Accounting for Managers

Accounting for Managers

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Introduction to Accounting InformationCHAPT

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INTRODUCTION

Rapid growth in cross-border investments over the past two decades has resulted in an increasing demand for high quality and uniform financial reporting. Investment decisions are made based primarily on the publicly available information. Given, it is imperative to ensure credible, comparable and transparent financial reporting on part of the listed firms so as to make sure that investors belief in the efficiency of the capital markets remains intact.

This Chapter introduces a conceptual framework for preparing financial statements, defining the objectives of financial reporting and the qualitative characteristics and elements of financial statements.

OBJECTIVES

After reading this chapter, you should be able to:

Assess the need for Accounting Information

Determine the need for a conceptual framework

Recognize the elements of financial statements

Identify the Principal Financial Statements

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Section 1

The Need for Accounting Information

We live in the information age, where every decision that we make requires collecting relevant data pe r ta in ing to t he dec i s i on , analyzing and converting them into usable information, identifying the various alternatives, considering their consequences and zeroing in on a decision. Take for instance a decision to purchase a car. We collect all the relevant information such as types of cars, makes, manufacturers, mileage, etc. Next we decide which car is suitable and best for us. It consumes resources in terms of money, time and mental work. Now, think of individuals and enterprises which manage billion-

r u p e e b u s i n e s s e s . I f t h e information provided to them is not accurate, timely, etc., it could lead to poor decisions and, in turn, cost organizations billions of rupees.

In an organization different people need d i f f e ren t i n f o rma t i on , collected from different sources for making different decisions. For example, investors and creditors use information to assess the future risks to and return on their potent ia l investments . Thus depending on the information needs , i n fo rmat ion may be quantitative or non-quantitative.

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The above figure clearly states that information can be quantitative or/and non-quantitative. Quantitive information can be accounting information and non-accounting information. Further, accounting information can be divided into Operating Information, Financial Accounting Information, Management Accounting Information and Tax Accounting Information. They are defined as follows:

Operating information: Information about the day-to-day operations of the business is referred to as operating information.

Management accounting: Accounting information specifically prepared to help managers make decisions and to manage the business.

Financial Accounting: Information relating to the financial performance and financial position of a firm/business is given by financial accounting. It is concerned with providing relevant financial information to various external users.

Ta x a c c o u n t i n g : T h i s information helps in filing tax returns. In some countries such as USA, companies need to maintain separate records for tax accounting p u r p o s e s o w i n g t o differences in rules for tax accounting and financial accounting.

Operating information and management accounting information is generated only for people internal to the organization, but financial accounting information is useful both for internal as well as external users. For example, investors, suppliers, customers, financial institutions and government make use of Financial Accounting Information extensively for decision-making purposes.

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Keynote 1.1.1: Quantitative and Non-quantitative Informa-tion

Video 1.1.1: Financial Accounting vs Managerial Accounting

CONCEPTUAL FRAMEWORK

The conceptual framework is a very important prerequisite to understand the financial statements. It describes the basic concepts that underlie the preparation of financial statements. It is designed to prescribe the nature, functions and limits of financial accounting and can be used as guidelines for maintaining consistency in standards. The objective of the framework is to narrow down the diverse accounting principles and procedures being followed, resulting in harmonized regulations, transparency and comparability. While the Financial Accounting Standards Board (FASB) has issued conceptual framework for companies listed in the US capital markets, the International Accounting Standards Board (IASB) has issued equivalent framework to be followed globally. The Institute of Chartered Accountants of India (ICAI) has issued framework to be complied by the companies operating in India.

Here we deal with the conceptual framework issued by the FASB of the US which constitutes foundation of Financial Reporting.

The objectives of the conceptual framework are:

To serve as the foundation upon which the Board (FASB) can construct standards that are both sound and internally consistent.

Intended for use by the business community to help understand and apply standards to assist in their development.

Provide guidance in analyzing new or emerging problems of financial accounting and reporting.

Solve complex financial accounting and reporting process by providing a set of common premises as a basis for discussion.

Solve complex financial accounting and reporting processes by limiting areas of judgment and discretion and exclude from consideration potential solutions that are in conflict with it.

Impose intellectual discipline on what traditionally has been a subjective and ad hoc reasoning process.

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C o n c e p t u a l framework issued by ICAI is provided here.

T h e C o n c e p t u a l Framework issued by the IASB is provided here

We shall limit our discussion here to only a few components of the conceptual framework. The scope of the Conceptual Framework is applicable to General Purpose Financial Statements. Financial statements may be general purpose financial statements and special purpose financial statements.

General purpose financial statements are prepared for the common needs of the users of the financial statements. Some users need additional information for their decision-making, so while preparing these statements their need should be kept in mind. Additional information is provided in the form of notes, schedules and explanatory notes, etc. Special purpose financial statements are prepared for special purposes like tax computations, for submitting it to financial institutions, etc. These special purpose financial statements are not covered by the said framework.

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ICAI

IFRS

The components of the conceptual framework given by FASB include:

Objectives of Financial Report-ing by Business Enterprises.

Qualitative Characteristics of Accounting Information.

Elements of Financial State-ments of Business Enterprises.

Objectives of Financial Report-ing by Non-Business Organiza-tions.

Recognition and Measurement in Financial Statements of En-terprises.

Elements of Financial State-ments.

Using Cash Flow Information and Present Value in Account-ing Measurements.

ICAI

IFRS

http://220.227.161.86/238acc_bodies_framework_ppfs.pdf

http://www.ifrs.org/NR/rdonlyres/363A9F3B-D41C-41E7-9715-79715E815BB1/0/EDConceptualFrameworkMar10.pdf

REVIEW 1.1.1

Check Answer

Question 1 of 3FASB conceptual framework is applica-ble to

A. Financial statements pre-pared for tax purposes

B. Financial statements pre-pared for registration pur-poses

C. General purpose financial statements

D. Financial statements pre-pared for cost audit purposep-poses

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Section 2

Components of Conceptual Framework

Objectives of Financial Reporting

As per the Statement of Financial Accounting Concepts (SFAC) 1 of the FASB, the objectives of financial reporting are:

Financial reporting provides information that is useful in m a k i n g b u s i n e s s a n d economic decisions. For this purpose, the users of financial statements may be internal to the organization such as management and directors of the business, or may be

external to the enterprise such as lenders, suppliers, potential investors, etc.

Financial reporting provides understandable information that will aid investors and creditors in predicting future cash flows of a firm. Investors a n d c r e d i t o r s r e q u i r e information to evaluate the t i m i n g , a m o u n t a n d uncertainties of future cash flows.

It provides information relative to an enterprises economic resources, claims to those

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resources/obligations, and the effect of those transactions, events and circumstances that change resources and claims to resources, etc.

Users of financial reporting require information so as to ascertain:

The Economic Position of the Enterprise: Financial Reporting information provides the users with the information on the economic resources, obligations and owners equity that indicates the firms strengths, weaknesses, liquidity and solvency.

The Economic Performance of the Enterprise: Financial Reporting information provides the users with information about the economic performance and earnings of the enterprise that help in predicting the future performance of the firm. This information helps in assessing the changes in the economic resources and predicting the companys ability to generate cash flows in the future based on the current resources.

The Liquidity and Solvency of the Firm: Financial Reporting information about cash and other funds flows such as cash flows from borrowings, repayment of borrowings, changes in economic resources, obligations, owners equity and earnings help in assessing the firms liquidity and solvency.

Management Stewardship and Performance: An enterprises efficient and profitable utilization of resources, which is reflected in its economic performance and position, speaks of the management stewardship and performance,

circumstances, uncertainties, etc., enhances the usefulness of financial information.

Qualitative Characteristics of Financial Statements

Information to be useful to the users should possess certain characteristics. The qualitative characteristics are the criteria to be used in choosing and evaluating the accounting and reporting policies. These characteristics help to evaluate the

strengths and weaknesses of accounting and its relevance to effective analysis and decision-making.

SFAC 2 identifies the f o l l o w i n g characterist ics that m a k e i n f o r m a t i o n useful.

RELEVANCE

Information should be r e l e v a n t t o t h e

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Video 1.2.1: Objectives and Qual-ity of Financial Reporting

decision-making needs of the user. Information is said to be relevant when it influences the economic decision of the users. Relevance of information is said to be affected by its nature and materiality. Information is said to be relevant when it provides feedback value and predictive value. Feedback value is derived from information concerning past events. Predictive value is derived from information concerning future events. Information to the relevant must be timely.

RELIABILITY

Information must be reliable. Reliability means the extent to which information is representationally faithful, verifiable and neutral. Representational faithfulness implies that information must represent faithfully the transactions and events it purports to represent. The quality of verifiability means that several independent measures obtain the same accounting measure. This quality helps to reduce and mitigate measurement bias. The quality of neutrality implies free from bias and material errors.

COMPARABILITY

It enhances the ability of investors and creditors to compare information across companies to make their resource allocation decisions. The financial statement users must be able to compare the statements of an entity through time in order to identify trends in financial position and compare the financial statements of different entities in order to evaluate their relative financial position and performance. Lack of consistency threatens the comparability of the financial statements.

CONSISTENCY

The quality of consistency requires the use of same accounting principles from one period to another. Consistency contributes to information usefulness. This does not in any way imply that a change in accounting principle cannot and should not be made. A change in accounting principle leads to inconsistency, but it is acceptable if the disclosure is made and the change was imperative.

Elements of Financial Statements

Financial statements portray the effects of financial transactions by grouping these into broad classes according to their economic characteristics termed as the elements of financial statements. SFAC 6 defines ten interrelated elements as follows:

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Keynote 1.2.1: Elements of Financial State-ments

ASSETS

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

LIABILITIES

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

EQUITY

The residual interest that remains in the assets after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

REVENUES

Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing major and central operations.

EXPENSES

Outflows or other using up of assets or occurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major and central operations.

GAINS

Increases in equity (Net Assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distribution to owners.

LOSSES

Decrease in equity (Net Assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distribution to owners.

COMPREHENSIVE INCOME

The change in equity of a business enterprise during a period from transactions and other events and circumstances from sources other than investments by owners or distribution to owners.

INVESTMENTS BY OWNERS

Increases in equity of a particular business enterprise resulting from transfers to it for the purpose of increasing ownership interests.

DISTRIBUTION TO OWNERS

Decreases in the equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners.

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Recognition Criteria of Elements of Financial Statements

The principles of recognition help determine as to when an element is to be included in the statements, while measuring principles determine the valuation of such elements. There are four revenue recognizing criteria: definitions, measurability, relevance and reliability. In case an element meets the definition of an element, is capable of being reliably measured, and makes a difference in the decision of the user and is verifiable, neutral and representationally faithful, it needs to be included in the financial statements.

Measurement Criteria of Elements of Financial Statements

Measurement is the process of determining the amount of elements to be recognized and carried to the income statement and balance sheet. There are following four basic measurement described in the framework:

HISTORICAL COST (HISTORICAL PROCEEDS)

Assets such as plant, property and equipment and most of the inventories are reported at their historical values. These are the amounts of cash or its equivalents that are paid in order to acquire such assets and are commonly adjusted after the acquisition for amortization or other allocations. Liabilities are reported at cash or its equivalent that is received when the obligation was incurred and may be adjusted after acquisition for the purpose of amortization or other such allocations.

CURRENT COSTS

This is used for some inventories and represents the cash or its equivalent that would have to be paid for acquiring the assets currently. Certain assets like investments are to be reported at their current market values. In the case of liabilities that involve marketable securities and commodities, these are to be reported at their current market value.

NET REALIZABLE (SETTLEMENT) VALUE

In the case of short-term receivables and some inventories, reporting is done on the basis of their net realizable values. Liabilities that are incurred and which are known or estimated and payable at future dates are reported at their net settlement values.

PRESENT (OR DISCOUNTED) VALUE OF FUTURE CASH FLOWS

In the case of long-term receivables, reporting is done at their present or discounted values which is the present value of the future cash inflows which an asset is expected to be converted in due course of the business less the present value of the cash outflows that are expected to be converted in the due course of the cash outflows that are necessary to obtain those funds.

Users of Financial Statements

The basic objective of preparation of financial statements is to provide information to the users of the statements. The users may be the internal people or external people to the organization.

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SHAREHOLDER/INVESTORS/OWNERS

The shareholders/owners are the investors who provide capital or resources to an enterprise in exchange for a share in ownership of the enterprise. The information provided in the financial statements help them to arrive at various investment decisions such as whether to invest further, or to withdraw the existing investments, etc. Similarly, potential investors use the financial statements to arrive at investment decisions.

MANAGEMENT

Since management has the ultimate responsibility for the financial performance, they periodically compile and interpret the financial statements. An analysis of the financial figures is essential for the smooth and efficient functioning of the enterprise.

LENDERS

Banks, financial institutions and other lenders provide funds to the business entity They would be willing to part their money only if they are assured a periodical return in the form of interest and ultimate return of their principal. The financial statements reflect the profitability and long-term solvency of the business and provide the assurance which the lenders look out for.

SUPPLIERS/CREDITORS

The suppliers look for the short-term liquidity and solvency of the business for judging the credibility of the firm through

the analysis of the statements. The financial statements facilitate the creditors in ascertaining the capacity of the organization to pay on time consideration for the goods and services supplied.

EMPLOYEES

Employees have vested interest in the continued and profitable operations of the organization in which they work. Most of the incentive plans of large number of enterprises are directly related to the profitability of their businesses. This further magnifies the interests of the employees in their companys future profitability and health.

CUSTOMERS

They comprise groups such as producers, wholesalers and retailers and final consumers. Legal obligations associated with guarantees, warranties and after sales service contracts tend to establish long-term relationship between the business and its customers. The financial statements may be used by the customers to draw inferences about the long-term viability of the firm.

GOVERNMENT AND OTHER REGULATORY AGENCIES

Governments and other regulatory agencies plans and policies in respect of taxation, subsidies and incentives are guided by the requirements of the industries and also their past performances. A lot of information in this regard can be gathered from a scrutiny of the financial statements of business enterprises.

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RESEARCH

Scholars undertaking research into management science covering diverse facets of business practices look into the financial statements for the information eventually used for analysis.

OTHERS

Diverse persons such as academicians, researchers and analysts may approach business firms for information regarding the financial performance. The public, in general, also examine the financial statements for employment opportunities, health of the business concerns, in particular, and the economy as a whole.

Additional resources to this section

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REVIEW 1.2.1

Check Answer

Question 1 of 3Which among the following is the objective of the FASB conceptual framework

A. Intended to serve as the foun-dation upon which the Board (FASB) can construct stan-dards that are both sound and internally consistent.

B. Intended for use by the busi-ness community to help under-stand and apply standards to assist in their development.

C. Provide guidance in analyzing new or emerging problems of financial accounting and re-porting.

D. All of the above.

Video 1.2.2: Conceptual Framework

Section 3

Principal Financial Statements

Basically there are three principal financial statements, viz., the balance sheet, the income statement and the statement of cash f lows. However, some countries r e q u i r e p r e p a r a t i o n o f additional statements such as preparation of changes in s h a r e h o l d e r s e q u i t y , explanatory notes, etc.

Balance Sheet

It is also called the Statement of Financial Position. It depicts the financial position of a company on a particular date.

It gives the information of how t h e c o m p a n y h a s b e e n financed and how that money has been invested in various p roduc t i ve resou rces . A company can obtain finance from owners and outsiders.

The balance sheet is prepared based upon the fundamental accounting equation of

Assets = Liabilities + Equity

Thus, the balance sheet has three major sections, viz., assets (i.e., the resources of the company), liabilities (i.e.,

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the debts of the company) and shareholders equity (i.e., the amount invested by owners). We have already defined it in the previous section.

The values given in the balance sheet change from time to time, hence the values appearing in the balance sheet pertain to a specific date, generally, the end of the business financial year (for example, March 31).

Income Statement

It is also called the Profit & Loss account or Income and Expenditure Statement. It indicates the amount of net income or loss obtained by the company during a particular period. The preparation of the income statement is governed by the matching principle which states that the performance can be measured only if revenues and related costs are accounted for during the same time period. As per SFAC 6, revenues are the inflows of an entity and expenses are the outflows of an entity as a result of delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations.

The main beneficiaries of this statement are the investors, creditors, management and other interested parties who are interested in knowing the financial performance of the entity. We have already dealt with the users of financial statements in the earlier section.

Statement of Shareholders Equity

Statement of shareholders equity consists of change in shareholding pattern of the company during a specified

p e r i o d . T h i s s t a t e m e n t provides information about the changes in owners interest in the company during the year. For example, an increase in equity resulting from profits is reflected in this statement. S imi lar ly, d is t r ibut ion of earnings to shareholders in the form of dividends is reflected in this statement. More specifically, this statements shows information about Preferred shares, Common shares, Additional paid in capital, Retained earnings, Treasury shares, Employee stock ownership plan adjustments, Minimum pension liability, Valuation allowance, Cumulative translation allowance, etc. In India, the statement of shareholders equity is not separately shown, but it forms a part of the Reserves and Surplus section on the Balance Sheet. This statement is useful for identifying reasons for changes in shareholders claims on assets of the company.

Some changes in assets and liabilities bypass the income statement and appear in the statement of changes in stockholders equity, viz., foreign currency translation adjustments, minimum pension liability adjustments and unrealized gains or losses on available-for-sale investments. Such adjustments and other non-recurring items make it difficult to discern the operating results of an enterprise. The FASB requires financial statement recognition and measurement of many financial instruments at fair value. This

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Video 1.3.1: Statement of changes in

Shareholders Equity

results in unrealized gains and losses on these instruments. The concept of comprehensive income offers a solution to these problems and this item appears as part of the Statement of Shareholders Equity.

Statement of Cash Flows

It is also called the Cash Flow Statement. It explains where the cash has come from, how that cash has been utilized and effects of all these transactions on the cash balance of the firm. It gives information on a companys cash flows relating to operating, financial and investing activities. Investing cash flows are those which result from acquisition or sale of property, plant and equipment; acquisition or sale of a subsidiary or segment and purchase or sale of investments in other firms. Financing cash flows are those which result from issuance or retirement of debt and equity securities and dividends paid to stockholders. Operating cash flows are those resulting from the revenue producing activities, or from operating activities of the firm.

Others

In addition to information provided by mandatory financial statements, both financial and non-financial information are provided in the Annual report of a firm under different heads.

SUGGESTED READINGS/REFERENCE MATERIAL

Gerald I. White, Ashwinpaul C. Sondhi, Dov Fried, The Analysis and Use of Financial Statements, John Wiley & Sons Inc.

Meigs and Meigs, Financial Accounting, McGraw Hills Inc.

How to Read a Balance Sheet, Oxford and IBH Publishing Co. P. Ltd.

Additional Resources

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Video 1.3.2: Core Financial Statements

Video 1.3.3: How to read Financials

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REVIEW 1.3 .1

Check Answer

Question 1 of 4The three principal financial statements are

A. Balance sheet, income statement and statement of cash flows.

B. Balance sheet, statement of changes in shareholders equity and income statement.

C. Balance sheet, statement of changes in shareholders equity and explanatory notes.

D. Balance sheet, income statement and explanatory notes.

Income Statement

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INTRODUCTION

The purpose of the income statement is the determination of profits of the business. This statement is also helpful in predicting the future profitability of the concern and the future cash generating ability of the enterprise. This statement reports the change in the owners capital or the shareholders equity as a result of operations of the enterprise.

OBJECTIVES

After going through the chapter, you should be able to:

Differentiate between the capital and revenue expenditure.

Describe briefly the concepts and principles governing Income Statement.

Explain the meaning of Income statement.

State the General format and contents of Income statement.

Prepare Income statement.

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Section 1

Performance Statement

The Income Statement is also called the Profit and Loss Account. It indicates the amount of net income or loss obtained by a company during a particular period. Net income is the excess of revenues over expenses, and the net loss is the excess of expenses over revenues. It gives the summar ized operat ing information about the sales, costs, incomes, profits and losses of the company during a

particular period. It is the best m e a s u r e t o a s s e s s t h e profitability and performance of a company.

The performance of a company captured in the Profit and Loss Account reveals the relationship between revenue, expenses and Profit/Loss:

Income Expenses = Profit

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Significance of Profit and Loss Account

i. It helps to know the overall net profit or loss earned or suffered by the firm during a particular period. This is the index of the profitability of the firm.

ii. It is very useful for inter-firm or intra-firm comparison.

iii. Comparison of various expenses in different periods is possible so that management can take effective control over various expenses.

iv. It helps in calculating cash from operations. Cash flow information is very important to security analysts and other users of financial statements.

v. The various profitability ratios help the users analyze/assess the profitability of the firm better.

Distinguish Between Capital and Revenue Items

The concept of capital and revenue is of fundamental importance in correctly determining the accounting profits of a business and recognizing the assets of an enterprise.

Capital and Revenue Expenditure

Expenses can be classified into capital or revenue expenditure based on their utility to the business entity. Capital expenditure relates to those expenses which generate benefits and assist the entity in earning revenue over a period of time (e.g., more than 12 months). Revenue expenditure relates to those expenses which are incurred in earning the revenues and the benefits of which get exhausted within the accounting period.

Table 1: Distinction between Revenue and Capital Expenditure

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Video 2.1.1: What is an Income Statement?

Deferred Revenue Expenditure

Expenditure that is basically of revenue nature for which payment has been made or liability incurred but the benefits are presumed to result in subsequent periods can be treated as deferred revenue expenditure. The guidance note issued by the ICAI defines deferred revenue expenditure as expenditure for which the payment has been made or a liability incurred but which is carried forward on the presumption that it will be of benefit over a subsequent period or periods.

The expenditure must be of revenue nature.

The exact amount and the period of time for which the benefit will be available cannot be precisely determined.

The expenditure does not result in acquisition of any tangible or intangible asset.

The expenditure is written off over a period of time during which benefits are assumed to result. Example: Heavy

advertisement expenditure incurred to launch a new product.

Capital Receipts and Revenue Receipts

The receipts, which do not affect the profits earned or losses incurred during the course of the year, are called Capital Receipts. These take the following forms:

Contributions made by the proprietor towards the capital of the business in the case of sole proprietorships. In the case of companies, the receipts from the issue of shares are considered as capital receipts.

Receipts from the sale of fixed assets, previously not intended for resale.

Receipts from sale of goods to customers or from rendering of services in the ordinary course of business are termed Revenue Receipts. These directly add to the profits of the business or decrease the losses of the business. The net profits remaining after deducting the revenue expenses are available for distribution to shareholders.

CONCEPTS RELATING TO PROFIT DETERMINATION

Determination of profit or net income is important in financial accounting. Accountants need to measure the business income or net income or profit. There are some concepts which guide the accountants while determining the income. A brief explanation of these concepts is given in this section as follows:

Accounting Period Concept24

Video 2.1.2: Capital vs Revenue

Determination of a definite period is very essential to measure net income or profit. Users of financial statements periodically would like to know the net income generated on the resources invested by them. Thus, they want regular reports about financial results and the financial position. Accountants may prepare reports for a particular period or after the completion of a particular project depending on the type of business. If the interval between the reports is one year, it will be helpful to the businessman and the users.

Realization Concept

The timing of revenue recognition is critical in profit determination. It ensures that proper cut-off is made to each reporting period. If this criterion is followed, it results in avoidance of overstatement or understatement of revenues. Revenue should be recognized in the period in which it is earned, not necessarily when cash is received.

Matching Concept

This concept helps in matching the revenues with the expenses. Determination of profit involves recognition of revenue and allocation of costs. As per this concept, the expenses are to be recognized in the period of their related revenue. Thus, matching concept requires the recognition of revenue and expenses on a comparable basis.

Conservatism Concept

According to this concept, accountants require to underplay favorable prospects until they are actually realized. They should Anticipate no profits, but provide for all possible losses. Thus,

revenues are to be recognized only when they are reasonably certain and expenses as soon as they are reasonably possible. This concept must be applied prudently so as not to result in secret profits and reserves which contravenes the convention of full disclosure.

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REVIEW 2.1.1

Check Answer

Question 1 of 2Capital expenditure is an expenditure which

A. Benefits the current accounting period.

B. Will benefit the next accounting period.

C. Results in the acquisition of a perma-nent asset.

D. Results in the acquisition of a current as-set.

Section 2

Format of Income Statement

No specific format exists for the presentation of the Income Statement. Hence c o m p a n i e s t a k e considerable leeway while presenting this statement, resulting in a variety of presentations. Nonetheless, two distinct types can be identified: Multiple Step Format and Single Step Format. The multiple step format reports the results in a series of sub-totals such as Gross Profit, Operating Profit Before Interest and Depreciation, Operating Pro f i t Before Tax and Exceptional items and Net Pro f i t Before Tax and

except ional i tems. For e x a m p l e , t h e i n c o m e s t a t e m e n t o f I n f o s y s Technologies is a multiple step income statement. In contrast, the single step format groups all revenues and deducts expenses in a single step, doing away with specific sub-totals. For e x a m p l e , t h e i n c o m e statement of Tata Steel Limited is a single step presentation.

Traditionally, the income statement (referred to as Trading and Profit and Loss Account) was presented in the fo rm o f a Ledger Account (also known as T

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form) with expenses and losses being shown on the left side and the incomes and gains on the right side of the account. Also, traditionally Income Statement was sub-divided into manufacturing account, Trading and Profit and Loss Account. In the case of Corporate entities, Part II of the Schedule VI of the Companies Act, 1956 does not prescribe any format for the profit and loss account, but only outlines the information to be included. The Companies Act does not require the preparation of Manufacturing Account or the Trading Account. Only the requirement of Profit and Loss has been specified. Most companies prepare Profit and Loss Account in Vertical Format.

Profit and Loss Account for the Year ended 31st March, xxxx

(Figures in Rs.)

COMPONENTS OF INCOME STATEMENT

Total Revenue: Total revenue represents the sales revenue generated from sale of goods or services to customers. The firm earns revenue from the sale of its principal products. Sales are usually shown net of any discounts, returns and allowances. Brokerage, commission paid to selling agents and cash discount other than the usual trade discounts are exhibited separately in other expenses. In the case of a service organization like Infosys, income generated from services can be the total revenue.

Costs of Revenue: The first expense deduction from sales is the cost the seller incurs while selling his products sold to customers. This expense is called cost of goods sold or cost of services rendered. For a retailing firm, the cost of goods sold equals beginning inventory plus purchases minus ending inventory. In case of a manufacturing concern, the cost of goods manufactured replaces purchases since the goods are produced rather than purchased. A service firm will not have cost of goods sold

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or cost of sales, but will often have cost of development or rendering of services.

Gross Profit: The difference between net sales and cost of goods sold is called gross profit or gross margin. Gross profit is the first step in measurement of profit on the multi step income statement and is a key analytical tool in assessing a firms operating performance. The gross profit indicates how much profit the firm is generating after deducting the cost of products sold.

Operating Expenses: Operating expenses can be broadly classified into five categories selling, administrative, depreciation and amortization, lease payments and repairs and maintenance:

Selling Expenses They re late to the expenses resulting from the companys effort to make sales including advertising, traveling, sales commission, sales supply and so on. Distr ibut ion expenses like advertisement, samples given to customers, storage expenses, etc., are expenses in the profit and loss account.

Administrative Expenses These relate to the expenses of general administration of the companys operations. They include salaries, rent, taxes, insurance, printing, stationary, postage and telephone, legal fees, audit fees, other general expenses, bad debt expenses and other costs difficult to allocate.

Abnormal Losses: Losses, which arise on account of abnormal reasons, are termed abnormal losses. For example, loss due to theft, fire, accident, etc. These losses, to the extent not covered by insurance claims, are losses/expenses in the profit and loss account.

Profit or Loss on Sale of Assets: Loss on sale of assets is loss/expense in the profit and loss account. Gain or profit arising on sale of fixed assets is taken as income/gain in the profit and loss account.

Cash Discount: It is the amount of cash discount given to the customers. It is a loss and is shown as an expense. The amount of cash discount received from creditors is an income and is shown on the credit side of the profit and loss account.

Bad Debts and Bad Debts Recovered: The amount, which cannot be recovered from customers, is termed as bad debt. It is a loss and is shown under expenses. If the amount which was previously written off as bad debt, is received, it is treated as income.

Lease Payments Lease payments include the costs associated with operating rentals of leased facilities for retail outlets. A Lease can be either an operating lease or a

28

Video 2.2.2: Enhancement of Income Statement

Video 2.2.1: More details on computation of Gross Profit

finance lease. Operating lease is a conventional rental agreement with no ownership rights conferred on the lessee. If a lease agreement satisfies four conditions (transfer of ownership to lessee, contains a bargain purchase option, has a lease term of 75% or more of the leased propertys economic life or has minimum lease payments with a present value of 90% or more of the propertys fair value), it is called as finance lease. Each lease payment is apportioned partly to reduce the outstanding liability and partly to interest expense.

Depreciation and Amortization The cost of assets that will benefit a business enterprise for more than a year is allocated over the assets service life rather than expensed in the year of purchase. The cost allocation procedure is determined by the nature of long-lived assets. Depreciation is used to allocate the cost of tangible fixed assets such as buildings, machinery, equipment, fixtures and fittings, motor vehicles, etc. Amortization is the process applied to the cost expiration of intangible assets such as patents, copyrights, trademarks, licenses, franchisees and goodwill. The cost of acquiring and developing natural resources like oil and gas, other minerals and standing timber is allocated through depletion.

Repairs and Maintenance These are the costs of maintaining the firms property, plant and equipment. Expenditures in this area should correspond to the level of investment in capital equipment and to the age and condition of the companys fixed assets.

Operating Profit: It is a companys profit from its core business operations. It is arrived at after deducting operating expenses from operating revenues. Operating profit does not include interest expenses or other financing costs. Nor does it include income generated outside the normal activities of the company, such as income on investments or foreign currency gains, or extraordinary incomes and other non-operating incomes. Operating income is a measure of profitability based on a companys operations.

Non-Operating Incomes and Expenses: Non-operating incomes and expenses are those which are not related to the company core business. Items such as dividend and interest earned on investments, rental income, hire charges, lease rentals, abnormal losses, profit and sale of assets, profit or loss on sale of investments, etc. are considered non-operating items.

29

Video 2.2.3: Income Statement

Profit Before Interest and Tax (PBIT): It measures the gross performance of the company. As the term indicates, it is the profit of the company (both operating and non-operating) excluding the interest expenses and taxation expenses. This measure is generally used to measure the performance of the company with reference to its total capital employed.

Interest: Interest paid on loans, overdrafts and to creditors is an expense. Any amount received in the form of interest is an income. For example, interest received on investment, interest received on deposits, etc. Interest paid on capital should be shown separately on the expense side of the profit and loss account and interest received on drawings should be shown on the income side of the profit and loss account in the case of sole proprietor and partnership firm.

Profit Before Tax (PBT): This indicates the profits available after interest but before charging tax. This is to understand the impact of tax which is a compulsory charge (expense) on the net profit of the company.

Profit After Tax (PAT): This is a measure of net profit of the company. It is the net profit earned by the company after deducting all expenses like interest, depreciation and tax. PAT can be fully retained by a company to be used in the business. Dividends, if declared, are paid to the shareholders from this residue.

Profits Available to Equity Shareholders: This indicates the amount of current profits plus the accumulated profits

available to equity shareholders after appropriating dividends to preference shareholders. These profits can be fully distributable to equity shareholders or fully retained or partly distributed and partly retained according to the company policy.

Special Items:

Extraordinary items Extraordinary items may be defined as material events and transactions distinguished by their unusual nature and by the infrequency of their occurrence. Extraordinary income or expenses in a particular period should be separately stated in the statement of profit and loss in a manner that its impact on current profit or loss can be perceived. Examples include a major casualty such as fire; prohibition under a newly enacted law, etc. These items net of their tax should be shown separately.

Prior period items The term refers to expenses and incomes which arise in the current period as a result of errors or omissions in the preparation of financial statements of one or more periods. Errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies, misinterpretation of facts, or oversight. Prior period items may be disclosed separately to ascertain the effect of such transactions on the profit/loss for the period.

In the Vertical form of Profit and Loss Account, appropriations are shown at the bottom of the Profit and Loss Account. Details such as appropriations made from the profits in

30

respect of preference dividend, interim and final equity dividends and transfer to reserves, etc. are shown here. The balance in the Profit and Loss Appropriation Account, if any, is taken to the liability side of the balance sheet under the heading Reserves and Surplus. If there is any short fall (very rare) in Profit and Loss Appropriation Account (that is, a loss), then the shortfall is shown on the Asset side under the heading Miscellaneous Expenditure.

See Exhibit

Profit is not Cash Flow

Profit is not cash flow. Adequate cash is essential to keep business running. Inadequate cash increases the risk of not

being able to meet current obligations as and when they arise which is dangerous to the company. There are many instances when businesses failed because of lack of cash inflows even though their operations were profitable. Similarly, a loss making enterprise may be holding huge cash reserves due to its inability to deploy funds for productive purpose. Under accrual system of accounting net income (revenue less expenses) does not equate net positive cash flows. The difference is the timing of sale; expenses and

profits do not coincide with their associated cash flows. Hence there is always a discrepancy between profit and net cash flow.

A statement of Cash Flows is an essential component of Financial Statements. As the profit and loss account and the balance sheet are prepared on accrual basis, the profits disclosed by the profit and loss account do not indicate the liquidity of the firm. A firm may be highly profitable but may find itself with hardly any cash or working capital to continue the operating cycle. On the contrary, a loss making firm may have sufficient cash flows.

31

PROFIT & LOSS ACCOUNT

TATA STEEL LTD

Video 2.2.4: Multi Step Income State-

mentVideo 2.2.5:

Profit vs Cash flow

http://www.ntpc.co.in/annualreports/2010-11/Profit-Loss-Account.pdf

http://www.tatasteel.com/investors/pdf/Q4-FY11.pdf

REViEW 1.2.1

Check Answer

Question 1 of 3For the purpose of calculating depreciation, cost of the asset means

A. Residual value

B. Market price

C. Cost + Transport + Installation ex-penses

D. Cost Price or Market Price which-ever is less

32

Section 3

Preparation of Profit and Loss Account

Preparation of Profit and L o s s A c c o u n t / I n c o m e Statement is easy. In the hor izontal form al l the expenses pertaining to the period for which it is drawn are taken to the left hand side of the account and Incomes & Gains as appear in the Trial Balance are taken to the right hand side o f the account . I f the Incomes and Gains exceed the expenses & losses, the enterprise has made profit, but it makes losses for the period if the expenses and losses exceed incomes and gains. In the vertical form of Income Statement all the incomes and gains are

shown first and there from the expenses are deducted. The balance is profit.

As already seen, the trial balance is the outcome of transaction analysis using Fundamental Equation, by taking all the expenses, losses on one side and incomes and gains on another side of account. However, there may be some year-end adjustments which have not been given affect to and do not appear in the trial balance. These adjustments are needed to adhere to the concepts such as accrual concept, going c o n c e r n c o n c e p t , conservatism concept and

33

Source:www.img.ehowcdn.com

matching concept. These appear as adjustments required to be made and integrated in the Income statement or the Balance Sheet. These adjustments call for transaction analysis through Fundamental Equation which imply they affect at least two items already appearing in the Income Statement or/and Balance Sheet.

Adjusting entries

Even when the events effecting the enterprise have been properly recorded using Fundamental Equation and transaction analysis, there are certain account balances which need to be updated before an accountant can proceed to prepare the Financial Statements from the Trial Balance. Such entries are called the Adjusting Entries. Adjusting entries are required to implement the accrual concept, more specifically, the realization concept and the matching concept. Adjusting entries help to ensure that all revenues earned in the period are recognized in the period regardless of when the exchange of cash took place. Similarly in the case of expenses, the adjusting entries ensure that the enterprise recognizes all the expenses incurred in the period regardless of when the payment for the expenses is made. This results in the Income statement reflecting a more

complete measurement of the enterprises operating performance and the Balance Sheet reflecting a more complete measurement of the financial position of the enterprise.

Some of the areas where adjustment entries are required include:

i. Accrued income. ii. Income received in advance.iii. Outstanding expenses. iv. Prepaid expenses. v. Closing stock.vi. Depreciation. vii. Bad debts. viii. Bad debts provision. ix. Provision for discount on debtors and creditors.x. Interest on capital. xi. Interest on drawings.

Accrued Income

Accrued income involves the recognition of revenue earned before it is actually received. It implies that if a portion of an income has been earned but it has not yet been received as the due date of payment falls in the next accounting period, then the income must be brought into account. Few examples of accrued

34

Video 2.3.1:P & L Preparation

or accruing incomes in r e s p e c t o f w h i c h adjustment entr ies may have to be made a r e i n t e r e s t o n government loans, d i scoun ts on b i l l , i n t e r e s t o n investments, rents and premium on leases, etc.

Income Received in Advance

Income received in advance results when the enterprise receives cash from customers in one accounting period for goods or services to be provided in the next accounting period. While preparing the financial statements adjustment entries are required for this item. Rent received in advance, subscriptions received in advance in the case of clubs, etc., a re few examples where income may be received in advance for which adjustment are required.

O u t s t a n d i n g Expenses

Outstanding expenses refers to expenses

incurred but not yet paid. Before the preparation of the financial statements it must be ensured that all the expenses which have fallen due to be paid but which have not been paid during the accounting period are brought to account. R e n t o u t s t a n d i n g , interest outstanding, wages outstanding are examples of expenses outstanding.

Prepaid Expenses

Prepaid expenses result when the cash outflow precedes the actual expense. In other words, these are amounts paid in the accounting period for services to be received i n the subsequen t accounting period. It is important to identify that port ion of the expenditure for which the payment has been made but the benefit is yet to be received and make an ad just ing entry. Rent paid in advance, Insurance

35

Keynote 2.3.1: Illustration

Keynote 2.3.2: Illustration

Keynote 2.3.3: Illustration

Keynote 2.3.4: Illustration

prepaid, etc., are a few examples where an adjusting entry is required.

Closing Stock

Under the periodic verification method, the closing inventory of every item is arrived at by physically counting the inventory available and assigning a value to the same. In concerns adopting the periodic verification method, the value of the closing inventory will be shown in the Balance Sheet as an asset and goes into Income statement as a component of Cost of Goods sold.

Depreciation

We will deal with depreciation in detail in the chapter on Fixed Assets. An adjustment for depreciation needs to be made. This results in decrease in the value of the asset which is shown in balance sheet at Cost. And since depreciation is an expense it appears in the Income statement.

Bad Debts

Debts which are uncollectible or irrecoverable are a loss to the business. Hence an adjustment is needed in the books in respect of this loss. Bad debts decrease the amount due from debtors to a business, in other words, accounts receivable are reduced from the Balance Sheet and are shown as an expense/loss in the Income Statement.

Bad Debts Provision

When it is feared that some of the amounts due from customers are uncollectible or i r recoverable i t is prudent to provide for the expected loss in t h e b u s i n e s s . A n ad jus t ing ent ry is needed to create a provision for these anticipated losses. This creation is a loss/expense in the Income Statement and the same is reduced from Debtors or Accounts receivable in the balance Sheet.

Provision for Discount on Debtors

The organization which allows the facility of making payments before the due date and enable their debtors to avail of cash discounts, must take into account the possible amount of discounts that may be allowed on closing debtors in the forthcoming year. This is necessary to show the closing sundry debtors at their realizable value.

The principles for creation and maintenance of the provision for discounts for debtors are the same as those discussed in the provision for bad debts. The only point to be noted is that discounts will be estimated on debts considered good. i.e. net

36

Keynote 2.3.5: Illustration

accounts receivable balance after the bad debts are reduced from it.

The above provision shall be shown in the balance sheet as a deduction from the Sundry Debtors/ Accounts Receivable

Illustration:

The following is trial balance of X Ltd., as on March 31, 2011.

Other Information:

l. Stock on March 31, 2011 was valued at Rs.41,500.

m. Total bad debts to be written off during the year were Rs.20,000.

n. A new machine was installed on December 31, 2010 costing Rs.20,000, but it was not recorded in the books and no payment was made for it. Wages of Rs.2,000 paid for its erection have been considered as Salaries.

o. An item of Rs.100 for bank charges appears in the bank statement but has not yet been entered and is not reflected in the bank account of X Ltd..

p. Provide depreciation at 10% per annum on furniture and building and 20% on plant and machinery.

q. No rent has been paid on the small business building during the year because of a dispute with the landlord. The rental agreement provides for a rent of Rs.24,000

r. A provision for doubtful debts is to be made at 5% on sundry debtors.

You are required to prepare an Income Statement for the period 2010-11.

Solution:

37

Particulars Expenses/Assets (Rs.)

Incomes/Liabilities (Rs.)

Equity share capital (Rs.10 each) 3,50,000Sundry creditors 1,23,000Sundry debtors 2,85,000Bills receivable 72,000Salaries 2,50,000Advertisement expenses 50,000Investment (@ 12% interest acquired on October 1, 2010) 2,55,000

Plant and machinery 3,80,000Provision for doubtful debts 12,000Bills payable 55,000Electricity 42,000Telephone bills 16,000Auditors fees 16,500Purchases 3,20,000Sales 9,80,000Cash at bank 38,000Opening stock (April 1st, 2010) 38,000Bad debts 17,500Furniture & Fixtures 3,62,300Interest on investment 6,300Building 2,70,000Preference shares capital (Rs.100 each) 6,00,00011% debenture 3,00,000Repairs 14,000

24,26,300 24,26,300

Income Statement of X Ltd. for the year ended 31.3.2011:

38

Schedule Rs.

a) Net Sales / Income from Operations 980000b) Other Operating Income 0Total Operating Income [ 1(a) + 1(b) ] 9,80,000Total Expenditurea) (Increase) / decrease in stock-in-trade -3500 b) Purchases of finished, semi-finished steel & other products 320000320000

c) Staff Cost 1 248000d) Advertisement 50,000e)Electricity 42,000f) Telephone Charges 16,000g) Auditor's Fees 16,500h)Repairs 14,000i) Bad debts 2 20,000j) Bank Charges 100k) Depreciation 3 140330l)Rent 24,000m) Provision for Bad Debts 2,125Total Expenditure 889555Profit Before Other Income, Finance Charges and Taxes 90,445

Other Income 4 15,300Profit before Interest and Tax 1,05,745Finance Charges 33,000Profit Before Tax 72,745

Schedule 1: Staff CostsSchedule 1: Staff CostsSchedule 1: Staff Costs

Salary 2,50,000

Less: Wages for machinery 2,000 2,48,000

Schedule 2:Bad DebtsSchedule 2:Bad DebtsSchedule 2:Bad Debts

Bad debts 17,500

Add: Additional 2,500 20,000

Schedule 3 : Depreciation Schedule 3 : Depreciation Schedule 3 : Depreciation

Depreciation on

Furniture @ 10% 36,230

Building @ 10% 27,000

Machinery @ 20%

Old 76,000

New 1,100 1,40,330

Schedule 4 : Other IncomeSchedule 4 : Other IncomeSchedule 4 : Other Income

interest on investment 6,300

Add: Accrued 9,000 15,300

Problems 1

On 31.3.2011 Mr. X has the following balances in his books Debtors Rs.40,000; Bad debts Rs.600. Mr. X decided to maintain the provision for doubtful debts at 5%. How much is the Provision for doubtful debts that needs to be maintained?

Solution

Since Rs.600 appears in trial balance as bad debts, it implies the transaction analysis is complete. Hence the provision to be m a i n t a i n e d w i l l b e 40,000 x 5% = Rs.2,000.

Problems 2

On 31.3.2011 Mr. X has the following balances in his books Debtors Rs.40,000; Bad debts Rs.600. At the end of the year Mr. X decided to write off additional bad debts of Rs.500 (for which no transactional analysis has been made) and maintain the provision for doubtful debts at 5%. How much is the Provision for doubtful debts that needs to be maintained?

Solution

Since Rs.600 appears in trial balance as bad debts, it implies the transaction analysis is complete. However, transactional analysis for additional bad debts of Rs.500 has not been performed. On performing the transactional analysis, debtors will reduce by Rs.500.

REVIEW 2.3.1

Check Answer

Question 1 of 2The adjustment to be made for income re-ceived in advance is

A. Added to respective income and show it as a liability.

B. Deducted from respective income and show it as an asset.

C. Added to respective income and show it as an asset.

D. Deducted from respective income and show it as a liability.

20 322,000 x x

100 12

Schedule 4 : Other Income interest on investment 6,300 Add: Accrued

12 62,55,000 x x100 12

9,000 15,300

Self-Assessment Questions 3

1. The adjustment to be made for income received in advance is a. Add to respective income and show it as a liability b. Deduct from respective income and show it as an asset c. Add to respective income and show it as an asset d. Deduct from respective income and show it as a liability e. Deduct from respective income and add to expenditure.

2. On 31.3.2011 Mr. X has the following balances in his books Debtors Rs.40,000; Bad debts Rs.600. Mr. X decided to maintain the provision for doubtful debts at 5%. How much is the Provision for doubtful debts that needs to be maintained?

3. On 31.3.2011 Mr. X has the following balances in his books Debtors Rs.40,000; Bad debts Rs.600. At the end of the year Mr. X decided to write off additional bad debts of Rs.500 (for which no transactional analysis has been made) and maintain the provision for doubtful debts at 5%. How much is the Provision for doubtful debts that needs to be maintained?

. 4. Ravi paid salaries for the period ended March 31, 2010 amounting to Rs.1,50,000. The salaries

paid are in respect of services rendered during 2009-10. Salaries outstanding on March 31, 2010 is Rs.25,000. The total amount to be considered as expense in Profit and Loss account is a. Rs.1,75,000 b. Rs.1,25,000 c. Rs.1,50,000 d. Rs.1,00,000 e. Rs.50,000.

5. The Admirable Company Limited was registered with a nominal capital of Rs.5,00,000 divided

into shares of Rs.10 each, of which 20,000 shares had been issued and fully paid.

Expenses/Assets Amount Rs. Incomes/Liabilities Amount

Rs.

39

Hence Net debtors = Rs.40,000 Rs.500 = Rs.39,500.

O n t h i s p r o v i s i o n o f 5 % w i l l b e (40,000 500) x 5/100 = Rs.1,975

into shares of Rs.10 each, of which 20,000 shares had been issued and fully paid.

Problems 3

The Admirable Company Limited was registered with a nominal capital of Rs.5,00,000 divided

You are required to prepare Income Statement for the year ended December 31, 2011 after taking into consideration the following adjustments.

a. Write off one-third preliminary expenses

40

b. Depreciation on plant and machinery at 20% and on office furniture at 10%

c. Manufacturing wages Rs.945 and office salaries Rs.600 had accrued due

d. Provide for interest on Bank loan for 6 months

e. The stock was valued at Rs.62,420 and Loose Tools at Rs.5,000

f. Reserve Rs.4,250 on debtors for doubtful debts

g. Reserve further Rs.1,560 for discounts on debtors

h. The directors recommend dividend at 5% for the year ending December 31, 2011 after providing for taxes amounting to Rs.11,500.

Solution

Income statement of Admirable Company Limited for the period ended 31st March 2011

41

Schedule Rs. a) Net Sales / Income from Operations 1 5,78,630b) Other Operating Income 0Total Operating Income [ 1(a) + 1(b) ] 5,78,630Total Expenditurea) (Increase) / decrease in stock-in-trade 30,790 b) Purchases of finished, semi-finished other products 2 4,05,825

c) Manufacturing Wages 3 55,815d) Manufacturing Expenses 9,620e)Carriage Inwards 2,455f) Power 7,105g) Repairs 4,305h) Carriage Outwards 4,630i) Rates & Electricity 1,700j) Directors fees & Remuneration 6,000k)Office salaries and expenses 4 7,100l) Auditors fees 625m)Commission 4,320n)Preliminary expenses written off 5 1,000o) Depreciation on Plant & Machinery 6 9,340p) Provision for bad debts 4,250q)Provision for discount on debtors 1,560r) Interest on Bank Loan 7 1,250Total Expenditure 5,57,690Profit Before Other Income and Taxes 20,940Other Income 20Profit before Tax 20,960Provision For Taxation 11,500Net Profits 9,460

42

Schedule 1:Schedule 1:Schedule 1:

sales 5,84,950

Less: Returns 6,320

5,78,630

Schedule 2:Schedule 2:Schedule 2:

Purchases 4,10,730

Less: Returns 4,905

4,05,825

Schedule 3 : Manufacturing Wages

Schedule 3 : Manufacturing Wages

Schedule 3 : Manufacturing Wages

Manufacturing wages 54,870

Add: Due 945 55,815

schedule 5: Preliminary Expenses

schedule 5: Preliminary Expenses

schedule 5: Preliminary Expenses

Preliminary expenses written off 1,000

Schedule 4: Office Salaries Schedule 4: Office Salaries Schedule 4: Office Salaries

Office salaries and expenses 6,500

Add: Outstanding 600 7,100

Schedule 6: DepreciationSchedule 6: DepreciationSchedule 6: Depreciation

Depreciation on Plant & Machinery 39,200 x 20% 7,840

Loose Tools (6,250 5,000) 1,250

Furniture 2,500 x 10% 250

Schedule 7: Interest Schedule 7: Interest Schedule 7: Interest

Interest on Bank loan 625

Add: Outstanding 625 1,250

Balance SheetCHAPT

ER

3

INTRODUCTION

Every businessman is interested in knowing two facts about his business. One is whether he has earned a profit or suffered a loss during a particular period and the other is his financial position on a particular date. For this purpose, financial statements are prepared at the end of the accounting period. Balance Sheet is a statement that captures the financial position of the business at a certain point of time.

OBJECTIVES

After going through the chapter, you should be able to:

State the concept of Balance Sheet.

Describe the concepts and principles governing the presentation of Balance Sheet.

Explain the brief contents of Balance Sheet.

Explain the Preparation of Balance Sheet.

State the Limitations of Balance Sheet.

44

Section 1

Statement of Financial Position

Balance Sheet is also known as S t a t e m e n t o f F i n a n c i a l Position. It depicts the financial position of a company on a particular date. It gives the information of how the company has been financed and how that money has been invested in various productive resources. The financial position of the enterprise, captured in the Balance Sheet, reveals the re la t ionsh ip be tween the economic resources of the enterprise and its claims against the said enterprise (obligations o f t h e s a i d e n t e r p r i s e ) . E c o n o m i c r e s o u r c e s i n accounting terminology are

called the Assets and the claims are called Liabilities, pertaining to creditor s claims whi le owners equity pertains to owners claims. This can be depicted in the form of an equation as follows:

45Source:www.lh3.ggpht.com

Video 3.1.1: Introduction to Balance

Sheet

Assets = Liabilities + Owners equity.

Assets

Assets are the probable future economic benefits obtained or controlled by a particular entity as a result of past transactions and events as stated in the Statement of Financial Accounting Concepts No.6, FASB. Assets simply mean what the enterprise owns.

Liabilities

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities simply mean amounts the enterprise owes to others.

Equity

Equity or owners equity is the residual interest in the assets of an entity that remains after deducting its liabilities. Simply put, equity or owners equity is the difference between the enterprises assets and its liabilities.

Some of the definitions of balance sheet are provided as follows:

The Balance sheet is a statement at a given date showing on one side the traders property and possessions and on the other side his liabilities.

Palmer

A Balance sheet is an itemized list of the assets, liabilities and proprietorship of the business of an individual at a certain date.

Freeman

A list of balances in the asset and liability accounts. This list depicts the position of assets and liabilities of a specific business at a specific point of time.

American Institute of CPA

Thus, balance sheet lists down the assets, liabilities and capital of the business on a specific date.

Concepts Relating to Balance Sheet

Generally, all accounting statements are prepared based on some concepts and conventions. Balance sheet is also an accounting statement. There are no specific rules for preparing a balance sheet. It is prepared based on certain

46

Video 3.1.2: Why balance sheet mat-

ters?

concepts and conventions. Let us reiterate some important concepts and conventions, which help prepare a balance sheet:

Going Concern Concept

Going concern concept implies that a business entity is assumed to carry on its operations indefinitely. This concept helps in categorizing assets into fixed and current. The Going concern concept implies that the resources of the concern would continue to be used for the purpose for which they are meant to be used. If the organization is not a going concern, then the fixed assets are recorded at their realizable values.

Cost Concept

As per this concept, the assets should be recorded in the books of accounts at a price which forms the basis for its subsequent accounting. Assets are recorded at the cost price at the time of purchase and subsequently their value is reduced by charging depreciation. Thus, according to this concept assets shown in the balance sheet are either at their cost price or at their written down value. This concept actually flows from the going concern concept.

Convention of Consistency

This convention requires a business enterprise to follow consistent accounting procedures and practices from time to time. This is required to enable a comparative study of the performance of the business over a period of time and also to make objective comparison within the industry.

Convention of Full Disclosure

The purpose of financial accounting is to provide information to the users for decision-making. This convention implies that all material information that could affect the decision of the user must be disclosed. Full disclosure ensures complete, fair and adequate disclosure of business transactions in financial reports.

Format of Balance Sheet

There is no specific form of balance sheet for non-corporate entities like sole proprietorship f i rms and partnership f i rms. However, the assets and liabilities may be shown in the order of:

a. Liquidity, or

b. Permanency. a. Liquidity Order: The assets, which are easily convertible

into cash (called as liquid assets), come first and those, which cannot be readily converted, come next and so on. Similarly, liabilities are also arranged in this manner. The liabilities which are payable on a priority basis come first and those payable later come next and so on.

b. Permanency Order: In the order of permanency, permanent assets are shown first and those of less permanence are shown next and so on. In other words, fixed assets are shown first, followed by liquid assets. On the liabilities side, permanent liabilities are shown first and less permanent ones are shown next and so on. In other words, capital is

47

Video 3.1.3: Classified balance sheet

shown first followed by long-term liabilities, short-term liabilities and current liabilities in that order.

In India, the Balance Sheets of companies is required to be set out in the forms prescribed under Part I of Schedule VI. Part I of Schedule VI contains two forms of Balance Sheet (1) Horizontal Form and (2) Vertical Form.

Format of Horizontal Form of Balance Sheet of xxx Ltd, as on March 31, 20xx

For a more detailed study of the Horizontal Form of Balance sheet visit

Vertical form of Balance Sheet is currently the most popular and is an outcome of demand for a more understandable and satisfactory format.

Most companies in India follow the Vertical Form of Balance Sheet because it holds the following advantages:

Easily Comprehensible: The traditional form of balance sheet was difficult to understand by a wide variety of users most of whom were not conversant with the principles of accounting. The Vertical form of Balance Sheet can be easily comprehended by all.

A Birds Eye View: Only broad heads are shown in the Balance Sheet without too many details. These details are shown in schedules and are cross referenced against the Balance Sheets broad heads. This helps the readers to get a birds eye view of the position of the company and at the same time get more details through the schedules.

Classification: The Balance Sheet is classified as Sources of Funds and Application of Funds. The Sources of Funds comprise Shareholders equity and Long-term debt. The Application of Funds comprise application towards Fixed Assets and Working Capital. Such nomenc la tures a lso fac i l i ta te a bet te r understanding of the concept. Further, in the traditional form of Balance Sheet the net working capital of the company could not be easily figured; however, this has been taken care of in the Vertical form of Balance Sheet.

The introduction of schedules which form a part of the Financial Statements has given scope for more disclosure and inclusion of details giving a better picture of the items being analyzed.

48

For a more detailed study of the Horizontal Form of Balance sheet

Format of Vertical Form of Balance Sheet

49

REVIEW 3.1.1

Check Answer

Question 1 of 4The balance sheet gives information regarding the

A. Results of operations for a particular period.

B. Financial position during a particular period.

C. Profit earning capacity for a particu-lar period.

D. Financial position as on a particular date.

Section 2

Understanding Balance Sheet

SOURCES OF FUNDS

The sources of funds is divided and disclosed under the heads:

Shareholders Funds

Loan Funds

Shareholders Funds

T h e y r e p r e s e n t t h e ownership interest in the company. It is the residual interest in assets that remains after meeting all liabilities. The owners bear

the greater risk because their claims are subordinate to creditors in the event of liquidation, but owners also benefit from the rewards of a successful enterprise. The ownership interest may be further sub-divided into:

Share Capital

Reserves and Surplus

Share Capital: The capital raised by the company through the issuance of shares is known as Share

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Capital. The Companies Act basically provides for two classes of shares Equity shares and Pre ference shares. Preference shares enjoy preferential treatment with regard to the payment of dividends and repayment of capital. Equity shareholders enjoy voting rights. But there is no obligation to the company to pay dividends at a fixed rate every year. Even at the time of winding up of the company, they receive their capital only after the payment to preference shareholders is made.

Further details of Share Capital are as below:

Authorized capital It must mention the total number of shares and the face value of each share.

Issued capital It must distinguish between the various classes of shares issued to the public and in respect of each class of shares, the total number of shares issued and the face value per share should be specified.

Subscribed capital It must distinguish between the various classes of shares actually taken up by the public and in respect of each class, the number of shares actually taken up and the face value should be disclosed. If shares have been allotted as fully paid-up for consideration other than cash (say, shares issued in the takeover of a business), then the number of such shares

so allotted must be disclosed. Also, the number of shares which have been allotted as fully paid-up by way of bonus shares should also be disclosed.

The called-up capital and any calls unpaid or in arrears should be shown as a deduction from the called-up capital to arrive at the paid-up capital.

In respect of calls-in-arrears, the calls unpaid by directors and by others must be shown distinctly.

Any forfeited shares to the extent they have not been reissued and to the extent of the value originally paid-up must be shown as an addition to the capital.

The particulars of different classes of preference shares should be provided. These include

Terms of redemption or conversion (if any), of any redeemable preference share capital should be stated together with earliest date of redemption or conversion.

The source from which the bonus shares have been issued, for example, capitalization of profits or reserves or from share premium account, should also be specified.

Reserves and Surplus: Reserves and surplus are profits the firm retains. Revenue reserves represent accumulated retained earnings from profits from normal business operations. These take several forms such as general reserve, investment allowance reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves arise out of gains which are not related to the normal

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Video 3.2.1: Share Capital/ Stock

business operations. Examples of such gains are the premium on issue of shares or gains on revaluation of assets.

Surplus is the balance in the profit and loss account which has not been appropriated (transferred) to any particular reserve account. It may be noted that reserves and surplus along with equity capital represents an owners equity.

The following items appear under Reserves and Surplus:

i. Capital Reserves

ii. Capital Redemption Reserve

iii. Share Premium Account

iv. Other Reserves specifying the nature of each reserve and the amount, less any debit balance in the Profit and Loss Account (if any)

v. Surplus, that is, balance in the Profit and Loss Account after providing for dividend, bonus or reserves

vi. Proposed additions to reserves

vii. Sinking funds

In respect of each of the item listed under Reserves and Surplus, the additions and deductions since the last balance sheet would be shown.

The word fund in relation to any Reserve should be used only where such reserve is specifically represented by earmarked investments.

The share premium account should include details of its utilization in the manner specified under the Companies Act.

Loan Funds

These represent the creditorship interest in the concern. Loan Funds are further divided and disclosed under the heads:

Secured Loans

Unsecured Loans

Secured Loans: Secured loans refer to loans wholly or partly secured against an asset. This head includes loans secured by hypothecation of fixed assets or current assets of the company. The nature of security is to be disclosed a l o n g w i t h g e t t i n g t h e hypothecation registered with the Registrar of Companies under the prov is ions o f Section 125 of the Companies Act. The following items are included under the category of secured loans:

i. Debentures (Companies sometimes disclose Debentures separately in the body of the Balance Sheet itself under the head of Loan Funds after Secured Loans)

ii. Loans and Advances from Banks

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iii. Loans and Advances from Subsidiaries

iv. Other Loans and Advances

Unsecured Loans: Loans taken by the company for which no securi ty is furnished are classi f ied as Unsecured loans. Under the Schedule to Unsecured Loans, the following items should be shown:

i. Fixed Deposits

ii. Loans and Advances from Subsidiaries

iii. Short-term Loans and Advances:

a. From Banks

b. From Others

iv. Other Loans and Advances:

a. From Banks

b. From Others

The similar details required to be disclosed in respect of Secured Loans should be disclosed in respect of Unsecured Loans also. The short-term loans will include those which are due for not more than one year as at the date of the balance sheet.

APPLICATION OF FUNDS

The Application of Funds are disclosed in the balance sheet under the heads

Fixed Assets

Investments

Net Current Assets

Miscellaneous Expenditure

Fixed Assets A fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods and services and is not held for sale in the normal course of business.

The term fixed assets shall consist of the following:

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Video 3.2.2: Bonds/ Debentures

Keynote 3.2.1: Fixed Assets

a. Goodwill

b. Land

c. Buildings

d. Leasehold

e. Railway Sidings

f. Plant and Machinery

g. Furniture and Fittings

h. Development of Property

i. Patents, Trade Marks and Designs

j. Livestock, and

k. Vehicles, etc.

Under each of the categories mentioned above, the original cost, additions during the accounting period and deductions therefrom during the period should be shown. Also, the total depreciation written-off or provided up to the end of accounting period should also be stated.

Where the fixed assets have been written up on revaluation or have been reduced in value either due to a reduction of capital or revaluation, each balance sheet for the first five years subsequent to the revaluation or reduction should show the amount of increase effected or the reduction made as the case may be. Also every balance sheet subsequent to the writing up

or reduction must show the increased or decreased value of the asset as the original cost.

F i x e d a s s e t s a r e t o b e presented as Gross Block and N e t B l o c k . G r o s s B l o c k represents the original cost of the assets and additions and adjustments arising due to the purchase, sale or transfer of assets. Net Block is the net value of the assets after providing for depreciation. In other words, it represents Gross Block minus depreciation.

Capital Work-in-progress It includes assets awaiting completion/installation, on-site inventories, net pre-operative expenses, including difference in income and expenditure in respect of production during trial run and interest capitalized in respect of assets not yet commissioned.

Investments Investments are the assets held by an enterprise for earning income by way of dividends, interest and rentals, for capital appreciation, or for other benefits to the investing enterprise. Some represent long-term commitment of funds called long-term investments. Other investments by their very nature are readily realizable and are intended to be held for not more than one year and are called short-term investments.

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The investments held by a company as on the date of the balance sheet are classified into:

i. Investments in Government or Trust Securities

ii. Investments in shares, debentures or bonds

iii. Immovable properties

iv. Investments in the capital of partnership firms

v. Balance of unutilized monies raised by issue

While listing the investments in shares, debentures or bonds, the following additional information is also given:

i. The shares which are fully paid-up and those which are partly paid-up are shown separately

ii. T h e s h a r e s a r e distinguished into different classes

iii. I n t h e c a s e o f i n v e s t m e n t s i n shares, debentures o r b o n d s o f s u b s i d i a r y c o m p a n i e s , information in respect of (i) and (ii) above is shown separately

iv. The mode of valuation of investments (whether cost or market value) is disclosed

v. In the case of quoted investments, the aggregate amount of such investments and also their market value is shown

vi. The aggregate value of the unquoted investments is also disclosed

vii. A separate disclosure is made of unutilized monies indicating the form in which such unutilized funds have been invested

Deferred Tax Assets: A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carry forwards. For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years and a deferred tax asset is recognized in the current year for the reduction in taxes payable in future years. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Net Current Assets The Components of Net Current Assets are disclosed in the Balance Sheet under the heads:

Current Assets, Loans and Advances

Less: Current Liabilities

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Video 3.2.3: Investment in securities

Current Assets Cash and other resources which get converted into cash during the operating cycle of the firm are defined as current assets. These are held for a short period of time as against fixed assets which are held for relatively longer periods. The major components of current assets are cash, debtors, inventories, loans and advances and pre-paid expenses.

Cash denotes funds readily disbursable by the firm. The bulk of it is usually in the form of bank balance while the rest comprises of currency held by the firm.

Debtors (also called accounts receivable) represent the amounts owed to the firm by its customers who have bought goods or services on credit. Debtors are shown in the balance sheet as the amount owed, less an allowance for the bad debts.

Inventories consist of stocks of raw materials, work-in-progress, finished goods, stores and spares. They are usually reported at the lower of cost or market value.

Loans and advances are the amounts given to employees, advances given to suppliers and contractors and deposits made to governmental and other agencies. They are shown at the actual amount.

Prepaid expenses are expenditures incurred for services to be rendered in the future. These are shown at the cost of unexpired reserve.

Under the category of Current Assets, the following should be listed individually under broad heads:

i. Stores and Spare parts

ii. Loose Tools

iii. Stock-in-Trade

iv. Work-in-Progress

v. Sundry debtors

vi. Cash balance on hand