, to know the factors which are related with the making decision regarding financial policy, to gain experience and knowledge of analyzing the financial statement. And justify the result from investor and creditor’s point of view. From this analysis we find out the financial performance and this analysis from the annual report issued by BOC Bangladesh Ltd. from the year 2004 to 2008, which was the main source of information.

After the analyzing the different ratios of BOC Bangladesh Ltd. we can see that there were a slight decrement in Earning Per Share and in 2008 their EPS was 13.27, which is good for any company. From the analysis we can also say that BOC has failed to use it’s asset efficiently. This position has a bad impact on investor view. As a whole from the analysis we can say that BOC had a bad year in 2008 because maximum ratios in 2008 have decreased from 2007. But according to chairman’s statement the business results for the year were satisfactory. From the sources of information there is no industry average and because of that we can’t compare those ratios. For this we can’t actually say that those ratios were good or bad.

To increase the performance of the company management had taken some new approaches. A second hand but unused Carbon Dioxide plant has been installed at the Tejgaon factory and has been accepted in November 2008 after suitable testing.

Introduction

One of the prime objectives of SoutheastUniversity is to provide executives with academic and practical excellence along with moral awareness with a view to serve the nation. Producing successful business executives is also one of the sub-objectives alongside the main objective.

No knowledge is fully complete unless it is fully supported by event on growth. Nobody in this competitive arena will be successful until he is not linked with practical orientation. This realization is more pronounce in the study of Business Administration where experience on ground plays a dominant role. For this purpose I choose The Chartered Accountants (CA) Firm as M. Abdus Salam & Co. for making my Internship report on the “Overall Evaluation of Financial Statement of BOC” as an assistant junior consultant.

Orientation in CA Firms generally expresses the overall activities of the Auditing & Business Valuation. The CA Firm is a service oriented organization. Firm’s aim is to provide service to its Clients and developed the overall economic conditions by actual audit services.

During this period, we have tried our best to use this opportunity to enrich our knowledge on the assigned topic. After observing thoroughly, we have completed this report on the basis of our finding and observing relating to the topic.

Origin of the Report

This report is prepared to fulfill the partial requirement of BUS 800 of Master of Business administration program of SoutheastUniversity on the Financial Statement analysis of a company. So the business organization Bangladesh Oxygen Company (BOC) Limited is chosen as an assistant junior consultant and I am discussing on different ratio of this company over five years from 2004 to 2008. I have based this report from the background information and knowledge that I acquired from BOC Bangladesh Limited and it provides a reliable and effective insight into the ratio analysis of the particular company. I did this report on financial performance because it’s a requirement of Internship Course. I have tried to reflect my experience on my report in terms of financial performance of BOC Bangladesh Limited.

 Objectives of the Study

The first objective of writing the report is fulfilling the partial requirements of the MBA program. In this report, I have attempted to give on overview of “The Overall Evaluation of Financial Statements”. Following are the specific objectives.

• To know the financial situation of the company through financial statement analysis.
• To know the factors, related with the making decision regarding financial policy.
• To gain experience and knowledge of analyzing the financial statement technique from the real life, this will help in practical working environment.

 Methodology of the Study

Information used to prepare this report has been collected from both the Secondary source and the primary survey. The secondary sources of information were collected from BOC Bangladesh Limited, Dhaka Stock Exchange, Annual report of BOC Bangladesh Limited, periodicals and materials from various newspapers and articles. An open discussion method was followed to gather primary information by interviewing the company secretary of the company.

Limitations of the Study

There are some limitations in my study. I have faced some problems during the study which are mentioning them as below-

• It was very difficult to collect the information from various business clients for their job constraint and some time there are some back dated information they provide
• The record system of the annual report is not efficient
• Lack of access in many section of the organization
• Time is not sufficient to complete the study perfectly
• Clients always contradict minded with the auditor or their representatives to provide adequate information
• I carried out such a study for the first time, so inexperience is one of the main constraints of the study.

Chapter 2

Basic Concept of the Financial Statement

&

Assurance

Preface of the Financial Statement

Entailing of the Financial Statements

• The financial statement is a written report which quantitatively describes the financial health of a company. This includes an income statement and a balance sheet, and often also includes a cash flow statement. Financial statement is usually compiled on a quarterly and annual basis.
• A financial statement is the main source of financial information to persons outside the organization. These convey to management and to interested outsiders a concise picture of the profitability and financial position of the organization.
• Financial Statements is a accounting statements that provide specific information about a company’s financial position including the Profit and Loss Statement, also known as the Income Statement, the Balance Sheet, and the Statement of Cash Flows.

Historical Definitions of the Financial Statements

• Financial statements (or financial reports) are formal records of the financial activities of a business, person, or other entity. In British English, including United Kingdom company law, financial statements are often referred to as accounts, although the term financial statements are also used, particularly by accountants.
• Financial Report is an accounting statement detailing financial data, including income from all sources, expenses, assets and liabilities. A financial report may also be an itemized accounting that shows how grant funds were used by a donee organization. Most foundations require a financial report from grantees.
• Financial statements provide an overview of a business or person’s financial condition in both short and long term. All the relevant financial information of a business enterprise presented in a structured manner and in a form easy to understand, is called the financial statements.

  Important of the Financial Statements

Financial statements are produced in order to satisfy the customer’s information needs. The book indicates the informa­tion that every financial statement depicts. Cash flow statements, the statement of the company’s capital changes, the purpose of annual reports presented by the management and the whole presented information are of great importance. The cash flow statement informs about such important issues as whether the company has cash enough to pay out dividends, to repay the loan, to engage in financial and investment activities. The company’s capital changes statement indicates an increase or decrease of economic gain in a financial year and presents other changes not depicted in the Income statement. The annual report must provide an overview of the company’s performance and development, descrip­tion of the most important risk factors the company faces, environmental and person­nel issues, information about branches and subsidiaries, most important post balance sheet events, information about research, the main shareholders, board member au­thorization; explanation of the factors that influence the company’s financial state and performance results.

 Purposes of the Financial Statements

“The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.” Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization’s financial position. Reported income and expenses are directly related to an organization’s financial performance.

Financial statements are intended to be understandable by readers who have “a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently.” Financial statements may be used by users for different purposes:

• Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management’s annual report to the stockholders.
• Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.
• Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.
• Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
• Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.
• Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.
• Media and the general public are also interested in financial statements for a variety of reasons.

  Classifications of the Financial Statements

Financial statements for a business relate to a set trading period such as a financial year. They  provide a record of cash inflows and outflows, the amounts owing and owed, details of plant & equipment for depreciation purposes and normally comprise of the following (four basic financial statements):-

• Balance Sheet: The Balance Sheet is a snap shot of the financial position of a business as of a certain date. It details assets, liabilities, debtors, creditors, proprietorship for the business. By comparing Balance Sheets from year to year a financial picture of the business can be obtained.
• Income Statement: also referred to as Profit and Loss statement (or a “P&L”), reports on a company’s income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state. The Profit and Loss Statement forms part of the “Financial Statements” of a business. It represents a historical record for a set period of time of the cash inflows and outflows of a business. Careful analyses of the Profit & Loss Statement may indicate expenses that can be ‘added back” to show the true net profit.
• Statement of Retained Earnings: explains the changes in a company’s retained earnings over the reporting period.
• Statement of Cash Flows: reports on a company’s cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set of Notes to the Financial Statements or accounts (also included depreciation schedule) and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Balance Sheet

In financial accounting, a Balance Sheet or Statement of Financial Position is a summary of a person’s or organization’s balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a company’s financial condition. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time.

A company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company and according to the accounting equation, net worth must equal assets minus liabilities.

Another way to look at the same equation is that assets equal liabilities plus owner’s equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner’s money (owner’s equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections “balancing.”

Records of the values of each account or line in the balance sheet are usually maintained using a system of accounting known as the double-entry bookkeeping system.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they can not, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.

Types of Balance Sheet

A balance sheet summarizes an organization or individual’s assets, equity and liabilities at a specific point in time. Individuals and small businesses tend to have simple balance sheets. Larger businesses tend to have more complex balance sheets, and these are presented in the organization’s annual report. Large businesses also may prepare balance sheets for segments of their businesses. A balance sheet is often presented alongside one for a different point in time (typically the previous year) for comparison.

Personal Balance Sheet

A personal balance sheet lists current assets such as cash in checking accounts and savings accounts, long-term assets such as common stock and real estate, current liabilities such as loan debt and mortgage debt due, or overdue, long-term liabilities such as mortgage and other loan debt. Securities and real estate values are listed at market value rather than at historical cost or cost basis. Personal net worth is the difference between an individual’s total assets and total liabilities.

Sample of Small Business Balance Sheet

A small business balance sheet lists current assets such as cash, accounts receivable, and inventory, fixed assets such as land, buildings, and equipment, intangible assets such as patents, and liabilities such as accounts payable, accrued expenses, and long-term debt. Contingent liabilities such as warranties are noted in the footnotes to the balance sheet. The small business’s equity is the difference between total assets and total liabilities.

Table 2.1: Sample of Small Business Balance Sheet

Public Business Entities Balance Sheet Structure

Guidelines for balance sheets of public business entities are given by the International Accounting Standards Committee and numerous country-specific organizations.

Balance sheet account names and usage depend on the organization’s country and the type of organization. Government organizations do not generally follow standards established for individuals or businesses.

If applicable to the business, summary values for the following items should be included on the balance sheet:

Assets

Current Assets

1. Cash and cash equivalents
2. Inventories
3. Accounts receivable
4. Prepaid expenses for future services that will be used within a year

Fixed Assets

1. Property, plant and equipment
2. Investment property, such as real estate held for investment purposes
3. Intangible assets
4. Financial assets (excluding investments accounted for using the equity method, accounts receivables, and cash and cash equivalents)
5. Investments accounted for using the equity method
6. Biological assets, which are living plants or animals. Bearer biological assets are plants or animals which bear agricultural produce for harvest, such as apple trees grown to produce apples and sheep raised to produce wool.

Liabilities

1. Accounts payable
2. Provisions for warranties or court decisions
3. Financial liabilities (excluding provisions and accounts payable), such as promissory notes and corporate bonds
4. Liabilities and assets for current tax
5. Deferred tax liabilities and deferred tax assets
6. Minority interest in equity
7. Issued capital and reserves attributable to equity holders of the Parent company
8. Unearned revenue for services paid for by customers but not yet provided

Equity

The net assets shown by the balance sheet equals the third part of the balance sheet, which is known as the shareholders’ equity. Formally, shareholders’ equity is part of the company’s liabilities: they are funds “owing” to shareholders (after payment of all other liabilities); usually, however, “liabilities” is used in the more restrictive sense of liabilities excluding shareholders’ equity. The balance of assets and liabilities (including shareholders’ equity) is not a coincidence. Records of the values of each account in the balance sheet are maintained using a system of accounting known as double-entry bookkeeping. In this sense, shareholders’ equity by construction must equal assets minus liabilities, and are a residual.

1. Numbers of shares authorized, issued and fully paid, and issued but not fully paid
2. Par value of shares
3. Reconciliation of shares outstanding at the beginning and the end of the period
4. Description of rights, preferences, and restrictions of shares
5. Treasury shares, including shares held by subsidiaries and associates
6. Shares reserved for issuance under options and contracts
7. A description of the nature and purpose of each reserve within owners’ equity

Sample Balance Sheet Structure

The following balance sheet structure is just an example. It does not show all possible kinds of assets, equity and liabilities, but it shows the most usual ones. Because it shows goodwill, it could be a consolidated balance sheet. Monetary values are not shown; summary (total) rows are missing as well.

 Income Statement

Income statement, also referred as profit and loss statement (P&L), earnings statement, operating statement or statement of operations, is a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.

Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments. This statement is commonly referred to as the statements of activities. Revenues and expenses are further categorized in the statement of activities by the donor restrictions on the funds received and expended.

The income statement can be prepared in one of two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Usefulness and Limitations of Income Statement

Income statements should help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows.

However, information of an income statement has several limitations:

• Items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty).
• Some numbers depend on accounting methods used (e.g. using FIFO or LIFO accounting to measure inventory level).
• Some numbers depend on judgments and estimates (e.g. depreciation expense depends on estimated useful life and salvage value).

Items on Income Statement

Operating Section

• Revenue – Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances.
• Expenses – Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations.
  • General and administrative expenses (G & A) – represent expenses to manage the business (officer salaries, legal and professional fees, utilities, insurance, depreciation of office building and equipment, office rents, office supplies)
  • Selling expenses – represent expenses needed to sell products (e.g., sales salaries, commissions and travel expenses, advertising, freight, shipping, depreciation of sales store buildings and equipment)
  • Selling General and Administrative expenses (SG&A or SGA) – consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. SGA is usually understood as a major portion of non-production related costs, opposing production related costs such as raw material and (direct) labor
  • R & D expenses – represent expenses included in research and development
  • Depreciation – is the charge for a specific period (i.e. year, accounting period) with respect to fixed assets that have been capitalized on the balance sheet.

Non-operating Section

• Other revenues or gains – revenues and gains from other than primary business activities (e.g. rent, patents). It also includes unusual gains and losses that are either unusual or infrequent, but not both (e.g. sale of securities or fixed assets)
• Other expenses or losses – expenses or losses not related to primary business operations.

Irregular Items

They are reported separately because this way users can better predict future cash flows – irregular items most likely will not recur. These are reported net of taxes.

• Discontinued operations are the most common type of irregular items. Shifting business location, stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations.
• Extraordinary items are both unusual (abnormal) and infrequent, for example, unexpected natural disaster, expropriation, prohibitions under new regulations. Note: natural disaster might not qualify depending on location (e.g. frost damage would not qualify in Canada but would in the tropics).
• Changes in accounting principle are, for example, deciding to depreciate an investment property that has previously not been depreciated. However, changes in estimates (e.g. estimated useful life of a fixed asset) do not qualify.

Sample of Income Statement

Table 2.2: Sample of Income Statement

* Number of Authorized share: 10, 00,000

Calculation of Earnings Per Share****

Because of its importance, earnings per share (EPS) are required to be disclosed on the face of the income statement. A company which reports any of the irregular items must also report EPS for these items either in the statement or in the notes.

By using this formula, above income statements EPS is-

EPS is 663 Taka in 2004

EPS is 1350 Taka in 2003

EPS is 381 Taka in 2002

There are two forms of EPS reported:

• Basic: in this case “weighted average of shares outstanding” includes only actual stocks outstanding.
• Diluted: in this case “weighted average of shares outstanding” is calculated as if all stock options, warrants, convertible bonds, and other securities that could be transformed into shares are transformed. This increases the number of shares and so EPS decreases. Diluted EPS is considered to be a more reliable way to measure EPS.

Statement of Retained Earnings

The Statement of Retained Earnings (also known as Equity Statement, Statement of Owner’s Equity for a single proprietorship, Statement of Partner’s Equity for partnership, and Statement of Retained Earnings and Stockholders’ Equity for corporation)is one of the basic financial statements as per Generally Accepted Accounting Principles, and it explains the changes in a company’s retained earnings over the reporting period. It breaks down changes affecting the account, such as profits or losses from operations, dividends paid, and any other items charged or credited to retained earnings. A retained earnings statement is required by Generally Accepted Accounting Principles (GAAP) whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule.

A simple illustration of Owner’s Equity Statement showing 2 columns with 5 used cells as follows; 1 is the Opening Capital (at inception it equals zero), 2 is the Increase or Addition (by owners investment & the net income), 4 represents summation of (opening capital 1 and the increase 2), 3 is the Decrease or Loss (by owners withdrawal & net loss), and 5 is the Closing Capital after a defined period of time (Opening Capital + Increase – Decrease, i.e. 4-3).

Therefore, the statement of retained earnings uses information from the income statement and provides information to the balance sheet. Retained earnings are part of the balance sheet (another basic financial statement) under “stockholders equity,” and are mostly affected by net income earned during a period of time by the company less any dividends paid to the company’s owners / stockholders. The retained earnings account on the balance sheet is said to represent an “accumulation of earnings” since net profits and losses are added/subtracted from the account from period to period.

The general equation can be expressed as following:

Ending Retained Earnings = Beginning Retained Earnings – Dividends Paid + Net Income

 Statement of Cash Flow

In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet and income accounts affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard-7 (IAS-7) is the International Accounting Standard that deals with cash flow statements.

People and groups interested in cash flow statements include:

• Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
• Potential lenders or creditors, who want a clear picture of a company’s ability to repay
• Potential investors, who need to judge whether the company is financially sound
• Potential employees or contractors, who need to know whether the company will be able to afford compensation

History and Variations

Cash basis financial statements were common before accrual basis financial statements. The “flow of funds” statements of the past were cash flow statements.

In the United States in 1971, the Financial Accounting Standards Board (FASB) defined rules that made it mandatory under Generally Accepted Accounting Principles (US GAAP) to report sources and uses of funds, but the definition of “funds” was not clear. “Net working capital” might be cash or might be the difference between current assets and current liabilities. From the late 1970 to the mid-1980s, the FASB discussed the usefulness of predicting future cash flows. In 1987, FASB Statement No. 95 (FAS 95) mandated that firms provide cash flow statements. In 1992, the International Accounting Standards Board issued International Accounting Standard 7 (IAS 7), Cash Flow Statements, which became effective in 1994, mandating that firms provide cash flow statements.

US GAAP and IAS 7 rules for cash flow statements are similar. Differences include:

• IAS 7 requires that the cash flow statement include changes in both cash and cash equivalents. US GAAP permits using cash alone or cash and cash equivalents.
• IAS 7 permits bank borrowings (overdraft) in certain countries to be included in cash equivalents rather than being considered a part of financing activities.
• IAS 7 allows interest paid to be included in operating activities or financing activities. US GAAP requires that interest paid be included in operating activities.
• US GAAP (FAS 95) requires that when the direct method is used to present the operating activities of the cash flow statement, a supplemental schedule must also present a cash flow statement using the indirect method. The IASC strongly recommends the direct method but allows either method. The IASC considers the indirect method less clear to users of financial statements. Cash flow statements are most commonly prepared using the indirect method, which is not especially useful in projecting future cash flows.

Purpose

The cash flow statement was previously known as the flow of funds statement. The cash flow statement reflects a firm’s liquidity.

The balance sheet is a snapshot of a firm’s financial resources and obligations at a single point in time, and the income statement summarizes a firm’s financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are usually reported in footnotes.

The cash flow statement is intended to-

• Provide information on a firm’s liquidity and solvency and its ability to change cash flows in future circumstances
• Provide additional information for evaluating changes in assets, liabilities and equity
• Improve the comparability of different firms’ operating performance by eliminating the effects of different accounting methods
• Indicate the amount, timing and probability of future cash flows.

The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.

Cash Flow Activities

The cash flow statement is partitioned into three segments, namely: cash flow resulting from operating activities, cash flow resulting from investing activities, and cash flow resulting from financing activities.

The money coming into the business is called cash inflow, and money going out from the business is called cash outflow.

Operating Activities

Operating activities include the production, sales and delivery of the company’s product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.

Under IAS 7, operating cash flows include:

• Receipts from the sale of goods or services
• Receipts for the sale of loans, debt or equity instruments in a trading portfolio
• Interest received on loans
• Dividends received on equity securities
• Payments to suppliers for goods and services
• Payments to employees or on behalf of employees
• Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)

Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:

• Depreciation (loss of tangible asset value over time)
• Deferred tax
• Amortization (loss of intangible asset value over time)
• Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement)

Investing Activities

Examples of investing activities are

• Purchase of an asset (assets can be land, building, equipment, marketable securities, etc.)
• Loans made to suppliers or customers

Financing Activities

Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement.

Under IAS 7, Financing cash flows include-

• Proceeds from issuing short-term or long-term debt
• Payments of dividends
• Payments for repurchase of company shares
• Repayment of debt principal, including capital leases
• For non-profit organizations, receipts of donor-restricted cash that is limited to long-term purposes

Items under the financing activities section include:

• Dividends paid
• Sale or repurchase of the company’s stock
• Net borrowings
• Payment of dividend tax

Disclosure of Non-cash Activities

Under IAS 7, non-cash investing and financing activities are disclosed in footnotes to the financial statements. Under US GAAP, non-cash activities may be disclosed in a footnote or within the cash flow statement itself. Non-cash financing activities may include-

• Leasing to purchase an asset
• Converting debt to equity
• Exchanging non-cash assets or liabilities for other non-cash assets or liabilities
• Issuing shares in exchange for assets

Preparation Methods

The direct method of preparing a cash flow statement results in a more easily understood report. The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method.

Direct Method

The direct method for creating a cash flow statement reports major classes of gross cash receipts and payments. Under IAS 7, dividends received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities.

 Sample of Cash Flow Statement Using the Direct Method

 Table 2.3: Sample of Cash Flow Statement (Direct Method)

Indirect Method

The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.

Rules

The following rules are used to make adjustments for changes in current assets and liabilities, operating items not providing or using cash and non operating items.

• Decrease in non cash current assets are added to net income
• Increase in non cash current asset are subtracted from net income
• Increase in current liabilities are added to net income
• Decrease in current liabilities are subtracted from net income
• Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period)
• Revenues with no cash inflows are subtracted from net income
• Non operating losses are added back to net income
• Non operating gains are subtracted from net income

Sample of Cash Flow Statement Using the Indirect Method

Table 2.4: Sample of Cash Flow Statement (Indirect Method)

 Notes to the Financial Statements

Notes to the Financial Statements are additional notes and information added to the end of the financial statements to supplement the reader with more information. Notes to Financial Statements help explain the computation of specific items in the financial statements as well as provide a more comprehensive assessment of a company’s financial condition. Notes to Financial Statements can include information on debt, going concern, accounts, contingent liabilities, or contextual information explaining the financial numbers (e.g. to indicate a lawsuit). The information contained within the notes not only supplements financial statement information, but they clarify line-items that are part of the financial statements. For example, if a company lists a loss on fixed asset impairment in their income statement, Notes to Financial Statements could serve to corroborate the reason for the impairment by providing specific information relative to how the asset became impaired. Notes to the Financial Statements are also used to explain the method of accounting used to prepare the financial statements (all publicly traded companies are required to use accrual basis accounting for financial reporting purposes as mandated by the SEC), and they provide valuations for how particular accounts have been represented. In consolidated financial statements, all subsidiaries should be listed as well as the amount of ownership (controlling interest) that the parent company has in the subsidiary companies. Any items within the financial statements that are valuated by estimation should be part of the Notes to Financial Statements if a substantial difference exists between the amount of the estimate previously reported and the amount of the actual results. Full disclosure of the effects of the differences between the estimate and the actual results should be in the note.

Consolidated Financial Statements

Consolidated financial statements are financial statements that factor the holding company’s subsidiaries into its aggregated accounting figure. It is a representation of how the holding company is doing as a group. The consolidated accounts should provide a true and fair view of the financial and operating conditions of the group. Doing so typically requires a complex set of eliminating and consolidating entries to work back from individual financial statements to a group financial statement that is an accurate representation of operations.

Consolidation (Business)

Consolidation or amalgamation is the act of merging many things into one. In business, it often refers to the mergers or acquisitions of many smaller companies into much larger ones. The financial accounting term of consolidation refers to the aggregated financial statements of a group company as consolidated account. The taxation term of consolidation refers to the treatment of a group of companies and other entities as one entity for tax purposes. Under the Halsbury’s Laws of England, ‘amalgamation’ is defined as “a blending together of two or more undertakings into one undertaking, the shareholders of each blending company, becoming, substantially, the shareholders of the blended undertakings. There may be amalgamations, either by transfer of two or more undertakings to a new company, or to the transfer of one or more companies to an existing company”. Thus, the two concepts are, substantially, the same. However, the term amalgamation is more common when the organizations being merged are private schools or regiments.

Types of Business Consolidations

There are three forms of business combinations:

• Statutory Merger: a business combination that results in the liquidation of the acquired company’s assets and the survival of the purchasing company.
• Statutory Consolidation: a business combination that creates a new company in which none of the previous companies survive.
• Stock Acquisition: a business combination in which the purchasing company acquires the majority, more than 50%, of the Common stock of the acquired company and both companies survive.
• Amalgamation: Means an existing Company which is taken over by another existing company. In such course of amalgamation, the consideration may be paid in cash or in Kind, and the purchasing company services in this process.

Terminology

• Parent-subsidiary relationship: the result of a stock acquisition where the parent is the acquiring company and the subsidiary is the acquired company.
• Controlling Interest: When the parent company owns a majority of the common stock.
• Non-controlling interest or Minority interest: the rest of the common stock that the other shareholders own.
• Wholly owned subsidiary: when the parent owns all the outstanding common stock of the subsidiary.

Amalgamated Company is formed when in the process of the amalgamation; the combined company is formed out of the transaction. The amalgamated company is otherwise called the transferee company. The company or companies, which merge into the new company, are called the transferor companies and, the company, into which the transferor companies merge, is known as the transferee company.

Note-“Amalgamating Company”: The company or companies, which are merged, are called the “amalgamating companies”. The amalgamating company or companies are also called the “transferor company/companies.”

 Accounting Treatment (GAAP)

A parent company can acquire another company in two ways:

 By Purchasing the Net Assets

• Treatment to the acquiring company: When purchasing the net assets the acquiring company records in its books the receipt of the net assets and the disbursement of cash, the creation of a liability or the issuance of stock as a form of payment for the transfer.
• Treatment to the acquired company: The acquired company records in its books the elimination of its net assets and the receipt of cash, receivables or investment in the acquiring company (if what was received from the transfer included common stock from the purchasing company). If the acquired company is liquidated then the company needs an additional entry to distribute the remaining assets to its shareholders.

 By Purchasing the Common Stock of another Company:

• Treatment to the purchasing company: When the purchasing company acquires the subsidiary through the purchase of its common stock, it records in its books the investment in the acquired company and the disbursement of the payment for the stock acquired.
• Treatment to the acquired company: The acquired company records in its books the receipt of the payment from the acquiring company and the issuance of stock.

Regardless of the method of acquisition direct costs, costs of issuing securities and indirect costs are treated:

• Direct costs: the acquiring company capitalizes direct costs paid to outside parties as part of the total acquisition cost.
• Costs of issuing securities: these costs reduce the issuing price of the stock.
• Indirect and general costs: the acquiring company expenses these costs as they are incurred.

 Reporting Inter-corporate Interest – Investments in Common Stock

 1 20% Ownership or Less:

When a company purchases 20% or less of the outstanding common stock, the purchasing company’s influence over the acquired company is not significant. (APB 18 specifies conditions where ownership is less than 20% but there is significant influence).

 The purchasing company uses the cost method to account for this type of investment. Under the cost method, the investment is recorded at cost at the time of purchase. The company does not need any entries to adjust this account balance unless the investment is considered impaired or there are liquidating dividends, both of which reduce the investment account.

Liquidating dividends: Liquidating dividends occur when there is an excess of dividends declared over earnings of the acquired company since the date of acquisition. Regular dividends are recorded as dividend income whenever they are declared.

Impairment loss: An impairment loss occurs when there is a decline in the value of the investment other than temporary.

20% to 50% Ownership — Associate Company

When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant. The deciding factor, however, is significant influence. If other factors exist that reduce the influence or if significant influence is gained at an ownership of less than 20%, the equity method may be appropriate (FASB interpretation 35 underlines the circumstances where the investor is unable to exercise significant influence). To account for this type of investment, the purchasing company uses the equity method. Under the equity method, the purchaser records its investment at original cost. This balance increases with income and decreases for dividends from the subsidiary that accrue to the purchaser.

 Treatment of Purchase Differentials: At the time of purchase, purchase differentials arise from the difference between the cost of the investment and the book value of the underlying assets.

Purchase differentials have two components:

• The difference between the fair market value of the underlying assets and their book value.
• Goodwill: the difference between the cost of the investment and the fair market value of the underlying assets.

 Purchase differentials need to be amortized over their useful life; however, new accounting guidance states that goodwill is not amortized or reduced until it is permanently impaired, or the underlying asset is sold.

More than 50% Ownership — Subsidiary

When the amount of stock purchased is 50% of the outstanding common stock, the purchasing company has control over the acquired company. Control in this context is defined as ability to direct policies and management. In this type of relationship the controlling company is the parent and the controlled company is the subsidiary. The parent company needs to issue consolidated financial statements at the end of the year to reflect this relationship. Consolidated financial statements show the parent and the subsidiary as one single entity. During the year, the parent company can use the equity or the cost method to account for its investment in the subsidiary. Each company keeps separate books. However, at the end of the year, a consolidation working paper is prepared to combine the separate balances and to eliminate the inter-company transactions, the subsidiary’s stockholder equity and the parent’s investment account. The result is one set of financial statements that reflect the financial results of the consolidated entity.

 International Financial Reporting (Statements)      Standards (IFRS)

 International Financial Reporting Standards (IFRS) are Standards, Interpretations and the Framework adopted by the International Accounting Standards Board (IASB).

Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS was issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and SICs. The IASB has continued to develop standards calling the new standards IFRS.

Structure of IFRS

IFRS are considered a “principles based” set of standards in that they establish broad rules as well as dictating specific treatments.

International Financial Reporting Standards comprise:

• International Financial Reporting Standards (IFRS) – standards issued after 2001
• International Accounting Standards (IAS) – standards issued before 2001
• Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC) – issued after 2001
• Standing Interpretations Committee (SIC) – issued before 2001

There is also a Framework for the Preparation and Presentation of Financial Statements which describes the principles underlying IFRS…

IAS 8 Par. 11

“In making the judgment described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order:

(a) The requirements and guidance in Standards and Interpretations dealing with similar and related issues; and

(b) The definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”

Framework

The Framework for the Preparation and Presentation of Financial Statements states basic principles for IFRS.

Role of Framework

The IASB states:

In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgment, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.

Objective of Financial Statements

A framework is the foundation of accounting standards. The framework states that the objective of financial statements is to provide information about the financial position, performance and changes in the financial position of an entity that is useful to a wide range of users in making economic decisions, and to provide the current financial status of the entity to its shareholders and public in general.

 Underlying Assumptions

The underlying assumptions used in IFRS are:

• Accrual basis – the effect of transactions and other events are recognized when they occur, not as cash is gained or paid.
• Going concern – the financial statements are prepared on the basis that an entity will continue in operation for the foreseeable future.

 Qualitative Characteristics of Financial Statements

The Framework describes the qualitative characteristics of financial statements as having

• Understandability
• Relevance
• Reliability & Comparability
• Accountability
• Timeliness

 Elements of Financial Statements

The financial position of an enterprise is primarily provided in the Statement of Financial Position, also known as the balance sheet. The elements of a balance sheet include:

1. Asset: An asset is a resource controlled by the enterprise as a result of past events, and from which future economic benefits are expected to flow to the enterprise.

2. Liability: A liability is a present obligation of the enterprise arising from the past events, the settlement of which is expected to result in an outflow from the enterprise’ resources, i.e., assets.

3. Equity: Equity is the residual interest in the assets of the enterprise after deducting all the liabilities. Equity is also known as owner’s equity.

The financial performance of an enterprise is primarily provided in an income statement or profit and loss account. The elements of an income statement or the elements that measure the financial performance are as follows:

4. Revenues: increases in economic benefit during an accounting period in the form of inflows or enhancements of assets, or decrease of liabilities that result in increases in equity. However, it does not include the contributions made by the equity participants, i.e., proprietor, partners and shareholders.

5. Expenses: decreases in economic benefits during an accounting period in the form of outflows, or depletions of assets or incurrence of liabilities that result in decreases in equity.

 Recognition of Elements of Financial Statements

An item is recognized in the financial statements when:

• It is probable that a future economic benefit will flow to or from an entity and
• When the item has a cost or value that can be measured with reliability.
• Financial stability

 Measurement of the Elements of Financial Statements

Par. 99. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.

 Par. 100. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

 (b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

 (c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

 (d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Par. 101. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realizable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.

 Concepts of Capital and Capital Maintenance

Concepts of Capital

Par. 102. A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day.

 Par. 103. The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.

Concepts of Capital Maintenance and the Determination of Profit

Par. 104. The concepts of capital in paragraph 102 give rise to the following concepts of capital maintenance:

(a) Financial capital maintenance- Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either Nominal monetary units or units of constant purchasing power.

(b) Physical capital maintenance- Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period.

Par. 105. The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.

Par. 106. The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain.

Par. 107. The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit.

Par. 108. Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains are, conceptually, profits. They may not be recognized as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.

Par. 109. Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit.

Par. 110. The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas; management must seek a balance between relevance and reliability. This Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.

Requirements of IFRS

IFRS financial statements consist of (IAS1.8)

• a Statement of Financial Position
• a comprehensive income statement
• either a statement of changes in equity (SOCE) or a statement of recognized income or expense (“SORIE”)
• a cash flow statement or statement of cash flows
• notes, including a summary of the significant accounting policies

Comparative information is provided for the previous reporting period (IAS 1.36). An entity preparing IFRS accounts for the first time must apply IFRS in full for the current and comparative period although there are transitional exemptions (IFRS1.7).

On 6 September 2007, the IASB issued a revised IAS 1 Presentation of Financial Statements. The main changes from the previous version are to require that an entity must:

• Present all non-owner changes in equity (that is, ‘comprehensive income’) either in one statement of comprehensive income or in two statements (a separate income statement and a statement of comprehensive income). Components of comprehensive income may not be presented in the statement of changes in equity.
• present a statement of financial position (balance sheet) as at the beginning of the earliest comparative period in a complete set of financial statements when the entity applies an accounting
• ‘balance sheet’ will become ‘statement of financial position’
• ‘income statement’ will become ‘statement of comprehensive income’
• ‘Cash flow statement’ will become ‘statement of cash flows’.

The revised IAS 1 is effective for annual periods beginning on or after 1 January 2009. Early adoption is permitted.

List of IFRS Statements

The following IFRS statements are currently issued:

• IFRS 1 First time Adoption of International Financial Reporting Standards
• IFRS 2 Share-based Payment
• IFRS 3 Business Combinations
• IFRS 4 Insurance Contracts
• IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
• IFRS 6 Exploration for and Evaluation of Mineral Resources
• IFRS 7 Financial Instruments: Disclosures
• IFRS 8 Operating Segments
• IAS 1: Presentation of Financial Statements.
• IAS 2: Inventories
• IAS 7: Cash Flow Statements
• IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors
• IAS 10: Events After the Balance Sheet Date
• IAS 11: Construction Contracts
• IAS 12: Income Taxes
• IAS 14: Segment Reporting (superseded by IFRS 8 on 1 January 2008)
• IAS 16: Property, Plant and Equipment
• IAS 17: Leases
• IAS 18: Revenue
• IAS 19: Employee Benefits
• IAS 20: Accounting for Government Grants and Disclosure of Government Assistance
• IAS 21: The Effects of Changes in Foreign Exchange Rate
• IAS 23: Borrowing Costs
• IAS 24: Related Party Disclosures
• IAS 26: Accounting and Reporting by Retirement Benefit Plans
• IAS 27: Consolidated Financial Statements
• IAS 28: Investments in Associates
• IAS 29: Financial Reporting in Hyperinflationary Economies
• IAS 31: Interests in Joint Ventures
• IAS 32: Financial Instruments: Presentation (Financial instruments disclosures are in IFRS 7 Financial Instruments: Disclosures, and no longer in IAS 32)
• IAS 33: Earnings Per Share
• IAS 34: Interim Financial Reporting
• IAS 36: Impairment of Assets
• IAS 37: Provisions, Contingent Liabilities and Contingent Assets
• IAS 38: Intangible Assets
• IAS 39: Financial Instruments: Recognition and Measurement
• IAS 40: Investment Property
• IAS 41: Agriculture

Internal Audit

Internal auditing is a profession and activity involved in helping organizations achieve their stated objectives. It does this by using a systematic methodology for analyzing business processes, procedures and activities with the goal of highlighting organizational problems and recommending solutions. Professionals called internal auditors are employed by organizations to perform the internal auditing activity.

The scope of internal auditing within an organization is broad and may involve topics such as the efficacy of operations, the reliability of financial reporting, deterring and investigating fraud, safeguarding assets, and compliance with laws and regulations.

Internal auditing frequently involves measuring compliance with the entity’s policies and procedures. However, internal auditors are not responsible for the execution of company activities; they advise management and the Board of Directors (or similar oversight body) regarding how to better execute their responsibilities. As a result of their broad scope of involvement, internal auditors may have a variety of higher educational and professional backgrounds.

Publicly-traded corporations typically have an internal auditing department, led by a Chief Audit Executive (“CAE”) who generally reports to the Audit Committee of the Board of Directors, with administrative reporting to the Chief Executive Officer.

The profession is unregulated, though there are a number of international standard setting bodies, an example of which is the Institute of Internal Auditors (“IIA”). The IIA has established Standards for the Professional Practice of Internal Auditing and has over 150,000 members representing 165 countries, including approximately 65,000 Certified Internal Auditors.

History of Internal Auditing

The Internal Auditing profession evolved steadily with the progress of management science after World War II. It is conceptually similar in many ways to financial auditing by public accounting firms, quality assurance and banking compliance activities. Much of the theory underlying internal auditing is derived from management consulting and public accounting professions. With the implementation in the United States of the Sarbanes-Oxley Act of 2002, the profession’s growth accelerated, as many internal auditors possess the skills required to help companies meet the requirements of the law.

 Organizational Independence

To perform their role effectively, internal auditors require organizational independence from management, to enable unrestricted evaluation of management activities and personnel. Although internal auditors are part of company management and paid by the company, the primary customer of internal audit activity is the entity charged with oversight of management’s activities. This is typically the Audit Committee, a sub-committee of the Board of Directors. To provide independence, most Chief Audit Executives report to the Chairperson of the Audit Committee and can only be replaced with the concurrence of that individual.

Role in Internal Control

Internal auditing activity is primarily directed at improving internal control. Under the COSO Framework, internal control is broadly defined as a process, affected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following internal control categories:

• Effectiveness and efficiency of operations.
• Reliability of financial reporting.
• Compliance with laws and regulations.

Management is responsible for internal control. Managers establish policies and processes to help the organization achieve specific objectives in each of these categories. Internal auditors perform audits to evaluate whether the policies and processes are designed and operating effectively and provide recommendations for improvement.

Role in Risk Management

Internal auditing professional standards require the function to monitor and evaluate the effectiveness of the organization’s Risk management processes. Risk management relates to how an organization sets objectives, then identifies, analyzes, and responds to those risks that could potentially impact its ability to realize its objectives.

Under the COSO enterprise risk management (ERM) Framework, risks fall under strategic, operational, financial reporting, and legal/regulatory categories. Management performs risk assessment activities as part of the ordinary course of business in each of these categories. Examples include: strategic planning, marketing planning, capital planning, budgeting, hedging, incentive payout structure, and credit/lending practices. Sarbanes-Oxley regulations also require extensive risk assessment of financial reporting processes. Corporate legal counsel often prepares comprehensive assessments of the current and potential litigation a company faces. Internal auditors may evaluate each of these activities, or focus on the processes used by management to report and monitor the risks identified. For example, internal auditors can advise management regarding the reporting of forward-looking operating measures to the Board, to help identify emerging risks.

In larger organizations, major strategic initiatives are implemented to achieve objectives and drive changes. As a member of senior management, the Chief Audit Executive (CAE) may participate in status updates on these major initiatives. This places the CAE in the position to report on many of the major risks the organization faces to the Audit Committee, or ensure management’s reporting is effective for that purpose.

Internal auditors may help companies establish and maintain Enterprise Risk Management processes. Internal auditors also play an important role in helping companies execute a SOX 404 top-down risk assessment. In these latter two areas, internal auditors typically are part of the project team in an advisory role.

Role in Corporate Governance

Internal auditing activity as it relates to corporate governance is generally informal, accomplished primarily through participation in meetings and discussions with members of the Board of Directors. Corporate governance is a combination of processes and organizational structures implemented by the Board of Directors to inform, direct, manage, and monitor the organization’s resources, strategies and policies towards the achievement of the organizations objectives. The internal auditor is often considered one of the “four pillars” of corporate governance, the other pillars being the Board of Directors, management, and the external auditor.

A primary focus area of internal auditing as it relates to corporate governance is helping the Audit Committee of the Board of Directors (or equivalent) perform its responsibilities effectively. This may include reporting critical internal control problems, informing the Committee privately on the capabilities of key managers, suggesting questions or topics for the Audit Committee’s meeting agendas, and coordinating carefully with the external auditor and management to ensure the Committee receives effective information.

Nature of the Internal Audit Activity

Based on a risk assessment of the organization, internal auditors, management and oversight Boards determine where to focus internal auditing efforts. Internal auditing activity is generally conducted as one or more discrete projects. A typical internal audit project involves the following steps:

• Establish and communicate the scope and objectives for the audit to appropriate management.
• Develop an understanding of the business area under review. This includes objectives, measurements, and key transaction types. This involves review of documents and interviews. Flowcharts and narratives may be created if necessary.
• Describe the key risks facing the business activities within the scope of the audit.
• Identify control procedures used to ensure each key risk and transaction type is properly controlled and monitored.
• Develop and execute a risk-based sampling and testing approach to determine whether the most important controls are operating as intended.
• Report problems identified and negotiate action plans with management to address the problems.
• Follow-up on reported findings at appropriate intervals. Internal audit departments maintain a follow-up database for this purpose.

Project length varies based on the complexity of the activity being audited and Internal Audit resources available. Many of the above steps are iterative and may not all occur in the sequence indicated.

By analyzing and recommending business improvements in critical areas, auditors help the organization meet its objectives. In addition to assessing business processes, specialists called Information Technology (IT) Auditors review information technology controls.

Developing the Plan of Engagements

Internal auditing standards require the development of a plan of audit engagements (projects) based on a risk assessment, updated at least annually. The input of senior management and the Board is typically included in this process. Many departments update their plan of engagements throughout the year as risks or organizational priorities change.

This effort helps ensure the audit activity is aligned with the organization’s objectives, by answering two key questions: First, what goals are the organizations trying to accomplish in the upcoming period? Second, how can the Internal Audit Department assist the organization in achieving these goals?

Internal auditors often conduct a series of interviews of senior management to identify potential engagements. Changes in people, processes, or systems often generate audit project ideas. Various documents are reviewed, such as strategic plans, financial reports, consulting studies, etc. Further, the results of prior audits and resolution of open issues are considered. For example, even if a business area is important, prior audit work and the nature and status of open issues may render further audit effort unnecessary. If the organization has a formal enterprise risk management (ERM) program, the risks identified therein help limit the amount of separate risk assessment performed by Internal Audit.

The preliminary plan of engagements is documented and prioritized. Audit resources and expertise are then considered and a final plan is presented to senior management and the Audit Committee. The presentations vary based on the needs of the stakeholders and may include the following:

• Summary of key goals, risks and corresponding major audits, to illustrate alignment;
• Analyses of audit effort along a variety of dimensions (e.g., by business segment, COSO objective category, IT, Sarbanes-Oxley, vs. prior year, etc.) along with commentary regarding changes;
• Brief description of critical projects identified;
• Projects requested but not planned for execution due to prioritization and resources;
• Required co-sourcing effort, typically where outside expertise is required or during peak periods;
• Coordination with other risk functions, such as legal, compliance or insurance, to ensure coverage of key organizational risks;
• Update on audit staffing levels, experience and certification; and

Best Practices in Internal Auditing

 Measuring the Internal Audit Function

The measurement of the internal audit function can involve a balanced scorecard approach. Internal audit functions are primarily evaluated based on the quality of counsel and information provided to the Audit Committee and top management. However, this is primarily qualitative and therefore difficult to measure. “Customer surveys” sent to key managers after each audit project or report can be used to measure performance, with an annual survey to the Audit Committee. Scoring on dimensions such as professionalism, quality of counsel, timeliness of work product, utility of meetings, and quality of status updates are typical with such surveys. Understanding the expectations of senior management and the audit committee represent important steps in developing a performance measurement process, as well as how such measures help align the audit function with organizational priorities.

Quantitative measures can also be used to measure the function’s level of execution and qualifications of its personnel. Key measures include:

Plan completion: This is a measure of the degree to which the annual plan of engagements is completed, measured at a point in time. This may be measured using the number of projects completed, weighted by the planned size of each project, with estimates for projects in-progress. Measured throughout the year, it is compared against the percentage of the year elapsed.

Report issuance: This is a measure of the time elapsed from completion of testing to issuance of the final audit report, including management’s action plans. This can be measured in average days or percentage of reports issued within a certain standard, such as 30 days. Establishing expectations for the timing of management’s response to report recommendations is critical. In addition, the scope and degree of change involved in the report’s action plans are key variables. For example, a report for a single retail store requiring only the store manager’s action might take 3–5 days to issue. However, a report consolidating findings from 20 retail stores, with action plans with national implications determined by top management, may take 30–60 days in complex organizations.

Issue closure: Reported audit findings are often called “issues” or “deficiencies.” Professional standards require audit functions to track reported findings to resolution, which effectively requires the maintenance of an issues follow-up database. The number of days that reported issues remains open, or open after their agreed-upon closure date, are key measures. In addition, reporting database statistics such as the number of issues open (unresolved), closed (resolved), and issues opened/closed during a given period are useful statistics.

Staff qualifications: This can be measured through the percentage of staff with professional certifications, graduate degrees, and overall years of experience.

Staff utilization rate: This is measured as the percentage of time spent on projects, as opposed to administrative time such as training or vacation. Many internal audit departments track time by audit project. This is typically captured in a database or spreadsheet.

Staffing level: The number of positions filled relative to the authorized staffing level. Due to the challenge of finding qualified staff, departments may have rotational programs to bring in management to complete tours in the function or be “guest” auditors. Audit departments also “co-source,” meaning they obtain contract auditors from service providers.

Developing and Retaining Staff

Developing and retaining quality professionals is a key concern in the profession. Key methods for developing and retaining internal audit staff personnel include:

• Providing challenging, varied assignments
• Ensuring quality supervision
• Ensuring staff participates in projects from start to finish, to learn all phases of the audit process
• Providing opportunities to lead (in-charge) projects, starting with more structured projects such as Sarbanes-Oxley work
• Participating on departmental improvement task forces, such as preparation for quality assurance review
• Participating in the recruiting and interviewing process for new hires
• Rotating through various audit teams (in larger departments) or audits of various businesses
• Providing both outside training (e.g., seminars) and in-house training (e.g., company systems) for two weeks/year
• Participation in annual risk assessment activities, whether asking key questions or just taking notes

 Reporting of Critical Findings

The Chief Audit Executive (CAE) typically reports the most critical issues to the Audit Committee quarterly, along with management’s progress towards resolving them. Critical issues typically have a reasonable likelihood of causing substantial financial or reputation damage to the company. For particularly complex issues, the responsible manager may participate in the discussion. Such reporting is critical to ensure the function is respected, that the proper “tone at the top” exists in the organization, and to expedite resolution of such issues. It is a matter of considerable judgment to select appropriate issues for the Audit Committee’s attention and to describe them in the proper context.

Financial Audit

A financial audit, or more accurately, an audit of financial statements, is the review of the financial statements of a company or any other legal entity (including governments), resulting in the publication of an independent opinion on whether or not those financial statements are relevant, accurate, complete, and fairly presented. Financial audits are typically performed by firms of practicing accountants due to the specialist financial reporting knowledge they require. The financial audit is one of many assurance or attestation functions provided by accounting and auditing firms, whereby the firm provides an independent opinion on published information. Many organizations separately employ or hire internal auditors, who do not attest to financial reports but focus mainly on the internal controls of the organization. External auditors may choose to place limited reliance on the work of internal auditors.

History of Financial Audit

The earliest surviving mention of a public official charged with auditing government expenditure is a reference to the Auditor of the Exchequer in England in 1314. The Auditors of the Impressive were established under Queen Elizabeth I in 1559 with formal responsibility for auditing Exchequer payments. This system gradually lapsed and in 1780, Commissioners for Auditing the Public Accounts were appointed by statute. From 1834, the Commissioners worked in tandem with the Comptroller of the Exchequer, who was charged with controlling the issue of funds to the government.

As Chancellor of the Exchequer, William Ewart Gladstone initiated major reforms of public finance and Parliamentary accountability. His 1866 Exchequer and Audit Departments Act required all departments, for the first time, to produce annual accounts, known as appropriation accounts. The Act also established the position of Comptroller and Auditor General (C&AG) and an Exchequer and Audit Department (E&AD) to provide supporting staff from within the civil service. The C&AG was given two main functions – to authorize the issue of public money to government from the Bank of England, having satisfied himself that this was within the limits Parliament had voted – and to audit the accounts of all Government departments and report to Parliament accordingly.

Accordingly, financial auditing standards and methods have tended to change significantly only after auditing failures. The most recent and familiar case is that of Enron. The company succeeded in hiding some important facts, such as off-book liabilities, from banks and shareholders. Eventually, Enron filed for bankruptcy, and (as of 2006^[update]) is in the process of being dissolved. One result of this scandal was that Arthur Andersen, then one of the five largest accountancy firms worldwide, lost their ability to audit public companies, essentially killing off the firm.

Purpose of Financial Audit

Financial audits exist to add credibility to the implied assertion by an organization’s management that its financial statements fairly represent the organization’s position and performance to the firm’s stakeholders (interested parties). The principal stakeholders of a company are typically its shareholders, but other parties such as tax authorities, banks, regulators, suppliers, customers and employees may also have an interest in ensuring that the financial statements are accurate.

The audit is designed to reduce the possibility that a material misstatement is not detected by audit procedures. A misstatement is defined as false or missing information, whether caused by fraud (including deliberate misstatement) or error. “Material” is very broadly defined as being large enough or important enough to cause stakeholders to alter their decisions.

Audits exist because they add value through easing the cost of information asymmetry, not because they are required by law. For example, a privately-held company that does not issue securities on a public exchange might engage a firm to audit its financial statements in order to obtain more desirable loan terms from a financial institution or trade accounts with its customers. Without the audit, the lending party would not have assurance as to whether or not the company’s financial position is accurate. In turn, the lender could price protect against this information asymmetry.

The exact form and content of the “audit opinion” will vary between countries, firms and audited organizations.

In the US, the CPA firm provides written assurance that financial reports are “fairly presented in conformity with generally accepted accounting principles (GAAP).” The measure for “fairly presented” is that there is less than 5% chance (5% audit risk) that the financial statements are “materially misstated.”

Stages of an Audit

A financial audit is performed before the release of the financial statements (typically on an annual basis), and will overlap the year-end (the date which the financial statements relate to).

The following are the stages of a typical audit:

Planning and Risk Assessment

Timing: before year-end

Purpose:

• To understand the business of the company and the environment in which it operates.
  • What should auditors understand?
    • The relevant industry, regulatory, and other external factors including the applicable financial reporting framework
    • The nature of the entity
    • The entity’s selection and application of accounting policies
    • The entity’s objectives and strategies, and the related business risks that may result in material misstatement of the financial statements
    • The measurement and review of the entity’s financial performance
    • Internal control relevant to the audit
    • To determine the major audit risks (i.e. the chance that the auditor will issue the wrong opinion). For example, if sales representatives stand to gain bonuses based on their sales, and they account for the sales they generate, they have both the incentive and the ability to overstate their sales figures, thus leading to overstated revenue. In response, the auditor would typically plan to increase the rigour of their procedures for checking the sales figures.

 Internal Controls Testing

Timing: before and/or after year-end

Purpose:

• To assess the operating effectiveness of internal controls (e.g. authorization of transactions, account reconciliations, segregation of duties) including IT General Controls. If internal controls are assessed as effective, this will reduce (but not entirely eliminate) the amount of ‘substantive’ work the auditor needs to do (see below).

Notes:

• In some cases an auditor may not perform any internal controls testing, because he/she does not expect internal controls to be reliable. When no internal controls testing are performed, the audit is said to follow a substantive approach.
• This test determines the amount of work to be performed i.e. substantive testing or test of details.

 Substantive Procedures

Timing: after year-end (see note regarding hard/fast close below)

Purpose:

• To collect audit evidence that the management assertions (actual figures and disclosures) made in the Financial Statements are reliable and in accordance with required standards and legislation.

Methods:

• where internal controls are strong, auditors typically rely more on Substantive Analytical Procedures (the comparison of sets of financial information, and financial with non-financial information, to see if the numbers ‘make sense’ and that unexpected movements can be explained)
• where internal controls are weak, auditors typically rely more on Substantive Tests of Detail (selecting a sample of items from the major account balances, and finding hard evidence (e.g. invoices, bank statements) for those items)

 Notes:

• Some audits involve a ‘hard close’ or ‘fast close’ whereby certain substantive procedures can be performed before year-end. For example, if the year-end is 31st December, the hard close may provide the auditors with figures as at 30th November. The auditors would audit income/expense movements between 1st January and 30th November, so that after year end, it is only necessary for them to audit the December income/expense movements and the 31st December balance sheet. In some countries and accountancy firms these are known as ‘roll forward’ procedures.

 Finalization

Timing: at the end of the audit

Purpose:

• To compile a report to management regarding any important matters that came to the auditor’s attention during performance of the audit,
• To evaluate and review the audit evidence obtained, ensuring sufficient appropriate evidence was obtained for every material assertion and
• To consider the type of audit opinion that should be reported based on the audit evidence obtained.

Commercial Relationships versus Objectivity

One of the major issues faced by private auditing firms is the need to provide independent auditing services while maintaining a business relationship with the audited company. The auditing firm’s responsibility to check and confirm the reliability of financial statements may be limited by pressure from the audited company, who pays the auditing firm for the service. The auditing firm’s need to maintain a viable business through auditing revenue may be weighed against its duty to examine and verify the accuracy, relevancy, and completeness of the company’s financial statements. Numerous proposals are made to revise the current system to provide better economic incentives to auditors to perform the auditing function without having their commercial interests compromised by client relationships. Examples are more direct incentive compensation awards and financial statement insurance approaches. See, respectively, Incentive Systems to Promote Capital Market Gatekeeper Effectiveness and Financial Statement Insurance.

Related Qualifications

There are several related professional qualifications in the field of financial audit including Certified General Accountant (CGA), Chartered Certified Accountant, Chartered Accountant and Certified Public Accountant.

 Chapter 3

The Analysis of Financial Statement of Bangladesh Oxygen Company Limited

A Brief History of BOC Bangladesh Limited

BOC Bangladesh Limited is both an old and a relatively new company. Old because it has been present in what is now Bangladesh, in one form or the other, since the days of British India. New because it was registered under it’s own identity only in 1973. The Company began, after the independence of Bangladesh, with a modest turnover of a little over Tk.6 million. The turnover in 2006 exceeded Taka 1 billion.

BOC Bangladesh Limited started out as Bangladesh Oxygen Limited with 3 small Oxygen plants and Dissolved Acetylene plants, one of each in Dhaka, Chittagong and Khulna. In addition, it had an operating contract to run the Oxygen plants of Chittagong Steel Mills (CSM), which is still there today. For the manufacture of Welding Electrodes the Company had only one very small extruder.

From inception, the Company had remained the sole supplier of Medical Oxygen in the Country. In the mid 70’s a Nitrous Oxide plant still the only one in Bangladesh, was imported and installed in Dhaka to provide the nation with this vital anesthetic gas. Later in the decade a Carbon Dioxide plant was bought and installed in Dhaka and this was the first in the Country to produce dry ice. In the early 80’s the first liquid gas plant was imported from New Zealand and again installed in Dhaka, where the demand for Oxygen was concentrated.

Shortly after that came the first boom in ship cutting and demand for Oxygen “went through the roof”. The Company invested immediately in additional compressing capacity for the surplus Oxygen at CSM while simultaneously pursuing the Government to permit it to invest in new production capacity. Eventually the Company was permitted to import 400 cubic meters per hour air separation plant from Australia, capable of producing Liquid Oxygen, Nitrogen and, for the first time in Bangladesh, Argon. This was installed in Chittagong, essentially to feed the ship cutting market on the beach. In the early 90’s booster was added to this to increase output, pending investment in further capacity.

Meanwhile, the welding business of the Company was also growing fast and in the early 80’s a state of the art RAM extruder was added to the production line, dramatically improving output and quality of electrodes. The Company, in another innovative move, invested in a wire drawing machine for the electrode factory. A second RAM was added in the late 80’s to keep up with demand.

The Company went “public” in 1985 when the Government renounced its right shares in favor of the public. Today, BOC Bangladesh is one of the premier companies in the Country. Bangladesh Oxygen Limited changed its name to BOC Bangladesh Limited in March 1995 in line with a world wide program of the BOC Group.

The 90’s witnessed another change in the fortunes of the Company with deregulation and liberalization of the economy. A site was specially purchased at Rupganj, near Dhaka, where the Company installed 30 tons per day air separation plant, the largest in the country. The US made plant produces Oxygen, Nitrogen and Argon and is technologically, as advanced as any in the world. It came on stream in 1995.

At the same time, the Company also invested in a modern integrated welding electrode plant, made by the largest welding electrode manufacturers in the world, which was imported and installed at the new site in Rupganj. A technical collaboration arrangement was also made with the suppliers ESABAB of Sweden and the plant went into production in 1995. Welding business received ISO 9002 certification in the following year. A distribution agreement has been signed with world class Welding Company, The Lincoln Company of USA.

In March 1998 a second line of production was added to the integrated Welding Electrode Factory at Rupganj, doubling the capacity. Same year, in November 1998 a new site with a 20 TPD liquid plant was acquired in Shitalpur, Chittagong.

The BOC Group, of which BOC Bangladesh Limited is a member, has its headquarters at Windlesham in the UK. It employs in excess of 40,000 people and contributes to the economies of nearly 60 countries world wide, with an annual turnover of E3.3 billion plus.

 Range of Products and Services

1. Special Gases & Gas mixtures
2. Gas Welding Rod & Flux
3. Gas Welding and Cutting Equipment
4. Any other gas on request
5. Refrigerant Gases (Freon & Suva)
6. Medical Gases Cylinders
7. Anesthesia Ventilators
8. Anesthesia Machines
9. ICU/CCU Monitoring System
10. ICU/CCU Ventilators
11. Infusion/Syringe Pump
12. Physiotherapy equipment
13. Autoclave/Sterilizer
14. Gynecological Tables
15. Medical Disposables
16. Medical Equipment on request
17. Compressed Oxygen
18. Liquid Nitrogen
19. Dissolved Acetylene
20. Carbon dioxide
21. Compressed Helium
22. Sulphurhexafluoride
23. Sulphurdioxide
24. Medical Oxygen
25. Liquid Oxygen
26. Compressed Nitrogen
27. Sterilizing Gases
28. Pulse Oximeter
29. Nerve Stimulator
30. Blood Gas Analyzer
31. Infant Warmer
32. Infant Incubators
33. Dry Ice
34. Argon
35. Lamp gases
36. LPG
37. Liquid Helium
38. Hydrogen
39. Entonox
40. Nitrous Oxide
41. OT Table
42. OT Light
43. Humidifier
44. Nebulizer
45. Resuscitators
46. Hemodialysis
47. Photo therapy

 Range of Data Over 5 Years (Tk. ‘000)

(Financial History)

Entry Item                 2008                2007                2006                2005                2004
Current Asset              342399            312853            300856            287691            276446
Current Liability         460319            412451            433542            372068            345996
Inventory                    202514            195955            211047            203028            188974
Sales                            1171801          1046682          1021890          842943           754586
Account receivable     50599              37274              34354              30360              23134
Cost of good sold       675751            601178            642553            525753            490151
Account payable         1559                4577                4394                3291                3796
Fixed Asset                 1313665          1316266          1100734          1009421          763728
Total Asset                  1658959          1632253          1404964          1297112        1040174
Gross Profit                 496050            445504            379337            317190            264435
Operating profit          264178            241851            191126            114248            96687
Net profit                    202018            203324            146134            118545            73617
Common equity          1094420          959362            816912            731651            670935
Total liability               561644            669757            584678            565461            369239
EBIT                           261143            245549            193795            156020            100991
Dividend                     66960              60873              60873              57829              45655
NOSO                         15218300        15218300        15218300        15218300  115218300

Various devices are used in the analysis of financial statement data to bring out the comparative and relative significance of the financial information presented. These devices include-

1. Comparative analysis
2. Percentage (Common size) analysis
3. Ratio analysis

Now these analyses discussed in turn-

Comparative Analysis

In Comparative analysis the same information is presented for two or more different dates or periods so that like items may be compared. In Comparative analysis an investment analyst can concentrate on a given item and determine whether it appears to be growing or diminishing year by year and the proportion of such change to related items.

Percentage (Common size) Analysis

Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given vase. All items in an income statement are frequently expressed as a percentage of sales or sometimes as a percentage of cost of good sold. This analysis facilitates comparison and is helpful in evaluating the r4elative size of items or the relative changes in items. It may facilitate comparison between companies of different sizes. Analyst can use this analysis to evaluate and compare companies.

Ratio Analysis

Ratio analysis involves methods of calculating and interpreting financial ratios to assess the firm’s performance.  Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors and firm’s own management.  Ratio analysis is the starting point in developing the information desired by the analyst. Ratio analysis provides only a single snapshot, the analysis being for one given point or period in time. In ratio analysis it is possible to compare the company ratio with a standard one. Ratio analysis can be classified as follows:

• Liquidity ratio
• Activity ratio
• Profitability ratio
• Debt-coverage ratio
• Owner’s Ratio

Now these ratios discussed in turn-

Liquidity Dimension

A firm’s ability to pay its debts can be measured partly through the use of liquidity ratios. A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. Short term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital (the excess of current assets over current liabilities), it is deemed to have sufficient liquidity. There are some ratios that are commonly used to measure liquidity directly, they are:

1. Current ratio
2. Quick ratio or acid test.
3. Cash ratio

Now a word about each-

Current Ratio

The current ratio is a ratio of the firm’s total current assets to its total current liabilities. The current ratio is computed by dividing current assets by current Liabilities. Current asset normally includes cash, sundry debtors, inventory, marketable securities, and current liability consists of Sundry creditors, short-term loans and advance current liabilities and provision for taxes and other accrued expenses. The ratio is generally an acceptable measure of short term creditors are covered by assets that are likely to be converted into cash in a period corresponding to the maturity of the claims.

A low ratio is an indicator that a firm may not be able to pay its future bills on time, particularly if conditions change, causing a slowdown in cash collections. A high ratio may indicate an excessive amount of current assets and management’s failure to utilize the firm’s resources properly.

Table 3.1: Current Ratio

Analysis
BOC Bangladesh Ltd. has formed only in 1975 but still their current asset is lower than current liability. As a result current ratio of this company is very low. We hope they will recover from this situation soon. In this case current ratio has decreased till 2006 from 2004 but in 2007 it has increased because in that year current liability has decreased. But in 2008 current liability has again increased and as a result the current ratio falls.

By going through over the components of current liability in year 2008 we see that short term bank loan and sundry creditors increased at a higher rate compare with year 2007 and other factors are almost same.

Analyzing current asset we see that all of the components has increased over 5 years. But most of the part of this asset is inventory. This inventory is not a pure liquid that’s why it doesn’t give us actual liquidity position of BOC. To get more pure ratio we will discuss about quick ratio.

Quick Ratio

The quick ratio, which is also known as acid-test ratio is a better test of financial strength than the current ratio, as it gives no consideration to inventory, which may be very slow moving. Here merchandise inventory is omitted because merchandise is normally sold on credit and then the receivable must be collected before cash is realized. A comparison of the current ratio with quick ratio would give an indication regarding inventory position. Moreover, in the very short-term the ability to meet requirements of cash can be judged only on the basis of a properly drawn cash budget and not on the basis of the quick ratio.

Table 3.2: Quick Ratio

Analysis
Here we see that current ratio in 2008 is 2.46 time higher than quick ratio because in that year current asset consists more than 59% of inventory. For this reason quick ratio has declined compared to current ratio. The quick ratio is increasing from 2006 because the components of current asset except inventory are increasing at higher arte than that of current liability. By analyzing quick ratio we have realized that the company is reserving more inventories, which can’t make any profit. They must follow just in time process to increase quick ratio and as well as their actual liquidity position.

Cash Ratio

The cash ratio is the most traditional assess of analyzing liquidity position. Generally we meet our current liability with our current asset but the use of either the current or quick ratio is not good enough to analyze the liquidity position of the firm because it consists of account receivable and inventory, which takes time to convert with cash. That’s why it is really important to look how much cash the firm has in hand or at bank to meet its current liability and the cash ratio gives a better result.

Table 3.3: Cash Ratio

Analysis

There is an unparallel cash ratio of BOC Bangladesh Ltd. Some time it is increasing and some time it is decreasing. In 2008 it has increased more than 29 times than the year 2007 because sales have increased more than 11% in that year. But there is a tendency of this firm keeping low cash and more stock.

In this case we can say that management has failed to use cash and it’s a big loss for the company. They must find some way to invest that cash instead of keeping it on hand.

Activity Dimension

Activity ratios reflect the firm’s efficiently in utilizing its assets. The funds of creditors and owners are invested in various kinds of assets to generate sales and profits. The better the management of assets the larger the amount of sales. These ratios are also called Turnover Ratios because they indicate the speed with which assets are being converted or turned over into sales. A proper balance between assets and sales generally reflects that the assets are managed well. There are some ratios under these criteria. They are as follows:

1. Accounts receivable turnover
2. Average collection period
3. Inventory turnover
4. Accounts Payable turnover
5. Accounts Payable turnover in days
6. Fixed asset turnover
7. Total asset turnover

Now these are discussed in turn-

Accounts Receivable Turnover

The Accounts receivable turnover is a comparison of the size of the firm’s sales and the size of its uncollected bills from customers. If the firm is having difficulty collecting it’s money, it has a large receivables balance and a low ratio. If it has a strict credit policy and aggressive collection procedures, it has a low receivable balance and a high ratio. It measures the effectiveness of the firm’s credit policy.

Table 3.4: Accounts Receivable Turnover (Times)

Analysis
From this analysis we get that the ratio is continuously decreasing from 2006. It means that Account receivable is increasing day by day which is very bad for the company because it has tied up a lot of cash money, which can be invested by the company in other sector. The turn over in 2008 has declined 1.2 times than that of year 2007. It means the company is following lax credit policy. This ratio indicates that the management has failed to use Account receivable efficiently. So the lower turnover means that the company is inefficient in managing it’s Account receivable.

 Average Collection Period

The average collection period provides a rough approximation of the average time that it takes to collect receivables. It compares the receivables balance with the daily sales required to produce the balance. The ratio reflects the average collection period.

Table 3.5: Average Collection Period (Days)

Analysis
As a result of increasing Account receivable turnover average collection period had decreased from 2006. The ratio has declined sharply on 2008 comparing with other tears. Lower ratio means the bad collection period and it is also a cause of lower cash balance. The goal of any company should be increase sale without increasing receivable because it tied up the cash balance and makes ultimate loss for the company.

Inventory Turnover

This relationship expresses the frequency with which average level of inventory investment is turned over through operations. The higher the inventory turnover the larger the amount of profit, the smaller the amount of capital tied up in inventory and the more current the merchandise stock. Moreover, a firm with a high turnover has a great competitive advantage as it can afford to sell its merchandise at a lower price because increased sales volume may yield a larger total profit even though the margin of profit unit is slightly less.

Table 3.6: Inventory Turnover (Times)

Analysis
Analysis shows a continuous improvement of inventory turnover through five years from 2004 to 2008. Here we found that the level of inventory is increasing day by day as well as the turnover is also increasing. It happens because the increasing rate of sales is higher than the rate of increase in inventory.

Normally when inventory turnover increases we think that the stock of inventory is going to be finished but in this case the level of inventory has not decreased and thus we can guess that the firm will not face any inventory problem. But one thing is important that they are holding much more inventory, which has tied up the cash balance.

 Accounts Payable Turnover

The accounts payable turnover indicates ratio of accounts payable compare with sales of a firm. This ratio indicates the rapidity of accounts payable to be turned into cash. It measures the tendency of a firm’s policy whether stretch payable or not.

Table 3.7: Accounts Payable Turnover (Times)

Analysis
Analysis shows that there is no consistency in Accounts payable turnover. In 2006 and 2007 it decreases from 2005 but there is a huge increment of this turnover in 2008, it means the firm maintains a low Accounts payable. So we can say that the firm pays their accounts payable immediately. As a result there is a low balance of cash.

One thing is important that a firm can earn money by stretching account payable because they don’t have to pay interest for that. Thus the way they can use cost free fund.

 Accounts Payable Turnover in Days

Accounts Payable turnover in days shows the number of days within which the firm pays their liability to their creditors. The more days means the company is stretching payable and the fewer days means the company is not holding their liability.

Table 3.8: Accounts Payable Turnover (Days)

Analysis
From this analysis we get that there is a continuous increment of this ratio from 2005 to 2007. But in 2008 the ratio falls because in that year the firm pays a huge payable. From this we can say that they have stretched payable till 2007 and in 2008 they have changed their policy and tried to pay the payable as early as possible to decrease current liability.

Fixed Asset Turnover

A similar measure of usage, but one, which concentrates on the productive capacity, as measured by fixed assets, indicates how successful the company is in generating sales from fixed assets. It measures how efficiently the companies are using fixed asset in generating sales.

Table 3.9: Fixed Assets Turnover (Times)

Analysis
From the analysis we see that the turn over is the turnover is sometime increasing and sometime it is decreasing. The ratio has increased in 2008 compare with 2007. This has happened because sales have increased more than 11% on the other hand fixed asset has decreased.

By this analysis we can say that management has able to use fixed asset efficiently. Thus the way they have increased their sales by decreasing the fixed asset.

 Total Asset Turnover

Total assets turnover indicates how well a company has used its fixed and current assets to generate sales. It is the most asset measure ratio. Such ratio is probably most useful as an indication of trends over of years. There is no particular value, which is too high or too low, but a sudden change would prompt the observer to ask questions. In these criteria a high ratio means the company is achieving more profit.

Table 3.10: Total Assets Turnover (Times)

Analysis
There is an uneven trend of total asset turnover over 5 years from 2004 to 2008. Here we find that the ratio has increased in 2008 compare with the year 2008. This increase has happened because the sales have increased at a higher rate than the rate of increase in total asset.

Profitability Dimension

There are many measures of profitability, which relate the returns of the firm to its sales, assets, or equity.  As a group, these measures allow the analyst to evaluate the firm’s earnings with respect to a given level of sales, a certain level of assets, or the owners’ investment.  Without profits, a firm could not attract outside capital.  Moreover, present owners and creditors would become concerned about the company’s future and attempt to recover their funds.  Owners, Creditors, and management pay close attention to boosting profits due to the great importance placed on earnings in the marketplace.

The profitability ratios are:

1. Gross profit margin

2. Operating profit margin

3. Net profit margin

4. Return on total asset (ROA)

5. Return on total equity (ROE)

Now a word about each-

Gross Profit Margin

The gross profit margin measures the percentage of each sales amount remaining after the firm has paid for its goods. It may be used as an indicator of the production operation and the relation between production cost and selling price. The gross profit margin is calculated as follows:

Table 3.11: Gross Profit Margin (%)

Analysis
The gross profit margin has slightly decreased in 2008 compare with 2007. In 2008 sales has increased as well as gross profit margin has also increased The decline in gross profit margin has happened because of cost of good sold. It has increased more than 12% in 2008 on the other hand sales has increased just 11.95%.

To increase gross profit margin they should try to decrease their cost of goods sold. So we can say that they have failed to handle the COGS.

Operating Profit Margin

The operating profit margin measures the percentage of each sales amount remaining after all costs and expenses other than interest and taxes are deducted. A high operating profit margin is preferred. Operating profit margin is calculated as follows:

Table 3.12: Operating Profit Margin (%)

Analysis
From the analysis we find that there is continuous increment of operating profit margin till 2007 but in the year 2008 the turnover has slightly decreased. This has happened for inefficient use of operating expense. During 2008 the sales has increased more than 11% but operating expense has increased more than 13%. As a result though operating margin increased but the ratio has failed to increase because of high operating cost.

From this discussion we can say that the firm had failed to control it’s operating cost and each and every components of operating cost has increased during 2008.

Net Profit Margin

The net profit margin measures the percentage of each sales remaining after all costs and expenses including interest and taxes deducted. The higher firm’s net profit margins the better. The net profit margin is calculated as follows:

Table 3.13: Net Profit Margin (%)

Analysis
In this case also net profit margin has decreased in 2008. Earlier we have said that the increasing rate of cogs and operating cost is higher than increasing rate of sales. But we don’t mention about tax and interest. These have also increased significantly. Though account payable has decreased but short-term bank loan has increased about 1.19 times. As a result interest has increased about 1.56 times and tax has also increased about 1.18 times in 2008 compare with the year 2007. This is the main reason of decreasing net profit margin over last year.

Return on Total Asset (ROA)

Calculating the return on total assets is another variation on measuring how well the assets of the business are used to generate profit Return on total assets also called return on investment. It measures the overall effectiveness of management to generate profit with its assets. It could be measures as follows:

Table 3.14: Return on Total Assets (%)

Analysis
From 5 years data we see that net income has continuously increased till 2007. But due to some problem in operating sector net income has decreased slightly in 2008. And this decline creates a problem on ROA. As a result it has decreased slightly in the year 2008.

 Return on Total Equity (ROE)

The return on shareholder’s equity is a measure of company performance from the shareholder’s perspective. It measures the return on the owners’ investment in the firm. Return on equity is calculated as follows:

Table 3.15: Return on Equity (%)

Analysis
For the same problem of net income ROE has decreased in the year 2008 compare with 2007. It means the company is loosing efficiency in production process. And this falls in ROE has a bad affect in common stock holder.

Debt Utilization Ratios

The debt utilization ratios measure the proportion of debt and how efficiently management used the debt capital. The higher the ratio, the greater the amount other peoples money being used in an attempt to generate profits. There are some ratios under these criteria. They are as follows:

1. Debt Ratio
2. Time interest earned

These are shortly discussed in turn-

Debt Ratio

The debt ratio measures the proportion of total assets financed by the time’s creditor. The higher the ratio, the greater the amount other peoples money being used in an attempt to generate profits. The ratio is calculated as follows:

Table 3.16: Debt Ratio (%)

Analysis shows that debt ratio has continuously decreased from 2005 though the total liability has decreased only in the year 2008. The ratio has decreased because total asset had increased at a higher rate than total debt. And it’s a good sign for the company. In this case creditor will allow them to sell their product to them on credit. The company is following the policy to pay the debt immediately. Thus the way they can save interest expanse. And as a result their net income will be high within a short period of time.

 Time Interest Earned

A useful measure of profit that does not link return to resources is the times interest earned ratio. It shows whether the company is able to pay it’s annual interest cost. Failure to meet this obligation can bring legal action by they firm’s creditors, possibly resulting in bankruptcy. It is calculated by dividing the firms operating income by the interest that it must pay on it’s debt.

Table 3.17: Time Interest Earned (Times)

Analysis

Higher ratio of time interest earned means firm has higher ability to pay the interest from their opportunity income. In this analysis we see that there is a mass movement of this ratio over 5 years. There is a sharp decline of this ratio in 2008 from 2007 indicated that the firm is paying more interest. In this year EBIT has increased only 6.75% but interest has increased about 56.12%.

By analyzing this ratio we must say that the company must decrease their short-term bank loan and if they continue to take loan this way, they will fall in big problem and it might be cause of bankruptcy.

Ownership Ratios

Ownership ratios assist the stockholder in analyzing present and future investment in a company. Stockholders are interested in the way certain variables affect the value of their holdings. The ratios compare the value of the investment with factors such as debt, dividends, earnings, and the market price of the stock. By understanding the profitability and liquidity ratios, the owner gains insights into the soundness of the firm’s business activities. By investigating ownership ratios, the stockholder is able to analyze the likely future market value of the stock. There are some ratios under this norm. They are as follows:

1. Earnings per Share (EPS)

2. Dividend ratio

Now these ratios discussed in turn-

 Earnings Per Share (EPS)

Stockholders are concerned about the earnings that will eventually be available to pay them dividends or that are used to expand their interest in the firm because the firm retains the earnings. These earnings may be expressed on a per share basis. Earnings per share are calculated by dividing net income by the number of shares outstanding. Shares authorized but not issued, or authorized, issued and repurchased (treasury stock), are omitted from the calculation.

Table 3.18: Earnings Per Share (Taka)

Analysis
Due to the decrease in net income in the year 2008 EPS has decreased. But in previous we see that there was a continuous increment of EPS till 2007. If company can control all sorts of expense it will be high again.

Dividend Per Share

The common stockholder is very concerned about the position taken by firm with respect to the payment of cash dividends. If the firm is paying insufficient dividends, the stock is not attractive to investors desiring some current income their investment. If it pays excessive dividends, it may not be retaining adequate funds to finance future growth. To pay consistent and adequate dividends, the firm must be liquid and profitable. Without liquidity, the firm cannot locate the cash needed to pay the dividends. Without profits, the firm does not have sufficient retained earnings to in dividend declarations.

Table 3.19: Dividend Per Share (Taka)

Analysis
The Company is following to pay more dividends to attract investor to invest in their company. But this strategy is not good because for the company for all time. In 2008 their EPS decreased but Dividend per share has increased and it will be a reason for decrease in cash balance. Instead of paying more dividends they should pay more attention in earning per share.

Chapter 4

Recommendations & Conclusion

Recommendations

Recommendations from an Investor’s Point of View

Investors who buy shares in a company want to be able to compare the benefit from the investment with the amount they have paid, or intend to pay, for their shares. There are two measures of benefit to the investors. One is the profit of the period. The other is the dividend which is an amount actually paid to the shareholders. Profit indicates wealth created by the business. That wealth may accumulate in the business or else part of it may be paid out in the form of dividend. There are some ratios, which may consider by the investor. They are as follows:

1. Net profit margin
2. Return on asset
3. Return on equity
4. Earning per share
5. Dividend per share
6. Asset per share

All of these ratios are related to profitability dimension. An investor wants to invest his money on those organizations, which are profitable for him. So he might give more emphasize on profitability dimension rather than other ratios. So that above ratio might give him a clear view of the company whether it is profitable or not. By the following ratio we will justify BOC Bangladesh Ltd. from an investor’s point of view.

Ratio                                       2008                2007                2006                2005         2004

Net profit margin                                17.23%                  19.42%                  14.30%                  14.06%      9.75%
Return on total asset (ROA)              12.18%                  12.46%                  10.40%                  9.12%        7.07%
Return on total equity (ROE)            18.46%                  21.19%                                  17.89%                  16.20%   10.97%
Earnings per Share (EPS)                   13.27 Taka           13.36 Taka           9.60 Taka             7.79 Tk     4.84Tk
Dividend per share                              4.40 Taka             3.99 Taka             3.99 Taka             3.80 Tk     3.00Tk
Asset per share                                     71.91 Taka           63.04 Taka           53.68 Taka      48.08Tk       44.09Tk

From the above ratio we see that except Dividend per share and Asset per share all of profitability ratios have gone down in the year 2008 from the year 2007. In 2008 sales has not increased in it’s average rate. On the other hand all of expenses have increased at a higher rate. As a result all of ratio has decreased and it has created a bad impact on investors. Here we also see that the cash and bank has increased about 33.58 times than 2007. It means the company is holding idle cash. And the investors never like this types of situation. In 2008 account receivable has also increased significantly. From this we can say that management has failed to manage all sorts of expenses as well as it’s assets.  Here one thing is important that every type of ratios under profitability dimension has continuously increased till the year 2007. So definitely a question arises. What is the problem for decreasing the ratio in 2008?

According to chairman’s statement the company has faced some sorts of problem during 2008. Difficulties were faced at almost every level of activity from clearing of goods at ports, movement of goods and personnel, and to marketing of products due to frequent closures caused by Hartals and other political activities. The activities of the Company had also to face deterioration in the law and order situation. And finally due to the event of September 11 last year in the United States of America, the company has faced a big problem because it has mostly destroyed the world economy. Despite all these, the Company had been able to keep up its progress.

In spite of all the above-mentioned factors a decent growth in the business of this Company was achieved last year. Profits available for distribution did not reflect this growth because of higher incidence of interest and tax, as expected. Moderate capital expenditure and good working capital management were able to bring down the level of borrowing. The turnover of the company increased over the previous year by about 12%. Though there was virtually no increase in the profits available for appropriation in the year, the directors recommends a dividend of Taka 4.40 per each share of Taka 10 that is 44%. Asset per share is also increasing day by day. In the year 2008 tax has also increased about 3,000,000 Taka. It shows a greater profit before tax. Ultimately the company is helping the government by giving more tax. We must concentrate on shareholders equity to understand the current position of the company in the market. The equity was 642,973,000 Taka in 2003 and it has increased to 1,094,420,000 Taka in 2008. To make a clear view of shareholders equity we can show a graph with 5 years data.

From this graph we can realize that how rapidly equity is increasing. An investor could be interested by seeing this graph because it shows a healthy position of the company in the competitive market. And finally we must give a close eye to the development strategy of BOC Bangladesh Ltd. In March 1998 a second line of production was added to the integrated Welding Electrode Factory at Rupganj, doubling the capacity. Same year, in November 1998 a new site with a 20 TPD liquid plant was acquired in Shitalpur, Chittagong. In November 2000 a second hand but unused carbon dioxide plant has been installed at the Tejgaon factory and has been accepted after suitable testing.

By analyzing all sorts of discussion an investor might be interested to invest his money in this organization. Though the company has suffered some problem in the year 2008 but they have a continuous growth in market. And we hope that the company will overcome those problems and will be back with it’s own position.

 Recommendations from a Creditor’s Point of View

Creditors are those people who lend money to the organization for better running in the competitive market. Their money is used in the company as a capital. They are not the owner of the company because they don’t get any dividend but they are the creditor of the company and they get interest against to their loan. The people from whom the company purchases material on credit are also the creditor of the company. Creditors mainly gave emphasize on Liquidity dimension and Debt utilization. Some time they also observe activity dimension. The ratios that creditor pay attention to lend money is as follows:

1. Current ratio
2. Quick ratio
3. Cash ratio
4. Account payable turnover
5. Turnover in days
6. Debt ratio
7. Time interest earnedive result that whether the company is able to pay their liability or not, how they are performing in the market and what is their liability position related with their total asset.

Here the current ratio is only .74 times, which means that current asset is less than current liability and this is the worst situation for any company from creditor’s point of view. The company has started in 1973 but it has a low current asset than current liability. The quick ratio and cash ratio bears the same result. In 2008 quick ratio is only .30 times and cash ratio is .0629 times. The liquidity position of this company is very bad. In this position no one will be interested to invest money in this organization. This company should pay attention to increase liquidity ratio as soon as possible because this situation is very much risky. In this condition there is a good chance for any company to become bankrupt.

Higher ratio of time interest earned means firm has higher ability to pay the interest from their opportunity income. There is a sharp decline of this ratio in 2008 from 2007 indicated that the firm is paying more interest because in that year their short-term bank loan became double. By analyzing this ratio we must say that the company must decrease their short-term bank loan and if they continue to take loan this way, they will fall in big problem and it might be cause of bankruptcy. So that in this case also any firm will not be interested to give them loan.

But there is still some good news for creditors. That is Debt Ratio and Accounts Payable turnover in days. In debt ratio we see that there is a continuous decrease of debt ratio from the year 2006. In 2008 the debt ratio is only 33.86%. It means that 33.86% of total asset is financed by creditor which is good for any company. The situation is still good because the company is in less riskier position. In 2008 Accounts Payable turnover in days is only .47 days. It means that the firm pays it’s debt very quickly. As a result account payable turnover has increased during 2008.

Now we must give a look on cash flow statement. From cash flow statement we see that the firm has not taken any loan in the year 2008. Moreover they have paid a large volume of it’s previous loan. As a result the current asset has decreased significantly. Now the decision is the firm must pay more attention in increasing it’s current asset.

By analyzing all sorts of these things we can say that the company’s overall situation is not good from a creditor’s point of view. Though the company is doing well from an investor’s point of view but it has to be careful about its liquidity and liability to build a good image from creditor’s point of view.

Conclusion

In this report we have discussed about the basic concept of financial statement, consolidate financial statement, IFRS, Internal & Financial Auditing and analysis of the financial statement of BOC Bangladesh Ltd. Our main job was to determine the financial position of this company whether it is running good or not. As we are very new in finance course, we face some problem while doing this assignment. But we have tried hard to complete this assignment successfully. From the over view of five years data we find that the company face some problem in different sector in 2008. Other wise everything is tolerable but they must try hard to increase their net income again to create a good impact on investor.

Bibliographies

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