Authored by Proff Kakani

Chapter 1:
Conceptual Basis of Accounting
Prof. Ram Kumar Kakani

XLRI School of Management, Jamshedpur, India
&
Prof. N. Ramachandran
AIT (Asian Institute of Technology), Bangkok, Thailand
Financial Accounting for Management by Ramachandran & Kakani 1
“Copyright with Tata McGraw-Hill Publishing Co Ltd, 2005"
Introduction
Accounting
Financial Accounting
Accounting Analysis
Used for reporting Providing information for

planning and control
Audience: Outside World Audience: Internal

(Govt. Bodies, society, etc.) (Managers and investors)
Financial Accounting – Evolution
Evidence of recording of
economic transactions in ancient
civilizations
Franciscan Monk Fra Luca Pacioli
(1445-1515) known as the Pacioli structured and
father of modern accounting organized the initial
His Summa de Arithmetica, accounting system
based on the ‘benefit
Geometria, Proportioni et and sacrifice’ principle
Proportionalita, is considered as
the first text on accounting

Accountant as a historian – keeps
records
But with a difference
Respects the facts
Bring into focus all known and knowable
relevant facts
Finally, provide an interpretation of the
history proposed

Financial Accounting – Evolution
Product of economic environment
Gradually evolved as a profession with the
development of economic activity
especially … Industrial Revolution
Scope and nature of accounting is closely
associated with the gradual changes in the
field of organization and management of
organizations
In the modern IT era, accounting is getting
integrated into software packages and
constantly adapting itself
Foundations of Accounting
3 Founding Ideas of Accounting
Capital Productive Profitable

Maintenance Capital Operations

Capital Maintenance
The idea is to preserve and maintain resources
used for generating wealth
Implies the generation of wealth while
keeping intact the resource used for such
generation
Income (during the year) =
Capital at the end of the year – Capital at the
beginning
If the above figure is negative, there is ‘capital
erosion’
Continuous capital erosion threatens business
survival
Productive Capital
Productive organization of modern industrial
society is founded on the use of capital
‘Wealth’ is used for generation of further
wealth
Accumulation and deployment of large-scale
productive capital involves the problem of
maintenance and preservation of such
resources
Consider the Oil Wells owned by the Oil
Companies
Throws up the important information
function of the valuation of such resources.
Profitable Operations
The idea of profit is the motive force
This induces one to go in for future
consumption in preference to present
consumption
Resources can be deployed for large
number of alternative uses. There is an
important criterion for making decisions in
the exercise of choice
This coupled with the idea of maintenance
of capital makes the problem of
measurement of profit crucial to
accounting.
Development of Accounting
Early medieval commerce was agency
book-keeping for a specified venture
Development of Joint Stock Companies
Operating individuals were not the
owners
Investment Banking – keeping records for
inspection
Large scale manufacturing and service
organizations
creation of artificial juridical entities
based on common stock of capital
collected from large number of investors
Recording and summarizing of business
related events and transactions for the
purpose of financial reporting
Two basic principles
Form of the ‘account’ – the basic
information formats
Equilibrium of the complete set of
accounts forms the foundation of the
accounting system

Accounting as a Measurement &
Valuation System
Basic orientation of financial accounting is

income determination
Oriented towards an entity- a business unit
Tries to prescribe a series of concepts,
standards, postulates and principles
Accounting theory as a doctrine is
explanatory in nature and the underlying
reasoning and justifications are related to
practice

Definition of accounting
Multiple definitions exist
According to American Institute of Certified
Public Accountants (AICPA) –
“accounting is the art of recording,

classifying and summarizing in a
significant manner and in terms of money,
transactions, and events, which are, in
part at least, of a financial character, and
interpreting the results thereof.”
Valuation in Accounting
Valuation could
trace values
through the entire
network of
Causal transformations,
Duality of Networking
Values which forms the
among Values
basis of all
Valuation in economic activity
Benefit and Accounting
Sacrifice
aspect of every
economic
transaction Transformation Exchange of a
of Values utility
differential to a
monetary
differential
Illustration – Valuation of a Machine
Adeep, a cotton yarn manufacturer, purchased a machine
paying cash Rs. 70,000. At which value do you record this
transaction?
¾Historical Cost
¾Current (Replacement) Cost
¾Net Realizable Value
¾Present Value
Due to its many advantages, historical cost is

the most used in the field of accounting

Three Types of Business Entities
Sole Proprietorship Partnership Company
Examples M/s Ladduram & Sons S S Billimoria & Co. Mro-tek Limited
Minimum: 2 Minimum: 7
No. of Shareholders One Person
Maximum: 20 Maximum: No Limit
Management Control Proprietor Partners Board of Directors
Liability Unlimited Unlimited Limited

Legal Registration No Provision Voluntary Compulsory
Flexibility Maximum Depends on Partners Comparatively Less

Basic Framework of Accounting
Concept refers to an idea, a general notion,
thought or assumption.
Standards are something established for use
as a rule, intended to act as a basis of
comparison and reference in measuring,
quantity, and or quality and assigning value
Postulates are assumptions; they are taken
to be true or real
Principles refer to a law, the method or a rule
of conduct.
Concepts Standards Postulates Principles
Generally Accepted Accounting
Principles - GAAP
Combination of authoritative standards
(set by policy boards) and the accepted
ways of doing accounting
Differs from country to country based
on the accounting principles and
standards adopted in that country
Rules that business entities are
expected to follow while preparing their
financial statements

Accounting Standards-setting
Organization in Selected Countries
Country Policy Setting Board
Australia Australian Accounting Standards Board (AASB) sets GAAP
Canadian Accounting Standards Board (CASB) of the Canada
Canada
Institute of Chartered Accountants (CICA) sets GAAP
Accounting Standards Board (ASB) of the Institute of Chartered
India Accountants of India (ICAI) is the body entrusted with the
work of preparing the standards.
Accounting Standards Board (ASB) is comprised of nine
U.K.
members drawn from different user groups.
Financial Accounting Standards Board (FASB) is the body
U.S.A.
solely in charge of issuing standards.
Interpreting GAAP and Accounting Standards
GAAP Accounting Standards
Accounting practices Authoritative standards (set by

holding sway in a country. policy boards)
Country specific International standards exist
Indian GAAP is to be followed in the pecking order of:

1. Accounting Standards laid down by ICAI
2. Statements issued by the ICAI.
3. Guidance notes issued by the ICAI.
4. Expert Advisory opinions issued by the ICAI
5. Technical guides and monographs issued by the ICAI.
Conceptual Basis
Concepts are essential ideas that permit
the identification and classification of
phenomena or other ideas
A concept must state all that the given
class includes and all that it excludes
Formed primarily by observation and
established through agreement

Basic concepts of accounting –
accepted as principles
Property Rights
the right of accounting entities to possess
and alienate property – value
Business Entity
the entity is separate and distinct from
the owners and the entity is liable to the
owner
Hence, in a limited liability company, the
enterprise is liable to the owner
(shareholder) based on the proportion of
the capital investment (share capital)
made by the latter
Concepts …
Going Concern
entities have a life of infinite duration,
unless facts are known that indicate
otherwise
the basis of valuation of resources is
influenced more by their future utility to
the business entity than by their current
market valuation
Money Measurement
Representation in a common
denominator and amenable to
summarization by addition & subtraction
Accounting Concepts
Matching
Determining the profits after charging
the expenses of a period with the
revenues earned in the same period
Realization
Determines the point of time when
revenue and hence returns (or profits)
can be recognized objectively, unbiased,
and with certainty
Consistency
Once a choice is made for the treatment
of a transaction, the same is consistently
followed
Concepts …
Diversity among Independent Entities
There are wide variations in the organization
and operations of entities Æ requirements
and demands are different
Conservatism
“Anticipate no gains, but provide for all
possible losses” and “if in doubt, write it off”
Results in an understatement of profits and
values
Close nexus with idea of ‘capital
maintenance’
Concepts …
Dependability of Data
Accounting entities ensure the standard of
internal controls to ensure that the data
used as the basis of accounting records are
controlled to ensure their quality
Materiality
Necessitated by practicability and feasibility
Timeliness
The idea of accounting periods is used so as
to ensure regularity and timeliness of
reporting

Accounting Policies
Specific accounting principles and the
methods of applying these principles for
the preparation and presentation of
financial statements of an enterprise
based upon the accounting concepts
followed by the enterprise
Areas of applicability
Valuation of Inventories, Fixed Assets,
Investments
Role of ICAI
Guidance Notes
Objectives of Accounting
Income determination
For rational economic decision-making
Financial reporting
Summarized as all those things of value
owned by the entity and all the claims
against these possessions
Disclosure
All the relevant & pertinent information is
supplied to the information users

Purposes Of Accounting
Information
Purposes of
Accounting Information
Score Attention Problem

Keeping Directing Solving
Reporting on Signaling the user Provision of such

the financial about the need to information that would
health take a decision enable to find solutions

Accounting & Management Control
Control means the process of keeping the
organization in course
This involves measurement through the control
system
The controller (accountant) and managers
obtain information, which enables them to
diagnose the situation

Illustration on using Accounting
Information
A firm sells three products P1, P2, P3. Profit of
the firm is declining
Year 1 Year 2
Sales Rs 1000 Rs 1000

Less: cost of goods sold 400 500
Gross margin 600 500
Less: Depreciation 200 200
Other operating expenses 100 100
Profit Rs 300 Rs 200
Illustration…
The Problem:
Decrease in profits during the period - as a result of overall
increase in the cost of goods sold
Now, which product is losing money?
Year 1 Year 2
P1 P2 P3 P1 P2 P3
Sales 300 300 400 400 400 200
Less: COGS 150 150 100 200 200 100
Gross margin 150 150 300 200 200 100
Sales of P3 have decreased.

Cost of sales to sales of P3 has doubled
Accounting Information users
Stakeholders are the ones who have an
interest in what happens as a result of the
entities activities
Stakeholders classified as
Internal users viz. managers
External users viz. creditors and equity
investors, government, society

Class Discussion…
Stakeholder Area of interest
Government Tax liabilities of the firm
Unions & staff Potential for pay awards and bonus deals
Public/Society Ethical & environmental activities of the firm
Lenders Whether the firm is has a long-term future
Shareholders Profitability and share performance
Ability of the firm to carry on providing a service
Customers
or producing a product
Note: These should not be regarded as the 'only' answers
BHEL and its Stakeholders
Stakeholder Would be interested due to
Government & its agencies Income tax & other tax liabilities
Top Managers, Workers, Unions Potential for pay hikes, bonus, and incentives
Public Ethical and environmental activities
Long-term Lenders, Present & Whether the firm has a long-term future
Potential Shareholders
Fund managers & Analysts Profitability & share performance
Customer Ability to take a bigger order, etc
Supplier & Other Creditors Whether to offer the firm credit and if so, terms

Branches of Accounting
Accounting
Government Enterprise Social

Accounting Accounting Accounting
Financial Management
Accounting Accounting

Enterprise Accounting
Specifically addresses issues of measurement
and valuation in the context of business
enterprises
Has evolved into two disciplines
Financial Accounting
Providing financial information relating to
the entity to ‘outsiders’
Management/Cost Accounting
Reporting the activities of the entity to
managers so as to enable them to plan
and control the activities of the entity vis-
à-vis other competing entities
Organizational Structure vis-à-vis
Role of Accounting
CEO
EXTERNAL AUDIT
CFO
Finance Accounts Accounts

Officer Officer 1 Officer 2
Clerk 1 Clerk 2 Clerk 3
INTERNAL AUDIT
Thank You

Chapter 2:
Balance Sheet

&
Introduction
A basic objective of accounting is to convey
information necessary to make an accurate
analysis of the health of the entity
This information is obtained through the
Balance Sheet
Balance Sheet is a quantitative summary
of a company’s financial condition at a
specific point in time, including assets,
liabilities and net worth.
It is a snapshot of the financial health of
an entity
What is a Balance Sheet?
Balance Sheet is concerned with
Reporting financial position of an entity as
of a particular point in time
Done by listing all the things of value
owned by the entity as also the claims
against these things of value
Position as represented by the balance
sheet is valid only until another transaction
is carried out by the entity
Allows comparisons with the past financial status
Also comparison between multiple entities (on financial health)
Balance Sheet – Conceptual Basis
I want to purchase a car costing Rs. 500,000.
To do so, I have to borrow. A bank agrees to
finance me if I can invest Rs. 100,000 on my
own
Two relevant questions:

What are the things of value you own?
How much do you owe, and to whom?

Illustration…
Things of value owned by Rs. Amounts owed by me Rs.
me
Savings deposit in bank 50,000 Loan from a friend 50,000
Term deposit in bank 150,000 Own claim or net worth 200,000
Other personal possessions 50,000
Total 250,000 Total 50,000
250,000
Say, the bank grants me the loan of Rs. 400,000

and I buy the car for Rs. 500,000. After purchase
of the car my financial position statement will
change as follows:
Illustration…
Things of value owned by Rs. Claims against things of Rs.
me value
Savings deposit in bank 50,000 Loan from a friend 50,000
Term deposit in bank 50,000 Own claim or net worth 200,000
Car 500,000 Bank Loan 400,000
Other personal possessions 50,000
Total 650,000 Total 650,000
As a result of this transaction my worth is

increased from Rs. 250,000 to Rs. 650,000
But, my net worth remains the same. Why?

Learnings from the example …
Things of value possessed by an entity are
referred to as assets
Accountants use the term “assets” to
describe things of value measurable in
monetary terms
The amount owed by an entity expressed in
monetary terms, which represents a claim by
outsiders against its assets, is referred to as
“liabilities”
Liabilities are claims of outsiders, against an
entity and are legally enforceable
And …
Net worth of the owner(s) of the entity = The
value of assets owned by the entity less
liabilities (or outsider’s claims)
Also known as “owner(s) equity”
As it represents the claims of owner(s) in
case of an entity
Hence, financial position statement is
a summary of the assets, liabilities and net
worth
as of a particular point in time

Lets compare …
Assets I II
Liabilities & I II
Net Worth
Bank Savings Deposit 50,000 50,000 Loan from a friend 50,000 50,000
Term deposit in bank 150,000 50,000 Own claim / Net worth 200,000 200,000
Car - 500,000 Bank Loan - 400,000
Personal Possessions 50,000 50,000
Total 250,000 650,000 Total 250,000 650,000
Outsiders claim has priority over the owner(s) claim on the assets
and hence owner(s) equity is always a residual claim against assets
It follows from this that at any point in time, for all accounting entities
owner(s) equity and liabilities will be equal to assets owned by that
entity.
Balance Sheet Equation
This idea fundamental to accounting could
be expressed as an equality:
Assets = Liabilities + Owners Equity
Owner(s) claim is residual:
Owners Equity = Assets – Liabilities
The ‘benefit-sacrifice’ aspect

Balance Sheet Changes
Balance sheet represents the position at a
particular point in time
Any material transaction or exchanges can
change the position
Let us look at some specific examples of
transactions changing Balance Sheet

Possible changes in Balance Sheet
Possibility Example
An increase in assets followed by an Purchase of a tractor using a bank loan
increase in liabilities and vice versa
A decrease in assets followed by a Using the savings deposit in bank to
decrease in liabilities and vice versa return the loan from a friend
An increase in assets followed by an Interest earned on the savings deposit
increase in equity and vice versa increasing the net worth
A decrease in assets followed by a Theft of some personal possessions
decrease in equity and vice versa leads to decrease in owners equity
An increase in an asset followed by a Using my savings balance in bank to
decrease in another asset and vice versa purchase a computer
An increase in a liability followed by a Taking a new bank loan to return the loan
decrease in another liability and vice versa from a friend
Balance Sheet in business – Illustration
First step in accounting is “creation” of the
entity
Ram starts “Ramstore” on January 1, 20X5
with an investment of Rs. 20,000 brought
from his personal savings
Assets Rs. Liabilities And Owners Rs.

Equity
Cash 20,000 Owners equity 20,000

Transactions during January
On January 2 the store purchases a shop for
Rs. 50,000 paying Rs. 10,000 cash and
signing a mortgage for Rs. 40,000.
A new asset, shop premises, is acquired
worth Rs. 50,000.
A new liability, mortgage on the shop is
contracted in the amount of Rs. 40,000.
Owners equity = Total assets – Liabilities,
that is,
Rs. 20,000 = Rs. 60,000 – Rs. 40,000.

Modified Trial Balance
This shows that there is no change in the
owner(s) equity. Thus, the new Balance sheet
will be as follows:
RAMSTORE
Balance Sheet As Of January 2, 20X5
Assets Liabilities And Owners Equity
Cash 10,000 Mortgage on shop 40,000
Shop premises 50,000 Owners equity 20,000
Total 60,000 Total 60,000

Further transactions…
On January 3, the store purchased merchandise
for Rs. 5,000 in cash
The store also purchased merchandise for Rs.
15,000 on credit from Vanik
RAMSTORE
Assets Rs. Liabilities And Owners Rs.
Equity
Merchandise inventory 20,000 Accounts payable 15,000
And more…
On January 4, the store sells the entire
merchandise inventory for Rs. 25,000 cash
RAMSTORE
Assets Rs. Liabilities And Owners Equity Rs.
Merchandise inventory - Accounts payable 15,000
Business profit is earned in this process of exchange

of ‘utility differential’ for a ‘monetary differential’
Revenue and Expenses
The increase in owner(s) equity to match the
asset increase realized from a sale transaction
is referred to as ‘revenue’
The decrease in owner(s) equity to match the
decrease in assets suffered to earn revenue
are referred to as ‘expenses’
Revenues increase owner(s) equity and the
expenses decrease owner(s) equity
The owner(s) equity increases or deceases
to the extent of profit or loss earned by
the entity.
Owner’s Equity
Owner(s) equity comprises two parts:
Owners Equity = Contributed Capital +
Retained Earnings
RAMSTORE
Income Computation
Owners equity on January 4, 20X5 25,000
Less: Owners equity on January 1, 20X5 20,000
Profit earned during the period 5,000

Take aways…
The dual aspect principle has particular
relevance to balance sheet
All the figures are expressed in monetary
units, irrespective of its nature
All the transactions we reflected were only
with respect to the business entity,
‘Ramstore’ (specific entity)
All the valuations were based on the
assumption of a going concern, and not based
on liquidation or break up value
All the asset valuations were based on
historical cost as the basis of valuation
Balance Sheet Items’ Classification
Lists assets, liabilities and capital separately
Usually grouped into sub-groups and listed in
the order of their liquidity or length of time
required for conversion into cash
Listed in the ascending or descending order
of liquidity
Prepared at the end of a specified period,
usually, a year; referred to as ‘accounting
period’, ‘fiscal year’, or ‘financial year’
Let us look at a typical Balance Sheet …
(next slide)
Ramsons Limited
Balance Sheet as at 31 December 2004 (all figures are in Rs. ‘000)
Assets Rs. Liabilities & Shareholders’ Equity Rs.
Current Assets Current Liabilities
Cash 500 Notes payable 600
Marketable Securities 200 Accounts payable 1,000
Notes/Bills receivable 300 Accrued Liabilities 800
Accounts receivable 1,000 Income Tax payable 400
Less: estimated loss on collection 100 900 Bank overdraft 200
Prepaid expenses 500 Current Liabilities Total 3,000
Merchandise inventory 1,100 Long term Liabilities
Current Assets Total 3,500 Debentures 1,000
Fixed Assets Long term loans 2,000
Land 2,000 Long term Liabilities 3,000
Buildings, plant and machinery: 3,000 Shareholder’s Equity
Less: Accumulated depreciation 1,000 2,000 Ordinary share capital 2,000
Property Plant and Equipment 4,000 Capital Reserves 500
Intangible Assets Reserves & Surplus 1,500
Goodwill 1,500 Share holders equity 4,000
Deferred Expenditure 1,000
Intangible Assets 2,500
Total Assets 10,000 Total Liabilities & Shareholders’ Equity 10,000
Classification of Assets
Based on purpose in business:
Current Assets – Held for final transformation
in to cash at the earliest opportunity during
the normal course of business. Example:
Inventory
Long Term/Fixed Assets – Held for use in the
business. Sold only on liquidation. Example:
Shop Premises
Can same asset be classified in both categories!!
Assets may also be classified as tangible or
intangible
Current Assets
Current literally means a flow
Assets which will normally be converted
into cash with in a fiscal year or within an
‘operating cycle’
The operating cycle is the duration of
time taken by a unit of cash to circulate
through the business operations and
return back as cash

Operating Cycle Concept
Work in Further processing,
packaging, storage Finished
Progress Goods
in warehouse
Inventory Inventory
Processing
is done CASH Sold on
credit
R ym m ers
p a fr o m
ec e
ei nt
cu
of l s
ve s
st
o
Raw ase r ia t s
c h t e en
Material r a n
P u m po
Inventory w m Accounts
a
r co Receivable
&
Current Assets
Cash
Includes cheques or any other instrument
that circulates as cash
Marketable Securities
Result of excess short-term cash; Valued at
‘lower of cost or market price’
Accounts Receivable
Amounts owed to the company by ‘debtors’;
collection losses are called bad debts
Accounts Receivable 750,000
Less: Estimated collection loss (Reserve) 75,000
Net realizable value of accounts receivable 675,000
Current Assets…
Notes or Bills Receivable
Arises out of credit sales. Often
converted into negotiable instruments
such as a ‘Bill of Exchange’
Negotiable instruments are written
‘promises to pay’ or ‘acceptance of an
order to pay’. Are transferable upon
endorsement

Promissory Notes
Current Assets
Prepaid Expenses
Paid in advance such as rent, taxes,
subscriptions and insurance
Merchandise Inventory
Merchandise goods held for sale to
customers in the ordinary course of
business
Manufacturing Inventory
Transformed into another product or
assembled together into another product
before being sold
Classified as raw material (steel for a car-
making unit) and components (tyres)
Fixed Assets
Are tangible, relatively long-lived items
owned by the business
To be used in the course of business
Not possible to trace them in the value of
the goods or services sold by the firm
Benefit over several accounting periods to
the extent of life of asset
Value of the asset is reduced
proportionate to the expired life of the
asset – depreciation

Example…
A trader buys a delivery van for Rs. 100,000.
Assume that the van will have to be discarded
as junk as the end of five years. At the end of
the first year it will be represented as:
Fixed Assets: Rs.

Delivery Van - at cost 100,000
Less: Depreciation to date 20,000
Net 80,000
At the end of second year it will be?

Example continued…
At the end of five years the valuation of the
asset will be zero
The value of the fixed assets at cost is
usually referred to as ‘Gross Fixed Assets’
or ‘Gross Block’
The amount of depreciation to date
(cumulative) as ‘Accumulated Depreciation’
Net value of the fixed asset is usually
referred to as ‘Net Fixed Assets’ or ‘Net
Block’.

Cost-Depreciation Relationship
100,000
80,000
60,000
40,000 Cost
Acc. Depreceiation
20,000
0
Year Year Year Year Year Year
0 1 2 3 4 5
Note: Depreciation is charged at the end of each accounting period

Depreciation
Fixed assets are valued on the basis of
cost of making the asset available and
‘ready for use’
Others costs (such as installation costs)
included are known as ‘capitalized
expenses’ and included as part of gross
fixed asset
Land is not depreciated
Exception: Quarry or any similar
extractive property involving depletion
on usage
Intangible and Other Assets
A non-physical resource or a legal right that
represents an advantage to a company's
position in the marketplace.
Example – ‘goodwill’. It reflects the ability of
a firm to earn profits in excess of normal
return
Process of expiration of the cost of intangible
asset (like patents) is called ‘amortization’
“Other Assets” are assets which are not
normally classified as current, fixed and
intangible
Investments
A ‘financial security’ is a piece of paper that
proves ownership of equity, loan, and other
similar investments
Usually carried at cost price
Investments
Current Long-term
Investments Investments
Readily Realizable Intention is to hold for

Financial Accounting for Management by Ramachandran & Kakani
more than a year 36
Deferred Tax Asset
Sometimes business entities prepay their tax
and adjust it in later years (like ‘prepaid
expenses’)
Deferred expenditure
Special case of intangible assets
Benefit of these expenses are expected
over several future periods and these
expenses are deferred over a period of
time; considered as expenses in the
normal course of business
Example: Restructuring expenses
Current Liabilities
Liabilities that are due within an accounting
period or the operating cycle of the
business
Accounts Payable
Arises in the normal course of business
as a result of acquisition of goods or
services on credit
Acceptance
‘Bills of exchange’ accepted by the firm
usually for goods purchased

Current Liabilities
Promissory Notes Payable
Written promises to pay the debt at a
specified future date
Accrued Liabilities
Expenses or obligations incurred in the
previous accounting period but the
payment would be made in the next
period. Examples: Salaries due but not
paid

Current Liabilities
Estimated Liabilities or Provisions
Liabilities are known but the amounts
cannot be precisely determined
The principle of conservatism
Example: Income taxes payable
Bank Overdraft
Short-term borrowing – ‘current account’
with the bank with a contract to permit
overdrawing these accounts up to a limit
Flexible borrowing

Liabilities …
Contingent Liabilities
These are no liabilities as of now as
neither ‘the amount’ nor ‘the liability’ is
certain
They become liabilities only on the
happening of a certain event
Example: A claim against the company
contested in a law court
Shown as part of ‘notes’ to the balance
sheet

Long-Term Liabilities
Are usually for more than one year
Cover almost all the liabilities not included
in the current liabilities and provisions
Long Term Liabilities
Secured Unsecured
(Asset Backing) (No asset backing)

Long-Term Liabilities
Debentures and Bonds
Special instruments of borrowing used
by registered companies under the State
Companies Act
Designated into standard units and one
or more of those units are issued to
lenders
Have standard form and legal backing

Owners Equity
Capital
Assets = Liabilities + Owners Equity
In the Ramsons Illustration:
Total assets 10,000,000
Liabilities 6,000,000
Owners equity 4,000,000
Owners Equity = Contributed Capital +
Retained Earnings
Share Premium paid by stockholders is an
example of capital reserve
Illustration
A Company has an authorized share capital of Rs. 200,000;
divided into 15000 ordinary shares of Rs. 10 each and 500,
10% preference shares of Rs. 100 each
The portion of the authorized capital, which is raised, is referred
to as ‘issued capital’. If the Company offered to the public 7500
ordinary shares and 500 preference shares for cash.
Issued capital Rs.
7500 ordinary shares of Rs. 10 each 75,000
500, 10% cumulative preference shares of Rs. 100 each 50,000
Total 125,000

Continued…
Subscribed, Called up and Paid up Capital
7500 ordinary shares of Rs.10 each 75,000
500, 10% cumulative preference shares of Rs.100 each 50,000
Total 125,000
The company needed only part of the capital

and hence chose to issue only one half of the
total authorized ordinary shares
The implication of authorized capital is that it
is maximum amount of capital a company
may raise without altering the deed of
registration
Preference Shares
Have some preference over ordinary shares
In case of liquidation the assets remaining
after payments to creditors are distributed
to preference shareholders first
Are first paid their ‘prefixed’ dividend
Usually redeemable after a specified period
Ordinary Shares
Have residual claim against all the assets
No preferential or fixed rights in either
repayment of capital or profit distribution

Reserve and Surplus
These are surpluses earned by the firm
(not distributed as dividends)
Retained earnings normally arise out of
profitable operations
They are ‘earned capital’ for the firm
Limit of dividend is retained earnings

Formats of Balance Sheet
Standard Format
Report Format
Vertical Format

Thank You

Chapter 3:
Profit & Loss Account

&
List of Transactions for Ram Software Ltd. (RSL)
On March 1, Ram & others invest Rs. 50,000 in cash in RSL.
On March 2, Ram took a loan of Rs. 20,000 from Venu for RSL.
On March 3, RSL purchased for cash two computers, each costing Rs.
29,000.
On March 4, RSL purchased supplies for floppy disks and stationary
for Rs. 6,000 on credit.
On March 19, RSL completes its maiden sale of software to a retail
store and receives a price of Rs. 12,000.
On March 21, RSL pays Rs. 2,000 to its creditors for supplies.
On March 29, RSL pays salaries to its employees, amounting to Rs.
4,000 and as office rent Rs. 1,200.
On March 30, RSL completes a software package for a shoe shop.
The customer agrees to pay the price of Rs. 8,000 a week later.
On March 31, Ram withdraws Rs. 3,500 for his personal use.
Questions asked by owners/managers
Was it a good year or bad year?
What was the volume of operations?
What was the margin available on sales
realization?
The answer…
Profit and Loss Account

While a Balance Sheet
Reports value of assets, liabilities and
owners equity at a particular point in time
And Reflects net change in owner(s)
equity brought about by operations
A Profit & Loss Account shows a company's
earnings and expenses over a given period
of time
It exclusively summarizes revenue and
expenses of the period and shows the net
difference i.e., profit or loss of the period
Measurement of Income
Identify Identify Match identified

realized related revenues and
revenues costs expired costs
Comparing the revenue from sales against the

cost of resources parted with for earning that
revenue

Balance Sheet Equation
Owners’ equity = Assets – Liabilities ... (1)
The amount of sales revenue realized
increased owner(s) equity
The amount of goods parted with decreased
the owner(s) equity
Thus, the resultant increase in owner(s)
equity was equal to the net increase in
assets. That is equal to the profit

Owner(s) Equity = Contributed Capital + Retained
Earnings
Retained earnings = Revenue – Expenses … (2)
From (1) i.e., previous slide
Assets = Liabilities + Contributed Capital +
Revenue - Expenses ... (3)
(2) is referred to as Profit & Loss Account

It measures the income generated by the
entity with the use of assets
Revenue and expenses relate to a period
and not to a point in time
Recognition and measurement of revenue
and expense are based on the ideas of
realization, accrual, and matching

Realization Principle
Process of converting non-cash resources and rights into
money
Recognition of revenue from sale of assets for cash (or
specifically claims to cash)
Revenue is recognized when goods are delivered (or services
are rendered)
Possible Rationale … Guess!!
Enables to have a reference in recognizing the expiration of
costs incurred in making available such goods (or services)
Exceptions:
Construction Contracts & Installment Sales contracts
Accrual Principle
It is a generally accepted accounting principle
(GAAP)
Evaluates every transaction in terms of its
impact on owner(s) equity
Implies recognized revenue results in
increase in owner(s) equity and expired costs
or recognized expense results in decrease in
owner(s) equity
Net income arises from events that change
owner(s) equity in a specified period which
are not necessarily the same as change in
the cash position
Illustration …
Ali Mehdi Khan starts his business on 1st July. He took a
loan of Rs. 1,00,000/- from bank @ 12% per annum for
purchasing plant & machinery, on the same day. The
machine has a life of 10 years with no scrap value. He
also paid Rs. 60,000/-, three months rent in advance
Bank borrowing does not represent revenue – increase in cash
is offset by an increase in liabilities
Interest (Rs. 1000) depreciation (Rs. 833/-) are accrued
expenses for July
Rent expense for July will be Rs. 20000/-
Illustration …
Khan had written orders worth Rs. 2,00,000 in the month of
June itself (even before starting his business). He started the
production accordingly; the total production cost was Rs.
1,20,000; sales of merchandise to its customers till 31-07-2004
are as follows:
Total Sales = Rs. 95,000 (Cash Sales 25,000 and Credit
Sales to Rajesh Rs. 70,000)
Sales for June:
Nil – Because revenue is recognized only when goods are
sold to the customers and not on receiving the order or on
incurring the production cost
Solution
Sales for July:
Rs 95,000
Accounting equation would be:
Cash + Debtors = Liabilities + Owner(s)
Equity
25,000 + 70,000 = 0 + 95,000
When Rajesh pays Rs. 70,000 in August
Sales does not occur
Cash would increase by Rs. 70,000 and the
debtors would decrease. The amount of
owner(s) equity remains same
Accrual Vs Cash Basis
Basis of
Accrual Basis Cash Basis
Accounting
Revenue When cash is
When earned
collected
Expense When cash is
When incurred
paid
GAAP
Yes No
Compliance

Illustration
We purchase merchandise worth Rs. 1,000
during the period; sell one half of this during
the period for Rs. 750. Rental for the
facilities during the period was Rs. 200

Discussion…
Item Remarks
Cost of inventory Rs 1000 The purchase prices of the merchandise.
Increase in owners equity i.e., The sale proceeds realized in exchange of one
Revenue Rs 750 half of the merchandise.
Expenses i.e., expiration of The cost of the merchandise parted with in
inventoriable cost Rs 500 exchange for the revenue. The cost with respect
to the revenue earned and hence expired cost.
Expenses i.e. expiration of The cost of rent for the facility is a cost incurred
non-inventoriable cost Rs 200 during the period and expiring during the period
i.e., a period cost.
Ending Inventory Rs 500 The unexpired cost. An asset merchandise
inventory, as a convention valued at cost.
Accounting Period
• A convenient segment of time, to collect,
summarize and report all information on the material
changes in owner(s) equity during the period
• Realization and Accrual principle will have to be
applied in the context of the accounting period
t0 Accounting period -1 t1 Accounting period -2 t2
Profit & Loss
Profit & Loss
Balance Balance Account for the Balance
Account for the first
Sheet 0 Sheet 1 second accounting Sheet 2
accounting period
period
Links in the information chain which makes up
the life of the enterprise
Matching Revenues & Expenses
The entire process of periodic earnings
measurement
Means deducting from revenues of a period
the cost of goods sold or other expenses
that can be identified with such revenues,
or of that period, on the basis of a cause
and effect relationship
The expenses to be matched against the
revenue of the period will be all those costs
expiring during the accounting period

Revenue
Broadly, it is the total amount realized from
the sale of goods (or provision of services)
together with earnings from interest,
dividend, rents and other items of income
‘Operating income’ Vs ‘non-operating
income’
Implication of Realization Principle
If the right to receive that income is
created or the time for which the income
relates have expired it is accrued income

Characteristics of Revenue
Normally, generated out of business
activities
Results in inflow of assets (cash or
receivable) and outflow of goods or services
Usually related to a specific period i.e.,
revenue of one year cannot be included in
revenue of the other year
Leads to increases in owner(s) equity
Different from ‘profit’ or ‘net income’

Expense
The expiration of the assets and the resultant
decrease in assets leading to the decrease in
owner(s) equity
Costs incurred and expired in connection with the
earning of revenue
Sacrifice made or resource consumed in relation to
the revenues earned during an accounting period
Costs that have expired during an accounting period
are treated as expense
The expired cost, directly or indirectly related to a
given fiscal period
Characteristics of Expense
Expenses are incurred for the purpose of
generating revenue or benefit
Benefit is usually derived during the same
accounting period under consideration
It is related to a particular period. However,
the payment of expenses can be made
before the recognition of expense or
afterwards
Leads to decreases in owner’s equity

More on expenses…
Expenses of a given period are
Costs and expenses of current accounting
period
Costs incurred in a previous accounting
period that become expenses or expired costs
during this year (such as prepaid rent and
prepaid insurance)
Expenses of this year, the monetary outlay
for which will be made during a subsequent
period (such as salaries payable and taxes
payable)
Expense recognition
Under following circumstances:
In the period in which there is direct
identification or association with the revenue
of the period
An indirect association with the revenue of
the period
Measurable expiration of assets (unexpired
costs) though not associated with the
production of revenue for the current period
Assets that become expenses: inventories,
prepaid expenses, and long-lived assets
Profit & Loss Account Preparation
It is a summary of all ‘accounts’ dealing with transactions relating
to revenue and expenses
Done by summarizing all individual accounts accumulating
information on different items relating to the elements of ‘expense’
and ‘revenue’
Assets = Liabilities + Contributed Capital + Revenue – Expenses – Dividends

A = L + C + R - (E + D)
‘Revenue - (Expenses + Dividends or Drawings)’ is equal to the ‘Retained
Earnings’

Illustration
During an accounting period Ramsons buys
twelve units of inventory for Rs. 1,200. Another
ten units are purchased on credit for Rs.1,000.
Fifteen units of inventory were sold during the
period on credit for Rs. 2,250. Five units of
inventory were sold for cash for Rs.750 during
the same period.

Horizontal and Vertical format of
P&L Account
Revenue of the period: Rs.
15 units sold on credit 2,250
5 units sold for cash 750
Total revenue of the period 3,000
Less: Cost of goods sold or expired cost of inventory 2,000
Profit of the period 1,000
RAMSONS
Profit & Loss Account (for an accounting period)
Expenses Rs Revenues Rs
Cost of goods sold 2,000 Sales 3,000
Profit for the period 1,000
3,000 3,000
Possible Future Expenses
Sometimes costs are incurred directly in
relation to the revenue of a given accounting
period, in subsequent periods
Amount of expense in question is estimated,
relating to an accounting period in order to
make a reasonably accurate measurement of
the profit or loss of the period
Example: Provision for bonus
Bad debt expense
Arises out of credit sales
Credit Sales Æ Receivables Æ Bad Debts
Possible Future Expenses
A business is started with owner(s) equity of
Rs. 2,500. The business makes four credit
sales of Rs. 250 each during a period. Cost of
sales for the same is known to be Rs 500.
Suppose one of the credit sales account
becomes doubtful

Financial Statements
for an accounting period
Cost of goods sold 500 Sales 1,000
Profit for the period 500
1,000 1,000
Balance Sheet
as at the close of an accounting period
Assets Rs Liabilities & Capital Rs
Accounts receivable 1,000 Retained earnings 500
Other assets 2,000 Owner(s) equities 2,500
After accounting for Bad Debts
Profit & Loss Account for an accounting period
Cost of goods sold 500 Sales 1,000
Bad Debt expense 250 Bottomline hit
Profit for the period 250 by Rs. 250
1,000 1,000
Balance Sheet as at the close of an accounting period

Accounts receivable 1,000 Retained earnings 250
Estimated Collection loss 250 750
Other assets 2,000 Other equities 2,500
2,750
Financial Accounting for Management by Ramachandran & Kakani 2,750
31
Fixed Assets and Depreciation
The cost of a fixed asset, written off or
matched as expense against the revenues of
different periods during which the asset is
used
It is the expired cost of an asset during an
accounting period
Illustration – A crushing machine purchased for
Rs 50,000 having a five-year life and no
salvage value is used in a business. During the
life of the asset, it will be able to earn revenue
of Rs 100,000
Computations…
Revenue over the period of use of the assets
Total Revenue = Rs 100,000
Period Æ 1 2 3 4 5
Amount Rs 20,000 Rs 20,000 Rs 20,000 Rs 20,000 Rs 20,000 = Rs 100,000
* Assuming that revenue is earned evenly
Hence, profit per annum is Rs 10,000
Cost expiration
or Rs over the
50,000 over the useful
period life
of use of the
of the assets
asset
Total Machine Cost =Rs 50,000
Period Æ 1 2 3 4 5
Amount Rs 10,000 Rs 10,000 Rs 10,000 Rs 10,000 Rs 10,000 =Rs 50,000
Unexpired at the Rs 40,000 Rs 30,000 Rs 20,000 Rs 10,000 Rs 0

end of the period
* Assuming that asset is used evenly over the useful life
Methods of Depreciation
Depreciation
Methods
Accelerated Uniform
Approach Approach
Larger amounts are Expires the cost
expired during the initial uniformly over the
years of life of the assets useful life of the assets
Principle of Conservatism Popular as it is an easy

method to follow
Depreciation: Some concepts
Original cost
Cost incurred in making the asset available for use at the first
instance. This amount is specific and known on the
acquisition of the asset
Salvage value
Recovery (or sales value) of the asset at the end of its useful
life. Value needs to be estimated (mostly).
Useful life
Expected time period for which the asset is to provide
economic service or productive life. Estimated based on
experience/technical factors
Depreciation: Some concepts
Depreciable cost
Original Cost of asset – Salvage Value
Book value
Original Cost – Accumulated Depreciation
3 Popular Depreciation Methods
Straight Line Written Sum of

Down Value Years’ Digit

Straight Line Method
Depreciable cost of the asset is proportionately
allocated as expense against the revenues
during each year of useful life of the asset
Illustration
A company acquires a machine at the
beginning of operations at Rs 10,000. It is
expected that machine will last 10 years and
will have no salvage value at the end of its
useful life

Depreciation @ 10% per annum:
Straight-line Method
Annual Accumulated Remaining Book
Year Cost
Depreciation Depreciation Value
0 10000 - - -
1 10000 1000 1000 9000
2 10000 1000 2000 8000
3 10000 1000 3000 7000
4 10000 1000 4000 6000
5 10000 1000 5000 5000
6 10000 1000 6000 4000
7 10000 1000 7000 3000
8 10000 1000 8000 2000
9 10000 1000 9000 1000
10 10000 1000 10000 0
Written Down Value Method
Depreciation is taken as a certain rate applied
to the written down value of the asset as at
the beginning of each year
The amount of expiration of the cost of the
asset is higher during the initial years

Written Down Value Method:
@20% per annum
Original Annual Accumulated Remaining Book
Year
Cost Depreciation Depreciation Value
0 10000 - - 10000
1 10000 2000 2000 8000
2 Since there
10000 is no salvage 3600
1600 value for 6400
3 the asset 1280
10000 at the end of its4880
useful 5120
life, the terminal year depreciation
4 10000 1024 5904 4096
will be taken as Rs. 1,342 i.e., Rs.
5 268 (the depreciation
10000 819 for 6723
the 3277
6 period) plus
10000 655Rs 1074 (the7379
terminal 2621
7 value of the
10000 524asset). 7903 2097
8 10000 419 8322 1678
9 10000 336 8658 1342
10 10000 268 8926 1074
Sum of the Years’ Digit Method
This method applies a declining fraction year to the depreciable
cost of the asset
The declining fraction is constructed by taking the number of years
of useful service left at the beginning of the year as numerator and
sum of the digits of the number of years of useful life as
denominator
Produces results akin to the written down value method with the
difference that there will be no residual left
If the asset has 10 years useful life the denominator of the fraction
will be equal to (10+9+8+7+6+5+4+3+2+1) i.e., 55
So, the first year’s depreciation charge will be 10/55, second years
depreciation will be 9/55 and so on
Sum of the Years’ Digit Method
Original Annual Accumulated Remaining
Year
Cost Depreciation Depreciation Book Value
0 10000 - - -
1 10000 1818 1818 8182
2 10000 1636 3455 6545
3 10000 1455 4909 5091
4 10000 1273 6182 3818
5 10000 1091 7273 2727
6 10000 909 8182 1818
7 10000 727 8909 1091
8 10000 545 9455 545
9 10000 364 9818 182
10 10000 182 10000 0
Intangible Assets & Amortization
Intangible assets such as patent rights or
distribution rights represent unexpired cost
The expiration of intangibles, though akin to
depreciation, is distinguished by referring to
it as amortization
Usual practice is to amortize on straight line
basis over a reasonably short period

Depreciation & Profit Measurement
Depending on the method used for charging
depreciation, we have a different amount of
charge for annual depreciation
Difference is only in terms of annual
apportionment
The net effect of the methods is therefore in
terms of showing less or more profit in any
particular year

Profit Measurement under Different
Depreciation Methods – Illustration
Earnings Profit Profit
Profit
Before Written Sum of the under under
Straight line under
Year Depreciation down value years’ digit written sum of
depreciation Straight
(say Rs.5000/- depreciation depreciation down the years’
line
per annum) value digit
1 5,000 1,000 2000 1818 4000 3000 3182
2 5,000 1,000 1600 1636 4000 3400 3364
3 5,000 1,000 1280 1455 4000 3720 3545
4 5,000 1,000 1024 1273 4000 3976 3727
5 5,000 1,000 819 1091 4000 4181 3909
6 5,000 1,000 655 909 4000 4345 4091
7 5,000 1,000 524 727 4000 4476 4273
8 5,000 1,000 419 545 4000 4581 4455
9 5,000 1,000 336 364 4000 4664 4636
10 5,000 1,000 269+1,074* 182 4000 3657 4818
50,000 10,000 10,000 10,000 40,000 40,000 40,000
Profit Measurement under Different
Depreciation Methods
5000
SL Depn.
4000
WDV Depn.
3000
SYD Depn.
2000
Profit-SL
1000
Profit-WDV
0
1 3 5 7 9 Profit-SYD
Profit & Loss A/c – Horizontal Format
Tools India Ltd.
Profit & Loss Account For the year ended December 31, 2000
Schedule Amount
Sales net 1 255
Other income 2 5
Total Revenue 260
Cost of goods sold 3 130
Gross profit 130
Operating expenses:
Personnel 4 49
Depreciation 5 11
Other expenses 6 28
Operating profit 42
Interest 7 12
Profit before taxes 30
Income tax provision 12
Net profit after tax 18

Profit & Loss A/c – Vertical Format
Tools India Ltd.
Profit & Loss Account for the year ended December 31, 2000
Debit Credit
Schedule Amount Schedule Amount
Cost of goods sold 3 130 Sales net 1 255
Gross profit 130 Other income 2 5
260 260
Personnel expenses 4 49 Gross profit 130
Depreciation 5 11
Other expenses 6 28
Operating profit 42
130 130
Interest 7 12 Operating income 42
Profit before taxes 30
42 42
Income tax provision 12 Profit before taxes 30
Net profit after tax 18
30 30
Schedule 1: Sales
Schedule 1: Sales (Rs Millions)
Gross sales 260.00
Less: Sales returns and allowances 1.75
Sales discount 3.25 5.00
Net sales 255.00
Net sales –Domestic
Machine Tools group 83
Watch group 87
Tractor group 60
Lamp group 13
Dairy Machinery group 2
Total domestic sales 245.00
Export:
Machine Tools Group 6
Watch Group 2
Others 2
Total Export Sales 10.00
Profit & Loss A/c Items
Sales Returns and Allowance
Not according to specifications, damaged,
or defective
Sales/Cash Discount
Sales discounts are reduction from invoice
price granted for prompt payment of the
invoice within specified time limit
‘Net amount’ or ‘No cash discount’ (N)
‘A 3 percent discount if payment is made
in 10 days otherwise net amount to be
paid in 60 days’ (3/10, n/60)
Trade discounts
Given when sales are done in bulk (i.e.,
discount is based on volume of business)
Never brought into accounts – the sales
and hence sales invoice are valued at net of
trade discount
Other Income
Operating income – Derived from the main-
line operations of the business
Other income – Arises from activities
incidental to the business
Schedule 2: Other Income
Rs Million
Interest – banks 0.50
Interest – staff and offices 1.20
Export incentives 1.80
Sales agency commission 0.50
Profit on sales of assets 0.30
Dividend on trade investments 0.20
Other miscellaneous income 0.50
Total 5.00
Cost of Goods Sold
Complex in cases of multi-product, multi-
division companies, having large volumes
of semi-finished goods
Two challenges:
First is with respect to changes in the
price per unit of purchase. At what
price should we identify the cost of
goods sold?
Second, how do we evaluate cost of
semi-finished goods?
Cost of Goods Sold Details
Schedule 3: Cost of goods sold
Rs Million
Inventory on January 1, 2000 81.00
Add: Purchase 110.00
Freight-in 10.00
Other direct material costs 15.00
Total goods available 216.00
Less: Raw material & semi finished inventory on Dec 31, 2000 71.00
Goods available for sale 145.00
Less: Finished goods inventory on December 31, 2000 15.00
Cost of goods sold 130.00

Gross Profit
Reflects the direct input costs
To a great extent variable with the volume
of operations
Operating Expenses
All those costs of making the inventory
available for sale
Are directly or indirectly traceable to the
inventory to be sold
Usually segregated under two groups –
selling expenses & administrative expenses
Personnel Expenses
Includes remuneration and other benefits to staff and workmen
Schedule 4: Personnel expenses
Rs Millions
Salaries, wages and bonus 37.81
House rent allowance 2.19
Gratuity 0.75
Contribution to provident fund 2.75
Contribution to Employees State Insurance (ESI) 0.50
Workmen and Staff Welfare expense 5.00
Total 49.00
Depreciation expense
Expiration of costs of fixed assets
Usual practice to classify the depreciation
expense for different groups of assets
Schedule 5: Depreciation
Rs Millions
Fixed assets 9.84
Tools and Instruments 0.02
Patterns, Jigs and Fixtures 1.14
Total 11.00
Other Expenses
Expenses other than those disclosed
separately are usually grouped together
Relatively very small when considered as
individual items

Schedule 6: Other Expenses
Rs Millions
Power and Fuel 3.10
Rent 0.50
Rates and Taxes 0.40
Insurance 0.50
Water and Electricity 0.60
Repairs to buildings 0.20
Repairs to machinery 0.80
Printing and Stationery 0.90
Advertisement and Publicity 2.40
Audit fees 0.05
Royalties 0.85
Sole selling and other agents commission 4.70
Directors fees 2.00
Provision for bad debts and advances 0.20
Loss on assets sold or discarded 1.30
Provision for warranty repairs 1.00
Miscellaneous expenses 8.50
Total 28.00
Operating Profit
Measure of ‘operational efficiency’
Obtained by deducting personnel, depreciation
and other expenses from gross profit
Usually referred to as OPBIT or EBIT
Interest Expense
Arises out of management’s decision to
finance part of the assets from borrowings
The level of interest expense presents the
amount of risk the company is carrying in
terms of fixed commitments
Schedule 7: Interest
Rs. Million
Debentures 0.58
Fixed deposits 1.50
Loans from Government 5.00
Term loans from Banks/Financial Institutions 0.42
Cash (packaging) credit from banks 3.50
Others 1.00
Total 12.00

Net Profit before Tax
The surplus after meeting all expenses including interest
The profit available as a result of both operating and
financing performance
Income Taxes
Determined by profit before tax
Tax payable is determined by tax laws
Net profit or Profit after Tax
It is the net amount of surplus earned by the company
The amount ultimately available for appropriation
Can be either distributed as dividends or retained
Methods of Inventory Valuation
“Only thing certain with prices normally is that
it is not certain”
The recording of inventory as well as its
expiration as cost of goods sold made on the
basis of historical cost
Methods of
Inventory Valuation
First in First Last in First Weighted Average

Out (FIFO) Out (LIFO) Cost (WAC)

Inventory Valuation: FIFO, LIFO, and WAC

Take Home …
Purchase Cost is the same irrespective of the
method of inventory valuation
Cost of goods sold and ending inventory at
the end of the period are different for the
three different methods of inventory
valuation
In all the cases inventory plus cost of goods
sold amount to the same, that is, Rs 47,500,
since it is based on actual historical cost only

THE ASSOCIATED CEMENT COMPANIES LIMITED,
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED MARCH 31, 2004
INCOME : Rs. Crore
1. SALE OF PRODUCTS AND SERVICES (Gross Sales) 3,888.30

LESS - EXCISE DUTY RECOVERED 603.83
SALE OF PRODUCTS AND SERVICES (Net Sales) 3,284.47
2. OTHER INCOME (Non-operating Income) 150.53
GROSS REVENUE 3,435.00
EXPENDITURE :
3. MANUFACTURING EXPENSES 1,345.00
GROSS PROFIT 2,090.00
4. OPERATING EXPENSES 1,556.08
OPERATING INCOME 533.92
4. DEPRECIATION 176.85
5. INTEREST 92.91
NET INCOME 264.16

Explanations to Items
Gross Sales (or Gross Turnover): The
aggregate amount for which product sales are
effected (or services rendered) by an
enterprise (inclusive of taxes paid)
Net Sales (or Net Turnover): The sales
after deduction of sales returns & allowances,
sales discounts, etc.
Operating Income: The net income arising
from the normal operations and activities of
an enterprise without taking into account
extraneous transactions and expenses of a
purely financial nature

Explanations to Items
Gross Profit (or Gross Margin or Gross
Loss): The excess of the proceeds of goods
sold and services, rendered during a period
over their cost, before taking into account
administration, selling, distribution and
financing expenses
Net Income (or Net Profit or Net Loss):
The excess of revenue during a particular
accounting period

Dividends & Retained Earnings
Dividends
An appropriation of profits among owners Æ not an expense
Technically the withdrawals by owners of the business
In Joint Stock Companies, it is subject to Company Law
Retained Earnings
After subtracting dividends declared from the net profit, any
surplus remaining is added to (accumulated) retained
earnings. Also referred to as reserves and surplus
Sometimes designated to signify retention of earnings for
different future purposes such as redemption of debt
(redemption reserve), replacement of assets etc.
Components Of Retained Earnings
Revenues
Revenuesfor
forthe
the
Period
Period
--
Expenses for
forthe
Å Profit
Expensesand
Period
the Loss Account Æ
Start of Period
the End of the
Period == Period
Beginning
BeginningBalance
Balance + Net Income (Loss) Ending
EndingBalance
Balance
+ Dividends
Dividendsfor
forthe
ofofRetained
Retained -- Net
for
Income (Loss) -- the == Of
OfRetained
Retained
Earnings for the
thePeriod
Period Period
Period Earnings
Earnings Earnings
Further Discussion (Optional)

Profit & Loss Account of a Manufacturing Concern
Profit & Loss account during a period can be divided into 4 parts:
Trading Account: Indicates the amount of gross profit earned
by matching the cost of sales with the revenues generated
Manufacturing Account: Gives the cost of goods
manufactured by the manufacturer
Profit & Loss Account: Used to measure the profit/loss of the
firm by way of deducting the administrative expenses, selling
& distribution expenses, non-trading losses, and finance
charges from gross profit and the non-trading income
Profit & Loss Appropriation Account: Reflects how the net
profit earned by the firm is utilized Æ it is an income
distribution statement
Thank You

Chapter 4:
Fund Flow and Cash Flow Statement

&
Flow of Funds
There is a continuous movement of resources into the
business, within the business and out of the business
The funds flow takes place only when there is a movement in
the current assets or the current liabilities during the
accounting period
Funds flow is used to refer to changes in or movement of
current assets and current liabilities
Example: If land is purchased out of a long-term loan, there is
no flow of funds. But if financed by a short-term loan or cash,
there is an outflow of funds as working capital is reduced

Working Capital
Working Capital = Current Assets – Current Liabilities
All the assets held by the business with the
objective of conversion to cash during an
operating cycle of the business
Part of the assets is financed by short-term
credits or borrowing which are to be met or
repaid during the operating cycle – these
are current liabilities
Fund implies amount of resources invested
in current assets from sources of finance
other than current liabilities
Funds Flow Statement
Based on a fundamental equation:
Sources of Funds – Application of
Funds = Change in Working Capital
A statement that depicts the ways and
reasons for movement in the funds of an
entity for a given accounting period
It is not mandatory under any law
There is no prescribed format or rules that
govern this statement

Need for Working Capital - Illustration
In Ramsons, a retail outlet, the investment in
the showroom, display counters, furniture
fixtures and so on was Rs 600,000. Ramsons
follows straight-line depreciation of fixed
assets at the rate of 10 percent per annum.
Estimated sales was Rs 150,000 per month:
Rs 50,000 cash sales and Rs 100,000 on
credit to be collected in four equal monthly
installments, with the first installment
collected at the time of sale. All sales were
made on 25 percent margin on selling price

Additional Information
Supply and sales constraints would warrant
carrying three months sales requirement in the
form of inventory. Similarly a month’s cash
expense requirements had to be held in cash
balance
Initial inventory was to be bought for cash and
replenishment purchases will receive a month’s
credit from suppliers
Average monthly cash requirement for meeting
operating expenses other than payment for
purchases amounted to Rs 26,000. Ram
needed to withdraw Rs 4,000 per month for his
personal needs
Pertinent Questions…
How much working capital will Ramsons
require to start operations?
Will he need any addition to working capital
during the first four months? Or will he have
surplus working capital during the first four
months?

Schedule of Cash Payments
Month Explanation Amount Rs. Total Rs.
January Operating expenses 26,000
Withdrawals 4,000
30,000
February January purchases 112,500
Operating expenses 26,000
Withdrawals 4,000
142,500
March February purchases 112,500
Withdrawals 4,000
142,500
April March purchases 112,500
Withdrawals 4,000
142,500
Schedule of Cash Receipts
Month Explanation Amount Rs. Total Rs.
January Cash Sales 50,000
Credit sales of the month first installment 25,000
75,000
February Cash Sales 50,000
January sales second installment 25,000
100,000
March Cash Sales 50,000
January sales - third installment 25,000
February sales second installment 25,000
125,000
April Cash Sales 50,000
January sales - fourth installment 25,000
February sales - third installment 25,000
March sales second installment 25,000
150,000
Balance Sheet
RAMSONS
Balance Sheet as of 1st January
Assets Rs. Liabilities and Rs.
Capital
Fixed Assets 600,000 Capital 967,500
Inventory 337,500
Cash 30,000
967,500 967,500
Assumption: The entire asset requirements at the first instance are
financed by Ram’s own capital

Schedule of Cash Balances
RAMSONS
Schedule of Cash Balances
January February March April
Opening Balance 30,000 75,000 32,500 15,000
Cash receipts 75,000 100,000 125,000 150.000
Total Cash available 105,000 175,000 157,500 165,000
Less: Cash payments 30,000 142,500 142,500 142,500
Cash Balance 75,000 32,500 15,000 22,500
Less than the required cash of Rs 30000

P/L Account for the period…
RAMSONS
Profit & loss Account for the month ending…
31 January 28 February 31 March 30 April
Total Sales 150,000 150,000 150,000 150,000
Less: Cost of Sales 112,500 112,500 112,500 112,500
Other Expenses 26,000 26,000 26,000 26,000
Depreciation 5,000 5,000 5,000 5,000
Total Expenses 143,500 143,500 143,500 143,500
Net Profit 6,500 6,500 6,500 6,500
Less: Drawings 4,000 4,000 4,000 4,000
Profit Retained 2,500 2,500 2,500 2,500

Balance Sheet (Assets)
RAMSONS
Balance Sheet as at the end of
Assets 1 Jan 31 Jan 28 Feb 31 Mar 30 Apr
Fixed Assets 600000 600,000 600,000 600,000 600,000
Less: Depreciation 5,000 10,000 15,000 20,000
Net Fixed Assets 600,000 595,000 590,000 585,000 580,000
Inventory 337,500 337,500 337,500 337,500 337,500
Receivable 75,000 125,000 150,000 150,000
Cash 30,000 75,000 32,500 15,000 22,500
Current Assets 367,500 487,500 495,000 502,500 510,000
967,500 1,082,500 1,085,000 1,087,500 1,090,000

Balance Sheet (Liabilities)
RAMSONS
Balance Sheet as at the end of
Liabilities & Capital 1 Jan 31 Jan 28 Feb 31 Mar 30 Apr
Capital 967,500 967,500 967,500 967,500 967,500
Add: Ret. Earnings 2,500 5,000 7,500 10,000
Owners Equity 967,500 970,000 972,500 975,000 977,500
Accounts Payable 112,500 112,500 112,500 112,500
Liabilities & Capital 967,500 1082,500 1,085,000 1,087,500 1,090,000

Changes in working capital and the
possible sources of their funding…
RAMSONS
Schedule of Working Capital
Assets 31 January 28 February 31 March 30 April
Current assets 487,500 495,000 502,500 510,000
Less. Current Liabilities 112,500 112,500 112,500 112,500
Working Capital 375,000 382,500 390,000 397,500
Funds From Operation
Net Profit 6,500 6,500 6,500 6,500
Add: Depreciation 5,000 5,000 5,000 5,000
Total Funds generated from operations 11,500 11,500 11,500 11,500
Less withdrawals 4,000 4,000 4,000 4,000
Net additions to Working Capital 7,500 7,500 7,500 7,500

Capital Invested In Business
Ramson’s Objective: “Invest money to make
money”
This investment of profits is known as ‘retained
earnings’
The balance sheet(s) of the business shows us
how Ramsons has utilized the money

Ramsons … we notice that …
The changes in fixed assets is represented by
accumulated depreciation only
There were no additions to fixed assets
Reduction in fixed assets due to depreciation
is a non-cash transaction
On the liability side also there was no
transaction involving long-term liabilities or
capital
Only change in the long-term items is the
increase in retained earnings
All changes are in working capital
Further…
The net change in working capital is an
increase of Rs 7,500 per period
This points to changes in current assets and
current liabilities
Changes in cash and receivable
Only item of current liability to change is
the accounts payable during the first
period, which is maintained later on
The increase in receivable needed funds to
finance it and it was provided in part by
the increase in payable
Contd…
If an increase in current assets is offset by an equal increase in
current liabilities, the net impact on working capital is zero
This leaves us with the only other item, which could have
financed the change in working capital Æ funds generated by
operations
The operations provided a profit of Rs 6,500 during each period
An expiration of fixed assets in the amount of Rs 5,000 per month
Thus operations generated is Rs 11,500 per period
The owner regularly withdrew cash of Rs 4,000 per period
leaving in business additional resources of Rs 7,500 per period,
which is the change in working capital
Changes in Working Capital
1 Jan 31 Jan 28 Feb 31 March 30 April
Working 367,500 375,000 382,500 390,000 397,500
Capital
• We could summarize the normal uses of funds

(working capital) as follows:
1. Acquisition of new non-current assets
2. Repayment of non-current debt
3. Profit distribution to owners
4. Increase in the balance of working capital
(current assets - current liabilities)
Cash and Receivables
Cash as an investment!
Amount which is required to be kept on hand to
meet day-to-day requirement of cash
This amount is determined by (a) the regularity and
uncertainties related to cash inflows and outflows;
and (b) need for investment in other assets
Receivables as investment!
Granting credit to customers implies ‘financing the
cost of materials for the duration of such credit’
Financing only to the extent of cost of goods sold
Opportunity aspect of credit granted is that one is
deferring receipt to the extent of receivable amount

Inventory, Supplies, Prepaid Expenses
Inventory is held whenever there is a time lag
between procurement and use of inventory of
materials and supplies
Quantum on inventory depends on:
Availability and regularity of supply
Lead-time for delivery
Credit allowed by supplier and terms of sale
Storage Capacity, etc.
Expenses that are to be paid before services
are used, such as rent, insurance, etc. in order
to ensure smooth operations
Fixed or Non-current Assets
We cannot expand our business beyond a certain
capacity that is limited by the facilities created by
fixed assets; an additional investment is required
Need for fixed asset investment and current asset
investment will vary from business to business
A trading company requires very little
investment in fixed assets and very large
investment in current assets
A complex manufacturing unit may need large
investment in factory and equipment
Capital requirements will also be determined by
specific firms at given volumes of their activity
Future Capital Requirements
Need for Additional Capital
For financing For financing

additional additional
fixed assets working capital
Increased Increased Increased

holding of credit to cash holding
customers requirement
inventory

Various Uses of Fund
Uses of fund
Dividends
Non-operating losses not passed through income statement
Redemption of redeemable preference share capital
Repayment of debentures/bonds
Repayment of long term loans
Purchase of fixed assets
Purchase of long term investment
Increase in working capital
Working Capital: Possible Sources
Working capital is required to finance that
portion of current assets, which are not
financed by current liabilities
Sources of Working Capital
Internal External
Generations Generations

Internal Sources
Use of existing
Funds generated Surplus Working
from operations Capital
(Revenue less First Internal

Expenses involving Internal Source
use of funds during Sources
the period)
Sale of Non-Current Assets

Not a regular and
continuing source of funds
External Sources
Two external sources:
1. Owners contributing additional capital,
i.e. by raising more capital
2. Increased long-term borrowing
Short-term borrowing will not increase
working capital
Working capital represents long-term
investment in current assets

Sources of Working Capital
Working Capital Sources
Internal External
Operations Non-Current Surplus Further Increased

Asset Sale Working Raising of long-term
Capital use Capital Borrowing
Factors affecting Fund Requirements
Fund requirements vary with the nature and type of business
Sales Volume growth
More inventories and receivables due to extended
credits
Impact of Seasonality
Fund requirements are restricted to a limited period
Providing funds on a permanent basis may lead to idle
funds during most part of the year
Velocity of Circulation of Current Assets
Terms available from the Suppliers (Extended credit Æ Less
funds required)
Illustration
A firm carries an average balance of Rs 10,000
accounts payable, payable in 30 days and an
average accounts receivable of Rs 15,000
receivable in 45 days.
The firm will have to keep a net working capital
for the differences of receipts from customers
and fund required meeting payable as follows:
Fund required to meet payable due within 30 days Rs 10,000
Less: Funds received from customers within 30 days: Rs 10,000
Received in 45 days, that is, Rs 15,000 x 30/45
Fund required in the form of additional net working capital NIL
Illustration…
Assuming the time taken for collection of
receivable is 90 days the situation will be:
Fund required to meet payable due within 30 days Rs 10,000
Less: Funds received from customers within 30 days: Rs 5,000
Received in 45 days, that is, Rs 15,000 x 30/90
Fund required in the form of additional net working capital Rs 5,000

Illustration–Bhawani Shanker Ltd.
M/s Bhawani Shanker Ltd.
Profit & loss account
For the year ending 31st March 20X5
Particulars Amount Particulars Amount
To, Salary 10,000 By, Gross Profit 1,50,000
To, Depreciation 25,000 By, Profit on sale of 50,000
To, Loss on sale of 50,000 Plant 40,000
Machinery 40,000 By, interest 10,000
To, Office Exp. 1,25,000 By, Dividend
To, Net Profit 2,50,000 2,50,000
Calculate the amount of funds from operation.

Solution
Particulars Amount
Net Profit as per Profit & Loss Account 1,25,000
Add: Non-fund or non-Operating expenses
Depreciation 25,000
Loss on sale of machinery 50,000 75,000
Less: Non-fund or non-Operating incomes 2,00,000
Profit on sale of Plant 50,000
Interest income 40,000
Dividend income 10,000 (1,00,000)
FUNDS FROM OPERATION Æ 1,00,000

Analyzing Changes in Working Capital
Ibis Ltd. – Case Discussion
Ibis Ltd.
Change in Working Capital (all figures in Rs million)
Year 1 Year 2
Current assets 180.00 232.00
Less: Current liabilities 80.00 105.00
Working capital 100.00 127.00
Working capital at the end of Year 2 127.00

Working capital at the close of Year 1 100.00
Increase in Working capital 27.00

Case Discussion – Ibis Ltd.
The Rs 27.00 million increase in working
capital of Ibis shows the composite changes in
the operating assets
Does not tell us much in terms of
operations of the business
The change could be the net result of
changes in all the accounts covered by
current items or some other reason
We need to analyze the changes in each of
the working capital accounts

Case Discussion – Ibis Ltd.
A statement of change in working capital can help us in
locating where these changes took place
Any increase in current assets and any decrease in current
liabilities shows an increase in working capital and vice
versa
Increases in current assets amounted to Rs 52.00 million
Total amount of decreases in working capital resulting from
increase in current liabilities amounted to Rs 25.00 million
This led to a net increase in working capital of Rs 27.00
million

Changes in Financial Position
An analysis of the fluctuations of current
assets and current liabilities
Tells where increased working capital is
invested and if decreased, from where funds
have been released
Funds Flow Statement
Describes the sources from which funds
were received and also the uses to which
these funds were applied
Traces the flow of funds through the
organization
Fund Flow Statement
The statement of funds flow is usually divided
into the two logical divisions
Sources of funds or inflows – net effect of
increasing the working capital
Uses of funds or applications of funds – net
effect of decreasing the working capital
Gives a summary of the impacts of managerial
decisions on the position of the business
Reflects the policies of financing, investment,
acquisition and retirement of fixed assets,
distribution of profits and the success of
operations
Moving Further …
There can be cases when a funds flow
statement alone may not be able to provide
detailed information and hence not helpful to
the investors
For example, there would only be a
mention that there is an increase in
working capital but no information as to
where the increase in working capital has
been utilized

Statement of Cash Flow
Is an extension of the funds flow statement
explained earlier
A statement that presents the flow of cash to
and from an organization due to various
transactions in a given accounting period
AS 3 issued by the ICAI guides the
preparation of cash flow statement in India
Helps assesses the ability of an enterprise to
generate cash and to utilize the cash
Also helps to assess the liquidity and solvency
of the entity
Illustration – Nasir Enterprises
Profit & loss Account
For the period ending 31-03-20X4
Particulars Amount Particulars Amount
Rs. Rs.
Purchases 7,50,000 Sales 10,00,000
Salaries 50,000 (includes 50%
Wages 30,000 credit)
Office Expenses 10,000
Selling & Distribution
Expenses 12,000
Depreciation 8,000
Net Profit. 1,40,000
Total 10,00,000 Total 10,00,000

Observations…
There is a profit of Rs 1,40,000 but assuming
all purchases to be cash purchases there is a
net cash outgo of Rs 3,52,000 during the
period
Since, the total cash inflow for the period is
5,00,000 (i.e., 50% of the total sales) and the
total cash outflow is Rs 8,52,000 (i.e., all the
expenses other than depreciation)
In the same way there can be a business loss
for the period but still can result in a positive
cash flow due to the non-cash expenses like
depreciation
Cash Flow Statement
It provides information on changes during an
accounting period by cash and to classify cash
flow under three activities:
Operating Activities
The profit adjusted for depreciation, gains
and/or losses on sale of non-current
assets, tax paid, and working capital
changes
Investing Activities
Purchases of non-current assets and
proceeds on the sale of non-current assets
Cash Flow Statement
Financing Activities
Proceeds on the issue of equity/preference
shares and loans/debentures and the
redemption of redeemable preference
shares and loan/debentures
So, a cash flow statement is a consequence of
the difference between profits and cash
It provides the user with a mechanism for
providing additional information on its business
activities and a better assessment of the
current liquidity of a business than a funds flow
statement
Preparing a Cash Flow Statement
All the cash flow activities are required to be
segregated under three activities viz.,
operating, investing and financing
The sum of these activities reflects the net
increase or decrease in the cash and cash
equivalents
Here, by cash we mean both cash in hand
and bank demand deposits, similarly cash
equivalents means all the short-term
investments which can be readily converted
into cash without decline in its value

Cash Flow vs. Funds Flow Statement
Basic difference is that cash flow tracks cash position for a given
period while funds flow tracks the working capital position
In a cash flow statement, the difference between the sources
and applications of cash represent the closing cash balance.
The difference in sources and applications of funds, in funds
flow statement represents the change in the working capital
Cash Flow statement takes items on cash basis while in funds
flow statement the basis is accrual system of accounting.
Cash flow statement can be helpful in assessing a business
entities capacity to meet its short-term obligations whereas the
funds flow statement helps in assessing the capacity to meet its
long-term obligations
Operating Activities
It is the principle revenue generating activities of an entity
Two ways of calculating it
Direct method
We independently analyze the changes that cash
transactions cause in each balance sheet non-cash
account
Indirect method
The Profit and Loss Account is adjusted for the effects of
transactions of non-cash and non-operating nature
Also known as “Reconciliation to Net Income”

Illustration – Kanishk Ent.
For the Year ending 31st March 20X4
Particulars Rs. Particulars Rs.
Purchases for the Year 80,000 Sales 1,65,000
Direct Expenses 20,000
Gross Profit 65,000
Total 1,65,000 Total 1,65,000
Rent 8,000 Gross Profit B/d 65,000
Salary 20,000 Profit on sale of old
Depreciation 15,000 machinery 13,000
Provision for Bad Debts 5,000
Proposed Dividends 10,000
Provision for Taxes 2,500
Preliminary Exp. written off 1,500
Net Profit 16,000
Solution – Direct Method
Kanishk Enterprises
Cash Flow Statement
For the Year ending 31st March 20X4 (all figures in Rs)
Cash Flow From Operating Activities:

Cash received on account of sale of goods 1,65,000
Less: Payment made on account of
Purchases of goods 80,000
Freight and Cartage 20,000
Salary Paid 20,000
Rent Paid 8,000 1,28,000
Cash Inflow Æ 37,000

Solution – Indirect Method
Kanishk Enterprises
Cash Flow From Operating Activities:
Net Profit as per Profit & loss Account 16,000
Add: Non-cash transaction
Provision for Bad Debts 5,000
Depreciation 15,000
Proposed Dividends 10,000
Provision for Taxes 2,500
Preliminary Expenses written off 1,500 34,000
Less: Non-operation incomes
Profit on sale of machinery 13,000
Cash Inflow Æ 37,000
Investing Activities
Activities related to acquisition and disposal of long-term
assets and other investments, which are not taken into
consideration under the cash equivalents head are investing
activities
Also includes investments made by business entities in other
company’s shares and debentures
Examples of investment activities include cash payments or
receipts to acquire or dispose fixed assets, shares, warrants,
debt instrument, etc.

Illustration - Kanishk
The following transactions occur at Kanishk
Enterprises:
Amount
Particulars
(Rs.)
Purchased a machinery for 1,50,000
Sold shares worth 2,00,000
Received interest on debentures purchased earlier 10,000
Received dividend on shares held 20,000
Sold old machinery 50,000

Solution
Kanishk Enterprises
Cash Flow Statement
Cash Flow from Investing Activities:
Sale of Shares 2,00,000
Interest received 10,000
Sale proceeds of old machinery 50,000
Dividend received 20,000
2,80,000
Less: Outflow on account of machine purchase 1,50,000
Cash flow from Investing Activities 1,30,000

Financing Activities
The activities that result in the change in size and composition
of the long-term capital employed in the firm are known as
financing activities
Includes both owner(s) capital and long-term borrowing of the
entity
Example: cash received from issue of share capital, issue of
loans and cash payment on dividend, redemption, etc.
Supposing during the year Kanishk Enterprises has taken a
loan of Rs 1,50,000 and paid an interest of Rs 15,000
thereon, the cash flow from financing activities for the year
comes to Rs 1,35,000 (i.e., 1,50,000 - 15,000)
Areas of Confusion
Interest received on long-term investments
vis-à-vis interest received on short-term
investments (including interest on trade
advances and operating receivables)
Interest paid on loans and debts vis-à-vis
interest paid on working capital loan
Dividend received in case of financial
enterprises vis-à-vis dividends received by any
other type of enterprise
Dividend paid is always classified as financing
activity

Thank You

Chapter 5:
Accounting Records

&
Introduction
Accounting concepts provide theoretical and practical basis
Structure and format for accumulation of information is derived
from the basic balance sheet equation
The basic information formats used for accumulation of material,
measurable information relating to the entity is an account
Depending on information needs, the information may be
classified and accumulated in many separate accounts
Only technical consideration to be kept in mind is that once
summarized it should maintain the balance sheet equality intact
This requirement dictates the form, contents and rules of
preparing accounting records
Balance Sheet Equation and Accounts
Expanded accounting equality could be written
as: A = L + C + R - (E + D)
Where, A = assets; L= liabilities; C = capital; R = revenue;
E = expenses; and D = dividends
Rearranging gives: A + E + D = L + C + R
This transposed equality is the basic
accounting equality
Quantities on the LHS are normally referred to
as ‘debit’ or ‘Dr. in short
Quantities on the RHS are known as ‘credit’,
or ‘Cr.’ in short
Balance Sheet Equation and Accounts
Accounts belonging to LHS terms, namely,
Assets, Expenses, and Dividends, their basic
accounting character being ‘debit’ have debit
balances
For these accounts: Debits - Credits ≥ 0
Similarly, in the case of accounts relating to
terms on the RHS of the equality: Liabilities,
Capital, and Revenues, normally have credit
balances
For these accounts: Credits - Debits ≥ 0
In any case, equal to zero implies no balance
Information Accumulation Process
In all accounts representing LHS terms, all
increases of those items are debited and all
decreases are credited in the same account
In case of accounts representing RHS,
increase with respect to an item is credited
and decreases are debited to that account
Actual balances as of a point in time would be
shown by the net difference
The terms ‘debit’ and ‘credit’ in accounting
has no more practical significance than ‘left’
and ‘right’ of an account
Steps in Formation of Accounting
Records
Identify Analyze and Recording

Transaction Classify the in Journal
Transaction
Transfer Ledger
Entries Posting
Financial Adjustment Preparing

Statements Entries Worksheet
Account
An account is a comprehensive and classified record of
transactions affecting one person, one kind of property or one class
of gains or losses arising out of expenses or incomes.
Since the transactions can either increase or decrease these items
an account is structured into two parts like a capital T, denoted by
Debit on the LHS and Credit on the RHS
Accounts are titled denoting the nature of information accumulated
in them viz. “cash account” or “receivable account” and so on
Debit Cash Account Credit

Classification of Accounts
Accounts Classified
Assets Liabilities Capital Income Expense

Ex. Land, Ex. Loans, Ex. Share Ex. Sales, Ex. Salary,
Stock, Cash Creditors, Capital, Interest Rent, Power
Bills Payable Proprietor’s A/c Earned

Classification of Accounts
The basic accounting equation reminds us that the accounts can
be divided into the following five broad categories:
Assets or the resources which a firm is enjoying
Liabilities or the obligations of the firm towards outsiders
Capital or the amount invested by the owners, the increase in
such capital and the decreases in it.
Income or expenses of the business affect the increase and
decrease in capital. Therefore, two more forms of account
Incomes or the amounts earned by the business
Expenses or the amounts expended by the business

Example – Cash Account
All transactions involving cash will be recorded in the ‘cash
account’
All increase or receipts of cash will be debited to and all
decreases or payments will be credited to the cash account
At the time of summarizing, balance in an account will be the
difference
Since it is not possible to make payments in excess of
receipts, the balance in the account will have to be debit
balance
If the payments are equal to receipts, then, there is no balance
of cash
Rules for Debit and Credit
Accounting Equation
Assets = Liabilities + Shareholders Equity

Or
Assets = Liabilities + (Contributed Capital + Retained
Earnings – Dividends + Revenue – Expenses )

The Journal
A chronological record of all transactions
showing the debit and credit of the accounts
affected by the transaction
Primary record for a transaction – “book of
prime entry”
Narrative Description
Sub-divided on the basis or type of transaction
into subsidiary books
JOURNAL
Date Explanation Ref. Debit Credit

Illustration - Journalizing
There is purchase of furniture for cash on
January 1, 20X1 as per Bill No. 001 from
Modern Furniture for Rs. 1000
Journal Entries in the books of M/s…
Date Explanation Ref. Debit Credit
Amount Amount
Jan. 1, Furniture account (Debit) Invoice 1,000 1,000

20X1 Cash Account (Credit) no: 001
(Being purchase of furniture for
cash from Modern Furniture as
per Bill No.001.)

Illustration
The following information relates to Shyam’s
Enterprise for a month
Date Transaction Rs.
January 1 Starts business with 1000
January 8 Buys merchandise and stores them 800
January 10 Receive order for half the merchandise from A
January 15 Delivered the merchandise, customer invoiced 500
January 17 Received order for other half of merchandise
January 31 Customer A pays 500

Understanding the transactions
Date Transaction Accounts affected

Jan 1 Starts business with ♦ Cash increase
♦ Capital increase
Jan 8 Buys merchandise ♦ Merchandize inventory
and stores them increase
♦ Cash decrease
Jan 10 Receive order for There is no transaction;
half the merchandise transaction takes place only when
from A transformation of value takes place

Understanding the transactions
Date Transaction Accounts affected
Jan 15 Delivered the ♦Merchandize inventory decrease
merchandise, ♦Cost of goods sold increase
customer invoiced ♦Revenue increase
♦Receivable increase
Jan 17 Received order for There is no transaction;
other half of transaction takes place only when
merchandise transformation of value takes
place
Jan 31 Customer A pays. ♦Cash increase
♦Accounts receivable decrease
Process of recording…
Starts business with Rs.1,000 – affects two accounts:
Cash increase - entry on the debit side of the account
Capital increases - entry on the credit side of the account
Purchases merchandise and stores them
Merchandise inventory increase - entry on the debit side of
the account
Cash decrease - entry on the credit side of the account.
Receipt of order for half the merchandise
Receipt of order does not warrant any record. We consider
realization of revenue only when goods are delivered

Delivered goods and customer invoiced
Cash is not collected simultaneously, it represents a
credit transaction. Increase in claims against ‘A’ accounts
receivable account created and debited
Revenue earned: sales account credited.
Cost of goods sold should also be considered:
We part with merchandise inventory worth Rs.400. Debit
cost of goods sold account with increase in expense or
expiration of cost
Credit the merchandise inventory account to show the
reduction in inventory
Receivables collected
Cash increase recorded by debit in cash account and a
credit to receivables (A) account
Credit to receivables account shows the liquidation of our
claim (asset). In practice this amounts to repayment of the
debt by A

Recording in T accounts
Dr. Cash Account Cr.
Date Explanation Amount Date Explanation Amount
Jan 1 Capital 1,000 Jan 8 Merchandize inventory 800
Jan 31 Accounts receivable 500 Jan 31 Balance 700
Dr. Capital Account Cr.

Jan 31 Balance 1,000 Jan 1 Cash 1,000
Dr Cost of Goods Sold Account Cr.

Jan 15 Merchandize Inventory 400 Jan 31 Balance 400

Recording in T accounts
Dr. Merchandize Inventory Account Cr.
Jan 8 Cash 800 Jan 15 Cost of goods sold 400
Jan 31 Balance 400
Dr Account Receivable Cr.

Jan 15 Sales Revenue 500 Jan 31 Cash 500
Jan 31 Balance 0
Dr. Sales Revenue Cr.

Jan 31 Balance 500 Jan 15 Account Receivable 500
Dr. Income Summary Cr.
Explanation Amount Explanation Amount
Cost of goods sold 400 Sales revenue 500
Profit 100
Balance Sheet on Jan. 31

Liabilities and
Assets Amount Owner(s) Equity Amount
Cash 700 Capital 1,000
Merchandise inventory 400 Profit retained 100
1,100 1,100
Exercise to cross check: Use accounting equation(s) to give effect to above transactions of Shyam.
Recording of Transactions
Possible for us to record each and every transaction of an entity
in a balance sheet
However not practically feasible
Thus, we accumulate the transactions in separate accounts
relating to revenue, expenses, assets and liabilities
All transactions are reduced to statements of facts. These facts
are then specified as a set of relationships
Each item on a balance sheet can be changed only in one of the
two possible ways by a transaction:
they can increase it, or
they can decrease it
Recording of Transactions
By recording of transaction in accounts we are just
accumulating increases and decreases of various items of
the balance sheet during a period to be summarized and
presented as the balance sheet at the end of the period
The record of changes in the particular item is referred to as
an ‘account’
It is summed up at the end of an account period and the
result of this summing up is the balance that would appear in
the profit & loss account or balance sheet as the case may
be

Alternate Account Classification
Personal Accounts or the accounts that
are related to persons i.e., specific parties
dealing with
Real Accounts or the account of tangible
nature; items that can be physically
possessed
Nominal Accounts or the intangible items
are the items that are not visible or which
cannot be touched
Temporary in nature

In a nutshell…
Rules of Debit and Credit

Personal Account : Debit the Receiver, Credit the
giver.
Tangible Accounts : Debit what comes in, Credit
what goes out.
Intangible Accounts : Debit all the expenses and
losses, Credit all the gains and
profits.

Ledger Accounts
Book of final entry in which a record of
debits and credits to various accounts are
kept
Nothing but a group of accounts
The ledger will contain at least as many
separate accounts as there are items on the
balance sheet and income statement
The number of accounts is governed by
Management’s need for information
Statutory requirements if any
Cost of keeping it
C ash A ll in d iv id u a l
a c c o u n ts c o m b in e d
M a n y in d iv id u a l a s s e t m a k e u p th e
a c c o u n ts c o m p a n y ’s le d g e r
A c c o u n ts Ledger
P a y a b le
M a n y in d iv id u a l
lia b ility a c c o u n ts
Com m on
S to c k
M a n y in d iv id u a l s to c k h o ld e r s ’
e q u ity a c c o u n ts

Posting of Transactions
Process of recording the transactions in the
ledger from the books of original entry is
termed as ‘posting’
Dual aspect principle ensures that each
transaction finds a place in at least two
accounts
Total amount of debits as a result of a
transaction will be equal to the credits

Journal Entry & Posting to the Ledger
Journal Entry :
Particulars Debit Credit
Cash A/c…….Dr. 50,000
To Common Stock A/c 50,000
( Issued Common stock to Owners )
Posting to the Ledger :
Common Stock A/c

Cash A/c
50,000 50,000

Illustration
Jan. 1 Sales for Cash Rs.3,000
Jan. 1 Purchases for Cash 1,000
Jan. 3 Rent paid in Cash 500
JOURNAL
Date Explanation Ref Dr. Cr.
Jan 1, 20X1 Cash (Debit) Sales 3,000 3,000
Sales (Credit) Invoice
(Being cash sales) no: 001
Jan 1, 20X1 Purchases (Debit) Purchase 1,000 1,000
Cash (Credit) Invoice
(Being cash purchases) no: 101
Jan 3, 20X1 Rent expense (Debit) Payment 500 500
Cash (Credit) Voucher
(Being rent paid in cash) no: 011

Ledger Posting in T Accounts
Dr. Sales Account Cr.
Date Explanation Ref. Amount Date Explanation Ref Amount
Jan 1 Cash 3,000
Dr. Cash Account Cr.

Jan 1 Sales 3,000 Jan 1 Purchases 1,000
Jan 2 Rent expense 500
Dr. Purchases Account Cr.

Jan 1 Cash 1,000
Dr. Rent Account Cr.
Jan 3 Cash 500
Journal vs. Ledger
Points Journal Ledger
Nature Book of prime entry Book of final entry
Style Chronological record Analytical Record
Process Recording here is Recording here is
known as 'journalizing' known as 'posting'
Unit Unit of classification of Unit of classification of
data is transaction data is account
Final Accounts cannot Final Accounts maybe
Objective be prepared from this compiled with this
alone

Subsidiary Books – Divisions of Journal
When volume of transactions of a business is
large it is highly advantageous to classify them
into groups of similar transactions
All those transactions repeatedly affecting one
aspect of an account are grouped together and
recorded in a subsidiary book, Ex. Sales
journal, Cash receipts journal, etc.
All transactions not passed through the
subsidiary books will be passed through the
general journal

Some subsidiary books
Sale Journal – Recording all credit sales
Purchase Journal – Recording all credit
purchases
Cash Receipts Journal records all cash
receipts
Cash Payments Journal records all cash
payments
The cash receipts and payments book can be
combined (like an account) there by
combining the primary and secondary record
in one place
Types of Cash Book
Entries in the cash book can be passed
directly, based on which the ledger accounts
are prepared
For this, there can be three types of cash
book
Simple cash book Æ single column cash book
Two column cash book Æ having cash-bank,
cash-discount, or bank-discount columns
Three column cash book Æ having all three
columns i.e., cash, bank and discount

Illustration
M/s Subham & Co. purchases furniture for Rs. 10,000 on which
he gets a discount of 10%. He also sells goods to M/s Sohan for
Rs. 15,000. It is known that M/s Sohan also makes the full
payment after availing a discount of 10%. The opening cash
balance is Rs. 5,000. Prepare Cash Book.
Taken to
the discount
M/s. Subham & Co. account in
Cash Book
the ledger
Date Particulars LF Dis. Amount Date Particulars LF Dis. Amount
To, Bal B/d 1,500 5,000 By, Furniture 1,000 9,000
To Sales 13,500 By, Bal C/d 9,500
1,500 18,500 1,000 18,500
Posting from Subsidiary Books
Possible to post the transactions periodically
Following are the transactions of credit purchases

on different dates
Jan. 1 Roy and Co. Rs.2,000
Jan. 2 Sen and Co. 3,000
Jan. 3 Carmaker and Co. 1,500
Jan. 4 Mondal and Co. 6,000
Jan. 5 Naskar and Co. 3,500

Purchase Journal…
PURCHASES JOURNAL
Date Credit Account of: Amount
Jan. 1 Roy and Co. Rs.2,000
Jan. 2 Sen and Co. 3,000
Jan. 3 Carmaker and Co. 1,500
Jan. 4 Mondal and Co. 6,000
Jan. 5 Naskar and Co. 3,500
Jan. 5 Purchase Account - Debit Rs 16,000

Respective ‘T’ Accounts
Dr. Purchases Account Cr.
Jan 5 Sundries 16,000
Dr. Roy and Co Account Cr.

Jan 1 Purchases A/c 2,000
Dr. Sen and Co Account Cr.


Respective ‘T’ Accounts
Dr. Carmaker and Co. Account Cr.
Date Explanation Ref Rs. Date Explanation Ref Rs.

Dr. Mondal and Co. Account Cr.

Dr. Naskar and Co. Account Cr.


Balancing & closing of accounts
Financial statements can only be produced
when accounts are closed
Each account is balanced at the end of the
accounting period to verify the accuracy of
the records
Debit and credit balances match
Done usually at the end of the accounting
period
Each account will show a balance depending
on which side of the account is heavier viz.
debit or credit
Nature of Balance
Nature of the ledger accounts Nature of balance
Asset accounts Debit balance
Permanent
Liability accounts Credit balance
Accounts
Capital and equity accounts Credit balance
Revenue accounts Credit balance
Temporary
Accounts
Expense accounts Debit balance
Permanent Exist as long as the business exists; balances extracted for
Accounts Balance Sheet
Temporary Summarized at the end of the accounting period in the P/L A/c
Accounts and net income transferred to the Equity A/c
Posting of Closing Entries
Closing Revenue and Expenses Dr. Cr.
All revenue accounts (Debit)
Profit & loss A/c or Income summary (Credit)
(being transfer of the balance in the revenue
accounts to the profit & loss account)
Profit & loss account or Income summary (Debit)

All expense accounts (Credit)
(being transfer of the balance in the expense
accounts to the profit & loss account)

Posting of Closing Entries
Closing Asset, Liability, and Equity Dr. Cr.
Asset account of next accounting period (Debit)
Asset account of current accounting period (Credit)
(being transfer of the balance in the account to the next
accounting period)
Liability account of current accounting period (Debit)

Equity account of next accounting period (Credit)
(being transfer of the balance in the account to the next period)
Equity account of current accounting period (Debit)

Equity account of next accounting period (Credit)
(being transfer of the balance in the account to the next period)

Adjustments
Needed so as to recognize the effects of known facts as of the
closing date, which was not known earlier
There may also be implicit accounting transactions which need to
be recognized in the records
Typically three types of adjusting entries
Deferrals – An adjustment of an asset or a liability for which
the business paid or received cash in advance
Depreciation – The systematic allocation of the cost of a
plant asset to expense over the asset’s useful life
Accrual – The process of recording of an expense or
revenue before paying or receiving cash.
Events Often Requiring Adjustments
Adjustment Required Debit A/c Credit A/c
Asset increase as a result of revenue recognition not Income or revenue Particular income
previously recorded. receivable or revenue a/c
Example – Interest receivable.
Expenses and liabilities not recorded. Respective Unpaid expense
Example – Rent expense due but not paid expense account account
Asset decreases and expenses not previously Respective Respective asset
recognized. expense account account
Example – Depreciation on fixed assets. decreases
Asset and liabilities not recorded. Usually arises in
case of transactions around closing period, which could
not be formally recorded due to non-receipt of
documents etc. The accounting record takes the form
of normal transaction only.

Trial Balance and Work Sheet
Process of preparation:
Balances of both debit and credit accounts
of all the ledger accounts are first
transferred to a worksheet called ‘original
trial balance’ or ‘unadjusted trial balance’
Adjustments are worked out giving rise to
an ‘Adjusted trial balance’
Finally, based on the type of the account
it is, the balances of individual accounts
are then taken to either of the two final
financial statements
Various Ledger Original Trial Adjustments Adjusted Trial Income Summary Balance Sheet
Items Balance Balance
Debit Credit Debit Credit Debit Credit Debit Credit Assets Liabilities
and
Equity
List all asset
ledger accounts
as per their
liquidity order
List all liability
and equity ledger
accounts as per
their liquidity
order
List all revenue
accounts
List all expense
accounts
Worksheet …
Helps in systematically finalizing an entities
financial statement from its ledger account
balances
Serves two purposes:
Checks for arithmetical errors
Results in clear allocation of individual
accounts to either of the two financial
statements viz., Balance Sheet or Profit &
Loss Account

Difference in Trial Balance
Indication that the accounts have not been made or posted
properly
If not rectified, balance sheet will also not tally and there will be
always be a difference between the total of the assets side and
the liabilities side
The trial balance is not a conclusive proof of accuracy that
no errors have been committed
It is only a prima facie evidence that the accounts are in order
Possible errors even when trial balance matches includes
issues such as (a) wrong posting; (b) wrong entry; (c) error of
principle; (d) compensating errors (in a series)
Steps for Locating Differences
Check the total on both the side of a trial
balance.
Check whether all the balances have been
taken to the trial balance
Check the balancing of individual accounts
properly
For very large differences, compare the
figures with those of the previous year
If error is yet undetected, check the posting
of subsidiary books first and then, the other
accounts are to be checked in detail
Rectification of errors
Once errors are located, correct entry is
required to be passed
Two types of errors
Errors that do not effect the trial balance
Errors that effect the trial balance

Errors not effecting Trial Balance
Exists in spite of balances both the sides of a trial balance
matching
Example: If the cash received from Ram Rs. 1,000 is wrongly
posted as received from Rahim, the trial balance will agree
but both the accounts of Ram and Rahim will have a wrong
figure. So in order to rectify such errors the following entry is
passed:
Rahim Account (Debit) 1,000
Ram Account (Credit) 1,000
(Being amount received from Ram wrongly posted to Rahim
account, now rectified)
Errors effecting Trial Balance
Placing the right figure on the right side rectifies it
Journal entry is not required to be passed because one account
out of two has been accounted for properly
Example: Goods purchased (as raw material) from M/s Prabhu
for Rs. 5,000 were taken to the purchases account with the same
amount but M/s Prabhu account was credited with Rs. 500 only
We need to credit M/s Prabhu account with another Rs. 4,500
saying “by mistake on date….rectified”

Suspense Account
An account maintained till the trial balance is not matched
A residual account to facilitate in the process of making the
books accurate and upholding the duality principle of accounting
transactions
Amounts relating to all the errors that affect the trial balance are
transferred to this account
As and when the errors are located, a corrective entry is passed
in the respective account with a corresponding entry to the
suspense account
When all the errors are located and rectified, the balance in the
suspense account becomes nil
Accounting for Receivables
Selling and buying in most of the businesses
is on credit and leads to the creation of
accounts receivable or sundry debtors
We also state that in most situations these
accounts are unsecured and have only the
personal security of the customer
Collection losses occur when debtors fail to
pay called, bad debts
Based on past experience and familiarity of
market conditions, it is possible to estimate
the future loss and make a provision for it
Accounting for Bad Debts
Such provisions are used to reduce the gross
accounts receivable to their estimated
realizable value
The estimated collection loss is known as
‘provision for bad debts’ or ‘reserve for
doubtful debts’, etc.
Two ways of accounting for bad or doubtful
debts:
writing them off
creating a provision for bad and doubtful
debts
Writing the bad debts off
The amount of debt which is irrecoverable is treated as a loss
and is transferred as bad debts expense
For example, Chandu, a trade debtor in the books of M/s Nandu
with an outstanding of Rs. 50,000, files a petition for bankruptcy.
The accountant of M/s Nandu make the following entry:
Bad Debt Expense (Debit) 50,000
Chandu Account (Credit) 50,000
(Being the amount receivable from Chandu transferred to the
bad debts account)
As a result of the above entry, the profit for the period is reduced by
Rs. 50,000
Bad Debt Recovery
Suppose, Chandu come back from the crisis and pays Rs. 15,000 in
the next year then the following journal entries are to be passed:
Cash / Bank Account (Debit) 15,000
Bad Debts Recovered Account (Credit) 15,000
(Being the amount recovered from Chandu)
This amount will off course go to the Profit & Loss Account and
increase the firms profit
Bad Debts Recovered Account (Debit) 15,000
Profit and Loss Account (Credit) 15,000
(Being the amount of bad debt recovered transferred to the profit &
loss account for the period)
Creating a Provision
Implies setting aside some amount, out of the
Profit and Loss account for the period
Done when the exact amount of bad debt to
be written off is unknown
A percentage (or absolute figure) of the total
amount can be ascertained based upon the
facts and circumstances of each case and a
provision can be created
Any amount required to be written off in the
coming year is met out of this provision

Illustration – Provision
Suppose, on 31st March 20X5, the following amounts were doubtful
of recovery: Dinesh 3,000; Mahesh 2,000; Somesh 5,000; Ramesh
10,000
The following entry is passed for the total amount of doubtful
recovery as follows:
Bad Debts Expense (Debit) 20,000
Provision for Bad & Doubtful Debt (Credit) 20,000
(Being the amount of provision made for the accounts of Dinesh,
Mahesh, Somesh and Ramesh)

Contd…
Let us further assume that the amount due on account of Dinesh and
Mahesh were paid while Ramesh and Somesh were declared
insolvent in the financial year ending 31-03-20X6. Also, an amount of
Rs 8,000 due from Harish was considered doubtful.
Provision for Bad & Doubtful Debt (Debit) 15,000
Accounts Receivable Account (Credit) 15,000
(Being amount outstanding from Ramesh & Somesh written off as bad
debt on becoming insolvent)
Bad Debts Expense (Debit) 3,000
Provision for Bad & Doubtful Debt (Credit) 3,000
(Being the amount of provision for the year)
Thank You

Chapter 6:
Accounts for Joint Stock Companies

&
Introduction
Basic tenet of accounting “Business Entity Concept”
A Company is an incorporated association
Formed by a group of people but acquires its status as a
juridical personality with perpetual succession by registration
under the law
Lead to Joint Stock Companies
The Indian Companies Act, 1956 regulates the formation
and working of Joint Stock Companies
Recognized in law as a separate and distinct entity from
the members constituting it
Forms of Companies
Public Limited Companies Most
Private Limited Companies Common
Statutory Corporations
Created for a specific and narrow purpose by an ‘Act of
Parliament’ and are closely controlled by state
Example: LIC and FCI
Guarantee Companies
Are limited by guarantees
Licensed by the state laws and appropriately empowered to
grant guarantees in respect of any legal proceedings
Example: Exim Bank is a guarantee company in Zimbabwe
Two Fundamental Documents
‘Memorandum of Association’ contains:
(1) Name (2) Domicile (3) The Objects (4) Statement of
Liability (5) Authorized Capital and its divisions and (6) The
Declaration of Association.
‘Articles of Association’ is the constitution for the internal
management of the companies
Defines the relationship between various members within
the company as well as between company and its
members
Both filed at the time of incorporation

Characteristics of Companies
Voluntary Association - Pre-determined objectives in the MoA.
Separate Legal Entity - Can sue and be sued in a court of law,
enter into contracts, acquire and dispose of assets, etc.
Perpetual Succession - Death, insolvency or lunacy of the
members does not interfere with the continuance of the entity
A shareholder cannot be held liable for the actions of the
company; nor can the company be held liable for the actions of
the shareholder.
Since the company is only a ‘legal personality’ and not a
‘physical personality’, it has to operate through its Agents. The
Board of Directors are the Agents for the company.
Shares and Share Capital
Sec 2(46) of the Indian Companies Act, 1956 defines “share” as
a unit in the share capital of the company
Section 86 of the Companies Act allows a company to issue
only two types of shares viz., Ordinary and Preference Shares
Ordinary equity shares represent the risk capital of an entity
No right to fixed dividends; Control through voting rights
Preference equity shares enjoy preferential rights with respect
to payment of fixed dividend and repayment of capital at the
time of liquidation
Additional rights can be granted to preference shares by virtue
of provisions contained in the MoA and AoA
Types of Preference Shares
Classified is dependent on the rights attached to them
Cumulative Preference Shares
Entitled to unpaid dividends in the past
Non-Cumulative preference shares
Shareholders do not carry any right to unpaid dividends
Participating Preference Shares
Carry a right to share in the profit after a fixed rate is paid
to equity shareholders (over and above the fixed dividend)
Redeemable Preference shares
Cumulative Redeemable Non-Participating Preference shares
are most common
Share Capital Types
Authorized Issued Un-Issued
Capital Capital Capital
Subscribed Unsubscribe
Capital d
Capital
Called-Up Un-Called
Capital Capital
Paid-Up Calls in
Capital Arrears
Share Capital Types - explained
Authorized or Registered Share Capital
Maximum amount of capital, which a company is allowed to
raise during its lifetime
Based on the amount mentioned in the MoA
Issued Capital
The portion of authorized capital, which has been issued to
all the investors including public
The amount of issued capital is taken in the balance sheet
only if the total amount of issued capital is subscribed,
called up by the company and paid by the share holders
Otherwise, its presentation is similar to authorized capital
Share Capital Types - explained
Subscribed Capital
The portion of the issued capital, which has been Real Life Examples
subscribed by all the investors including the public
Called up Capital
The portion of the subscribed capital that has been called
up by the company for payments is the called up capital
Paid-up Capital
That part of called up capital, which has been paid up by
the subscribers of share capital
The amount, which is due but yet to be received, is known
as calls in arrears
Debentures/Bonds
A debenture is an acknowledgement under seal of a debt or
loan
It is a large amount of loan raised by a company wherein the
loan is divided into regular parts and is usually offered to retail
and institutional investors
A debenture could also be privately placed
Interest on Debenture is a charge against profits
Debentures are usually tradeable (unlike fixed deposits)
Hence one can say that ‘Shares’ stand for ‘ownership’ and
‘Debentures’ stand for Long-term creditors

Classes of Debentures
Secured or Mortgage debentures
Secured by a fix charge or by a floating charge (in general
it would be accounts receivable or inventory)
First and Second debentures (a.k.a senior and junior
debentures)
Simple or Naked debentures
Unsecured debentures i.e., in case of default any asset as
security does not back them
Redeemable and Irredeemable debentures
Repaid in a specified period Vs a permanent loan
Registered and Bearer debentures
Issue of Securities
Issue of
Prospectus
Steps to Raise
Receiving Capital
Applications with
Application Money
Allotment
of shares
Making Calls
for payment of
“Copyright with Tata McGraw-Hill Publishing Co Ltd, 2005" balance money
Prospectus
Is a regulator-approved document inviting offers from the public
for the subscription or purchase of any shares or debentures
Can be issued only by public limited companies
Prospectus needs to be signed by every director before its
publication and a copy of the same filed with the Registrar of
Companies (RoC) and the regulator, Securities Exchange
Board of India (SEBI)
It should supply all the important information for the company on
the basis of which the general public can take a decision
whether to subscribe for the share capital or not

Receiving Applications
Needs to be in the prescribed form along with the prescribed
application money and delays
The initial application money shall not be less than 5 percent
If within the prescribed time a company does not receive
applications equal to the minimum subscription, the whole of the
application money received has to be refunded to the applicants
For delays, the directors of the company are liable to repay the
amount with a penal interest
Share application money has to be kept deposited in a
scheduled bank until the company has received the minimum
subscription
Allotment of Shares
Implies acceptance of the offer of the applicant for the
purchase of share of the company by the directors
Done when the company has received applications
amounting to the minimum subscription
In case of over subscription, the allotment is based on a
pro-rata basis in consultation with a stock exchange
Once the allotment is made the applicant becomes liable to
pay the full amount of the shares allotted

Making Calls
The company can either collect the whole amount due on such
shares on allotment or a part on allotment and the balance in
one or more installments
After allotment, installments demanded by the directors against
the sum payable by shareholders on their shares are known as
calls. Calls must be made on a uniform basis on all shares
within the same class
Example: Using the installment route, Nagarjuna Fertilizers and
Chemicals Limited issued Rs 10 par value share in 1990 (par
value was divided as Rs 2.50 on application; Rs 2.50 on
allotment; Rs 2.50 on first call; and Rs 2.50 on final call)

Par Value and No Par Value Shares
Indian company laws requires shares to have a par value; it is a
certain amount of joint stock is divided into a number of shares
However, the companies may issue a share at a price above,
equal to or below the par value
Share Premium
When the issue price is higher than the face value, the
amount received in excess is considered as share premium
No Par Value Shares
The company will only have a certain number of shares
with no par value ascertained
Value will be what a shareholder is prepared to pay for it
Forfeiture, Shares at a Discount
Forfeiture of Shares
When some shareholders fail to pay on demand any money
due, the issued shares may be forfeited
Results in the removal of name. The company forfeits
amount already paid in by such shareholders
The directors can reissue the forfeited shares (the price
charged should not be less than the amount in arrears)
Shares at a Discount
Ordinarily, shares cannot be issued at a discount (unless
such shares were previously forfeited)
Issue is subject to the stringent conditions
Share Issue – Accounting Records
Based on the GAAP and the Company Law
The accounting entries can be split into three parts – (a) issue
of shares; (b) allotment of shares; and (c) making calls for
balance payment of allotted equity shares
Accounting Record for issue of shares
On receipt of share applications along with application money
Bank (Dr)
Share Application (Cr.)
(Narration: Being the amount of application money received on
_______ shares at Rs. ___ per share)
Money is collected by banks and kept in special accounts
Issue of shares – Entries
When the directors allot the shares, the application money
received is transferred to the share capital account
Share Application (Dr)
Share Capital (Cr.)
(Narration: Being the amount of application money transferred to
Share capital account)
In some cases, the directors do not allot any shares. In this
case, the application money is required to be returned
Share Application (Dr)
Bank Account (Cr)
(Narration: Being the excess of application money returned back to
the applicants who have not been allotted any shares)
Illustration
Gurmeet Company Ltd. issued a prospectus inviting application
for 1,00,000 shares of Rs. 10 each for which Rs. 2 per share is
required to be paid with application
The company received applications for 1,10,000 shares along
with the application money
The directors of the company decided to allot shares to
applicants applying for 1,00,000 shares and returning back the
money to the applicants who have not been allotted any shares

Solution
Bank (Dr) 2,20,000
Share Application (Cr.) 2,20,000
(Narration: Being the amount of application money received on 1,10,000
shares at Rs. 2 per share)
Share application (Dr) 2,00,000
Share capital (Cr.) 2,00,000
(Narration: Being the amount of application money transferred to Share
capital account)
Share Application (Dr) 20,000
Bank Account (Cr.) 20,000
(Being the excess of application money returned back to applicants of
10,000 shares who were not allotted any shares)
Allotment of shares – Entries
The company sends allotment letters to the applicants who have
been allotted the shares. With the allotment letter, the allotment
money becomes due and the entry required to be passed is
Share Allotment (Dr)
Share Capital (Cr)
(Being amount due on ____ Shares at Rs. __ per share)
On receipt of the allotment money from equity shareholders we

pass the same entry that is passed for receipt of money i.e,
Bank Account (Dr)
Share Allotment (Cr)
(Being amount received on allotment of ____ shares)
Illustration Continues …
Continuing with the same example of Gurmeet Company. If the
amount payable on allotment is Rs. 5 per share then the journal
entries will be
Share Allotment (Dr) 5,00,000

Share Capital (Cr) 5,00,000
(Being amount due on 1,00,000 Shares at Rs. 5 per share)
Bank Account (Dr) 5,00,000

Share Allotment (Cr) 5,00,000
(Being amount received on allotment of 1,00,000 Shares)

Journal entries on Call
Whenever the shareholders are informed to pay the call money, the
call money becomes due for payment by the shareholders
Share Call (Dr)

Share Capital (Cr)
(Being the amount due on call on _____ shares at __ per share)
On receipt of the call money we pass the following entry
Bank Account (Dr)
Share Call (Cr)
(Being the amount received on ____ shares at __ per share)
Similar entries are passed on subsequent calls
Illustration Continues …
Assuming that Rs. 3 is to be paid on account of first and final call. We
pass the entry for due and receipt in the following way
Share Call (Dr) 3,00,000

Share Capital (Cr) 3,00,000
(Being the amount due on call on 1,00,000 shares at 3 per share)
On receipt of the call money:
Bank Account (Dr) 3,00,000

Share Call (Cr) 3,00,000
(Being the amount received on 1,00,000 shares at 3 per share)
Calls in Arrears & Calls in Advance
Calls in Arrears
Amount of called up money, which has not been received
Transferred to the calls in arrears account at the end of the
accounting year
Shown as a deduction from the paid up capital
Calls in Advance
Amount which is received before the calls are made
Balance of calls in advance for the period is shown
separately in the balance sheet under the called up and
paid up capital of the company
Interest rate on the calls is prescribed by the AoA
Forfeiture of Shares
When the amount is not paid by any shareholder as and when
the amount is due, the directors of the company are
empowered, by the AoA, to forfeit the shares
Done only after issuing 14 days notice to the shareholder
The board of directors of the company must pass a
resolution for forfeiture of the shares
Name of the defaulter shareholder is struck off from the
register of members and the amount received till date on
such shares will be forfeited by the company
The gain on re-issue of these shares is a capital gain in
nature – transferred to the Capital Reserve Account
Illustration
Lilly was holding 100 shares of Rs. 10 each of Bhuva Tea Limited.
She had paid Rs. 3 on application, Rs. 5 on allotment but failed to
pay the first and final call of Rs. 2 per share. The company forfeited
these shares after passing a valid resolution by the board.
Share Capital Account (Dr) 1,000

Share First & Final Call Account (Cr) 200
Shares Forfeiture Account (Cr) 800
(Being 100 shares forfeited on account of non-payment of first and
final call of Rs. 2 per share. The amount already paid on these 100
shares at Rs. 8 per equity share has been forfeited pursuant to the
forfeiture)
Illustration …
If the reissue is at a discount, such discount should not exceed the balance in the
forfeited shares account. The entries would be
Bank (face value less discount allowed) (Dr)
Discount on Reissue of Forfeited shares (Dr)
Share capital (Face value of shares) (Cr.)
Transfer to the forfeited shares account will write off the discount on ‘reissue of
forfeited shares account’
Forfeited Shares Account (Dr)
Discount on Reissue of Forfeited Shares (Cr.)
After the reissue and adjusting for any discounts allowed, the balance, if any
remaining in the forfeited shares account will be transferred to the capital reserves
Forfeited shares account (Dr)
Capital Reserves (Cr.)
Legal Requirements
As per the provisions of the law, every company shall keep
proper books of account at its registered office with respect to:
All sums of the money received and expended;
All sales and purchases of goods by the company;
The assets and liabilities of the company; and
Particulars relating to utilization of material or to other items
of cost as may be prescribed for companies in production
The books of account relating to a period of last eight years
together with the vouchers relevant to any entry in such books
shall be preserved. The books shall be open to inspection
during business hours by authorized Government Officers
Annual Accounts
At every AGM held, the Board of Directors shall lay before members -
A balance sheet at the end of the relevant period and a profit & loss
account for that period;
The profit & loss account shall relate -
In the case of the first AGM to the period ending with a day not
preceding by more than nine months
Other AGM’s: To the period beginning with the day immediately
after the period for which the account was last submitted and
ending with a day not preceding by more than six months.
The accounting period may be less or more than a calendar year,
but it shall not exceed fifteen months (or eighteen months in rare
cases)
Approval of the Accounts
Form and Contents of Statements
Balance Sheet: should be as per Part I of Schedule VI of Companies
Act with due regard to the general instructions under the heading
‘notes’ at the end of the schedule
Profit & Loss Account should give a true and fair view of the company
and comply with the requirements of Part II of Schedule VI of the Act
Every financial statement of a company shall be signed on behalf of
the Board of Directors (BoD) by secretary and by not less than two
directors (compulsorily including the managing director)
The BoD shall approve these financial statements before they are
signed on behalf of the Board and submitted to the auditors for their
report thereon
The profit & loss account is usually annexed to the balance sheet and
the auditor’s report shall be attached thereto
Distribution of Profits
No dividend shall be declared or paid by a company for any
financial year except out of the profits of the company for that
year; or revenue reserves; or out of money, provided by the
government for the payment of dividend in pursuance of a
guarantee given by that government.
No dividend shall be payable except in cash

Dividend – Types
Dividend
Interim Final
Dividend Dividend
• Dividend announced during the • At the end of an accounting period

accounting period due to exceptional • Based on company’s performance during the
performance whole of the accounting period
• Provisions in Companies Act, 1956 • See Sections 205, 205A, 205C, 206 and
(Section 205) 206A of the Companies Act
Depreciation
For computing Net Income, depreciation has to be provided as
per the following broad guidelines:
a) Depreciation shall be calculated as per written down value of
the assets at rates specified for the assets by the Indian Income
Tax Act, 1922
b) If any asset is sold or destroyed before the depreciation of such
asset has been provided for in full, the excess, shall be written
off in the same financial year
c) In respect of each item of depreciable asset, depreciable
amount is arrived at by dividing 95% of the original cost by the
specified period in respect of such asset
d) Any other basis approved by the Central Government
Company Law Requirements
Company Law lays down elaborate requirements as to
disclosure & presentation of company accounts in
Schedule VI of the Indian Companies Act 1956
Forms of Balance Sheet
Horizontal Form Vertical Form

SEBI Guidelines for Issue of Shares
Regulates the way money is raised by firms from interested
investors, both retail and institutional in India
The issuing companies offer through an offer document, shall,
satisfy the following broad norms specified by SEBI:
No company shall make any public issue of securities,
unless a prospectus has been filed (and approved) with the
SEBI, through an eligible Merchant Banker
No listed company shall make any issue of security though
a rights issue where the aggregate value exceeds Rs. 50
lakhs, unless the letter of offer is filed (and approved) with
the SEBI, through an eligible Merchant Banker
Other Regulatory Restrictions
Companies barred not to issue security
If the company has been prohibited from accessing the
capital market under any order passed by the SEBI
Application for Listing
No company shall make any public issue of securities
unless it has made an application for listing
Issue of securities in dematerialized form
No company shall make public or rights issue or an offer for
sale of securities, unless the company enters into an
agreement with a depository for dematerialization of
securities proposed to be issued
Public Issue by Unlisted Cos.
An unlisted company is eligible to make a public issue of any
equity shares at a later date subject to the following:
It has a pre-issue net worth of not less than Rs. 1 crore in
three out of preceding five years (especially, last two years)
It has a track record of distributable profits in terms of the
Companies Act, 1956, for at least three out of immediately
preceding five years
Provided that the issue size (i.e., offer through offer
document plus firm allotment plus promoters’ contribution
through the offer document) does not exceed five times its
pre-issue net worth
Public Issue by Unlisted Cos.
An unlisted company can make a public issue of equity shares
(or any security convertible into equity shares at a later date),
only through the book-building process if,
It does not comply with the ‘minimum net worth’ condition
specified in previous slide; or
Its proposed issue size exceeds five times its pre-issue net
worth as per the last available audited accounts either at
the time of filing draft offer document with the SEBI or at
the time of opening of the issue; or
A company, whose equity shares are offered through an
offer for sale, shall also comply with the provisions
mentioned above
Public Issue by Listed Cos.
A listed company shall be eligible to make a public issue of
equity shares provided:
The issue size does not exceed five times its pre-issue net
worth as per the last available audited accounts either at
the time of filing draft offer document with the SEBI or at
the time of opening of the issue.
Partly Paid Up Equity Shares
No company shall make a public or rights issue of equity
share, unless all the existing partly paid-up shares have
been fully paid or forfeited in a manner specified in the
Companies Act
Classification of Equity Reserves
Reserve is the amount taken out (or
separated) from the profit for some purpose
The term reserve fund means a fund that is
earmarked for some purpose other than the
normal business activities
Hence the amount used for the business
operations is usually not termed as reserve

Reserves – Classification
Reserves
Revenue Capital
Reserve Reserve
General Specific
Reserve Reserve

Revenue Reserve
The reserves created out of the revenue profits
Can be distributed among the shareholders as dividends
General reserves (a.k.a. free reserves)
Created to add financial strength
Ensures funds to meet future expenses or contingencies
Example: Contingency Reserve
Specific Reserves
Created for some specific purpose, which when attained
the balance (if any) can be transferred to General reserve
Examples: Statutory reserve, debenture redemption
reserve
Capital Reserve
These reserves are created out of capital profits
Arise due to non-operational activities of any business
Examples: Profit on sale of fixed assets, Premium on issues of
shares/debentures, and Revaluation of fixed assets/liabilities
As they are not earned through regular business hence these
reserves are often not available for distribution among the
shareholders as dividends
Exception: Profit on sale of fixed assets can be distributed
among the shareholders as dividend under specific conditions
(such as, in consonance with AoA; Profits realized in cash;
Profit remains after revaluation of the balance sheet items)
Thank You

Chapter 7:
Financial Statement Analysis

&
Financial Statements –
Basic Relationships
Balance Sheet Profit & Loss Account
Cash Flow
Statement
Primary
Balance Sheet
The entity in order to achieve its objectives has arrived at a
decision to apportion the resources and deployed it in fixed
assets and in current assets
The proportions of funds that are borrowed on short term, on
long term as well as what is the contribution of owners towards
the total financial requirement of the entity
Gives the cost structure of the business and the relationship of
costs to the revenues
It gives the information relating to margin available on the sales
Relation and Comparison of Data
Accounting data in absolute terms do not provide much
meaning – the analysis involves comparison and relation
Ratio Æ Whenever one item is expressed (as a fraction or a
decimal fraction or an integer) in terms of another item
Example – A firm earns a net profit of Rs. 20,000 on a sale of
Rs. 500,000. We could express this relationship as ____?
Comparisons could be made
With Company’s past performance
With Competing Firms
With an Absolute Standard
With Industry/Economy trend
With Budgets (Planning and Control)
But…
In most cases, there are no standards against which a
particular ratio value could be tested
We make relative conclusions by comparing the ratios with
industry averages
Thus, at best the conclusions could be ‘better than’ or ‘worse
than’ or ‘average’
Possible pitfalls in these comparisons could be the different
accounting conventions
Inventory valuation (LIFO vs. FIFO)
Different methods of depreciation
Typical items (eg. Retirement benefits)
Common Size Financial Statements
A financial statement presented by representing each item as a
percentage to the total amount of which it is a part
Example
X had a sale of Rs 15 mn during the year and cost of goods sold
of Rs 12 mn whereas Y has a sale of Rs 8 mn and cost of goods
sold of Rs 4.8 mn
The above is not amenable to direct understanding.
Cost of goods sold of X is 80% of sales and for Y it is 60% of
sales
This is more lucid and meaningful. Useful while dealing with
many companies in the same industry
Common Size Financial Statements
Here we show the net sales as 100% and each of the
components of expenses and profits as a percentage of net
sales
Balance Sheet
Constructed by showing each item of asset as a percentage of
total assets, similarly each item of liability and owner’s equity is
shown as a percentage of total liabilities and owners equity
The common-size financial statements could either be prepared
in summary or in details

Vinyl Chemicals Limited
Vinyl Chemicals Ltd. is a mid

sized organic chemicals
manufacturer owned by the
Pidilite Parekh group

Common Size Analysis
VCLisismore
VCL morefixed
fixedasset
assetintensive
intensive
VCLhas
VCL hasless
lessinventory
inventorylevels
levels
than
thanits
itscompetitors
competitors
AtVCL,
At VCL,there
thereaadecrease
decreaseininthethe
inventory
inventorylevels
levelsand
andincrease
increaseininthe
the
receivables
receivables
AtVCL,
At VCL,there
thereisisaadecrease
decreaseininthethe
investments
investmentsofofthe
thecompany
company
What
Whatcould
couldbe
bethe
thereasons
reasonsforforsuch
such
changes?
changes?WhatWhatarearethe
thebroad
broad
implications?
implications?


VCLisishaving
VCL havingless
lessleverage
leverage
than
thancompetitors
competitors
Duringthe
During theyear
yearVCL
VCLhas
hasaa
increase
increaseininits
itslong-term
long-term
liabilities
liabilities
CurrentLiabilities
Current Liabilitiesacross
acrossthe
the
industries
industriesseem
seemtotobebestable
stable
What
Whatcouldcouldbe
bethe
thereasons
reasonsfor
for
such
suchchanges?
changes?WhatWhatare
arethe
the
broad
broadimplications?
implications?


What
Whatcould
couldbebethe
thereasons
reasonsfor forthe
the
companies
companiesturnaround?
turnaround?
Isititaadecrease
Is decreaseininraw
rawmaterials
materials
ororincrease
increaseininthe
thesale
saleprices
pricesoror
increase
increaseininthe
thesales
salesvolumes
volumes
Why
Whyisisthe
thecompany
companystill
stilllagging
lagging
behind?
behind?
What
Whatcould
couldbebethe
thereason
reasonfor forthe
the
company
companydeclaring
declaringdividend?
dividend?

Using Financial Ratios…
Many pieces of information do not have significant meaning in
isolation – they become more meaningful when related to an
appropriate base
Ratios reduce large figures to an easily understood relationship
Ratios do not make conclusions – It is for the analyst to draw
conclusion by evaluating and relating the ratios
There are no “good” ratios and “bad” ratios – It is only possible to
make relative inferences
Company performance is usually analyzed on two parameters
Profitability
Liquidity
Profitability Ratios
Gross Profit Margin
Operating Profit Margin
Margin
Earnings Before Interest & Tax
on sales Profit before tax
Net Profit Margin (i.e., Profit after tax)
Operating Profit to Operating Assets
Return on
Net Income to Total Assets
Investment
Return on Equity
Total Asset Turnover
Operating Asset Turnover
Efficiency
Working Capital Turnover
Shareholder Equity Turnover
Earnings per share
Return
Earnings to price
per share
Dividends per share
Solvency Ratios
Net Working Capital
Current Ratio
Quick Ratio
Short-term Accounts Receivable Turnover
Collection Period
Inventory Turnover
Conversion Period
Total Debt to Total Capital
Long Term Debt to Total Capital
Long Term Debt to Fixed Assets
Long-term Interest Cover
Times Fixed Charges Covered
Gearing
Equity Multiplier
PROFITABILITY
The long-term survival depends on ability to earn sufficient
surpluses and to grow
Only if the operations are profitable the company will survive in
the long run
Margin on Sales
Profits are generated by sales
First step in analyzing profitability is understanding of costs in
relation to revenue and thus profits in relation to revenue
Each component of profit & loss account is expressed as
percentages of sales

Illustration – Tools & Tools Ltd.
(Table on Profit Margins)
Rs Million % (2004) Rs Million % (2003)
Sales 300 100 280 100
Cost of goods sold 148 49.33 140 50.00
Gross Profit (i) 152 50.67 140 50.00
Total operating expenses 85 28.33 80 28.57
Operating Profit (ii) 67 22.33 60 21.43
Interest expense 14 4.67 13 4.64
Profit Before Tax (iii) 53 17.67 47 16.79
Income tax 26 8.67 23 8.21
Profit After Tax (iv) 27 9.00 24 8.57
Dividends 2 0.67 2 0.71
Profit Retained (v) 25 8.33 22 7.86
Depreciation expense 13 11
Gross Margins & Operating Margins
Gross Margins
The surplus available out of sales revenues after subtracting
cost of goods sold
It is obtained over the input costs and as such would reflect the
efficiency of use of direct inputs given the price
Operating Margins
It is the reflection of the operations of the company and hence
considered as a reflection of the management’s performance
Frequently used as a basis of comparison across companies
Any non-operating surplus or deficit is adjusted to the operating
profit margin to obtain the earnings before interest and taxes
PBT, PAT, and Retained Earnings
Profit Before Tax
It is the surplus amount obtained after meeting interest expense
Influenced to a great extent by the financing decisions
Profit After Tax (a.k.a. Net Income)
Overall surplus available out of sales to shareholders
This is influenced by three major factors namely, operating
efficiency, financing efficiency and taxation
As a percentage of sales it is known as Net Profit Margin and is
used to compare margins of players in the same industry
Retained Earnings (a.k.a Retained Profit)
Amount of profit remaining after the distribution of dividends
Tools & Tools Ltd. – Analysis
Rs Million % (04) Rs Million % (03)
Most margin
SalesIndicators are 300 100 280 100
Cost of improving
goods sold 148 49.33 140 50.00
Gross Profit (i) 152 50.67 140 50.00
Net margins
Total operating expenses 85 28.33 80 28.57
increased to 9%
Operating Profit (ii) 67 22.33 60 21.43
Interest expense 14 4.67 13 4.64
Gross margins
Profit Before Tax (iii) 53 17.67 47 16.79
increased to 50.6%
Income tax 26 8.67 23 8.21
Profit After Tax (iv) 27 9.00 24 8.57
Decrease in
company’s direct costs
Dividends 2 0.67 2 0.71
& operating
Profit expenses
Retained (v) 25 8.33 22 7.86
Return on Investment
Profitability has to be judged on the basis of the amount of
resource used in obtaining the profit
The management has to be evaluated on the basis on to how far
they had been successful in profitably utilizing the assets
Î The assets used is to be related to the profit earned
Return on Operating Assets (ROA)
Operating profit to operating assets is obtained by dividing
the operating profit by average value of operating assets used
during the year
Operating assets refer to total current assets and fixed assets
used
Tools & Tools Ltd. - ROA
Return on Operating Assets (ROA) 20X4 20X3
Current assets (Rs Million) 232 190
Fixed assets (Rs Million) 94 79
Total operating assets (Rs Million) 326 269
Operating Profit Before Interest and Taxes 67 60
(OPBIT) (Rs Million)
Return on Operating Assets (%) 20.55 22.30
ROA based on average operating assets 22.52
(326+269)/2 (%)
The company had used on average Rs 297.5 million and it has
to be justified in terms of the opportunity cost
ROTA and ROE …
Return on Total Assets (ROTA)
The rate of profit the company is able to earn after meeting the
cost of financing of a portion of the total assets
It is the amount available to the shareholders in relation to the
total amount of resources used in the business
Here again the average total assets is used (Why?)
Return on Equity (ROE)
Net income is the amount available to owners for compensating
their investment and the risk being carried by them
ROE measures the net income as a percentage of shareholders
investment
Net Income to Total Assets
Return on Total Assets (ROTA) 20X4 20X3
Total Assets (Rs Million) 330 270
Profit After Taxes (PAT) 27 24
Return on Total Assets 8.18% 8.89%
ROTA based on average total assets 9.00%
(330+270)/2
Able to earn The company used
9% return on an average Rs 300 mn
Total Assets in total assets to
earn Rs 27 mn
ROE Computations …
Return on Equity (ROE) 20X4 20X3
Total Equity (Rs Million) 135 110
Profit After Taxes (PAT) 27 24
Return on Equity (%) 20.00 21.82
ROE based on average total assets 22.04
ROE of 22% is not only the result of management’s ability to

employ the assets profitably, but also the result of its ability to use
a favorable debt equity structure
Whenever, management is able to borrow money and use it to
earn more than the cost of such borrowing the ROE increases
Return Per Share
Interest of a shareholder lies in the amount of dividend that can
be earned on the investment in shares and the increase in the
price of shares that can be had by holding the same
Earnings per share (EPS) is computed by dividing ‘net income
to ordinary shareholders’ by the ‘number of ordinary shares
outstanding’
Earnings per Share (EPS) 20X4 20X3

Profit After Taxes (PAT) (Rs Million) 27 24
Number of ordinary shares (Million) 3.7 3.7
Earnings per Share (EPS) (Rs) 7.30 6.49
Earnings-Price Ratio (E/P)
The earnings per share related to the current market price of the
share provides a measure of the rate of yield
Earnings Price Ratio= EPS / MP per share
This yield measure could be used by the shareholder in making
decisions about this investment in comparison to other alternate
investments
Earnings-Price Ratios (E/P) 20X4 20X3
Earnings per Share (EPS) (Rs) 7.30 6.49
Market price per share (Rs) 30 28
Earnings/Price Ratio (%) 24.3 23.18
Price Earnings Ratio 4.1 4.31
Dividend per Share
It is a common practice to express the E/P ratio by reversing the
relationship to measure the price-earnings (P/E) relationship
Here, this relationship expresses market price as a certain multiple
of the earnings per share
Dividend per share is another per share calculation, which shows
the cash income available to the shareholder of a share
Dividend per Share (DPS) (Rs) 20X4 20X3

Dividend (Rs Million) 2 2
Number of ordinary shares (Million) 3.7 3.7

Dividend per Share (Rs) 0.54 0.54
Efficiency
The relationship of assets used to sales measures the level of
sales generated by given quantum of assets
This is a measure of the efficiency of use of assets
This relationship of assets to sales indicates the number of
times assets turned over as a result of volume of sales
generated
Thus, the relationship of net income to assets is the turnover of
assets times’ margin on sales. This is shown as follows:
Net Income / Total Assets = Net Income X Sales
Sales Total Assets

Example – Tools & Tools Ltd
Particulars 20X4 20X3
Total Assets (Rs Million) 330 270
Profit After Taxes (PAT) (Rs Million) 27 24
Sales (Rs Million) 300 280
Net Income/ Sales (%) 9.00 8.57
Sales / Total Assets (a.k.a. Asset Utilization Ratio) 0.91 1.04
Return on Total Assets (Net Income / Total Assets) (%) 8.18 8.89
Sales / Average Total Assets 1
Various asset (or investment) turnover ratios are measures of

efficiency of their use in terms of their ability to convert profit
margins to rate of return on assets
Operating Assets Turnover
Relates sales to the operating assets used
This ratio assesses the efficiency of the use of operating assets,
that is, their ability to generate revenue
Similar to return on total assets the operating assets turnover
times operating profit margin gives us the operating profit to
operating asset
Return on Operating Assets (ROA) =
(Operating Asset Turnover) X (Operating Profit Margin)

Example – Tools & Tools
Operating Assets Turnover and Return (ROA) 20X4 20X3
Operating profit (Rs Million) 67 60
Operating Profit Margin (OPM) (%) 22.33 21.43
Fixed assets (Rs Million) 94 79
Total operating assets (Rs Million) 326 269
Operating Asset Turnover (OAT) 0.92 1.04
Fixed Asset Turnover 3.19 3.54
Return on Operating Assets (OPM*OAT) (%) 20.55 22.30
Avg. Operating Assets Turnover = Sales /AO Assets 1.01
ROA - on average operating assets (326+269)/2 (%) 22.52

Working Capital Turnover
It is an efficiency ratio intended at evaluating the efficiency of
use of working capital
It looks at the relationship of revenues earned to working capital
investment
Working Capital turnover = Sales / Average Working Capital
Net Working Capital efficiency 20X4 20X3
Net Working Capital 127 110
Working Capital Turnover 2.36 2.55
Avg. Working Capital Turnover (127 + 110)*0.5 2.53
Shareholders Equity Turnover
Shows the management ability in terms of efficiently utilizing the
shareholders funds both with respect to efficient operations and
in terms of efficient financial management
Shareholders equity turnover = Sales/Average shareholders
equity
ROE = Equity turnover * Net profit margin
Shareholders Equity 135 110
Shareholders Equity Turnover (ETO) 2.22 2.55
Average Equity Turnover (135 + 110)*0.5 2.45
Solvency
Ability to meet all the short-term commitments and ability to
keep sufficient assets to cover all the liabilities in the long run
Companies can be liquid (solvent) but not profitable.
For example, imagine a cash rich construction company
with no orders
Companies can be profitable but not liquid.
For example, a construction company with lot of orders but
no cash to execute them
Hence, we need both profitability and solvency
Solvency can be of two types – Short Term and Long Term

Evaluating Short-Term Solvency
Liquidity is of major concern to short-term creditors and
management
Sale of merchandise (inventory turnover) and collection of
receivable generates liquidity (receivable turnover)
Assessing excess of current assets over current liabilities –
Working Capital
Net working capital is financed by long-term sources of funds
and as such provides a cushion for liquidity
This is obvious since it is financed by long-term sources it is not
required to be repaid in the short-term

Illustration – Ramsons
RAMSONS, Balance sheet
Current Assets 500 Current liabilities 250
Net Fixed Assets
Short Term 500 Long-term loans 500
finance available Shareholders equity 250
is Rs. 250
Total Assets 1000 Liabilities & Capital 1000
Î Net Working capital is: Current assets – Current liabilities = 250
RAMSONS, Balance sheet (Long-Term)
Net Working Capital 250 Long-term loans 500
Net Fixed Assets 500 Shareholders equity 250
Total Assets 750 Liabilities & Capital 750
Discussion …
The rationale for financing part of the current assets with long-
term finance is that a part of the current asset remains in stock
all through the life of the business
So, Working Capital is the long-term investment in operating CA
Current Ratio measures the relationship of CA to CLs
Margin of
Tools & Tools Limited
Safety increased
20X4 20X3
Byassets
Current Rs. 17mn
(Rs Million) 232 190
Current liabilities(Rs Million) 105 80
Current Increase in
Ratio
Net Working
decreased Æ
has Capital(Rs Million)
CA is
not in proportion to
Current ratio: CA / CL that of CL
127
2.21
110
2.38
Current Ratio and Quick Ratio
Current Ratio is one of the most widely used balance sheet
ratios
However, making a specific conclusion on the adequacy of any
value of current ratio would depend on several factors such as:
Proportion of various components of the current assets
Time taken for conversion of these current assets to cash
Speed of maturity of current liabilities, etc.
Quick ratio is usually computed by taking assets which are
quick to be converted into cash divided by current liabilities
It is usual practice to subtract inventories from current assets to
arrive at the quick assets
Quick ratio – Tools & Tools Ltd.
Quick Ratio 20X4 20X3
Current assets (Rs Million) 232 190
Inventory (Rs Million) 121 99
Quick Assets(Rs Million) 111 91
Current liabilities(Rs Million) 105 80
Net Working Capital(Rs Million) 127 110
Quick ratio: 1.06 1.14
Quick assets/Current liabilities
>1 implies
comfortable
Financial Accounting for Management by Ramachandran & Kakani position 41
Expenses Cover
We hold the current asset mostly as an insurance against
future contingencies
Cash is held with the objective of making payments
whenever required
Inventory is held to meet the need for inventory either for
production or for sale
Liquidity is essential as cover for the daily operating expenses
The current assets could thus be expressed as number of day’s
expenses equivalent
Similarly cash and quick asset could be viewed as cover for
expenses
Example…
Current assets
Cash amount to more 19 11
than a year’s
Current Operating expenses
assets (Rs Million) 232 190
Quick Assets (Rs Million) 111 91
Current liabilities (Rs Million) 105 80
Cash holding
Average Dailyfor
sufficient expenses
a (Rs Million) 0.6027 0.5726
month’s
Cash cover (number of days) 32 19
expenses
Quick assets cover (number of days) 184 158
Current
Current assets cover (number ofliabilities
days) 384 332
amount
Current liabilities cover (numbertoofalmost
days) 174 140
6 months’
daily expenses
43
Accounts Receivable Turnover …
Sales per day (Rs Million) 0.82 0.77
Accounts receivable(Rs Million) 32 20
Accounts receivable turnover 9.37 14
Average Collection period (number of days) 38.9 26.1
Average Collection period using Average 31.6
Accounts Receivable during the period
On an average
Cycle of credit
(number of days)
Sales and its collection it takes approximately
happened
Average more
Accounts receivable turnover 32 days for collection
11.54 of
than 12 times accounts receivable
during the year
Average Collection Period
Turnover of receivable computed by dividing credit sales by
average receivable outstanding gives the velocity of circulation
of receivable
When credit sales figures are not available we could still
compute using net sales (assuming that all the sales are on
credit basis)
The time period taken for collection of receivable is of great
interest in evaluating working capital, known as, Average
Collection Period
Comments will depend on the normal period of credit and credit
terms given by the company and the level of deviation
Inventory Turnover …
Cost of goods sold (Rs Million) 148 140
Cost of goods sold per day (Rs Million) 0.41 0.38
Inventory (Rs Million) 121 99
Inventory turnover 1.22 1.41
Inventory turnover
Inventory Holding Period=
(number of days) 299 259
Cost of Goods
Average InventorySold/Average
Turnover inventory 1.35
Inventory Holding Period based on average inventory 270
Inventory
(number of days) Inventory
Holding period is
turns over just
about 1.3 times Æ 270 days or
9 months

Inventory Conversion Period
Excess inventory represents wasteful use of the resources
The need for holding inventory will also be influenced by the
availability, time taken for deliveries, seasonal nature of
business and a host of other factors
Inventory turnover tries to assess the velocity with which
inventories are converted to revenue
Conversion period is the time taken for the money invested in
raw material to convert into a sale. In Tools & Tools case this is
about 9 months on the average
Management’s objective should be to turn over the inventory as
fast as possible
Long-Term Solvency
Two approaches in evaluating long-term solvency
Evaluating the margin of safety available for lenders
represented by owners’ equity
Ability of the firm to earn sufficient surpluses to meet all the
long-term commitments
Debt-Equity Ratios
The claims against assets are those of creditors and
shareholders
Creditors have a prior claim on the assets of the company and to
that extent the owner’s equity forms the extent of margin of
safety for lenders’ claims
Debt-Equity Ratio
Total Debt (Rs Million) 195 160
Shareholders Equity (Rs Million) 135 110
Total Debt to Shareholders Equity 1.44 1.45
For every Rupee of shareholders funds in the company there is
Rs 1.4 of lenders claim
Lower the lender’s claim to shareholders claim; lower are the
demands on firm’s earnings for meeting fixed commitment in
terms of interest
There is lesser leverage in the capital structure of the company
Long-term Debt to Total Capital
Measures the relationship long-term debt bears to owners’ total
investment in the company
Tools & Tools Ltd. 20X4 20X3
Long-term Debt (Rs Million) 90 80
Long-term Debt to Shareholders Equity (%) 66.67 72.73
For every Rupee of owners’ funds there is a long-term debt

commitment of Rs 0.67 only

Long-term Debt to Fixed Asset
Measures the amount of fixed assets available as a backing for
long-term debt
Long-term Debt (Rs Million) 90 80
Net Fixed Assets (Rs Million) 94 79
Long-term Debt to Net Fixed Assets (%) 95.75 101
The long-term debt is more than covered by net fixed assets of
the company during 20X4

Times Interest Earned
This ratio measures the relationship of earnings before interest
and taxes to the fixed interest commitment
Larger the cover greater is the safety of lender's interest
Alternately it also shows the risk in case the firm's earnings
decrease
Interest Cover = Earnings before interest & taxes / Interest expense

Earnings before interest and taxes 67 60
Interest expense (Rs Million) 14 13
Long-term Debt to Net Fixed Assets (%) 4.79 4.62
Times fixed charges covered
It is computed usually if the company has other fixed
commitments (say lease payments) under non-cancelable lease
obligations:
Times fixed charges covered = Earnings before interest and
fixed charges / interest & fixed charges
If information is available then one should also be including
items like scheduled repayment of the loans (a commitment
made by the company) in the fixed charges as above
Interpretation of this ratio is similar to the interest cover and
shows the extent of safety provided by current operating
earnings
Gearing …
It is the extent to which the company is in a position to increase
the earnings to shareholders by having fixed interest bearing
borrowing in the capital structure. This could be worked out by
disaggregating the earnings on borrowed funds as follows:
Profit earned by average borrowed funds (using 0.5(195 + 160) * 38.52
the earlier computed operating profit margin) 22.33
Less: interest cost 14.0
Gain from borrowed funds 24.52
Less tax liability on the gain 24.52 x 49.06% 12.03
Net gain from borrowed funds 12.49
The net profit realized as a result of gearing (12.49/177.5)* 100 7.04%
Equity Multiplier
Equity Multiplier = Total Assets / Owners Equity
The equity multiplier will show the extent of enhancement of
return to equity holder due to leverage or borrowing
Total Debt (Rs Million) 195 160
Total Assets 330 270
Equity multiplier (Total Assets/Owners Equity) 2.44 2.45
Return on Total Assets (%) 8.18 8.89
Return on Equity ( ROTA * Equity Multiplier)(%) 20 21.8

Du Pont Analysis
A combination of margin on sales ratio, efficiency ratio, and
long-term solvency ratio is popularly known as the DuPont
analysis
Return on Equity (ROE) =
Net Profit Margin (defined as Net Profit/Sales) x Asset
Utilization Ratio (defined as Sales/Total Asset) x Equity
Multiplier Ratio (Total Assets/Owners Equity)
The DuPont analysis approach helps in identifying and
pinpointing the reasons behind high or low profitability of a
firm vis-à-vis its competitors

Using Financial Information
Computation of financial statement ratios does enhance the
understanding of the financial statement information
The rich information could be used for many purposes:
Evaluating investments
Deciding on credit terms for customers
Comparing financial performance of companies, etc.
Important tool for supporting planning for future
Financial analysis of other competing firms can be used for
tracking the “time-trend” behavior of the industry
It is also a usual practice to identify a peer group and keep
monitoring for benchmarking
Hidden Assumptions Mean Caution
All the firms have similar accounting policies and practices
(such as the method of depreciation allocation)
All the firms did not have any significant change in accounting
policy (such as a change in the inventory valuation policy)
The processes of generating the accounting numbers are
reliable across the firms
Financial ratios are primarily used for comparison (instead of
absolute values) in order to facilitate adjustments for size.
However, while doing this we are also assuming that ratios
posses the appropriate statistical properties for handling and
summarizing data
Hidden Assumptions Mean Caution
A large number of such assumptions might be violated even
while making comparisons of a single firm over many years
Hence, care must be taken in terms of making any significant
conclusions
One should carefully read the notes of accounts for any
significant comments such as changes on accounting policy or
any significant provisions or contingent liabilities that may arise
Importance ought to be given to qualitative factors, such as
differing economic and cultural environments, while doing
financial analysis for firms across industries, geographies, and
time periods
Thank You

Chapter 8:
Developments in Accounting

&
Depreciation
Revenue generation process of any business reduces value of
its long-term assets
Only fixed assets are depreciated
So, depreciation is a non-cash charge that represents a
reduction in the value of assets due to wear and tear, age, or
obsolescence
Hence, it is a charge against the business profit
Purchase of fixed asset is like a prepaid expense for the
business
Similar to rent that would have been payable if the machine
was not purchased
Accounting for Depreciation
Depreciation Accounting
Charging the amount by reducing the A provision for depreciation account

respective fixed asset is maintained
• Depreciation amount • Amount credited to the

reduced from Provision account
the fixed asset • Balance shown in the
• Shown as a reduction liabilities side
in Balance Sheet • Asset shown at cost

Entry under 1st method (Year 1)
Milind Kaapi Co., purchased a hut for Rs. 100,000 having a
useful life of 10 years with the salvage value after 10 years
becoming nil. Account for depreciation under both the methods.
Solution: Assuming uniform cost allocation over the life
Depreciation Account (Debit) 10,000
Hut Account (Credit) 10,000
(Being reduction in the value of hut on account of depreciation)
The Hut in the balance sheet shall be shown at Rs. 90,000 after Year 1, Rs. 80,000 after Year 2 …
Profit & loss Account (Debit) 10,000

Depreciation Account (Credit) 10,000
(Being depreciation expense to be charged to the profit & loss account)
Entry under 2nd method (Year 1)
Under this method, the journal entries will be same with a slight
difference that instead of crediting the hut account we will credit
“Provision for Depreciation Account.” As a result the entry
becomes
Provision for Depreciation Account (Credit) 10,000
(Being provision made for depreciation for the year)
Here, the Hut account in the balance sheet will stand at Rs. 100,000 for all the 10 years …
Profit & loss Account (Debit) 10,000

Depreciation Account (Credit) 10,000
(Being depreciation expense to be charged to the profit & loss account)
Contra Account
In the second method, the ‘provision for depreciation’ account
shall increase by Rs. 10,000 every year (popularly known as
‘accumulated depreciation’ account)
Contra Account
A contra-asset account has a credit balance and offsets the
debit balance of the corresponding asset (such as, accumulated
depreciation and provision for bad receivables)
A contra-liability account has a debit balance and offsets the
credit balance of the corresponding liability (such as, discount
on trade payables and discount on bills payable)

Sale of Asset
At the end of Year 1, Hut account in the balance sheet will look:
Gross Fixed Assets (Hut) Rs 100,000
Less: Provision for depreciation 10,000
Net Fixed Asset (Hut) Rs 90,000
Assuming further that the hut is sold for Rs. 60,000 at the end of
5 years. The accounting entries in first method would be:
Cash Account (Debit) 60,000
(Being sale of hut for Rs. 60,000)
Hut Account (Debit) 10,000
Profit & loss Account (Credit) 10,000
(Being gain on sale of hut transferred to Profit & loss Account)
Sale of Asset under Second Method
Cash Account (Debit) 60,000
Provision for Depreciation A/c (Debit) 50,000
Profit & loss Account (Credit) 10,000
What
(Sale would
of hut be credited
for Rs 60,000 and
and profit being by what
Rs 10,000 amount?
transferred to profit &
loss account)
Depreciation Methods
Straight Line Written Down Sum of Depletion

Method Value Method Years’ Digit Method
Method
Depletion Method
It is suitable in cases of depreciating assets, such as mines,
quarries, and oil exploration, where the depreciation is based
upon pace of extraction of deposits
Depreciation is computed by multiplying the units of output (or
deposit) with the rate of depletion of resources
Example
If a mine with estimated minerals of 50,000 tonnes is purchased
for Rs. 1,00,000, the rate of the mineral resource will be Rs. 2
per tonne of output (Rs. 1,00,000 / 50,000 tonnes)
So if the output in year 1 is 10,000 tonnes, the depreciation to be
charged for that year would be Rs. 20,000
Practice of Block Depreciation
All the identical assets, having similar expected life are grouped
as a single block
The depreciation is calculated on the block as a whole and not
on the individual asset
The rate of depreciation is calculated on the expected life and
the salvage values of the assets of that group
Profit (or loss) on sale of asset is not computed until the block
has no asset in it
Sale of individual asset from the block do not result in any
gain or loss on account of sale
Followed by Tax Authorities
Illustration
A company purchases 5 machines for Rs. 10,000 each having
an average life of 5 years with a salvage value of Rs. 2,000 each
Assuming straight line depreciation method, the amount of
depreciation expense would be Rs 8000 every year
At the end of year 2 one machine was sold for Rs. 4,000 and
another purchased for Rs. 8,000 having salvage value as zero
Year 1 Machinery Account (Debit) 50,000
Bank Account (Credit) 50,000
(Being machinery purchased)
Provision for Depreciation (Credit) 8,000
(Being depreciation on the block charged at 20%)
Journal Entries – Year 2
Year 2 Depreciation Account (Debit) 8,000
Provision for depreciation (Credit) 8,000
(Being depreciation on the block charged for the 2nd year at 20%)
Bank Account (Debit) 4,000
Provision for Depreciation (Debit) 6,000
Machinery Account (Credit) 10,000
(Being machinery sold for Rs 4,000 and difference between Cost
and Sale Value transferred to provision for Depreciation Account)
Machinery Account (Debit) 8,000
Bank Account (Credit) 8,000
(Being machinery purchased)
Journal Entries – Year 3
Year 3 Depreciation Account (Debit) 8,000
Provision for depreciation (Credit) 8,000
Account
(Depreciation on block consisting of 4 machines purchased at Rs
10,000 each and 1 machine purchased at 8,000 at 20%)
Remaining machines in block (excluding new purchased) 4

Value of 4 machines after reducing scrap value 32,000
Machinery purchased at the end of year 2 8,000
Value of Block 40,000
Depreciation @ 20% 8,000

Change in Method of Depreciation
A method of depreciation selected has to be applied consistently
Whenever there is a change in depreciation policy it results in
influencing not only the amount of current depreciation but it will
also affect the accumulated depreciation also and hence needs
rewriting of the past figures of various items also
Factors influencing the ‘Choice of Method of Deprecation’
Easiness in understanding and implementation
Want of higher profits during initial years or later years
Taxation policies
Management remuneration packages having profit linked bonus
may also influence
Accounting of Inventories
Inventory is the part of goods purchased or manufactured that
remained unconsumed or unsold
Types of ‘inventory’
Integrated Steel Manufacturing Firm Steel Trading Firm
Raw Material Inventory Finished Inventory
Iron Ore, Limestone, and Coal Steel and Steel Products
Work-In-Progress Inventory kept in Warehouses
Molten Metal and Steel Slabs
Finished Good Inventory
Cold Rolled Steel in Stockyards
Stores and Spares Inventory
Stationary, Bearings, and Grease in Stores
Methods of Inventory Valuation
Inventory valuation and income measurement are inter-related
For the ascertainment of income it is only the “cost of goods sold”
that should be charged against revenue
This is because not all the goods purchased (or produced) during
the year are sold
METHODS OF
INVENTORY VALUATION
First in First Last in First Weighted Average Specific Identification

Out (FIFO) Out (LIFO) Cost (WAC) Method

Inventory Valuation: FIFO, LIFO, and WAC

LIFO Vs FIFO
The difference between LIFO and FIFO ending inventory is due
to the rising prices. This leads to FIFO method showing higher
ending inventory and lower cost of goods sold
Î FIFO method would show higher profit than LIFO method.
Accountants rarely use the physical movement of inventory to
decide on the inventory methodology (due to difficulty in
tracking)
Instead they make assumptions about flow of costs
LIFO is not recommended to be followed by the Accounting
Standard 2 on “Valuation of Inventories.” In a few exceptions it
is allowed
Observations …
Accounting policy adopted in relation to inventory valuation and
depreciation can to a large extent influence income
determination (by a firm) for a particular period
Profits and financial performance can be manipulated by
switching from one method of valuation to another
So, Company Law requires that particular method accepted
should be consistently tried at least for a period of three years

Cost of Goods Sold & Gross Profit
Cost of Goods Sold
= Beginning Inventory + Purchases– Ending Inventory
Gross Profit = Sales – Cost of Goods Sold
Every year the unsold inventory will be carried forward to the
next year and charged against the revenue of next year and
hence the above accounting equation can be re-written as:
Gross Profit = Sales – (Ending Inventory of Last Period +
Purchases – Ending Inventory of Present Accounting Period)
In order to avoid situations of improper valuation accountants in
such situations adopt the policy of valuing inventory at ‘lower of
cost or market price’
Illustration on Presentation
Market price indicates the ‘net realizable value’ by selling the
inventory
Govind started the business of vending milk in the city of Indore.
He followed a weekly accounting period. He has been procuring
milk at a steady rate of Rs 10 per liter from the nearby small
farmers. Govind used to sell this milk to the local community at a
rate of Rs 20 per liter. At the end of the first week, he had an
ending inventory of 10 liters. During second week, he purchased
100 liters of milk and at the end of second week he found the
stock of milk to be only 1 liter. Compute the gross profit of
Govind’s business and present it in as many possible ways as
possible
Computation of Sales
Beginning inventory of 2nd week was Rs 100 (10 liters @ Rs 10 per liter)
Purchases in 2nd week was Rs 1000 (100 liters @ Rs 10 per liter)
Ending inventory of 2nd week was Rs 10 (being 1 liter @ Rs 10 per liter)
Cost of Goods Sold of 2nd week would be Rs 1090 (being 109 liters @ Rs 10 per liter)
Sales of 2nd week would be Rs 2180 (being 109 liters @ Rs 20 per liter)
Income Statement: Simplest Form
Sales Rs 2180
Expenses Used by companies
like Blue Dart Express
Less Cost of Goods Soldand HLL Rs 1090
Gross Profit Rs 1090
Other Forms of Presentation …
Sales Rs 2180
Add Increase/(Decrease) in Stocks (Rs 90)
Adjusted Sales Used by European Rs 2090
Expenses and very few Indian
Less Purchases
firms Rs 1000
Sales Rs 2180
Expenses: Used by Raymond
Less Purchases & Television Rs 1000
Eighteen
Less (Increase)/Decrease in Stocks Rs 90
Stages in Accounting of Debentures
Debentures are documents certifying (or
acknowledging) debt
They are large loans being split into standard
Issue of small sized instruments, to enable companies
Debentures raise money from multiple investors
The debenture certificates contain the terms
Interest of repayment of principle amount and the
Payments interest thereon
Writing off discount on
issue of debentures
Redemption of
“Copyright with Tata McGraw-Hill Publishing Co Ltd, 2005" Debentures
Issue of Debentures
The accounting entries for recording the issues of debentures are
same as Share Capital except that a Debenture Account is
opened instead of share capital account
There is no restriction on the amount of discount that can be
allowed on issue of debentures
A private company can issue debentures but cannot issue any
invitation to the public to subscribe to it
If the issue of debentures consists of application, allotment and
calls, the entries for due and receipt are passed accordingly
The debentures can be issued for cash or for a consideration
other than cash (say, for purchase of a fixed asset)
Illustration – Hari Ltd.
Hari Limited purchased land from Virat Ltd., having a book value
of Rs 1,50,000. It was agreed that the purchase consideration
will be paid by issuing debentures of Rs. 100 face value each
carrying a coupon rate of 12% and redeemable after five years.
Pass necessary journal entries assuming the debentures were
issued at Par
Land and Building Account (Debit) 1,50,000
Virat Ltd. Account (Credit) 1,50,000
(Being assets purchased from Virat Ltd.)
Virat Ltd. Account (Debit) 1,50,000

12% Debentures Account (Credit) 1,50,000
(Being issue of debentures at par)
Issue at Discount or Premium
Debentures issued at Discount
Discount on Debentures A/c (Debit) 16,700
(Being issue of debentures of Rs 100 each at a discount of 10%)
Debentures issued at Premium :

Premium on Debentures A/c (Credit) 13,600
(Being issue of 1364 debentures of Rs 100 each for Rs. 110)

Issue of Debentures as Security
Collateral security is a type of secondary security which is asked
by the loan provider. The secondary security is utilized only
when the principal security is not sufficient for repayment of loan
In case where a company issues debentures as a collateral
security, the provider of loan becomes the holder of debentures
when the primary security fails to repay the money (since the
relevant loan clause acts as the trigger)
Hence on taking a loan, no formal entry is passed, instead under
the loan item in the balance sheet a note is written that the loan
is secured by issue of debentures as a collateral security
When the loan is defaulted, the debenture entry is triggered
Interest on Debentures
Interest on debentures is required to be paid whether the
company earns a net profit or not which is in contrast to
dividend on equity shares
Illustration
Jogi & Co. issues 50,000, 8% debentures of face value Rs 100
each on 1st January 20X4. The interest is payable half yearly
on 30th June and 31st December every year. Income Tax Act at
that time states that a TDS of 10% is to be deducted on behalf
of the debenture holders (and is to be deposited with Income
Tax Authorities)
Pass Journal entries for the first interest payment
Jogi & Co. Solution
01-01-X4 Bank A/c (Debit) 50,00,000
(Being amount received on account of issue of 50,000 debentures)
30-06-X4 Interest on Debentures A/c (Debit) 2,00,000
Income Tax Account (Credit) 20,000
Debenture Holders Account (Credit) 1,80,000
(Being half yearly interest due at 8% p.a. and tax at 10% there on)
30-06-X4 Debenture Holders Account (Debit) 1,80,000

Income Tax Account (Debit) 20,000
Bank Account (Credit) 2,00,000
(Being interest and tax thereon paid at applicable dates)
Comments …
These entries are required to be passed when the interest is
due
It has been assumed here that the interest is paid when it
becomes due but if the due date and the date of actual
payment are different, the entry for payment is passed on the
date when it is actually paid
Like interest expense on a loan, the interest on debentures is
an allowable expenditure for the company. Therefore, at the
end of each accounting year the amount paid on account of
debenture interest is debited to the profit & loss account of that
year

Discount on Issue of Debentures
It is a loss for the company because the redemption is done at
par (or even at premium)
The discount is a facilitating asset and is required to be written
off within the lifetime of the debentures
Generally, discounts are written off equally every year
Achintya Co. issues 14% debentures of Rs 100,000 redeemable
after 5 years at a discount of 5%. The journal entry of writing off
every year will be
Profit & loss Account (Debit) 1000
Discount on issue of Debentures A/c (Credit) 1000
(Discount on issue of debentures written off)
Redemption of Debentures
Redemption is repayment of money
It can be either at par or premium
For redemption of debentures at par, the entry, which was
passed at the time of issue, shall be reversed
For redemption at premium there is a capital loss to the
company which is known at the time of issue
The loss on issue of debentures is required to be written off
during the lifetime of the debentures (very similar to issue of
debentures at a discount)
Example: If a debenture of Rs 100 is to be redeemed at Rs 110
by FP Co., the following entry is passed on issue of debentures
Journal Entry
Bank Account (Debit) 100
Loss on issue of Debentures Account (Debit) 10
Debentures Account (Credit) 100
Premium on redemption of
(Credit) 10
Debentures Account
FP Co.
Balance Sheet as at the year end …
ASSETS Rs. LIABILITIES Rs.
Bank Account 100 Debentures Account 100
Miscellaneous expenditure to
the extent not written off 10 Premium on redemption 10
(loss on issue of debentures) Of debentures
110 110
Accounting for Investments
Investments may be in form of different types of securities
For more than one type of investment, it is prudent to maintain
separate account for each investment so that the interest,
dividend and the profit (or loss) on the investment can be
ascertained separately
Journal Entries
For all the purchases, expenses and losses, the investment
account should be debited
Î For all the incomes or gains, the account should be credited
It is advisable to maintain a separate column in the investment
account for income on investment due to interest and dividend
Important points …
Purchase price – It always includes the price of securities and
the cost of transfer i.e., brokerage, commission and other
charges for acquiring the securities
Sale Price – It should be reduced by the cost of transaction
i.e., brokerage, commission, etc.
Interest – Generally the price quoted for debentures and bonds
do not include the interest portion. The interest till the time held
by the seller is to be paid in addition to the price of the
debentures (or government securities)
“Cum-interest” price means the interest benefit goes to the
buyer Î buyer need not pay anything over the agreed price
Example
Leena on 1st August 20X4 purchases Rs 4000 worth, 12%
coupon rate debentures at Rs 96 (net) per debenture cum-
interest. The face value is Rs 100 per debenture
If the interest is paid by the issuing company half-yearly (i.e., on
30th June and 31st December every year) then it would mean the
interest component is included in Rs 4000
This interest due at 12% per annum on Rs 4000 comes to Rs 80.
In other words the value of debenture is Rs. 3760 [= (Rs 96 x 40
debentures) – Rs 80 interest accrued]
Dividend. The treatment of ex-dividend or cum-dividend in similar
to the treatment of interest
Important points…
Bonus shares – Reward given by the company due to its
consistently good current performance and also in the
foreseeable future
The bonus equity shares are issued at no cost
These bonus shares are issued by companies by capitalizing
the reserves of the companies
Gangaram & Company has Rs 1 crore equity shares of Rs 10
par value and has reserves worth Rs 100 crores. If it decides to
issue bonus shares in the ratio of 1 share for every 2 shares
owned then the companies Balance Sheet would get modified
as follows:
Bonus Issue & Balance Sheet
Gangaram & Company
Equity Portion of Balance Sheet before Issuing Bonus Shares:
Equity Share Capital Rs. 10 crores
(Rs 10 par value for 1 crore shares)
Reserves and Surplus Rs. 100 crores
=============
Total Shareholders Funds Rs. 110 crores
Gangaram & Company =============
Equity Portion of Balance Sheet after Issuing Bonus Shares:
(Rs10 par value for 1.5 crore shares)
Transfer of 5 crores =============
Total Shareholders Funds
from Reserves to Rs. 110 crores
Capital =============
Raising Additional Capital
Raising Additional Capital via Share Issue
Private Rights Public

Placement Issue Issue
Placement of The existing ‘Invitation offer’ to
shares of the shareholders given public at large
company with opportunity to invest
exclusive investors in more shares of the Refer to chapter on
same company on Joint Stock
Usually done at a Companies
premium payment
Rights Issue & Private Placement
The journal entry for rights issue and private placement is similar
to the journal entries passed for issue of additional securities
(through public issue)
This is because it is new issue of securities whether to same
shareholders or new investors or exclusive investors
Example: If Gangour Sweets Limited with Rs 1 crore shares of
Rs 10 par value has reserves worth Rs 10 crores decides to
make a rights issue in the ratio of 1 share for every 10 shares
owned at a price of Rs 100 then the companies liability side of
the Balance Sheet would get modified:

Rights Issue & Balance Sheet
Gangour Sweets Limited
Equity Portion of Balance Sheet before Issuing Rights Shares:
(Rs 10 par value 1 crore shares)
=============
=============
Gangour Sweets Limited

Equity Portion of Balance Sheet after Issuing Rights Shares:
(Rs 10 par value 1.1 crore shares)
=============
=============
Valuation of Investments
In a scenario of a company investing in shares of another
company - an entry is passed for purchase of securities i.e.
debiting the investment account with amount paid to get the
shares on account of right issues
Long-term investments (like other long-term assets) are valued
on cost basis (unless there is a decrease in the market value of
a permanent nature)
But, companies are required to also provide exhaustive
information of each and every security held (including market
prices if listed)
Profit (or loss) on account of sale of investment should be
transferred to profit & loss account for the period
Valuation of Investments …
Same treatment is done for decrease in the market value of the
investments
Illustration
Sawadhee & Co. held 10% coupon rate debentures of face value Rs 1000
of Rx Ice creams Ltd. on 1st April 20X4. The total face value of these
debentures was Rs 100,000 (but was purchased for Rs 80,000). The
market value of these debentures on 31st March 20X4 was Rs 110,000.
Interest was paid on 31st March every year
On 1st August 20X4 the firm purchased another set of debentures worth
Rs 10,000 for Rs 8,000 ex-interest. On 31st December 20X4, debentures
of nominal value of Rs 2,000 were sold cum-interest for Rs 1,900
Prepare Investment account in the books of Sawadhee & Co. showing
profit or loss on sale of investment
Solution
Nominal Nominal
Date Particulars Interest Principal Date Particulars Interest Principal
Value Value
1.1.X4 To balance 100000 --- 80000 31.12.X4 By Bank 2000 150 1750
b/d 31.3.X5 By Bank 10800
1.8.X4 To Bank 10000 667 8000 ByBal c/d 10800 86400
31.12.X4 To Profit &
Loss A/c 150
(on sales of
debentures)
31.3.X5 To Profit &
Loss A/c 10283
110000 10950 88150 110000 10950 88150
†Profit on sale of debentures is calculated on FIFO basis in the following way

Proportionate purchase price for debentures of 2,000 is 1600
Sale price of debentures excluding interest 1750 80,000 X 2000
Net Profit on sale 150 100,000
Negotiable Instrument
A document used in commercial transactions and monetary
dealings
Example: Promissory note, Bill of exchange, and a Cheque
Can be “Bearer” instrument or “Order” instrument (i.e., The
payment is to be made according to the order)
The provision of the Negotiable Instruments Act 1881 is
applicable to all negotiable instruments
A Promissory Note is “an instrument in writing containing an
unconditional undertaking, signed by the maker, to pay a certain
sum of money only to or to the order of a certain person or to the
bearer of the instrument.”
Specimen of Promissory Note
Rs. 10,000
JAMSHEDPUR
Payee (Creditor) Jul. 31, 2005
…….. months [or …… days] after date, I

promise to pay Ms Latha or order the sum
of Rupees Ten thousand only for value
received.
Maker (Debtor) Rohan

Bills of Exchange
A Bill of Exchange is “An instrument in writing containing an
unconditional order, signed by the maker, directing certain
person, to pay a certain sum of money only to, or to the order of
a certain person or to the bearer of the instrument”
Three Parties
Same party can be both Drawer and Payee
Maker or Drawee Payee

Drawer
Liable to pay the Entitled to get the
Also the creditor money or debtor money

Discussion on Negotiable Instruments
In case of a Bill of Exchange the maker being the creditor,
orders the drawee to pay a certain sum of money
In case of a Promissory note, the maker being the debtor
promises to pay to certain sum of money
A Bill of exchange can also be made payable to the bearer
A cheque is “a, bill of exchange drawn on a specified bank and
payable on demand”
A cheque is similar to a bill of exchange with a difference that it
is always drawn on a specific banker and it is always payable on
demand

Accounting Entries
The negotiable instruments are transferable upon endorsement
or mere delivery (in case of bearer instrument)
When the receiver of Bill of Exchange keeps it till the date of
maturity, he passes the entry through Bills receivable account
while the drawee will pass the entry through Bills Payable
account
Ashutosh sells goods worth Rs. 10,000 to Santosh on 1st
January 20X4 and receives a 90-day Bill of Exchange duly
accepted by Santosh. The Bill of exchange gets matured on 31st
March 20X4 and Ashutosh receives money. The following
entries are passed in the book of Ashutosh:

Solution…
01-01- X4 Santosh A/c (Debit) 10,000
Sales Account (Credit) 10,000
(Being goods sold to Santosh)
Bills Receivable Account (Debit) 10,000

Santosh Account (Credit) 10,000
(Being Bill of Exchange duly accepted by Santosh received)
31-3- X4 Cash Account (Debit) 10,000

Bills Receivable Account (Credit) 10,000
(Being payment received on maturity of the Bill of Exchange)

Endorsing a Bill
Till the actual payment on Bill is made, it will be shown in the
Balance Sheet of Ashutosh under the current assets as Bills
Receivable while Santosh will show this amount under current
liabilities as Bills Payable
When the Bill of exchange is endorsed in favour of another
creditor, the drawee is not concerned with the endorsement
For drawer, the entries relating to sale of goods and receipt of
Bill of Exchange will be same but the entry on exchange/
transfer will be changed
For example, in the previous case, if Ashutosh endorses the Bill
in favour of his creditor Wasi Ahmed, the entry will be:
Bill Discounting
Wasi Ahmed Account (Debit) 10,000
Bills Receivable Account (Credit) 10,000
(Being the Bill of exchange endorsed in favour of Wasi Ahmed)
Discounting with a bank means relinquishing the right on Bill of

Exchange in favour of bank and receiving the payment
The bank makes the payment after deducting some charges
known as discounting charges
The drawee is not concerned with the act of discounting as it
makes no difference for him whether the drawer keeps the Bill
with him or gets discounted from his bankers
However, it is a Contingent Liability for the drawer
Thank You

Chapter 9:
Accounting Standards

&
Accounting Standards
Basic rules for preparing and presenting the financial
statements kept on changing with the passage of time
Changes were catalyzed by the changing business environment
across the globe
The Institute of Chartered Accountants of India (ICAI) issues the
Accounting Standards in India
It suggests the rules for recognition, measurement, treatment,
presentation and disclosure of accounting transactions in the
financial statements of an organization
Facilitates the disclosure of financial information which is
important but not required to be disclosed by law
Standards Preparation
The Accounting Standards Board of ICAI (ASB) performs the
functions of preparation of the accounting standards in India
The ASB comprises of representatives from industries, Central
Board of Direct Taxes, Company Law Board, Comptroller and
Auditor General and other parties
IASC (or IASB) is responsible for making the International
Accounting Standards (IAS)
It is a committee of professional accounting bodies of more than
75 countries
Many countries either follow the IAS or prepare their local
accounting standards as per the guidelines of the IAS
IASB issues
Exposure Draft (ED) ASB issues ED at website
ASB may conduct ASB taps onto

separate public ICAI list of
Feedback/ consultations interested parties
Exposure
Period.
Feedback from stakeholders to
ASB via email/fax/post Exposure
stage and
review of
End of consultation comments
ICAI reviews comments

received and drafts comment
letter for ASB’s consideration
End of consultation
IASB reviews
comments received
and deliberates on
final IAS IASB
issues
ASB and ICAI IAS
monitor developments
IASB issues final IAS
ASB decides
whether to adopt the
Flowchart of the Process

AS in India
ASB
Involved in Preparation Publication of the AS on

website and gazetting of
issues AS
of Accounting Standards the amendments to the

required regulations.
ICAI and Companies Act Link …
29 AS’s have been issued till March 2005 by the ASB in India
Importance of AS comes due to the following portions of the
Companies Act, 1956:
Section 211 (3A) requires that the financial statements of a
company should be prepared as per the Standards
Section 217(2AA) (1) states that the directors should mention
that during preparation of the annual accounts all the applicable
accounting standards have been followed, in the Directors
Responsibility Statement
Section 227(3) requires the auditors to report whether in their
opinion the financial statements were prepared as per the AS
AS 1 on Disclosure of Policies
There is no single list of accounting policies which are applicable
under all the circumstances because of the fact that the
enterprises operate in different situations
The choice of accounting policies depends on the judgment of the
management
The objective of AS 1 is to promote better understanding of the
financial statements by proper disclosure of significant accounting
policies
Such disclosure will facilitate a more meaningful comparison
between financial statements of different enterprises

AS 1 – Highlights
All significant accounting policies adopted should be disclosed
Disclosure should form part of the financial statements and the
significant policies should be disclosed at one place
Any change in accounting policy having material effect on the
financial statement of the current year should be disclosed and
the amount be ascertained. If the amount is not ascertainable,
the fact should be disclosed
The basic assumptions underlying the presentation of financial
statements such as Going Concern, Consistency, and Accrual
are to be followed. If these basic assumptions are not followed
then the facts are required to be disclosed.
Illustration
Swastik Ltd. used to prepare its accounts on accrual basis. But
for the year ended 31st March 20X5, it decides to maintain its
books of accounts on cash basis. Accordingly, it discloses in the
financial statements that cash basis of accounting is one of its
significant accounting policy. As an auditor of the company, do
you think the disclosure to be appropriate?
The Companies Act requires the books of accounts to be
maintained only on Accrual Basis. Therefore, it is not proper to
maintain the books of accounts only on Cash basis
As an auditor, the fact that the applicable Accounting Standards
were not followed by the company should be clearly mentioned
in the Report
AS 2 – Inventory Valuation
Inventories do not include the specific machinery spares which
can be used only in connection with an item of fixed asset.
Valuation should be based on lower of ‘cost’ and ‘net realizable
value’
The cost of inventories should comprise all costs of purchase
(duties, taxes), cost of conversion (direct labour) and other costs
Net realizable value means the estimated price that can be
realized in ordinary course of business as reduced by the cost of
completion and cost of sale
Generally, the inventories are to be valued as per FIFO or
weighted average cost
Inventory Valuation by
Marico Industries Ltd.

Inventory Valuation by
Marico Industries Ltd.

Illustration
Dr. Mungeri Lal Laboratories Limited produces a chemical, “Jadoo”.
Jadoo’s costing details are provided below:
Raw material Rs 2
Direct Labour Rs 1
Direct Expenses Rs 3
Fixed Overheads Rs 20,000
Variable Overheads Rs 10,000
The normal capacity of the plant is to produce 10,000 units per
annum but the actual production for the year was 5,000 units.
The stock with Dr. Mungeri Lal Laboratories was 5000 units of
stock at the end of the year. Calculate the value of the inventory
stock.
Solution
The fixed overheads are to be allocated on the basis of normal
capacity while the variable overheads are to be allocated on the
basis of actual capacity. Accordingly, the cost per unit is:
Particulars Cost per unit
Raw material 2
Direct Labour 1
Direct Expenses 3
Fixed Overhead 2 (Rs. 20,000 for 10,000 units)
Variable Overheads 2 (Rs. 10,000 for 5,000 units)
Total per Unit 10
The value of inventory is Rs 5000 x 10 or Rs. 50,000

AS 3: Statement of Cash Flow
The cash flow statement explains the movement of cash under
the heads: cash flow from operating, investing; and financing
activities
It contains the details of cash and cash equivalents that have
increased or decreased during the period due to any of the
above heads
AS 3 is mandatory for…
All the listed companies or companies that are in the process of
issuing securities that will be listed on a recognized stock
exchange in India
All other commercial, industrial and business enterprises,
whose turnover for the accounting period exceeds Rs. 50 crores
AS 4: Events after Balance Sheet Date
Deals with events which takes place after the balance sheet date
but before approval of balance sheet by the Board of Directors
The prudent accounting policies require the making of provision
for all known liabilities and losses even for those liabilities or
events which are probable
Adjustments are required for events occurring after the Balance
Sheet date that provide information which materially affects the
business
Example: If a debtor becomes insolvent after the balance sheet
date, adjustment should be made for loss on receivables in the
balance sheet
AS 4: Events after Balance Sheet Date
If the events do not relate to the conditions existing at the balance
sheet date, no adjustments are required to be made
Example: If a major fire occurs in the factory of a company one
week after the closure of its books of accounts, damaging majority
of its assets is not an event occurring after the Balance Sheet
Date because as on the balance sheet date, there was no
indication about the loss on account of fire. However, this incident
materially effects the financial position of the company, so should
be disclosed by way of notes to the accounts
In the notes to accounts one should disclose the nature of the
event and the estimated financial effect or a relevant statement
that such an estimate cannot be made
AS 29: Provisions and Contingencies
ICAI came out with a new standard AS 29
It also applies to financial instruments (including guarantees)
that are not carried at fair value
Provisions are liabilities that can be measured only by using a
substantial degree of estimation
A provision should be recognized when:
an enterprise has a present obligation as a result of a past
event;
it is probable that an outflow of resources will be required to
settle the obligation;
a reliable estimate can be made of the amount of obligation
‘Provisions’ in AS 29
Provision amount recognized should be the best estimate of the
expenditure required to settle the present obligation at the
balance sheet date
Future events that may affect the amount required to settle an
obligation should be reflected in the amount of a provision where
there is sufficient objective evidence that they will occur
Provisions should be reviewed at each balance sheet date and
adjusted to reflect the current best estimate
If it is no longer probable that an outflow of resources embodying
economic benefits will be required to settle the obligation, the
provision should be reversed
‘Contingent Liability’ in AS 29
A possible obligation that arises from past events and the
existence of which will be confirmed only by the occurrence or
non-occurrence of one or more uncertain future events not
wholly within the control of the enterprise; or
A present obligation that arises from past events but is not
recognized because:
It is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation; or
A reliable estimate of the obligation amount cannot be made
An enterprise should not recognize (i.e., provide for) a
contingent liability
Main Recognition Requirements for Provisions and Contingent Liabilities
Start
No
Present obligation as a No Possible
result of an obligating obligation?
event?
Yes Yes
No Yes
Probable outflow? Remote?
Yes
No
No (rare)
Reliable estimate?
Yes
Provide Disclose contingent Do nothing

Financial Accounting for Management by Ramachandran
liability & Kakani 20
‘Contingent Asset’ in AS 29
A possible asset that arises from past events the existence of
which will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not
completely within the control of the enterprise
Example: A claim that an enterprise is pursuing through legal
processes, where the outcome is uncertain
Are not recognized in financial statements since this may result
in the recognition of income that may never be realized.
However, when the realization of income is virtually certain, then
the related asset is not a contingent asset and its recognition is
appropriate
Usually disclosed in the report of the Board of Directors
Disclosure Requirements
For each class of provision, an enterprise should disclose:
the carrying amount at the beginning and end of the period;
additional provisions made in the period; amounts used (i.e.
incurred and charged against the provision) during the
period; and unused amounts reversed during the period
An enterprise should disclose the following for each class of
provision:
a brief description of the nature of the obligation and the
expected timing of any resulting outflows of economic
benefits;
an indication of the uncertainties about those outflows
An enterprise should disclose for each class of contingent
liability at the balance sheet date a brief description of the nature
of the contingent liability and, where practicable:
an estimate of its financial effect;
an indication of the uncertainties relating to any outflow
In extremely rare cases, disclosure of some or all of the
information can be expected to prejudice seriously the position
of the enterprise in a dispute with other parties on the subject
matter of the provision or contingent liability
In such cases, an enterprise need not disclose the information,
but should disclose the general nature of the dispute
Illustration
Narayan Bhandar Ltd. is a reputed retail store. It starts a policy
of refunding purchases by dissatisfied customers, even though it
is under no legal obligation to do so. Its policy of making refunds
is generally well known and hence it invites large number of
customers and hence good business this year. The owner is
confused regarding the accounting of this policy – please help
The obligating event is the sale of the product, which gives rise
to an obligation because obligations also arise from normal
business practice
An outflow of resources in settlement is quite probable
Thus, a provision is recognized for the best estimate of the costs
of refunds
AS 5: Net Income & Changes in Policies
It requires the classification and disclosure of certain
items within profit or loss
Ordinary Activities – Undertaken by an enterprise as part of
its business. It also includes those activities that are
incidental to the main business.
Extra-ordinary activities – Are different, Activities not
expected to recur frequently or repeatedly.
Prior period items – Are the income or expenses that arise
in the current period as a result of the errors or omissions in
preparation of the financial statements in one or more
previous year.
Implications of AS 5
Where the items of income and expense within profit and loss
from ordinary activities are of such nature, size or incidence that
their disclosure is relevant to explain the performance of the
enterprise for a period, the nature and amount of such items
should be disclosed separately. For example –
Writing down the inventories to their net realizable value
Disposal of fixed assets
Litigation settlements
The nature of prior period items and its amount should be
separately disclosed in the profit & loss account in a manner
that their impact on the current profit and loss can be perceived
Illustration
Alibaba Limited filed a case against Alladin & Company for
breach of contract in the year 20X2-X3. The amount of claim
was Rs. 10 lakhs but no entry was passed in the books for the
year 20X2-X3. Alibaba won the case in 20X4-X5 and Alladin
was required to pay the money which was received in the same
year. The finance manager of Alibaba is confused about the
treatment for the amount gained. Please help him
Non-passing of entry in any year does not necessarily make it a
prior period item because in the given case, there was no
certainty in the year 20X2-X3 regarding the amount to be
received on account of filing the care and winning it
The amount should be credited for the year 20X4-X5
AS 6 – Depreciation Accounting
If the management, after making an estimate, feels that the rates
of depreciation should be higher than the rates prescribed by the
Companies Act, then it is allowed to do so
But if it wants to lower the rate, the same is required to be in
accordance with the requirements of the Companies Act
Once a depreciation method is followed, the same should be
used consistently.
Any change in the method is allowed only if: -
it is required by the statute,
needed for compliance with the AS, or
for a better presentation of the financial statements
AS 6 Implications
Where the method of depreciation is changed, the depreciation
is re-calculated according to the new method as if the same is
used from the date of the asset coming into use
The surplus (or deficiency) arising due to the change in method
is accounted for in the profit & loss account during the year of
change
AS 6 is not applicable on
Forests and similar regenerative natural resources
Wasting assets such as expenditure on exploration for oil
Expenditure on research and developments
Goodwill
Live stock
Disclosure Requirements – AS 6
The depreciation method used is to be mentioned along with the
total amount for each class of asset, gross amount of each class
of depreciable asset, and the accumulated depreciation
If the historical value of an asset is changed because of
additions and change in duties, then the depreciation on the
revised unamortized depreciable amount is provided
prospectively over the residual life of the assets.
If the modernization of a fixed asset has material effect on the
amount of depreciation, it should be disclosed
Change in the method needs to be disclosed clearly with the
reasons for the change being mentioned
AS 9 : Revenue Recognition
In case of sale of goods, the following conditions be satisfied:
The goods are transferred to the buyer for a price wherein
all the significant risks and rewards of ownership has been
transferred to the buyer.
No significant uncertainty exists regarding the amount of
consideration that will be derived from the sale of goods
Revenue from sale transaction should be recognized provided
that at the time of execution, it is not unreasonable to expect the
ultimate collection (of receivable)
In case of any doubt, the recognition should be postponed till the
certainty is achieved
AS 9 : Revenue Recognition
In case of services, the execution (performance) is measured
either under completed service contract method or under the
proportionate completion method whichever relates revenue to
the work carried out.
Revenue arising from the use by others of enterprise resources
yielding interest, royalties and dividends should only be
recognized when no significant uncertainty as to its
measurability or collect-ability exists. Recognition is based on:
Interest: On time-period proportionate basis
Royalties: As per the terms of agreement on accrual basis
Dividend: When the owners right to receive is established
Sale of Goods …
If delivery is delayed at buyers request and the buyer takes title
and accepts billing -
The revenue should be recognized irrespective of the fact
that the physical delivery is not made
If delivery is subject to conditions of installation and inspection -
Revenue is not recognized until the customer accepts the
delivery and the installation as well as inspection are
completed
In some cases, the installation process is so simple that the
revenue can be recognized even if the inspection and
installation are pending
AS 10 : Fixed Assets
Planned Revaluation – An entire class of asset should be
revalued or the selection of assets for revaluation should be
made on a systematic basis and the basis be disclosed
In case of revaluation, the increase in value should be credited
to the revaluation reserve.
Disposal of Fixed Assets – The difference between the net
proceeds and the net book value should be charged to the profit
& loss account
For any amount standing to the credit of revaluation reserve
account relating to the asset disposed, then the loss amount is
charged from revaluation reserve. Balance in the account
should be transferred to General Reserve Account.
AS 10 Requirements …
Joint ownership of fixed assets – The enterprises share in such
asset and the proportion of original cost and accumulated
depreciation are to be disclosed
Goodwill – Only the amount of purchased goodwill is to be
shown. If a business is purchased, the amount of goodwill is
calculated by the excess of price paid over the value of assets
taken.
Patents – Direct costs attributable to patents should be
capitalized and written off over their legal term or working life
Know-How – Amount paid for plans, layouts, designs should be
capitalized under the relevant asset head and the depreciation is
calculated on the whole amount
AS 22 : Taxes on Income
The difference between the tax expenses (which is calculated as
per the books of accounts) and current tax liability as per
Income-tax Act is called deferred tax (assets/liability).
Î Tax expense for any year = Current Tax + Deferred Tax.
Deferred tax (asset/ liability) arises only when there is a
difference in the taxes due to the timing difference. Permanent
difference does not result in any tax (Asset/Liability).
Permanent differences are the differences between taxable
income and accounting income for a period that originate in one
period and do not reverse subsequently. For example, while
computing taxable income, the tax laws disallows a part of an
item of expenditure.
Deferred tax assets and liabilities should be distinguished from
assets and liabilities representing current tax for the period. It
should be disclosed under a separate heading in the balance
sheet of the enterprise, separately from current assets and
current liabilities
The break-up of deferred tax assets and deferred tax liabilities
into major components of the respective balances should be
disclosed in the notes to accounts
The nature of the evidence supporting the recognition of
deferred tax assets should be disclosed, if an enterprise has
unabsorbed depreciation or carry forward of losses under tax
laws
Example …
Moolchand Cements Tax as per Books of Accounts
Year ending 31st March 20X5 20X6 20X7
Profit 400000 400000 400000
Less: Depreciation 100000 100000 100000
Taxable Profit 300000 300000 300000
Tax @ 30% 90000 90000 90000
Moolchand Cements Tax as per the Income Tax Act

Year ending 31st March 20X5 20X6 20X7
Profit 400000 400000 400000
Less: Depreciation 300000 0 0
Taxable Profit 100000 400000 400000
Tax @ 30 % 30000 120000 120000
Journal Entry (1st Year)
In the first year, we need to create a deferred tax liability of Rs.
60,000
This difference is because of the difference in the depreciation
rates (Rs. 3,00,000 – 1,00,000) at the tax rates applicable
In this case we pass the following journal entry…
Profit & loss account (Debit) 90000
Current Tax Account (Credit) 30000
Deferred Tax Liability (Credit) 60000
(Being the amount of tax including deferred tax charged to the profit
and loss for the year)

AS 26 : Intangible Assets
An intangible asset is an identifiable non-monetary asset,
without physical substance, held for use in the production or
supply of goods or services, for rental to others, or for
administrative purposes.
AS 26 is to be applied by all enterprises for intangible assets
except those enterprises dealing with financial assets and
mining and other exploration rights
An intangible asset should be measured initially at cost
Internally generated intangibles such as goodwill, brands,
mastheads, and publishing titles, should not be recognized as an
asset
AS 26 – Highlights
An intangible asset arising from development can be recognized
only if that enterprise can demonstrate its feasibility, ability to
sell, generation of future economic benefits, intention and
availability of resource for completion and ability to measure the
expenditure
If any expenditure on an intangible asset is recognized as
expense in any year the same cannot be part of cost of an
intangible asset at a later date. Subsequent expenditure can be
added to the cost only if is probable that the expenditure will
generate future benefits that are in excess of the original
estimates
An intangible asset to be amortized on a straight-line method
AS 21 : Consolidated Statements
These consolidated statements are intended to present financial
information about a parent and its subsidiaries as a single
economic entity to show the economic resources controlled by
the group, the obligations of the group and results the group
achieves with its resources
AS 21 should be applied in accounting for investments in
subsidiaries in the separate financial statements of a parent
AS 21 does not deal with accounting for investments in joint
ventures and investment in associates
The consolidated financial statements are presented, to the
extent possible, in the same format as that adopted by the
parent for its separate financial statements
Consolidation Procedures
While in a parent’s separate financial statements, investments in
subsidiaries would be accounted for in accordance with AS 13
for Investments but in preparing consolidated financial
statements, the financial statements of the parent and its
subsidiaries should be combined on a line by line basis by
adding together like items of assets, liabilities, income and
expenses.
Some of the steps to be taken are as follows:
The cost to the parent of its investment in each subsidiary and
the parent’s portion of equity of each subsidiary, at the date on
which investment in each subsidiary is made, should be
eliminated
Steps…
Any excess of the cost to the parent of its investment in a
subsidiary over the parent’s portion of equity of the subsidiary, at
the date on which investment in the subsidiary is made, should
be described as goodwill to be recognized as an asset in the
consolidated financial statements
Intragroup balances and intragroup transactions and resulting
unrealized profits should be eliminated in full. Unrealized losses
resulting from intragroup transactions should also be eliminated
Consolidated financial statements should be prepared using
uniform accounting policies for like transactions and other events
in similar circumstances. If it is not practicable to use uniform
accounting policies then that fact should be disclosed.
A list of all subsidiaries including the name, country of
incorporation or residence, proportion of ownership interest and,
if different, proportion of voting power held;
Where applicable, the nature of the relationship between the
parent and a subsidiary, if the parent does not own, more than
one-half of the voting power of the subsidiary;
The names of the subsidiaries of which reporting date(s) is/are
different from that of the parent and the difference in reporting
dates

Auditor Qualifications and Notes
SEBI had announced that the listed companies will have to
disclose audit qualifications in the audited financial statements
along with the impact of the auditors qualification on their profit
or loss
This has resulted in all listed companies to mandatorily disclose
audit qualifications in their published annual results
Notes to accounts are the place where all the matters which are
disputed or needs further disclosure can be seen
If an auditor gives a qualification in the auditors description on
the firm’s financial statements and accounting practices then the
management also has a chance to represent its views in the
‘notes to accounts’
Computerization of Accounts
Computerized accounting systems are just automated traditional
manual book-keeping procedures
It results in immense speed and improved accuracy in the
accounting process
However, the fundamental problems associated with traditional
manual accounting processes (such as, a wrong journal entry)
remains
Computerization of accounts can be of various stages – right
from ‘running of the whole system on computers’ to ‘just do
some sales invoicing’. It could mean ‘automating just the main
ledgers’ or ‘it could mean a order processing-cum-stock control
system’
Computerization of Accounts
An increasing number of enterprises have largely shifted to
computerized accounting systems
Small businesses can buy ‘off-the shelf’ accounting packages
Medium sized business opt for customized accounting packages
Large sized companies get customized accounting programs as
part of their ERP
The disadvantages are required to be taken care before
implementation of an accounting package
A good manager is expected to overcome most of these
disadvantages using his knowledge, skill, experience and
position in the organization
Thank You


Authored by Proff Kakani

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Chapter 1:

Conceptual Basis of Accounting

Prof. Ram Kumar Kakani

Used for reporting Providing information for

Audience: Outside World Audience: Internal

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3 Founding Ideas of Accounting

Capital Productive Profitable

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 Basic orientation of financial accounting is

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“accounting is the art of recording,

 Due to its many advantages, historical cost is

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Management Control Proprietor Partners Board of Directors

Liability Unlimited Unlimited Limited

Flexibility Maximum Depends on Partners Comparatively Less

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GAAP Accounting Standards

Accounting practices Authoritative standards (set by

Country specific International standards exist

Indian GAAP is to be followed in the pecking order of:

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Score Attention Problem

Reporting on Signaling the user Provision of such

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Sales Rs 1000 Rs 1000

Sales of P3 have decreased.

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Government Enterprise Social

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Finance Accounts Accounts

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Prof. Ram Kumar Kakani

 Two relevant questions:

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 Say, the bank grants me the loan of Rs. 400,000

 As a result of this transaction my worth is

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Assets Rs. Liabilities And Owners Rs.

Cash 20,000 Owners equity 20,000

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Cash 10,000 Mortgage on shop 40,000

Shop premises 50,000 Owners equity 20,000

Total 60,000 Total 60,000

Business profit is earned in this process of exchange

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Fixed Assets: Rs.

At the end of second year it will be?

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Basic orientation of financial accounting is

Due to its many advantages, historical cost is

Two relevant questions:

Say, the bank grants me the loan of Rs. 400,000

As a result of this transaction my worth is

The company needed only part of the capital

Comparing the revenue from sales against the