account 05mba14

8/8/2019 Account 05MBA14

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DEFINITION AND MEANING of ACCOUNTING

The American Institute of Certified Public Accountants (1941) defines Accounting is theart of recording, classifying and summarising in 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.

ACCOUNTING AS AN INFORMATION CYCLE

ACCOUNTANCY, ACCOUNTING AND BOOK-KEEPING

1

Input Process Output


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IMPORTANCE OF ACCOUNTING

1. Facilitates to replace memory and comply with legal requirements

2. Facilitates to ascertain net result of operations and also to know the financial position

3. Facilitates the users to take effective decisions

4. It is helpful in a comparative study

5. It assists the management

6. It facilitates to have control over assets

7. It facilitates the settlement of tax liability

8. It facilitates raising of loans

9. It acts as a legal evidence

10. It facilitates ascertainment of value of business.

SCOPE OF ACCOUNTING

1. Identifying

2. Measuring

3. Recording

4. Classifying

5. Summarising

6. Analysing

7. Interpreting

8. Communication

TYPES OF ACCOUNTING

Accounting

Financial Cost Management Social Responsibility

Accounting Accounting Accounting Accounting

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ACCOUNTING PRINCIPLES

Accounting principles are a body of doctrines commonly associated with the theory and

procedures and as a guide for selection of conventions or procedures where alternatives exist.

These principles are classified into two categories:

1. Accounting Concepts 2. Accounting Conventions

ACCOUNTING CONCEPTS

Concept means a general notion, a theory or belief held by person or group of persons.

The term concepts includes those basic assumptions or conditions upon which the science ofaccounting is based.

1. Business entity concept

2. Money measurement concept

3. Cost concept

4. Going concern concept

5. Dual aspect concept

6. Realisation concept

7. Accrual concept

ACCOUNTING CONVENTIONS

A convention means a custom or an established usage formed or adopted by anagreement. The term conventions includes those customs or traditions which guide theaccountant while preparing the accounting statements.

1. Convention of consistency2. Convention of full disclosure

3. Convention of conservatism

4. Convention of materiality

ACCOUNTING STANDARDS

The Accounting standards bring uniformity in the preparation and presentation offinancial statements and aids in comparison of different financial statements of companies in the

same or different industries.

Procedure for framing Accounting Standards

The International Accounting Standards are issued by the IASC

These Standards are received by ICAI assigned to ASB

The Accounting standards are issued under the authority of the council of ICAI.

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So far the ASB of ICAI has issued 28 Accounting standards as shown below

Accounting

StandardTitle

Mandatory for

Accounting period

beginning on or

afterAS-1 Disclosure of Accounting Policies 1.4.1991

AS-2(Revised) Valuation of inventories 1.4.1999

AS-3(Revised) Cash Flow Statements 1.4.2001

AS-4(Revised)Contingencies and Events occurring after Balance

Sheet Date1.4.1995

AS-5(Revised)Net Profit or Loss, prior period items and changes inAccounting policies

1.4.1996

AS-6(Revised) Depreciation Accounting 1.4.1995

AS-7(Revised) Accounting for construction contracts 1.4.2003

AS-8 Accounting for Research and Development 1.4.1991

AS-9 Revenue Recognition 1.4.1991

AS-10 Accounting of Fixed Assets 1.4.1991

AS-11(Revised)Accounting for the effect of changes in foreign

exchange rates1.4.1995

AS-12 Accounting for Government Grants 1.4.1994

AS-13 Accounting for Investments 1.4.1995

AS-14 Accounting for Amalgamations 1.4.1994

AS-15Accounting for retirement benefits in the financial

statements of employers1.4.1995

AS-16 Borrowing costs 1.4.2000

AS-17 Segment reporting 1.4.2001AS-18 Related Party Disclosures 1.4.2001

AS-19 Leases 1.4.2001

AS-20 Consolidated Financial Statements 1.4.2001

AS-21 Earnings per share 1.4.2001

AS-22 Accounting for taxes on income 1.4.2001

AS-23Accounting for investments in consolidated finance

statements1.4.2002

AS-24 Discounting operations 1.4.2004

AS-25 Interim financial reporting 1.4.2002

AS-26 Intangible assets 1.4.2003AS-27 Financial reporting of interest in joint ventures 1.4.2002

AS-28 Impairment of Assets 1.4.2004

AS-29Provisions, Contingent Liabilities and ContingentAssets

1-4-2004

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ACCOUNTING EQUATIONS

An accounting equation is a statement of equality between the resources and the sourcesthat finance the resources.

Resources = Sources of finances-------------- (1)

Resources means Assets & Sources of finances means Equity. If we substitute the above

synonyms, the equation will be as under:

Total Assets = Total Equities------------ (2)

Equities means borrowed funds, which may be funds borrowed from internal sources and those

that can be from external sources. These are also called internal equities and external equities. In

that case the above equation may also be written as under:Assets = Internal Equity + External Equity-----------(3)

It is a known fact that Internal Equity means Capital and External Equity means Liability. So the

above equation can be written as

Assets = Capital + Liabilities ---------------(4)OR

Assets Liabilities = Capital --------------(5)

OR

Assets Capital = Liabilities ------------(6)

Equations 4,5,6 are accounting equations

USERS OF FINANCIAL STATEMENTS

1. Creditors (short term & long term)

2. Investors (present & potential)

3. Management

4. Employees

5. Tax Authorities

6. Customers

7. Government and their agencies

8. Public

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2. Classification based on accounting equation

Asset Liabilities Capital Revenue Expenses

Accounts Accounts Accounts Accounts Accounts

Rules of debit and credit for classification based on accounting equation

PROCESS OF RECORDING BUSINESS TRANSACTIONS

Step 4 Preparation of final accounts

Type of Account Debit Credit

Asset Accounts Increase Decrease

Liabilities Accounts Decrease Increase

Capital Accounts Decrease Increase

Revenue Accounts Decrease Increase

Expenditure Accounts Increase Decrease

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Step 3 Preparation of Trial Balance

Step 2 Books of Final Entry

Step 1 Books of Original Entry

ACCOUNTING CYCLE

Step 1 Journalising (the transactions)

Step 2 Posting (to the ledger)

Step 3 Balancing (the accounts in the ledger)

Step 4 Trial Balance

Step 5 Income Statement

Final Accounts

Step 6 Position Statement

Figure showing various steps in the accounting cycle

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RECORDS MAINTAINED BY AN ORGANISATION

The books of accounts maintained by an organisation may be classified into two as

a. Books of Prime / Original Entry

b. Books of Second entry / Final entry

Books of Prime / Original Entry

1. Journal

2. Cash Book

3. Subsidiary Books

JOURNAL / DAY BOOK

Format of a Journal

Date Particulars LedgerFolio DebitRs. CreditRs.

.

To.

(Being)

LEDGER

Also called as General Ledger, this is a principal book that contains all the accounts i.e.,

accounts of Assets liabilities, capital, revenue and expenses. The entries from the books of

original entry are transferred to this book. Hence it is also called as a book of final entry. There

are a number of accounts in a general ledger. All similar transactions are grouped under oneaccount.

Dr Cr

Date Particulars FolioAmount

Rs.Date Particulars Folio

Amount

Rs.

To Balance b/d(Opening balance) --------

By Balance c/d

(Closing balance)

--------

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The opening and closing balances will appear only in case of assets, liabilities and capital

accounts but not in case of incomes and expenditures.

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CASH BOOK

Debit: All Cash receipts and Bank receipts and Discount Allowed

Credit: All Cash payments and Bank payments and Discount Received.

The cashbook is classified into 4 types viz.,1. Single column cash book

2. Two columnar cash book

3. Three columnar cash book4. Petty cash book

Format of a single column cash book

Dr Cr

Date Particulars L.F.Amount

Rs.Date Particulars L.F.

Amount

Rs.

To Balance b/d

(Opening balance) --------

By Balance c/d

(Closing balance)

--------

Format of a double column cash book

Dr CrDt Particulars L.F

Discount

Rs.

Cash

Rs.Dt Particulars L.F

Discount

Rs.

Cash

Rs.

To

Balance

b/d(Opening

balance)

-------

ByBalance

c/d

(Closingbalance)

-------

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Format of a double column cash book

OR

Dr Cr

OR

Dr Cr

Format of a Three Columnar Cash Book

Dr Cr

Dt Particulars L.FDiscount

Rs.

Bank


Discount

Rs.

Bank

Rs.

ToBalanceb/d

(Opening

balance)

-------

ByBalancec/d

(Closing

balance)

-------

Dt Particulars L.FCash

Rs.

Bank


Cash

Rs.

Bank

Rs.

To Balance

b/d

(Openingbalance)

-------

-

-------

-

ByBalance

c/d

(Closingbalance)

-------

-

--------

Dt Particulars L.FDiscount

Rs.

Cash

Rs.

Bank


Discount

Rs.

Cash

Rs.

Bank

Rs.

To

Balanceb/d

(Openingbalance)

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

-

By Balancec/d

(Closing

balance)

-------

-

-------

-

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Petty Cash Book

It is a cash book in which all the petty cash expenses incurred daily by an organisation isrecorded.

Dr Cr Date Particulars CBF

Total

Rs.Dt. Particulars

Vr.

No.Postage Conveyance Wages

Business

PromotionTotal

PURCHASES BOOK

This is a subsidiary book in which all the credit purchases made by the organisation is

recorded. The monthly total from the purchase book is transferred to the General Ledger to thePurchases Account.

Date

Purchase

Invoice

No.

Name of the supplier LF

Details Total Amount

Rs. Ps. Rs. Ps.

PURCHASE RETURNS BOOKA book in which all the purchase returns (returns outwards) are recorded.

Date

Debit

NoteNo. Name of the supplier LF


Rs. Ps. Rs. Ps.

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SALES BOOK

The credit sales are recorded in this book. The monthly totals are transferred to the salesaccount in the General Ledger.

Date

Sales

Invoice

No.

Name of the purchaser LF


Rs. Ps. Rs. Ps.

SALES RETURNS BOOK

A book of account in which all the sales returns (returns outwards) made by the

organisation are recorded.

Date

Credit

Note

No.

Name of the purchaser LF


Rs. Ps. Rs. Ps.

JOURNAL PROPER

Those journal entries that cannot be recorded in any of the subsidiary books are recordedin the journal proper. The following are recorded in the journal proper:

a. Opening Entries

b. Closing Entries

c. Transfer Entries

d. Adjustment Entries

e. Rectification Entries

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TRIAL BALANCEIt is a statement that shows the balance in all the accounts in a ledger. It contains all the

debit and credit balances. A trial balance is a list of debit and credit balances of all the ledgeraccounts prepared on any particular date to verify whether the entries in the books of accounts

are arithmetically correct or not.

S.No. Head of Account LFDebit Balance Credit Balance

Rs. Ps. Rs. Ps.

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ELEMENTS OF FINANCIAL STATEMENTS

1. Asset: An Asset is a resource controlled by an enterprise and from which futureeconomic benefits are expected t flow to the enterprise.

2. Liability: A liability is a present obligation of an enterprise arising from past events,the settlement of which is expected to result in an outflow from the enterprise of

resources embodying economic benefits.

3. Equity: Equity is the residual interest in the assets of the enterprise after deducting its

liabilities. It is also termed as capital.

4. Income: Income is the increase in the economic benefits during the accounting periodin the form of inflows or enhancement of assets or decrease in liabilities that result in

the increase of equity other than those relating to the contribution from equity

participants.

5. Expenses: Expenses are decreases in the economic benefits during the accounting

period in the form of outflows of depletion of assets or increase of liabilities thatresults in the decrease of equity other than relating to the distribution to equity

participants.

FINANCIAL STATEMENTS

Manufacturing Account: This is a statement of account prepared by an enterprise engaged in

manufacturing activity to find out the cost of goods sold.

Trading and Profit and Loss Account: This is statement of account prepared to ascertain the

profits (gross, net and operating profits) earned by an organisation during an accounting

period.

Balance Sheet: This is a statement not an account which shows as on a particular date, the

financial position of an enterprise in terms of the assets in its possession and the liabilities

owed by it.

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MANUFACTURING ACCOUNTManufacturing Account is prepared by an enterprise engaged in manufacturing activities.

It is prepared to ascertain the cost of goods manufactured during an accounting period. Thisaccount is closed by transferring its balance to the Trading Account.

Manufacturing Account of M/s .for the period ending on ..

Dr Cr

ParticularsAmount

Rs.Particulars

Amount

Rs.

To Opening Work in progress

Raw material consumed:Opening Stock xxxx

Add: Purchases xxxx

Cartage inwards xxxx Freight inwards xxxx

Less: Closing Stock xxxx

To Wages

Salary to works manager

Power, electricity & water Fuel

Postage & Telephone

Depreciation on:Plant & Machinery

Factory Land & Building

Repairs to :

Plant & MachineryFactory Land & Building

Insurance on :

Plant & MachineryFactory Land & Building

Rent and Taxes

General Expenses Royalty paid

xxxxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxx

xxxxx

By Sale of scrap

Closing Work in Progress Transfer to trading account

( Cost of goods produced)

xxxx

xxxxxxx

xxxxx

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TRADING ACCOUNT

Trading Account is one of the financial statements, which shows the result of buying andselling of goods and or services during an accounting period. The purpose of drawing a trading

account is to know the gross profit or loss during the accounting period.

Trading Account of M/s .for the period ending on ..

Dr Cr

ParticularsAmount

Rs.Particulars

Amount

Rs.

To Opening Stock

Purchases xxxxx

Less: Returns xx

Royalty

Direct Expenses Rent and Rates

Wages and Salaries

Lighting

Freight inwardCustoms and Octroi duty

Carriage inwards

Cartage inwards Fuel and Power

Gross Profit transferred to

Profit and loss account

xxxxx

xxxx

xxx

xxxxxx

xxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxxxx

By Sales xxxxx

Less: Returns xx

Closing Stock

Abnormal loss of stock

Gross loss transferred to profitand Loss Account

xxxxxxxx

xxx

xxxx

xxxxx

NOTE:

A. Closing Stock:

a If it is shown outside a trial

balance in the adjustment,

i. Credit the trading accountii. Show as an asset in the balance sheet

b If shown in the trial balance, show only in the balance sheet on the assets

side

B. Royalty:

a. If it depends on the output it is a manufacturing expense and hence debited

in the trading account.

b. If it depends on the sales, debit the profit and loss account.

C. Adjusted purchases

Adjusted Purchases = Net purchases + Opening Stock Closing Stock

D. Cost of Goods sold

Cost of goods sold = Opening Stock + Purchases + Direct Expenses Closing Stock

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PROFIT AND LOSS ACCOUNTIt is prepared to ascertain the Net Profit or Net Loss incurred by a business entity during

an accounting period.

Net Profit: Excess of all revenues over expensesNet Loss: Excess of all expenses over revenues

Operating Profit: Excess of operating revenues over operating expenses.

All the indirect revenue expenses and loss (i.e., other than those shown in the credit side

of the trading account) are debited in the profit and loss account and all the indirect incomes (i.e.,

other than those that are shown on the credit side of the trading account) are credit side of the

trading account.

Dr Profit and Loss Account of M/s .for the period ending on .. Cr

ParticularsAmount

Rs.

ParticularsAmount

Rs.To Gross Loss b/d

Salaries and Wages

Rent, Rates and Taxes

Fire Insurance Premium Repairs and Maintenance

Depreciation

Audit Fess Bank charges

Legal charges

Miscellaneous Expenses

Discount Allowed Carriage Allowed

Freight Outward Commission to salesman

Travelling Expenses

Entertainment Expenses

Sales Promotion Expenses Advertisement and Publicity

Bad Debts

Packing Expenses Interest on loan

Loss by theft

Loss by fire Loss by embezzlement

Net profit transferred tocapital account

xxxxx

xxxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxx

xxxxxx

xxxxxx

xxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxxxx

By Gross Profit b/d

Interest Earned

Commission Earned

Rent Earned Profit on sale of fixed assets

Income from investments

Sale of scrap Miscellaneous Income

Net loss transferred to capital

Account

xxxx

xxx

xxx

xxxxxx

xxx

xxxxxx

xxx

xxxxx

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BALANCE SHEET

A balance sheet is a financial statement that shows the balance of assets and liabilities as

on a particular date: It is only a statement and not an account

It is prepared as on a particular date but not for a

particular period

It is a summary of balances in accounts which not have

been closed

It shows the nature and amount of assets and liabilities

The format of a balance sheet (Horizontal Form) is as follows:

Balance Sheet of M/s .as on .

LiabilitiesAmount

Rs.Assets

Amount

Rs.Capital:

Opening Balance xxx

Add: Net Profit xxx(Less: Net Loss xxx)

xxxx

Less: Drawings xx

Closing Balance

Long Liabilities

Current LiabilitiesIncome received in advance

Sundry CreditorsOutstanding Expenses

Bills Payable

Bank Over Draft

xxx

xxx

xxx

xxxxxx

xxx

xxx

xxxxx

Fixed Assets

Goodwill

Land and BuildingsPlant and Machinery

Furniture and Fixtures

Investment

Current Assets

Closing StockAccrued Income

Prepaid ExpensesSundry Debtors

Bills Receivable

Cash at BankCash in Hand

xxx

xxxxxx

xxx

xxx

xxxxxx

xxxxxx

xxx

xxxxxx

xxxx

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VERTICALFORMOF PROFITAND LOSS ACCOUNT

Profit and Loss Account of M/s ..for the period ending on .

Particulars Rs. Rs. Rs.

A. Net Sales

Sales (gross)Less: Returns

B. Cost of Goods Sold

Opening StockAdd: Purchases

Less: Returns

Add: Direct Expenses

Carriage / cartage / freight / wages /Insurance

Cost of goods available for sales

Less: Closing Stock

C. GROSS PROFIT

D. Operating Expenses

a) Selling Expenses

Carriage outwards / sales promotions

Expenses / discount allowed / travelling

Expenses / commission allowed /Entertainment expenses

b) Office & Administrative Expenses

Sales expenses / Rent, Rates & taxes /

Repairs / insurance / printing & stationery /Water & electricity / Postage & telegrams /

staff welfare expenses /conveyance expenses/

miscellaneous expenses / depreciation

E. NET OPERATING PROFIT / LOSS C-D

F. Net Operating Resulta) Interest earned / commission earned /

discount earned / miscellaneous incomes

b) Non-Operating expenses and lossesex: interest allowed

Loss on sale of fixed assets

G. NET PROFIT

xxxxxxxx

xxxx

xxxx

xxxx

xx

xxxx

xxxxxxxx

xxxx

xxxxxxxx

xxxx

xxxxxxxx

xxxx

xxxx

xxxx

xxxx

Xxxxxxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

xxxx

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VERTICALFORMOF BALANCE SHEET

Balance Sheet of M/s .. as on ..

Particulars Rs. Rs. Rs.A. SOURCES OF FUNDS

a) Proprietors funds

b) Long term debts

B. APPLICATION OF FUNDS

a) NET WORKING CAPITALi) Current Assets

Cash in handCash at BankBills Receivable

Accrued Income

DebtorsStock

Prepaid Expenses

ii) Less: Current LiabilitiesBank Over Draft

Accrued Expenses

Bills PayableTrade Creditors

Income received in advance

b) INVESTMENTS

C) FIXED ASSETSFurniture & Fixtures

Patents and Trade Marks

Plant and MachineryBuilding

Goodwill

XxxxXxxxXxxx

Xxxx

XxxxXxxx

XxxxXxxx

Xxxx

Xxxx

Xxxx

Xxxx

XxxxXxxx

Xxxx

Xxxx

Xxxx

Xxxxx

Xxxxx

Xxxxx

Xxxx

Xxxx

Xxxx

Xxxx

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Schedule of Proprietors funds

Particulars Rs. Rs,

A. Capital in the beginning

B. Add: Additional capital introduced

Interest on CapitalSalary to partner

Profit for the current accounting period

C. Less: Drawings

Interest on Drawings

Loss for current accounting period

Capital at the end of the Accounting Period (A+B-C)

Xxxx

XxxxXxxx

Xxxx

Xxxx

Xxxx

Xxxx

Xxxxx

Xxxx

Xxxx

Xxxx

Xxxx

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Balance Sheet of a Joint Stock Company

VERTICAL FORM

Name of the Company ..........................

Balance Sheet as at ..........................

ScheduleNo.

Figuresas at the

end of

currentfinancial

year

Figures as at the endof previous financial

year

I. SOURCES OF FUNDS:

(1

)

Shareholder's funds

(a) Capital xxxx Xxxx

(b) Reserves and Surplus Xxxx Xxxx

(2

)

Loan funds

(a) Secured loans xxxx Xxxx(b) Unsecured loans Xxxx xxxx

TOTAL : Xxxx XxxxII. APPLICATIONS OF FUNDS:

(1

)

Fixed assets

(a) Gross block Xxxx Xxxx(b) Less depreciation Xxxx xxxx(c) Net block xxxx Xxxx

(d) Capital work-in-progress Xxxx xxxx

(2

)

Investments xxxx Xxxx

(3

)

Current assets, loans, and advances :

(a) Inventories Xxxx Xxxx

(b) Sundry debtors Xxxx Xxxx

(c) Cash and bank balances xxxx xxxx

(d) Other current assets Xxxx Xxxx(e) Loans and advances xxxx xxxx

Less :

Current liabilities and provisions : (a) Liabilities Xxxx Xxxx

(b) Provisions Xxxx Xxxx

Net current assets xxxx xxxx(4

)

(a) Miscellaneous expenditure to the extent

not written off or adjusted

Xxxx Xxxx

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(b) Profit and Loss account xxxx xxxx

TOTAL : Xxxx Xxxx

Notes -

1. Details under each of the above items shall be given in separate Schedules. The Schedulesshall incorporate all the information required to be given under A - Horizontal Form read withnotes containing general instructions for preparation of balance sheet.

2. The Schedules, referred to above, accounting policies and explanatory notes that may be

attached shall form an integral part of the balance-sheet.3. The figures in the balance-sheet may be rounded off to the nearest '000' or '00' as may be

convenient or may be expressed in terms of decimals of thousands.

4. A foot-note to the balance sheet may be added to show separately contingent liabilities.

Profit and Loss Account of a Joint Stock Company

VERTICAL FORM

Name of the Company ..........................

Income Statement for the year ending ..........................

Rs. Rs.Sales Xxxx

Less Sales returns xxxxSales Tax/Excise Duty Xxxx Xxxx

Net Sales (1) XxxxxCost of goods sold: xxxx

Materials consumed xxxx

Direct labour xxxx

Manufacturing Expenses xxxx Xxxx

Add/Less: Adjustment for change in stock xxxxCost of goods sold (2) XxxxxGROSS PROFIT (1) - (2) Xxxxx

Less: Operating Expenses xxxxOffice and Administrative Expenses xxxx

Selling and Distribution Expenses xxxx xxxx

OPERATING PROFIT XxxxxAdd: Non-Operating Income Xxxx

Xxxxx

Less: Non-Operating Expenses (including interest) Xxxxx

Profit before interest and tax XxxxxLess: Interest Xxx

Profit before tax Xxxxx

Less: Tax xxx Profit After Tax Xxxxx

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Appropriations

Transfer to reserves xxx

Dividends declared/paid xxxSurplus carried to Balance Sheet xxx xxx

Xxxxx

DEPRECIATION CONCEPTS & METHODS

Meaning of Depreciation

Causes of Depreciation

Basic Features of Depreciation

Depletion, Amortisation, Dilapidation

Objectives of Providing Depreciation

Factors to Be Considered to Arrive at Depreciation

METHODS FOR PROVIDING DEPRECIATION

1. Uniform charge methods

a Fixed instalment methodb Depletion method

c Machine Hour Rate Method

2. Decline charge or accelerated depreciation method

a Diminishing balance method

b Sum of the year digits methodc Double declining method

3. Other methods

a Group Depreciation method

b Inventory system of depreciation

c Annuity method

d Depreciation fund methode Insurance policy method

1. FIXED INSTALMENT METHOD

In this method, the amount of depreciation charged to the asset is fixed for every year.

This method is also called as Straight Line method.

Depreciation = Original cost of the fixed asset Estimated Scrap Value

Life of the asset in number of accounting periods

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D = C-S

N

Rate of Depreciation R = D X 100C

2. DEPLETION METHODThe charge of depreciation depends on 3 factors viz.,

a Total amount paid

b Total estimated quantities of outputc The actual quantity taken out during the accounting year.

This is suitable for quarries, mines, oil wells where it is possible to make an estimate of

the output available. The depreciation is charged as a percent of out put and the

depreciation per year is found by multiplying the output by the rate of depreciation perunit.

3. MACHINE HOUR RATE METHODAlso known as Service Hours Method, this method takes into account the running time of

an asset for calculation of depreciation. This is useful for charging depreciation onmachines, aircrafts etc,.

4. DIMINISHING BALANCE METHOD

According to this method, depreciation is charged on the book value of the asset each

year. Thus the amount of depreciation goes on decreasing every year.

The formula for calculating the rate of depreciation under diminishing balance

method (where n = years of economic life of the asset) is as follows:

Depreciation rate = 1 - n Net residual valueAcquisition cost

5. SUM OF YEARS DIGITS METHOD

The depreciation is calculated according to the following formula:

Remaining Life of the Asset ( including the current year) X Original CostSum of all the digits of the life of the asset in years

DOUBLE DECLINING BALANCE METHOD

This method is similar to reducing to declining balance method except that the rate of

depreciation is charged at the rate which is twice the straight line rate.

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GROUP DEPRECIATION METHOD

Under this method, all homogenous assets, generally having similar average life expectancy

are grouped together in a single asset category. One summary account is established for eachgroup and original cost of all assets in the group is charged to this account. Depreciation is

charged for the group in total and not item-by-item.

6. INVENTORY SYSTEM OF DEPRECIATION

This method is followed in case of those assets which are of small values such as loose

tools or where the life of the asset cannot be ascertained with certainty ex: live stock etc. In case

of these assets, the depreciation is charged on the following basis:

Cost of the assets in working condition at the beginning of the accounting year xxxxx

Add: Cost of the assets purchased during the accounting year xxxxx

xxxxx

Less cost of the assets in working condition at the end of the accounting year xxxxxDepreciation to be charged xxxxx

7. ANNUITY METHOD

the depreciation is charged on the basis that besides

losing the original cost of the asset, the business also loses interest on the amount used forbuying the asset.

amount charged by way of depreciation takes into

account not only the cost of the asset but also interest there on at an accepted rate.

The amount of interest is calculated on the book valueof the asset in the beginning of each year.

The amount of depreciation is uniform and is

determined on the basis of the annuity table.

8. DEPRECIATION (OR SINKING) FUND METHOD

the amount charged by way of depreciation is invested

in certain securities carrying a particular rate of interest.

The amount received on account of interest from these

securities is also reinvested

At the end of the useful life of the asset, the securities

are sold away and money realised on account of the sale of the securities is used for thepurchase of new asset.

This method has the advantage of providing separatesum for replacement of the asset.

9. INSURANCE POLICY METHOD

o The method is similar to the Depreciation Fund Method but with a slight change.

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o Under this method instead of investing in securities, an insurance policy for the

required amount is taken.

o A fixed premium is paid every year. However, this amount will have to be paid at

the beginning of each year.

o At the end of the specified period, the insurance company pays the agreed amount

with which the new asset can be purchased.

INVENTORIESInventories Defined

According to Accounting Standard 2 on Valuation of Inventories, issued by the Institute

of Chartered Accountants of India, Para 1, Inventories are tangible property held (i) for sale in the ordinary

course of business, or (ii) in the process of production for such sale,or (iii) for consumption in the production of goods or services for sale.

Components of Inventory

For a manufacturing firm, raw materials, semi-finished goods and finishedgoods.

For merchandising firm, only the finished goods

INVENTORY VALUATION METHODS

The following are the methods of inventory valuation. There are mainly four commonlyused methods in the valuation of inventory. Accountants generally accept all these four methods,

but each of these is based on a different cost flow assumption.

To illustrate the four methods, the following data will be assumed for an accountingperiod:

Units Unit Cost ( Rs.) Total Cost (Rs.)Jan. 1 Beginning Inventory 100 2 200

Mar. 27 Purchase 100 3 300

June 12 Purchase 100 4 400

Sept. 19 Purchase 100 5 500Nov. 30 Purchase 100 6 600

Available for sale 500 2,000

Sold 350

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Dec. 31 Ending Inventory 150

Specific Identification MethodThis method assigns specific costs to each unit sold and each unit on hand. This method

may be used if the units the ending inventory can be identified as coming from specific

purchases. The specific identification method is particularly suited to inventories of high-value,low-volume items such as jewellery. Each unit in inventory must be identified with an

identification tag.

To illustrate, assume that December 31 inventory consisted of 60 units from March 27purchase, 70 units from the June 12 purchase, and 20 units from the September 19 purchase. The

cost of ending inventory is then computed as follows:

60 units from the purchase of March 27 at Rs.3 Rs.18070 units from the purchase of June 12 at Rs.4 280

20 units from the purchase of September 19 at Rs.5 100

________Ending Inventory 560

________

The cost of goods sold is computed by subtracting the ending inventory from the cost of goods

available for sale, as shown below:

Cost of goods available for sale Rs.2,000Less Ending inventory 560

________

Cost of goods sold 1,440

________

First-in, First-out (FIFO) MethodThis method assumes that the first units acquired are the first units sold. Therefore the

cost of the units in the ending inventory is that of the most recent purchases. Although the FIFO

method is a cost flow assumption, physical flow often follows the first-in first-out rule.

In the previous illustration the cost of the 150 units in the ending inventory would beRs.850, computed as follows:

50 units from the purchase of September 19 at Rs.5 Rs.250

100 units from the purchase of November 30 at Rs.6 600Ending Inventory 850

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Under FIFO method, the cost of goods sold is Rs.1,150 which is computed as follows:

Cost of goods available for sale Rs.2,000Less Ending Inventory 850


Last-in, First-out (FIFO) MethodThe last in first out method assumes that the last units acquired are the first units sold.

Therefore the cost of the units in the ending inventory is that of the earliest purchases.

Under the LIFO method, the cost of 150 units in the ending inventory would be Rs.350,

computed as follows:100 units from the purchase of January at Rs.2 Rs.200

50 units from the purchase of March 27 at Rs.3 150

Ending inventory 350

The cost of goods sold is Rs.1,650, computed as follows:

Cost of goods available for sale Rs.2,000Less Ending Inventory 350


2. Weighted-Average Cost MethodThis method assumes that the goods available for sale are homogenous. Average cost is

computed by dividing the cost of goods available for sale, which comprise the cost of the

beginning inventory and all the purchases, by the number of units available for sale. Theweighted-average unit cost that results from this computation is applied to the units in the

ending inventory.

In the previous illustration, the unit cost under this method would be Rs.4, computed as

under:

Cost of goods available for sale Rs.2,000

Number of units available for sale 500

Weighted-average unit cost Rs. 4Ending Inventory: 150 units @ Rs.4/- Rs. 600

The cost of goods sold is Rs.1,400, computed as follows:

Cost of goods available for sale Rs.2,000Less Ending Inventory 600Cost of goods sold 1,400

3. Base Stock Method

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The base stock method proceeds on the assumption that a minimum quantity of inventory

(base stock) must be held at al times in order to carry on the business. Inventories up to

this quantity are stated at the cost at which the base stock was acquired. Inventories Iexcess of the base stock are dealt with other methods discussed above.

6. Standard Cost MethodUnder this method, a standard cost is set for each item of material and this cost is used asa basis for pricing the material issues.

NATURE AND INCIDENCE OF WINDOW DRESSING

Window Dressing

It is the act or instance of making something appear deceptively attractive or favourable;

something used to create a deceptively attractive or favourable impression. The act or practice ofgiving something superficial appeal by skilful presentation.

Nature of Window Dressing

1. Inflate the sales from the current year by advancing the sales from the following year.

2. Alter the other income figure by playing with non-operational figures like sale of fixed

assets.

3. Fiddle with the method and rate of depreciation. (A switch may be effected from the

written down value method to the straight line method or vice versa.)

4. Change the method of stock valuation from, say, direct costing to absorption, to minimize

the cost of goods sold.

5. Capitalise certain expenses like research and development costs and product promotion

cost, that are ordinarily written off in the profit and loss account.

6. Defer certain discretionary expenditures (like repairs, advertising, research and

development) to the following year.

7. Make inadequate provision for certain known liabilities (gratuity etc.,) and treat certain

liabilities as contingent liabilities

8. Make extra provisions during prosperous years and written them back in lean years.

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EPS (Earnings Per Share)The ultimate profitability of the common shareholders (also called as ordinary or equityshare holders) investments can be measured by calculating the earnings per share. The earnings

per share is calculated by dividing the profit after taxes by the total number of common sharesoutstanding.

EPS = Profit After Tax

Number of common shares outstanding

DPS (Dividend Per Share)

It was indicated earlier, that the EPS does not say anything about the dividend declaredper share. To know this, the DPS is calculated. DPS is the earnings distributed to the ordinary

share holders divided by the number of ordinary shares outstanding.

DPS = Earnings paid to shareholders (dividends)Number of common shares outstanding

PAYOUT RATIOThe dividend-payout ratio (or simply payout ratio) is DPS (or total dividends) divided bythe EPS (or profit after tax).

DPS = Dividends per share

Earnings per shareThis figure helps to know the extent to which dividend has been declared to the

shareholders out of the total earnings of the firm.

1-Dividend Payout Ratio = Retention Ratio

P/E RatioThe PriceEarnings Ratio is arrived at by dividing the Market Value per share by the

Earnings Per Share. It is shown as underPrice Earnings Ratio = Market Value per share

Earnings per share

NET WORTH

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The term Net worth is used for the sum of share capital and reserves and surplus i.e., the

owners equity. This term is misleading. It connotes the erroneous meaning that the owners

equity is worth something. The term in fact implies market or real value while the ownersequity in the Balance Sheet is the recorded book value.

ROCE (Return on Capital Employed)The funds employed in net assets are known as capital employed. Net assets equal thenet fixed assets plus current assets minus current liabilities excluding bank loans.

ROCE = Earnings Before Interest and Taxes (EBIT)Net Assets (NA)

RONW (Return on Net Worth)

This ratio is calculated by dividing the profits after taxes by the share holders equity.

RONW = Profit After Taxes (EBIT)

Net worth

Note:i. Net worth or the shareholders equity will include paid-up share capital, share premium

and reserves and surplus less accumulated losses.ii. Net worth can also be found by subtracting total liabilities from total assets.

BOOK VALUE

The book value of an asset or liability is the stated value on the balance sheet, recorded

according to the generally accepted accounting principles. While the book value is handledconsistently for accounting purposes, it usually has little relationship to the current economic

value. It is a historical value, which, at one time, may have represented economic value to the

company, but the passage of time and changes in economic conditions increasingly distort it.

The value of an asset, a liability or equity, as recorded in the accounts of a firm. The

book value of an ordinary share is equal to the paid-up capital plus retained earnings, that is networth.

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WHATISACOMPANY?

The word company is derived from the Latin word com i.e. with or together andpanis i.e.

bread.

It denotes a group of persons and the effect of registration under the companies Act isthat such group becomes a corporate body having perpetual succession and common seal.

The term company is defined in Section 2(10). The definition only says that a companymeans a company as defined in Section 3 of the Companies Act. Section 3 further

explains the meaning of expression company, existing company, private company

and public company.

Apart from these categories the different kinds of company are holding company,

subsidiary company, foreign company and companies, which are limited guarantee and

lastly unlimited company.

Maintenance of Books of Accounts

Section 209 of the Companies Act states that the books of accounts shall be maintained atthe companys registered office unless the Board of Directors decide to keep them at another

place in India. It is a duty of the company to inform the Registrar of Companies within seven

days of the decision in case of the board of Directors decides to maintain books at the placeother than the registered office.

Every company is required to keep proper books of accounts showing

i. All monies received and spent and the

details thereof

ii. Sales and purchases of goods, and

iii. Assets and liabilities

A company engaged in production, processing, manufacturing or miningactivities has also to maintain, if required by the Central Government, cost accounting

records i.e., particulars relating to utilisation of material, labour and other items of cost.

Proper books of accounts shall not be deemed to be kept if there are notkept such books as are necessary to give a true and fair view of the state of affairs of the

company or branch office, as the case may be, and to explain its transaction.

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Also if such books are not kept on accrual basis and according to thesystem of double entry book keeping, proper books of accounts shall not be deemed to have

been kept.

Statutory Books

The following statutory books are required to be maintained by a company under the

different sections of the Companies Act:

1. Register of Investments of the company not

held in its own name2. Register of mortgages and charges

3. Register of members and index

4. Register of Debenture holders and index5. Foreign register of members and of

debentures-holders and their duplicates6. Minutes Books7. Register of contracts, companies and firms

in which directors are interested

8. Register of directors, managing director,

manager and secretary9. Register of directors share-holding

10. Register of loans made, guarantees given or

securities provided to companies under the same management11. Register of investments in share and

debentures of other companies

Registers and documents relating to the issue of shares are also maintained viz.,

i. Share application and allotment book

ii. Share call bookiii. Certificate book

In respect of shares, the company in addition to maintaining register of members, which it

has to maintain statutorily, it also maintains (a) share transfer book and (b) dividend register

Annual Return

Under Section 149 of the Companies Act, every company having a share capital, shall

within sixty days from the day of which each of the annual general meeting is held, prepare andfile with the Registrar the annual return containing the particulars specified like the income,

details of income, details of the board of directors.

Final Accounts

Under section 210 of the Companies Act, at the annual general meeting of a company,

the Board of Directors of the company shall lay before the company:a A balance sheet as at the end of the period

b A profit and loss account for that period

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In case of a company not carrying on business for profit, an income and expenditure account

shall be laid before the company at its annual general meeting instead of profit and loss account.

Every balance sheet of the company shall give a true and fair view of the state of affairs of

the company and at the end of the financial year an shall subject to the provisions of the Sectionbe in the form of the Part I of Schedule VI i.e., horizontal or vertical form, as near thereto as the

circumstances admit.

Every Profit and Loss Account of a company shall comply with the requirements of Part

II of the Schedule VI of the Companies Act again either in horizontal or vertical form.

The balance sheet can be prepared either in Horizontal Form or Vertical Form.However there is no specified form of Profit and Loss Account. Schedule VI Part II gives only

the requirements as to the Profit and Loss Account. Part III of Schedule VI gives interpretation.

The Companies Act of 1956 also required to attach a Cash flow statement in the AnnualReport of the companies.

An annual report of a company is report containing the Directors Report and theAuditors report about the working of the company.

It also contains the Profit and Loss Account and Balance Sheet with all the necessary

schedules and sub-schedules.

Audit of a company

Audit means a systematic verification of the books of a company to give a true and fairview about its working and also about the financial results of the company.

In India only a Chartered Accountant who has passed the professional examinationconducted by the Institute of Chartered Accountant can conduct the audit and certify under his

hand about his opinion on the maintenance of the books of accounts.

Directors report

This is essentially an account of a companys performance in the previous year and its

prospects as seen by its board of directors. The objective is to give the reader a sense of the state of the business. It touches upon both

quantitative and qualitative issues.

Typically, it starts with a summary of the companys performance in the previous year, and

the dividends and bonuses declared.

Then, it launches into a discussion of which parts of the business did well and which didnt,

what were the conditions in the industry, the enabling factors and the limitations, and the

outlook for the business.

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Provisions of Companies Act of 1956 Regarding Financial Statements

Sec 209 - Books of account to be kept by company.

Sec 209A - Inspection of books of account, etc., of companies.

Sec 210 - Annual accounts and balance sheet.

Sec 211 - Form and contents of balance sheet and profit and loss account.

Sec 215 - Authentication of balance sheet and profit and loss account.

Sec 219 - Right of members to copies of Balance Sheet and Auditors' Report.

Sec 220 - Three copies of Balance Sheet, etc., to be filed with Registrar.

Provisions of Companies Act of 1956 Regarding the Auditors

Sec 224 - Appointment and remuneration of Auditors.

Sec 226 - Qualifications and disqualifications of Auditors.

Sec 227 - Powers and duties of auditors.

Sec 229 - Signature of audit report, etc.

Sec 230 - Reading and inspection of auditor's report.

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INTRODUCTION TO FINANCIAL ANALYSIS

Analysis means methodical classification of the data given in the financial statements.

Interpretation means explaining the meaning and significance of the data so simplified.

Financial Analysis is the process of identifying the financial strengths and weakness of

the firm by properly establishing relationships between the items of the balance sheet and

the profit and loss account.

Different tools of financial AnalysisThe various tools used for the analysis of the financial statements of a firm are:

1. Comparative Financial Statements

2. Common size Financial Statements

3. Trend Analysis

4. Ratio Analysis.

ILLUSTRATION

The following illustration will be used for explaining the various tools of financial analysis:

Illustration: From the following profit and loss Account and Balance sheets of Swadeshi

Polytex Ltd. For the year ended 31st December 1987 and 1988, you are required to prepare aComparative Income Statement and a Comparative Balance Sheet.

Profit and Loss Account (in lakhs of rupees)

Balance Sheet (in lakhs of rupees)

Particulars 1987

Rs.

1988

Rs.

Particulars 1987

Rs.

1988

Rs.

To Cost of goods soldTo Operating Expenses:

Administrative expensesSelling expenses

To Net Profit

600

2030

150

800

750

2040

190

1000

By Net Sales 800

800

1000

1000

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COMPARATIVE FINANCIAL STATEMENTS

A simple method for financial analysis is Comparative Financial Statements.

Comparative financial statements will contain items at least for two periods. Changes

increases and decreases in income statement and balance sheet over period are shown.

Comparative Financial Statements can be prepared for more than two periods oron more than two dates.

Illustration: From the illustration of M/s Swadeshi Polytex Ltd prepare comparative incomestatement comparative balance sheet.

Swadeshi Polytex Ltd.

Comparative Income Statement for the years ended 31st December 1987 and 1988

(in lakhs of rupees)

Liabilities1987

Rs.

1988

Rs.Assets

1987

Rs.

1988

Rs.

Bills Payable

Sundry CreditorsTax Payable

14% Debentures16% Preference CapitalEquity Capital

Reserves

50

150100

100300400

200

1,300

75

200150

150300400

245

1, 520

Cash

Sundry DebtorsStock

LandBuildingPlant

Furniture

100

200200

100300300

100

1,300

140

300300

100270270

140

1,520

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Particulars1987

Rs.

1988

Rs.

Absoluteincrease(+)

or

decrease (-)in 1988

Rs.

Absoluteincrease (+)

or

decrease(-)in 1988

%Net Sales

Less: Cost of goods sold

Gross Profit

Operating Expenses:

Administrative expensesSelling expenses

Total Operating expenses

Net Profit

800

600

200

20

30

50

150

1000

750

250

2040

60

190

+200

+150

+50

--

+10

+20

+40

+25

+25

+25

--

+33.33

+20

+26.67

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Swadeshi Polytex Ltd.

Comparative Balance Sheet for the years ended 31st December 1987 and 1988

(in lakhs of rupees)

1987

Rs.

1988

Rs.

Absolute

increase(+)or

decrease (-)

in 1988Rs.

Absolute

increase (+)or

decrease(-)

in 1988%

ASSETS

Current Assets

Cash

Debtors

Stock

Total Current Assets

Fixed Assets

Land

BuildingPlant

Furniture

Total Fixed Assets

Total Assets

LIABILITIES & CAPITAL

Current liabilities

Bills PayableSundry creditors

Taxes Payable

Total CurrentLiabilities

Long term Liabilities

14% Debentures

Total LiabilitiesCapital and Reserves

16% Preference Capital

Equity Capital

Reserves

Total Share HoldersFunds

Total Liabilities and capital

100

200

200

500

100

300300

100

800

1,300

50150

100

300

100

400

300

400200

900

1,300

140

300

300

740

100

270

270140

780

1,520

75200

150

425

150

575

300

400245

945

1,520

+40

+100

+100

+240

--

-30-30

+40

-20

+220

+25

+50

+50

+125

+50+175

----

+45

+45

220

+40

+50

+50

+50

--

-10

-10+40

-2.50

+17

+50+33.33

+50

+41.66

+50

+43.75

--

--+22.50

+5.00

17.00

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COMMON SIZE FINANCIAL STATEMENTS

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Comparative Financial Statements can be prepared for more than two periods or on more

than two dates. However, it becomes very cumbersome to study the trend with more than two

periods data. Trend percentages are more useful in such cases.

Common size financial statements are those in which figures reported are converted into

percentages to some common base. In the income statement, the sale figure is assumed to be 100

and all figures are expressed as a percentage of sales. Similarly, in the Balance Sheet, the total

of assets or liabilities is taken as 100 and all figures are expressed as a percentage of this total.

Illustration: On the basis of the data given in the previous illustration pertaining to Swadeshi

Polytex limited, prepare the common size income statement and common size balance sheet for

the years ended 31

st

March 1987 and 1988.

Solution:

Swadeshi Polytex limited

Common Size Income Statement for the years ended 31st March 1987 and 1988

1987 1988

Net s ales 100 100

Less :Cos t of goods s old 75 75

G RO S S P ROF IT 25 25

Ope rat ing Exp enses:

A dm inis trat ive E xpens es 2.50 2.00

S elling E xpens es 3.75 4.00

Total O perat ing Ex pens es 6.25 6.00

Figures in %Part iculars

Interpretation

The above statement shows that though in absolute terms, the cost of goods has gone up,

the percentage of its cost to sales remains consistent at 75%. This is the reason why the gross profit continues at 25% of sales. Similarly, n absolute terms the amount of administrative

remains the same but as percentage to sales it has come down by 0.5%. Selling expenses have

increased by0.25%. These all lead to net increase in net profit by 0.25%.

Swadeshi Polytex limitedCommon Size Balance Sheet for the years ended 31st March 1987 and 1988

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1987 1988

% %

100 100

CURRENT ASSETS

Cash 7.70 9.21

Debtors 15.38 19.74

Stock 15.38 19.74

Total Current Assets 38.46 48.69

FIXED ASSETS

Building 23.07 17.76

Plant 23.07 17.76

Furniture 7.70 9.21

Land 7.70 6.68

Total fixed assets 61.54 51.31

TOTAL ASSETS 100.00 100.00

1987 1988

% %

100 100

CURRENT LIABILITIES

Bills Payable 3.84 4.93

Sundry Creditors 11.54 13.16

Taxes payable 7.69 9.86

Total Current Liabilities 23.07 27.95

LONG TERM LIABILITIES

14% Debentures 7.69 9.86

CAPITAL & RESERVES

16% Preference share capital 23.10 19.72

Equity share capital 30.76 26.32

Reserves 15.38 16.15

Total Shareholders' Funds 76.93 72.05

TOTAL LIABILITIES AND CAPITAL 100 100

Particulars

Particulars

InterpretationThe percentage of current assets to total assets was 38.46 in 1987. It has gone up to 48.69

in 1988. Similarly the percentage of current liabilities to total liabilities (including capital) hasgone up from 2307 in 1987 to 27.95 in 1988. Thus the proportion of current assets has increased

by percentage of 10 as compared to increase in the proportion of current liabilities, which is

about 5%. This has improved the working capital position of the company. There has been aslight deterioration in the debt-equity ratio though it continues to be sound. The proportion of

shareholders funds in the total liabilities has come down from 69.24% to 61.19% while that of

debenture holders has gone up from 7.69% to 9.86%.

TREND ANALYSIS

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Trend percentages are immensely useful in making a comparative

study of financial statements for several years.

The method of calculating trend percentages involves thecalculation of percentage relationship that each item bears to the same item in the base year.

Any year may be taken as the base year. It is usually the earliest

year. Any intervening year may also be taken as the base year. Each item of base year is taken as 100 and on that basis the

percentage for each item of the years is calculated.

These percentages can also be taken as Index Numbers showingrelative changes in the financial data resulting with the passage of time.

Illustration: From the following data relating to the assets side of the balance sheet of

Kamadhenu Ltd., for the period 31st December 1985 to 31st December 1988 you are required to

calculate the trend percentage taking 1985 as the base year.

Assets 1985 1986 1987 1988

Cash 100 120 80 140

Debtors 200 250 325 400

Stock-in-trade 300 400 350 500

Others current assets 50 75 125 150

Land 400 500 500 500

Building 800 1,000 1,200 1,500

Plant 1,000 1,000 1,200 1,500

TOTAL 2,850 3,345 3,780 4,690

In lakhs of Rs. As on 31st December

Solution

ASSETSDecember 31st (Rupees in lakhs) Trend percentages Base year 1985

1985 1986 1987 1988 1985 1986 1987 1988

Current Assets

Cash 100 120 80 140 100 120 80 140

Debtors 200 250 325 400 100 125 163 200

Stock-in-trade 300 400 350 500 100 133 117 167

Other Current Assets 50 75 125 150 100 150 250 300

Total Current

Assets 650 845 880 1190 100 129 135 183

Fixed Assets

Land 400 500 500 500 100 125 125 125Building 800 1000 1200 1500 100 125 150 175

Plant 1000 1000 1200 1500 100 100 100 150

Total Fixed Assets 2200 2500 2900 3500 100 114 132 159

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Ratios for Financial Statement Analysis

A ratio gives the mathematical relationship between one variable and another. Ratios are

well known and most widely used tools for financial analysis.

The various types of ratios have been classified into the following categories:

1. Liquidity ratios

2. Turnover ratios

3. Profitability ratios

4. Ownership ratios

Earnings ratio

Dividend ratios

Leverage ratios -- Capital structure ratios

-- Coverage ratios

LIQUIDITY RATIOS

Liquidity implies a firms ability to pay its debts in the short term. This ability can bemeasured by the use of liquidity ratios. Short term liquidity involves the relationship

between current assets and current liabilities.

Current Ratio

Current Assets

Current Ratio = ----------------------------Current Liabilities

Current assets include cash, marketable securities, debtors, inventories, loans and

advances and prepaid expenses. Current liabilities include loans and advances taken, tradecreditors, accrued expenses and provisions.

1. Quick RatioThis ratio is also termed as Acid Test Ratio.

Quick AssetsQuick Ratio =-----------------------------Current Liabilities

Quick Assets = Current Assets Inventories

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TURNOVER RATIOS

3. Accounts Receivable Turnover Ratio

Accounts Receivable Ratio

(Debtors turnover ratio) = Net sales (or) Net Credit salesReceivables Average Accounts Receivables

The average accounts receivable is obtained by adding the beginning receivables of theperiod and the ending receivables and by dividing the sum by 2. The net sales or net credit sales

made by the firm should be taken for analysis.

4. Average Collection Period

The average number of days for which the debtors remain outstanding is called the

average collection period. It is calculated as under:

Average Collection period = 360

Average Accounts Receivables Turnover

(Or)= Average Accounts Receivables

Average daily sales

Inventory turnover ratio

The liquidity of a firms inventory may be calculated by dividing the cost of gods sold, by the

firms inventory. The inventory or stock turnover, measures how fast the inventory is moving

through the firm and generating sales. It is calculated by the following formula:

Inventory turnover = Cost of goods sold (or) Net sales

Average inventory Inventory

Where, average inventory is the average of the opening and closing inventory in any

year and inventory means only the closing inventory at the end of a year.

Fixed Assets Turnover ratio

Fixed assets turnover ratio = Net sales (or) _Cost of goods soldFixed assets fixed sales

This ratio is supposed to measure the efficiency with which the fixed assets are employed

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7. Total Assets Turnover Ratio

Total Assets Turnover Ratio = Net salesTotal Assets.

Total assets are simply the balance sheet total at the end of the year.

PROFITABILITY RATIOS

8. Gross Profit Margin Ratio

Gross profit is the difference between the net sales and the cost of goods sold

Gross Profit Margin Ratio = Gross profit

Net salesThis ratio shows the margin left after meeting manufacturing costs.

9. Net Profit Margin Ratio

Net Profit Margin Ratio = Net profit

Net salesIt shows the earnings left for the shareholders (both equity and preference) as a

percentage of net sales.

10. Earnings power

Earnings is a measure of the operating profitability and is arrived at by the followingformula:

Earnings Power = Earnings before interest and taxes

Average total assets

EARNINGS RATIO

11. Earnings per share

The shareholders are concerned about the earnings of the firm in two ways. One is theavailability of the funds with the firm to pay their dividends and the other is to expand their

interest in the form of retained earnings that the firm can use to improve its profitability.Earnings are expressed on a per share basis which is in short called EPS.

Earnings Per Share = Net Profit after TaxNumber of outstanding shares

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12. P/E Ratio

It is calculated as under

Price Earnings Ratio = Market Value per share

Earnings per share

13. Capitalisation Rate

The capitalisation rate is just the inverse of the Price-Earnings Ration.

Capitalisation Rate = Earnings per share

Market Value per share

LEVERAGE RATIOS

Leverage refers to the use of debt finance. While debt capital is a cheaper source offinance, it is also riskier source of finance. Leverage ratios help in assessing the risk arising

form the use of debt capital.

14. Debt Ratio

The firm may be interested to know the proportion of interest bearing funded debt in the

capital structure. Then this debt ratio will be helpful. It is arrived at by dividing the totaldebt (TD) by the capital employed (CE) or Net Assets (NA)

Debt Ratio = Total Debt (TD) = Total Debt (TD)Total Debt (TD) + Net Worth (NW) Capital Employed (CE)

Note: 1. Capital Employed =Net Assets = Net Fixed Assets + Net Current Assets 2. Net Current Assets = Current Assets Current liabilities excluding interest

bearing short term debt for working capital.

NFA + CA = NW + TD + CL

NFA + CA CL = NW + TD

NFA + NCA = NW + TD

NA = CE

Because equality of capital employed and Net assets, the debt ratio can also expressed as

Debt Ratio = Total Debt (TD)

Capital Employed (CE)

15. Debt-Equity Ratio

This ratio indicates the relative contributions of creditors and owners

Debt Equity ratio = DebtEquity

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DU-PONT ANALYSIS- INTER-RELATIONSHIP BETWEEN RATIOS

The Du Pont Company of the U.S. pioneered a system of financial analysis which has

received wide spread recognition and acceptance. A useful system of analysis, it considers

important inter-relationships based on the information found the financial statements

X

+

The Left Hand Side of the Du Pont Chart shows the details underlying the net profit margin ratio.

The Right Hand Side of the Du Pont Chart throws light on the determinants of the total assets

turnover ratio.

54

Return on

Total Assets

Net Profit Mar in Total Assets Turnover

Net Income Net Sales Net Sales Total Assets

Net Sales +/-Non-Operating

Surplus / Deficit

Total

Costs Current

Assets

Fixed

Assets

Cost of

Goods sold

Operating

Expenses

Interest Tax

Operating

ExpensesReceivables

Inventories Others


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Extension of Du Pont ChartThe basic Du Pont Chart may also be extended to explore the determinants of equity.

Net Profit = Net Profit X Sales X Total Assets

Equity Net Sales Total Assets Equity

ROTA NPM TATR (1+D/E)

The third component on the Right Hand Side of the above equation needs a little

explanation. Total assets divided by equity is equal to 1 plus debtequity ratioas shown below:

Total Assets = Equity + Debt = 1 + Debt

Equity Equity Equity

The extension of Du Pont Chart is shown below:

FUNDS FLOW STATEMENT

55

Return on Equity

Return on Total

Assets

Total Assets to

Equity Ratio


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Meaning of fundsFor some, it is nothing but cash while for some others it cash and marketable securities.

Some others say it is nothing but gross working capital. But the correct meaning is probably

given International Accounting Standard No.7, which says that net working capital should be

taken for funds. Net working capital is nothing but the excess of current assets over currentliabilities.

Current Assets1. Cash including fixed deposits with bank

2. Accounts receivable i.e., trade debtors and bills receivable

3. Inventory i.e., raw materials, work in progress and finished goods

4. Advances recoverable5. Prepaid expenses

Current Liabilities

1. Accounts Payable2. Outstanding expenses

3. Bank Over Draft4. Short term loans

5. Advances payments received by the business for the services to be rendered in the future

6. Current maturities of long term loans

7. Provision against current assets ex: provisions for bad and doubtful debts, provisions forloss stock, provision for discount on debtors etc.

Non-Current Assets: All assets other than current assets

Non-Current Liabilities: All liabilities other than current liabilities

Meaning of Flow of FundsMeans change in funds or changes in working capital. In other words, any increase or

decrease in working capital means Flow Funds. The term flow includes both inflow and outflow.

Hence in flow of funds, both inflow and outflow of funds are analysed. Any inflow of fundsresults in an increase of funds and hence called Sources of Funds. Any outflow of funds results

in a decrease of funds and hence termed asApplication of Funds.

Rules to decide on flow of funds

1. There will be a flow of funds if a transaction involves:

a Current assets and fixed assets ex: purchase of building for cashb Current assets and capital ex: issue of shares for cash

c Current assets and fixed liabilities ex: redemption of debentures in cash

d Current liabilities and fixed liabilities ex: creditors paid of in debenturese Current liabilities and capital ex: creditors paid off in shares

f Current liabilities and fixed assets ex: buildings transferred to transferred to creditors in

satisfaction of their claims

2. There will be no flow of funds if it involves:

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a Current assets and current liabilities ex: payment made to creditors in cash

b Fixed assets and fixed liabilities ex: building purchase and payment made in

debenturesc Fixed assets and capital ex: building purchased ad payment made in shares

Finding out of transaction involving change in working capital In case the entry involves accounts only of a fixed (asset or

liability) nature oronly of a current(asset or liability) nature then there will be no flow

of funds.

But a cross transaction(i.e., a transaction involving a fixed asset

or a fixed liability and a current asset or a current liability) will result in flow of funds.

Meaning of a Funds Flow StatementA funds flow statement is a statement depicting change in working capital. It is also

termed as a Statement of sources and application of funds, Summary of financial operations,

funds generated and expended, where got and where gone statement,statement showing changesin working capital.

Uses of funds flow statement1. It explains the financial consequences of business operations

2. It answers intricate questions3. It acts as an instrument for allocation of resources

4. It is a test as to the effective use of working capital

PREPARATION OF A FUNDS FLOW STATEMENT

In order to prepare a Funds Flow Statement, it is necessary to find out the sources andapplication of funds.

SOURCESOF FUNDSThe sources from which the funds flow into the organisation are called sources of funds.

The sources of funds can be both internal and external.

1. Internal sourcesFunds from operations are the only internal source of funds. However, the following

adjustments will be required to be made in the figure of Net Profit for finding out real funds fromoperations.

Addthe following items, as they do not result in outflow of funds.

i. Depreciation on fixed assetsii. Preliminary expenses or goodwill etc., written off

iii. Contribution to debenture redemption fund, transfer to general reserve, etc., if they have

been deducted before arriving at the figure of the net profitiv. Provision for taxation and proposed dividend are usually taken as appropriation of profits

only and not current liabilities for the purpose of Funds Flow Statement.

v. Tax or dividends actually paid are taken as application of funds. Similarly intermdividend paid is shown as an application of funds. All these items will be added back to net

profit, if already deducted, to find funds from operations.

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vi. Loss on sale of fixed assets.

Deductthe following items, as they do not increase the funds:

i. Profits on sale of fixed assets since the full sale proceeds are taken as a separate source of

funds and inclusion here will result in duplication.

ii. Profit on revaluation of fixed assetsiii. Non-operating incomes such as dividend received or accrued dividend, refund of income

tax, rent received or accrued rent. These items will increase funds but they are non-operating

incomes. They will be shown under separate heads as source of funds in the funds flowstatement.

iv. In case the Profit and Loss Account shows Net Loss, this should be taken as an item

which decreases the funds.

2. External Sources:These sources include

i. Funds from long-term loans Long-term loans such as debentures, borrowings from

financial institutions will increase the working capital and therefore will be flow of funds.However if the debentures have been issued against fixed assets, there will be no flow offunds.

ii. Sale of fixed assets Sale of land, buildings, long-term investments will result in

generation of funds.

iii. Funds from increase in share capital Issue of shares for cash or for any other currentasset results in increase in working capital and hence there will be flow of funds.

APPLICATIONOF FUNDSThe uses to which funds are put are called application of funds. Following are some of

the purposes for which funds may be used:

1. Purchase of fixed assets like land, building, plant and machinery etc.

2. Payment of dividend will affect funds since it decreases a fixed liability.

3. Payment of fixed liabilities like redemption of debentures, redemption of redeemable

preference shares. It results in decrease of working capital and hence treated as an applicationof funds.

4. Payment of tax liability If the tax has been paid, it is taken as an application of funds.

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STATEMENTOFCHANGESINWORKINGCAPITAL

ItemsAs on As on Change

(previous year end) (current year end) Increase Decrease

Current AssetsCash balanceBank Balance

Marketable securities

Accounts ReceivablesStock-in-trade

Prepaid Expenses

Total Current AssetsA xxxxx Xxxxx

Current Liabilities

Bank Overdraft

Outstanding Expenses

Accounts PayableTotal Current LiabilitiesB xxxxx xxxxx xxx Xxx

Increase / Decrease inxxxxx xxxxx xxx Xxx

working capitalA B

Note: At the end of the period there will be either increase or decrease only but not both.

Rules of preparing the schedule:

i. Increase in a current asset, results in increase (+) in working capital

ii. Decrease in a current asset, results in decrease (+) in working capital

iii. Increase in a current liability, results in decrease (+) in working capital

iv. Decrease in a current liability, results in increase (+) in working capital

Funds Flow Statement

The funds flow statement can also be prepared in T form as follows:

*Note only figure will be there

(Or)

Particulars Rs. Particulars Rs.

Sources of funds Application of funds

Issue of debentures Redemption of redeemable preference shares

Issue of shares Redemption of Debentures

Long-term borrowings Payment of other long-term loans

Sale of fixed assets Purchased of fixed assets

Operating profit* Operating Loss* Decrease of working capital Payment of dividends, tax etc.,

Increase of working capital

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*Note only figure will be there

Adjusted Profit and Loss Account:This Account is drawn to know funds from operations .The format is given as under

Particulars Rs Particulars Rs.

To Opening balance xxxBy Opening balance xxx

(P&L A/c Dr) (P&L a/c cr)

To transfer to By transfer from excess xxx

Sinking fund xxx Reserve

General Reserve xxxBy Appreciation on fixed assets xxx

Capital redemption reserve xxxBy profit o revaluation or sale xxx

Other reserves Of fixed assets or long term

To depreciation on fixed assets xxx Investments

To goodwill, patents written off xxx By non-operating incomes

To share discount, preliminary expenses xxxDividend received xxx

Advertising, suspense a/c etc. Interest received xxx

Written off Rent received xxx

To loss on revaluation/sale of fixed xxx Income tax refund received xxx

Assets and long term investments Other incomes xxx

To provision for taxation xxxBy closing balance xxx

To Dividends paid xxx (p&l a/c dr. balance)

To Interim dividend paid xxxBy funds from operations xxx

To proposed dividend xxx (Balance figure)

To closing balance of p&l a/c xxx

(Credit balance)

To funds lost in operations xxx

(Balance figure)

xxx xxx

CASH FLOW STATEMENTMEANING

Particulars Amount

Sources of funds

Issue of debentures

Issue of shares

Long-term borrowings

Sale of fixed assetsOperating profit*

Total sources xxx

Application of funds

Redemption of redeemable preference shares

Redemption of Debentures

Payment of other long-term loans

Purchased of fixed assets

Operating Loss*

Payment of dividends, tax etc.,

Total Uses xxx

Net Increase / Decrease of working capital xxx

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Cash flow statement is a statement, which describes the inflows and outflows of cash and

cash equivalents in an enterprise during a specific period of time. Such statement takes into

account the receipts and disbursements of cash. A cash flow statement summarises the causes ofchanges in cash position of a business enterprise between two dates.

CLASSIFICATIONOFCASHFLOWSThe cash flow are classified into three main categories as:1. Cash flow from operating activities

2. Cash flow from investing activities3. Cash flow from financing activities

1. CASHFLOWFROMOPERATINGACTIVITIES

Operating activities are the principal revenue producing activities of the enterprise andother activities that are not investing or financing activities. Cash flow from operating activities

is principally derived from the principal revenue-producing activities of the enterprise.

The cash inflows from operating activities include receipts from customers for sales orgoods and services (including collection from debtors). Cash outflows from operating

activities include payments to suppliers for purchase of materials and for services, payments toemployees for services and payments to governments for tax duties.

2. CASHFLOWFROMINVESTINGACTIVITIES

Investing activities are the acquisition and disposal of long-term assets and other

investments not included in cash equivalents. It involves making and collecting of loans and

acquiring and disposing of debt and equity instruments and fixed assets.

The cash inflows from investing activities are receipts from collection of loans, receiptsfrom sales of shares, debt or similar instruments of other enterprises, receipts from sales of fixedassets, and interest and dividends received on loans and investments. Cash outflows frominvesting activities are disbursements of loans, payments to acquire shares, debt or similar

instruments of other enterprises, and payments (including advance and down payments) toacquire fixed assets.

3. CASHFLOWFROMFINANCINGACTIVITIES

Financing activities are the activities that result in change in the size and consumption of

the owners capital (including preference share capital in case of a company) and borrowings

of the enterprise.Cash inflows from financing activities are proceeds from issuing shares or other similar

instruments, debentures, mortgages, bonds and other short or long-term borrowings. Cash

outflows from financing activities are the payments of dividends, payments to acquire orredeem shares or other similar instruments of the enterprise, repayments of amounts

borrowed, principal payments to creditors who have extended long-term credit, and interest

paid.

Cash flow statement for the year ended___________

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Particulars Rs. Rs.

Cash flows from Operating Activities

Either

Cash receipts from customers xxxxx

(-) Cash paid to customers (xxx)

Cash generated from operations xxxxx

(-) Income tax paid (xxx)

Cash flow before extra ordinary items xxxxx

Extraordinary items xxxxx

Net cash from (used in) operating activities xxxxx

OR

Net profit before tax and extraordinary items xxxxx

Adjustments for non-cash and non-operating items xxx

[List of individual items such as depreciation, foreign

exchange loss, loss on sale of fixed assets, interest

Income, dividend income, interest expense etc.]

Operating profit before working capital changes xxxxx

Adjustments for changes in current assets and

Current liabilities ( list of individual items) xxx

Cash generated from (used in) operations before tax xxxx

(-) Income tax paid (xxx)

Cash flow before extra ordinary items xxxx

Extraordinary items xxxx

Net cash from (used in) operating activities xxxxx

Cash flow from Investing Activities

Individual items of cash inflows and cash outflows from investing activities xxx

[Such as purchase/sale of fixed assets, purchase or sale of investments, xxx

Interest received, dividend received etc.] xxxNet cash from (used in) investing activities xxxx

Cash flows from Finance Activities

Individual items of cash inflows and cash outflows from financing activities xxxx

[Such as proceeds from issue of shares, long-term borrowings, repayments xxxx

of long-term borrowings, interest paid, dividend paid etc. xxxx

Net cash from (used in) investing activities xxxxx

Net Increase (Decrease) in cash and cash equivalents xxx

Cash and cash equivalents at the beginning of the period xxxxx

Cash and cash equivalents at the end of the period xxxxx

CASHINFLOWS ACTIVITIES CASHOUTFLOWS

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Payments to suppliers and

employees for materials

and services


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account 05mba14

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