DEFINITION AND MEANING of ACCOUNTING

The American Institute of Certified Public Accountants (1941) defines ‘Accounting is the
art of recording, classifying and summarising in significant manner and in terms of money,
transactions and events which are in part, at least of a financial character and interpreting the
results thereof.’

ACCOUNTING AS AN INFORMATION CYCLE

Input Process Output

ACCOUNTANCY, ACCOUNTING AND BOOK-KEEPING

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 IMPORTANCE OF ACCOUNTING

1. Facilitates to replace memory and comply with legal requirements

2. Facilitates to ascertain net result of operations and also to know the financial position
3. Facilitates the users to take effective decisions
4. It is helpful in a comparative study
5. It assists the management
6. It facilitates to have control over assets
7. It facilitates the settlement of tax liability
8. It facilitates raising of loans
9. It acts as a legal evidence
10. It facilitates ascertainment of value of business.

SCOPE OF ACCOUNTING

1. Identifying
2. Measuring
3. Recording
4. Classifying
5. Summarising
6. Analysing
7. Interpreting
8. Communication

TYPES OF ACCOUNTING

Accounting

Financial Cost Management Social Responsibility

Accounting Accounting Accounting Accounting

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 ACCOUNTING PRINCIPLES

Accounting principles are a body of doctrines commonly associated with the theory and
procedures and as a guide for selection of conventions or procedures where alternatives exist.
These principles are classified into two categories:

1. Accounting Concepts 2. Accounting Conventions

ACCOUNTING CONCEPTS

Concept means a general notion, a theory or belief held by person or group of persons.
The term ‘concepts’ includes those basic assumptions or conditions upon which the science of
accounting is based.

1. Business entity concept

2. Money measurement concept
3. Cost concept
4. Going concern concept
5. Dual aspect concept
6. Realisation concept
7. Accrual concept
ACCOUNTING CONVENTIONS

A convention means a custom or an established usage formed or adopted by an

agreement. The term ‘conventions’ includes those customs or traditions which guide the
accountant while preparing the accounting statements.

1. Convention of consistency
2. Convention of full disclosure
3. Convention of conservatism
4. Convention of materiality

ACCOUNTING STANDARDS

The Accounting standards bring uniformity in the preparation and presentation of

financial statements and aids in comparison of different financial statements of companies in the
same or different industries.

Procedure for framing Accounting Standards

 The International Accounting Standards are issued by the IASC
 These Standards are received by ICAI assigned to ASB
 The Accounting standards are issued under the authority of the council of ICAI.

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 So far the ASB of ICAI has issued 28 Accounting standards as shown below

Mandatory for
Accounting Accounting period
Title
Standard beginning on or
after
AS-1 Disclosure of Accounting Policies 1.4.1991
AS-2(Revised) Valuation of inventories 1.4.1999
AS-3(Revised) Cash Flow Statements 1.4.2001
Contingencies and Events occurring after Balance
AS-4(Revised) 1.4.1995
Sheet Date
Net Profit or Loss, prior period items and changes in
AS-5(Revised) 1.4.1996
Accounting policies
AS-6(Revised) Depreciation Accounting 1.4.1995
AS-7(Revised) Accounting for construction contracts 1.4.2003
AS-8 Accounting for Research and Development 1.4.1991
AS-9 Revenue Recognition 1.4.1991
AS-10 Accounting of Fixed Assets 1.4.1991
Accounting for the effect of changes in foreign
AS-11(Revised) 1.4.1995
exchange rates
AS-12 Accounting for Government Grants 1.4.1994
AS-13 Accounting for Investments 1.4.1995
AS-14 Accounting for Amalgamations 1.4.1994
Accounting for retirement benefits in the financial
AS-15 1.4.1995
statements of employers
AS-16 Borrowing costs 1.4.2000
AS-17 Segment reporting 1.4.2001
AS-18 Related Party Disclosures 1.4.2001
AS-19 Leases 1.4.2001
AS-20 Consolidated Financial Statements 1.4.2001
AS-21 Earnings per share 1.4.2001
AS-22 Accounting for taxes on income 1.4.2001
Accounting for investments in consolidated finance
AS-23 1.4.2002
statements
AS-24 Discounting operations 1.4.2004
AS-25 Interim financial reporting 1.4.2002
AS-26 Intangible assets 1.4.2003
AS-27 Financial reporting of interest in joint ventures 1.4.2002
AS-28 Impairment of Assets 1.4.2004
Provisions, Contingent Liabilities and Contingent
AS-29 1-4-2004
Assets

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 ACCOUNTING EQUATIONS

An accounting equation is a statement of equality between the resources and the sources
that finance the resources.
Resources = Sources of finances-------------- (1)

Resources means Assets & Sources of finances means Equity. If we substitute the above
synonyms, the equation will be as under:
Total Assets = Total Equities------------ (2)

Equities means borrowed funds, which may be funds borrowed from internal sources and those
that can be from external sources. These are also called internal equities and external equities. In
that case the above equation may also be written as under:
Assets = Internal Equity + External Equity-----------(3)

It is a known fact that Internal Equity means Capital and External Equity means Liability. So the
above equation can be written as

Assets = Capital + Liabilities ---------------(4)

OR
Assets – Liabilities = Capital --------------(5)
OR
Assets – Capital = Liabilities ------------(6)

Equations 4,5,6 are accounting equations

USERS OF FINANCIAL STATEMENTS

1. Creditors (short term & long term)

2. Investors (present & potential)

3. Management

4. Employees

5. Tax Authorities

6. Customers

7. Government and their agencies

8. Public

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 DOUBLE ENTRY SYSTEM OF BOOK-KEEPING

The main principle involved in Double Entry system is the duality transactions i.e., for
every debit, there is an equal and opposite credit.

Total Debits = Total Credits

PRINCIPLES OF DOUBLE ENTRY SYSTEM

Classifications of accounts under double entry system

1. Traditional classification

Personal Accounts Real Accounts Nominal Accounts

Names of Assets Expenses,
individuals, And losses and
firms, Liabilities incomes and
companies and gains
other entities

Assets: Resources, things or rights or value owned by a business

Liability: Claims of others against a business / Assets owned by the business to the outsiders
Expenses: An expenditure in return for which a benefit is received.
Loss: An expenditure in return for which no benefit is received.
Income: Refers to the earnings of a business for the expenses incurred
Profit: Refers to the earnings of a business for no expenses incurred or proportionally meagre
expenses incurred

Rules for debit and credit under traditional classification.

Type of Account Debit Credit

Personal Account The receiver The giver
Real Account What comes in What goes out
Nominal Account All expenses and losses All incomes and gains

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 2. Classification based on accounting equation

Asset Liabilities Capital Revenue Expenses

Accounts Accounts Accounts Accounts Accounts

Rules of debit and credit for classification based on accounting equation

Type of Account Debit Credit

Asset Accounts Increase Decrease
Liabilities Accounts Decrease Increase
Capital Accounts Decrease Increase
Revenue Accounts Decrease Increase
Expenditure Accounts Increase Decrease

PROCESS OF RECORDING BUSINESS TRANSACTIONS

Step 4 Preparation of final accounts

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 Step 3 Preparation of Trial Balance

Step 2 Books of Final Entry

Step 1 Books of Original Entry

ACCOUNTING CYCLE

Step 1 – Journalising (the transactions)

Step 2 – Posting (to the ledger)

Step 3 – Balancing (the accounts in the ledger)

Step 4 – Trial Balance

Step 5 – Income Statement

Final Accounts

Step 6 – Position Statement

Figure showing various steps in the accounting cycle

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RECORDS MAINTAINED BY AN ORGANISATION

The books of accounts maintained by an organisation may be classified into two as

a. Books of Prime / Original Entry
b. Books of Second entry / Final entry

Books of Prime / Original Entry

1. Journal
2. Cash Book
3. Subsidiary Books

JOURNAL / DAY BOOK

Format of a Journal
Ledger Debit Credit
Date Particulars
Folio Rs. Rs.
…………….
To………….
(Being…………)

LEDGER

Also called as General Ledger, this is a principal book that contains all the accounts i.e.,
accounts of Assets liabilities, capital, revenue and expenses. The entries from the books of
original entry are transferred to this book. Hence it is also called as a book of final entry. There
are a number of accounts in a general ledger. All similar transactions are grouped under one
account.

Dr Cr
Amount Amount
Date Particulars Folio Date Particulars Folio
Rs. Rs.
To Balance b/d
(Opening balance) --------

By Balance c/d --------

(Closing balance)

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 The opening and closing balances will appear only in case of assets, liabilities and capital
accounts but not in case of incomes and expenditures.

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 CASH BOOK

Debit: All Cash receipts and Bank receipts and Discount Allowed
Credit: All Cash payments and Bank payments and Discount Received.

The cashbook is classified into 4 types viz.,

1. Single column cash book
2. Two columnar cash book
3. Three columnar cash book
4. Petty cash book

Format of a single column cash book

Dr Cr
Amount Amount
Date Particulars L.F. Date Particulars L.F.
Rs. Rs.
To Balance b/d
(Opening balance) --------

By Balance c/d --------

(Closing balance)

Format of a double column cash book

Dr Cr
Discount Cash Discount Cash
Dt Particulars L.F Dt Particulars L.F
Rs. Rs. Rs. Rs.
To
Balance -------
b/d
(Opening
balance) ByBalance -------
c/d
(Closing
balance)

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Format of a double column cash book
OR
Dr Cr
Discount Bank Discount Bank
Dt Particulars L.F Dt Particulars L.F
Rs. Rs. Rs. Rs.
To
Balance -------
b/d
(Opening
balance) ByBalance -------
c/d
(Closing
balance)

OR

Dr Cr
Cash Bank Cash Bank
Dt Particulars L.F Dt Particulars L.F
Rs. Rs. Rs. Rs.
To Balance
b/d ------- -------
(Opening - -
balance)
ByBalance ------- --------
c/d -
(Closing
balance)

Format of a Three Columnar Cash Book

Dr Cr
Discount Cash Bank Discount Cash Bank
Dt Particulars L.F Dt Particulars L.F
Rs. Rs. Rs. Rs. Rs. Rs.

To -------- -------
Balance -
b/d
(Opening By Balance
balance) c/d ------- -------
(Closing - -
balance)

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 Petty Cash Book

It is a cash book in which all the petty cash expenses incurred daily by an organisation is
recorded.

Dr Cr
Total Vr. Business
Date Particulars CBF Dt. Particulars Postage Conveyance Wages Total
Rs. No. Promotion

PURCHASES BOOK

This is a subsidiary book in which all the credit purchases made by the organisation is
recorded. The monthly total from the purchase book is transferred to the General Ledger to the
Purchases Account.

Purchase Details Total Amount

Date Invoice Name of the supplier LF
Rs. Ps. Rs. Ps.
No.

PURCHASE RETURNS BOOK

A book in which all the purchase returns (returns outwards) are recorded.

Debit Details Total Amount

Date Note Name of the supplier LF
Rs. Ps. Rs. Ps.
No.

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 SALES BOOK

The credit sales are recorded in this book. The monthly totals are transferred to the sales
account in the General Ledger.

Sales Details Total Amount

Date Invoice Name of the purchaser LF
Rs. Ps. Rs. Ps.
No.

SALES RETURNS BOOK

A book of account in which all the sales returns (returns outwards) made by the
organisation are recorded.

Credit Details Total Amount

Date Note Name of the purchaser LF
Rs. Ps. Rs. Ps.
No.

JOURNAL PROPER

Those journal entries that cannot be recorded in any of the subsidiary books are recorded
in the journal proper. The following are recorded in the journal proper:

a. Opening Entries

b. Closing Entries

c. Transfer Entries

d. Adjustment Entries

e. Rectification Entries

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 TRIAL BALANCE
It is a statement that shows the balance in all the accounts in a ledger. It contains all the
debit and credit balances. A trial balance is a list of debit and credit balances of all the ledger
accounts prepared on any particular date to verify whether the entries in the books of accounts
are arithmetically correct or not.

Debit Balance Credit Balance

S.No. Head of Account LF
Rs. Ps. Rs. Ps.

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 ELEMENTS OF FINANCIAL STATEMENTS

1. Asset: An Asset is a resource controlled by an enterprise and from which future

economic benefits are expected t flow to the enterprise.

2. Liability: A liability is a present obligation of an enterprise arising from past events,

the settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits.

3. Equity: Equity is the residual interest in the assets of the enterprise after deducting its
liabilities. It is also termed as capital.

4. Income: Income is the increase in the economic benefits during the accounting period
in the form of inflows or enhancement of assets or decrease in liabilities that result in
the increase of equity other than those relating to the contribution from equity
participants.

5. Expenses: Expenses are decreases in the economic benefits during the accounting
period in the form of outflows of depletion of assets or increase of liabilities that
results in the decrease of equity other than relating to the distribution to equity
participants.

FINANCIAL STATEMENTS

Manufacturing Account: This is a statement of account prepared by an enterprise engaged in

manufacturing activity to find out the cost of goods sold.

Trading and Profit and Loss Account: This is statement of account prepared to ascertain the
profits (gross, net and operating profits) earned by an organisation during an accounting
period.

Balance Sheet: This is a statement not an account which shows as on a particular date, the
financial position of an enterprise in terms of the assets in its possession and the liabilities
owed by it.

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 MANUFACTURING ACCOUNT
Manufacturing Account is prepared by an enterprise engaged in manufacturing activities.
It is prepared to ascertain the cost of goods manufactured during an accounting period. This
account is closed by transferring its balance to the Trading Account.

Manufacturing Account of M/s …………….for the period ending on ……………..

Dr Cr
Amount Amount
Particulars Particulars
Rs. Rs.
To Opening Work in progress xxxxx By Sale of scrap xxxx
” Raw material consumed: ” Closing Work in Progress xxxx
Opening Stock xxxx ” Transfer to trading account xxx
Add: Purchases xxxx ( Cost of goods produced)
” Cartage inwards xxxx
” Freight inwards xxxx
Less: Closing Stock xxxx
xxx
To Wages xxx
” Salary to works manager xxx
” Power, electricity & water xxx
” Fuel xxx
” Postage & Telephone xxx
” Depreciation on:
Plant & Machinery xxx
Factory Land & Building xxx
” Repairs to :
Plant & Machinery xxx
Factory Land & Building xxx
” Insurance on :
Plant & Machinery xxx
Factory Land & Building xxx
” Rent and Taxes xxx
” General Expenses xxx
” Royalty paid xxx

xxxxx xxxxx

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 TRADING ACCOUNT

Trading Account is one of the financial statements, which shows the result of buying and
selling of goods and or services during an accounting period. The purpose of drawing a trading
account is to know the gross profit or loss during the accounting period.

Trading Account of M/s …………….for the period ending on ……………..

Dr Cr
Amount Amount
Particulars Particulars
Rs. Rs.
To Opening Stock xxxxx By Sales xxxxx
” Purchases xxxxx Less: Returns xx
Less: Returns xx xxxx
xxxx ” Closing Stock xxxx
” Royalty xxx ” Abnormal loss of stock xxx
” Direct Expenses xxx ” Gross loss transferred to profit
” Rent and Rates xxx and Loss Account xxxx
” Wages and Salaries xxx
” Lighting xxx
” Freight inward xxx
”Customs and Octroi duty xxx
” Carriage inwards xxx
” Cartage inwards xxx
” Fuel and Power xxx
” Gross Profit transferred to
Profit and loss account xxx

xxxxx xxxxx

NOTE:
A. Closing Stock:
a If it is shown outside a trial
balance in the adjustment,
i. Credit the trading account
ii. Show as an asset in the balance sheet
b If shown in the trial balance, show only in the balance sheet on the assets
side
B. Royalty:
a. If it depends on the output it is a manufacturing expense and hence debited
in the trading account.
b. If it depends on the sales, debit the profit and loss account.
C. Adjusted purchases
Adjusted Purchases = Net purchases + Opening Stock – Closing Stock

D. Cost of Goods sold

Cost of goods sold = Opening Stock + Purchases + Direct Expenses – Closing Stock

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 PROFIT AND LOSS ACCOUNT
It is prepared to ascertain the Net Profit or Net Loss incurred by a business entity during
an accounting period.
Net Profit: Excess of all revenues over expenses
Net Loss: Excess of all expenses over revenues
Operating Profit: Excess of operating revenues over operating expenses.

All the indirect revenue expenses and loss (i.e., other than those shown in the credit side
of the trading account) are debited in the profit and loss account and all the indirect incomes (i.e.,
other than those that are shown on the credit side of the trading account) are credit side of the
trading account.

Dr Profit and Loss Account of M/s …………….for the period ending on …………….. Cr
Amount Amount
Particulars Particulars
Rs. Rs.
To Gross Loss b/d xxxxx By Gross Profit b/d xxxx
” Salaries and Wages xxxx ” Interest Earned xxx
” Rent, Rates and Taxes xxx ” Commission Earned xxx
” Fire Insurance Premium xxx ” Rent Earned xxx
” Repairs and Maintenance xxx ” Profit on sale of fixed assets xxx
” Depreciation xxx ” Income from investments xxx
” Audit Fess xxx ” Sale of scrap xxx
” Bank charges xxx ” Miscellaneous Income xxx
” Legal charges xxx ” Net loss transferred to capital
” Miscellaneous Expenses xxx Account xxx
” Discount Allowed xxx
” Carriage Allowed xxx
” Freight Outward xxx
” Commission to salesman xxx
” Travelling Expenses xxx
” Entertainment Expenses xxx
” Sales Promotion Expenses xxx
” Advertisement and Publicity xxx
” Bad Debts xxx
” Packing Expenses xxx
” Interest on loan xxx
” Loss by theft xxx
” Loss by fire xxx
” Loss by embezzlement xxx

” Net profit transferred to xxx

capital account
xxxxx xxxxx

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 BALANCE SHEET

A balance sheet is a financial statement that shows the balance of assets and liabilities as
on a particular date:
− It is only a statement and not an account
− It is prepared as on a particular date but not for a
particular period
− It is a summary of balances in accounts which not have
been closed
− It shows the nature and amount of assets and liabilities

The format of a balance sheet (Horizontal Form) is as follows:

Balance Sheet of M/s …………….as on …………….
Amount Amount
Liabilities Assets
Rs. Rs.
Capital: Fixed Assets
Opening Balance xxx Goodwill xxx
Add: Net Profit xxx Land and Buildings xxx
(Less: Net Loss xxx) Plant and Machinery xxx
xxxx Furniture and Fixtures xxx
Less: Drawings xx
Closing Balance xxx Investment xxx

Long Liabilities xxx

Current Assets
Current Liabilities Closing Stock xxx
Income received in advance xxx Accrued Income xxx
Sundry Creditors xxx Prepaid Expenses xxx
Outstanding Expenses xxx Sundry Debtors xxx
Bills Payable xxx Bills Receivable xxx
Bank Over Draft xxx Cash at Bank xxx
Cash in Hand xxx

xxxxx xxxx

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 VERTICAL FORM OF PROFIT AND LOSS ACCOUNT

Profit and Loss Account of M/s ……………..for the period ending on …………….
Particulars Rs. Rs. Rs.
A. Net Sales
Sales (gross) Xxxxx
Less: Returns xxx xxxx
B. Cost of Goods Sold
Opening Stock xxxx
Add: Purchases xxxx
Less: Returns xxxx
Add: Direct Expenses
Carriage / cartage / freight / wages / xxxx
Insurance
Cost of goods available for sales xxxx
Less: Closing Stock
xx xxxx
C. GROSS PROFIT
xxxx
D. Operating Expenses
a) Selling Expenses
Carriage outwards / sales promotions
Expenses / discount allowed / travelling xxxx
Expenses / commission allowed / xxxx
Entertainment expenses xxxx
xxxx xxxx
b) Office & Administrative Expenses
Sales expenses / Rent, Rates & taxes /
Repairs / insurance / printing & stationery / xxxx
Water & electricity / Postage & telegrams / xxxx
staff welfare expenses /conveyance expenses/ xxxx
miscellaneous expenses / depreciation xxxx xxxx xxxx
xxxx
E. NET OPERATING PROFIT / LOSS C-D xxxx
F. Net Operating Result
a) Interest earned / commission earned /
discount earned / miscellaneous incomes xxxx
xxxx xxxx
b) Non-Operating expenses and losses
ex: interest allowed
” Loss on sale of fixed assets xxxx xxxx xxxx
xxxx
G. NET PROFIT xxxx

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 VERTICAL FORM OF BALANCE SHEET

Balance Sheet of M/s …………….. as on …………..

Particulars Rs. Rs. Rs.

A. SOURCES OF FUNDS
a) Proprietor’s funds Xxxxx
b) Long term debts Xxxxx
Xxxxx
B. APPLICATION OF FUNDS
a) NET WORKING CAPITAL
i) Current Assets
Cash in hand Xxxx
Cash at Bank Xxxx
Bills Receivable Xxxx
Accrued Income Xxxx
Debtors Xxxx
Stock Xxxx Xxxx
Prepaid Expenses

ii) Less: Current Liabilities

Xxxx
Bank Over Draft
Xxxx
Accrued Expenses
Xxxx
Bills Payable Xxxx
Xxxx Xxxx
Trade Creditors
Income received in advance

b) INVESTMENTS Xxxx

C) FIXED ASSETS
Furniture & Fixtures Xxxx
Patents and Trade Marks Xxxx
Plant and Machinery Xxxx
Building Xxxx
Goodwill Xxxx Xxxx

Xxxx

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 Schedule of Proprietor’s funds

Particulars Rs. Rs,

A. Capital in the beginning Xxxxx

B. Add: Additional capital introduced Xxxx

Interest on Capital Xxxx
Salary to partner Xxxx
Profit for the current accounting period Xxxx Xxxx
Xxxx
C. Less: Drawings Xxxx
Interest on Drawings Xxxx
Loss for current accounting period Xxxx
Xxxx

Capital at the end of the Accounting Period (A+B-C) Xxxx

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24
 Balance Sheet of a Joint Stock Company

VERTICAL FORM

Name of the Company ..........................

Balance Sheet as at ..........................

Schedule Figures Figures as at the end

No. as at the of previous financial
end of year
current
financial
year
I. SOURCES OF FUNDS:
(1 Shareholder's funds
)
(a) Capital xxxx Xxxx
(b) Reserves and Surplus Xxxx Xxxx
(2 Loan funds
)
(a) Secured loans xxxx Xxxx
(b) Unsecured loans Xxxx xxxx
TOTAL : Xxxx Xxxx
II. APPLICATIONS OF FUNDS:
(1 Fixed assets
)
(a) Gross block Xxxx Xxxx
(b) Less depreciation Xxxx xxxx
(c) Net block xxxx Xxxx
(d) Capital work-in-progress Xxxx xxxx
(2 Investments xxxx Xxxx
)
(3 Current assets, loans, and advances :
)
(a) Inventories Xxxx Xxxx
(b) Sundry debtors Xxxx Xxxx
(c) Cash and bank balances xxxx xxxx
(d) Other current assets Xxxx Xxxx
(e) Loans and advances xxxx xxxx
Less :
Current liabilities and provisions :
(a) Liabilities Xxxx Xxxx
(b) Provisions Xxxx Xxxx
Net current assets xxxx xxxx
(4 (a) Miscellaneous expenditure to the extent Xxxx Xxxx
) not written off or adjusted

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 (b) Profit and Loss account xxxx xxxx
TOTAL : Xxxx Xxxx

Notes -
1. Details under each of the above items shall be given in separate Schedules. The Schedules
shall incorporate all the information required to be given under A - Horizontal Form read with
notes containing general instructions for preparation of balance sheet.
2. The Schedules, referred to above, accounting policies and explanatory notes that may be
attached shall form an integral part of the balance-sheet.
3. The figures in the balance-sheet may be rounded off to the nearest '000' or '00' as may be
convenient or may be expressed in terms of decimals of thousands.
4. A foot-note to the balance sheet may be added to show separately contingent liabilities.

Profit and Loss Account of a Joint Stock Company

VERTICAL FORM

Name of the Company ..........................

Income Statement for the year ending ..........................

Rs. Rs.
Sales Xxxx
Less Sales returns xxxx
Sales Tax/Excise Duty Xxxx Xxxx
Net Sales (1) Xxxxx
Cost of goods sold: xxxx
Materials consumed xxxx
Direct labour xxxx
Manufacturing Expenses xxxx Xxxx
Add/Less: Adjustment for change in stock xxxx
Cost of goods sold (2) Xxxxx
GROSS PROFIT (1) - (2) Xxxxx
Less: Operating Expenses xxxx
Office and Administrative Expenses xxxx
Selling and Distribution Expenses xxxx xxxx
OPERATING PROFIT Xxxxx
Add: Non-Operating Income Xxxx
Xxxxx
Less: Non-Operating Expenses (including interest) Xxxxx
Profit before interest and tax Xxxxx
Less: Interest Xxx
Profit before tax Xxxxx
Less: Tax xxx
Profit After Tax Xxxxx

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 Appropriation Transfer to reserves xxx
s
Dividends declared/paid xxx
Surplus carried to Balance Sheet xxx xxx
Xxxxx
DEPRECIATION CONCEPTS & METHODS

Meaning of Depreciation

Causes of Depreciation

Basic Features of Depreciation

Depletion, Amortisation, Dilapidation

Objectives of Providing Depreciation

Factors to Be Considered to Arrive at Depreciation

METHODS FOR PROVIDING DEPRECIATION

1. Uniform charge methods

a Fixed instalment method
b Depletion method
c Machine Hour Rate Method

2. Decline charge or accelerated depreciation method

a Diminishing balance method
b Sum of the year digits method
c Double declining method

3. Other methods
a Group Depreciation method
b Inventory system of depreciation
c Annuity method
d Depreciation fund method
e Insurance policy method

1. FIXED INSTALMENT METHOD

In this method, the amount of depreciation charged to the asset is fixed for every year.
This method is also called as Straight Line method.

Depreciation = Original cost of the fixed asset – Estimated Scrap Value

Life of the asset in number of accounting periods

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 D = C-S
N
Rate of Depreciation R = D X 100
C

2. DEPLETION METHOD
The charge of depreciation depends on 3 factors viz.,
a Total amount paid
b Total estimated quantities of output
c The actual quantity taken out during the accounting year.
This is suitable for quarries, mines, oil wells where it is possible to make an estimate of
the output available. The depreciation is charged as a percent of out put and the
depreciation per year is found by multiplying the output by the rate of depreciation per
unit.

3. MACHINE HOUR RATE METHOD

Also known as Service Hours Method, this method takes into account the running time of
an asset for calculation of depreciation. This is useful for charging depreciation on
machines, aircrafts etc,.

4. DIMINISHING BALANCE METHOD

According to this method, depreciation is charged on the book value of the asset each
year. Thus the amount of depreciation goes on decreasing every year.

The formula for calculating the rate of depreciation under diminishing balance
method (where ‘n’ = years of economic life of the asset) is as follows:
Depreciation rate = 1 - n Net residual value
Acquisition cost

5. SUM OF YEARS DIGITS METHOD

The depreciation is calculated according to the following formula:

Remaining Life of the Asset ( including the current year) X Original Cost
Sum of all the digits of the life of the asset in years

DOUBLE DECLINING BALANCE METHOD

This method is similar to reducing to declining balance method except that the rate of
depreciation is charged at the rate which is twice the straight line rate.

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 GROUP DEPRECIATION METHOD
Under this method, all homogenous assets, generally having similar average life expectancy
are grouped together in a single asset category. One summary account is established for each
group and original cost of all assets in the group is charged to this account. Depreciation is
charged for the group in total and not item-by-item.

6. INVENTORY SYSTEM OF DEPRECIATION

This method is followed in case of those assets which are of small values such as loose
tools or where the life of the asset cannot be ascertained with certainty ex: live stock etc. In case
of these assets, the depreciation is charged on the following basis:

Cost of the assets in working condition at the beginning of the accounting year xxxxx
Add: Cost of the assets purchased during the accounting year xxxxx
xxxxx
Less cost of the assets in working condition at the end of the accounting year xxxxx
Depreciation to be charged xxxxx

7. ANNUITY METHOD
− the depreciation is charged on the basis that besides
losing the original cost of the asset, the business also loses interest on the amount used for
buying the asset.
− amount charged by way of depreciation takes into
account not only the cost of the asset but also interest there on at an accepted rate.
− The amount of interest is calculated on the book value
of the asset in the beginning of each year.
− The amount of depreciation is uniform and is
determined on the basis of the annuity table.

8. DEPRECIATION (OR SINKING) FUND METHOD

− the amount charged by way of depreciation is invested
in certain securities carrying a particular rate of interest.
− The amount received on account of interest from these
securities is also reinvested
− At the end of the useful life of the asset, the securities
are sold away and money realised on account of the sale of the securities is used for the
purchase of new asset.
− This method has the advantage of providing separate
sum for replacement of the asset.

9. INSURANCE POLICY METHOD

o The method is similar to the Depreciation Fund Method but with a slight change.

29
 o Under this method instead of investing in securities, an insurance policy for the
required amount is taken.
o A fixed premium is paid every year. However, this amount will have to be paid at
the beginning of each year.
o At the end of the specified period, the insurance company pays the agreed amount
with which the new asset can be purchased.

INVENTORIES
Inventories Defined
According to Accounting Standard 2 on Valuation of Inventories, issued by the Institute
of Chartered Accountants of India, Para 1,
Inventories are tangible property held (i) for sale in the ordinary
course of business, or (ii) in the process of production for such sale,
or (iii) for consumption in the production of goods or services for sale.

Components of Inventory
♦ For a manufacturing firm, raw materials, semi-finished goods and finished
goods.
♦ For merchandising firm, only the finished goods

INVENTORY VALUATION METHODS

The following are the methods of inventory valuation. There are mainly four commonly
used methods in the valuation of inventory. Accountants generally accept all these four methods,
but each of these is based on a different cost flow assumption.
To illustrate the four methods, the following data will be assumed for an accounting
period:

Units Unit Cost ( Rs.) Total Cost (Rs.)

Jan. 1 Beginning Inventory 100 2 200
Mar. 27 Purchase 100 3 300
June 12 Purchase 100 4 400
Sept. 19 Purchase 100 5 500
Nov. 30 Purchase 100 6 600

Available for sale 500 2,000

Sold 350

30
Dec. 31 Ending Inventory 150

Specific Identification Method

This method assigns specific costs to each unit sold and each unit on hand. This method
may be used if the units the ending inventory can be identified as coming from specific
purchases. The specific identification method is particularly suited to inventories of high-value,
low-volume items such as jewellery. Each unit in inventory must be identified with an
identification tag.

To illustrate, assume that December 31 inventory consisted of 60 units from March 27

purchase, 70 units from the June 12 purchase, and 20 units from the September 19 purchase. The
cost of ending inventory is then computed as follows:
60 units from the purchase of March 27 at Rs.3 Rs.180
70 units from the purchase of June 12 at Rs.4 280
20 units from the purchase of September 19 at Rs.5 100
________
Ending Inventory 560
________
The cost of goods sold is computed by subtracting the ending inventory from the cost of goods
available for sale, as shown below:

Cost of goods available for sale Rs.2,000

Less Ending inventory 560
________
Cost of goods sold 1,440
________

First-in, First-out (FIFO) Method

This method assumes that the first units acquired are the first units sold. Therefore the
cost of the units in the ending inventory is that of the most recent purchases. Although the FIFO
method is a cost flow assumption, physical flow often follows the first-in first-out rule.

In the previous illustration the cost of the 150 units in the ending inventory would be
Rs.850, computed as follows:
50 units from the purchase of September 19 at Rs.5 Rs.250
100 units from the purchase of November 30 at Rs.6 600
Ending Inventory 850

31
 Under FIFO method, the cost of goods sold is Rs.1,150 which is computed as follows:

Cost of goods available for sale Rs.2,000

Less Ending Inventory 850
Cost of goods sold 1,150

Last-in, First-out (FIFO) Method

The last in first out method assumes that the last units acquired are the first units sold.
Therefore the cost of the units in the ending inventory is that of the earliest purchases.

Under the LIFO method, the cost of 150 units in the ending inventory would be Rs.350,
computed as follows:
100 units from the purchase of January at Rs.2 Rs.200
50 units from the purchase of March 27 at Rs.3 150
Ending inventory 350

The cost of goods sold is Rs.1,650, computed as follows:

Cost of goods available for sale Rs.2,000

Less Ending Inventory 350
Cost of goods sold 1,650

2. Weighted-Average Cost Method

This method assumes that the goods available for sale are homogenous. Average cost is
computed by dividing the cost of goods available for sale, which comprise the cost of the
beginning inventory and all the purchases, by the number of units available for sale. The
weighted-average unit cost that results from this computation is applied to the units in the
ending inventory.

In the previous illustration, the unit cost under this method would be Rs.4, computed as
under:

Cost of goods available for sale Rs.2,000

Number of units available for sale 500
Weighted-average unit cost Rs. 4
Ending Inventory: 150 units @ Rs.4/- Rs. 600

The cost of goods sold is Rs.1,400, computed as follows:

Cost of goods available for sale Rs.2,000

Less Ending Inventory 600
Cost of goods sold 1,400

3. Base Stock Method

32
 The base stock method proceeds on the assumption that a minimum quantity of inventory
(base stock) must be held at al times in order to carry on the business. Inventories up to
this quantity are stated at the cost at which the base stock was acquired. Inventories I
excess of the base stock are dealt with other methods discussed above.

6. Standard Cost Method

Under this method, a standard cost is set for each item of material and this cost is used as
a basis for pricing the material issues.

NATURE AND INCIDENCE OF WINDOW DRESSING

Window Dressing

It is the act or instance of making something appear deceptively attractive or favourable;

something used to create a deceptively attractive or favourable impression. The act or practice of
giving something superficial appeal by skilful presentation.

Nature of Window Dressing

1. Inflate the sales from the current year by advancing the sales from the following year.

2. Alter the ‘other income’ figure by playing with non-operational figures like sale of fixed

assets.

3. Fiddle with the method and rate of depreciation. (A switch may be effected from the

written down value method to the straight line method or vice versa.)

4. Change the method of stock valuation from, say, direct costing to absorption, to minimize

the cost of goods sold.

5. Capitalise certain expenses like research and development costs and product promotion

cost, that are ordinarily written off in the profit and loss account.

6. Defer certain discretionary expenditures (like repairs, advertising, research and

development) to the following year.

7. Make inadequate provision for certain known liabilities (gratuity etc.,) and treat certain

liabilities as contingent liabilities

8. Make extra provisions during prosperous years and written them back in lean years.

33
9. Use totally unacceptable accounting practices.

10. Revalue assets to create the impression of substantial reserves.

11. Lengthen the accounting year in an attempt to cover poor performance.

DETERMINATION OF EARNINGS

A company’s earning (profit) is called by various names in various stages.

1. EBDIT (PBDIT) Earnings (Profit) Before Depreciation, Interest and Tax

This is equal to revenue minus all operating expenses except depreciation, interest
and taxes. Some companies call EBDIT as gross profit.

2. EBIT (PBIT) Earnings (Profit) Before Interest and Tax

This is also called as operating profit and this is the difference between the gross
profit and all operating expenses consisting of general, administrative and selling
expenses and depreciation

So, Operating Profit = Gross Profit –operating expenses-Depreciation.

PBDIT XXXXX
Less: Operating Expenses XXX
Less: Depreciation XXX
EBIT (PBIT) XXXXX

3. EBT (PBT) Earnings ( Profit) Before Tax

It is the Difference between the profit before interest and taxes and interest
charges (EBT = EBIT – Int). EBT may also include non-operating profit.

EBIT XXXXX
Less: Interest XXX
EBT XXXX

4. EAT (PAT) Earnings (Profit) After Tax

It is the Difference between Profit before tax and taxes (EAT = EBT-Tax). This
EAT is also called as Net Profit

EBT XXXXX
Less: Tax XXX
EAT XXXX

34
 EPS (Earnings Per Share)
The ultimate profitability of the common shareholders’ (also called as ordinary or equity
share holders) investments can be measured by calculating the earnings per share. The earnings
per share is calculated by dividing the profit after taxes by the total number of common shares
outstanding.

EPS = Profit After Tax

Number of common shares outstanding

DPS (Dividend Per Share)

It was indicated earlier, that the EPS does not say anything about the dividend declared
per share. To know this, the DPS is calculated. DPS is the earnings distributed to the ordinary
share holders divided by the number of ordinary shares outstanding.

DPS = Earnings paid to shareholders (dividends)

Number of common shares outstanding

PAYOUT RATIO
The dividend-payout ratio (or simply payout ratio) is DPS (or total dividends) divided by
the EPS (or profit after tax).
DPS = Dividends per share
Earnings per share
This figure helps to know the extent to which dividend has been declared to the
shareholders out of the total earnings of the firm.

1-Dividend Payout Ratio = Retention Ratio

P/E Ratio
The Price–Earnings Ratio is arrived at by dividing the Market Value per share by the
Earnings Per Share. It is shown as under
Price – Earnings Ratio = Market Value per share
Earnings per share

NET WORTH

35
 The term Net worth is used for the sum of share capital and reserves and surplus i.e., the
owners’ equity. This term is misleading. It connotes the erroneous meaning that the owners’
equity is worth something. The term in fact implies market or real value while the owners’
equity in the Balance Sheet is the recorded book value.

ROCE (Return on Capital Employed)

The funds employed in net assets are known as capital employed. Net assets equal the
net fixed assets plus current assets minus current liabilities excluding bank loans.
ROCE = Earnings Before Interest and Taxes (EBIT)
Net Assets (NA)

RONW (Return on Net Worth)

This ratio is calculated by dividing the profits after taxes by the share holders’ equity.
RONW = Profit After Taxes (EBIT)
Net worth
Note:
i. Net worth or the shareholders’ equity will include paid-up share capital, share premium
and reserves and surplus less accumulated losses.
ii. Net worth can also be found by subtracting total liabilities from total assets.

BOOK VALUE

The book value of an asset or liability is the stated value on the balance sheet, recorded
according to the generally accepted accounting principles. While the book value is handled
consistently for accounting purposes, it usually has little relationship to the current economic
value. It is a historical value, which, at one time, may have represented economic value to the
company, but the passage of time and changes in economic conditions increasingly distort it.

The value of an asset, a liability or equity, as recorded in the accounts of a firm. The
book value of an ordinary share is equal to the paid-up capital plus retained earnings, that is net
worth.

36
37
 WHAT IS A COMPANY?

 The word company is derived from the Latin word com i.e. with or together and panis i.e.
bread.

 It denotes a group of persons and the effect of registration under the companies Act is
that such group becomes a corporate body having perpetual succession and common seal.

 The term company is defined in Section 2(10). The definition only says that a company
means a company as defined in Section 3 of the Companies Act. Section 3 further
explains the meaning of expression ‘company’, ‘existing company’, ‘private company’
and ‘public company’.

 Apart from these categories the different kinds of company are holding company,
subsidiary company, foreign company and companies, which are limited guarantee and
lastly unlimited company.

Maintenance of Books of Accounts

Section 209 of the Companies Act states that the books of accounts shall be maintained at
the company’s registered office unless the Board of Directors decide to keep them at another
place in India. It is a duty of the company to inform the Registrar of Companies within seven
days of the decision in case of the board of Directors decides to maintain books at the place
other than the registered office.

Every company is required to keep proper books of accounts showing

i. All monies received and spent and the

details thereof

ii. Sales and purchases of goods, and

iii. Assets and liabilities

♦ A company engaged in production, processing, manufacturing or mining

activities has also to maintain, if required by the Central Government, cost accounting
records i.e., particulars relating to utilisation of material, labour and other items of cost.
♦ Proper books of accounts shall not be deemed to be kept if there are not
kept such books as are necessary to give a true and fair view of the state of affairs of the
company or branch office, as the case may be, and to explain its transaction.

38
 ♦ Also if such books are not kept on accrual basis and according to the
system of double entry book keeping, proper books of accounts shall not be deemed to have
been kept.

Statutory Books

The following statutory books are required to be maintained by a company under the
different sections of the Companies Act:
1. Register of Investments of the company not
held in its own name
2. Register of mortgages and charges
3. Register of members and index
4. Register of Debenture holders and index
5. Foreign register of members and of
debentures-holders and their duplicates
6. Minutes Books
7. Register of contracts, companies and firms
in which directors are interested
8. Register of directors, managing director,
manager and secretary
9. Register of directors’ share-holding
10. Register of loans made, guarantees given or
securities provided to companies under the same management
11. Register of investments in share and
debentures of other companies

Registers and documents relating to the issue of shares are also maintained viz.,
i. Share application and allotment book
ii. Share call book
iii. Certificate book

In respect of shares, the company in addition to maintaining register of members, which it

has to maintain statutorily, it also maintains (a) share transfer book and (b) dividend register

Annual Return
Under Section 149 of the Companies Act, every company having a share capital, shall
within sixty days from the day of which each of the annual general meeting is held, prepare and
file with the Registrar the annual return containing the particulars specified like the income,
details of income, details of the board of directors.

Final Accounts
Under section 210 of the Companies Act, at the annual general meeting of a company,
the Board of Directors of the company shall lay before the company:
a A balance sheet as at the end of the period
b A profit and loss account for that period

39
 In case of a company not carrying on business for profit, an income and expenditure account
shall be laid before the company at its annual general meeting instead of profit and loss account.

Every balance sheet of the company shall give a true and fair view of the state of affairs of
the company and at the end of the financial year an shall subject to the provisions of the Section
be in the form of the Part I of Schedule VI i.e., horizontal or vertical form, as near thereto as the
circumstances admit.

Every Profit and Loss Account of a company shall comply with the requirements of Part
II of the Schedule VI of the Companies Act again either in horizontal or vertical form.

The balance sheet can be prepared either in Horizontal Form or Vertical Form.
However there is no specified form of Profit and Loss Account. Schedule VI – Part II gives only
the requirements as to the Profit and Loss Account. Part III of Schedule VI gives interpretation.

The Companies Act of 1956 also required to attach a Cash flow statement in the Annual
Report of the companies.
An annual report of a company is report containing the Director’s Report and the
Auditors report about the working of the company.
It also contains the Profit and Loss Account and Balance Sheet with all the necessary
schedules and sub-schedules.

Audit of a company

Audit means a systematic verification of the books of a company to give a true and fair
view about its working and also about the financial results of the company.

In India only a Chartered Accountant who has passed the professional examination
conducted by the Institute of Chartered Accountant can conduct the audit and certify under his
hand about his opinion on the maintenance of the books of accounts.

Directors’ report

• This is essentially an account of a company’s performance in the previous year and its
prospects as seen by its board of directors.
• The objective is to give the reader a sense of the state of the business. It touches upon both
quantitative and qualitative issues.
• Typically, it starts with a summary of the company’s performance in the previous year, and
the dividends and bonuses declared.
• Then, it launches into a discussion of which parts of the business did well and which didn’t,
what were the conditions in the industry, the enabling factors and the limitations, and the
outlook for the business.

40
Provisions of Companies Act of 1956 Regarding Financial Statements

Sec 209 - Books of account to be kept by company.

Sec 209A - Inspection of books of account, etc., of companies.

Sec 210 - Annual accounts and balance sheet.

Sec 211 - Form and contents of balance sheet and profit and loss account.

Sec 215 - Authentication of balance sheet and profit and loss account.

Sec 219 - Right of members to copies of Balance Sheet and Auditors' Report.

Sec 220 - Three copies of Balance Sheet, etc., to be filed with Registrar.

Provisions of Companies Act of 1956 Regarding the Auditors

Sec 224 - Appointment and remuneration of Auditors.

Sec 226 - Qualifications and disqualifications of Auditors.

Sec 227 - Powers and duties of auditors.

Sec 229 - Signature of audit report, etc.

Sec 230 - Reading and inspection of auditor's report.

41
 INTRODUCTION TO FINANCIAL ANALYSIS

 Analysis means methodical classification of the data given in the financial statements.
 Interpretation means explaining the meaning and significance of the data so simplified.
 Financial Analysis is the process of identifying the financial strengths and weakness of
the firm by properly establishing relationships between the items of the balance sheet and
the profit and loss account.

Different tools of financial Analysis

The various tools used for the analysis of the financial statements of a firm are:
1. Comparative Financial Statements
2. Common size Financial Statements
3. Trend Analysis
4. Ratio Analysis.

ILLUSTRATION
The following illustration will be used for explaining the various tools of financial analysis:

Illustration: From the following profit and loss Account and Balance sheets of Swadeshi
Polytex Ltd. For the year ended 31st December 1987 and 1988, you are required to prepare a
Comparative Income Statement and a Comparative Balance Sheet.

Profit and Loss Account (in lakhs of rupees)

Particulars 1987 1988 Particulars 1987 1988
Rs. Rs. Rs. Rs.
To Cost of goods sold 600 750 By Net Sales 800 1000
To Operating Expenses:
Administrative expenses 20 20
Selling expenses 30 40
To Net Profit 150 190
800 1000 800 1000

Balance Sheet (in lakhs of rupees)

42
 1987 1988 1987 1988
Liabilities Assets
Rs. Rs. Rs. Rs.
Bills Payable 50 75 Cash 100 140
Sundry Creditors 150 200 Sundry Debtors 200 300
Tax Payable 100 150 Stock 200 300
14% Debentures 100 150 Land 100 100
16% Preference Capital 300 300 Building 300 270
Equity Capital 400 400 Plant 300 270
Reserves 200 245 Furniture 100 140
1,300 1, 520 1,300 1,520

COMPARATIVE FINANCIAL STATEMENTS

A simple method for financial analysis is Comparative Financial Statements.

Comparative financial statements will contain items at least for two periods. Changes –
increases and decreases – in income statement and balance sheet over period are shown.

♦ Comparative Financial Statements can be prepared for more than two periods or
on more than two dates.

Illustration: From the illustration of M/s Swadeshi Polytex Ltd prepare comparative income
statement comparative balance sheet.

Swadeshi Polytex Ltd.

Comparative Income Statement for the years ended 31st December 1987 and 1988
(in lakhs of rupees)

43
 Absolute Absolute
increase(+) increase (+)
1987 1988 or or
Particulars
Rs. Rs. decrease (-) decrease(-)
in 1988 in 1988
Rs. %
Net Sales 800 1000 +200 +25
Less: Cost of goods sold 600 750 +150 +25
Gross Profit 200 250 +50 +25

Operating Expenses:
Administrative expenses 20 20 -- --
Selling expenses 30 40 +10 +33.33
Total Operating expenses 50 60 +20 +20
Net Profit 150 190 +40 +26.67

44
 Swadeshi Polytex Ltd.
Comparative Balance Sheet for the years ended 31st December 1987 and 1988
(in lakhs of rupees)

Absolute Absolute
increase(+) increase (+)
1987 1988 or or
Rs. Rs. decrease (-) decrease(-)
in 1988 in 1988
Rs. %
ASSETS
Current Assets
Cash 100 140 +40 +40
Debtors 200 300 +100 +50
Stock 200 300 +100 +50
 Total Current Assets
500 740 +240 +50

Fixed Assets
Land 100 100 -- --
Building 300 270 -30 -10
Plant 300 270 -30 -10
Furniture 100 140 +40 +40
 Total Fixed Assets 800 780 -20 -2.50
1,300 +220
Total Assets 1,520 +17

LIABILITIES & CAPITAL

Current liabilities
50 +25
Bills Payable 75 +50
150 +50
Sundry creditors 200 +33.33
100 +50
Taxes Payable 150 +50
300 +125
 Total Current 425 +41.66
Liabilities
100 +50
Long term Liabilities 150 +50
400 +175
14% Debentures 575 +43.75
 Total Liabilities --
300 300 --
Capital and Reserves --
400 400 --
16% Preference Capital +45
200 245 +22.50
Equity Capital +45
900 945 +5.00
Reserves
 Total Share Holders
Funds 1,300 220
1,520 17.00

Total Liabilities and capital

45
COMMON SIZE FINANCIAL STATEMENTS

46
 Comparative Financial Statements can be prepared for more than two periods or on more
than two dates. However, it becomes very cumbersome to study the trend with more than two
periods data. Trend percentages are more useful in such cases.

Common size financial statements are those in which figures reported are converted into
percentages to some common base. In the income statement, the sale figure is assumed to be 100
and all figures are expressed as a percentage of sales. Similarly, in the Balance Sheet, the total
of assets or liabilities is taken as 100 and all figures are expressed as a percentage of this total.

Illustration: On the basis of the data given in the previous illustration pertaining to Swadeshi
Polytex limited, prepare the common size income statement and common size balance sheet for
the years ended 31st March 1987 and 1988.

Solution:

Swadeshi Polytex limited

Common Size Income Statement for the years ended 31st March 1987 and 1988

1987 1988
P artic ulars
F igures in %
Net s ales 100 100
Les s :Cos t of goods s old 75 75
G RO S S P RO F IT 25 25
O p e ra tin g Ex p e n se s:
A dm inis trative E x pens es 2.50 2.00
S elling E x pens es 3.75 4.00
Total O perating E x pens es 6.25 6.00

Interpretation

The above statement shows that though in absolute terms, the cost of goods has gone up,
the percentage of its cost to sales remains consistent at 75%. This is the reason why the gross
profit continues at 25% of sales. Similarly, n absolute terms the amount of administrative
remains the same but as percentage to sales it has come down by 0.5%. Selling expenses have
increased by0.25%. These all lead to net increase in net profit by 0.25%.

Swadeshi Polytex limited

Common Size Balance Sheet for the years ended 31st March 1987 and 1988

47
 1987 1988
Particulars % %
100 100
CURRENT ASSETS
Cash 7.70 9.21
Debtors 15.38 19.74
Stock 15.38 19.74
Total Current Assets 38.46 48.69
FIXED ASSETS
Building 23.07 17.76
Plant 23.07 17.76
Furniture 7.70 9.21
Land 7.70 6.68
Total fixed assets 61.54 51.31

TOTAL ASSETS 100.00 100.00

1987 1988
Particulars % %
100 100
CURRENT LIABILITIES
Bills Payable 3.84 4.93
Sundry Creditors 11.54 13.16
Taxes payable 7.69 9.86
Total Current Liabilities 23.07 27.95
LONG TERM LIABILITIES
14% Debentures 7.69 9.86
CAPITAL & RESERVES
16% Preference share capital 23.10 19.72
Equity share capital 30.76 26.32
Reserves 15.38 16.15
Total Shareholders' Funds 76.93 72.05

TOTAL LIABILITIES AND CAPITAL 100 100

Interpretation
The percentage of current assets to total assets was 38.46 in 1987. It has gone up to 48.69
in 1988. Similarly the percentage of current liabilities to total liabilities (including capital) has
gone up from 2307 in 1987 to 27.95 in 1988. Thus the proportion of current assets has increased
by percentage of 10 as compared to increase in the proportion of current liabilities, which is
about 5%. This has improved the working capital position of the company. There has been a
slight deterioration in the debt-equity ratio though it continues to be sound. The proportion of
shareholders’ funds in the total liabilities has come down from 69.24% to 61.19% while that of
debenture holders has gone up from 7.69% to 9.86%.

TREND ANALYSIS

48
 • Trend percentages are immensely useful in making a comparative
study of financial statements for several years.
• The method of calculating trend percentages involves the
calculation of percentage relationship that each item bears to the same item in the base year.
• Any year may be taken as the base year. It is usually the earliest
year. Any intervening year may also be taken as the base year.
• Each item of base year is taken as 100 and on that basis the
percentage for each item of the years is calculated.
• These percentages can also be taken as Index Numbers showing
relative changes in the financial data resulting with the passage of time.

Illustration: From the following data relating to the assets side of the balance sheet of
Kamadhenu Ltd., for the period 31st December 1985 to 31st December 1988 you are required to
calculate the trend percentage taking 1985 as the base year.

In lakhs of Rs. As on 31st December

Assets 1985 1986 1987 1988
Cash 100 120 80 140
Debtors 200 250 325 400
Stock-in-trade 300 400 350 500
Others current assets 50 75 125 150
Land 400 500 500 500
Building 800 1,000 1,200 1,500
Plant 1,000 1,000 1,200 1,500
TOTAL 2,850 3,345 3,780 4,690

Solution

December 31st (Rupees in lakhs) Trend percentages Base year 1985

ASSETS
1985 1986 1987 1988 1985 1986 1987 1988
Current Assets
Cash 100 120 80 140 100 120 80 140
Debtors 200 250 325 400 100 125 163 200
Stock-in-trade 300 400 350 500 100 133 117 167
Other Current Assets 50 75 125 150 100 150 250 300
Total Current
Assets 650 845 880 1190 100 129 135 183
Fixed Assets
Land 400 500 500 500 100 125 125 125
Building 800 1000 1200 1500 100 125 150 175
Plant 1000 1000 1200 1500 100 100 100 150
Total Fixed Assets 2200 2500 2900 3500 100 114 132 159

49
 Ratios for Financial Statement Analysis
A ratio gives the mathematical relationship between one variable and another. Ratios are
well known and most widely used tools for financial analysis.

The various types of ratios have been classified into the following categories:

1. Liquidity ratios
2. Turnover ratios
3. Profitability ratios
4. Ownership ratios
⇒ Earnings ratio
⇒ Dividend ratios
⇒ Leverage ratios -- Capital structure ratios
-- Coverage ratios

LIQUIDITY RATIOS

Liquidity implies a firm’s ability to pay its debts in the short term. This ability can be
measured by the use of liquidity ratios. Short term liquidity involves the relationship
between current assets and current liabilities.

Current Ratio
Current Assets
Current Ratio = ----------------------------
Current Liabilities

Current assets include cash, marketable securities, debtors, inventories, loans and
advances and prepaid expenses. Current liabilities include loans and advances taken, trade
creditors, accrued expenses and provisions.

1. Quick Ratio
This ratio is also termed as Acid Test Ratio.

Quick Assets
Quick Ratio = -----------------------------
Current Liabilities

Quick Assets = Current Assets – Inventories

50
 TURNOVER RATIOS

3. Accounts Receivable Turnover Ratio

Accounts Receivable Ratio

(Debtors turnover ratio) = Net sales (or) Net Credit sales
Receivables Average Accounts Receivables

The average accounts receivable is obtained by adding the beginning receivables of the
period and the ending receivables and by dividing the sum by 2. The net sales or net credit sales
made by the firm should be taken for analysis.

4. Average Collection Period

The average number of days for which the debtors remain outstanding is called the
average collection period. It is calculated as under:

Average Collection period = 360

Average Accounts Receivables Turnover

(Or)
= Average Accounts Receivables
Average daily sales

Inventory turnover ratio

The liquidity of a firm’s inventory may be calculated by dividing the cost of gods sold, by the
firm’s inventory. The inventory or stock turnover, measures how fast the inventory is moving
through the firm and generating sales. It is calculated by the following formula:

Inventory turnover = Cost of goods sold (or) Net sales

Average inventory Inventory
Where, average inventory is the average of the opening and closing inventory in any
year and inventory means only the closing inventory at the end of a year.

Fixed Assets Turnover ratio

Fixed assets turnover ratio = Net sales (or) _Cost of goods sold
Fixed assets fixed sales

This ratio is supposed to measure the efficiency with which the fixed assets are employed

51
 7. Total Assets Turnover Ratio

Total Assets Turnover Ratio = Net sales

Total Assets.

Total assets are simply the balance sheet total at the end of the year.

PROFITABILITY RATIOS

8. Gross Profit Margin Ratio

Gross profit is the difference between the net sales and the cost of goods sold

Gross Profit Margin Ratio = Gross profit

Net sales
This ratio shows the margin left after meeting manufacturing costs.

9. Net Profit Margin Ratio

Net Profit Margin Ratio = Net profit

Net sales
It shows the earnings left for the shareholders (both equity and preference) as a
percentage of net sales.

10. Earnings power

Earnings is a measure of the operating profitability and is arrived at by the following
formula:

Earnings Power = Earnings before interest and taxes

Average total assets

EARNINGS RATIO

11. Earnings per share

The shareholders are concerned about the earnings of the firm in two ways. One is the
availability of the funds with the firm to pay their dividends and the other is to expand their
interest in the form of retained earnings that the firm can use to improve its profitability.
Earnings are expressed on a per share basis which is in short called EPS.

Earnings Per Share = Net Profit after Tax

Number of outstanding shares

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12. P/E Ratio
It is calculated as under

Price – Earnings Ratio = Market Value per share

Earnings per share

13. Capitalisation Rate

The capitalisation rate is just the inverse of the Price-Earnings Ration.

Capitalisation Rate = Earnings per share

Market Value per share

LEVERAGE RATIOS

Leverage refers to the use of debt finance. While debt capital is a cheaper source of
finance, it is also riskier source of finance. Leverage ratios help in assessing the risk arising
form the use of debt capital.

14. Debt Ratio

The firm may be interested to know the proportion of interest bearing funded debt in the
capital structure. Then this debt ratio will be helpful. It is arrived at by dividing the total
debt (TD) by the capital employed (CE) or Net Assets (NA)

Debt Ratio = Total Debt (TD) = Total Debt (TD)

Total Debt (TD) + Net Worth (NW) Capital Employed (CE)

Note: 1. Capital Employed = Net Assets = Net Fixed Assets + Net Current Assets
2. Net Current Assets = Current Assets – Current liabilities excluding interest
bearing short term debt for working capital.

NFA + CA = NW + TD + CL
NFA + CA – CL = NW + TD
NFA + NCA = NW + TD
NA = CE

Because equality of capital employed and Net assets, the debt ratio can also expressed as

Debt Ratio = Total Debt (TD)

Capital Employed (CE)

15. Debt-Equity Ratio

This ratio indicates the relative contributions of creditors and owners

Debt – Equity ratio = Debt

Equity

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DU-PONT ANALYSIS- INTER-RELATIONSHIP BETWEEN RATIOS

The Du Pont Company of the U.S. pioneered a system of financial analysis which has
received wide spread recognition and acceptance. A useful system of analysis, it considers
important inter-relationships based on the information found the financial statements

Return on
Total Assets

Net Profit Margin X Total Assets Turnover

Net Income ÷ Net Sales Net Sales ÷ Total Assets

Net Sales +/- Total

Non-Operating
Surplus / Deficit
Costs Current
Assets + Fixed
Assets

Cost of Operating Operating Receivables

Goods sold Expenses Expenses

Inventories Others
Interest Tax

The Left Hand Side of the Du Pont Chart shows the details underlying the net profit margin ratio.

The Right Hand Side of the Du Pont Chart throws light on the determinants of the total assets
turnover ratio.

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Extension of Du Pont Chart
The basic Du Pont Chart may also be extended to explore the determinants of equity.

Net Profit = Net Profit X Sales X Total Assets

Equity Net Sales Total Assets Equity

ROTA NPM TATR (1+D/E)

The third component on the Right Hand Side of the above equation needs a little
explanation. Total assets divided by equity is equal to 1 plus debt- equity ratioas shown below:

Total Assets = Equity + Debt = 1 + Debt

Equity Equity Equity

The extension of Du Pont Chart is shown below:

Return on Equity

Return on Total Total Assets to

Assets Equity Ratio
t

FUNDS FLOW STATEMENT

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Meaning of funds
For some, it is nothing but cash while for some others it cash and marketable securities.
Some others say it is nothing but gross working capital. But the correct meaning is probably
given International Accounting Standard No.7, which says that net working capital should be
taken for funds. Net working capital is nothing but the excess of current assets over current
liabilities.

Current Assets
1. Cash including fixed deposits with bank
2. Accounts receivable i.e., trade debtors and bills receivable
3. Inventory i.e., raw materials, work in progress and finished goods
4. Advances recoverable
5. Prepaid expenses

Current Liabilities
1. Accounts Payable
2. Outstanding expenses
3. Bank Over Draft
4. Short term loans
5. Advances payments received by the business for the services to be rendered in the future
6. Current maturities of long term loans
7. Provision against current assets ex: provisions for bad and doubtful debts, provisions for
loss stock, provision for discount on debtors etc.

Non-Current Assets: All assets other than current assets

Non-Current Liabilities: All liabilities other than current liabilities

Meaning of Flow of Funds

Means change in funds or changes in working capital. In other words, any increase or
decrease in working capital means Flow Funds. The term flow includes both inflow and outflow.
Hence in flow of funds, both inflow and outflow of funds are analysed. Any inflow of funds
results in an increase of funds and hence called Sources of Funds. Any outflow of funds results
in a decrease of funds and hence termed as Application of Funds.

Rules to decide on flow of funds

1. There will be a flow of funds if a transaction involves:

a Current assets and fixed assets ex: purchase of building for cash
b Current assets and capital ex: issue of shares for cash
c Current assets and fixed liabilities ex: redemption of debentures in cash
d Current liabilities and fixed liabilities ex: creditors paid of in debentures
e Current liabilities and capital ex: creditors paid off in shares
f Current liabilities and fixed assets ex: buildings transferred to transferred to creditors in
satisfaction of their claims

2. There will be no flow of funds if it involves:

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 a Current assets and current liabilities ex: payment made to creditors in cash
b Fixed assets and fixed liabilities ex: building purchase and payment made in
debentures
c Fixed assets and capital ex: building purchased ad payment made in shares

Finding out of transaction involving change in working capital

• In case the entry involves accounts only of a fixed (asset or
liability) nature or only of a current (asset or liability) nature then there will be no flow
of funds.
• But a cross transaction (i.e., a transaction involving a fixed asset
or a fixed liability and a current asset or a current liability) will result in flow of funds.

Meaning of a Funds Flow Statement

A funds flow statement is a statement depicting change in working capital. It is also
termed as a Statement of sources and application of funds, Summary of financial operations,
funds generated and expended, where got and where gone statement, statement showing changes
in working capital.

Uses of funds flow statement

1. It explains the financial consequences of business operations
2. It answers intricate questions
3. It acts as an instrument for allocation of resources
4. It is a test as to the effective use of working capital

PREPARATION OF A FUNDS FLOW STATEMENT

In order to prepare a Funds Flow Statement, it is necessary to find out the sources and
application of funds.

SOURCES OF FUNDS
The sources from which the funds flow into the organisation are called sources of funds.
The sources of funds can be both internal and external.
1. Internal sources
Funds from operations are the only internal source of funds. However, the following
adjustments will be required to be made in the figure of Net Profit for finding out real funds from
operations.
Add the following items, as they do not result in outflow of funds.
i. Depreciation on fixed assets
ii. Preliminary expenses or goodwill etc., written off
iii. Contribution to debenture redemption fund, transfer to general reserve, etc., if they have
been deducted before arriving at the figure of the net profit
iv. Provision for taxation and proposed dividend are usually taken as appropriation of profits
only and not current liabilities for the purpose of Funds Flow Statement.
v. Tax or dividends actually paid are taken as application of funds. Similarly interm
dividend paid is shown as an application of funds. All these items will be added back to net
profit, if already deducted, to find funds from operations.

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vi. Loss on sale of fixed assets.
Deduct the following items, as they do not increase the funds:

i. Profits on sale of fixed assets since the full sale proceeds are taken as a separate source of
funds and inclusion here will result in duplication.
ii. Profit on revaluation of fixed assets
iii. Non-operating incomes such as dividend received or accrued dividend, refund of income
tax, rent received or accrued rent. These items will increase funds but they are non-operating
incomes. They will be shown under separate heads as source of funds in the funds flow
statement.
iv. In case the Profit and Loss Account shows Net Loss, this should be taken as an item
which decreases the funds.

2. External Sources:
These sources include
i. Funds from long-term loans Long-term loans such as debentures, borrowings from
financial institutions will increase the working capital and therefore will be flow of funds.
However if the debentures have been issued against fixed assets, there will be no flow of
funds.
ii. Sale of fixed assets Sale of land, buildings, long-term investments will result in
generation of funds.
iii. Funds from increase in share capital Issue of shares for cash or for any other current
asset results in increase in working capital and hence there will be flow of funds.

APPLICATION OF FUNDS
The uses to which funds are put are called application of funds. Following are some of
the purposes for which funds may be used:

1. Purchase of fixed assets like land, building, plant and machinery etc.
2. Payment of dividend will affect funds since it decreases a fixed liability.
3. Payment of fixed liabilities like redemption of debentures, redemption of redeemable
preference shares. It results in decrease of working capital and hence treated as an application
of funds.
4. Payment of tax liability If the tax has been paid, it is taken as an application of funds.

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 STATEMENT OF CHANGES IN WORKING CAPITAL

As on As on Change
Items
(previous year end) (current year end) Increase Decrease
Current Assets
Cash balance
Bank Balance
Marketable securities
Accounts Receivables
Stock-in-trade
Prepaid Expenses
Total Current Assets A xxxxx Xxxxx
Current Liabilities
Bank Overdraft
Outstanding Expenses
Accounts Payable
Total Current Liabilities B xxxxx xxxxx xxx Xxx
Increase / Decrease in
xxxxx xxxxx xxx Xxx
working capital A – B

Note: At the end of the period there will be either increase or decrease only but not both.

Rules of preparing the schedule:

i. Increase in a current asset, results in increase (+) in working capital
ii. Decrease in a current asset, results in decrease (+) in working capital
iii. Increase in a current liability, results in decrease (+) in working capital
iv. Decrease in a current liability, results in increase (+) in working capital

Funds Flow Statement

The funds flow statement can also be prepared in T form as follows:

Particulars
Sources of funds
Issue of debentures
Issue of shares
Long-term borrowings
Sale of fixed assets
Operating profit*
Decrease of working capital
Rs. Particulars Rs.
Application of funds
Redemption of redeemable preference shares
Redemption of Debentures
Payment of other long-term loans
Purchased of fixed assets
Operating Loss*
Payment of dividends, tax etc.,
Increase of working capital

*Note only figure will be there

(Or)

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 Particulars Amount
Sources of funds
Issue of debentures
Issue of shares
Long-term borrowings
Sale of fixed assets
Operating profit*
Total sources xxx
Application of funds
Redemption of redeemable preference shares
Redemption of Debentures
Payment of other long-term loans
Purchased of fixed assets
Operating Loss*
Payment of dividends, tax etc.,
Total Uses xxx
Net Increase / Decrease of working capital xxx

*Note only figure will be there

Adjusted Profit and Loss Account:

This Account is drawn to know funds from operations .The format is given as under

Particulars Rs Particulars Rs.

To Opening balance xxx By Opening balance xxx
(P&L A/c Dr) (P&L a/c cr)
To transfer to By transfer from excess xxx
Sinking fund xxx Reserve
General Reserve xxx By Appreciation on fixed assets xxx
Capital redemption reserve xxx By profit o revaluation or sale xxx
Other reserves Of fixed assets or long term
To depreciation on fixed assets xxx Investments
To goodwill, patents written off xxx By non-operating incomes
To share discount, preliminary expenses xxx Dividend received xxx
Advertising, suspense a/c etc. Interest received xxx
Written off Rent received xxx
To loss on revaluation/sale of fixed xxx Income tax refund received xxx
Assets and long term investments Other incomes xxx
To provision for taxation xxx By closing balance xxx
To Dividends paid xxx (p&l a/c dr. balance)
To Interim dividend paid xxx By funds from operations xxx
To proposed dividend xxx (Balance figure)
To closing balance of p&l a/c xxx
(Credit balance)
To funds lost in operations xxx
(Balance figure)
xxx xxx
CASH FLOW STATEMENT
MEANING

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 Cash flow statement is a statement, which describes the inflows and outflows of cash and
cash equivalents in an enterprise during a specific period of time. Such statement takes into
account the receipts and disbursements of cash. A cash flow statement summarises the causes of
changes in cash position of a business enterprise between two dates.

CLASSIFICATION OF CASH FLOWS

The cash flow are classified into three main categories as:
1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities

1. CASH FLOW FROM OPERATING ACTIVITIES

Operating activities are the principal revenue – producing activities of the enterprise and
other activities that are not investing or financing activities. Cash flow from operating activities
is principally derived from the principal revenue-producing activities of the enterprise.

The cash inflows from operating activities include receipts from customers for sales or
goods and services (including collection from debtors). Cash outflows from operating
activities include payments to suppliers for purchase of materials and for services, payments to
employees for services and payments to governments for tax duties.

2. CASH FLOW FROM INVESTING ACTIVITIES

Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents. It involves making and collecting of loans and
acquiring and disposing of debt and equity instruments and fixed assets.

The cash inflows from investing activities are receipts from collection of loans, receipts
from sales of shares, debt or similar instruments of other enterprises, receipts from sales of fixed
assets, and interest and dividends received on loans and investments. Cash outflows from
investing activities are disbursements of loans, payments to acquire shares, debt or similar
instruments of other enterprises, and payments (including advance and down payments) to
acquire fixed assets.

3. CASH FLOW FROM FINANCING ACTIVITIES

Financing activities are the activities that result in change in the size and consumption of
the owners capital (including preference share capital in case of a company) and borrowings
of the enterprise.
Cash inflows from financing activities are proceeds from issuing shares or other similar
instruments, debentures, mortgages, bonds and other short or long-term borrowings. Cash
outflows from financing activities are the payments of dividends, payments to acquire or
redeem shares or other similar instruments of the enterprise, repayments of amounts
borrowed, principal payments to creditors who have extended long-term credit, and interest
paid.

Cash flow statement for the year ended___________

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 Particulars Rs. Rs.
Cash flows from Operating Activities
Either
Cash receipts from customers xxxxx
(-) Cash paid to customers (xxx)
Cash generated from operations xxxxx
(-) Income tax paid (xxx)
Cash flow before extra ordinary items xxxxx
Extraordinary items xxxxx
Net cash from (used in) operating activities xxxxx
OR
Net profit before tax and extraordinary items xxxxx
Adjustments for non-cash and non-operating items xxx
[List of individual items such as depreciation, foreign
exchange loss, loss on sale of fixed assets, interest
Income, dividend income, interest expense etc.]
Operating profit before working capital changes xxxxx
Adjustments for changes in current assets and
Current liabilities ( list of individual items) xxx
Cash generated from (used in) operations before tax xxxx
(-) Income tax paid (xxx)
Cash flow before extra ordinary items xxxx
Extraordinary items xxxx
Net cash from (used in) operating activities xxxxx

Cash flow from Investing Activities

Individual items of cash inflows and cash outflows from investing activities xxx
[Such as purchase/sale of fixed assets, purchase or sale of investments, xxx
Interest received, dividend received etc.] xxx
Net cash from (used in) investing activities xxxx

Cash flows from Finance Activities

Individual items of cash inflows and cash outflows from financing activities xxxx
[Such as proceeds from issue of shares, long-term borrowings, repayments xxxx
of long-term borrowings, interest paid, dividend paid etc. xxxx
Net cash from (used in) investing activities xxxxx
Net Increase (Decrease) in cash and cash equivalents xxx
Cash and cash equivalents at the beginning of the period xxxxx
Cash and cash equivalents at the end of the period xxxxx

CASH INFLOWS ACTIVITIES CASH OUTFLOWS

Payments to suppliers and

employees for materials
and services
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Receipts from customers
for sales of goods and OPERATING ACTIVITIES
services activities
Payments to government
for taxes and duties

Receipts from sale of

fixed assets Payment for purchase
of fixed assets
Receipts from sales of
investments and fro INVESTING ACTIVITIES
collection of loans
Payments for purchase
Receipts from interest
of investments and
and dividends on loans
making loans
and investments

Receipts from issuance Payments for

of share capital dividends on share
capital

FINANCING Payments for principal

Receipts from issuance
on debentures and
of debentures
ACTIVITIES other borrowings

Payments for interest

Receipts from other on debentures and
long-term borrowings other borrowings

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