FINANCIAL ACCOUNTING AND ANALYSIS

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Copyright:
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ISBN: 978-81-265-6058-5

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 CONTENTS

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Introduction to Financial Accounting 1

2 Accounting Process 13

3 Financial Statements 35

4 Preparation of Financial Statements 57

5 Financial Reporting Standards I 79

6 Financial Reporting Standards II 93

7 Corporate Financial Statements 105

8 Statement of Cash Flows 141

9 Analysis of Financial Statements I 159

10 Analysis of Financial Statements II 183

11 Case Studies 199

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FINANCIAL ACCOUNTING AND ANALYSIS

CURRICULUM

FINANCIAL ACCOUNTING AND ANALYSIS

Introduction to Financial Accounting: Introduction, Accounting, Users and Uses of Accounting

Information, Sub-Fields of Accounting, Accounting Terms, Financial Statements, Generally
Accepted Accounting Principles, Advantages of Financial Accounting, Limitations of Financial
Accounting

Accounting Process: Introduction, Steps in the Accounting Cycle, Analysis of Accounting

Transactions, Accounting Records

Financial Statements: Introduction, Balance Sheet, Assets, Liabilities, Basic Concepts Underlying
Preparation of Balance Sheet, Statement of Profit and Loss, Basic Concepts

Preparation of Financial Statements: Introduction, Trial Balance, Relationship between Profit and
Loss Account and Balance Sheet, Preparation of Profit and Loss Account, Preparation of Balance
Sheet, Adjustment Entries, Adjusted Trial Balance

Financial Reporting Standards I: Introduction, Accounting Standards Board, Constitution of Accounting

Standard Board of India, Procedure for Issuing Accounting Standards, Compliance with Accounting
Standards, Implementation of Accounting Standards in India, Convergence of Indian Accounting
Standards with IFRS

Financial Reporting Standards II: Generally Accepted Accounting Principles, International Financial
Reporting Standards

Corporate Financial Statements: Introduction, Books of Accounts to be Kept by a Company, Financial

Statements, Assets, Equity, Other Equity, Liabilities, Contingent Liabilities and Commitments,
Revenue from Operations, Other Income, Expenses, Profit Before Exceptional Items and Tax,
Exceptional Items, Tax Expense, Profit (Loss) for the Period from Continuing Operations,
Discontinued Operations, Profit (Loss) for the Period, Other Comprehensive Income, Earnings per
Share, Income Taxes, Dividend

Statement of Cash Flows: Introduction, Cash and Cash Equivalents, Purposes of Cash Flow Statement,
Operating Activities, Investing Activities, Financing Activities, Reporting Cash Flows from
Operating Activities, Reporting Cash Flows from Investing Activities, Reporting Cash Flows from
Financing Activities, Treatment of Special Items, Format of Cash Flow Statement (Direct Method),
Format of Cash Flow Statement (Indirect Method)

Analysis of Financial Statements I: Introduction, Profitability Measures, Tests of Efficiency in Investment

Utilization (Efficiency Ratios), Tests of Financial Position, Ratios Involving Share Information,
Limitations of Ratio Analysis

Analysis of Financial Statements II: Introduction, Techniques of Financial Analysis, Common-Size

Analysis, Trend Analysis, Percentage Change Analysis (Comparative Financial Statements),
Management Discussion and Analysis, Thinking Beyond Numbers, Quality of Earnings, Sustainable
Income

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 C H A
1 P T E R

INTRODUCTION TO FINANCIAL ACCOUNTING

CONTENTS

1.1 Introduction
1.2 Accounting
1.3 Users and Uses of Accounting Information
Self-Assessment
Questions Activity
1.4 Sub-Fields of Accounting
1.5 Accounting Terms
1.5.1 Asset
1.5.2 Liability
1.5.3 Capital/Owners’ Equity
1.5.4 Revenue
1.5.5 Cost
1.5.6 Expense
1.5.7 Goods
1.5.8 Debtors (Accounts Receivable)
1.5.9 Creditors (Accounts Payable)
1.5.10 Debits and Credits
Self-Assessment Questions
1.6 Financial Statements
1.6.1 Income Statement
1.6.2 Balance Sheet
1.6.3 Statement of Cash Flow
Activity
1.7 Generally Accepted Accounting
Principles
1.8 Advantages of Financial Accounting
1.9 Limitations of Financial Accounting
1.1 Summary
0
Key Words
1.11 Descriptive
1.12 Questions Answer
Key

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2 FINANCIAL ACCOUNTING AND ANALYSIS

INTRODUCTORY CASELET

MODERN COFFEE HOUSE

On January 2, 2019, Ashok and Ramesh decided to join hands to

open Modern Coffee House (MCH) in Delhi. Ashok had been
working with a manufacturing company on the shop floor and
had about 10 years’ experience. Ramesh had been working on an
ad-hoc basis with a multi- national company for quite some time.
He became the victim of down- sizing and was finally retrenched.
He sought retirement under Early Separation Scheme from the
company.
They contributed Rs. 2,00,000 each, hired a small premises on
rent, pur- chased furniture for Rs. 1,05,000, utensils for Rs.
92,000, equipment for Rs. 63,000 and made a security deposit of
Rs. 1,05,000 with a soft drinks company. They did not keep
proper accounting records but just main- tained a cash register
and a day book. At the end of June 2019, they found their assets,
liabilities and other items as under:

Rs. Rs.
Cash 25,000 Bank balance 100,000
Utensils 92,000 Equipment 63,000
Sale proceeds 260,00 Rent paid 15,000
0
Total expense on 155,00 Furniture 105,000
food & 0
They thought that they had only Rs. 125,000 left in cash and
bank balance and therefore, their capital had been reduced by
Rs. 275,000 representing the loss made by the business
during the period of 6 months. They had to take a decision
whether to continue running the coffee house.

QUESTIONS

1. Analyze the caselet and find out the prevailing situation

of Modern Coffee House. (Hint: Profit or loss is
determined by preparing the statement of profit and
loss and not on the basis of cash and bank balance.)
2. Examine the decision whether to continue running the
coffee house or not.

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INTRODUCTION TO FINANCIAL ACCOUNTING 3

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the role of accounting information in making eco- nomic decisions.
Identify the users and uses of accounting information. Understand the sub-fields of accounting and their
> Describe the contents and the purpose of different financial statements.
Understand the purpose of generally accepted accounting principles.
>
>
>
>
1. INTRODUCTION
Decision making is a part and parcel of carrying on a business. There
are many stakeholders in a business enterprise. These include
owners, man-
agers, investors, lenders, customers, suppliers, labor unions and the
government. All these stakeholders make some or the other kind of
decision. For making decisions, the stakeholders need relevant
economic information. “Accounting” provides the relevant economic
information required by stakeholders.

1. ACCOUNTING
Accounting has been aptly defined by the American Accounting Association as:
Accounting is the process of identifying, measuring and
communicating eco- nomic information to permit informed
judgments and decisions by the users of accounts.
This definition implies that there are certain users of accounts who
need information for judgment and decision making, and accounting
is a process of identifying users’ information requirements and
collecting, processing and communicating such information to the
users.

1.3 USERS AND USES OF ACCOUNTING

INFORMATION
Accounting information has both internal and external users. Internal
users are managers in all areas of functional responsibility such as
marketing, finance, human resources and general management.
Marketing managers use account- ing information to make decisions
relating to pricing of products, sales promo- tion, etc. Finance
managers use accounting information to decide on making new
investments, raising funds, payment of dividends, etc. Human
! IMPORTANT CONCEPT
resources managers make decisions relating to pay revision, Accounting information has both internal (man
declaration of bonus, etc. on the basis of accounting information.
General managers make decisions on the product-mix of the entity
using accounting information. The type of reports generated by the
accounting information system for use by managers include forecasts
of income, projections of funds requirement and availability, compar-

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 ison of financial results of alternative courses of action, etc.

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4 FINANCIAL ACCOUNTING AND ANALYSIS

External users of accounting information include investors, lenders,

cus- tomers, suppliers, labor unions and the government. Owners and
investors are interested in knowing whether the business would be
able to provide a reasonable return on their investment and
whether to continue with the investment in the business, how to
finance the expansion of business, etc. Lenders need information for
determining the capacity of the business to pay interest and to repay
loans in time. Customers want to know whether the business will
continue producing the item they are using so that there are no
problems relating to servicing of its products and associated
warranties. Suppliers want to satisfy themselves about the ability of
the business to make payments of their dues on time. Labor unions
are interested in know- ing whether the business will be able to pay
increased wages and bonuses. Government wants to know whether
the business is rightly determining its profit or loss and whether it is
duly paying the taxes due from it.

1. The group of users of accounting information charged with

achieving the goals of the business is its
a. auditors b. investors
c. managers d. creditors
2. Which of the following groups uses accounting information
to determine whether the company can pay its obligations?
a. Investors in common stock
b. Marketing managers
c. Creditors
d. Chief Financial Officer
3. Which of the following groups uses accounting information
to determine whether the company’s net income will result
in a stock price increase?
a. Investors in common stock
b. Marketing managers
c. Creditors
SELF-ASSESSMENT QUESTIONS
d. Chief Financial Officer

ACTIVITY 1
Would you advise Ashok and Ramesh to close down the coffee
house or to take external advice?

1. SUB-FIELDS OF ACCOUNTING
Information needed by managers and owners is more detailed, and
QUICK TIP the sub- field of accounting that generates this information is known
Financial accounting and as managerial accounting. Managers use managerial accounting
Managerial accounting are information to set orga- nizational goals, evaluate individual and
two important sub-fields departmental performances, make decisions relating to the
of accounting. introduction of new products or entering new mar- kets, etc.
Managerial accounting information need not be organized in a par-
ticular format. The presentation depends on the decision at hand. A
major
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INTRODUCTION TO FINANCIAL ACCOUNTING 5

part of managerial accounting consists of information relating to the

cost of products and services. Managerial accounting uses both
historical informa- tion and projections for the future.
The other sub-field of accounting is called financial accounting. It
relates to the preparation of financial statements for use by both
managers and exter- nal stakeholders. Financial accounting reports
present information about all activities of the business, be it
operating activities (main revenue-producing activities); investing
activities (activities involving purchase and sale of long- lived
assets and investments); or financing activities (activities that
change the amount and composition of financial resources).
Financial accounting is basically historical in nature.

1. ACCOUNTING TERMS
The following terms commonly used in financial accounting are of
interest to different users of accounting information:

1.5.1 ASSET
Assets are economic resources controlled by an entity whose cost (or
fair value) at the time of acquisition could be objectively measured. A
resource is an economic resource if it provides future cash flows to
the entity. An asset can be: (i) cash or something convertible into
cash (e.g. accounts receivable),
(ii) goods expected to be sold and cash received from them and (iii)
items to be used in future activities that will generate cash flows.
Land and building, plant and machinery, furniture and fixtures,
inventories, debtors and cash balance are examples of assets.

1.5.2 LIABILITY
Liabilities are claims to assets. A business raises financial resources
from both its owners and outside parties. Both have claims to the
assets of the entity. Liabilities are claims to assets of parties other
than owners. Loans, debentures (bonds), creditors, unpaid expenses
are examples of liabilities. Liabilities create negative future cash
flows for the entity.
For example, a business has assets worth Rs. 10 million which are
financed by owners’ funds of Rs. 6 million and loans of Rs. 4 million.
The loan of Rs. 4 million represents a claim to 40 percent of the
assets and is termed as a liability of the business.

1.5.3 CAPITAL/OWNERS’ EQUITY

Capital (owners’ equity) generally refers to the amount invested in an
enter- prise by the owners. It is also used to refer to the claim of
owners to the assets of an enterprise. The claims of owners to assets
are secondary to those of creditors and lenders.
Changes in owners’ equity occurs when: (i) owners either invest in or
with- draw cash or other assets from the business and (ii) the
business either earns income from profitable operations or incurs
losses from unprofitable operations.

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6 FINANCIAL ACCOUNTING AND ANALYSIS

1.5.4 REVENUE
Revenue is the gross inflow of cash, receivables or other
consideration aris- ing during the course of ordinary activities of an
enterprise from the sale of goods, rendering of services, and from
the use by others of enterprise resources yielding interest, royalties
and dividends.

1.5.5 COST
Cost is a monetary measurement of the amount of resources used for
some purpose. For example, an entity incurs a cost when it purchases
an item of equipment.

1.5.6 EXPENSE
All costs incurred by an entity are not expenses. An expense is that
cost which relates to the operations of an accounting period (e.g.
rent) or to the revenue earned during the period (cost of goods sold)
or the benefits of which do not extend beyond that period. Expenses,
thus, have a relation with the accounting period and represent that
part of the cost of an asset or service that is consumed during the
accounting period.
For example, a businessman dealing in televisions buys 1,000
QUICK TIP television sets at a cost of Rs. 20 million during an accounting year.
An expense is a cost that This amount of Rs. 20 million is a cost as it represents the amount of
satisfies certain conditions. resource (cash) used. During this accounting period, the businessman
sells only 800 televisions. The cost of 800 televisions, that is, Rs. 16
million is the expense of that accounting year as it represents the
cost that corresponds to the revenue earned during the year from the
sale of 800 televisions.
A business that prepares its accounts every calendar year (January–
December) buys an yearly insurance cover on its assets on 1 April by
paying a premium of Rs. 50,000. This amount of Rs. 50,000 is a cost
as it represents the amount of resource (cash) used. However, the
business will not enjoy the entire benefit of this cost in the accounting
period that ends on 31 December. The benefit of the insurance cover
extends to 31 March of the next accounting period. Only three- fourth
of this cost relates to 9 months of the current accounting period, that
is, Rs. 37,500 will be treated as an expense of the current accounting
period.

1.5.7 GOODS
The term ‘Goods’ refers to the property in which the business deals.
Goods are purchased by a business for resale and not for use in the
business. For example, furniture acquired for resale by a furniture
dealer will be treated as goods and furniture acquired by such a
dealer for use in his/her office will be treated as an asset.

1.5.8 DEBTORS (ACCOUNTS RECEIVABLE)

Debtor refers to a person who owes money to the business for goods
pur- chased from the business.

1.5.9 CREDITORS (ACCOUNTS PAYABLE)

Creditor refers to the person to whom the business owes money for
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goods
purchased
by the
business
from that
person.

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INTRODUCTION TO FINANCIAL ACCOUNTING 7

1.5.10 DEBITS AND CREDITS

The accounting system keeps a separate record for each item of
assets, lia- bilities, income and expense. This record is called an
4. Which of the following is the most appropriate and modern
account. An account has two sides, the left-hand side and the right-
definition of accounting?
hand side. Accounting records are maintained using a double-entry
a. The
accounting information
system. Undersystem that identifies,
this system, debit andrecords
creditandentries of
communi- cates the economic
equal amount are made to record every business events of an organization
transaction.
Entering an to amount
interestedonusers.
the left-hand side of the account is called
A means
debitingb. the accountofand
collecting information.
entering an amount on the right-hand side
c. The is
of an account interconnected
called creditingnetwork of subsystems
the account. necessary
Accounting recordstoare
consideredoperate
accuratea business.
only when the sum of all debits is equal to the
sum of d.
all credits.
Electronic collection, organization, and communication of
vast amounts of information.
SELF-ASSESSMENT QUESTIONS
5. The common characteristic possessed by all assets is
.
a. long life b. great monetary value
c. tangible nature d. future economic benefit
6. Resources owned by a business are referred to as .
a. owners’ equity b. liabilities
c. assets d. revenues
7. Debts and obligations of a business are referred to as
.

1. FINANCIAL STATEMENTS
Information to users of accounting information is provided in the form
of financial statements that arrange assets, liabilities, revenue and
expenses in different ways. Every business enterprise generally
prepares three financial statements: income statement, balance
sheet and statement of cash flows.

1.6.1 INCOME STATEMENT

The income statement (or the profit and loss account) reports the
result of business operations during the accounting period. It matches
the expenses for the accounting period with the revenues earned,
and reports the result- ing net income (profit or loss). The income
statement is of particular use to investors, lenders and creditors.
Investors use the past net income as a basis to predict the future net
income and to make their investment decisions. Lenders to the
business use information provided by the income statement to form
an opinion about the ability of the business to repay loans and to pay
interest on time. Creditors use the income statement to form an
opinion about the ability of the business to pay their dues on time.

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8 FINANCIAL ACCOUNTING AND ANALYSIS

1.6.2 BALANCE SHEET

! IMPORTANT CONCEPT The balance sheet reports the financial position of the business at a
particu- lar point of time, generally at the end of the accounting
The accounting equation that always holds is Assets = Owners’ Capital + Liabilities
period. It shows the amount of assets owned by the business and the
claims on these assets. The claims on the assets belong to the
providers of resources to buy the assets, i.e., the owners and
creditors/lenders. As the business cannot spend more on buying
assets than the resources it has, the following relationship (also
called the accounting equation) always holds.
Assets  Owners’ Capital  Liabilities
Creditors and lenders analyze the balance sheet to understand the
ability of the business to repay their dues. The proportion of owners’
capital in relation to outside liabilities also serves as an indicator of
the financial strength of the business.

1.6.3 STATEMENT OF CASH FLOW

The statement of cash flow provides information about the cash
receipts and cash payments during an accounting period. Particularly,
it shows the sources from which cash is received, the uses to which
cash is put and the change in the cash balance during the accounting
period.
The presentation of financial statements for external users depends
on the type of business organization. A business can be organized as
QUICK TIP sole- proprietorship (having a single owner), a partnership (with two
Only companies are required or more owners or partners) or a company (having a large number
to prepare annual as well as of owners or shareholders). Only companies are required by law to
quarterly financial statements. keep the prescribed set of books and to present their financial
statements in the prescribed format. Other forms of business
organization need to maintain their accounts in a manner that
enables determination of their income for income tax purposes.
Normally, companies are required to prepare annual and quarterly
finan- cial statements. The quarterly financial statements are also
known as interim financial statements. Certain business organizations
are, however, not required to prepare interim financial statements for
external reporting.

ACTIVITY 2 Find out the profit or loss made by Modern Coffee House during
the period of 6 months.

1.7 GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES
Generally accepted accounting principles (GAAP) are a set of conven-
tions, rules and procedures that define the accepted accounting
practice at a particular time. These result from a broad agreement
on the theory and practice of accounting at a particular time. The
purpose of GAAP is to ensure that the information provided in the
financial statements is reliable and understandable to the users. The
users should be able to meaningfully compare the current
performance of a business entity with its past per- formance and the
performance of other business entities. The GAAP keep
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INTRODUCTION TO FINANCIAL ACCOUNTING 9

changing from time to time as the circumstances or the information

needs of the users change.
In India, the sources of GAAP include the Companies Act, 2013, Indian
accounting standards and the pronouncements of the accounting
profession.

1. ADVANTAGES OF FINANCIAL ACCOUNTING

1. Reveals the financial performance of a business during a period
and its financial position at the end of that period.
2. Provides relevant information to investors and lenders, both
present and prospective to take appropriate investment and
lending decisions.

1. LIMITATIONS OF FINANCIAL ACCOUNTING

1. Provides only historical information about the performance
and financial performance of business. It fails to provide
estimates and projections for future which form the basis of
business decisions.
2. Financial accounting provides information about matters that
can be quantified. Many other items such as quality of
management are important for the success of a business. Since
these items cannot be quantified, these are not reported by
Financial Accounting.

1.1 SUMMARY
 Understand the role of accounting information in making economic
decisions. There are a number of stakeholders in a business who
make some or the other kind of decision. For making these
decisions, the stakeholders need relevant economic information.
It is account- ing that provides the relevant economic
information required by the stakeholders.
 Identify the users and uses of accounting information. Accounting
information includes both internal and external users.
Managers are internal users. Investors, lenders, customers,
suppliers, labor unions and the government are external users.
 Understand the sub-fields of accounting and their relevance. There
are two sub-fields of accounting: managerial accounting and
financial accounting. Managerial accounting generates detailed
information for owners and managers. On the contrary, financial
accounting relates to the preparation of financial statements for
use by both managers and external stakeholders.
 Understand the purpose of generally accepted accounting principles.
Generally accepted accounting principles (GAAP) are a set of
conven- tions, rules and procedures that define the accepted
accounting practice at a particular time. These result from a
broad agreement on the theory and practice of accounting at a
particular time.

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10 FINANCIAL ACCOUNTING AND ANALYSIS

1. Accounting system keeps a separate record for each item of

assets, liabilities, income and expense. This record is called
an account. An account has two sides, the left-hand side and
the right-hand side.
2. Accounting is the process of identifying, measuring and
communicating economic information to permit informed
judgments and decisions by the users of accounts.
3. Assets are economic resources controlled by an entity
whose cost (or fair value) at the time of acquisition could
be objectively measured.
4. Capital/owners’ equity generally refers to an amount invested
in an enterprise by the owners.
5. Cost is a monetary measurement of the amount of resources
used for some purpose.
6. Credit results from entering an amount on the right-hand
side of an account.
7. Creditors (accounts payable) are persons to whom the
business owes money for goods purchased by the business.
8. Debit results from entering an amount on the left-hand side
of an account.
9. Debtors (accounts receivable) are persons who owe money to
the business for goods purchased.
10. Expense is the cost relating to the operations of an
KEY WORDS accounting period or to the revenue earned during the
period or to the benefits of which do not extend beyond that

1.1 DESCRIPTIVE QUESTIONS

1. Define accounting.
2. How does managerial accounting differ from financial accounting?
3. How does an expense differ from a cost?
4. Who are the main users of accounting information and how do
they use this information?
5. Define the terms revenue, asset and liability.

1.1 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Users and Uses of 1. c. managers
Accounting Information
2. c. Creditors
3. a. Investors in common stock
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INTRODUCTION TO FINANCIAL ACCOUNTING 11

Topics Q. No. Answers

Accounting Terms 4. a. The information system that identi-
fies, records and communicates the
economic events of an organization
to interested users
5. d. future economic benefit
6. c. assets
7. c. liabilities

1.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Anthony, R.N., Hawkins, D.E. and Merchant, K.A. (2015).
Accounting Text and Cases, Tata McGraw Hill.
 Bhattacharyya, A.K. (2014). Financial Accounting for Business
Managers, Prentice Hall of India.

E-REFERENCES
 Horngren C.T., Sundem G.L. and Elliot J.A. (2013). Introduction to
Financial Accounting and Analysis, Pearson Education.
 Khan M.Y. and Jain, P.K. (2010). Management Accounting: Text,
Problems and Cases, Tata McGraw Hill (KJ).

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 C H A
2 P T E R

ACCOUNTING PROCESS

CONTENTS

2. Introduction
1
Steps in the Accounting
2.
Cycle Self-Assessment
2
Questions
Analysis of Accounting
2.
3 Transactions Self-
Assessment Question
2.4. Activity
2. 1 Accounting
4 2.4. Records
2 Account
2.4. Journal and Ledger
3 Subsidiary Books
Self-Assessment Questions
2. Summary
5 Key Words
Descriptive
2. Questions Answer
6 Key
2. Self-Assessment Questions
7
Suggested Books and E-
References
2.
8

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14 FINANCIAL ACCOUNTING AND ANALYSIS

INTRODUCTORY CASELET

STATE BANK OF INDIA

You have a savings bank account with State Bank of India.

Whenever you want to know the balance of money in your
account, you are able to instantly find it online. To ensure the
accuracy of the balance in your account and availability of an
updated balance in your account at all times, the bank needs to
have a proper accounting system.
(Hint: For any business other than banking, transactions
recorded at the time of their occurrence are transferred to the
ledger accounts after an interval according to the convenience
of the business. But, in banking, there can be no gap between
the initial recording and subse- quent transfer. Why?)

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 ACCOUNTING PROCESS 15

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the accounting process that leads to the preparation of financial statements.
Analyze the effect of accounting transactions on the basic account- ing equation.
> Understand the use of an account in the process of building accounting records.
Understand the rules of debit and credit in recording business transactions in relevant accounts.
> Understand how a journal is maintained and the concept of sub- sidiary books.
> Understand the posting of entries in the ledger. Understand how trial balance is extracted and its purpos

>
>
>

INTRODUCTION
2.
An enterprise must have a proper accounting system for recording
the effect of economic events such as purchase of raw materials, sale QUICK TIP
of goods, acqui- sition and disposal of assets, etc. The final step in Examples of economic events
the accounting process is the preparation of financial statements. are purchase of an item of
Financial statements, however, are not prepared after every equipment, payment of
transaction. A continuous sequence of steps (called accounting cycle) salaries to employees.
is followed to record, classify and summarize business transactions in
accounting records. The data in these accounting records is then
used to prepare financial statements. Accounting records are also
used for several other purposes.

2. STEPS IN THE ACCOUNTING CYCLE

The accounting cycle consists of the following steps:
1. Analysis of transactions in terms of their effect on assets,
liabilities and owners’ capital.
2. Accounts are prepared for each item of assets, liabilities,
revenues and expenses using the rules of debit and credit.
These accounts are maintained in a record called ledger. Entries
can be made directly into the ledger or another intermediate
record called journal. In some cases, the journal is subdivided
into a number of journals called subsidiary books.
3. Closing balances of all accounts are transferred to a statement
called
trial balance.
4. At the end of the accounting period, some adjustment entries
are made and an adjusted trial balance is prepared.
5. Financial statements are prepared using the information in the
adjusted trial balance.

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16 FINANCIAL ACCOUNTING AND ANALYSIS

6. Certain closing entries are passed and an after-closing trial

balance is prepared.
This chapter covers the accounting cycle up to the stage of
preparation of trial balance. The remaining steps are covered in the
next chapter.

1. ‘A’ purchased a car for Rs. 500,000, making a down

payment of Rs. 100,000 and signing a Rs. 400,000 bill
payable due in 3 months. As a result of this transaction
.
a. total assets increased by Rs. 500,000
b. total liabilities increased by Rs. 400,000
c. total assets increased by Rs. 400,000
d. total assets increased by Rs. 400,000 with corresponding
increase in liabilities by Rs. 400,000
2. Capital brought in by the proprietor is an example of
.
a. increase in asset and increase in liability equity
b. increase in liability and decrease in asset
c. increase in asset and decrease in liability
d. increase in one asset and decrease in another asset
3. A transaction results in a Rs. 90,000 decrease in both assets
and liabilities. The transaction could have been a .
a. repayment of bank loan of Rs. 90,000
SELF-ASSESSMENT QUESTIONS b. collection from debtors of Rs. 90,000
c. purchase of an item of equipment for Rs. 90,000

! IMPORTANT CONCEPT
An accounting transaction occurs when an economic event causes a change in the assets, liabilities or owners’ capital.

QUICK TIP
All accounting transactions
can be analyzed using the
basic accounting equation.
Each transaction has a dual
effect on the accounting
equation.
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 A change occurs in the assets, liabilities or owners’ capital as a result of
this event.
N
All accounting transactions are analyzed in terms of their effect on
A assets, liabilities and owners’ capital. Since the basic accounting
L equation provides a relationship between assets, liabilities and
Y owners’ capital, the accounting transactions can be analyzed using
the basic accounting equation.
S
I Since the accounting equation must balance, each transaction has a
dual effect on the accounting equation. An increase in an asset must
S be matched by a decrease in another asset, or an increase in a
liability or an increase in owners’ capital. On purchase of furniture,
O either the cash balance will be reduced or a liability to the supplier
will increase. Alternatively, only a part of the cost of furniture may be
F paid in cash and the balance reflected as an increase in liabilities.

A
C
C
O
U
N
T
I
N
G

T
R
A
N
S
A
C
T
I
O
N 2.
S 3
An accounting
transaction
occurs when an
economic event
causes a change
in the assets,
liabilities or
owners’ capital.
Examples of
economic events
are purchase of
an item of
equipment,
payment of
salaries to
employees.
Appointment of a
manager is not
an economic
event as no

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 ACCOUNTING PROCESS 17

Illustration 2.1

Consider the following transactions pertaining to A’s business:

1. Started business with cash Rs. 300,000.
2. Purchased goods for cash Rs. 120,000.
3. Purchased goods on credit Rs. 60,000.
4. Purchased furniture for cash Rs. 20,000.
5. Deposited Rs. 50,000 in the bank account.
6. Sold goods costing Rs. 15,000 for Rs. 18,000, on credit.
7. Sold goods costing Rs. 30,000 for Rs. 36,000, in cash.
8. Paid rent Rs. 10,000 and salaries Rs. 20,000.
9. Withdrew Rs. 15,000 from the bank account to pay for
private expenses.
10. Received cash against goods sold on credit Rs.
18,000. Each transaction can be analyzed in the
following manner:
 Transaction 1: The business received cash of Rs. 300,000; it is
an asset to the business. The business owes this amount to A,
the proprietor, and therefore, it also represents the capital of
the business. Capital of Rs. 300,000 is equal to assets of Rs.
300,000.
 Transaction 2: Purchase of goods for cash increases goods (an
asset) and reduces cash (another asset). The accounting
equation remains the same as after transaction 1.
 Transaction 3: Purchase of goods on credit increases goods (an
asset) and simultaneously increases creditors (a liability). The
sum of liabil- ities and capital is now Rs. 360,000 matched by
assets of Rs. 360,000.
 Transaction 4: Purchase of furniture for cash increases an asset
(fur- niture) and reduces another asset (cash). The accounting
equation remains the same as after transaction 3.
 Transaction 5: Deposit of cash in the bank account increases one
asset (balance in the bank account) and reduces another
asset (cash). The accounting equation remains the same as
after transaction 4.
 Transaction 6: Sale of goods costing Rs. 15,000 for Rs. 18,000 on
credit decreases an asset (goods) by Rs. 15,000 and increases
another asset (debtors) by Rs. 18,000. The difference of Rs.
3,000 between the two amounts is profit. The profit belongs to
the proprietor and increases his/her business capital. After
this transaction, the liabilities are Rs. 60,000, capital is Rs.
3,03,000 and assets are Rs. 363,000.
 Transaction 7: Sale of goods costing Rs. 30,000 for Rs. 36,000 on
cash basis decreases an asset (goods) by Rs. 30,000,
increases another asset (cash) by Rs. 36,000 and also
increases the capital by the amount of profit (Rs. 6,000). After
this transaction, the liabilities are Rs. 60,000, capital is Rs.
309,000 and assets areNMIMS
Rs. 369,000.
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18 FINANCIAL ACCOUNTING AND ANALYSIS

 Transaction 8: Payment of rent Rs. 10,000 and salaries Rs.

20,000 decreases an asset (cash) by Rs. 30,000 and also
decreases capital by Rs. 30,000. After this transaction, the
liabilities are Rs. 60,000, capital is Rs. 279,000 and assets are
Rs. 339,000.
 Transaction 9: Withdrawal of Rs. 15,000 from the bank account
for meeting private expenses decreases one asset (bank
balance) and also reduces capital by Rs. 15,000. After this
transaction, the liabil- ities are Rs. 60,000, capital is Rs.
264,000 and assets are Rs. 324,000.
 Transaction 10: Receipt of cash against goods sold on credit
increases one asset (cash) and reduces another asset
(debtors) by the same amount. The accounting equation
remains the same as after transaction 9.
The accounting equation after different transactions can be
presented as in Table 2.1.
TABLE 2.1 ACCOUNTING EQUATION FOR
DIFFERENT TRANSACTIONS
Assets Liabilities Capital
No. Transaction (Rs.) = (Rs.) + (Rs.)
1. Started business with 300,000 300,00
cash Rs. 300,000 0
2. Purchased goods for cash 300,000 300,00
Rs. 120,000 0
3. Purchased goods on credit 360,000 60,00 300,00
Rs. 60,000 0 0
4. Purchased furniture for 360,000 60,00 300,00
cash Rs. 20,000 0 0
5. Deposited Rs. 50,000 in 360,000 60,00 300,00
the bank account 0 0
6. Sold goods costing 363,000 60,00 303,00
Rs. 15,000 for Rs. 18,000, 0 0
on credit
7. Sold goods costing 369,000 60,00 309,00
Rs. 30,000 for Rs. 36,000, 0 0
in cash
8. Paid rent Rs. 10,000 339,000 60,00 279,00
and salaries Rs. 0 0
20,000
9. Withdrew Rs. 15,000 from 324,000 60,00 264,00
the bank account to pay 0 0
for private expenses
10. Received cash 324,000 60,00 264,00
against goods sold 0 0
on credit Rs.

The simple accounting equation in Illustration 2.1 can be expanded to

show the effect of business transactions on specific assets and
liabilities.

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 ACCOUNTING PROCESS 19

SELF-ASSESSMENT QUESTION
4. Indicate which alternative in each of the following cases is
consid- ered to be correct:
(i) The liabilities of a firm are Rs. 30,000. The capital of the
proprie- tor is Rs. 70,000. The total assets are .
ACTIVITY 1
Rs. following
Analyse a.the 70,000 transactions in terms of their effect on
b. Rs.
assets, lia- 100,000
bilities and capital using the accounting equation. The
starting capital is Rs. 200,000.
c. Rs. 40,000
ACCOUNTING RECORDS
2.1. (ii) The assets
Purchased of for
goods thecash
business as on
Rs. 100,000 March 31, 2015 are
! IMPORTANT CONCEPT
worth Rs. 500,000 and its capital is Rs. 350,000. Its The accounting system keeps a separate recor
2.4.1 2.ACCOUNT
Purchased goods on credit Rs. 50,000
liabilities on that date shall be . Accounts can be classified into the following ca
The 3.accounting Rs.system
Paida.salaries keeps a separate record for each item that
Rs. 10,000
850,000 Asset accounts
appears in b.theRs. financial
150,000statement. This record is called an account. Liability accounts
The account for any item records increases and decreases in that Capital accounts
c. Rs. 350,000
item as a result of business transactions and determines the balance Expense accounts
of that(iii)
itemTheat accounting
any time afterequation
one orstates
morethat .
transactions affecting that Income accounts
item have taken place. Assets  Liabilities
a. Capital
For example, b. aCapital
person Liabilities  Assetswith say Rs. 50,000. In this
starts a business
case, his/ her Assets isLiabilities
c. capital Rs. 50,000  Capital
and assets in the form of cash are
also Rs. (iv) The owners’ equity (i.e., capital)into
50,000. Transactions entered shallby the increased
stand firm will by
either
increase the cash balance (e.g., transactions such as sales for cash
and collections. from customers, etc.) or decrease the cash balance
(e.g., payment for goods purchased, salaries, rent, etc.). The cash
a. proprietor’s drawings
balance can be changed with every transaction by erasing the
b. purchasing furniture on credit

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20 FINANCIAL ACCOUNTING AND ANALYSIS

old amount and entering the new amount for each transaction. This is
quite cumbersome and time consuming. Instead, it is convenient if all
the transac- tions that lead to an increase or decrease in cash are
collected together in the cash account. The new cash balance can be
calculated by adding the sum of increases to the starting balance and
then subtracting the sum of decreases.
An account has a title and two columns. It resembles the English
letter ‘T’ and is called a ‘T Account’. The left-hand side of the account
is called the debit side and the right-hand side is called the credit
side. An illustration of an account is shown in Table 2.2.

TABLE 2.2 SIMPLE FORM OF AN ACCOUNT

Cash
Debit Side (Rs.) Credit Side (Rs.)
Starting balance 40,000 Decreases 8,000
Increases 4,400 2,000
2,000 4,000
1,000 1,500
300
47,700 15,500
New balance 32,200

What we have done is to put the increase of cash on the left-hand

side and the decrease on the right-hand side. An alternate form in
which an account can be presented is given in Table 2.3.

Date Particulars
TABLE Reference Amount
2.3 ALTERNATE FORM OFDate Particulars Reference
PRESENTING Amount
AN ACCOUNT

Note: Reference indicates the source of information.

CLASSIFICATION OF ACCOUNTS
Accounts can be classified into the following categories: (i) asset accounts,
(ii) liability accounts, (iii) capital accounts, (iv) expense accounts and
(v)income accounts.
! IMPORTANT CONCEPT
Under the double-entry accounting system,RULES
debit andFOR
creditDEBIT AND
entries of equalCREDIT
amount are made to record every transaction.
Accounting records are maintained using a double-entry accounting
system. Under this system, debit and credit entries of equal amount
are made to record every transaction. Entering a transaction on the
left-hand side of an account is known as debiting the account and
entering a transaction on the right-hand side is called crediting the
account. The rules of debit and credit differ with the account type,
and are as follows:
1. Increases in assets are debits; decreases in assets are credits.
2. Increases in liabilities are credits; decreases in liabilities are debits.

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 ACCOUNTING PROCESS 21

3. Increases in owners’ capital are credits; decreases in owners’

capital are debits. QUICK TIP
4. Expenses and losses are debits; incomes and gains are To identify the correct debit
or credit, one needs to first
credits. Accounts can also be classified into the following
determine the accounts that
categories: are involved in a transaction.
Then, one has to identify which
1. Personal accounts: These accounts relate to persons. Accounts of
account has increased or
customers, suppliers, lenders and bankers fall in this category.
decreased and apply the debit/
The capital account of the owners is also a personal account.
credit rule.
2. Real accounts: These accounts relate to assets of the firm such as
land, building, investments, fixed deposits, cash balance, etc.
3. Nominal accounts: These accounts relate to expenses, revenues, QUICK TIP
losses and gains. Salaries paid, interest paid, commission Entering a transaction on
received are examples of nominal accounts. Nominal accounts the left-hand side of an
are temporary only as their net result is reflected as profit or account is known as
loss, which is transferred to the capital account. ‘debiting the account’ and
entering a
For this alternative classification of accounts, the following rules of
debit and credit are followed: transaction on the credit side is
called ‘crediting the account’.
1. For personal accounts, debit the receiver and credit the giver.
2. For real accounts, debit what comes in and credit what goes out.
QUICK TIP
3. For nominal accounts, debit all expenses and losses and credit
all incomes and gains. Increases in assets are debits;
decreases in assets are credits;
Increases in liabilities are
credits; decreases in liabilities
Illustration 2.2 are debits; Increases in owners’
capital are credits; decreases in
A, after starting business on January 1, 2016, with cash of Rs. 100,000, enteredowners’
into the following
capital are debitstransactions:
and
Jan 3: Purchased machinery for Rs. 50,000 Jan 5: Paid rent for the shop Rs. 2,000
Expenses and losses are debits;
Jan 31: Paid salary to employee Rs. 3,000 Jan 31: Received commission Rs. 15,000incomes and gains are credits.
These transactions can be analyzed in terms of accounts involved (assets, liabilities, expenses, incomes) and debit

TABLE 2.4 ANALYSIS OF TRANSACTIONS

Date Accounts Type of Debit Credit

(2016) Particulars Involved Account Effect (Rs.) (Rs.)
Jan 1 Rs. 100,000 Cash Asset Increased 100,00
cash A’s capital Capital Increased 0
invested 100,00
in 0
business
Jan 3 Purchased Machinery Asse Increased 50,000
machinery Cash t Decrease 50,000
for Rs.
50,000 Asse d
t
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22 FINANCIAL ACCOUNTING AND ANALYSIS

TABLE 2.4 ANALYSIS OF TRANSACTIONS—CONTINUED

Date Accounts Type of Debit Credit
(2016) Particulars Involved Account Effect (Rs.) (Rs.)
Jan 5 Paid rent for Ren Expense Increased 2,000
the shop t Asset Decrease 2,000
Rs. 2,000
Cas d
h
Jan 31 Paid salary Salary Expense Increased 3,000
to Cash Asset Decrease 3,000
employee
d
Rs. 3,000
Jan 31 Received Cash Asset Increased 15,000
commission Commissio Incom Increased 15,000
Rs. 15,000
n e

The transactions in Table 2.4 can be analyzed in terms of the

alternative classification of accounts involved (personal, real,
nominal) and debit/ credit rules as in Table 2.5.

TABLE 2.5 ANALYSIS OF TRANSACTIONS USING ALTERNATIVE

CLASSIFICATION OF ACCOUNTS

Date Accounts Type of Debit Credit

(2016) Particulars Involved Account Effect (Rs.) (Rs.)
Jan 1 Rs. 100,000 Cash Real Comes in 100,00
cash A’s Capital Personal Giver 0
invested in 100,00
business 0
Jan 3 Purchased Machiner Real Comes in 50,000
machinery y Cash Real Goes out 50,000
for Rs.
50,000
Jan 5 Paid rent for Rent Nomina Expense 2,000
the shop Cash l Real Goes out 2,000
Rs. 2,000
Jan 31 Paid salary Salary Nomina Expense 3,000
to Cash l Real Goes out 3,000
employee
Rs. 3,000
Jan 31 Received Cash Real Comes 15,000
Based on Tables 2.4 and 2.5, the ‘T’ form accounts in Table 2.6
can be prepared.

TABLE 2.6 LEDGER ACCOUNTS

Amount Amount
Date Particulars Reference (Rs.) Date Particulars Reference (Rs.)
Cash account
Increases Decreases
(Dr.) (Cr.)
Jan 1 A’s Capital 100,00 Jan 3 Machinery 50,00
0 0
Jan 31 Commissio 15,000 Jan 5 Rent 2,00
n 0
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Jan 31 Salary 3,00
0
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 ACCOUNTING PROCESS 23

TABLE 2.6 LEDGER ACCOUNTS—CONTINUED

Amount Amount
Date Particulars Reference (Rs.) Date Particulars Reference (Rs.)
A’s capital account
Decreases Increases
(Dr.) (Cr.)
Jan 1 Cash

100,000
Machinery account
Increases Decreases
(Dr.) (Cr.)
Jan 3 Cash 50,00
0
Rent account
Increases (Dr.) Decreases (Cr.)
Cash
Jan 5 2,000
Salary account

Increase Decrease
s (Dr.) s (Cr.)
Jan 31 Cash 3,000
Commission account
Decrease Increase
s (Dr.) s (Cr.)
Jan 31 Cash 15,000

2.4.2 JOURNAL AND LEDGER

! IMPORTANT CONCEPT
The accounting record where all the accounts are kept together is
called the ledger. It is also referred to as the principal book. Though Transactions are first entered in the Journal in
accounts can be written directly in the ledger, it is common to use recorded in the journal are subsequently transf
two records for the pur- pose. These are the journal and the ledger.

JOURNAL
Transactions are first entered in this record to show the accounts to
be deb- ited and credited. Journal is also called a subsidiary book.
Transactions are entered in a chronological order in the journal. The
debit and credit amounts recorded in the journal are subsequently
transferred to the relevant accounts in the ledger at convenient
intervals.

ENTERING TRANSACTIONS INTO THE JOURNAL

The journal is prepared in the following manner (Table 2.7).

TABLE 2.7 FORMAT OF JOURNAL

Date Particulars L.F. Dr. Amount Cr. Amount

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24 FINANCIAL ACCOUNTING AND ANALYSIS

1. In the first column, the date of the transaction is entered. At

the top, the year is written and below the year, the month and
the date are written.
2. In the second column, the names of the accounts involved are
written. The account to be debited is written first with the word
‘Dr.’ (which stands for debit). It is written towards the end of the
column. In the next line, a little space is left, then the word ‘To’
is written, after which the name of the account to be credited is
written. In the next line, ‘narration’ is written which refers to the
explanation for the entry being made and the necessary details
relating thereto. It starts with the words ‘Being’.
3. In the third column, L.F. refers to ‘Ledger Folio’, which is the
page of the ledger containing the account in which the entry is
written up or posted.
4. The fourth column refers to the debit amount. In this column,
the amounts to be debited are entered.
5. In the fifth column, the amounts to be credited are
entered. The process of entering the transactions in the
journal is called
journalizing.

Illustration 2.3

A has entered into the following transactions during January 2016.

Date (2016) (Rs.)

Jan 1 A started business with cash 100,00
0
Jan 3 Deposited cash into the bank 75,000
Jan 4 Purchased stationary 500
Jan 5 Purchased goods for cash 20,000
Jan 7 Purchased goods from B on 25,000
credit
Jan 8 Sold goods for cash 15,000
Jan 9 Sold goods to C on credit 18,000
Jan 10 Drew cash from bank 10,000
Jan 15 Paid to B 24,500
Discount allowed by B 500
Jan 20 Received cash from C 17,700
Discount allowed to C 300
Jan 31 Paid salary 2,000
The above transactions will appear in A’s journal as shown in Table 2.8.

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 ACCOUNTING PROCESS 25

TABLE 2.8 JOURNAL OF A

Dr. Cr.
Date Amount Amount
(2016) Particulars L.F. (Rs.) (Rs.)
Jan 1 Cash account Dr. 100,000
To Capital account 100,00
(being the amount invested by 0
A in his/her business)
Jan 3 Bank account Dr. 75,000
To Cash account 75,000
(being the amount deposited in
bank)
Jan 4 Stationery Dr. 500
account To 500
Cash account
(being stationery purchased for
cash)
Jan 5 Purchases Dr. 20,000
account To 20,000
Cash account
(being goods purchased for
cash)
Jan 7 Purchases Dr. 25,000
account To B’s 25,000
account
(being goods purchased
from B on credit)
Jan 8 Cash account Dr. 15,000
To Sales account 15,000
(being goods sold for cash)
Jan 9 C’s account Dr. 18,000
To Sales account 18,000
(being goods sold to C on credit)
Jan 10 Cash account Dr. 10,000
To Bank account 10,000
(being cash withdrawn from bank)
Jan 15 B’s account Dr. 25,000
To Cash account 24,500
To Discount account 500
(being cash paid to B and
discount allowed by him/her)
Jan 20 Cash account Dr. 17,700
Discount account Dr. 300
To C’s account 18,000
(being cash received from C and
discount allowed to him/her)
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26 FINANCIAL ACCOUNTING AND ANALYSIS

TABLE 2.8 JOURNAL OF A—CONTINUED

Dr. Cr.
Date Amount Amount
(2016) Particulars L.F. (Rs.) (Rs.)
Jan 30 Salaries account Dr. 2,000
To Cash 2,000
account
(being the amount paid for
salary)

POSTING ENTRIES INTO THE LEDGER

Entries are posted into the ledger from the journal. The transfer of
QUICK TIP jour- nal entry amounts to the ledger is called posting. The journal
shows the account to be debited and the account to be credited
• The accounting record along with the amounts involved. A ledger account has two sides: the
where all the accounts are debit side on the left and the credit side on the right. For the account,
kept together is called the which is to be debited, the entry will be made on the left-hand side of
ledger. the account. The date of the transaction will be entered in the date
• The transfer of journal entry column and the particulars in the particulars column of the account.
amounts to the ledger is The particulars will be preceded by the word ‘To’.
called ‘posting’.
For the account to be credited, the entry will be made on the right-
hand side of the account. The particulars will be preceded by the
word ‘By’.

FINDING THE BALANCE IN A LEDGER ACCOUNT

To find the balance in an account at the end of the accounting period
or at any other time, the two sides of the account are totaled and the
difference between the two is calculated. This difference represents
the balance in the account. The balance is a credit balance when the
total of the credit side of the account is greater than the total of
the debit side. If the total of the debit side is greater, the balance in
the account is a debit balance. The credit balance is written on the
debit side as ‘To balance c/d’, where c/d stands for ‘carried down’.
Similarly, a debit balance is written on the credit side as ‘By balance
QUICK TIP c/d’. The totals of the two sides are now equal and are written on the
The balance in an account is a two sides opposite each other. After determining the total, the credit
credit balance when the balance is written on the credit side as ‘By balance b/d’, where b/d
total of the credit side of the stands for brought down. It represents the starting balance of the
account is greater than the next accounting period. Similarly, the debit balance is written on the
total of the debit side. debit side as ‘To balance b/d’ in the next period.
If the total of the debit side The revenue and expense accounts are not balanced, but their
is greater, the balance in the amounts are transferred to the profit and loss account. This is the
account is a debit balance. reason these accounts are also referred to as temporary accounts,
while asset and liability accounts are referred to as permanent
accounts.
The posting of transactions given in Illustration 2.3 and the balancing
of ledger accounts is shown in Tables 2.9.

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 ACCOUNTING PROCESS 27

TABLE 2.9 POSTING OF TRANSACTIONS INTO LEDGER ACCOUNTS

LEDGER
Cash account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Capital A/c 100,000 2016 Jan By Bank A/c 75,000
1 3
8 To Sales A/c 15,000 4 By Stationary 500
A/c
10 To Bank A/c 10,000 5 By Purchases 20,000
A/c
20 To C’s A/c 17,700 15 By B’s A/c 24,500
31 By Salaries A/c 2,000
By Balance c/d 20,700
142,700 142,700
Feb 1 To Balance 20,700
b/d

Capital account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Balance 100,00 2016 Jan 1 By Cash A/c 100,00
31 c/d 0 0
100,000 100,00
0
Feb 1 By Balance 100,00
b/d 0

Bank account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan 3 To Cash A/c 75,000 2016 Jan By Cash A/c 10,000
10
By Balance 65,000
31 c/d
75,000 75,000
Feb 1 To Balance 65,000
b/d

Stationary account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan 4 To Cash 500
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TABLE 2.9 POSTING OF TRANSACTIONS INTO

LEDGER ACCOUNTS—CONTINUED
LEDGER
Purchases account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Cash A/c 20,00
5 0
Jan 7 To B’s A/c 25,00
0

Sales account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 2016 Jan 8 By Cash A/c 15,000
9 By C’s A/c 18,000

B’s account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Cash A/c 24,50 2016 Jan 7 By Purchases 25,000
15 0 A/c
To Discount 500
A/c
25,000 25,000

C’s account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Sales A/c 18,00 2016 Jan By Cash A/c 17,700
9 0 20
By Discount A/c 300
18,000 18,000

Discount account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To C’s 300 2016 Jan By B’s A/c 500
20 Account 15
Salaries account
Dr. Cr.
Amount Amount
Date Particulars (Rs.) Date Particulars (Rs.)
2016 Jan To Cash 2,000
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 ACCOUNTING PROCESS 29

2.4.3 SUBSIDIARY BOOKS

Most of the transactions in a business relate to receipts and
payments of cash, purchase of goods and sale of goods. Instead of
routing these trans- actions through the journal, these transactions
are recorded in separate records meant for each class of
transactions. These books are called subsidi- ary books or books of
prime entry because transactions are first recorded in these books
before these are posted into the ledger. The following subsidiary
books are commonly used in a business:
1. Cash book to record receipts and payments of cash and also
receipts into and payments out of the bank.
2. Purchases book to record credit purchases of goods which a
business deals in or of materials and stores required for
production.
3. Sales book to record the credit sales of goods in which the firm deals.
4. Purchases returns book to record the returns of purchased
goods and materials to suppliers.
5. Sales returns book to record return of goods by customers.
6. Bills receivable book to record bills of exchange or promissory
notes received from other parties.
7. Bills payable book to record bills of exchange or promissory
notes issued to other parties.
8. Journal proper to record those transactions that cannot be
recorded in any of the above mentioned subsidiary books.
Subsidiary books are maintained because they offer many advantages
such as division of work, specialization, saving of time, availability of
separate informa- tion for each class of transactions and easy
detection and correction of errors.

SELF-ASSESSMENT QUESTIONS
5. Select the best answer:
(i) Rent account is a .
a. nominal account
b. personal account
c. asset account
(ii) Salary outstanding account is a .
a. personal account
b. nominal account
c. real account
(iii) Bank account is a .
a. real account
b. personal account
c. nominal account
(iv) Loss on account of fire is a .
a. real account
b. nominal account
c. personal account

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30 FINANCIAL ACCOUNTING AND ANALYSIS

6. In the case of balance sheet accounts .

a. decreases in asset accounts are recorded by debits
b. increases in asset accounts are recorded by credits
c. decreases in liability accounts are recorded by debits
d. increases in liability accounts are recorded by debits
7. Which of the following statements relating to revenue and
expense accounts is not correct?
a. Revenue accounts have debit balances.
b. Expense accounts have debit balances.
c. Expenses are recorded as debits in ledger accounts.
d. Revenues are recorded as credits in ledger accounts.
8. Indicate the incorrect answer.
a. Drawings are withdrawals by the owners from the
business.
b. Drawings decrease the net income.
c. Drawings decrease the owners’ capital.
d. Drawings are not treated as business expense.
9. A revenue account .
a. is increased by debits
b. is decreased by credits
c. has a normal balance of a debit
d. is increased by credits

2. SUMMARY
 Understand the accounting process that leads to the preparation of
financial statements. Transactions are analyzed in terms of their
effect on assets, liabilities and owners’ capital. Following the
rules of debit and credit, these are entered into the journal or
the ledger.
 Analyze the effect of business transactions on the basic accounting
equation. The effect of transactions on assets, liabilities and
owners’ cap- ital can be analyzed using the basic accounting
equation.
 Understand the use of an account in the process of building accounting
records. A ‘T’ shaped account is a convenient way of determining the
bal- ance of an item at any time. The left-hand side of the account is
called the debit side and the right-hand side is called the credit side.
Increases in the account are entered on one side and decreases on
the other. The difference in the amounts on the two sides represents
the balance in the account.
 Understand the rules of debit and credit in recording business trans-
actions in relevant accounts. Entering the transactions in an
account is based on certain rules that differ with the account
type. Increases in assets are debits; decreases in assets are
credits. Increases in liabilities are credits; decreases in liabilities
are debits. Increases in the owners’ capital are credits; decreases
in the owners’ capital are debits. Expenses and losses are debits;
incomes and gains are credits.
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 ACCOUNTING PROCESS 31

 Understand how a journal is maintained and the concept of subsidiary

books. The journal has a specific format that consists of five
columns. Sometimes, a journal is subdivided according to the
nature of transac- tions. The parts of the journal are called
subsidiary books.
 Understand the posting of entries in the ledger. The debit and credit
amounts in the journal and the subsidiary books are transferred to
the relevant side of accounts maintained in the ledger. To find the
balance in an account at the end of the accounting period or at
any other time, the two sides of the account are totaled and the
difference between the two is calculated. This difference
represents the balance in the account.
 Understand how trial balance is extracted and its purpose. The clos-
ing balances of all ledger accounts are transferred to a statement
called the trial balance. It serves as a summary of the contents of
the ledger. Agreement of the totals of debit and credit balances in
the trial balance is an indication of absence of arithmetical errors
in the accounting process.

KEY WORDS
1. Account is a two-column format, resembling the English
alphabet ‘T’, used to record accounting transactions.
2. Accounting transaction occurs when an economic event causes
a change in the assets, liabilities or owners’ capital.
3. Double-entry accounting system requires debit and credit
entries of equal amount to record every transaction.
4. Journal is an accounting record in which transactions are
entered as they occur.
5. Ledger is an accounting record with separate accounts for
each account classification in which transactions are posted
from the journal.
6. Nominal accounts relate to expenses, revenues, losses and
gains.
7. Personal accounts relate to persons. An account of customers,
suppliers, lenders and bankers fall in this category. The
capital account of the owners is also a personal account.
8. Real accounts relate to assets of the firm such as land,
building, investments, fixed deposits, cash balance, etc.
9. Subsidiary books are records used to enter special types of
transactions such as purchase and sale of goods, receipts
and payments of cash, etc. Such transactions may otherwise
be recorded in the journal.
10. Trial balance is the statement that shows the closing
balances of all ledger accounts separately for debit and

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32 FINANCIAL ACCOUNTING AND ANALYSIS

2. DESCRIPTIVE QUESTIONS
1. Following is the list of various accounts. Find the assets,
liabilities, capital, revenue or expense accounts:
(i) Machinery
(ii) Bank
(iii) Sales
(iv) Unsold stock
(v) Bank overdraft
(vi) Ram (customer)
(vii) Purchases
(viii) Cash
(ix) Interest received
(x) Mohan (Proprietor)
2. Classify the following under personal, real and nominal accounts:
(i) Stock
(ii) Loan
(iii) Bank loan
(iv) Capital
(v) Drawings
(vi) Furniture
(vii) Cash
(viii) Bank
(ix) Ram (a purchaser)
3. Name the steps involved in the accounting cycle.
4. What are the two alternative ways in which
accounts can be classified?

2. ANSWER KEY
SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Steps in the 1. d. total assets increased by Rs. 400,000
Accounting Cycle with corresponding increase in
liabilities by Rs. 400,000
2. a. increase in asset and increase in
liability equity
3. a. repayment of bank loan of Rs. 90,000
Analysis of 4. (i)b, (ii)b, (iii)b, (iv)b, (v)c, (vi)a,
Accounting (vii)b
Transactions
Accounting Records 5. (i)a, (ii)a, (iii)b, (iv)b
6. c. decreases in liability accounts are
recorded by debits

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 ACCOUNTING PROCESS 33

Topics Q. No. Answers

7. a. Revenue accounts have debit
balances
8. b. Drawings decrease the net income
9. d. is increased by credits

2. SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Anthony R.N., D.E. Hawkins and K.A. Merchant (2015). Accounting
Text and Cases, Tata McGraw Hill.
 Horngren C.T., Sundem G.L. and Elliot J.A. (2014). Introduction to
Financial Accounting, Pearson Education.
 Weygandt, J.J., Kimmel, P.D., and Kieso, D.E. (2015). Accounting
Principles, Wiley India.

E-REFERENCES
 Anthony, R.N., Hawkins, D.E. and Merchant, K.A. (2015).
Accounting Text and Cases, Tata McGraw Hill.
 Bhattacharyya, A.K. (2014). Financial Accounting for Business
Managers, Prentice Hall of India.

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Chapter 2_Accounting Process.indd 34 5/14/2020 3:32:28 PM
 C H
3
A P T E R

FINANCIAL STATEMENTS

CONTENTS

3. 3.5.5
1
3.1.
1
3.1.
2
3. 3.1.
2 3
3.7.1
3.
3.7.2
3
3.3.
1
3.3.
2
3. 3.3.
4 3
3.3.
4

3.4.
1
3.
5 3.4.
2
3.4.
3

3.5.
1
3.5.
2
3. 3.5.
6 3

3. 3.5.
7 4
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Introduction l tion of Assets Liabilities
I a Long-Term Liabilities
n n Short-Term
c c Liabilities
o e Owners’ Capital or Owners’
m Equity Self-Assessment
e S Questions
h Basic Concepts Underlying Preparation of Balance Sheet
S e Business Entity Concept
t e Money Measurement
a t Concept Going Concern
t Concept
e A Self-Assessment
m s Question Cost Concept
e s Dual Aspect Concept
n e Self-Assessment
t t Question Activity
s Statement of Profit and Loss
B Fix Self-Assessment
a ed Questions
l Ass Basic Concepts
a ets Accounting Period
n (No Concept Conservatism
c n- Concept
e Cur Self-Assessment Questions
ren
S t
h Ass
e ets
e )
t Inv
est
S me
t nts
a Cur
t ren
t
e
Ass
m ets
e O
n r
t d
e
o r
f
o
C f
a
s P
h r
e
F s
l e
o n
w t
B a
a
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36 FINANCIAL ACCOUNTING AND ANALYSIS

3.7. Realization Concept

3 Matching Concept
3.7. Self-Assessment
4 Questions Consistency
Self-Assessment
3.7. Question Accrual
5
Concept Materiality
Activity
3.7.
3.8 6 Summary
3.7. Key Words
3.9 7 Descriptive
Questions
3.10 Answer Key
Self-Assessment Questions
3.11 Suggested Books and E-References

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 FINANCIAL STATEMENTS37

INTRODUCTORY CASELET

ANALYSIS OF FINANCIAL ASPECTS

A wealthy person is looking to invest money in a company that
will pro- vide a reasonable return on his investment on a regular
basis both by way of dividend and capital appreciation. At the
same time, he wants the investment to be not too risky. How can
he pick such a company? From where, can he get the necessary
information to make the investment decision? One important
source of information that the investor is look- ing for is the
financial statements of a company.
Companies convey vital information about their performance,
finan- cial position and cash flows through financial statements
comprising of statement of profit and loss, balance sheet and
cash flow statement. The statement of profit and loss reveals the
profit earned or loss incurred by the company in an accounting
period. The balance sheet shows the financial position of the
company at the end of an accounting period. The cash flow
statement presents the sources and uses of cash during an
accounting period.

QUESTION

1. What are the other possible sources of information that

the investor is looking for? (Hint: Websites of investment
advisors, stock exchanges, etc.)

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38 FINANCIAL ACCOUNTING AND ANALYSIS

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the nature and purpose of balance sheet. Understand the fo
Explain the accounting principles that underlie the preparation of a bala
> Understand the nature and purpose of statement of profit and loss. Und
Explain the accounting principles that underlie the preparation of statem
>
>
>
>

3. INTRODUCTION
Information to users of accounting information is provided in the form
of financial statements that arrange assets, liabilities, revenue and
expenses in different ways. Every business enterprise generally
prepares three financial statements: income statement, balance
sheet and statement of cash flows.

3.1.1 INCOME STATEMENT

The income statement (or the profit and loss account) reports the
result of business operations during the accounting period. It matches
the expenses for the accounting period with the revenues earned,
and reports the result- ing net income (profit or loss). The income
statement is of particular use to investors, lenders and creditors.
Investors use the past net income as a basis to predict the future net
income and to make their investment decisions. Lenders to the
business use information provided by the income statement to form
an opinion about the ability of the business to repay loans and to pay
interest on time. Creditors use the income statement to form an
opinion about the ability of the business to pay their dues on time.

3.1.2 BALANCE SHEET

The balance sheet reports the financial position of the business at a
particu- lar point of time, generally at the end of the accounting
period. It shows the amount of assets owned by the business and the
claims on these assets. The claims on the assets belong to the
providers of resources to buy the assets, i.e., the owners and
creditors/lenders. As the business cannot spend more on buying
assets than the resources it has, the following relationship (also
called the accounting equation) always holds.
Assets = Owners’ Capital + Liabilities
Creditors and lenders analyze the balance sheet to understand the
ability of the business to repay their dues. The proportion of owners’
capital in relation to outside liabilities also serves as an indicator of
the financial strength of the business.

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 FINANCIAL STATEMENTS39

3.1.3 STATEMENT OF CASH FLOW

The statement of cash flow provides information about the cash
receipts and cash payments during an accounting period. Particularly,
it shows the sources from which cash is received, the uses to which
cash is put and the change in the cash balance during the accounting
period.
The presentation of financial statements for external users depends
on the type of business organization. A business can be organized as
sole- proprietorship (having a single owner), a partnership (with two
or more owners or partners) or a company (having a large
number of owners or shareholders). Only companies are required
by law to keep the pre- scribed set of books and to present their
financial statements in the pre- scribed format. Other forms of
business organization need to maintain their accounts in a manner
that enables determination of their income for income tax purposes.
Normally, companies are required to prepare annual and quarterly
finan- cial statements. The quarterly financial statements are also
known as interim financial statements. Certain business organizations
are, however, not required to prepare interim financial statements for
external reporting.

3. BALANCE SHEET
A balance sheet reveals the financial position of an entity. It sets out
QUICK TIP
the assets, liabilities and owners’ capital of an entity as on a certain A balance sheet shows the
date. Assets are economic resources controlled by an entity which financial position of an entity
provide future cash flows to the entity. These economic resources are on a particular date.
in the form of land and building; plant and machinery; furniture and
fixtures; investments; inven- tories; receivables; cash balances; etc.
Liabilities represent the claims of persons other than owners on these
assets or the amount of money pro- vided by them for acquisition of
assets. Capital represents the claims of owners on the assets or the
amount of money invested by the owners to acquire the assets.
It is prepared on a particular date and is true only on that date
because even a single transaction will affect the assets or liabilities
and, there- fore, the owners’ capital shown in the balance sheet
drawn on that date. It is prepared only after preparing the profit
and loss account as the net income revealed by the profit and loss
account is added to the owners’ cap- ital. The two sides of the
balance sheet must have the same total because capital is always
equal to the difference between assets and liabilities, and the
amount of capital is independently arrived at by the capital account.
The non-agreement of the two sides indicates the presence of some
error in the preparation. QUICK TIP
Balance sheet is useful to both investors and lenders. Investors Balance Sheet provides
analyze the balance sheet to form an opinion about the financial useful information to both
strength of the business. Lenders use the balance sheet to investors and lenders.
understand the capacity of the entity to repay the borrowed money.

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40 FINANCIAL ACCOUNTING AND ANALYSIS

Balance sheet of a typical non-corporate entity in horizontal form

is pre- sented in Table 3.1.

TABLE 3.1 BALANCE SHEET OF X AS ON MARCH 31, 2016

(HORIZONTAL FORM)
Amount Amount
Liabilities and Capital (Rs.) Assets (Rs.)
Capital 600,00 Fixed assets
0
Long-term debt Land 200,000
Current liabilities 300,00 Building 300,000
0
Creditors 50,000 Equipment 100,000
Accrued 40,000 Furniture 80,000
expenses
Patents 60,000
90,00
0
Investments 740,000
Current 60,000
assets
Cash 50,000
Debtors 40,000
Inventories 80,000
Prepaid 20,000
expenses
In the vertical form of the balance sheet, capital and liabilities are
listed at the top. The vertical form of the balance sheet given in Table
3.1 is presented in Table 3.2.

TABLE 3.2 BALANCE SHEET OF X AS ON

MARCH 31, 2016 (VERTICAL FORM)
Sources of Funds
Capital and Liabilities Rs.
Capital 600,000
Long-term debt 300,000
Current liabilities
Creditors 50,000
Accrued expenses 40,000
90,000
990,000
Application of funds
Fixed assets
Land 200,000
Building 300,000
Equipment 100,000

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 FINANCIAL STATEMENTS41

TABLE 3.2 BALANCE SHEET OF

X AS ON MARCH 31, 2016
(VERTICAL FORM)—CONTINUED
Applications of Funds
Fixed Assets Rs.
Furniture 80,000
Patents 60,000
740,000
Investments 60,000
Current assets
Cash 50,000
Debtors 40,000
Inventories 80,000
Prepaid expenses 20,000
190,000
990,000

The various elements of the balance sheet are explained in the next and
section.

3. ASSETS

3.3.1 FIXED ASSETS (NON-CURRENT ASSETS)

Fixed assets are meant for a long-term use and are not acquired for
the purpose of resale. Fixed assets are of two types: tangible and
intangible. Tangible fixed assets have a physical existence while
intangible assets do not. Goodwill, patents, copyrights, trademarks,
brands, etc. are examples of intangible assets. Land, Buildings, Plant
and Machinery and Furniture are examples of tangible fixed assets.
Fixed assets are shown at their net value after accounting for
accumulated depreciation.

3.3.2 INVESTMENTS
Investments refer to money invested outside the business in the form
of shares, bonds or other instruments. Investments made for a period
of more than one year are called long-term investments. Investments
made for a period of less than one year are called current
investments or marketable securities. While long-term investments
are referred to as non-current assets, short-term investments are
included in current assets.

3.3.3 CURRENT ASSETS

Current assets are either in the form of cash or are meant to be
converted into cash or other current assets during the accounting
period or the operat- ing cycle of the business, whichever is longer.
The operating cycle is the time period between two points. The first
point is the time of payment by an entity for purchase of raw
materials. The second point is the time of realization of cash from
customers for sale of finished goods that are converted from the raw
material. Cash, marketable securities, debtors (accounts receivable)
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 ! IMPORTANT CONCEPT
Fixed assets are acquired for long-term use and

QUICK TIP
Non-current assets include fixed assets and other long-term assets such as
investments.

QUICK TIP
Tangible fixed assets have a physical existence. Intangible assets have no
physical existence.

QUICK TIP
Long-term investments are those that are made for a period of more than 1 year.
Investments made for a period of less than a year are called current investments.

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42 FINANCIAL ACCOUNTING AND ANALYSIS

inventories of raw material and finished goods are examples of

QUICK TIP current assets. Current assets reflect the ability of the business to
Current assets consist of cash pay its short-term liabilities.
and other assets that are
expected to be converted into
cash during the accounting 3. LIABILITIES
period or the entity’s The liabilities to outsiders can either be short term or long term.
operating cycle, whichever is
longer. 3.4.1 LONG-TERM LIABILITIES
Long-term liabilities include borrowings from banks or financial
institutions for a period of more than one year. These may be secured
or unsecured. In the case of secured loans, some assets of the firm
serve as collateral for the loan. Long-term liabilities also include
bonds and debentures, which gener- ally have a maturity of more
than one year.
QUICK TIP
3.4.2 SHORT-TERM LIABILITIES
Long-term liabilities are for a
period of more than one year. Short-term or current liabilities are those that must be settled within
Short-term liabilities are meant one year, for example, creditors (accounts payable), outstanding
to be settled within a period of expenses, etc.
one year.
3.4.3 OWNERS’ CAPITAL OR OWNERS’ EQUITY
For a non-corporate entity, owners’ capital consists of the capital
originally contributed by the owner and adjusted for subsequent
profits/losses and drawings (withdrawals of money or goods by
owners for their personal use). In the case of a corporate entity,
owners’ capital or shareholders’ equity consists of share capital,
retained earnings, securities premium and other reserves.

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 1. Sources of funds for an enterprise are reflected on the
a. income side of profit and loss account
b. expense side of profit and loss account
c. asset side of the balance sheet
d. liability side of the balance sheet
2. Which of the following is incorrect about a company’s balance
sheet?
a. It displays the sources and uses of cash.
b. It displays the sources and uses of funds.
c. It is an expansion of the basic accounting equation:
Assets = Liabilities + Owners’ Equity.
d. It is also referred to as a statement of the financial
position.
3. The balance sheet
a. Summarizes the changes in retained earnings for a
specific period of time.
b. Reports the changes in assets, liabilities and
stockholders’ equity over a period of time.
c. Reports the assets, liabilities and stockholders’
SELF-ASSESSMENT QUESTIONS equity at a specific date.
d. Presents the revenues and expenses for a specific

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 FINANCIAL STATEMENTS43

3. BASIC CONCEPTS UNDERLYING

5 PREPARATION OF BALANCE SHEET
In preparing the balance sheet, certain basic principles or concepts
are fol- lowed. Every entity is expected to follow these concepts so
that their finan- cial statements provide reliable information, are
consistent and comparable with those of other entities. These are:
1. Business entity concept
2. Money measurement concept
3. Going concern concept
4. Cost concept
5. Dual aspect concept

3.5.1 BUSINESS ENTITY CONCEPT

Business entity concept requires that the business enterprise and the
owners be treated as two independent entities. The affairs of the
business should not be mixed up with the personal affairs of the
owners. The implication of the entity concept is that personal
transactions of the owner are not recorded in the books of the
business. This concept helps determine the profit or loss made by the
business. Personal assets of the owner are also not included in
determining the business assets. The business is liable to the owner
for the capital invest- ment made by the latter. Any amount withdrawn
by the owner for personal use is treated as a reduction of the capital
and not as an expense of the business.

3.5.2 MONEY MEASUREMENT CONCEPT

Only those transactions that can be measured in terms of money are
to be recorded in the books of accounts. Many aspects of business
such as quality of management, level of customer satisfaction, etc.,
which cannot be expressed in terms of money are not recorded. The
reason for using this concept is that a common unit of measurement
is needed for preparing the financial state- ments of business that
report the operating results and financial position of the business.
Money serves as a common denominator in which the value of
different items such as a piece of land, a piece of equipment and raw
material can be expressed. A further assumption made by
accountants is that the value of money does not change with the
passage of time. This is a limitation of this concept as it is well known
that the purchasing power of money declines during periods of rising
prices and rises during periods of falling prices.

3.5.3 GOING CONCERN CONCEPT

Financial statements are prepared on the assumption that the
enterprise would continue to exist for an indefinite period of time.
The enterprise has no intention of liquidating the business in the near
future. Following the going concern concept, those expenditures
which are expected to provide future benefits are treated as assets
rather than expenses. For example, the expenditure on purchasing a
machine is treated as a fixed asset. The cost of the machine is spread
over its useful life in the form of depreciation which is set-off against
revenue in the income statement of different
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periods over the life of the machine. At the end of each accounting
period, the value of the machine is shown at its acquisition cost
minus accumulated depreciation, and it represents the cost
applicable to its remaining useful life. In the absence of the going
concern assumption, the cost of the machine shown in the books will
have a different value (e.g. current market price). Similarly, the
amount of prepaid expenses and inventories are carried for- ward at
the end of an accounting period to be charged against the revenue of
future periods. The going concern concept provides a sound basis for
the measurement of income and motivates investors by ensuring the
continuity of returns from investments.
An implicit assumption is made that the accounts have been prepared
on a going concern basis. If this is not the case, then the fact has to be
explicitly disclosed, and the basis on which accounts have been
prepared also needs to be disclosed.

SELF-ASSESSMENT QUESTION
4. The going concern concept implies that .
a. the business will continue to be profitable
b. the
3.5.4 COST business will continue to exist in the foreseeable
CONCEPT
future
The value
c. of
theanowners
asset shown in the balance
are concerned sheet
about the is theof
success price
the paid for
its acqui- sition and not its current market value. For example, a
business
machine acquired for Rs. 100,000 is shown in the books at a value of
Rs. 100,000. This value is easily determinable, objective and free
from bias. Recording the assets at its current cost presents a
problem because it may change every day. It may also not be easily
determinable because exactly the same asset may not be available.
Similarly, the realizable value of an asset can be known only when it
is sold. Following the cost concept, an asset will not be shown in the
books of accounts if the entity has not paid anything for acquiring the
asset. For example, an entity can show goodwill as an asset in its
balance sheet only when it has purchased that goodwill for a price.
The problem with using this concept is that it loses its relevance
when infla- tion affects the price of an asset. For example, a piece of
land purchased for Rs. 1 million ten years earlier may cost Rs. 5
million now. If the cost of the land is shown in the books at Rs. 1
million, the accounts will not reflect the true position of the capital
used in the business. Secondly, this concept results in loss of
comparability. Two assets acquired at different points of time at
differ- ent costs may give equal cash flows. The old asset would
appear to be more efficient as it is shown at a lower cost. However, a
different conclusion may be drawn if the current cost of that machine
is taken into account. Thirdly, many assets such as human assets do
not have any acquisition cost. Such assets, though important to an
organization, do not get recognized under the cost concept. Finally,
when the cost principle is followed, the balance sheet does not reveal
the current worth of the business.

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In some cases, an exception is made to the cost principle. Highly

liquid assets that are expected to be shortly converted into cash (e.g.
short-term invest- ments, accounts receivables, etc.) are shown at
their net realizable value. The net realizable value is the amount
expected to be realized when the asset is converted into cash.
Similarly, a business may make investments in other enterprises,
which it intends to sell in the near future. Such investments are
shown at their current market value in the balance sheet.

3.5.5 DUAL ASPECT CONCEPT

Every transaction or event has two aspects. It affects two items of
the accounting equation simultaneously in one of the following ways:
1. It increases one asset and decreases another asset; or
2. It increases an asset and a liability simultaneously; or
3. It decreases one asset and increases another asset; or
4. It decreases an asset and simultaneously decreases a liability; or
5. It increases one liability and decreases another liability; or
6. It increases a liability and increases an asset; or
7. It decreases a liability and increases another liability; or
8. It decreases a liability and decreases an asset.
For example, if a machine is purchased for cash, it results in an
increase of one asset (machine) and decrease of another asset
(cash). If the machine is purchased on credit, it results in an increase
of an asset (machine) and increase of a liability (creditor).
The dual aspect concept leads to the basic accounting equation:
Equity (Capital) + Liabilities =
Assets which always holds true.
The basic accounting equation implies that the assets of a
business are always equal to the claims of owners and outsiders to
these assets. The owners’ claims are termed as capital and
outsiders’ claims are termed as liabilities.

SELF-ASSESSMENT QUESTION
5. The dual aspect concept means that .
a. when a transaction is recorded in the accounting system,
there are at least two effects on the accounting equation
b. both parties to a transaction have to record the
transaction
c. both the income statement and the balance sheet are
affected by the transaction
d. one account increases and the other account decreases
as a result of the transaction

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Match the accounting concept with the description of the concept that is given

ConceptDescription of the Concept

A Business Entity Every
A transaction or event has two aspects
B Money Measurement
Financial
B statements are prepared on the assumption that the
CBooks of account record only those transactions that can be

CCost

D Going ConcernDThe value of an asset shown in the balance

sheet is not its current market value but is the price paid for its acquisition

EDual-aspect EThe business enterprise and its owners are independent ent
ACTIVITY 1

3. STATEMENT OF PROFIT AND LOSS

Statement of profit and loss or the income statement is prepared to
! IMPORTANT CONCEPT show the amount of profit earned or loss suffered by an entity during
a period. It shows the various items of income and expenditure,
Gross profit is the difference between sales grouped
revenue under different heads, relating to an accounting period. It is
and the cost of goods sold and operating profit is the difference
generally between
prepared in the gross profit
different and operating
sections. For a expenses.
trading firm, the first
section measures the gross profit, which is simply the difference
between sales revenue and the cost of goods sold. In the next sec-
tion, the operating profit is determined by deducting operating
expenses from the gross profit. Operating expenses relate to the
normal operating activities of the business such as administrative,
selling and general expenses. Finally, the net profit is determined by
adjusting non-operating expenses (such as interest expense, loss on
sale of fixed assets) and non-operating income (such as inter- est
income, profit on sale of fixed assets) from the operating profit.
In a manufacturing concern, the cost of goods sold also includes all
expenses incurred in the factory for producing the goods such as
wages, power and fuel and rent of factory premises. A typical multi-
step statement of profit and loss is presented in Table 3.3.

TABLE 3.3 MULTI-STEP STATEMENT OF PROFIT AND

LOSS OF A FOR THE YEAR ENDED MARCH 31, 2016
Particulars Amount (Rs.)
Net sales 5,000,000
Less: Cost of goods sold 3,800,000
Gross profit 1,200,000
Less: Selling, general and administrative 400,000
expenses
Operating profit 800,000
Interest expense (50,000)
Interest income 30,000
Net profit 780,000

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From the trading account, the cost of goods sold, Rs. 3,800,000, can
be worked out as follows:

Beginning inventory 350,000

Add: Purchases (net of 3,150,000
returns)
Carriage on purchases 150,000
Wages 300,000
Cost of goods available for 3,950,000
sale
Less: Ending inventory 150,000
Cost of goods sold 3,800,000

The selling, general and administrative expenses of Rs. 400,000 in Table 3.3
is the sum of the following expenses:

Rs.
Depreciation 150,000
Insurance 40,000
Printing expenses 25,000
Carriage on sales 27,000
Salaries 130,000
Bad debts 28,000
400,000
The division of the statement of profit and loss under different
sections provides more information to the users leading to better
decision making. Comparison of current gross profit rate with past
rates and that of other firms in the industry reveals the effectiveness
of a firm’s purchasing and pric- ing policies. Similarly, non-operating
income may form a significant portion of the total income. External
users of financial statements focus more on the operating income as
they consider this income to be sustainable in the future and non-
operating income to be non-recurring.

SELF-ASSESSMENT QUESTIONS
6. The income statement shows .
a. Cash balance at the end of the period
b. Contributions by the owner during the period
c. Revenues earned during the period
d. Profit earned or loss incurred during the period
7. Which of the following statements is incorrect?
a. Net income is reported by an entity for a period of time
b. Net income increases the owner’s capital
c. Net income is equal to revenue minus expenses
d. Net income is equal to revenue minus the sum of
expenses and drawings

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3. BASIC CONCEPTS
As in the case of the balance sheet, certain basic principles or
concepts are followed in the preparation of statement of profit and
loss also to secure reliability, consistency and comparability with
other entities. The basic con- cepts underlying the preparation of
statement of profit and loss include:
(i) accounting period, (ii) conservatism, (iii) realization, (iv) matching,
(v) con- sistency, (vi) accrual and (vii) materiality.

3.7.1 ACCOUNTING PERIOD CONCEPT

A business is expected to have a long-life, and its exact profit or loss
can be determined only when the business is wound up. Measuring
the perfor- mance over a long period of time loses value because no
corrective steps can be taken to improve it if it is below the owner’s
expectations. To track the business performance and to measure its
financial position from time to time, its life is divided into relatively
small intervals of time, usually a year. The accounting period is called
an accounting year or a financial year.
The adoption of accounting year for reporting purposes is also
influenced by certain legal requirements. Under the law relating to
companies, a company is required to submit annual reports to its
shareholders. The law relating to taxation of income requires
determination of annual taxable income. The accounting period
usually adopted by a business is either a calendar year (January–
December) or a financial year (April–March). Listed companies are
also required to prepare quarterly income statements.
The adoption of the accounting period concept requires identification
of transaction that relate to a specific accounting period. For some
transactions, the identification is easy and straightforward. For many
transactions, such as acquisition of a fixed asset that affect more
than one accounting year, alloca- tions have to be made to determine
the consumption of the asset in a partic- ular accounting period.

3.7.2 CONSERVATISM CONCEPT

In preparing financial statements of a business, an accountant should
be conservative. He/she should apply that accounting treatment to a
transaction that results in the lowest (most conservative) estimate of
the income. He/she should not anticipate incomes and should provide
for all possible losses. An income should be recognized only when it
has been realized. Further, when there are many alternative values of
an asset, an accountant should choose the method that leads to a
lesser value. Following the conservatism concept, the rule ‘cost or
market value, whichever is lower’ is followed in valuing inventories.
Following this rule, the value of inventories is written down to its
market value if it declines below its cost. However, the value of
invento- ries is not revised upward if its market value goes above its
cost. There are many other instances where conservatism is applied,
for example, making provision for doubtful debts; marking
investments to market to reflect their current market value, etc.

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8. What is the underlying concept that supports the immediate

recognition of an estimated loss?
a. Substance over form
b. Consistency
c. Matching
d. Conservatism
9. A businessman purchased goods for Rs. 2,500,000 and sold
80% of such goods during the accounting year ended
March 31, 2016. The market value of the remaining goods
was Rs. 400,000. He valued the closing stock at Rs.
500,000. He violated____________________________________.
a. Money measurement concept
b. Accounting standard for Revenue Recognition
SELF-ASSESSMENT QUESTIONS
c. Accounting standard for valuation of inventory
d. Periodicity concept

3.7.3 REALIZATION CONCEPT

According to the realization concept, revenue should be recognized
when it is realized. Revenue from sales or service transactions is
considered to be realized only when certain requirements relating to
performance (such as transfer of property or transfer of risks and
rewards of ownership) are satisfied, and at the time of performance
there is no significant uncertainty regarding the ultimate collection of
revenue.
Revenue may be recognized even when the payment for a
transaction is yet to be received. As a result, even credit sales are
recognized by a business as revenue. For example, a business
receives an order from a customer for the supply of a custom-made
machine in the year 2013. The business supplies the machine to the
customer in 2014, and the customer makes the payment in 2015. In
this case, the condition for recognition of revenue is satisfied in the
year 2014, and hence revenue should be recognized in 2014.
The realization concept also has another interpretation. According to
this interpretation, any change in the value of goods is to be recorded
only when the business realizes it, that is, when the goods are sold.

3.7.4 MATCHING CONCEPT

To determine the income of an accounting period, revenues earned
during the accounting period are matched with the expenses incurred
to earn the revenues. The first step in the matching of revenues and
expenses is to deter- mine the revenue earned during an accounting
period. After determining the revenue for an accounting period, all
expenses incurred to earn that revenue are deducted from the
revenue to determine the income of that accounting period. If the
recognition of revenue is deferred on the basis that it is not yet
earned, all expenses pertaining to such revenue must also be
deferred. The question of matching arises because of accrual and
periodicity concepts.

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X buys 500 chairs @ Rs. 1,000 each during the period

1.4.2014 to 31.3.2015. During the accounting period, he has
paid Rs. 450,000 to the supplier of chairs. He sells 400 of
these chairs @ Rs.1,200 each. His customers are yet to pay
him Rs. 20,000 as on March 31, 2015. He hires an employee @
Rs. 1,000 per month. The salary of the employee for the
month of March 2015 is yet to be paid.
Following the matching concept, X will recognize the revenue for
the 400 chairs sold and treat the cost of 400 chairs as an
expense. The bal- ance 100 chairs will be shown as stock in hand.
Accordingly, the revenue for the period will be Rs. 480,000, from
which expenses of Rs. 400,000 on account of purchase cost of
chairs and Rs. 12,000 on account of salary (for 12 months
following the accrual concept) will be deducted. X will show a
profit of Rs. 68,000 for the year.
The actual amount received from the customers and the actual
amount paid to the supplier are not relevant for measuring profit
or loss. What is relevant is the revenue earned and expenses
incurred during the account- ing period, irrespective of the
amount received or paid.
It is easy to match those expenses to revenue that are directly
associated with the earning of revenue. An example is the cost of
goods sold. For some expenses, subjective judgement is required
to apply the matching concept. An example is the cost of fixed
assets. which provide benefits over a number of accounting
EXAMPLE 1 periods. There are other expenses such as administrative
expenses that cannot be associated with particular goods or

SELF-ASSESSMENT QUESTIONS
10. A purchased goods for Rs. 1,500,000 and sold 4/5 th of the
goods for Rs. 1,800,000 and met expenses amounting to Rs.
250,000 during the year 2015. He counted the net profit as
Rs. 350,000. Which of the accounting concepts was followed
by him?
a. Entity b. Periodicity
c. Matching d. Conservatism
11. The determination of expenses for an accounting period is
based on the principle of .
a. Objectivity b. Materiality
c. Matching d. Periodicity

3.7.5 CONSISTENCY
Consistency implies that the same accounting policies and
procedures are followed by an enterprise in preparing its accounts
from one account- ing period to another. Accounting standards
provide for equally accept- able accounting alternatives in respect of
certain matters. For example, an enterprise can value its
inventories using either the First-in, First-out (FIFO) method or the
Last-in,
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 FINANCIAL STATEMENTS51

method, the cost of older inventories is used to determine the profit

or loss, while the ending inventories represent the most recently
purchased items. Under the LIFO method, the cost of most recently
purchased items is used to determine the profit or loss and the
ending inventories rep- resent items purchased earlier in time.
Change in the method from one accounting period to another can
have a significant impact on the amount of expense recognized and
the value of inventory in hand at the end of the accounting period.
Similarly, several alternative methods, such as the straight-line
method, written-down-value method, sum-of-the-years-digits method,
etc. are avail- able to provide for depreciation on fixed assets. Again,
change in the method of providing depreciation can have a significant
impact on the amount of depreciation expense recognized and the
value of fixed assets in hand at the end of the accounting period.
The consistency principle helps to achieve comparability of financial
state- ments of an enterprise through time. It is not that the
accounting policies, once adopted, cannot be changed. Accounting
standards allow change in accounting policies under certain
circumstances. Whenever a change is made, the accounting
standards require that the enterprise should make a full disclosure of
the change and also of the rupee effect of the change on the reported
income and financial position of the enterprise.

12. An enterprises follows the written-down-value method

of depreciating machinery year after year due to .
a. Reliability
b. Convenience
c. Consistency SELF-ASSESSMENT QUESTION
d. All of the above

3.7.6 ACCRUAL CONCEPT

Under the accrual concept, revenues are recognized when they are
earned and expenses are recognized when the related goods or
services are used. The timing of receipt of revenues and payment of
expenses is immaterial. The accrual concept facilitates measurement
of income for a particular accounting period. Applying appropriate
tests, the revenue pertaining to an accounting period is recognized
first. Then the expenses incurred to earn that revenue are recognized.
Income for the accounting period is then determined as the difference
between the revenue recognized and the matched expenses.
For example, X buys goods worth Rs. 500,000, paying a cash of Rs.
350,000 and sells the goods for Rs. 650,000, of which customers pay
only Rs. 400,000. X’s revenue would be Rs. 650,000, his expense is
Rs. 5,00,000 and his profit based on the accrual concept will be Rs.
150,000. Cash receipt of Rs. 500,000 and cash payment of Rs.
350,000 do not enter the calculation of profit.
The alternative to accrual accounting is the cash basis accounting.
Revenue may not be realized in cash. Cash may be received
simultaneously or before the revenue is created or after the revenue
is created. The same is the case with expenses. Pure cash basis
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52 FINANCIAL ACCOUNTING AND ANALYSIS

the profitability of economic activities carried out during the

accounting period.

3.7.7 MATERIALITY
The term ‘materiality’ refers to the relative importance of an item or
event. An item or event is considered material if its knowledge is
likely to affect the decisions of the users of financial statements.
Accountants should ensure that all material items are properly
reported in the financial state- ments. In determining the materiality
of an item, they need to compare the value of information with the
cost of providing such information. The value must exceed the cost.
For immaterial items, accountants can use estimates instead of
keeping detailed records and can also disregard certain account- ing
principles. Professional judgment is required to assess the materiality
of an item.
For example, the cost of small value items such as stationery, lighting
material may not be treated as an asset and may be written off as
expenses. Ignoring the matching principle, utility bills may be
charged as expenses when bills are received rather than when
services are rendered.

Match the accounting concept with the description of the concept that is given

ConceptDescription of the Concept

AAccounting PeriodASame accounting policies and procedures are
followed in preparing accounts year after year
BConservatism BRevenue earned during an accounting period is matched

CRealization CLife of the business is divided into small intervals of time

DMatching DAn accountant should not anticipate incomes and should

EConsistency EAccountants ensure that all material items are properly r

FAccrual FRevenue is recognized when it is earned and not when it

ACTIVITY 2 GMateriality GRevenue is recognized when it is realized.

3. SUMMARY
The balance sheet
 Understand the nature and purpose of balance sheet.
reveals the financial position of an entity. It is prepared on a
particular date, and is true only on that date. It is prepared only
after the preparation of the profit and loss account. The two sides
of the balance sheet must have the same total.
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 Understand the format and contents of a balancesheet. It sets out the

assets, liabilities and owners’ capital of an entity as on a certain
date. The balance sheet can be prepared in a horizontal or vertical
form.

KEY WORDS
1. Accounting period is a small interval of time, usually a year out
of the life of business, determined to track the business
performance and to measure its financial position.
2. Accrual basis of accounting implies that revenues are
recognized when these are earned and expenses are
recognized when these are incurred. The timing of receipt
of revenues and payment of expenses is immaterial.
3. Consistency means that the same accounting policies and
proce- dures are followed by an enterprise in preparing its
accounts from one accounting period to another.
4. Conservatism is the non-anticipation of incomes and making
provision for all possible losses.
5. Cost concept is the concept on which the value of an asset is
determined on the basis of its acquisition cost, which is the
most objective basis.
6. Cost of goods sold is the cost of that part of goods available for
sale (beginning inventory + purchases), which is sold during
the accounting period. It is calculated as the cost of goods
available for sale minus the cost of ending inventories.
7. Current assets are assets, which are either in the form of cash
or are meant to be converted into cash or other current
assets during the accounting period or its operating cycle,
whichever is longer.
8. Current liabilities are liabilities that must be settled within one year.
9. Dual aspect concept states that every transaction or event has
two aspects. The impact of a transaction is such that the
accounting equation: Assets = Liabilities + Owners’ Capital
always holds.
10. Entity concept is a concept in which the affairs of business are
distinguished from the personal affairs of the owners.

3. DESCRIPTIVE QUESTIONS
1. In what order are assets listed on a balance sheet of a sole proprietor?
2. At the instance of the management, you want to show the good
quality of management in financial statements. As an
accountant, which accounting concept will you be violating?
3. A company wants to:
a. Treat goods drawn from the business by the owner as his/her
personal expense.
b. Ignore the increase in the price of some inventory items.

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State the accounting concept the company would need to follow

in the above cases.
4. Why is a business treated as a separate entity for accounting purposes?
5. Name the two main forms in which a balance sheet can be prepared.
6. Why should the two sides of a balance sheet always match?
7. How are fixed assets different from current assets?
8. What are intangible fixed assets? Give some examples.
9. How is the going concern assumption applied in the
presentation of financial statements?
10. State the problems that arise in the application of the cost
concept to the preparation of balance sheet.

3.1 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Liabilities 1. d. liability side of the balance
sheet
2. a. It displays the sources and
uses of cash.
3. c. Reports the assets, liabilities
and stockholders’ equity at a
specific date.
Basic Concepts Underlying 4. b. the business will continue to
Preparation of Balance Sheet exist in the foreseeable future
5. a. when a transaction is
recorded in the accounting
system, there are at least two
effects on the account- ing
equation
Statement of Profit and Loss 6. d. Profit earned or loss incurred
during the period
7. d. Net income is equal to
revenue minus the sum of
expenses and drawings
Basic Concepts 8. a. Substance over form
9. c. Accounting standard for
valuation of inventory
10. c. Matching
11. c. Matching
12. c. Consistency

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3.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Narasimhan M. S. (2016). Financial Statement and Analysis.
Cengage Learning India Private Limited; First edition.
 Financial Accounting Essentials You Always Wanted To Know: 4
(Self Learning Management). Vibrant Publishers, 2017.

E-REFERENCES
 Food and Agriculture Organisation, Statistical Database, Various
years, http://faostat.fao.org accessed on 30 April, 2011.
 Accountingtools.com - Financial Statement Analysis.

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 C H
4
A P T E R

PREPARATION OF FINANCIAL STATEMENTS

CONTENTS

4.1 Introduction
4.2 Trial
Balance
4.3 Activity
Relationship between Profit and Loss Account and Balance
Sheet Self-Assessment Questions
4.4 Preparation of Profit and Loss Account
4.4.1 Gross Profit
4.4.2 Sales Revenue
4.4.3 Sales Returns and Allowances
4.4.4 Goods and Services Tax
4.4.5 Cost of Goods Sold
4.4.6 Operating Profit
4.4.7 Net Profit
4.4.8 Income Tax
Self-Assessment Questions
Activity
4.5 Preparation of Balance Sheet
4.6 Adjustment Entries
4.6.1 Prepaid Expenses
4.6.2 Depreciation and Amortization
4.6.3 Income Received in Advance or Unearned
Income
4.6.4 Outstanding (Accrued) Expenses
4.6.5 Outstanding or Accrued Income
4.6.6 Provision for Bad and Doubtful Debts
Self-Assessment Question
4.7 Adjusted Trial Balance
4.7.1 Closing Entries
4.7.2 Post-Closing Trial Balance

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 4.8 Summary
Key Words
4.9 Descriptive Questions
4.10 Answer Key
Self-Assessment Questions
4.11 Suggested Books and E-References

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INTRODUCTORY CASELET

MODERN COFFEE HOUSE

Ashok and Ramesh who had set up Modern Coffee House on

January 2, 2018 (refer Chapter 1) carried on the business till
December 31, 2018. As on December 31, 2018, their accounting
records revealed the following balances:

Rs. Rs.
Materials purchased 1,500,00 Miscellaneou 850,00
0 s expenses 0
Sale proceeds & 4,100,00 Salaries 510,00
collections 0 0
Expenses on eatables 580,00 Rent 360,00
0 0
Capital 400,00 Cash and bank 900,00
0 balance 0
Suppliers 200,00
0

They noted that as of December 31, 2018, they had yet to pay
Rs. 35,000 to their workers. On the other hand, they had paid
rent for a year on July 1, 2018. Materials costing Rs. 100,000
were still at hand on December 31, 2018. They did not know how
to determine the profit and loss of the business for the year just
ended taking into account these items and their financial position
as on December 31, 2018.

QUESTIONS

1. Calculate the amount of material consumed by Modern

Coffee House during the year. (Hint: Deduct stock of
materials at the end of the year from the amount of
materials purchased.)
2. Calculate the amount of rent expense that pertains to
the accounting year January to December 2019. (Hint:

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60 FINANCIAL ACCOUNTING AND ANALYSIS

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the relationship between profit and loss account and balanc
Prepare profit and loss account and balance sheet from the given trial b
> Understand how to make adjustments for accruals, deferrals and other i
Prepare profit and loss account and balance sheet after accounting for a
> Prepare closing entries and post-closing trial balance.
>
>

4. INTRODUCTION
Ashok and Ramesh can determine the profit or loss made by Modern
Coffee House during the year by preparing a Statement of Profit and
Loss and their financial position at the end of the year by preparing a
Balance Sheet. The balance sheet shows the amount of assets and
liabilities of the business at the close of an accounting period. These
two statements are closely related to each other. However, they need
to first prepare the trial balance as on December 31, 2018, which will
form the basis of preparation of the other financial statements.

4. TRIAL BALANCE
After the transactions are posted in the ledger, a statement showing
the accounts with debit and credit balances separately is prepared.
This state- ment is called the trial balance. It serves as a summary of
the contents of the ledger. It has two columns. The debit balances
are listed in the left-hand column and the credit balances are listed in
the right-hand column.
The trial balance is prepared on a particular date, which is mentioned
at the top of the trial balance. The general format of the trial balance
is shown in Table 4.1.

TABLE 4.1 TRIAL BALANCE AS ON ___________

Debit Balance Credit Balance
S. No. Ledger Account L.F. (Rs.) (Rs.)

The totals of the debit and credit balances must agree if there are no
arith- metical errors in the accounting process because under the
double-entry system all debits and credits taken together must be
equal. Instead of using balances of ledger accounts, the trial balance
may be prepared using the totals of the debit and credit sides of all
ledger accounts.

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The trial balance agreement implies that the accounting work is free
from clerical errors, even though other errors may still be present.
Some entries may have been omitted or posted to the wrong ledger
account, but on the correct side. Mistakes in posting on the debit side
may have been offset by mistakes in posting on the credit side.
If the debit and credit totals of the trial balance do not agree, one or
more of the following errors might have been committed:
1. A debit amount is posted as a credit amount or vice-versa.
2. Arithmetic mistakes in determining account balances.
3. Error in carrying the amount from the ledger account to the trial
balance or listing the account balance in the wrong column of
the trial balance.
4. Errors in calculating totals of the trial balance.
The work of preparing financial statements starts after establishing
the agreement of the trial balance. This is because it is desirable to
ensure that the total of accounts with debit balances is equal to the
total of accounts with credit balances. Preparation of financial
statements becomes difficult in the absence of an agreed trial
balance.

RECTIFICATION OF ERRORS
Agreement of the total of debit balances and credit balances in the
Trial Balance does not mean absence of errors in the books of
account. Agreement of the Trial Balance simply means that for every
debit, there is an equivalent credit entry. For example, the Trial
Balance may agree even though a trans- action is not entered at all in
the books of account.

TYPES OF ERRORS
There could be four types of errors in the books of account.
1. Errors of Omission
2. Errors of Commission
3. Errors of Principle
4. Compensating Errors
Errors of Omission occur when a transaction is omitted to be entered
in the books of account. For example, a credit purchase might not be
recorded at all in the books. Even then, the Trial Balance will agree.
Such an error is detected when statements of account are received
from creditors or sent to debtors.
Errors of Commission occur when the balancing or totaling of an
account is incorrect or an amount is wrongly posted or the balance of
an account that is carried forward to the next period is not correct,
etc. For example, an amount of Rs. 2,000 received from a debtor
may be posted to his account as a credit

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62 FINANCIAL ACCOUNTING AND ANALYSIS

of Rs. 20,000. Such errors are easy to detect as they affect the
agreement of the Trial Balance.
Errors of Principle occur when a capital expenditure is treated as a
reve- nue expenditure or vice versa. Similarly, a capital receipt may
be treated as revenue receipt or vice versa. For example, amount
received from sale of a piece of equipment may be credited to the
sales account instead of equip- ment account. Such errors are also
difficult to detect because these errors do not affect the agreement of
the Trial Balance.
Compensating Errors are those errors that compensate each other
and, therefore, do not affect the agreement of the Trial Balance. For
example, A purchase of Rs. 50,000 from A is credited to his account
as Rs. 5,000. Another purchase of Rs. 5,000 from B is credited to his
account as Rs. 50,000. These two errors compensate each other.

TREATMENT OF ERRORS
The accountant should take all steps to detect the errors in the books
of account. If the errors are not detected quickly, there may be a
delay in clos- ing the books of account for the accounting year. To
avoid such delay, the difference in the trial balance may be
transferred to an account known as ‘Suspense Account’, As and when
the errors are detected, suitable account- ing entries are passed to
rectify the errors. Rectification of all errors will result in closure of the
Suspense Account.

ACTIVITY 1
From the data given in the beginning of the chapter, prepare a
Trial Balance of Modern Coffee House without considering the
adjustments that need to be made.
4. RELATIONSHIP BETWEEN PROFIT AND
LOSS ACCOUNT AND BALANCE SHEET
! IMPORTANT CONCEPT 3
Both the profit and loss account and the balance sheet are
Both the profit and loss account and the balance sheet are interrelated.
interrelated. A costrelating
A cost relating toto
thethe
operations of an accounting
operations period or to the revenue earn
of an accounting
of the cost whose benefits extend beyond the accounting period is treated as an asset and shown in the balance
period or to the reve- nue earned during the period whose benefits sheet.
do not extend beyond that period is treated as an expense and is
shown in the profit and loss account. Any cost or a part of the cost
whose benefits extend beyond the accounting period is treated as an
asset and shown in the balance sheet. For exam- ple, a part of the
cost of a machine that is depreciation for an accounting period is
shown in the profit and loss account while the remaining cost of the
machine is shown as an asset in the balance sheet. It is important
that the parts of a cost to be charged in the profit and loss account
and the part to be shown in the balance sheet are properly
determined so that both the statements show the correct scenario.
For this purpose, the matching prin- ciple is followed.
The profit earned during an accounting period and retained in the
business (net profit minus drawings) forms part of the owners’ capital
in the balance sheet.

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PREPARATION OF FINANCIAL STATEMENTS63

1. Which one of the following financial statements is

generally prepared first?
a. Income statement b. Balance sheet
c. Cash flow statement d. Statement of retained earnings
2. Which one of the following items is not reported in the
income statement as an expense?
a. Salaries b. Depreciation
SELF-ASSESSMENT QUESTIONS
c. Rent d. Dividend

4. PREPARATION OF PROFIT
4 AND LOSS ACCOUNT

4.4.1 GROSS PROFIT

Gross profit is the difference between the sales revenue and the cost
of goods sold. The cost of goods sold in the case of a trading firm
consists of purchases (adjusted for increase or decrease in stocks) QUICK TIP
and all other expenses incurred in bringing the goods to their present
location and condition. Examples of such expenses are freight paid Gross profit is the difference
on purchases, cartage, octroi and customs duty. In a manufacturing between the sales revenue and
concern, the cost of goods sold also includes all expenses incurred in the cost of goods sold.
the factory for producing goods such as wages, power and fuel and
rent of factory premises.

4.4.2 SALES REVENUE

Revenue recognition principles govern the time at which a firm
recognizes earning of sales revenue. The total sales revenue for an
accounting period is taken from the sales account in which day-to-
day sales transactions are entered on the basis of sales invoices.

4.4.3 SALES RETURNS AND ALLOWANCES

Sales returns are that part of sales revenue that represents the value
of goods returned by customers as they were not in accordance with
the specifica- tions, or damaged or defective. Sometimes, instead of
returning such goods, customers retain these goods and are given an
allowance to compensate them for change in specification, damage
or defect.
Sales returns and allowances are a counter revenue account to sales
reve- nue and are shown as a deduction from the sales revenue in
the profit and loss account.

4.4.4 GOODS AND SERVICES TAX

Goods and Services Tax (GST) is shown as a deduction from gross
sales. It is an indirect tax that the seller recovers from the customer
and deposits it with the government.

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64 FINANCIAL ACCOUNTING AND ANALYSIS

Net sales figure is calculated as follows:

Gross sales
Less: returns
sales
GST

Net sales

4.4.5 COST OF GOODS SOLD

The following items form part of the calculation of cost of goods sold.
1. Beginning inventory: The beginning inventory of an accounting
period is the closing inventory of the previous accounting
period. This figure is taken from the trial balance.
2. Purchases: The total purchases figure for the accounting period is
taken from the purchases account in which day-to-day purchase
transactions are entered on the basis of purchase invoices.
Purchases are shown at net value after deducting any trade
discount allowed by the supplier for purchasing a quantity of
merchandise in excess of a specified amount. Sometimes,
suppliers also give allowances by way of reduction in the invoice
price for goods that do not meet the quality standards of the
purchaser. Such allowances are also deducted from the
purchase price.
3. Purchases returns: The cost of purchased items that is returned to
sellers is accumulated in the purchases returns account and is
shown as a deduction from the purchases figure in the profit and
loss account.
4. Freight on purchases: Freight on purchase of inventory items is a
part of purchase cost and is added to the purchase price of the
goods for calculation of cost of goods sold.
5. Wages: Wages paid to workers in stores and warehouses also
form a part of cost of goods sold. However, wages paid in
relation to an item of fixed assets is added to the cost of that
asset.

QUICK TIP 6. Ending inventory: Unsold goods at the end of an accounting

period constitute the ending inventory. There is no account
Operating profit is calculated that provides the value of the ending inventory.
as gross profit minus
operating expenses. 4.4.6 OPERATING PROFIT
The operating profit is calculated as gross profit minus operating
expenses. Operating expenses are related to normal operations of
the business and include administrative, selling and general
expenses.
Administrative expenses include salaries paid to office employees, rent
of office building, lighting expenses, legal expenses, postage and
telephone charges, audit fee, etc. Selling and distribution expenses
include salesmen’s salaries and commission, advertisement expenses,
packing expenses, ware- housing expenses, freight and carriage on
sales,Global
NMIMS export duties,
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vehicles,
insurance
expenses, bad
debts, etc.
General
expenses include
maintenance
costs, security
expenses, etc.

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PREPARATION OF FINANCIAL STATEMENTS65

4.4.7 NET PROFIT

Net profit is calculated by adjusting the operating profit for non-
operating revenues, non-operating expenses, gains and losses. Non-
operating items are not related to the main business operations and
include such items as interest income, dividend income, interest
expense, profit or loss on disposal of fixed assets, etc.

4.4.8 INCOME TAX

For companies, income tax is treated as a separate business
expense. In the case of sole-proprietorship, income tax is treated as a
personal expense and is adjusted in the owners’ capital account.
SELF-ASSESSMENT QUESTIONS
3. Which one of the following items will not appear on a firm’s
income statement?
a. Rent expense b. Salaries ACTIVITY 2
From the information given below, determine the amount of gross profit, operating profit and net profit.
c. Insurance expense d. Purchase price of furniture
4. A firm received a rental income of Rs. 50,000 during a year.
Sales Rs. 5,000,000Cost of goods sold Rs. 3,750,000
It, however, wrongly recorded it as a rental expense. What is
Salaries
the effectRs.
of 300,000
this error on Rent Rs. 200,000
the firm’s income?
a. −50,000
Interest b. +50,000
paid Rs. 100,000Interest received Rs. 50,000
c. +100,000 d. −100,000

4. PREPARATION OF BALANCE SHEET

Assets, liabilities and owners’ equities are arranged either in a
horizontal or vertical format, as described in Chapter 9.

Illustration 4.1

From the balances extracted from the books of Naveen Brothers for the year ended March 31, 2016 (Table 4.2), pre

TABLE 4.2 BALANCES FROM THE BOOKS OF NAVEEN

BROTHERS FOR THE YEAR ENDED MARCH 31, 2016
(Rs.) (Rs.)
Opening stock 50,000 Plant and 249,20
machinery 0
Sales 472,00 Purchase returns 55,200
0
(Continue
d)

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66 FINANCIAL ACCOUNTING AND ANALYSIS

TABLE 4.2 BALANCES FROM THE BOOKS OF

NAVEEN BROTHERS FOR THE YEAR ENDED
MARCH 31, 2016—CONTINUED
(Rs.) (Rs.)
Depreciation 26,680 Cash in hand 37,680
Commission received 8,440 Salaries 30,000
Insurance 15,200 Accounts 185,400
receivable
Carriage on 12,000 Discount allowed 13,120
purchases
Furniture 26,800 Wages 63,560
Printing expenses 19,240 Sales returns 66,360
Carriage on sales 8,000 Bank overdraft 160,000
Capital 369,120 Purchases 347,160
Accounts payable 92,840 Bad debts 7,200

Closing stock as on March 31, 2016 is Rs. 148,000.

Solution: See Tables 4.3 and 4.4.

TABLE 4.3 TRADING AND PROFIT AND LOSS ACCOUNTS OF

NAVEEN BROTHERS FOR THE YEAR ENDED MARCH 31,
2016
(Rs.) (Rs.)
To 50,000 By Sales 472,000
opening
stock
Purchases 347,160 Less: 66,360
Returns
Less: Returns 55,200 405,640
291,960 Closing stock 148,000
Wages 63,560
Carriage 12,000
on
purchases
Gross profit 136,120
c/d
553,640 553,640
To 26,680 By gross 136,120
depreciation profit b/d
Insurance 15,200 Commission 8,440
Printing 19,240
expenses
Carriage 8,000
on sales
Salaries 30,000
Discount 13,120
Bad debts 7,200
Net profit 25,120
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144,560 144,560

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PREPARATION OF FINANCIAL STATEMENTS67

TABLE 4.4 BALANCE SHEET OF NAVEEN BROTHERS

AS ON MARCH 31, 2016
Liabilities (Rs.) Assets (Rs.)
Capital 369,120 Plant and machinery 249,20
0
Add: Net profit 25,120 Furniture 26,800
394,240 Closing stock 148,00
0
Accounts 92,840 Accounts receivable 185,40
payable 0
Bank overdraft 160,000 Cash 37,680
647,080 647,08
0

ADJUSTMENT ENTRIES
4.
Some business activities affect revenues and expenses of more than
one accounting period. Some adjustments are required at the end of
the accounting period to ensure proper measurement of income for
an account- ing period and to give a true picture of the state of affairs
of the business at the end of the accounting period. Adjustment QUICK TIP
entries apply both the realiza- tion and matching principles to
Adjustment entries affect both
transactions affecting two or more periods.
the income statement and the
Adjustment entries affect both the income statement and the balance balance sheet.
sheet. This is because the adjustment entries relate to recognition of
revenue and expenses causing a change in the owners’ capital. As
already known, the basic accounting equation always holds.
Therefore, a change in the owners’ capital is accompanied by a
change in assets or liabilities.
These adjustments usually relate to the following:
1. Adjustments needed to convert assets into expenses:
(a) Prepaid expenses
(b) Depreciation and amortization
2. Adjustments needed to convert liabilities into revenue:
(a) Income received in advance or unearned income
3. Adjustments needed to accrue unpaid expenses and uncollected
revenue:
(a) Outstanding expenses
(b) Outstanding or accrued income
4. Adjustments needed to account for expected future expenses:
(a) Provision for bad debts

4.6.1 PREPAID EXPENSES

For some items such as insurance and rent, payments are made in
advance. These payments may benefit more than one accounting
period, and there may be some unexpired part of such expenditure at
the end of the account- ing year. At the time of payment, such
expenditure is treated as an NMIMS
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68 FINANCIAL ACCOUNTING AND ANALYSIS

The adjusting entry treats the part of the asset consumed during the
account- ing period as an expense and the remaining part is shown
as an asset in the balance sheet.
To account for such expenses, the prepaid expenses account is debited
and the relevant expense account is credited. The effect of this entry
is that the amount of expense for the accounting period is reduced,
and an asset account in the form of prepaid expenses account is
created. The prepaid portion of the expense is deducted from the
amount of such expenses actually paid during the accounting year and
the remaining amount is shown on the debit side of the trading
account or the profit and loss account. To complete the dual effect, the
amount of prepaid expenses is shown on the asset side of the balance
sheet.
Prepaid expenses appearing in the trial balance imply that the
amount of expenses during the accounting period has already been
reduced by the pre- paid expenses. In such a case, the prepaid
expenses will not be deducted from the amount of expenses paid when
shown in the trading account or profit and loss account. These will only
be shown as an asset in the balance sheet.

Illustration 4.2
A firm pays an annual insurance premium of Rs. 48,000 on January 1, 2015. The
Therefore, only Rs. 12,000 out of Rs. 48,000 paid pertains to the account- ing ye

4.6.2 DEPRECIATION AND AMORTIZATION

Depreciation is the charge for the consumption of property, plant and
! IMPORTANT CONCEPT equip- ment, and amortization is a charge for the expiry of benefits
from intangible assets, such as goodwill, patents, etc. Depreciation
Depreciation is the charge for the consumption
andofamortization
property, plant and equipment,
convert the and amortization
consumed is a charge
part of theforasset
the expiry of benefits
during the from intangib
accounting year into an expense.
Depreciation (amortization) account is debited and the related asset
account is credited. Depreciation (amortization) account is
transferred to the profit and loss account and it appears on the debit
side of the profit and loss account. The value of the asset in the
balance sheet is reduced by the amount of depreciation provided
during the accounting period. The depreciation (amortization) amount
QUICK TIP for the accounting year is shown as a deduction from the written-
Depreciation and down value (net of depreciation) of items of property, plant and
amortization convert the equipment and items of intangible assets as at the beginning of the
consumed account- ing year in the balance sheet.
part of the asset during the When there is no provision for depreciation account (or accumulated
accounting year into an depre- ciation account), there is no depreciation account in the trial
expense. balance,
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Continuing at their written-down value.

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PREPARATION OF FINANCIAL STATEMENTS69

When the depreciation account is given in the trial balance, it means

that the value of the asset has already been reduced by the amount
of depreciation for the current accounting year. In such a case,
depreciation (amortization) account is transferred to the profit and
loss account, and it appears on the debit side of the profit and loss
account. The value of the asset in the bal- ance sheet is not reduced
by the amount of depreciation provided during the accounting period.

Illustration 4.3
In the books of A, the net value (written-down value) of property,
plant and equipment at the beginning of the accounting year is
Rs. 192,000. The original cost of assets was Rs. 300,000 and a
total depreciation of Rs. 108,000 was charged on these assets till
the beginning of the year. Depreciation is charged at 20% on the
written-down value of assets.
The depreciation for the current accounting year is Rs. 38,400
(20% of Rs. 192,000). This amount is debited to the profit and
loss account. When there is provision for depreciation
(accumulated depreciation) account, the balance in the account
is increased by Rs. 38,400 to Rs. 146,400.
The disclosure in the balance sheet will be as follows (Tables 4.5 and 4.6):
Method 1: When there is no provision for depreciation
(accumulated depreciation) account.

TABLE 4.5 BALANCE SHEET

Liabilities Assets (Rs.) (Rs.)
Property, plant and 192,000
equipment
Less: Depreciation 38,400
153,60
0

Method 2: When there is provision for depreciation (accumulated

depreciation) account.

TABLE 4.6 BALANCE SHEET

Liabilities Assets (Rs.) (Rs.)
Property, plant and equipment 300,00
0
Less: Provision for 146,400
depreciation
(accumulated depreciation)
153,60
0

4.6.3 INCOME RECEIVED IN ADVANCE OR UNEARNED INCOME

Sometimes, a firm receives an advance payment for goods to be
supplied or for services to NMIMS
be rendered in future.
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subscriptions may be

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70 FINANCIAL ACCOUNTING AND ANALYSIS

received in advance by publishers of a magazine or insurance

premium may be received in advance by an insurance company. Such
receipts cannot be treated as revenue until the related goods have
been supplied or the services have been rendered. Till such time,
these receipts are treated as liabilities. The purpose of the
adjustment entry is to transfer that part of the liability to revenue
that has been earned during the accounting period.
Part of the payment received, which has not been earned at the end
of the accounting year, is known as income received in advance or
unearned income. To account for such income, relevant income
account is debited and the income received in advance account is
credited. The effect of this entry is that the amount of income for the
accounting period is reduced and a lia- bility account in the form of
income received in advance is created. Income received in advance is
shown as deduction from the related head of income in the profit and
loss account and recognized as a liability in the balance sheet.
If the unearned income appears in the trial balance, it implies that the
amount of income earned during the accounting period has already
been reduced by the unearned income. In such a case, the unearned
income will not be deducted from the amount of income earned when
shown in the trading account or profit and loss account. This will only
be shown as a liability in the balance sheet.

Illustration 4.4
An insurance company receives an annual premium of Rs. 50,000 on an insuran
The insurance company will show Rs. 25,000 as an unearned income by way of

4.6.4 OUTSTANDING (ACCRUED) EXPENSES

Outstanding expenses are expenses that are not paid till the end of
the accounting year. For example, salaries payable to the employees
of the firm in the last month of the year are paid in the first month of
the next account- ing period. These expenses relate to the previous
accounting year and should be part of that year’s expense.
To account for such expenses, the relevant expense account is debited
and the outstanding expenses account is credited. The effect of this
entry is that the amount of expense for the accounting period is
increased and a liability account in the form of outstanding expenses
account is created. The unpaid amount of expenses is added to the
amount of such expenses actually paid during the accounting year, and
the total amount is shown on the debit side of the trading account or
the profit and loss account. To complete the dual effect, the amount of
outstanding expenses is shown on the liability side of the balance
sheet.
If the outstanding expenses appear in the trial balance, it implies that
the amount of expenses paid during the accounting period has
already been increased by the outstanding expenses. In such a case,
the outstanding expenses will not be added to the amount of
expenses
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- Schoolshown in theEducation
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account. These will only be shown as a liability in the balance sheet.

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PREPARATION OF FINANCIAL STATEMENTS71

Illustration 4.5
A firm has a monthly salary expense of Rs. 100,000. For the accounting year ended on March 31, 2015, it has p
The salary expense for the accounting year ended on March 31, 2015 debited in the profit and loss account will

4.6.5 OUTSTANDING OR ACCRUED INCOME

Sometimes interest on securities or deposits is earned, and it is
accumulated over time, but is not due for collection by the firm till the
end of the accounting year. The firm may be entitled to receive
dividends declared on its investments, which are not received by the
firm during the accounting year. A firm may have rendered services,
which have not been billed and collected by the end of the accounting
year. All these are examples of accrued or outstanding income. Such
incomes must be accounted for to report the correct amount of income.
To account for such an income, the accrued income account is
debited, and the relevant income account is credited. The effect of
this entry is that the amount of income for the accounting period is
increased and an asset account in the form of accrued income is
created. In the profit and loss account, the amount of the relevant
income actually received during the accounting year is increased by
the amount of accrued income, and the amount of accrued income is
shown as an asset in the balance sheet.
If the accrued income appears in the trial balance, it implies that the
amount of income earned during the accounting period has already
been increased by the accrued income. In such a case, the accrued
income will not be added to the amount of income earned when
shown in the trading account or profit and loss account. This will only
be shown as an asset in the balance sheet.

Illustration 4.6
A firm has invested Rs. 100,000 in debentures of a company that bear 14% interest. The interest is paid on June 3
The firm is entitled to receive Rs. 7,000 every six months on June 30 and December 31. As on March 31, the firm
30. The firm will show Rs. 3,500 (50% of Rs. 7,000) as an accrued interest income in the profit and loss account f
When the firm receives Rs. 7,000 on June 30 next year, it will debit cash account by Rs. 7000, credit accrued inte

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72 FINANCIAL ACCOUNTING AND ANALYSIS

4.6.6 PROVISION FOR BAD AND DOUBTFUL DEBTS

Bad debts are losses that result from debts that default on their
obligation to pay. Bad debts account is debited and the debtors
account is credited. The balance in the bad debts account is
transferred to the debit of the profit and loss account. The balance in
the debtors account is reduced by the amount of bad debts. When
the amount of bad debts is given in the trial balance, it means that
the balance of debtors (accounts receivable) account has already
been reduced by the amount of bad debts. No further adjustment is
required in the amount of debtors when it is carried to the balance
sheet.
There are some debts that have not yet become bad but their
recovery is uncertain. As the amount of bad debts is uncertain, a
provision is created for bad and doubtful debts by debiting the profit
and loss account and crediting the provision for bad and doubtful
debts account. If there is any balance in the provision account at the
beginning of the accounting year, the same is reduced from the
amount of provision to be maintained at the end of the accounting
year and only the remaining amount is debited to the profit and loss
account.
If the amount of provision to be maintained at the end of the
accounting year is less than the balance in the provision account at
the beginning of the year, the difference is credited to the profit and
loss account.
In the balance sheet, the provision for bad and doubtful debts is
shown as deduction from the balance in the debtors account.

Illustration 4.7
The trial balance of a firm shows a balance of Rs. 100,000 in the debtors account
In this case, the balance of Rs. 8,000 in the bad debts account will be transferred

TABLE 4.7 BALANCE SHEET

Liabilities Assets (Rs.) (Rs.)
Debtor 100,000
s
Less: Provision for bad 5,000
and doubtful
debts
95,000

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PREPARATION OF FINANCIAL STATEMENTS73

Illustration 4.8

The following balances appear in the trial balance of a firm as on March 31, 2015.

(Rs.)
Bad debts 8,000
Debtors 100,00
0
Provision for bad and doubtful debts (as on April 1, 5,000
2014)

It is proposed to maintain a provision of 10% on debtors for bad and doubtful debts.
In this case, Rs. 8,000 of bad debts will be debited to the profit and loss account. The required provision is Rs. 1

5. The charge for the expiry of benefits from intangible assets is

called
. SELF-ASSESSMENT QUESTION
a. depreciation b. depletion

ADJUSTED TRIAL BALANCE

4. QUICK TIP
After posting of adjustment entries in the ledger, an adjusted trial
balance is prepared that carries a summary of updated account Ending inventory and provision
balances. for bad debts are not reflected
Illustration 4.9 in the adjusted trial balance.

Closing stock and provision for bad debts are not reflected in the adjusted trial balance (Table 4.8) because their d

TABLE 4.8 ADJUSTED TRIAL BALANCE

Debit Amount (Rs.) Credit Amount (Rs.)
Purchases and sales 550,000 1,040,000
Sales returns 30,000
Purchase returns 18,00
0
Freight on purchases 24,800
Wages and salaries 117,200
Miscellaneous expenses 4,400
(Continued)

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74 FINANCIAL ACCOUNTING AND ANALYSIS

TABLE 4.8 ADJUSTED TRIAL BALANCE—(CONTINUED)

Debit Amount (Rs.) Credit Amount (Rs.)
Rent 24,000
Insurance 4,000
Audit fees 2,400
Debtors/creditors 226,600 128,600
Printing and advertising 11,000
Commission 2,800
Opening stock 72,000
Cash in hand 25,600
Cash at bank 53,600
Bank loan 40,000
Interest on loan 6,000
Capital 500,000
Drawings 30,000
Property, plant and 540,000
equipment
Depreciation 60,000
Commission outstanding 80
0
Rent received in advance 2,000
Outstanding interest 3,000
1,758,400 1,758,400
The financial statements prepared on the basis of adjusted trial
balance are presented in Tables 4.9 and 4.10.

TABLE 4.9 TRADING AND PROFIT AND LOSS ACCOUNT FOR

THE YEAR ENDED ON MARCH 31, 2015
Amount Amount
Particulars (Rs.) Particulars (Rs.)
To opening 72,000 By Sales 1,040,000
stock
Purchases 550,000 Less: 30,000
Returns
Less: Returns 18,000 1,010,000
532,000 Closin 120,000
g
stock
Wages & 117,200
salaries
Freight on 24,800
purchases
Gross profit 384,000
c/d
1,130,000 1,130,000
(Continued)

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PREPARATION OF FINANCIAL STATEMENTS75

TABLE 4.9 TRADING AND PROFIT AND LOSS ACCOUNT FOR

THE YEAR ENDED ON MARCH 31, 2015—(CONTINUED)
Amount Amount
Particulars (Rs.) Particulars (Rs.)
To Insurance 4,000 By gross 384,000
profit b/d
Audit fee 2,400 Rent 26,000
Printing and 11,000 Less:
advertising Received
Interest on loan 3,000 in advance 2,000
Add: 3,000 24,000
Outstanding
6,000 Commission 2,000
Depreciation 60,000 Add: 800
Outstandin
g
Provision for 11,330 2,800
bad debts
Miscellaneou 4,400
s expenses
Net profit 311,670
410,800 410,800

TABLE 4.10 BALANCE SHEET AS ON MARCH 31, 2015

Liabilities Amount Assets Amount
(Rs.) (Rs.)
Capital 500,000 Property, 600,000
plant and
equipment
Add: Net profit 311,670 Less: 60,000
Depreciation
540,000
811,670 Debtors 226,600
Less: Drawings 30,000 Less: Provision 11,330
for bad debts
781,670 215,270
Bank loan 40,000
Add: Closing stock 120,000
Outstanding
interest 3,000 Cash in hand 25,600
43,000 Cash at bank 53,600
Creditors 128,600 Commission 800
outstanding
Rent received in 2,000
advance
955,270 955,270

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4.7.1 CLOSING ENTRIES

! IMPORTANT CONCEPT Revenue and expenses accounts are temporary accounts as these are
not car- ried forward to the next accounting year. At the end of the
Revenue and expenses accounts are temporary accounts asperiod,
accounting these are these
not carried forward toare
accounts the next accounting
closed year.
by transferring their
balances to the profit and loss account. Revenue accounts have credit
balances. To close these accounts, they are debited with a
corresponding credit to the profit and loss account, the amount being
equal to the balance in the account. Similarly, expense accounts are
credited with a corresponding debit to the profit and loss account.
After the balances in revenue and expense accounts have been
transferred to the profit and loss account, the balance in the profit
and loss account will either show the net profit (when the sum of
credit balances is more than the sum of debit balances) or the net
loss (when the sum of debit balances is more than the sum of credit
balances).
The profit and loss account is also closed by transferring the balance
to the owners’ capital or retained earnings (in the case of
companies).

4.7.2 POST-CLOSING TRIAL BALANCE

The post-closing trial balance is prepared after closing the revenue
and expense accounts. This trial balance consists of only those
accounts that appear in the balance sheet. The purpose of preparing
this trial balance is to check the accuracy in posting of closing
entries. It also serves as the starting point for recording transactions
in the next accounting period.

4. SUMMARY
 Understand the relationship between profit and loss account and bal-
ance sheet. Both the profit and loss account and balance sheet are
inter- related. A cost relating to the operations of an accounting
period or to the revenue earned during the period whose benefits
do not extend beyond that period is shown in the profit and loss
account.
 Prepare profit and loss account and balance sheet from the given trial
balance, without accounting for any adjustment entries. First, the
gross profit is determined by deducting the cost of goods
sold from the sales revenue.
Operating profit is calculated as gross profit minus operating
expenses. Net profit is calculated by adjusting the operating profit
for non-operat- ing revenues, expenses, gains and losses.
Income-tax and drawings are treated as personal expenses of the
owner and are, therefore not shown in the profit and loss account.
 Understand how to make adjustments for accruals, deferrals and
other items. Some business activities affect revenues and expenses
of more than one accounting period. Some adjustments are
required at the end of the accounting period to ensure proper
measurement of income for an accounting period and to give a
true picture of the state of affairs of the business at the end of the
accounting period. Adjustments are usually made relating to
outstanding
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PREPARATION OF FINANCIAL STATEMENTS77

accrued income, income received in advance or unearned income,

depre- ciation and amortization, and provision for bad debts.
 Prepare profit and loss account and balance sheet after accounting for
adjustment entries. The amounts in the trial balance get adjusted
with the amount of adjustments made. Following the same
principles that apply in the absence of adjustments, the profit and
loss account and the balance sheet are prepared on the basis of
the adjusted trial balance.
 Prepare closing entries and post-closing trial balance. At the end of
the accounting period, revenue and expense accounts are closed
by trans- fer to profit and loss account. The balance in the profit
and loss account is transferred to owners’ capital account or
retained earnings account. Thereafter, post-closing trial balance is
prepared that consists of only bal- ance sheet accounts.

KEY WORDS
1. Adjusted trial balance After posting of adjustment entries in the
ledger, an adjusted trial balance is prepared that carries a
summary of updated account balances.
2. Closing entries At the end of the accounting period, expense
and revenue accounts are closed by transferring their
balances to the profit and loss account. The profit and loss
account is also closed by transferring the balance to the
owners’ capital or retained earnings (in the case of
companies).
3. Cost of goods sold is equal to the cost of goods available for
sale (beginning inventory  net purchases  direct expenses)
minus ending inventory.
4. Gross profit is the difference between the sales revenue
and the cost of goods sold.
5. Perpetual inventory system keeps a detailed record of each
inventory purchase and sale. The inventory that should be
on hand is available perpetually from these records.
6. Periodic inventory system does not keep a detailed record of
inventory on hand. The value of the ending inventory is
determined by taking a physical inventory count.
7. Operating profit is calculated as gross profit minus operating
expenses.
8. Operating expenses are related to normal operations of the
business and include administrative, selling and general
expenses.
9. Net profit is calculated by adjusting the operating profit for

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 78 FINANCIAL ACCOUNTING AND ANALYSIS

4. DESCRIPTIVE QUESTIONS
1. How is gross profit measured?
2. What are allowances in relation to sales revenue?
3. How is GST treated in accounts?
4. How is the cost of goods sold calculated?
5. What expenses are classified as operating expenses?
6. Define operating profit.
7. State any five adjustment entries made in the preparation of
financial statements at the end of the accounting period.
8. Differentiate between the terms depreciation and amortization.

4.1 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Relationship Between Profit 1. a. Income statement
and Loss Account and Balance
Sheet
2. d. Dividend
Preparation of Profit and 3. d. Purchase price of furniture
Loss Account
4. d. −100,000
Adjustment Entries 5. c. amortization

4.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Bhattacharyya, A.K. (2014). Financial Accounting for Business
Managers, Prentice Hall of India.
 Anthony, R.N., Hawkins, D.E. and Merchant, K.A. (2015).
Accounting Text and Cases, Tata McGraw Hill.

E-REFERENCES
 Khan M.Y. and Jain, P.K. (2010). Management Accounting: Text,
Problems and Cases, Tata McGraw Hill (KJ).
 Horngren C.T., Sundem G.L. and Elliot J.A. (2013). Introduction to
Financial Accounting, Pearson Education.

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 C H
5
A P T E R

FINANCIAL REPORTING STANDARDS I

CONTENTS

5. Introduction
1
Accounting Standards Board
5.
Self-Assessment
2
Questions Activity
Constitution of Accounting Standard Board of India
5. Procedure for Issuing Accounting Standards
3 Self-Assessment Questions
5. Activity
4 Compliance with Accounting
Standards Self-Assessment
Questions
5. Implementation of Accounting Standards in
5 India Self-Assessment Questions
5.7. Convergence of Indian Accounting Standards with IFRS
5. 1 Applicability of Ind AS
6 Self-Assessment
Questions Summary
5. Key Words
7
Descriptive
Questions

5.
8

5.
9
5.10 Answer Key
Self-Assessment Questions
5.11 Suggested Books and E-References

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LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the meaning and importance of accounting standards.
Understand the role of Accounting Standards Board in bringing out new
> Understand how new accounting standards are issued and how is compl
Understand the current structure of Accounting Standards in India.
>
>

5. INTRODUCTION
Accounting standards are pronouncements made by accounting
! IMPORTANT CONCEPT bodies spec- ifying the accounting requirements for recognition,
measurement, presen- tation and disclosure of different transactions
Accounting standards are meant to bring about uniformity in financial
and events. Entities prepare their financial statements based on
reporting and make financial statements of different entities comparable.
accounting standards. Financial state- ments based on accounting
standards are expected to make a fair presen- tation of an entity’s
financial performance, financial position and cash flows to different
users of financial statements. Accounting standards also bring about
uniformity in financial reporting and make financial statements of dif-
ferent entities comparable.
Accounting standards are pronouncements made by accounting
bodies spec- ifying the accounting requirements for different
transactions and events. Accounting bodies in different countries are
responsible for developing and implementing Accounting Standards
in their respective countries.

QUICK TIP ACCOUNTING STANDARDS BOARD

5.
Accounting Standards Accounting bodies in different countries are responsible for
Board (ASB) has formulated formulating the accounting standards applicable to that country. In
the Indian Accounting India, accounting stan- dards are formulated by the Council of the
Standard (Ind-AS). Institute of Chartered Accountants of India (ICAI) through its
Accounting Standards Board (ASB). The objec- tive of the ASB is to
standardize different accounting policies and practices so that
financial statements prepared by different entities are reliable and
comparable.

1. The purpose of Accounting Standards is to

a. make a fair presentation of an entity’s financial
performance, financial position and cash flows
b. bring about uniformity in financial reporting
c. make financial statements of different entities comparable.
SELF-ASSESSMENT QUESTIONS
d. All of the above

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FINANCIAL REPORTING STANDARDS I 81

2. ASB stands for

a. Accounting Standards Bureau
b. Accounting Standards Bulletin
c. Accounting Standards Board
d. None of the above

ACTIVITY 1
Refer to the website https://www.icai.org/post.html?post_id=379
and com- prehend the objectives and functions of the accounting
standards board (ASB. Make a note on the Subjects on which new
Accounting Standards are under
CONSTITUTION OFpreparation.
ACCOUNTING
5.
3 STANDARD BOARD OF INDIA
Some members of the ASB are nominated by ICAI. Other members of
the ASB consist of the following:
1. Nominee of the central government representing the
Department of Company Affairs on the council of the ICAI.
2. Nominee of the central government representing the office of
the Comptroller (Controller) and Auditor General of India on the
council of ICAI.
3. Nominee of the central government representing the Central
Board of Direct Taxes on the council of ICAI.
4. Representative of the Institute of Cost and Works Accountants of India.
5. Representative of the Institute of Company Secretaries of India.
6. Representative of Industry Association from “Associated
Chambers of Commerce and Industry (ASSOCHAM),” from
Confederation of Indian Industry (CII) and from Federation of
Indian Chambers of Commerce and Industry (FICCI).
7. Representative of Reserve Bank of India (RBI).
8. Representative of Securities and Exchange Board of India (SEBI).
9. Representative of Controller General of Accounts.
10. Representative of Central Board of Excise and Customs.
11. Representative of academic institutions from universities and
from Indian institutes of management.
12. Representative of financial institutions.
13. Eminent professionals co-opted by ICAI.

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82 FINANCIAL ACCOUNTING AND ANALYSIS

14. Chairman of the Research Committee and chairman of the

Expert Advisory Committee of the ICAI, if they are not otherwise
members of the Accounting Standards Board.
15. Representative of any other body, as considered appropriate by
the ICAI.

NOTE 5. PROCEDURE FOR ISSUING ACCOUNTING

ASB is a committee 4 STANDARDS
under the Institute of In India, accounting standards are formulated by the Council of the
Chartered Accountants of Institute of Chartered Accountants of India (ICAI) through its ASB.
India (ICAI), which consists Thereafter, these accounting standards are considered by the
of representatives from National Financial Reporting Authority (NFRA). The Central
government department, Government may prescribe the Standards of Accounting or any
academicians, and other addendum thereto, as recommended by the ICAI, in consultation with
professional bodies (viz., ICAI, and after examination of the recommendations made by the NFRA.
ASSOCHAM, CII, FICCI, etc.).

3. Which of the following is instrumental in formulating the

accounting standards that standardize different accounting
policies and practices?
a. Board of Direct Education
b. Accounting Standards Board (ASB)
c. Board of Secondary Education
d. Corporate Affairs Board
4. Which among the following advises the Central Government
on the formulation and laying down of accounting policy and
accounting standards for adoption by companies.
a. International Financial Reporting Standards (IFRS)
b. Ministry of Corporate Affairs (MCA)
c. National Financial Reporting Authority (NFRA)
SELF-ASSESSMENT QUESTIONS
d. Indian Accounting Standard (Ind-AS)

ACTIVITY 2
In the Indian context, check out the procedure for issuing
accounting standards (AS). Note when the council of the
institution considers the final draft.

5. COMPLIANCE WITH ACCOUNTING

5 STANDARDS
Accounting Standards become mandatory from the date specified in
the Accounting Standards.
The ICAI enforces compliance with Accounting Standards through the
audit- ing process. It is the duty of the auditors to check whether
requirements of

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FINANCIAL REPORTING STANDARDS I 83

the Accounting Standards are complied with or not complied with. In

the case of any deviation, such deviations have to be reported in the
audit reports to bring it to the attention of the users of financial
statements.
Compliance with Accounting Standards is also enforced through the
provi- sions of the Companies Act, 2013 in the following manner.
1. Sub-section 1 of Section 129 of the Companies Act, 2013
provides that the financial statements have to comply with the
accounting standards notified under section 133 of the
Companies Act, 2013.
Further, the financial statements are required to be in the form
or forms as specified in Schedule III of the Act and the items
contained in such financial statements are required to be in
accordance with the Accounting Standards.
2. Sub-section 5 of Section 129 provides that where the financial
statements of a company do not comply with the accounting
standards referred to in sub-section (1), the company is required
to make the following disclosures:
a. Deviation from the accounting standards.
b. The reasons for such deviation.
c. The financial effects, if any, arising out of such deviation.
3. The directors are required to attach ‘Directors’ Responsibility
Statement’ to the report of Board of Directors that is placed
before the company in general meeting under sub-section 3 of
Section 134 of the Companies Act, 2013. This statement is
required to state that in the preparation of the annual accounts,
the applicable accounting standards had been followed along
with proper explanation relating to material departures;

SELF-ASSESSMENT QUESTIONS
5. Which of the following disclosures does a company need to
make if its financial statements do not comply with the
accounting standards?
a. Deviation from the accounting standards
b. The reasons for deviation from the accounting standards
c. The financial effects of deviation from accounting
standards
d. All of the above.
6. Which Schedule of the Companies Act, 2013 prescribes the
forms in which the financial statements are required to be
QUICK TIP
prepared?
Indian Accounting Standard
(abbreviated as Ind-AS) is the
5. IMPLEMENTATION OF ACCOUNTING Accounting standard adopted
6 STANDARDS IN INDIA by companies in India and
issued under the supervision
Currently, the following accounting standards, also commonly known
of Accounting Standards
as the Indian GAAP (generally accepted accounting standards), have
Board (ASB) which was
been notified:
constituted as a body in the
1. AS 1: Disclosure of Accounting Policies year 1977.

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84 FINANCIAL ACCOUNTING AND ANALYSIS

2. AS 2: Valuation of Inventories (Revised)

3. AS 3: Cash Flow Statement

4. AS 4: Contingencies and Events Occurring after the Balance

Sheet Date (Revised)

5. AS 5: Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies

6. AS 7: Construction Contracts

7. AS 9: Revenue Recognition

8. AS 10: Property, Plant and Equipment (Revised)

9. AS 11: The Effects of Changes in Foreign Exchange Rates

10. AS 12: Accounting for Government Grants

11. AS 13: Accounting for Investments (Revised)

12. AS 14: Accounting for Amalgamations (Revised)

13. AS 15: Employee Benefits (revised 2005)

14. AS 16: Borrowing Costs

15. AS 17: Segment Reporting

16. AS 18: Related Party Disclosures

17. AS 19: Leases

18. AS 20: Earnings Per Share

19. AS 21: Consolidated Financial Statements (Revised)

20. AS 22: Accounting for Taxes on Income

21. AS 23: Accounting for Investments in Associates in Consolidated

Financial Statements

22. AS 24: Discontinuing Operations

NOTE
Generally Accepted 23. AS 25: Interim Financial Reporting
Accounting Principles (GAAP)
24. AS 26: Intangible Assets
are basic accounting principles
and guidelines which provide 25. AS 27: Financial Reporting of Interests in Joint Ventures
the framework for more
detailed and comprehensive 26. AS 28: Impairment of Assets
accounting rules, standards
and other industry-specific 27. AS 29: Provisions, Contingent Liabilities and Contingent Assets (Revised)
accounting practices.

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FINANCIAL REPORTING STANDARDS I 85

7. Ind AS stands for

a. Indian Financial Reporting Standards
b. International Financial Reporting Standards
c. International Accounting Standards
d. Indian Accounting Standards
8. IFRS stands for
a. International Financial Reporting Standards
b. Indian Financial Reporting Standards
c. Indian Federal Reporting Standards SELF-ASSESSMENT QUESTIONS
d. International Financial Report Structure

5. CONVERGENCE OF INDIAN ACCOUNTING

7 STANDARDS WITH IFRS
Every country has its own set of rules for accounting and financial
reporting. As a result, financial statements prepared on the basis of
accounting stan- dards prevailing in a country are not comparable to
financial statements pre- pared on the basis of accounting standards
in the other country. This imposes a limitation on the ability of
business enterprises in a country to raise funds from other countries.
Such a problem will not arise if the accounting stan- dards in the two ! IMPORTANT CONCEPT
countries are either consistent with each other or with a set of global International Financial Reporting Standards (IFR
standards. Countries can either adopt global accounting standards as and comparable around the world.
they are or can achieve convergence of their accounting standards
with global accounting standards. In convergence, there may be
departures from global accounting standards in respect of some
accounting treatments.
Convergence of a country’s financial reporting and accounting
standards with the global accounting standards has the following
benefits:
1. It leads to growth of international business and capital inflows in
a country.
2. It improves the ability of investors from other countries to better
understand investment opportunities in that country.
3. Companies can raise capital from foreign markets at a lower cost.
International Accounting Standards Committee (IASC) that represents
pro- fessional accounting bodies of more than 75 countries was set
up in 1973 to develop international accounting standards. It
released many account- ing standards during the period 1973 to
2001. IASC was restructured and renamed as International
Accounting Standards Board (IASB) in 2001. The pronouncements STUDY HINT
made by IASB are referred to as International Financial Reporting The convergence of accounting standards refers
Standards (IFRS) while those made by IASC are referred to as of establishing a single set of accounting standar
International Accounting Standards (IAS).
IFRS comprises of IFRS issued by IASB, IAS issued by IASC, interpreta-
tions issued by the Standards Interpretations Committee (SIC) and
IFRS interpretation Committee of IASB. IFRS establishes broad
principles of accounting rather than directions relating to specific
treatment of accounting
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transactions. Different countries are in the process of either adopting

or mod- ifying their own accounting standards to make them
consistent with IFRS. The latter process is referred to as
Convergence.
The Institute of Chartered Accountants of India (ICAI), in consultation
with the Government of India, decided against outright adoption of
IFRS. Some departures have been made from IFRS which reflect
difference in the eco- nomic environment of India and the economic
environment that underlies IFRS.
In a move towards convergence with IFRS, in 2007, the ICAI
commenced the process of developing a complete set of
accounting standards that are “converged with” IFRS. These are
known as Indian Accounting Standards or Ind AS.
Implementing the new accounting standards, the Ministry of
Corporate Affairs (MCA) of India has notified The Companies (Indian
Accounting Standards) Rules, 2015. The following Ind AS have been
notified under the rules:
1. Indian Accounting
Standard (Ind AS) 101 First-Time Adoption of Indian
2. Indian Accounting Accounting Standards
Standard (Ind AS) 102 Share-Based
3. Indian Accounting
Standard (Ind AS) 103 Payment Business
4. Indian Accounting
Standard (Ind AS) 104 Combinations
5. Indian Accounting
Standard (Ind AS) 105 Insurance Contracts
6. Indian Accounting
Standard (Ind AS) 106 Non-Current Assets Held for
7. Indian Accounting Sale and Discontinued
Standard (Ind AS) 107 Operations Exploration for and
8. Indian Accounting Evaluation of Mineral
Standard (Ind AS) 108 Resources
9. Indian Accounting Financial Instruments:
Standard (Ind AS) 109 Disclosures
10. Indian Accounting Operating Segments
Standard (Ind AS) 110
11. Indian Accounting Financial Instruments
Standard (Ind AS) 111
12. Indian Accounting Consolidated
Standard (Ind AS) 112 Financial Statements
13. Indian Accounting Joint Arrangements
Standard (Ind AS) 113
14. Indian Accounting Disclosure of Interests in Other
Standard (Ind AS) 114 Entities
15. Indian Accounting Fair Value Measurement
Standard (Ind AS) 115
16. Indian Accounting Regulatory Deferral Accounts
Standard (Ind AS) 116
Revenue from Contracts with
Customers
Leases
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17. Indian Accounting Standard Presentation of

(Ind AS) 1 Financial Statements
18. Indian Accounting Standard Inventories
(Ind AS) 2
19. Indian Accounting Standard Statement of Cash Flows
(Ind AS) 7
20. Indian Accounting Standard Accounting Policies, Changes
(Ind AS) 8 in Accounting Estimates and
Errors
21. Indian Accounting Standard Events after the Reporting Period
(Ind AS) 10
22. Indian Accounting Standard Income Taxes
(Ind AS) 12
23. Indian Accounting Standard Property, Plant and Equipment
(Ind AS) 16
24. Indian Accounting Standard Employee Benefits
(Ind AS) 19
25. Indian Accounting Standard Accounting for Government
(Ind AS) 20 Grants and Disclosure of
Government Assistance
26. Indian Accounting Standard The Effects of Changes in
(Ind AS) 21 Foreign Exchange Rates
27. Indian Accounting Standard Borrowing Costs
(Ind AS) 23
28. Indian Accounting Standard Related Party Disclosures
(Ind AS) 24
29. Indian Accounting Standard Separate Financial Statements
(Ind AS) 27
30. Indian Accounting Standard Investments in Associates and
(Ind AS) 28 Joint Ventures
31. Indian Accounting Standard Financial Reporting in
(Ind AS) 29 Hyperinflationary Economies
32. Indian Accounting Standard Financial Instruments:
(Ind AS) 32 Presentation
33. Indian Accounting Standard Earnings per Share
(Ind AS) 33
34. Indian Accounting Standard Interim Financial Reporting
(Ind AS) 34
35. Indian Accounting Standard Impairment of Assets
(Ind AS) 36
36. Indian Accounting Standard Provisions, Contingent
(Ind AS) 37 Liabilities and Contingent
Assets
37. Indian Accounting Standard Intangible Assets
(Ind AS) 38
38. Indian Accounting Standard Investment Property
(Ind AS) 40
39. Indian Accounting Standard Agriculture
(Ind AS) 41

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9. What among the following of a country’s accounting standards with global

a. Convergence b. divergence
c.discrepancy d. variations
ICAI and MCA decided to
adopt the IFRS
c.converge with IFRS b. recreate the AS
SELF-ASSESSMENT QUESTIONS
d. differ on their mandates

5.7.1 APPLICABILITY OF IND AS

From April 1, 2016, Ind AS have been made mandatory for companies
whose equity and/or debt securities are listed or are in the process of
listing on any stock exchange in India or outside India and having a net
worth of Rs. 500 crore or more.
From April 1, 2016, all listed and unlisted companies having a net
worth above Rs. 500 crore are required to follow the new accounting
standards. The deadline was also made applicable to other entities
having a net worth of Rs. 500 crore or more and to holding,
subsidiary, joint venture or associate companies of these two classes
of entities.
From April 1, 2017, Ind AS have been made mandatory for:
1. Companies whose equity and/or debt securities are listed or are
in the process of being listed within India or outside India –
having a net worth of less than Rs. 500 crore.
2. Other companies, that are unlisted having a net worth of Rs. 250
crore or more but less than Rs. 500 crore.
Holding, subsidiary, joint venture or associate companies of these
entities have also to comply with this deadline.
Companies whose securities are listed or in the process of listing on
SME exchanges are not required to apply Ind AS. Such companies
shall continue to comply with the existing accounting standards
unless they choose other- wise.

QUICK TIP Companies were also allowed to follow Ind AS norms on a voluntary
basis from April 1, 2015. However, these companies cannot
Companies can voluntarily subsequently revoke the norms.
choose to incorporate IND AS
in their reports for accounting An Indian company’s overseas subsidiary, associate, joint venture
periods beginning on or after and other similar entities can prepare their stand-alone financial
April 01, 2015. statements in accor- dance with requirements of the concerned
jurisdiction. However, such com- panies are required to prepare their
consolidated financial statements in accordance with the Ind AS.
Companies which are not required to follow Ind AS can continue to
follow accounting standards as prescribed in Companies (Accounting
Standards) Rules, 2006. These are the earlier accounting standards
formulated by ICAI. Ind AS are also not applicable to banking,
insurance and non-banking finance companies.

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5. SUMMARY
 Understand the meaning and importance of accounting standards.
Accounting standards are pronouncements made by
accounting bodies specifying the accounting requirements for
different transac- tions and events. Accounting standards also
bring about uniformity in financial reporting and make
financial statements of different entities comparable.
 Understand the role of Accounting Standards Board in bringing out
new accounting standards. Accounting Standards Board (ASB) is
instrumental in formulating the accounting standards that
standardize different accounting policies and practices so that
financial statements prepared by different entities are reliable
and comparable.
 Understand how new accounting standards are issued and how is com-
pliance with accounting standards ensured. The Central Government
may prescribe the Standards of Accounting or any addendum
thereto, as recommended by the ICAI, in consultation with and
after examina- tion of the recommendations made by the
National Financial Reporting Authority (NFRA).
 Understand the current structure of Accounting Standards in India.
Except for some categories of companies, Indian companies
are required to follow the new ‘Ind AS’. These are accounting
standards that are con- verged to IFRS. Convergence means
that there are certain departures from IFRS in Ind AS. Other
companies are required to follow the existing accounting
standards commonly known as the Indian GAAP (generally
accepted accounting principles).

KEY WORDS
1. Accounting Standards are pronouncements made by
accounting bodies specifying the accounting
requirements for different transactions and events.
2. Directors’ Responsibility Statement is the report of Board of
Directors that states that in the preparation of the annual
accounts, the applicable accounting standards had been
followed along with proper explanation relating to material
departures;
3. AS (Accounting Standards) is a common set of principles,
standards, and procedures that define the basis of financial
accounting and policies and practices.
4. GAAP (generally accepted accounting principles) is a collection
of commonly-followed accounting rules and standards for
financial reporting.
5. International Accounting Standards (IAS) are older accounting
standards issued by the International Accounting Standards
Board (IASB), an independent international standard-setting
body based in London. The IAS were replaced in 2001 by
International Financial Reporting Standards (IFRS).

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90 FINANCIAL ACCOUNTING AND ANALYSIS

6. IFRS (International Financial Reporting Standards) are accounting

standards that are issued by the International Accounting
Standards Board (IASB) with the objective of providing a
common accounting language to increase transparency in the
presentation of financial information.
7. Indian Accounting Standard (Ind-AS) is the Accounting standard
adopted by companies in India and issued under the
supervision of Accounting Standards Board (ASB) which was
constituted as a body in the year 1977.
8. International Accounting Standards Board (IASB) is an
independent, private-sector body that develops and approves
International Financial Reporting Standards (IFRSs).

5. DESCRIPTIVE QUESTIONS
1. What are Accounting Standards? Why are these necessary for
the preparation and presentation of financial statements?
2. What is the objective of the Accounting Standards Board?
3. Explain the procedure of issuing Accounting Standards in India.
4. How is compliance with Accounting Standards enforced in India?
5. How does ‘Directors’ Responsibility Statement’ secure
companies’ compliance with Accounting Standards?
6. What advantage can Indian companies derive by preparing and
presenting their financial statements in accordance with IFRS?
7. Are Ind AS exactly similar to IFRS? Comment.
8. Some categories of companies have been exempted from
adoption of Ind AS. Name these categories.

5.1 ANSWER KEY

SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers
Accounting Standards 1. d. All of the above
Board
2. c. Accounting Standards Board
Procedure for Issuing 3. b. Accounting Standards Board (ASB)
Accounting Standards
4. c. National Financial
Reporting Authority (NFRA)
Compliance with 5. d. All of the above
Accounting Standards
6. c. Schedule III

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FINANCIAL REPORTING STANDARDS I 91

Topics Q. No. Answers

Implementation of 7. d. Indian Accounting
Accounting Standards Standards
in India
8. a. International Financial
Reporting Standards
Convergence of 9. a. Convergence
Indian Accounting
Standards with IFRS
10. c. Converge with IFRS

5.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Raiyani J.R. and Lodha G. (2012). International Financial Reporting
Standards (IFRS) and Indian Accounting Practices. Ingram.
 Epstein B.J. and Mirza A.A. (2006). Wiley IFRS 2006: Interpretation
and Application of International Financial Reporting Standards.
John Wiley & Sons.
 Sharma P. and Bhalla K. (2019). Scanner Cum Compiler
Financial Reporting (CA-Final). Taxman.
 Rawat D.S. (2019). Students’ Guide to Financial Reporting with
Applicable Ind ASs (CA-Final). Taxman.

E-REFERENCES
 Indian Accounting Standards (Ind AS): An Overview (revised
2019). https://resource.cdn.icai.org/55845indas45234a.pdf
 IFRS Pocket Guide 2013.
http://taxclubindia.com/simple/2013-14/IFRS% 2BPocket
%2BGuide_2013_PWC.pdf
 The Institute of Chartered Accountants of India (2019). Indian
Accounting Standards (IND AS): An Overview (Revised 2019).
https://resource.cdn. icai.org/55845indas45234a.pdf
 Advanced Corporate Accounting.
http://www.universityofcalicut.info/
SDE/advanced_corporate_accounting_on13April2016.pdf

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Chapter 5_Financial Reporting Standards I.indd 92 5/14/2020 3:40:12 PM
 C H
6
A P T E R

FINANCIAL REPORTING STANDARDS II

CONTENTS

6. Generally Accepted Accounting

1
Principles Self-Assessment
Questions
6.
International Financial Reporting Standards
2 6.2.
1 Advantages of Adopting IFRS
Self-Assessment Questions
6.2. Indian Accounting Standards
2 Comparisons of Indian GAAP, IFRS and Ind
6.2. AS Self-Assessment Question
3
Summary
6.
3 Key Words
Descriptive
6. Questions Answer
4 Key
6. Self-Assessment Questions
5 Suggested Books and E-
References
6.
6

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94 FINANCIAL ACCOUNTING AND ANALYSIS

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the concept of generally accepted accounting princi- ples (G
Understand the structure of International Financial Reporting Standards
> Understand the key differences between Indian GAAP, IFRS and Indian A

>

6. GENERALLY ACCEPTED
1 ACCOUNTING PRINCIPLES
Generally accepted accounting principles (GAAP) are a set of
! IMPORTANT CONCEPT conventions, rules and procedures that define the accepted
accounting practice at a par- ticular time. These result from a broad
Generally accepted accounting principles (GAAP) are a set of
agreement onconventions,
the theory rulesand
and procedures
practice ofthataccounting
define the accepted
at a accounting
particularpractice at a pa
time. These principles are “generally accepted” because an
authoritative body has set them or the accounting profession widely
accepts them as appropriate. The purpose of GAAP is to ensure that
the information provided in the financial statements is reliable and
under- standable to the users. The users should be able to
meaningfully compare the current performance of a business entity
with its past performance and the performance of other business
entities. The GAAP keep changing from time to time as the
circumstances or the information needs of the users change.
In India, the sources of GAAP include the Companies Act, 2013, Indian
accounting standards and the pronouncements of the accounting
profession. Companies can also voluntarily adopt International
Financial Reporting Standards (IFRS) for financial reporting.

SELF-ASSESSMENT QUESTIONS
1. GAAP stands for
a. generally accepted accounting principles
b. generally agreed accounting protocols
c. general accounting accreditation pool
d. generally accepted accounting protocols
2. IFRS stands for
a. Indian Financial Reporting Standards
b. International Fund Reporting Standards
c. International Financial Reporting Standards
d. Indian Financial Reportage Standards

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FINANCIAL REPORTING STANDARDS II 95

INTERNATIONAL FINANCIAL REPORTING

6. STANDARDS
2
As the business world becomes closer in its financial and trade ties,
many countries are moving towards International Financial Reporting
Standards (IFRS). IFRS are common accounting rules for financial
reporting. IFRS comprise the following:
1. Two series of standards – those explicitly called International
Financial Reporting Standards and the older series of NOTE
International Accounting Standards (IAS) and
IFRS are common accounting
2. Two series of interpretations – those issued by the former rules for financial reporting.
Standing Interpretations Committee (SIC) and those issued by
the existing International Financial Reporting Interpretations
Committee (IFRIC) of the International Accounting Standards
Board.

6.2.1 ADVANTAGES OF ADOPTING IFRS STUDY HINT

International Financial Reporting Standards (IFR
Adoption of IFRS has many advantages. Investors can compare
financial statements of companies located in different countries and
decide where to invest money. It becomes easier for companies to
raise money outside their home country and for countries to attract
foreign investment. As IFRS are principle-based rather than rule-
based, these can be adapted to specific business conditions in a
country.

3. IFRS are common accounting rules for

a. marketing budget
b. financial reporting
c. Indian firms
d. BSE and NSE
4. Based on which among the followings, investors can
compare financial statements of companies located in
different countries and decide where to invest money?
a. Ind AS
b. ICAI rules
c. Indian GAAP
SELF-ASSESSMENT QUESTIONS
d. IFRS

QUICK TIP
Indian Accounting
6.2.2 INDIAN ACCOUNTING STANDARDS
Standard (abbreviated
IFRS has many advantages, and hence many countries have adopted as Ind-AS) is the
it as their national standard. India has decided to converge its Accounting standard
accounting stan- dards with IFRS instead of adopting IFRS. In a move adopted by companies
towards convergence with IFRS, in 2007 the ICAI commenced the in India and
process of developing a com- plete set of accounting standards that issued under the supervision
are “converged with” IFRS. These of Accounting Standards Board
(ASB) which was constituted as
a body in the year 1977.

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96 FINANCIAL ACCOUNTING AND ANALYSIS

are known as Indian Accounting Standards or Ind AS. Ind AS have

certain modifications to IFRS to reflect “Indian conditions”.

6.2.3 COMPARISONS OF INDIAN GAAP, IFRS AND IND AS

NOTE
Ind AS norms are converged with the IFRS, but those are not IFRS-
Indian GAAP differs from
equivalent. Further, some companies in India will follow the old
accounting principles and
accounting standards (Indian GAAP), while others follow Ind AS. It
auditing standards with which
would be of interest to see the key differences between the
prospective investors may be
requirements of Indian GAAP, IFRS and Ind AS. These differences in
familiar in other countries,
respect of some important types of account- ing transactions and
such as U.S. GAAP and IFRS.
events are presented in Table 6.1.

5. Instead of adopting, India has decided to converge its

accounting standards with
a. IFRS
b. ICAI rules
SELF-ASSESSMENT QUESTION c. International Accounting Standards (IAS)
d. International Accounting Standards Board (IASB)

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Chapter 6_Financial Reporting Standards II.indd

TABLE 6.1 COMPARISON OF INDIAN GAAP, IFRS AND IND AS

Presentation
of Financial
Statements Indian GAAP IFRS Ind AS
Component The requirements for the A complete set of financial A complete set of financial
s of presentation of financial statements comprises of a statements under Ind AS 1
financial statements are set out in Statutes statement of financial comprises of a balance sheet
statements that govern the entity. For position, a statement of at the end of the period
instance, comprehensive income, a (including statement of
Schedule VI to the Companies statement of changes in changes in equity which is
Act sets out financial equity, a statement of cash presented as a part of the
statement flows and notes to the balance sheet), statement of
financial profit and loss, a statement of
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requirements in case of
companies; Schedule III to the statements including summary cash flows and notes including
Banking Regulation Act, 1949 (for of accounting policies. summary
banks) sets out financial of accounting policies and
statement requirements in case other explanatory information.
of banks.
Formats Schedule VI prescribes
Only illustrative formats Ind AS 1 does not include
mandatory formats for
for presentation of any illustrative formats for
presentation of balance sheet
financial statements have the presentation of
and statement of profit and
been given. financial statements
loss. However, the same stand
though Ind AS 27
modified, if any change is
does set out the form in which

FINANCIAL REPORTING STANDARDS II

required for compliance with
consolidated financial
the
statements are to be
requirements of the Companies
presented.
Act including Accounting
Standards.
Definition Financial statements should Omissions or misstatements Similar to IFRS.
of disclose all “material” items, the are material if individually or
“material” knowledge of which might collectively they could
influence the decisions of the influence the economic
user of the financial statements. decisions that users take on
the basis of financial
statements. (Continued
)
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Chapter 6_Financial Reporting Standards II.indd

9
FINANCIAL ACCOUNTING AND ANALYSIS
TABLE 6.1 COMPARISON OF INDIAN GAAP, IFRS AND IND AS—CONTINUED
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Presentation
of Financial
Statements Indian GAAP IFRS Ind AS
Extraordinar Extraordinary items are disclosed Entities are not permitted to Similar to IFRS.
y items separately in the statement of present any item of income or
profit and loss and are included in expense as extraordinary.
the determination of the net profit
or loss for the period.
Statement of A statement of changes in equity A statement of changes in A statement of changes in
changes in is not required. equity is presented showing: equity is presented as part of
equity Movements in share capital, (a) the total comprehensive the balance sheet. The
retained earnings and other income for the period, (b) statement of changes in equity
reserves are to be presented in effects of retrospective contains information which is
the notes to accounts. application or restatement of similar to that under IFRS.
each component of equity, (c)
for each component of equity,
a reconciliation between
opening and closing balances,
separately disclosing changes
resulting from:
(i) profit or loss, (ii) each item
of other comprehensive
income and
(iii) transactions with owners in
their capacity as owners,
showing separately
contributions by and
distributions to owners and
changes in ownership interests
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in subsidiaries that do not

result in a loss of control.
Chapter 6_Financial Reporting Standards II.indd

TABLE 6.1 COMPARISON OF INDIAN GAAP, IFRS AND IND AS—CONTINUED

Presentation
of Financial
Statements Indian GAAP IFRS Ind AS
Capital AS 1 does not require an entity to Requires disclosure of Similar to IFRS.
disclose information that enables information about the
users of its financial statements to management of capital and
evaluate the entity’s objectives, compliance with capital
policies and processes of managing requirements.
capital.
Change in Requires retrospective Changes in depreciation Similar to IFRS.
the method re-computation of method are considered as
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of depreciation. Any excess or change in accounting

depreciation deficit on such re- estimate, and applied
computation is required to be prospectively.
adjusted in the period in which such
change is effected. Such a change
is treated as
a change in accounting policy and
its effect is quantified and disclosed.
Revenue Indian GAAP IFRS Ind AS
Definition Revenue is the gross inflow of Revenue is the gross inflow of Similar to IFRS.
cash, economic benefits during the
receivables or other consideration period arising in the course of

FINANCIAL REPORTING STANDARDS II

arising in the course of ordinary ordinary activities of an entity
activities from the sale of goods, when these inflows result in
from the rendering of services, increases in equity, other than
and use by others of enterprise increases relating to
resources yielding interest, royalty contributions from equity
and dividends. participants.
On AS 30 becoming effective,
there will be no difference (Continued
between AS 9 and IAS 18. )
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Chapter 6_Financial Reporting Standards II.indd

1
FINANCIAL ACCOUNTING AND ANALYSIS
TABLE 6.1 COMPARISON OF INDIAN GAAP, IFRS AND IND AS—CONTINUED
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Revenue Indian GAAP IFRS Ind AS

Measurement Revenue is recognized at the Fair value of revenue from Similar to IFRS.
nominal sale of goods and services
amount of consideration when the inflow of cash
receivable. and cash equivalents is
On AS 30 becoming effective, deferred is determined by
there will be no difference discounting all
between AS 9 and IAS 18. future receipts using an
implied rate of interest. The
difference between the value
and nominal amount of
consideration is recognized
as interest income using the
effective interest method. Similar to IFRS.
Fair value of services
Services rendered No specific guidance in AS 9. provided is measured with
However, the Guidance Note on reference to non-barter
Accounting for Dot.com transactions that occur
companies provides guidance for frequently, representing a
advertising barter transactions substantial number of
which is similar to IFRS. transactions. Consideration
involves cash or other securities
that has a reliable measure of
fair value and do not involve
transactions with the
same counterpart to the
barter transaction.
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Chapter 6_Financial Reporting Standards II.indd

TABLE 6.1 COMPARISON OF INDIAN GAAP, IFRS AND IND AS—CONTINUED

Related Party
Disclosures Indian GAAP IFRS Ind AS
Items to Generally disclosed in aggregate. The amount of transactions Similar to IFRS.
be with related parties and the
Disclosure of the volume of
disclosed amount of outstanding
transactions with related parties,
either as an amount or as an balances including
appropriate proportion and commitments.
amounts or appropriate proportions
of outstanding items.

Earnings Per Share

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Indian GAAP IFRS Ind AS

Extraordinar EPS with and without There is no concept Similar to IFRS.
y items extraordinary items should be of extraordinary
presented. item.

Mandatorily No specific requirement. Ordinary shares to be Similar to IFRS.

convertible issued on conversion of a
instrument mandatorily
convertible instrument are
included in the calculation of
basic EPS from the date the
contract is entered into.

FINANCIAL REPORTING STANDARDS II

Segments Indian GAAP IFRS Ind AS
Determination Requires an enterprise to Operating segments are Similar to IFRS.
of segments identify two sets of segments identified based on the
(business and financial information that is
geographical), using risks and regularly reviewed by the chief
rewards approach, with the operating decision maker in
enterprise’s system of internal deciding how to allocate
financial reporting to key resources and in assessing
management personnel serving performance.
only as the starting point for the
identification of such segments.

1
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102 FINANCIAL ACCOUNTING AND ANALYSIS

6. SUMMARY
 Understand the concept of GAAP. Generally accepted accounting
principles (GAAP) are a set of conventions, rules and procedures
that define the accepted accounting practice at a particular time.
 Understand the structure of International Financial Reporting
Standards (IFRS) and advantages of adopting them. IFRS comprise
two series of standards and two series of interpretations. By
adopt- ing IFRS, investors can compare financial statements
of companies located in different countries and decide where
to invest money.
 Understand the key differences between Indian GAAP, IFRS and Ind
AS with respect to important accounting transactions and events.
Ind AS are more or less converged with IFRS. There are major
differ- ences in the Indian GAAP and the Ind AS with respect to
the presenta- tion of financial statements, inventory
accounting, presentation of cash flows, revenue recognition,
etc.

1. GAAP or generally accepted accounting principles are a

set of conventions, rules and procedures that define the
accepted accounting practice at a particular time.

KEY WORDS 2. IFRS are common accounting rules for financial reporting
developed by International Accounting Standards Board
(IASB).

6. DESCRIPTIVE QUESTIONS
1. Explain the term ‘Generally Accepted Accounting Principles’.
2. What all is included in ‘International Financial Reporting
Standards (IFRS)’?
3. What advantages can companies derive by adopting IFRS?
4. How is convergence with accounting standards different from
adoption of accounting standards?

6. ANSWER KEY
SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Generally Accepted 1. a. generally accepted accounting
Accounting Principles principles
2. c. International Financial
Reporting Standards
International Financial 3. b. financial reporting
Reporting Standards
4. d. IFRS
5. a. IFRS

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FINANCIAL REPORTING STANDARDS II 103

6. SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Sekar G., Saravana Prasath B. (2018). Padhuka’s Students’
Guide on Financial Reporting (For CA Final New Syllabus). 13th
Edition, Wolters Kluwer India Pvt. Ltd.
 Welkins S.K. (2019). Financial Reporting Made Easy. Bharat Law
House Pvt. Ltd.

E-REFERENCES
 The Institute of Chartered Accountants of India (2019). Indian
Accounting Standards (IND AS): An Overview (Revised 2019).
https://resource.cdn. icai.org/55845indas45234a.pdf
 Advanced Corporate Accounting.
http://www.universityofcalicut.info/
SDE/advanced_corporate_accounting_on13April2016.pdf

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Chapter 6_Financial Reporting Standards II.indd 104 5/14/2020 3:42:33 PM
 C H
7
A P T E R

CORPORATE FINANCIAL STATEMENTS

CONTENTS

7.1 2
7.2
7.3
7.3. 7.8.1
1
7.4 7.3. 7.9.1
2

7.4.
7.5 1
7.4.
2

7.6
7.5.
1
7.5.
2

7.7 7.6.
1
7.6.
2
7.8 7.6.
3
7.6.
7.9
4
7.6.
5

7.7.
1
7.7.

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Introduction t ity
B a Equity Share Capital
o t Preference Shares
o e Self-Assessment
k m Question Other Equity
s e Share Application Money Pending
n Allotment Capital Reserve
o t Securities Premium
f s Reserve Retained
Co Earnings Revaluation
A nso Surplus
c lida Liabilities
c ted Non-Current
o Fin Liabilities Current
u anc Liabilities
n ial Self-Assessment Questions
t Sta Contingent Liabilities and
s te Commitments
me Statement of Profit and
t nts Loss Revenue from Operations
o Sta Revenue Recognition
te Activity
b me
e nt
of
K Ch
e ang
p es
t in
Eq
b uit
y y
A
a s
s
e
C t
o s
m No
p n-
a Cur
n ren
y t
Ass
F ets
i Cur
n ren
a t
n Ass
c ets
i Act
a ivit
l y
E
S q
u
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7.10 Other
Income
Activity
7.11 Expenses
7.11.1 Cost of Materials Consumed
7.11.2 Purchases of Stock-in-Trade
7.11.3 Changes in Inventories of Finished Goods, Work-in-Progress
and Stock-in-Trade
7.11.4 Employee Benefits Expense
7.11.5 Finance Costs
7.11.6 Depreciation and Amortization
Expenses Activity
7.11.7 Other Expenses
7.12 Profit Before Exceptional Items and Tax
7.13 Exceptional
Items
Activity
7.14 Tax Expense
7.15 Profit (Loss) for the Period from Continuing Operations
7.16 Discontinued Operations
7.17 Profit (Loss) for the Period
7.18 Other Comprehensive
Income Activity
7.19 Earnings per Share
7.19.1 Basic Earnings per Share
7.19.2 Diluted Earnings per Share
7.20 Income Taxes
7.20.1 Advance Tax
7.20.2 Provision for Tax
7.21 Dividend
7.21.1 Interim Dividend
7.21.2 Final Dividend
7.21.3 Accounting Treatment of Dividends
7.22 Summary
Key Words
7.23 Descriptive Questions
7.24 Answer Key
Self-Assessment Questions
7.25 Suggested Books and E-References

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CORPORATE FINANCIAL STATEMENTS107

INTRODUCTORY CASELET

MODERN
Ashok and COFFEE
Ramesh of HOUSE
Modern Coffee House desired to have a
nation- wide presence of the coffee house. They knew that they
will need large financial resources to do so and that the present
form of their business organization, i.e., partnership, was not
suitable for carrying out large- scale business. They could not
garner money from public at large for their business and at the
same time they had unlimited liability for busi- ness debts.
They decided to convert their partnership firm into a limited
company. They would have access to public money, their liability
for business debts would be limited and they could freely transfer
their shares. However, the company will have to comply with
strict regulatory requirements relating to governance and
financial reporting.

QUESTION

1. What is the implication of unlimited liability for partners

in a partnership firm? (Hint: Personal assets of partners
can also be used to satisfy the liabilities of the

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108 FINANCIAL ACCOUNTING AND ANALYSIS

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Explain the books of account companies are required to keep and the fin
Explain the form and contents of corporate financial statements. Prepare
>
>

7. INTRODUCTION
There is no fundamental difference in the manner in which financial
state- ments are prepared by companies and non-company entities,
such as sole owners and partnerships. All entities follow the same
basic principles. Some special features of company financial
statements are as follows:
1. Companies have to follow the requirements of the Companies
Act and other applicable laws in preparing their financial
statements.
2. Financial statements of companies are published for use by
interested parties; these are public documents.
3. Financial statements of companies carry comparative figures of
the previous accounting period.
This chapter explains the statutory provisions relating to the books of
accounts to be maintained by companies; form and contents of
financial statements (balance sheet and statement of profit and loss);
and year-end accounting adjustment entries, some of which are
specifically applicable to companies. Many solved problems are
provided to facilitate understanding. The statement of cash flow is
covered in Chapter 9.

7. BOOKS OF ACCOUNTS TO BE KEPT

2 BY A COMPANY
Section 128(1) of the Companies Act, 2013 requires every company
to prepare and keep at its registered office books of account and
other relevant books and papers and financial statements for every
financial year, which give a true and fair view of the state of affairs of
the company, including that of its branch office or offices, if any, and
explain the transactions effected both at the registered office and its
branches. Such books shall be kept on an accrual basis and according
to the double entry system of accounting.
According to Section 2(13) of the Companies Act, 2013, “books of
account” include records maintained in respect of:
1. all sums of money received and expended by a company and
matters in relation to which the receipts and expenditure take
place;
2. all sales and purchases of goods and services by the company;
3. assets and liabilities of the company; and

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CORPORATE FINANCIAL STATEMENTS109

4. the items of cost as may be prescribed under Section 148 in the

case of a company which belongs to any class of companies
specified under that section.

7. FINANCIAL STATEMENTS
Section 129 of the Companies Act, 2013 requires that at every annual
general meeting of a company, the Board of Directors of the company
shall lay before such meeting the financial statements for the
financial year.
According to Ind AS 1 Presentation of Financial Statements, a
complete set of financial statements comprises:
1. a balance sheet as on the end of the period;
2. a statement of profit and loss for the period;
3. statement of changes in equity for the period;
4. a statement of cash flows for the period;
5. notes, comprising a summary of significant accounting policies
and other explanatory information;
6. comparative information in respect of the preceding period; and
7. a balance sheet as on the beginning of the preceding period if
the company has applied an accounting policy retrospectively,
or made a retrospective restatement of items in its financial
statements, or has reclassified items in its financial statements.
Section 129 of the Companies Act, 2013 further requires that the
financial statements shall give a true and fair view of the state of
affairs of the com- pany or companies, comply with the accounting
standards notified under Section 133 and shall be in the form or
forms as may be provided for different class or classes of companies
in Schedule III.
QUICK TIP
7.3.1 CONSOLIDATED FINANCIAL STATEMENTS Consolidated financial
Where a company has one or more subsidiaries, it shall also prepare statements are required to
a consol- idated financial statement of the company and of all the be prepared by a company if
subsidiaries. Where a company is required to prepare Consolidated it has one or more subsidiary
Financial Statements, that is, consolidated balance sheet, companies.
consolidated statement of changes in equity and consolidated
statement of profit and loss, the company shall follow the same
requirements of Schedule III as are applicable to a company in the
prepara- tion of balance sheet, statement of changes in equity and
statement of profit and loss.

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110 FINANCIAL ACCOUNTING AND ANALYSIS

Schedule III of the Companies Act, 2013 which provides the form of Financial
Statements is given as follows:
Schedule III
Part I – Balance Sheet

Name of the Company Balance Sheet as on

(Rupees in )

Figures as on the Figures as on the

end of the current end of the previous
Particulars Note No. reporting period reporting period
1 2 3 4
Assets
Non-current assets
Property, plant and equipment
Capital work-in-progress
Investment property
Goodwill
Other intangible assets
Intangible assets under development
Financial assets
Investments
Trade receivables
Loans
Others (to be specified)
Deferred tax assets (net)
Other non-current assets
Current assets
Inventories
Financial assets
Investments
Trade receivables
Cash and cash equivalents
Bank balances other than (iii) above
Loans
Others (to be specified)

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CORPORATE FINANCIAL STATEMENTS111

(c) Current tax assets (net)

(d) Other current assets
Total Assets
Equity and Liabilities

Equity
(a) Equity share capital
(b) Other equity
Liabilities
1. Non-current liabilities
(a) Financial liabilities
(i) Borrowings
(ii) Trade payables
(iii) Other financial liabilities (other than those specified in
item (b), to be specified)
(b) Provisions
(c) Deferred tax liabilities (net)
(d) Other non-current liabilities
2. Current liabilities
(a) Financial liabilities
(i) Borrowings
(ii) Trade payables
(iii) Other financial liabilities (other than those specified
in item (c))
(b) Other current liabilities
(c) Provisions
(d) Current tax liabilities (net)
Total Equity and Liabilities

For reference, the balance sheet of Asian Paints as on March 31,

2017 is presented in Exhibit 7.1.

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 Balance sheet of Asian nts Ltd. on March 31, 7
Pai as 201
pees in Millions)
(Ru
As on
As on 31.03.2016
Notes 31.03.2017
Assets
Non-Current Assets
Property, plant and
equipment 2 25,120.1 25,329.7
Capital work-in-progress 2,197.6 927.
9
Goodwill 3A 353.6 353.
6
Other intangible assets 3B 573.1 606.
6
Financial Assets
Investments 4 14,545.5 13,196.4
Loans 5 702.7 610.
7
Others Financial Assets 6 1980.5 305.
4
Current tax assets (Net) 7 364.8 151.
5
Other non-current 8 2003.9 350.
assets 1
47,841.8 41,831.9
Current Assets
Inventories 9 21,940.9 1,610.12
Financial assets
Investments 4 13,154.0 1,477.00
Trade receivables 10 9,946.3 759.06
Cash and cash 11A 613.4 76.75
equivalents
Other balances with 11B 1,439.3 84.03
banks
Loans 5 135.5 9.65
Other financial assets 6 4,744.3 306.27
Assets classified as held
for sale 12 5.7 0.96
Other current assets 8 2319.4 217.92
54,298.8 45,417.6
Total Assets 102,140.6 87,249.5

Equity and Liabilities

EXHIBIT 7.1
Equity
Equity share capital 13 959.2 959.

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CORPORATE FINANCIAL STATEMENTS113

As on As on
Notes 31.03.2017 31.03.2016
Liabilities
Non-Current Liabilities
Financial liabilities
Borrowings 15 103.8 292.7
Other financial 16 23.1 16.8
liabilities
Provisions 17 1,098.4 942.3
Deferred tax liabilities 18C 2,611.7 2,171.7
(Net)
Other non-current 19 36.5 18.2
liabilities
3,873.5 3441.7
Current Liabilities
Financial liabilities
Borrowings 15 268.3 —
Trade payables
Due to micro
and small 20 265.9 179.5
enterprises
Due to others 20 16,446.7 13,152.0
Other financial 16 8,798.0 8,234.7
liabilities
Other current liabilities 19 2,063.2 1,982.3
Provisions 17 362.00 363.5
Current tax liabilities 21 553.2 638.00
(Net)
28,757.3 24,550.5
Total Equity and 102,140.6 87,249.5
Liabilities

(Sourc Asian Paints al Report 2016–

7.3.2 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity is prepared in two parts. Part A
depicts the changes in equity share capital and part B depicts
changes in other equity.

Statement of Changes in
Equity

Name of the Company

Statement of changes in Equity for the period ended
(Rupees in )

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A. Equity Share Capita l

Balance at the Changes in Equity
Beginning of the Share Capital during Balance at the end of
Reporting Period the Year the Reporting Period

The statement of changes in equity share capital of Asian Paints

Limited is presented in Exhibit 7.2.

Statement of Changes in Equity Share Capital of Asian Paints Ltd. for

the Year ended 31st March, 2017
(Rupees in Millions)
Equity Share Capital As on 31.03.2017 As on 31.03.2016
Balance at the beginning of 959.2 959.2
the reporting year
Changes in equity share capital — —
during the year
Balance at the end of 959.2 959.2
EXHIBIT 7.2 the reporting year

Part B of the statement of changes in equity requires the following

informa- tion to be presented.
Each component of the balance sheet is discussed in detail in the
following sections.

7. ASSETS
QUICK TIP Assets are economic resources controlled by an entity whose cost (or
An economic resource is a fair value) at the time of acquisition could be objectively measured. A
resource that provides future resource is an economic resource if it provides future cash flows to
cash flows to the entity. the entity. An asset can be: (i) cash or something convertible into
cash (e.g. accounts receivable),
(ii) goods expected to be sold and cash received from them and (iii)
items to be used in future activities that will generate cash flows.
A basic classification of assets is between current assets and non-
current assets. An asset is classified as current when it satisfies any of
the following criteria:
1. It is expected to be realized in, or is intended for sale or
consumption in, the company’s normal operating cycle. An
operating cycle is the time between the acquisition of assets for
processing and their realization in cash or cash equivalents.
Where the normal operating cycle cannot be identified, it is
assumed to have duration of 12 months.
2. It is held primarily for the purpose of being traded.

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3. It is expected to be realized within 12 months after the reporting date.

4. It is cash or cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least 12 months
after the reporting date.
All other assets are classified as non-current.

7.4.1 NON-CURRENT ASSETS

Non-current assets are further classified as:
1. Property, plant and equipment
2. Capital work-in-progress
3. Investment property
4. Goodwill
5. Other intangible assets
6. Financial assets
(a) Investments
(b) Trade receivables
(c) Loans
(d) Others (to be specified)
7. Deferred tax assets (net)
8. Other non-current assets

PROPERTY, PLANT AND EQUIPMENT

Ind AS 16 defines property, plant and equipment as tangible items that
(i) are held for use in the production or supply of goods or services,
for rental to others, or for administrative purposes and (ii) are
expected to be used during more than one period.
The following classification is required to be given in respect of
property, plant and equipment
1. Land
2. Buildings
3. Plant and equipment
4. Furniture and fixtures
5. Vehicles
6. Office equipment
7. Others (specify nature)
Any item of property, plant and equipment that is held under lease by a
com- pany needs to be separately specified. Companies are also
required to show a reconciliation of the gross and net carrying amounts
of each class of assets at the beginning and end of the reporting period
showing additions, disposals, acquisi- tions through business
combinations and other adjustments. Depreciation and impairment
losses/reversals related to these assets are to be disclosed separately.
If a company reduces the value of assets on a reduction of its capital
or increases the value of assets on revaluation of assets, the
company will have
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to show the reduced or increased figure and also the amount and
date of the reduction or increase in every balance sheet for the first 5
years subsequent to the date of such reduction or increase.

CAPITAL WORK-IN-PROGRESS
Capital work-in-progress is the amount invested in constructing a
tangible non-current asset that is not yet complete and ready for its
intended use. Amounts paid as advance to suppliers of such assets
also fall under this head.

INVESTMENT PROPERTY
Investment property is that property that is held by a company for
long-term rental income or capital appreciation or both and that is
not occupied by the group. Companies are required to show a
reconciliation of the gross and net carrying amounts of each class of
property at the beginning and end of the reporting period showing
additions, disposals, acquisitions through busi- ness combinations,
and other adjustments and the related depreciation and impairment
losses or reversals shall be disclosed separately.

GOODWILL
Companies are also required to show a reconciliation of the gross and
net carrying amount of goodwill at the beginning and end of the
reporting period showing additions, impairments, disposals and other
adjustments.

OTHER INTANGIBLE ASSETS

Other intangible assets are shown under the following classification:
1. Brands/trademarks
2. Computer software
3. Mastheads and publishing titles
4. Mining rights
5. Copyrights, patents and other intellectual property rights,
services and operating rights
6. Recipes, formulae, models, designs and prototypes
7. Licenses and franchise
8. Others (specifying nature)
In a manner similar to that for tangible assets, companies are
required to show reconciliation of gross and net carrying amount at
the beginning and end of reporting period for each class of other
intangible assets. The reconcil- iation should show additions,
disposals, acquisitions through business com- binations and other
adjustments. The related amortization and impairment losses or
reversals need to be disclosed separately.
Provisions relating to disclosure of reduction or increase pursuant to
reduc- tion of capital or revaluation of assets are similar to those for
tangible assets.

FINANCIAL ASSETS
According to Ind AS 32 Financial Instruments: Presentation, a
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financial asset is any asset that is:

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CORPORATE FINANCIAL STATEMENTS117

1. Cash or,
2. An equity instrument of another entity or,
3. A contractual right: (i) to receive cash or another financial asset
from another entity; or (ii) to exchange financial assets or
financial liabilities with another entity under conditions that are
potentially favorable to the entity.
Financial assets are further classified as:
1. Investments
2. Trade receivables
3. Loans
4. Others (to be specified)

INVESTMENTS

Investments are amounts of money invested outside the business in

stocks, other securities, firms, subsidiary companies and other assets.
Non-current invest- ments are long term in nature and are not expected
to be sold within a year.
These are required to be classified as:
1. Investments in Equity Instruments;
2. Investments in Preference Shares;
3. Investments in Government or trust securities;
4. Investments in debentures or bonds;
5. Investments in Mutual Funds;
6. Investments in partnership firms; or
7. Other investments (specify nature).

TRADE RECEIVABLES

A receivable is classified as a trade receivable if it is in respect of the

amount due on account of goods sold or services rendered in the
normal course of business.
Trade receivables are required to be further classified as:
1. Secured, considered good;
2. Unsecured considered good; and
3. Doubtful.

LOANS

Loans include loans extended by a company to its officers, directors

or out- side parties.
Loans are required to be further classified as:
1. Security deposits,
2. Loans to related parties (giving details thereof), and
3. Other loans (specifying their nature).

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Further sub-classification of the above types of loans is required as:

1. Secured, considered good,
2. Unsecured, considered good, and
3. Doubtful.

OTHER FINANCIAL ASSETS

Some examples of other financial assets are:

1. Bank deposits with more than 12 months of original maturity
2. Subsidy receivable from government
3. Term deposits kept as margin money by the bank against
guarantees given by the bank
4. Cash and bank balances not available for immediate use, for
example, balance in the account representing unpaid dividend

DEFERRED TAX ASSETS

Deferred tax assets and deferred tax liabilities are netted off against
each other. An amount against deferred tax assets will appear in the
balance sheet when the amount of deferred tax assets exceed the
amount of deferred tax liabilities.

OTHER NON-CURRENT ASSETS

Other non-current assets are required to be classified as:

1. Capital advances and
2. Advances other than capital advances.
Capital advances are moneys given as advance for procurement of
non- current assets and the company does not expect to realize these
in the next 12 months or within the normal operating cycle.
Advances other than capital advances should be further classified as:
1. Security deposits,
2. Advances to related parties (giving details thereof) and
3. Other advances (specifying nature).
Examples of advances other than capital advances include security
deposits with port, customs and other statutory authorities.
NOTE
Any asset that does not meet
the requirements of the 7.4.2 CURRENT ASSETS
definition of current asset is Current assets are liquid assets of the company that are held either
treated as non-current asset. in the form of cash or can be easily converted into cash within one
accounting period, usually a year. Schedule III of the Companies Act,
2013 classifies current assets in the following manner:
1. Inventories
2. Financial Assets
(a) Investments
(b) Trade receivables

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CORPORATE FINANCIAL STATEMENTS119

(c) Cash and cash equivalents

(d) Bank balances other than (c) above
(e) Loans
(f) Others (to be specified)
4. Other current assets
3. Current tax assets
! IMPORTANT
Bank deposits CONCEPT
having a maturity up to 12 mont
INVENTORIES treated as non-current asset.

Inventories are assets held for sale in the ordinary course of business;
in the process of production for such sale; or in the form of materials
or supplies to be consumed in the production process or in the
rendering of services. Inventories encompass goods purchased and
held for resale; for example, merchandise purchased by a retailer and
held for resale, computer software held for resale, or land and other
property held for resale. Inventories also encompass finished goods
produced, or work in progress being produced by the enterprise
and include materials, maintenance supplies, consumables and loose
tools awaiting use in the production process.
The schedule of inventories appearing in the annual report of Asian
Paints for the year 2016–17 is reproduced in Exhibit 7.3.

EXHIBIT 7.3
Inventories of Asian Paints as on March 31, 2017
Rs. in Millions
Inventories As on As on
(at lower of cost and net realizable March 31, March 31,
value) 2017 2016
(a) Raw materials 5,167.8 4,551.1
Raw materials-in-transit 811.6 792.3
5,979.4 5,343.4
(b) Packing materials 363.2 401.3
(c) Work-in-progress 748.0 664.7
(d) Finished goods 12,315.0 7,759.9
Finished goods-in-transit 18.0 24.2
12,333.0 7,784.1
(e) Stock-in-trade (acquired for 1,824.1 1,345.2
trading)
Stock-in-trade (acquired for trading) 29.7 5.0
1,853.8 1,350.2
(f) Stores, spares and consumables 661.0 577.5
Stores, spares and consumables in 2.5 —
transit
663.5 577.5
Total 21,940.9 16,101.2

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120 FINANCIAL ACCOUNTING AND ANALYSIS

INVESTMENTS
Current investments are short-term securities that are easily
convertible into cash. Companies usually invest liquid assets in
excess of transaction cash needs in such securities to generate better
returns. In a company’s balance sheet, current investments are
required to be classified as:
1. Investments in equity instruments
2. Investment in preference shares
3. Investments in government or trust securities
4. Investments in debentures or bonds
5. Investments in mutual funds
6. Investments in partnership firms
7. Other investments (specify nature)

TRADE RECEIVABLES
Trade receivables are required to be further classified as:
1. Secured, considered good;
2. Unsecured considered good; and
3. Doubtful.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents include cash in hand, cheques and drafts
in hand pending their deposit in the bank account, and balance in
bank accounts (current accounts and time deposit accounts).

LOANS
Loans are required to be further classified as:
1. Security deposits;
2. Loans to related parties (giving details thereof) and
3. Other loans (specifying their nature).
Further sub-classification of the above types of loans is required as:
1. Secured, considered good;
2. Unsecured, considered good; and
3. Doubtful.

OTHER CURRENT ASSETS

This is an all-inclusive heading, which incorporates current assets that
do not fit into any other asset categories. Other current assets are to
be classified as:
1. Advances to suppliers
2. Advances to employees
3. Export benefits receivable
4. Prepaid expenses

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CORPORATE FINANCIAL STATEMENTS121

State the classification of financial assets to be provided according ACTIVITY 1

to Schedule III of the Companies Act, 2013.

7. EQUITY
Equity generally refers to the amount invested in an enterprise by the
owners (shareholders). These are also used to refer to the claim of
owners to the assets of an enterprise. The claims of owners to assets
are secondary to those of creditors and lenders. These are also called
the residual claims as owners get only what is left after all obligations
to outsiders have been paid. Changes in equity occur when (i) new
shares are issued by the company or existing shares are bought back
and (ii) the business earns income from profitable operations or
incurs losses from unprofitable operations of business. Equity is
divided into two parts: equity share capital and other equity.

7.5.1 EQUITY SHARE CAPITAL

The capital of a company is divided into small units called shares. QUICK TIP
Companies can have two classes of share capital, equity share capital
and preference share capital. Equity shares or ordinary shares are Bonus shares are shares
the basic types of equity shares. These shares have the usual rights that are allotted to existing
of ownership: right to vote, right to receive dividend and a residual shareholders without any
claim on the assets of the company in the case of liquidation. consideration being received
in cash.
7.5.2 PREFERENCE SHARES
Preference shares have a preference over equity shares in the matter
of payment of dividend and repayment of capital at the time of
liquidation. Preference shares are entitled to a fixed rate of dividend ! IMPORTANT CONCEPT
and normally do not carry any voting rights. The holders of A company generally decides to buy back its
preference shares do not have a guarantee that they will receive the the company has surplus cash.
fixed dividend. It is only when the board of directors declare a
dividend that the company has an obligation to pay dividend to its
shareholders. In such a case, dividend is first paid to holders of
preference shares.

AUTHORIZED SHARE CAPITAL

Authorized share capital is the value of shares that the company is
authorized to issue by its Memorandum of Association. The
companies are governed by the provisions of their constitution
which is known as Memorandum of Association. Authorized capital is
the maximum capital which a company can issue without altering the
capital clause of the Memorandum of Association for an increase in
its authorized capital.

ISSUED, SUBSCRIBED AND PAID-UP CAPITAL

NOTE
Issued capital is the nominal or face value of shares which are offered Shares are said to be issued
by the company to the public for subscription. It cannot be more than at a premium when these are
the autho- rized capital. Subscribed capital is the nominal value of
issued at a price higher than
shares taken up by the public. Subscribed capital is equal to issued
their par value.
capital if all the shares offered to the public are taken up by the
public. That part of the subscribed capital that has been called up by
the company is called called-up capital. Paid-up capital
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122 FINANCIAL ACCOUNTING AND ANALYSIS

is that part of the called-up capital which has been paid up by the
sharehold- ers. If all the called-up capital has been received, paid-up
capital is equal to the called-up capital. That part of the called-up
capital that has not yet been received is called calls in arrear or calls
unpaid.

PAR VALUE
Par value (also called face value or nominal value) represents the
legal capital per share. The shareholders’ funds cannot be reduced
below the par value of share capital except by losses suffered by the
company or by special legal action. The company is not allowed to
declare a dividend that will reduce the shareholders’ funds below the
par value of share capital. Majority of compa- nies in India have par
value of Rs. 10 per share. Others have Rs. 5 or Rs. 2 or Rs. 1 as par
value of a share.
Illustration 7.1
Mars Limited issues 5,000 equity shares of Rs. 10 each at Rs. 20. The whole amou

(Rs.)
Bank (Dr.) 100,00
0
To equity share capital 50,000
To securities premium 50,000

ISSUE OF SHARES FOR CONSIDERATION OTHER THAN CASH

A company may issue shares for consideration other than cash. This
may happen when a company pays for purchase of fixed assets in the
form of shares or when a company acquires another business and
pays either the full or part of purchase consideration by way of its
own shares. When a com- pany issues shares for cash, it debits cash
account and credits share capi- tal account. When a company pays
for assets by way of shares, it debits the vendor or the seller and
credits share capital account.
Illustration 7.2
Mars Limited buys a piece of equipment priced at Rs. 60,000. The vendor agrees to

(Rs.)
Equipment (Dr.) 60,000
To Vendor 60,000
Vendor (Dr.) 60,000
To equity share capital 30,000
To securities premium 30,000

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CORPORATE FINANCIAL STATEMENTS123

ISSUE OF BONUS SHARES

Bonus shares are the shares allotted to existing equity shareholders
without any consideration being received in cash or in kind. When a
company issues bonus shares, it converts its accumulated profits and
other reserves into share capital.

SELF-ASSESSMENT QUESTION
1. A company issues 300,000 equity shares of Rs. 10 face
value at Rs. 15 per share. The company will show in its
balance sheet
a. Equity share capital of Rs. 3,000,000
7. b.OTHER EQUITY
Equity share capital of Rs. 4,500,000
Other equity comprises
c. Equity of:
share capital of Rs. 3,000,000 and securities
1. Sharepremium of Rs.
application money1,500,000
pending allotment
d. Equity
2. Capital share capital of Rs. 3,000,000 and retained
reserve
earnings of Rs. 1,500,000.
3. Securities premium reserve
4. Retained earnings
5. Revaluation surplus
Companies need to disclose, under each of these heads, additions
and deductions since last balance sheet.

7.6.1 SHARE APPLICATION MONEY PENDING ALLOTMENT

When a company issues its equity shares to the public to raise funds,
it receives the application money from the applicants. However, the
equity shares are allotted to the applicants on a later date. It is only
on allotment of shares, that the application money gets transferred to
the equity share capital.

7.6.2 CAPITAL RESERVE

It is a reserve created as a result of capital profits. Capital profits are
prof- its other than those earned from normal business operations.
These include profit on sale of fixed assets, profit prior to
incorporation, premium on issue of shares, premium on issue of
debentures, profit on purchase of business. Capital reserve is not
available for distribution of dividend. However, it may be used to
issue bonus shares and setting off of capital losses.

7.6.3 SECURITIES PREMIUM RESERVE

When shares are issued at a price higher than the par value, it is
called an issue of shares at a premium. Excess of issue price over
face value is called the securities premium. It is a capital profit for the
company and this profit has to be credited to a separate account
called the securities premium reserve.

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7.6.4 RETAINED EARNINGS

A part of the profit earned by a company may be distributed as
dividend. The remaining profit is retained within the business and
gets accumulated year after year and appears as retained earnings in
the balance sheet. The bal- ance in retained earnings gets depleted
when the company uses the amount in this account to issue bonus
shares, for redemption of preference shares or for redemption of
debentures.

7.6.5 REVALUATION SURPLUS

Revaluation surplus arises when items of property, plant and equipment
are valued at their fair value instead of their book value. A credit is
given to the revaluation surplus when the value of an item of property,
plant and equipment is written up on revaluation. The amount of credit
is the difference between the fair value and the book value of the item
of property, plant and equipment. A company cannot distribute its
revaluation surplus as dividend to shareholders.

7. LIABILITIES
Liabilities are claims to assets. A business raises financial resources
from both its owners and outside parties. Both have claims to the
assets of the entity. Liabilities are claims to assets of parties other
than owners. Liabilities are classified as current liabilities and non-
current liabilities. According to Schedule III of the Companies Act,
2013, a liability shall be classified as current when it satisfies any of
the following criteria:
1. It is expected to be settled in the company’s normal operating
cycle. An operating cycle is the time between the acquisition of
assets for processing and their realization in cash or cash
equivalents. Where the normal operating cycle cannot be
identified, it is assumed to have a duration of 12 months.
2. It is held primarily for the purpose of being traded.
3. It is due to be settled within 12 months after the reporting date.
4. The company does not have an unconditional right to defer
settlement of the liability for at least 12 months after the
reporting date. Terms of a liability that could, at the option of the
counterpart, result in its settlement by the issue of equity
instruments do not affect its classification.
Liabilities other than those classified as current are classified as non-
current liabilities.

7.7.1 NON-CURRENT LIABILITIES

Non-current liabilities are long-term in nature. These usually arise
from major expenditures such as acquisition of non-current assets or
acquisition of another business. Large amounts are generally
involved in relatively few transactions related to non-current
liabilities. Schedule III further classifies current liabilities in the
following manner:
1. Financial liabilities
(a) Borrowings
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CORPORATE FINANCIAL STATEMENTS125

(c) Other financial liabilities (other than those specified in item

(b), to be specified)
2. Provisions
3. Deferred tax liabilities (net)
4. Other non-current liabilities

BORROWINGS

Borrowings having a maturity of more than 1 year are considered as

non- current liability. These may take one of the following forms:
1. Bonds or debentures
2. Term loans
(a) From banks
(b) From other parties
3. Deposits
4. Loans from related parties
5. Other loans and advances (specify nature)

BONDS OR DEBENTURES

When a large loan is split into small transferable units, these are
called bonds or debentures. These are interest-bearing instruments
which are generally sold to the investing public but may also be
sometimes placed privately with financial institutions. A major
advantage of debentures is that these are flex- ible instruments that
offer a wider choice to issuers with regard to maturity, security,
interest rates and other features.

TERM LOANS

Term loans are a form of long-term debt finance provided to companies

by banks and financial institutions for setting up new projects or for
expansion and modernization. These are generally secured by the
assets that are financed by such loans. These loans can be in domestic
currency or in foreign curren- cies. Interest on term loans is payable at
quarterly or half-yearly intervals.

DEPOSITS

Companies are allowed to accept deposits from public as well as its

employees. These deposits can have a maturity ranging from 6
months to 3 years. Deposits with a maturity of more than one year
are considered as long-term borrowings. These deposits are
unsecured. Deposits are a convenient source of finance for companies
as these are unsecured and do not carry any restrictive covenants.
However, companies can raise only limited amounts of funds through
deposits.

TRADE PAYABLES

A payable is classified as a trade payable if it is in respect of the

amount due on account of goods purchased or services received in
the normal course of business.

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OTHER FINANCIAL LIABILITIES

Some examples of non-current other financial liabilities are:

1. Retention money relating to capital expenditure
2. Deposits from contractors or dealers
3. Amounts payable under derivative contracts

PROVISIONS
A provision is an amount set aside from a company’s profits to meet
an expected liability or for the decrease in the value of an asset, but
the amount of the liability is uncertain and requires estimation.
Important liabilities for which provisions are required are employee
pensions and product warran- ties. Schedule III of the Companies Act,
2013 requires provisions to be clas- sified as provision for employee
benefits and other provisions, specifying their nature.

DEFERRED TAX LIABILITIES

These arise due to difference between the profit as per statement of
profit and loss and the taxable income calculated under the Income
Tax Act.
A deferred tax liability is created when the tax on accounting income is
more than the tax payable under the Income Tax Act. This happens
when account- ing income is more than taxable income. A deferred tax
asset is created when the tax on accounting income is less than the
tax payable under the Income Tax Act. This happens when accounting
income is less than the taxable income.
Deferred tax assets and deferred tax liabilities are netted off against
each other. An amount against deferred tax liabilities will appear in the
balance sheet when the amount of deferred tax liabilities exceeds the
amount of deferred tax assets.

OTHER NON-CURRENT LIABILITIES

Other long-term liabilities include liabilities other than those
mentioned under specific heads. These are further classified as:
1. Advances
2. Others
Examples of other non-current liabilities are:
1. Deferred income arising from government grants
2. Annuity payable to VRS optees
3. Advances from customers
4. Sales tax deferment loan from state government

7.7.2 CURRENT LIABILITIES

We have already defined current liabilities as those liabilities which
sat- isfy the requirements specified by Schedule III of the Companies
Act, 2013. Schedule III further classifies current liabilities in the
following manner:
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1. Financial Liabilities
(a) Borrowings
(b) Trade payables
(c) Other financial liabilities (other than those specified in item (c)
2. Other current liabilities
3. Provisions
4. Current Tax Liabilities (Net)

BORROWINGS
Borrowings shown under the head ‘current liabilities’ represent short-
term borrowings. These are to be classified as:
1. Loans repayable on demand
(a) from banks
(b) from other parties
2. Loans and advances from related parties
3. Deposits
4. Other loans and advances (specify nature)

OTHER FINANCIAL LIABILITIES

Other current financial liabilities are required to be classified as:
1. Current maturities of long-term debt;
2. Interest accrued;
3. Unpaid dividends;
4. Unpaid matured deposits and interest accrued thereon;
5. Unpaid matured debentures and interest accrued thereon and
6. Others (specify nature).

OTHER CURRENT LIABILITIES

These are classified as:
(a) revenue received in advance;
(b) other advances (specify nature) and
(c) others (specify nature)

REVENUE RECEIVED IN ADVANCE

Sometimes, a company receives an advance payment for goods to be

sup- plied or for services to be rendered in future. For example,
subscriptions may be received in advance by publishers of a
magazine or insurance premia may be received in advance by an
insurance company. Such receipts cannot be treated as revenue until
the related goods have been supplied or the services have been
rendered. Till such time, these receipts are treated as current
liabilities.

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128 FINANCIAL ACCOUNTING AND ANALYSIS

PROVISIONS
Like long-term provisions, short-term provisions are classified as
provision for employee benefits and others, specifying the nature of
other provisions.

SELF-ASSESSMENT QUESTIONS
2. Which of the following would not be classified as a long-term
liability?
a. Current maturities of long-term debt
7. b. CONTINGENT
Debentures LIABILITIES
8 AND COMMITMENTS
c. Bonds
d. Finance lease obligations
A contingent liability is: (a) a possible obligation that arises from
QUICK TIP Which and
past3. events of thewhose
following will be classified
existence as a current
will be confirmed liability?
only by the
occurrence or non-occurrence
a. Debentures of one or more uncertain future
A contingent liability is not events b.notAccounts
wholly within the control of the entity; or (b) a present
a real liability but a payable
obligation that arises from past events but is not rec- ognized
potential liability that c. Finance lease obligations
because: (i) it is not probable that an outflow of resources
depends on an uncertain d. Bonds
embodying economic benefits will be required to settle the
future event. obligation; or (ii) the amount of the obligation cannot be measured
with sufficient reliability.
A contingent liability is not a real liability but a potential liability that
depends on an uncertain future event. A company is not required to
recognize a con- tingent liability. It needs to just disclose the
contingent liability in notes to accounts. If the possibility of an outflow
of resources embodying economic benefits is remote, no disclosure is
required.

7.8.1 STATEMENT OF PROFIT AND LOSS

The Statement of Profit and Loss includes:
1. Profit or loss for the period and
2. Other Comprehensive Income for the period.
The sum of (1) and (2) above is ‘Total Comprehensive Income’.
The form of Statement of Profit and Loss is provided by Part II of
Schedule III to the Companies Act, 2013. The provisions of Part II
apply to the income and expenditure account, in like manner as they
apply to the Statement of Profit and Loss.

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CORPORATE FINANCIAL STATEMENTS129

Part II – Form of Statement of Profit and Loss

Name of the Company

Statement of Profit and Loss for the period ended
(Rupees
in)
Figures for Figures for
the current the previous
Note reporting reporting
Particulars No. period period
I Revenue from xx
operations II Other x
income xx
III Total revenue (I  x
II) IV Expenses: xx
Cost of materials x
consumed Purchases of xx
stock-in-trade x
Changes in inventories
of finished goods, work-
in- progress and stock-
in-trade
Employee benefits
expense Finance costs
Depreciation and
amortiza- tion expense
Other expenses
Total expenses
(IV)
V Profit/(loss) before
excep- tional items and xxx
tax (I – IV)
VI Exceptional items xx
VII Profit/(loss) before x
tax (V – VI) xx
VIII Tax expense: x
(1)Current tax
(2)Deferred tax xxx
IX Profit (loss) for the
period from continuing
opera- tions (VII – VIII)
xxx
X Profit (loss) from
discon- tinued
operations
XI Tax expense of xx (Continued)
discontin- ued
operations x
XII Profit (loss) from
discon- tinued xx
operations (after tax)
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(X – XI) x

xxx

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130 FINANCIAL ACCOUNTING AND ANALYSIS

XIII Profit (loss) for the xx

period (IX  XII)
XIV Other x
Comprehensive
Income xx
A (i) Items that will not
be reclassified to
profit or loss x
(ii) Income tax relating
to items that will
not be reclassified
to profit or loss
B (i) Items that will be
reclassified to
profit or loss
(ii) Income tax
relating to items
that will be
reclassified to
profit or loss
XV Total Comprehensive In-
come for the period
(XIII xxx
+ XIV) (Comprising Profit
(Loss) and Other
Compre- hensive Income

For reference, the statement of profit and loss of Asian Paints for the
year ended March 31, 2017 is presented in Exhibit 7.4.

EXHIBIT 7.4 Statement of Profit and Loss of Asian Paints Ltd. for the year ended 31st March, 2017
(Rupees in Millions)

Year Year
2016–17 2015–16
Revenue from Operations
Revenue from sale of products
(includ- ing excise duty) 22A 141,545.4 131,323.2
Revenue from sale of services 22B 75.9 126.3
Other operating revenues 22C 1,983.0 1,872.3
Other income 23 3,009.0 2,494.3
Total Income (I) 146,613.3 135,816.1
Expenses
Cost of materials consumed 24A 67,374.5 58,659.4
Purchases of stock-in-trade 24B 6,465.3 5,244.2
(Continued
)

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CORPORATE FINANCIAL STATEMENTS131

Year Year
2016–17 2015–16
Changes in inventories of finished
goods, stock-in-trade and work-in- 24C (5,155.8) 1,945.1
progress
Excise duty 17,133.2 15,018.5
Employee benefits expense 25 7,428.3 6,668.3
Other expenses 26 23,644.4 21,017.0
Total (II) 116,889.9 108,552.5
Earning before Interest, Tax, Deprecia-
tion and Amortization 29,723.4 27,263.6
Finance costs 27 188.6 234.0
Depreciation and amortization expense 28 2,954.3 2,345.1
Profit before Exceptional Items and Tax 26,580.5 24,684.5
Exceptional items 45 — 653.5
Profit before Tax 26,580.5 24,031.0
Tax Expense 18
(1) Current tax 8,172.2 7,437.4
(2) (Excess)/Short tax provision
for earlier years (36.0) (33.3)
(3) Deferred tax 413.3 398.8
Total tax expense 8,549.5 7,802.9
Profit before Tax 18,031.0 16,228.1
The various components of the statement of profit and loss are
discussed in detail in the following sections.

7. REVENUE FROM OPERATIONS

Revenue is the gross inflow of economic benefits during the period
arising during the ordinary activities of an entity when those inflows
result in increases in equity, other than increases relating to
contributions from equity participants.
A company has to disclose revenue from operations under the
following heads in the notes:
1. Sale of products (including excise duty or goods and services tax)
2. Sale of services
3. Other operating revenues
Other operating revenue is the revenue arising from activities which
are incidental to the main revenue earning activities of the company,
e.g. reve- nue from sale of scrap by a manufacturing company or
revenue from sale of waste paper or packaging material by a
merchandising company.
Excise duty (goods and services tax) is an indirect tax payable by a
company to the government.

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7.9.1 REVENUE RECOGNITION

There are two interrelated issues associated with revenue
recognition: quan- tum of revenue and timing of recognition. Revenue
is recognized using the accrual principle.
Revenue from the rendering of services is recognized by reference
to stage of completion of the transaction at the end of the reporting
period. The recognition occurs only when the outcome of the
transaction can be estimated reliably.

ACTIVITY 2
Name the three main components of revenue from operations for a
non- finance enterprise and for a financial company.

7.1 OTHER INCOME

In addition to income from its regular operating activities, a company
may also generate income from other sources such as income from
rent, dividend, interest, gain or loss on sale of assets or investments.
Interest income earned by a finance company is part of its operating
revenue.
Companies are required to report other income classified as:
1. interest Income;
2. dividend Income and
3. other non-operating income (net of expenses directly
attributable to such income).

ACTIVITY 3
Name the two main sources of other income.

7.1 EXPENSES
Expenses are matched with revenue to determine the profit or loss
made by a business during an accounting period. An expense is that
cost which relates to the operations of an accounting period (e.g.
rent) or to the revenue earned during the period (cost of goods sold)
or the benefits of which do not extend beyond that period. Expenses,
thus, have a relation with the account- ing period and represent that
part of the cost of an asset or service that is consumed during the
accounting period. Companies are required to report expenses under
the following heads:
1. Cost of materials consumed
2. Purchases of stock-in-trade
3. Changes in inventories of finished goods, work-in-progress and
stock- in-trade
4. Employee benefits expense
5. Finance costs
6. Depreciation and amortization expense
7. Other expenses

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7.11.1 COST OF MATERIALS CONSUMED

The purpose of the statement of profit and loss is to calculate profit
or loss made by a business during the accounting period. This is
achieved by matching expenses and revenue. The first step in this
direction is matching of revenue with cost of goods sold. Cost of
goods sold represents aggregation of expenses directly related to
earning of revenue, i.e. the direct costs of goods that have been sold.
This comprises cost of materials consumed and other manufactur- ing
and merchandising cost. Cost of goods sold is calculated as cost of
goods available for sale adjusted for change in the inventory of
finished goods.
Cost of material consumed  Beginning inventory of materials 
Material purchased
 Ending inventory of materials

7.11.2 PURCHASES OF STOCK-IN-TRADE

Many companies do not manufacture all the items that they sell. They
also engage in merchandising transaction and purchase of finished
goods for resale. The cost of purchase of such items is reported under
this head. Purchase of stock-in-trade is the second element of the
cost of goods sold.

7.11.3 CHANGES IN INVENTORIES OF FINISHED GOODS,

WORK-IN-PROGRESS AND STOCK-IN-TRADE
Computation of cost of goods sold requires adjustment for the cost of
dif- ferent types of inventory items at the beginning and end of the
accounting period. Manufacturing companies usually carry three
types of inventory items: inventory of materials, work-in-process and
finished goods.
The inventory adjustment for raw materials is done when the cost of
mate- rial consumed is calculated. Work-in-process inventory
represents inventory of semi-finished goods. As these semi-finished
items get finished, there is a change in the work-in-process inventory.
This change reflects addition to the cost of goods available for sale.
Cost of goods available for sale  Cost of materials consumed 
Direct manufacturing cost 
Purchase of stock-in-trade  Change
in inventory of work-in-process

All goods produced and purchased by a company may not be sold.

Some part of manufactured and purchased goods may end up in
inventory at the end of the accounting period. A part of the goods
sold may come from the inventory of finished goods carried over from
the previous year. Cost of goods available for sale need to be
adjusted for change in the inventory of finished goods to calculate
cost of goods sold.
Cost of goods sold  Cost of goods available for sale
 Change in inventory of finished
goods and stock-in-trade

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7.11.4 EMPLOYEE BENEFITS EXPENSE

Under this head, companies have to show separately expenses incurred on:
1. Salaries and wages
2. Contribution to provident and other funds
3. Share based payments to employees
4. Staff welfare expenses

7.11.5 FINANCE COSTS

Finance costs are costs related to the borrowings of the company.
These costs are to be reported under the following classification:
1. interest;
2. dividend on redeemable preference shares;
3. exchange differences regarded as an adjustment to borrowing costs and
4. other borrowing costs (specifying nature).

7.11.6 DEPRECIATION AND AMORTIZATION EXPENSES

Most of the items of property, plant and equipment have limited
useful life. The cost of an item of property, plant and equipment
needs to be appropri- ated on a systematic basis over its useful life.
This process of appropriation is called depreciation in relation to
tangible assets and amortization in relation to intangible assets. The
appropriation is based upon the matching principle.

ACTIVITY 4
Explain the difference between depreciation and amortization.

7.11.7 OTHER EXPENSES

Expenditure on each of the following items is required to be shown
separately:
1. Consumption of stores and spare parts
2. Power and fuel
3. Rent
4. Repairs to buildings
5. Repairs to machinery
6. Insurance
7. Rates and taxes, excluding taxes on income

7.1 PROFIT BEFORE EXCEPTIONAL ITEMS

2 AND TAX
Profit before exceptional items and tax is the difference between total
reve- nue and total expenses.

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7.1 EXCEPTIONAL ITEMS

Exceptional items are those items that occur during the ordinary
course of the business but need to be disclosed due to their size or
incidence. Examples are:
1. Profit/loss on disposal of surplus properties
2. Profit/loss on disposal of business/subsidiary.
3. Impairment loss on non-current assets of subsidiary companies
4. Restructuring costs
5. Impairment loss on investments
6. Employee separation cost
The purpose of reporting exceptional items separately is to allow
users of financial statements to assess the ability of the business to
generate income from its regular operating activities.
Profit before tax is calculated after deducting exceptional expenses
from profit before exceptional items and tax.

ACTIVITY 5
Name three items of exceptional nature.

7.1 TAX EXPENSE

A company is required to pay income tax on the income earned
during an accounting period. The tax is calculated in accordance with
the provisions of the Income Tax Act, 1961. The tax expense is
calculated separately for continuing operations and discontinued
operations. A detailed treatment of income tax expense is provided
later in this chapter.

7.1 PROFIT (LOSS) FOR THE PERIOD FROM

5 CONTINUING OPERATIONS
Profit (loss) for the period from continuing operations is calculated
after deducting tax expense from profit before tax. It measures the
profit/loss from ongoing operations and helps in making predictions
about a company’s future earnings.

7.1 DISCONTINUED OPERATIONS

If the company has decided to discontinue a line of activity or has
entered into a contract to sell a segment of the business, the results
of such line of activity or segment are shown separately in the
statement of profit and loss. This enables the users of financial
statements to better evaluate the perfor- mance of the company’s
continuing operations.

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7.1 PROFIT (LOSS) FOR THE PERIOD

Profit (loss) for the period is the sum of profit (loss) from continuing
opera- tions and profit (loss) from discontinued operations.

7.1 OTHER COMPREHENSIVE INCOME

The performance of a company is reported in the statement of profit
and loss and other comprehensive income. Profit or loss is the total of
income less expenses, excluding the components of other
comprehensive income’. Other comprehensive income (OCI)
comprises items of income and expense (includ- ing reclassification
adjustments) that are not recognized in profit or loss as required or
permitted by different accounting standards. Thus, other compre-
hensive income comprises those items that are not reported on the
statement of profit and loss but have an effect on the balance sheet
amount of equity.
The components of other comprehensive income include:
1. Changes in revaluation surplus;
2. Actuarial gains and losses on defined benefit plans;
3. Gains and losses arising from translating the financial
statements of a foreign operation;
4. Gains and losses on remeasuring available-for-sale financial assets;
5. The effective portion of gains and losses on hedging instruments
in a cash flow hedge.

ACTIVITY 6
Explain the term ‘Other Comprehensive Income’ and provide two
examples.

7.1 EARNINGS PER SHARE

Earnings per share (EPS) of equity share capital is an important
accounting statistic widely used by existing and prospective equity
shareholders of the company. Companies are required by accounting
standards to present the EPS on the face of the statement of profit
and loss to improve performance comparisons between different
entities in the same reporting period and between different reporting
periods for the same entity.

7.19.1 BASIC EARNINGS PER SHARE

An entity is required to calculate basic earnings per share amounts
for profit or loss attributable to ordinary equity holders of the entity
and, if presented, profit or loss from continuing operations
attributable to those equity holders.
Basic earnings per share shall be calculated by dividing profit or loss
attribut- able to ordinary equity holders of the entity (the numerator)
by the weighted average number of ordinary shares outstanding (the
denominator) during the period.

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Profit or loss (profit or loss from continuing

operations) Attributable to ordinary equity holders
Basic EPS 
Weighted average number of ordinary shares outstanding

The weighted average number of ordinary shares outstanding during

the period is the number of ordinary shares outstanding at the
beginning of the period, adjusted by the number of ordinary shares
bought back or issued during the period multiplied by a time-
weighting factor. The time-weighting factor is the number of days
that the shares are outstanding as a proportion of the total number of
days in the period.
For example, if the number of ordinary shares outstanding is 100,000
during the first nine months of the accounting year and 150,000
during the last three months, the weighted average number of
ordinary shares outstanding during the accounting year is 112,500
(100,000  9/12  150,000  3/12).

7.19.2 DILUTED EARNINGS PER SHARE

Companies are also required to report diluted earnings per share in
addition to basic earnings per share. The purpose of reporting the
diluted earnings per share is to inform investors about the potential
dilution that might occur in the earnings per share.
For the purpose of calculating diluted earnings per share, profit or
loss attributable to ordinary equity holders of the entity and the
weighted aver- age number of shares outstanding is adjusted for the
effects of all dilutive potential ordinary shares.
If in the previous example, the company had 50,000 stock options
outstand- ing at the beginning of the accounting period entitling the
holders of the option to get one ordinary share, the weighted average
number of ordinary shares outstanding during the accounting year for
the purpose of calculating the diluted EPS will be 162,500 (150,000 
9/12  200,000  3/12).

7.2 INCOME TAXES

7.20.1 ADVANCE TAX
Even though the income of the Previous Year is taxable during the
Assessment Year, assesses have to pay taxes as they earn, that is, in
advance. Whenever a company makes advance payment of income
tax, it debits Advance Income Tax Account and credits Bank Account.
Income tax paid in advance is shown as tax asset (current or non-
current) in the balance sheet.

7.20.2 PROVISION FOR TAX

At the end of each accounting year, a company calculates its taxable
income and income tax liability in accordance with the Income Tax
Act. The com- pany makes a provision for income tax by debiting
Profit and Loss Account and crediting provision for Income Tax
Account.
Provision for tax is shown as ‘current tax liability’ in the balance sheet.
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7.2 DIVIDEND
Dividend is the distribution of profits by a company to its
shareholders. Companies generally pay two types of dividends:
interim dividend and final dividend.

7.21.1 INTERIM DIVIDEND

Interim dividend is paid by a company during a financial year. Section
123(3) of the Companies Act, 2013 provides that the Board of
Directors of a company may declare interim dividend during any
financial year out of the surplus in the profit and loss account and out
of profits of the financial year in which such interim dividend is
sought to be declared.

7.21.2 FINAL DIVIDEND

At every annual general meeting of the company, the shareholders
consider for approval any dividend that the directors propose to pay
to the share- holders for a financial year. This dividend is generally
known as the final dividend. The declaration of the final dividend is
also subject to the require- ments of Section 123 of the Companies
Act, 2013.

7.21.3 ACCOUNTING TREATMENT OF DIVIDENDS

All dividends paid by the company are shown as deduction from the
“Retained Earnings” under “Reserves and Surplus” in the balance
sheet.

7.2 SUMMARY
 Explain requirements relating to corporate books of account and
financial statements. Companies Act, 2013 requires every company
to prepare and keep books and papers and financial statements
for every financial year, which give a true and fair view of the
state of affairs of the company.
 Explain the form and contents of corporate financial statements.
Financial statements of a company include the balance sheet;
profit and loss account; cash flow statement; statement of
changes in equity, if applicable and explanatory notes annexed to
these statements. Financial statements are required to give a true
and fair view of the state of affairs of the company or companies,
comply with the notified accounting stan- dards and shall be in
the form or forms as may be provided for different class or classes
of companies in Schedule III.
 Prepare corporate financial statements. Income and expense accounts
from the trial balance accounts are carried to the Profit and Loss
account. The net result of the Profit and Loss account represents
the net profit or loss made by the business during the accounting
period. Asset and Liability accounts are transferred to the Balance
Sheet along with the net result of the Profit and Loss account.

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CORPORATE FINANCIAL STATEMENTS139

KEY WORDS
1. Current asset is an asset that is expected to be realized in, or is
intended for sale or consumption in, the company’s normal
operating cycle; held primarily for the purpose of being
traded; expected to be realized within 12 months after the
reporting date; or is cash or cash equivalent unless it is
restricted from being exchanged or used to settle a liability
for at least 12 months after the reporting date.
2. Current liability is a liability that is expected to be settled in the
company’s normal operating cycle; it is held primarily for the
purpose of being traded; it is due to be settled within 12
months after the reporting date; or the company does not
have an unconditional right to defer settlement of the liability
for at least 12 months after the reporting date.
3. Financial statement in relation to a company includes a balance
sheet as on the end of the financial year; a profit and loss
account for the financial year; cash flow statement for the
financial year; a statement of changes in equity, if applicable
and related explanatory notes.
4. Non-current asset is an asset other than a current asset.
5. Non-current liability is a liability other than a current liability.
6. Operating cycle is the time between the acquisition of assets for
processing and their realization in cash or cash equivalent.
Where the normal operating cycle cannot be identified, it is
assumed to have a duration of 12 months.
7. Other comprehensive income (OCI) comprises those items that are
not reported on the statement of profit and loss but have an
effect on the balance sheet amounts.
8. Trade payable is a payable in respect of the amount due on
account of goods purchased or services received in the normal
course of a business.
9. Trade receivable is a receivable in respect of the amount due on
account of goods sold or services rendered in the normal
course of a business.

7.2 DESCRIPTIVE QUESTIONS

1. A debt that is payable within a year is a current liability. Do you
agree? Explain.
2. What are the requirements relating to the presentation of non-
current liabilities in financial statements?
3. What are the two major components of equity?
4. How do you account for depreciation of fixed assets in financial
statements?
5. What is the difference between interest accrued and due and
interest accrued but not due?
6. Name the broad heads under which assets and liabilities are
classified in the form of a balance sheet prescribed by Schedule
III to the Companies Act, 2013.

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 140 FINANCIAL ACCOUNTING AND ANALYSIS

7. What liabilities are classified as current liabilities?

8. What assets are classified as non-current assets?
9. How would you define an operating cycle?
10. What receivable is classified as trade receivable?

7.2 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Equity 1. c. Equity share capital of Rs. 3,000,000
and securities premium of Rs.
1,500,000
2. a. Current maturities of long-term debt
3. b. Accounts payable

7.2 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Anthony R.N., D.E. Hawkins and Merchant K.A. (2015). Accounting
Text and Cases, Tata McGraw Hill.
 Horngren C.T., Sundem G.L., and Elliot J.A. (2014). Introduction to
Financial Accounting, Pearson Education.

E-REFERENCES
 http://www.ezinearticles.com/Accounting convention and
Accounting theory; accessed on 25/11/2010.
 http://www.Accountingformanagement.com/accountingtheory and
con- cepts; accessed on 25/11/2010.

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 C H A
8 P T E R

STATEMENT OF CASH FLOWS

CONTENTS

8.1 Introduction
8.2 Cash and Cash Equivalents
8.3 Purposes of Cash Flow
Statement
8.4 Self-Assessment
8.5 Question Operating
8.6 Activities
Investing Activities
8.7 Financing Activities
8.7.1 Activity
8.7.2 Reporting Cash Flows from Operating
Activities Direct Method
Indirect Method
8.8 Self-Assessment Questions
Activity
8.9 Reporting Cash Flows from Investing
Activities Self-Assessment Question
8.10 Reporting Cash Flows from Financing
8.10.1 Activities Self-Assessment Questions
8.10.2 Treatment of Special Items
8.10.3 Foreign Currency Cash
8.10.4 Flows Interest and
8.10.5 Dividend
8.10.6 Taxes on Income
Non-Cash Investing and Financing
Transactions Components of Cash and Cash
8.11 Equivalents Other Disclosures
8.12 Self-Assessment Questions
8.13 Activity
Format of Cash Flow Statement (Direct
Method) Format of Cash Flow Statement
8.14
(Indirect Method) Summary
8.15
Key Words
Descriptive
8.16
Questions Answer
Key
Self-Assessment Questions
Suggested Books and E-References

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142 FINANCIAL ACCOUNTING AND ANALYSIS

INTRODUCTORY CASELET

OMAX ELECTRONICS

Omax Electronics produces and sells computer games. The

average sell- ing price is Rs. 3,850 per unit, variable cost is Rs.
2,450 per unit and fixed expenses are Rs. 700,000 per month. At
the start of the year 2019, the accounts books revealed the
following balances:

Rs. Rs.
Cash 2,500,00 Equity 6,787,50
0 0
Inventories 2,450,00
0
Receivables 1,837,50
0

The sales during January, February, March and April were 1,000,
1,500, 2,000 and 2,500 units, respectively. The company had a
policy of produc- ing the expected quantity of sales one month
prior to the sales. All sales were on one month’s credit. The cash
flows for the first three months are presented below:

January February March

Net Income 700,000 1,400,000 2,100,000
Increase (1,225,00 (1,225,00 (1,225,00
in 0) 0) 0)
inventorie
s
Increase in (612,500) (1,225,00 (1,225,00
receivables 0) 0)
Net decrease (1,137,50 (1,050,00 (350,000)
in cash 0) 0)
balance
Beginning cash 2,500,000 1,362,500 312,500
balance

The management is puzzled as to why, despite increasing income

levels, the company is facing shortage of cash.

QUESTION

1. Why should the management be concerned about the

negative cash balance? (Hint: Negative cash balances
mean the company will not be in a position to meet its
financial obligations as they arise without liquidating

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 STATEMENT OF CASH FLOWS 143

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the purpose of preparing the cash flow statement. Understand the classification of cash flow
Understand the difference between direct and indirect methods of computing cash flows from operating
> Understand how to deal with certain special items such as income taxes, foreign currency cash flows, ca
Understand how to deal with financing and investing activities that do not involve any cash flow.
>
>
>

8. INTRODUCTION
An entity earning handsome profits may face shortage of cash due to
the pres- ence of accruals, deferrals and non-cash items in its income
statement. The entity needs sufficient amount of cash to sustain its
operations and to meet its obliga- tions towards creditors and investors.
Cash flow statement is a statement that shows the flow of cash during a
period. Flow here means change or movement in cash. Transactions
which increase cash are classified as cash inflows, and transactions
which decrease cash are classified as cash outflows. Information
contained in the cash flow statement is of particular significance to
investors and creditors as they can use past cash flows to project future
cash flows and form an opinion about the ability of the entity to honor
its obligations towards them.

8. CASH AND CASH EQUIVALENTS

Cash includes cash (cash on hand, demand deposits with bank) and
cash equiv- alents. Cash equivalents are short-term, highly liquid
investments that are readily convertible into known amounts of cash,
and are subject to an insignif- icant risk of changes in value, for
example, securities with a maturity period of 3 months or less from ! IMPORTANT CONCEPT
the date of acquisition (acquisition of debt or preference shares shortly
Cash includes cash on hand, demand deposits w
before redemption, bank deposits with a short maturity period).
Cash Equivalents are short-term, highly liquid
Two accounting standards AS-3 “Cash Flow Statement” and Indian investments that are readily convertible into ca
Accounting Standard 7 (Ind AS-7) “Statement of Cash Flows” issued
by the Institute of Chartered Accountants of India, contain guidelines
for the prepa- ration of cash flow statement. Ind AS-7 is applicable to
certain specified com- panies. Ind AS-7 includes bank overdrafts that
are repayable on demand as a part of cash and cash equivalent,
whereas the existing AS-3 is silent on this aspect.

8. PURPOSES OF CASH FLOW STATEMENT

Cash flow statement provides information about the cash flows
associated with the period’s operations and also from the entity’s
investing and financing activities. Both the accounting standards
require that the cash flow statement should report cash flows during

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144 FINANCIAL ACCOUNTING AND ANALYSIS

operating, investing and financing activities. Using the cash flow statement,
shareholders, lenders and other users can assess:
1. Whether the entity will be able to generate positive cash flows in the future.
2. Whether the entity will be able to meet its obligations and pay dividends.
3. Whether the entity needs to raise more funds.
4. Why there is a difference between the amount of net income
and related net cash flows from operating activities.
5. The effect of entity’s investing and financing activities on its
cash and other accounts.
6. The reasons behind change in the beginning and ending balance
of cash and cash equivalents.

SELF-ASSESSMENT QUESTION
1. What information would you find in a statement of cash flow
that you would not be able to get from the other two
primary financial statements?
8. a.OPERATING
Cash provided by ACTIVITIES
or used in financing activities
b. Cash balance at the end of the
Operating activities are the principal period
revenue producing activities of
an enterprise, and include
c. Total liabilities due toactivities
creditors that
at theare
endnot investing
of the period or
financing
d. activities.
Net income Cash flows from operating activities include cash
effects of those transactions and events that determine the net profit
or loss (except profit or loss on sale of fixed assets). Some examples
of cash flows from operating activities are:
1. Cash receipts from sale of goods or rendering of services.
2. Cash receipts from royalties, fees, commission and other revenue.
3. Cash payment to suppliers for goods and services.
4. Cash payment to and on behalf of employees.
5. Cash receipts and cash payments of an insurance entity for
premiums and claims, annuities and other policy benefits.
6. Cash payment or refund of income taxes unless they can be
specifically identified with financing and investment activities.
7. Cash receipts and payments from contracts held for dealing or
trading purposes.

8. INVESTING ACTIVITIES
Investing activities include acquisition and disposal of long-term
assets and other investments not included in cash equivalents. Some
examples of investing activities are:
1. Cash payments to acquire property, plant and equipment,
intangibles and other long-term assets. These payments
include those relating to

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capitalized development costs and self-constructed property,

plant and equipment.
2. Cash receipts from sale of property, plant and equipment,
intangibles and other long-term assets.
3. Cash payments to acquire equity or debt instruments of other
entities and interests in joint ventures (other than payments for
those instruments considered to be cash equivalents or those
held for dealing or trading purposes).
4. Cash receipts from sale of equity or debt instruments of other
entities and interests in joint ventures (other than receipts for
those instruments considered to be cash equivalents and those
held for dealing or trading purposes).
5. Cash advances and loans made to other parties (other than
advances and loans made by a financial institution).
6. Cash receipts from repayment of advances and loans made to
other parties (other than advances and loans of a financial
institution).
7. Cash payments for future contracts, forward contracts, option
contracts and swap contracts except when the contracts are
held for dealing or trading purposes, or the payments are
classified as financing activities.
8. Cash receipts from future contracts, forward contracts, option
contracts and swap contracts except when the contracts are
held for dealing or trading purposes, or the receipts are
classified as financing activities.

8. FINANCING ACTIVITIES
Financing activities are activities that result in changes in the size and
com- position of the owner’s capital (including preference share capital
in case of a company) and borrowings of an enterprise. Examples of
financing activities are:
1. Cash proceeds from issuing shares or other equity instruments.
2. Cash payments to owners to acquire or redeem the entity’s shares.
3. Cash proceeds from issuing debentures, loans, notes, bonds,
mortgages and other short- or long-term borrowings.
4. Cash repayments of amounts borrowed.
5. Cash payments by a lessee for the reduction of outstanding
liability relating to a finance lease.

ACTIVITY 1
A company reports the following cash flows during a month:
1. Paid salaries of Rs. 1,500,000
2. Purchased equipment costing Rs. 5,000,000
3. Collected Rs. 3,500,000 from customers
4. Issued new shares collecting Rs. 7,500,000
5. Obtained a loan of Rs. 2,500,000 from the
company’s bank Name the cash flow activity to which
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8. REPORTING CASH FLOWS FROM

7 OPERATING ACTIVITIES
Cash flows from operating activities can be calculated using either
the direct method or the indirect method.

8.7.1 DIRECT METHOD

In the case of direct method, gross cash receipts and gross cash
payments are shown under major classes. Cash receipts include cash
sales, receipts from debtors, commission and fee received and
interest. Cash payments include payments for purchases, payments
to and for employees, operating expenses, interest payments and
direct tax payments.
The format for calculating cash flows from operating activities using the
direct method is given as follows:

! IMPORTANT CONCEPT Cash Flows from Operating Activities

Cash receipts
Ind AS-7 “Statement of Cash Flows” encourages entities to report cash from customers
flows from ---
operating activities using the direct method. Cash paid to suppliers and employees (---)
Cash generated from operations ---
Income taxes paid (---)
Cash flows before extraordinary items ---
Extraordinary items ---
Net cash flows from operating ---
activities

Cash receipts from customers include receipts from cash sales and
receipts from debtors in respect of credit sales. To calculate the cash
receipts from debtors, credit sales need to be adjusted for change in
the balance of debtors during the accounting period. If the balance of
debtors increases during the accounting period, the cash receipts
from credit sales will be less than the amount of credit sales. The
inverse will be the case when the balance of debt- ors decreases
during the accounting period. The relationship between credit sales
and cash receipts from credit sales is given by
Cash receipts from credit sales  Beginning balance of debtors 
Credit sales Ending balance of debtors
Cash paid to suppliers includes payment for cash purchases and
payments to creditors in respect of credit purchases. To calculate the
cash payment to suppliers, credit purchases need to be adjusted for
change in the balance of creditors during the accounting period. If
the balance of creditors increases during the accounting period, the
cash payment for credit purchases will be less than the amount of
credit purchases. The inverse will be the case when the balance of
creditors decreases during the accounting period. The rela- tionship
between credit purchases and cash paid to suppliers is given by
Cash paid to suppliers  Beginning balance of creditors  Credit
purchases Ending balance of creditors
When the information relating to credit purchases or credit sales is
not avail- able, the entire sales or purchases are assumed to be on
credit basis.
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Illustration 8.1

A company registers sales of Rs. 250 million in a year. The

debtors at the beginning and at the end of the year were Rs. 46
million and Rs. 84 million, respectively. Cash receipts from
customers can be calculated in the following manner.

Statement Showing Cash Receipts from Customers

(Rs. in Million)
Sales 250
Add: Debtors at the beginning 46
296
Less: Debtors at the end 84
Cash receipts from customers 21
2
The company in the above example reports its cost of sales
during the year at Rs. 160 million. The inventories at the
beginning and at the end of the year were Rs. 14 million and Rs.
18 million, respectively. Creditors at the beginning and at the end
of the year were Rs. 33 million and Rs. 30 million, respectively.
Cash payments to suppliers can be calcu- lated in the following
manner.

Statement Showing Cash Payments to Suppliers

(Rs. in Million)
Cost of sales 160
Add: Creditors at the 33
beginning
Stock at the end 18
51
(Rs. in Million)
Less: Creditors at the end 30
Stock at the beginning 14
44
Cash paid to suppliers 167

Based on the above information the cash generated from

operating activities using the direct method can be calculated as
follows:

Cash Flows from Operating Activities

Cash receipts from customers 212
Cash paid to suppliers and employees (167)
Cash generated from operations 45

Sometimes, the amount of purchases is embedded in the amount of

cost of sales. In such a case, the amount of cost of sales has to be
adjusted for change in the amount of inventories during the
accounting period. The amount of closing inventories is added to the
cost of sales and the amount of beginning inventories is deducted
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from the resulting sum. The relationship between cost of sales and
purchases is given by

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148 FINANCIAL ACCOUNTING AND ANALYSIS

Cost of sales  Beginning inventories  Purchases Ending inventories

Payments to employees also need to be adjusted for prepayments
and out- standing amounts. For example, the expense on salaries and
wages during an accounting period is Rs. 100,000. An amount of Rs.
10,000 has been paid as advance salary while an amount of Rs.
15,000 has not been paid at the end of the accounting period. The
payment to employees in this case is Rs. 95,000 (Rs. 100,000  Rs.
10,000 Rs. 15,000).

8.7.2 INDIRECT METHOD

Under the indirect method, the net profit or loss disclosed by the
income statement is adjusted for:
1. Non-cash items such as depreciation, provisions and unrealized
foreign exchange gains or losses.
2. change in current assets and current liabilities.
3. Any deferrals or accruals of past or future operating cash
receipts or payments.
4. All other items that affect investing or financing cash flows.
The format for calculating cash flows from operating activities using
the indi- rect method is given as follows:

QUICK TIP Cash Flows from Operating Activities

Depreciation is added back Net profit before tax and extraordinary items ---
to net income to calculate Adjustment for:
cash flows from operating Depreciation ---
activities even though it is
Non-cash items ---
an
operating expense. The reason Non-operating items (dividend, interest ---
is that there is no cash outflow income)
associated with depreciation. Operating profit before working capital changes ---
Working capital adjustment ---
Cash generated from operations ---
Income taxes paid (---)
Cash flows before extraordinary items ---
Extraordinary items ---
Net cash flows from operating activities ---
Illustration 8.2
Following information is available from the books of a company.

(Rs.)
2014 2015
Net profit 500,000
Depreciation 25,000
Income received in advance 1,000 1,200

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Prepaid expenses 3,200 2,800

Debtors 210,000 230,000
Creditors 116,000 110,000
Outstanding expenses 5,000 4,000
Accrued income 3,000 2,400
Cash flow from operating activities can be calculated using the indirect method as follows:

Net profit 500,000

Add: Depreciation 25,000

Operating profit before working capital 525,000
changes
Increase in income received in advance 200
Decrease in pre-paid expenses 400
Increase in debtors (20,000)
Decrease in creditors (6,000)
Decrease in outstanding expenses (1,000)
Decrease in accrued income 600

SELF-ASSESSMENT QUESTIONS
2. A company had a net income of Rs. 165,000 during 2015. It
provided for a depreciation of Rs. 75,000 during the year.
During
Ind AS-7 the year,
“Statement accounts
of Cash Flows”receivable
encouragesincreased by report
entities to Rs.
55,000 and accounts payable increased by Rs. 25,000.
cash flows from operating activities using the direct method. The The
company’s
direct method pro-cash
videsflow from operating
information activities
that may wasin estimating
be useful .
a. Rs. 320,000 b. Rs. 170,000
future cash flows and is not available under the indirect method.
c. Rs. 210,000 d. Rs. 120,000
3. Decrease in the amount of creditors results in . ACTIVITY 2
A company reports a net income of Rs. 500,000 for the recently
a. increase in cash b. decrease in cash
ended year after charging depreciation of Rs. 50,000 and loss on
c. decrease in assets d. no
sale of equipment of Rs. 25,000. change in assetsat the beginning
The inventory
of the year was Rs. 150,000 and at the end of the year was Rs.
160,000. Determine the cash flows from operating activities
during the year.

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8. REPORTING CASH FLOWS FROM

8 INVESTING ACTIVITIES
Cash flows from investing activities arise from purchase and sales of
fixed assets and financial assets. These also include receipt of
dividends and inter- est. Cash flows from investing activities are
calculated from the changes in the balance of fixed assets and
investments. The cash effect of any transac- tions related to these
assets during the accounting period is also considered.

SELF-ASSESSMENT QUESTION
4. During 2015, a company purchased land for Rs. 3,750,000.
The company also sold a building for Rs. 950,000. The
company’s cash flow from investing activity was .
QUICK TIP a. Rs. 46,50,000 b. Rs. 28,50,000

When a company issues

8. c.REPORTING
Rs. 28,00,000 CASH d. FLOWS FROM
Rs. 35,50,000
shares for cash, cash flow 9 FINANCING ACTIVITIES
from financing activity is not Cash flows from financing activities arise from issue and redemption
the face value of the shares of cap- ital and loans. These also include payment of dividends and
issued but the amount interest. Cash flows from financing activities are calculated from the
actually collected by the changes in the balance of shareholders’ funds and borrowings. The
company. cash effect of any transactions related to these items during the
accounting period is also considered.

5. Dividend paid is always classified as a/an .

a. operating activity b. investing activity
c. financing activity d. none of the above
6. Which of the following is not a financing activity in the cash
flow statement of a non-finance company?
SELF-ASSESSMENT QUESTIONS a. Issue of shares b. Payment of dividends
c. Receipt of dividends d. Borrowing money from a bank

Illustration 8.3
As onfrom
Following information is available 31.3.2014 As of
the books on a31.3.2015
company:
Particular (Rs.) (Rs.)
Equity share capital 9,330,000 15,300,000
Preference share 2,530,000 2,930,000
capital
Loans 116,500,000 115,200,000
Dividend paid 4,660,000

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Cash flow from investing activities can now be worked out as follows:
Cash Flows from Financing Activities

Issue of share capital 5,970,000

Issue of preference capital 400,000
Repayment of loans (1,300,000)
Dividend paid (4,660,000)
Net cash inflow from financing activities 410,000

8.1 TREATMENT OF SPECIAL ITEMS

8.10.1 FOREIGN CURRENCY CASH FLOWS
An entity should record cash flows arising from transactions in a
foreign cur- rency in the entity’s functional currency by applying to
the foreign currency amount the exchange rate between the
functional currency and the foreign currency on the date of cash flow.
Functional currency is the currency of the primary economic
environment in which the entity generates and expends cash. The
cash flows of a foreign subsidiary should be translated at the
exchange rate between the functional currency and the foreign
currency on the dates of cash flows.

8.10.2 INTEREST AND DIVIDEND

Cash flows from interest and dividends received and paid should be
dis- closed separately. Cash flows arising from the interest paid, and
interest and dividends received in the case of a financial enterprise
should be classified as cash flows arising from operating activities. In
the case of other enterprises, cash flows arising from interest paid
should be classified as cash flows from financing activities, while
interest and dividends received should be classi- fied as cash flows
from investing activities. Dividends paid should be classi- fied as cash
flows from financing activities.

8.10.3 TAXES ON INCOME

Cash flows arising from taxes on income are to be separately
disclosed, and need to be classified as cash flows from operating
activities unless they can be specifically identified with financing and
investing activities.

8.10.4 NON-CASH INVESTING AND FINANCING

TRANSACTIONS
Investing and financing transactions that do not require the use of
cash or cash equivalents should be excluded from the cash flow
statement. Such transactions should be disclosed elsewhere in the
financial statements in a way that provides all the relevant
information about the investing and financing activities.

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Examples of non-cash transactions are:

1. The acquisition of assets by assuming directly related liabilities
or by means of a finance lease.
2. The acquisition of an enterprise by means of issue of shares.
3. The conversion of debt to equity.

8.10.5 COMPONENTS OF CASH AND CASH EQUIVALENTS

An entity is required to disclose the components of cash and cash
equivalents and to present a reconciliation of the amounts in its
statement of cash flows with the equivalent items reported in the
balance sheet. An entity also has to disclose the policy which it
adopts in determining the composition of cash and cash equivalents
and the effect of any change in the policy for determin- ing
components of cash and cash equivalents. For example, a change in
the classification of financial instruments previously considered to be
part of an entity’s investment portfolio.

8.10.6 OTHER DISCLOSURES

An entity is required to disclose, together with a commentary by
manage- ment, the amount of significant cash and cash equivalent
balances held by the entity that are not available for use by the
group. There are various cir- cumstances in which cash and cash
equivalent balances held by an entity are not available for use by the
group. Examples include cash and cash equiva- lent balances held by
a subsidiary that operates in a country where exchange controls or
other legal restrictions apply when the balances are not available for
general use by the parent or other subsidiaries.

SELF-ASSESSMENT QUESTIONS
7. Which of the following cash flow activities represents a non-
cash financing transaction?
a. Purchase of goods for cash
b. Issue of shares for cash
c. Sale of equipment for cash
d. Purchase of plant by issuing shares
8. Which of the following cash flow activities represents a non-
cash investing transaction?
a. Purchase of goods for cash
b. Issue of shares for cash
c. Sale of equipment for cash
d. Exchange of plant assets

ACTIVITY 3
Identify the cash flow activity associated with the following cash
flows:
1. Dividend received by a financial enterprise
2. Payment of income tax
3. Payment of dividend by a non-financial enterprise
4. Interest paid by a financial enterprise
5. Interest received by a non-financial enterprise
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8.1 FORMAT OF CASH FLOW

1 STATEMENT (DIRECT METHOD)

A. Cash flows from operating activities

Cash receipts from customers ---
Cash paid to suppliers and employees (---)
Cash generated from operations ---
Income taxes paid (---)
Cash flows before extraordinary items ---
Extraordinary items ---
Net cash flows from operating activities ---
B. Cash flows from investing activities
Purchase of fixed assets (---)
Purchase of investments (---)
Sale of fixed assets ---
Sale of investments ---
Interest received ---
Dividend received ---
Net cash flows from investing activities ---
C. Cash flows from financing activities
Proceeds from issue of share capital ---
Proceeds from long-term borrowings ---
Repayment of long-term borrowings (---)
Dividend paid (---)
Net cash flows from financing activities ---
Net increase (or decrease) in cash ---
and cash equivalents (A  B  C)
Cash and cash equivalents as at ------ --
(opening)
Cash and cash equivalents as at ------ ---
(closing)

8.1 FORMAT OF CASH FLOW

2 STATEMENT (INDIRECT METHOD)
A. Cash flows from operating activities
Net profit before tax and extraordinary items ---
Adjustment for:
Depreciation ---
Non-cash items ---
Non-operating items (dividend, interest income) ---
(Continue
d)

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Operating profit before working capital changes ---

Working capital adjustment ---
Cash generated from operations ---
Income taxes paid (---)
Cash flows before extraordinary items ---
Extraordinary items ---
Net cash flows from operating activities ---
B. Cash flows from investing activities
Purchase of fixed assets (---)
Purchase of investments (---)
Sale of fixed assets ---
Sale of investments ---
Interest received ---
Dividend received ---
Net cash flows from investing activities ---
C. Cash flows from financing activities
Proceeds from issue of share capital ---
Proceeds from long-term borrowings ---
Repayment of long-term borrowings (---)
Dividend paid (---)
Net cash flows from financing activities ---
Net increase (or decrease) in cash and cash ---
equiva- lents (A  B  C)
Cash and cash equivalents as at- -(opening) ---
Cash and cash equivalents as at- -(closing) ---

8.1 SUMMARY
 Understand the purpose of preparing the cash flow statement. The
purpose of the cash flow statement is to provide information
about the company’s ability to generate positive cash flows in
future periods, to meet its obligations and to pay dividends.
 Understand the classification of cash flows from different activities.
Cash flow statement should report cash flows during the period
from operating, investing and financing activities.
 Understand the difference between direct and indirect methods
of computing cash flows from operating activities. In case of direct
method, gross cash receipts and gross cash payments are
shown under major classes such as cash sales, receipts from
debtors, commission and

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fee received and interest received, payments for purchases,

payments to and for employees, operating expenses, interest
payments and direct tax payments.
 Under the indirect method, the net profit or loss disclosed by the
income statement is adjusted for non-cash items such as
depreciation, provisions and unrealized foreign exchange gains or
losses; change in current assets and current liabilities; and all
other items for which the cash effects are on investing or
financing cash flows.
 Understand how to deal with certain special items such as income
taxes, foreign currency cash flows, cash flows from interest and divi-
dend, etc. in preparing the cash flow statement. An entity should
record cash flows arising from transactions in a foreign
currency in the enti- ty’s functional currency by applying to the
foreign currency amount the exchange rate between the
functional currency and the foreign currency on the date of the
cash flow.
 Cash flows arising from interest paid and interest and dividends
received in the case of a financial enterprise should be classified
as cash flows arising from operating activities. In the case of other
enterprises, cash flows arising from interest paid should be
classified as cash flows from financing activities, while interest
and dividends received should be clas- sified as cash flows from
investing activities. Dividends paid should be classified as cash
flows from financing activities.
 Cash flows arising from taxes on income are to be separately
disclosed and need to be classified as cash flows from operating
activities unless they can be specifically identified with financing
and investing activities.
 Understand how to deal with financing and investing activities that do not
involve any cash flow. Investing and financing transactions that do
not require the use of cash or cash equivalents should be
excluded from the cash flow statement and should be
disclosed elsewhere in the finan- cial statements.

KEY WORDS
1. Cash includes cash (cash on hand, demand deposits with
bank) and cash equivalents.
2. Cash equivalents are short-term, highly liquid investments that
are readily convertible into known amounts of cash, and are
subject to an insignificant risk of changes in value.
3. Cash inflows are transactions which increase cash.
4. Cash outflows are transactions which decrease cash.
5. Financing activities are activities that result in changes in
the size and composition of the owner’s capital (including
preference share capital in case of a company) and
borrowings of an enterprise.
6. Functional currency is the currency of the primary economic
environment in which the entity generates and expends

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156 FINANCIAL ACCOUNTING AND ANALYSIS

7. Investing activities include the acquisition and disposal of

long- term assets and other investments not included in
cash equivalents.

KEY WORDS 8. Operating activities are the principal revenue producing

activities of the enterprise and other activities that are not
investing or financing activities.

8.1 DESCRIPTIVE QUESTIONS

1. What is a cash flow statement?
2. What are the main purposes of preparing a cash flow statement?
3. Describe the three kinds of activities used for reporting cash
flows in the cash flow statement, giving examples of cash flows
from different activities.
4. Financing and investing activities also involve certain non-cash
transactions. Give some examples of such transactions and
state how these transactions are disclosed.
5. Describe the direct method of determining cash flows from
operating activities.
6. State the adjustments made to the income figure for arriving at
the cash flows from operating activities under the indirect
method.
7. Define cash equivalents. Give three examples.
8. Describe the treatment of interest and dividend income and
expense in the cash flow statement prepared by financial
enterprises and other enterprises.

8.1 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Purposes of Cash Flow 1. a. Cash provided by or used
Statement in financing activities
Reporting Cash Flows from 2. c. Rs. 210,000
Operating Activities
3. b. decrease in cash
Reporting Cash Flows from 4. c. Rs. 28,00,000
Investing Activities
5. c. financing activity
6. c. Receipt of dividends
Treatment of Special Items 7. d. Purchase of plant by issuing
shares
8. d. Exchange of plant assets

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 STATEMENT OF CASH FLOWS 157

8.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Anthony R.N., D.E. Hawkins and K.A. Merchant (2015). Accounting
Text and Cases, Tata McGraw Hill.
 Horngren C.T., Sundem G.L. & Elliot J.A. (2013). Introduction to
Financial Accounting, Pearson Education.

E-REFERENCES
 http://mca.gov.in/Ministry/pdf/INDAS7.pdf; accessed on 15/10/2019.
 https://www.charteredclub.com/cash-flow-statement-direct-
indirect- method/; accessed on 15/10/2019.

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 C H
9
A P T E R

ANALYSIS OF FINANCIAL STATEMENTS I

CONTENTS

9.1
9.1. 9.5.1
9.2 1 9.5.2
9.5.3
9.2.
1
9.2.
2
9.3 9.2.
3
9.2.
4
9.2.
5

9.3.
9.4 1
9.3.
2

9.3.
3
9.3.
9.5
4

9.4.
1
9.6 9.4.
2
9.4.
3
9.4.
4

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Introduction gin nvestment Utilization (Efficiency Ratios) Inventory
A Ear Turnover Ratio
d nin Debtors’ Turnover Ratio
d gs Self-Assesment
i per Question Creditors’
t Sha Turnover Ratio
i re Cash-to-Cash Operating
o Ret Cycle Activity
n urn Tests of Financial
on
a Position Current
Ca
l pit Ratio
al Quick Ratio Debt–
I Em Equity Ratio Interest
n plo Coverage Ratio
yed
f Self-Assessment Question
De
o Ratios Involving Share
co
r Information
mp
m Dividend Payout
osi
a Ratio Dividend Yield
ng
t Price/Earnings Ratio (P/E
Ret
i Ratio) Self-Assessment
urn
o Question
on
n Limitations of Ratio Analysis
Ca
Self-Assessment
pit
P Questions
al
r
Em
o
plo
f
yed
i
Ret
t
urn
a
on
b
Eq
i
uit
l
y
i
Test
t
s
y

o
M
f
e
a
E
s
f
u
f
r
i
e
c
s
i
P
e
r
n
o
c
f
y
i
t
i
n
M
a
I
r
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 9.7 Summary
Key Words
9.8 Descriptive Questions
9.9 Answer Key
Self-Assessment Questions
9.10 Suggested Books and E-References

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ANALYSIS OF FINANCIAL STATEMENTS I161

INTRODUCTORY CASELET

BETTER INVESTMENT OPTION

An investor is considering investment in one of the two

companies A and B. He collects the following financial
information relating to the two companies for the most recent
accounting year:

Company A Company B
Total Revenue (Rs. Million) 1,470 3,050
Gross Profit (Rs. Million) 36 671
7
Operating expenses (Rs. Million) 22 305
0
Financial expenses (Rs. Million) 37 122
Net Profit (Rs. Million) 11 183
0
Equity share capital 40 100
0 0
Reserves and surplus 90 220
Debt 24 815
5

The investor is of the opinion that Company B should be a better

investment as Company B has higher revenue and profit than
that of Company A.

QUESTION

1. Would you advise the investor to invest in Company A or

Company B? (Hint: Analyze profitability and financial
position ratios to arrive at the decision.)

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162 FINANCIAL ACCOUNTING AND ANALYSIS

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand and compute ratios used in analyzing profitability, efficiency
Understand limitations of ratio analysis.

>

9. INTRODUCTION
Financial statement analysis is the study of relationships between the
elements of the same statement or different financial statements and
the trend of these elements. The purpose of financial statement
analysis is to determine the mean- ing and significance of the data
contained in the statements so that a forecast may be made of the
prospects for future earnings, expected dividends and the ability of the
business to pay interest and debt as it matures. It provides useful
information that supplements the information contained in financial
statements.
Let’s understand one of the components of Financial Statement
Analysis – “Ratio Analysis”.
QUICK TIP Ratio Analysis is an important tool of financial analysis that is used by
A ratio may be expressed inves- tors and lenders to make important financial decisions.
as a number, a fraction, a Ratio Analysis is a technique of establishing meaningful relationships
percentage or a proportion. between significant variables of financial statements, and interpreting
the relationships to form judgment regarding the financial affairs of the
unit. Ratio analysis is usually employed to assess the profitability,
efficiency and financial condition of an enterprise. Depending on the
purpose they serve, ratios may be classified as:
1. Measures of Profitability
2. Tests of Efficiency in Investment Utilization (efficiency ratios)
3. Tests of Financial Position
4. Ratios involving Share Information.

TABLE 9.1 STATEMENT OF PROFIT AND LOSS OF ASIAN PAINTS

LTD. FOR THE YEAR ENDED MARCH 31, 2014
Rs. (in Million) Rs. (in Million)
Net sales and other operating revenue 104,18
7
Other income
1,737
Less: Expenses 105,92
4
Cost of materials consumed
Purchase of stock-in-trade
Changes in inventories of 57,587
F.G., WIP and stock-in-trade
Employee benefit expenses 2,566
Other expenses (753)
4,824
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22,191
(Continue
d)

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ANALYSIS OF FINANCIAL STATEMENTS I163

TABLE 9.1 STATEMENT OF PROFIT AND LOSS OF ASIAN PAINTS

LTD. FOR THE YEAR ENDED MARCH 31, 2014—CONTINUED
Rs. (in Million) Rs. (in Million)
EBITDA
Depreciation and amortization 86,415
Finance cost 19,509
2,123
Profit before exceptional items 261
Exceptional items 17,125
Profit before tax 100
Less: tax expense 17,025
Profit after tax 5,335
11,690

Ratios are illustrated using the information contained in the following

finan- cial statements of Asian Paints Ltd. given in Table 9.1 and 9.2 and
additional information.
Raw material purchased by the company during the year ended
March 31, 2014 amounted to Rs. 58,531 million.

TABLE 9.2 BALANCE SHEET OF ASIAN PAINTS LTD.

AS ON MARCH 31, 2014
(Rupees in Million)
31.03.2014 31.03.2013
Equities and Liabilities
Shareholders’ funds
Share capital
Reserves and surplus 959 959
29263
35,05
0
Non-current liabilities 36,00 30,222
9
Long-term borrowings
Deferred tax liability (net) 395 463
Long-term provisions 1,77 1,433
1
803 771
Current liabilities 2,96 2,667
9
Trade payables
Other current liabilities
Short-term provisions 14,98 12,141
8
7,47 7,194
5
5,37 4,237
5
Total 27,83 23,572
8
Assets 66,816 56,461
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Non-current assets
Fixed assets
Tangible assets
(Continued)

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164 FINANCIAL ACCOUNTING AND ANALYSIS

TABLE 9.2 BALANCE SHEET OF ASIAN PAINTS LTD.

AS ON MARCH 31, 2014—CONTINUED
(Rupees in Million)
31.03.2014 31.03.2013
Intangible assets
Capital work-in-progress
Non-current investments 19,732 20,749
Long-term loans and advances 390 270
Other non-current assets 379 525
20,501 21,544
Current Assets 5,482 3,597
Current investments 946 911
Inventories 63 —
Trade receivables
Cash and bank
Short-term loans and advances 4,820 1,050
Other current assets 16,650 14,808
7,124 6,339
7,454 5,515
Total 2,015 1,627
1,761 1,070
39,824 30,409
66,816 56,461

9.1.1 ADDITIONAL INFORMATION

Share capital of the company consists of 959 million shares of Rs. 1
each. The company paid a dividend of Rs. 5.30 per share for the year
ended March 31, 2014. The total amount paid as dividend was Rs.
5,084 million, and the company paid Rs. 820 million as dividend
distribution tax. Cash flows from operating activities for the year
ended March 31, 2014 was Rs. 13,688 million. The closing price of
the share on the Bombay Stock Exchange as on March 31, 2014 was
Rs. 546.50.

9. PROFITABILITY MEASURES
The profitability ratios are used to check if the company is generating
an acceptable return for its owners. Both creditors and investors are
inter- ested in the profit-making ability of a company. Lack of
adequate profitabil- ity adversely affects the liquidity of the company,
its ability to raise external financing and its growth prospects. Widely
used measures of profitability include profit margins, earnings per
share (EPS), return on capital employed (ROCE), return on assets
(ROA) and return on equity (ROE).

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9.2.1 PROFIT MARGIN

Profit margins are used to analyze the profit made per unit of sales.
Three kinds of profit margins are generally used: gross profit margin,
operating profit margin and net profit margin.
Gross profit margin is calculated as follows:
Grossprofit
Grossprofit ratio   100
Sales

Gross profit is the difference between sales value and cost of goods
sold. The cost of goods sold is not directly provided in the Statement
of profit and loss and needs separate computation. ! IMPORTANT CONCEPT
Profitability of operations and efficiency of the management have a Gross profit is the difference between sales val
bearing on gross profit. Companies enjoying a monopoly in the
market have a high gross profit ratio.
Operating profit is the profit before interest and tax and does not
include other income. Net profit is the profit after tax.

Pr ofit before int erest and tax

Operating profit ratio 
 
Sales

For Asian Paints, the operating profit margin for the year ended
March 31, 2014 is
! IMPORTANT CONCEPT
19,509 
Operating profit  100  16.69% Operating profit is the profit before interest and
2,123
ratio 
104,187

and the net profit margin for the year ended March 31, 2014 is

Net profit
Net profit ratio   100
Sales
11,690
  100  11.22%
104,187

9.2.2 EARNINGS PER SHARE

Earnings per share are the net income available per equity share. It is
calcu- lated as:

Net profit  Preferencedividend

Earnings per share  Number of equity shares
11,690
Rs. 12.19

959
 ! IMPORTANT CONCEPT
Earnings per share are the net income availab
Listed companies are required to report two versions of EPS: Basic
EPS and Diluted EPS.

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166 FINANCIAL ACCOUNTING AND ANALYSIS

This ratio helps in evaluating the prevailing market price of the share.
Higher earnings per share translate into a higher market price
because it indicates better performance and prospects of the
company.

9.2.3 RETURN ON CAPITAL EMPLOYED

Return on Capital Employed measures the returns generated by the
busi- ness on the amount invested in the business. Capital employed
refers to total of owners’ funds and non-current liabilities, and hence
represents funds entrusted to a concern for relatively long periods of
time. It can also be calcu- lated by adding net working capital to fixed
assets. This ratio is calculated as:

Profit before interest and tax

Return on capital employed   100
Average(Long- term liabilitie s 
Owner s, equity)

! IMPORTANT CONCEPT For Asian Paints, ROCE for the year ended March 31, 2014 is
Capital employed refers to total of owners’ funds and non-current liabilities.
17,386
ROCE  
100 (36404  30744)
/2
17,386
33,574  
 51.7%

ROCE becomes difficult to interpret when the total capital is low; the
profits are volatile; new capital has been raised during the year and
only used for part of the year; and the assets are at historic values
and are out of date.
A variant of this ratio is ROA. This ratio relates profit to investment in
the enterprise and shows how much the firm has earned on the
investment of all the financial resources, that is, owners’ equity, long-
term liabilities and cur- rent liabilities. It is also expressed as a
percentage. ROA is often used by the top management to evaluate
the performance of divisional managers in the use of assets. The
divisional manager has a significant influence over the use of assets,
but little control on how these assets are financed. ROCE is a better
measure for those division managers who have a significant influence
on asset acquisition, purchasing and production schedules, credit
policy, cash management and the level of current liabilities.

Profit before interest and tax

Re turn onassets  Average total assets  100

For Asian Paints, ROA for the year ended March 31, 2014 is

17,386
ROA 
100 (56461
66,816)/ 2
 28.2%
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9.2.4 DECOMPOSING RETURN ON CAPITAL EMPLOYED

The ROCE can be decomposed into two ratios:
Asset Utilization (Turnover) Ratio. It reflects the efficiency with which
assets are utilized, and is calculated as:
Sales revenue
Asset utilization ratio 

Average (Shareholder s funds  Long- term debt)

For Asian Paints, the asset utilization ratio for the year ended March
31, 2014 is 104187/33,574 = 3.1.
Profit Margin (or Return on Sales) Ratio. It reflects the profits made per
unit of sales, and is calculated as:

Profit before interest and tax

Profit margin  Sales revenue

For Asian Paints, the profit margin for the year ended March 31, 2014
is 17,386/104,187 = 0.1669 or 16.69%.
ROCE is the product of the above two ratios:

ROCE  3.1  16.69%  51.7% ! IMPORTANT CONCEPT

Return on capital employed depends on efficie
Companies selling undifferentiated products (e.g. fast moving
consumer goods) generally work on low margins and high turnover.
On the contrary, companies selling differentiated products (e.g.
customized furniture) work on high margins and low turnover. The
decomposition of ROCE into Profit Margin and Asset Utilization Ratio,
also called the “Du-Pont Analysis”, helps analysts to understand the
reason underlying the change in ROCE among different companies
during a time period and for the same company over a period of time.
Comparison of profit margin and turnover usually is mean- ingful only
in evaluating firms in the same industry. Cross-industry compari- son
of these two ratios is often meaningless and can even be misleading.

9.2.5 RETURN ON EQUITY

The return on equity relates profits to owners’ equity, and is
expressed as a percentage. Equity stands for owners’ funds and
includes equity share cap- ital, general reserves, capital reserves,
balance in share premium account and other reserves available to
shareholders. However, accumulated losses and fictitious assets to be
written off should be deducted from equity. The term “profit” here
means the profits to which the shareholders are entitled to after
meeting all expenses, including interest on loans and income tax.
Also non-operating incomes such as interest income on investment
are included in profit. The ratio is calculated as under:

Profit after interest and tax  Preference dividend

Re turn on equity  Average equity 100

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168 FINANCIAL ACCOUNTING AND ANALYSIS

For Asian Paints, ROE for the year ended March 31, 2014 is

11,690
ROE   100 
35.3% (36,009  30,222) / 2

This ratio may be used for declaration of dividend and building up of

reserves. It also indicates the efficiency with which funds are
deployed in the business. For example, if the rate of return on equity
! IMPORTANT CONCEPT is 10% and the interest available on bank deposits is 12%, it would
indicate that the funds are not profitably deployed and the investors
Return on equity depends on three factors, would
namely, not
profitbe
margin, asset
willing toturnover
investand leverage.
in that enterprise.
To understand the factors affecting a firm’s ROE, particularly its trend
over time and its performance relative to competitors, analysts often
“decompose” ROE into the product of a series of ratios.

9. TESTS OF EFFICIENCY IN INVESTMENT

3 UTILIZATION (EFFICIENCY RATIOS)
The efficiency ratios measure the effectiveness with which a concern
uses the resources or assets at its disposal. These ratios are usually
calculated on the basis of sales or cost of sales, and are expressed in
number of times rather than as a percentage. Such ratios should be
calculated separately for each type of asset. The greater the ratio,
the more will be the efficiency of asset usage. A lower ratio will show
underutilization of resources available to the concern. The following
are the important efficiency ratios usually calcu- lated by a concern:

! IMPORTANT CONCEPT 9.3.1 INVENTORY TURNOVER RATIO

Efficiency ratios measure the effectiveness with which a concern uses the resources or assets at its disposal.
The inventory turnover ratio relates the cost of goods sold to the
average inventory. It measures how many times the average
inventory is sold during the year. Average inventory is the mean of
the opening inventory and closing inventory. The ratio is calculated
as:

Cost of goods sold or Sales

Inventory turnover ratio 
Average inventory

For Asian Paints, the inventory turnover ratio for the year ended
March 31, 2014, is

104,187
14,808 16,650 / 2

104,187
 15,729
 6.62

The cost of goods sold can either be calculated as (Sales – Gross

profit) or as (Opening stock + Purchases + Manufacturing expenses
– Closing stock).

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This ratio reflects the efficiency of inventory management. A higher

ratio is a sign of higher efficiency and vice versa. However, there is a
need to balance between a very high or a very low ratio. A very high
ratio resulting from extremely low level of inventory may result in
loss of sales in future due to the inability to deliver goods promptly.
Efficiency in inventory management can also be determined by
calculating another ratio, the number of days’ inventory held.
Number of days’ inventory indicates how long the inventory is held
by the company on an average.
This ratio is calculated as follows:
 Average inventory
Number of days inventory   365
Cost of goods sold or Sales

Or as 365/Inventory turnover ratio.

For Asian Paints:
 15,729
Number of days inventory   365
104,187
 55 days
Alternatively
,

Number of days inventory   55 days
365
6.62
This figure can be used to compare the efficiency in inventory
management with other units in the same industry.

9.3.2 DEBTORS’ TURNOVER RATIO

The debtors’ turnover ratio shows the relation between sales and
outstand- ing amount due from the debtors to whom goods were sold
on credit. The ratio is calculated as follows:
 Net credit sales
Debtors turnover ratio 
Average debtors

For Asian Paints,

 104,187
Debtors turnover ratio 
6,339  7,124 / 2
104,187
 6,732  15.48

For the calculation of this ratio, debtors include sundry debtors and
trade bills receivables. It is preferable to take the average of the
value of the debtors in the beginning and the end. If the company
sells goods both for cash and on credit, only credit sales figure should
be used to calculate debtors’ turnover ratio. Since the information on
credit sales is not available in the financial statements of the
company, the ratio may be calculated with reference to the
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total sales figure. Though the ratio becomes distorted, it still may be
useful to compare the ratio of an entity over time if the proportion of
credit and cash sales remains constant from year to year.
A high debtors’ turnover ratio shows prompt collection of bills, and a
low ratio shows that the enterprise is having difficulty in collection of
dues from debtors. Debtors’ turnover ratio can be used to calculate
the average col- lection period. Average collection period shows the
accounts receivables in terms of the number of days of credit sales
during a particular period. This is a measure of the average length of
time taken for debtors to settle their balance. Average collection
period can be calculated as follows:

Average collection period   365

Debtors turnover ratio

For Asian Paints

365
Average collection period 
15.48
 24
days

It can also be calculated as:

Average debtors
Average collection period   Number of days
ina period Net credit sales
6,732
104,187 100
 24 days

The average collection period shows how the credit policy of the
concern is enforced. For example, if a company allows 30 days’ credit
to its customers and the collection period is 45 days, it means
collection from debtors is not efficient.

SELF-ASSESSMENT QUESTION
1. The debt collection period may increase (decrease)
between one period and another for a number of reasons
except for any one of those mentioned below:
9.3.3 CREDITORS’ TURNOVER RATIO
a. If credit is given to unsatisfactory customers.
The creditors’ turnover
b. Earlier ratio shows
the business the relation
had a zero between
debt collection purchases
period.
and out- standing amount due to the creditors
c. Credit terms to an existing customer changes.from whom goods
were purchased on credit. The ratio is calculated as follows:
d. If there is no consistent follow-up of overdue debts.
 Credit purchases
Creditors turnover ratio 
Average creditors

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ANALYSIS OF FINANCIAL STATEMENTS I171

For Asian Paints,

 58,531 2,566
Creditors turnover ratio 
12,14114,988 / 2
61,097
13,565
 4.5

For the calculation of this ratio, creditors include sundry creditors and
trade bills payables. It is preferable to take the average of the value of
the creditors in the beginning and at the end. If the company
purchases goods both for cash and on credit, only credit purchases
figure should be used to calculate credi- tors’ turnover ratio. Since the
information on credit purchases is not available in the financial
statements of the company, the ratio may be calculated with reference
to the total purchases figure. Though the ratio becomes distorted, it
still may be useful to compare the ratio of an entity over time if the
proportion of credit and cash purchases remains constant from year to
year.
Creditors’ turnover ratio can be better interpreted by converting it
into Average Payment Period.
The average payment period shows the average number of days of
credit that the company has from its suppliers. It can be calculated as
follows:

365
Average payment
 turnover
Creditors
period 
ratio
365
 4.5
 81days

It can also be calculated

as:
Average creditors
Average payment period   Number of days
ina period Credit purchases
13,565
  365  81 days
61,097

A high creditors’ turnover ratio means that the company takes a long
time to pay for credit purchases. This may be due to the company’s
ability to obtain a long credit period from its suppliers. A long credit
period is always good for a company’s cash flow.

9.3.4 CASH-TO-CASH OPERATING CYCLE

Cash-to-cash operating cycle measure the length of time between
purchase of inventory and collection of cash from sales. It is the sum QUICK TIP
of number of days’ inventory and the average collection period. Cash-to-cash operating cycle
is the sum of number of days’
Cash-to-cash operating cycle  Number of days inventory 
inventory and the average
Average collection period collection period.

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172 FINANCIAL ACCOUNTING AND ANALYSIS

For Asian Paints

Cash-to-cash operating cycle  55 days  24 days  79 days

In the year ended March 31, 2014, it took Asian Paints 79 days on an
average to convert purchased inventories into cash.

Mat h each of the following with the associated formula

c ratios
Formula
Ratio
1 Number of days’ A 
Number of days inventory 
inventory Average collection period

Averagecreditors
2 Average collection period B 
Credit purchases
365

Average inventory
3 Average payment period C Cost of goods sold or
365
Sales
ACTIVITY 1 Average debtors
4 Cash-to-cash operating D
Net credit sales  365
cycle

9. TESTS OF FINANCIAL POSITION

Tests of financial position include tests of both short-term and long-
term solvency of the business. Tests of short-term solvency focus on
the liquidity position of the company. While a business should be
profitable, profit, by itself, is not sufficient to ensure survival of the
business. A company must have sufficient liquid assets to meet its
short-term obligations. A company could be forced into liquidation in
the absence of sufficient liquid funds. Two important ratios used to
measure short-term liquidity are Current Ratio and Quick Ratio. These
two ratios are commonly called “Liquidity Ratios”.
Tests of long-term solvency focus on the ability of the company to
pay inter- est and repay principal of its long-term borrowings. The
main ratios in this category are debt–equity ratio and interest
coverage ratio. These ratios are commonly called “Solvency Ratios”.

9.4.1 CURRENT RATIO

Current ratio is the relation of a company’s current assets to its
current liabil- ities. This ratio establishes the ability of the business to
meet its short-term obligations and is therefore of particular
significance to short-term creditors. Current assets are “cash and
other assets that are expected to be converted into cash or
consumed in the production of goods or rendering of services in the
normal course of business.” These include cash in hand, cash at
bank, sundry debtors, bills receivables, loans and advances,
inventory, prepaid expenses, accrued income and short-term
investments in the form of mar- ketable securities.
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A current liability is a “liability including loans, deposits and bank

over- draft which fall due for payment in a relatively short period,
normally not more than 12 months.” Current liabilities include bank
overdraft, short-term loans, bills payable, sundry creditors, provision
for taxation, proposed divi- dend and outstanding expenses.
The current ratio is calculated as follows:

Currrent assets
Current ratio Current liabilities

For Asian
Paints,
39,824
Current ratio   1.43
27,838

for 2013–14;
and 30,409
Current ratio   1.29
23,572

for 2012–13.
A low current ratio (less than 1) may indicate that a company would
have difficulty in paying bills as they become due without selling
some long-term assets. A high current ratio may not always be good
as it may indicate too much money being tied up in inventory,
receivables and unproductive cash balances. It is difficult to specify a
normal level of current ratio as this level differs from one industry to
another. It is advisable to compare a compa- ny’s current ratio with
the industry average and to observe its trend over a number of years.

SELF-ASSESSMENT QUESTION
2. The current ratio of a company depends on a number of
factors listed below except one of the following options:
a. Volatility of the working capital requirement.
9.4.2 QUICK RATIO
b. Nature of company’s business.
Quick ratio is a more of
c. Imminence precise
currentmeasure of liquidity than the current
liabilities.
ratio. This ratio is also known as “Acid Test Ratio” or “Liquid Ratio”.
d. Long-term investments of the company.
Quick ratio relates quick current assets to current liabilities. Quick
current assets are those current assets, which are convertible into
cash rather early such as cash, marketable securities, debtors and
bills receivables. Inventory is not treated as a quick current asset as
it is not likely to be realized early. Quick ratio is calculated as follows:

Current assets Inventories

Quick ratio  Current liabilities

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For Asian
Paints,
39,824  16,650
Quick ratio   0.83
27,838

for 2013–14;
and 30,409  14,808
Quick ratio   0.66
23,572

for 2012–13.
This ratio shows the ability of the firm to pay its obligations without
relying on the sale and collection of inventories. In a business, a 1:1
ratio of quick current assets to current liabilities is treated as a
satisfactory relation.

SELF-ASSESSMENT QUESTION
3. If X = (Current assets – Stocks)/(Current liabilities), X is
known as
.
9.4.3 DEBT–EQUITY RATIO
a. quick ratio b. acid test ratio
The debt–equity ratio relates debt to equity or owners’ funds. Debt
here means long-term liabilities that mature after 1 year and include
long-term loans from financial institutions and banks, public deposits
and debentures. Equity means owners’ funds and includes equity
share capital, preference share capital, general reserves, capital
reserves, share premium and other reserves available to equity
shareholders. Accumulated losses and fictitious assets such as
preliminary expenses, discount on issue of shares or deben- tures,
which are yet to be written off, should be deducted from the equity.
The debt–equity ratio is calculated as follows:
Debt
Debt  equity ratio 
Equity

For Asian
Paints,
395
Debt  equity ratio   0.01
36,00
9
for 2013–14;
and
463
Debt  equity ratio   0.01
30,22
2
for 2012–13.
Asian Paints has a very small amount of debt in its capital structure.
This ratio indicates the degree of protection enjoyed by long-term
lenders. The lower the ratio, the higher will be the degree of
protection to the lenders. A debt–equity ratio of 2:1 is considered
satisfactory. For capital-intensive
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industries such as ship-building, power units, cement units etc. a

higher ratio is allowed.

9.4.4 INTEREST COVERAGE RATIO

The interest coverage ratio relates interest obligations to profits
before inter- est and tax and indicates the number of times interest
obligation is covered by the profits for the period. It is always
desirable to have profits more than the interest payable; otherwise
the position of the lenders is unsafe. This ratio is calculated as
follows:

Profit before interest and tax

Interest coverage ratio  Int erest
For Asian Paints,
17,386
Interest coverage ratio   66.7 times
261
for 2013–14;
and
15,464
Interest coverage ratio   50.5 times
306
for 2012–13
Asian Paints has a very healthy interest coverage ratio that has
improved in 2013–14 over 2012–13.
Since interest is a charge on profit and is allowed as deduction for tax
pur- poses, profit in the numerator is profit before interest and tax.
This ratio is expressed as a number and not as a percentage.
Table 9.7 provides a comparison of Asian Paint’s financial position
ratios for the year ended March 31, 2014 with its peers and Table 9.8
presents the com- pany’s financial position ratios over the 5-year
period 2010-2014.

TABLE 9.7 TESTS OF FINANCIAL POSITION OF ASIAN PAINTS AND

ITS PEERS AS ON MARCH 31, 2014
Measure of Financial Asian Akzo Berger Kansai
Position Paints Nobel Paints Nerolac

Current ratio (times) 1.43 1.23 1.3 1.79

6
Quick ratio (times) 0.83 0.94 0.7 0.84
3
Debt-equity ratio (times) 0.01 0.10 0.0 0.06
1
Interest coverage ratio 66.7 136.6 10. 681.7
(times) 6

Short-term liquidity position of Asian Paints is comparable with its

peers. All the major companies in the paints industry employ a very
small amount of debt in their capital structure. Interest coverage
ratio of Asian Paints is quite high though Akzo Nobel and Kansai
Nerolac have a much higher ratio.
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TABLE 9.8 TESTS OF FINANCIAL POSITION OF ASIAN PAINTS FOR

THE PERIOD 31.3.2010-31.3.2014 FOR THE PERIOD 31.3.2010-31.3.2014
Measure of Financial
Position 31.3.2010 31.3.2011 31.3.2012 31.3.2013 31.3.2014
Current ratio (times) 0.92 0.99 1.29 1.29 1.43
Quick ratio (times) 0.40 0.38 0.69 0.66 0.83
Debt-equity 0.04 0.03 0.02 0.01 0.01
ratio (times)
Interest 79.4 74.2 45.2 50.6 66.7
coverage ratio
(times)

The trend of the current ratio and the quick ratio shows an improved
liquid- ity position of the company. The solvency position of the
company is strong as it has a very low amount of debt. This is also
reflected in a high interest coverage ratio.

4. Which of the following would normally be included in the

calculation of debt–equity ratio?
SELF-ASSESSMENT QUESTION a. Debentures b. Preference shares
c. Bank overdraft d. All of the above

QUICK TIP 9. RATIOS INVOLVING SHARE INFORMATION

Current ratio and Quick ratio Investors in equity shares are more interested in the return from their
are used to measure short- invest- ment in the form of dividend and price appreciation. Ratios
term liquidity. Debt-equity such as Dividend Payout, Dividend Yield and Price Earnings ratio that
ratio and Interest coverage capture the relation- ship among dividend, earnings and market price
ratio are used to measure long- of share are of particular interest to existing and potential investors
term solvency. in a company’s shares.

9.5.1 DIVIDEND PAYOUT RATIO

The dividend payout (D/P) ratio measures the relationship between
the earn- ings belonging to equity shareholders and the dividend paid
to them. It can be calculated in one of the following two ways:

otal dividend paid

to equity shareholders
(i)
Dividend payout ratio  100
Total net profit belonging
to equity shareholders

For Asian Paints,

5,084
Dividend payout ratio  100
11,690
 43.5%

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Dividend per equity share (DPS)

(ii)
Dividend payout ratio   100
Earnings per share (EPS)
5.30
  100
12.19
 43.5%

This ratio reflects the dividend policy followed by the company, and
the extent to which profits are retained in the business (which can be
determined by deducting the D/P ratio from 100). The D/P ratio is
likely to be low for a growth company as such a company would
require large amount of funds for reinvestment. A mature company
that has not many profitable investment opportunities is likely to
have a higher D/P ratio.

9.5.2 DIVIDEND YIELD

The dividend yield ratio indicates the percentage return provided by
the div- idend on the market price of the share and is calculated as
follows:
Dividend per share
Dividend yield   100
Market price per share

For Asian Paints, the dividend yield for an investor who purchases the
share on March 31, 2014 for Rs. 473.05 is

Rs.5.30
Dividend yield   100
Rs.546.50
 0.97%

A low dividend yield may mean that either the investors expect the
dividends to grow rapidly or the share is overpriced. A high dividend
yield may indi- cate that investors consider investment in the
company’s share to be a risky investment or the share is
underpriced. Dividend yield should not be inter- preted as expected
return from the share. There is another component of returns from
investment in a share: the change in price over the holding period.

SELF-ASSESSMENT QUESTION
5. Given that earnings per share = Rs. 50, dividend payout
ratio = 40%, dividend yield = 3.2%. The price of ordinary
shares implied by the above data is .
9.5.3 PRICE/EARNINGS RATIO (P/E RATIO)
a. Rs. 78 b. Rs. 625
Market c.price
Rs.of the share incorporates
1,563 everything the market knows
d. Rs. 3,906
about the company. Earnings are the net profit available to equity
shareholders. Relating the market price to the earnings gives an
insight into how the inves- tors judge the performance of the concern.

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It is calculated as follows:
Market price per share
Pr ice / Earnings ratio 
Earnings per share

For Asian Paints, P/E ratio for 2013-14 is Rs. 546.50/Rs. 12.19 = 44.83
The earnings per share used in the denominator can be last year’s
figure or the forecasted figure for the next year.
A high P/E ratio suggests that the share is an attractive investment in
the eyes of investors. The attractiveness may arise out of the belief
that the share carries a low risk or that the earnings are expected to
grow quickly in the future. An unduly high P/E ratio relative to
companies with similar risk- return profile may mean that the share is
overpriced.
This measure is not under the direct control of the company. But if
there is a decline in the P/E ratio of a company without a general
decline in the stock market prices, it becomes a cause of concern for
the management.

6. Which of the following ratio is considered to assess the likely

growth prospects of the company and whether the company
is a low risk investment?
SELF-ASSESSMENT QUESTION a. Earnings per share b. Diluted earnings per share
c. Price–earnings ratio d. Dividend yield

9. LIMITATIONS OF RATIO ANALYSIS

Ratio analysis fails to take into account many qualitative factors that
affect a company’s performance and future prospects. For example,
ratios do not capture the size effect. Large companies have better
bargaining power and enjoy economies of scale. Notes to the
accounts contain important informa- tion which is not reflected in
ratios. For example, contingent liabilities and commitments faced by
the company.
Different accounting policies followed by companies in respect of
deprecia- tion, inventory valuation and other matters can distort
comparison among companies. Ratio analysis also ignores the effect
of industry characteristics on profitability.
Some companies deliberately manipulate financial statements by
creative accounting and window-dressing. Ratio analysis becomes
useless in such cases.

SELF-ASSESSMENT QUESTIONS
7. Financial analysis of a business may not be able to achieve
any one of the following issues:
a. Improve the profitability of the project.
b. Delineate the risks involved in the project.
c. Highlight the salient factors that lead to the greatest
uncertainty.
d. Possibly suggest methods by which the risks might be
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Which of the following financial ratios will be affected by an error in recording the value of inventory in the fi
Inventory turnover ratio
(iii) Earnings per share (ii) Current ratio
(iv) Interest coverage ratio
Options (i) and (ii) All of the above
a. Option (i) onlyb.
c.Options (i), (ii) and (iii)d.

9. SUMMARY
 Understand and compute ratios used in analyzing profitability, effi-
ciency in asset utilization, financial position and market standing of a
company. The profitability ratios are used to check if the company
is gen- erating an acceptable return for its owners. Widely used
measures of prof- itability include profit margins, earnings per
share (EPS), return on capital employed (ROCE), return on assets
(ROA) and return on equity (ROE).
 Ratios used to measure efficiency in asset utilization measure the
effec- tiveness with which a concern uses the resources or assets
at its disposal. Main ratios in this category include debtors’
turnover ratio, inventory turnover ratio, creditors’ turnover ratio,
and cash-to-cash operating cycle.
 Tests of financial position include tests of both short-term and
long- term solvency of the business. Tests of short-term solvency
focus on the liquidity position of the company. Two important
ratios used to measure short-term liquidity are: current ratio and
quick ratio. Tests of long-term solvency focus on the ability of the
company to pay interest and repay principal of its long-term
borrowings. The main ratios in this category are: debt–equity ratio
and interest coverage ratio.
 The market standing of the company is reflected in the market
price of the share. Ratios such as dividend payout, dividend yield
and price earn- ings ratio capture the relationship among
dividend, earnings and market price of share.
 Understand limitations of ratio analysis. Ratio analysis fails to take
into account the size and contingent liabilities of the company.
Different accounting policies followed by companies in respect of
depreciation, inventory valuation and other matters can distort
comparison among companies.

KEY WORDS
1. Average collection period shows the accounts receivables in
terms of number of days of credit sales during a particular
period. It is calculated dividing 365 days by debtors’
turnover ratio.
2. Current ratio is the relation of a company’s current assets to
its current liabilities. This ratio establishes the ability of the
business to meet its short-term obligations.

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3. Debt–equity ratio relates debts to equity or owners’ funds, and

measures the ability of the business to meet its long-term
obligations.
4. External analysis is the analysis carried out by parties external
to the organization such as investors, credit rating agencies,
government agencies etc.
5. Interest coverage ratio relates interest obligations to the profits
before interest and tax and indicates the number of times
interest obligation is covered by the profits for the period.
6. Inventory turnover ratio relates the cost of goods sold to the
average stock. It measures how many times the average
stock is sold during the year.
7. Price–earnings (P/E) ratio compares the market price per share
to the earnings per share. It is calculated as the market
price per share divided by earnings per share.
8. Quick ratio is a more precise measure of liquidity than the
current ratio. Quick ratio relates quick current assets to
current liabilities. Quick current assets are current assets
minus inventories. Quick ratio is also known as “Acid Test
Ratio” or “Liquid Ratio”.
9. Return on assets relates profit to investment in all the financial
resources, that is, owners’ equity, long-term liabilities and
current liabilities.
10. Return on capital employed measures the returns generated

9. DESCRIPTIVE QUESTIONS
1. List the possible reasons for high P/E ratio of a share.
2. Which of the profitability ratios is the most reliable for analysis and why?
3. Explain the limitations of financial ratio analysis in the
interpretation of the financial statements of a company.
4. Explain how P/E ratio and dividend yield ratio can be used in
formulating appropriate equity investment recommendations
5. Define current ratio and quick ratio. Briefly explain the reasons
for calculating these ratios.
6. Out of a mature and a growth company, which company is likely
to have a higher dividend payout ratio and why?
7. Define debtors’ turnover ratio and inventory turnover ratio and
explain their use.

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9. ANSWER KEY
SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Tests of Efficiency in 1. b. Earlier the business had a
Investment Utilization zero debt collection period
(Efficiency Ratios)
Tests of Financial Position 2. d. Long-term investments
of the company
3. d. both options (a) and (b)
4. d. All of the above
Ratios Involving 5. b. Rs. 625
Share Information
6. c. Price–earnings ratio
Limitations of Ratio Analysis 7. a. Improve the profitability of
the project
8. d. All of the above

9.1 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Datt G. and A. Mahajan (2012): Datt and Sudharam Indian
Economy (New Delhi: S. Chand & Company Ltd.).
 Department of Industrial Policy & Promotion. (2010-11). Annual
Report 2010-11. Ministry of Commerce and Industry, Government
of India.

E-REFERENCES
 Food and Agriculture Organisation, Statistical Database, Various
years, http://faostat.fao.org accessed on 30 April, 2011.
 Indiastat, Statistical database, various years, www.indiastat.com
accessed on 2 August 2011.

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 C
10
H A P T E R

ANALYSIS OF FINANCIAL STATEMENTS II

CONTENTS

10.1 Introduction
10.2 Techniques of Financial Analysis
10.3 Common-Size Analysis
Self-Assessment
Questions Activity
10.4 Trend
Analysis
Activity
10.5 Percentage Change Analysis (Comparative Financial
Statements) Self-Assessment Questions
Activity
10.6 Management Discussion and Analysis
10.7 Thinking Beyond Numbers
10.8 Quality of Earnings
10.9 Sustainable
Income Solved
Problems
Self-Assessment Question
10.10 Summary
Key Words
10.11 Descriptive Questions
10.12 Answer Key
Self-Assessment Questions
10.13 Suggested Books and E-References

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184 FINANCIAL ACCOUNTING AND ANALYSIS

INTRODUCTORY CASELET

ALPHA LIMITED

The CFO of Alpha Limited is looking at the summary income

statement of the company for the year ended on March 31, 2019.
Summary Income Statement of Alpha Limited for the year ended
on March 31, 2019:

March 31, 2019 March 31, 2018

(Rs. Million) (Rs. Million)
Sales revenue 2,079 1,89
0
Operating expenses 1,351 1,13
4
Interest expense 31 284
3
Profit before tax 41 472
5

The CFO is trying to analyze why, despite a 10% increase in sales

rev- enue over the last year’s figure, the profit before tax has
declined by nearly 12% compared to the previous year.

QUESTION

1. Analyze the reason for the decline in profit before tax in

the current year from that of the previous year. (Hint:
Prepare common-size income statement for the 2

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ANALYSIS OF FINANCIAL STATEMENTS II 185

LEARNING OBJECTIVES

After reading this chapter, you will be able to:

> Understand the objectives of financial analysis.
Describe and perform horizontal, vertical and trend analysis. Understand the concept of quality of earnin
> Understand the concept of sustainable income.

>
>
10. INTRODUCTION
Financial statement analysis involves rearrangement of financial
informa- tion, comparison, analysis and interpretation of that
information. It can be external or internal; horizontal or vertical; and
intra-firm or inter-firm.
Analysis done by the management to assess the financial health of
the organi- zation and its operational efficiency is called internal
analysis. Analysis car- ried out by parties external to the organization
such as investors, credit rating agencies, government agencies etc. is
called external analysis. Horizontal analysis compares financial data
over a number of years to analyze the trend. Vertical analysis is
based on the financial data of a particular year. Inter-firm analysis
compares financial variables of two or more firms to get an idea of
their relative competitive position. Intra-firm analysis compares the
perfor- mance of different units of the same firm.

10. TECHNIQUES OF FINANCIAL ANALYSIS

The following techniques can be used for analyzing the financial statements:
1. Vertical analysis (common-size analysis)
2. Horizontal analysis
(a) Trend analysis
(b) Percentage change analysis
3. Ratio analysis
4. Quality of earnings
5. Sustainable income
Ratio analysis has been covered in Chapter 9 of the book. The other
tech- niques of financial statement analysis are covered in this
chapter.

10. COMMON-SIZE ANALYSIS

Common-size analysis, also known as vertical analysis, can be used
to com- pare the financial statements of two periods to identify
variations which form the basis for further analysis. In common-size
analysis, all figures of a financial statement are expressed as a
percentage of a common base, which is taken as 100. This common
base is the sales figure in the case of

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186 FINANCIAL ACCOUNTING AND ANALYSIS

Statement of Profit and Loss and the total of assets or of liabilities in

the case of Balance Sheet. Common-size balance sheets are shown in
Table 10.1 and common-size income statements in Table 10.2.

SELF-ASSESSMENT QUESTIONS
1. By what other name is common-size analysis known as?
a. Vertical analysis b. Directional analysis
c. Horizontal analysis d. Trend analysis
2. Expressing each item of a balance sheet as a percent is an
example of
a. Trend analysis b. Common-size analysis
c. Horizontal analysis d. Comparative analysis
Reserves and surplus 4,825,000 25.5 6,250,000 26.3
3. In vertical analysis, each item in a financial statement is
Long-term loans 2,000,000 10.6 2,500,000 10.5
expressed as
Accounts
a. payable
An amount in Rupees 1,250,000 6.6 1,500,000 6.3
Taxes b. A percent of some base figure
payable 850,000 4.5 1,000,000 4.2
c. A percent of the amount of the same item in the
Total current liabilities 2,100,000 11.1 2,500,000 10.5
preceding year
Total liabilities and in Euro
d. An amount 18,925,000 23,750,00
stockholders’ equity 0
4. The relationship of components of a financial statement is
==== 100.0 ==== 100.0
best expressed by preparing:
= =
a. A common size statement b. A trend analysis report
Land 4,375,000 23.1 5,000,000 21.1
c. An analysis of ratios d. A profit–loss analysis
Property, plant and equipment 2,375,000 12.6 5,375,000 22.6

TABLE 10.1 COMMON-SIZE BALANCE SHEETS

2018 (Rs.) % 2019 (Rs.) %
Equity share capital 10,000,000 52.8 12,500,000 52.7

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TABLE 10.1 COMMON-SIZE BALANCE SHEETS—CONTINUED

2018 (Rs.) % 2019 (Rs.) %
Accumulated depreciation (2,000,000) (10.6 (2,625,00 (11.1
) 0) )
1,875,000 9.9 2,750,000 11.6
Long-term investments 2,750,000 14.5 3,250,000 13.7
Cash 3,000,000 15.9 3,250,000 13.7
Accounts receivable 5,375,000 28.4 5,625,000 23.7
Inventory 1,175,000 6.2 1,125,000 4.7
Prepaid expenses ------------- -------------
Total current assets 12,300,00 65.0 13,250,00 55.8
0 0
Total assets 18,925,00 100.0 23,750,00 100.
0 0 0

The common-size balance sheets indicate the growing size of the

business of the company. The assets have increased from Rs. 18.93
million in 2013 to Rs.23.75 million. New investment has mainly
been made in property, plant and equipment, their percentage of
total assets has increased from 12.6% to 22.6%. Other assets have
also increased in absolute terms but not in percent terms because
of a higher increase in the overall size of the balance sheet. A major
part of the funds for this investment have come from retained
profits which are reflected in increase in reserves and surplus to
26.3% of equity and liabilities from 25.5% in the previous year.
Equity share capital and long-term loans have also increased in
absolute amount but not in percent terms.
Composition of assets and liabilities has changed. The share of QUICK TIP
current assets in the total assets has declined from 65% to 55.8% In a common-size balance
with a corre- sponding increase in the share of non-current assets. sheet, all items of the balance
Current liabilities have declined 0.6% from 11.1% to 10.5% with a sheet are expressed as
corresponding increase in non-current liabilities. This implies that percentage of total assets.
the company is able to release more funds for long-term investment
with a more efficient management of its working capital.

5. In a common size balance sheet, which item represents the

100% figure?
a. Total assets b. Total current assets
c. Total non-current assets d. None of the above
6. The base figure in terms of which value of property, plant
and equipment is expressed in a common size statement is:
SELF-ASSESSMENT QUESTIONS
a. Total non-current assets b. Total assets
c. Net sales d. Total revenue

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ABC Ltd. provides the following summary al information for

year 2018 and year 2019. financi the

2018 2019
Rs. Million Rs. Million
Share capital 4,80 5,280
0
Non-current liabilities 3,36 3,801
0
Current liabilities 720 63
3
Investments 720 84
ACTIVITY 1 6
Current assets 3200 3,300

TABLE 10.2 COMMON-SIZE INCOME STATEMENTS

2018 (Rs.) % 2019 (Rs.) %
Sales revenue 16,250,000 100.0 17,500,000 100.0
Cost of goods sold 11,375,000 70.0 12,500,000 71.4
Gross profit 4,875,000 30.0 5,000,000 28.6
Employee benefit 1,056,250 6.5 1,250,000 7.1
expenses
Other administrative 1,175,000 7.2 1,200,000 6.9
expenses
Depreciation 375,000 2.3 875,000 5.0
Total expenses 2,606,250 16.0 3,325,000 19.0
Operating income 2,268,750 14.0 1,675,000 9.6
Interest expense (125,000) (0.8) (175,000) (1.0)
Other income 1,250,000 7.7 1,875,000 10.7
Net income before tax 3,393,750 20.9 3,375,000 19.3
Tax (1,006,25 (6.2) (1,000,000) (5.7)
0)

QUICK TIP Common-size income statements of the company show an increase of

In a common-size income 1.4% in cost of goods sold and an increase of 3.0% in operating
statement, all items of expenses. Operating income has declined by 4.4%. Interest expense
the income statement are has also increased by 0.2%. However due to increase in other income
expressed as percentage of by 3% and decrease of 0.5% in tax expense, the decrease in net
total revenue. income is only 1.1%.

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ANALYSIS OF FINANCIAL STATEMENTS II 189

7. The base that is used to express the percent material

consumption in common-size analysis is:
a. Fixed assets b. Net sales
c. Total assets d. Fixed assets
8. In a common size income statement, which item represents
the 100% figure?
a. Cost of goods sold b. Net sales
c. Net income d. Total expenses
9. The base figure in terms of which cost of goods sold is
expressed in a common size statement is
a. Total selling expenses b. Total revenue
c. Total expenses d. Net sales
10. Which of the following is used to represent sales revenue in
a common size statement?
a. Net income b. Cost of goods sold
SELF-ASSESSMENT QUESTIONS
c. Net sales d. Total revenue

TREND ANALYSIS
10.
These are useful for making a comparative study of the financial
statements over a number of years. The earliest year used for QUICK TIP
comparison is treated as the base year. The base year figure for each
item of the financial statements is taken as 100. The figures for the In trend analysis, the base year
subsequent years are expressed as per- centages of the base year figure for each item of the
figure. An illustration of trend percentages is given in Table 10.3. financial statements is taken
as 100.

TABLE 10.3 TREND ANALYSIS

Amount (Rs. Millions) Trend Percentage
2015 2016 2017 2018 2015 2016 2017 2018
Income Statement
Net Sales 94,30 111,30 108,89 114,81 100. 118. 115. 121.7
Operating EBITDA 0 0 0 0 0 0 5 78.4
Profit before Tax 19,21 21,96 16,29 15,07 100. 114. 84.8 73.7
0 0 0 0 0 3 79.7 88.2
Profit after Tax
15,40 14,51 12,27 11,35 100. 94.2 82.7
0 0 0 0 0 80.0
13,25 10,61 10,96 11,68 100.
0 0 0 0 0
Balance Sheet
Shareholders’ 71,92 73,83 78,25 82,36 100. 102. 108.8 114.
Funds Borrowings 0 0 0 0 0 7 6.8 5
Net Fixed 5,11 1,63 350 0 100. 31.9 96.2 0
0 0 63,24 75,13 0 93.9 89.4 114.
Assets Cash
65,73 61,75 0 0 100. 107. 3
Current Assets 0 0 0 94.2
26,21 16,86 0 57.
Current liabilities 29,32 31,37 0 0 100. 83.9 98.9 5
Capital Employed 0 0 34,76 34,85 0 101.8 94.
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36,91 30,98 0 0 100. 102. 4
0 0 37,26 39,00 0 5 103.
37,68 38,63 0 0 100. 98.1 5
0 0 83,67 87,71 0 106.
82,21 80,63 0 0 100. 7
0 0 0

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190 FINANCIAL ACCOUNTING AND ANALYSIS

Alpha Limited reports the following amounts of sales revenue (in

million rupees) for the last five years:
Year 2015 2016 2017 2018 2019
Sales revenue 50 55 60 63 58

ACTIVITY 2 Present the above information in the form of a trend analysis

report using the year 2015 as the base.

10. PERCENTAGE CHANGE ANALYSIS

5 (COMPARATIVE FINANCIAL
STATEMENTS)
Figures of two or more periods are placed side by side. Comparison of
abso- lute as well as percentage change in the figures over the
periods is made to derive meaningful conclusions. Percentage
change analysis is a type of horizontal analysis. An illustration of
comparative balance sheets is given in Table 10.4 and of comparative
income statements in Table 10.5.

TABLE 10.4 COMPARATIVE BALANCE SHEETS

Rupee
Change % Change
2018 2019 Increase Increase
Rs. Rs. (Decrease) (Decrease)
Equity share capital 10,000,00 12,500,00 2,500,000 25.0
0 0
Reserves and Surplus 4,825,000 6,250,000 1,425,000 29.5
Long-term Loans 2,000,000 2,500,000 500,000 25.0
Accounts Payable 1,250,000 1,500,000 250,000 20.0
Taxes Payable 850,000 1,000,000 150,000 17.6
Total Liabilities and 2,100,000 2,500,000 400,000 19.0
Stockholders’ Equity
Land 18,925,00 23,750,00 48,25,000 25.5
0 0
Property, Plant & 4,375,000 5,000,000 625,000 14.3
Equipment
Accumulated 2,375,000 5,375,000 3,000,000 126.3
Depreciation
Long-term investments (2,000,00 (2,625,00 (625,000) (31.3)
0) 0)
Cash 1,875,000 2,750,000 875,000 46.7
Accounts receivable 2,750,000 3,250,000 500,000 18.2
Inventory 3,000,000 3,250,000 250,000 8.3
Prepaid expenses 5,375,000 5,625,000 250,000 4.7
Total current assets 1,175,000 1,125,000 (50,000) (4.3)
TotalGlobal
NMIMS assets 12,300,00
Access - School for Continuing 13,250,00
Education 950,000 7.7

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 0 0
18,925,00 23,750,00 4,825,000 25.5
0 0

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ANALYSIS OF FINANCIAL STATEMENTS II 191

TABLE 10.5 COMPARATIVE INCOME STATEMENTS

Rupee Change % Change
Increase Increase
2018 2019 (Decrease) (Decrease)
Sales revenue 16,250,000 17,500,000 1,250,000 7.7
Cost of goods sold 11,375,000 12,500,000 1,125,000 9.9
Gross Profit 4,875,000 5,000,000 125,000 2.6
Employee benefit 1,056,250 1,250,000 193,750 18.3
expenses
Other administrative 1,175,000 1,200,000 25,000 2.1
expenses
Depreciation 375,000 875,000 500,000 133.3
Total expenses 2,606,250 3,325,000 718,750 27.6
Operating income 2,268,750 1,675,000 593,750 (26.2)
Interest expense (125,000) (175,000) (50,000) 40.0
Other income 1,250,000 1,875,000 625,000 50.0
Net income before 3,393,750 3,375,000 (18,750) (0.06)
tax
Tax (1,006,250) (1,000,000) 6,250 (0.06)
Net income 2,387,500 2,375,00 (12,500) (0.05)
0

SELF-ASSESSMENT QUESTIONS
11. Horizontal analysis is based on data pertaining to
a. One period of time b. A number of periods
c. A particular date d. None of the above
ACTIVITY 3
12. Comparative financial statements:
a. Are prepared for one year
b. Are prepared for at least 2 years
Rs. (million)
c. Show only the rupee amount 2019 2018
d. Present comparison
Net Sales of only balance
700 sheet items
600
Cost of Goods Sold 602 510
Prepare a comparative
Gross profitincome statement
98 from the following
90 data taken from the financial statements of Kohinoo

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QUICK TIP 10. MANAGEMENT DISCUSSION AND ANALYSIS

Management Discussion and Analysis (MD&A) Report is a
Management Discussion and requirement of the listing agreement of the company with the stock
Analysis (MD&A) Report is exchange. This require- ment, therefore, applies to a listed company
not a requirement under the only.
Companies Act, 2013, but
of the listing agreement of Clause 49 of the listing agreement provides that as part of the
the company with the stock directors’ report or as an addition thereto, a MD&A report should form
exchange. part of the Annual Report to the shareholders. This MD&A should
include discussion on the following matters within the limits set by
the company’s competitive position:

1. Industry structure and developments

2. Opportunities and Threats
3. Segment-wise or product-wise performance
4. Outlook
5. Risks and concerns
6. Internal control systems and their adequacy
7. Discussion on financial performance with respect to operational
performance
8. Material developments in Human Resources/Industrial Relations
front, including the number of people employed.

MD&A report provides useful insights about the industry in which a

com- pany operates, its competitive position in the industry, future
prospects of the company and the risks facing the company.

10. THINKING BEYOND NUMBERS

Ratio Analysis and other tools of financial analysis fail to take into
account many qualitative factors that affect a company’s
performance and future prospects. For example ratios do not capture
the size effect. Large compa- nies have better bargaining power and
enjoy economies of scale. Notes to the accounts contain important
information which is not reflected in ratios. For example contingent
liabilities and commitments faced by the company.
Different accounting policies followed by companies in respect of
deprecia- tion, inventory valuation and other matters can distort
comparison among companies. Ratio analysis also ignores the effect
of industry characteristics on profitability.
Some companies deliberately manipulate financial statements by
creative accounting and window-dressing. Ratio analysis becomes
useless in such cases. A proper analysis of financial performance and
financial position of a company requires looking beyond numbers.
Two important tools for this purpose are measurement of quality of
earnings and sustainable income.

10. QUALITY OF EARNINGS

The term quality of earnings is used in the context of making
accounting choices. It is the degree to which managers, when faced
with a choice of
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items that have a high impact on earnings, choose items that result
in income recognition that is more likely to lead to recurring
patterns of income. The more likely an item of income is to recur,
the higher its quality will be. To generate confidence of investors and
lenders in financial reports and to make capital markets efficient, it is
necessary that the earnings reported by companies are of high
quality.
Quality of earnings suffers when earnings are managed. Earnings
manage- ment is planned timing of revenues, expenses, gains and
losses to smooth net income. The following ways are generally used
to manage earnings:

1. Use of one-time items such as sale of investments or fixed assets.

2. Inflate revenues in the short-run by providing sales incentives to
achieve higher sales at the end of the year. These goods might
! IMPORTANT CONCEPT
be returned by the customers in the next year. Earnings management is planned timing of rev
3. Use of improper adjusting entries, for example, recognizing
revenue on multi-year contracts too quickly and treating
operating expenses as capital expenditure.

10. SUSTAINABLE INCOME

For forecasting future cash flows, analysts need to ensure that
current earn- ings do not include irregular items. Net income adjusted ! IMPORTANT CONCEPT
for irregular items is called Sustainable Income. It is the most likely Sustainable income is the net income adjusted
level of income to be achieved in the future. It differs from the actual
net income by the amount of irregular revenues, expenses, gains and
losses.
Two major irregular items are as follows:
1. Discontinued Operations
! IMPORTANT CONCEPT
2. Extraordinary items
Discontinued operations refer to the disposal o
Discontinued Operations refer to the disposal of a significant part of
the busi- ness or an activity. As the results of discontinued operations
will not be a part of an entity’s results in the future, the entity is
required to report the profit and loss from discontinued operations
net of tax.
Extraordinary items are events and transactions that are both
! IMPORTANT CONCEPT
unusual in nature and occur infrequently, for example, loss caused by
a natural calamity that is not usual in a particular area. However, loss Extraordinary items are events and transaction
to crop due to weather is not an extraordinary item as it is not
infrequent. Other examples of extraordinary items are expropriation
of property by a foreign government, and effect of a newly elected
law.

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194 FINANCIAL ACCOUNTING AND ANALYSIS

SOLVED PROBLEMS
1. Amar Raja Limited provides the following information for the
immediately preceding two years:

2019 2018
Rs. Million Rs. Million
Sales 5,000 3,750
Cost of goods sold 3,000 2,450
Operating expenses 750 490
Financial expenses 500 340
Income tax 150 95
Net profit 600 375

Prepare Comparative Income statement of the company for the

two- year period.
Solution
Comparative Income Statements of Amar Raja Limited for the
Years 2018 and 2019

2018 2019 Rupee % Change

(Rs. Million) (Rs. Million) Change Increase
Increase (Decrease)
(Decrease)
Sales revenue 3,750 5,000 1,25 33.33
0
Cost of goods 2,450 3,000 550 22.45
sold
Gross Profit 1,300 2,000 700 53.85
Operatin (490) (750) (260) 53.06
g
expenses
Operating income 810 1,250 440 54.32
Financial (340) (500) 160 47.06
expenses
Net income 470 750 280 59.57
before tax
Income tax (95) (150) 55 57.89
Net profit 375 600 225 60.00

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ANALYSIS OF FINANCIAL STATEMENTS II 195

2. The following items appear in the financial statement of Steelco Limited.

Rs. Million
2018 2017 2016
Net Sales 169 162 150
Cost of Goods Sold 111 105 94
Gross profit 58 57 56

Prepare a trend analysis statement for three years treating 2016

as the base and comment on the results.
Solution
Trend Analysis of Gross Profit of Steelco Limited
for the period 2016–2018

Amount (Rs. Million) Trend Percentages

2016 2017 2018 2016 2017 2018
Net sales 150 162 169 100.0 108.0 112.7
Cost of goods 94 105 111 100.0 111.7 118.1
sold
Gross profit 56 57 58 100.0 101.8 103.5
Net Sales, Cost of goods sold and gross profit show an
increasing trend. Increase in sales is higher than increase in cost
of goods sold due to which gross profit is increasing.
3. Prepare common-size income statement from the following data
taken from the financial statements of Xi Limited for the years
2018 and 2019.

Rs. Million
2019 2018
Net Sales 540 475
Cost of Goods Sold 405 378
Gross profit 135 97
Solution
Common-Size Income Statement of Xi Limited for
the Years 2018 and 2019

2018 2019
(Rs. Million) % (Rs. Million) %
Net sales 475 100.0 540 100.0
Cost of goods 378 79.6 405 75.0
sold
Gross profit 97 20.4 135 25.0

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196 FINANCIAL ACCOUNTING AND ANALYSIS

13. Disposal of a significant part of the business or an activity is

known as
SELF-ASSESSMENT QUESTION a. An exceptional item b. An extraordinary item
c. Discontinued operationsd. Cessation of business

10.10 SUMMARY
 Understand the objectives of financial analysis. The purpose of finan-
cial statement analysis is to determine the meaning and
significance of the data contained in the statements so that a
forecast may be made of future earnings and financial position.
 Describe and perform horizontal, vertical and trend analysis.
Horizontal analysis compares financial data over a number of
years to analyze the trend. Comparative Balance Sheets and
Comparative Profit and Loss Statements are used to perform
horizontal analysis. Vertical analysis is based on the financial
data of a particular year. It is carried out by preparing
common-size Balance Sheet and common-size Income
Statement.
 Understand the concept of quality of earnings. Quality of earnings indi-
cates the degree to which full and transparent information is
provided to the users of financial statements. Quality of earnings
suffers when earn- ings are managed. Earnings management is
the planned timing of reve- nues, expenses, gains and losses to
smooth the net income.
 Understand the concept of sustainable income. Net income adjusted
for irregular items is called sustainable income. It is the most
likely level of income to be achieved in the future.

KEY WORDS
1. Common base In common-size analysis, all figures of a
financial statement are expressed as a percentage of a
common base, which is taken as 100. This common base
is the sales figure in the case of Statement of Profit and
Loss and the total of assets or of liabilities in the case of
Balance Sheet.
2. Common-size analysis, also known as vertical analysis, can be
used to compare the financial statements of two periods to
identify variations which form the basis for further analysis.
3. Discontinued operations refer to the disposal of a significant
part of the business or an activity.
4. Extraordinary items are events and transactions that are both
unusual in nature and occur infrequently.
5. Financial statement analysis is the study of relationships
between the elements of the same statement or different
financial statements and the trend of these elements.
6. Horizontal analysis compares financial data over a number of
years to analyze the trend.

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ANALYSIS OF FINANCIAL STATEMENTS II 197

7. Quality of earnings indicates the degree to which full and

transparent information is provided to the users of financial
statements.
8. Sustainable income is the most likely level of income to be
achieved in the future. It differs from the actual net income
by the amount of irregular revenues, expenses, gains and
losses.
9. Vertical analysis is based on the financial data of a particular
year and is carried out by expressing each item in the

10.11 DESCRIPTIVE QUESTIONS

1. Explain what kind of information can be obtained from common-
size analysis?
2. How is vertical analysis used to make competitive analysis?
3. Explain the difference between horizontal analysis and vertical analysis.
4. Provide three examples of the ways that companies use to
manage their earnings.
5. Explain the term ‘Sustainable Income’. How is sustainable
income related to the treatment of irregular items in the
statement of profit and loss?
6. Explain the limitations of financial ratio analysis in the
interpretation of the financial statements of a company.
7. When are the earnings of an entity considered to be of good quality?

10.12 ANSWER KEY

SELF-ASSESSMENT QUESTIONS

Topics Q. No. Answers

Common-Size Analysis 1. a. Vertical analysis
2. b. Common-size analysis
3. b. A percent of some base
figure
4. a. A common-size
statement
5. a. Total assets
6. b. Total assets
7. b. Net sales
8. d. Total expenses
9. d. Net sales
10. c. Net sales
Percentage Change Analysis 11. b. A number of periods
(Comparative Financial
Statements)

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 198 FINANCIAL ACCOUNTING AND ANALYSIS

Topics Q. No. Answers

12. b. Are prepared for at
least 2 years
Sustainable Income 13. c. Discontinued
operations

10.13 SUGGESTED BOOKS AND E-REFERENCES

SUGGESTED BOOKS
 Narasimhan M.S. (2016). Financial Statement and Analysis.
Cengage Learning India Private Limited; First edition.
 Grewal T. S., Grewal H. S., Grewal G. S., Khosla R. K. (2019). T.S.
Grewal’s Analysis of Financial Statements. Sultan Chand & Sons
Private Limited.

E-REFERENCES
 Ahsan M. I.(2019). CFA 2019 Level 1: Financial Reporting and
Analysis: Complete FRA in one week Kindle Edition.
 Goel S. (2019). Finance for Non-Finance People. 2nd Edition, Kindle
Edition.

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 C
11
H A P T E R

CASE STUDIES

CONTENTS

Case Study 1: Modern Coffee House

Case Study 2: Aarti Enterprises
Case Study 3: Asian Chemicals
Limited Case Study 4: Remco
Limited
Case Study 5: Rama Sales
Corporation Case Study 6: Fresca
Limited

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200 FINANCIAL ACCOUNTING AND ANALYSIS

CASE STUDY 1

MODERN COFFEE HOUSE

Modern Coffee House is a partnership firm formed on January 1,

2017, by two persons Mr. Ram Ashish and Mr. Ram Naresh. Mr.
Ram Ashish was working with a manufacturing company on the
shop floor and had about 10 years’ experience. Mr. Ram Naresh
was working as an ad hoc with a multinational company for quite
some time. He became the victim of downsizing and was finally
retrenched. Ram Ashish sought retirement under Early
Separation Scheme (ESS) from the company. The two,
enthusiastic and energetic, in their early 30s, formed a
partnership in a well-developed township near Delhi. The
township is well connected with different parts of the country and
a large number of multinational and Indian companies have set
up their corporate offices there. Ram Ashish and Ram Naresh
were very hard working and determined young men. However,
running a coffee house was new to them and they did not
possess any commercial experience.
They contributed Rs. 2,000,000 each, hired a small premises on
rent, purchased furniture for Rs. 1,050,000, utensils for Rs.
920,000, equip- ment for Rs. 630,000 and made a security
deposit of Rs. 1,050,000 with a soft drinks company. They did not
keep proper accounting records but just maintained a cash
register and a daybook. At the end of July 2017, they found their
assets, liabilities and other items as follows:

Cash Rs. 250,000 Bank Balance Rs. 1,000,000

Utensils 920,000 Equipment 630,000
Sale proceeds 2,600,000 Rent paid 150,000
Total expense on Furniture 1,050,000
Food & beverages 1,550,000

From August 1, 2017 to July 31, 2018, activities of the I increased

consid- erably. They employed four helpers and took a loan of Rs.
2,500,000 from a bank. During this period, their takings and
expenses were as follows:

Materials Rs. Repayment Rs. 250,000

purchased 1,500,000 of bank loan
Sale proceeds & 6,000,000 Travelin 160,000
collections g
expense
s
Expenses on 2,280,000 Interest 250,000
eatables on bank
loan
Gas & fuel 360,000 Miscellaneou 36,000
s expenses
Wages 60,000 Loan (balance) 2,250,000
Soft drink 600,000 Withdrawals 400,000
expenses
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 CASE STUDIES 201

CASE STUDY 1

During this period, they maintained a simple cashbook and a

daybook. They also provided depreciation on fixed assets:
utensils 20%, furniture 10%, and equipment 15%. The closing
stock was Rs. 1,050,000.
The activities of Modern Coffee House expanded further. They
started packed lunch delivery to customers. At the end of July
2019, they found their revenues total to Rs. 7,700,000.
Expense and other items were as follows:

Materials Rs. Repayment of bank Rs. 2,50,000

purchased 40,00,000 loan
Wages 4,80,000 Travelling expenses 2,32,000
Gas & fuel 5,00,000 Interest on bank loan 225,000
Soft 8,48,000 Miscellaneou 280,000
drink s expenses
expenses
Fixed deposits 3,00,000 Operating expenses 8,00,000
Rent paid 300,000 Loan balance 2,000,000
Drawings 5,00,000

As the business had expanded considerably, they employed an

accoun- tant who could keep proper books of accounts, so that
they could prepare financial statements and measure the
performance of their business more accurately. The
accountant adopted accrual basis of accounting. Wages and
other outstanding expenses on July 31, 2019 were Rs. 360,000.
They provided depreciation on furniture @10%, utensils
@20%, and other equipment @ 15%. Stock of materials was
Rs. 1,850,000.

QUESTIONS

1. Draw up a balance sheet of Modern Coffee House as on

July 31, 2017, taking into account the events that took
place up to that date. (Hint: Total of Balance Sheet Rs.
4,900,000.)
2. Mr. Ram Naresh and Mr. Ram Ashish did not possess
accounting skills and in the beginning thought that
hiring an accountant to keep accounting records would
involve costs that their small business could not afford.
Do you agree with their view? Give your comments.
(Hint: The benefit of hiring a professional accountant will
more than offset the cost by facilitating better
decisions.)
3. Draw up an income statement and a balance sheet of
Modern Coffee House for the accounting year ended on
July 31, 2018. (Hint: Profit Rs. 1,120,500; Balance Sheet
total Rs. 7,870,500.)
4. Do you think that the two bases of income
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202 FINANCIAL ACCOUNTING AND ANALYSIS

CASE STUDY 1

QUESTIONS

5. Prepare the necessary financial statements of Modern

Coffee House for the year ended on July 31, 2019.
(Hint: Profit Rs. 91,500, Balance Sheet total Rs.
7.572,000.)
6. Is there any linkage between the financial statements
themselves? Discuss briefly. (Hint: The profit/loss from the

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 CASE STUDIES 203

CASE STUDY 2

AARTI ENTERPRISES

Aarti enterprises has been in existence for the last 3 years. The
company is engaged in the manufacture and sale of specialty
chemicals. It is now planning to expand its operations and
requires funds for the purpose. It has approached its bankers for
a term loan of Rs. 100 million.
The bank’s lending policy states that a company is eligible for a
loan if it satisfies the following two conditions:
1. The current ratio of the borrower must be at least 1.5.
2. The quick ratio of the borrower must be at least 1.0.
The accountant of the firm prepared and submitted the following
bal- ance sheet to the bank:
Balance Sheet of Aarti Enterprises as on March 31, 2019

Assets Rs. (Million)

Property, plant and equipment 2,80
0
Cash and cash equivalents 325
Accounts receivable 310
Inventories 350
Total Assets 3,785
Capital and Liabilities
Equity share capital 1,71
0
Retained earnings 700
Long-term loan 750
Short-term loan 500
Accounts payable 125

The accountant claimed that the company met both the

requirements for being eligible for the bank loan. The bank,
however, required the company to submit an audited balance
sheet. The company approached a Chartered Accountant for
auditing the balance sheet of the company.
The Chartered Accountant noted that the accountant had
overlooked making the following year-end adjustments:
1. Inventories at the end of the year were Rs. 250 million.
2. Wages of Rs. 35 million and other expenses of Rs. 15 million
were unpaid at the end of the year.

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204 FINANCIAL ACCOUNTING AND ANALYSIS

CASE STUDY 2

QUESTIONS

1. Prepare the corrected balance sheet of the company as

on March 31, 2019. (Hint: (a) Replace inventories of Rs.
350 million under assets with inventories of Rs. 250
million. (b). Adjust retained earnings for decrease in
inventories and for outstanding expenses. (c). Show
outstanding expenses as a new item of liabilities.)
2. Based on the corrected balance sheet, state whether
the company met the two requirements of eligibility for
the bank loan. (Hint: The new current ratio 1.31; quick
ratio 0.94.)

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 CASE STUDIES 205

CASE STUDY 3

ASIAN CHEMICALS LIMITED

At the tenth annual general meeting of Asian Chemicals Limited,

the Chief Financial Officer (CFO) was presenting the financial
statements of the company for the year ended March 31, 2019,
before the shareholders. When the CFO was presenting the
schedule of the balance sheet relating to ‘Other Equity’, some
shareholders requested the CFO to explain the various
components of ‘Other Equity’.
The balance sheet schedule covering ‘Other Equity’ is
presented in the next page.

QUESTION

1. As CFO of Asian Chemicals Limited, explain each element

of ‘Other Equity’ to the shareholders. (Hint: Refer
Chapter 7 for components of ‘Other Equity’.)

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Chapter 11_Case study.indd

2
FINANCIAL ACCOUNTING AND ANALYSIS
Notes to the Financial Statements
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Other Equity (Rs. Million)

Capital Debt Equity

Capital Redemption General Retained Instruments Instruments
Reserve Reserve Reserve Earnings through OCI through OCI Total
Balance as at 31.03.2018 450 5 41,500 33,900 12 1,02 76,887
0
Additions during the year 21,350 21,350
Profit for the year

CASE STUDY
Items of OCI, net of tax
Re-measurement of defined (265) (265)
benefit plans
Net fair value gain on 95 95
investment in equity
instruments through OCI
Net fair value (loss) on invest- (12) (12)
ment in debt instruments
through OCI
Total Comprehensive Income 21,085 (12) 95 21,168
for the year 2018-19
Reductions during the year
Dividends (8,540) (8,540)
Income tax on dividends (1,735) (1,735)
Total (10,275) (10,275)
5/14/2020 3:50:22

Balance as at 31.03.2019 450 5 41,500 44,710 1,11 87,780

5
 CASE STUDIES 207

CASE STUDY 4

REMCO LIMITED

The Accountant of Remco Limited (RL) has prepared the following

statement of sources and uses of cash for the year ended March
31, 2019.
Statement of sources and uses of cash for the year ended March 31,
2019

Sources of Cash Rs. Million

Sale of goods and services 2,000
Issue of shares 2,310
Sale of investments 44
0
Borrowings from bank 11
0
Dividend received 30
3
Interest received 33
Total Sources of Cash (A) 5,196
Uses of Cash
Purchases of materials 1,419
Purchase of equipment 1,815
Operating expenses 1,100
Repayment of bonds 35
8
Interest paid 23
The Accountant claims that the company has performed very well
as reflected in the increase in the cash balance. The accounts
manager, how- ever, infers that the operations of the company
have resulted in a loss. He asks the accountant to prepare a cash
flow statement in proper form also taking in account the beginning
cash balance of Rs. 200 million.

QUESTIONS

1. Prepare the cash flow statement of RL for the year

ended March 31, 2019. (Hint: Cash flows from: operating
activities (Rs. 519 million); investing activities (Rs. 1,039
million); financing activities Rs. 2039 million.)
2. Comment on the performance of the company during
the year and on the factors contributing to increase in
the cash balance. (Hint: Beginning cash balance Rs. 200
million; Ending cash balance Rs. 681 million. The
company has incurred losses in operations. The increase
in cash balance is due to raising of additional financial
resources from issue of shares.)

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208 FINANCIAL ACCOUNTING AND ANALYSIS

CASE STUDY 5

RAMA SALES CORPORATION

Rama Sales Corporation approached its bank on September 20,

2019, for a term loan of Rs. 5 million. The bank asked the
company to submit its income statement for the accounting year
ended on March 31, 2019, and a balance sheet on that date by
October 30, 2019. On October 3, 2019, certain important records
of the company were lost due to flooding of an office. These
records included financial statements for the year 2019.
Management of Rama Sales started looking for records that could
help them in constructing the financial statements required by
the bank. Fortunately, they were able to get the abridged income
statement (Table 1), abridged balance sheet (Table 2) of the
previous accounting year and some other information and ratios
(Table 3). The ratios were calculated on the basis of the year-end
financial information pertain- ing to the current accounting year.
The management also remembered that the sales revenue in
2019 grew 25% over that of 2018 and both gross margin and net
profit margin per- centage in 2019 was the same as in 2018.

TABLE 1 INCOME STATEMENT OF

RAMA SALES CORPORATION FOR THE
YEAR ENDED ON MARCH 31, 2018
Rs.
Sales 57,616,000
Less: Cost of sales 43,212,000
Gross profit 14,404,000
Less: Other expenses 8,642,400
Net profit 5,761,600

TABLE 2 BALANCE SHEET OF RAMA

SALES CORPORATION AS ON MARCH 31,
2018
Rs.
Cash and cash equivalents 2,560,000
Accounts receivable 3,640,000
Inventories 5,930,000
Non-current assets 19,785,000

Total assets 31,915,000

Current liabilities 11,150,000

Long-term loan 6,005,000
Equity 14,760,000

Total capital and Liabilities 31,915,000

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 CASE STUDIES 209

CASE STUDY 5

TABLE 3 SELECT FINANCIAL DATA AND RATIOS

OF RAMA SALES CORPORATION FOR THE YEAR
ENDED ON MARCH 31, 2019
Total assets turnover (times) 2
Debt: equity ratio 0.60:
1
Long-term liabilities/total assets 0.68:
1
Current ratio 1.2:1
Quick ratio 0.67:

QUESTION

1. Prepare the income statement of Rama Sales Corporation

for the year ended on March 31, 2019, and a balance
sheet on that date using the given information. (Hint:
Solve following these steps. 1. Calculate Sales for the
year 2019; 2. Calculate total assets at the end of year
2019; 3. Calculate long-term liabilities;
4. Calculate debt, equity and current liabilities; 5.
Calculate current assets; 6. Calculate debtors; 7.
Calculate inventories;
8. Calculate cash balance; 9. Calculate non-current
assets; 10. Calculate gross profit and cost of sales; 11.
Calculate net profit and other expenses. Gross Profit Rs.
18,005,000, Net profit Rs. 7,202,000, Total assets Rs.

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210 FINANCIAL ACCOUNTING AND ANALYSIS

CASE STUDY 6

FRESCA LIMITED

Fresca Limited has provided the balance sheet of the company for
the years 2018 and 2019 as follows:

2019 2018
Rs. Million Rs. Million
Assets
Non-current assets 2,046 1,99
7
Cash and cash equivalents 2,543 4,64
2
Short-term investments 8,171 9,76
8
Accounts receivable 3,235 3,08
5
Inventories 6,138 5,03
3
Total assets 22,133 24,525
Capital and Liabilities
Equity share capital 9,643 9,54
4
Retained earnings 9,251 12,833
Long-term loan 112 378
Accounts payable 2,354 913
Outstanding expenses 773 857
Total capital and liabilities 22,133 24,525

QUESTIONS

1. Prepare common-size balance sheet for the 2 years and

comment on the results. (Hint: Express every item as a
percent of Rs. 24,525 million in 2018 and of Rs. 22,133
million in 2019.)
2. Analyze the short-term liquidity position of the company. Is
the company facing any short-term liquidity problem?
(Hint: Calculate Current ratio and Quick ratio for both the
years.)
3. Identify the possible reasons for the change in the
amount of equity share capital and retained earnings of
the company over the 2-year period. (Hint: Changes in
equity share capital result from issue or buyback of
shares. Changes in retained earnings occur due to

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