Finanicial Accounting

8/2/2019 Finanicial Accounting

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1

By

Prof. Harvinder S. Chawla

Introduction toAccounting


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Accounting was born before writing ornumbers existed, some 10,000 years ago inMesopotamia later know as Persia (Iran andIraq). This area contains the Tigris river

valley, fertile area with a large population andactive trading being done between towns andcities up and down the river valley.

And what happens next will directly lead tothe invention of both writing and numbersystems.


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Before shipping their goods, a merchant would takeone token for each item in the shipment, and encasethe tokens in a ball of clay, called a "BOLLAE"(pronounced "bowl-eye") - meaning ball. This ballwould be dried in the sun, given to the boatman, andthen broken by the buyer on the other end of thetransaction. The buyer would match the tokens withthe items, to verify that everything sent wasaccounted for. This is the function of protection ofassets, and is a major function of all modernaccounting systems. It was important 10,000 yearsago and is just as important now.


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Written accounting records are some of the oldestwritings that have been excavated across the world.These early records were simple single-entry listings ofwages paid, temple assets, taxes and tributes to the

king or Pharaoh.

Picture in the Tomb of Chnemhotep, pharaoh of Egyptdated 1950 BC.

Minute care is not only taken in the case of largeamounts, but even the smallest quantities of corn or

dates are conscientiously entered." In ancient Egypt,the accountants literally counted food, beer, clothingand everything else. Ancient Egyptians were paid inkind as the concept of money was not invented tillthen.


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Marble tablet: Account of Disbursements of theAthenian State c. 418-415 BC

By the time Christopher Columbus was trying

to sail west, a new form of accounting was inuse by merchants in Venice .

Luca Pacioli set down in writing for the firsttime a description of the double-entry system

of accounting, which we still use today in thesame form. Although he didn't actually inventthe system he is called "The Father OfAccounting" for his contributions and fordocumenting the system in his fifth book on

mathematics Summa de Arithmetica,Geometria, Proportioni et Proportionalita(Everything About Arithmetic, Geometry andProportion).


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6

By


ImportantConcepts &Necessity ofAccounting


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Why should managers and other decision-makers know accounting?

If Finance is the language of business, then

Accounting is its grammar. Accounting is an information system

Accounting provides information formaking decisions

Accounting and economic decisions


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Are the

companys share

good for medium

to long term

investment

horizon?

Investor

Can the borrower

repay its

obligation on

time & what

should be the

collateral?

Lender

How is our

company

performing As

compared to our

competitors? Can

we improve?

Manager

Assess whether

the employer can

meet the future

obligations i.e.

Bonus, Salary.etc?

Employee &

Trade Unions

Can the company

pay on time for

purchases?

Can the borrowerpay interest on

time?

Suppliers &

Trade

Financiers

The supplier will

be able to provide

spare parts?

Can suppliermeets warranty

obligations?

Customers

Is the company

evading income

tax, excise duty

and othergovernment

levies?

Government

& Regulatory

Authorities

Is the company

exploiting its

customers,

labour, naturalresources,

suppliers, etc?

The Public


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Accounting entity

Business is distinct from owner

Going concern

Business is a continuing enterprise

Periodicity Business activities divided into periods

Money measurement

Money is a stable measurement unit

Accrual Concept

Record business transaction when theyoccur not when the cash is received


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Importance of GAAP

What is GAAP?

Institutions that influence GAAP Government

Accounting profession

Securities regulators

Other regulators

International organizations


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FORMS OF

BUSINESS

ORGANIZATION

TYPICAL SIZE

DECISION MAKING

GOVT.

REGULATION

SUITABILITY

SOLE

PROPRIETORSHIP

Single

Owner

Completely

Flexible

None

Small Business

PARTNERSHIP

Few Individuals

(Min 2 - Max20)

Largely Flexible but

Partners may disagree

Virtually None

Small to Medium


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FORMS OF

BUSINESS

ORGANIZATION

TYPICAL SIZE

DECISION

MAKING

GOVT.

REGULATION

SUITABILITY

LIMITED COMPANY

(Private)

Few Individuals(Min 2 Max50)

Largely Flexible

but Directors may

disagree

Companies Act

(applies but to very

less extent)

Small to Medium

(often due to legal

restriction

Permit, Licence,

Loan, etc.)

LIMITED CO.

PUBLIC (Not listed)

Min 7 to UnlimitedShareholders

Very Rigid

(Shareholders

approval needed at

every stage)

Companied Act

(applies to full extent

Filing of

Documents,

Disclosure, etc.)

Medium to Larger

LIMITED CO.

PUBLIC (Listed)

Min 7 to Unlimited

Shareholders

Very Rigid (Shareholders

approval needed at every

stage)

Companied Act & SEBI Act(applies to full extent Filing

of Documents, Disclosure,

etc.)

Large to Very Large

Business (especiallyones which need huge

Capital Investment)


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By


Overview ofIncome Statement& Balance Sheet


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Measurement:Past & Current Performance

Forecasting: Future Financial Position

Decision Making: Relevant information tousers

Comparison & Evaluation: Targets vs. Actual

Control: Identify Weakness & offer Feedback

Government Regulation & Taxation


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Profit and loss account

Statement of financial performanceRevenues; Expenses (Profitability)

Balance sheet

Statement of financial positionAssets; Liabilities; Equity (Solvency)

Cash flow statement

Statement of cash receipts and cashpayments

Activities: Operating;Investing;Financing

(Changes in Financial Position)


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THE DOUBLE ENTRY SYSTEM&

ACCOUNTING EQUATION


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Sources of Funds = Uses of Funds Equities = Asset

Assets=Liabilities + EquityCapital+ RevenuesExpensesDrawingsDividends

Can be rewritten as (Assets + Expenses + Drawings +Dividends = Liabilities + Capital + Revenues


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Probable future economic benefits (Cash orsomething that can generate cash forbusiness)

Assets = what a business owns Examples

Cash, Cash at Bank, Bills Receivables, PrepaidExpenses, Debtors or Account Receivable,Stock (of Raw Material, Work in Progress,

Finished Goods, etc.) Land, Buildings, Plant & Machinery, Patents,

Copyrights, Loose Tools, Goodwill, etc.


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Probable future sacrifices of economicbenefits

Liabilities = what a business owes(Contractual, statutory, or constructive)

Examples

Bank Overdraft, Outstanding Expenses,Bills Payable, Creditors on accounts, Loan

short term as well as long term,Debentures, etc.


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Equity represent the claims of those who

supplied or invested the money to start thebusiness.

Difference between Asset Liabilities.

Equity is the residual interest in the asset of the

business after deducting all its liabilities. Example Money supplied by the Proprietor for business or

seed money (less withdrawals)

Reserve & surplus of profit (accumulated profit)


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Increase in one Asset Decrease in another Asset

Increase in one Liability Decrease in another Liability

Increase in one item of

Proprietor's Equity

Decrease in one item of

Proprietor's Equity

Increase in Proprietor's Equity Decrease in Liability

Increase in Liability Decrease in Proprietor's Equity

Decrease in Asset Decrease in Proprietor's Equity

Increase in Asset Increase in Proprietor's Equity

Increase in Asset Increase in Liability

Decrease in Asset Decrease in Liability


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The account is the basic building block of any accounting

system. An accounting system classifies transactions intomeaningful categories to prepare financial statements &reports.

Accounts facilitates easy & quick retrieval of companys

financial data. An account is used to record increase &decrease in these item (assets, liabilities, capital,revenue, drawings, dividends & expenses) resulting frombusiness transactions.

No matter whether a company uses either a manual orelectronic accounting system, it is essential to have aproper system of classification of transaction into variousaccounts.


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The T account

We need to record each transaction in two accounts so that the

accounting equation is always in balance. Double Entry Systemrecords every transaction with equal debits & credits. As a result,the total of all Debits must equal total of all Credits

Credit = RightDebit = Left

Debits = Credits


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The terms Debit (Dr.) & Credit (Cr.) are used to describe the left hand side

& right hand side of an account.To debit means to make an entry in the left hand side of an account & to

credit means to make an entry on the right hand side.

The term debit & credit has no other meaning in accounting.

All accounts show entries recording increase & decrease. In someaccounts increase are recorded on the left side & decrease on right side

whereas in other accounts the reverse is true. It means debits & creditsby themselves do not indicate increase & decrease unless reference ismade to a specific account to determine the debits & credits representincreases & decreases.

(Any type of Account)Debit CreditAlways the left side Always the right side


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RequiredEffect

Assets,

Expenses,Drawings,

Dividends

Liabilities,

Equity,Revenues

Debit Credit

Credit Debit

Asset Accounts

Debit Side Credit Side

Shows Increases Shows DecreasesNormal Balance - Debit

Expenses Account


Shows Increases Shows Decreases

Normal Balance - Debit

Liabilities Account


Shows Decreases Shows Increases

Normal Balance - CreditOwners' Equity Account

Debit Side Credit SideShows Decreases Shows Increases

Normal Balance - Credit

Revenue Account


Shows Decreases Shows Increase

Normal Balance - Credit

Drawings Account


Shows Increases Shows Decreases

Normal Balance - Debit


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The accounts maintained by the business organizationcan be classified into three types.

Personal Account: It deals with accounts of individualslike Creditors, Debtors, Bank etc. It give you an ideaabout the balance due to these individuals or duefrom them on a particular date.

Real Account: It relates to assets of the firm but notdebts. Eg: Machinery, Land, Buildings, Fixed DepositsGoodwill etc. This account shows the worth of anasset on a particular date.

Nominal Account: It consists of different types ofexpenses or losses and income or profit. The accountshows the amount of income earned or expensesincurred for a particular period.


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PERSONAL ACCOUNT Debit the receiver,

Credit the giver. REAL ACCOUNT Debit what comes in, Credit

what goes out.

NOMINAL ACCOUNT Debit all expenses &

losses, Credit all incomes & gains.

Required

Effect

Assets,

Expenses,

Drawings,

Dividends

Liabilities,

Equity,

Revenues

Debit Credit

Credit Debit


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Sr. No Title of Account1 BUILDING

2 STOCK

3 BANK DEPOSIT

4 RENT

5 CASH

6 DEBTORS

7 LOAN

8 DRAWINGS

9 FURNITURE

Equation Approach Traditional ApproachASSET

ASSET

ASSET

EXPENSES

ASSET

ASSET

LIABILITY

DRAWINGS

ASSET

REAL

REAL

PERSONAL

NOMINAL

REAL

PERSONAL

PERSONAL

PERSONAL

REAL


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JOURNAL ENTRIES,

LEDGER

&

TRIAL BALANCE


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The Journal is a chronological record oftransaction entered into by the business. It is

called the Book of Original entry or primarybook because we record all the businesstransaction first in this book.

The process of recording transaction in Journalis called Journalizing.


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The procedure for recording transactions in thejournal is as follows:

Enter the year, month & date of the transaction

on the Date Column Write the account titles under the Description

Column Enter the account to debit on the firstline. Enter the account to credit under the

debited account & indent it to set the accountapart from the debited account. If there areseveral accounts enter them one after another.

JOURNALDate Description Post. Ref Debit (Dr.) Credit (Cr.)

(1) (2) (3) (4) (5)

NARRATION (6)


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Enter the amount of the debit in the DebitColumn alongside the account to debit & theamount of the credit in the Credit Column

alongside the account to credit. Write a brief explanation of the transaction

The Post. Ref. (Posting Reference) is left blank

at the time of making the journal entry.


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After recording transaction in the Journals, allentries are classified & grouped into set of

accounts. Transferring information from Journalto Ledger is called Posting.

A ledger account has two sides debit side &

credit side. Each of this sides has fourcolumns: Date, Particulars, Journal Folio,Amount.r. ACCOUNT NAME Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

1/6/10 To Vijays A\c 1,000 10/6/10 By Machinery A\c 500


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Separate account is opened in ledger book for eachaccount & entries from ledger posted to respective

account accordingly. It is a practice to use words TO & BY while posting

debit & credit entries respectively.

To ascertain the balance, total both the sides and find

out the difference.Cr. > Dr. The account has a credit balance.

Dr. > Cr. The account has a debit balance.Dr. CASH ACCOUNT Cr.Date Particulars J.F. Amount Date Particulars J.F. Amount1/6/10 To Vijays A\c 1,000 10/6/10 By Machinery A\c 500

31/6/10 By Balance 500

1,000 1,000

1/7/10 To Balance b\d 500


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We know that under double entry system, thedebit & credit amounts must be equal.

The TRIAL BALANCE is a device for verifying theequality of debits & credits. The TRIAL balancelist each account in the ledger, with the debit

balance in the left column, & credit balance inthe right column.

Each column has a total & the two total must be

equal. When this happens, the accounts are saidto be inbalances.

TRIAL BALANCE as on 31 March, 2010

Account Name Debit Credit

Th lit f th d bit & dit t t l f th


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The equality of the debit & credit totals of theTRIAL balance proves that we have recordedequal debits & credits in the accounts. However,

we could have made errors that do not affect theequality of debits & credits:

Errors of principle: Posting a journal entry to awrong account will not affect the Trial Balance.

Eg: Suppose that for payment of RENT we debitedOffice Furniture instead of Rent expense. TheTrial Balance will still balance.

Errors of omission & repetition: The trial balance

will not reveal either the complete omission of atransaction from the ledger or the recording ofthe same transaction more than once.

C h d f h


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Compensatory errors: The recording of the sameerroneous amount for both the debit & credit ofa transaction will not show up in the trial

balance.

LOCATING ERRORS:

Posting a debit as a credit or a credit as a debit.

Computing an account balance incorrectly. Copying the amount of an account balance to the

trial balance incorrectly.

Copying a debit balance in an account as a credit

balance or a credit balance as an debit balance. Omitting an account balance from the trial balance

Totaling the trial balance incorrectly.

Correcting Errors: If you discover an error in a journal


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Correcting Errors: If you discover an error in a journalentry before posting, you can cross out the wrongamount & insert the correct amount immediately.However, erasing errors may give a wrong impressionof misappropriation or misuse.

We should avoid the above situation. In order to rectifywrong posting of journal entries, a useful way is to

determine the correcting entry & compare it with theincorrect entry. Eg: Electricity Expenses Paid Rs.4,000.

Incorrect Entry:

Rent Expenses A\c Dr. Rs.4000

To Cash A\c Rs. 4000

C E


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Correct Entry:

Electricity Bills A\c Dr. Rs. 4000

To Cash A\c Rs. 4000

To correct the error, pass the below entry:

Electricity Bills A\c Dr. Rs. 4000

To Rent A\c Rs. 4000

Please note that credit to Cash A\c is correct & does notneed correction.

When the trial balance is not in Balance, the normalpractice is to place the difference initially in aSuspense Account. Then the accounting records are

verified to locate the errors. Finally, the correct entryis passed to debit or credit Suspense A\c & therelevant account.


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The following are the transactions for Pulp &Paper Co. Ltd.(printing press) for October 10are as follows:

1st - Mr. Kapoor began business by investing Rs.10,000

3rd Paid cash for two months office rent inadvance Rs. 2,000

4th Bought machine for cash Rs. 1,200

6th Bought raw material for cash Rs. 700

9th Received cash for printing work completed

Rs. 8,60011th Paid cash for an advertisement done for

business promotion Rs. 1,400

13th R i d h f i ti t t b k R


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13th Received cash for printing text books Rs.11,200

17th Bill of Rs. 13,100, send to customer for

work done.20th Paid cash as salary to marketing manager

Rs. 1,500

23rd Cash paid for telephone bill Rs. 240

28th Received cash as part payment fromcustomer billed on 17th Oct, 2010, Rs. 4,800

29th Declared & Paid cash dividend of Rs. 2,500

Pass Journal Entries for all the transaction, Postthem into Ledger & prepare Trial Balance.

Journal Entries in the books Pulp & Paper Co Ltd


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Journal Entries in the books Pulp & Paper Co. Ltd.


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POSTING JOURNALS ENTRIES INTO LEDGER ACCOUNTS


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CAPITAL&

REVENUE


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All the transaction of a business enterprise can

be classified into Current Period Transaction &Futuristic Transaction.

All the expenses & receipts can be classified as

revenue expenditure, capital expenditure,deferred expenditure, revenue receipts &capital receipts.

This classification in necessary in order toprovide appropriate treatment to these itemsunder financial statement.


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Expenses are classifies as revenue expenses, capitalexpenses & deferred revenue expenses.

REVENUE EXPENSES These are the expenses, thebenefits of which are not available for more than oneaccounting year. Such expense nether lead toaddition into any of the assets nor increase the

earning capacity of the business. They are incurred toenable enterprise to carry out the day to day businessactivities such as payment of salary, wages, rent, etc.

EXPENDITURE

REVENUEEXPENSES

CAPITALEXPENSES

DEFERREDREVENUEEXPENSES

Features of Revenue Expenses:


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Features of Revenue Expenses:

Recurring in nature.

Benefit exhaust within one accounting year.

These are generally routine expenses. Find place in trading or Profit & Loss Account.

CAPITAL EXPENSES These are the expenses, thebenefit of which is not exhausted within oneaccounting year. Such expense either lead to additioninto any of the assets or increase the earning capacityof the business. They are non recurring in nature. Inthe financial statements these expense are shown on

asset side of Balance Sheet. Expenditure incurred forconstruction, acquisition, purchase, installationcharges, freight charges incurred on fixed asset.

Features of Capital Expenses:


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Features of Capital Expenses:

Non - recurring in nature.

Benefits are provided for long period of time.

Lead to increase in the earning capacity of thebusiness.

Find place in Balance Sheet of the firm.

DEFERRED REVENUE EXPENSES These are the expenseswhich are basically revenue in nature but their benefitis not exhausted within one accounting year. Hencethe amount of such expenditure is written off over acertain period of time. The written off portion is

debited to the Profit & Loss Account and balance isshown on the asset side of Balance Sheet.

Feature of Deferred Revenue Expenses:


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Feature of Deferred Revenue Expenses:

Non recurring in nature

Benefits are provided for long period of time.

Does not lead to addition in the fixed assets.

Generally heavy amount of expenditure.

Find place in Profit & Loss Account (of the

extent written off) as well as Balance Sheet(balance amount).


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The receipts are classified as revenue receipts &capital receipts for the purpose of ensuring

appropriate treatment in the books of account &financial statement.

CAPITAL RECEIPTS Receipts which are generated outof capital transactions like sale of fixed assets ortaking the loan. Thus, when a capital receipts takesplace then it is the consequence of either decrease infixed asset (by way of sale) or increase in liability likecollecting public deposits, etc.

RECEIPTS

CAPITALRECEIPTS REVENUERECEIPTS

REVENUE RECEIPTS Receipts generated out of


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REVENUE RECEIPTS Receipts generated out ofroutine business transaction or operatingtransaction. Amount of sales proceeds received,

interest received, commission received, dividendreceived, etc. When a amount is received underrevenue receipts then there is no impact orchange in the amount of asset or liability.

EXAMPLES:

Customs duty paid Rs. 5,000 on import ofmachinery. Capital Expenditure: Because the import duty paid in

connection with the purchase of new fixed asset &hence it is also to be included in capital expenditure.

W id f f ti f th d ti l t R


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Wages paid for formation of the production plant Rs.3,000.

Capital Expenditure Because wages are paid in

connection with erecting new plant which itself is acapital expenditure

Repairing expenses Rs. 5,000 before putting to use asecond hand delivery van.

Capital Expenditure Because any repairs made toany asset immediately on purchase & before it isput to use are considered as capital expenditure &added in the value of assets.

Rs. 3,400 paid for replacing a worn out part of amachine with the new part.

Revenue Expenditure Because it is incurred for


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Revenue Expenditure Because it is incurred forkeeping the asset in working condition. It does notlead to any addition in fixed assets nor does itenhances the earning capacity above the existing

level.

Amount of Rs. 500 paid for repairs of existingplant. Revenue Expenditure Any expenditure for repairs

on the existing asset is considered as revenueexpenditure.

Rs. 8,00,000 paid for advertisement forlaunching a new product into the market. Thebenefit of such advertisement will be accruedfor 4 to 5 years.

Deferred Revenue Expenditure Heavy advertisement


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Deferred Revenue Expenditure Heavy advertisementmade for launching of a new product will benefit forlong period of time but it does not lead to additionin value of fixed assets.

Collection from debtors Rs. 20,000. Revenue Receipt Collection from the debtors is

against credit sales made to them, hence such

collection is considered as revenue receipts.

Loan taken Rs. 15,000. Capital Receipt Loan taken leads to increase in

liability, hence such receipts is capital receipts.


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DEPRICIATION


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In any business, fixed assets are used for a long

period of time. Hence certain proportion of its costis required to be measured & charged againstperiodic revenue of the business.

Such an appropriate proportion of cost to be charged

against annual revenue is called as DEPRECIATION.In other words depreciation means reduction in thevalue of fixed assets due to its wear and tear.Depreciation is charged on fixed assets only and it istermed as loss to the business. Depreciation is alsotermed as provision for the replacement of asset atthe end of its useful life.


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Features of Depreciation Depreciation is charged on fixed assets only. Depreciation is a gradual process.

Depreciation is a permanent decrease in thevalue of fixed asset.

Depreciation takes place continuously.

It is basically a fall in the value of depreciablefixed asset.


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Need for Providing Depreciation To show the fixed asset at reasonable value.

To find out the true amount of profit or lossof business.

To show the correct financial position.

To spread the cost of fixed asset over itsuseful life.

To meet the legal requirements.


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On the basis of maintaining the accounts for

depreciation, there are two systems whichare as follows.

Charging depreciation directly to asset - Underthis system a separate asset account ismaintained and the amount of annualdepreciation is credited directly to asset account.Under this method at the end of every accounting

year, the balance in asset account is consideredas written down value of that asset.

Under


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Creating provision for depreciation account- Underthis system asset account is maintained at costthrough out its life and a separate account called

provision for deprecation account is prepared forcrediting the amount of annual depreciation. Overa period of time the amount of depreciation getsaccumulated in this account.

METHODS OF CHARGING DEPRECIATIONFixed installment method- It is also known as

straight line method or original cost method.

Under this method every year during the useful lifeof asset, depreciation is calculated as certain fixedpercentage of original cost of asset.

Therefore, the amount of depreciation remains


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, pconstant over the useful life of asset. In thismethod annual installment of depreciation can

also be calculated by the following formula.Depreciation (p.a.) = Cost of Fixed Asset Scrap Value of AssetEstimated useful life

Reducing balance method- also known asdiminishing balance method or written downvalue method. Under this method depreciation ischarged at certain % on original cost in the firstyear and subsequently on opening written down

value of an asset every year. Due to this anamount of depreciation changes every year andit goes on reducing.

- It is not a separate method of


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Change of method It is not a separate method ofdepreciation as such. After charging depreciationunder particular method for few years a

businessman may decide to change the method.A businessman may either shift from fixedinstallment method to reducing balance methodor reducing balance method to fixed installment

method. There are two ways of implementingsuch change which are as follows.

Prospective change- Under such change themethod of providing depreciation changes from

the current year only that is the change iseffective from the year in which it isimplemented.

- Under this method a


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Retrospective change- Under this method achange is implemented in the current year witheffect from the very beginning that is from the

first year of an asset. Under such change theremay be a profit or a loss arising from the changeof method which is transferred to the profit andloss account of the year in which such a change

is implemented. EXAMPLE 1: APJ Traders Pvt. Ltd. Purchased

Machinery costing Rs. 30,000 on 1st July, 2000.They purchased additional Machinery of Rs.15,000 on 1st April, 2001. It was decided todepreciate it @ 10% on 31st March every yearunder Straight line Method.

Machinery Purchased on 1st July 2000 was sold


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Machinery Purchased on 1 July, 2000 was soldfor Rs. 25,000 on 31st March, 2002. PrepareMachinery A/c, Depreciation A/c & Ascertain the

Profit or Loss on the sale of machinery.

EXAMPLE 2: Chill Fruit Juice Pvt. Ltd. Purchasedequipment costing Rs. 3,00,000 on 1st July,2000. They purchased additional equipment ofRs. 1,50,000 on 1st April, 2001. It was decided todepreciate it @ 15% on 31st March every yearunder Reducing Balance Method. EquipmentPurchased on 1st July 2000 were sold for Rs.1,60,000 on 31st March, 2002.

EXAMPLE 3: ACL Ltd Purchased building worth Rs


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EXAMPLE 3: ACL Ltd. Purchased building worth Rs.20,000 on 1st Jan 2002 & started depreciating it@ 10% p.a. on RBM on every 31st Dec. In the year

2004 it was decided to change the method toFIM @ 8% with retrospective effect. PrepareBuilding A/c for 4 years from the beginning.

IMPORTANT: If the answer of total depreciation asper old method minus total depreciation as pernew method comes positive then it is consideredas profit and if it come negative it is consideredas loss on change of method


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The final-accounts are the group of three differentaccounts viz. Trading Account, Profit and Loss

Account and Balance Sheet.

This group of three accounts is called final accountsbecause it gives final results of the business done in

the accounting year.

In other words, final accounts generally refer to twoimportant accounting statements prepared by thebusiness unit at the end of the financial year and

those accounting statements are: Income statements and

Statement of financial position.


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It is a part of final accounts which is prepared on thebasis of direct expenses and direct incomes of

business to ascertain the gross result of the business,done in the accounting year.

On the debit side of trading account, direct expenses,opening stock and purchases are recorded and on the

credit side of account direct income, closing stock andsales are recorded.

Debit balance of this account indicates gross loss andcredit balance of this account indicates gross profit.

Results shown by this account i.e. either gross profitor gross loss is carried forward to the profit and lossaccount.


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Profit and Loss account is a part of final

accounts which is prepared on the basis ofindirect expenses and indirect incomes of thebusiness to ascertain the net result of thebusiness done in the accounting year.

Expenses and incomes which have no directrelation with production and whose absence donot affect production, are called indirectexpenses and indirect incomes.


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An accounting statement which shows thefinancial position of all assets and liabilitiesof the business as on particular date is calledthe Balance Sheet.

Balance sheet is not an account but apositional statement showing financialposition of a business concern as on aparticular date.


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Additional business information provided after

completion of trial balance for preparation offinal accounts are known as adjustments. Toget a clear view and real results of businessdone in the trading year, some other business

information, which do not find place in the trialbalance, are required to be considered, whilepreparing final accounts.

It has 2 or more effects.

EXAMPLE 1: The TRIAL Balance of Shree Traders as on 31st Mar04.


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Trading and P&L A\c for the year ended 31st Mar '04

Particular Rs. Rs. Particular Rs. Rs.


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To Opening Stock 11,000 By Sales 75,500

To Purchases 47,500 Less: Sales Returns 1,500 74,000

Less: Purchase Return 1,000 46,500 By Good destroyed by Fire 5,000

To Carriage Inward 350 By Drawing 250

To Wages 6,000 By Closing Stock 15,000

Add: Outstanding 600 6,600

To Gross Profit c\f 29,800

94,250 94,250

To Commission 500 By Gross Profit b\d 29,800

To Rent & Insurance 400 By Discount Earned 50

Add: Outstanding 700 1,100

To Bad Debt 250

Add: New R.D.D. 880

1,130

Less: Old R.D.D. 750 380

To Discount 100

To Printing & Stationery 700

To Depreciation

Plant & Machinery 600

Furniture 250 850To Salaries 2,500

To Trade Expenses 300

To Postage & Telegram 200

To Interest on Loan 165

To Interest on Capital 1,250

To Loss by Fire 800

To Net Profit c\f 21,00529,850 29,850

Balance Sheet as on 31st Mar '04

Li biliti R R A t R R


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Liabilities Rs. Rs. Assets Rs. Rs.

Capital 25,000 Land 20,000

Less: Drawing 750 Plant & Machinery 6,000

Less: More Drawings 250 Less: Dep @ 10% 600 5,400

Add: Interest on Capital 1,250 Cash @ Bank 550

Add: Net Profit 21,005 46,255

Outstanding Wages 600 Sundry Debtors 17,600

Outstanding Rent 700 Less: R.D.D. @ 5% 880 16,720

Sundry Creditors 12,600 Furniture 5,000

Outstanding Salaries 100 Less: Dep @ 5% 250 4,750

Loan 11,000 Prepaid Insurance 300

Add: Interest for 3 months 165 11,165 Cash in Hand 2,000

Patents 2,500

Insurance claims receivables 4,200

Closing Stock 15,000

71,420 71,420

Example 2 - The following is the trial balance of


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Example 2 The following is the trial balance ofRJ & Co. at 31st March, 2008 and it is desired toprepare final statements of account showing the

results of the transaction for the year:Particulars Dr (Rs.) Cr (Rs.)

Capital Account 8,000

Plant &

Machinery

10,000

Office Furniture

& Fittings

520

Stock

01/04/2007

9,600

Motor Vans2,400

Sundry Debtors 9,600

Cash in hand 80

Cash at bank 1,300

Wages: Factory 30,000

Wages: Office 2,800

Purchases 42,700

Particulars Dr (Rs.) Cr (Rs.)

Sales 96,000

Bills Receivable 1,440

Bills Payable 1,120

Sundry Creditors 10,400Returns Inwards 1,860

Provision for

Doubtful Debts

500

Drawing 1,400

Returns

Outwards

1,100

Rent 1,200Factory lighting

and heating

160

Telephone 70

ParticularsDr (Rs.) Cr (Rs.)

Insurance 60

Advertising 1,130

General Expenses 200

Bad Debts 500

Discount allowed 840

Discount Received 740

TOTAL 117,860 117,860

The following adjustments are to be made


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The following adjustments are to be made.

Stock on 31st March 2008 Rs. 10,400. Rent due but not paid up to 31st March 2008

Rs. 400.

Three months factory lighting and heating duebut not paid Rs. 60.

Insurance paid in advance Rs. 20. Depreciate Plant and Machinery by 1O%,

Furniture by5% and Motor vans by 25%.

Write off further bad debts Rs.140 and increase

the provision for doubtful debts for Rs. 600. Discount of2 %on debtors and creditors are

to be anticipated.

Trading and Profit & Lass A\c. of RJ & Co. For the year ended 31stMar 08.


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Particulars Rs. Particulars Rs.


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EXAMPLE 3: From the following trial balance prepare the Trading and Profit & Loss Account &Balance Sheet after taking into considerations all the following adjustments.


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Trial Balance as on 31st March, 2003.

DEBIT BALANCES Rs. CREDIT BALANCES Rs.

OPENING STOCK 20,000 BILLS PAYABLE 10,000

SUNDRY DEBTORS 28,000 RETURN OUTWARDS 2,500

PURCHASE 40,000 SUNDRY CREDITORS 21,500WAGES 8,500 SALES 70,000

SALARIES 2,700 R.D.D. 400

OFFICE EXPENSES 2,445 CAPITAL 90,000

INSURANCE 1,300 10% LOAN (TAKEN ON 1ST OCT '02) 3,000

PLANT & MACHINERY 30,000 COMMISSION 1,000

RENT 1,800 DISCOUNT RECEIVED 500

TRAVELLING EXPENES 1,400 RENT RECEIVED 700

RETURN INWARD 3,500

LAND & BUILDING 44,800

BILLS RECEIVABLES 4,000

BANK BALANCE 6,655

FURNITURE 2,400

SUNDRY EXPENSES 800

BAD DEBTS 600

ADVERTISEMENT 700

199,600 199,600

ADJUSTMENTS:

CLOSING STOCK VALUED AT RS. 15,000

OUTSTANDING: WAGES RS. 500 & SALARIES RS. 300

PREPAID INSURANCE RS. 300

DEPRECIATE PLANT & MACHINERY @ 10%, LAND & BUILDING @ 15% AND FURNITURE @ 5%

PROVIDE RS. 500 FOR FUTHER BAD DEBTS & MAINTAIN RESERVE FOR DOUBTFUL DEBTS @ 5%

PROVIDE 5 % INTEREST ON CAPITAL

Trading and P&L A\c for the year ended 31st Mar '03

Particular Rs. Rs. Particular Rs. Rs.

TO OPENING STOCK 20,000 BY SALES 70,000

TO PURCHASES 40,000 LESS: RETURN 66,500

Balance Sheet as on 31st Mar '04

Liabilities Rs. Rs. Assets Rs. Rs.

CAPITAL 90 000


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TO PURCHASES 40,000 LESS: RETURN

INWARD 3,500

66,500

LESS: RETURN

OUTWARDS 2,500 37,500

BY CLOSING

STOCK

15,000

TO WAGES 8,500

ADD: OUTSTANGING 500 9,000

TO GROSS PROFITc\f 15,000

81,500 81,500

TO SALARIES 2,700 BY GROSS PROFIT

b\d

15,000

ADD: OUTSTANGING 300 3,000 BY COMMISSION 1,000

TO OFFICE EXPENSES 2,445 BY DISCOUNT RECEIVED 500

TO INSURNCE 1,300 BY RENT RECEIVED 700

LESS: PREPAID 300 1,000 BY NET LOSS c\f 10,510

TO RENT 1,800

TO TRAVELLING

EXPENES

1,400

TO SUNDRY

EXPENSES

800

TO DEPRECIATION

PLANT &

MACHINERY

3,000

LAND & BUILDING 6,720

FURNITURE 120 9,840

TO BAD DEBTS 600

ADD: FURTHER B.D. 500

ADD: NEW R.D.D. 1,375

2,475

LESS: OLD R.D.D. 400 2,075

TO ADVERTISEMENT 700

TO INTEREST ON

CAPITAL

4,500

TO INTEREST ON

LOAN

150

27,710 27,710

CAPITAL 90,000

ADD: INTEREST ON

CAPITAL

4,500 SUNDRY DEBTORS 28,000

LESS: NET LOSS 10,510 83,990 LESS: FURTHER B.D. 500

BILLS PAYABLE 10,000 27,500

SUNDRY CREDITORS 21,500 LESS: NEW R.D.D. 1,375 26,125

LOAN TAKEN 3,000 PLANT & MACHINERY 30,000

ADD: INTEREST @ 10

(FOR 6 MONTHS)

150 3,150 LESS: DEP @ 10% 3,000 27,000

OUTSTANDING WAGES 500 LAND & BUILDING 44,800

OUTSTANDING SALARIES 300 LESS: DEP @ 15% 6,720 38,080

BILLS RECEIVABLES 4,000

BANK BALANCE 6,655

FURNITURE 2,400LESS: DEP @ 5% 120 2,280

CLOSING STOCK 15,000

PREPAID INSURANCE 300

119,440 119,440


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RATIO ANALYSIS

RATIO ANALYSIS


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Ratio Analysis - is the process by which therelationship of different variables in financial

accounting (& especially of financial statements)are computed, established and presented.

It is a mathematical tool that measures therelationship between two figures, which are

interrelated to each other and mutuallyinterdependent.

It is an attempt to derive quantitative measuresconcerning the financial position & profitability of a

business enterprise.It can be used in understanding the future trend as

well as for static & comparative analysis.


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There are ratios for different purposes, for differenttypes of users and for different types of analysis. Ratios

can be expressed under the following the heads: Traditional Classification

Functional Classification

TRADITIONAL CLASSIFICATION Balance Sheet Ratio or Financial Ratios: they deal with

relationship between two item and group of items,which are together found in the balance sheet for e.g.

Ratio of Current Assets and Current Liabilities, Ratio ofStock to Working Capital etc

Revenue Statement Ratio or Income Statementh d l h h l h


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Ratio: These ratios deal with the relationshipbetween two items or two groups of items

which are both found in the income statementfor e.g. Ratio of Net Profit to Sales, Ratio ofExpense to Sales etc.

Composite Ratio or Inter-Statement Ratio orCombined Ratio: These ratios indicate therelationship between two items or two groupsof items of which one is found in the Balance

Sheet and other in the Income Statement fore.g. 'Ratio of Return on Capital Employed, Ratioof Return on Proprietors' Fund etc.

Functional Classification - The ratio may be classifiedin accordance ith the p rposes that it ser es for the


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in accordance with the purposes that it serves for thedifferent users of accounting information. On thisbasis the ratio are categorized as follows.

Liquidity ratio: these ratios analyze short time &immediate financial status of a businessorganization and indicate the ability of the firm tomeet its short-term current liabilities out if itsavailable short term resources. They are alsoknown as solvency ratios.

Leverage ratio: these ratios measure the

relationship between proprietors' funds &borrowed funds. They indicate the degree of thedebt financing in the capital structure of a firm.

Activity ratio: these ratios are designed to


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Activity ratio: these ratios are designed toindicate the efficiency of a firm in utilizing itsmonetary resources, its degree of productivity,effectiveness & its standards of performance.Hence they are also known as "efficiency &performance ratios.

Profitability ratios: these ratios are intended toreflect the overall efficiency of themanagement of the organization, its ability toearn a handsome return on capital employedor on shares issued and the effectiveness ofits investment strategies.

Balance Sheet Ratios


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Current Ratio - also known as solvency ratio or'Working Capital Ratio'. Standard current ratio is

2:1. Current ratio indicates the short-termfinancial position of the firm. It is expressed aspure ratio.

CURRENT ASSETS

CURRENT LIABILITIES

Current assets consists of Debtors, Cash &Bank Balance, Bills Receivable, Stock, PrepaidExpenses

Current liabilities consist of Creditors, BillsPayable, Outstanding Expenses, Bank Overdraft

Liquid Ratio - also known as quick ratio or acid


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test ratio. Standard quick ratio is 1:1.Greater theratio, stronger the financial position. It indicates

the solvency & financial soundness of thebusiness. It is expressed as pure ratio.

Quick Assets

Quick liabilities

Quick assets consist of Debtors, Cash, BankBalance, Bills Receivable.

Quick liabilities consist of Creditor, Bills

Payable, Outstanding Expenses.

Debt Asset Ratio - This ratio indicates the percentageor the proportion of the total assets created by the


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or the proportion of the total assets created by thecompany through short-term & long-term debt.

DEBT

ASSETS

Debt - all liabilities including the short term or long term &

Assets = all assets, i.e., fixed and current

Debt equity ratio - It shows the proportion of debt toequity. It is expressed pure ratio.

DEBT

EQUITY

Debt - all liabilities including long term and short term

Equity= Net Worth + Preference Capital

Proprietary Ratio This ratio indicates theproportion of proprietors' funds to the total assets


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proportion of proprietors funds to the total assetsof the firm.

Proprietors fund

Total assets

Stock to working capital ratio: it expresses therelationship between closing stock & working

capital. Closing stock x 100

Working capital

Capital Gearing Ratio it indicates the relation

between fixed income bearing securities to fundson which no fixed returns are to be paid.

Capital gearing ratio = Fixed income bearing securities

N fi d i b i i i


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Non fixed income bearing securities

Revenue Statement Ratio Gross Profit Ratio: Gross profit ratio indicates the

efficiency of production and trading operations. It isexpressed as percentage Gross profit ratio=Gross Profit x 100

Net Sales

Operating Ratio: It is index of managerial operation tocontrol operating expenses.

Operating ratio:Cost of Goods Sold + Operating Expenses x 100Net sales

Expenses Ratio: The ratio of each item of expense oreach group of expenses to Net Sales is known as an


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each group of expenses to Net Sales is known as anExpenses Ratio expressed as a percentage inrelation to net sales.

Administrative Expenses Ratio = Administrative Expenses x 100

Net Sales

Selling & Distribution Expenses Ratio = S&D Expenses x 100Net Sales

Financial Expenses Ratio = Financial Expenses x 100

Net Sales

Material Consumed Ratio = Material Consumed x 100

Net Sales

Net Profit Ratio: Net Profit Ratio indicated thel ti hi b t t fit d t l N t


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relationship between net profit and net sales. NetProfit can be either operating net profit or net profit

after tax or net profit before tax. Net Profit before Tax Ratio = Net Profit before Tax x 100

Net Sales

Net Profit after Tax Ratio = Net Profit after Tax x 100

Net Sales

Net Operating Profit Ratio: It is a relationship betweennet operating profit and net sales which is express inpercentage. Net operating profit is equal to grossprofit minus all operating expenses.

Net Operating Profit Ratio = Net Operating Profit x 100

Net Sales

Stock Turnover Ratio: Stock Turnover Ratio is alsoknown as Inventory Ratio" or "Inventory Turnover


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known as Inventory Ratio or Inventory TurnoverRatio or Stock Velocity Ratio. This ratio measure thenumber of times stock turns or flows or rotates in anaccounting period compared to the sales effectedduring the period.

Stock Turnover Ratio = Cost of Goods Sold x 100

Average Stock

Average Stock is calculated by adding inventory in thebeginning of the period to the inventory at the close ofthe period and the product is divided by two. When the

opening stock figure is not available, closing stock canbe considered as the average stock

Average Stock = Opening stock + Closing Stock2

Combined Ratios - Combined Ratios or Inter-Statement Ratios shows relationship between two


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Statement Ratios shows relationship between twoitems or two groups of item of which one is fromBalance Sheet and one of the revenue statements.

Return on Capital Employed - This ratio explains the relationshipbetween total profits earned by the business and total investmentmade or total assets employed. This ratio, thus measures theoverall efficiency of the business operations. This ratio is also

known as "Return on Total Resources". Return on Total Resourcesis calculated by dividing Net Profit before interest on loans anddebentures by total assets (fixed assets and current assets). Thisis always expressed as a percentage.

Return on Capital Employed Ratio = Net Profit before Interest and Tax x 100

Capital Employed

Capital Employed = Owned Funds + Borrowed Funds (OR)

Capital Employed = Fixed Assets + Current Assets -Current Liabilities

Return on Proprietor's Funds - It is also known as"Return on Proprietors Equity" or "Return on


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Return on Proprietors Equity or Return onShareholders Investment". The above ratio indicatesthe relationship between net profit earned and totalProprietors' Funds.

Return on Proprietors' Ratio = Net Profit Tax x 100

Proprietors Fund

Proprietors Funds = Equity Share Capital + Preference

Share Capital + Reserve and Surplus - MiscellaneousExpenses

Return on Equity Share Capital - This ratio indicates therate of earning on the equity or ordinary share capital.

Return on Eq. Share Capital Ratio = Net profit after Tax- Preference Dividend x 100Equity Share Capital


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Debtors Turnover Ratio (Debtors Velocity) - DebtorsTurnover Ratio is also known as "Accounts ReceivableT R ti " "A C ll ti P i d" It tt t t


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Turnover Ratio" or "Average Collection Period". It attempts tomeasure the collectability of debtor's and other accountreceivable. It shows the rate at which the trade debtors arebeing collected.

Debtors Turnover Ratio = Credit Sales x 100

Avg. Debtors + Avg. Bills Receivable

Debt Collection Period - Debt Collection Period indicates theextent to which the debts have been collected in time.

Debt Collection period = No. of days in a year

Debtors Turnover

Creditors turnover ratio - Creditors' turnover shows thespeed with which payments are made to the supplier forpurchases made from them. It is a relationship between netcredit purchases and average creditors.

Creditors turnover ratio = Credit Sales x 100

Avg Creditors+ Avg Bills Payable


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Avg. Creditors+ Avg. Bills Payable

Credit Collection Period - Creditors TurnoverRatio is further used to find out the average rateof payables by using the following formula. Credit Collection period= No. of days in a year

Creditors Turnover

FINANCIAL RATIO ANALYSIS


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EXAMPLE - Following is the Balance Sheet of XYZ Ltd. Balance Sheet as on 31stMarch, 2007


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You are required to calculate Balance Sheet ratios.

In the Books of XYZ Ltd. Vertical Balance Sheet as on 31stMar 07


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Following is the Profit and Loss A/c of SAM JAM Ltd. For the year ended 31st Mar 06.You are required to prepare Vertical Income Statement for the purpose of calculationof Gross Profit Ratio, Operating Cost Ratio, Stock Turnover Ratio


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o G oss o t at o, Ope at g Cost at o, Stoc u o e at o


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Financial Statements are prepared with a view to exhibit thetrue and fair financial position of the concern.

But in the real scenario, inflationary trends affects, the positionas shown in the financial statements thereby not depicting thetrue and fair value of financial position of the company.

Under the conditions of inflation, the prices of all the factorsand inputs of the production are on a constant rise.

The value of money declines in real term as the same quantity

of goods is purchased at higher costs.

Limitations of Historical costs-based Financial Statements: Undercharging depreciation & higher value of inventories


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Undercharging depreciation & higher value of inventories.

Unreliable results shown by financial statements leading

to wrong decision making by the users of financialaccounting information.

Payment of heavy dividends and taxes as the profits areinflated

Insufficient funds for replacement of fixed assets after theend of useful life.

Inefficient working capital management.

Comparison of financial figures becomes difficult andmisleading.

Gains from the appreciation of assets are not accountedfor.

MERITS OF INFLATION ACCOUNTINGThe objective of inflation accounting is to embraces the true and fair


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value view of accounts & following are the merits of Inflationaccounting:

Correlation of current cost with the current revenue leading tomore realistic profitability position of the business.

Prevents heavy payment of dividend & taxes.

Depreciation is charged on current values of the assets

It facilitates meaningful comparison of the records of the differentperiod.

Guides decision making of investors and public, as it depicts trueprofitability and financial position of the organization .

DEMERITS OF INFLATION ACCOUNTING Implementation and follow up has many obstacles in it.


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p p y

Makes financial statements more complicated as change to price level

needs to be given adjusted.

Valuation at current prices takes different views.

Income tax department does not except the accounts prepared &profits shown under the inflation accounting system.

In deflation, complex calculation are required there by furthercomplicating the accounting process.

Charging of the depreciation more than the cost of the asset notallowed by standard accounting principles.

METHODS OF MAINTAINING INFLATION ACCOUNTINGThere are two methods of maintaining the books of accounts as per

i fl i i


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inflation accounting.

Current Purchasing Power (CPP): Under CCP the historical costs areadjusted with the general price index. The items in the financialstatement are adjusted & revalued at the general price level.

For e.g. an asset purchased at Rs. 15000 in 1981-82 has to have X

value in 2009-10. This X value is found out by dividing purchaseprice of asset by general index value of the year of purchase and thenmultiplying it with the general price index value of the current year.General Price index value of 1980 is 100 whereas its current yearsvalue is 551. So the value of asset in 2009-10 is 15000/100 x 551 =82650. The depreciation will be charged on this current value of

asset.

Current Cost Accounting (CCA): The CCA method is morerealistic as it reflects more correct impact of inflation by


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p ymeasuring the current cost of individual asset by applyingspecific index value instead of general index value.

This method attempts to show the assets at current costinstead of showing the changes in general purchasing power ofthe money.


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Fund Flow&

Cash Flow Statements

A statement which summaries the changes in the amount


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A statement which summaries the changes in the amountof the funds of a firm, indicating the sources from which

the funds have come in the pool of Working Capital andthe uses to which the funds have been put. A Funds FlowStatement concentrates on the inflows and outflows inthe Working Capital. It shows the sources

The term 'Funds' may denote working capital or cash.

Working Capital: A statement of inflow & outflow ofWorking Capital (Current Assets - Current Liabilities) isknown as a Funds Flow Statement.

Cash: A statement of inflow and outflow of cash is called

Cash Flow Statement

Limitations of Balance Sheet: A Balance Sheet shows theamounts of Funds Available and the Funds Employed on aparticular date


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particular date.

Balance Sheet: Funds Available = Funds EmployedThe Funds Available during a year change due to inflow of

funds from various sources such as issue of shares, issue ofdebentures, obtaining new loan, sale of assets and above allthe profits made by the concern during the year. The FundsEmployed during a year change due to outflow of funds for

various uses such as repayment of loan, purchase of assets,redemption of debentures etc.

Funds Flow: Change in Funds Available = Change in FundsEmployedSince the Balance Sheet does not show the flow of funds of a

concern during a year, a separate statement has to beprepared for this purpose. Such statement is called theFunds Flow Statement.


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Funds Flow Statement treats working capital as a fund. Let us understand how theworking capital of a concern constitutes a Fund. Cash is the basic 'Fund' of anenterprise. The cash balance in the cash box can be said to be a fund-an amountset aside to meet the immediate cash payments However not all business


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set aside to meet the immediate cash payments. However, not all businesstransactions involve immediate receipt or payment of cash. For example, in creditsales cash is receivable or credit purchases cash is payable only after certain

period. When cash is receivable or payable in future, the transaction gives rise toDebtors or Creditors. Thus, credit sales give rise Current Assets & creditpurchases give rise to Current Liabilities. Current Assets show the CashReceivable and Current Liabilities show the Cash payable.

The difference between Current Assets (CA) and Current Liabilities (CL) shows theamount of Working Capital (WC). Working Capital is thus Cash Receivable less

Cash Payable. It is the net Cash Receivable by a concern in near future.Working Capital = Current Assets - Current Liabilities [WC = CA - CL]Working Capital = Net Cash ReceivableSo, Working Capital is like the cash balance in the cash box. Cash balance shows

excess of cash received over cash paid. Working Capital shows the excess of cashreceivable over cash payable. Just as a concern should always have enough cash

in the cash box to be able to make cash payments whenever required, it shouldalways have sufficient Working Capital to be able to meet short term liabilities.Thus, Working Capital (Net Cash Receivable) is a fund: an amount set aside out ofCash Receivables to meet liabilities on account of Cash Payables.

Flow of funds means increase or decrease in the fund ofWorking Capital. Increase in funds is due to inflow of


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g pfunds from various sources. Decrease in funds is due tooutflow of funds for various purposes. There is a flow offunds when any transaction changes the amount ofWorking Capital. Working Capital is a Fund whichincreases when Current Assets increase or CurrentLiabilities decrease or Working Capital decreases when

Current Assets decrease or Current Liabilities increase. An Increase in CA causes an Increase in Working Capital

An decrease in CA causes an decrease in Working Capital

An Increase in CL causes an decrease in Working Capital

An decrease in CL causes an Increase in Working Capital

The cash flow statement is more useful when cash flows are classified intomeaningful groups. A typical classification has been to separate sourcesfrom uses of cash. The disadvantage of such a classification is that it doesnot focus on categories of related cash flo s In estors creditors &


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not focus on categories of related cash flows. Investors, creditors, &managers consider the relationships among certain components of cashflows to be important to their analysis of financial performance.

Besides, the sources and uses classification often ends up as a listing ofchanges in balance sheet amounts, providing little explanation about anenterprise's ability to meet obligations and pay dividends, or about itsneeds for external financing.

The cash flow statement will reflect the cash flow effects of each of the

major activities of the enterprise when cash flows are classified accordingto whether they stem from operating, investing, or financing activities.

Such a classification enables significant relationships within and among thethree kinds of activities to be evaluated. Grouping of cash flows into thesecategories will also assist investors, creditors, and managers inunderstanding trends in the cash flows of an enterprise as well as in

making comparisons with other enterprises. The classification of cashflows into operating, investing and financing categories will depend onthe nature of the business.

Operating activities. These involve producing and delivering goods and providing services.

Cash inflows from operating activities. Examples:: Cash sales of goods and services,Advances from customers, Collections of debtors.


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Cash outflows from operating activities. Examples: Payments to suppliers for materialsand for services, Payments to employees for services, Payments to governments for taxesand duties.

Investing activities. These involve making and collecting loans, acquiring & disposing ofdebt and equity instruments, and fixed assets.

Cash inflows from investing activities. Examples: Sales of fixed assets, Collections ofloans, Sales of shares and bonds ofother enterprises, Interest and dividends received onloans and investments.

Cash outflows from investing activities. Examples:Payments (including advance or downpayments) to buy fixed assets, Disbursements of loans, Payments to buy shares andbonds ofother enterprises.

Financing activities. These involve obtaining resources from owners and providing themwith a return on, and return of, their investment, borrowing money and repayingamounts borrowed, and obtaining and paying for other resources obtained from longterm creditors.

Cash inflows from financing activities. Examples: Proceeds from issuing shares andbonds, Proceeds from loans.

Cash outflows from financing activities. Examples: Payments to buy back or redeem ownshares, Principal payments of bonds and loans, Payments of interest, Payments ofdividends.

Non-cash investing and financing activities: These aretransactions that affect assets or liabilities but do not resulti h i fl tfl


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in cash inflows or outflows.

Examples: Converting debt into equity, Acquiring assets by

assuming directly related liabilities such as purchasing abuilding incurring a mortgage to the seller, Obtaining anasset by entering into a hire purchase or a finance lease,Exchanging non-cash assets or liabilities for other non-cashassets or liabilities.

Although non-cash transactions do not result in cash inflows oroutflows in the period in which they occur, they generallyhave a significant effect on the prospective cash flows of acompany. For example, conversion of debt into equity willeliminate payment of interest on the debt. Again, enteringinto a finance lease obligation requires future lease paymentsin cash. An enterprise should provide information about allnoncash investing and financing activities in a note orschedule to the cash flow statement.


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Net Cash Flow from Operating Activities - The profit and loss account shows whether anenterprise's operations have resulted in a profit or loss but does not indicate cash inflows andoutflows from the operations. This is because net profit is based on accrual: we recordrevenues and expenses when earned or incurred although we may not have received or paid all


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revenues and expenses when earned or incurred although we may not have received or paid allof them. Further, depreciation, amortization, and provision for doubtful debts do not reflectcash outflows in both current and future periods. Thus, the net profit will not indicate the netcash flow from operations. In order to arrive at net cash flow from operating activities, we have

to restate revenues and expenses on a cash basis. We do this by undoing the accrualaccounting adjustments.

Starting with net profit, we eliminate the effect of revenues not received and expenses not paid in order to arrive at net cashflow from operating activities.

There are two alternatives for reporting net cash flow fromoperating activities(i) direct method & (ii) indirect method.

Th di t th d h j l f ti h


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The direct method shows major classes of operating cashreceipts and payments, such as cash received from

customers, cash paid to suppliers and employees, andincome tax paid, the sum of which is the net cash flow fromoperating activities, as shown now:

The indirect method starts with net profit and adjusts it forrevenue and expense items that did not involve operatingcash receipts or cash payments in the current period to


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cash receipts or cash payments in the current period toarrive at net cash flow from operating activities as follows:

FORMAT OF THE CASH FLOW STATEMENT - The statement reports cash flows from operating,investing and financing activities, usually in that order. Within each category, cash inflows andoutflows are reported separately. For example, cash outflows for acquisition of fixed assets areshown separately from proceeds from sale of fixed assets, and not offset. Similarly, cashi fl f b i h l f h fl l


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inflows from borrowings are shown separately from cash outflows to repay loans. Net cashprovided by refers to net cash inflow, and net cash used in refers to net cash outflow. Asupplemental schedule of noncash investing and financing activities appears at the end of thestatement.

We need to make the following three types of adjustments in order to convert netprofit into net cash flow from operating activities:

Non-cash items: Provision for doubtful debts, depreciation, depletion, andamortization do not require cash outflows in the current period Hence we add


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amortization do not require cash outflows in the current period. Hence, we addthem back to net profit to arrive at net cash flow from operating activities.

Non-operating items: We remove non-operating items, such as gains and losses

on disposal of fixed assets and investments, interest income, and interestexpense from the operating activities section and take them to the investing orfinancing activities section, as appropriate.

Changes in working capital items: We adjust net profit for changes in workingcapital items, such as debtors, inventory, prepaid expenses, creditors, and billspayable. For example, if debtors increased during the current period, cash

received from customers will be less than sales reported in the profit and lossaccount. Similarly, if inventories increased during the current period, purchaseswill be more than cost of goods sold. Thus, to convert net profit into net cashflow from operating activities, we deduct increase (add decrease) in debtors,inventory, and prepaid expenses from (to) the net profit. On the contrary, we addincrease (deduct decrease) in creditors and bills payable to (from) the net profit.We should consider change in income tax payable if the starting point of the

computation is profit after tax. Note that the adjustments for changes incurrentassets and current liabilities are exactly the same as discussed under the directmethod.

Adjustments to Convert Net Profit into Net Cash Flow from Operating Activities-Indirect Method. Converting net profit into operating cash flow requires three kindsof adjustments.


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PREPARING THE CASH FLOW STATEMENT: We now see how to prepare the cash flowstatement. The data for the example given below consist of a balance sheet at twoconsecutive dates, a profit and loss account, and details of selected transactions.


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Additional information: Purchased machinery costing Rs 173,000; Sold machinery withcost of Rs 67,000 and accumulated depreciation of Rs 51,000 for Rs 22,000; Purchasedinvestments for Rs 26,000; Sold investments costing Rs 51,000 for Rs 42,000; Purchased

machinery for Rs 49,000 on unsecured credit; Issued at par shares for Rs 100,000;Converted secured debentures of Rs 50,000 to equity shares of Rs 10 at par; Paiddividends of Rs 25,000; Repaid unsecured loans of Rs 1,000; Redeemed secureddebentures of Rs 27,000 at par; Wrote off Rs 10,000 of debtors when a customer becameinsolvent and provided Rs 12,000 for doubtful debts included in Selling and AdministrativeExpenses; Received Rs 3,000 from an insurance claim for loss suffered in an earthquake.


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EXAMPLE 2: In the above balance sheet, the CA & CL items are related to workingcapital. The working capital on the balance sheet date (i.e., 1stJan 06) is:

Current assets - Current liabilities = Working capital

Assuming that after the balance sheet date, the following transactions take place:Obtained a further unsecured loan of Rs. 1,00,000 in cash.Sold Rs.2,00,000 worth of inventories (at cost) for a price of Rs.3,00,000 on credit.Sold investments costing Rs. 1,00,000 for Rs. 1,20,000.

Purchased fixed assets for Rs.1,00,000. The amount being payable after 10 years-the loan is secured by the property.Collected Rs. 2,00,000 from book debts.

Working Capital Affected Working Capital Not Affected

Sr.

No.

Transaction Item Increase

(Rs.)

Decrease

(Rs.)

Item Increase

(Rs.)

Decrease

(Rs.)


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1 Unsecured Loan Obtained Bank & Cash 100,000 Unsecured Loan 100,000

2 Sale of Inventories Book Debts 300,000 Accumulated

Profit

100,000

Inventory 200,000

3 Sale of Investment Bank 120,000 Invesement 100,000

Profit on

Investment

20,000

4 Purchase of Fixed Assets

through Loan

No Affect Fixed Assets 100,000

Secured Loans 100,0005 Collection of Money from

Debtors

Bank & Cash 200,000

Book Debts 200,000

Net Increase in Working

Capital

320,000

720,000 720,000

Example 3: The following is the Balance Sheet of B.S. Industries as on 31st Mar '2003 with the corresponding figures

Particulars 31-3-2003 Previous Years

Fixed Asset

Land & Building 370,000 394,600


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g

Plant & Machinery 50,000 29,680

Current Assets, Loans & Advances

Stock in Trade 220,000 152,500

Sundry Debtors 166,000 156,000

Bills Receivables 34,000 18,500

Advances paid to Contractors 10,000 2,000

Cash in Bank 20,000 10,000

870,000 763,280

Liabilities

Issued Share Capital

3500 Equity Shares of Rs. 100 each 350,000 350,000

Recerves & Surplus 254,000 180,000

Secured Laons from Banks 16,000 -

Current Liabilities

Sundry Creditors

190,000 187,280

Bills Payables 60,000 46,000

870,000 763,280

You are required to prepare the Statement of Changes in Working Capital


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Example 4: Following are the Balance Sheet of Shree Traders for two years:

Particulars 31-3-2003 31-3-2002

Liabilities

201 500 162 000


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Capital201,500 162,000

Creditors45,000 30,000

Accured Expenses 5,000 -

251,500 192,000

Assets

Machineries90,000 40,000

Furniture10,000 10,000

Stock 35,000 35,000

Debtors108,000 90,000

Cash on hand7,500 6,000

Cash at Bank1,000 11,000

251,500 192,000

Prepare the statement of changes in working capital


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