BASIC ACCOUNTING CONCEPTS 1.Going Concern Going concern refers to a company's ability to continue functioning as a business entity for an indefinite period. It is the responsibility of the directors to assess whether the going concern assumption is appropriate when preparing the financial statements. This concept implies that financial statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets will be used in future operations. This concept also allows companies to spread (amortize) the cost of an asset over its expected useful life.
BASIC ACCOUNTING CONCEPTS 2.Dual Aspect This dual aspect concept is also called Double Entry Methodology. The key point is that all transactions have two dimensions. This follows from the basic accounting equation which is: ASSETS= LIABILITIES + OWNERS’ EQUITY 3.Time period This concept defines a specific interval of time for which an entity’s reports are prepared. This can be a fiscal year (July 1 – June 30), calendar year (January 1 – December 31), or any other meaningful period such as a quarter or a month.
BASIC ACCOUNTING CONCEPTS 4.Realization Revenues are recognized when they are earned or realized. This concept is related to prudence concept in which revenue is only recorded when it actually occurs and not at the point in time when a contract is awarded. 5.Matching To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period. For example, if the company bills Rs. 20,000 of services in a month, in order to accurately represent the income for the month, it must report the expenses incurred in generating that income in the same month.
BASIC ACCOUNTING CONCEPTS 6.Consistency This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way. 7.Materiality Materiality relates to the importance/significance of an amount, transaction, or discrepancy. Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.
PURPOSE OF FINANCIAL STATEMENTS There are two main purposes of financial statements: 1.To report on the financial position of an entity (e.g. a business, an organization) on a certain date; and 2.To show how the entity has performed financially over a particular period of time (an "accounting period").
BALANCE SHEET A balance sheet or statement of financial position is a summary of the financial balances of a company. Assets, liabilities and owners’ 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". Interpretation of Balance Sheet –Do we have enough working capital to avoid cash flow problems –Our assets are enough to meet our liability –Show the wealth of the share holders –Net worth of the Company
PROFIT & LOSS ACCOUNT Profit and loss account (P&L), indicates how the revenue is transformed into the Net profit. 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 Profit & Loss Account is to show managers and investors whether the company made a profit or loss during the period being reported.
Gross Premium Earned = Gross Written Premium + Opening unearned premium – closing unearned premium Unearned premium represents the portion of premium written relating to the unexpired period of coverage and is deferred to the subsequent accounting period. It is recognized as a liability by the company. This liability is generally calculated by applying the 1/24 method. STATEMENT OF PREMIUM
REVENUE RECOGNITION OF PREMIUM 1/24 METHOD Suppose a company earns gross premium of Rs. 20,000 in a year then it will calculate unearned premium at a end as follows:
STATEMENT OF CLAIMS 1.Claims paid 2.Outstanding claims 3.Claims expenses 4.Reinsurance and other recoveries received 5.Reinsurance and other receivables 6.Reinsurance and other recoveries revenue 7.Net claims
Claims incurred Claims incurred for any period consists of: The actual amount of losses settled during the period concerned Add: Related handling expenses Add: Adjustment to estimate made for losses reported in earlier periods Add: Adjustment for provision for those losses that have occurred but not reported (IBNR) as at the end of the period. Less: Proceeds from recoveries from Salvage /subrogation rights recoveries Values received from assets salvaged after insurer has settled a claim on total loss basis or the exercise of subrogation rights, should be used to reduce the amount of claims incurred. STATEMENT OF CLAIMS
Reinsurance Recoveries Insurers are entitled to recoveries based on their reinsurance contracts which should be reflected in the accounts. In addition to direct recoveries, others based on the following provisions should be also accrued: –Outstanding claims –Claims incurred but not reported Reinsurance claims recoveries could be shown in the financials as deduction from gross claims incurred. STATEMENT OF CLAIMS
STATEMENT OF EXPENSES 1.Commission Expense 2.Other management expenses 3.Underwriting Expenses 4.Commission from reinsurer 5.Total
The underwriting expenses include: – business acquisition cost, such as commissions, –salaries of staff, stationery cost, office space, etc. The costs that are directly and wholly linked to underwriting activities are straightforward and do not pose any difficulty. But where relevant costs cannot be directly linked, the expenses are apportioned on Gross Premium basis or Net Premium basis. Only Commission cost should be deferred. The costs deferred should be that proportion of the total commission costs which the unearned premiums provision bears to gross written premiums for relevant class of business. Deferred Commission costs should be shown in the balance sheet under assets. STATEMENT OF EXPENSES
COMMISSION INCOME Insurers earn commission on business they pass on to reinsurance companies. This should be added in determination of the underwriting result for the company. Just as a portion of the commission cost should be deferred as an asset, relevant portion of the commission income should be deferred as unearned commission income. This should appear in the balance sheet as liability and the commission income earned should be the figure after adjustments for opening and closing unearned commission income. STATEMENT OF EXPENSES
CASH FLOW STATEMENT A cash flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash & cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet.
NOTES TO 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 the method of accounting used to prepare the financial statements, debt, going concern, accounts, contingent liabilities, or information explaining the financial numbers (e.g. to indicate a lawsuit). The information contained within the notes not only supplement financial statement information, but they clarify line-items that are part of the financial statements.
WHAT ARE RATIOS 1.Ratios are ways to compare figures 2.Ratios help in comparing previous results or competitors 3.Identify change in performance
BALANCE SHEET RATIOS BREAK UP VALUE OF SHARE 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. Break up Value of Share = Shares Holder’s Equity Number of Shares Share Holders’ Equity = Rs. 8,444 Number of Shares = 102 Break up Value of Share = 8,444 102 = Rs. 82.78 per Share
PROFITABILTY RATIOS RETURN ON EQUITY (ROE) Return on Equity measures the rate of return on the shareholders’ equity. It measures a company’s efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses shareholders’ funds to generate earnings growth. Return on Equity Ratio (ROE) = Net Profit. Total Equity Net Profit = Rs. 1,099 Total Equity = Rs. 8,444 Return on Equity Ratio (ROE) = 1,099 x 100 8,444 = 13 %
EARNING PER SHARE (EPS) The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. Earning per Share = Net Profit _____X 100. No. of Shares Net Profit = Rs. 1,099 No. of Shares = 102 Earning per Share = 1,099 X 100 102 = Rs. 10.77 per share PROFITABILTY RATIOS
PRICE EARNING RATIO A valuation ratio of a company's current share price compared to its per-share earnings. Price Earning Ratio = Market Value per Share. Earning per Share Market Value per share = Rs. 125 Earning per Share = Rs. 10.77 Price Earning Ratio = 125 10.77 = 11.61 PROFITABILTY RATIOS
COMBINED RATIO A measure of profitability used by an insurance company to indicate how well it is performing in its daily operations. A ratio below 100% indicates that the company is making underwriting profit while a ratio above 100% means that it is paying out more money in claims than it is receiving from premiums. The combined ratio is comprised of the claims ratio and the expense ratio. The Claims Ratio is net claims as a percentage of net premiums. The Expense Ratio is operating costs (underwriting expenses and net commission) as a percentage of net premiums. The combined ratio is calculated by taking the sum of losses and expenses and then dividing them by net premium. PROFITABILTY RATIOS
COMBINED RATIO (Contd.) Combined Ratio= Net Claims + Underwriting Exp. + Net Commission X 100 Net Premium Net Premium = Rs. 7,488 Net Claims = Rs. 5,173 U/W Expenses = Rs. 1,206 Net Commission = Rs. 741 Combined Ratio = 5,173 + 1,206 + 741 X 100 7,488 = 95% PROFITABILTY RATIOS
UNDERWRITING PROFIT RATIO This is reverse of combined ratio. It can be calculated by either of the following formulas: Underwriting Profit Ratio =1 – Combined Ratio = 1- 0.95 =.05 or 5% OR = Underwriting Profit Net Premium = 367 7,488 = 5% PROFITABILTY RATIOS
OPERATIONAL PROFIT % Operating Profit % = Underwriting result – General & Admin Exp + other income x 100 Net Premium Underwriting result = Rs. 367 General & Admin = Rs. 512 Other income = Rs 184 Operating Profit (in %) = 362 - 512 + 184 X 100 7,488 = 0.45% PROFITABILTY RATIOS
NET PROFIT % Net Profit % = Net Profit after tax x 100 Net Premium Net Profit = Rs. 1,099 Net Premium = Rs. 7,488 Net Profit % = 1,099 X 100 7,488 = 14.67% PROFITABILTY RATIOS