Home Unlabelled Accounting for Managers

Accounting for Managers

UNIT – I

LESSON – 1.1

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ACCOUNTING – AN INTRODUCTION

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1.1.1 INTRODUCTION

Accounting is aptly called the language of business. This

designation is applied to accounting because it is the method of

communicating business information. The basic function of any

language is to serve as a means of communication. Accounting duly

serves this function. The task of learning accounting is essentially

the same as the task of learning a new language. But the

acceleration of change in business organization has contributed to

increasing the complexities in this language. Like other languages,

it is undergoing continuous change in an attempt to discover better

means of communications. To enable the accounting language to

convey the same meaning to all people as far as practicable it

should be made standard. To make it a standard language certain

accounting principles, concepts and standards have been developed

over a period of time. This lesson dwells upon the different

dimensions of accounting, accounting concepts, accounting

principles and the accounting standards.

1.1.2 OBJECTIVES

After reading this lesson, the reader should be able to:

• Know the evolution of accounting

• Understand the definition of accounting

• Comprehend the scope and function of accounting

• Ascertain the users of accounting information

• Know the specialised accounting fields

• Understand the accounting concepts and conventions

• Realise the need for accounting standards

1.1.3 CONTENTS

1.1.3.1 Evolution of Accounting

1.1.3.2 Book Keeping and Accounting

1.1.3.3 Definition of Accounting

1.1.3.4 Scope and Functions of Accounting

1.1.3.5 Groups Interested in Accounting Information

1.1.3.6 The Profession of Accounting

1.1.3.7 Specialised Accounting Fields

1.1.3.8 Nature and Meaning of Accounting Principles

1.1.3.9 Accounting Concepts

1.1.3.10 Accounting Conventions

1.1.3.11 Accounting Standards

1.1.3.12 Summary

1.1.3.13 Key Words

1.1.3.14 Self Assessment Questions

1.1.3.15 Books for Further Reading

1.1.3.1 EVOLUTION OF ACCOUNTING

Accounting is as old as money itself. It has evolved, as have medicine,

law and most other fields of human activity in response to the social and

economic needs of society. People in all civilizations have maintained various

types of records of business activities. The oldest known are clay tablet records

of the payment of wages in Babylonia around 600 B.C. Accounting was

practiced in India twenty-four centuries ago as is clear from Kautilya's book

`Arthshastra' which clearly indicates the existence and need of proper

accounting and audit.

For the most part, early accounting dealt only with limited aspects of the

financial operations of private or governmental enterprises. Complete

accounting system for an enterprise which came to be called as "Double Entry

System" was developed in Italy in the 15th century. The first known description

of the system was published there in 1494 by a Franciscan monk by the name

Luca Pacioli.

The expanded business operations initiated by the Industrial

Revolution required increasingly large amounts of money which in turn

resulted in the development of the corporation form of organisations. As

corporations became larger, an increasing number of individuals and

institutions looked to accountants to provide economic information about

these enterprises. For e.g. prospective investors and creditors sought

information about a corporation's financial status. Government agencies

required financial information for purposes of taxation and regulation.

Thus accounting began to expand its function of meeting the needs of

relatively few owners to a public role of meeting the needs of a variety

of interested parties.

1.1.3.2 BOOK KEEPING AND ACCOUNTING

Book-keeping is that branch of knowledge which tells us how to

keep a record of business transactions. It is considered as an art of

recording systematically the various types of transactions that occur in a

business concern in the books of accounts. According to Spicer and

Pegler, "book-keeping is the art of recording all money transactions, so

that the financial position of an undertaking and its relationship to both

its proprietors and to outside persons can be readily ascertained".

Accounting is a term which refers to a systematic study of the principles

and methods of keeping accounts. Accountancy and book-keeping are

related terms; the former relates to the theoretical study and the latter

refers to the practical work.

1.1.3.3 DEFINITION OF ACCOUNTING

Before attempting to define accounting, it may be made clear that

there is no unanimity among accountants as to its precise definition.

Anyhow let us examine three popular definitions on the subject:

Accounting has been defined by the American Accounting

Association Committee as: ". . . the process of identifying, measuring

and communicating economic information to permit informed judgments

and decisions by users of the information". This may be considered as a

good definition because of its focus on accounting as an aid to decision

making.

The American Institute of Certified and Public Accountants

Committee on Terminology defined accounting as: "Accounting is the art

of recording classifying and summarising, in a 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". Of all

definitions available, this is the most acceptable one because it

encompasses all the functions which the modern accounting system

performs.

Another popular definition on accounting was given by American

Accounting Principles Board in 1970, which defined it as: "Accounting

is a service society. Its function is to provide quantitative information,

primarily financial in nature, about economic entities that is useful in

making economic decision, in making reasoned choices among

alternative courses of action". This is a very relevant definition in a

present context of business units facing the situation of selecting the best

among the various alternatives available. The special feature of this

definition is that it has designated accounting as a service activity.

1.1.3.4 SCOPE AND FUNCTIONS OF ACCOUNTING

Individuals engaged in such areas of business as finance,

production, marketing, personnel and general management need not be

expert accountants but their effectiveness is no doubt increased if they

have a good understanding of accounting principles. Everyone engaged

in business activity, from the bottom level employee to the chief

executive and owner, comes into contact with accounting. The higher the

level of authority and responsibility, the greater is the need for an

understanding of accounting concepts and terminology.

A study conducted in United States revealed that the most

common background of chief executive officers in United States

Corporations was finance and accounting. Interviews with several

corporate executives drew the following comments:

"…… my training in accounting and auditing practice has been

extremely valuable to me throughout". "A knowledge of accounting

carried with it understanding of the establishment and maintenance of

sound financial controls- is an area which is absolutely essential to a

chief executive officer".

Though accounting is generally associated with business, it is not

only business people who make use of accounting but also many

individuals in non-business areas that make use of accounting data and

need to understand accounting principles and terminology. For e.g. an

engineer responsible for selecting the most desirable solution to a

technical manufacturing problem may consider cost accounting data to

be the decisive factor. Lawyers want accounting data in tax cases and

damages from breach of contract. Governmental agencies rely on an

accounting data in evaluating the efficiency of government operations

and for approving the feasibility of proposed taxation and spending

programs. Accounting thus plays an important role in modern society

and broadly speaking all citizens are affected by accounting in some way

or the other.

Accounting which is so important to all, discharges the following vital

functions:

Keeping systematic records: This is the fundamental function of accounting.

The transactions of the business are properly recorded, classified and

summarised into final financial statements – income statement and the balance

sheet.

Protecting the business properties: The second function of accounting is to

protect the properties of the business by maintaining proper record of various

assets and thus enabling the management to exercise proper control over them.

Communicating the results: As accounting has been designated as the language

of business, its third function is to communicate financial information in respect

of net profits, assets, liabilities, etc., to the interested parties.

Meeting legal requirements: The fourth and last function of accounting is to

devise such a system as will meet the legal requirements. The provisions of

various laws such as the Companies Act, Income Tax Act, etc., require the

submission of various statements like Income Tax returns, Annual Accounts and

so on. Accounting system aims at fulfilling this requirement of law.

It may be noted that the functions stated above are those of

financial accounting alone. The other branches of accounting, about

which we are going to see later in this lesson, have their special

functions with the common objective of assisting the management in its

task of planning, control and coordination of business activities. Of all

the branches of accounting, management accounting is the most

important from the management point of view.

As accounting is the language of business, the primary aim of

accounting, like any other language, is to serve as a means of

communication. Most of the world's work is done through organisations

– groups of people who work together to accomplish one or more

objectives. In doing its work, an organisation uses resources – men,

material, money and machine and various services. To work effectively,

the people in an organisation need information about these sources and

the results achieved through using them. People outside the organisation

need similar information to make judgments about the organisation.

Accounting is the system that provides such information.

Any system has three features viz. input, processes and output.

Accounting as a social science can be viewed as an information system

since it has all the three feature i.e., inputs (raw data), processes (men

and equipment) and outputs (reports and information). Accounting

information is composed principally of financial data about business

transactions. The mere records of transactions are of little use in making

"informed judgements and decisions". The recorded data must be sorted

and summarised before significant analysis can be prepared. Some of the

reports to the enterprise manager and to others who need economic

information may be made frequently: other reports are issued only at

longer intervals. The usefulness of reports is often enhanced by various

types of percentage and trend analyses. The "BASIC RAW

MATERIALS" of accounting are composed of business transactions

data. Its "primary end products" are composed of various summaries,

analyses and reports.

The information needs of a business enterprise can be outlined

and illustrated with the help of the following chart:

CHART SHOWING TYPES OF INFORMATION

Information

Nonquantitative Quantitative

Information Information

Accounting Non accounting

Information Information

Operating Financial Management Cost

Information Accounting Accounting Accounting

The chart clearly presents the different types of information that

might be useful to all sorts of individuals interested in the business

enterprise. As seen from the chart, accounting supplies the quantitative

information. The special feature of accounting as a kind of a quantitative

information and as distinguished from other types of quantitative

information is that it usually is expressed in monetary terms. In this

connection it is worthwhile to recall the definitions of accounting as

given by the American Institute of Certified and Public Accountants and

by the American Accounting Principles Board.

The types of accounting information may be classified into four

categories: (1) Operating information, (2) Financial accounting

information (3) Management accounting information and (4) Cost

accounting information.

Operating Information: By operating information, we mean the information

which is required to conduct the day-to-day activities. Examples of operating

information are: Amount of wages paid and payable to employees, information

about the stock of finished goods available for sale and each one's cost and

selling price, information about amounts owed to and owing by the business

enterprise, information about stock of raw materials, spare parts and accessories

and so on. By far the largest quantity of accounting information provides the raw

data (input) for financial accounting, management accounting and cost

accounting.

Financial Accounting: Financial accounting information is intended both for

owners and managers and also for the use of individuals and agencies external to

the business. This accounting is concerned with the recording of transactions for

a business enterprise and the periodic preparation of various reports from such

records. The records may be for general purpose or for a special purpose. A

detailed account of the function of financial accounting has been given earlier in

this lesson.

Management Accounting: Management accounting employs both historical and

estimated data in assisting management in daily operations and in planning for

future operations. It deals with specific problems that confront enterprise

managers at various organisational levels. The management accountant is

frequently concerned with identifying alternative courses of action and then

helping to select the best one. For e.g. the accountant may help the finance

manager in preparing plans for future financing or may help the sales manager

in determining the selling price to be fixed on a new product by providing

suitable data. Generally management accounting information is used in three

important management functions: (1) control (2) co-ordination and (3) planning.

Marginal costing is an important technique of management accounting which

provides multi dimensional information that facilitates decision making. More

about it can be had in the Unit IV.

Cost Accounting: The Industrial Revolution in England posed a challenge to the

development of accounting as a tool of industrial management. This necessitated

the development of costing techniques as guides to management action. Cost

accounting emphasizes the determination and the control of costs. It is

concerned primarily with the cost of manufacturing processes. In addition one of

the principal functions of cost accounting is to assemble and interpret cost data,

both actual and prospective, for the use of management in controlling current

operations and in planning for the future.

All of the activities described above are related to accounting and

in all of them the focus is on providing accounting information to enable

decisions to be made. More about cost accounting can be gained in

unit V

1.1.3.5 GROUPS INTERESTED IN ACCOUNTING INFORMATION

There are several groups of people who are interested in the accounting

information relating to the business enterprise. Following are some of them:

Shareholders: Shareholders as owners are interested in knowing the profitability

of the business transactions and the distribution of capital in the form of assets

and liabilities. In fact, accounting developed several centuries ago to supply

information to those who had invested their funds in business enterprise.

Management: With the advent of joint stock company form of organisation the

gap between ownership and management widened. In most cases the

shareholders act merely as renters of capital and the management of the

company passes into the hands of professional managers. The accounting

disclosures greatly help them in knowing about what has happened and what

should be done to improve the profitability and financial position of the

enterprise.

Potential Investors: An individual who is planning to make an investment in a

business would like to know about its profitability and financial position. An

analysis of the financial statements would help him in this respect.

Creditors: As creditors have extended credit to the company, they are much

worried about the repaying capacity of the company. For this purpose they

require its financial statements, an analysis of which will tell about the solvency

position of the company.

Government: Any popular Government has to keep a watch on big businesses

regarding the manner in which they build business empires without regard to the

interests of the community. Restricting monopolies is something that is common

even in capitalist countries. For this, it is necessary that proper accounts are

made available to the Government. Also, accounting data are required for

collection of sale-tax, income-tax, excise duty etc.

Employees: Like creditors, employees are interested in the financial statements

in view of various profit sharing and bonus schemes. Their interest may further

increase when they hold shares of the companies in which they are employed.

Researchers: Researchers are interested in interpreting the financial statements

of the concern for a given objective.

Citizens: Any citizen may be interested in the accounting records of business

enterprises including public utilities and Government companies as a voter and

tax payer.

1.1.3.6 THE PROFESSION OF ACCOUNTING

Accountancy can very well be viewed as a profession with stature

comparable to that of law or medicine or engineering. The rapid

development of accounting theory and techniques especially after the

late thirties of 20th century has been accompanied by an expansion of

the career opportunities in accounting and an increasing number of

professionally trained accountants. Among the factors contributing to

this growth have been the increase in number, size and complexity of

business enterprises, the imposition of new and increasingly complex

taxes and other governmental restrictions on business operations.

Coming to the nature of accounting function, it is no doubt a

service function. The chief of accounting department holds a staff

position which is quite in contra distinction to the roles played by

production or marketing executives who hold line authority. The role of

the accountant is advisory in character. Although accounting is a staff

function performed by professionals within an organization, the ultimate

responsibility for the generation of accounting information, whether

financial or managerial, rests with management. That is why one of the

top officers of many businesses is the Financial Controller. The

controller is the person responsible for satisfying other managers'

demands for management accounting information and for complying

with the regulatory demands of financial reporting. With these ends in

view, the controller employs accounting professionals in both

management and financial accounting. These accounting professionals

employed in a particular business firm are said to be engaged in private

accounting. Besides these there are also accountants who render

accounting services on a fee basis through staff accountants employed by

them. These accountants are said to be engaged in public accounting.

1.1.3.7 SPECIALISED ACCOUNTING FIELDS

As in many other areas of human activity, a number of specialised

fields in accounting also have evolved besides financial accounting.

Management accounting and Cost accounting are the result of rapid

technological advances and accelerated economic growth. The most

important among them are explained below:

Tax Accounting: Tax accounting covers the preparation of tax returns and the

consideration of the tax implications of proposed business transactions or

alternative courses of action. Accountants specialising in this branch of

accounting are familiar with the tax laws affecting their employer or clients and

are upto date on administrative regulations and court decisions on tax cases.

International Accounting: This accounting is concerned with the special

problems associated with the international trade of multinational business

organisations. Accountants specialising in this area must be familiar with the

influences that custom, law and taxation of various countries bring to bear on

international operations and accounting principles.

Social Responsibility Accounting: This branch is the newest field of accounting

and is the most difficult to describe concisely. It owes its birth to increasing

social awareness which has been particularly noticeable over the last three

decades or so. Social responsibility accounting is so called because it not only

measures the economic effects of business decisions but also their social effects,

which have previously been considered to be unmeasurable. Social

responsibilities of business can no longer remain as a passive chapter in the text

books of commerce but are increasingly coming under greater scrutiny. Social

workers and people's welfare organisations are drawing the attention of all

concerned towards the social effects of business decisions. The management is

being held responsible not only for the efficient conduct of business as reflected

by increased profitability but also for what it contributes to social well-being and

progress.

Inflation Accounting: Inflation has now become a world-wide phenomenon.

The consequences of inflation are dire in case of developing and underdeveloped

countries. At this juncture when financial statements or reports are

based on historical costs, they would fail to reflect the effect of changes in

purchasing power or the financial position and profitability of the firm. Thus the

utility of the accounting records, not taking care of price level changes is

seriously lost. This imposes a demand on the accountants for adjusting financial

accounting for inflation to know the real financial position and profitability of a

concern and thus emerged a future branch of accounting called Inflation

accounting or Accounting for price level changes. It is a system of accounting

which regularly records all items in financial statements at their current values.

Human Resources Accounting: Human Resources Accounting is yet another

new field of accounting which seeks to report and emphasise the importance of

human resources in a company's earning process and total assets. It is based on

the general agreement that the only real long lasting asset which an organisation

possesses is the quality and calibre of the people working in it. This system of

accounting is concerned with, "the process of identifying and measuring data

about human resources and communicating this information to interested

parties".

1.1.3.8 NATURE AND MEANING OF ACCOUNTING PRINCIPLES

What is an accounting principle or concept or convention or

standard? Do they mean the same thing? Or does each one have its own

meaning? These are all questions for which there is no definite answer

because there is ample confusion and controversy as to the meaning and

nature of accounting principles. We do not want to enter into this

controversial discussion because the reader may fall a prey to the

controversies and confusions and lose the spirit of the subject.

The rules and conventions of accounting are commonly referred to

as principles. The American Institute of Certified Public Accountants

have defined the accounting principle as, "a general law or rule adopted

or professed as a guide to action; a settled ground or basis of conduct or

practice". It may be noted that the definition describes the accounting

principle as a general law or rule that is to be used as a guide to action.

The Canadian Institute of Chartered Accountants has defined accounting

principles as, "the body of doctrines commonly associated with the

theory and procedure of accounting, serving as explanation of current

practices and as a guide for the selection of conventions or procedures

where alternatives exist". This definition also makes it clear that

accounting principles serve as a guide to action.

The peculiar nature of accounting principles is that they are manmade.

Unlike the principles of physics, chemistry etc. they were not

deducted from basic axiom. Instead they have evolved. This has been

clearly brought out by the Canadian Institute of Chartered Accountants

in the second part of their definition on accounting principles: "Rules

governing the foundation of accounting actions and the principles

derived from them have arisen from common experiences, historical

precedent, statements by individuals and professional bodies and

regulation of governmental agencies". Since the accounting principles

are man made they cannot be static and are bound to change in response

to the changing needs of the society. It may be stated that accounting

principles are changing but the change in them is permanent.

Accounting principles are judged on their general acceptability to

the makers and users of financial statements and reports. They present a

generally accepted and uniform view of the accounting profession in

relation to good accounting practice and procedures. Hence the name

generally accepted accounting principles.

Accounting principles, rules of conduct and action are described

by various terms such as concepts, conventions, doctrines, tenets,

assumptions, axioms, postulates, etc. But for our purpose we shall use all

these terms synonymously except for a little difference between the two

terms – concepts and conventions. The term "concept" is used to connote

accounting postulates i.e. necessary assumptions or conditions upon

which accounting is based. The term convention is used to signify

customs or traditions as a guide to the preparation of accounting

statements.

1.1.3.9 ACCOUNTING CONCEPTS

The important accounting concepts are discussed hereunder:

Business Entity Concept: It is generally accepted that the moment a business

enterprise is started it attains a separate entity as distinct from the persons who

own it. In recording the transactions of the business the important question is:

How do these transactions affect the business enterprise? The question as

to how these transactions affect the proprietors is quite irrelevant. This concept

is extremely useful in keeping business affairs strictly free from the effect of

private affairs of the proprietors. In the absence of this concept the private

affairs and business affairs are mingled together in such a way that the true

profit or loss of the business enterprise cannot be ascertained nor its financial

position. To quote an example, if the proprietor has taken Rs.5000/- from the

business for paying house tax for his residence, the amount should be deducted

from the capital contributed by him. Instead if it is added to the other business

expenses then the profit will be reduced by Rs.5000/- and also his capital more

by the same amount. This affects the results of the business and also its financial

position. Not only this, since the profit is lowered, the consequential tax

payment also will be less which is against the provisions of the Income-tax Act.

Going Concern Concept: This concept assumes that the business enterprise will

continue to operate for a fairly long period in the future. The significance of this

concept is that the accountant while valuing the assets of the enterprise does not

take into account their current resale values as there is no immediate expectation

of selling it. Moreover, depreciation on fixed assets is charged on the basis of

their expected life rather than on their market values. When there is conclusive

evidence that the business enterprise has a limited life the accounting procedures

should be appropriate to the expected terminal date of the enterprise. In such

cases, the financial statements could clearly disclose the limited life of the

enterprise and should be prepared from the `quitting concern' point of view

rather than from a `going concern' point of view.

Money Measurement Concept: Accounting records only those transactions

which can be expressed in monetary terms. This feature is well emphasized in

the two definitions on accounting as given by the American Institute of Certified

Public Accountants and the American Accounting Principles Board. The

importance of this concept is that money provides a common denomination by

means of which heterogeneous facts about a business enterprise can be

expressed and measured in a much better way. For e.g. when it is stated that a

business owns Rs.1,00,000 cash, 500 tons of raw material, 10 machinery items,

3000 square meters of land and building etc., these amounts cannot be added

together to produce a meaningful total of what the business owns. However, by

expressing these items in monetary terms Rs.1,00,000 cash, Rs.5,00,000 worth

of raw materials, Rs,10,00,000 worth of machinery items and Rs.30,00,000

worth of land and building – such an addition is possible.

A serious limitation of this concept is that accounting does not

take into account pertinent non-monetary items which may significantly

affect the enterprise. For instance, accounting does not give information

about the poor health of the Chairman, serious misunderstanding

between the production and sales manager etc., which have serious

bearing on the prospects of the enterprise. Another limitation of this

concept is that money is expressed in terms of its value at the time a

transaction is recorded in the accounts. Subsequent changes in the

purchasing power of moneys are not taken into account.

Cost Concept: This concept is yet another fundamental concept of accounting

which is closely related to the going-concern concept. As per this concept: (i) an

asset is ordinarily entered in the accounting records at the price paid to acquire it

i.e., at its cost and (ii) this cost is the basis for all subsequent accounting for the

asset.

The implication of this concept is that the purchase of an asset is

recorded in the books at the price actually paid for it irrespective of its

market value. For e.g. if a business buys a building for Rs.3,00,000, the

asset would be recorded in the books at Rs.3,00,000 even if its market

value at that time happens to be Rs.4,00,000. However, this concept does

not mean that the asset will always be shown at cost. This cost becomes

the basis for all future accounting for the asset. It means that the asset

may systematically be reduced in its value by changing depreciation. The

significant advantage of this concept is that it brings in objectivity in the

preparations and presentation of financial statements. But like the money

measurement concept this concept also does not take into account

subsequent changes in the purchasing power of money due to

inflationary pressures. This is the reason for the growing importance of

inflation accounting.

Dual Aspect Concept (Double Entry System): This concept is the core of

accounting. According to this concept every business transaction has a dual

aspect. This concept is explained in detail below:

The properties owned by a business enterprise are referred to as

assets and the rights or claims to the various parties against the assets are

referred to as equities. The relationship between the two may be

expressed in the form of an equation as follows:

Equities = Assets

Equities may be subdivided into two principal types: the rights of

creditors and the rights of owners. The rights of creditors represent debts of the

business and are called liabilities. The rights of the owners are called capital.

Expansion of the equation to give recognition to the two types of equities results

in the following which is known as the accounting equation:

Liabilities + Capital = Assets

It is customary to place `liabilities' before `capital' because creditors

have priority in the repayment of their claims as compared to that of owners.

Sometimes greater emphasis is given to the residual claim of the owners by

transferring liabilities to the other side of the equation as:

Capital = Assets – Liabilities

All business transactions, however simple or complex they are, result in

a change in the three basic elements of the equation. This is well explained with

the help of the following series of examples:

(i) Mr.Prasad commenced business with a capital of Rs.3,000: The

result of this transaction is that the business, being a separate

entity, gets cash-asset of Rs.30,000 and has to pay to Mr.Prasad

Rs.30,000 his capital. This transaction can be expressed in the

form of the equation as follows:

Capital = Assets

Prasad Cash

30,000 30,000

(ii) Purchased furniture for Rs.5,000: The effect of this transaction is

that cash is reduced by Rs.5,000 and a new asset viz. furniture

worth Rs.5,000 comes in thereby rendering no change in the total

assets of the business. The equation after this transaction will be:

Capital = Assets

Prasad Cash + Furniture

30,000 25,000 5,000

(iii) Borrowed Rs.20,000 from Mr.Gopal: As a result of this

transaction both the sides of the equation increase by Rs.20,000;

cash balance is increased and a liability to Mr.Gopal is created.

The equation will appear as follows:

Liabilities + Capital =Assets

Creditiors + Prasad Cash + Furniture

20,000 30,000 45,000 5,000

(iv) Purchased goods for cash Rs.30,000: This transaction does not

affect the liabilities side total nor the asset side total. Only the

composition of the total assets changes i.e. cash is reduced by

Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in.

The equation after this transaction will be as follows:

Liabilities + Capital =Asset

Creditors Prasad Cash + Stock + Furniture

20,000 30,000 15,000 30,000 5,000

(v) Goods worth Rs.10,000 are sold on credit to Ganesh for

Rs.12,000. The result is that stock is reduced by Rs.10,000 a new

asset namely debtor (Mr.Ganesh) for Rs.12,000 comes into

picture and the capital of Mr.Prasad increases by Rs.2,000 as the

profit on the sale of goods belongs to the owner. Now the

accounting equation will look as under:

Liabilities + Capital =Asset

Creditors Prasad Cash +Debtors+Stock+ Furnitures

20,000 32,000 15,000 12,000 20,000 5,000

(vi) Paid electricity charges Rs.300: This transaction reduces both the

cash balance and Mr.Prasad's capital by Rs.300. This is so

because the expenditure reduces the business profit which in turn

reduces the equity. The equation after this will be:

Liabilities + Capital =Asset

Creditors + Prasad Cash +Debtors+Stock+ Furnitures

20,000 31,700 14,700 12,000 20,000 5,000

Thus it may be seen that whatever is the nature of transaction, the

accounting equation always tallies and should tally.

The system of recording transactions based on this concept is

called double entry system.

Account Period Concept: In accordance with the going concern concept it is

usually assumed that the life of a business is indefinitely long. But owners and

other interested parties cannot wait until the business has been wound up for

obtaining information about its results and financial position. For e.g. if for ten

years no accounts have been prepared and if the business has been consistently

incurring losses, there may not be any capital at all at the end of the tenth year

which will be known only at that time. This would result in the compulsory

winding up of the business. But if at frequent intervals information are made

available as to how things are going, then corrective measures may be suggested

and remedial action may be taken. That is why, Pacioli wrote as early as in

1494: `Frequent accounting makes for only friendship'. This need leads to the

accounting period concept.

According to this concept accounting measures activities for a

specified interval of time called the accounting period. For the purpose

of reporting to various interested parties one year is the usual accounting

period. Though Pacioli wrote that books should be closed each year

especially in a partnership, it applies to all types of business

organisations.

Periodic Matching of Costs and Revenues: This concept is based on the

accounting period concept. It is widely accepted that desire of making profit is

the most important motivation to keep the proprietors engaged in business

activities. Hence a major share of attention of the accountant is being devoted

towards evolving appropriate techniques of measuring profits. One such

technique is periodic matching of costs and revenues.

In order to ascertain the profits made by the business during a

period, the accountant should match the revenues of the period with the

costs of that period. By `matching' we mean appropriate association of

related revenues and expenses pertaining to a particular accounting

period. To put it in other words, profits made by a business in a

particular accounting period can be ascertained only when the revenues

earned during that period are compared with the expenses incurred for

earning that revenue. The question as to when the payment was actually

received or made is irrelevant. For e.g. in a business enterprise which

adopts calendar year as accounting year, if rent for December 1989 was

paid in January 1990, the rent so paid should be taken as the expenditure

of the year 1989, revenues of that year should be matched with the costs

incurred for earning that revenue including the rent for December 1989,

though paid in January 1990. It is on account of this concept that

adjustments are made for outstanding expenses, accrued incomes,

prepaid expenses etc. while preparing financial statements at the end of

the accounting period.

The system of accounting which follows this concept is called as

mercantile system. In contrast to this there is another system of

accounting called as cash system of accounting where entries are made

only when cash is received or paid, no entry being made when a payment

or receipt is merely due.

Realisation Concept: Realisation refers to inflows of cash or claims to cash like

bills receivables, debtors etc. arising from the sale of assets or rendering of

services. According to Realisation concept, revenues are usually recognized in

the period in which goods were sold to customers or in which services were

rendered. Sale is considered to be made at the point when the property in goods

passes to the buyer and he becomes legally liable to pay. To illustrate this point,

let us consider the case of A, a manufacturer who produces goods on receipt of

orders. When an order is received from B, A starts the process of production and

delivers the goods to B when the production is complete. B makes payment on

receipt of goods. In this example, the sale will be presumed to have been made

not at the time when goods are delivered to B. A second aspect of the

Realisation concept is that the amount recognized as revenue is the amount that

is reasonably certain to be realized. However, lot of reasoning has to be applied

to ascertain as to how certain `reasonably certain' is … Yet, one thing is clear,

that is, the amount of revenue to be recorded may be less than the sales value of

the goods sold and services rendered. For e.g. when goods are sold at a discount,

revenue is recorded not at the list price but at the amount at which sale is made.

Similarly, it is on account of this aspects of the concept that when sales are made

on credit though entry is made for the full amount of sales, the estimated amount

of bad debts is treated as an expense and the effect on net income is the same as

if the revenue were reported as the amount of sales minus the estimated amount

of bad debts.

1.1.3.10 ACCOUNTING CONVENTIONS

Convention of Conservation: It is a world of uncertainity. So it is always better

to pursue the policy of playing safe. This is the principle behind the convention

of conservatism. According to this convention the accountant must be very

careful while recognising increases in an enterprise's profits rather than

recognising decreases in profits. For this the accountants have to follow the rule,

anticipate no profit, provide for all possible losses, while recording business

transactions. It is on account of this convention that the inventory is valued `at

cost or market price whichever is less', i.e. when the market price of the

inventories has fallen below its cost price it is shown at market price i.e. the

possible loss is provided and when it is above the cost price it is shown at cost

price i.e. the anticipated profit is not recorded. It is for the same reason that

provision for bad and doubtful debts, provision for fluctuation in investments,

etc., are created. This concept affects principally the current assets.

Convention of full disclosure: The emergence of joint stock company form of

business organisation resulted in the divorce between ownership and

management. This necessitated the full disclosure of accounting information

about the enterprise to the owners and various other interested parties. Thus the

convention of full disclosure became important. By this convention it is implied

that accounts must be honestly prepared and all material information must be

adequately disclosed therein. But it does not mean that all information that

someone desires are to be disclosed in the financial statements. It only implies

that there should be adequate disclosure of information which is of considerable

value to owners, investors, creditors, Government, etc. In Sachar Committee

Report (1978) it has been emphasised that openness in company affairs is the

best way to secure responsible behaviour. It is in accordance with this

convention that Companies Act, Banking Companies Regulation Act, Insurance

Act etc., have prescribed proforma of financial statements to enable the

concerned companies to disclose sufficient information. The practice of

appending notes relating to various facts on items which do not find place in

financial statements is also in pursuance to this convention. The following are

some examples:

(a) Contingent liabilities appearing as a note

(b) Market value of investments appearing as a note

Convention of Consistency: According to this concept it is essential that

accounting procedures, practices and method should remain unchanged from

one accounting period to another. This enables comparison of performance in

one accounting period with that in the past. For e.g. if material issues are priced

on the basis of FIFO method the same basis should be followed year after year.

Similarly, if depreciation is charged on fixed assets according to diminishing

balance method it should be done in subsequent year also. But consistency never

implies inflexibility as not to permit the introduction of improved techniques of

accounting. However if introduction of a new technique results in inflating or

deflating the figures of profit as compared to the previous methods, the fact

should be well disclosed in the financial statement.

Convention of Materiality: The implication of this convention is that accountant

should attach importance to material details and ignore insignificant ones. In the

absence of this distinction accounting will unnecessarily be overburdened with

minute details. The question as to what is a material detail and what is not is left

to the discretion of individual accountant. Further an item should be regarded as

material if there is reason to believe that knowledge of it would influence the

decision of informed investor. Some examples of material financial information

are: fall in the value of stock, loss of markets due to competition, change in the

demand pattern due to change in government regulations, etc. Examples of

insignificant financial information are: rounding of income to nearest ten for tax

purposes etc. Sometimes if it is felt that an immaterial item must be disclosed,

the same may be shown as footnote or in parenthesis according to its relative

importance.

1.1.3.11 ACCOUNTING STANDARS

The information revealed by the published financial statements is

of considerable importance to shareholders, creditors and other

interested parties. Hence it is the responsibility of the accounting

profession to ensure that the required information is properly presented.

If the accountants present the financial information using their own

discretion and in their own way, the information may not be valid and

hence may not serve the purpose. There is, therefore, the urgent need

that certain standard should be followed for drawing up the financial

statements so that there is the minimum possible ambiguity and

uncertainty about the information contained in them. The International

Accounting Standards Committee (IASC) has undertaken this task of

drawing up the standards.

The IASC was established in 1973. It has its headquarters at London. At

present, the IASC has two classes of membership:

(a) Founder members, being the professional accounting bodies of the

following nine countries:

Australia Mexico

Canada Netherlands

France U.K. and Ireland

Germany U.S.A.

Japan

(b) Members being accounting bodies from countries other than the

nine above which seek and are granted membership.

The need for an IAS Program has been attributed to three factors:

(a) The growth in international investment. Investors in international

capital markets are to make decisions based on published accounting

which are based on accounting policies and which again vary from

country to country. The International Accounting Statements will

help investors to make more efficient decisions.

(b) The increasing prominence of multinational enterprises. Such

enterprises render accounts for the countries in which their

shareholders reside and in local country in which they operate,

accounting standards will help to avoid confusion.

hoped that the IASC can harmonise these separate rule making

efforts.

The objective of the IASC is `to formulate and publish in the

public interest standards to be observed in the presentation of audited

financial statements and to promote their world-wide acceptance and

observance'. The formulation of standards will bring uniformity in

terminology, procedure, method, approach and presentation of results.

The International Accounting Standards Board (IASB) replaced the

IASC in 2001. Since then the IASB has amended some International

Accounting Standards, has proposed to replace some International

Accounting Standards with new International Financial Reporting

Standards (IFRSs) and has adopted or proposed certain new IFRSs on

topics for which there was no previous International Accounting

Standards. Since its inception the IASC has so far issued 41 International

Accounting Standards.

INDIA AND ACCOUNTING STANDARDS

The Institute of Chartered Accountants of India (ICAI) and the

Institute of Cost and Works Accountants of India (ICWAI) are associate

members of the IASC. But the enforcement of the standards issued by

the IASC has been restricted in our country. Instead, the ICAI is drawing

up its own standards. The Accounting Standards Board (ASB) which was

established by the council of the ICAI in 1977 is formulating accounting

standards so that such standards will be established by the council of the

ICAI.

The ICAI has issued a mandate to its members to adopt uniform

accounting system for the corporate sector w.e.f. 1-4-1991, in view of

the fact that the International Accounting Standards are being followed

all over the world and so, the auditor of companies will now insist on

compliance of these mandatory accounting standards. As at 28-2-2005

the ASB of ICAI has issued 29 Indian Accounting Standards.

1.1.3.12 SUMMARY

Accounting is rightly called the language of business. It is as old

as money itself. It is concerned with the collecting, recording, evaluating

and communicating the results of business transactions. Initially meant

to meet the needs of a relatively few owners, it gradually expanded its

functions to a public role of meeting the needs of a variety of interested

parties. Broadly speaking all citizens are affected by accounting in some

way. Accounting as an information system possesses with accountants

engaged in private and public accounting. As in many other areas of

human activity a number of specialised fields in accounting also have

evolved as a result of rapid changes in business and social needs.

Accounting information should be made standard to convey the

same meaning to all interested parties. To make it standard, certain

accounting principles, concepts, conventions and standards have been

developed over a period of time. These accounting principles, by

whatever name they are called, serve as a general law or rule that is to be

used as a guide to action. Without accounting principles, accounting

information becomes uncomparable, inconsistent and unreliable. An

accounting principle to become generally accepted should satisfy the

criteria of relevance, objectivity and feasibility. The FASB (Financial

Accounting Standards Board) is currently the dominant body in the

development of accounting principles. The IASC is another professional

body which is engaged in the development of the accounting standards.

The ICAI is an associate member of the IASC and the ASB started by the

ICAI is formulating accounting standards in our country. The IASC and

ICAI both consider going concern, accrual and consistency as

fundamental accounting assumptions.

1.1.3.13 KEY WORDS

Accounting: Language of business.

Financial Accounting: Concerned with the recording of transactions for a

business enterprise and the periodic preparation of various reports from such

records

Management Accounting: Accounting for internal management needs.

Cost Accounting: Accounting for determination and control of costs.

Accounting Principle: The body of doctrines commonly associated with the

theory and procedure of accounting.

Accounting Concept: Accounting postulates i.e. necessary assumptions or

conditions upon which accounting is based.

Accounting Conventions: Convention signifies the customs or traditions which

serve as a guide to the preparation of accounting statements.

Accounting Standard: Standards to be observed in the presentation of financial

statements.

1.1.3.14 SELF ASSESSMENT QUESTIONS

1. Why is accounting called the language of business?

2. What are the functions of accounting?

3. Accounting as a social science can be viewed as an information system.

Examine.

4. Is accounting a staff function or line function? Explain the reasons.

5. Give an account of the various branches of accounting.

6. `Accounting is a service function'. Discuss the statement in the context of a

modern manufacturing business.

7. Distinguish between Financial Accounting and Management Accounting.

8. What are accounting concepts and conventions? Is there any difference

between them?

9. What is the significance of dual aspect concept?

10. Write a short note on Accounting Standards.

11. What is the position in India regarding the formulation and enforcement of

accounting standards?

UNIT – I

LESSON – 1.2

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THE ACCOUNTING PROCESS

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1.2.1 INTRODUCTION

During the accounting period the accountant records transactions

as and when they occur. At the end of each accounting period the

accountant summarises the information recorded and prepares the Trial

Balance to ensure that the double entry system has been maintained. This

is often followed by certain adjusting entries which are to be made to

account the changes that have taken place since the transactions were

recorded. When the recording aspect has been made as complete and

upto-date as possible the accountant prepares financial statements

reflecting the financial position and the results of business operations.

Thus the accounting process consists of three major parts:

(i) the recording of business transactions during that period;

(ii) the summarizing of information at the end of the period, and

(iii) the reporting and interpreting of the summary information.

The success of the accounting process can be judged from the

responsiveness of financial reports to the needs of the users of

accounting information. This lesson takes the readers into the

accounting process.

1.2.2 OBJECTIVES

After reading this lesson the reader should be able to:

• Understand the rules of debit and credit

• Pass journal entries

• Prepare ledger accounts

• Prepare a trial balance

• Make adjustment and closing entries

• Get introduced to tally package

1.2.3 CONTENTS

1.2.3.1 The Account

1.2.3.2 Debit – Credit

1.2.3.3 The Ledger

1.2.3.4 Journal

1.2.3.5 The Trial Balance

1.2.3.6 Closing Entries

1.2.3.7 Adjustment Entries

1.2.3.8 Preparation of Financial Statements

1.2.3.9 Introduction to Tally Package

1.2.3.10 Summary

1.2.3.11 Key Words

1.2.3.12 Self Assessment Questions

1.2.3.13 Books for Further Reading

1.2.3.1 THE ACCOUNT

The transactions that takes place in a business enterprise during a

specific period may effect increases and decreases in assets, liabilities,

capital, revenue and expense items. To make upto-date information

available when needed and to be able to prepare timely periodic financial

statements, it is necessary to maintain a separate record for each item.

For e.g. it is necessary to have a separate record devoted exclusively to

recording increases and decreases in cash, another one to record

increases and decreases in supplies, a third one on machinery, etc. The

type of record that is traditionally used for this purpose is called an

account. Thus an account is a statement wherein information relating to

an item or a group of similar items are accumulated. The simplest form

of an account has three parts:

(i) a title which gives the name of the item recorded in the account

(ii) a space for recording increases in the amount of the item, and

(iii) a space for recording decreases in the amount of the item. This

form of an account is known as a `T' account because of its

similarity to the letter `T' as illustrated below:

Title

Left side

(Debit side)

Right side

(Credit side)

1.2.3.2 DEBIT CREDIT

The left-hand side of any account is called the debit side and the

right-hand side is called the credit side. Amounts entered on the left

hand side of an account, regardless of the tile of the account are called

debits and the amounts entered on the right hand side of an account are

called credits. To debit (Dr) an account means to make an entry on the

left-hand side of an account and to credit (Cr) an account means to make

an entry on the right-hand side. The words debit and credit have no other

meaning in accounting, though in common parlance, debit has a negative

connotation, while credit has a positive connotation.

Double entry system of recording business transactions is

universally followed. In this system for each transaction the debit

amount must equal the credit amount. If not, the recording of

transactions is incorrect. The equality of debits and credits is maintained

in accounting simply by specifying that the left side of asset accounts is

to be used for recording increases and the right side to be used for

recording decreases; the right side of a liability and capital accounts is to

be used to record increases and the left side to be used for recording

decreases. The account balances when they are totaled, will then

conform to the two equations:

1. Assets = Liabilities + Owners' equity

2. Debits = Credits

From the above arrangement we can state that the rules of debits

and credits are as follows:

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Debit signifies Credit signifies

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1. Increase in asset accounts 1. Decrease in asset accounts

2. Decrease in liability accounts 2. Increase in liability

accounts

3. Decrease in owners' equity 3. Increase in owners' equity

accounts accounts

-------------------------------------------------------------------------------------------------

From the rule that credit signifies increase in owners' equity and

debit signifies decrease in it, the rules of revenue accounts and expense

accounts can be derived. While explaining the dual aspect of the concept

in the preceding lesson, we have seen that revenues increase the owners'

equity as they belong to the owners. Since owners' equity accounts

increase on the credit side, revenue must be credits. So, if the revenue

accounts are to be increased they must be credited and if they are to be

decreased they must be debited. Similarly we have seen that expenses

decrease the owners' equity. As owners' equity account decreases on the

debit side expenses must be debits. Hence to increase the expense

accounts, they must be debited and to decrease it they must be credited.

From the above we can arrive at the rules for revenues and expenses as

follows:

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Debit signifies Credit Signifies

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Increase in expenses Decrease in expenses

Decrease in revenues Increase in revenues

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1.2.3.3 THE LEDGER

A ledger is a set of accounts. It contains all the accounts of a specific

business enterprise. It may be kept in any of the following two forms:

(i) Bound Ledger and

(ii) Loose Leaf Ledger

A bound ledger is kept in the form of book which contains all the

accounts. These days it is common to keep the ledger in the form of

loose-leaf cards. This helps in posting transactions particularly when

mechanized system of accounting is used.

1.2.3.4 JOURNAL

When a business transaction takes place the first record of it is

done in a book called journal. The journal records all the transactions of

a business in the order in which they occur. The journal may therefore be

defined as a Chronological record of accounting transactions. It shows

names of accounts that are to be debited or credited, the amounts of the

debits and credits and any additional but useful information about the

transaction. A journal does not replace but precedes the ledger. A

proforma of a journal is given in Illustration 1.

Illustration 1:

Journal

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Date Particulars L.F. Debit Credit

-------------------------------------------------------------------------------------------------

2005 Cash a/c (Dr) 3 30,000

August 2 Sales a/c (Cr) 9 30,000

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In the illustration 1 the debit entry is listed first, the debit amount

appears in the left-hand amount column; the account to be credited

appears below the debit entry and the credit amount appears in the right

hand amount column. The data in the journal entry are transferred to the

appropriate accounts in the ledger by a process known as posting. Any

entry in any account can be made only on the basis of a journal entry.

The column L.F. which stands for ledger folio gives the page number of

accounts in the ledger wherein posting for the journal entry has been

made. After all the journal entries are posted in the respective ledger

accounts, each ledger account is balanced by subtracting the smaller total

from the bigger total. The resultant figure may be either debit or credit

balance and vice-versa.

Thus the transactions are recorded first of all in the journal and

then they are posted to the ledger. Hence the journal is called the book of

original or prime entry and the ledger is the book of second entry. While

the journal records transactions in a chronological order, the ledger

records transactions in an analytical order.

1.2.3.5 THE TRIAL BALANCE

The Trial Balance is simply a list of the account names and their

balance as of a given moment of time with debit balances in one column

and credit balances in another column. It is prepared to ensure that the

mechanics of the recording and posting of the transaction have been

carried out accurately. If the recording and posting have been accurate

then the debit total and credit total in the Trial Balance must tally

thereby evidencing that an equality of debits and credits has been

maintained. In this connection it is but proper to caution that mere

agreement of the debt and credit total in the Trial Balance is not

conclusive proof of correct recording and posting. There are many errors

which may not affect the agreement of Trial Balance like total omission

of a transaction, posting the right amount on the right side but of a

wrong account etc.

The points which we have discussed so far can very well be

explained with the help of the following simple illustration.

Illustration 2:

January 1 - Started business with Rs.3,000

January 2 - Bought goods worth Rs.2,000

January 9 - Received order for half of the goods from `G'

January 12 - Delivered the goods, G invoiced Rs.1,300

January 15 - Received order for remaining half of the total goods

purchased

January 21 - Delivered goods and received cash Rs.1,200

January 30 - G makes payment

January 31 - Paid salaries Rs.210

- Received interest Rs.50

Let us now analyse the transactions one by one.

January 1 – Started business with Rs.3,000: The two accounts involved are

cash and owners' equity. Cash, an asset increases and hence it has to be debited.

Owners' equity, a liability also increases and hence it has to be credited.

January 2 – Bought goods worth Rs.2,000: The two accounts affected by this

transaction are cash and goods (purchases). Cash balance decreases and hence it

is credited and goods on hand, an asset, increases and hence it is to be debited.

January 9 – Received order for half of the goods from `G': No entry is

required as realisation of revenue will take place only when goods are delivered

(Realisation concept).

January 12 – Delivered the goods, `G' invoiced Rs.1,300: This transaction

affects two accounts – Goods (Sales) a/c and Receivables a/c. Since it is a credit

transaction receivables increase (asset) and hence is to be debited. Sales

decreases goods on hand and hence goods (Sales) a/c is to be credited. Since the

term `goods' is used to mean purchase of goods and sale of goods, to avoid

confusion purchase of goods is simply shown as Purchases a/c and Sale of goods

as Sales a/c.

January 15 – Received order for remaining half of goods: No entry.

January 21 – Delivered goods and received cash Rs.1,200: This transaction

affects cash a/c. Since cash is realized, the cash balance will increase and hence

cash account is to be debited. Since the stock of goods becomes nil due to sale,

Sales a/c is to be credited (as asset in the form goods on hand has reduced due to

sales).

January 30 - `G' makes Payment: Both the accounts affected by this transaction

are asset accounts – cash and receivables. Cash balance increases and hence it is

to be debited and receivables balance decreases and hence it is to be credited.

January 31 – Paid Salaries Rs.210: Because of payment of salaries cash

balance decreases and hence cash account is to be credited. Salary is an expense

and since expense has the effect of reducing owners' equity and as owners'

equity account decreases on the debit side, expenses account is to be debited.

January 31 – Received Interest Rs.50: The receipt of interest increases cash

balance and hence cash a/c is to be debited. Interest being revenue which has the

effect of increasing the owners' equity, it has to be credited as owners' equity

account increases on the credit side.

When journal entries for the above transaction are passed, they

would be as follows:

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Date Particulars L.F. Debit Credit

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Jan.1 Cash a/c (Dr) 3,000

Capital a/c 3,000

Jan.2 Purchase a/c (Dr) 2,000

Cash a/c 2,000

Jan.12 Receivables a/c (Dr) 1,300

Sales a/c 1,300

Jan.21 Cash a/c (Dr) 1,200

Sales a/c 1,200

Jan.30 Cash a/c (Dr) 1,300

Receivables a/c 1,300

Jan.31 Salaries a/c (Dr) 210

Cash a/c 210

Jan.31 Cash a/c (Dr) 50

Interest a/c 50

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Now the above journal entries are posted into respective ledger

accounts which in turn are balanced.

-------------------------------------------------------------------------------------------------

Debit Cash a/c Debit

-------------------------------------------------------------------------------------------------

Capital a/c 3,000 Purchase a/c 2,000

Sales a/c 1,200 Salaries a/c 210

Receivables a/c 1,300 Balance 3,340

Interest a/c 50

------- -------

5,550 5,500

-------------------------------------------------------------------------------------------------

Capital a/c

Balance 3,000 Cash a/c 3,000

Purchases a/c

Cash a/c 2,000 Balance 2,000

Receivables a/c

Sales a/c 1,300 Cash a/c 1,300

Sales a/c

Balance 2,500 Receivables a/c 1,300

Cash a/c 1,200

------- -------

2,500 2,500

------- -------

Salaries a/c

Cash a/c 210 Balance 210

Interest a/c

Balance 50 Cash a/c 50

-------------------------------------------------------------------------------------------------

Now a Trial Balance can be prepared and when prepared it would

appear as follows:

Trial Balance

-------------------------------------------------------------------------------------------------

Debit Credit

-------------------------------------------------------------------------------------------------

Cash 3,340 Capital 3,000

Purchases 2,000 Sales 2,500

Salaries 210 Interest 50

------- -------

5,550 5,550

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1.2.3.6 CLOSING ENTRIES

Periodically, usually at the end of the accounting period, all

revenue and expense account balances are transferred to an account

called Income summary or Profit and Loss account and are then said to

be closed. (A detailed discussion on Profit and Loss account can be had

in a subsequent lesson). The balance in the Profit and Loss account,

which is the net income or net loss for the period, is then transferred to

the capital account and thus the Profit and Loss account is also closed. In

the case of corporation the net income or net loss is transferred to

retained earnings account which is a part of owners' equity. The entries

which are passed for transferring these accounts are called as closing

entries. Because of this periodic closing of revenue and expense

accounts, they are called as temporary or nominal accounts whereas

assets, liabilities and owners' equity accounts, the balances of which are

shown on the balance sheet and are carried forward from year to year are

called as Permanent or Real accounts.

The principle of framing a closing entry is very simple. If an

account is having a debit balance, then it is credited and the Profit and

Loss account is debited. Similarly if a particular account is having a

credit balance, it is closed by debited it and crediting the Profit and Loss

account.

In our example Sales account and Interest account are revenues

and Purchases account and Salaries account are expenses. Purchases

account is an expense because the entire goods have been sold out in the

accounting period itself and hence they become cost of goods sold out.

This aspect would become more clear when the reader proceeds to the

lessons on Profit and Loss account. The closing entries would appear as

follows:

(1) Profit and Loss a/c (Dr) 2,210

Salaries a/c (Cr) 210

Purchases a/c (Cr) 2,000

(2) Sales a/c (Dr) 2,500

Profit and Loss a/c (Cr) 2,500

(3) Interest a/c (Dr) 50

Profit and Loss a/c (Cr) 50

Now Profit and Loss a/c, Retained Earnings a/c and Balance Sheet

can be prepared which would appear as follows:

Profit and Loss Account

Purchase a/c 2,000 Sales a/c 2,500

Salaries a/c 210 Interest a/c 50

Retained Earnings a/c 340

------- -------

2,550 2,550

------- -------

Retained Earnings a/c

Balance 340 Profit and Loss a/c 340

------- -------

340 340

------- -------

Balance Sheet

Cash 3,340 Capital 3,000

Retained Earnings 340

------- -------

3,340 3,340

------- -------

1.2.3.7 ADJUSTMENT ENTRIES

Because of the adopting of accrual accounting, after the

preparation of Trial Balance, adjustments relating to the accounting

period have to be made in order to make the financial statements

complete. These adjustments are needed for transactions which have not

been recorded but which affect the financial position and operating

results of the business. They may be divided into four kinds: two in

relation to revenues and the other two in relation to expenses. The two in

relation to revenues are:

(i) Unrecorded revenues: i.e. income earned for the period but not received in

cash. For e.g. interest for the last quarter of the accounting period is yet to be

received though fallen due. The adjustment entry to be passed is:

Accrued interest a/c (Dr)

Interest a/c (Cr)

(ii) Revenues received in advance: i.e. income relating to the next period

received in the current accounting period, e.g. rent received in advance. The

adjustment entry is:

Rent a/c (Dr)

Rent received in advance a/c (Cr)

The two relating to expenses are:

(i) Unrecorded expenses: i.e. expenses were incurred during the period but no

record of them as yet have been made, e.g. Rs.500 wages earned by an employee

during the period remaining to be paid. The adjustment entry would be:

Wages a/c (Dr)

Accrued wages a/c (Cr)

(ii) Prepaid expenses: i.e., expenses relating to the subsequent period paid in

advance in the current accounting period. An example which is frequently cited

is insurance paid in advance. The adjustment entry would be:

Prepaid Insurance a/c (Dr)

Insurance a/c (Cr)

In the above four cases unrecorded revenues and prepaid expenses

are assets and hence debited (as debit may signify increase in assets) and

revenues received in advance and unrecorded expenses are liabilities and

hence credited (as credit may signify increase in liabilities).

Besides the above four adjustments, some more are to be done

before preparing the financial statements. They are:

1. Inventory at the end

2. Provision of Depreciation

3. Provision for Bad Debts

4. Provision for Discount on receivables and payables

5. Interest on Capital and Drawings

1.2.3.8 PREPARATION OF FINANCIAL STATEMENTS

Now everything is set ready for the preparation of financial

statements for the accounting period and as of the last day of the

accounting period. Generally Agreed Accounting Principles (GAAP)

require that three such reports be prepared:

(i) A Balance Sheet

(ii) A Profit and Loss Account (or) Income Statement

(iii) A Fund Flow Statement

A detailed discussion on these three financial statements follows

in the succeeding lessons.

1.2.3.9 INTRODUCTION TO TALLY PACKAGE

Today an increasingly large number of companies have adopted

mechanised accounting. The main reasons for this development are that:

(i) the size of firms have become very large resulting in manifold

increase in accounting data to be collected and processed.

(ii) the requirements of modern management which want detailed

analysis, in many ways, of the accounting and statistical

information for the efficient discharge of their duties.

(iii) collection of statistics not only for the firm's own use but also for

submission to various official authorities.

In this context, the use of computers in accounting is worth

mentioning. Late 80's and early 90's was an era of Financial Accounting

Software. Many software developers offered separate Financial and

Inventory Softwares to take care of the needs of the concerns but users

wanted a single software that will take care of Production and Inventory

Management i.e. they wanted a single software where if an invoice is

entered that will update Accounts as well as Inventory Information. Here

Tally comes in handy.

Tally is one of the acclaimed accounting software with large user

base in India and abroad, which is continuously growing. There is good

potential for Tally professionals even in small towns. Tally which is a

vast software covers a lot of areas for various types of industries and

loaded with options. So, every organisation needs a hardcore Tally

professional to exploit its full capabilities and functionality to implement

Tally. Tally which is a Financial and Inventory Management System is

developed in India using Tally Development Language. Tally has been

created by Pentronics (P) Limited, Bangalore.

Features of Tally:

(i) Accounts without any account codes.

(ii) Maintains complete range of Books of Accounts, Final Accounts

like Balance Sheets, Profit and Loss Statements, Cash and Fund

Flows, Trial Balance and others.

(iii) Provides option to post stock value from inventory directly to

Balance Sheet and Profit and Loss a/c as per the valuation

method specified by user. This greatly simplifies the procedure

and one gets the Final Accounts which is in tune with the stock

statements of the Inventory System.

(iv) Provides Multiple Reports in diverse formats.

(v) Various options for interest calculation.

(vi) Allows accounts of multiple companies simultaneously.

(vii) Multiple currencies in the same transactions and viewing all

reports in one or more currency.

(viii) Unlimited budgets and periods, user definable security levels for

access control and audit capabilities to track malafide changes.

(ix) Allows Import and Export of data from or to other systems.

(x) Online Help.

(xi) Backup and Restore of Data.

(xii) Facilitates printing of cheques, etc.

1.2.3.10 SUMMARY

The following steps are involved in the accounting process:

1. The first and the most important part of the accounting process is the

analysis of the transactions to decide which account is to be debited

and which account is to be credited.

2. Next comes journalising the transactions i.e. recording the

transactions in the journal.

3. The journal entries are posted into respective accounts in the ledger

and the ledger accounts are balanced.

4. At the end of the accounting period, a trial balance is prepared to

ensure quality of debits and credits.

5. Adjustment and closing entries are made to enable the preparation of

financial statements.

6. As a last step financial statements are prepared.

These six steps taken sequentially complete the accounting

process during an accounting period and are repeated in each subsequent

period.

1.2.3.11 KEY WORDS

Account: A statement wherein information relating to all items are accumulated.

Debit: Signifies increase in asset accounts, decrease in liability accounts and

decrease in owners' equity accounts.

Credit: Signifies decrease in asset accounts, increase in liability accounts and

increase in owners' equity accounts.

Ledger: A set of accounts of a specific business enterprise.

Journal: A book of prime entry.

Trial Balance: A list of balances of accounts to ensure arithmetical accuracy.

Closing Entries: Entries passed to transfer the revenue accounts to profit and

loss a/c.

Adjustment Entries: Entries passed for transactions which are not recorded but

which affect the financial position and operating results of the business.

1.2.3.12 SELF ASSESSMENT QUESTIONS

1. Explain the following:

(a) A Journal

(b) An Account

2. Bring out the relationship between a journal and a ledger.

3. Explain the significance of Trial Balance.

4. Why adjustment entries are necessary?

5. Narrate the rules of debit and credit.

6. Distinguish nominal accounts from real accounts.

7. Explain the mechanism of balancing an account.

8. How and why closing entries are made?

9. The following transactions relate to a business concern for the month of

December 2005. Journalise them, post into ledger accounts, balance and

prepare the Trial Balance.

March 1 - Started business with a capital of Rs.9,000

March 2 - Purchased furniture Rs.300

March 3 - Purchased goods Rs.6,000

March 11 - Received order for half-of goods from `C'

March 15 - Delivered goods, `C' invoiced Rs.4,000

March 17 - Received order for the remaining half of goods

March 21 - Delivered goods, cash received Rs.3,800

March 31 - Paid wages Rs.300

1.2.3.13 BOOKS FOR FURTHER READING

1. M.A.Arulanandam & K.S.Raman: Advanced Accounts, Himalaya

Publishing House.

2. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Vol.I, Sultan Chand,

New Delhi.

3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co. New

Delhi.

UNIT-I

LESSON 1.3

-------------------------------------------------------------------------------------------------

PREPARATION OF FINAL ACCOUNTS

-------------------------------------------------------------------------------------------------

1.3.1 INTRODUCTION

The primary objective of any business concern is to earn income.

Ascertainment of the periodic income of a business enterprise is perhaps the

important objective of the accounting process. This objective is achieved by the

preparation of profit and loss account or the income statement. Profit and loss

account is generally considered to be of greatest interest and importance to endusers

of accounting information. The profit and loss account enables all

concerned to find out whether the business operations have been profitable or

not during a particular period. Usually the profit and loss account is

accompanied by the balance sheet as on the last date of the accounting period for

which the profit and loss account is prepared. A balance sheet shows the

financial position of a business enterprise as of a specified moment of time. It

contains a list of the assets and liabilities and capital of a business entity as of a

specified date, usually at the close of the last day of a month or a year. While the

profit and loss account is categorised as a flow report (for a particular period the

balance sheet is categorised as a status report as on a particular date).

1.3.2 OBJECTIVES

After reading this lesson the reader should be able to:

• Understand the basic ideas of income and expense

• Prepare a profit and loss account/income statement in the proper

format

• Understand the basic ideas about a balance sheet

• Classify the different assets and liabilities

• Prepare a balance sheet in the proper format

1.3.3 CONTENTS

1.3.3.1 Basic Ideas about Income and Expense

1.3.3.2 Form and Presentation of Profit and Loss Account /

Income Statement

1.3.3.3 Explanation of Items on the Income Statement

1.3.3.4 Statement of Retained Earnings

1.3.3.5 Balance Sheet

1.3.3.6 Form and Presentation of Balance Sheet

1.3.3.7 Listing of Items on the Balance Sheet

1.3.3.8 Classification of Items in the Balance Sheet

1.3.3.9 Summary

1.3.3.10 Key Words

1.3.3.11 Self Assessment Questions

1.3.3.12 Key to Self Assessment Questions

1.3.3.13 Case Analysis

1.3.3.14 Books for Further Reading

1.3.3.1 BASIC IDEAS ABOUT INCOME AND EXPENSE

Profit and Loss account consists of two elements: One element is the

inflows that result from the sale of goods and services to customers which are

called as revenues. The other element reports the outflows that were made in

order to generate those revenues; these are called as expenses. Income is the

amount by which revenues exceed expenses. The term `net income' is used to

indicate the excess of all the revenues over all the expenses. The basic equation

is:

Revenue – Expenses = Net Income

This is in accordance with the matching concept.

Income and Owner's Equity: The net income of an accounting period increases

owner's equity because it belongs to the owner. To quote an example goods

costing Rs.20,000 are sold on credit for Rs.28,000. The result is that stock is

reduced by Rs.20,000 and a new asset namely debtor for Rs.28,000 is created

and the total assets increase by the difference Rs.8,000. Because of the dual

aspect concept we know that the equity side of the balance sheet would also

increase by Rs.8,000 and the increase would be in owner's equity because the

profit on sale of goods belongs to the owner. It is clear from the above example

that income increases the owner's equity.

Income Vs Receipts: Income of a period increases the owner's equity but it need

not result in increase in cash balance. Loss of a period decreases owner's equity

but it need not result in decrease in cash balance. Similarly increase in cash

balance need not result in increased income and owner's equity and decrease in

cash balance need not denote loss and decrease in owner's equity. All these are

due to the fact that income is not the same as cash receipt. The following

examples make clear the above point:

i) When goods costing Rs.20,000 are sold on credit for Rs.28,000 it

results in an income of Rs.8,000 but the cash balance does not

increase.

ii) When goods costing Rs.18,000 are sold on credit for Rs.15,000

there is a loss of Rs.3,000 but there is no corresponding decrease

in cash.

iii) When a loan of Rs.5,000 is borrowed the cash balance increases

but there is no impact on income.

iv) When a loan of Rs.8,000 is repaid it decreases only the cash

balance and not the income.

Expenses: An expense is an item of cost applicable to an accounting period. It

represents economic resources consumed during the current period. When an

expenditure is incurred the cost involved is either an asset or an expense. If the

benefits of the expenditure relate to further periods it is an asset. If not, it is an

expense of the current period. Over the entire life of an enterprise, most

expenditures become expenses. But according to accounting period concept,

accounts are prepared for each accounting period. Hence we get the following

four types of transactions relating to expenditure and expenses:

Expenditures that are also expenses: This is the simplest and most common

type of transaction to account for. If an item is acquired during the year, it is

expenditure. If the item is consumed in the same year, then the expenditure

becomes expense. e.g. raw materials purchased are converted into saleable

goods and are sold in the same year.

Assets that become expenses: When expenditures incurred result in benefits for

the future period they become assets. When such assets are used in subsequent

years they become expenses of the year in which they are used. For e.g.

inventory of finished goods are assets at the end of a particular accounting year.

When they are sold in the next accounting year they become expenses.

Expenditures that are not expenses: As already pointed out when the benefits

of the expenditure relate to future periods they become assets and not expenses.

This applies not only to fixed assets but also to inventories which remain unsold

at the end of the accounting year. For e.g. the expenditure incurred on inventory

remaining unsold is asset until it is sold out.

Expenses not yet paid: Some expenses would have been incurred in the

accounting year but payment for the same would not have been made within the

accounting year. These are called accrued expenses and are shown as liabilities

at the year end.

1.3.3.2 FORM AND PRESENTATION OF PROFIT AND LOSS

ACCOUNT / INCOME STATEMENT

In practice there is considerable variety in the format and degree of detail

used in income statements. The profit and loss account is usually prepared in

"T" shape. The following (Illustration-A) is the summarised profit and loss

account of Ali Akbar Ltd.

Illustration – A:

Ali Akbar Ltd

Profit and Loss Account for the year ended 31st March 2005

(Rs. in `000)

-------------------------------------------------------------------------------------------------

Cost of goods sold 78,686 Sales (less discount) 89,740

Expenses (Schedule 17) 33,804 Other income 39,947

Interest (Schedule 18) 2,902 (Schedule 13)

Director's Fees 11

Depreciation 2,094

Provision for Taxation 6,565

Net Profit 5,625

----------- -----------

1,29,687 1,29,687

-------------------------------------------------------------------------------------------------

In the "T" shaped profit and loss account expenses are shown on the left

hand side i.e., the debit side and revenues are shown on the right hand side i.e.,

the credit side. Net profit or loss is the balancing figure.

The profit and loss account can also be presented in the form of a

statement when it is called as income statement. There are two widely used

forms of income statement: single step form and multiple-step form.

The single-step form of income statement derives its name from the fact

that the total of all expenses is deducted from the total of all revenues.

Illustration – A can be presented in the single-step form as given in

Illustration – B.

Illustration – B:

Ali Akbar Ltd

Income Statement for the year ended 31st March 2005

(Rs. in `000)

-------------------------------------------------------------------------------------------------

Revenues

Sales (less discount) 89,740

Other income (Schedule 13) 39,947

-------- 1,29,687

Expenses

Cost of goods sold 78,686

Expenses (Schedule 17) 33,804

Director's Fees 11

Interest (Schedule 18) 2,902

Depreciation 2,094

Provision for Taxation 6,565

-------- 1,24,062

----------

5,625

----------

-------------------------------------------------------------------------------------------------

The single-step form has the advantage of simplicity but it is inadequate

for analytical purpose.

The multi-step form income statement is so called because of its

numerous sections, sub-sections and intermediate balances. Illustration – C is a

typical proforma of multiple-step income statement.

Illustration – C:

Proforma of a Multiple-step Income Statement

Gross sales xxx

Less Sales returns xxx

-----

Net Sales xxx

Less Cost of goods sold

Raw materials cost

Opening stock of raw material xxx

Add Purchase of raw material xxx

Freight xxx

-----

Raw materials available xxx

Less Closing stock of raw material xxx

-----

Raw materials consumed xxx

Direct Labour Cost xxx

Manufacturing Expenses xxx

-----

Total Production Cost xxx

Add Opening work-in-progress xxx

-----

Total xxx

Less Closing work-in-progress xxx

-----

Cost of goods manufactured xxx

Add Opening finished goods xxx

-----

Cost of goods available for sale xxx

Less Closing finished goods xxx

-----

Cost of goods sold xxx

-----

Gross Profit xxx

Less Operating Expenses

Administrative Expenses xxx

Selling and Distribution Expenses xxx

----- xxx

Operating Profit xxx

-----

Add Non-operating Income

(Such as dividend received

profit on sale of assets etc.) xxx

-----

Less Non-operating Expenses

(Such as discount on issue of shares

written off, loss on sale of assets, etc.) xxx

-----

Profit (or) Earnings before Interest &

Tax (EBIT) xxx

Less Interest xxx

-----

Profit (or) Earnings Before Tax (EBT) xxx

Less Provision for Income-Tax xxx

-----

Net profit (or) Earnings After Tax (EAT) xxx

-----

Earnings per share of Common Stock xxx

-----

-------------------------------------------------------------------------------------------------

The multiple-step form of Illustration `C' would be as given under

Illustration `D'.

Illustration – D:

Ali Akbar Ltd

Income Statement for the year ended 31st March 2005

(Rs. in `000)

-------------------------------------------------------------------------------------------------

Net Sales 89,740

Less Cost of goods sold 78,686

--------

Gross Profit 11,054

Less Operating Expenses

Expenses (Schedule 17) 33,804

Director's Fee 11

Depreciation 2,094 35,909

--------- ----------

Operating Loss (-) 24,855

Add Non-Operating Income

Other income (Schedule 13) 39,947

---------

Profit or Earnings before Int.& Tax 15,092

(EBIT)

Less Interest (Schedule 18) 2,902

---------

Net Profit or Earnings Before Tax (EBT) 12,190

Less Provision for Taxation 6,565

---------

Net Profit or Earnings After Tax (EAT) 5,625

---------

-------------------------------------------------------------------------------------------------

The advantage of multiple-step form of income statement over singlestep

form and the "T" shaped profit and loss account is that there are a number

of significant sub totals on the road to net income which lend themselves for

significant analysis.

Income statements prepared for use by the managers of an enterprise

usually contain more detailed information than that shown in the above

illustrations.

1.3.3.3 EXPLANATION OF ITEMS ON THE INCOME STATAEMENT

The heading of the income statement must show:

i) the business enterprise to which it relates (Ali Akbar Ltd)

ii) the name of the statement (income statement)

iii) the time period covered (year ended 31st March of the relevant

year)

The income statement is generally followed by various schedules

that give detailed account of the items, listed on them. Information about

these schedules are given against each item in the financial statements.

One important objective in reporting revenue on an income

statement is to disclose the major source of revenue and to separate it

from miscellaneous sources. For most companies the major source of

revenue is the sale of goods and services.

Sales Revenue: An income statement often reports several separate items in the

sales revenue section, the net of which is the net sales figure. Gross sales is the

total invoice price of the goods sold or services rendered during the period. It

should not include sales taxes or excise duties that may be charged to the

customers. Such taxes are not revenues but rather represent collections that the

business makes on behalf of the government and are liabilities to the

government until paid. Similarly, postage, freight or other items billed to the

customers at cost are not revenues. These items do not appear in the sales figure

but instead are an offset to the costs the company incurs for them.

Sales returns and allowances represent the sales values of goods that

were returned by customers or allowance made to customers because the goods

were defective. The amount can be subtracted from the sales figure directly

without showing it as a separate item on the income statement. But it is always

better to show them separately.

Sometimes called as cash discounts sales discounts are the amount of

discounts allowed to customers for prompt payment. For e.g. if a business offers

a 3% discount to customers who pay within 7 days from the date of the invoice

and it sells Rs.30,000 of goods to a customer who takes advantage of this

discount the business receives only Rs.29,100 in cash and records the balance

Rs.900 as sales discount. There is another kind of discount called as trade

discount which is given by the wholesaler or manufacturer to the retailers to

enable them to sell at catalogue price and make a profit: e.g. List less 30 percent.

Trade discount does not appear in the accounting records at all.

Miscellaneous or Secondary Sources of Revenues: These are revenues earned

from activities not associated with the sale of the enterprise's goods and

services. Interest or dividends earned on marketable securities, royalties, rents

and gains on disposal of assets are examples of this type of revenues. For e.g. in

the case of Ali Akbar Ltd., its operating loss has been converted into net profit

only because of other income, other than sales revenue. Schedule 13 gives

details of other income earned by Ali Akbar Ltd.

Schedule 13 – Other Income

(Rs.`000)

Income from Trade Investments 825

Interest on Bank Deposits & others 1,042

Profit on Sale of Investments 456

Profit on Sale of Inventories 813

Miscellaneous income 2,394

Factory charges recovered 9,081

Bottle deposits forfeited 25,336

--------

39,947

--------

Cost of Goods sold: When income is increased by the sale value of goods or

services sold, it is also decreased by the cost of these goods or services. The cost

of goods or services sold is called the cost of sales. In manufacturing firms and

retailing business it is often called the cost of goods sold. The complexity of

calculation of cost of goods sold varies depending upon the nature of the

business. In the case of a trading concern which deals in commodities it is very

simple to calculate the most of goods sold and it is done as follows:

Opening Stock xxx

Add: Purchase xxx

Freight xxx

-----

Goods available for sale xxx

Less: Closing stock xxx

-----

Cost of goods sold xxx

-----

The calculation becomes a complicated process in the case of

manufacturing concern, especially when a number of products are

manufactured because it involves the calculation of the work in progress and

valuation of inventory. The cost of goods sold in the case of Ali Akbar Ltd

would have been calculated as given in Illustration `E'.

Illustration E:

Cost of goods sold

(Rs. in `000)

Opening stock 4,436

Raw materials consumed 22,151

Packing materials consumed 48,536

Excise Duty 7,805

--------

82,928

Less: Closing stock 4,242

--------

Cost of goods sold 78,686

--------

Gross Profit: The excess of sales revenue over cost of goods sold is gross

margin or gross profit. In the case of multiple-step income statement it is shown

as a separate item. Significant managerial decisions can be taken by calculating

the percentage of gross profit on sale. This percentage indicates the average

mark up obtained on products sold. The percentage varies widely among

industries, but healthy companies in the same industry tend to have similar gross

profit percentages.

Operating Expenses: Expenses which are incurred for running the business and

which are not directly related to the company's production or trading are

collectively called as operating expenses. Usually operating expenses include

administration expenses, finance expenses, depreciation and selling and

distribution expenses. Administration expenses generally include personnel

expenses also. However sometimes personnel expenses may be shown

separately under the heading Establishment Expenses.

Until recently most companies included expenses on research and

development as part of general and administrative expenses. But now-adays

the Financial Accounting Standards Board (FASB) requires that this

amount should be shown separately. This is so because the expenditure

on research and development could provide an important clue as to how

cautious the company is in keeping its products and services upto date.

Operating profit: Operating profit is obtained when operating expenses are

deducted from gross profit.

Non-operating Expenses: These are expenses which are not related to the

activities of the business e.g. loss on sale of asset, discount on shares written off

etc. These expenses are deducted from the income obtained after adding other

incomes to the operating profit. Other incomes or miscellaneous receipts have

already been explained. The resultant profit is called as Profit (or) Earning

before interest and tax (EBIT).

Interest Expenses: Interest expense arises when part of the expenses are met

from borrowed funds. The FASB requires separate disclosure of interest

expense. This item of expense is deducted from income or earnings before

interest and tax. The resultant figure is profit (or) earnings before tax (EBT).

Income Tax: The provision for tax is estimated based on the quantum of profit

before tax. As per the corporate tax laws the amount of tax payable is

determined not on the basis of reported net profit but the net profit arrived at has

to be recomputed and adjusted for determining the tax liability. That is why the

liability is always shown as a provision.

Net Profit: This is the amount of profit finally available to the enterprise for

appropriation. Net profits is reported not only in total but also per share of stock.

This per share amount is obtained by dividing the total amount of net profit by

the number of shares outstanding. The net profit is usually referred to as profit

or earnings after tax. This profit could either be distributed as dividends to

shareholders or retained in the business. Just like gross profit percentage, net

profit percentage on sales can also be calculated which will be of great use for

managerial analysis.

1.3.3.4 STATEMENT OF RETAINED EARNINGS

The term retained earnings means the accumulated excess of earnings

over losses and dividends. The statement of retained earnings is generally

included with almost any set of financial statements although it is not considered

to be one of the major financial statements. A typical statement of retained

earnings starts with the opening balance of retained earnings, the net income for

the period as an addition, the dividends as a deduction, and ends with the closing

balance of retained earnings. The statement may be prepared and shown on a

separate sheet or included at the bottom of the income statement. The balance

shown by the income statement is transferred to the balance sheet through the

statement of retained earnings after making necessary appropriations. This

statement thus links the income statement to the retained earning item on the

balance sheet. This statement can be prepared in `T' shape also when it is called

as Profit and Loss Appropriation Account. Illustration `F' gives the statement of

retained earning of Ali Akbar Ltd.

Illustration – F:

Ali Akbar Ltd.

For the year ended 31st March 2005

(Rs. in `000)

-------------------------------------------------------------------------------------------------

Retained earnings at the beginning of the year 700

Add: Net Income 5,625

-------

6,325

Less: Dividends 5,600

General Reserve 625

-------

6,225

-------

Retained earning at the end of the year 100

-------

-------------------------------------------------------------------------------------------------

1.3.3.5 BALANCE SHEET

The balance sheet is basically a historical report showing the cumulative

effect of past transactions. It is often described as a detailed expression of the

following fundamental accounting equation:

Assets = Liabilities + Owners' Equity (capital)

Assets are costs which represent expected future economic benefits to the

business enterprise. However, the rights to assets have been acquired by the

enterprise as a result of past transactions.

Liabilities also result from past transactions: they represent obligations which

require settlement in the future either by conveying assets or by performing

services. Implicit in these concepts of the nature of assets and liabilities is the

meaning of owners' equity as the residual interest in the assets of the enterprise.

1.3.3.6 FORM AND PRESENTATION OF A BALANCE SHEET

Two objectives are dominant in presenting information in a balance

sheet. One is clarity and readability; the other is disclosure of significant facts

within the framework of the basic assumptions of accounting. Balance sheet

classification, terminology and the general form of presentation should be

studied with these objectives in mind.

It is proposed to explain the various aspects of the balance sheet with the

help of the following typical summarised balance sheet of an imaginary

partnership firm:

Illustration A:

Sundaram & Sons

Balance Sheet as at 31st December 2005

-------------------------------------------------------------------------------------------------

Assets Liabilities & Capital

-------------------------------------------------------------------------------------------------

Current Assets Current Liabilities

Cash 1,000 Bills payable 7,000

Bank 2,000 Creditors 7,000

Marketable Securities 3,000 Outstanding expenses 7,000

Bills Receivables 3,000 Income received in 1,000

Debtors 10,000 advance

Less Provision Provision for Income

For Doubtful Debts 1,000 9,000 Tax 10,000

--------

Inventory 12,000 Total Current 32,000

Prepaid expenses 3,000 Liabilities

--------- Long Term Liabilities

Total current assets 33,000 Mortgage loan 20,000

Investments: Owners' Equity

Long term securities 3,000 S's capital 10,000

at costs A's capital 15,000

Fixed Assets: U's capital 20,000

Furniture & Fixtures 1,000 General Reserve 10,000

Less: Accumulated Dep. 100 900

Plant & Machinery 10,000

Less: Accumulated Dep. 2,000 8,000

Land 20,000

Buildings 20,000

Intangile Assets

Patents 2,100

Trade Marks 11,000

Goodwill 9,000 Total Liabilities &

----------- Owners' equit ----------

Total Assets 1,07,000 1,07,000

----------- ----------

-------------------------------------------------------------------------------------------------

Conventions of preparing the Balance Sheet: There are two conventions of

preparing the balance sheet, the American and the English. According to the

American convention assets are shown on the left hand side and the liabilities

and the owners' equity on the right hand side. Under the English convention just

the opposite is followed i.e. assets are shown on the right hand side and the

liabilities and owners' equity are shown on the left hand side. In the illustration

`A', the American convention has been followed.

Forms of presenting the Balance Sheet: There are two forms of presenting the

balance sheet – account form and report form. When the assets are listed on the

left hand side and liabilities and owners' equity on the right hand side we get the

account form of balance sheet. It is so called because it is similar to an account.

An alternative practice is the report form of balance sheet where the assets are

listed at the top of the page and the liabilities and owners' equity are listed

beneath them. In illustration `A' we have followed the account form of balance

sheet. Now-a-days Joint Stock companies present Balance Sheet in the form of a

statement in the Annual Reports. To illustrate, the Balance Sheet of Ali Akbar

Ltd. Pondicherry as on 31-3-2005 is given below:

Illustration `B':

Ali Akbar Ltd.

Balance Sheet as at 31-3-2005

-------------------------------------------------------------------------------------------------

Schedule 2004-05 2003-04

Rs.'000 Rs.'000

-------------------------------------------------------------------------------------------------

I. SOURCES OF FUNDS

1. SHAREHOLDERS' FUNDS

Capital 1 1,40,00 1,40,00

Reserves and surplus 2 12,11,94 12,73,93

2. LOAN FUNDS

Secured loans 3 2,45,15 2,67,62

Unsecured loans 4 ----- 24

----------- -----------

15,97,09 16,81,79

----------- -----------

II. APPLICATION OF FUNDS

1. FIXED ASSETS 5

Gross block 14,19,93 13,73,59

Less: Depreciation 4,64,56 3,81,38

----------- -----------

Net block 9,55,37 9,92,21

Capital work-in-progress --- 9,55,37 16,27 10,08,48

---------- -----------

2. INVESTMENTS 6 76,39 63,07

3. CURRENT ASSETS

LOANS AND ADVANCES

Inventories 7 1,55,71 2,37,55

Sundry debtors 8 3,59,65 3,16,52

Cash and Bank balances 9 69,52 74,55

Loans and advances 10 2,22,03 2,11,60

---------- -----------

8,06,91 8,40,22

Less: CURRENT

LIABILITIES &

PROVISIONS

Liabilities 11 1,85,58 1,74,77

Provisions 12 56,00 55,21

----------- ----------

2,41,58 2,29,98

NET CURRENT ASSETS 5,65,33 6,10,24

---------- ---------

15,97,09 16,81,79

---------- ----------

Notes on the Accounts: Schedules 1 to 12 and 19 referred to above form an

integral part of the Balance Sheet.

From the above balance sheet it would have been found that previous

years figures are also given. As per the Companies Act, 1956 it is mandatory for

the companies to give figures for the previous year also. Further one would have

noticed the "Schedule" column in the above balance sheet. The schedules

attached to the Balance Sheet give details of the respective items. For e.g.

schedule 3 gives details of the secured loan as given below:

Schedule 3 – Secured Loans

Rs. '000

2004-05 2003-04

From Banker

Term Loan (Secured by charge on certain 17,00 28,00

plant & machinery)

Cash Credit-account (Secured by hypothecation 2,28,15 2,39,62

Of raw materials, stock-in-progress, finished

Goods, stocks and other current assets) --------- ---------

2,45,15 2,67,62

--------- ---------

1.3.3.7 LISTING OF ITEMS ON THE BALANCE SHEET

Assets in balance sheet are generally listed in two ways – i) in the order

of liquidity or according to time i.e. in the order of the degree of ease with which

they can be converted into cash or ii) in the order of permanence or according to

purpose i.e., in the order of the desire to keep them in use. Some assets cannot

be easily classified. For e.g. investments can be easily sold but the desire may be

to keep them. Investments may therefore be both liquid and semi-permanent that

is why they are shown as a separate item in the balance sheet. Liabilities can

also be grouped in two ways either in the order of urgency of payment or in the

reverse order. The various assets and liabilities grouped in the two orders will

appear as follows:

Order of Liquidity

Assets Liabilities

Cash Bills payable

Bank Creditors

Marketable securities Outstanding expenses

Debtors Income received in advance

Inventory Provision for income-tax

Prepaid expenses Mortgage loan

Investments Debentures

Furniture and Fixtures Owners' equity

Plant and Machinery

Land and Buildings

Patents

Trade Marks

Goodwill

Order of Permanence

Assets Liabilities

Goodwill Owner's equity

Trade Marks Debentures

Patents Mortgage loans

Land and Buildings Provision for income-tax

Plant and Machinery Income received in advance

Furniture and Fixtures Outstanding expenses

Investments Creditors

Prepaid expenses Bills payable

Inventory

Debtors

Bills receivable

Marketable securities

Bank

Cash

Whatever is the order, it is always better to follow the same order for

both assets and liabilities. In the illustration `A' the order of liquidity has been

followed.

1.3.3.8 CLASSIFICATION OF ITEMS IN THE BALANCE SHEET

Although each individual asset or liability can be listed separately on the

balance sheet, it is more practicable and more informative to summarise and

group related items into categories called as account classifications. The

classifications or group headings will vary considerably depending on the size of

the business, the form of ownership, the nature of its operations and the users of

the financial statements. For e.g. while listing assets, the order of liquidity is

generally used by sole traders, partnership firms and banks whereas joint stock

companies by law follow the order of permanence. As a generalisation which is

subject to many exceptions, the following classification of balance sheet items is

suggested as representative:

Assets

Current Assets

Investments

Fixed Assets

Intangible Assets

Other Assets

Liabilities

Current Liabilities

Long term liabilities

Owners' Equity

Capital

Retained earnings

Classification of Assets

Consumed Current Assets: Current assets are those which are reasonably

expected to be realised in cash or sold or consumed during the normal operating

cycle of the business enterprise or within one year, whichever is longer. By

operating cycle we mean the average period of time between the purchase of

goods or raw materials and the realisation of cash from the sale of goods or the

sale of products produced with the help of raw materials. Current assets

generally consist of cash, marketable securities, bills receivables, debtors,

inventory and prepaid expenses.

Cash: Cash consists of funds that are readily available for disbursement. It

includes cash kept in the cash chest of the enterprise as also cash deposited on

call or current accounts with banks.

Marketable Securities: These consist of investments that are both readily

marketable and are expected to be converted into cash within a year. These

investments are made with a view to earn some return on cash that otherwise

would be temporarily idle.

Accounts Receivable: Accounts receivable consist of amounts owed to the

enterprise by its consumers. This represents amounts usually arising out of

normal commercial transactions. These amounts are listed in the balance sheet at

the amount due less a provision for portion that may not be collected. This

provision is called as provision for doubtful debts. Amounts due to the

enterprise by someone other than a consumer would appear under the heading

`other receivables' rather than `accounts receivables'. If the amounts due are

evidenced by written promises to pay, they are listed as bills receivables.

Accounts receivables are expected to be realised in cash.

Inventory: Inventory consists of i) goods that are held in stock for sale in the

ordinary course of business, ii) work-in-progress that are to be currently

consumed in the production of goods or services to be available for sale.

Inventory is expected to be sold either for cash or on credit to customers to be

converted into cash. It may be noted in this connection that inventory relates to

goods that will be sold in the ordinary course of business. A van offered for sale

by a van dealer is inventory. A van used by the dealer to make service calls is

not inventory; it is an item of equipment which is a fixed asset.

Prepaid Expenses: These items represent expenses which are usually paid in

advance such as rent, taxes, subscriptions and insurance. For e.g. if rent for three

months for the building is paid in advance then the business acquires a right to

occupy the building for three months. This right to occupy is an asset. Since this

right will expire within a fairly short period of time it is a current asset.

Long Term Investments: The distinction between a marketable security shown

under current asset and as an investment is entirely based on time factor. Those

investments like investments in shares, debentures, bonds etc. that will be

retained for more than one year or one operating cycle will appear under this

classification.

Fixed Assets: Tangible assets used in the business that are of a permanent or

relatively fixed nature are called plant assets or fixed assets. Fixed assets include

furniture, equipment, machinery, building and land. Although there is no

standard criterion as to the minimum length of life necessary for classification as

fixed assets, they must be capable of repeated use and are ordinarily expected to

last more than a year. However the asset need not actually be used continuously

or even frequently. Items of spare equipments held for use in the event of

breakdown of regular equipment or for use only during peak periods of activity

are also included in fixed assets.

With the passage of time, all fixed assets with the exception of land lose

their capacity to render services. Accordingly the cost of such assets should be

transferred to the related expense amounts in a systematic manner during their

expected useful life. This periodic cost expiration is called depreciation. While

showing the fixed assets in the balance sheet the accumulated depreciation as on

the date of balance sheet, is deducted from the respective assets.

Intangible Assets: While tangible assets are concrete items which have physical

existence such as buildings, machinery etc., intangible assets are those which

have no physical existence. They cannot be touched and felt. They derive their

value from the right conferred upon their owner by possession. Examples are:

goodwill, patents, copyrights and trademarks.

Fictitious Assets: These items are not at all assets. Still they appear in the asset

side simply because of a debit balance in a particular account not yet written off

– eg. debit balance in current account of partners, profit and loss account, etc.

Classification of Liabilities

Current Liabilities: When the liabilities of a business enterprise are due within

an accounting period or the operating cycle of the business, they are classified as

current liabilities. Most of current liabilities are incurred in the acquisition of

materials or services forming part of the current assets. These liabilities are

expected to be satisfied either by the use of current assets or by the creation of

other current liabilities. The one year time interval or current operating cycle

criterion applies to classifying current liabilities also. Current liabilities

generally consists of bills payable, creditors, outstanding expenses, incomereceived

in advance, provision for income-tax etc.

Accounts payable: These amounts represent the claims of suppliers related to

goods supplied or services rendered by them to the business enterprise for which

they have not yet been paid. Usually these claims are unsecured and are not

evidenced by any formal written acceptance or promise to pay. When the

enterprise gives a written promise to pay money to a creditor for the purchase of

goods or services used in the business or the money borrowed, then the written

promise is called as bills payable or notes payable. Amounts due to financial

institutions which are suppliers of funds, rather than of goods or services are

termed as short-term loans or by some other name that describes the nature of

the debt instrument, rather than accounts payable.

Outstanding Expenses: These are expenses or obligations incurred in the

previous accounting period but the payment for which will be made in the next

accounting period. A typical example is wages or rent for the last month of the

accounting period remaining unpaid. It is usually paid in the first month of the

next accounting period and hence it is an outstanding expense.

Income received in advance: These amounts relate to the next accounting

period but received in the previous accounting period. This item of liability is

frequently found in the balance sheet of enterprises dealing in the publication of

newspapers and magazines.

Provision for Taxes: This is the amount owed by the business enterprise to the

Government for taxes. It is shown separately from other current liabilities both

because of the size and because the amount owed may not be known exactly as

on the date of balance sheet. The only thing known is the existence of liability

and not the amount.

Long term liabilities: All liabilities which do not become due for payment in

one year and which do not require current assets for their payment are classified

as long-term liabilities or fixed liabilities. Long term liabilities may be classified

as secured loans or unsecured loans. When the long-term loans are obtained

against the security of fixed assets owned by the enterprise, they are called as

secured or mortgage loans. When any asset is not attached to these loans they

are called as unsecured loans. Usually long-term liabilities include debentures

and bonds, borrowings from financial institutions and banks, public debts, etc.

Interest accrued on a particular secured long term loan, should be shown under

the appropriate sub-heading.

Contingent Liabilities: Contingent liabilities are those liabilities which may or

may not result in liability. They become liabilities only on the happening of a

certain event. Until then both the amount and the liability are uncertain. If the

event happens there is a liability; otherwise there is no liability at all. A very

good example for contingent liability is a legal suit pending against the business

enterprise for compensation. If the case is decided against the enterprise the

liability arises and in the case of favourable decision there is no liability at all.

Contingent liabilities are not taken into account for the purpose of totaling of

balance sheet.

Capital or Owners' Equity: As mentioned earlier, owners' equity is the residual

interest in the assets of the enterprise. Therefore the owners' equity section of

the balance sheet shows the amount the owners have invested in the entity.

However, the terminology `owners' equity, varies with different forms of

organisations depending upon whether the enterprise is a joint stock company or

sole proprietorship / partnership concern.

Sole Proprietorship / Partnership Concern: The ownership equity in a sole

proprietorship or partnership is usually reported in the balance sheet as a single

amount for each owner rather than distinction between the owners initial

investment and the accumulated earnings retained in the business. For e.g. in a

sole-prorprietor's balance sheet for the year 2005, the capital account of the

owner may appear as follows:

Rs.

Owner's capital as on 1-1-2005 2,50,000

Add: 2005 – Profit 30,000

-----------

2,80,000

Less: 2005 – Drawings 15,000

-----------

Owner's capital as on 31-12-2005 2,65,000

Joint Stock Companies: In the case of joint stock companies, according to the

legal requirements, owners' equity is divided into two main categories. The first

category called share capital or contributed capital is the amount the owners

have invested directly in the business. The second category of owners' equity is

called retained earnings.

Share capital is the capital stock pre-determined by the company by the

time of registration. It may consist of ordinary share capital or preference share

capital or both. The capital stock is divided into units called as shares and that is

why the capital is called as share capital. The entire predetermined share capital

called as authorised capital need not be raised at a time. That portion of

authorised capital which has been issued for subscription as on a date is referred

to as issued capital.

Retained earnings is the difference between the total earning to date and

the amount of dividends paid out to the shareholders to date. That is, the

difference represents that part of the total earnings that have been retained for

use in the business. It may be noted that the amount of retained earnings on a

given date is the accumulated amount that has been retained in the business from

the beginning of the company's existence upto that date. The owners' equity

increases through retained earnings and decreases when retained earnings are

paid out in the form of dividends.

1.3.3.9 SUMMARY

The profit and loss account or income statement summarises the

revenues and expenses of a business enterprise for an accounting period. The

information on the income statement is regarded by many to be more important

than information on the balance sheet because the income statement reports the

results of operations and enables to analyse the reasons for the enterprises'

profitability or loss thereof. A close relationship exists between income

statement and balance sheet; the statement of retained earnings which is a

concomitant of income statement explains the change in retained earnings

between the balance sheets prepared at the beginning and the end of the period.

Balance sheet is one of the most important financial statements

which shows the financial position of a business enterprise as on a

particular date. It lists as on a particular date, usually at the close of the

accounting period, the assets and liabilities and capital of the enterprise.

An analysis of balance sheet together with profit and loss account will

give vital information about the financial position and operations of the

enterprise. The analysis becomes all the more useful and effective when

a series of balance sheets and profit and loss accounts are studied.

1.3.3.10 KEY WORDS

Income: Revenues – Expenses.

Expense: Item of cost applicable to an accounting period.

Cost of goods sold: Opening stock + Purchase + Freight – Closing stock.

Gross Profit: Excess of sales revenue over cost of goods sold.

Operating Expenses: Expenses incurred for running the business.

Operating Profit: Gross profit – Operating expenses.

Non Operating Expenses: Expenses which are not related to the activities of the

business.

Net Profit: Amount of profit finally available to the enterprise for appropriation.

Retained Earnings: The term retained earnings means the accumulated excess

of earnings over losses and dividends.

Status Report: Financial position on a particular date.

Flow Report: Financial position for a particular period.

Assets: Costs which represent expected future economic benefits to the business

enterprise.

Liabilities: Represent obligations which require settlement in the future.

Current Assets: Assets which are reasonably expected to be realised in cash or

sold or consumed during the normal operating cycle of the business enterprise or

within one year, whichever is longer.

Operating Cycle: The average period of time between the purchase of goods or

raw materials and the realisation of cash from the sale of goods.

Fixed Assets: Tangible assets used in the business that are of a permanent or

relatively fixed nature.

Intangible Assets: Those assets which have no physical existence.

Fictitious Assets: They are not assets but appear in the asset side simply because

of a debit balance in a particular account not yet written off.

Current Liabilities: Liabilities due within an accounting period or the operating

cycle of the business.

Long Term Liabilities: Liabilities that become due for payment after one year.

Contingent Liabilities: Items which become a liability only on the happening of

a certain event.

Capital or Owner's Equity: This is the residual interest in the assets of the

enterprise.

1.3.3.11 SELF ASSESSMENT QUESTIONS

1. What is an expenditure? When does it become an expense?

2. What is income? How is it different from receipt?

3. Explain the following:

(a) Gross Profit

(b) Operating Profit

(d) Earnings after tax

4. What is meant by Statement of Retained Earnings?

5. The following are the balances taken from the books of Meena Ltd on 31st

December 2005:

Stock on 1-1-2005 15,000 Debtors 5,000

Wages 8,000 Creditors 6,000

Sales 40,000 P&L a/c 3,500

Returns inward 500 (Credit balance)

Purchases 6,000 Plant 18,000

Discounts earned 200 Cash in hand 600

Salaries 800 Bank account 3,400

Rent 2,000 Bad Debts Reserve 175

Discount allowed 250 Bad debts 150

General expenses 1,300 Insurance 300

Dividend (interim) 575 Capital 12,000

Closing stock was valued at Rs.9,000. Rs.500 still due to labourers.

Insurance unexpired Rs.50. Provide for a Bad Debts Reserve of 5% and a

Reserve for Discount at 1%. Prepare Trading and Profit and Loss Account as at

31st December 2005.

6. From the following figures relating to a leading software producing

company, prepare the Income statement for the year ended 30th June 2005.

1. Sales 20,17,69,212

2. Dividend received 1,06,755

3. Costs of goods sold 5,86,88,675

4. Interest received 18,76,661

5. Manufacturing expenses 5,38,56,719

6. Selling expenses 81,81,822

7. Administration expenses 2,99,32,794

8. Managerial Remuneration 1,78,200

9. Excise duty 48,94,360

10. Bad Debts 16,48,157

11. Overseas Project expenses 58,35,260

12. Interest paid 5,69,16,495

13. Depreciation 2,33,40,163

14. Auditor's remuneration 71,488

15. Increase in stocks 9,16,30,652

16. Other income 94,13,004

17. Balance of profit brought forward 3,51,87,048

from previous year

18. Proposed dividend 4,64,19,410

19. Transfer to general reserve 30,62,608

Also prepare the statement of Retained Earnings.

7. Explain the following:

(a) Assets

(b) Liabilities

(d) Income received in advance

(e) Investments

8. What are the two forms of presenting a balance sheet?

9. Explain Owner's equity. How is it to be presented in the Balance Sheet?

10. From the following Trail Balance extracted from the books of the General

Traders Limited as on 31st December 2005, you are required to prepare

Trading and Profit and Loss Account and Balance Sheet:

Share Capital Rs. Rs.

20,000 shares of Rs.10 each 2,00,000

Stock on 1st January 2005 36,000

Sales 58,000

Salaries 5,250

Purchases 44,000

Sundry Debtors 23,000

Wages 3,000

Calls in arrears 21,500

Sundry Creditors 7,200

Postage and Telegrams 470

Advertisement 960

Preliminary expenses 7,500

Printing and Stationery 640

Land and Buildings 65,000

General expenses 2,200

Furniture 1,200

Repairs 650

Bad Debts 910

Rent received 2,700

Machinery 30,000

Cash with bank 24,100

Cash in hand 1,520

------------- -----------

2,67,900 2,67,900

------------- -----------

The stock on 31st December 2005 was Rs.49,000. Write off Rs.2,500 out of

preliminary expenses. Depreciate machinery by 10 percent and furniture by 6

percent.

11. The books of Aranarasu show the following balances as on 31st December

2005. You are required to prepare a Trading and Profit and Loss Account

and Balance Sheet.

Stock on 1st January 2005 67,000

Sales 5,24,600

Bills payable 1,500

Purchases 4,88,000

Salaries and wages 9,800

Rent 1,100

Travelling expenses 2,600

Sundry creditors 57,000

Postage and Telegrams 620

General charges 2,250

Printing and Stationery 350

Capital Account 75,000

Interest and Commission 2,200

Lighting charges 175

Repairs 35

Sundry Receipts 175

Furniture 3,000

Bills Receivable 4,000

Bad Debts 475

Sundry debtors 85,000

Aranarasu's current account 17,000

Cash with bank 6,500

Cash in hand 2,170

----------- -----------

6,75,275 6,75,275

----------- -----------

Depreciate furniture by 6 percent. Salaries and rent were outstanding Rs.1,100

and Rs.100 respectively. Stock at 31st December 2005 was valued at Rs.70,350.

12. From the following balances relating to Software India Ltd. prepare the

Balance sheet as at 31st December 2005.

(a) Equity capital 36,42,58,510

(b) Reserves and surplus 23,58,26,861

(c ) Debentures 1,03,36,000

(d) Secured loans 21,27,57,441

(e) Fixed assets 37,07,93,048

(f) Investments 5,94,80,459

(g) Inventories 20,78,28,095

(h) Sundry debtors 10,21,66,468

(i) Cash and Bank balances 1,49,87,264

(j) Other current assets 57,75,568

(k) Loans and Advances 12,49,59,370

(l) Current Liabilities 4,71,71,358

(m) Provisions 4,64,19,410

(n) Miscellaneous expenditure 3,07,79,308

The balance sheet may be prepared in account form and report form.

1.3.3.12 KEY TO SELF ASSESSMENT QUESTIONS (FOR

PROBLEMS ONLY)

Q.No.5: Gross Profit: Rs.19,000; Net Profit: Rs.14,327; Profit carried to

Balance Sheet: Rs.17,252.

Q.No.6: Net Profit: Rs.6,12,52,151; Retained Earnings Balance:

Rs.4,69,57,182.

Q.No.10: Gross Profit: Rs.24,000; Net Profit: Rs.10,048; Balance Sheet

Total: Rs.1,95,748.

Q.No.11: Gross Profit: Rs.39,950; Net Profit: Rs.19,140; Balance Sheet

Total: Rs.1,70,840.

1.3.3.13 CASE ANALYSIS

To give a practical insight to the students about the various aspects of

Profit and Loss Account and of a Balance Sheet we give the Financial

Statements as at 31st March 2005 of TT Limited a yarn manufacturing company:

T T LIMITED

BALANCE SHEET AS AT 31ST MARCH, 2005

Particulars Schedule Current Year Previous Year

Rs. Rs.

I. SOURCES OF FUNDS

1. Share Capital 1 107490250.00 107490250.00

Reserve & Surplus 2 202213218.39 190240718.95

2. LOAN FUNDS

Secured loans 3 447855991.83 423528431.00

Unsecured loans 4 69532615.80 56901290.19

3. DEFERRED TAX

LIABILITY 42276806.36 43673781.36

----------------- -----------------

869368882.38 821834471.50

----------------- -----------------

II. APPLICATION OF FUNDS

1. FIXED ASSETS

Gross Block 5 734104404.86 700390441.72

Less: Depreciation 217233181.41 184869109.73

----------------- -----------------

Net Block 516871223.45 515521331.99

Capt. work in progress 4305600.00 521176823.45 0.00 515521331.99

/ Advances ----------------- -----------------

2. Investments 6 1591141.57 1591642.57

3. i.Current Assets,

Loans & Advances 510807958.00 457861043.73

ii. Less: Current

Liabilities & Provisions 164207040.63 153139546.79

----------------- -----------------

Net Current Assets 7 346600917.37 304721496.94

(i-ii) ------------------- -------------------

869368882.38 821834471.50

----------------- -------------------

T T LIMITED

PROFIT & LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH,

2005

Particulars Schedule Current Year Previous Year

Rs. Rs.

INCOME

Sales 1656633139.30 1470167645.65

Less: Excise duty 9164920.45 59656449.44

------------------- -------------------

Net Sales 8 1649235545.85 1410511196.21

Other Income 9 3194055.78 9178442.33

Increase (Decrease) 10 23509662.45 22572632.64

in stock ------------------- -------------------

1675939264.08 1442262271.18

------------------- ------------------

EXPENDITURE

Material 11 1262208246.11 1107760578.66

Manufacturing,

Personnel, Admin. &

Selling Expenses etc.12 308899137.99 254353516.32

Financial expenses13 47902372.00 30855197.88

Depre. on Fixed 34107486.97 33127938.23

Assets

Less:Transferred from 2906557.05 31200929.92 3657679.05 29470259.18

Revaluation Reserve ------------ ----------------

----------------- ----------------

1650210686.02 1422439552.04

------------------ -----------------

PROFIT

Profit Before Tax 25728578.06 19822719.14

Less: Provision for Taxation

- for the year 2000000.00 400000.00

- Deferred Tax - 1396975.00 603025.00 4750084.00 5150084.00

---------------- ----------------

Add: Taxation Adjustment 0.00 2154911.83

Of Previous Years (net)

Profit After Taxation 25125553.06 16827546.97

Add: Balance B/F from 33458012.39 28831460.48

Previous Year ---------------- ----------------

58583565.45 45659007.45

----------------- ----------------

APPROPRIATION

Dividend 8599220.00 8599220.00

Dividend Distribution Tax 1123810.56 1101775.06

Trf to General Reserve 10000000.00 2500000.00

Balance Carried Forward 38860534.88 33458012.19

------------------ ----------------

58583565.45 45659007.45

---------------- ---------------

Earning per Share (equity shares, par value

Rs.10 each) Basic & Diluted 2.34 1.57

-------------------------------------------------------------------------------------------------

1.3.3.14 BOOKS FOR FURTHER READING

1. M.A.Arulanandam and K.S.Raman: Advanced Accounts, Himalaya

Publishing House.

2. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Vol.I, Sultan Chand &

Sons, New Delhi.

3. S.P.Jain and K.L.Narang: Advanced Accounts, Kalyani Publishers.

4. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co. New

Delhi.

5. Tulsian: Financial Accounting, Pearson Education.

UNIT II

LESSON 2.1

-----------------------------------------------------------------------------------------

CAPITAL AND REVENUE EXPENDITURE AND RECEIPTS

-----------------------------------------------------------------------------------------

2.1.1 INTRODUCTION

In the lessons under Unit-I pertaining to the preparation of Profit

and Loss Account the reader would have had an exposure to the concepts

relating to expenses, expenditure and incomes. The term expenditure is a

broad term and it is classified into capital expenditure, revenue

expenditure and deferred revenue expenditure. All incomes are not

receipts and all receipts are not incomes. For eg. under accrual or

mercantile system of accounting even income earned but not received is

treated as income. Similarly all receipts are not recognised as incomes.

This lesson deals with the classification of capital and revenue

expenditure and receipts.

2.1.2 OBJECTIVES

After reading this lesson the reader should be able to:

(i) Understand capital expenditure

(ii) Distinguish capital expenditure from revenue expenditure

(iii) Identify Capital receipts and Revenue receipts

2.1.3 CONTENTS

2.1.3.1. Capital Expenditure

2.1.3.2. Revenue Expenditure

2.1.3.3. Distinction between Capital and Revenue Expenditure

2.1.3.4. Deferred Revenue Expenditure

2.1.3.5. Capital and Revenue Profits, Receipts and Losses

2.1.3.6. Illustrations

2.1.3.7. Summary

2.1.3.8. Key Words

2.1.3.9. Self Assessment Questions

2.1.3.10. Key to Self Assessment Questions

2.1.3.11. Case Analysis

2.1.3.12. Books for Further Reading

2.1.3.1 CAPITAL EXPENDITURE: Capital expenditure is that expenditure

the benefit of which is not fully consumed in one period but spread over periods

i.e. the benefits are expected to accrue for a long time. Any expenditure which

gives the following outcomes is a capital expenditure:

(i) Increases the capacity of an existing asset.

(ii) Increases the life of an existing asset.

(iii) Increases the earning capacity of the concern.

(iv) Results in the acquisition of a new asset.

(v) Decreases the cost of production.

Following are the examples of capital expenditure:

(i) Expenditure resulting in the acquisition of fixed assets e.g. land,

building, machines, etc.

(ii) Expenditure resulting in extension or improvement of fixed assets

e.g. amount spent on increasing the seating accommodation in the

picture hall.

(iii) Expenditure in connection with installation of a fixed asset.

(iv) Expenditure incurred for acquiring the right to carry on a

business e.g. patents, copyright, etc.

(v) Major repairs and replacements of parts resulting in increased

efficiency of a fixed asset.

An expenditure cannot be said to be a capital expenditure only because:

(i) The amount is large.

(ii) The amount is paid in lump sum.

(iii) The amount is paid out of that fund which has been received out

of the sale of fixed asset.

(iv) The receiver of the amount is going to treat it for the purchase of

fixed asset.

2.1.3.2 REVENUE EXPENDITURE: An expenditure which is consumed

during the current period and which affects the income of the current period is

called revenue expenditure. Also an expenditure which merely seeks to maintain

the business of high assets in good working conditions is revenue expenditure.

Following are the examples of revenue expenditure:

(i) Expenses of administration, expenses incurred in manufacturing

and selling products.

(ii) Replacements for maintaining the existing permanent assets.

(iii) Costs of goods purchased for resale.

(iv) Depreciation on fixed assets, interest on loans for business, etc.

2.1.3.3 DISTINCTION BETWEEN CAPITAL AND REVENUE

EXPENDITURE:

The proper distinction between capital and revenue as regard to expenditure,

payments, profits, receipts and losses is one of the fundamental principles of

correct accounting. It is very essential that in all cases this distinction should be

rigidly observed and amounts rightly allocated between capital and revenue.

Failure or neglect to discriminate between the two will falsify the whole of the

results of accounting. However the distinction is not always easy. In actual

practice there is a good deal of difference of opinion as to whether a particular

item is capital or revenue expenditure. However the rules mentioned above may

serve as a guide for making distinction between capital and revenue expenditure.

2.1.3.4 DEFERRED REVENUE EXPENDITURE: A heavy expenditure of

revenue nature incurred for getting benefit over a number of years is classified

as deferred revenue expenditure. In some cases the benefit of revenue

expenditure may be available for a period of two or three or even more years.

Such expenditure is to be written off over a period of two or three years and not

wholly in the year in which it is incurred. For example a new firm may advertise

very heavily in the beginning to capture a position in the market. The benefit of

this advertisement campaign will last quite a few years. It will be better to write

off the expenditure in three or four years and not only in the first year. Some

other examples of deferred revenue expenditure: Preliminary expenses,

brokerage on issue of shares and debentures, exceptional repairs, discount on

issue of shares or debentures, expenses incurred in removing the business to

more convenient premises, etc.

2.1.3.5 CAPITAL AND REVENUE PROFITS, RECEIPTS AND LOSSES:

Capital and Revenue Profits: Capital profit is a profit made on the sale of a

fixed asset or a profit earned on getting capital for the business. For example if

the original cost of a fixed asset is Rs.50,00,000 and if it is sold for Rs.60,00,000

then Rs.10,00,000 is capital profit. Similarly if the shares having an original cost

of Rs.4,000 are sold for Rs.5,000, the profit of Rs.1,000 thus made is capital

profit. Capital profits should not be transferred to the profit and loss account but

should be transferred to capital reserve which would appear as a liability in the

balance sheet. Revenue profit, on the other hand, is a profit by trading, e.g. profit

on sale of goods, income from investments, discount received, commission

earned, rent received, interest earned etc. Such profits are taken to profit and loss

account.

Capital and Revenue Receipts: The distinction between capital receipts and

revenue receipts is also important. Money obtained from the sale of fixed assets

of investments, issue of shares, debentures, money obtained by way of loans are

examples of capital receipts. On the other hand revenue receipts are: cash from

sales, commission received, interest on investments, transfer fees, etc. Capital

receipts are shown in the balance sheet and revenue receipts in the profit and

loss account.

Capital and Revenue Losses: Capital losses are those losses which occur at

selling fixed assets or raising share capital. For e.g. if investments having an

original cost of Rs.20,000 are sold for Rs.16,000, there will be a capital loss of

Rs.4,000. Similarly when the shares of the face value of Rs.100 are issued for

Rs.90, the amount of discount i.e. Rs.10 per share will be a capital loss. Capital

losses should not be debited to Profit and Loss Account but may be shown on

the asset side of Balance Sheet. As and when capital profits arise, losses are met

against them. Revenue losses are those losses which arise during the normal

course of business i.e. in trading operations such as losses on the sale of goods.

Such losses are debited to Profit and Loss Account.

2.1.3.6 ILLUSTRATIONS

Illustration 1: State which of the following expenditures are capital in nature

and which are revenue in nature:

(i) Freight and cartage on the new machine Rs.150; erection charges

Rs.200.

(ii) A sum of Rs.10,000 on painting the new factory.

(iii) Fixtures of the book value of Rs.1,500 was sold off at Rs.600 and

new fixtures of the value of Rs.1,000 were acquired, cartage on

purchase Rs.50.

(iv) Rs.1,000 spent on repairs before using a second hand car

purchased recently.

Solution:

(i) Capital expenditure to be debited to machinery account.

(ii) Painting charges of new or old factory are maintenance charges

and be charged to revenue. However, if felt proper painting

charges of new factory may be treated as deferred revenue

expenditure. However, some say painting of new factory is

capital expenditure.

(iii) Loss of Rs.900 on the sale of fixtures be treated as revenue

expense but the cost of new fixture Rs.1,000 together with

cartage Rs.50 be debited to fixture account as these are capital

expenditure.

(iv) Rs.1,000 being expense to bring the asset in usable condition is a

capital expenditure.

Illustration 2:

(i) The sum of Rs.30,000 has been spent on a machine as follows:

Rs.20,000 for additions to increase the output; Rs.12,000 for

repairs necessitated by negligence and Rs.8,000 for replacement

of worn-out parts.

(ii) The sum of Rs.17,200 was spent on dismantling, removing and

reinstalling in order to remove their works to more suitable

premises. Classify these expenses into capital and revenue.

Solution:

(i) Rs.20,000 spent on additions is to be capitalised but Rs.12,000

and Rs.8,000 spent on repairs and replacement of worn-out parts

respectively are to be charged to revenue.

(ii) Rs.17,200 spent for removing to a more suitable premises is to be

charged to revenue as it does not increase efficiency and income.

It, may, however be treated as deferred revenue at the most.

2.1.3.7 SUMMARY

Final accounts are prepared from the balances appearing in the

trial balance. All accounts appearing in the Trial Balance are taken to

either Trading and Profit and Loss Account or Balance Sheet. All

revenue expenditures and receipts are taken to Trading and Profit and

Loss Account and all capital expenditures and receipts are taken to

Balance Sheet. It is therefore necessary to realise the importance of

distinction between capital and revenue items.

2.1.3.8 KEY WORDS

Capital Expenditure: It is that expenditure the benefit of which is expected to

accrue for a number of years.

Revenue Expenditure: It is that expenditure the benefit of which is consumed

during the current year.

Capital Receipt: Moneys obtained from sale of fixed assets, issue of capital,

borrowing of loans, etc.

Revenue Receipt: Cash from sales, commission received, etc. are examples of

revenue receipts.

2.1.3.9 SELF ASSESSMENT QUESTIONS

State which of the following items should be charged to capital and

which to revenue:

(i) Rs.6,000 paid for removal of stock to new site.

(ii) Rs.2,000 paid for the erection of a new machine.

(iii) Rs.2,500 paid on the repairing of new factory.

(iv) A car engine's rings and pistons were changed at a cost of

Rs.15,000; this resulted in improvement of petrol consumption to

12 km per litre; earlier it had fallen from 15 km to 8 km.

2.1.3.10 KEY TO SELF ASSESSMENT QUESTIONS

(i) Deferred Revenue Expenditure.

(ii) Capital Expenditure.

(iii) Capital Expenditure.

(iv) Revenue Expenditure.

2.1.3.11 CASE ANALYSIS

Raja Ram Ltd., for which you are the Accounts Manager, has removed

the works factory to a more suitable site. During the removal process the

following stream of expenditure were incurred:

(i) A sum of Rs.47,500 was spent on dismantling, removing and reinstalling

plant, machinery and fixtures.

(ii) The removal of stock from old works to new works cost Rs.5,000.

(iii) Plant and machinery which stood in books at Rs.7,50,000 included a

machine at a book value of Rs.15,000. This being obsolete was sold off

for Rs.5,000 and was replaced by a new machine which costs Rs.24,000.

(iv) The fixtures and furniture appeared in the books at Rs.75,000. Of these

some portion of the book value of Rs.15,000 was discarded and sold off

for Rs.16,000 and new furniture of the value of Rs.12,000 was acquired.

(v) A sum of Rs.11,000 was spent on painting the new factory.

Your accounts clerk has come to you seeking your help to classify the

above expenditure as to capital expenditure and revenue expenditure. Advise

him.

Solution:

(i) Rs.47,500 will have to be treated as revenue expenditure. It may be

treated as deferred revenue expenditure item and spread over a term of

years say four to five years.

(ii) The cost of removal of stock from the old works to the new works does

not either add to the value of the profit earning capacity of the asset and

as such it should be treated as an item of revenue expenditure.

(iii) Rs.10,000 the difference between the book value of the machine sold and

the amount realised on sale, will have to be charged off to revenue as

depreciation. Rs.24,000, the cost of new machine, will have to be

capitalised.

(iv) Rs.1,000 the difference between the book value of the fixtures and

fittings discarded and the amount realised there from will be treated as

capital profit and therefore be credited to capital revenue account.

Rs.12,000 the cost of new furniture, will be capitalised.

(v) A sum of Rs.11,000 spent on painting a new factory is capital

expenditure and will be added to the cost of factory building as it is all to

the new factory.

2.1.3.12 BOOKS FOR FURTHER READING

1. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Sultan Chand

& Sons, New Delhi.

2. S.P.Jain and K.L.Narang: Advanced Accountancy, Kalyani

Publishers, New Delhi.

3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co.,

New Delhi.

4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.

5. Warren Reeve Fess: Financial Accounting, Thomson, South Westem.

UNIT-II

LESSON 2.2

-----------------------------------------------------------------------------------------

DEPRECIATION

-----------------------------------------------------------------------------------------

2.2.1 INTRODUCTION

With the passage of time, all fixed assets lose their capacity to

render services, the exceptions being land and antics. Accordingly a

fraction of the cost of the asset is chargeable as an expense in each of the

accounting periods in which the asset renders services. The accounting

process for this gradual conversion of capitalised cost of fixed assets

into expense is called depreciation. This lesson explains the different

aspects of depreciation.

2.2.2 OBJECTIVES

After reading this lesson the reader should be able to:

(i) Understand the meaning of depreciation.

(ii) Know the causes of depreciation.

(iii) Appreciate the need for depreciation accounting.

(iv) Evaluate the methods of depreciation.

2.2.3 CONTENTS

2.2.3.1. Meaning of Depreciation

2.2.3.2. Causes of Depreciation

2.2.3.3. Need for Depreciation Accounting

2.2.3.4. Methods of Depreciation

2.2.3.5. Straight Line Method of Depreciation

2.2.3.6. Diminishing Balance Method of Depreciation

2.2.3.7. Annuity Method of Depreciation

2.2.3.8. Summary

2.2.3.9. Key Words

2.2.3.10. Self Assessment Questions

2.2.3.11. Key to Self Assessment Questions

2.2.3.12. Case Analysis

2.2.3.13. Books for Further Reading

2.2.3.1 MEANING OF DEPRECIATION

In common parlance depreciation means a fall in the quality or

value of an asset. But in accounting terminology, the concept of

depreciation refers to the process of allocating the initial or restated

input valuation of fixed assets to the several periods expected to benefit

from their acquisitions and use. Depreciation accounting is a system of

accounting which aims to distribute the cost or other basic value of

tangible capital assets, less salvage (if any), over the estimated useful

life of the unit (which may be a group of assets) in a systematic and

rational manner. It is a process of allocation, not of valuation.

The International Accounting Standards Committee (IASC) (now

International Accounting Standards Board) defines depreciation as

follows: Depreciation is the allocation of the depreciable amount of an

asset over the estimated useful life. The useful life is in turn defined as

the period over which a depreciable asset is expected to be used by the

enterprise. The depreciable amount of a depreciable asset is its historical

cost in the financial statements, less the estimated residual value.

Residual value or salvage value is the expected recovery or sales value

of the asset at the end of its useful life.

2.2.3.2 CAUSES OF DEPRECIATION

Among other factors, the two main factors that contribute to the decline

in the usefulness of fixed assets are deterioration and obsolescence.

Deterioration is the physical process wearing out whereas obsolescence refers to

loss of usefulness due to the development of improved equipment or processes,

changes in style or other causes not related to the physical conditions of the

asset. The other causes of depreciation are:

(i) Efflux of time – mere passage of time will cause a fall in the

value of an asset even if it is not used.

(ii) Accidents – an asset may reduce in value because of meeting

with an accident.

(iii) Fall in market price – a sudden fall in the market price of the

asset reduces its value even if it remains brand new.

2.2.3.3 NEED FOR DEPRECIATION ACCOUNTING

The need for depreciation accounting arises on three grounds:

(i) To Calculate Proper Profit: According to matching concept of

accounting, profit of any year can be calculated only when all costs of

earning revenues have been properly charged against them. Asset is an

important tool in earning revenues. The fall in the book value of assets

reflects the cost of earning revenues from the use of assets in the current

year and hence like other costs like wages, salary, etc., it must also be

provided for proper matching of revenues with expenses.

(ii) To Show True Financial Position: The second ground for providing

depreciation is that it should result in carrying forward only that part of

asset which represents the unexpired cost of expected future service. If

the depreciation is not provided then the asset will appear in the balance

sheet at the overstated value.

(iii) To Make Provision for Replacement of Assets: If no change were made

for depreciation, profits of the concern would be more to that extent. By

making an annual charge for depreciation, a concern would be

accumulating resources enough to enable it to replace an asset when

necessary. Replacement, thus, does not disturb the financial position of

the concern.

2.2.3.4 METHODS OF DEPRECIATION

The amount of depreciation of a fixed asset is determined taking into

account the following three factors: its original cost, its recoverable cost at the

time it is retired from service and the length of its life. Out of these three factors

the only factor which is accurately known is the original cost of the asset. The

other two factors cannot be accurately determined until the asset is retired. They

must be estimated at the time the asset is placed in service. The excess of cost

over the estimated residual value is the amount that is to be recorded as

depreciation expense during the assets life-time. There are no hard and fast rules

for estimating either the period of usefulness of an asset or its residual value at

the end of such period. Hence these two factors, which are inter-related are

affected to a considerable extent by management policies.

Let the reader consider the following example: A machine is

purchased for Rs.1,00,000 with an estimated life of five years and

estimated residual value of Rs.10,000. The objective of depreciation

accounting is to charge this net cost of Rs.90,000 (original cost –

residual value) as an expense over the 5 year period. How much should

be charged as an expense each year? To give an answer to this question a

100

number of methods of depreciation are available. In this lesson three

such methods viz. straight line method, diminishing balance method and

annuity method are discussed.

2.2.3.5 STRAIGHT LINE METHOD OF DEPRECIATION

This method which is also known as `fixed installment system', provides

for equal amount of depreciation every year. Under this method, the cost of

acquisition plus the installation charges, minus the scrap value, is spread over

the estimated life of the asset to arrive at the annual charge. In other words, this

method writes off a fixed percentage, say 20%, of the original cost of the asset

every year in such a way that the asset is reduced to nil or scrap value at the end

of its life.

Evaluation: The chief merit of this method is that it is easy to calculate

depreciation, and hence, it is simple. Depreciation charge is constant from year

to year, regardless of the extent of use of the asset. This method can be

employed in the case of assets like furniture and fixtures, short leases, etc.,

which involve little capital outlay, or which have no residual value. This method

is criticised on the ground that the depreciation charge remaining the same every

year, cost of repairs and maintenance would be increasing as the asset becomes

older. The efficiency of the asset declining, it is unfair to charge the same

amount of depreciation every year.

2.2.3.6 DIMINISHING BALANCE METHOD

This method which is also known as the, `reducing installment system',

or `written down value method', applies depreciation as a fixed percentage to

the balance of the net cost of the asset not yet allocated at the end of the

previous accounting period. The percentage of depreciation is so fixed that,

theoretically, the balance of the unallocated cost at the end of the estimated

useful life of the asset should be equal to the estimated residual value.

101

Evaluation: Unlike the fixed installment system, depreciation under this method

is not fixed, but gradually decreasing. As such, in the initial periods the amount

will be much higher, but negligible in the later period of the asset. Thus this

method tends to offset the amount of depreciation on the one hand and repairs

and maintenance on the other. This method is also simple, although the

calculation of depreciation is a bit complicated. Further as and when additions

are made to the asset, fresh calculations do not become necessary. This method

is best suited to assets such as plant and machinery which have a long life.

Entries Required: The entry to be made on writing off depreciation under any

method is:

Depreciation a/c ….. Dr

To Asset a/c

The depreciation account goes to the debit of the Profit and Loss

Account. The entry for this is:

Profit and Loss a/c … Dr

To Depreciation a/c

The asset appears at its reduced value in the Balance Sheet.

Illustration 1: On 1-1-2003, machinery was purchased for Rs.3,00,000.

Depreciation at the rate of 10% has to be written off. Write up the machinery

account for three years under:

(i) Straight Line Method (SLM) and

(ii) Written Down Value Method (WDV)

Solution:

102

Machinery Account

Date

1-1-2003

1-1-2004

1-1-2005

1-1-2006

Particulars

To Bank a/c

To Balance b/d

SLM

3,00,000

-----------

3,00,000

-----------

2,70,000

-----------

2,70,000

-----------

2,40,000

-----------

2,40,000

-----------

2,10,000

WDV

3,00,000

----------

3,00,000

----------

2,70,000

----------

2,70,000

----------

2,43,000

----------

2,43,000

----------

2,18,700

Date

31-12-2003

31-12-2004

31-12-2005

Particulars

By Depreciation

By Balance c/d

By Depreciation

By Balance c/d

By Depreciation

By Balance c/d

SLM

30,000

2,70,000

-----------

3,00,000

-----------

30,000

2,40,000

-----------

2,70,000

-----------

30,000

2,10,000

-----------

2,40,000

-----------

WDV

30,000

2,70,000

-----------

3,00,000

-----------

27,000

2,43,000

-----------

2,70,000

-----------

24,300

2,18,700

-----------

2,43,000

-----------

From the above illustration it can be seen that under SLM method each

year depreciation is calculated at 10% on original cost of asset i.e. on

Rs.3,00,000, while under WDV method each year depreciation is calculated at

10% on the written down value i.e. for eg. in the 2nd year depreciation is

calculated at 10% on Rs.2,70,000 and so on.

Illustration 2: On 1-1-2002, machinery was purchased for Rs.30,000.

Depreciation at the rate of 10% on original cost was written off during the first

two years. For the next two years 15% was written off the diminishing balance

of the amount. The machinery was sold for Rs.15,000. Write up the machinery

account for four years and close the same.

103

Machinery Account

1-1-2002

1-1-2003

1-1-2004

1-1-2005

To Bank

a/c

Balance

b/d

Balance

b/d

Balance

b/d

Rupees

30,000

--------

30,000

--------

27,000

--------

27,000

--------

24,000

--------

24,000

--------

20,400

--------

20,400

--------

31-12-2002

31-12-2003

31-12-2004

31-12-2005

By Depreciation

(10% on 30,000)

By Balance c/d

By Depreciation

(10% on 30,000)

By Balance c/d

By Depreciation

(15% on 24,000)

By Balance c/d

By Depreciation

(15% on 20,400)

By Bank sale

By Profit&Loss

a/c(loss on sale)

Rupees

3,000

27,000

--------

30,000

--------

3,000

24,000

--------

27,000

--------

3,600

20,400

--------

24,000

--------

3,060

15,000

2,340

--------

20,400

--------

104

Illustration 3: A company whose accounting year is the calendar year

purchased on 1-1-2003 a machinery for Rs.40,000. It purchased further

machinery on 1-10-2003 for Rs.20,000 and on 1st July 2005 for Rs.10,000.

On 1-7-2006, one-fourth of the machinery installed on 1-1-2003 became

obsolete and was sold for Rs.6,800. Show the machinery account for all

the 3 years under fixed installment system. Depreciation is to be provided

at 10%p.a.

Machinery Account

2003

Jan 1

Oct 10

2004

Jan 1

July 1

2005

Jan 1

To Bank-Purchase

To Balance b/d

To Bank-Purchase

To Balance b/d

Rupees

40,000

20,000

--------

60,000

--------

55,500

10,000

--------

65,500

--------

59,000

2003

Dec 31

2004

Dec 31

2005

July 1

Dec 31

By Depreciation

-on Rs.40000 for 1 year

-on Rs.20000 for 3 month

By Balance c/d

By Depreciation

-on Rs.40000 for 1 year

-on Rs.20000 for 1 year

-on Rs.10000 for 6 month

By Balance c/d

By Depreciation

On machine sold

By Bank-Sale

By P&L a/c (loss on sale)

By Depreciation

-on Rs.30000 for 1 year

-on Rs.20000 for 1 year

Rupees

4,000

500

55,500

--------

60,000

--------

4,000

2,000

500

59,000

--------

65,500

--------

500

6,800

700

3,000

2,000

105

2006

Jan 1

To Balance b/d

--------

59,000

--------

45,000

-on Rs.10000 for 1 year

By Balance c/d

1,000

45,000

--------

59,000

--------

Working Notes – Loss on sale of machinery

Original cost of machinery on 1-1-2003: 4000 x ¼ = 10,000

Less Depreciation for 2003 at 10% 1,000

--------

Book value on 1-1-2004 9,000

Less Depreciation for 2004 at 10% on 10,000 1,000

--------

Book value on 1-1-2005 8,000

Less Depreciation upto 1-7-2005 at 10% on 10000 500

--------

Book value on date of sale 7,500

Less Sale proceeds 6,800

--------

Loss on sale 700

--------

2.2.3.7 ANNUITY METHOD OF DEPRECIATION

Under the first two methods of depreciation the interest aspect has been

ignored. Under this method, the amount spent on the acquisition of an asset is

regarded as investment which is assumed to earn interest at a certain rate. Every

year the asset is debited with the amount of interest and credited with the

amount of depreciation. This interest is calculated on the debit balance of the

asset account at the beginning of the year. The amount to be written off as

depreciation is calculated from the annuity table an extract of which is given

below:

106

Years 3% 3.5% 4% 4.5% 5%

3 0.353530 0.359634 0.360349 0.363773 0.367209

4 0.269027 0.272251 0.275490 0.278744 0.282012

5 0.218355 0.221481 0.224627 0.227792 0.230975

The amount to be written off as depreciation is ascertained from

the annuity table and the same depends upon the rate of interest and the

period over which the asset is to be written off. The rate of interest and

the amount of depreciation would be adjusted in such a way that at the

end of its working life, the value of the asset would be reduced to nil or

its scrap value.

Evaluation: This method has the merit of treating purchase of an asset as an

investment within the business, and the same is supposed to earn interest.

However, calculations become difficult when additions are made to the asset.

The method is suitable only for long leases and other assets to which additions

are not usually made and as such in case of machinery this method is not found

suitable.

Illustration 4: A lease is purchased for a term of 4 years by payment of

Rs.1,00,000. It is proposed to depreciate the lease by annuity method charging

4% interest. If annuity of Re.1 for 4 years at 4% is 0.275490, show the lease

account for the full period.

Amount of annual depreciation = Rs.1,00,000 x Re.0.275490

= Rs.27,549

Lease Account

1st year

To Bank

To Interest at 4%

100000.00

4000.00

--------------

104000.00

--------------

1st year

By Depreciation

By Balance c/d

27549.00

76451.00

-------------

104000.00

-------------

107

2nd

year

3rd year

4th year

To Balance b/d

To Interest at 4%

To Balance b/d

To Interest at 4%

To Balance b/d

To Interest at 4%

(adjusted)

76451.00

3058.04

--------------

79509.04

--------------

51960.04

2078.40

--------------

54038.44

--------------

26489.44

1059.56

-------------

27549.00

-------------

2nd

year

3rd year

4th year

By Depreciation

By Balance c/d

By Depreciation

By Balance c/d

By Depreciation

27549.00

51960.04

-------------

79509.04

-------------

27549.00

26489.44

-------------

54038.44

-------------

27549.00

-------------

27549.00

-------------

2.2.3.8 SUMMARY

Though depreciation to a common man means a fall in the value of an

asset actually it is not a process of valuation. It is a process of cost allocation.

Through depreciation accounting the cost of a tangible asset less salvage value,

if any, is distributed over the estimated useful life of the asset. Depreciation is to

be accounted to know the true profit earned by the concern, to exhibit a true and

fair view of the state of assets of the concern and to provide funds for

replacement of the asset when it is worn out. Among the number of methods of

depreciation available three methods, viz. straight line method, diminishing

balance method and annuity method are discussed.

2.2.3.9 KEY WORDS

Depreciable Asset: It is that asset on which depreciation is written off.

108

Depreciation: It is the allocation of the depreciable amount of an asset over the

estimated useful life.

Useful Life: It is the period over which a depreciable asset is expected to be

used by the enterprise.

Depreciable Amount: The depreciable amount of a depreciable asset is its

historical cost less estimated residual value.

Residual Value: It is the expected recovery or sales value of an asset at the end

of its useful life.

2.2.3.10 SELF ASSESSMENT QUESTIONS

Question 1: A manufacturing concern, whose books are closed on 31st March,

purchased machinery for Rs.1,50,000 on 1st April 2002. Additional machinery

was acquired for Rs.40,000 on 30th September 2003 and for Rs.25,000 on 1st

April 2005. Certain machinery which was purchased for Rs.40,000 on 30th

September 2003 was sold for Rs.34,000 on 30th September 2005. Give the

machinery account for the year ending 31st March 2006 taking into account

depreciation at 10% p.a. on the written down value.

Question 2: A seven years lease has been purchased for a sum of Rs.60,000 and

it is proposed to depreciate it under the annuity method charging 4% interest.

Reference to the annuity table indicates that the required result will be brought

about by charging annually Rs.9996.55 to depreciation account. Show how the

lease account will appear in each of the seven years.

Question 3: Examine the need for providing depreciation.

2.2.3.11 KEY TO SELF ASSESSMENT QUESTIONS

Question 1: Machinery Account

2005 To Balance b/d 1,43,550 2005 By Depreciation 1,710

April 1 To Bank 25,000 Sep 30 By Bank 34,000

109

Sep 30 To P&L a/c 1,510 2006 By Depreciation 13,435

Profit on sale

Mar 31 By Balance c/d 1,20,915

----------- -----------

1,70,060 1,70,060

----------- -----------

Question 2: Interest for seven years:

1st year: Rs.2,400; 2nd year: Rs.2,096.14; 3rd year: Rs.1,780.12; 4th year:

Rs.1,451.46; 5th year: Rs.1,109.66; 6th year: Rs.754.19; 7th year: Rs.384.28.

2.2.3.12 CASE ANALYSIS

Pondicherry Roadways Ltd which depreciates its machinery at 10% p.a.

on written down value desires to change the basis to straight line method, the

rate remaining the same. The decision is taken on 31st December 2005 to be

effective from 1st January 2003.

On 1st January 2005 the balance in the machinery account is

Rs.29,16,000.

On 1st July 2005 a part of machinery purchased on 1st January 2003 for

Rs.2,40,000 was sold for Rs.1,35,000. On the same day a new machine is

purchased for Rs.4,50,000 and installed at a cost of Rs.24,000.

Analyse the above case and answer the following questions:

(i) What was the loss incurred on the machine sold?

(ii) What was the book value of unsold machinery on 1-1-2003.

(iii) What would be the additional depreciation due to change in

method?

(iv) What should be the depreciation to be charged for 2005?

Answers:

(i) Rs.49,680

(ii) Rs.33,60,000

(iii) Rs.33,600

(iv) Rs.3,59,700

110

2.2.3.13 BOOKS FOR FURTHER READING

1. R.L.Gupta and M.Radhaswamy: Advanced Accounts, Sultan Chand & Sons,

New Delhi.

2. S.P.Jain and K.L.Narang: Advanced Accountancy, Kalyani Publishers, New

Delhi.

3. M.C.Shukla and T.S.Grewal: Advanced Accounts, S.Chand & Co., New

Delhi.

4. Tulsian: Financial Accounting, Pearson Education (P) Ltd., Delhi.

5. Warren Reeve Fess: Financial Accounting, Thomson, South Westam.

111

UNIT-III

LESSON 3.1

-------------------------------------------------------------------------------------------------

ANALYSIS AND INTREPRETATION OF FINANCIAL STATEMENTS

-------------------------------------------------------------------------------------------------

3.1.1 INTRODUCTION

Financial statements by themselves do not give the required

information both for internal management and for outsiders. They are

passive statements showing the results of the business i.e. profit or loss

and the financial position of the business. They will not disclose any

reasons for dismal performance of the business if it is so. What is wrong

with the business, where it went wrong, why it went wrong, etc. are

some of the questions for which no answers will be available in the

financial statements. Similarly no information will be available in the

financial statements about the financial strengths and weaknesses of the

concern. Hence to get meaningful information from the financial

statements which would facilitate vital decisions to be taken, financial

statements must be analysed and interpreted. Through the analysis and

interpretation of financial statements full diagnosis of the profitability

and financial soundness of the business is made possible. The term

`analysis of financial statements' means methodical classification of the

data given in the financial statements. The term `interpretation of

financial statements' means explaining the meaning and significance of

the data so classified. A number of tools are available for the purpose of

analysing and interpreting the financial statements. This lesson discusses

in brief tools like common size statement, trend analysis, etc., and gives

a detailed discussion on ratio analysis.

112

3.1.2 OBJECTIVES

After reading this lesson the reader should be able to:

• Realise the limitations of financial statements

• Appreciate the need for analysis and interpretation of financial

statements

• Understand the nature and types of financial analysis

• Know the various tools of financial analysis

• Understand the meaning of ratio analysis

• Appreciate the significance of ratio analysis

• Understand the calculation of various kinds of ratios

• Calculate the different ratios from the given financial statements

• Interpret the calculated ratios

3.1.3 CONTENTS

3.1.3.1 Nature of Financial Analysis

3.1.3.2 Types of Financial Analysis

3.1.3.3 Tools of Financial Analysis

3.1.3.4 Illustrations

3.1.3.5 Meaning and Nature of Ratio Analysis

3.1.3.6 Capital Structure or Leverage Ratios

3.1.3.7 Fixed Assets Analysis

3.1.3.8 Analysis of Turnover or Analysis of Efficiency

3.1.3.9 Analysis of Liquidity Position

3.1.3.10 Analysis of Profitability

3.1.3.11 Analysis of Operational Efficiency

3.1.3.12 Ratios from Shareholders Point of View

3.1.3.13 Illustrations

3.1.3.14 Summary

3.1.3.15 Key Words

113

3.1.3.16 Self Assessment Questions

3.1.3.17 Key to Self Assessment Questions

3.1.3.18 Case Analysis

3.1.3.19 Books for Further Reading

3.1.3.1 NATURE OF FINANCIAL ANALYSIS

The focus of financial analysis is on the key figures contained in the

financial statements and the significant relationship that exists between them.

"Analysing financial statements is a process of evaluating the relationship

between the component parts of the financial statements to obtain a better

understanding of a firm's position and performance".

The type of relationship to be investigated depends upon the

objective and purpose of evaluation. The purpose of evaluation of

financial statements differs among various groups: creditors,

shareholders, potential investors, management and so on. For example,

short-term creditors are primarily interested in judging the firm's ability

to pay its currently-maturing obligations. The relevant information for

them is the composition of the short-term (current) liabilities. The

debenture-holders or financial institutions granting long-term loans

would be concerned with examining the capital structures, past and

projected earnings and changes in the financial position. The

shareholders as well as potential investors would naturally be interested

in the earnings per share and dividends per share as these factors are

likely to have a significant bearing on the market price of shares. The

management of the firms, in contrast, analyses the financial statements

for self-evaluation and decision making.

The first task of the financial analyst is to select the information

relevant to the decision under consideration from the total information

contained in the financial statements. The second step involved in

114

financial analysis is to arrange the information in such a way as to

highlight significant relationships. The final step is the interpretation and

drawing of inferences and conclusions. In brief, financial analysis is the

process of selection, relation and evaluation.

3.1.3.2 TYPES OF FINANCIAL ANALYSIS

Financial analysis may be classified on the basis of parties who

are undertaking the analysis and on the basis of methodology of analysis.

On the basis of the parties who are doing the analysis, financial analysis

is classified into external analysis and internal analysis.

External Analysis: When the parties external to the business like creditors,

investors, etc. do the analysis, the analysis is known as external analysis. This

analysis is done by them to know the credit-worthiness of the concern, its

financial viability, its profitability, etc.

Internal Analysis: This analysis is done by persons who have control over the

books of accounts and other information of the concern. Normally this analysis

is done by management people to enable them to get relevant information to

take vital business decision.

On the basis of methodology adopted for analysis, financial

analysis may be either horizontal analysis or vertical analysis.

Horizontal Analysis: When financial statements of a number of years are

analysed, then the analysis is known as horizontal analysis. In this type of

analysis figures of the current year are compared with the standard or base year.

This type of analysis will give an insight into the concern's performance over a

period of years. This analysis is otherwise called as dynamic analysis as it

extends over a number of years.

Vertical Analysis: This type of analysis establishes a quantitative relationship of

the various items in the financial statements on a particular date. For e.g. the

ratios of various expenditure items in terms of sales for a particular year can be

115

calculated. The other name for this analysis is `static analysis' as it relies upon

one year figures only.

3.1.3.3 TOOLS OF FINANCIAL ANALYSIS

The following are the important tools of financial analysis which can be

appropriately used by the financial analysts:

1. Common-size financial statements

2. Comparative financial statements

3. Trend percentages

4. Ratio analysis

5. Funds Flow analysis

6. Cash Flow analysis

Common-size Financial Statements: In this type of statements figures in the

original financial statements are converted into percentages in relation to a

common base. The common base may be sales in the case of income statements

(profit and loss account) and total of assets or liabilities in the case of balance

sheet. For e.g. in the case of common-size income statement, sales of the

traditional financial statement are taken as 100 and every other item in the

income statement is converted into percentages with reference to sales. Similarly

in the case of common-size balance sheet, the total of asset/liability side will be

taken as 100 and each individual asset/liability is converted into relevant

percentages.

Comparative Financial Statements: This type of financial statements are ideal

for carrying out horizontal analysis. Comparative financial statements are so

designed to give them perspective to the review and analysis of the various

elements of profitability and financial position displayed in such statements. In

these statements figures for two or more periods are compared to find out the

changes both in absolute figures and in percentages that have taken place in the

116

latest year as compared to the previous year(s). Comparative financial

statements can be prepared both for income statement and balance sheet.

Trend Percentages: Analysis of one year figures or analysis of even two years

figures will not reveal the real trend of profitability or financial stability or

otherwise of any concern. To get an idea about how consistent is the

performance of a concern, figures of a number of years must be analysed and

compared. Here comes the role of trend percentages and the analysis which is

done with the help of these percentages is called as Trend Analysis.

Trend analysis is a useful tool for the management since it

reduces the large amount of absolute data into a simple and easily

readable form. The trend analysis is studied by various methods. The

most popular forms of trend analysis are year to year trend change

percentage and index-number trend series. The year to year trend change

percentage would be meaningful and manageable where the trend for a

few years, say a five year or six year period is to be analysed.

Generally trend percentage are calculated only for some important

items which can be logically related with each other. For e.g. trend ratio

for sales, though shows a clear-cut increasing tendency, becomes

meaningful in the real sense when it is compared with cost of goods sold

which might have increased at a lower level.

Ratio Analysis: Of all the tools of financial analysis available with a financial

analyst the most important and the most widely used tool is ratio analysis.

Simply stated ratio analysis is an analysis of financial statements done with the

help of ratios. A ratio expresses the relationship that exists between two

numbers and in financial statement analysis a ratio shows the relationship

between two interrelated accounting figures. Both the accounting figures may be

taken from the balance sheet and the resulting ratio is called a balance sheet ratio

or both the figures may be taken from profit and loss account when the resulting

117

ratio is called as profit and loss account ratio and composite ratio is that ratio

which is calculated by taking one figure from profit and loss account and the

other figure from balance sheet. A detailed discussion on ratio analysis is made

available in the pages to come.

Funds Flow Analysis: The purpose of this analysis is to go beyond and behind

the information contained in the financial statements. Income statement tells the

quantum of profit earned or loss suffered for a particular accounting year.

Balance sheet gives the assets and liabilities position as on a particular date. But

in an accounting year a number of financial transactions take place which have a

bearing on the performance of the concern but which are not revealed by the

financial statements. For e.g. a concern collects finance through various sources

and uses them for various purposes. But these details could not be known from

the traditional financial statements. Funds flow analysis gives an opening in this

respect. All the more, funds flow analysis reveals the changes in working capital

position. If there is an increase in working capital what resulted in the increase

and if there is a decrease in working capital what caused the decrease, etc. will

be made available through funds flow analysis.

Cash Flow Analysis: While funds flow analysis studies the reasons for the

changes in working capital by analysing the sources and application of funds

cash flow analysis pays attention to the changes in cash position that has taken

place between two accounting periods. These reasons are not available in the

traditional financial statements. Changes in the cash position can be analysed

with the help of a statement known as cash flow statement. A cash flow

statement summarises the change in cash position of the concern. Transactions

which increase the cash position of the concern are labelled as `inflows' of cash

and those which decrease the cash position as `outflows' of cash.

118

3.1.3.4 ILLUSTRATIONS

Illustration 1: From the following Profit and Loss Accounts and the Balance

Sheets of Murugan Ltd. for the year ended 31st December, 2004 and 2005, you

are required to prepare a comparative income statement and a comparative

balance sheet.

PROFIT AND LOSS ACCOUNT

(Rs. in '000)

--------------------------------------------------------------------------------------------------------------------

2004 2005 2004 2005

--------------------------------------------------------------------------------------------------------------------

To Cost of goods sold 6,000 7,500 By Net Sales 8,000 10,000

To Operating expenses:

Administrative expenses 200 200

Selling expenses 300 400

To Net profit 1,500 1,900

------------------ ------------------

8,000 10,000 8,000 10,000

------------------ ------------------

--------------------------------------------------------------------------------------------------------------------

BALANCE SHEET AS ON 31ST DECEMBER

(Rs. in '000)

--------------------------------------------------------------------------------------------------------------------

Liabilities 2004 2005 Assets 2004 2005

-------------------------------------------------------------------------------------------------------------------

Bills payable 500 750 Cash 1,000 1,400

Sundry creditors 1,500 2,000 Debtors 2,000 3,000

Tax payable 1,000 1,500 Stock 2,000 3,000

6% Debentures 1,000 1,500 Land 1,000 1,000

6% Preference capital 3,000 3,000 Building 3,000 2,700

Equity capital 4,000 4,000 Plant 3,000 2,700

Reserves 2,000 2,450 Furniture 1,000 1,400

--------------------------- ---------------------------

13,000 15,200 13,000 15,200

Solution:

119

MURUGAN LIMITED

COMPARATIVE INCOME STATEMENT

For the Years ended 31st December, 2004 and 2005

(Rs.

in '000)

------------------------------------------------------------------------------------------------

Absolute % increase

increase or or decrease

decrease in in

2004 2005 2005 2005

------------------------------------------------------------------------------------------------

Net Sales 8,000 10,000 +2,000 +25

Cost of goods sold 6,000 7,500 +1,500 +25

--------------------------------------

Gross profit 2,000 2,500 + 500 +25

--------------------------------------

Operating Expenses:

Administrative exp. 200 200 --- ---

Selling expenses 300 400 + 100 +33.33

--------------------------------------

Total Operating 500 600 + 100 +20

Expenses --------------------------------------

Operating profit 1,500 1,900 + 400 +26.67

------------------------------------------------------------------------------------------------

MURUGAN LIMITED

COMPARATIVE BALANCE SHEET

As on 31st December, 2004 and 2005

-----------------------------------------------------------------------------------------------

Absolute %

increase increase

ASSETS or or

decrease decrease

2004 2005 in 2005 in 2005

-----------------------------------------------------------------------------------------------

Current Assets

Cash 1,000 1,400 400 +40

Debtors 2,000 3,000 1,000 +50

Stock 2,000 3,000 1,000 +50

--------------------------------------------------------------------

120

Total

current

assets 5,000 7,400 2,400 +48

--------------------------------------------------------------------

Fixed Assets

Land 1,000 1,000 --- ---

Building 3,000 2,700 - 300 -10%

Plant 3,000 2,700 - 300 -10%

Furniture 1,000 1,400 +400 +40%

--------------------------------------------------------------------------

Total Fixed

Assets 8,000 7,800 - 200 - 2.5

--------------------------------------------------------------------------

Total

Assets 13,000 15,200 2,200 +17%

------------------------------------------------------------------------------------------------

Liabilities

& Capital

Current

Liabilities:

Bills

payable 500 750 +250 +50%

Sundry

Creditors 1,500 2,000 +500 +33.33%

Taxes

Payable 1,000 1,500 +500 +50%

----------------------------------------------------------------------------

Total

current 3,000 4,250 +1,250 +41.66%

Liabilities

------------------------------------------------------------------------------

Long term

liabilities

6% Debentures1,000 1,500 +500 +50%

------------------------------------------------------------------------

Total

Liabilities 4,000 5,750 +1,750 +43.75%

-------------------------------------------------------------------------

Capital & Reserves:

6% Pref. Capital 3,000 3,000 ---- ----

Equity Capital 4,000 4,000 ---- ----

121

Reserves 2,000 2,450 450 22.5

-------------------------------------------------------------------------

Total

Shareholder's 9,000 9,450 450 5%

Funds -------------------------------------------------------------------------

Total

Liabilities & 13,000 15,200 2,200 17%

Capital

------------------------------------------------------------------------------------------------

Illustration 2: From the data given in Illustration 1 prepare Common-size

Income Statement and Balance Sheet.

MURUGAN LIMITED

COMMON-SIZE INCOME STATEMENT

For the years ended 31st December 2004 and 2005

-----------------------------------------------------------------------------------------------

(Figures in percentages)

2004 2005

------------------------------------------------------------------------------------------------

Net sales 100 100

Cost of goods sold 75 75

-----------------------

Gross profit 25 25

-----------------------

Operating Expenses:

Administrative Expenses 2.50 2

Selling Expenses 3.75 4

-----------------------

Total operating expenses 6.25 6

------------------------

Operating Profit 18.75 19

---------------------

------------------------------------------------------------------------------------------------

122

MURUGAN LIMITED

COMMON-SIZE INCOME STATEMENT

As on 31st December 2004 and 2005

------------------------------------------------------------------------------------------------

2004 2005

Assets % %

100 100

------------------------------------------------------------------------------------------------

Current Assets:

Cash 7.70 9.2

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 6.58

----------------------------------

Total fixed assets 61.54 51.31

----------------------------------

Total assets 100 100

------------------------------------------------------------------------------------------------

2004 2005

% %

Liabilities and Capital 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:

6% Debentures 7.69 9.86

Capital & Reserves:

6% Preference share capital 23.10 19.72

Equity share capital 30.76 26.32

Reserves: 15.38 16.15

123

---------------------------------

Total shareholders funds 76.93 72.05

----------------------------------

Total Liabilities and Capital 100 100

-----------------------------------------------------------------------------------------------

Illustration 3: From the following data relating to the assets side of the Balance

Sheet of Thirumal Limited for the period 31st December 2002 to 31st December

2005, you are required to calculate the trend percentages taking 2002 as the base

year.

(Rupees in Thousands)

-----------------------------------------------------------------------------------------------

Assets As on 31st December

2002 2003 2004 2005

-----------------------------------------------------------------------------------------------

Cash 1,000 1,200 800 1,400

Debtors 2,000 2,500 3,250 4,000

Stock in Trade 3,000 4,000 3,500 5,000

Other current assets 500 750 1,250 1,500

Land 4,000 5,000 5,000 5,000

Building 8,000 10,000 12,000 15,000

Plant 10,000 10,000 12,000 15,000

-------------------------------------------------------------

28,500 33,450 37,800 46,900

-------------------------------------------------------------------------------------------------

Solution:

COMPARATIVE BALANCE SHEET

As on December 31, 2002-2005

-------------------------------------------------------------------------------------------------

December 31 Trend

Percentages

(Rs. in thousands) Base year 2002

Assets ---------------------------------------------------------------------

2002 2003 2004 2005 2002 2003 2004 2005

-------------------------------------------------------------------------------------------------

Current Assets:

Cash 1,000 1,200 800 1,400 100 120 080 140

Debtors 2,000 2,500 3,250 4,000 100 125 163 200

124

Stock-in

-trade 3,000 4,000 3,500 5,000 100 133 117 167

Other

current

assets 500 750 1,250 1,500 100 150 250 300

--------------------------------------------------------------------------------------

Total

Current

assets 6 ,500 8,450 8,800 11,900 100 130 135 183

----------------------------------------------------------------------------------------

Fixed Assets:

Land 4,000 5,000 5,000 5,000 100 125 125 125

Building 8,000 10,000 12,000 15,000 100 125 150 187.5

Plant 10,000 10,000 12,000 15,000 100 100 120 150

----------------------------------------------------------------------------------------

Total

Fixed

Assets 22,000 25,000 29,000 35,000 100 114 132 159

-------------------------------------------------------------------------------------------------

3.1.3.5 MEANING AND NATURE OF RATIO ANALYSIS

Ratio expresses numerical relationship between two numbers. In the

words of Kennedy and McMullen, "The relationship of one item to another

expressed in simple mathematical form is known as a ratio". Thus, the ratio is a

measuring device to judge the growth, development and present condition of a

concern. It plays an important role in measuring the comparative significance of

the income and position statement. Accounting ratios are expressed in the form

of time, proportion, percentage, or per one rupee. Ratio analysis is not only a

technique to point out relationship between two figures but also points out the

devices to measure the fundamental strengths or weaknesses of a concern. As

James C.Van Horne observes: "To evaluate the financial condition and

performance of a firm, the financial analyst needs certain yardsticks. One of the

yardsticks frequently used is a ratio. The main purpose of ratio analysis is to

measure past performance and project future trends. It is also used for inter-firm

and intra-firm comparison as a measure of comparative productivity. The

125

significance of the various components of financial statements can be judged

only by ratio analysis. The financial analyst X-Rays the financial conditions of a

concern by the use of various ratios and if the conditions are not found to be

favourable, suitable steps can be taken to overcome the limitations. The main

objectives of ratio analysis are:

(i) to simplify the comparative picture of financial statements.

(ii) to assist the management in decision making.

(iii) to guage the profitability, solvency and efficiency of an

enterprise, and

(iv) to ascertain the rate and direction of change and future

potentiality.

Financial ratios may be categorised in various ways. Van Horne has

divided financial ratios into four categories, viz., liquidity, debt, profitability and

coverage ratios. The first two types of ratios are computed from the balance

sheet. The last two are computed from the income statement and, sometimes,

from both the statements. For the purpose of analysis the present lesson gives a

detailed description of ratios, the formula used for their computation and their

significance. The ratios have been categorised under the following headings:-

(i) Ratios for analysis of Capital Structure or Leverage.

(ii) Ratios for Fixed Assets Analysis.

(iii) Ratios for Analysis of Turnover.

(iv) Ratios for Analysis of Liquidity Position.

(v) Ratios for Analysis of Profitability.

(vi) Ratios for Analysis of Operational Efficiency.

3.1.3.6 CAPITAL STRUCTURE OR LEVERAGE RATIOS

Financial strength indicates the soundness of the financial resources of

an organisation to perform its operations in the long run. The parties associated

with the organisation are interested in knowing the financial strength of the

126

organisation. Financial strength is directly associated with the operational ability

of the organisation and its efficient management of resources. The financial

strength analysis can be made with the help of the following ratios:

(1) Debt-Equity Ratio

(2) Capital Gearing Ratio

(3) Financial Leverage

(4) Proprietary Ratio and

(5) Interest Coverage.

Debt-Equity Ratio: The debt-equity ratio is determined to ascertain the

soundness of the long-term financial policies of the company. This ratio

indicates the proportion between the shareholders' funds (i.e. tangible networth)

and the total borrowed funds. Ideal ratio is 1. In other words, the investor

may take debt equity ratio as quite satisfactory if shareholders' funds are equal

to borrowed funds. However, creditors would prefer a low debt-equity ratio as

they are much concerned about the security of their investment. This ratio can be

calculated by dividing the total debt by shareholders' equity. For the purpose of

calculation of this ratio, the term shareholders' equity includes share capital,

reserves and surplus and borrowed funds which includes both long-term funds

and short-term funds.

Debt

DEBT-EQUITY RATIO = -----------

Equity

A high ratio indicates that the claims of creditors are higher as compared

to owners' funds and a low debt-equity ratio may result in a higher claim of

equity.

Capital Gearing Ratio: This ratio establishes the relationship between the fixed

interest-bearing securities and equity shares of a company.

127

It is calculated as follows:

Fixed Interest-bearing securities

Capital Gearing Ratio = ---------------------------------------

Equity Shareholders' Funds

Fixed-interest bearing securities carry with them the fixed rate of

dividend or interest and include preference share capital and debentures.

A firm is said to be highly geared if the lion's share of the total capital is

in the form of fixed interest-bearing securities or this ratio is more than

one. If this ratio is less than one, it is said to be low geared. If it is

exactly one, it is evenly geared. This ratio must be carefully planned as

it affects the firm's capacity to maintain a uniform dividend policy

during difficult trading periods that may occur. Too much capital should

not be raised by way of debentures, because debentures do not share in

business losses.

Financial Leverage Ratio: Financial leverage results from the presence of fixed

financial charges in the firm's income stream. These fixed charges do not vary

with the earnings before interest and tax (EBIT) or operating profits. They have

to be paid regardless of the amount of earnings before interest and taxes

available to pay them. After paying them, the operating profits (EBIT) belong to

the ordinary shareholders. Financial leverage is concerned with the effects of

changes in earnings before interest and taxes on the earnings available to equity

holders. It is defined as the ability of a firm to use fixed financial charges to

magnify the effects of changes in EBIT on the firm's earning per share.

Financial leverage and trading on equity are synonymous terms. The EBIT is

calculated by adding back the interest (interest on loan capital + interest on long

term loans + interest on other loans) and taxes to the amount of net profit.

Financial leverage ratio is calculated by dividing EBIT by EBT (earnings before

128

tax). Neither a very high leverage nor a very low leverage represents a sound

picture. (EBIT ÷ EBT).

Proprietary Ratio: This ratio establishes the relationship between the

proprietors' funds and the total tangible assets. The general financial strength of

a firm can be understood from this ratio. The ratio is of particular importance to

the creditors who can find out the proportion of shareholders' funds in the

capital assets employed in the business. A high ratio shows that a concern is less

dependent on outside funds for capital. A high ratio suggests sound financial

strength of a firm due to greater margin of owners' funds against outside sources

of finance and a greater margin of safety for the creditors. A low ratio indicates

a small amount of owners' funds to finance total assets and more dependence on

outside funds for working capital. In the form of formula this ratio can be

expressed as:-

Net Worth

Proprietary Ratio = ---------------

Total Assets

Interest Coverage: This ratio measures the debt servicing capacity of a firm in

so far as fixed interest on long-term loan is concerned. It is determined by

dividing the operating profits or earnings before interest and taxes (EBIT) by the

fixed interest charges on loans. Thus,

EBIT

Interest Coverage = ----------

Interest

It should be noted that this ratio uses the concept of net profits

before taxes because interest is tax-deductible so that tax is calculated

after paying interest on long-term loans. This ratio, as the name suggests,

shows how many times the interest charges are covered by the EBIT out

of which they will be paid. In other words, it indicates the extent to

which a fall in EBIT is tolerable in the sense that the ability of the firm

129

to service its debts would not be adversely affected. From the point of

view of creditors, the larger the coverage, the greater the ability of the

firm to handle fixed-charge liabilities and the more assured the payment

of interest to the creditors. However, too high a ratio may imply unused

debt capacity. In contrast, a low ratio is danger signal that the firm is

using excessive debt and does not have the ability to offer assured

payment of interest to the creditors.

3.1.3.7 FIXED ASSETS ANALYSIS

The successful operation of a business generally requires some

assets of fixed character. These assets are used primarily in producing

goods and in operating the business. With the help of these, raw

materials are converted into finished products. Fixed assets are not

meant for sale and are kept as a rule permanently in the business in order

to carry on day-to-day operations.

Analysis of fixed assets is very important from investors' point of

view because investors are more concerned with long term assets. Fixed

assets are property of non-current nature which are acquired to provide

facilities to carry on business. They include land, building, equipment,

furniture, etc. They are generally shown in balance sheet by aggregating

them into groups of gross block as reduced by the accumulated amount

of depreciation till date. Investment in fixed assets is of a permanent

nature and therefore should be financed by owners' funds (permanent

sources of funds). The owners' funds should be sufficient to provide for

fixed assets. Fixed assets are generally financed by owners' equity and

long-term borrowings. The long-term borrowings are in the form of longterm

loans and of almost permanent nature. Under such a situation it

becomes more or less irrelevant to relate the fixed assets with only the

130

owners' equity. Therefore, the analysis of the source of financing of

fixed assets has been done with the help of the following ratios:-

(a) Fixed Assets to Net Worth

(b) Fixed Assets to Long-term Funds

Fixed Assets to Net Worth: In the words of Anil B.Roy Choudhary, "this ratio

indicates the relationship between Net Worth (i.e. shareholders' funds) and

investments in net fixed assets (i.e. Gross Block minus depreciation)".

The higher the ratio the lesser would be the protection to

creditors. If the ratio is less than 1, it indicates that the net worth

exceeds fixed assets. It will further indicate that the working capital is

partly financed by shareholders' funds. If the ratio exceeds 1, it would

mean that part of the fixed assets has been provided by creditors. The

formula for derivation of this ratio is:-

Net Fixed Assets

Fixed Assets to Net Worth Ratio = ------------------------

Net Worth

Fixed Assets to Long-term Funds: This ratio establishes the relationship

between the fixed assets and long-term funds and it is obtained by the formula:

Fixed Assets

FIXED ASSET RATIO = ------------------------

Long-term Funds

The ratio should be less than one. If it is less than one, it shows

that a part of the working capital has been financed through long-term

funds. This is desirable because a part of working capital termed as "core

working capital" is more or less of a fixed nature. The ideal ratio is 0.67.

If this ratio is more than one, it indicates that a part of current

liability is invested in long-term assets. This is a dangerous position.

Fixed assets include "net fixed assets" i.e. original cost less depreciation

131

to date and trade investments including shares in subsidiaries. Long-term

funds include share capital, reserves and long-term borrowings.

3.1.3.8 ANALYSIS OF TURNOVER (OR) ANALYSIS OF EFFICIENCY

Turnover ratios also referred to as Activity Ratios are concerned

with measuring the efficiency in asset management. Sometimes, these

ratios are also called as efficiency ratios or asset utilisation ratios. The

efficiency with which the assets are used would be reflected in the speed

and rapidity with which assets are converted into sales. The greater the

rate of turnover or conversion, the more efficient the

utilisation/management, other things being equal. For this reason such

ratios are also designated as turnover ratios. Turnover is the primary

mode for measuring the extent of efficient employment of assets by

relating the assets to sales. An activity ratio may, therefore, be defined

as a test of the relationship between sales (more appropriately with cost

of sales) and the various assets of a firm. Depending upon the various

types of assets, there are various types of activity ratios. Some of the

more widely used turnover ratios are:-

(1) Fixed Assets Turnover Ratio

(2) Current Assets Turnover Ratio

(3) Working Assets Turnover Ratio

(4) Inventory (or stock) Turnover Ratio

(5) Debtors Turnover Ratio

(6) Creditors Turnover Ratio

Fixed Assets Turnover Ratio: The Fixed Assets Turnover Ratio measures the

efficiency with which the firm is utilising its investment in fixed assets, such as

land, building, plant and machinery, furniture, etc. It also indicates the adequacy

of sales in relation to investment in fixed assets. The fixed assets turnover ratio

132

is sales divided by the net fixed assets (i.e., the depreciated value of fixed

assets).

Sales

Fixed Assets Turnover Ratio = -----------------------

Net Fixed Assets

The turnover of fixed assets can provide a good indicator for

judging the efficiency with which fixed assets are utilised in the firm. A

high fixed assets turnover ratio indicates efficient utilisation of fixed

assets in generating operating revenue. A low ratio signifies idle

capacity, inefficient utilisation and management of fixed assets.

Current Assets Turnover Ratio: The current assets turnover ratio ascertains the

efficiency with which current assets are used in a business. Professor Guthmann

observes that "current assets turnover is to give an overall impression of how

rapidly the total investment in current assets is being turned". This ratio is

strongly associated with efficient utilisation of costs, receivables and inventory.

A higher value of this ratio indicates greater circulation of current assets while a

low ratio indicates a stagnation of the flow of current assets. The formula for the

computation of current assets turnover ratio is:

Sales

Current Assets Turnover Ratio = ---------------------

Current Assets

Working Capital Turnover Ratio: This ratio shows the number of times

working capital is turned-over in a stated period. Working capital turnover ratio

reflects the extent to which a business is operating on a small amount of working

capital in relation to sales. The ratio is calculated by the following formula:-

Sales

Working Capital Turnover Ratio = ---------------------------

Net Working Capital

133

The higher the ratio, the lower is the investment in working

capital and greater are the profits. However, a very high turnover of

working capital is a sign of over trading and may put the firm into

financial difficulties. On the other hand, a low working capital turnover

ratio indicates that working capital is not efficiently utilised.

Inventory Turnover Ratio: The inventory turnover ratio, also known as stock

turnover ratio normally establishes the relationship between cost of goods sold

and average inventory. This ratio indicates whether investment in inventory is

within proper limit or not. In the words of S.C.Kuchal, "this relationship

expresses the frequency with which average level of inventory investment is

turned over through operations". The formula for the computation of this ratio

may be expressed thus:

Cost of Goods Sold

Inventory Turnover Ratio = -----------------------------

Average Inventory

In general, a high inventory turnover ratio is better than a low

ratio. A high ratio implies good inventory management. A very high

ratio indicates under-investment in, or very low level of inventory which

results in the firm being out of stock and incurring high stock-out cost. A

very low inventory turnover ratio is dangerous. It signifies excessive

inventory or over-investment in inventory. A very low ratio may be the

results of inferior quality goods, over-valuation of closing inventory,

stock of unsaleable/obsolete goods.

Debtors Turnover Ratio and Collection Period: One of the major activity ratios

is the receivables or debtors turnover ratio. Allied and closely related to this is

the average collection period. It shows how quickly receivables or debtors are

converted into cash. In other words, the debtors turnover ratio is a test of the

liquidity of the debtors of a firm. The liquidity of a firm's receivables can be

134

examined in two ways: (i) debtors/receivables turnover and (ii) average

collection period. The debtors turnover shows the relationship between credit

sales and debtors of a firm. Thus,

Net Credit Sales

Debtors Turnover Ratio = -------------------------

Average Debtors

Net credit sales consists of gross credit sales minus returns if any,

from the customers. Average debtors is the simple average of debtors at

the beginning and at the end of the year.

The second type of ratio measuring the liquidity of a firm's

debtors is the average collection period. This ratio is, in fact, interrelated

with and dependent upon, the receivables turnover ratio. It is

calculated by dividing the days in a year by the debtors turnover. Thus,

Days in year

Average Collection Period = ---------------------

Debtors turnover

This ratio indicates the speed with which debtors/accounts

receivables are being collected. The higher the turnover ratio and shorter

the average collection period, the better the trade credit management and

better the liquidity of debtors. On the other hand, low turnover ratio and

long collection period reflects that payments by debtors are delayed. In

general, short collection period (high turnover ratio) is preferable.

Creditors' Turnover Ratio and Debt Payment Period: Creditors' turnover ratio

indicates the speed with which the payments for credit purchases are made to the

creditors. This ratio can be computed as follows:-

Average Accounts Payable

Creditors' Turnover Ratio = -----------------------------------

Net Credit Purchases

135

The term accounts payable include trade creditors and bills

payable. A high ratio indicates that creditors are not paid in time while a

low ratio gives an idea that the business is not taking full advantage of

credit period allowed by the creditors.

Sometimes, it is also required to calculate the average payment

period or average age of payables or debt period enjoyed to indicate the

speed with which payments for credit purchases are made to creditors. It

is calculated as:

Days in a year

Average age of payables = -----------------------------------

Creditors' Turnover Ratio

Both the creditors' turnover ratio and the debt payment period

enjoyed ratio indicate about the promptness or otherwise in making

payment for credit purchases. A higher creditors' turnover ratio or lower

credit period enjoyed ratio signifies that the creditors are being paid

promptly.

3.1.3.9 ANALYSIS OF LIQUIDITY POSITION

The liquidity ratios measure the ability of a firm to meet its short-term

obligations and reflect the short-term financial strength/solvency of a firm. The

term liquidity is described as convertibility of assets ultimately into cash in the

course of normal business operations and the maintenance of a regular cash

flow. A sound liquid position is of primary concern to management from the

point of view of meeting current liabilities as and when they mature as well as

for assuring continuity of operations. Liquidity position of a firm depends upon

the amount invested in current assets and the nature of current assets. The under

mentioned ratios are used to measure the liquidity position:-

(1) Current Ratio

(2) Liquid (or) Quick Ratio

136

(3) Cash to Current Assets Ratio

(4) Cash to Working Capital Ratio

Current Ratio: The most widely used measure of liquid position of an enterprise

is the current ratio, i.e., the ratio of the firm's current assets to current liabilities.

It is calculated by dividing current assets by current liabilities:

Current Assets

Current Ratio = -----------------------------

Current Liabilities

The current assets of a firm represent those assets which can be in the

ordinary course of business, converted into cash within a short period of time,

normally not exceeding one year and include cash and bank balance, marketable

securities, inventory of raw materials, semi-finished (work-in-progress) and

finished goods, debtors net of provision for bad and doubtful debts, bills

receivable and pre-paid expenses. The current liabilities defined as liabilities

which are short-term maturing obligations to be met, as originally contemplated,

within a year, consist of trade creditors, bills payable, bank credit, provision for

taxation, dividends payable and outstanding expenses. N.L.Hingorani and others

observe: "Current Ratio is a tool for measuring the short-term stability or ability

of the company to carry on its day-to-day work and meet the short-term

commitments earlier". Generally 2:1 is considered ideal for a concern i.e.,

current assets should be twice of the current liabilities. If the current assets are

two times of the current liabilities, there will be no adverse effect on business

operations when the payment of current liabilities is made. If the ratio is less

than 2, difficulty may be experienced in the payment of current liabilities and

day-to-day operations of the business may suffer. If the ratio is higher than 2, it

is very comfortable for the creditors but, for the concern, it indicates idle funds

and lack of enthusiasm for work.

137

Liquid (or) Quick Ratio: Liquid (or) Quick ratio is a measurement of a firm's

ability to convert its current assets quickly into cash in order to meet its current

liabilities. It is a measure of judging the immediate ability of the firm to pay-off

its current obligations. It is calculated by dividing the quick assets by current

liabilities:

Quick Assets

Liquid Ratio = ------------------------

Current Liabilities

The term quick assets refers to current assets which can be

converted into cash immediately or at a short notice without diminution

of value. Thus quick assets consists of cash, marketable securities and

accounts receivable. Inventories are excluded from quick assets because

they are slower to convert into cash and generally exhibit more

uncertainty as to the conversion price.

This ratio provides a more stringent test of solvency. 1:1 ratio is

considered ideal ratio for a firm because it is wise to keep the liquid

assets atleast equal to the current liabilities at all times.

Cash to Current Assets Ratio: Efficient management of the inflow and outflow

of cash plays a crucial role in the overall performance of a business. Cash is the

most liquid form of assets which safeguards the security interest of a business.

Cash including bank balances plays a vital role in the total net working capital.

The ratio of cash to working capital signifies the proportion of cash to the total

net working capital and can be calculated by dividing the cash including bank

balance by the working capital. Thus,

Cash

Cash to Working Capital Ratio = ------------------------

Working Capital

138

Cash is not an end in itself, it is a means to achieve the end.

Therefore, only a required amount of cash is necessary to meet day-today

operations. A higher proportion of cash may lead to shrinkage of

profits due to idleness of resources of a firm.

3.1.3.10 ANALYSIS OF PROFITABILITY

Profitability is a measure of efficiency and control. It indicates the

efficiency or effectiveness with which the operations of the business are carried

on. Poor operational performance may result in poor sales and therefore low

profits. Low profitability may be due to lack of control over expenses resulting

in low profits. Profitability ratios are employed by management in order to

assess how efficiently they carry on business operations. Profitability is the main

base for liquidity as well as solvency. Creditors, banks and financial institutions

are interested in profitability ratios since they indicate liquidity or capacity of

the business to meet interest obligations and regular and improved profits

enhance the long term solvency position of the business. Owners are interested

in profitability for they indicate the growth and also the rate of return on their

investments. The importance of measuring profitability has been stressed by

Hingorani, Ramanathan and Grewal in these words: "A measure of profitability

is the overall measure of efficiency".

An appraisal of the financial position of any enterprise is

incomplete unless its overall profitability is measured in relation to the

sales, assets, capital employed, net worth and earnings per share. The

following ratios are used to measure the profitability position from

various angles:

(1) Gross Profit Ratio

(2) Net Profit Ratio

(3) Return on Capital Employed

(4) Operating Ratio

139

(5) Operating Profit Ratio

(6) Return on Owners' Equity

(7) Earnings Per Share

(8) Dividend Pay Out Ratio

Gross Profit Ratio: The Gross Profit Ratio or Gross Profit Margin Ratio

expresses the relationship of gross profit on sales / net sales. B.R.Rao opines that

"gross profit margin ratio indicates the gross margin of profits on the net sales

and from this margin only, all expenses are met and finally net income

emerges". The basic components for the computation of this ratio are gross

profits and net sales. `Net Sales' means total sales minus sales returns and `gross

profit' means the difference between net sales and cost of goods sold. The

formula used to compute Gross Profit Ratio is:

Gross Profit

Gross Profit Ratio = ------------------ x 100

Sales

Gross profit ratio indicates to what extent the selling prices of

goods per unit may be reduced without incurring losses on operations. A

low gross profit ratio will suggest decline in business which may be due

to insufficient sales, higher cost of production with the existing or

reduced selling price or the alround inefficient management. A high

gross profit ratio is a sign of good and effective management.

Net Profit Ratio: Net profit is a good indicator of the efficiency of a firm. Net

profit ratio or net profit margin ratio is determined by relating net income after

taxes to net sales. Net profit here is the balance of profit and loss account which

is arrived at after considering all non-operating incomes such as interest on

investments, dividends received, etc. and non-operating expenses like loss on

sale of investments, provisions for contingent liabilities, etc. This ratio indicates

net margin earned on a sale of Rs.100. The formula for calculating the ratio is:

140

Net Profit

Net Profit Ratio = ---------------- x 100

Sales

This ratio is widely used as a measure of overall profitability and

is very useful for proprietors. A higher ratio indicates better position.

Return on Capital Employed: The prime objective of making investments in

any business is to obtain satisfactory return on capital invested. Hence, the

return on capital employed is used as a measure of success of a business in

realising this objective. Otherwise known as Return on Investments, this is the

overall profitability ratio. It indicates the percentage of return on capital

employed in the business and it can be used to show the efficiency of the

business as a whole. The formula for calculating the ratio is:

Operating Profit

Return on Capital Employed = -------------------------- x 100

Capital Employed

The term "Capital Employed" means [Share capital + Reserves

and Surplus + Long Term Loans] minus [Non-business assets +

Fictitious assets] and the term "Operating Profit" means profit before

interest and tax. The term `interest' means interest on long-term

borrowings. Non-trading income should be excluded for the above

purpose. A higher ratio indicates that the funds are invested profitably.

Operating Ratio: This ratio establishes the relationship between total operating

expenses and sales. Total operating expenses includes cost of goods sold plus

other operating expenses. A higher ratio indicates that operating expenses are

high, as such profit margin is less and therefore lower the ratio better is the

position. The operating ratio is an index of the efficiency of the conduct of

business operations. An ideal norm for this ratio is between 75% to 85% in a

manufacturing concern. The formula for calculating the operating ratio is thus:

141

Cost of goods sold + Operating experience

Operating Ratio = ----------------------------------------------------- x 100

Sales

Operating Profit Ratio: This ratio indicates net-margin earned on a sale of

Rs.100. It is calculated as follows:

Net Operating Profit

Operating Profit Ratio = ------------------------- x 100

Sales

The operating profit ratio helps in determining the efficiency with

which affairs of the business are being managed. An increase in the ratio

over the previous period indicates improvement in the operational

efficiency of the business provided the gross profit ratio is constant.

Operating profit is estimated without considering non-operating income

such as profit on sale of fixed assets, interest on investments and nonoperating

expenses such as loss on sale of fixed assets. This is thus, an

effective tool to measure the profitability of a business concern.

Return on Owners' Equity (or) Shareholders' Fund (or) the Net Worth:

The ratio of return on owners' equity is a valuable measure for judging the

profitability of an organisation. This ratio helps the shareholders of a firm to

know the return on investment in terms of profits. Shareholders are always

interested in knowing as to what return they earned on their invested capital

since they bear all the risk, participate in management and are entitled to all the

profits remaining after all outside claims including preference dividend are met

in full. This ratio is computed as a percentage by using the formula:

Net Profit after interest and tax

Return on Owners' Equity = ------------------------------------------ x 100

Owners' Equity (Net Worth)

142

This is the single most important ratio to judge whether the firm

has earned a satisfactory return for its equity-shareholders or not. A

higher ratio indicates the better utilisation of owners' fund and higher

productivity. A low ratio may indicate that the business is not very

successful because of inefficient and ineffective management and over

investment in assets.

Earnings Per Share (EPS): The profitability of a firm from the point of view of

the ordinary shareholders is analysed through the ratio `EPS'. It measures the

profit available to the equity shareholders on a per share basis, i.e. the amount

that they can get on every share held. It is calculated by dividing the profits

available to the shareholders by the number of the outstanding shares. The

profits available to the ordinary shareholders are represented by net profit after

taxes and preference dividend.

Net profit after tax – Preference Dividend

Earnings Per Share = ----------------------------------------------------

Number of Equity Shares

This ratio is an important index because it indicates whether the

wealth of each shareholder on a per-share basis has changed over the

period. The performance and prospects of the firm are affected by EPS.

If EPS increases, there is a possibility that the company may pay more

dividend or issue bonus shares. In short, the market price of the share of

a firm will be affected by all these factors.

Dividend Pay Out Ratio: This ratio measures the relationship between the

earnings belonging to the ordinary shareholders and the dividend paid to them.

In other words, the dividend pay out ratio shows what percentage share of the

net profits after taxes and preference dividend is paid out as dividend to the

equity shareholders. It can be calculated by dividing the total dividend paid to

the owners by the earnings available to them. The formula for computing this

ratio is:

143

Dividend per equity share

Dividend payout ratio = ---------------------------------

Earnings per share

This ratio is very important from shareholder's point of view as

its tells him that if a firm has used whole, or substantially the whole of

its earnings for paying dividend and retained nothing for future growth

and expansion purposes, then there will be very dim chances of capital

appreciation in the price of shares of such firms. In other words, an

investor who is more interested in capital appreciation must look for a

firm having low payout ratio.

3.1.3.11 ANALYSIS OF OPERATIONAL EFFICIENCY

The operational efficiency of an organisation is its ability to

utilise the available resources to the maximum extent. Success or failure

of a business in the economic sense is judged in relation to expectations,

returns on invested capital and objectives of the business concern. There

are many techniques available for evaluating financial as well as

operational performance of a firm. The two important techniques adopted

in this study are:

1. Turnover to Capital Employed or Return on Investment (ROI)

2. Financial Operations Ratio

Turnover to Capital Employed: This is the ratio of operating revenue to capital

employed. This is one of the important ratios to find out the efficiency with

which the firms are utilising their capital. It signifies the number of times the

total capital employed was turned into sales volumes. The term capital employed

includes total assets minus current liabilities. The ratio for calculating turnover

to capital employed (in percentage) is:

Operating Revenue

Turnover to capital employed = --------------------------- x 100

Capital Employed

144

The higher the ratio, the better is the position.

Financial Operations Ratio: The efficiency of the financial management of a

firm is calculated through financial operations ratio. This ratio is a calculating

device of the cost and the return of financial charges. This ratio signifies a

relationship between net profit after tax and operating profit. The formula for the

computation of this ratio is:

Net Profit after tax

Financial Operations Ratio = --------------------------- x 100

Operating Profit

Here, the term "operating profit" means sales minus operating

expenses. A higher ratio indicates the better financial performance of the

firm.

3.1.3.12 RATIOS FROM SHAREHOLDERS' POINT OF VIEW

1. Preference Dividend Cover: This ratio expresses Net Profit after tax as so

many times of Preference Dividend Payable. This is calculated as:

Net Profit after tax

---------------------------

Preference Dividend

2. Equity Dividend Cover: This ratio gives information about net profit available

to equity shareholders. This ratio expresses profit as number of times of equity

dividend payable. This ratio is calculated using the following formula:

Net Profit After Tax – Preference Dividend

--------------------------------------------------------

Equity Dividend

3. Dividend Yield on Equity Shares or Yield Ratio: This ratio interprets

dividend as a percentage of Market Price Per Share. It is calculated at:

Dividend Per Share

-------------------------------- x 100

Market Price Per Share

145

4. Price Earning Ratio: This ratio tells how many times of earnings per share is

the market price of the share of a company. The formula to calculate this ratio is:

Market Price Per Share

---------------------------------

Earnings Per Share

3.1.3.13 ILLUSTRATIONS

Illustration 4: The following are the financial statements of Yesye Limited for

the year 2005.

BALANCE SHEET AS AT 31-12-2005

------------------------------------------------------------------------------------------------

Rs. Rs.

Equity Share capital 1,00,000 Fixed Assets 1,50,000

General Reserve 90,000 Stock 42,500

Profit & Loss Balance 7,500 Debtors 19,000

Sundry Creditors 35,000 Cash 61,000

6% Debentures 30,000 Proposed Dividends 10,000

---------- ----------

2,72,500 2,72,500

-----------------------------------------------------------------------------------------------

TRADING AND PROFIT AND LOSS ACCOUNT

for the year ended 31-12-2005

-----------------------------------------------------------------------------------------------

Rs. Rs.

To Cost of goods sold 1,80,000 By Sales 3,00,000

To Gross profit c/d 1,20,000

---------- ----------

3,00,000 3,00,000

---------- ----------

To expenses 1,00,000 By Gross profit b/d 1,20,000

To Net Profit 20,000

---------- ----------

1,20,000 1,20,000

----------------------------------------------------------------------------------------------

146

You are required to compute the following:

1) Current ratio

2) Acid Test ratio

3) Gross Profit ratio

4) Debtors' Turnover ratio

5) Fixed Assets to net tangible worth

6) Turnover to fixed assets

Solution:

Current Assets

1) Current Ratio = ----------------------------

Current Liabilities

1,22,500

= -----------

45,000

= 2.7:1.

Quick Assets

2) Acid Test Ratio = --------------------------

Quick Liabilities

80,000

= -----------

45,000

= 1.8:1.

Gross Profit

3) Gross Profit Ratio = ---------------------- x 100

Sales

1,20,000

= ----------- x 100

3,00,000

= 40%

147

Net Sales

4) Debtors' Turnover = -----------------------

Ratio Average Debtors

3,00,000

= -----------

19,000

= 15.78 times.

No. of days in the year

Collection Period = -----------------------------

Debtors' Turnover

365

= -----------

15.78

= 23 days

Fixed Assets

5) Fixed Asset to Net Tangible Worth = ----------------------- x 100

Proprietor's Fund

1,50,000

= ----------- x 100

1,97,500

= 76%

Net Sales

6) Turnover to Fixed Assets = ------------------

Fixed Assets

3,00,000

= -----------

1,50,000

= 2 times

148

Illustration 5: From the following details prepare a statement of proprietary

fund with as many details as possible.

1) Stock Velocity 6

2) Capital Turnover Ratio 2

3) Fixed Assets Turnover Ratio 4

4) Gross Profit Turnover Ratio 20%

5) Debtors' Velocity 2 months

6) Creditors' Velocity 73 days

Gross profit was Rs.60,000. Reserves and surplus amount to 20,000. Closing

stock was Rs.5,000 in excess of opening stock.

Solution:

1. Calculation of Sales

Gross Profit

Gross Profit Ratio = ---------------

Sales

= 20%

Rs.60,000 20

--------------- = --------

Sales 100

= ---

Sales: Rs.3,00,000

2. Calculation of Sundry Debtors

Debtors

Debtors' Velocity = ------------ x 12 months

Sales

Let Debtors be x

2 = ----------- x 12

3,00,000

149

x 1

------------- = ---

3,00,000 6

x = Rs.50,000

Debtors: Rs.50,000

It is assumed that all sales are credit sales.

3. Calculation of Stock

Cost of goods sold

Stock Turnover Ratio = ---------------------------

Average stock

= 6

Cost of goods sold = Sales – Gross Profit

= Rs.3,00,000 – Rs.60,000

= Rs.2,40,000

Rs.2,40,000

------------------ = 6

Average Stock

Rs.2,40,000

Average Stock = ---------------

= Rs.40,000

Opening stock + Closing stock

Average Stock = --------------------------------------

Let opening stock be Rs.x.

Then closing stock will be x + 5,000

x + x + 5,000

---------------- = 40,000

2x + 5,000

------------ = 40,000

150

Cross multiplying

2x + 5,000 = 80,000

2x = 80,000 – 5,000

= 75,000

x = 37,500

Opening stock Rs.37,500

Closing stock Rs.42,500

4. Calculation of Creditors

Total Creditors

Creditors' velocity = ------------------------------ x 365

days

Credit Purchases

= 73 days

Purchase = Cost of goods + Closing Stock – Opening stock

= Rs.2,40,000 + 42,500 – 37,500

= Rs.2,45,000

Let the creditors be x

-------------- x 365 = 73

2,45,000

365 x = 2,45,000 x 73

2,45,000 x 73

x = ----------------

365

Creditors = Rs.49,000

5. Calculation of Fixed Assets

Costs of goods sold

Fixed Assets Turnover Ratio = -----------------------------

Fixed Assets

= 4

151

Let Fixed assets be x

2,40,000

---------- = 4

x = 60,000

Fixed Assets = Rs.60,000

6. Shareholders' Fund

Cost of goods sold

Capital Turnover Ratio = ----------------------- = 2

Proprietary Fund

2,40,000

--------------------- = 2

Proprietary Fund

Proprietary Fund = Rs.1,20,000

Shareholders' fund includes Share capital, Profit & Reserve.

Share Capital = Shareholders' Fund – (Profit + Reserve)

= Rs.1,20,000 – Rs.80,000

= Rs.40,000

7. Calculation of Bank Balance

Shareholders' Fund + Current Liabilities = Fixed Assets + Current Assets

Rs.1,20,000 + 49,000 = Rs.60,000 + Current Assets

Current Assets = Rs.1,09,000

Current Assets = Stock + Debtors + Bank Balance

Bank Balance = Current Assets – (Stock + Debtors)

= Rs.1,09,000 – (42,500 + 50,000)

= Rs.1,09,000 – 92,500

= Rs.16,500

152

Balance Sheet as on …

-----------------------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

-----------------------------------------------------------------------------------------------

Share capital 40,000 Fixed Assets 60,000

Reserves & Surplus 20,000 Current Assets:

Profit 60,000 Stock 42,500

Current liabilities 49,000 Debtors 50,000

Bank 16,500

1,09,000

---------- -- - ----------

1,69,000 1,69,000

-----------------------------------------------------------------------------------------------

Illustration 6: The following data is furnished:

a) Working capital Rs.45,000

b) Current ratio 2.5

c) Liquidity ratio 1.5

d) Proprietary ratio – (Fixed assets

to proprietary funds) 0.75

e) Overdraft Rs.10,000

f) Retained earnings Rs.30,000

There are no long term loans and fictitious assets.

Find out:

1) Current assets

2) Current liabilities

3) Fixed assets

4) Quick assets

5) Quick liabilities

6) Stock

7) Equity

Solution:

Current Assets

Current assets 2.5

Current liability 1.0

---

Working capital 1.5

153

If working capital is 1.5, current asset will be 2.5.

If working capital is Rs.45,000, current assets will be Rs.75,000

Current Assets = Rs.75,000

Current Liability

Current Liability = Current assets – Working capital

= Rs.75,000 – Rs.45,000

= Rs.30,000

Fixed Assets

Shareholders' Fund+ Current Liabilities = Fixed Assets + Current Assets

Shareholders' Fund=Fixed assets + Current assets – Current Liabilities

= Fixed assets + Rs.75,000 – Rs.30,000

= Fixed assets + Rs.45,000

Let the shareholders' fund be x, fixed assets will be ¾ x

x = Rs. ¾ x + Rs.45,000

¼ x = Rs.45,000

x = Rs.1,80,000

¾ x = Rs.1,35,000

Fixed assets = Rs.1,35,000

∴Shareholders Funds = Rs.1,35,000 + Rs.45,000

= Rs.1,80,000

Stock

Quick assets

Liquid ratio = -------------------

Quick liabilities

Quick assets = Current assets – Stock

154

Quick liabilities = Current liabilities – Bank overdraft

Let the value of stock be x.

Quick assets Rs.75,000 – x

-------------------- = ---------------------

Quick liabilities 30,000 – 10,000

75,000 - x

= ------------- = 1.5

20,000

Cross multiplying

75,000 – x = 20,000 x 1.5

75,000 – x = 30,000

x = 45,000

Stock = Rs.45,000

Quick Assets = Rs.75,000 – Rs.45,000

= Rs.30,000

Quick Liabilities = Rs.20,000

Equity

Shareholders' Fund = Equity + Retained earnings

Shareholders' Fund = Rs.1,80,000 (as calcualted)

Retained earnings = Rs.30,000 (as given)

Equity = Rs.1,50,000

Illustration 7: From the following balance sheet of Dinesh Limited calculate (i)

Current ratio (ii) Liquid ratio (iii) Debt-equity ratio (iv) Proprietary ratio, and (v)

Capital gearing ratio.

Balance Sheet of Dinesh Limited as on 31-12-2005

-----------------------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

-----------------------------------------------------------------------------------------------

Equity share capital 10,00,000 Goodwill 5,00,000

6% preference capital 5,00,000 Plant & Machinery 6,00,000

Reserves 1,00,000 Land & Buildings 7,00,000

Profit & Loss a/c 4,00,000 Furniture 1,00,000

Tax provision 1,76,000 Stock 6,00,000

Bills payable 1,24,000 Bills receivables 30,000

Bank overdraft 20,000 Sundry debtors 1,50,000

155

Sundry creditors 80,000 Bank account 2,00,000

12% debentures 5,00,000 Short term investment 20,000

------------ -----------

29,00,000 29,00,000

-----------------------------------------------------------------------------------------------

Current Assets

(i) Current = ------------------------

ratio Current Liabilities

Stock + Bills receivables + Debtors + Bank + S.T. Investments

= ----------------------------------------------------------------------

S.Creditors + Bills Payable + Bank O.D. + Tax Provision

10,00,000

= ------------ = 2.5 : 1.

4,00,000

Interpretation: The current ratio in the said firm is 2.5:1 against a standard ratio

of 2:1. It is a good sign of liquidity. However, the stock is found occupying 60

percent of current assets which may not be easily realisable.

Current Assets – Stocks

(ii) Liquid ratio = --------------------------------

Current Liabilities

Liquid Assets

= ------------------------

Current Liabilities

4,00,000

= ----------

4,00,000

= 1:1.

156

Interpretation: The standard for quick ratio is 1:1. The calculated ratio in case

of Dinesh Limited is also 1:1. The above two ratios show the safety in respect of

liquidity in the said firm.

Long term Debt

(iii) Debt Equity ratio = -------------------------------------

Equity Shareholders' Fund

Debentures

= ----------------------------------------------------------------------------

Equity capital + Preference capital + Reserves + Profit & Loss a/c

5,00,000

= ----------------------------------------------------------------

10,00,000 + 5,00,000 + 1,00,000 + 4,00,000

= 1:4.

Interpretation: Debt-equity ratio indicates the firm's long term solvency. It can

be observed that the firm's long term loans are constituting 25 percent to that of

the owners' fund. Although such a low ratio indicates better long term solvency,

the less use of debt in capital structure may not enable the firm to gain from the

full stream of leverage effects.

Proprietors' Funds

(iv) Proprietary ratio = ---------------------------

Total assets

20,00,000

= ------------ = 20:29

29,00,000

Interpretation: Out of total assets, seven-tenths are found financed by owners'

funds. In other words a large majority of long term funds are well invested in

various long term assets in the firm.

Owners' resources

(v) Capital gearing ratio = -------------------------------------------

Fixed-interest bearing resources

157

Equity Share Capital + Reserves + P&L A/c

= --------------------------------------------------------

Preference Capital + Debentures

10,00,000 + 1,00,000 + 4,00,000

= --------------------------------------------

5,00,000 + 5,00,000

15,00,000

= --------------- = 1.5:1.

10,00,000

Interpretation: Keeping Rs.15 lakhs of equity funds as security, the firm is

found to have mobilised Rs.10 lakhs from fixed interest bearing sources. It

indicates that the capital structure is low geared.

Illustration 8: The following are the balance sheet and profit and loss account of

Sundara Products Limited as on 31st December 2005.

Profit and Loss Account

To opening stock 1,00,000 By Sales 8,50,000

Purchases 5,50,000 Closing stock 1,50,000

Direct expenses 15,000

Gross profit 3,35,000

------------ ------------

10,00,000 10,00,000

------------ ------------

To Admn. expenses 50,000 By Gross profit 3,35,000

Office establishment 1,50,000 Non-operating income 15,000

Financial expenses 50,000

Non-Operating

Expenses/losses 50,000

Net profit 50,000

----------- -----------

3,50,000 3,50,000

-----------------------------------------------------------------------------------------------

158

Balance Sheet

-----------------------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

-----------------------------------------------------------------------------------------------

Equity share capital Land & Buildings 1,50,000

(2000 @ 100) 2,00,000 Plant & Machinery 1,00,000

Reserves 1,50,000 Stock in trade 1,50,000

Current Liabilities 1,50,000 Sundry Debtors 1,00,000

P&L a/c Balance 50,000 Cash & Bank 50,000

---------- -----------

5,50,000 5,50,000

---------- -----------

-----------------------------------------------------------------------------------------------

Calculate turnover ratios.

Solution:

(i) Share capital to turnover ratio

Sales

= ----------------------------------

Total Capital Employed

Sales

= ---------------------------------------------------

Equity + Reserve + P & L a/c Balance

8,50,000

= ----------

4,00,000

= 2.13 times.

Interpretation: This turnover ratio indicates that the firm has actually converted

its share capital into sales for about 2.13 times. This ratio indicates the

efficiency in use of capital resources and a high turnover ratio ensures good

profitability on operations on an enterprise.

(ii) Fixed Asset's Turnover Ratio

Sales

= ----------------------------

Total Fixed Assets

159

Sales

= ------------------------------------

Land + Plant & Machinery

8,50,000

= ----------

2,50,000

= 3.4 times.

Interpretation: Although fixed assets are not directly involved in the process of

generating sales, these are said to back up the production process. A ratio of 3.4

times indicates the efficient utilisation of various fixed assets in this

organisation.

(iii) Net Working Capital Turnover:

Sales

= ----------------------------

Net Working Capital

Sales

= -----------------------------------------------

Current Assets – Current Liabilities

8,50,000

= -----------------------

3,00,000 – 1,50,000

= 5.67 times.

Interpretation: Net working capital indicates the excess of current assets

financed by permanent sources of capital. An efficient utilisation of such funds

is of prime importance to ensure sufficient profitability along with greater

liquidity. A turnover ratio of 5.7 times is really appreciable.

(iv) Average Collection Period:

Credit Sales

Debtor's turnover = -----------------------

Average Debtors

Assuming that 80% of the sales of 8,50,000 as credit sales:

160

6,80,000

= ----------

1,00,000

= 6.8 times

Average collection period

360 days

= ---------------------------

Debtors' Turnover

360

= -------

6.8

= 53 days

Interpretation: Average collection period indicates the time taken by a firm in

collecting its debts. The calculated ratio shows that the realisation of cash on

credit sales is taking an average period of 53 days. A period of roughly two

months indicate that the credit policy is liberal and needs a correction.

(v) Stock Turnover Ratio

Cost of goods sold

= ---------------------------

Average stock

Sales – Gross Profit

= ------------------------------------------------

(Opening stock + Closing stock) + 2

5,15,000

= ----------

1,25,000

= 4.12 times.

161

Interpretation: Stock velocity indicates the firm's efficiency and profitability.

The stock turnover ratio shows that on an average inventory balances are cleared

once in 3 months. Since there is no standard for this ratio, the period of

operating cycle of this firm is to be compared with the industry average for

better interpretation.

Illustration 9: Comment on the performance of Arasu Limited from the ratios

given below:

Industry Average Ratios of

Ratios Arasu Ltd.

1. Current ratio 2:1 2.5:1

2. Debt-equity ratio 2:1 1:1

3. Stock turnover ratio 9.5 3.5

4. Net profit margin ratio 23.5% 15.1%

Solution:

(i) Current ratio: The ratio indicates the liquidity position of a firm. The ability

of a firm in meeting its current liabilities could be understood by this ratio. The

calculated results show that the liquidity in Arasu Limited is even greater than

industry average, showing the safety. However, excess liquidity locks up the

capital in unnecessary current assets.

(ii) Debt-equity ratio: It is an indicator of a firm's solvency in terms of its ability

to repay long term loans in time. The calculated ratio shows better solvency of

1:1 indicating that for every one rupee of debt capital, to repay one rupee of

equity base exists in Arasu Ltd. However, this ratio is not likely to ensure the

leverage benefits that a firm gains by using higher dose of debt.

(iii) Stock turnover ratio: Stock velocity is an indicator of a firm's activeness. It

directly influences the profitability of a firm. The calculated ratio for Arasu Ltd.

is very poor when compared to industry average. This poor ratio indicates the

inefficient use of capacities, consequently, the likely low profitability.

(iv) Net Profit margin ratio: Although the firms in a particular industry could

sell the product more or less at same price, the net profits differ among firms due

to their cost of production, excessive administrative and establishment expenses

162

etc. This picture is found true in case of Arasu Ltd. A poor profitability of 15.1%

compared to an industry average of 23.5% may be due to low stock turnover,

inefficiency in management, excess overhead cost and excessive interest

burdens.

3.1.3.14 SUMMARY

Financial statements by themselves do not give the required

information both for internal management and for outsiders. They must

be analysed and interpreted to get meaningful information about the

various aspects of the concern. Analysing financial statements is a

process of evaluating the relationship between the component parts of

the financial statements to obtain a proper understanding of a firm's

performance. Financial analysis may be external or internal analysis or

horizontal or vertical analysis. Financial analysis can be carried out

through a number of tools like Ratio analysis, Funds flow analysis, Cash

flow analysis etc. Among the various tools available for their analysis,

ratio analysis is the most popularly used tool. The main purpose of ratio

analysis is to measure past performance and project future trends. It is

also used for inter-firm and intra-firm comparison as a measure of

comparative productivity. The financial analyst X-rays the financial

conditions of a concern by the use of various ratios and if the conditions

are not found to be favourable, suitable steps can be taken to overcome

the limitations.

3.1.3.15 KEY WORDS

Analysis: Analysis means methodical classification of the data given in the

financial statements.

Interpretation: Interpretation means explaining the meaning and significance of

the data so classified.

Financial Statements: Income statement and Balance sheet.

163

Ratio: The relationship of one item to another expressed in simple mathematical

form is known as a ratio.

Ratio Analysis: This process of computing, determining and presenting the

relationship of items and groups of items in financial statements.

Financial Leverage: The ability of a firm to use fixed financial charges to

magnify the effects of changes in EBIT on the firm's earnings per share.

Net Worth: Proprietors' funds – Intangible Assets – Fictitious Assets.

Debt: Both long term and short term liabilities.

Operating Profit: Gross Profit – Operating expenses.

Equity: Proprietors' fund.

Capital Employed: Net worth + long term liabilities.

3.1.3.16 SELF ASSESSMENT QUESTIONS

1. Explain the meaning of the term `Financial Statements'. State their nature

and limitations.

2. Explain the different types of financial analysis.

3. Explain the various tools of financial analysis.

4. Justify the need for analysis and interpretation of financial statements.

5. Collect the annual reports of any public limited company for a period of 5

years. Calculate the trend percentages and prepare a report.

6. What is meant by Ratio Analysis? Explain its significance in the analysis

and interpretation of financial statements.

7. Explain the importance of Ratio analysis in making comparisons between

firms.

8. How the ratios are broadly classified? Explain how ratios are calculated

under each classification.

9. What are the limitations of Ratio Analysis?

10. From the below given Summary Balance Sheet calculate current ratio and

long term solvency ratio.

164

Balance Sheet as on 31st December 2005

-----------------------------------------------------------------------------------------------

Liabilities Rs. Assets Rs.

-----------------------------------------------------------------------------------------------

Share capital 4,00,000 Fixed assets 4,00,000

Long term loans 2,00,000 Current assets 4,00,000

Current liabilities 2,00,000

---------- -----------

8,00,000 8,00,000

-----------------------------------------------------------------------------------------------

11. From the following trading and profit and loss account and balance sheet

calculate (i) stock turnover ratio (ii) debtors' velocity (iii) sales to working

capital (iv) sales to total capital employed (v) return on investment (vi)

current ratio (vii) net profit ratio and (viii) operating ratios.

Trading and Profit and Loss Account

-----------------------------------------------------------------------------------------------

Rs. Rs.

To Opening stock 1,00,000 By Sales 10,00,000

Purchase 5,50,000 Closing stock 1,50,000

Gross profit 5,00,000

----------- ------------

11,50,000 11,50,000

----------- ------------

Gross Profit 5,00,000

Admn. Expenses 1,50,000

Interest 30,000

Selling expenses 1,20,000

Net profit 2,00,000

---------- ------------

5,00,000 5,00,000

-----------------------------------------------------------------------------------------------

165

Balance Sheet

-----------------------------------------------------------------------------------------------

Share capital 10,00,000 Land & Building 5,00,000

Profit & Loss a/c 2,00,000 Plant & Machinery 3,00,000

S.Creditors 2,50,000 Stock 1,50,000

Bills payable 1,50,000 Debtors' 1,50,000

Bills receivable 1,25,000

Cash in hand 1,75,000

Furniture 2,00,000

------------ ------------

16,00,000 16,00,000

-----------------------------------------------------------------------------------------------

12. Triveni Engineering Limited has the following capital structure:

9% Preference shares of Rs.100 each 10,00,000

Equity shares of Rs.10 each 40,00,000

------------

50,00,000

------------

The following information relates to the financial year just ended:

Profit after taxation 22,00,000

Equity Dividend paid 20%

Market price of Equity shares Rs.20 each

You are required to find

(a) Dividend yield on equity shares

(b) The cover for preference and equity dividend

(d) P/E ratio

3.1.3.17 KEY TO SELF ASSESSMENT QUESTIONS (For Problems only)

Q.No.10: Current ratio: 2:1; Debt equity ratio: 1:2 or 1:1.

Q.No.11: (i) 4 times; (ii) 100 days; (iii) 5 times; (iv) 0.83 times; (v)

19.17%; (vi) 1.5:1; (vii) 20%; (viii) 77%.

Q.No.12: (a) 10%; (b) 24.4 times and 2.6 times (c) Rs.5.275; (d) 3.8 times.

166

3.1.3.18 CASE ANALYSIS

The following figures are extracted from the Balance Sheets of a

Company:

2002-03 2003-04 2004-05

Rs. Rs. Rs.

Assets

Buildings 12,000 10,000 20,000

Plant and Equipment 10,000 15,000 10,000

Stock 50,000 50,000 70,000

Debtors 30,000 50,000 60,000

-----------------------------------------------

1,02,000 1,25,000 1,60,000

-----------------------------------------------

Liabilities

Paid up Capital (Rs.10 shares – 56,000 56,000 56,000

Rs.7-50 paid up)

Profit & Loss A/c 10,000 13,000 15,000

Trade Creditors 11,000 26,000 39,000

Bank 25,000 30,000 50,000

----------------------------------------------

1,02,000 1,25,000 1,60,000

----------------------------------------------

Sales 1,00,000 1,50,000 1,50,000

Gross Profit 25,000 30,000 25,000

Net Profit 5,000 7,000 5,000

Dividend Paid 4,000 4,000 3,000

The opening stock at the beginning of the year 2002-03 was

Rs.4,000. As a financial analyst comment on the comparative short-term,

167

activity, solvency, profitability and financial position of the company

during the three year period.

Solution:

To test the short-term solvency the following ratios are calculated for

three years:

i. Current Ratio and

ii. Quick Ratio

(i) Current Ratio:

2002-03 2003-04 2004-05

Current Assets 80,000 1,00,000 1,30,000

------------------------ -------- ----------- -----------

Current Liabilities 36,000 56,000 89,000

2.22:1 1.80:1 1.46:1

(ii) Quick Ratio:

2002-03 2003-04 2004-05

Quick Assets (Debtors) 30,000 50,000 60,000

--------------------------------- -------- -------- --------

Quick Liabilities (Creditors) 11,000 26,000 39,000

2.7:1 1.9:1 1.5:1

As the standard for Current Ratio is 2:1 the working capital position of

the company has weakened in the 2nd year and 3rd year. However the Quick

Ratio for all the three years is well above the standard of 1:1. Thus it can be said

that the short term solvency position of the company shows a mixed trend.

Activity Ratios: To test the operational efficiency of the company the following

ratios are calculated. Debtors Turnover Ratio and Inventory Turnover Ratio.

168

Debtors Turnover Ratio:

2002-03 2003-04 2004-05

Sales 1,00,000 1,50,000 1,50,000

-------------------- ---------- ---------- ----------

Average Debtors 30,000 40,000 55,000

3.33 times 3.75 times 2.73 times

The sales as a number of times of debtors has improved in the

year 2003-04 but has deteriorated in the year 2004-05.

Inventory Turnover Ratio:

2002-03 2003-04 2004-05

Cost of Goods Sold (Sales – G.P.) 75,000 1,20,000 1,25,000

----------------------------------------- --------- ---------- ----------

O.S + C.S 27,000 50,000 60,000

Average Stock (--------------)

2 2.78 times 2.40 times 2.08 times

Though there is no standard for Inventory Turnover Ratio, higher

the ratio better is the activity level of the concern. From this angle the

Ratio has come down gradually during the three year period indicating

slow moving of stock.

Profitability Ratios: To analyse the profitability position of the company Gross

Profit Ratio and Net Profit Ratio are calculated.

169

Gross Profit Ratio:

2002-03 2003-04 2004-05

Gross Profit 25,000 30,000 25,000

-------------- x 100 ----------- ---------- ----------

Sales 1,00,000 1,50,000 1,50,000

25% 20% 16.7%

Net Profit Ratio:

2002-03 2003-04 2004-05

Net Profit 5,000 7,000 5,000

------------ x 100 ---------- ---------- ----------

Sales 1,00,000 1,50,000 1,50,000

5% 4.7% 3.3%

The profitability ratios show that there is steady decline in the

profitability of the concern during the period. One reason for this

declining profitability among others, is the low and decreasing inventory

turnover ratio.

Financial Position: Here the long term solvency position of the concern is

analysed by calculating Debt/Equity Ratio and Debt/Asset Ratio.

Debt/Equity Ratio:

2002-03 2003-04 2004-05

Debt 36,000 56,000 89,000

--------- -------- -------- --------

Equity 66,000 69,000 71,000

0.545:1 0.812:1 1.254:1

170

Debt/Asset Ratio:

2002-03 2003-04 2004-05

Debt 36,000 56,000 89,000

--------- ---------- ----------- -----------

Assets 1,02,000 1,25,000 1,61,000

0.35:1 0.448:1 0.556:1

Debt Equity Ratio expresses the existence of Debt for every Re.1 of

Equity. From this standpoint the share of debt in comparison to equity is

increasing year after year and in the last year the debt is even more than equity.

Debt Asset Ratio gives how much of assets have been acquired using debt funds.

The calculation of this ratio reveals that in the 1st year 35% of assets were

purchased using debt funds which has increased to 44.8% in the 2nd year and

55.6% in the 3rd year. Thus both the ratios reveal that the debt component in the

capital structure is increasing which has for reaching consequences.

3.1.3.19 BOOKS FOR FURTHER READING

1. James Jiambalvo: Managerial Accounting, John Wiley & Sons.

2. Khan & Jain: Management Accounting, Tata McGraw Hill Publishing Co.

3. J.Made Gowda: Management Accounting, Himalaya Publishing House.

4. S.N.Maheswari: Management Accounting, Sultan Chand & Sons.

5. N.P.Srinivasan & M.Sakthivel Murugan: Accounting for Management,

S.Chand & Co. New Delhi.

171

UNIT-III

LESSON 3.2

-----------------------------------------------------------------------------------------------

FUNDS FLOW ANALYSIS AND CASH FLOW ANALYSIS

------------------------------------------------------------------------------------------------

3.2.1 INTRODUCTION

At the end of each accounting period, preparation and presentation of

financial statements are undertaken with an objective of providing as much

information as possible for the public. The Balance Sheet presents a snapshot

picture of the financial position at a given point of time and the Income

Statement shows a summary of revenues and expenses during the accounting

period. Though these are significant statements especially in terms of the

principal goals of the enterprise, yet there is a need for one more statement

which will indicate the changes and movement of funds between two balance

sheet dates which are not clearly mirrored in the Balance Sheet and Income

Statement. That statement is called as Funds Flow Statement. The analysis

which studies the flow and movement of funds is called as Funds Flow Analysis.

Similarly one more statement has to be prepared known as Cash Flow

Statement. This requires the doing of Cash Flow Analysis. The focus of Cash

Flow Analysis is to study the movement and flow of cash during the accounting

period. This lesson deals at length both the analyses.

3.2.2 OBJECTIVES

After reading this lesson, the reader should be able to

• Understand the concept of funds and flow;

• Evaluate the changes in working capital in an organisation;

• Ascertain the sources and uses of funds from a given financial

statement;

• Prepare Fund Flow Statement.

172

• Understand the concepts of Cash and Cash Flow.

• Understand the Cash Flow Analysis.

• Prepare Cash Flow Statement.

3.2.3 CONTENTS

3.2.3.1 Concept of Funds

3.2.3.2. Flow of Funds

3.2.3.3 Importance and Utility of Funds Flow Analysis

3.2.3.4 Preparation of Funds Flow Statement

3.2.3.5 Illustrations

3.2.3.6 Meaning of Concepts of Cash, Cash Flow and Cash Flow

Analysis

3.2.3.7 Cash Flow Statement

3.2.3.8 Calculation of Cash from Operations

3.2.3.9 Utility of Cash Flow Analysis

3.2.3.10 Cash Flow Analysis Vs Funds Flow Analysis

3.2.3.11 Illustrations

3.2.3.12 Summary

3.2.3.13 Key Words

3.2.3.14 Self Assessment Questions

3.2.3.15 Key to Self Assessment Questions

3.2.3.16 Case Analysis

3.2.3.17 Books for Further Reading

3.2.3.1 CONCEPT OF FUNDS

How are funds defined? Perhaps the most ambiguous aspect of funds

flow statement is understanding what is meant by funds. Unfortunately there is

no general agreement as to precisely how funds should be defined. To a lay man

the concept of funds means `cash'. According to a few, `funds' mean `net

current monetary assets' arrived at by considering current assets (cash +

173

marketable securities + short term receivables) minus short term obligations. A

third view, which is the most acceptable one, is that concept of funds means

`Working Capital' and in this lesson the term `funds' is used in the sense of

Working Capital.

WORKING CAPITAL CONCEPT OF FUNDS

The excess of an enterprise's total current assets over its total current

liabilities at some point of time may be termed as its net current assets or

Working Capital. To illustrate let us assume that on the balance sheet date the

total current assets of an enterprise are Rs.3,00,000 and its total current

liabilities are Rs.2,00,000. It working capital on that date will be Rs.3,00,000 –

Rs.2,00,000 = Rs.1,00,000. It follows from the above that any increase in total

current assets or any decrease in total current liabilities will result in a change in

working capital.

3.2.3.2 FLOW OF FUNDS

The term `flow' means change and therefore, the term `flow of funds'

means `change in funds' or `change in working capital'. According to

Manmohan and Goyal, "the flow of funds" refers to movement of funds

described in terms of the flow in and out of the working capital area. In short,

any increase or decrease in Working Capital means `flow of funds'.

Many transactions which take place in a business enterprise may increase

its working capital, may decrease it or may not effect any change in it. Let us

consider the following examples.

(i) Purchased machinery for Rs.3,00,000: The effect of this transaction is that

working capital decreases by 3,00,000 as cash balance is reduced. This change

(decrease) in working capital is called as application of funds. Here the accounts

involved are Current Assets (Cash a/c) and Fixed Asset (Machinery a/c).

174

(ii) Issue of share capital of Rs.10,00,000: This transaction will increase the

working capital as cash balance increases. This change (increase) in working

capital is called as source of funds. Here the two accounts involved are current

assets (Cash a/c) and Long-Term Liability (Share Capital a/c).

(iii) Sold plant for Rs.3,00,000: This transaction will have the effect of

increasing the working capital by Rs.3,00,000 as the cash balance increases by

Rs.3,00,000. It is a source of funds. Here the accounts involved are current

assets (Cash a/c) and Fixed Assets (Plant a/c).

(iv) Redeemed debentures worth Rs.1,00,000: This transaction has the effect of

reducing the working capital, as the redemption of debentures results in

reduction in cash balance. Hence this is an example of application of funds. The

two accounts affected by this transaction are Current Assets (Cash a/c) and

Long-Term Liability (Debenture a/c).

(v) Purchased inventory worth Rs.10,000: This transaction results in decrease in

cash by Rs.10,000 and increase in stock by Rs.10,000 thereby keeping the total

current assets at the same figure. Hence there will be no change in the Working

Capital (There is no flow of funds in this transaction). Both the accounts

affected are Current Assets.

(vi) Notes payables drawn by creditors accepted for Rs.30,000: The effect of

this transaction on Working Capital is Nil as it results in increase in notes

payable (a current liability) and decreases the creditors (another current

liability). Since there is no change in total current liabilities there is no flow of

funds.

(vii) Building purchased for Rs.30,00,000 and payment is made by shares:

This transaction will not have any impact on working capital as it does not result

in any change either in the current asset or in the current liability. Hence there is

no flow of funds. The two accounts affected are Fixed Assets (Building a/c) and

Long Term Liabilities (Capital a/c).

175

From the above series of examples, we arrive at the following rules on

flow of funds.

I. There will be flow of funds only when there is a cross-transaction i.e., only

when the transaction involves:

(i) Current Assets and Fixed Assets e.g., Purchase of Machinery for Cash

(application of funds) or Sale of Plant for a Cash (Source of funds).

(ii) Current assets and capital, e.g., Issue of Shares (Source of funds).

(iii) Current Assets and Long Term Liabilities, e.g., Redemption of

Debentures in Cash (Application of Funds).

(iv) Current Liabilities and Long-Term Liabilities, e.g., Creditors paid off in

Debentures or Shares (Source of funds).

(v) Current Liabilities and Fixed Assets, e.g., Building transferred to

creditors in satisfaction of their claims (Source of funds).

II. There will be no flow of funds when there is no cross transaction i.e., when

the transaction invoves:

(i) Current Assets and Current Assets, e.g., Inventory Purchased for

Cash.

(ii) Current Liabilities and Current Liabilities, e.g., Notes Payables

issued to Creditors.

(iii) Current Assets and Current Liabilities, e.g., Payments made to

Creditors.

(iv) Fixed Assets and Long Term Liabilities, e.g., Building purchased

and payment made in Shares or Debentures.

(A) Sources and Application of Funds: The following are the main sources of

funds:

(i) Funds from Operations: The operations of the business generate revenue and

entail expenses. Revenues augment working capital and expenses, other than

depreciation and other amortizations. The following adjustments will be

required in the figures of net profit for finding out the real funds from

operations:

176

-------------------------------------------------------------------------------------------------

Funds From Operations

-------------------------------------------------------------------------------------------------

Net Profit for the year x x x

Add*: Depreciation of Fixed Assets x x x

Preliminary expenses, goodwill, etc.

Written off x x x

Loss on sale of Fixed Assets x x x

Transfers to Reserve x x x

Less: Profit on sale or revaluation x x x

Dividends received, etc. x x x

Funds from Operations x x x

-------------------------------------------------------------------------------------------------

* These items are added as they do not result in outflow of funds. In case of `Net

Loss' for the year these items will be deducted.

-------------------------------------------------------------------------------------------------

(ii) Issue of Share Capital: An issue of share capital results in an Inflow of

Funds.

(iii) Long-Term Borrowings: When a long-term loan is taken there is an

increase in working capital because of cash inflow. A short term loan, however,

does not increase the working capital because a short-term loan increases the

current assets (cash) and the current liability (short term loan) by the same

amount, leaving the size of working capital unchanged.

(iv) Sale of Non-Current Assets: When a Fixed Asset or a Long-Term

Investment or any other Non-Current Asset is sold, there will be inflow

represented by cash or short-term receivables.

(B) Uses of Funds: The following are the main uses of funds:

(i) Payment of Dividend: The transaction results in decrease in working capital

owing to outflow of cash.

(ii) Repayment of Long-term Liability: The repayment of long-term loan

involves cash outflow and hence it is use of working capital. The repayment of a

current liability does not affect the amount of working capital because it entails

an equal reduction in Current Liabilities and Current Assets.

(iii) Purchase of Non-Current Assets: When a firm purchases Fixed Assets or

other non-current assets, and if it pays cash or incurs a short-term debt, its

working capital decreases. Hence it is a use of funds.

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3.2.3.3 IMPORTANCE AND UTILITY OF FUNDS FLOW ANALYSIS

Funds flow analysis provides an insight into the movement of funds and

helps in understanding the change in the structure of assets, liabilities and

owners' equity. This analysis helps financial managers to find answers to

questions like:

(i) How far capital investment has been supported by long term

financing?

(ii) How far short-term sources of financing have been used to

support capital investment?

(iii) How much funds have been generated from the operations of a

business?

(iv) To what extent the enterprise has relied on external sources of

financing?

(v) What major commitments of funds have been made during the

year?

(vi) Where did profits go?

(vii) Why were dividends not larger?

(viii) How was it possible to distribute dividends in excess of current

earnings or in the presence of a net loss during the current

period?

(ix) Why are the current assets down although the income is up?

(x) Has the liquidity position of the firm improved?

(xi) What accounted for an increase in net current assets despite a net

loss for the period?

(xii) How was the increase in working capital financed?

3.2.3.4 PREPARATION OF FUNDS FLOW STATEMENT

Two statements are involved in Funds Flow Analysis.

(i) Statement or Schedule of Changes in Working Capital

(ii) Statement of Funds Flow

(A) Statement of Changes in Working Capital: This statement when prepared

shows whether the working capital has increased or decreased during two

Balance Sheet dates. But this does not give the reasons for increase or decrease

in working capital. This statement is prepared by comparing the current assets

and the current liabilities of two periods. It may be shown in the following form:

178

Schedule of Changes in Working Capital (Proforma)

Items As on As on Change

Increase Decrease

Current Assets

Cash Balances

Bank Balnces

Marketable Securities

Stock in Trade

Pre-paid Expenses

Current Liabilities

Bank Overdraft

Outstanding Expenses

Accounts Payable

Provision for Tax

Dividend

Increase / Decrease in

Working Capital

Any increase in current assets will result in increase in Working Capital

and any decrease in Current Assets will result in decrease in Working Capital.

Any increase in current liability will result in decrease in working capital and

any decrease in current liability will result in increase in working capital.

(B) Funds Flow Statement: Funds Flow Statement is also called as Statement of

Changes in Financial Position or Statement of Sources and Applications of

Funds or where got, where gone statement. The purpose of the funds flow

statement is to provide information about the enterprise's investing and

financing activities. The activities that the funds flow statement describes can be

classified into two categories:

(i) activities that generate funds, called Sources, and

(ii) activities that involve spending of funds, called Uses.

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When the funds generated are more than funds used, we get an

increase in working capital and when funds generated are lesser than the

funds used, we get decrease in working capital. The increase or decrease

in working capital disclosed by the schedule of changes in working

capital should tally with the increase or decrease disclosed by the Funds

Flow Statement.

The Funds Flow Statement may be prepared either in the form of a

statement or in `T' shape form. When prepared in the form of the

statement it would appear as follows:

Funds Flow Statement

-----------------------------------------------------------------------------------------------

Sources of Funds

Issues of Shares x x x

Issue of Debentures x x x

Long term borrowings x x x

Sale of Fixed Assets x x x

*Operating Profit

(Funds from Operations) x x x

-------------------------------------------------

Total Sources x x x

-------------------------------------------------

Application of Funds

Redemption of Redeemable

Preference shares x x x

Redemption of Debentures x x x

Payments for other long-term loans x x x

Purchase of fixed assets x x x

* Operation loss (Funds lost from x x x

Operations) ---------------------------------------

Total uses x x x

---------------------------------------

Net increase / decrease in working capital

(Total Sources – Total uses)

------------------------------------------------------------------------------------------------

When prepared in `T' shape form, the Funds Flow Statement would

appear as follows:

180

Funds Flow Statement

------------------------------------------------------------------------------------------------

Sources of Funds Application of Funds

------------------------------------------------------------------------------------------------

* Funds from operation x x x *Funds lost in operations x x x

Issue of shares x x x Redemption of Preference

Shares x x x

Issue of Debentures x x x Redemption of Debentures x x x

Long-term borrowings x x x Payment of other long-term

Loans x x x

Sale of fixed assets x x x Purchase of fixed assets x x x

* Decrease in working Payment of dividend, tax,

capital x x x etc. x x x

Increase in working capital x x x

------ ------

------------------------------------------------------------------------------------------------

*Only one figure will be there.