MBH22104T FINANCIAL ANALYSIS AND DECISION MAKING FOR

HEALTHCARE PROFESSIONALS

UNIT I
Basic Introduction to Financial Accounting-Accounting Principles-Accounting Concepts-
Concepts: Conventions in Accounting-Journal Entry: Basic Entries-Ledger Posting-Preparation
of Trail Balance-Preparation of Trading Account-Adjustments in Trading Account-Preparation
of P&L Account-Adjustment in P&L Account-Preparation of Balance Sheets-Preparation of
Balance Sheets in Healthcare organization
UNIT II
Introduction to Financial Statements-Comparative Income Statements-Preparation of
Comparative Income Statements-Comparative Balance Sheets-Preparation of Comparative
Balance Sheets-Common Size Income Statements-Preparation of Common Size Income
Statements-Common Size Balance Sheet-Preparation of Common Size Balance Sheet-
Interpretation from the Common size statements-Interpretation from the Comparative
statements-Trend Analysis
UNIT III
Introduction to Ratio Analysis-Advantages of Ratios-Types of Ratios-Liquidity Ratios-
Solvency Ratios-Profitability Ratios-Preparation of Balance Sheet from Ratio Analysis-
Preparation of Ratios from Balance Sheets-Cash Flow Statement: Introduction-Preparation of
Cash Flow Statements
UNIT IV
Introduction to Budget-Meaning and Significance-Importance of Budgeting Managerial
Decision Making-Types of Budget-Preparation of Functional Budget-Preparation of Flexible
Budget-Other Budget types preparation-Zero Based Budgeting
UNIT V
Annual Report: Introduction-Items in Annual Report-Key Points in Annual Report-Segment
Reporting: Introduction-Different Segments in Annual Report-Notes in Financial Statement-
How to interpret notes in Financial Statements?-Disclosures in Financial Statements and
Comparative Statements-Analysis of Management Discussion-Recent Trends in Accounting-
Recent Trends in Accounting for Health care organizations--Contemporary Practices(Expert
Lecture)

References
1. Louis C.Gapenski,. (1997). Financial Analysis and Decision-making for Healthcare
Organizations. McGraw-Hill.
2. Hanif Mand Mukherjee A. (2020). Financial Repo r tin g and Fin an cia l Statement
Analysis. McGraw-Hill Education.
3. S.P.Jain, K.L.Narang. (2004). Financial Accounting analysis. Kalyani publisher, New
Delhi.
4. T.S.Grewal,S.C.Gupta. (2008). Introduction to Accountancy. S.Chand &company Ltd .,
NewDelhi.
5. R.K.Sharma,SashiK.Gupta. (2008). Management Accounting, Principles and Practice.
KalyaniPublishers,NewDelhi.
6. M.Y.Khan, P.K.Jain. (2010). Management Accounting Text, problems and cases, TataMc
graw HillPublishing Company Limited, New Delhi.

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 UNIT 1
Basic Introduction to Financial Accounting-Accounting Principles-Accounting Concepts-
Concepts: Conventions in Accounting-Journal Entry: Basic Entries-Ledger Posting-Preparation
of Trail Balance-Preparation of Trading Account-Adjustments in Trading Account-Preparation
of P&L Account-Adjustment in P&L Account-Preparation of Balance Sheets-Preparation of
Balance Sheets in Healthcare organization

BASIC INTRODUCTION TO FINANCIAL ACCOUNTING

Accounting meaning
Accounting is the recording, classifying, and summarizing of business transaction in
terms of cash, the preparation of financial report, the analysis and interpretation of these reports
for the information and guidance of management

Accounting Definition
❖ Accounting is defined by the AICPA as "The art of recording, classifying, and summarizing
in a significant manner and in terms of money, transactions and events which are, in part at
least, of financial character, and interpreting the results thereof."
❖ Accounting is the process of identifying, measuring, and communicating economic
information to permit informed judgements and decisions by users of the information.”

Branches of Accounting
a. Financial accounting: The accounting system concerned only with the financial state of
affairs and financial results of operations is known as Financial Accounting. It is the
original from of accounting. It is mainly concerned with the preparation of financial
statements for the use of outsiders like creditors, debenture holders, investors and financial
institutions. The financial statements i.e., the profit and loss account and the balance sheet,
show them the manner in which operations of the business have been conducted during a
specified period.
b. Cost accounting: It is that branch of accounting which is concerned with the accumulation
and assignment of historical costs to units of product and department, primarily for the
purpose of valuation of stock and measurement of profits. Cost accounting seeks to
ascertain the cost of unit produced and sold or the services rendered by the business unit
with a view to exercising control over these costs to assess profitability and efficiency of
the enterprise. It generally relates to the future and involves an estimation of future costs to
be incurred. The process of cost accounting based on the data provided by the financial
accounting.
c. Management accounting: It is an accounting for the management i.e., accounting which
provides necessary information to the management for discharging its functions. According
to the Anglo-American Council on productivity, “Management accounting is the
presentation of accounting information is such a way as to assist management in the
creation of policy and the day-to-day operation of an undertaking.” It covers all
arrangements and combinations or adjustments of the orthodox information to provide the

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 Chief Executive with the information from which he can control the business e.g.
Information about funds, costs, profits etc. Management accounting is not only confined to
the area of cost accounting but also covers other areas (such as capital expenditure
decisions, capital structure decisions, and dividend decisions) as well

Management accounting information

The accounting information specifically prepared to aid managers is called
management accounting information. This information is used in 3 managerial functions:-
a. Planning: it is the process of deciding what action should be taken in the future.
An important of planning is budgeting. Budgeting is the process of planning the
overall activities of an organisation for a year
b. Implementation: it involves specific actions planned in advance to fulfil the
budgets
c. Control: it is the process to ensure that employees perform properly.

Objective of Accounting
a. To keeping systematic record: It is very difficult to remember all the business transactions
that take place. Accounting serves this purpose of record keeping by promptly recording
all the business transactions in the books of account.
b. To ascertain the results of the operation: Accounting helps in ascertaining result i.e.,
profit earned or loss suffered in business during a particular period. For this purpose, a
business entity prepares either a Trading and Profit and Loss account or an Income and
Expenditure account which shows the profit or loss of the business by matching the items
of revenue and expenditure of the some period.
c. To ascertain the financial position of the business: In addition to profit, a businessman
must know his financial position i.e., availability of cash, position of assets and liabilities
etc. This helps the businessman to know his financial strength. Financial statements are
barometers of health of a business entity.
d. To portray the liquidity position: Financial reporting should provide information about
how an enterprise obtains and spends cash, about its borrowing and repayment of
borrowing, about its capital transactions, cash dividends and other distributions of
resources by the enterprise to owners and about other factors that may affect an enterprise’s
liquidity and solvency.
e. To protect business properties: Accounting provides upto date information about the
various assets that the firm possesses and the liabilities the firm owes, so that nobody can
claim a payment which is not due to him.
f. To facilitate rational decision – making: Accounting records and financial statements
provide financial information which help the business in making rational decisions about
the steps to be taken in respect of various aspects of business.
g. To satisfy the requirements of law: Entities such as companies, societies, public trusts
are compulsorily required to maintain accounts as per the law governing their operations
such as the Companies Act, Societies Act, and Public Trust Act etc. Maintenance of
accounts is also compulsory under the Sales Tax Act and Income Tax Act.

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Importance / Users of Accounting
a. Owners: The owners provide funds or capital for the organization. They possess curiosity
in knowing whether the business is being conducted on sound lines or not and whether the
capital is being employed properly or not. Owners, being businessmen, always keep an eye
on the returns from the investment.
b. Management: The management of the business is greatly interested in knowing the
position of the firm. The accounts are the basis, the management can study the merits and
demerits of the business activity. Thus, the management is interested in financial
accounting to find whether the business carried on is profitable or not. The financial
accounting is the “eyes and ears of management and facilitates in drawing future course of
action, further expansion etc.”
c. Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders of
money. It is usual that these groups are interested to know the financial soundness before
granting credit. The progress and prosperity of the firm, two which credits are extended,
are largely watched by creditors from the point of view of security and further credit.
d. Employees: Payment of bonus depends upon the size of profit earned by the firm. The
more important point is that the workers expect regular income for the bread. The demand
for wage rise, bonus, better working conditions etc. depend upon the profitability of the
firm and in turn depends upon financial position.
e. Investors: The prospective investors, who want to invest their money in a firm, of course
wish to see the progress and prosperity of the firm, before investing their amount, by going
through the financial statements of the firm. This is to safeguard the investment
f. Government: The state and central Governments are interested in the financial statements
to know the earnings for the purpose of taxation.
g. Consumers: The establishment of a proper accounting control, which in turn will reduce
to cost of production, in turn less price to be paid by the consumers. Researchers are also
interested in accounting for interpretation.
h. Research Scholars: To make a study into the financial operations of a particular firm, the
research scholar needs detailed accounting information relating to purchases, sales,
expenses, cost of materials used, current assets, current liabilities, fixed assets, long-term
liabilities and share-holders funds which is available in the accounting record maintained
by the firm.

Scope of Accounting
• Accounting has got a very wide scope and area of application.
• Its use is not confined to the business world alone, but spread over in all the spheres of the
society and in all professions.
• In any social institution or professional activity, whether that is profit earning or not,
financial transactions must take place. So there arises the need for recording and
summarizing these transactions when they occur and the necessity of finding out the net
result of the same after the expiry of a certain fixed period.
• In the modern world, accounting system is practiced not only in all the business institutions
but also in many non-trading institutions like Schools, Colleges, Hospitals, Charitable Trust

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 Clubs, Co-operative Society etc. and also Government and Local Self-Government in the
form of Municipality, Panchayat.
• The scope of accounting as it was in earlier days has undergone lots of changes in recent
times.

Nature of Accounting:
1. Accounting as a service activity: Its function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in making
economic decisions, in making reasoned choices among alternative courses of action. It
means that accounting collects financial information for the various users for taking
decisions and tackling business issues.
2. Accounting as a profession: A profession is a career that involve the acquiring of a
specialised formal education before rendering any service. Accounting is a systematized
body of knowledge developed with the development of trade and business over the past
century. The accounting education is being imparted to the examinees by national and
international recognised the bodies like The Institute of Chartered Accountants of India
(ICAI), New Delhi in India and American Institute of Certified Public Accountants
(AICPA) in USA etc.
3. Accounting as a social force: The society is composed of people as customer,
shareholders, creditors and investors. The accounting information/data is to be used to solve
the problems of the public at large such as determination and controlling of prices.
Therefore, safeguarding of public interest can better be facilitated with the help of proper,
adequate and reliable accounting information and as a result of it the society at large is
benefited.
4. Accounting as a language: Accounting is rightly referred the "language of business". It is
one means of reporting and communicating information about a business. As one has to
learn a new language to converse and communicate, so also accounting is to be learned and
practiced to communicate business events.
5. Accounting as science or art: Science is a systematised body of knowledge. It establishes
a relationship of cause and effect in the various related phenomenon. It is also based on
some fundamental principles. Art requires a perfect knowledge, interest and experience to
do a work efficiently. Art also teaches us how to do a work in the best possible way by
making the best use of the available resources. Accounting is an art as it also requires
knowledge, interest and experience to maintain the books of accounts in a systematic
manner.
6. Accounting as an information system: Accounting discipline will be the most useful one
in the acquisition of all the business knowledge in the near future. Accounting information
serves both profit-seeking business and non-profit organisations. The accounting system of
a profit-seeking organisation is an information system designed to provide relevant
financial information on the resources of a business and the effect of their use.

Functions of Accounting
a. Record Keeping Function: The primary function of accounting relates to recording,
classification and summary of financial transactions-journalisation, posting, and
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 preparation of final statements. These facilitate to know operating results and financial
positions. The purpose of this function is to report regularly to the interested parties by
means of financial statements.
b. Managerial Function: The day-to-day operations are compared with some predetermined
standard. The variations of actual operations with pre-determined standards and their
analysis is possible only with the help of accounting.
c. Legal Requirement function: Auditing is compulsory in case of registered firms. Auditing
is not possible without accounting. Thus accounting becomes compulsory to comply with
legal requirements. Accounting is a base and with its help various returns, documents,
statements etc., are prepared.
d. Language of Business: Accounting is the language of business. Various transactions are
communicated through accounting. There are many parties-owners, creditors, government,
employees etc., who are interested in knowing the results of the firm and this can be
communicated only through accounting.

Methods of Accounting
Business transactions are recorded in two different ways.
a. Single Entry: It is incomplete system of recording business transactions. The business
organization maintains only cash book and personal accounts of debtors and creditors. So
the complete recording of transactions cannot be made and trail balance cannot be prepared.
b. Double Entry: It this system every business transaction is having a two fold effect of
benefits giving and benefit receiving aspects. The recording is made on the basis of both
these aspects. Double Entry is an accounting system that records the effects of transactions
and other events in atleast two accounts with equal debits and credits.

Steps involved in Double entry system

✓ Preparation of Journal: Journal is called the book of original entry. It records the
effect of all transactions for the first time. Here the job of recording takes place.
✓ Preparation of Ledger: Ledger is the collection of all accounts used by a business.
Here the grouping of accounts is performed. Journal is posted to ledger.
✓ Trial Balance preparation: Summarizing. It is a summary of ledge balances
prepared in the form of a list.
✓ Preparation of Final Account: At the end of the accounting period to know the
achievements of the organization and its financial state of affairs, the final accounts
are prepared.

Advantages of Double Entry System

✓ Scientific system: This system is the only scientific system of recording business
transactions in a set of accounting records. It helps to attain the objectives of
accounting.
✓ Complete record of transactions: This system maintains a complete record of all
business transactions.
✓ A check on the accuracy of accounts: By use of this system the accuracy of
accounting book can be established through the device called a Trail balance.

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 ✓ Ascertainment of profit or loss: The profit earned or loss suffered during a period
can be ascertained together with details by the preparation of Profit and Loss
Account.
✓ Knowledge of the financial position of the business: The financial position of the
firm can be ascertained at the end of each period, through the preparation of balance
sheet.
✓ Full details for purposes of control: This system permits accounts to be prepared
or kept in as much detail as necessary and, therefore, affords significant information
for purposes of control etc.
✓ Comparative study is possible: Results of one year may be compared with those
of the precious year and reasons for the change may be ascertained.
✓ Helps management in decision making: The management may be also to obtain
good information for its work, specially for making decisions.
✓ No scope for fraud: The firm is saved from frauds and misappropriations since full
information about all assets and liabilities will be available.

Meaning of Debit and Credit

The term ‘debit’ is supposed to have derived from ‘debit’ and the term ‘credit’ from
‘creditable’. For convenience ‘Dr’ is used for debit and ‘Cr’ is used for credit. Recording of
transactions require a thorough understanding of the rules of debit and credit relating to
accounts. Both debit and credit may represent either increase or decrease, depending upon the
nature of account.

Types of Accounting
Types of
Accounting

Personal Real Nominal

Accounts Accounts Accounts

Natural Tangible Real

persons Accounts

Artificial or legal Intangible Real

persons Accounts

Groups/Representative
personal Accounts

1. Personal Accounts: Accounts recording transactions with a person or group of persons are
known as personal accounts. These accounts are necessary, in particular, to record credit
transactions. Personal accounts are of the following types:
a. Natural persons: An account recording transactions with an individual human
being is termed as a natural persons’ personal account. eg., Kamal’s account, Mala’s
account, Sharma’s accounts. Both males and females are included in it

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 b. Artificial or legal persons: An account recording financial transactions with an
artificial person created by law or otherwise is termed as an artificial person,
personal account, e.g. Firms’ accounts, limited companies’ accounts, educational
institutions’ accounts, Co-operative society account.
c. Groups/Representative personal Accounts: An account indirectly Representing
a person or persons is known as representative personal account. When accounts
are of a similar nature and their number is large, it is better tot group them under
one head and open a representative personal accounts. e.g., prepaid insurance,
outstanding salaries, rent, wages etc. When a person starts a business, he is known
as proprietor. This proprietor is represented by capital account for all that he invests
in business and by drawings accounts for all that which he withdraws from business.
So, capital accounts and drawings account are also personal accounts.
The rule for personal accounts is: Debit the receiver
Credit the giver
2. Real Accounts: Accounts relating to properties or assets are known as ‘Real Accounts’, A
separate account is maintained for each asset e.g., Cash Machinery, Building, etc., Real
accounts can be further classified into tangible and intangible
a. Tangible Real Accounts: These accounts represent assets and properties which can
be seen, touched, felt, measured, purchased and sold. e.g. Machinery account Cash
account, Furniture account, stock account etc.
b. Intangible Real Accounts: These accounts represent assets and properties which
cannot be seen, touched or felt but they can be measured in terms of money.e.g.,
Goodwill accounts, patents account, Trademarks account, Copyrights account, etc.
The rule for Real accounts is: Debit what comes in
Credit what goes out
3. Nominal Accounts: Accounts relating to income, revenue, gain expenses and losses are
termed as nominal accounts. These accounts are also known as fictitious accounts as they
do not represent any tangible asset. A separate account is maintained for each head or
expense or loss and gain or income. Wages account, Rent account Commission account,
Interest received account are some examples of nominal account
The rule for Nominal accounts is: Debit all expenses and losses
Credit all incomes and gains

Accounting Process
1) Recording in the Journal (Journalizing): Journal is the first book of entry. Transactions
are first recorded in the Journal Book. This book is also known as the book of original
entry. The journal has a prescribed format. The purpose of journal is formatting accounting
information for convenient transfer of information into Ledger Accounts.
2) Recording in the Ledger (Posting to Ledger): The ledger is the main book of accounting
information. Under double entry book keeping, every journal entry is subsequently entered
into at least two accounts. At this stage the transactions are recorded at the appropriate side
of the ledger as mentioned in the journal. The left hand side of an account is known as
‘debit side’ and the right hand side is known as ‘credit side’.

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3) Summarizing the Activities: This is the process of re-grouping or summarizing the ledger
accounts to help easy understanding of facts. This involves listing of all accounts with their
respective balances in one statement called ‘Trial Balance”. A trial balance contains all
accounts of a business. Thus it is a list of Assets, Liabilities, Capital, Incomes and
Expenses.
4) Analysis and Interpretation: This is the final stage of accounting process. Business
information has value only when they are effectively used for decision making. Analysis
of information will help the management to identify the result of their past decisions. The
business can run smoothly by paying full attention to the right spots.

Advantages of Accounting
• It helps in having complete record of business transactions.
• It gives information about the profit or loss made by the business at the close of a year and
its financial conditions. The basic function of accounting is to supply meaningful
information about the financial activities of the business to the owners and the managers.
• It provides useful information from making economic decisions,
• It facilitates comparative study of current year’s profit, sales, expenses etc., with those of
the previous years.
• It supplies information useful in judging the management’s ability to utilize enterprise
resources effectively in achieving primary enterprise goals.
• It provides users with factual and interpretive information about transactions and other
events which are useful for predicting, comparing and evaluation the enterprise’s earning
power.
• It helps in complying with certain legal formalities like filing of income tax and sales-tax
returns. If the accounts are properly maintained, the assessment of taxes is greatly
facilitated.

Limitations of Accounting
• Accounting is historical in nature: It does not reflect the current financial position or worth
of a business.
• Transactions of non-monetary mature do not find place in accounting. Accounting is
limited to monetary transactions only. It excludes qualitative elements like management,
reputation, employee morale, labour strike etc.
• Facts recorded in financial statements are greatly influenced by accounting conventions
and personal judgements of the Accountant or Management. Valuation of inventory,
provision for doubtful debts and assumption about useful life of an asset may, therefore,
differ from one business house to another.
• Accounting principles are not static or unchanging-alternative accounting procedures are
often equally acceptable. Therefore, accounting statements do not always present
comparable data
• Cost concept is found in accounting. Price changes are not considered. Money value is
bound to change often from time to time. This is a strong limitation of accounting.
Accounting statements do not show the impact of inflation.

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• The accounting statements do not reflect those increase in net asset values that are not
considered realized.

ACCOUNTING PRINCIPLES

❖ Accounting principles have been defined by the Canadian Institute of Chartered

Accountants as “The body of doctrines commonly associated with the theory and procedure
of accounting serving as an explanation of current practices and as a guide for the selection
of conventions or procedures where alternatives exists. Rules governing the formation of
accounting axioms and the principles derived from them have arisen from common
experience, historical precedent statements by individuals and professional bodies and
regulations of Governmental agencies”.
❖ According to ‘Dictionary of Accounting’ prepared by Prof. P.N. Abroal, “Accounting
standards refer to accounting rules and procedures which are relating to measurement,
valuation and disclosure prepared by such bodies as the Accounting Standards Committee
(ASC) of a particular country”.
❖ Accounting principles are the assumptions and roles of accounting, the methods and
procedures of accounting and the application of these rules, methods and procedures to the
actual practice of accounting.

Meaning and criteria for Accounting Principles

It is a set of rules, concepts and conventions used in the preparation of accounting
reports. The purpose of describing the GAAP is to ensure the uniformity in preparations of the
reports. These principles are developed on the basis of three criteria:
a. Usefulness: Provided information should be accurate and reliable to the users for their
decision making.
b. Objectivity: it is not enough that the information provided is reliable and accurate, but
the same has to be supplemented by facts and relevant documents which reduces the
individual bias.
c. Economy: It should be simple to adopt and these principles should be followed without
incurring abnormal cost and excessive effort as well.

The accounting principles can be classified into two categories: 1. Accounting Concepts
and 2. Accounting Conventions

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 ACCOUNTING CONCEPTS

The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or
conditions upon the edifice of which the accounting super-structure is based. The following are
the common accounting concepts adopted by many business concerns.
a. Business Entity Concept
b. Money Measurement Concept
c. Going Concern Concept
d. Dual Aspect Concept
e. Periodicity Concept
f. Historical Cost Concept
g. Matching Concept
h. Realisation Concept
i. Accrual Concept
j. Objective Evidence Concept

a. Business Entity Concept:

• A business unit is an organization of persons established to accomplish an economic
goal.
• Business entity concept implies that the business unit is separate and distinct from
the persons who provide the required capital to it.
• This concept can be expressed through an accounting equation, viz.,
Assets = Liabilities + Capital.
• The equation clearly shows that the business itself owns the assets and in turn owes
to various claimants. It is worth mentioning here that the business entity concept as
applied in accounting for sole trading units is different from the legal concept.
• The expenses, income, assets and liabilities not related to the sole proprietorship
business are excluded from accounting..
b. Money Measurement Concept:
• In accounting all events and transactions are recode in terms of money.
• Money is considered as a common denominator, by means of which various facts,
events and transactions about a business can be expressed in terms of numbers.
• Facts, events and transactions which cannot be expressed in monetary terms are not
recorded in accounting.
• Hence, the accounting does not give a complete picture of all the transactions of a
business unit.
• This concept does not also take care of the effects of inflation because it assumes a
stable value for measuring.
c. Going Concern Concept:
• The transactions are recorded assuming that the business will exist for a longer
period of time, i.e., a business unit is considered to be a going concern and not a
liquidated one.

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 • Keeping this in view, the suppliers and other companies enter into business
transactions with the business unit. This assumption supports the concept of valuing
the assets at historical cost or replacement cost.
• This concept also supports the treatment of prepaid expenses as assets, although
they may be practically unsaleable.
d. Dual Aspect Concept:
• According to this basic concept of accounting, every transaction has a two-fold
aspect, Viz., 1.giving certain benefits and 2. Receiving certain benefits.
• The basic principle of double entry system is that every debit has a corresponding
and equal amount of credit. This is the underlying assumption of this concept.
• The accounting equation viz., Assets = Capital + Liabilities or Capital = Assets –
Liabilities, will further clarify this concept, i.e., at any point of time the total assets
of the business unit are equal to its total liabilities.
• Liabilities here relate both to the outsiders and the owners. Liabilities to the owners
are considered as capital.
e. Periodicity Concept:
• Under this concept, the life of the business is segmented into different periods and
accordingly the result of each period is ascertained.
• Though the business is assumed to be continuing in future the measurement of
income and studying the financial position of the business for a shorter and definite
period will help in taking corrective steps at the appropriate time.
• Each segmented period is called “accounting period” and the same is normally a
year. The businessman has to analyse and evaluate the results ascertained
periodically.
• At the end of an accounting period, an Income Statement is prepared to ascertain
the profit or loss made during that accounting period and Balance Sheet is prepared
which depicts the financial position of the business as on the last day of that period.
During the course of preparation of these statements capital revenue items are to be
necessarily distinguished.
f. Historical Cost Concept:
• According to this concept, the transactions are recorded in the books of account
with the respective amounts involved.
• For example, if an asset is purchases, it is entered in the accounting record at the
price paid to acquire the same and that cost is considered to be the base for all future
accounting. It means that the asset is recorded at cost at the time of purchase but it
may be methodically reduced in its value by way of charging depreciation.
• However, in the light of inflationary conditions, the application of this concept is
considered highly irrelevant for judging the financial position of the business.
g. Matching Concept:
• The essence of the matching concept lies in the view that all costs which are
associated to a particular period should be compared with the revenues associated
to the same period to obtain the net income of the business.

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 • Under this concept, the accounting period concept is relevant and it is this concept
(matching concept) which necessitated the provisions of different adjustments for
recording outstanding expenses, prepaid expenses, outstanding incomes, incomes
received in advance, etc., during the course of preparing the financial statements at
the end of the accounting period.
h. Realisation Concept:
• This concept assumes or recognizes revenue when a sale is made.
• Sale is considered to be complete when the ownership and property are transferred
from the seller to the buyer and the consideration is paid in full. However, there are
two exceptions to this concept, viz., 1. Hire purchase system where the ownership
is transferred to the buyer when the last instalment is paid and 2. Contract accounts,
in which the contractor is liable to pay only when the whole contract is completed,
the profit is calculated on the basis of work certified each year.
i. Accrual Concept:
• According to this concept the revenue is recognized on its realization and not on its
actual receipt. Similarly the costs are recognized when they are incurred and not
when payment is made.
• This assumption makes it necessary to give certain adjustments in the preparation
of income statement regarding revenues and costs. But under cash accounting
system, the revenues and costs are recognized only when they are actually received
or paid.
• Hence, the combination of both cash and accrual system is preferable to get rid of
the limitations of each system.
j. Objective Evidence Concept:
• This concept ensures that all accounting must be based on objective evidence, i.e.,
every transaction recorded in the books of account must have a verifiable document
in support of its, existence. Only then, the transactions can be verified by the
auditors and declared as true or otherwise. The verifiable evidence for the
transactions should be free from the personal bias, i.e., it should be objective in
nature and not subjective.
• However, in reality the subjectivity cannot be avoided in the aspects like provision
for bad and doubtful debts, provision for depreciation, valuation of inventory, etc.,
and the accountants are required to disclose the regulations followed.

CONVENTIONS IN ACCOUNTING

The term "accounting conventions" refer to the customs or traditions, which are used
as a guide in the preparation of meaningful financial records in the form of the income
statement (Profit and Loss Account) and the position statement (Balance Sheet).
These are as follows.
a. Consistency: The convention of consistency refers to the state of accounting rules,
concepts, principles, practices and conventions being observed and applied constantly,
i.e., from one year to another there should not be any change. If consistency is there,

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 the results and performance of one period can he compared easily and meaningfully
with the other. It also prevents personal bias as the persons involved have to follow the
consistent rules, principles, concepts and conventions. This convention, however, does
not completely ignore changes. It admits changes wherever indispensable and adds to
the improved and modern techniques of accounting.
b. Disclosure: The convention of disclosure stresses the importance of providing
accurate, full and reliable information and data in the financial statements which is of
material interest to the users and readers of such statements. This convention is given
due legal emphasis by the Companies Act, 1956 by prescribing formats for the
preparation of financial statements. However, the term disclosure does not mean all
information that one desires to get should be included in accounting statements. It is
enough if sufficient information, which is of material interest to the users, is included.
c. Conservatism: In the prevailing present day uncertainties, the convention of
conservatism has its own importance. This convention follows the policy of caution or
playing safe. It takes into account all possible losses but not the possible profits or gains.
A view opposed to this convention is that there is the possibility of creation of secret
reserves when conservatism is excessively applied, which is directly opposed to the
convention of full disclosure. Thus, the convention of conservatism should be applied
very cautiously
d. Materiality: The accountant should attach importance to material details and ignore
insignificant details. The question what constitutes a material detail is left to the
discretion of the accountant. An item is material if there is reason to believe that
knowledge of it would influence the decision of the informed investor.

JOURNAL ENTRY: BASIC ENTRIES

JOURNAL
Journal is a book of first entry. Business transactions are first entered in the journal
before they are taken to the appropriate accounts in the ledger. Journalising is the process of
recording journal entries in chronological order by applying the rules of debit and credit. The
following is a form of journal:
Date(1) Particulars(2) Ledger Folio Debit(4) Credit(5)
Number(3)

A Journal has five columns. They are:

a. Date column: Date of the transaction is entered in dd/mm/yyyy format
b. Particulars column: Debit and credit aspects are entered. While entering the debit entry,
it is always ends with Dr. the credit aspects starts with ‘To’ In addition to this, you have to
write about the transaction briefly below the entry is called Narration.
c. Ledger Folio: It states the page number of account in the ledger where the particular
amount is transferred/ posted. (While preparing the journal this column remains blank)
d. Debit Column The debit amount will be entered.
e. Credit Column The credit amount will be entered.

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Rules of Debiting and Crediting in Journal
In the Journal the business transactions of the financial nature are recorded on the basis
of debit and credit. The accounts are debited and credited on the basis of following rules. These
rules are based on the english classification of accounts.
1. Personal Account: If in a transaction, a person receives something in cash or goods, it is
debited and if that person gives, that is credited. Debit account is denoted by ‘Dr.’ while
credit account is denoted by ‘Cr.’ In brief, the rule of personal account is

2. Real Account: If in a transaction, the assets are coming into business, they are debited and
if those are going outside from business, they are credited. Thus these rules are as below:

3. Nominal Account: The rules of debiting and crediting of nominal account are – the
expenses and losses of the business are debited and the gains and profit of the business are
credited. In brief the rules are:

At the time of Journalising of the transactions, when an account is debited it is denoted

by ‘Dr.’ and crediting of an account by ‘To’. When a transaction is recorded first of all its two
aspects (accounts) are identified, those may of the same group (same type of account) or
different groups (different types of accounts). Then the rules of debiting and crediting are
applied. On the completion of a page of the Journal it is totalled and the balance is carried
forward to the next page

Compound Journal Entry

If two or more transactions of the same nature occur on the same day and either debit
account and/or credit account are common in them, instead of passing a separate entry for each
such transaction, one combined entry may be passed. Such type of entry is known as compound
journal entry. Compound entry can be of following three types:
(a) Single debit account and more than one credit account
(b) Single credit account and more than one debit accounts
(c) More than one debit account and more than one credit account

Advantages of Journal
• Journal gives complete information about the business transactions
• It includes a brief explanation of the transactions
• Since it follows double entry system for recording, the errors are reduced.

15
Subsidiary Books of Accounts
A journal is subdivided into various books (or journals) is known as sub divisions of the
journal or subsidiary books. This division is for the sake convenience and handling of numerous
transactions of repetitive nature. It reduces the work involved in the posting and entering of
each transaction in the journal and ledger. All similar transactions are recorded in one particular
book. For example, all credit sales are recorded in one book known as the sales Day Book. The
following are the subsidiary books maintained as follows:
a. Purchase Book: this book is also called “Purchase Journal”, Bought Book’, ‘Purchase Day
Book’, ‘Invoice Book’. It is used for credit purchases and not for cash purchases. Here
purchases of any assets are not recorded. At the end of every month, all transactions are
transferred to general ledger along with the suppliers’ invoices. The form of purchases book
is as follows:
Date Name of the L.F No. Inward Invoices Amount
Supplier No.

b. Sales Book: This book is also called “Sales Journal”, ‘Sold Book’, ‘Sales Day Book’. It is
used for credit sales and not for cash sales. Here sale of any old assets are not recorded. At
the end of every month, all transactions are transferred to general ledger. The form of Sales
book is as follows:
Date Name of the Customer L.F No. Outward Amount
Invoices No.

c. Purchases Return Book: It is also called as return outwards book. The purpose of this
subsidiary book is to record transactions relating to return of goods to suppliers. The ruling
of the book is similar to that of purchases book except for the fact that column no.3 is
provided for debit note numbers. The form of purchases return book is as follows:
Date Name of the Customer L.F No. Debt Note Amount
Nos.

d. Sales Return Book: It is also called return inwards book. The purpose of this subsidiary
book is to record transactions relating to return of goods from our customers. The ruling of
the book is similar to that of sales book except for the fact that column no.3 is provided for
credit note numbers. The form of Sales return book is as follows:
Date Name of the Customer L.F No. Credit Note Amount
Nos

e. Cash Book: It serves both as a journal and ledger. All cash transactions are recorded in this
book. The format is similar to ledger. Debit side is called as receipts and credit side is called
as payments. There are three types of cash book:
➢ Single column Cash Book – one column on both sides.
➢ Double column Cash Book – discount and cash column on both the sides.
➢ Three Column Cash Book – discount, cash and bank column on both sides.

16
f. Bills receivable and payable Book: transactions regarding bills receivables accepted by
our customers are recorded in bills receivables book. At the end of the month, this will
transfer to general ledger account. If any outstanding is there, it will appear in the asset side
of the balance sheet. Similarly, Transactions regarding bills payable are accepted by us and
drawn by our suppliers are recorded in bills payable book. At the end of the month, this
will transfer to general ledger account. If any outstanding is there, it will appear in the
liability side of the balance sheet.
g. Journal Proper: Transactions which cannot be recorded in any of the above mentioned
books will be recorded in journal proper. The following are the examples:
➢ Opening and closing entries
➢ Adjustment entries
➢ Transfer entries
➢ Rectification entries

LEDGER POSTING

Ledger
The ledger is the main book of accounts or a book of final entry. It refers to a set of
books. The business transactions are entered in various subsidiary books (Journal is a
subsidiary book), as and when it happens. From these subsidiary books all information
connected with any single account cannot be seen at a glance. Therefore all information
connected with one single account-personal, property, expenses or income - are grouped
together so as to get the desired information immediately. Such grouping of transactions is
done in another book called Ledger. Hence it may be defined as a “a summary statement of all
the transactions relating to a person, asset, expenses or income which have taken place during
a given period of time and shows their net effect”. In small organization it is possible to keep
all the ledger accounts in one ledger. But in large size organizations, it is convenient to sub-
divide the ledger to facilitate easy reference as under:
a. General ledger: It contains all accounts other than Debtors and creditors which
includes owner’s account, assets accounts, purchases account, and all the nominal
accounts.
b. Subsidiary Ledger: this can be further divided into two:
• Debtors Ledger: It contains credit sales and related activities which enable
the businessman to calculate the amount owing by his customers easily.
• Creditors Ledger: it contains credit purchases and related activities which
enable the businessman to calculate the amount due to each creditor

Specimen ledger Account

Dr (Left hand side) (Right hand side) Cr
Date Particulars J.F No Rs Date Particulars J.F No. Rs.

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Posting and Balancing the Ledger
If a particular account is debited, it is posted in the debit side (left hand side) of that
account and vice-versa. When a ledger account is balanced, we can really understand the
position of that account. From the balance we can easily ascertain the amount due to someone
or amount due from someone or total of a particular expense or income is shown
The procedure of posting is as follows:
1. Enter the debit aspect of the transaction entered in journal on the debit side of the
account in the ledger with all the relevant details in the respective column.
2. Similarly, enter the credit aspect of the transaction in the journal on the credit side of
the account in the ledger with all the relevant details in the respective column.
3. In the folio column of the journal, the page number of the ledger in which posting is
done is entered. (this column remains blank)
4. It is customary to prefix the name of the account credited and entered on the debit side
of the account in the ledger with word “To.”
5. Similarly, the name of the account debited and entered on the credit side of the account
in the ledger is prefixed with “By.”
It may be noted that the words “To” and “By” do not have any special meaning.
Hence, the prefix can be conveniently ignored as done by modern accountants.

Steps in Balancing:
1. We have to make a total of both sides separately
2. Difference between the totals of both sides is known as balance.
3. The balance is written on the account in the side for which the total is short. If the credit
side is short, the balance is written as “By balance c/d” on the credit side. If the Debit side
is short, the balance is written as “To balance c/d” on the Debit side.
4. The balance has brought down to the opposite side. The balance written on credit side as
“By Balance c/d” is brought down to the debit side of the account as “To Balance b/d” after
completing the totals. Similarly, the balance written on debit side as “To Balance c/d” is
brought down to the credit side of the account as “By Balance b/d” after completing the
totals

PREPARATION OF TRAIL BALANCE

TRIAL BALANCE
❖ Trail balance is a statement containing the balances of all ledger accounts, as at any given
date, arranged in the form of debit and credit columns placed side by side and prepared
with the object of checking the arithmetical accuracy of ledger postings”.
❖ Trial Balance is a list of closing balances of ledger accounts on a certain date and is the
first step towards the preparation of financial statements. It is usually prepared at the end
of an accounting period to assist in the drafting of financial statements. Ledger balances
are segregated into debit balances and credit balances. Asset and expense accounts appear
on the debit side of the trial balance whereas liabilities, capital and income accounts appear
on the credit side. If all accounting entries are recorded correctly and all the ledger balances

18
 are accurately extracted, the total of all debit balances appearing in the trial balance must
equal to the sum of all credit balances.

Purpose of a Trial Balance

• Trial Balance acts as the first step in the preparation of financial statements. It is a
working paper that accountants use as a basis while preparing financial statements.
• Trial balance ensures that for every debit entry recorded, a corresponding credit
entry has been recorded in the books in accordance with the double entry concept
of accounting. If the totals of the trial balance do not agree, the differences may be
investigated and resolved before financial statements are prepared. Rectifying basic
accounting errors can be a much lengthy task after the financial statements have
been prepared because of the changes that would be required to correct the financial
statements.
• Trial balance ensures that the account balances are accurately extracted from
accounting ledgers.
• Trail balance assists in the identification and rectification of errors.

Importance /significance/ objectives of preparing the trial balance

a. It helps in knowing the balance of any particular account in the ledger
b. It helps in preparation of final accounts.
c. It ensures the arithmetical accuracy
d. It helps to prove that double entry has been followed while recoding the transactions

Methods of Preparing Trail Balance

A trail balance refers to a list of the ledger balances as on a particular date. It can be
prepared in the following manner:
a. Total Method: According to this method, debit total and credit total of each account of
ledger are recorded in the trail balance.
ST’S Books
Trail Balance as on……
S. No Name of Account L.F Debit Total Amount Credit Total Amount
Rs Rs

b. Balance Method: According to this method, only balance of each account of ledger is
recorded in trail balance. Some accounts may have debit balance and the other may have credit
balance. All these debit and credit balances are recorded in it. This method is widely used
MT’S Books
Trail Balance as on……
S. No Name of Account L.F Debit Balance Credit Balance
Rs Rs

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Example: Following is an example of what a simple Trial Balance looks like:
ABC LTD
Trial Balance as at 31 June 2015
Account Title Debit Credit
Rs Rs
Share Capital 15,000
Furniture & Fixture 5,000
Building 10,000
Creditor 5,000
Debtors 3,000
Cash 2,000
Sales 10,000
Cost of sales 8,000
General and Administration Expense 2,000
Total 30,000 30,000

• Title provided at the top shows the name of the entity and accounting period end for
which the trial balance has been prepared.
• Account Title shows the name of the accounting ledgers from which the balances have
been extracted
• Balances relating to assets and expenses are presented in the left column (debit side)
whereas those relating to liabilities, income and equity are shown on the right column
(credit side).
• The sum of all debit and credit balances are shown at the bottom of their respective
columns

Guidelines for preparing Trail balance

Trial balance consists of balances found in various ledger accounts which are appearing
in the trial balance as follows:
• An asset is always appeared in debit side of trial balance
• Liabilities is always appeared in credit side of trial balance
• All the incomes or gains appear in credit side of trial balance
• All the expenses or losses appear in debit side of trial balance
• Opening stock, purchases, and sales return always appear in debit side of the trial
balance
• Closing stock, sales, and purchases return always appear in credit side of the trial
balance
• Reserves and provisions appear credit side of the trial balance.

PREPARATION OF TRADING ACCOUNT -PREPARATION OF P&L

ACCOUNT- PREPARATION OF BALANCE SHEETS

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FINAL ACCOUNT
Final accounts are otherwise called annual accounts. Normally final accounts are
prepared at the end of the financial year or accounting year. The purpose of preparing final
accounts is to enable one to know the progress of the business, profit or loss and financial
position of the firm at the right time.
The preparation of final account is not the first step of the accounting process but it is
the final product of the accounting process. It will give valuable information to the management
and outsiders at the end of the accounting period. Only after the preparation of trial balance it
is possible to prepare final account. Final account consists of the following parts
1. Trading account
2. Profit and loss account
3. Balance sheet

1. TRADING ACCOUNT
Trading account is prepared for an accounting period to find the trading results or gross
margin of the business i.e., the amount of gross profit the concern has made from buying
and selling during the accounting period. The difference between the sales and cost of sales
is gross profit. For the purpose of computing cost of sales, value of opening stock of
finished goods, purchases, direct expenses on purchasing and manufacturing are added up
and closing stock of finished goods is reduced. The balance of this account shows gross
profit or loss which is transferred to the profit and loss account.

Preparation of Trading Account

Trading account is a ledger account. It has to be prepared in conformity with double
entry principles of debit and credit.

Items shown in trading account: (A) Debit side

a. Opening stock: The stock at the beginning of an accounting period is called opening
stock. This is the closing stock as per the last balance sheet. It includes stock of raw
materials, work in progress, (where manufacturing account is not separately prepared)
and finished goods. Trading account starts with opening stock on the debit side.
b. Purchases: The total value of goods purchased after deducting purchase returns is
debited to trading a/c. Purchases comprise of cash purchases am credit purchases.
c. Direct expenses: Direct expenses are incurred to make the goods sale able. They
include wages, carriage and freight on purchases, import duty, customs duty, clearing
and forwarding charges manufacturing expenses or factor. Expenses (where
manufacturing account is not separately prepared). All direct expenses are extracted
from trial balance.

Items shown in trading account :(B) Credit side:

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 a. Sales: It includes both credit and cash sales. Sales returns are reduced from sales and
net sales are shown on the credit side of trading account. The sales and returns are
extracted from the trial balance.
b. Closing stock: Closing stock is the value of goods remaining at the end of the
accounting period. It includes closing stock of raw materials, work progress (where
manufacturing account is not separately prepared) and finished stock. The opening
stock is ascertained from trial balance but closing stock is not a part of ledger. It is
separately valued and given as an adjustment. If it is given in trial balance, it is after
adjustment of opening and closing stocks in purchases. If closing stock is given in trial
balance it is shown only as current asset in balance sheet. If closing stock is given
outside trial balance, it is shown on credit side of trading account and also as current
asset in the balance sheet

Closing Entries Relating To Trading Account

The Journal entries given below are passed to transfer the relevant ledger account balances
to trading account

(i) For opening stock, purchases and direct expenses.

Trading A/c Dr Xxx
To Opening Stock A/c xxx
To Purchases (Net) A/c xxx
To Direct expenses A/c Xxx
[Being transfer of trading a/c debit
side items]

(ii) For transfer of sales (after reducing sales returns)

Sales (net) A/c Dr Xxx
To Trading A/c Xxx
[Being transfer of sales to Trading A/c]

(iii) For transferring gross profit

Trading A/c Dr xxx
To Profit & Loss A/c Xxx
[Being transfer of gross profit to P&L A/c]

(iv) For Gross Loss

Profit & Loss A/c Dr xxx
To Trading A/c Xxx
[Being transfer of gross loss to P&L A/c]

Note: Closing stock is taken into account by an adjustment journal entry along with other
adjustments.

Specimen of trading account is shown below

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 Trading account for the year ended ……………
Particulars Rs. Rs. Particulars Rs. Rs.
To Opening stock Xxx By Sales Xxx
To purchases xxx Less: Returns inwards ..,..,
(or) xxx
Sales Returns ----- xxx
Less: purchase returns xxx xxx xxx
To Direct expenses:
Wages xxx By closing stock xxx
Fuel & Power xxx By Gross loss c/d * xxx
Carriage inwards xxx (transferred to profit
and loss A/c)
xxx
Royalty on production xxx
Power xxx
Coal water, Gas xxx
Import duty xxx
Consumable stores xxx
Factory expenses xxx
To Gross profit c/d -----
(transferred to profit and
loss A/c)
* Balancing figure will be either gross profit or loss in Trading A/c

Trading Account Equation

Trading account is prepared for calculating gross profit or gross loss. Gross profit or
gross loss is the difference between the „cost of goods sold‟ and “sales‟.
Gross Profit = Sales – Cost of goods and sold
(Or) Gross Profit + Cost of goods sold = Sales

Advantages of Trading Account

• The result of trading can be known separately.
• The various items of trading account of different periods can be compared.
• The adjustment in the selling price can be made by knowing the percentage of gross
profit on net sales.
• Over-stocking/under-stocking can be known in order to act wisely.
• If gross loss is disclosed, the business can be closed immediately because the loss will
further increase when the indirect expenses are added to it.
• The progress can be studied on the basis of gross Profit ratio, year after year

2. PROFIT AND LOSS ACCOUNT

❖ “Profit and loss account is an account into which all gains and losses are collected in
order to ascertain the excess of gains over the losses or vice versa.”
❖ A financial statement that summarizes the revenues, costs and expenses incurred during
a specific period of time - usually a fiscal quarter or year. These records provide
information that shows the ability of a company to generate profit by increasing revenue

23
 and reducing costs. The P&L statement is also known as a "statement of profit and
loss", an "income statement" or an "income and expense statement".
❖ The profit and loss account is opened by recording the gross profit (on credit side) or
gross loss (debit side).

Preparation of Profit And Loss Account

Profit and loss account starts with gross profit brought down from trading
account on the credit side. (If gross loss, on the debit side). All the indirect expenses
are debited and all the revenue incomes are credited to the profit and loss account and
then net profit or loss is calculated. If incomes or credit is more, than the expenses or
debit, the difference is net profit. On the other hand if the expenses or debit side is more,
the difference is net loss.
Debit side: Expenses shown on the debit side of profit and loss account are classified
into two categories
a. Operating expenses: These expenses are incurred to operate the business
efficiently. They are incurred in running the organisation. Operating expenses
include administration, selling, distribution, finance, depreciation and maintenance
expenses.
b. Non operating expenses: These expenses are not directly associate with day today
operations of the business concern. They include loss on sale of assets,
extraordinary losses, etc.
Credit side: Gross profit is the first item appearing on the credit side of profit and loss
account. Other revenue incomes also appear on the credit side of profit and to account.
The other incomes are classified as operating incomes and non operating incomes.
a. Operating incomes: These incomes are incidental to business and earned from
usual business carried on by the concern. Examples: discount received, commission
earned, interest received etc
b. Non operating incomes: These incomes are not related to the business carried on
by the firm. Examples are profit on sale of fixed assets, refund of tax etc.

Profit and Loss Account For the year ended 31st March 2019

Particulars Rs Particulars Rs
To Gross loss b/d xxx To Gross profit b/d xxx
To Administration expenses By dividends received xxx
Salaries xxx By interest received xxx
Rent rates & taxes xxx By discount received xxx
Printing & Stationery xxx By commission received xxx
Postage and Telegrams xxx By Rent received xxx
Telephone expenses xxx By profit on sale of assets xxx
Legal charges xxx By sundry revenue receipts xxx
Insurance xxx By net loss transferred to capital xxx
A/c (Bal Fig)*
Audit fees xxx
Directors fees Xxx

24
 General expenses Xxx
To Selling & Distribution Expenses
Showroom expenses Xxx
Advertising Xxx
Commission paid to salesman Xxx
Bad debts Xxx
Provision for doubtful debts Xxx
Godown rent Xxx
Carriage outward Xxx
Upkeep of delivery vans Xxx
To Depreciation and maintenance
Depreciation Xxx
Repairs Xxx
To Financial expenses
Interest on borrowings Xxx
Discount allowed Xxx
To abnormal losses
Loss on sale of assets Xxx
To net profit transferred to capital Xxx
A/c(Bal Fig)
Xxx xxx
The purpose and importance of preparing profit and loss account.
• To determine the future line of action
• To know the net profit or loss of business
• To calculate different ratios
• To compare the actual performance of the business with the desired one.

Principles of Preparing Profit Of Loss Account

a) Only revenue receipts should be entered
b) Only revenue expenses together with losses should be taken into account.
c) Expenses and incomes relating only to the period for which the accounts are being prepared
should be considered.
d) All expenses and income relating to the period concerned should be considered even if the
expense has not yet been paid in cash or the income has not yet been received in cash.
e) All personal expenses of the proprietor and pertners must be debited to the capital or
drawings accounts and must not be debited to the profit and loss account. Similarly any
income has been earned from the private assets of the proprietor which is received by firm,
it must be credited to the capital or drawings account.

3. BALANCE SHEET
❖ The Balance sheet comprises of lists of assets, liabilities and capital fund on a given
date.
❖ It presents the financial position of a concern as revealed by the accounting records.
❖ It reflects the assets owned by the concern and the sources of funds used in the
acquisition of those assets.

25
 ❖ In simple language it is prepared in such a way that true financial position is revealed
in a form easily readable and more rapidly understood than would be possible from a
view of the detailed information contained in the accounting records prepared during
the currency of the accounting period.
❖ Balance sheet may be called a ‘statement of equality’ in which equality is established
by representing values of assets on one side and values of liabilities and owners' funds
on the other side.
Title
A Balance sheet is called by different names probably due to lack of uniformity in
accounting systems. Generally, the following titles are used in respect of balance sheet:
a. Balance sheet or General Balance sheet;
b. Statement of Financial position or condition;
c. Statement of assets and liabilities;
d. Statement of assets and liabilities and owners’ fund etc.
Of the above, the title 'Balance sheet" is mostly used. The use of this title implies that
data presented in it have been taken from the balances of accounts,
Definition
❖ “Balance sheet is a ‘Classified summary’ of the ledger balances remaining after closing
all revenue items into the profit and loss account.” - Cropper.
❖ “Balance sheet is a screen picture of the financial position of a going business concern
at a certain moment” - Francis.

Classification of Assets And Liabilities

A clear and correct understanding of the basic divisions of the assets and liabilities and
the meanings which they signify and the amounts which they represent is very essential for a
proper perspective of financial position of a business concern. Assets and liabilities are
classified under the following major headings
a. Assets: Assets are properties of business. They are classified on the basis of theirnature.
Different types of assets are as under:
a. Fixed assets: Fixed assets are the assets which are acquired and held permanently and
used in the business with the objective of making profits. Land and building, Plant and
machinery, Furniture and Fixtures are examples of fixed assets.
b. Current assets: The assets of the business in the form of cash, debtors bank balances,
bill receivable and stock are called current assets as they can be realised within an
operating cycle of one year to discharge liabilities.
c. Tangible assets: Tangible assets have definite physical shape or identity and existence;
they can be seen, felt and have volume such as land, cash, stock etc. Thus tangible assets
can be both fixed assets and current assets.
d. Intangible assets: The assets which have no physical shape which cannot be seen or
felt but have value are called intangible assets. Goodwill, patents, trade marks and
licences are examples of intangible assets. They are usually classified under fixed
assets.
e. Fictitious assets: Fictitious assets are not real assets. Past accumulated losses or
expenses which are capitalised for the time being, expenses for promotion of

26
 organisations (preliminary expenses), discount on issue of shares, debit balance of
profit and loss account etc. are the examples of fictitious assets.
f. Wasting assets: These assets are also called depleting assets. Assets such as mines,
Timber forests, quarries etc. which become exhausted in value by way of excavation of
the minerals, cutting of wood etc. are known as wasting assets. Such assets are usually
natural resources with physical limitations.
g. Contingent assets: Contingent assets are assets, the existence, value possession of
which is based on happening or otherwise of specific events. For example, if a business
firm has filed a suit for a particular property now in possession of other persons, the
firm will get the property if the suit is decided in its favour. Till the suit is decided, it is
a contingent asset.
b. Liabilities: A liability is an amount which a business firm is ‘liable to pay’ legally. All the
amounts which are claims by outsiders on the assets of the business are known as liabilities.
They are credit balances in the ledger. Liabilities are classified into four categories as given
below.
a. Owner's capital: Capital is the amount contributed by the owners of the business. In
addition to initial capital introduced, proprietors may introduce additional capital and
withdraw some amounts from business over a period of time. Owner’s capital is also
called ‘net worth’. Net worth is the total fund of proprietors on a particulars date. It
consists of capital, profits and interest on capital subject to reduction of drawings and
interest on drawings. In case of limited companies, capital refers to capital subscribed
by shareholders. Net worth refers to paid up equity capital plus reserves and profits,
minus losses.
b. Long term Liabilities: Liabilities repayable after specific duration of long period of
time are called long term liabilities. They do not become due for payment in the
ordinary ‘operating cycle’ of business or within a short period of lime. Examples are
long term loans and debentures. Long term liabilities may be secured or unsecured,
though usually they are secured.
c. Current liabilities: Liabilities which are repayable during the operating cycle of
business, usually within a year, are called short term liabilities or current liabilities.
They are paid out of current assets or by the creation of other current liabilities.
Examples of current liabilities are trade creditors, bills payable, outstanding expenses,
bank overdraft, taxes payable and dividends payable.
d. Contingent liabilities: Contingent liabilities will result into liabilities only if certain
events happen. Examples are: Bills discounted and endorsed

Performa of Balance Sheet

Balance Sheet as on ………
Liabilities Rs Assets Rs
Capital xxx Fixed assets xxx
Add: Net profit xxx Goodwill xxx
Add: interest on capital xxx Land & Buildings xxx
-------- Loose tools xxx
Less: Drawing xxx Furniture & fixtures xxx

27
 Less: Int. on drawing xxx Vehicles xxx
Less: Loss if any xxx Patents xxx
-------- xxx Trade marks xxx
Long term liabilities Long term loans(advances xxx
Loan on mortgage xxx Investments
Current assets
Bank loan xxx Closing stock xxx
Current liabilities Sundry debtors xxx
Sundry creditors xxx Bills receivable xxx
Bills payable xxx Prepaid expenses xxx
Bank overdraft xxx Accrued incomes xxx
Creditors for outstanding exp xxx Cash at hand xxx
Income received in advance xxx Cash in hand xxx
Fictitious assets
Preliminary expenses xxx
Advertisement expenses xxx
Underwriting commission xxx
Discount on issue of shares xxx
Discount on issue of debentures xxx
xxx xxx

Function of a Balance Sheet

1. A Balance Sheet exhibits the true financial position of a firm at a particular date.
2. Financial position can be ascertained clearly with the help of Balance Sheet.
3. It provides valuable information to the management for taking better decision through ratio
analysis.
4. Balance Sheet helps in knowing past and present position of an enterprise. It may be called
the horoscope of the concern.
5. It is a mirror of a business.

Limitations of Balance Sheet

1. It is prepared on a historical cost basis. Changes in prices are not considered.
2. Historical Cost of Balance Sheet does not convey fruitful information
3. Different assets are valued according to different rules.
4. It is measured in terms of money or money’s worth. That is, only those assets are
recorded in it which can be expressed in money.
5. Balance Sheet has some fictitious assets, which have no market values. Such items are
unnecessarily inflate the total value of assets.

Difference between a Trial Balance and a Balance Sheet

Balance Sheet Trial Balance
1 Balance sheet columns are headed by Trial balance columns are headed by Dr.
Liabilities and Assets. and Cr.

28
2 It is a statement showing closing balances It is codified summary of all ledger
of Personal and Real Accounts. balances-Personal, Real and Nominal
accounts.
3 It is the last step in final accounts. It is the first step in the final accounts.
4 It contains only closing stock. It contains opening stock.
5 In reveals the true the financial position of It establishes the arithmetical accuracy of
a firm. the accounting work.
6 It is prepared after the preparation of It is prepared before the preparation of
Revenue accounts. revenue accounts.
7 Stock taking is essential for the preparation Stock taking is not necessary for a Trial
of Balance Sheet. Balance.
8 The arrangement of assets and liabilities There is no order as to the arrangement of
are made in order of liquidity or ledger balance in a Trial Balance.
performance.
9 To complete the accounting circle. Balance To complete the accounting circle. Trial
Sheet is essential. Balance is not necessarily prepared.
10 It gives a clear picture of the trend of the It will not give any guidance to understand
firm. the trend of the firm

ADJUSTMENTS IN TRADING ACCOUNT - ADJUSTMENT IN P&L

ACCOUNT

Adjustments Profit and Loss a/c Balance sheet

Closing Stock Credit Trading a/c with the value Show the closing stock in the
[Current Asset] of closing stock Asset side.
Stock destroyed by fire Credit Trading a/c with full value Add the claim received in
[Abnormal loss] of stock destroyed. Debit P&L a/c cash with Cash a/c OR show
with the actual loss [total stock the Insurance Company a/c
destroyed less insurance claim] in the Asset side.
Outstanding Expenses Add to the concerned item of Shown all Outstanding
[Current Liability] expenses in debit side. Expenses in the Liability side
Prepaid expenses Deduct from the concerned item Shown all prepaid expenses
[Current Asset] of expense in the debit side. in the Asset side
Depreciation Debit with the amount of Deduct the amount of
[Operating loss] depreciation of individual asset depreciation from the
concerned item of asset Or
add the amount with the
Depreciation Reserve in the
liability side.
Bad debts Debit the amount of bad debts Deduct the amount of bad
[Operating loss] debts from sundry Debtors.

29
Problems
1. The following is the Trail Balance of Mr.Viswanathan on 31st December, 2006.

Name of Accounts Debit Credit

(Rs) (Rs)
Capital 20,000
Plant and Machinery 25,000
Office furniture and Fittings 1,300
Stock on 1.1.2006 24,000
Motor vehicle 6,000
Sundry Debtors 22,850
Cash in hand 200
Cash at Bank 3,250
Wages 75,000
Salaries 7,000
Purchases 1,06,750
Sales 2,40,000
Bills receivable 3,600
Bills payable 2,800
Sundry creditors 26,000
Returns inwards 4,650
Provision for doubtful debts 1,250
Drawings 3,500
Return outwards 2,750
Rent 3,000
Factory lighting 400
Insurance 3,150
General expenses 500
Bad debts 1,250
Discount 3,250 1.850
2,94,650 2,94,650
The following adjustments are to be effected:
i. Stock on 31st December, 2006 Rs. 26,000
ii. Furniture to be depreciated by 5%
iii. Factory lighting is due for 3 months, but not paid Rs. 150
iv. Write off further bad debts FRs.350
v. The provision for doubtful debts to be increased to Rs.1,500, and provision for
discount on debts at 2% to be made
vi. During the year, machinery was purchased for Rs.10,000, but it was debited to
purchase Account
You are required to prepare Trading, Profit and Loss Account and the Balance sheet
as on 31st December, 2006

Solution
Trading account as on 31st December, 2006
Particulars Rs Rs particulars Rs Rs
To Opening Stock 24,000 By sales 2,40,000
To Purchases 1,06,750 Less: sales return 4,650 2,35,350

30
Less: return Outwards 2,750 By closing stock 26,000
Less: Machinery Purchase 10,000 94,000
To wages 75,000
To factory lighting 400
Add: outstanding 150 550
To gross profit 67,800
2,61,350 261,350

Profit and loss account as on 31st December, 2006

Particulars Rs Rs particulars Rs Rs
To salaries 7,000 Gross Profit 67,800
To rent 3,000
To insurance 3,150 Provision for doubtful 1,250
debts
To general expenses 500 Discount 1,850
To discount 3,250
Bad debts 1,250
To bad debts 350 2,280
Provision for bad debts 1500
Provision for Discount on 430
debt@2%
To depreciation on 65
furniture
To net profit 50,405
70,900 70,900

Balance sheet as on 31st December, 2006

Liabilities Amount. Amount. Assets Amount. Amount.
Rs Rs Rs Rs
Capital 20,000 66905 Plant and Machinery 25,000
(+)Net Profit 50,405 Add Purchase Account 10,000 35,000
(-)Drawing 3,500
Bills payable 2,800 Office furniture and 1,300
Fittings
Depreciation 65 1,235
Sundry 26,000 Motor vehicle 6,000
creditors
Outstanding 150 Sundry Debtors 22,850
factory (-) Bad Debts 350
lighting (-) Provision for bad 22,500
debts 1,500
Provision for Discount 21,000
on debt@2% 430 20570
Cash in hand 200
Bills receivable 3,600
Closing stock 26,000
Cash at Bank 3250
95,855 95,855

31
 UNIT II

Introduction to Financial Statements - Comparative Income Statements- Preparation of

Comparative Income Statements - Comparative Balance Sheets - Preparation of Comparative
Balance Sheets- Common Size Income Statements - Preparation of Common Size Income
Statements - Common Size Balance Sheet- Preparation of common size Balance Sheet-
Interpretation from the Common size statements- Interpretation from the Comparative
statements- Trend Analysis

INTRODUCTION TO FINANCIAL STATEMENTS

Financial statements
Every business concern wants to know the various financial aspects for effective decision
making. The preparation of financial statement is required in order to achieve the objectives of
the firm as a whole. The term financial statement refers to an organized collection of data on
the basis of accounting principles and conventions to disclose its financial information.
Financial statements are broadly grouped in to two statements:
I. Income Statements (Trading, Profit and Loss Account)
II. Balance Sheets

➢ Financial statements are those statement which includes the income statement,
balance sheets, statement of retained earnings and the statement of sources and uses
of funds. The income statement includes the trading account and the profit & loss
account of the business concern and the balance sheet includes the assets and
liabilities of the business.
➢ The financial statement provides the vital information relating to the profitability,
liquidity and solvency of the business. The main aim of the financial statement is
to provide reliable information relating to the economic resources, business
obligations, changes in net resources etc.
➢ Financial statements are prepared primarily for decision-making. They play a
dominant role in setting the framework of managerial decisions. But the information
provided in the financial statements is not an end in itself as no meaningful
conclusions can be drawn from these statements alone

Nature of Financial Statements

According to the American Institute of Certified Public Accountants, financial
statements reflect ‘A combination of recorded facts, accounting conventions and personal
judgements and the judgements and conventions applied affect them materially.’ This implies
that data exhibited in the financial statements are affected by recorded facts, accounting
conventions and personal judgements.
a) Recorded facts: The term ‘recorded facts’ means facts, which have been recorded in the
accounting books. Facts which have not been recorded in the financial books are not
depicted in the financial statements, however material they might be. For example, fixed

32
 assets are shown at cost irrespective of their market or replacement price since such price
is not recorded in the books.
b) Accounting conventions: Accounting conventions imply certain fundamental accounting
principles which have been sanctified by long usage. For example, on account of the
convention of ‘conservatism’, provision is made of expected losses but expected profits are
ignored. This means that the real financial position of the business may be much better than
what has been shown by the financial statements.
c) Personal judgements: Personal judgements also have an important bearing on the
financial statements. For example, the choice of selecting a method of depreciation lies on
the accountant. Similarly, the mode of amortization of fictitious assets also depends on the
personal judgement of the accountant.

Purposes and Objectives of Financial Statements

Financial statements are very useful as they serve varied affected group having an
economic interest in the activities in the business entity. Let us analyse the purpose served ƅy
financial statement.
a) The basic purpose of financial statement is communicated to their interested users,
quantitative and objectives information is useful in making economic decisions.
b) Secondly, financial statements are intended to meet the specialized needs of conscious
creditors and investors.
c) Thirdly, financial statements are prepared to provide reliaƅle information aƅout the earning
of a ƅusiness enterprise and it aƅility to operate of profit in future. The users who are in
this information are generally the investors, creditors, suppliers and employees.
d) Fourthly, financial statements are intended to provide the ƅase for tax assessments.
e) Fifthly, financial statement prepare in a way a provide information that is useful in
predicting the future earning power of the enterprise.
f) Sixthly, financial statements are prepared to provide reliaƅle information aƅout the changes
in economic resources.
g) Seventhly, financial statements are prepared to provide information aƅout the changes in
net resources of the organization that result from profit directed activities.
Thus, financial statement satisfies the information requirements of a wide cross-section
of the society representing corporate managers, executives, ƅankers, creditors, shareholders
investors, laƅourers, consumers, and government institution.

Importance of Financial Statements

The need or importance of financial statement is to satisfy the needs of the users of the
financial statements and which provides relevant information's about the business to the
interested parties like Government, management, creditors, share holders etc. The importance
of Financial statements are as follows:-
a. Importance to Management: In the competitive business environment, it is difficult
to sustain the business without any advanced planning or forecasting. The financial
statements helps the management to know about the current position of the business as
up to date, accurate and systematic information relating to the business. It enables the
management to identify the current position, progress of the business and the business

33
 prospectus which leads the managers to take necessary remedies and plans to develop
the business environment.
b. Importance to Shareholders. In the case of companies, management is separated from
the ownership of the organisation and the shareholders are not authorized to take part
in the day to day business activities of the concern. But in the Annual General Meeting,
the results and activities of the concern will be reported to the shareholders in the form
of financial statements. This financial statements enables the shareholders to know
about the performance of the management and it will give the relevant information of
the effectiveness, efficiency and the current financial position
of the business also.
c. Importance to Leaders or Creditors: The financial statements provides the useful
information or guide to the suppliers or the creditors of the company. This is done with
the help of critical evaluation of the financial statements and which provides the clear
idea about the liquidity, profitability and the solvency of the business enterprises.
d. Importance to Labour: The financial statement provides the profit and loss account
of the business. This enables the staff to identify the profit condition of the business
and helps to negotiate for the better salary because the profit of the company depends
on the salary for the staffs.
e. Importance to the public: Every business is a social entity which includes the co-
operation of the various groups which includes lawyers, trade unions, financial analysts,
teachers, research scholars etc. These groups are intended to know the financial position
of the business and this will be available only through the financial statements.
f. Importance to National Economy: The economic development of a country is highly
depends on the growth and development of business environment. Financial statement
discloses the relevant details of the business to the needy and this is importance to the
tax authorities and other statutory aspects in the country.

Types of Financial Analysis

These can be of the following types:

• External Analysis: This type of analysis is done by outsiders who do not have access to
internal accounting records of the company.

34
• Internal Analysis: Analysis done by persons who have access to internal accounting
records of the firm is called internal analysis.
• Horizontal Analysis: Here, every item in the financial statement is analysed over a number
of years, order to ascertain its trend. Comparative statements and Trend percentages are the
two tools used in this type of analysis.
• Vertical Analysis: It refers to the study of relationship between various items in a specific
years financial statement. Common size financial statements and financial ratios are the
two tools used in this analytical mode.

Tools used in financial analysis

Financial Analyst can use a variety of tools for the purposes of analysis and interpretation
of financial statements particularly with a view to suit the requirements of the specific
enterprise. The principal tools are as follows:-

a. Comparative Financial Statements

b. Common-size Statements
c. Trend Analysis
d. Cash Flow Statement
e. Ratio Analysis
f. Funds Flow statements

a. Comparative Financial Statements : Comparative financial statements are those

statements which have been designed in a way so as to provide time perspective to the
consideration of various elements of financial position embodied in such statements. In
these statements figures for two or more periods are placed side by side to facilitate
comparison. Both the Income Statement and Balance Sheet can be prepared in the form
of Comparative Financial Statements.
i. Comparative Income Statement: The comparative Income Statement is the study
of the trend of the same items/group of items in two or more Income Statements of
the firm for different periods.
ii. Comparative Balance Sheet: The comparative Balance Sheet analysis would
highlight the trend of various items and groups of items appearing in two or more
Balance Sheets of a firm on different dates. The changes in periodic balance sheet
items would reflect the changes in the financial position at two or more periods.
b. Common-size Financial Statements: 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 the figures are expressed as a percentage of this total.
i. Common Size Income Statement: In the case of Income Statement, the sales
figure is assumed to be equal to 100 and all other figures are expressed as percentage
of sales. The relationship between items of Income Statement and volume of sales
is quite significant since it would be helpful in evaluating operational activities of

35
 the concern. The selling expenses will certainly go up with increase in sales. The
administrative and financial expenses may go up or may remain at the same level.
In case of decline in sale, selling expenses should definitely decrease.
ii. Common Size Balance Sheet: For the purpose of common size Balance Sheet, the
total of assets or liabilities is taken as 100 and all the figures are expressed as
percentage of the total. In other words, each asset is expressed as percentage to total
assets/liabilities and each liability is expressed as percentage to total
assets/liabilities. This statement will throw light on the solvency position of the
concern by providing an analysis of pattern of financing both long-term and
working capital needs of the concern.
c. Trend Analysis: The third tool of financial analysis is trend analysis. This is
immensely helpful in making a comparative study of the financial statements of several
years. Under this method trend percentages are calculated for each item of the financial
statement taking the figure of base year as 100. The starting year is usually taken as the
base year. The trend percentages show the relationship of each item with its preceding
year's percentages. These percentages can also be presented in the form of index
numbers showing relative change in the financial data of certain period. This will
exhibit the direction, (i.e., upward or downward trend) to which the concern is
proceeding. These trend ratios may be compared with industry ratios in order to know
the strong or weak points of a concern. These are calculated only for major items instead
of calculating for all items in the financial statements.
d. Cash Flow Statement: A cash flow statement shows an entity's cash receipts classified
by major sources and its cash payments classified by major uses during a period. It
provides useful information about an entity's activities in generating cash from
operations to repay debt, distribute dividends or reinvest to maintain or expand its
operating capacity; about its financing activities, both debt and equity; and about its
investment in fixed assets or current assets other than cash. In other words, a cash flow
statement lists down various items and their respective magnitude which bring about
changes in the cash balance between two balance sheet dates. All the items whether
current or non-current which increase or decrease the balance of cash are included in
the cash flow statement. Therefore, the effect of changes in the current assets and
current liabilities during an accounting period on cash position, which is not shown in
a fund flow statement is depicted in a cash flow statement. The depiction of all possible
sources and application of cash in the cash flow statement helps the financial manager
in short term financial planning in a significant manner because the short term business
obligations such as trade creditors, bank loans, interest on debentures and dividend to
shareholders can be met out of cash only. The preparation of cash flow statement is also
consistent with the basic objective of financial reporting which is to provide
information to investors, creditors and others which would be useful in making rational
decisions. The basic objective is to enable the users of information to make prediction
about cash flows in an organisation since the ultimate success or failure of the business
depends upon the amount of cash generated. This objective is sought to be met by
preparing a cash flow statement.

36
 e. Ratio Analysis: Ratio Analysis Ratio Analysis is one of the important techniques
which is used to measure the establishment of relationship between the two interrelated
accounting figures in financial statements. This analysis helps to Management for
decision making. Ratio Analysis is an effective tool which is used to ascertain the
liquidity and operational efficiency of the concern.
f. Funds Flow Statement Fund Flow Analysis is one of the important methods for
analysis and interpretations of financial statements. This is the statement which acts as
a supplementary statement to the profit and loss account and balance sheet. Fund Flow
Analysis helps to determine the changes in financial position on working capital basis
and on cash basis. It also reveals the information about the sources of funds and has
been utilized or employed during particular period.

COMPARATIVE INCOME STATEMENTS- PREPARATION OF

COMPARATIVE INCOME STATEMENTS

The comparative Income Statement is the study of the trend of the same items/group of
items in two or more Income Statements of the firm for different periods. The changes in the
Income Statement items over the period would help in forming opinion about the performance
of the enterprise in its business operations. The Interpretation of Comparative Income
Statement would be as follows:
➢ The changes in sales should be compared with the changes in cost of goods sold. If
increase in sales is more than the increase in the cost of goods sold, then the profitability
will improve.
➢ An increase in operating expenses or decrease in sales would imply decrease in
operating profit and a decrease in operating expenses or increase in sales would imply
increase in operating profit.
➢ The increase or decrease in net profit will give an idea about the overall profitability of
the concern.

Different objectives of a Comparative Income Statement are as follows:

1. The basic objective of a Comparative Income Statement or Statement of Profit & Loss
is to analyse every item of Revenue and Expenses for two or more years.
2. It is also prepared to analyse the increase or decrease in every item of Revenue and
Expenses in terms of rupees and percentages. With this increase or decrease, the trend
of each item is determined.
3. A Comparative Statement of Profit & Loss or Income Statement also compares data
of more than one year, showing the overall trend of profit.
4. Lastly, it is prepared to analyse and determine the reasons behind the change in the
financial performance of the company.

Steps in preparing a comparative income statement

1. First Column: In the first column, every item of the Statement of Profit & Loss
(Revenue and Expenses) is written. Revenue from Operations and Other Income are

37
 written separately. Expenses such as Cost of Materials Consumed, Purchase of Stock-in-
Trade, Changes in Inventories of Finished Goods, Work-in-Progress and Stock-in-Trade,
Employees Benefit Expenses, Depreciation and Amortisation Expenses, Finance Cost,
and Other Expenses are written.
2. Second Column: In the second column, Note No. given against the item in the Income
Statement is written.
3. Third Column: In the third column, the amounts of the previous year are written.
4. Fourth Column: In the fourth column, the amounts of the current year are written.
5. Fifth Column: In this column, the difference (increase or decrease) in the amounts
between the current and previous accounting year is recorded.
6. Sixth Column: In the last column, the difference determined in the previous column is
expressed in percentage form by taking the previous year’s amount as a base. It can be
determined with the help of the following formula:

The format of a comparative income statement is as follows:

Note: If the current year’s value of a company has decreased, then show the Absolute Change
and Percentage Change in brackets to reflect the negative item.

38
 COMPARATIVE BALANCE SHEETS - PREPARATION OF
COMPARATIVE BALANCE SHEETS

A technique of comparing financial statements through which the balance sheet of a

company is analysed by comparing its Asset, and Equity and Liabilities for two or more two
accounting periods is known as Comparative Balance Sheet. It is a horizontal analysis of
Balance Sheet, and with this tool, every item of Assets, and Equity and Liabilities is analysed
for two or more accounting periods. This analysis can help in forming an opinion regarding
the progress of the enterprise. The Interpretation of Comparative Balance Sheets are as
follows:
➢ The increase in working capital would imply increase in the liquidity position of
the firm over the period and the decrease in working capital would imply
deterioration in the liquidity position of the firm.
➢ An assessment about the long-term financial position can be made by studying the
changes in fixed assets, capital and long-term liabilities. If the increase in capital
and long-term liabilities is more than the increase in fixed assets, it implies that a
part of capital and long-term liabilities has been used for financing a part of working
capital as well. This will be a reflection of the good financial policy. The reverse
situation will be a signal towards increasing degree of risk to which the long-term
solvency of the concern would be exposed to.
➢ The changes in retained earnings, reserves and surpluses will give an indication
about the trend in profitability of the concern. An increase in reserve and surplus
and the Profit and Loss Account is an indication of improvement in profitability of
the concern. The decrease in these accounts may imply payment of dividends, issue
of bonus shares or deterioration in profitability of the concern.

Objectives of Comparative Balance Sheet:

1. The basic objective of a comparative balance sheet is to analyse every item of Assets, and
Equity and Liabilities of two or more accounting years.
2. It is also prepared to analyse an increase or decrease in every item of Equity and
Liabilities, and Assets in terms of percentage and rupees, and also to determine the trend
and effect of each item.
3. Lastly, it is prepared to analyse and determine the reasons for any change in financial
position.

Steps in preparing a comparative balance sheet

A Comparative Balance Sheet has the following six columns:
1. First Column: In the first column, the components or items, or elements of the Balance
Sheet are recorded.
2. Second Column: In the second column, Note No. given against the line item is Balance
Sheet is recorded.
3. Third Column: In this column, the amounts of the previous year are recorded.
4. Fourth Column: In this column, the amounts of the current year are recorded.

39
5. Fifth Column: In the fifth column, the difference (increase or decrease) in amounts
between the current and previous year are shown.
6. Sixth Column: In the last column, the difference of amount in the previous column is
expressed in percentage form by taking Column 3 as the base. The amount of the sixth
column can be determined with the help of the following formula:

Format of Comparative Balance Sheet:

40
Advantages of Comparative Balance Sheet:
1. More Realistic Approach: A Balance Sheet only shows the balances of Assets, and
Equity and Liabilities of a company after closing the books of accounts at a certain date.
However, a Comparative Balance Sheet not only shows the balances of Assets, and
Equity and Liabilities at a certain date, but also the extent to which those figures have
increased or decreased between these dates.

41
2. Emphasis on Changes: A Balance Sheet emphasises on the status of the company;
however, a Comparative Balance Sheet emphasises on the change.
3. Reflects Trend: A Comparative Balance Sheet allows the user to study the nature, size,
and trend of change in various items of a Balance Sheet. Therefore, it is more useful than
a Balance Sheet of a single year.
4. Link between Balance Sheet and Statement of Profit & Loss: A Comparative
Balance Sheet acts as a link between the Balance Sheet and Statement of Profit & Loss
of a company as it shows the effects of business operations on its Assets, and Equity and
Liabilities.
5. Facilitates Planning: A Comparative Balance Sheet helps an organisation in
determining the trends of its growth or decrease in the value of its Assets, and Equity and
Liabilities. The trends ultimately help in planning the future course of action of the firm.

COMMON SIZE INCOME STATEMENTS - PREPARATION OF

COMMON SIZE INCOME STATEMENTS

A statement that shows the percentage relation of each income/expense to the

Revenue from Operations (Net Sales), is known as a Common-size Income Statement. To
express the amounts as the percentage of the total, Revenue from Operations (Net Sales) is
taken as 100. One may prepare a Common-size Statement of Profit & Loss (Income
Statement) for different periods of the same firm or for the same period of different firms.
With the help of the comparison between the Common-size Income Statements of different
periods, one can understand the efficiency in earning revenues and incurring expenses.

Objectives of Common Size Income Statement

1. The basic objective of a Common-size Income Statement is to analyse the change in
individual terms of the Income Statement.
2. It is also prepared to study the trend in different items of Incomes and Expenses.
3. Lastly, it is prepared for the assessment of efficiency.

Preparation of Common Size Income Statement

A Common-size Income Statement has the following six columns:
1. First Column: In the first column, the items of the Income Statement (Statement of
Profit & Loss); i.e., revenue/income and expenses are recorded.
2. Second Column: In the second column, Note No. given against the item in the Income
Statement of the company is recorded.
3. Third Column: In the third column, the amounts of the previous year are written in
case the Common-size Statement for different periods of the same firm is being prepared.
And if the Statement is being prepared for two different firms, then the amount relating
to the first firm (say, X Ltd.) is recorded.
4. Fourth Column: In the fourth column, the amounts of the current year are written in
case the Common-size Statement for different periods of the same firm is being prepared.

42
 And if the Statement is being prepared for two different firms, then the amount relating
to the other firm (say, Y Ltd.) is recorded.
5. Fifth Column: In the fifth column, the percentage of different items of the Income
Statement of the previous year or first firm (as the case may be) to Revenue from
Operations; i.e., Net Sales (taken as 100) is recorded.
6. Sixth Column: In the sixth column, the percentage of different items of the Income
Statement of the current year or any other firm (as the case may be) to Revenue from
Operations; i.e., Net Sales (taken as 100) is recorded.

Format of Common-size Income Statement (Statement of Profit & Loss):

COMMON SIZE BALANCE SHEET- PREPARATION OF COMMON

SIZE BALANCE SHEET

A statement that shows the percentage relation of each asset/liability to the total
assets/total of equity and liabilities, is known as a Common-size Balance Sheet. To express
the amounts as the percentage of the total, the total assets or total equity and liabilities are

43
taken as 100. Common-size statements are also called as “Component Statements” or “100
percent Statements” because each statement is reduced to the total of 100 and each individual
item is expressed as a percentage of this total. With the help of a Comparative Common-size
Balance Sheet of different periods, one can highlight the trends in different items. If a
Common-size Balance Sheet is prepared for the industry, it facilitates the assessment of the
relative financial soundness and helps in understanding the financial strategy of the
organisation.

Objectives of Common Size Balance Sheet

1. The basic objective of a Common-size Balance Sheet is to analyse the changes in the
individual items of a Balance Sheet.
2. It is also prepared to see the trends of different items of assets, equity and liabilities of a
Balance Sheet.
3. Lastly, it is prepared for the assessment of the financial soundness of the organisation and
to understand its financial strategy.

Preparation of Common Size Balance Sheet

A Common-size Balance Sheet has the following six columns:
1. First Column: In the first column, the items of the Balance Sheet are written.
2. Second Column: In the second column, Note No. given against the line item is written.
3. Third Column: In the third column, the amounts of different items; i.e., assets, equity,
and liabilities of the previous year are written.
4. Fourth Column: In the fourth column, the amounts of different items; i.e., assets,
equity, and liabilities of the current year are written
5. Fifth Column: In the fifth column, the percentage relation of the different items of the
previous year’s Balance Sheet to the Total of Equity and Liabilities/Total Assets are
written. Here, the Total of Equity and Liabilities/Total Assets are taken as 100.
6. Sixth Column: In the last column, the percentage relation of the different items of the
current year’s Balance Sheet to the Total of Equity and Liabilities/Total Assets are
written. Here, the Total of Equity and Liabilities/Total Assets are taken as 100.

44
Format of Common Size Balance Sheet

45
 INTERPRETATION FROM THE COMMON SIZE STATEMENTS

The two comparative statements are

a) Balance sheet
b) Income statement.

The example of common size Balance Sheet is shown below:-

Common-size Balance Sheet

[as on June 2001 and 2002]
Rs. In Lakhs
Assets 2001 Percentage 2002 Percentage
Amount 100% Amount 100%
Rs Rs
Fixed assets:
Premises less depreciation 600 32.09 570 31.09
Plant machinery less depreciation 400 21.39 500 27.27
Furniture less depreciation 100 5.35 85 4.64
Total fixed Assets [A] 1,100 58.82 1,155 63.00
Investments [B] 200 10.70 150 8.19
Current Assets:
Stock 300 16.05 300 16.37
Debtors 200 10.70 150 8.18
Bank 50 2.61 60 3.27
Cash 20 1.06 18 0.99
Total Current assets[C] 570 30.48 528 28.81
Total Assets [A+B+C] 1,870 100.00 1,833 100.00
2001 Percentage 2002 Percentage
Liabilities Amount 100 Amount 100
Rs in Rs in
lakhs . lakhs
Capital:
8% Preference capital 200 10.70 300 16.37
Equity capital 500 26.74 500 27.27
Reserves 200 10.69 250 13.64
Proprietor’s funds [1] 900 48.13 1,050 57.28
Secured Loan: [2] 350 18.71 200 10.91
10% Debentures
Current Liabilities:
Sundry Creditors 300 16.05 350 9.09
Bills Payable 200 10.70 175 9.55
Taxes Payable 120 6.41 58 3.17
Total Current Liabilities [3] 620 33.16 583 31.81
Total Liabilities [2+3] 970 51.87 783 42.72
Total capital and liabilities[1+2+3]
1,870 100.00 1,833 100.00

46
Interpretation
The percentage of fixed assets to total assets increased from 58.83% in 2001 to 63% in
2002. At the same time the percentage of current assets decreased from 30.47% to 28.31%.
This indicates a poor current assets management policy. The value of investments has also
decreased from 10.70% to 8.19%, which may be in order to finance the increase in fixed assets.
The preference share capital has increased from 10.70% to 16.37% and reserves from 10.69%
to 13.64% but at the same time, the long-term as well as the current liabilities to total liabilities
has come down from 51.87% to 42.72%. Compared to total current liabilities the total current
assets are inadequate. Hence, the working capital position is not satisfactory. In general the
financial policy of the concern is highly unsatisfactory.

Common –size Income statement

The example of common size Income is shown below:-

Interpretation:
The gross profit percentage has increased from 33.33 to 37.50. This increase is more
than proportionate compared to sales. This is because the increase in cost of goods sold is less
than proportional. Similarly the net profit percentage has also increased from 26.67 to 31.25.
In general, the overall operating efficiency of the business is highly satisfactory.

INTERPRETATION FROM THE COMPARATIVE STATEMENTS

The two comparative statements are

c) Balance sheet
d) Income statement.

The following examples would illustrate the method of preparation of a Comparative

Balance Sheet and a Comparative Income Statement with imaginary figures:

47
 Comparative Balance Sheet
[as on 30th June 2001 and 2002]
[in lakhs of rupees]
Assets 30-6-2001 30-6-2002 Amount of Percentage
Rs Rs increase or of increase
decrease in or decrease
2002 in 2002
Rs %
Fixed assets:
Premises [less dep.] 600 570 -30 -5.00
Plant & machinery [less dep.] 400 500 100 25.00
Furniture [less dep.] 100 85 -15 -15.00
Total fixed assets 1,100 1,155 55 5.00
Investments 200 150 50 -25.00
Current assets:
Stock 300 300 - -
Debtors 200 150 -50 -25.00
Cash & bank 70 78 8 11.43
Total current assets 570 528 -42 -7.40
Total Assets 1,870 1,833 -37 -2.00
30-6-2001 30-6-2002 Amount of Percentage
Rs Rs increase or of increase
Liabilities decrease in or decrease
2002 in 2002
Rs %
Capital:
8% Preference Capital 200 300 +100 +50.00
Equity Capital 500 500 - -
Reserves & Surplus 200 250 +50 +25.00
Total Proprietors funds 900 1,050 +150 +16.67
Secured Loans:
10% Debentures 350 200 -150 -43.00
Current Liabilities:
Sundry creditors 300 350 +50 +16.67
Bills payable 200 175 -25 -12.50
Taxes payable 120 58 -62 -50.00
Total current liabilities 620 583 -37 -5.97
Total liabilities 970 783 -187 -19.28
Total capital & liabilities 1,870 1,833 -37 -2.00

Tentative Conclusions:
Total fixed assets have been added during the year 2002 by Rs.55 lakhs [i.e., about 5%]
compared to 2001, for which long-term investments worth Rs.50 lakhs have been realized. The
level of current assets worth Rs.42 lakhs has been reduced. Despite the increase in fixed assets,
the total assets have been decreased by Rs.37 lakhs. It implies that the addition to fixed assets
has been partly financed by the sale or reduction of other assets. Increase in fixed assets and
decrease in current assets reflect a poor financial policy. The relationship between the total
current assets and total current liabilities is not satisfactory.
48
 Increase in the preference share capital of Rs.100 lakhs might have been due to the fresh
issue of shares for the redemption of debentures. Also, the increase in reserves may represent
the redemption of debentures out of profits.

Comparative Income Statement:

Similar to the Comparative Balance Sheet, the Comparative Income Statement contains
the same columns and supplies the same type of information. It is illustrated below:
The Comparative Income Statement explains the relationship between sales and cost of
goods sold and its effect on gross profit. Increase in selling expenses and office and
administration expenses relating to the increase in sale should not be proportional. This will
indicate clearly the efficiency of operations by showing changes in absolute figures and also in
terms of percentage of the operating profits from one period to another. The Companies Act of
India insists that companies should give figures for different items for the previous year
together with the current year’s figures in the Profit and Loss account and Balance Sheet.

Comparative Profit and Loss Statement

[for the year ended 30th June 2001 and 2002
[Rs. In lakhs]
Particulars 2001 2002 Amount of Percentage
increase or of increase
decrease in or decrease
2002 in 2002
Rs. Rs. Rs. %
Net sales 600 800 +200 +33.33
Cost of goods sold 400 500 +100 +25.00
Gross profit 200 300 +100 +50.00
Operating expenses:
Office expenses 20 20 - -
Selling expenses 20 30 +10 +50.00
Total operating expenses 40 50 +10 +25.00
Operating profit 160 250 +90 +56.25

Inferences:
While net sales have increased by 33.33%, the cost of goods sold has increased by 25%.
The percentage of profits has increased by 50%. The increase in total operating expenses is
25% only, which has increased the net operating profits by 56.25%. The overall performance
in 2002 is satisfactory compared to 2001.
The main limitation of Comparative Financial Statements is that they fail to show the
changes that have taken place from year to year in relation to total assets, total liabilities and
capital or total net sales. Common-size Analysis eliminates this limitation.

TREND ANALYSIS

The financial statements may be analysed by computing trends of series of information.

Trend analysis determines the direction upwards or downwards and involves the computation

49
of the percentage relationship that each item bears to the same item in the base year. In case of
comparative statement, an item is compared with itself in the previous year to know whether it
has increased or decreased or remained constant. Common size analysis is to ascertain whether
the proportion of an item (say cost of revenue from operations) is increasing or decreasing in
the common base (say revenue from operations). But in case of trend analysis, we learn about
the behaviour of the same item over a given period, say, during the last 5 years. Generally,
trend analysis is done for a reasonably long period. Many companies present their financial
data for a period of 5 or 10 years in various forms in their annual reports. While calculating
trend percentages, the following precautions may be taken:
➢ The accounting principles and practices must be followed constantly over the period
for which the analysis is made. This is necessary to maintain consistency and
comparability.
➢ The base year selected should be normal and representative year.
➢ Trend percentages should be calculated only for those items which have logical
relationship with one another.
➢ Trend percentages should also be carefully studied after considering the absolute
figures on which these are based. Otherwise, they may give misleading conclusions.
➢ To make the comparison meaningful, trend percentages of the current year should
be adjusted in the light of price level changes as compared to base year

Procedure for Calculating Trend Percentage

One year is taken as the base year. Generally, the first year is taken as the base year.
The figure of base year is taken as 100. The trend percentages are calculated in relation to this
base year. If a figure in other year is less than the figure in base year, the trend percentage will
be less than 100 and it will be more than 100 if figure is more than the base year figure. Each
year’s figure is divided by the base year figure.

The accounting procedures and conventions used for collecting data and preparation of
financial statements should be similar; otherwise the figures will not be comparable.

Limitations
• The trend ratios are incomparable, if there is inconsistency in accounting
policies and practices.
• The price level changes are represented in trend ratios
• The trend ratios musty be studied along with absolute data for correct analysis.
• While analyzing the trend ratios, non-financial data should also be considered
otherwise conclusions would be misleading

50
 UNIT III

Introduction to Ratio Analysis - Advantages of Ratios - Types of Ratios- Liquidity Ratios-

Solvency Ratios - Profitability Ratios- Preparation of Balance Sheet from Ratio Analysis-
Preparation of Ratios from Balance Sheets- Cash Flow Statement: Introduction- Preparation of
Cash Flow Statements

INTRODUCTION TO RATIO ANALYSIS

A ‘Ratio is defined as an arithmetical/quantitative/ numerical relationship between two

numbers. Ratio analysis is the process of determining and interpreting numerical relationships
based on financial statements. Ratio analysis is a useful management tool that will improve
your understanding of financial results and trends over time, and provide key indicators of
organizational performance. The following are the four steps involved in the ratio analysis :
a) Selection of relevant data from the financial statements depending upon the
objective of the analysis.
b) Calculation of appropriate ratios from the above data.
c) Comparison of the calculated ratios with the ratios of the same firm in the past, or
the ratios developed from projected financial statements or the ratios of some other
firms or the comparison with ratios of industry to which the firm belongs.
d) Interpretation of the ratio

Managerial uses of ratio analysis

1. Helps in Financial Forecasting: Ratio analysis is very helpful in financial forecasting.
Ratios relating to past sales, profits and financial position form the basis for setting future
trends.
2. Helps in Comparison: With the help of ratio analysis, ideal ratios can be composed and
they can be used for comparing a firm's progress and performance. Inter-firm comparison
or comparison with industry averages is made possible by the ratio analysis.
3. Financial Solvency of the Firm: Ratio analysis indicates the trends in financial solvency
of the firm. Solvency has two dimensions-long-term solvency and short-term solvency.
Long-term solvency refers to the financial viability of a firm and it is closely related with
the existing financial structure. On the other hand, short-term solvency is the liquidity
position of the firm. With the help of ratio analysis conclusions can be drawn regarding the
firm's liquidity and long term solvency position.
4. Evaluation of Operating Efficiency: Ratio analysis throws light on the degree of
efficiency in the management and utilisation of its assets and resources. Various activity
ratios measure this kind of operational efficiency and indicate the guidelines for economy
in costs, operations and time.
5. Communication Value: Different financial ratios communicate the strength and financial
standing of the firm to the internal and external parties. They indicate the over-all
profitability of the firm.

51
6. Others Uses: Financial ratios are very helpful in the diagnosis of financial health of a firm.
They highlight the liquidity, solvency, profitability and capital gearing etc. of the firm.

Draw backs of ratio analysis

1. Limited use of a single ratio: Ratio can be useful only when they are computed in a
sufficient large number. A single ratio would not be able to convey anything. At the same
time, if too many ratios are calculated, they are likely to confuse instead of revealing any
meaningful conclusion.
2. Effect of inherent limitations of accounting: Because ratios are computed from historical
accounting records, so they also possess those limitations and weaknesses as accounting
records possess.
3. Lack of proper standards : While making comparisons, it is always a challenging job to
find out an adequate standard. It is not possible to calculate exact and well accepted absolute
standard, so a quality range is used for this purpose. If actual performance is within this
range, it may be regarded as satisfactory.
4. Past is not indicator of future : It is not always possible to make future estimates on the
basis of the past as it always does not come true.
5. No allowance for change in price level : While making comparisons of ratios, no
allowance for changes in general price level is made. A change in price level can seriously
affect the validity of comparisons of ratios computed for different time periods.
6. Difference in definitions : Comparisons are also made difficult due to differences in
definitions of various financial terms. The terms like gross profit, net profit, operating profit
etc. have not precise definitions and an established procedure for their computation.
7. Window Dressing : Financial statements can easily be window dressed to present a better
picture of its financial and profitability position to outsiders. Hence one has to be careful
while making decision on the basis of ratios calculated from such window dressing made
by a firm.
8. Personal Bias : Ratios are only means of financial analysis and is not an end in itself.
Ratios have to be interpreted carefully because the same ratio can be looked at, in different
ways.

ADVANTAGES OF RATIOS

a. Simplifies Financial Statements: Ratio analysis simplifies the comprehension of

financial statements. Ratios tell the whole story of changes in the financial condition of
the business.
b. Facilitates Inter-firm Comparison: Ratio analysis provides data for inter- firm
comparison. Ratios highlight the factors associated with successful and unsuccessful
firms. They also reveal strong firms and weak firms, over- valued and under-valued
firms.
c. Makes Intra-firm Comparison Possible: Ratio analysis also makes possible
comparison of the performance of the different divisions of the firm. The ratios are

52
 helpful in deciding about their efficiency or otherwise in the past and likely
performance in the future.
d. Helps in Planning: Ratio analysis helps in planning and forecasting. Over a period of
time, a firm or industry develops certain norms that may indicate future success or
failure. If relationship changes in firm’s data over different time periods, the ratios may
provide clues on trends and future problems

TYPES OF RATIOS

Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity ratios (iii)
Leverage/Capital structure ratios (iv) Coverage ratios (v) Profitability ratios.

1. Liquidity Ratios : Liquidity refers to the ability of a firm to meet its current obligations as
and when they become due. The ratios which indicate the liquidity of a firm are
a. Net working capital: NWC is really not a ratio, it is frequently employed as a measure
of a company's liquidity position. NWC represents the excess of current assets over
current liabilities.
NWC = Total Current Assets – Total Current Liabilities
b. Current ratio: The current ratio is the ratio of total current assets to total current
liabilities. It is calculated by dividing Current Assets by Current Liabilities

c. Acid test/quick ratio: The acid test ratio is a measure of liquidity designed to overcome
this defect of the current ratio.

The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Included in this category
of current assets are (i) cash and bank balances; (ii) short-term marketable securities
and (iii) debtors/receivables.
d. Cash-Position Ratio or Super-Quick Ratio : It is a variant of Quick ratio. When
liquidity is highly restricted in terms of cash and cash equivalents, this ratio should be
calculated. It is calculated by dividing the super-quick current assets by the current
liabilities of a firm. The super-quick current assets are cash and marketable securities.
It can be calculated as below :

2. Activity ratios: Activity ratios which are also called efficiency ratio or asset utilisation
ratios are concerned with measuring the efficiency in asset management. The efficiency
with which the assets are used would be reflected in the speed and rapidity with which
assets are converted into sales. The greater is the rate of turnover or conversion, the more

53
efficient is the utilisation/management, other things being equal. For this reason, such ratios
are also designated as turnover ratios.

a. Inventory Turnover Ratio : It is computed as follows

The cost of goods sold means sales minus gross profit. The average inventory
refers to the simple average of the opening and closing inventory. The ratio indicates
how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice
versa. A low ratio would signify that inventory does not sell fast and stays on the shelf
or in the warehouse for a loan time.
b. Debtors Turnover Ratio : This ratio is determined by dividing the net credit sales by
average debtors outstanding during the year. Thus,

Net credit sales consist of gross credit sales minus sales returns, if any, from
customers. Average debtors is the simple average of debtors at the beginning and at the
end of year. The ratio measures how rapidly debts are collected. A high ratio is
indicative of shorter time-lag between credit sales and cash collection. A low ratio
shows that debts are not being collected rapidly.
c. Creditors Turnover Ratio : It is a ratio between net credit purchases and the average
amount of creditors outstanding during the year. It is calculated as
follows:

Net credit purchases = Gross credit purchases less returns to suppliers

Average creditors = Average of creditors outstanding at the beginning and at the end of
the year
d. Average Age of Sundry Debtors : The main objective of calculating average
collection period is to find out cash inflow rate from realisation from debtors. It is
found by a simple transformation of the firm's accounts receivable turnover :

It can be calculated as follows also :

e. Assets Turnover Ratio : This ratio is also known as the investment turnover ratio. It
is based on the relationship between the cost of goods sold and assets/ investments of a
firm. A reference to this was made while working out the overall profitability of a firm
as reflected in its earning power. Depending upon the different concepts of assets
employed, there are many variants of this ratio. Thus,

54
3. Leverage/Capital structure ratios : The long-term solvency of a firm can be examined
by using leverage or capital structure ratios. The leverage ratios may be defined as financial
ratios which throw light on the long-term solvency of a firm as reflected in its ability to
assure the long-term creditors with regard to (i) periodic payment of interest during the
period of the loan and (ii) repayment of principal on maturity or in predetermined
installments at due dates.
a. The Debt-equity Ratio – This ratio establishes the relationship between the long-term
funds provided by creditors and those provided by the firm's owners. It is commonly
used to measure the degree of financial leverage of the firm. It is calculated as follows
:

Or

b. Proprietary Ratio : This ratio is also known as Shareholders' Equity to Total Equities
Ratio or Net Worth to Total Assets Ratio. It indicates the relationship of Shareholders'
equity to total assets or total equities. As per formula :

c. The Solvency Ratio – It is also known as Debt Ratio. It is a difference of 100 and
proprietary ratio. It measures the proportion of total assets provided by the firm's
creditors. This ratio is calculated as follows :

d. Fixed Assets to Net Worth Ratio – If aggregate of fixed assets exceeds the net worth
(or proprietors' funds), it proves that fixed assets have been financed with outsiders'
funds (or creditors' funds). It may create difficulty in the long-run. This ratio is
calculated as follows :

e. Proprietors' Liabilities Ratio : This ratio indicates the relationship of proprietors'

funds to total liabilities. It is calculated as follows :

55
 f. Fixed Assets Ratio A variant to the ratio of fixed assets to net worth is the ratio of fixed
assets to all long-term funds which is calculated as :

g. Ratio of Current Assets to Proprietary's Funds The ratio is calculated by dividing

the total of current assets by the amount of shareholder's funds.

h. Debt-Service Ratio: Net income to debt service ratio or simply debt service ratio is
used to test the debt-servicing capacity of a firm. The ratio is also known as interest
coverage ratio or fixed charges cover or times interest earned. This ratio is calculated
by dividing the net profit before interest and taxes by fixed interest charges.

4. Coverage Ratios : These ratios are computed from information available in the profit and
loss account. The coverage ratios measure the relationship between what is normally
available from operations of the firms and the claims of the outsiders. The important
coverage ratios are as follows :
1. Interest Coverage Ratio : This ratio measures the debt servicing capacity of a firm
insofar as fixed interest on long-term loan is concerned. It is determined by dividing
the operating profits or earnings before interest and taxes (EBIT) by the fixed interest
charges on loans.

2. Dividend Coverage Ratio : It measures the ability of a firm to pay dividend on

preference shares which carry a stated rate of return. This ratio is computed as under

3. Total Coverage Ratio : The total coverage ratio has a wider scope and takes into
account all the fixed obligations of a firm, that is, (i) interest on loan, (ii) preference
dividend, (iii) Lease payments, and (iv) repayment of principal. Symbolically,

4. Debt-Services Coverage Ratio (DSCR) : This ratio is considered more comprehensive

and apt measure to compute debt service capacity of a business firm.

56
5. Profitability Ratios: : The profitability or financial performance is mainly summarised
in the statement of profit and loss. Profitability ratios can be determined on the basis
of either sales or investments.
a. Profitability Ratios Related to Sales : These ratios are based on the premise that a
firm should earn sufficient profit on each rupee of sales. These ratios consist of
• Profit margin: it measures the relationship between profit and sales. There are 2
types of profit margin
➢ Gross profit margin

➢ Net profit margin: Net profit margin is also known as net margin. This
measures the relationship between net profits and sales of a firm. Depending
on the concept of net profit employed, this ratio can be computed in two
ways

• Expenses Ratio : Another profitability ratio related to sales is the expenses ratio. It
is computed by dividing expenses by sales

b. Rate of Return on Equity Share Capital : This ratio is calculated by dividing the net
profits (after deducing income-tax and dividend on preference share capital) by the paid
up amount of equity share capital. It is usually expressed in percentage as below :

c. Return on Proprietors Funds on Return on Net Worth : . The proprietors funds or

net worth represents the total interest of shareholders which include share capital
(whether equity or preference) and all accumulated profits.

d. Return on Investment (ROI) Ratio : It examines the overall operating efficiency or

earning power of the company in relation to total investment in business.

57
e. Return on Capital Employed (ROCE) : The profits are related to the total capital
employed. The term capital employed refers to long-tern funds supplied by the creditors
and owners of the firm. The higher the ratio, the more efficient is the use of capital
employed

f. Earning Per Share (EPS) measures the profit available to the equity shareholders on
a per share basis, that is, the amount that they can get on every share held. It is calculated
by dividing the profits available to the shareholders by the number of the outstanding
shares.

g. Divided Per Share (DPS) is the dividends paid to shareholders on a per share basis.

h. Divided-Pay Out (D/P) Ratio : This is also known as pay-out ratio. It measures the
relationship between the earnings belonging to the ordinary shareholders and the
dividend paid to them.

i. Earnings and Dividend Yield : This ratio is closely related to the EPS and DPS. While
the EPS and DPS are based on the book value per share, the yield is expressed in terms
of the market value per share.

j. Price Earnings (P/E) Ratio is closely related to the earnings yield/earnings price ratio.
It is actually the reciprocal of the latter. This ratio is computed by dividing the market
price of the shares by the EPS. Thus

58
 LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its current obligations as and when they
become due. The importance of adequate liquidity in the sense of the ability of a firm to
meet current/short-term obligations when they become due for payment can hardly be
overstressed. In fact, liquidity is a prerequisite for the very survival of a firm. The ratios
which indicate the liquidity of a firm are
e. Net working capital: NWC is really not a ratio, it is frequently employed as a measure
of a company's liquidity position. NWC represents the excess of current assets over
current liabilities.
NWC = Total Current Assets – Total Current Liabilities
f. Current ratio: The current ratio is the ratio of total current assets to total current
liabilities. It is calculated by dividing Current Assets by Current Liabilities

g. Acid test/quick ratio: The acid test ratio is a measure of liquidity designed to overcome
this defect of the current ratio. It is often referred to as quick ratio because it is a
measurement of a firm's ability to convert its current assets quickly into cash in order
to meet its current liabilities. Thus, it is a measure of quick or acid liquidity.

The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Included in this category
of current assets are (i) cash and bank balances; (ii) short-term marketable securities
and (iii) debtors/receivables.
h. Cash-Position Ratio or Super-Quick Ratio : It is a variant of Quick ratio. When
liquidity is highly restricted in terms of cash and cash equivalents, this ratio should be
calculated. It is calculated by dividing the super-quick current assets by the current
liabilities of a firm. The super-quick current assets are cash and marketable securities.
It can be calculated as below :

SOLVENCY RATIOS

Solvency ratios (also known as long-term solvency ratios) measure the ability of a
business to survive for a long period of time. These ratios are very important for stockholders
and creditors. Solvency ratios are normally used to:
• Analyze the capital structure of the company
• Evaluate the ability of the company to pay interest on long term borrowings

59
 • Evaluate the ability of the the company to repay principal amount of the long term
loans (debentures, bonds, medium and long term loans etc.).
• Evaluate whether the internal equities (stockholders’ funds) and external equities
(creditors’ funds) are in right proportion
The following ratios are normally computed for evaluating solvency of the business.
a. Debt to equity ratio
b. Proprietary ratio
c. Fixed assets to shareholders’ fund ratio
d. Current assets to proprietors’ funds ratio
e. Interest Coverage Ratio:
f. Capital gearing ratio

a. The Debt-equity Ratio – This ratio establishes the relationship between the long-term
funds provided by creditors and those provided by the firm's owners. It is commonly
used to measure the degree of financial leverage of the firm. It is calculated as follows
:

Or

External equities refer to the total outside liabilities. The term internal equities
refers to all claims of preference shareholders and equity shareholders such as share
capital reserves and surplus. Outsider’s fund refers to all short term debts like mortgage,
bills etc. Computation of long term financial ratios, the term debt, like debentures are
to be considered. Acceptable norm for this ratio is considered to be 2:1
b. Proprietary Ratio : This ratio is also known as Shareholders' Equity to Total Equities
Ratio or Net Worth to Total Assets Ratio. It indicates the relationship of Shareholders'
equity to total assets or total equities. As per formula :

Shareholder’s fund includes preference share capital, equity share capital, reserves
surplus, profit & Loss Account Balance if any. Total assets represent all assets including
goodwill. But total tangible assets means total assets minus goodwill, Profit & Loss A/c
9Debit) Balance, Preliminary Expenses.
c. Fixed assets to shareholders’ fund ratio
This ratio establishes the relationship between fixed assets and shareholders’ funds. The
purpose of this ratio is to indicate the percentage of owners’ funds invested in fixed
assets. It is calculated as follows:

60
 The fixed assets are considered at their depreciated book values and the proprietors’
funds consist of all the items of internal equities such as preference shareholders’ claims
and equity share holders’ claims, viz., equity share capital and reserves and surplus.
This ratio may be expressed as a percentage or as a proportion.
d. Current assets to proprietors’ funds ratio
This ratio establishes the relationship between current assets and shareholders’ funds.
The purpose of this ratio is to indicate the percentage of shareholders’ funds invested
in current assets. This may be expressed as a percentage or as a proportion. It is
calculated as follows:

e. Interest Coverage Ratio: It is a ratio which deals with the servicing of interest on loan.
It is a measure of security of interest payable on long-term debts. It expresses the
relationship between profits available for payment of interest and the amount of interest
payable. It is calculated as follows:
Net Profit before Interest and Tax
Interest Coverage Ratio =
Interest on long − term debts

Significance: It reveals the number of times interest on long-term debts is covered by

the profits available for interest. A higher ratio ensures safety of interest on debts.

f. Capital gearing Ratio: Capital gearing ratio is a useful tool to analyze the capital
structure of a company and is computed by dividing the common stockholders’ equity
by fixed interest or dividend bearing funds. It is calculated as:

Equity share capital includes equity capital and all reserves and surplus that belong to
equity shareholders. Fixed interest or dividend funds include debentures, preference
shares and other long-term loans. It may be noted that the gearing is in inverse ratio to
the equity share capital.
Highly geared – low equity share capital
Low geared – high equity share capital

PROFITABILITY RATIOS

The profitability or financial performance is mainly summarised in the statement of profit

and loss. Profitability ratios are calculated to analyse the earning capacity of the business which
is the outcome of utilisation of resources employed in the business. There is a close relationship

61
between the profit and the efficiency with which the resources employed in the business are
utilised. Profitability ratios can be determined on the basis of either sales or investments.

a. Profitability Ratios Related to Sales : These ratios are based on the premise that a
firm should earn sufficient profit on each rupee of sales. These ratios consist of
• Profit margin: it measures the relationship between profit and sales. There are 2
types of profit margin
➢ Gross profit margin

➢ Net profit margin: Net profit margin is also known as net margin. This
measures the relationship between net profits and sales of a firm. Depending
on the concept of net profit employed, this ratio can be computed in two
ways

• Expenses Ratio : Another profitability ratio related to sales is the expenses ratio. It
is computed by dividing expenses by sales

b. Rate of Return on Equity Share Capital : This ratio is calculated by dividing the net
profits (after deducing income-tax and dividend on preference share capital) by the paid
up amount of equity share capital. It is usually expressed in percentage as below :

c. Return on Proprietors Funds on Return on Net Worth : . The proprietors funds or

net worth represents the total interest of shareholders which include share capital
(whether equity or preference) and all accumulated profits.

d. Return on Investment (ROI) Ratio : It examines the overall operating efficiency or

earning power of the company in relation to total investment in business.

62
e. Return on Capital Employed (ROCE) : The profits are related to the total capital
employed. The term capital employed refers to long-tern funds supplied by the creditors
and owners of the firm. The higher the ratio, the more efficient is the use of capital
employed

f. Earning Per Share (EPS) measures the profit available to the equity shareholders on
a per share basis, that is, the amount that they can get on every share held. It is calculated
by dividing the profits available to the shareholders by the number of the outstanding
shares.

g. Divided Per Share (DPS) is the dividends paid to shareholders on a per share basis.

h. Divided-Pay Out (D/P) Ratio : This is also known as pay-out ratio. It measures the
relationship between the earnings belonging to the ordinary shareholders and the
dividend paid to them.

i. Earnings and Dividend Yield : This ratio is closely related to the EPS and DPS. While
the EPS and DPS are based on the book value per share, the yield is expressed in terms
of the market value per share.

j. Price Earnings (P/E) Ratio is closely related to the earnings yield/earnings price ratio.
It is actually the reciprocal of the latter. This ratio is computed by dividing the market
price of the shares by the EPS. Thus

63
PREPARATION OF BALANCE SHEET FROM RATIO ANALYSIS

From the following information , you are required to prepare a balance sheet:
Current ratio 1.75
Liquid ratio 1.25
Stock turnover ratio (cost of sales/ closing stock) 9
Gross profit ratio 25%
Debt collection period 1.5 months
Reserves and surplus to capital 0.2
Fixed assets turnover(on cost of sales) 1.2
Capital gearing ratio(long term debt to share capital 0.6
Fixed assets to net worth 1.25
Sales for the year Rs. 12,00,000

Solution
i. Cost of goods sold + gross profit = sales
75% + 25% = 100%
9,00,000 + 3,00,000 = 12,00,000
ii. Stock turnover ratio = 9
Cost of Goods Sold = 9
Average stock (X)
9,00,000 = 9
X
Stock(X) = 1,00,000
iii. Current ratio 1.75 3,50,000
Quick ratio 1.25 2,50,000
Stock 0.50 1,00,000
iv. Debt collection period = 1.5 months
Debtors x 12 = 1.5
Sales
Debtors x 12 = 1.5
12,00,000
Debtors = 1.5 x 12,00,000
12
Debtors = 1,50,000
v. Turnover of fixed assets 1.2
Turnover = 1.2
(X) fixed Assets
9,00,000 = 1.2
X
Fixed assets (X) = 7,50,000
vi. Fixed assets to : net worth 1.25 :1
1.25 : 1.00
7,50,000 :6,00,000

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vii. Reserves and surplus to Capital 0.2 :1
Reserves + share capital = net worth
0.2 + 1.00 = 1.2
1,00,000 + 5,00,000 = 6,00,000
6,00,000 x 1 = 5,00,000
1.2
viii. Capital gearing Ratio
(X) Fixed Interest Bearing = 0.6
Equity Share Capital
X = 5,00,000 x 0.6
Long term Debt = Rs. 3,00,000
Balance sheet
Liabilities Rs Assets Rs
Equity share capital 5,00,000 Fixed assets 7,50,000
Long-term Debt 3,00,000 Current assets 3,50,000
Reserves 1,00,000
Current liabilities 2,00,000
11,00,000 11,00,000

PREPARATION OF RATIOS FROM BALANCE SHEETS

The balance sheet of Sriram Ltd., as on 31.12.2008 is as follows: -

Liabilities Rs. Assets Rs

Equity share capital 5,00,000 Lands and buildings 6,00,000
Preference capital 2,00,000 Plant and machinery 5,00,000
Reserves and surplus 3,00,000 Stock in trade 2,40,000
Debentures 4,00,000 Sundry debtors 1,95,000
Sundry creditors 1,50,000 Cash in hand 60,000
Bank overdraft 50,000 Prepaid expenses 5,000
16,00,000 16,00,000
Calculate: (a) Current ratio (b)Liquid ratio (c) Debt-equity ratio (d) Capital gearing
ratio (e) Proprietary ratio

Solution
a. Current ratio = Current Assets
Current liabilities
= Rs. 2,40,000+Rs. 1,95,000+Rs. 60,000+Rs. 5,000
Rs. 1,50,000+ Rs. 50,000
= 50,0000
200,000
= 2.5 or 2.5:1
b. Liquid ratio = Liquid Assets
Liquid liabilities

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 = 195,000 + 60000+5,000 = 2,60,000
150,000 +50,000 2,00,000
= 1.3:1
c. Debt equity ratio = External debt
Internal debt
= 4,00,000
5,00,000+2,00,000+300,000
= 400000
100000
= 0.4 or 0.4 :1
d. Capital gearing ratio = Fixed interest / dividend bearing funds
Equity shareholders funds
= 400000+ 2,00,000 = 600000
500000 + 300000 800000
= 0.75 :1
e. Proprietary = shareholder’s funds
Total tangible Assets
= 5,00,000+2,00,000+3,00,000 = 10,00,000
16,00,000 16,00,000
= 0.625 :1

CASH FLOW STATEMENT: INTRODUCTION- PREPARATION OF

CASH FLOW STATEMENTS

It is a statement which is prepared from the historical data showing the inflow and
outflow of cash. It shows the sources and uses of cash between the two balance sheet dates. It
clearly explains the causes for charges in cash position between two periods. Simply, it is a
receipts and payment account in a summary form.

Steps in preparation of cash flow statement

It can be prepared on the same pattern on which fund flow statement is prepared. But
here statement of change in working capital does not need to be prepared. Remaining all other
procedures were same in fund flow statement.
Cash flow statement is prepared on any one of the following assumptions:
➢ When all transactions are taken as cash transactions
➢ When all transactions are not cash transactions.

Steps
1. No need to prepare working capital statement
2. Preparation of cash flow statement
3. Preparation of profit and loss account – computation of cash from operation
4. Preparation of separate ledger if necessary
5. Treatment of adjustments

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1. No need to prepare working capital statement: Changes in current assets and current
liabilities are adjusted in the cash flow statement itself. So separate statement is not
necessary for the changes in working capital
2. Preparation of cash flow statement
Cash flow statement (Proforma)
Inflow of cash Amount Outflow of cash Amount
Rs. Rs.
Opening cash balance xx Redemption of Preference shares xx
(including bank balance) Repayment debentures holders xx
Issues of shares xx Repayment of loans xx
Issue of debentures xx Purchase of fixed assets xx
Raising of Loans xx Dividend paid xx
Sale of fixed assets xx Income tax paid xx
Dividend received xx Cash from operation (Lost in
Share premium received xx operation) Transfer from P&L A/c xx
Cash from operation Closing balance(Including bank
(Transfer from P&L A/c) balance)
xx xx

3. Preparation of profit and loss account – computation of cash from operation: Cash
from operation can be found out in two methods. One is statement form anther one is
preparation of profit and loss account. Normally, cash from operation can be found out with
the help of the preparation of profit and loss account because it is an easy and convenient
method. Here profit and loss account is prepared in usual procedure.
Profits and Loss account
Dr Cr
Amount Amoun
Rs t Rs
To Goodwill written off Xx By Operating balance b/d xx
To General reserve xx By Dividend received xx
To Preliminary Expenses written off xx By interest on investments xx
To Depreciation xx By Profit on sale of assets xx
To Loss on Sale of fixed assets xx By Cash from operation xx
To Loss on Sale of investments xx (Balancing figure)
To Patents & Trade mark written off xx
To Income tax provided xx
To Interim Dividend paid xx
To Closing balance c/d xx
To Cash from operation xx
(Balancing figure)
xx xx

4. Preparation of separate ledger if necessary: If information of any particulars assets or

liabilities are given in the adjustments, we have to prepare separate asset or liabilities
account. Balances from this ledger can be transferred to cash flow statement

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5. Treatment of adjustments: The additional information which are given apart from the
balance sheet are, simply called as adjustment. All the adjustment will appear in two places.
The following are the important adjustments and their treatment
Adjustment Treatment
1 Dividend paid Cash flow statement- outflow side
Profit & Loss A/c -Debit side
2 Depreciation P.L. A/c Debit side
Respective asset A/c credit side
3 Loss on sale of fixed assets P.L. A/c Debit side
Respective asset A/c credit side
4 Income tax provision P.L. A/c Debit side
Income tax A/c credit side

Uses and Importance of Cash Flow Statements

Cash flow statements are of great importance to a financial manager. The information
contained in cash flow statement can help the management in the field of short-run financial
planning and cash control. Some of the important advantages of cash flow statements are
discussed below :
a. The projected cash flow statements if prepared in a business disclose surplus or shortage
of cash well in advance. This helps in arranging utilisation of surplus cash as bank
deposits or investment in marketable securities for short periods. Should there be
shortage of cash, arrangement can be mode for raising the bank loan or sell marketable
securities.
b. Cash flow statements are of extreme help in planning liquidation of debt, replacement
of plant and fixed assets and similar other decisions requiring outflow of cash from the
business as they provide information about the cash generating ability of the business.
c. The cash flow statement pertaining to a particular year compared with the budget for
that year reveals the extent to which the actual sources and applications of cash were in
consonance with the budget. This exercise helps in refining the planning process in
future.
d. The inter-firm and temporal comparison of cash flow statements reveals the trend in
the liquidity position of a firm in comparison to other firms in the industry. It can serve
as a pointer to the need for taking corrective action if it is observed that the management
of cash in the firm is not effective.
e. Cash flows statements are more useful in short term financial analysis as compared to
fund flow statements since in the short run it is cash which is more important for
executing plans rather than working capital.

Difference between cash flow analysis and fund flow analysis

Cash Flow statement Fund Flow statement

1 It start with the opening cash balance and No opening and closing balance
ends with the closing cash balance by
processing through various sources and uses

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 2 Cash from operation Fund from operation
3 No separate statements for increase or Separate statements are prepared for the
decrease in working capital are prepared purpose of finding out increase or
decrease in working capital
4 It explains the causes for the changes in cash It indicates the causes for the changes
and bank balances i,e., cash receipts and cash in net working capital
payments alone
5 It is suitable for short term financial planning It is appropriate for long term financial
and decision planning and decisions
6 It deals with the movement of actual or It deals with not only cash but also the
notional cash items constituting working capital

Limitation of cash flow analysis

• It cannot be equated with the income statement. An income statement considers both cash
and non cash items. So cash does not mean net income of business
• It may not represent the real liquid position of the concern. Due to this aspect, postponing
of purchases and payments could be developed
• It cannot replace the income statement or fund flow statement. Each and every statement
has a separate function to perform
• Due to inflation, economic depression and other external factors, projected cash flow
statement may not achieve its results.

Problem
1. Goodwill Ltd. Supplies you the following balance sheets on 31st December 2011 and 2012
Liabilities 2011 2012 Assets 2011 2012
Rs Rs Rs Rs
Share capital 70,000 74,000 Bank balance 9,000 7,800
Bonds 12,000 6,000 Accounts Receivable 14,900 17,700
Accounts Payable 10,360 11,840 Inventories 49,200 42,700
Provision for 700 800 Land 20,000 30,000
Doubtful Debts
Reserve and surplus 10,040 10,560 Goodwill 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
Following additional information has also been supplied to you:
i. Dividends amounting to Rs. 3,500 were paid during the year 2012
ii. Land was purchased for Rs. 10,000
iii. Rs. 5,000 were written off on account of goodwill during the year
iv. Bonds of Rs. 6,000 were paid during the course of the year.
You are required to prepare a Cash Flow Statement.

Solutions
Cash flow statement
Inflow of cash Amount Outflow of cash Amount
Rs Rs
Opening cash balance 9,000 Increase in debtors 2,800
Issue of hares 4,000 Dividend paid 3,500
Increase in creditors 1,480 Purchase of land 10,000

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 Decrease in marketable securities 6,500 Redemption of debentures 6,000
Cash from operation 9,120 Closing cash balance 7,800
30,100 30,100

Profit and loss Account

Amount Amount
Rs Rs
To provision of doubtful debts 100 By balance b/d 10,040
To dividend paid 3,500 By cash from operation 9,120
To goodwill written off 5,000
To Balance c/d 10,560
19,160 19,160

Debentures Account
To cash (b/f) 6,000 By balance b/d 12,000
To balance c/d 6,000
12,000 12,000

Land Account
To balance b/d 20,000 By balance c/d 30,000
To cash 10,000
30,000 30,000

Goodwill Account
To balance b/d 10,000 By P&L A/c 5,000
By balance c/d 5,000
10,000 10,000

2. From the following balance sheet of XYZ Ltd., prepare cash flow statement:

Liabilities 1999 Rs 2000 Rs Assets 1999 Rs 2000 Rs

Equity share capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
Redeemable preference Land and buildings 2,00,000 1,70,000
Share capital 1,50,000 1,00,000 Plant 80,000 2,00,000
General reserve 40,000 70,000 Debtors 1,60,000 2,00,000
Profit and loss A/c 30,000 48,000 Stock 77,000 1,09,000
Proposed dividend 42,000 50,000 Bills receivable 20,000 30,000
Creditors 55,000 83,000 Cash in hand 15,000 10,000
Bills payable 20,000 16,000 Cash at bank 10,000 8,000
Provision for taxation 40,000 50,000
6,77,000 8,17,000 6,77,000 8,17,000
The following information are given below:-
i. Depreciation of Rs.10,000 and Rs.20.000 have been charged on plant and land and
buildings in 2000
ii. A dividend of Rs. 20,000 has been paid in 2000
iii. Income tax of Rs. 35,000 has been paid during 2000

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 Solutions
Inflow of cash Amount Outflow of cash Amount
Rs Rs
Opening cash balance 25,000 Redemption of preference
Issue of shares 1,00,000 Shares 50,000
Increase in sundry creditors 28,000 Dividend paid 42,000
Sale of land &building 10,000 Decrease in Bills payable 4,000
Cash from operation 2,18,000 Increase in Debtors 40,000
Increase in stock 32,000
Increase in bills receivable 10,000
Purchase of plant 1,30,000
Interim dividend paid 20,000
Income Tax paid 35,000
Closing cash balance 18,000
(10,000 +8,000)
3,81,000 3,81,000

Workings : 1. Profit and Loss Account

Amount Amount
Rs Rs
To general reserve 30,000 By balance c/d 30,000
To proposed dividend 50,000 By cash from operation 2,18,000
To goodwill written off 25,000
To depreciation of plant 10,000
To depreciation of land & 20,000
buildings
To interim dividend paid 20,000
To income Tax provided (2) 45,000
To Balance c/d 48,000
2,48,000 2,48,000
2. Provision for Taxation Account
To cash (Tax paid) 35,000 By balance b/d 40,000
To Balance c/d 50,000 By P &L A/c [Tax Provision] 45,000
85,000 85,000
3. Land & Buildings Account
To Balance b/d 2,00,000 By depreciation A/c 20,000
By balance c/d 1,70,000
By cash (b/f) 10,000
2,00,000 2,00,000
4. Plant Account
To Balance b/d 80,000 By depreciation 10,000
To cash (b/f) 1,30,000 By balance c/d 2,00,000
2,10,000 2,10,000

CASH FLOW (AS PER ACCOUNTING STANDARD 3)

Cash flow statement is a statement which shows the inflow and out flow of cash in a
firm during a particular period, usually one year. It indicates the causes for changes in cash
71
between two balance sheet dates. The traditional cash flow statement is prepared taking the
operating cash balance as a starting point. Cash inflows and outflows are recorded as separate
items. The resulting figure is the closing balance of cash. No specific format is prepared for the
traditional cash flow statement

Meaning of cash and cash flows

Cash includes cash in hand, bank balance and demand deposits with banks. Cash
equivalent refers to highly liquid short-term investments such as treasury bills and commercial
paper.
Cash flows refer to inflows and outflows of cash and cash equivalents.
Net cash flow is the difference between the cash inflows and outflows. It may be net
cash inflow or net cash out flow

Objective of Accounting Standard 3 - Cash Flow Statements –

• To provide information about the cash flows of an enterprise for assessing its ability to
generate and utilise cash flows.
• To enable the users of financial statements to evaluate the timing and certainty of cash
flows
• To classify the cash flows on the basis of operating, investing and financing activities.

Accounting Standard 3
The institute of Charted Accountants of India has issued Accounting Standard 3 (AS3):
cash flow Statements. As per the revised AS3, cash flows are classified and reported under
three heads
1. Cash Flows from Operating activities: these are net cash flows generated or used in the
business operations of the firm.
2. Cash flows from investing activities: these are cash flows from transactions such as sale
of assets, purchase of assets, sale of investments, purchase of investments, receipt of
dividends and interest
3. Cash flow from financing activities: these are cash flows caused by issue of shares and
other securities, raising of long-term loans, repayment of long-term loans, payment of
dividends etc.
The cash flow statement shows the net cash inflow or outflow from each group of
activities. It shows the reasons for changes in cash balance during the period.
The revised AS3 is mandatory for all listed companies and other firms with an annual
turnover of more than Rs. 50 Crores

Cash From Operating Activities

It generally includes, the operating activities which primarily arise from the principles
of revenue producing activities of the enterprise. The amount of cash flows arising from
operating activities is a key indicator of the extent to which the operations of the entity have
generated sufficient cash flows to repay loans, maintain the operating capability of the entity,
pay dividends and make new investments without recourse to external sources of financing.

72
Information about the specific components of historical operating cash flows is useful, in
conjunction with other information, in forecasting future operating cash flows.
Cash flows from operating activities are primarily derived from the principal revenue
producing activities of the entity. Therefore, they generally result from the transactions and
other events that enter into the determination of profit or loss.
Examples of Operating Activities are:
Cash receipts from sale of goods or rendering of service.
Cash receipts from royalty, fees and other revenue.
Cash paid to suppliers for goods and services.
Cash paid to Income Tax dept

Cash From Investing Activities

The separate disclosure of cash flows arising from investing activities is important
because the cash flows represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows. Only expenditures that result in a
recognized asset in the balance sheet are eligible for classification as investing activities. Cash
Flow Arising out Acquisition and Disposal of the long term Assets and Investment are
classified under the Investing activities.
Examples of Investing Activities are:
• Cash receipts from the disposal of the Fixed Assets including intangible.
• Cash paid to purchase Fixed Assets , to acquire shares, debenture of any companies
• Cash received from dividend and Interest from the other sources.
• Cash paid for purchase of investments to other companies

Cash From Financing Activities

The separate disclosure of cash flows arising from financing activities is important
because it is useful in predicting claims on future cash flows by providers of capital to the
entity. It includes Inflow and Outflow of the capital funds.
Examples of Operating Activities are:
Issue of share
Buy back of share
Redemption of preference share
Issue/Redemption of Debenture
Paid to interest and dividend
Paid long term loan

Applicability of Ind AS:

Indian Accounting Standards, (Ind AS) are a set of Accounting Standards notified by
the Ministry Of Corporate Affairs which are converged with International Financial Reporting
standards (IFRS). These Accounting Standards are formulated by Accounting Standard Board
of Institute of Chartered Accountants of India. Now India will receive two Sets of Accounting
Standards.
a) Existing Accounting Standards under companies (Accounting Standards) Rules, 2006

73
 b) IFRS converged with Indian Accounting Standards (Ind AS).

The Ind AS named and numbered in the same way as the corresponding IFRS. As
on the date of Ministry Of Corporate Affairs notifies 35 Indian Accounting Standards (Ind AS).

Convergence with IFRS:

The Inception of the Idea of Convergence of Indian GAAP with IFRS was made by
India’s commitment in G20 to align Indian Accounting Standards with IFRS. Thereafter ICAI
has decided to converge its Accounting Standards with IFRS.

As per Ind AS-7, there is some Accounting treatment different from AS-3

Ind As-7 AS-3

Bank borrowings are generally considered to be Not Mention on this Aspect.
financing activities. However, where bank
overdrafts which are repayable on demand form an
integral part of an entity's cash Management, bank
overdrafts are included as a component of cash and
cash equivalents.
Treatment of Cash Payments to Manufacture or Does not contain Such
Acquire Assets held for Rental to others and Requirements.
Subsequently held for sale to ordinary Course of
business is treated as Cash Inflow from Operating
Activities.

Significance Cash Flow Statement:

1. Indication of Profitability and Liquidity:-The virtue of Cash Flow Statement lies in its
ability to reveal firm’s liquidity as well as profitability simultaneously. Liquidity position
of the firm refers to its capacity to meet short term obligation such as payment of wages
and other operating Expenses, creditors’ payment, repayment of loan maturing in the
current year etc. From cash flow statement we are able to understand how well the firm is
meeting these obligations. At the same the ability of the firm in cash Earning can be known
from cash flow statement. As a matter of fact, firm’s profitability is ultimately dependent
upon its cash earning capacity.
2. Planning and Co-ordination:- With the help of projected cash flow statement the
management can plan and co-ordinate its financing activities effectively. In the absence of
planning and co-ordination, situations might crop up to land the firm in acute cash crisis.
Again sometimes the firm might have surplus cash. Neither of these situations is desirable.
The projected cash flow statement can prevent this kind of situations. Management can
streamline its financing activities before hand prevent such events.
3. Performance Evaluation:-The management can evaluate its performance by means of
comparison of actual cash flow statement with projected cash flow statement. In this
process performance of the firm can be improved.

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4. Capital Budgeting Decision:-Most of the techniques of taking capital Budgeting decisions
which has long run Implications for the firm are based on Projected cash flow of the
proposed project.
5. Objectivity:-Cash Flow Information is more objective and Authentic the Actual based
Accounting. A lot of Subjectivity is involved in the technical Adjustments made in the
traditional Accrual Accounting.
6. Answer of Intricate Questions:-Cash Flow Statement is Able to Explain Some Intricate
Questions often solved by Management Such as- Why the Company unable to pay dividend
In spite of Making Profit.

DIRECT METHOD:
• The information is shown which is not shown elsewhere in the financial statement.
• The method shows true cash flows trading operations in the entity.
• The knowledge of the specific sources of cash inflows purpose of cash payment in made
in past, which might be useful to the future cash flows.

INDIRECT METHOD:
• It Reconciles the Operating profit to Net cash flows from operating activities.
• The cost involved in preparation relatively less.

Format of cash flow statement approved by SEBI

Cash Flow statement for the year ended .....................
Rs. Rs.
A. Cash flow from operating Activities
Net profit before tax and extraordinary items
Adjustment for:
Depreciation
Gain/Loss on sale of fixed assets
Foreign exchange
Miscellaneous expenditure written off
Investment income
Interest
Dividend
Operating profit before working capital changes:
Adjustment for:
Trade and other receivables
Inventories
Trade payables
Cash generated from operations
Interest paid
Direct taxes paid
Cash flows before extraordinary items
Net cash from operating activities
B. Cash Flow from Investing Activities
Purchase of fixed assets
Sale of fixed assets

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 Purchase of investments
Sale of investments
Interest received
Dividend received
Net cash from / used in investing activities
C. Cash Flow from Financing Activities
Proceeds from issue of share capital
Proceeds from long-term borrowings / banks
Payment of long-term borrowings
Dividend paid
Net cash from / used in financing activities
Net increase / Decrease in cash and cash equivalents (A+B+C)
Cash and cash equivalents as at----
(Opening balance)
Cash and cash equivalents as at----
(Closing balance)

Problems
1. From the balance sheet as on 31st March 2007 and 31st March 2008, prepare a cash
flow statement

Balance sheet
31.3.07 21.3.08 31.3.07 31.3.08
Liabilities Assets
Rs Rs Rs Rs
Share capital 1,00,000 1,50,000 Fixed assets 1,00,000 1,50,000
P&L account 80,000 1,20,000 Goodwill 50,000 40,000
10% Debentures 50,000 60,000 Stock 30,000 70,000
Creditors 30,000 40,000 Debtors 50,000 90,000
Outstanding expenses 10,000 15,000 Bills receivable 30,000 20,000
Bank 10,000 15,000
2,70,000 3,85,000 2,70,000 3,85,000

Solution
Cash Flow statement
AS-3 Revised Method
Rs. Rs.
A. Cash flow from operating Activities
Net profit before tax 40,000
Add: Goodwill written off (W.N.2) 10,000
Cash operating profit 50,000
Working capital changes:
Increase in creditors (inflow) 10,000
Increase in Outstanding expenses (inflow) 5,000
Decrease in Bills receivable (inflow) 10,000
Increase in stock (outflow) (40,000)
Increase in debtors (outflow) (40,000)
Net cash used in operating activities (5,000)
B. Cash Flow from Investing Activities
Purchase of fixed assets (outflow) (W.N.1) (50,000)
Net cash used in investing activities (50,000)

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 C. Cash Flow from Financing Activities
Issue of share (inflow) (W.N.3) 50,000
Issue of debenture (inflow) (W.N.4) 10,000
Net cash from financing activities 60,000
Net increase in cash and cash equivalents 5,000
Cash and cash equivalents at the beginning 10,000
Cash and cash equivalents at the end 15,000

Working notes Opening balance Closing balance

1 Fixed assets 1,00,000 1,50,000
Purchase of fixed assets 50,000 Outflow–Investment activity
Opening balance Closing balance
2 Goodwill 50,000 40,000
Goodwill written off Rs.10,000. It is added back to net profit to find out
cash from operations
Opening balance Closing balance
3 Share capital 1,00,000 1,50,000
Issues of shares. Rs.50,000. Inflow financial activity
Opening balance Closing balance
10% debentures 50,000 60,000
Issues of debentures. Rs.10,000. Inflow financial activity

2. The following are the summarised balance sheet of Anand & balu as on 1.1.08 and
31.12.08.
1.1.07 31.12.08 1.1.08 31.12.08
Liabilities Assets
Rs Rs Rs Rs
Creditors 40,000 44,000 Cash 10,000 7,000
Loan from Mrs. Anand 20,000 - Debtors 30,000 50,000
Loan from bank 40,000 50,000 Stock 35,000 30,000
Capital 1,25,000 1,53,000 Machinery at cost 1,00,000 90,000
Provision for Land 40,000 50,000
depreciation on 25,000 40,000 Building 35,000 60,000
machinery 2,50,000 2,87,000 2,50,000 2,87,000
Machinery costing Rs. 10,000 was sold without any loss during the year 2008 amounted
to Rs. 50,000. Prepare cash flow statement

Solution
Cash Flow statement
AS-3 Revised Method
Rs. Rs.
A. Cash flow from operating Activities
Net profit before tax 50,000
Add: Provision for depreciation made during the year (W.N.2) 15,000
Cash operating profit 65,000
Working capital changes:
Decrease in stock (inflow) 5,000
Increase in creditors (inflow) 4,000
Increase in debtors (outflow) (20,000)
Net cash from operating activities 54,000
B. Cash Flow from Investing Activities 10,000

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 Sale of machinery (inflow) (W.N.1) (10,000)
Purchase of land (outflow) (25,000)
Purchase of building (outflow) (25,000)
Net cash used in investing activities
C. Cash Flow from Financing Activities
Loan from bank (inflow) 10,000
Repayment of Mrs. Anand’s loan (outflow) (20,000)
Drawings (outflow) (W.N.3) (22,000)
Net cash from financing activities (32,000)
Net decrease in cash and cash equivalents (3,000)
Cash and cash equivalents at the beginning 10,000
Cash and cash equivalents at the end 7,000

Working notes Opening balance Closing balance

1 Machinery at cost Rs. 1,00,000 Rs.90,000
Sale of machinery – Rs. 10.000. inflow–Investment activity
Opening balance Closing balance
2 Provision for depreciation Rs. 25,000 Rs. 40,000
Provision made during the year Rs.15,000. The amount is added back
to net profit to find out cash flow from operation
3 Capital Account
Rs Rs
To Drawings (?) 22,000 By Balance b/d 1,25,000
To Balance (c/d) 1,53,000 By Net profit 50,000
175,000 1,75,000
Drawing Rs 22,000 - outflow financial activity
Opening balance Closing balance
4 Loan from bank Rs. 40,000 Rs. 50,000
Loan from bank – Rs.10,000 - inflow financial activity
5 Opening balance Closing balance
Loan from anand Rs. 20,000 -
Repayment of the Anand’s loan – Rs.20,000 outflow financial activity

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 UNIT IV

Introduction to Budget - Meaning and Significance- Importance of Budget in Managerial

Decision Making - Types of Budget- Preparation of Functional Budget - Preparation of Flexible
Budget-- Other Budget types preparation- Zero Based Budgeting

INTRODUCTION TO BUDGET

A budget is a plan expressed in quantitative, usually monetary terms, covering a specific

period of time, usually one year. In other words, a budget is a systematic plan for the utilisation
of manpower and material resources. In a business organisation a budget represents an estimate
of future costs and revenues. Budgets may be divided into two basic classes : Capital Budgets
and Operating Budgets.
Capital budgets are directed towards proposed expenditure for new projects and often
require special financing (this topic is discussed in the next unit). The operating budgets are
directed towards achieving short term operational goals of the organisation, for instance,
production or profit goals in a business firm. Operating budgets may be sub-divided into
various departmental or functional budgets. The main characteristics of a budget are:
1. It is prepared in advance and is derived from the long term strategy of the organisation
2. It relates to future period for which objectives or goals have already been laid down
3. It is expressed in quantitative from, physical or monetary units, or both
Different types of budgets are prepared for different purposes e.g. Sales Budget. Production
Budget, Administrative Expense Budgets, Raw-material Budget, etc. All these sectional
budgets are afterwards integrated into a master budget which represents an overall plan of the
organisation. A budget helps its in the following ways:
a) It brings about efficiency and improvement in the working of the organisation.
b) It is a way of communicating the plans to various units of the organisation. By
establishing the divisional, departmental, sectional budgets, exact responsibilities are
assigned.
c) It thus minimizes the possibilities of buck-passing if the budget figures are not met.
d) It is a way of motivating managers to achieve the goals set for the units.
e) It serves as a benchmark for controlling on-going operations.
f) It helps in developing a team spirit where participation in budgeting is encouraged.
g) It helps in reducing wastage's and losses by revealing them in time for corrective action
h) It serves as a basis for evaluating the performance of managers.
i) It serves as a means of educating the managers.

MEANING AND SIGNIFICANCE

Definition of Budget
According to ICMA, a budget is “a financial and/or quantitative statement, prepared
and approved prior to a defined period of time, of the policy to be perused during the period
for the purpose of attention a given objective”

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Budgetary Control
In the word of ICMA, budgetary control is, “the establishment of budgets relating to
the responsibility of executive to the requirement of a policy and the continuous comparison
of actual with budgeted result either to secure by individual action the objectives of that policy
or to provide a basic for its revision”

Budgeting
Budgeting is the complete process of designing, implementing and operating budgets.
The main emphasis in this is short-term budgeting process involving the provision of resources
to support plans which are being implemented.

Importance of budgetary control

• Budgetary control defines the objectives and policies of the undertaking as a whole.
• It helps in estimating the financial needs of the concern. Hence the possibility of under or
over capitalization is eliminated.

SIGNIFICANCE OF BUDGET

In all democratic countries, the budget has been a dominant policy document. It is not
only the main instrument for implementing government activities but also used extensively to
regulate and influence economic and social activities in the private sector of mixed economies.
A budget is a work plan and an evaluation tool that gives direction to the implementation of
public policies and programmes. Hence is the need of budget to carry out multifarious activities
of the government. Budget is the vital aspect of financial administration and since it operates
within the limits of legislative authorisation, the executive is responsible for legal and financial
accountability to the legislature. Admittedly budget has commanded a dominant position in the
scheme of governance. The budget system today not only provides the legislature to have an
over-all control over the revenue collected and expenditure incurred by the executive, but it
also becomes an important means for evaluating the progress of various government projects
and schemes.
A budget gives the direction in which government intends to go in the near future,
usually in the next fiscal year. Emphasising the need and importance of budget, Bridges (1964)
says, “Whatever else a Government may or may not do, one thing it cannot avoid doing each
year if it is to continue to exist, and that is to obtain the authority of Parliament to raise revenue
to meet expenditure which is done by the Budget and the accompanying Finance Bill”.
Recognising the important place of budgeting in administration, a Study Group of the Royal
Institute of Public Administration (1959) observes: “In all organisations, however, budgeting
can assist management at every level in several ways. In the first place, it helps in making
reviewing policy, by encouraging comprehensive forward-looking planning and decision
making and providing both the information and the occasions for regular reviews of plans and
prospects for the future. Secondly, it supplies yardsticks against which the actual results can be
judged, thus helping to assess their significance and results can be judged, thus helping to assess
their significance and decide what action may be called for in consequence. A budget can be

80
used in both these ways, whether it relates to income and expenditure on revenue account,
capital expenditure, or finance and cash transactions”. In brief, budget has acquired great
dimension not only from the constitutional point of view to assert legislative control over
executive, but also administratively it has become an important aid to management, both for
policy-making and for keeping check on its execution. Indeed, it is the heart of administrative
management. It also serves as a powerful tool of coordination, and negatively, an effective
device of eliminating wasteful financial expenditure.
Budget is one of the major instruments for the expression of a government’s programme.
It has a vital role to play in the economy of a welfare state. Through a budget, citizens are
benefited from various plans and programmes of the government. The government tries to
narrow down the class distinctions and inequalities through its taxation policy.
The budget policy of the government aims at removal of poverty, unemployment, social
and economic inequalities in society. By imposing heavy taxation upon articles of
consumption, it can encourage investment, and thus, promote the economic growth of the
nation. By taxing the rich, it can mitigate economic inequality. The signs of the welfare state
are reflected in the budget with its heavy outlay on social services and the like. In this way, it
is an instrument of socioeconomic change.
Budget also acts as an allocator of social resources. Because people cannot always acquire
all goods and services that they need for themselves; they must rely on others for help. It is the
government which allocates society’s resources by mandating that taxes be collected and then
by deciding where those taxes are spent. Governmental allocations are necessary because the
market mechanism is not adequate to serve all societal needs.
Budgeting is the heart of administrative management. It serves as a powerful tool of
coordination, an effective device of eliminating duplication and wastage. The budget is many
things-an economist view it as a device of influencing the country’s economy, the politician
employs it for defending or criticizing the government, the administrator uses it as a framework
for communication and coordination as well as for exercising administrative discipline
throughout the administrative structure.

IMPORTANCE OF BUDGET IN MANAGERIAL DECISION MAKING

1. Resource Allocation: Budgets help managers allocate resources such as money, time,
and manpower effectively. They provide a roadmap for how funds should be
distributed across different departments and projects.
2. Goal Setting: Budgets set financial and operational goals for the organization. They
provide a benchmark against which actual performance can be measured. This helps
in setting clear objectives for the management team.
3. Performance Evaluation: Budgets allow managers to compare actual results with the
budgeted figures. This helps in identifying variances and taking corrective actions if
the organization is not meeting its targets.
4. Cost Control: Budgets help in controlling costs by providing a predetermined limit
on expenditures. Managers can track expenses and ensure they stay within the
allocated budget.

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 5. Decision Support: Budgets provide a basis for decision-making. For example, when
considering a new project or investment, managers can assess its financial feasibility
by comparing the expected costs and revenues with the budget.
6. Prioritization: Limited resources require prioritization. Budgets force managers to
prioritize projects and activities based on their financial impact, ensuring that the most
critical initiatives receive adequate funding.
7. Communication: Budgets serve as a communication tool, helping to convey financial
and operational plans to various stakeholders, including employees, investors, and
creditors.
8. Motivation: Budgets can motivate employees by setting performance targets. When
employees have clear goals and see how their work contributes to the overall budget, it
can boost morale and productivity.

TYPES OF BUDGET

Classification of Budgets
The budgets are classified according to their nature. The following are the types of
budgets which are commonly used.
1. Classification According to Time
a. Short period Budget: These budgets are usually for a period of one year.
b. Long period Budget: These budgets are for a longer period say 5 to 10 years.
c. Current Budget: These budgets are for a very short period, say, a month or a
quarter and are related to current conditions.
2. Classification According to Function: A functional budget is a budget which relates to
any of the functions of an organization. The following are the commonly used functional
budgets.
a. Sales Budget: It gives the sales to be achieved during the period, in terms of division,
type of products, quantity of each product and sales value. It is prepared by the sales
manager.
b. Production Budget: It is an estimate of goods that must be produced during the budget
period, in terms of division, type of product and quantity of each type. It is prepared
by the production manager.
c. Production Cost Budget: It gives the total cost to be incurred for production during
the budget period. Since production includes material, labour and overheads, the
budget is divided accordingly into material cost budget, labour cost budget and
overhead cost budget.
d. Materials Budget: This budget deals with only direct material requirement. Indirect
materials are included in factory overheads budget. It gives an estimate of the materials
required for production and an estimate of raw materials to be purchased.
e. Labour Budget: It gives an estimation of the different classes of labour required for
each department, than pay rate, and the hours to be spent.

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 f. Overhead Budgets: It shows the details of overhead expenses likely to be incurred
during the budget period, in terms of factory overhead, administration overhead, selling
and distribution overhead.
g. Administrative Expenses Budget: The budget is an estimate of administrative
expenses to be incurred in the budget period. E.g. rent, salaries, insurance etc
h. Selling and Distribution Overhead Budget: The budget gives an estimate of selling
and distribution expenses to be incurred in the budget period.
i. Capital Expenditure Budget: This budget shows the estimated expenditure on fixed
assets during the budget period. Separate budgets may be prepared for each item of
assets, if necessary.
j. Cash Budget: This budget gives an estimate of receipts and payments of cash during
the budget period. It is prepared by the chief accountant. It shows the cash available
and needed from time to meet the capital requirements of the organization.
k. Master Budget: Finally, master budget is prepared incorporating all functional
budgets. It is defined as, “the summary budget incorporating the functional budgets
which is finally approved, adopted and employed”, The budget may take the form of
budgeted profit and loss account and balance sheet. It has to be approved by the board
of directors before it is put into operation.
3. Classification According to Flexibility:
a. Fixed Budget: Fixed budget is also called static budget. It may be defined as, “a
budget designed to remain unchanged irrespective of the level of activity actually
attained”. This budget is most suited for fixed expenses, which have no relation to
the volume of output. It is ineffective for cost control purposes. It is useless for
comparison with actual performance when the level of activity changes.
b. Flexible Budget: Flexible budget is also called variable budget. It may be defined
as, “A budget designed to change in accordance with the level of activity actually
attained”. It shows estimated costs and profit at different levels of output. It
facilitates comparison of actual performance with the budget at any level of output.
To prepare flexible budget, all costs should be classified into fixed, variable and
semi-variable. It is more elastic, useful and practical. It is used for the purpose of
control.

PREPARATION OF FUNCTIONAL BUDGET

In the case of a manufacturing business accounting information should be supplied to

management in the form of a series of budgets. The main functional budgets and the methods
of arranging for the compilation of these budgets are as set out hereunder :

1. Sales Budget : These should be analysed as between products, periods and areas. By
reference to the trends disclosed by the past figures and with the aid of information supplied
by the sales department, a forecast of anticipated sales for the forthcoming period can be
made. In making such forecast regard must be had to general trading conditions, any special
conditions affecting the particular business, elasticity of demand, pricing policy, future

83
 advertising policy and the relevant factors. The sales forecast or sales budget is the basic
core budget on which other budgets depend. As such rational efforts should be made to
develop a proper sales budget which can be reasonably accomplished

Preparation of Sales Budget :

It has already been stated that the Sales Budget is prepared by the sales manager. He is,
therefore, to consider the following matters at the time of its preparation :
a. Analysis of Historical Sales : Analysis of past sales, with the help of statistical
measurements, cyclical trends, seasonal fluctuations etc., provides valuable
information which ultimately helps to predict future sales.
b. Reports by Salesmen : Salesmen also can submit a report to the sales manager
which is highly significant since they are in frequent contact with customers having
an internal knowledge about the habits, tastes, and demand of the customers.
c. Business Conditions : The general business conditions can also be studied from
the national as well as international economic statistics, political influences etc.
d. Market Analysis : Market analysis may be employed by the large firms whereas
specialists are employed by the small firms for collecting necessary information
about the market demands, product-designs, fashion trends, degrees of competition
etc
e. Special condition : There are certain events which may influence sales outside the
firm e.g., introduction of electricity to a village will increase the demand for
electrical appliances.
2. Purchase Budget : The purchase budget indicates, either in terms of money or of quantity,
the expected purchases of raw materials to be made during the budget period. After
ascertaining the proper requirement of different types of raw materials, it needs adjustment
between the contract already made for the purchase of raw materials and the existing level
of stock (in order to maintain a balanced level of stock of raw materials). In this respect, it
may also be mentioned that internal sources of raw materials, if any, are also to be
considered. However, this budget is based on Sales Budget, Production Cost Budget,
Maximum and Minimum Stock, Stock Level, Economic Order Quantity (EOQ) etc
3. Production Budget : Production budget is prepared after the preparation of Sales Budget,
to determine the quantity of goods which should be produced to meet the budgeted sales.
It is expressed in physical terms, such as : (a) Units of output; (b) Labour hours and (c)
Material requirement. The Production Budget is prepared by the production management
and is submitted to the budget committee for its approval. The following points are to be
carefully noted at the time of its preparation.
(i) To determine the quantity of each product which will be produced during the budget
period.
(ii) To prepare the production plan on the basis of the Sales Budget.
(iii) To consider the key factor or limiting factor, if any.
(iv) To consider the production plant capacity and production planning.
(v) To consider the volume of production.
4. Raw Material Budget : This budget reveals the quantities of materials which are needed
to make the budgeted production. It also shows the anticipated cost of materials to be

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 purchased, terms of credit from suppliers, the time taken to procure raw materials etc. This
budget serves :
(i) to provide information about the position of stock ;
(ii) to give an idea about the total requirement of raw materials;
(iii) to supply necessary data to the purchase department for their purchase programme;
and
(iv) to determine the cost of different types of raw materials
5. Direct Labour Budget: The direct labour budget tells about the estimates of direct labour
requirements essential for carrying out the budgeted output. The direct labour cost is
estimated as a result of the evaluation of standard hours worked or the quantity of work
done by the individual worker in terms of certain average wage rate. This average wage
rate may be different for each department. For estimating the average wage rates the
following different approaches can be used :
(i) The rates for the last budget period may be taken. Historical ratio may be calculated.
This is arrived at by taking the ratio of wages paid to the direct labour hours worked.
This ratio can be adjusted in the light of fresh changes, if any.
(ii) Wage rates may be fixed by the agreement with the trade union.
(iii) The current wage rate of the industry, trade or the national wage rate may be taken
as average wage rate.
6. Manufacturing Overhead Budget : Manufacturing or Factory overhead include the cost
of indirect labour, indirect materials and indirect expenses. The manufacturing overhead
can be classified into three categories, (i) Fixed, i.e. which tend to remain constant
irrespective of any change in the volume of output, (ii) Variable, i.e. which tend to vary
with the output and (iii) Semi-variable, i.e., which are partly variable and partly fixed. The
Manufacturing Overhead Budget will provide an estimate of all these overheads to be
incurred in the budget period.
7. Selling and distribution overheads budget : The selling expenses include all items of
expenditure on the promotion, maintenance and distribution of finished products. Sales
office rent, salaries, depreciation and other miscellaneous expenses are provided for as a
fixed amount per month. Advertising, selling commission, bad debts, travelling and
delivery expenses are provided for as a percentage of budgeted sales. Although selling
expenses are not included as a part of product cost, these are frequently analysed by lines
of product, sales territories, customers, salesmen or some such unit basis. Such an analysis
of selling expenses can be applied in planning sales activity. Besides, if selling costs are
budgeted and computed on a unit responsibility basis (products, territories, type of
salesmen, customers etc.), it may be possible to identify differences by sales territories,
salesmen, customer group etc. Thus, selling costs, like manufacturing costs, can be
identified by area of responsibility and can be used as a means for control. The selling and
distribution overheads budget is closely linked with the sales budget and should be prepared
simultaneously with the sales budget. The sales manager, advertising manager and sales
office manager will cooperate with the budget officer in the preparation of this budget.
8. Cash Budget : The cash budget is a summary of the firm's expected cash inflows and
outflows over a particular period of time. In other words, cash budget involves a projection
of future cash receipts and cash disbursements over various time intervals. There must be

85
 a balance between cash and the cash demanding activities/operations, capital expenditure
and so on. Very often, the need for additional cash is not realised until the situation becomes
critical. The cash budget consists of two parts :
1. The projected cash receipts (inflows) and;
2.The planned cash disbursements (outflows).
The main purposes of the cash budget may be outlined as follows :
1. To indicate the probable cash position as a result of planned operations.
2. To indicate cash excess or shortages.
3. To indicate the need for borrowing or the availability of idle cash for
investment.
4. To make provision for the coordination of cash in relation to (a) total
working capital; (b) sales; (c) investment; and (d) debt.
5. To establish a sound basis for credit.
6. To establish a sound basis for exercising control over cash and liquidity of
the firm.

9. The Master Budget : The Institute of Cost and Management Accountings, England,
defines it as 'the Summary Budget; incorporating its component functional budgets, which
is finally approved, adopted and employed'. In other words, it is a summary budget which
is prepared from and summarises all the functional budgets. This summarising is done in
the form of :
(a) Budgeted Profit and Loss Account/Budgeted Profit and Loss Appropriation Account,
(b) Budgeted Balance Sheet.
Budgeted Profit and Loss/Profit and Loss appropriation Account shows the
principal items of revenue, expenses, loss as well as profit whereas the Budgeted Balance
Sheet reveals the principal items of Balance Sheet. This budget is prepared by the budget
officer. After its preparation, it is submitted to the budget committee for its approval. If the
budget committee does not find it satisfactory, it makes suitable changes in this budget and
puts it into action when the final approval is given, However, once it is approved, the
company seeks to a achieve the targets during the budget period

PREPARATION OF FLEXIBLE BUDGET

The preparation of a flexible budget requires the analysis of total costs into fixed and
variable components. This analysis of course is, not unusual to the flexible budgeting, is more
important in flexible budgeting then in fixed budgeting. This is so because in flexible
budgeting, varying levels of output are considered and each class of overhead will be different
for each level. Thus the flexible budget has the following main distinguishing features:
• It is prepared for a range of activity instead of a single level.
• It provides a dynamic basis for comparison because it is automatically related to
changes in volume.

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 The formulation of a flexible budget begins with analyzing the overhead into fixed and
variable cost and determining the extent to which the variable cost will vary within the normal
range of activity. In a simple equation form it could be put as:
Y=a+bx and it is illustrated as below:

There are two methods of preparing such a budget:

a. Formula Method / Ratio Method: This is also known as the Budget Cost Allowance
Method. In this method the budget should be prepared as follows:
• Before the period begins:
✓ Budget for a normal level of activity,
✓ Segregate into fixed and variable costs,
✓ Compute the variable cost per unit of activity
• At the end of the period:
✓ Ascertain the actual activity
✓ Compute the variable cost allowed for this level, add the fixed cost to give
the budget cost allowance.
The whole process is expressed in the formula:
Allowed cost = Fixed cost + (Actual units of activity for the period) (Variable cost
per unit of activity)
b. Multi‐Activity Method: This method involves computing a budget for every major level
of activity. When the actual level of activity is known, the allowed cost is found
“interpolating” between the budgets of activity levels on either side.
✓ Different levels of activity are expressed in terms of either production units or sales
values. The levels of activity are generally expressed in production units or in terms of
sales values.
✓ The fixation of the budget cost gives allowance for the budget centres. According to
CIMA London, the budget cost allowance means, "the cost which a budget centre is
expected to incur during a given period of time in relation to the level of activity attained
by the budget centre."
✓ The determination of the different levels of activity for which the flexible budget is to
be prepared.
c. Graphic Method: In this method, estimates of budget are presented graphically. In this
costs are divided into three classes, viz., fixed, variable and semi‐variable cost. Values of
costs are obtained for different levels of production. These values are signified in the form
of a graph.

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 OTHER BUDGET TYPES PREPARATION
Period Budgets
(i) Long Period Budgets: Long period budgets are those budgets which
incorporate planning for five to ten years and even more. Research and
development budget is an example of long period budget.
(ii) Short Period Budgets: Short period budgets are prepared for the period less
than one year. Material budget, Cash budget, etc. are the examples of short
period budgets.

Condition Budgets
(i) Basic Budget: A basic budget is one which is established for use unaltered over
a long period of time. Current circumstances are not considered while preparing
this budget.
(ii) Current Budget: A current budget is one which is established for use over a
short period of time and it is related to current conditions. This budget is more
useful than basic budget.

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 ZERO BASED BUDGETING

Zero Base budgeting is defined as “a planning and budgeting process which required
each manager to justify his entire budget request in detail from scratch [hence zero base] and
shifts the burden of proof to each manager to justify why he should spend money at all. The
approach requires that all activities be analyzed in decision packages which are evaluated by
systematic analysis and ranked in the order of importance”.
According to Certified Institute of Management Accountants, London, "Zero base
budgeting is a method of budgeting whereby all activities are re-evaluated each time a budget
is set. Discrete levels of each activity are valued and a combination chosen to match funds
available.

Procedure of Zero‐base Budgeting:

1. Determination of the objective: This is an initial step for determining the objective to
introduce ZBB. It may result into the decreased cost in personnel overheads or debunk the
projects which do not fit in the business structure or which are not likely to help accomplish
the business objectives.
2. Degree at the ZBB is to be introduced: It is not possible every time to evaluate every
activity of the whole business. After studying the business structure, the management can
decide whether ZBB is to be introduced in all areas of business activities or only in a few
selected areas on the trial basis.
3. Growth of Decision units: Decision units submit their data as to which cost benefit
analysis should be done in order to arrive at a decision that helps them decide to continue
or abandon. It could be a functional department, a programme, a product‐line or a sub‐line.
Here the decision unit sexist independent of all the other units so that when the cost analysis
turns unfavourable that particular unit could be closed down.
4. Growth of Decision packages: Decision units are to be identified for preparing data
relating to the proposals to be included in the budget, concerned manager analyzes the
activities of his or her own decision units. His job is to consider possible different ways to
fulfill objectives. The size of the business unit and the volume of goods it deals with
determine the number of decision units and packages. The decision package has to contain
all the information which helps the management in deciding whether the information is
necessary for the business, what would be the estimated costs and benefits expected from
it.
5. Assessment and Grading of decision packages: These packages invented and formulated
are submitted to the next level of responsibility within the organization for ranking
purposes. Ranking basically decides as to whether or not to include the proposals in the
budget. The management ranks the different decision packages in the order from decreasing
benefit or importance to the organization. Preliminary ranking is done by the unit manager
himself and for the further review it is sent to the superior officers who consider overall
objectives of the organization.
6. Allotment of money through Budgets: It is the last step engaged in the ZBB process.
According to the cost benefit analysis and availability of the funds management has ranks

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 and thereby a cut‐off point is established. Keeping in view reasonable standards, the
approved designed packages are accepted and others are rejected. The funds are then
allotted to different decision units and budgets relating to each unit are prepared.

Advantages of Zero-Base Budgeting

a) Efficient allocation of resources, as it is based on needs and benefits rather than history.
b) It helps in identifying and eliminating wasteful and obsolete operations.
c) It helps in detecting inflated budgets.
d) It increases communication and coordination within the organization.
e) It enables the management to find cost effective ways to improve operations.
f) Responsibility and accountability are more specifically fixed under zero based
budgeting as compared to traditional budgeting.
g) It increases staff motivation by providing greater initiative and responsibility in
decision making.
h) It is useful in Government department where all expenditure are incurred on the basis
of budgets.
i) It focuses on cost benefit analysis to reach on maximization of profit of the company.
j) It can be used for implementation of “Management by objective’ (MBO). Thus it can
be used not only for fulfillment of the objective, but also for variety of the purpose.
k) It identifies activities involving wasteful expenditure.
l) It involves rational decision making.
m) It promotes operating efficiency.

Limitations of zero-Base Budgeting

1. It is more time consuming than traditional budgeting as every single item is paid
attention to afresh.
2. It requires specific training due to increased complexity as compared to traditional
budgeting.
3. It increases paper work
4. Cost of preparing the decision package may be very high.
5. There is a problem in defining decision units and decision packages.
6. Wrong cost-benefit analysis may hamper the future growth of the organization. For
example, cutting present advertisement cost may effect future sales. Similarly, cutting
research and development cost may effect the future growth and cost effectiveness of
the organization.
7. The concept ZBB needs clarity at top management level otherwise conflict among
departments may affect the overall profitability of the organizations.
ZBB is highly relevant in ‘continuous improvement’ environment because of its nature of
continuous evaluation of costs and benefits. This technique is relevant for effective utilization
of resources and increasing the profitability of the organizations. So ZBB can be implemented
as a planning device in the overall corporate strategy.

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Problem
1. Prepare a flexible budget for overheads on the basis of the following data and ascertain
overhead rates at 50%, 60% and 70% capacity
At 60% capacity
Rs
Variable overheads:
Indirect material 6,000
Indirect labour 18,000
Semi – variable overheads:
Electricity (40 % fixed 60% variable) 30,000
Repairs (80% fixed 20% variable) 3,000
Fixed overheads:
Depreciation 16,500
Insurance 4,500
Salaries 15,000
Total overheads 93,000
Estimated direct labour hours 1,86,000

Solutions

Particulars 50% Rs 60% Rs 70% Rs

Variable overheads:
Indirect material 5,000 6,000 7,000
Indirect labour 15,000 18,000 21,000
Semi – variable overheads:
Electricity (60% variable) 15,000 18,000 21,000
Repairs (20% variable) 500 600 700
Total variable cost 35,500 42,600 49,700
Fixed overheads:
Depreciation 16,500 16,500 16,500
Insurance 4,500 4,500 4,500
Salaries 15,000 15,000 15,000
Electricity (40 % ) 12000 12000 12000
Repairs (80% ) 2400 2400 2400
Total fixed cost 50,400 50,400 50,400
Total overheads (FC &VC) 85,900 93,000 1,00,100
Estimated direct labour hours 1,55,000 1,86,000 2,17,000
Overhead rate [TC/T. Hr] 0.55 0.50 0.46

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 UNIT V

Annual Report: Introduction-Items in Annual Report-Key Points in Annual Report-Segment

Reporting: Introduction-Different Segments in Annual Report-Notes in Financial Statement-
How to interpret notes in Financial Statements?-Disclosures in Financial Statements and
Comparative Statements-Analysis of Management Discussion-Recent Trends in Accounting-
Recent Trends in Accounting for Health care organizations--Contemporary Practices(Expert
Lecture)

ANNUAL REPORT: INTRODUCTION

Annual report is a report that is prepared yearly. It contains information about the firm‘s
business and its financial position and performance. The readers can navigate through the
annual report to learn about the qualitative aspects with respect to the firm. Various
stakeholders like investors, analysts, suppliers, customers, and employees use the annual report
to facilitate decision-making in areas such as investments, credit granting, and establishing
customer-supplier relationship.
An annual report is a document that publicly traded (or listed) companies must provide
annually to shareholders. It describes the company‘s operations and financial
performance/position in a detailed manner. Apart from this, it contains images and graphics
coupled with an accompanying narrative, all of which highlight the company‘s activities over
the past year. The annual report may also provide information regarding the company‘s
forecasts.

Importance of annual report

• Communicating with investors : An annual report is an important element of a
financial communication strategy to attract and retain investors.
• Building customers’ confidence : Annual reports keep customers informed on the
status of a company and help build confidence in it as a long-term suppliers.
• Attracting and retaining employees : Employees want to know that are working
for a progressive company that can offer them secure future and strong job
opportunities.
• Informing and influencing the media : Journalists monitor companies’ activities
to report on financial and business performance. They pay particular attention to
company’s results and its prospects

ITEMS IN ANNUAL REPORT

The four broad contents of an annual report, namely,

1. Non-audited information
2. Financial statement
3. Notes to the accounts

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 4. Accounting policies

Annual
Report

Non-audited Financial Notes to the Accounting

information Statements accounts policies

Non-
Narrative Balance Profit and Cash flow
narrative
items Sheet Loss account statement
items

1. Non-audited information: The non-audited information is further classified into:

a) Narrative items: Within narrative items in the annual report, following are some of the
important statements:
i. Chairman‘s statement: Chairman‘s statement highlights corporate activities,
strategies, researches, labour relations, main achievements, focuses on future
goals, growth. In corporate annual report, the chairman‘s statement may or may
not always be found but may be provided to shareholders as a separate
document. Chairman‘s statement may concentrate on economic condition of the
industry to which the corporate unit belongs and the economy of the country. It
also provides an overview of the trading year, a personalized overview of the
company‘s performance over the past year and usually covers strategy, financial
performance and future prospects.
ii. Directors‘Report: Its principal objective is to supplement the financial
information with other information consider necessary for a full appreciation of
the company‘s activities. It includes:
• A description of the principal activities of the company
• A fair review of the current and future prospects of the business
• Information on the sale, purchase or valuation of assets Recommended
dividends
• Employee statistics
• Names of directors and their interests
• Details of political or charitable donations
iii. Operating and financial review
• This is a statement in the annual report which provides a formalized,
structured explanation of financial performance

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 • The operating review covers items such as operating results, profit and
dividend
• The financial review discusses items such as capital structure and
treasury policy
iv. Statement of corporate governance: Statement of corporate governance
includes a statement of corporate governance procedures and compliance,
information on board composition, statements on the company's performance,
and information about compliance and conformance with best practices for
good corporate governance. Corporate Governance focuses on a company‘s
structure and processes to ensure transparent and responsible corporate
behaviour. Corporate governance is a dynamic process. Effective corporate
governance not only reduces the agency costs incurred due to division of
ownership but it helps in saving of time and resources of investors. On one hand,
poor corporate governance practices enhance the agency costs and reduce firm
valuation whereas on the other, good corporate governance facilitates
independent supervision of company‘s management and encourages effective
decision making which enhances firm value, reputation, credit rating, improves
overall performance, lowers cost of capital, improves access to capital markets
and increases competitive edge.
v. Auditor‘s report: The independent and external audit report is typically
published with the company's annual report. The auditor's report is important
because banks and creditors require an audit of a company's financial statements
before lending to them. The auditors shall make a report to the members of the
company. It is the obligatory duty of the directors to get the accounts of
company audited every year by qualified auditors. An auditor is appointed by
the shareholders of a company to audit accounts and as such, auditor addresses
the report to the shareholders of the company on the accounts audited by him.
It is the duty of the board of directors to attach the auditor‘s report to the balance
sheet so as to provide a copy of auditor‘s report to every member of company.
vi. Statement of directors‘ responsibilities: It is an important statement in the
annual report and is prepared in accordance with section 135 (5) of the
Companies Act, 2013.
vii. Sustainability report: A sustainability report is a report published by a
company about the economic, environmental and social impacts caused by its
everyday activities. A sustainability report is the key platform for
communicating sustainability performance and impacts – whether positive or
negative.
Apart from the broader overview of sustainability, the Sebi (Securities
and Exchange Board of India) has developed new norms, voluntary this year
(2019-20) and mandatory thereafter, which would apply to the top 1,000 listed
entities. The Sebi reporting norms on business responsibility follow the
National Guidelines on Responsible Business Conduct, put forth by the ministry
of corporate affairs last year. The norms require that businesses conduct
themselves with integrity and transparency, provide goods and services in a
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 safe, sustainable manner, and respect the interests of all their stakeholders,
which is unexceptionable.
The new requirements include disclosure on redressal procedures for
complaints/grievances, including on those pending resolution, R&D spends on
better environmental and social outcomes, employee skill levels, including of
those differently abled, and provision for insurance, maternity, paternity and
day-care facilities. But also required now are routine disclosures upfront of
energy consumed to turnover, ditto for water, and, more generally, the
percentage of recycled or reused input materials to total raw material usage (by
value) is also to be revealed.
Gender diversity should get more attention in the reporting, and a board
committee, rather than just a board member, should be accountable for ESG
reporting.
Businesses are, of course, accountable to their shareholders. But,
increasingly, consumers, employees and investors also seek sustainability,
social responsibility and good governance in corporate performance.
ESG — short for environment, social and governance — is quite the
rage among large investors. That means that companies must disclose their
governance processes, social practices and environmental impacts. That is what
Sebi wants.
viii. Management Discussion and Analysis: This section is perhaps one of the most
important sections in the whole of Annual Report. The most standard way for
any company to start this section is by talking about the macro trends in the
economy. They discuss the overall economic activity of the country and the
business sentiment across the corporate world. If the company has high
exposure to exports, they even talk about global economic and business
sentiment. Following this, the companies usually talk about industry trends and
what they expect for the year ahead. This is an important section as we can
understand what the company perceives as threats and opportunities in the
industry. Remember, until this point, the discussion in the Management
Discussion and Analysis is broad-based and generic (global economy, domestic
economy, and industry trends). However, in the future, the company would
discuss various aspects related to its business. It talks about how the business
had performed across various divisions, how it fares compared to the previous
year, etc.
b) Non-narrative items: Within non-narrative items in the annual report are: Financial
highlights, highlights of the year and shareholder information.
i. Financial highlights: Financial highlights include year on year comparison of
revenue from operations, EBITDA (Earnings before Interest, Tax, Depreciation
and Amortization), ROE (Return on Equity) and PAT (Profit after Tax) for the
financial years 2018-19 and 2019-20.
ii. Highlights of the year: It includes other than financial highlights, for instance,
launching new products, brands, opening new showrooms and the like.

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2. Financial Statements: There are three financial statements discussed in the annual report,
namely, a) Balance Sheet, b) Profit and Loss account and c) Cash flow statement
a) Balance Sheet: A balance sheet is a statement of the resources owned and controlled
by a business at a single point in time. It gives a snapshot of assets, liabilities and capital
at a point in time. It provides information about the company‘s funds and how they are
used in the business. Balance sheet which is also known as position statement provides
a bird‘s eye view on company‘s financial position as well as condition. This statement
indicates whatever company has and whatever company owes. The excess of assets
over liabilities is known as owners equity/shareholders funds.
b) Profit and loss account: The Profit and Loss Account is a statement which shows total
business revenue less expenses. The P&L account quantifies and explains the gains or
losses of the company over the period of time bounded by two balance sheets. It
provides a summary of the year‘s trading activities: revenue from sales (turnover),
business cost, and profit or (loss). The profit and loss account which is also known as
Income Statement indicates net profits earned by company during current financial
year. Income statement also indicates profits available for distribution and
appropriation after meeting tax liabilities. Profit and Loss Appropriation Account or
Retained Earnings Account is also submitted with profit and loss account which
indicates appropriations made during the period.
c) Cash flow statement
• This is a statement which shows the flow of cash into and out of the business
• It is not the same as a profit and loss account
• The cash flow statement only records movements of cash and, for example, does
not include credit sales or purchases until such time as cash actually flows
• This statement became mandatory because of some high profile business failures of
the 1980s/90s - these were companies that, in terms of the P&L, were profitable but
were short of cash to pay their debts
• The cash flow statement should not be confused with a cash flow forecast. The
former is historical whereas the latter is a forecast about the future.
3. Notes to the accounts: Provides a more detailed analysis of some of the entries in the
accounts including:
• Disclosure of accounting policies used (e.g. depreciation) and any changes to these
policies
• Inventories
• Sources of turnover from different product segments
• Details of fixed assets and share capital
• Directors‘ emoluments (how much the Directors earned)
• Earnings per share
In this part, we will look at some of the important notes to the accounts sourcing the
same from Titan Company‘s Annual Report 2019-20.
i. Depreciation: Depreciable amount for assets is the cost of an asset, or other
substituted for cost, less its estimated residual value. Depreciation is calculated on
the basis of the estimated useful lives using the straight line method and is generally

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 recognized in the statement of consolidated profit and loss. Depreciation for assets
purchased / sold during the year is proportionately charged from/up to the date of
disposal. Free hold land is not depreciated.
The estimated useful lives of items of property, plant and equipment for the
current and comparative periods are as follows:
Asset category Management estimate of Useful life as per
useful life Schedule II
Building 30 to 60 years 30 to 60 years
Plant, machinery and 5 to 15 years 10 to 15 years
equipment
Computers and server 3 to 6 years 3 to 6 years
Furniture and Fixtures 5 to 10 years 10 years
Office equipment 5 years 5 years
Vehicles 4 to 5 years 8 years

Leasehold improvements are depreciated over the lease term ranging from 1-9
years.
ii. Inventories: Inventories [other than quantities of gold for which the price is yet to
be determined with the suppliers (Unfixed gold)] are stated at the lower of cost and
net realizable value determined on an item-by-item basis. Cost is determined as
follows:
a) Gold is valued on first-in-first-out basis.
b) Stores and spares, loose tools and raw materials are valued on a moving
weighted average rate.
c) Work-in-progress and finished goods (other than gold) are valued on full
absorption cost method based on the moving average cost of production.
d) Traded goods are valued on a moving weighted average rate/ cost of purchases.
Cost comprises all costs of purchase including duties and taxes (other than
those subsequently recoverable by the Group), freight inwards and other
expenditure directly attributable to acquisition. Work-in-progress and finished
goods include appropriate proportion of overheads and, where applicable, other
taxes. Unfixed gold is valued at the provisional gold price prevailing on the date of
delivery of gold. Net realizable value represents the estimated selling price for
inventories less estimated costs of completion and costs necessary to make the sale.
iii. Revenue from operations: In this note, sources of revenue from different product
segments like watches, jewellery, eyes wear and others are stated.
iv. Details of fixed assets and share capital
Fixed assets: Land and buildings held for use in the production or supply of goods
or services, or for administrative purposes, are stated at cost less accumulated
depreciation and accumulated impairment losses. Freehold land is not depreciated.
Property, plant and equipment are carried at cost less accumulated depreciation and
impairment losses, if any. The cost of property, plant and equipment comprises its
purchase price/ acquisition cost, net of any trade discounts and rebates, any import

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 duties and other taxes (other than those subsequently recoverable from the tax
authorities), any directly attributable expenditure on making the asset ready for its
intended use, other incidental expenses and interest on borrowings attributable to
acquisition of qualifying property, plant and equipment up to the date the asset is
ready for its intended use. Machine spare parts are recognized in accordance with
this Ind AS (Indian Accounting Standard) when they meet the definition of
property, plant and equipment; otherwise, such items are classified as inventory.
Subsequent expenditure on property, plant and equipment after its purchase /
completion is capitalized only if such expenditure results in an increase in the future
benefits from such asset beyond its previously assessed standard of performance.
The estimated useful life of the tangible assets and the useful life are reviewed at
the end of the each financial year and the depreciation period is revised to reflect
the changed pattern, if any. An item of property, plant and equipment is
derecognized upon disposal or when no future economic benefits are expected to
arise from continued use of the asset. Any gain or loss arising on the disposal or
retirement of an item of property, plant and equipment is determined as the
difference between the sales proceeds and the carrying amount of the asset and is
recognized in the statement of consolidated profit and loss.
Share capital: The share capital is categorized into two types, namely, authorized
share capital and issued share capital. Authorized share capital is the maximum
extent of funding that can be raised through issue of shares. It is laid out in the
company's charter documents. Issued and paid up share capital is the part of
authorized share capital against which shares have been issued to share holders of
a company against full payment.
v. Directors’ emoluments: The information required under Section 197 of the Act
read with Rule 5(1) of the Companies (Appointment and Remuneration of
Managerial Personnel) Rules, 2014.
vi. Earnings per share: Basic Earnings Per Share (‘EPS‘) is computed by dividing the
net profit attributable to the equity shareholders by the weighted average number of
equity shares outstanding during the year. Diluted earnings per share is computed
by dividing the net profit by the weighted average number of equity shares
considered for deriving basic earnings per share and also the weighted average
number of equity shares that could have been issued upon conversion of all dilutive
potential equity shares. Dilutive potential equity shares are deemed converted as of
the beginning of the year, unless issued at a later date. In computing diluted earnings
per share, only potential equity shares that are dilutive and that either reduces
earnings per share or increases loss per share are included.
4. Accounting policies
• Companies must describe the accounting policies they use in preparing financial
statements
• Companies have a choice of accounting policies in many areas such as foreign
currencies, goodwill, pensions, sales and stocks

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 • As different accounting policies will result in different figures it is necessary to state
the policy that was used so that readers of the accounts can make an informed judgment
about performance
• It is also important to state the effect of any changes in accounting policies – restating
prior year numbers where this is materially significant

KEY POINTS IN ANNUAL REPORT

Annual reports provide a comprehensive overview of a company's performance and

operations over the past year. Key points typically found in an annual report include:

1. Chairman's Letter or CEO's Message: An opening message from the company's

leadership, discussing the year's achievements, challenges, and strategic focus.
2. Financial Highlights: A summary of the company's financial performance, including
key financial metrics like revenue, net income, earnings per share, and dividends.
3. Management Discussion and Analysis (MD&A): A detailed narrative explaining the
financial results, performance factors, risks, and future outlook of the company.
4. Financial Statements: The core financial statements, including the balance sheet,
income statement, cash flow statement, and statement of changes in equity.
5. Notes to the Financial Statements: Explanations and additional information about
accounting policies, significant estimates, contingencies, and other details that
complement the financial statements.
6. Auditor's Report: An independent auditor's report providing assurance on the
reliability and accuracy of the financial statements.
7. Business Overview: A description of the company's business, its products, services,
and any recent developments in its industry.
8. Market and Industry Analysis: An assessment of the industry and market conditions
in which the company operates, including trends, competition, and opportunities.
9. Corporate Governance: Information on the company's governance structure, board of
directors, and adherence to corporate governance principles.
10. Sustainability and ESG Reporting: Details on the company's environmental, social,
and governance practices, including sustainability initiatives and corporate social
responsibility.
11. Risk Factors: A discussion of the significant risks and uncertainties that could impact
the company's operations and financial performance.
12. Segment Reporting: If applicable, information about the company's operating
segments and their financial results.
13. Legal and Regulatory Matters: Disclosure of any significant legal proceedings,
regulatory issues, or compliance matters.
14. Management Team and Compensation: Profiles of key executives and details about
their compensation packages.
15. Shareholder Information: Information about the company's stock, including stock
performance, dividends, and a summary of shareholder rights.

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 16. Corporate Social Responsibility (CSR) and Sustainability Initiatives: Information
about the company's efforts to be socially responsible, including its impact on the
environment and local communities.
17. Future Outlook and Strategy: The company's strategic goals, plans for the future, and
how it aims to address challenges and seize opportunities.
18. Financial and Operating Metrics: Key operational and financial metrics that provide
insight into the company's performance and trends.
19. Dividend Policy: Details about the company's dividend policy, including past dividend
payments and future intentions.
20. Investor Relations: Contact information for the investor relations department,
resources for shareholders, and information about upcoming shareholder meetings.
These key points in an annual report offer a comprehensive view of a company's financial
health, operations, governance, and future direction, providing valuable information to
investors, stakeholders, and the general public

SEGMENT REPORTING: INTRODUCTION- DIFFERENT SEGMENTS

IN ANNUAL REPORT
Meaning
• Segment reporting is the reporting of the operating segments of a company in the
disclosures accompanying its financial statements.
• Segment reporting is intended to give information to investors and creditors regarding
the financial results and position of the most important operating units of a company,
which they can use as the basis for decisions related to the company.
• A segment may be in the form of a subsidiary or division or a department, and In some
cases a joint venture.
• Segment reporting is required for publicly-held entities, and is not required for
privately held ones.
• Under Generally Accepted Accounting Principles (GAAP), an operating segment
engages in business activities from which it may earn revenue and incur expenses,
has discrete financial information available, and whose results are regularly
reviewed by the entity's chief operating decision maker for performance assessment
and resource allocation decisions.

Objectives
• For a better understanding of the performance and evaluation of the organization’s results.
• To provide the information to the stakeholders about the important units of the organization
to evaluate and make decisions about the investment.
• To make the accounts more transparent and understandable.
• To make better decisions by taking in mind the business from different segments.
• For a better analysis of the risk and returns of the organization.
• To analyze the most profitable or Loss-making units.

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Segment Reporting Rules
Follow these rules to determine which segments need to be reported:
• Aggregate the results of two or more segments if they have similar products,
services, processes, customers, distribution methods, and regulatory environments.
• Report a segment if it has at least 10% of the revenues, 10% of the profit or loss,
or 10% of the combined assets of the entity.
• If the total revenue of the segments you have selected under the preceding criteria
comprise less than 75% of the entity's total revenue, then add more segments until
you reach that threshold.
• We can add more segments beyond the minimum just noted, but consider a
reduction if the total exceeds ten segments

Importance of segment reporting

Segmental reporting is important for the organization, its investors, and the
stakeholders in the following way:
• It provides investors the complete details about the units, their profitability, etc.
They can analyze and decide upon the investment in the organization.
• It helps the organization in better decision making as the planning about expansion
or diversification is to be done based on the result of the segment.
• It helps the creditors decide the credit terms based upon the analysis of each
segment separately.
• It helps the shareholders decide whether to retain the shares or sell them.
• It helps management decide whether to expand the segment or sell off the segment.

Need for Segment Reporting:

Diversified companies present a unique type of problem for investment decision
making. The performance of a diversified company can be judged from the performance of all
several segments. The success of diversified company depends on success of all segments that
is why segmental disclosures in company’s annual reports are more useful to investors and
other user groups.

Benefits of Segment Reporting

• Segmental Reporting gives a better understanding of financial statements.
• The profit-making and loss-making units can be easily identified with the help of
segmental reporting.
• It helps in the optimum utilization of resources and better presentation.
• It helps potential investors in better investment decisions.

Limitations of Segment Reporting

• There are many disclosures required in the case of segmental reporting; hence it is a
time-consuming process.
• The data presented can be misinterpreted by the investors or creditors.
• Method of reporting Inter-segment transactions are different for each organization.

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 • The base of the segment is also different as some organizations divide the segment
based on geographical location, and some organizations divide it based on product-
wise.
• The common costs are sometimes difficult to allocate.

TYPES OF SEGMENT

1. Business segment:- business segment is a distinguishable part of an enterprise that is

involved in providing an individual product or service or a group of related product or
services and that is subject to risks and returns that are different from those of other
business segment.
2. Geographical segment:- geographical segment is distinguished part of an enterprise
that is involved in providing products or services within a particular economic
environment and that is subject to risk and returns that are different from those of
components operating in other economic environments
3. Reportable Segment: Reportable Segment is a business segment or a geographical
segment identified based on the foregoing definition for which segment information is
required to be disclosed.

Terminology of Segment Reporting:

1. Segment Revenue: Segment Revenue reported in the statement of profit and loss of
an enterprise that is directly attributable to a segment and the relevant portion of
enterprise revenue that can be allocated on a reasonable basis to a segment, whether
from sales external customers or from transactions with other segments of the same
enterprise.
2. Segment Expense: Segment Expense is an Expense resulting from the operating
activities of a Segment that is directly attributable to the segment and the relevant
portion of an expense that can be allocated on a reasonable basis to a segment,
including expenses relating to sales to external customers and expenses relating to
transactions with other segments of the same enterprise.
3. Segment Result: Segment result is Segment revenue less segment expenses.
4. Segment Assets: Segment Assets are those operating assets that are used by a
segment in its operating activities and that either are directly attributable to the segment
or can be allocated to the segment on a reasonable basis.
5. Segment Liabilities: Segment Liabilities are those operating liabilities which result
from the operating activities of a division and either are directly attributable to the
division or can be allocated to the division on a reasonable basis.
6. Segment Accounting Policies: Segment accounting policies are accounting policies
framed for preparing and presenting the financial statement of the enterprise as well as
those accounting policies that relate specifically to segment reporting.

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 NOTES IN FINANCIAL STATEMENT

• Notes to the financial statements disclose the detailed assumptions made by accountants
when preparing a company’s: income statement, balance sheet, statement of changes of
financial position or statement of retained earnings.
• The notes are essential to fully understanding these documents.
• Usually, the first notes in the series explain the “basis for accounting”—if cash
or accrual rules were used to prepare the documents—and the methods used to report
amortization/depreciation expenses.
• The rest of the notes explain, in greater detail, how the figures have been calculated. This
gives the reader the information needed to do deeper analysis.
• The notes are used to explain the assumptions used to prepare the numbers in the financial
statements as well as the accounting policies adopted by the company.
• Footnotes are used by both analysts and auditors to better understand the company’s
financial position.
• However, the information included in the footnotes is up to management’s discretion.

Understanding Financial Statement Footnotes

Footnotes are often quite long and help to clearly describe the smaller details that
connect with specific parts of the financial statements. The financial statement footnotes
provide greater information to specific portions of the statements, which helps improve the
flow of information for the reader and makes sure the essential explanatory details are included.
Footnotes are mainly used by analysts reviewing the financial statements to give them
a much more detailed and comprehensive outlook on the company’s financial situation. It helps
the analysts understand the accounting policies and how they might affect the company’s
underlying financial health.
Auditors will also use the financial statements and their footnotes to help understand
the company’s financial position. Their findings within the audit will be based almost as
heavily on the footnotes as the other core areas of the financial statements.
Footnotes also depend heavily on the accounting framework that is being followed for
the specific company. For example, the financial statement footnotes will look different for a
company that follows IFRS standards compared to US GAAP. Publicly held companies will
require even more extensive financial statements and footnotes mandated by authorities like
the Securities and Exchange Commission (SEC) in the United States.

Drawbacks of Financial Statement Footnotes

Footnotes are an essential part of any financial statement. However, they come with a
few disadvantages. Footnotes are required only to the point “beyond the legal minimum” to
protect the company from liability. How footnotes are conveyed and which information is
included is up to the discretion of management.
Some footnotes will be filled with accounting jargon, which may make the information
conveyed difficult for the reader to understand. It could be to hide something from the public,
and investors should be wary of any financial statements like them.

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Common Types of Footnotes
There is a long list of the different types of financial statement footnotes. Any
information that is needed to clarify or add additional detail to a financial statement will be
found in the footnotes.
Examples can include unexpected changes from the previous year, required disclosures,
adjusted figures, accounting policy, etc. Footnotes may also contain notable future activities
that are expected to have a significant impact on the company’s future.
Below is a list of some of the common footnotes found in a company’s financial
statements. The list below is by no means comprehensive and just an example to showcase a
few of the footnotes you might expect to see. Depending on the company and industry, the
financial statements can include some very niche explanatory footnotes.
1. Accounting policies: These notes outline the general accounting policies/principles
that the company is following.
2. Depreciation of assets: The depreciation section will explain the company’s method
to depreciate its assets over time. The method will depend on the type of asset and
industry it works in.
3. Inventory valuation: Valuation of inventory can be found in several different ways.
This footnote clarifies the valuation method from period to period and makes it easier
to compare over time.
4. Intangible assets: Intangible assets do not have a physical form and therefore are
harder to value. The footnote will clarify the valuation of these assets as well as the
company’s amortization policy.
5. Financial investments: All financial investments should have a footnote clarifying
their fair value and any unrealized losses or gains from the investment.
6. Employee benefits: Companies generally disclose their employee’s retirement plans
and other benefits.
7. Stock-based compensation: A footnote will be included if a company offers stock-
based compensation plans explaining its stock options, types of restricted stock, and
other performance plans.
8. Taxes: Tax rates will vary between jurisdictions and industries. Financial statements
will clarify the details and breakdown of each portion of their company’s taxes and its
overall effect.
9. Significant trends or risks: Companies will often disclose important trends or risks
that have the potential to impact the future projections of their company.

HOW TO INTERPRET NOTES IN FINANCIAL STATEMENTS?

Interpreting notes in financial statements is crucial for gaining a deeper understanding of a

company's financial health and operations. Here are some key steps to interpret these notes
effectively:

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 1. Read the Notes Thoroughly: Start by carefully reading all the notes to the financial
statements. They provide additional context and explanations for the numbers presented
in the main statements.
2. Understand Accounting Policies: Notes often disclose the company's accounting
policies. Pay attention to how revenue is recognized, depreciation methods, and other
critical accounting choices. Differences in policies can impact financial results.
3. Contingent Liabilities: Look for information on contingent liabilities, such as legal
claims, warranties, or pending lawsuits. These may have a significant impact on the
company's future financial performance.
4. Related Party Transactions: Notes might reveal any transactions with related parties,
such as company insiders or affiliates. This information is important for assessing
potential conflicts of interest.
5. Segment Reporting: If the company operates in multiple segments or geographies, the
notes may provide breakdowns of financial results by segment. This can help in
evaluating the performance of different parts of the business.
6. Debt and Financing Details: Information on the terms of debt, including interest rates
and maturity dates, can be found in the notes. This is crucial for assessing the company's
financial obligations.
7. Income Taxes: Notes often contain information about the company's income tax
expenses and deferred tax assets/liabilities. This can provide insight into tax planning
strategies.
8. Leases: With the adoption of new accounting standards like IFRS 16 and ASC 842,
companies now disclose more details about their lease arrangements in the notes.
9. Subsequent Events: Check for information on events occurring after the end of the
reporting period but before the financial statements are issued. These events might
affect the company's financial position.
10. Auditor's Report: Notes may include details of the auditor's report, which can provide
insights into the auditor's assessment of the financial statements' reliability.
11. Footnotes: Pay attention to any footnotes that provide clarifications, definitions, or
additional context for specific items in the financial statements.
12. Comparative Analysis: Compare the current year's notes to previous years to identify
trends, changes in accounting policies, or significant developments.
13. Ask Questions: If something is unclear or you need more information, don't hesitate to
reach out to the company's investor relations department or consult with financial
experts.
Interpreting financial statement notes requires a good understanding of accounting
principles and the company's industry. It's often helpful to combine this information with an
analysis of the main financial statements for a comprehensive view of a company's financial
performance.

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 DISCLOSURES IN FINANCIAL STATEMENTS

Disclosures in financial statements typically refer to the notes or footnotes that

accompany the primary financial statements, such as the balance sheet, income statement, and
cash flow statement. These disclosures provide additional information and explanations about
the amounts presented in the financial statements. Key disclosures include:
1. Accounting Policies: Details about the accounting methods and policies used in
preparing the financial statements, including changes in policies if any.
2. Significant Accounting Estimates: Explanation of significant judgments and
estimates made by management, such as depreciation, allowances for bad debts, and
fair value measurements.
3. Contingent Liabilities: Information about potential liabilities, such as pending
lawsuits or warranties, that may have an impact on the company's financial position.
4. Related Party Transactions: Disclosure of transactions with related parties, including
details of the nature of the transactions and any amounts involved.
5. Subsequent Events: Information about significant events or transactions that occurred
after the reporting date but before the financial statements were issued or available to
be issued
6. Leases and Debt: Details about the company's lease obligations, including future lease
payment schedules, and information about long-term debt, including interest rates and
maturities.
7. Revenue Recognition: Explanation of the company's revenue recognition policies and
criteria, particularly if the company uses the new revenue recognition standard (e.g.,
IFRS 15 or ASC 606).
8. Income Taxes: Information about income tax provisions and deferred tax assets and
liabilities.
9. Pension and Employee Benefits: Disclosures about employee benefit plans, including
pension obligations, healthcare, and stock-based compensation.
10. Segment Reporting: Information about the company's operating segments and
geographic areas, particularly if it operates in multiple business segments or regions.

DISCLOSURES IN COMPARATIVE STATEMENTS

Comparative statements, often found in the financial statements, allow users to make year-
over-year or period-over-period comparisons of a company's financial performance and
position. The most common comparative statements include:
1. Balance Sheet Comparatives: These show the assets, liabilities, and equity as of the
end of the current reporting period and at least one prior period, enabling users to assess
changes over time.
2. Income Statement Comparatives: These provide the revenues, expenses, and net
income for the current reporting period and at least one prior period, allowing users to
evaluate changes in profitability.

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 3. Cash Flow Statement Comparatives: These illustrate cash flows from operating,
investing, and financing activities for the current period and at least one prior period,
showing changes in cash flow patterns.
4. Equity Statement Comparatives: These show changes in equity over time, including
dividends, share issuances, and any changes due to accounting adjustments.

Comparative statements are crucial for trend analysis, helping users assess a company's
financial performance and position over time, identify patterns, and make informed decisions
about the company's financial health and stability

ANALYSIS OF MANAGEMENT DISCUSSION

• MD&A stands for Management Discussion and Analysis. It is a part of the financial
statements where the company’s management provides a qualitative and quantitative
analysis to help investors understand details that may not be readily available for
analysis.
• MD&A covers various topics, including the industry’s macroeconomic performance,
the company’s vision and strategy, and key financial indicators with explanations for
their rationale.
• MD&A provides investors with useful information, and its content and presentation can
reflect good corporate governance practices and foster a strong relationship between
the company and its investors.
• Management discussion and analysis (MD&A) is a section within a company’s annual
report or quarterly filing where executives analyze the company’s performance.
• The section can also include a discussion of compliance, risks, and future plans, such
as goals and new projects.
• The MD&A section is not audited and represents the thoughts and opinions of
management.
• Companies often use the MD&A section to invoke confidence in investors by explain
how and why future plans of the company will be successful.
• However, the MD&A section is less helpful as management does not want to reveal
too much of its forward-looking plans in a publicly-availably, required filing.

Contents of Management Discussion and Analysis

The Management Discussion and Analysis section consists of the following important points:
1. Business Status: Industry structure, competitive structure, and key developments in
recent times with respect to the company’s business. Also, it should speak about the
impact and changes in the regulatory environment or new regulations that are expected
to be introduced in the near future.
2. SWOT Analysis: Though no one would like to talk about its weakness. However, in
an indirect manner, the report should do a proper SWOT analysis of the company. It
should talk about its strengths, weaknesses, opportunities, and imminent threats.

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 3. Financial Aspects: The financial aspects of the business- its performance in the recent
past and what to expect in the future. The key financial aspects of the company need to
be elaborated. The report should mention any new products or portfolio the company
intends to launch that can significantly lead to a rise in future revenue.
4. Performance Analysis: Complete performance analysis of the company. It should
speak about its goals and targets for both the short-term and long-term. Also, it should
give an overview of what the future should be like for the company. If any, capital
expenditures to be undertaken should have been mentioned in the report. The
arrangement of funds for the same and steps to manage the liquidity position should
also be taken care of. If the management plans to raise funds by an issue of bonds or
stock, it should be put in the report.
5. Threats: The threats that can affect the company in the near future. Also, the steps the
management intends to take to tackle those threats. Any major change in the company’s
economic environment that can affect its income from operations should have been
mentioned in the report. The responsive action that the management plans to tackle the
situation should be mentioned in detail.
6. Internal Checks and Controls: An overview of the internal checks and controls put
in place by the company. It should also tell how successful the company has been in
taking care of internal errors, thefts, frauds, and other anomalies.
7. Departmental Handling: The report should elaborate on the company’s handling of
its operations and various departments associated with it.
8. Human Resources Management: The report should also talk about its Human
Resource Department’s performance. It should throw enough light and details on any
key changes that happened or are planned in the managerial structure, if any, in the near
future or past.
9. Conflict of Interest Situation: Any other internal matter or a conflict of interest
situation that needs to be highlighted should be mentioned in the report. The
management should disclose every bit of information that can create a conflict in any
way to bring the utmost transparency to the company’s operations.

Key Factors Found in the Management Discussion and Analysis

The following is some of the key information that should be found in the MD&A
section of the annual report:
1. Important accounting policies and estimates: The SEC urges companies to provide
detailed information regarding their accounting policies in the MD&A section of
the annual report. It enables investors and other stakeholders to understand the impacts
of the accounting policies and the decisions made following the application of the
policies and possible variations should the company have applied other assumptions.
2. Operational results and position: Companies are expected to disclose the results or
performance of operations following notable economic changes that may have had an
influence on income or possible extraordinary events and transactions. In addition, the
companies are expected to disclose any trends or risks that may positively or negatively
impact revenue from operations.

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 3. Liquidity and capital resources: The management should report on any notable
events that may have altered the liquidity and capital resources. They should also
provide information on any existing or potential future capital expenditure
commitments and the funding options available to meet the capex commitments.

Importance of the Management Discussion and Analysis

This report is important for an investor, creditors, lenders, and every other stakeholder
in a company.
1. Corporate Governance Practice: The report gives details of the corporate governance
practices followed by the company. It provides an overview of the management hierarchy,
responsibilities that the members share, and their future planning with regard to the
operations of the company. How does the company handle any complaints and
whistleblower information? And how do they investigate it further?
2. Financial and Departmental Disclosures: It helps a reader understand the company’s
financial situation and its future prospects. It also gives an insight into the strength of the
operations and the human resource of the business, its capabilities, and future potential.
Also, a reader can judge the transparency and standards of the disclosures made by the
management. He can get an insight into the accounting methods and policies followed by
the company. The report helps to do a fundamental analysis of the company.

Understanding Management Discussion and Analysis (MD&A)

In the management discussion and analysis (MD&A) section of the annual report,
management provides commentary on financial statements, systems and controls, compliance
with laws and regulations, and actions it has planned or has taken to address any challenges
the company is facing. Management also discusses the upcoming year by outlining future
goals and approaches to new projects. The MD&A is an important source of information for
analysts and investors who want to review the company’s financial fundamentals and
management performance.
The MD&A is just one of many sections required by the Securities and Exchange
Commission (SEC) and the Financial Accounting Standards Board (FASB) to be included in
a public company’s annual report to shareholders. A company that issues stock or bonds to
the public at large must register its offerings with the SEC, which oversees public companies’
compliance with U.S. securities laws and ensures investors are given adequate information
about companies they invest in. The SEC mandates 14 items to be included in the 10-K report.
The MD&A section is Item #7.
The FASB is a nonprofit, private regulatory organization, which the SEC has
designated as the body responsible for promulgating accounting standards for public
companies in the United States. FASB outlines its requirements for the MD&A section of
filings.

Requirements for Management Discussion and Analysis (MD&A)

Securities law dictates that companies must hire an independent auditor to verify a
company’s financial statements, such as its balance sheet, income statements, and statement
of cash flows. Auditors perform test work to determine if the financial statements are

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materially correct, but these certified public accountants (CPAs) do not audit the MD&A
section. The MD&A represents the thoughts and opinions of management and provides a
forecast of future operations. Therefore, these statements can’t typically be authenticated.
That said, the MD&A section must meet certain standards. According to FASB,
“MD&A should provide a balanced presentation that includes both positive and negative
information about the topics discussed.” Even if management is giving its opinion on the state
of its business, competition, and risks, these statements must be based on fact, and there must
be an attempt to paint a balanced picture of the company’s future prospects.

MD&A section
The MD&A section often includes an "Overview and Outlook" section. This part of
the financial statement is used to explain what the future of the organization looks like. It is
also management's opportunity to explain why variances (both positive or negative) occurred
and what they expect from the market.
Next, management also typically discusses liquidity, solvency, and capital resources.
Management must identify trends, demands, or long-term commitments that may strain
capital. This section also usually contains information about management's future plans for
material, major capital expenditures.
Management uses this section to explain the results of operations. Management can
explain unusual events, material transactions, or significant economic changes. The company
often uses this opportunity to explain why net revenues and expenses varied from expected or
budgeted financial plans. The company may also use this section to explain its successes, such
as how a specific product outperformed during its new launch or how new markets have beat
expectations.
Last, this section is often used to shine light on management's estimates used for
accounting practices. Some accounting rules require professional judgement; management can
explain why they valued capital assets, inventory, or other assets as a certain amount. It can
also explain how it arrived at estimates for other balance sheet or income statement amounts,
such as an allowance for bad debt and resulting bad debt expense.

Limitations of MD&A
The MD&A section of a 10-K primarily uses words to explain a financial position
instead of numbers. Therefore, management can use soft or hard language to manipulate how
financial performance has been going or is expected to occur. Whereas financial reporting via
generally accepted accounting principles (GAAP) have strict rules, a company can choose
how to represent itself using the MD&A section.
When management prepares this section, they are aware that this information is going
to be publicly available. This means that competitors will be able to extract information on
the company's strategy. Therefore, in addition to wanting to paint a rosy picture, the company
wants to be as secretive as possible without revealing information that could take away its
competitive advantage.
Last, the MD&A section is entirely up to management interpretation. This means a
company may interpret data one way, when in reality the markets will play out an entirely

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differently way. Even if management puts forth a projection to the best of its knowledge, its
analysis is still prone to error and may not materialize.

RÉCENT TRENDS IN ACCOUNTING

a) Accounting software solutions: In these years, there has been a leap in accounting
software solutions. By far, most industries are harnessing the power of the digital world,
and accounting is no different. There are more demands than ever on computerized
accounting and software companies working hard to make sure that manual tasks can be
limited and minimum.
b) Cloud accounting: Today everything is in the cloud: our photos, music, and even
passwords are stored in the cloud. Cloud accounting saves cost and time. In fact, about two-
thirds of accountants believe it will be useful in their work. The great advantage of cloud
accounting software is that our team can access and update our numbers anytime,
anywhere, and most importantly at the same time. Collaboration is easier than ever and
there are no permanent archives and no email exchange required. Speaking of archiving,
cloud accounting software ensures that our data is stored securely with military-grade
encryption that definitely beats USB sticks.
c) Automatic accounting: The automated accounting process saves time, money and, above
all, errors. Companies are investing in accounting based automated software and processes
as this can be very profitable for companies like never before. In addition, it also enhances
companies’ ability to make data-driven decisions and allows them to do so faster than ever
before. However, automatic billing has its drawbacks. Like any technology-driven process,
it carries cybersecurity risks that need to be properly assessed and continuously monitored.
d) Balance between work and personal life: Another benefit of the growth of automated
processes and cloud-based software is that more accountants can work from anywhere with
no barrier of time and better work-life balance. This development also saves a lot of time
exchanging emails and filing so accountants can enjoy more of the moment.
e) Accountants become consultants: There has always been some overlap between
accountants and financial advisors, but now the accounting industry is increasingly focused
on data analysis and so many accountants are shifting to more advisory roles.
Developments in accounting technology allow accountants to provide more accurate
information and provide valuable advice to their clients. Indeed, harnessing the power of
technology for business consulting is a way for accountants to ensure that they are not
eventually replaced by machines.
f) Social media: Accounting and social media may seem like odd friends, but networking is
essential to any business. The coronavirus pandemic means that even the toughest crazies
have to use platforms like Facebook and LinkedIn to interact with their colleagues and
prospects. There is no denying that social media platforms allow accounting firms to build
brands, drive more traffic to their websites, and create new links. This channel is a powerful
marketing tool for any business and accounting is no exception, so it’s time for the industry
to catch up.

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