FINANCIAL STATEMENTS: An Overview Business entities may have many objectives and goals.

Two primary objectives of every business are profitability and solvency.

Profitability is the ability to generate income. Solvency is the ability to pay debts as they become due. Unless a business can produce satisfactory income and pay its debts as they become due, the business can not survive to realise its other objectives.

The financial statement that reflects a companys profitability is the income statement or Profit and Loss Acoount. The balance sheet that is also called the statement of financial position reflects a companys solvency. Another important statement is the statement of cash flows which shows the cash inflows and outflows for a company over a period of time.

The Income Statement or Profit & Loss Account The income statement reports the profitability of a business organisation for a stated Period of time say 1 year. We measure profitability by comparing the revenues generated with the expenses incurred to produce these revenues.

Revenues are the inflows of assets (such as cash) resulting from the sale of products or rendering of services to customers.

Expenses are the costs incurred to produce revenues.

If the revenues of a period exceeds the expenses of the same period, net income or net profit results. Thus, Net Profit = Revenues Expenses.

On the other hand if expenses exceed revenues, net loss results.

The Balance Sheet The Balance Sheet lists the companys assets, liabilities, and stockholders equity as of a specific moment in time.

A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The income statement is for a period of time.

Assets are things of value owned by the business. Assets have value because a business can use or exchange them to produce the services or products of the business. Liabilities are the debts owed by a business. Typically, a business must pay its debt by certain dates.

The owners interest in a corporation is referred to as stockholdersequity which consists of paid up capita, reserve & surplus.

DESCRIPTION OF ELEMENTS IN FINANCIAL STATEMENT: In India Financial Statements of a company include two statements: Income statement and balance Sheet. In this section we provide the description of important elements of Balance Sheet and Income Statement. Element of Balance Sheet The balance sheet shows the financial condition or financial position of a company on a particular date. The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders equity). By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders equity. The balanching equation is expressed as: Assets = Liabilities + Stockholders equity. We will discuss now different elements of both side of the Consolidated Balance Sheet of Ashok Leyland as at 31st March, 2000, Exhibit 1. ASSETS: Fixed Assets Fixed assets are also called tangible, long-lived, and capital assets. These assets produce economic benefits for more than one year, and they are considered tangible because they have a physical substance. Fixed assets generally include land, building, plant & machinery, furniture, equipment and capital work-in-progress. Capital work-in-progress is the capital asset which is under construction and yet to be ready to give the economic benefit to the company. These are the costs of constructing new buildings which are not

Exhibit 1: Balance Sheet of Ashok Leyland Ltd. as 31 March, 2000( Rs in Millions) 31. 03. 2000 31.03.1999

SOURCES OF FUNDS Shareholders Fund Capital Reserves and Surplus

1,189.29 10,212.18 _________ 11,401.47 _________ 5,500.96 4,155.95 _________ 9,656.91 __________ 21,058.38 _________ 14,944.23 5,793.89 _________ 9,150.34 308.00 ________ 9,458.34 1,203.84 4,577.94 7,561.83 372.84 2,129.77 _________ 14,642.38 _________ 3,637.03 675.93 __________ 4,312.96 ___________ 10,329.42 66.78 _________ 21,058.38

1,189.29 9,905.78 ________ 11,095.07 ________ 5,525.08 4,096.58 ________ 9,621.66 _________ 20,716.73 __________ 14,087.69 5,152.47 ________ 8,935.22 612.31 _______ 9,547.53 624.70 4,277.47 7,605.75 621.55 1,956.27 ________ 14,461.04 ________ 3,649.84 320.56 _______ 3,970.40 ________ 10,490.64 53.86 _________ 20,716.73

Loan Funds Secured Loans Unsecured Loans

Total APPLICATION OF FUNDS Fixed Assets Gross Block Less Depreciation Net Block Capital Work-in Progress Investments Current Assets, Loans and Advances Inventories Sundry Debtors Cash and Bank Balances Loans and Advances

Less Current Liabilities and Provisions Liabilities Provisions

Net Current Assets Miscellaneous Expenditure Total

yet complete. Fixed assets other than land (which has a theoretically unlimited life span) and capital work-in-progress (which is yet to be ready for use), are depreciated over the period of time they benefit the firm. The process of depreciation is a method of allocating the cost of longlived assets. The original cost, less any estimated residual value at the end of the assets life, is spread over the expected life of the asset. Cost is also considered to encompass any expenditures made to ready the assets for operating use. On any balance sheet date fixed assets are shown at book value (Net Block), which is the difference between original cost (Gross Block) and any accumulated depreciation to date. In Ashok Layland company the gross block of fixed assets other than capital work-in-progress for the current year is Rs.14,944.23 millions. After deducting the accumulated depreciation of Rs.5,793.89 millions for the year, the Net Block appears to be Rs9,150.34 millions. The capital work-in-progress for the current year appears in the balance sheet to be Rs308 millions.

Investment: This element includes only the long-term investment of the firm. Investment may be in government security as well in corporate security. Corporate security comprises shares and debenture. Company may subscribe shares and debenture of other companies. It may also include the shares and debenture of subsidiary companies. Total amount of investment of Ashok Layland Ltd. has increased from Rs.624.70 millions in 1999 to Rs.1,203.84 millions in 2000.

Current Assets

Current assets include cash or those assets expected to be converted into cash within one year. The designation current refers essentially to those assets that are continually used up and replenished in the ongoing operations of the business. The term working capital or net working capital is used to designate the amount by which current assets exceed current liabilities (current assets less current liabilities). Different components of current assets are inventories, sundry

debtors, cash and marketable securities and prepaid expenses etc. Inventories Inventories are items held for sale or used in the manufacture of products that will be sold. A retail company lists only one type of inventory on the balance sheet i.e., merchandise inventories purchased for resale to the public. A manufacturing firm, in contrast, would carry three different types of inventories: raw materials, work-in-progress, and finished goods. For most firms, inventories are the firms major revenue producer. In exhibit I, inventories figure Rs4,577.94 millions.

Sundry Debtors or Accounts Receivable Sundry debtors are customer balances outstanding on credit sales and are reported on the balance sheet at their net realizable value, that is, the actual amount of the account less a provision for doubtful debt accounts. Management must estimate - based on such factors as past experience, knowledge of customer quality, the state of the economy, and the firms collection policies the rupee amount of accounts expected to be uncollectible during an accounting period. The estimated amount is treated as doubtful debtors. The actual bad debt figure is written off against the provision account which is adjusted at the end of each accounting period. The net sundry

debtors amount of the Ashok Leyland company for the year 2000 is given by Rs 7,561.83 millions. Cash and bank balance This account is exactly the cash in hand and cash at bank. This is the most liquid asset of the firm. Any time the firm must have some cash either in the form of cash awaiting deposit or in a bank account. Sometimes the company might have bank overdraft that is shown as short term liability of the firm in the balance sheet. Marketable security Marketable securities are cash substitutes, cash that is not needed immediately in the business and is temporarily invested in short-term securities to earn a return. The securities must be relatively risk less securities and highly liquid so that funds can be readily withdrawn as needed. Instruments used for such purposes include short term treasury bills, certificates of deposits, commercial paper etc. Ashok Leyland Ltd. does not have this account on its balance sheet. Prepaid expenses Prepaid expenses are costs of unexpired services which have been paid in advance. An example of such an asset might be a fire insurance policy taken out for one year on 1 st of January of 2000. When the accounts are closed in March in 2000 ( in case of Ahok Leyland Ltd), only one forth of the premium paid in advance could be considered as expense for the period which ended on 31st March and the remaining three forth would be shown as assets under the head prepaid expanses, because the company has still to receive fire insurance cover for the remaining three quarter year, the premium for which has already been paid in advance. The balance sheet of Ashok Leyland Ltd, however, does not include any prepaid expense. Loans and advances

This account includes dues from employees of the company, advances paid for capital items and sometimes balances remaining with Customs, Central Excise etc. Balance sheet of Ashok Leyland Ltd. reports Rs 112.08 million for Loans and Advances. Miscellaneous expenditure When a company is promoted it has to incur initially some expenditure. This is preliminary expenses. Whole amount of the expenditure is not charged to the profit & loss account for the initial year. Instead, the total expenditure is spread to a few years as decided by the

management and a portion of the same is charged to the profit & loss account for each year. The remaining balance that is yet to be charged to P&L A/c in futute years may be shown as miscellaneous expenditure in the balance sheet. Other items included in this expenditure are expenses relating to issuance of debenture, Loan raising expenses etc. Ashok Leyland Ltd. reports miscellaneous expenditure of Rs66.78 million in it current years balance sheet.

STOCKHOLDERS EQUITY The ownership interests in the company are represented in the balance sheet, stockholders equity or shareholders equity. Ownership equity is the residual interest in assets that remains after deducting liabilities. The owners bear the greatest risk because their claims are subordinate to creditors in the event of liquidation; but owners also benefit from the rewards of a successful enterprise. On the date of the balance sheet, i.e., on March 31, 2000 Ashok Leyland company has total subscribed share capital of Rs 1,189.29 million. The other part of owners equity is represented in the balance sheet by reserves and surplus amounting to Rs10,212.18 million. These consist of profits which were not distributed to the shareholders as dividends on the earlier years primarily because of the fact that the directors and shareholders wanted to plough back part

of the profits earned in order to facilitate future expansion of the activities of the business. The other items which are sometimes included in this heading are capital reserve, investment

allowance reserve debenture redemption reserve etc.

LIABILITIES Debt capital Most companies raise long term fund by way of issuing debenture in addition to equity capital. The debenture holders get a fixed rate of interest on the principal amount invested in the company. The company is legally bound to pay interest to debenture holders irrespective of the fact whether it is profitable or not. In the event of liquidation they would get the priority to get back their principal amount over equity holders of the company. In Ashok Leylands balance sheet, the total debt capital has been broken down into two components secured loan and unsecured loan of Rs5,500.96 millions and Rs4,155.95 million respectively. Secured loans are the loans which are issued against specific security. In the event of liquidation the creditors of these loans can realize their loan funds by selling the assets mortgaged for the loans. Unsecured loans are issued against no security.

Current Liabilities Liabilities represent claims against assets, and current liabilities are those that must be satisfied within one year. Current liabilities include sundry creditors, the current portion of long-term debt, accrued liabilities, and deferred taxes etc. Sundry creditors

Sundry creditors are short term obligations that arise from credit extended by suppliers for the purchase of goods and services. For example, when Ashok Leyland Ltd. buys raw materials on credit from different suppliers for its own production purpose, the transactions creates sundry creditors account. The condensed balance sheet of Ashok Leyland does not show sundry creditors account separately. It is included in the current liabilities. Current portion of long-term debt: When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability. In the present example there is no such portion of long-term debt outstanding which is due in the coming year. Outstanding Liabilities Most of the companies use the accrual rather than the cash basis of accounting: Revenue is recognized when it is earned, and expenses are recorded when they are incurred, regardless of when the cash is received or paid. Outstanding liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. Thus they are liabilities because there will be an eventual cash outflow to satisfy the obligations. Assume that a company has taken a loan of Rs1,00,000 on April 1 in an accounting year with 12% interest per annum due in annual installment on March 31. For a balance sheet prepared on December 31, interest will be accrued for nine months (April to December): Rs1,00,000 x .12 = Rs 12,000 annual interest Rs 12,000 x 9/12 = Rs9,000 accrued interest for nine months. The December 31 balance sheet would include an outstanding liability of Rs9,000. Outstanding also arise from salaries, rent, insurance, taxes and other expanses.

Deferred Income Taxes: Deferred taxes are the result of temporary differences in the revenue and expense for taxable income related to reported income. Most large companies use one set of rules for calculating income tax expense, and another set for figuring income reported in the financial statements. The objective is to take advantage of all available tax deferrals in order to reduce actual tax payments, while showing the highest possible amount of reported net income. There are many areas in which firms are permitted to use different procedures for tax and reporting purposes. One important area is depreciation where a firm using different depreciation figures may calculate separate net income for two purposes.

To illustrate the accounting for deferred taxes, assume that a company has a total annual revenue of Rs5,00,000; expenses other than depreciation are Rs2,50,000; depreciation expense is Rs1,00,000 for tax accounting and Rs50,000 for financial reporting (eventually this difference would reverse and the reported depreciation expense in later years would be greater than the tax depreciation expense). The income for tax and reporting purposes would be computed two ways, assuming a 40% tax rate: Revenue Expenses Earnings before tax Tax expenses Net income Tax (Rs) 5,00,000 3,50,000 ________ 1,50,000 60,000 ________ 90,000 Reporting (Rs) 5,00,000 3,00,000 ___________ 2,00,000 80,000 ___________ 1,20,000

Taxes actually paid (Rs60,000) are less than the tax expense (Rs80,000) reported in the financial statements. To reconcile the Rs20,000 difference between the expense recorded and the cash outflow, there is a deferred tax liability of Rs20,000: Reported tax expense Cash paid for taxes Deferred tax liability Rs80,000 60,000 _________ Rs20,000

Other Balance Sheet Items Corporate balance sheets are not limited to the accounts described above for Ashok Leyland Ltd. The reader of annual reports will encounter additional accounts and will also find many of the same accounts listed under a variety of different titles. Those discussed above, however, should be generally sufficient for understanding the basics of most balance sheet presentations in a set of published financial statements.

Exhibit 2: Profit and Loss Account of Ashok Leyland Ltd. For the Year Ended 31 March, 2000 31 March 2000 31 March 1999 INCOME Sales 25,987.18 20,450.71 Other income 127.00 353.80 __________ _________ 26,114.18 20,804.51 EXPENDITURE Manufacturing expenses 23,378.97 18,794.76 Employees expenses 2,286.04 2,083.88 Other expenses 2,026.43 1,647.65 Depreciation 824.43 761.91 Financial expenses 977.92 1,014.66

Profit before tax Provision for taxation Profit after tax Balance profit from last year Transfer from/ (to) Investment allowance reserve Debenture redemption reserve General reserve Proposed dividend Tax on proposed dividend Balance profit carried to balance sheet

___________ 25,181.32 932.86 148.00 _________ 784.86 210.83 18.70 790.42 (700.00) _________ 1,104.81 414.25 45.79 _________ 642.77

__________ 20,571.33 233.18 29.50 __________ 203.68 239.86 22.12 (372.82) 250.00 _________ 342.84 118.93 13.08 _________ 210.83

The Income Statement or Profit & Loss Account The Income Statement or Profit & Loss Account measures the net income or net profit which is one of the most important yardsticks to measure the profitability of a company. This net profit is calculated by deducting total expenses of the firm from its total income for a particular year. The incomes and expenses are measured on an accrual basis rather than a cash basis, which means that net income reported on the income statement, is not the same as cash generated during the accounting period.

The income statement comes in two basic formats and with considerable variation in the degree of detail presented. A single-step format groups all items of revenue together, and then deducts all categories of expense to arrive at a figure for net income. The multy-step version of the income statement provides several intermediate profit measures gross profit, operating profit, and earning before tax and earnings after tax. The income statement of Ashok Leyland is

presented in combination of both the formats. All items of revenues are grouped together and then all categories of expense other than tax are deducted to calculate the Profit before tax. Profit after tax is shown separately after making a provision for tax. Exhibit 2 illustrates the income statement of Ahok Leyland Ltd for the year ending March 31, 2000.

Certain special items, if they occur during an accounting period, must be disclosed separately on an income statement, regardless of format. These include discontinued operations, extraordinary transactions, and the cumulative effect of changes in accounting principles. Discontinued operations occur when a firm sells a major portion of its business. The results of continuing operations are shown separately from the operating results of the discontinued portion of the business. Any gain or loss on the disposal is also disclosed separately. Extraordinary gains and losses are items that meet two criteria: unusual in nature and not expected to recur in the foreseeable future, considering the firms operating environment. The cumulative effect of a change in accounting principles is disclosed when a firm changes an accounting policy, for example, from a reducing balance method of depreciation to the straight-line method.

Revenues Income statement starts with revenue ( sometimes shown as income). In the profit & loss account of Ashok Leyland, it is observed that the total income of the company is comprised of income from sales and other income. While some companies show their sales revenue for goods sold or services rendered at gross figures others deduct items such as sales returns and allowances, trade discounts and commissions to arrive at net sales figure. Ashok Leyland has given its net sales figure.

The other income amount comprises of a lot of different types of income. The criterion for considering an income as other income is that the income is not derived directly from the business operations. In Ashok Leylands case details of other income have been provided in its annual report as follows: OTHER INCOME 31.03.2000 Income from long term investment Dividend: Trade Others Interest: Trade Others Rent received Profit on sale of fixed assets Profit on sale of long term investment Profit on sale of current investment Lease rental Miscellaneous income 36.93 5.93 1.74 ---________ 44.60 0.50 11.46 --1.03 39.64 29.77 _______ 127.00 31.03.1999 46.16 10.95 2.31 0.01 _______ 59.43 0.26 12.45 144.00 --64.25 73.41 ________ 353.80 0.24

Tax deducted at source on income from long term investments 0.38

Expenses The income statement then deducts different expenses from the total revenue to calculate net profit before tax. Expenditure of Ashok Leyland includes five different items. These are Manufacturing expenses, Employee expenses, Other expenses, Depreciation and Financial expenses which are to be incurred to

Expenses. Manufacturing expenses are those direct

produce the goods or services to be rendered. These usually include consumption of Raw

materials, Work-in-progress, and finished goods; and other expenses which are directly related to production. Employee expenses include all payments to employees and the expenses incurred for the welfare of the employees. Other expenses in Ashok Leyland include all indirect operating expenses other than employees expenses and depreciation. These are usually rent, insurance, selling and distribution expenses etc. Depreciation is an important concept and is discussed separately. Financial expenses are basically the interest expenses of the company.

Depreciation and Amortization The cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the assets service life rather than expensed in the year of purchase. Land is an exception to the rule because land is considered to have an unlimited useful life. The cost allocation procedure is determined by the nature of long-lived asset. Depreciation is used to allocate the cost of tangible fixed assets such as buildings, machinery, equipment, furniture and fixtures, and motor vehicles. Amortization is the process applied to the cost expiration of intangible assets such as patents, copyrights, trademarks, licenses, franchises, and goodwill. The cost of acquiring and developing natural resources oil and gas, other minerals, and standing timber is allocated through depletion. The amount of expense recognized in any accounting period will depend on the level of investment in the relevant asset, estimates with regard to the assets life and redidual value, and the method of depreciation used. In case of Ashok Leyland, total depreciation is reported to be Rs.824.43 millions.

After charging

all the expenditures of Rs25,181.32 millions against its total income of

Rs26,114.18 million, Ashok Leyland has calculated its profit after tax of Rs 932.86 millions.

Provision for tax has been made for Rs 148.00 millions and profit after tax has arrived at Rs 784.86 millions.

While some business enterprises show the distribution of available profits by way of dividends and by way of profits retained as internal funds in the profit and loss account itself, others show it separately as a profit and loss appropriation account or retained earnings statement. Ashok Leyland has shown the distribution of available profit in its profit and loss account and finally reported its balance profit carried to balance sheet of Rs 642.77 millions which has increased to three times of balance profit from last year ending March 31, 1999.

THE FINANCIAL ACCOUNTING PROCESS: We explain now the accounting equation the framework for the entire accounting process. We have already seen in the balance sheet of Ashok Leyland Ltd. that the total assets are equal to its total liabilities and stockholders equity. This equality shows that the assets of a business are equal to its equities; that is Assets = Equities. Here equities are all claims to assets.

Assume that you purchase a new company for Rs 15,000 by investing Rs 10,000 from your own pocket and the balance of Rs 5,000 borrowing from a bank. The balance sheet will appear as Balance Sheet Stockholders equity Bank Loan 10,000 5,000 _______ 15,000 Total Assets 15,000 _________ 15,000

Thus the basic accounting equation becomes: Assets (A) = Liabilities (L) + Stockholders equity (E)

Transaction: An accounting transaction is a business activity or event that can be measured in monetary terms. Whenever a transaction takes place, it is recorded following the rules of debit and credit.

Effect of Transactions on the Accounting Equation: Every economic transaction affecting a business has a dual effect on the accounting equation. The following transactions illustrate how this dual effect maintains the balance of the accounting equation:

Mr. X has started business with cash of Rs.50,000 Assets +Rs50,000(cash) = Liabilities + Owners Equity + Rs 50,000(capital)

Mr. X buys an equipment for Rs.10,000 on credit Assets +Rs 50,000(cash) +Rs 10,000(equipment) = Liabilities + Owners Equity +Rs.50,000 (capital) +Rs.10,000 (creditor for equipment)

Mr. X buys furniture for Rs.5,000 Assets +Rs 50,000(cash) = Liabilities + Owners Equity +Rs.50,000(capital)

- Rs 5,000 (cash) _____________ +Rs45,000(cash) +Rs 10,000(equipment) +Rs5,000(furniture)

+Rs.10,000(creditor for equipment)

Mr. X purchases goods on credit Rs 10,000 Assets +Rs 45,000(cash) +Rs 10,000(equipment) +Rs5,000(furniture) +Rs10,000(inventory) = Liabilities + Owners Equity Rs50,000(capital)

+Rs.10,000(creditor for equipment) +Rs 10,000(creditor for goods)

Mr. X sells total goods on credit Rs 20,000 Assets +Rs 45,000(cash) +Rs 10,000(equipment) +Rs5,000(furniture) +Rs20,000(debtors) _______________ +Rs80,000 = Liabilities + Owners Equity Rs50,000(capital)

+Rs.10,000 (creditor for equipment) +Rs 10,000 Rs10,000(profit) (creditor for goods) __________________ = Rs20,000 + Rs60,000

Mr. X pays wages Rs5,000. Assets +Rs80,000 - Rs5,000(cash) ____________ +Rs75,000 = Liabilities = = Rs20,000 ___________ Rs20,000 + + + Owners Equity Rs60,000 -Rs5,000 _________ Rs 55,000

By studying this transaction, you can see that the expense decreased assets, because the assets cash was used to pay the wages. It is also recorded as a decrease to owners equity, because the asset that was used (cash) was entirely owned by the owner.

Mr. X receives commission of Rs2,000. Assets +Rs80,000 - Rs5,000(cash) +Rs2,000(cash) ____________ +Rs77,000 = Liabilities = Rs20,000 ___________ + Rs20,000 + + Owners Equity Rs60,000 -Rs5,000 +Rs2,000 _________ + Rs 57,000

By studying this transaction, you can see that the revenue was earned in the form of cash assets. The amount earned is recorded under assets because the asset cash has increased. It is also recorded as an increase to owners equity, because the owner has the complete ownership of these assets. Notice that the equality of the accounting equation is maintained.

To summarize the effects of revenue and expenses on the accounting equation, we can state the following accounting principles: 1. An increase in revenue generally increases the assets of a business and increases owners equity. 2. An increase in operating expenses generally decreases a companys assets and decrease owners equity.

We have examined the impact of a number of transactions on the balance sheet and seen that the relationship Assets (A) = Liabilities (L) + Stockholders equity (E) remains true in all circumstances.

To maintain the relationship A = L + E, each transaction must have two equal, but opposite effects, which is the fundamental to the system of double entry book-keeping. Every time there is a change in one balance sheet account, there must be an equal and opposite change in one or more other balance sheet accounts. Recording both changes will maintain the equality of assets and equities.