Unit 3

Financial Statements

Financial statements are written records that convey the business activities and the financial
performance of a company. Financial statements are often audited by government agencies,
accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. For-
profit primary financial statements include the balance sheet, income statement, statement of
cash flow, and statement of changes in equity. Nonprofit entities use a similar but different set
of financial statements.

Meaning of Financial Statement:

Financial statements are basically reports that depict financial and accounting information relating
to businesses. A company’s management uses it to communicate with external stakeholders. These
include shareholders, tax authorities, regulatory bodies, investors, creditors, etc.

These statements basically include the following reports:

1. Balance sheet
2. Profit and Loss statement
3. Statement of cash flow
4. Income sheet

Nature of Financial Statements

Financial statements are prepared using facts relating to events, which are recorded chronologically.
Thus, we have to first record all these facts in monetary terms. Then, we have to process them using
all applicable rules and procedures. Finally, we can now use all this data to generate financial
statements.

Based on this understanding, the nature of financial statements depends on the following points:

1. Recorded facts: We need to first record facts in monetary form to create the statements.
For this, we need to account for figures of accounts like fixed assets, cash, trade receivables,
etc.

2. Accounting conventions: Accounting Standards prescribe certain conventions applicable

in the process of accounting. We have to apply these conventions while preparing these
statements. For example, the valuation of inventory at cost price or market price, depending
on whichever is lower.
3. Postulates: Apart from conventions, even postulates play a big role in the preparation of
these statements. Postulates are basically presumptions that we must make in accounting. For
 example, the going concern postulate presumes a business will exist for a long time. Hence,
we have to treat assets on a historical cost basis.
4. Personal judgments: Even personal opinions and judgments play a big role in
the preparation of these statements. Thus, we have to rely on our own estimates while
calculating things like depreciation.

Objectives of Financial Statements

Stakeholders of a company heavily rely on financial statements to understand its functioning. They
portray the true state of affairs of the company. Here are some objectives of financial statements:

 These statements show an accurate state of a company’s economic assets and liabilities.
External stakeholders like investors and authorities generally do not possess this information
otherwise.

 They help in predicting the extent of a company’s capacity to earn profits. Shareholders
and investors can use this data to make their financial decisions.
 These statements depict the effectiveness of a company’s management. How well a
company is performing depends on its profitability, which these statements show.
 They even help readers of these statements know the accounting policies used in them.
This helps in understanding statements more comprehensively.
 These statements also provide information relating to the company’s cash flows. Investors
and creditors can use this data to predict the company’s liquidity and cash requirements.
 Finally, they explain the social impact of businesses. This is because it shows how the
company’s external factors affect its functioning.

Elements
The preparation of financial statements includes specifications regarding the transactions made,
be it revenue generated or expenses incurred. These details are listed under different categories,
which constitute the elements or components of the financial statements. Some of them are:

 Assets
 Liabilities
 Net assets (equity)
 Revenues
 Expenses
 Types
Now, let us look at the types of financial statements below:
#1 – Balance Sheet
The balance sheet is a financial statement that provides a snapshot of the assets, liabilities, and
shareholders’ equity. Many companies use the shareholders’ equity as a separate financial
statement. But usually, it comes with the balance sheet.
The equation that you need to remember when you prepare a balance sheet is this –
Assets = Liabilities + Shareholders Equity

#2 – Income Statement
The income statement is the next financial statement everyone should look at. It looks quite
different from the balance sheet.

#3 – Cash Flow Statement

The Cash Flow Statement is the third most important statement every investor should look at.
There are three separate statements of a cash flow statement. These statements are cash flow
from the operating activities, cash flow from investing activities, and cash flow from finance
activities.

#4 – Statement of Changes in Shareholders Equity

Statement of Changes in Shareholders Equity is a financial statement that summarizes changes
in the shareholder’s equity in a given period.

Final Accounts

Final Accounts is the ultimate stage of the accounting process where the different ledgers
maintained in the Trial Balance (Books of Accounts) of the business organization are presented
in the specified way to provide the profitability and financial position of the entity for a specified
period to the stakeholders and other interested parties, i.e., Trading Account, Statement of Profit
& Loss, Balance Sheet.

Features

1. The final account is legally required for the entities. The financial accounting and
preparation of Financial statements are obligatory for the entities and getting those accounts
audited.
2. These accounts are prepared to present and provide the entity’s financial performance and
status to the stakeholders, users, investors, promoters, etc.
3. The presentation of comparable figures for the current period from the previous period
increases the utility of the statements of accounts.
4. It presents an accurate & fair view of the organization’s financial performance by
providing accurate & full information regarding the business with proper notes and disclosures
of the real facts.

Objectives of Final Accounts

1. They are prepared to calculate Gross profit & net profit earned by the organization for the
relevant period by presenting the Statement of Profit & Loss.
2. The Balance sheet is prepared to provide the company’s correct financial position as of
the date.
3. These accounts use the bifurcation of direct expenses to obtain the gross profit & loss
and bifurcation in indirect expenses to ascertain the organization’s net profit & loss.
4. Through the Balance sheet, these accounts bifurcate the assets & liabilities as per the
holding & usage periods of the same.

Importance

 As the size and the business of the organization grows, it becomes necessary for the
organization’s management to take proper steps to maintain the growth of the organization and
create the appropriate internal control in the organization for the prevention of fraud & errors. It
helps the management find the possible weak areas of the entity and identify the major areas that
need special attention.
 Final Accounts is the source for the external components like shareholders and investors
to study the status of the entity and the entity’s business. Based on the entity, the investors decide
whether to invest their funds in the same business industry or not.
 It provides authenticated information to the public, which is the company’s judgment
based on who its future lies. Ultimately the company aims to satisfy its consumers. Final
Accounts provide just enough data and information to the users to assess the entity’s worth.

Advantages

 The preparation of Final Accounts increases the accuracy and effectiveness of the
accounts.
 During the preparation, any innocent mistakes or fraud can be discovered and could be
rectified quickly.
 This account shows the status of the entity and business for the period, and the audit of
the same creates a check on the entity and its processes, which reduces the risk of fraud and
misstatement.
 Provide the information for the valuation of the business and evaluation of the real worth
of the business.
 Disadvantages

 Final accounts are mainly prepared based on historical & monetary transactions. This
only provides the presentation and status of the money transaction to the users and public but
does not provide the information relating to the work environment of the entity, customer
satisfaction for the services & goods supplied by the company.
 It cannot be assured that the Financials are entirely free from any misstatements as there
are inherent limitations in the audit of the financials, which cannot ensure the 100% guarantee
that the financials are free to form any inaccuracies.
 There are substantial chances that the financials are influenced due to the personal
judgment of the accountant or the judgment of the management personnel.

The final accounts of an entity consists of the following accounts:

1. Manufacturing and Trading Account

2. Profit and Loss Account
3. Balance Sheet
4. Profit and Loss Appropriation account

Manufacturing Account

Manufacturing entities need to prepare a Manufacturing account before preparing the Trading
Account. It determines the Cost of goods sold.

Manufacturing of goods is the conversion of raw materials into finished or semi-finished

goods. There are many products which need to be manufactured before selling to the general
public like lays, Parle G biscuits, coca cola etc. In order to manufacture finished goods,
companies will acquire raw materials, engage labour, and other inputs necessary to change the
raw materials into finished goods.
The main purpose of preparing the manufacturing account is to ascertain the cost of goods
manufactured during the financial year and to ascertain the amount of any profit or loss
occurred during the manufacturing process.
The manufacturing account provides information of all the expenses and costs incurred in the
preparation of the goods to be sold. It includes the expenses incurred in preparing the goods
but not the finished goods. All the expenses including the cost of raw materials, the cost of
machines and their maintenance, the salaries and wages of both skilled and unskilled workers,
depreciation of the assets are also included under this account.
Majorly Manufacturing Costs are Divided into the Following Types:

1. Direct Material Costs: These are costs which are directly used in the manufacturing of
a product. For example, materials used in the preparation of plastic tables like glue plastic
sheets, paints etc.
2. Direct labour costs: Costs which are paid directly to the worker involved in the
manufacturing of a product. For example, in the preparation of Plastic tables wages are
paid to the worker involved directly.
3. Direct Expenses: Expenses incurred in the manufacture of a product. For example,
charges for special equipment used in the process of manufacture.
4. Factory Overheads: Expenses incurred indirectly in the manufacturing of a product.
For example, factory rents, factory power and lighting etc.
5. Administrative Expenses: Administrative expenses are the expenses incurred in the
process of planning, controlling and directing the business organization. For example,
office rents, office electricity etc.
6. Selling and Distribution Expenses: Expenses incurred in the process of selling,
marketing and distributing the goods manufactured. For example cost of advertising,
carriage outwards, salary to salesperson etc.
7. Finance Costs: Expenses such as bank charges, discounts allowed and other monetary
expenses are included in Factory Expenses.

Steps Involved in the Preparation of the Manufacturing Account

The following steps will be followed in order to prepare a manufacturing account:

1. Opening stock of raw materials will be added to the purchases and the stock of raw
materials shall be deducted. We will get the cost of materials used during the period.
2. All the Indirect costs will be added
3. All the indirect manufacturing costs will be added
4. To get the production cost of all goods completed, opening stock of Work in progress
shall be added and thereafter closing stock of work in progress will be deducted
5. The total in the manufacturing account shows the total available for sale during the
period.
 Format of Manufacturing Account

Trading Account

Trading account is used to determine the gross profit or gross loss of a business which results
from trading activities. Trading activities are mostly related to the buying and selling activities
involved in a business. Trading account is useful for businesses that are dealing in the trading
business.
The formulae for calculating gross profit is as follows:
Gross profit = Net sales – Cost of goods sold
Where
Net sales = Gross sales of the business minus sales returns, discounts and allowances.

Cost of Goods Sales = Opening Stock + Goods Purchase – Closing Stock

Features of Trading Account

1. It is the first stage in the preparation of financial accounting statement of a trading

concern.
2. It records only the net sales and direct cost of goods sold.
3. The balance of this account discloses the gross profit and gross loss.
4. We transfer the balance of the trading account to the profit and loss account.

The trading account considers only the direct expenses and direct revenues while calculating
gross profit. This account is mainly prepared to understand the profit earned by the business on
the purchase of goods.

Items that are seen in the debit side include purchases, opening stock and direct expenses while
credit side includes closing stock and sales.

Closing entries for Gross Loss or Gross Profit

The following entries are passed

In case of Gross Loss

Profit and Loss A/c Dr.
To Trading A/c

In case of Gross Profit

Trading A/c Dr.
To Profit and Loss A/c
Contents of a Trading Account
Trading Account Statement include
 Opening Stock
 Purchases
 Direct expenses
 Gross profit

Opening Stock
In the case of trading concern, the opening stock means the finished goods only. We take the
amount of opening stock from Trial Balance.

Purchases
The amount of purchases during the year includes cash as well as credit purchases. The deductions
from purchases are purchase return, drawings of goods by the proprietor, distribution of goods as
free samples, etc.

Direct expenses
It means all those expenses which are incurred from the time of purchases to making the goods in
suitable condition. This expense includes freight inward, octroi, wages etc.
Gross profit
If the credit side of Trading A/c is greater than the debit side of Trading A/c gross profit will arise.

The following are the items appearing in the credit side of Trading Account
 Sales Revenue
 Closing Stock
 Gross Loss

Sales Revenue
The sales revenue i.e. the income earned from the main business activity or activities. When goods
or services are sold to customers then the income is earned.
If there is any return, it should be deducted from the sales value. As per the accrual concept, income
should be recognized as soon as it is accrued and not necessarily only when the cash is paid for.

Closing Stock
In the case of trading business, there will be closing stocks of finished goods only. According to the
convention of conservatism, the stock is valued at cost or net realizable value whichever is lower.

Gross Loss
When the debit side of Trading A/c is greater than the credit side of Trading A/c, the gross loss will
appear.

Format of Trading Account

Example
From the following trial balance of ZB Sons, prepare a trading
account for the year ending 31 December 2019.
 The closing stock was valued at $160,000.

Solution

Advantages of Trading Account in Accounting:

The following are the Major Benefits or Advantages below are;

 It shows the relationship between gross profit and gross loss, sales that help to measure
profitability or losses position.
 The account shows the ratio between the cost of goods sold and gross profit.
 They give information about the efficiency of trading activities.
 They help to compare the cost of goods sold and gross profit.
 It provides information regarding stock and the cost of goods sold.
 The result of trading can know separately.
 The various items of this account of different periods can compare.
 The adjustment in the selling price can make by knowing the percentage of gross profit
on net sales.
 Over-stocking/under-stocking can know to act wisely.
 If the gross loss discloses, the business can close immediately because the loss will
further increase when the indirect and non-expenses add to it.
 The progress can study based on the gross profit ratio, year after year.

Disadvantages and limitations of Trading Account in Accounting:

The following are the Major limitations or disadvantages below are;

 It only defines the gross profit or gross loss, so this account can not result from net profits
and net loss for the company; the company needs to make another account in accounting for net
profits and net loss, it calls profit or loss account.
 Its report can not share with the company shareholder.
 They only mention direct expenses, not to indirect and non-expenses.

Needs & Importance of Trading Account in Accounting:

It is very important to want to know what is the gross profit or gross loss; for the company to
also want to know whether purchasing goods, what manufacturing of goods and sales are
sufficient for earning or not.

The following main needs and importance below are.

 It helps to know gross profit or loss.
 They provide information about direct expenses.
 They provide safety against possibilities of loss.
 It helps in comparison with closing stock with last year’s stock.

Profit & Loss Account

Profit and Loss (P&L) Statement

Profit and loss (P&L) statement refers to a financial statement that summarizes the revenues,
costs, and expenses incurred during a specified period, usually a quarter or fiscal year. These
records provide information about a company’s ability or inability to generate profit by
increasing revenue, reducing costs, or both. P&L statements are often presented on a cash or
accrual basis. Company managers and investors use P&L statements to analyze the financial
health of a company.

Characteristics of Profit and Loss Account

 It is the second financial statement prepared by an organization.

 It is a nominal account.
 It is prepared on an accrual basis.
 It depicts the net profit or net loss during the year.
 The net result of this account is added to (in case of net profit) or subtracted (in case of
net loss) from the Capital on the Liabilities side of the Balance Sheet.

Purposes of Profit and Loss Account

 To calculate net profit or a net loss.
 To ascertain the net profit ratio and to compare this year’s net
profit ratio with that of the desired and proposed target in order
to assess the efficiency and effectiveness.
 To measure the adequacy and reasonability of indirect expenses
incurred by ascertaining the ratio between indirect expenses and
net profit.
 To compare the current year’s actual performance with desired
and planned performance.
 To provide various provisions and reserves to meet unforeseen
future conditions and to toughen the financial position of the
business.

Types of Profit and Loss (P&L) statements

There are two kinds of P&L statements: cash accounting method and accrual method.

Cash accounting method – In cash accounting, revenue and expenses are recognized when the
actual cash transactions occur, providing a simplified way for small businesses to manage their
finances and track their cash flow. The cash accounting method considers only the received or paid
cash. This method is widely used by small businesses.
Accrual Method – On the other hand, the accrual method takes into account the earnings, even if
the money is not yet received. It also tracks the liabilities that are not yet expenses. The accrual
method provides a more comprehensive financial picture by recording revenues and expenses when
they are earned or incurred, regardless of when the actual cash transactions take place, making it
suitable for larger businesses with complex financial operations.

Components of the profit and loss account

The profit and loss account consists of various components that record the income and expenses of
the business under various categories. The details of the same are mentioned below.
a. Revenue/ Income
The revenue of a business is also referred to as the top line. The income of the business is classified
into two main categories. The revenue from the primary business operations are recorded first. It
includes the revenue generated in the normal course of business. The next category refers to the
other income or the miscellaneous income of the business. It will include the income generated from
the various investments of the company (for example, interest or dividend income).
b. COGS
The next broad category of the profit and loss statement is the cost of goods sold (COGS). It
includes the direct cost of operating the business like the raw material cost, labour cost, or the direct
overheads of the business entity related to the manufacturing or purchasing the goods. These
expenses are the first line of expenses deducted from the revenue to generate the gross margin of the
business.
It is important that the business has a higher gross margin as the operating and non-operating
expenses to be deducted from the gross margin further reduce the profits of the business. It is,
therefore, important to keep the COGS in check to ensure net higher gains for the owners or the
shareholders of the company.
c. Operating expenses
Operating expenses are not the direct expenses involved in the production or manufacturing process
but the indirect cost of running a business. These expenses include administrative expenses like
employee costs, depreciation costs, selling, marketing and distribution costs, research and
development costs, etc. These costs have a direct impact on the net profits of the business. If the
operating costs of the business are too high, it can turn the positive gross margin into a net loss too.
d. Operating profit
The operating profit is the positive balance from the gross margin after deducting the operating
expenses. It is also referred to as EBIT (Earnings before Interest and Taxes). A positive operating
margin assures the investors and the stakeholders of the profitability and the solvency of the
business.
e. Net income
The net income of a business is the bottom line or the net profit generated by the business after
deducting all the operating and non-operating expenses as well as interest and taxes. This is the
profit that is available for distribution to the shareholders. The earning per share are also calculated
based on the net profit or the net income of the business.

Items recorded on the Debit Side of Profit and Loss Account

We know that all the indirect expenses are recorded on the debit of the Profit and Loss Account.
The following are some categories under which indirect expenses are grouped:

Administration and Office Expenses: These are the expenses that are incurred for making and
implementing the plans for the efficient running of the business and maintenance of the office.
These expenses are considered as indirect expenses and recorded on the debit side of the Profit
and Loss Account. The following are some examples of administration and office expenses.

 Office Salaries
 Office Rent
 Postage, Printing, and Stationery
 General/Trade Expenses
 Telephone or Internet Charges
 Insurance
 Maintenance of Office Equipments
 Lighting
 Audit Fees
 Consultation Fees
 Legal Charges
Selling Expenses: These are the expenses that are incurred in connection with promoting the
sales and maintaining the existing customers. These are also indirect expenses and are recorded
on the debit side of the Profit and Loss Account. The following are some examples of selling
expenses.

 Advertisement Expenses
 Salaries to Salesman
 Commission to Salesman/Agents
 Bad Debts
 Free Samples
 Postage, Printing, and Stationery related to Sales
 Free Samples
 Royalty on Sales
 Other sales department expenses
Distribution Expenses: These are the expenses that are incurred in relation to distributing and
transporting the goods. In simple words, these expenses are incurred for executing the orders of
the business. It also includes the expenses incurred for maintaining the warehouse of the finished
goods. As these are indirect expenses and therefore, are shown on the debit side of the Profit and
Loss Account. The following are some examples of distribution expenses.
  Warehousing or Storage Charges
 Packing Costs
 Carriage or Freight Outward
 Carriage on Sales
 Transportation Costs
 Vehicle Maintenance Costs (used for delivering the goods)
Financial Expenses: These expenses are incurred for raising the funds required by a business
which means that these expenses are incurred in connection with arranging the finance for the
business. Being indirect expenses, these are shown on the debit side of the Profit and Loss
Account. The following are some examples of financial expenses.

 Interest on Loans
 Interest on Capital
 Interest on Overdraft
 Cash Discount Allowed
Abnormal Losses: It includes all the losses that are accidental to a business enterprise. In simple
words, these losses are not frequently incurred by the business. These losses are debited to the
Profit and Loss Account. The given below are some factors that result in abnormal losses to a
business.

 Loss of Goods/Stock or Assets by Fire or Theft

 Loss on Sale of Fixed Assets
 Cash Embezzlement
 Loss of Goods due to Accidents
Other Expenses: These expenses include the following and are shown on the debit side of the
Profit and Loss Account.

 Depreciation
 Charity
 Donations
 Repairs and Maintenance of Assets or types of equipment

Items recorded on the Credit Side of Profit and Loss Account

Gross Profit: The first item recorded on the credit side of the Profit and Loss Account is the
Gross Profit transferred from the Trading Account.

Financial and Other Incomes/Gains: All the incomes or gains to a business enterprise are
shown on the credit side of the Profit and Loss Account. It includes the following

 Rent Received
 Commission Received
 Interest Received
  Dividend Received
 Discount Received
 Income from Investments
 Profit on Sale of Assets
 Bad Debts Recovered
 Insurance Claim Received
 Interest on Drawings
 Tax Refunded
 Other Miscellaneous Incomes

The Advantages & Disadvantages of a Profit & Loss Statement

Advantages of Profit & Loss Account

Maintenance of business records

It records all the financial transaction pertaining to the respective year systematically in the books of
accounts. It is not possible for management to remember each and every transaction for a long time
due to their size and complexities.

Preparation of financial statements

Financial statements like Trading and profit and loss account, Balance Sheet can be prepared easily
if there is a proper recording of transactions. Proper recording of all the financial transactions is very
important for the preparation of financial statements of the entity.
Comparison of results
It facilitates the comparison of the financial results of one year with another year easily. Also,
the management can analyze the systematic recording of all the financial transactions according to
the policies of the entity.

Decision making
Decision making becomes easier for management if there is a proper recording of financial
transactions. Accounting information enables management to plan its future activities, make
budgets and coordination of various activities in various departments.

Evidence in legal matters

The proper and systematic records of the financial transactions act as evidence in the court of law.

Provides information to related parties

It makes the financial information of the organization available to stakeholders like owners,
creditors, employees, customers, government etc. easily.

Helps in taxation matters

Various tax authorities like income tax, indirect taxes depends on the accounts maintained by the
management for settlement of taxation matters.

Valuation of business
For proper valuation of an entity’s business accounting information can be utilized. Thus, it helps in
measuring the value of the entity by using the accounting information in the case of sale of the
entity.

Replacement of memory
Proper recording of accounting transactions replaces the need to remember transactions.

Disadvantages of Profit & Loss Account

Expresses Accounting information in terms of money

Non-financial transactions cannot be given effect to in books of accounts. Only transactions of
financial nature are measurable by the accountant. In fact, financial transactions are expressed in
terms of money.

Accounting information is based on estimates

There are some accounting data which are based on estimates. Thus, inaccuracy in estimates is
possible.
Accounting information may be biased
Accountants personal influence affects the accounting information of the entity. Different methods
of inventory valuation, depreciation methods, treatment of revenue and capital expenses etc can be
adopted by the accountant for measurement of income of the entity.

Hence, the income arrived in certain cases might be incorrect due to the lack of objectivity.

Recording of Fixed assets at the original cost

There can be a difference between the original cost and current replacement cost of a fixed asset due
to efflux of time, change in technology etc. Thus, the balance sheet may not show the true financial
status of an entity.

Manipulation of Accounts
The accountant or management can manipulate or misrepresent the profits of an entity.

Money as a measurement unit changes in value

Stability in the value of money is not possible. Accounting information will not show the true
financial position if changes in the price level are not considered

Format for Profit and Loss Account

Difference between Trading and Profit and Loss Account

The following points of difference exist between the Trading and Profit and Loss Account

Parameters Trading Account Profit and Loss Account

Meaning Trading account used to find the gross Profit and loss account or Income
profit/loss of the business for an accounting statement is used to find the net profit/loss
period of the business for an accounting period

Timing Trading Account is prepared first and then Profit/Loss Account is prepared after the
profit and loss account is prepared. trading account is prepared.

Purpose For knowing the gross profit or gross loss of For knowing the net profit or net loss of a
a business business

Stage It is the first stage in the creation of the final it is the second stage in the creation of the
account. final account.

Dependency It is not dependent on trial balance It is dependent on trading account

 Transfer The balance in the form of Gross loss or The balance in the form of Net loss or Net
of Balance Gross Profit of the trading account will be Profit of the profit and loss account will
transferred to the Profit and Loss Account be transferred to the Balance Sheet

Balance Sheet

A balance sheet is a financial statement that contains details of a company’s assets or liabilities at
a specific point in time. It is one of the three core financial statements (income
statement and cash flow statement being the other two) used for evaluating the performance of a
business.
A company’s balance sheet is a financial record of its liabilities, assets and shareholder’s equity
at a specific date. It helps evaluate a business’s capital structure and also calculates the rate of
returns for its investors.
Key elements & components of a balance sheet
A balance sheet consists of two main headings: assets and liabilities. Let us take a detailed look
at these components.

Assets
An asset is something that the company owns and that is beneficial for the growth of the
business. Assets can be classified based on convertibility, physical existence, and usage.

a. Convertibility: This describes whether the asset can be easily converted to cash. Based on
convertibility, assets are further classified into current assets and fixed assets.

1. Current assets: Assets which can be easily converted into cash or cash equivalents
within a duration of one year. Examples include short-term deposits, marketable securities, and
stock.
2. Fixed assets: Assets which cannot be easily or readily converted to cash. For example,
buildings, machinery, equipment, or trademarks.

b. Physical existence: Assets can be of two types, tangible and intangible.

1. Tangible assets: Assets which you can see and feel, like office supplies, machinery,
equipment, and buildings.
2. Intangible assets: Assets which do not have physical existence, like patents, brands, and
copyrights.

c. Usage: Assets can be classified as operating and non-operating assets.

1. Operating assets: Assets which are necessary to conduct business operations. For
example, buildings, machinery, and equipment.
2. Non-operating assets: Short-term investments or marketable securities that are not
necessary for daily operations.

Liabilities
Liabilities are what the company owes to other parties. This includes debts and other financial
obligations that arise as an outcome of business transactions. Companies settle their liabilities by
paying them back in cash or providing an equivalent service to the other party. Liabilities are
listed on the right side of the balance sheet.

Depending on context, liabilities can be classified as current and non-current.

1. Current liabilities: These include debts or obligations that have to be fulfilled within a year.
Current liabilities are also called short-term assets, and they include accounts payable, interest
payable, and short-term loans.

2. Non-current liabilities: These are debts or obligations for which the due date is more than a
year. Non-current liabilities, also called long-term liabilities, include bonds payable, long-term
notes payable, and deferred tax liabilities.

Owner’s Equity/ Earnings

Owner’s equity is equal to total assets minus total liabilities. In other words, it is the amount that
can be handed over to shareholders after the debts have been paid and the assets have been
liquidated. Equity is one of the most common ways to represent the net value of the
company. Part of shareholder’s equity is retained earnings, which is a fixed percentage of the
shareholder’s equity that has to be paid as dividends.

Features of a balance sheet

The features of a balance sheet are as follows:
 A balance sheet consists of all the liabilities and assets of a company. It shows their value
and nature enabling you to know the position of the capital on a specific date. However, it
does not show any revenues or expenses.
 Balance sheets follow the equation “Asset = Liability + Capital”, and both of its sides are
always equal.
 It takes into account the credit as well as debit balances of a company’s current and
personal accounts. The credit balance comes under the personal account and is called the
liabilities of a business. In comparison, the debit balance comes under the real account
and is known as the assets of a business.
 A company’s accountants generally prepare the balance sheet on the last day of an
accounting year. This is so as it is the ultimate step of final accounts and needs an
 assessment of the company’s trading as well as profit and loss account for its
preparation.
Importance of a balance sheet

A balance sheet is an essential component that assists in the smooth running of a business. Here
are some of the reasons that explain the importance of a company’s balance sheet:
Assist banks in evaluating a firm’s net worth
When a business wants to expand its operations and make future investments, it seeks loans from
banks. Under such circumstances, the banks will look at the firm’s balance sheet to evaluate
whether or not it has the financial position to pay back the loan amount.
Helps investors take decisions
While choosing a firm for the purpose of investment, a majority of investors look at the
company’s balance sheet to determine its financial position. Moreover, they combine it with
various other factors to assess the firm’s future growth potential.
Serves as a determiner for risk and returns
If you are a business owner, maintaining a balance sheet will enable you to determine the ease at
which you can meet your short-term obligations. Furthermore, you can also put a check on the
liabilities of your business if they are rapidly growing and avoid the chances of bankruptcy.
Enables financial analysis
Having a proper balance sheet will let you get a clear idea of the liquidity conditions of your
company. Thus, you can view the cash flow of your firm, working capital funding, trade
receivable status and also how much daily transactions your business can afford.

The difference between a trial balance and a balance sheet are as follows:

Trial Balance Balance Sheet

Trial balance is not a financial statement The balance sheet is a financial statement that

and does not form a part of a company’s is an important component of a company’s

final account final account

It is made for use within the company It is made for the company’s external affairs

All its accounts are divided into debit and All its accounts are divided into equity,
credit balances liabilities and assets

It records the closing balances of all the It records a company’s equity, liabilities and

general ledgers of accounts assets

Its purpose is to determine whether the

Its purpose is to verify that the total debits
business’s assets are equal to the sum of its
and credits of all the ledgers are in balance
liabilities and equity

For trial balances, there is no specific For balance sheets, there is a specific

arrangement rule arrangement format

Auditor’s signature is not mandatory Auditor’s signature is mandatory

Recorded at the end of every year, half-year

Recorded at the end of every financial year
and quarter

Balance Sheet Format (I)

The balance sheet of a company will look like the image given below.
Balance Sheet Format (II)
This is a sample of a vertical balance sheet format that is generally used by businesses:
Company Name
Balance sheet as on XX/XX/XXXX

Figures recorded at the Figures recorded at the

Note
Particulars end of the current end of the previous
Number
reporting period reporting period

Equity And Liabilities

 Figures recorded at the Figures recorded at the
Note
Particulars end of the current end of the previous
Number
reporting period reporting period

Shareholders’ Funds

Share Capital Rs.X Rs.X

Reserves And Surplus Rs.X Rs.X

* Funds Received
Rs.X Rs.X
Against Share Warrants

* Share Application
Money Pending
Allotment

Non-Current Liabilities

Long-Term Borrowings Rs.X Rs.X

Long-Term Provisions Rs.X Rs.X

* Other Long-Term Tax

Rs.X Rs.X
Liabilities

* Net Deferred Tax

Rs.X Rs.X
Liabilities

Current Liabilities

Short-Term Provisions Rs.X Rs.X

Short-Term Borrowings Rs.X Rs.X

 Figures recorded at the Figures recorded at the
Note
Particulars end of the current end of the previous
Number
reporting period reporting period

Trade Payables Rs.X Rs.X

Other Current
Rs.X Rs.X
Liabilities

Total

Assets

Current Assets

Inventories Rs.X Rs.X

Current Investments Rs.X Rs.X

Cash And Cash

Rs.X Rs.X
Equivalents

Trade Receivables Rs.X Rs.X

Short-Term Loans And

Rs.X Rs.X
Advances

Other Current Assets Rs.X Rs.X

Non-Current Assets

Fixed Assets

Tangible Assets Rs.X Rs.X

Intangible Assets Rs.X Rs.X

 Figures recorded at the Figures recorded at the
Note
Particulars end of the current end of the previous
Number
reporting period reporting period

Intangible Assets Under

Rs.X Rs.X
Development

Capital Work-In-
Rs.X Rs.X
Progress

Non-Current
Rs.X Rs.X
Investments

Other Non-Current
Rs.X Rs.X
Assets

Net Deferred Tax

Rs.X Rs.X
Assets

Long-Term Loans And

Rs.X Rs.X
Advances

Total

How to prepare a Balance Sheet?

Below are the steps mentioned to prepare a balance sheet.

1. Compose a trial balance- It is a regular report included in any accounting programme. If

it is a manual mode, then create a trial balance by transferring every general ledger
account’s ending balance to a spreadsheet.
2. Arrange the trial balance- It is important to arrange the initial trial balance to assure
that the balance sheet similar to the relevant accounting structure. While using adjusting
entries to adjust the trial balance all the entry should be completely recorded so the
auditors can understand why it was made.
3. Discard all expense and revenue accounts- The trial balance includes expenses,
revenue, losses, gains, liabilities, equity, and assets. Delete all from the trial balance
 except equity, liabilities, and assets. However, the deleted accounts are used to create an
income statement.
4. Calculate the remaining accounts- In this stage, sum up all the trial balance account
used to create a balance sheet. The typical line items used in the balance sheet are:

 Cash
 Accounts receivable
 Inventory
 Fixed assets
 Other assets
 Accounts payable
 Accrued liabilities
 Debt
 Other liabilities
 Common stock
 Retained earnings
2. Validate the balance sheet- The total for all assets recorded in the balance sheet should
be similar to the liabilities and stockholders’ equity accounts.
3. Present in the required balance sheet format.

Advantages of Balance Sheet

1. Shows company’s financial health – A balance sheet provides a snapshot of a
company’s financial wellbeing at a certain point in time.
2. Indicates assets and liabilities – It details what a company owns (assets) and owes
(liabilities), giving a clear picture of its economic standing.
3. Helps in decision-making – It plays a crucial role in making informed decisions
regarding business strategies, based on the company’s financial status.
4. Assists in tracking performance – By comparing balance sheets over time, one can
track the company’s performance, identifying trends and areas of growth.
5. Useful for potential investors – Potential investors can use a balance sheet to assess the
financial stability of a company before deciding to invest.

Disadvantages of Balance Sheet

 1. Doesn’t show market values – A balance sheet doesn’t reflect the current market value of
assets and liabilities. It only shows their cost price, which can be different from the actual
values.
2. Ignores inflation effects – The impact of inflation is not considered in a balance sheet.
This can distort the real financial position of a business.

3. Misses intangible assets – Intangible assets like brand reputation or intellectual property
often don’t appear on the balance sheet, despite their potential value.

4. Can’t predict future performance – A balance sheet is a snapshot of a company’s

financial position at a specific point in time and can’t forecast future performance or
profitability.

5. Doesn’t capture all liabilities – It may not account for all liabilities. Some obligations
like lawsuits or environmental damages might not be included, giving an incomplete
picture.

Concept of Cash Flow Statement

A cash flow statement is a financial statement that provides aggregate data regarding all cash
inflows that a company receives from its ongoing operations and external investment sources. It
also includes all cash outflows that pay for business activities and investments during a given
period.

 A cash flow statement provides data regarding all cash inflows that a company receives
from its ongoing operations and external investment sources.
 The cash flow statement includes cash made by the business through operations,
investment, and financing—the sum of which is called net cash flow.
 The first section of the cash flow statement is cash flow from operations, which includes
transactions from all operational business activities.
 Cash flow from investment is the second section of the cash flow statement, and is the
result of investment gains and losses.
 Cash flow from financing is the final section, which provides an overview of cash used
from debt and equity.

Cash Flow Statement Components

A statement of cash flows displays incoming and outgoing money from three types of activities:
operating, investing, and financing.
Operating Activities

Cash flows from operating activities include money spent or generated by selling products,
goods, or services. Line items in this section may include:

 Depreciation and amortization: how much an asset loses value over the course of its
lifetime
 Changes in working capital: transactions that affect current assets or liabilities
 Accounts receivable: money owed to the company by clients and customers
 Accounts payable: money the company owes to clients and customers
 Inventory: sellable products or goods
Investing Activities

Investing activities include changes to long-term assets, such as real estate, and changes in
capital expenditures (CapEx). Line items for this section include:

 PP&E purchases: plant, property, and equipment (PP&E) purchases, such as warehouse
space, office equipment, or production plants
 Proceeds from PP&E sales: money generated from selling PP&E
 Purchase of marketable securities: buying stocks or bonds
 Proceeds from sale of marketable securities: money generated from selling stocks or
bonds
 Business acquisition proceeds: money made or spent as part of acquiring another
business or part of the company being acquired
Financing Activities

Cash flows from financing activities involve any money spent or generated from issuing debt,
paying dividends to shareholders, and repaying long-term loans. Line items in the financing
activities section include:

 Dividend payments: Revenue or earnings redistributed to shareholders as cash or stock

reinvestments
 Repurchase of common stock: Buying back previously issued public shares
 Proceeds from issuing debt: Money made by selling debt to investors
 Repayments of long-term debt: Money spent to repay loans

Methods of Cash Flow Statement

Calculate Operating Activities Cash Flows
Accountants have two methods to choose from when calculating operating cash flows: direct or
indirect cash flows.
Direct Method
The direct cash flows approach involves adding all the cash the company made or paid for the
reporting period. This includes money paid to suppliers, salary payments, and cash from selling
products or services. Businesses that use the cash basis of accounting typically use the direct
method. In cash basis accounting, money is only counted when it is actually received or spent by
the business. The opposite of this is the accrual basis of accounting which counts cash if earned
or expensed, even if those transactions have not been completely processed.

Indirect Method
The indirect cash flows approach involves using the company’s net income and adjusting it
based on non-cash transactions. For example, if the balance of accounts receivable increases, that
increase is revenue but not cash because the money has not been received yet.

Choosing Which Method to Use

Although the indirect cash flow approach may seem more complicated, it is the most commonly
used approach. This is because accountants can easily find most of the adjustments to net income
on the company’s balance sheet. On the other hand, the direct method is more time-consuming
and has higher chances of error if a receipt is missing or transactions are inaccurate.

Calculate Investing Cash Flows

Calculating investing cash flows involves tallying up any cash spent or generated from buying
property, selling real estate, investing in office equipment, or acquiring a business. These cash
flows only include transactions completed with free cash or money the company has on hand to
spend. Investing cash flows do not include transactions that use financing or debt.

Calculate Cash Flows from Financing Activities

When calculating financing cash flows, accountants should include debt and equity financing —
money used to fund the business and pay back borrowed funds. U.S.-based accountants who
adhere to generally accepted accounting principles (GAAP) should list shareholder dividends in
the financing activities section. However, international accountants who follow international
financial reporting standards (IFRS) should include dividends as part of operating activities
instead.

Calculate Ending Balance

Each section of the cash flow statement should have a total balance — total cash flows for
operating activities, investing, and financing. At the end of the statement, these totals are
combined to determine the company’s total cash flow balance for the period. A positive cash
flow means the company had more cash coming in than it spent. On the other hand, a negative
balance suggests the company spent more than it generated.
Objectives of Cash Flow Statement:

The Main Objectives Are:

 To provide information about cash inflows and outflows from operating, investing and
financing activities.
 To determine net changes in cash and cash equivalents.

What are Inflows and Outflows of Cash?

Inflows of Cash
 All transactions that lead to an increase in cash and cash equivalents are classified as
inflow of cash.
Outflows of Cash
 All transactions that lead to a decrease in cash and cash equivalents are classified as
outflows of cash.
Cash and Cash Equivalents:
Cash
 Cash comprises of cash in hand and demand deposits with banks.
Cash Equivalents
 Cash equivalents are short term, highly liquid investment that is readily convertible into a
known amount of cash.
Cash And Cash Equivalents As Per Schedule III, Part I Of The Companies Act, 2013
1 Balance with banks
2 Cheque on hand
3 Cash on hand
4 Short-term marketable securities
5 Balance with banks held as margin money
6 Bank deposits with more than 12 months of maturity

Limitations of Cash Flow Statement

(1) Ignores Non-cash transactions
(2) Ignores the accrual concept
(3) Historical in Nature
(4) Not a Substitute for an Income Statement
(5) Not suitable for judging Liquidity of the enterprise

Why does business cash flow matter?

Business cash flow is important for several reasons:

It ensures the survival of the business
Cash flow is the lifeblood of any business. It is essential to keep the business running by paying
employees, suppliers, and other expenses. Without adequate cash flow, a business can run into
financial trouble and potentially go bankrupt.
It enables growth and expansion
Positive cash flow allows a business to invest in growth opportunities such as hiring new
employees, expanding operations, or launching new products or services. By having enough cash
on hand, businesses can take advantage of these opportunities and continue to grow.
It helps with financial planning
Cash flow is an important factor in financial planning. By forecasting cash inflows and outflows,
businesses can plan for the future and make informed decisions about investments and expenses.
It makes a business more attractive to investors
Investors are interested in businesses that have a positive cash flow. This is because positive cash
flow indicates that a business is financially stable and has the ability to pay back loans or
generate profits.
It helps with tax planning
Understanding cash flow is important for tax planning. By managing cash flow effectively,
businesses can reduce their tax liabilities by maximizing deductions and taking advantage of tax
credits.

How to maintain positive cash flow

Maintaining positive cash flow is critical for the long-term success and sustainability of any
business. Here are some tips that can help:

 Develop a cash flow budget

Creating a cash flow budget will help you plan your expenses and ensure that you have enough
cash to cover them. This budget should include all of your expenses, such as rent, utilities,
payroll, and taxes, as well as any expected inflows, such as sales revenue.
 Invoice promptly
One of the most common reasons for a negative cash flow is slow payment from customers. To
prevent this, make sure you send out your invoices as soon as possible and follow up on overdue
payments promptly.
 Manage inventory levels
Holding too much inventory can tie up cash that could be used for other expenses. To avoid this,
keep track of your inventory levels and adjust your orders to match your sales demand.
 Control your expenses
Keep your expenses under control by negotiating with suppliers, looking for ways to reduce your
overhead costs, and avoiding unnecessary expenses.
 Monitor your cash flow regularly
Review your cash flow regularly to make sure you’re staying on track. This will help you
identify any potential problems early and take action to prevent them.

How to improve your cash flow

Improving your cash flow can be a crucial step to the success of your business or personal
finances. Here are some tips to improve your cash flow:

 Create a cash flow forecast

This involves creating a detailed plan of your expected cash inflows and outflows over a certain
period, typically a month or a quarter. This will help you predict your cash needs and identify
potential cash shortages before they occur. We have a cash flow forecast template available to
download.
 Invoice promptly and follow up on unpaid invoices
Send invoices as soon as possible after the service or product has been delivered, and follow up
on any overdue payments. This will help you receive payment faster and improve your cash
flow.
 Offer discounts for early payment
Consider offering a discount for customers who pay their invoices early. This can encourage
them to pay sooner and improve your cash flow.
 Negotiate payment terms with suppliers
Negotiate with your suppliers for longer payment terms or discounts for early payment. This can
help you manage your cash flow better.
 Cut costs
Review your expenses and look for ways to reduce costs. This can include negotiating better
prices with suppliers, reducing inventory levels, or using technology to automate processes.
 Increase revenue
Explore ways to increase your revenue, such as by expanding your product or service offering,
improving marketing efforts, or targeting new customer segments.
By implementing these tips, you can improve your cash flow and help ensure the success of your
business or personal finances.

Format of Cash Flow Statement (Indirect Method)

Format of Cash Flow Statement (Direct Method)
Advantages of Cash Flow Statement: -

 A cash flow statement helps a business owner assess net assets.

 It helps in evaluating the cash-generating capability of a firm.

 Aids in planning policies for profit-maximizing.
 Understanding and assessing the cash flow of a firm helps in optimizing profit and
sustainability.
 Helps investors get an idea and judge the risk of investing in the firm.
 Helps creditors understand a firm's resources in terms of liquidity and other assets as well
as plan a budget for the firm's operational budget and other expenses and debts.

Difference Between Cash Flow and Fund Flow

The following table elucidates the cash flow and fund flow difference clearly to clear the
concept.

Basis of
Cash Flow Fund Flow
Comparison

It shows how a company spends its It charts the financial standing of a

Meaning
cash revenue by giving a record of company. Also the source of the cash
all inflows and outflows. fund and application of it.

What Is
The real cash or cash-like assets are
Measured? Only funds and capital are calculated
calculated

What does it
The source and application of existing
Display? Inflows and Outflows of hard cash
funds.

To keep a record of cash from the The transformation of the business,

Purpose
initial stage to the end of a specific from last financial quarter to existing
period one
Reveals The short-term position of a
The long-term standing of a business
business

Difference Between Cash Flow Statement and Fund Flow Statement

Fund flow and cash flow both are recorded through a statement which is called Fund Flow
Statement and Cash Flow Statement respectively.

Points of
Fund Flow Statement Cash Flow Statement
Comparison

On the broader concept of working On the narrower concept of

Basis of Analysis
capital cash only

States the opening cash

Source
States the sources of funds generation balance and closing cash
balance

Usage In accessing long-range financial Computes short term

planning spending details

Working Capital Changes in current liabilities and assets It shows those changes
Change Schedule are shown through the movement of through the cash flow
working capital statement itself

End Result Portrays the reasons for the change in net Portrays the reasons for
capital changes in cash flows only

Accounting Principle Follows cash basis of

Follows accrual basis of accounting
accounting
 Unit -4

Ratio Analysis
Ratio analysis is a quantitative procedure of obtaining a look into a firm’s functional efficiency,
liquidity, revenues, and profitability by analysing its financial records and statements. Ratio
analysis is a very important factor that will help in doing an analysis of the fundamentals of
equity.
Uses of Ratio Analysis

1. Comparisons

One of the uses of ratio analysis is to compare a company’s financial performance to similar
firms in the industry to understand the company’s position in the market. Obtaining financial
ratios, such as Price/Earnings, from known competitors and comparing it to the company’s ratios
can help management identify market gaps and examine its competitive advantages, strengths,
and weaknesses. The management can then use the information to formulate decisions that aim
to improve the company’s position in the market.

2. Trend line

Companies can also use ratios to see if there is a trend in financial performance. Established
companies collect data from the financial statements over a large number of reporting periods.
The trend obtained can be used to predict the direction of future financial performance, and also
identify any expected financial turbulence that would not be possible to predict using ratios for a
single reporting period.

3. Operational efficiency

The management of a company can also use financial ratio analysis to determine the degree of
efficiency in the management of assets and liabilities. Inefficient use of assets such as motor
vehicles, land, and building results in unnecessary expenses that ought to be
eliminated. Financial ratios can also help to determine if the financial resources are over- or
under-utilized.

4 Ways of expressing ratio:

1. As a fraction or a ratio
A quotient is a unit of expression of this form, which is formed by dividing one thing by

another. As an example: The working capital turnover ratio is . It means that the Net Sales is
5 times the working capital of the business.
2. As a decimal
Ratios are commonly stated as fractions, but they may also be presented as decimals. It can be
converted between fractions and decimals when dealing with a mixture of fractions and
decimals and comparing ratios presented in either form.
3. As a percentage
It can be expressed in percentage form i.e. by dividing one figure by another and multiplying
by hundred. For instance, the Net Profit Ratio is 20%. It represents the connection between net
earnings and revenue. This indicates that every ₹100 sale generates a net profit of ₹20 for the
company.
4. As a proportion
The quantities of the two figures can be stated in a common thread. For example, the current
ratio can be written as 2.5:1. That signifies that the current assets are worth Rs.250 and the
current liabilities are worth Rs.100.
Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all stakeholders of an
entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management.
Let us take a look at some objectives that ratio analysis fulfils.

1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs
last year, how will you determine if that is a good or bad figure? Context is required to measure
profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense
ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find
out problem areas and improve upon them.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and
other resources. It is important that assets and financial resources be allocated and used efficiently to
avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any
mismanagement of assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So
the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm
maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if
there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to
quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-
Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding
of its financial health and fiscal position. The management can take corrective action if the
standards of the market are not met by the company. The ratios can also be compared to the
previous years’ ratio’s to see the progress of the company. This is known as trend analysis.

Advantages of Ratio Analysis

The benefits of ratio analysis include a quick and easy approach to analyzing a business’s
financial results, the ability to compare firms, and the ability to spot patterns and shifts over the
years. Here are some of the advantages of Ratio Analysis:
1. Planning: Through doing trend analysis, it aids in predicting and planning.
2. Estimation: By analyzing prior trends, it is possible to estimate the firm’s budget.
3. Informative: It gives users accounting information and important information about
the business’s performance.
4. Solvency: It aids in determining the firm’s liquidity as well as its long-term solvency.
5. Comparison: It helps in the comparison of different firms on various scales as well as
inter-firm analysis.

Limitations of Ratio Analysis

1. Historical Information: Information used in the analysis is based on past results that
the company releases. Therefore, ratio analysis metrics do not necessarily represent future
company performance.
2. Inflationary effects: Financial statements are provided on a regular basis, thus there
are time gaps between each publication. If there has been inflation between periods, actual
prices are not represented in the financial accounts.
3. Changes in accounting policies: If the company’s accounting standards and practices
have changed, this may have a substantial impact on financial reporting.
4. Operational changes: A company’s operational structure can alter dramatically, from
its supply chain strategy to the product it sells. When large operational changes occur,
comparing financial indicators before and after the change may lead to inaccurate
inferences about the company’s accomplishments and various reports.

Types of Ratio Analysis

1. Current Ratio Definition

The current ratio is also referred to as the working capital ratio. This ratio compares a company’s
current assets to its current liabilities, testing whether it sustainably balances assets, financing,
and liabilities. Typically, the current ratio is used as a general metric of financial health since it
shows a company’s ability to pay off short-term debts.

(A) Current Ratio Formula

The formula to calculate the current ratio is:

Current Ratio = Current Assets / Current Liabilities

Components of the Formula

Current Assets

Current assets are a company’s resources that could be liquified within one year. Some common
types of current assets include:

 Cash and cash equivalents: Paper cash, coin, or currency, as well as the balance of
checking and savings accounts
 Marketable securities: Financial instruments available for sale or purchase on public
exchanges, such as stocks and bonds
 Accounts receivable: Money owed to a company by clients and customers
 Inventory: Goods a company sells and the materials used to produce goods
 Other current assets: Assets too rare or insignificant to warrant a full category on their
own, including selling a piece of equipment or real estate (Prepaid expenses, like prepaid
rent or taxes, may also fall into the “other current assets” category, depending on the
company.)
Current Liabilities

Current liabilities are debts the company must repay within the following year. Some categories
of liabilities include:

 Accounts payable: Money a company owes to clients, creditors, customers, and

suppliers
 Term debt: A loan or other form of financing with fixed interest rates
 Deferred revenue: Money that the company receives from customers before delivering
goods or services — sometimes referred to as unearned income
 Other current liabilities: Inconsequential or uncommon fees that are too minor to have
a separate category on the balance sheet — includes miscellaneous fees, accrued property
taxes, or unpaid costs associated with franchise operations.

(B) Quick Ratio Definition

The quick ratio, also called an acid-test ratio, measures a company’s short-term liquidity against
its short-term obligations. Essentially, the ratio seeks to figure out if a company has enough
liquid assets (cash or things that can easily be converted into cash) to cover its current liabilities
and impending debts. A key point to note, though, is this isn’t a test to see how much debt a
company has or if it could seek financing to cover any current debts. Rather, the quick ratio just
looks at whether a company’s liquid assets outnumber its liabilities.
Quick Ratio Formula

The formula for finding a company’s quick ratio involves dividing the company’s most liquid
assets, or current assets, by the company’s total current liabilities. The formula is:

Quick Ratio = Liquid Assets / Current Liabilities

Components of the Quick Ratio

Liquid Assets

A company’s liquid assets are assets that are cash or close to cash. This may include cash and
savings, marketable securities (stocks and bonds), and accounts receivable (money owed to the
company by customers and clients).

Liquid Assets Formula

The consolidated Liquid Assets are cash and such securities that can be readily subjected to cash
conversion without the current liabilities. The formula is mentioned below.

(Marketable Securities + cash)-Current Liabilities=Liquid Assets

List of Liquid Assets

Among a host of Liquid Assets, few have been mentioned below.

 Cash at Bank
Cash at a Bank pertains to the sum of the amount that is deposited in a financial
institution. It is considered to be a current Asset in a highly Liquid form.

 Cash in Hand
It usually refers to the total accessible cash of an organisation. In the context of a
company, cash in hand helps in the inference of the number of days for which an
organisation can carry on with paying its operating expenses with the available cash.

 Cash Equivalent
The short-term investment securities are known as cash equivalents with maturity periods
to be usually around 90 days or less. Examples of cash equivalent include Treasury bills,
legal tender, cheques that are received but not deposited etc.

 Government Bonds
A government may issue debt security to raise funds. The holder of a government bond
earns a fixed amount of interest against the amount loaned to a governmental body.

 Promissory Notes
 A promissory note is a financial instrument that shows the written promise by an issuer to
pay a definite sum of money to a payee on a determined future date. It creates a legal
obligation on the issuer to pay such loan.

 Accrued Income
Accrued income is such an amount of money that has already been earned but yet not
received. Interest earned on investment that has not been received is an example of
accrued income.

 Stocks
It is an investment in company shares representing ownership corresponding to the
volume of stocks owned. Through an increase in the value of stocks, investors can earn
capital gains by selling such shares.

 Account Receivables
Account receivables pertain to such proceeds or payment that the customers of a
company will have to pay for purchasing services or goods on credit.

2. Solvency Ratio

Solvency ratios are a key component of the financial analysis which helps in determining
whether a company has sufficient cash flow to manage the debt obligations that are due.
Solvency ratios are also known as leverage ratios. It is believed that if a company has a
low solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and
is likely to default in debt repayment.

Types of Solvency Ratios

Solvency ratio is calculated from the components of the balance sheet and income statement
elements. Solvency ratios help in determining whether the organisation is able to repay its long
term debt. It is very important for the investors to know about this ratio as it helps in knowing
about the solvency of a company or an organisation.

Let us see in detail about the various types of solvency ratios.

1. Debt to equity ratio

Debt to equity is one of the most used debt solvency ratios. It is also represented as D/E
ratio. Debt to equity ratio is calculated by dividing a company’s total liabilities with the
shareholder’s equity. These values are obtained from the balance sheet of the company’s
financial statements.
It is represented as

Debt to equity ratio = Long term debt / shareholder’s funds

Or

Debt to equity ratio = total liabilities / shareholders’ equity

A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the
company is using debt for fuelling its growth. It also indicates lower solvency of the business.

2. Debt Ratio

Debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is
calculated by taking the total liabilities and dividing it by total capital. If the debt ratio is higher,
it represents the company is riskier.

The long-term debts include bank loans, bonds payable, notes payable etc.

Debt ratio is represented as

Debt Ratio = Long Term Debt / Capital or Debt Ratio = Long Term Debt / Net Assets

Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt
about a firm’s long-term stability. Trading on equity is possible with a higher ratio of debt to
capital which helps generate more income for the shareholders of the company.

3. Proprietary Ratio or Equity Ratio

Proprietary ratios is also known as equity ratio. It establishes a relationship between the
proprietors funds and the net assets or capital.

It is expressed as

Equity Ratio = Shareholder’s funds / Capital or Shareholder’s funds / Total Assets

4. Interest Coverage Ratio

The interest coverage ratio is used to determine whether the company is able to pay interest on
the outstanding debt obligations. It is calculated by dividing company’s EBIT (Earnings before
interest and taxes) with the interest payment due on debts for the accounting period.
It is represented as

Interest coverage ratio = EBIT / interest on long term debt

Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.

A higher coverage ratio is better for the solvency of the business while a lower coverage ratio
indicates debt burden on the business.

(C) Activity ratios

Activity ratios are used to determine the efficiency of the organisation in utilising its assets for
generating cash and revenue. It is used to check the level of investment made on an asset and the
revenue that it is generating. For this reason, the activity ratio is also known as the efficiency
ratio or the more popular turnover ratio.

The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by
careful analysis of the inventories, fixed assets and accounts receivables.

Types of Activity Ratios

1. Stock Turnover ratio or Inventory Turnover Ratio

2. Debtors Turnover ratio or Accounts Receivable Turnover Ratio
3. Creditors Turnover ratio or Accounts Payable Turnover Ratio
4. Working Capital turnover ratio.
5. Investment Turnover Ratio

The following are discussed below.

Stock Turnover Ratio

This is one of the most important turnover ratios which highlights the relationship between the
inventory or stock in the business and cost of the goods sold. It shows how fast the inventory
gets cleared in an accounting period or in other words, the number of times the inventory or the
stock gets sold or consumed. For this reason, it is also known as the inventory turnover ratio.
It is calculated by the following formula

Stock Turnover Ratio = Cost of Goods Sold / Average Inventory

Average Inventory = Opening Inventory + Closing Inventory / 2

A high stock turnover ratio is indicative of fast moving goods in a company while a low stock
turnover ratio indicates that goods are not getting sold and are being stored at warehouses for an
extended period of time.

Debtor Turnover Ratio

This ratio is an important indicator of a company which shows how well a company is able to
provide credit facilities to its customers and at the same time is also able to recover the due
amount within the payment period.

It is also known as accounts receivable turnover ratio as the payments for credit sales that will be
received in the future are known as accounts receivables.

The formula for calculating Debtor Turnover ratio is

Debtor Turnover Ratio = Credit Sales / Average Debtors

Average Debtors = Opening Balance + Closing Balance / 2

A higher ratio indicates that the credit policy of the company is sound, while a lower ratio shows
a weak credit policy.

Creditors Turnover Ratio

Creditors turnover ratio is a measure of the capability of the company to pay off the amount for
credit purchases successfully in an accounting period.

It shows the number of times the account payables are cleared by the company in an accounting
period. For this reason, it is also known as the Accounts payable turnover ratio.

The formula for calculating creditors turnover ratio is

Creditors Turnover ratio = Net Credit Purchases / Average Creditors

Average Creditors = Opening Balance + Closing Balance / 2

Where average creditors are also known as average accounts payable.

A high ratio is indicative that a company is able to finance all the credit purchases and vice
versa.

Working Capital Turnover Ratio

This ratio is helpful in determining the effectiveness with which a company is able to utilise its
working capital for generating sales of its goods.

The formula for calculating working capital turnover ratio is

Working capital turnover ratio = Sale or Costs of Goods Sold / Working Capital

Working Capital = Current Assets – Current Liabilities

If a company has a higher level of working capital it shows that the working capital of the
business is utilized properly and on the other hand, a low working capital suggests that business
has too many debtors and the inventory is unused.

Investment Turnover Ratio or Net Asset Turnover Ratio

Investment Turnover Ratio is related to the sales taking place in the business and the net assets or
the capital employed. It determines the ability of the business to generate sales revenue by the
use of net assets of the business. The ratio is calculated using the following formula

Investment Turnover Ratio = Net Sales/ Capital Employed

(D) Profitability Ratio

Profitability ratios are a type of accounting ratio that helps in determining the financial
performance of business at the end of an accounting period. Profitability ratios show how well a
company is able to make profits from its operations.

Types of Profitability Ratios

The following types of profitability ratios are discussed for the students of Class 12 Accountancy
as per the new syllabus prescribed by CBSE:

1. Gross Profit Ratio

 2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Return on Investment (ROI)
6. Return on Net Worth
7. Earnings per share
8. Book Value per share
9. Dividend Payout Ratio
10. Price Earning Ratio

Gross Profit Ratio

Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit
and net sales revenue. When it is expressed as a percentage, it is also known as the Gross Profit
Margin.

Formula for Gross Profit ratio is

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

A fluctuating gross profit ratio is indicative of inferior product or management practices.

Operating Ratio

Operating ratio is calculated to determine the cost of operation in relation to the revenue earned
from the operations.

The formula for operating ratio is as follows

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/

Net Revenue from Operations ×100

Operating Profit Ratio

Operating profit ratio is a type of profitability ratio that is used for determining the operating
profit and net revenue generated from the operations. It is expressed as a percentage.
The formula for calculating operating profit ratio is:

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Or Operating Profit Ratio = 100 – Operating ratio

Net Profit Ratio

Net profit ratio is an important profitability ratio that shows the relationship between net sales
and net profit after tax. When expressed as percentage, it is known as net profit margin.

Formula for net profit ratio is

Net Profit Ratio = Net Profit after tax ÷ Net sales

Or

Net Profit Ratio = Net profit/Revenue from Operations × 100

It helps investors in determining whether the company’s management is able to generate profit
from the sales and how well the operating costs and costs related to overhead are contained.

Return on Capital Employed (ROCE) or Return on Investment (ROI)

Return on capital employed (ROCE) or Return on Investment is a profitability ratio that

measures how well a company is able to generate profits from its capital. It is an important ratio
that is mostly used by investors while screening for companies to invest.

The formula for calculating Return on Capital Employed is :

ROCE or ROI = EBIT ÷ Capital Employed × 100

Where EBIT = Earnings before interest and taxes or Profit before interest and taxes

Capital Employed = Total Assets – Current Liabilities

Return on Net Worth

This is also known as Return on Shareholders funds and is used for determining whether the
investment done by the shareholders are able to generate profitable returns or not.
It should always be higher than the return on investment which otherwise would indicate that the
company funds are not utilised properly.

The formula for Return on Net Worth is calculated as :

Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100

Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100

Earnings Per Share (EPS)

Earnings per share or EPS is a profitability ratio that measures the extent to which a company
earns profit. It is calculated by dividing the net profit earned by outstanding shares.

The formula for calculating EPS is:

Earnings per share = Net Profit ÷ Total no. of shares outstanding

Having higher EPS translates into more profitability for the company.

Book Value Per Share

Book value per share is referred to as the equity that is available to the the common shareholders
divided by the number of outstanding shares

Equity can be calculated by:

Equity funds = Shareholders funds – Preference share capital

The formula for calculating book value per share is:

Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding Common
Shares.

Dividend Payout Ratio

Dividend payout ratio calculates the amount paid to shareholders as dividends in relation to the
amount of net income generated by the business.

It can be calculated as follows:

Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share

Price Earning Ratio

This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a
company and the earnings per share. It is very helpful for investors as they will be more
interested in knowing the profitability of the shares of the company and how much profitable it
will be in future.

P/E ratio is calculated as follows:

P/E Ratio = Market value per share ÷ Earnings per share

It shows if the company’s stock is overvalued or undervalued.

Market Capitalization

Market capitalization refers to the total dollar market value of a company's

outstanding shares of stock. The investment community uses this figure to determine a
company's size instead of sales or total asset figures. In an acquisition, the market cap is used to
determine whether a takeover candidate represents a good value or not to the acquirer.

Market Capitalization Categories

Broadly speaking, based on market capitalization, the stock market classifies stocks into various
categories:
 Large Cap – Companies with a market cap above $10 billion are classified as large-cap
stocks. Some examples would be Apple, Microsoft, IBM, Facebook, etc.
 Mid Cap – Companies whose market cap ranges from $1 billion to $10 billion. Mid-cap
stocks, in general, are more volatile than large-cap stocks and consist more of growth-
oriented stocks.
  Small Cap – Companies with a market capitalization between $250 million to $1 billion.
They are high risk and high return stocks, as the companies are in the growth stage. A
large number of companies belong to the small-cap category.
 Micro Cap – They are the penny stocks that are relatively young. The micro-cap
companies’ potential for growth and decline are of similar nature. They are not
considered to be the safest investment. Hence, they require lots of research before
investment.

Leverage Ratio Analysis

Leverage ratio is one of the most important of the financial ratios as it determines how much of
the capital that is present in the company is in the form of debts. It also analyses how the
company is able to meet its obligations.
Leverage ratio becomes more critical as it analyzes the capital structure of the company and the
way it can manage its capital structure so that it can pay off the debts.
Let us look at some of the leverage ratios that are generally used
There are two broad types of leverage ratios which are:

1. Capital Structure Ratio

2. Coverage Ratio

Capital Structure Ratio

Capital structure ratio is used to determine the financing strategy that is used so that the company
can focus on the long term solvency.

The ratios that fall under the capital structure ratio are:
i. Equity Ratio
ii. Debt Ratio
iii. Debt to equity ratio

i. Equity ratio
This is used to calculate the amount of assets that are funded by the owners investments. It shows
what portion of the assets of the company is being financed by investors and how much
leveraged a company is by using debt.
It is calculated as follows
Equity Ratio = Total Equity/ Total Assets
Or it can be calculated as
Equity Ratio = Shareholder Equity/ Total Capital Employed
A higher equity ratio shows to potential investors that existing investors have trust in the
company and are willing to invest further in the company.

ii. Debt Ratio

Debt ratio is a type of financial ratio that is useful in calculating the extent of financial leverage a
firm is utilising. It is represented in percentage and is very useful in understanding the proportion
of assets which are financed by debt.
The formula for calculating debt ratio is
Debt Ratio = Total Debt / Total Assets
Where total debt = Short Term and Long Term Borrowings, Debentures and Bonds
A higher debt ratio is usually an indicator of high financial risk but many firms use high debts to
generate more business. If the profit earned from using the debt is more than the interest needed
for repaying the debt, it is said to be profitable for the business.

iii. Debt to Equity Ratio

This ratio calculates the proportion of debt and equity that a company uses for funding the
operations of the business. It is an important financial ratio that shows how a company is funding
its operations.
It is calculated by the following formula
Debt to equity ratio = Total Debt/ Shareholders Fund
Or
Debt to equity ratio = Total Liabilities / Total Shareholders equity.
D/E ratio or Debt to equity ratio is different for different kinds of industries. It is more in
companies requiring high amounts of debt.

Coverage Ratios
Coverage ratios determine the ability of a company to meet its debt obligations which include
interest payments or dividends. A higher coverage ratio makes it easier for a business to pay off
the dividends and interest payments.

Let us discuss the types of coverage ratios here

i. Debt Service Coverage Ratio
ii. Interest coverage ratio
iii. Capital gearing ratio

i. Debt service coverage ratio or DSCR

Debt service coverage ratio is used in corporate finance to determine the cash flow available to
business which can be used for clearing off the current debt obligations which are in the form of
interest payments or dividends or sinking funds etc.
It is calculated by the following formula
Debt service coverage ratio = Net Operating Income / Total Debt Service
Where Total Debt service is the current debt obligations that a company owes.
A ratio of 1.5 to 2 is regarded as an idea ratio for a company while a value which is less than 1 is
indicative of a negative cash flow which makes a company more vulnerable to being unable to
clear current debt obligations.

ii. Interest Coverage Ratio

Interest coverage ratio is a financial ratio that is used by investors to determine how easily a
company is able to clear off the interest. It is calculated by dividing a company’s EBIT which
refers to Earnings before Interest and Taxes by interest payments that are due in the current
accounting period.
It is shown as
Interest Coverage Ratio = EBIT / Interest Due
It is a margin of safety that a company should have for paying its debts within the given
accounting period.

iii. Capital Gearing Ratio

Capital gearing ratio is a critical ratio that helps in evaluating the financial health of the
company. This ratio calculates the capital structure of the company and analyses the proportion
of debts and equity. Debt is a low cost option but will put more burden as a liability in the
financial statements of the company.
Capital gearing ratio ratio measures the impact that debt has on the company’s capital structure.
It can be calculated by the following formula
Capital gearing ratio = Common stockholders equity / Fixed cost bearing funds
 Unit – 5

Common Size Statement

Common size statement is a form of analysis and interpretation of the financial statement. It is
also known as vertical analysis. This method analyses financial statements by taking into
consideration each of the line items as a percentage of the base amount for that particular
accounting period.

Types of Common Size Statements

There are two types of common size statements:

1. Common size income statement

2. Common size balance sheet

1. Common Size Income Statement

This is one type of common size statement where the sales is taken as the base for all
calculations. Therefore, the calculation of each line item will take into account the sales as a
base, and each item will be expressed as a percentage of the sales.

Use of Common Size Income Statement

It helps the business owner in understanding the following points

1. Whether profits are showing an increase or decrease in relation to the sales obtained.
2. Percentage change in cost of goods that were sold during the accounting period.
3. Variation that might have occurred in expense.
4. If the increase in retained earnings is in proportion to the increase in profit of the
business.
5. Helps to compare income statements of two or more periods.
6. Recognises the changes happening in the financial statements of the organisation, which
will help investors in making decisions about investing in the business.

Objectives of Common Size Income Statement

Different objectives of a Common-size Income Statement are as follows:

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. 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):

2. Common Size Balance Sheet:

A common size balance sheet is a statement in which balance sheet items are being calculated as
the ratio of each asset in relation to the total assets. For the liabilities, each liability is being
calculated as a ratio of the total liabilities.

Common size balance sheets can be used for comparing companies that differ in size. The
comparison of such figures for the different periods is not found to be that useful because the
total figures seem to be affected by a number of factors.

Standard values for various assets cannot be established by this method as the trends of the
figures cannot be studied and may not give proper results.

Objectives of Common Size Balance Sheet

Different objectives of a Common-size Balance Sheet are as follows:

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.
Format of Common Size Balance Sheet
Comparative Statement
Financial Statements are prepared to know the profitability and financial position of the
business in the market. The content of a financial statement does not reveal the earning
capacity, financial soundness, and liquidity of a company. The users cannot easily understand
them; therefore, the data is analysed for presenting it in a simple and understandable form.
Different tools used for the analysis of financial statements are Comparative Statements,
Common Size Statements, Trend Analysis/Ratios, Accounting Ratios/Ratio Analysis, Cash
Flow Statement, Funds Flow Statement, and Break-Even Point Analysis.

Comparative Analysis is the study of the trend of same items, groups of items, compound items
in two or more financial statements of the same business enterprise of different dates.
– Ray. A. Foulke

Purpose or Importance of Comparative Statements:

The importance of Comparative Statements are as follows:
1. To make the data simpler and more understandable: The main aim behind the
preparation of Comparative Financial Statements is to put the data for a number of years in a
simple and comparable form. When the data for a number of years are put side by side, the
comparison between their figures becomes easier. Besides, one can also easily draw
conclusions regarding the operating results and financial health of the company/companies.
2. To indicate the strong points and weak points of the concern: By making a comparison
between the financial statements for a number of years, one can also indicate the strong and
weak points of the firm. With these strong and weak points, the management of the firm can
then investigate and find out the reasons for its weak points and can take corrective measures.
3. To indicate the trend: The Comparative Financial Statements of a company indicate its
trend of change by putting the figures of revenue from operations, production, expenses,
profits, etc., for a number of years, side-by-side. For example, If the Cost of Production is
increasing over the years along with an increase in its expenses, it indicates that the business is
not in good condition and needs to perform some corrective measures.
4. To compare the firm’s performance with the average performance of the
industry: With the help of Comparative Financial Statements, a business unit can compare its
performance with the average performance of the industry.
5. To help in forecasting: By performing a comparative study of the changes in the key
figures of a company over a period can help its management in forecasting the profitability and
financial soundness of the business.
6. To make data comparable: When an organisation is preparing comparative financial
statements, it should put the data in a comparable form, as it will facilitate comparison and will
help the company in drawing conclusions regarding its operating and financial performance.
7. To indicate the soundness of an enterprise: The Comparative Financial Statements of a
Company also indicate its weakness and soundness about its liquidity, profitability, and
solvency position over a period of time.

Forms or Techniques of Presenting Financial Statements:

The techniques of presenting Financial Statements are as follows:
1. To show the absolute data in Rupee amount only: One way to present the Financial
Statements of a company is by showing only rupee amounts for various periods. For
example, the Revenue from Operations of Tanya Ltd. in 2020 and 2021 are ₹4,00,000 and
₹6,00,000, respectively.
2. To show the increases and decreases in absolute data in terms of money value: For
example, in comparison to 2020, revenue from operations of Tanya Ltd. in 2021 increased by
₹2,00,000.
3. To show the increases and decreases in absolute data in terms of percentages: For
example, in comparison to 2020, revenue from operations of Tanya Ltd. in 2021 increased by
50%.
4. Comparisons expressed in ratios: Sometimes, an extra column is added in the
Comparative Financial Statements, which shows the changes over the years in terms of ratio.
To determine the ratio, the data of the current year is divided by the data of the previous year.
If the ratio is more than 1, it indicates an increase in the current year as compared to the
previous year. However, if the ratio is less than 1, it indicates a decrease in the current year as
compared to the previous year. For example, If the Revenue from Operations of Tanya Ltd. in
2020 and 2021 are ₹4,00,000 and ₹6,00,000, respectively, then the ratio will be
6,00,000/4,00,000 = 3:2 or 1.5.
5. Use of cumulative figures and averages: For example, Revenue from operation of Tanya
Ltd. in 2018, 2019, 2020, and 2021 are ₹2,50,000; ₹3,00,000; ₹4,00,000; and ₹6,00,000,
respectively, then average revenue from operations will be 15,50,000/4 = ₹3,87,500. Now the
average figure of revenue from operations will be used for making a comparison between the
individual figures of revenue from operations of each year and then deviations are calculated.

Comparative Balance Sheet

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.
Comparative Balance Sheet analysis is the study of the trend of the same items, group of
items, and computed items in two or more Balance Sheets of the same business enterprise on
different dates.
-Foulka
Objectives of Comparative Balance Sheet:
Different objectives of a comparative balance sheet are as follows:
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.

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.
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.

Preparation of 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.
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:
*Schedule III of the Companies Act 2013, is amended. And according to this, “Property,
Plant and Equipment, and Intangible Assets” is used in place of Fixed Assets, and “Property,
Plant and Equipment” is used in place of Tangible Assets.
Notes:
1. 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.
2. Accounting treatment or entries related to items like Money received against Share
Warrants, Application Money Pending Allotment, Deferred Tax Assets, etc., will not be asked
in the examination.

Comparative Income Statement

A Statement of Profit & Loss or Income Statement shows the profit earned or loss incurred by
an organisation during the year. However, a Comparative Income Statement or Comparative
Statement of Profit & Loss is a horizontal analysis of the Income Statement showing operating
results for more than one accounting year. In simple terms, it shows the absolute change and
percentage change in the figures from one period to another.

Objectives of Comparative Income Statement (Statement of Profit & Loss)

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.
Advantages of Comparative Income Statement (Statement of Profit & Loss)
The advantages of Comparative Balance sheet are as follows:
1. Comparative Balance sheet helps to identify the increase and decrease in sales.
2. Comparative Balance sheet helps to identify the increase or decrease in the cost of goods
sold.
3. Comparative Balance sheet helps to identify the increase or decrease in gross profit.
4. Comparative Balance sheet helps to identify the increase or decrease in operating profit.
5. Comparative Balance sheet helps to identify the increase or decrease in operating expenses.
6. Comparative Balance sheet helps to identify the increase or decrease in non-operating
incomes or expenses.
7. Comparative Balance sheet helps to identify the increase or decrease in net profit.
Preparation of Comparative Income Statement (Statement of Profit & Loss)

A Comparative Income Statement has the following six columns:

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 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:
Format of Comparative Income Statement (Statement of Profit & Loss):

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.

Financial Analysis

Financial Analysis can be defined as evaluating the critical financial information in the
financial statements in order to understand the operations of a firm and make decisions
regarding it. It is basically the analysis of various facts and figures in a financial statement and
interprets it so as to increase business profits.
In other words, it means establishing relationships between various items of a financial
statement and gaining useful insights. Once the data is interpreted, it can be used to find the
strengths and weaknesses of a firm and work on the areas that need improvement.
Need for Financial Analysis:

Financial analysis is needed for various purposes and is very important for any organisation.
Financial Analysis is needed to:
1. Measure the profitability and earning potential of a business: It helps to check whether
the profits earned are up to the expectations or not. After analysing the financial statements, the
trend of profit can be ascertained, and earning potential of the company can be checked.
2. Measure the financial strength of the business: It helps to understand how strong a
business is financially and judge its position in the market.
3. Comparative study: Financial Analysis is helpful to compare the position of two firms in
the market or compare the growth of a firm. The comparison can be further of 2 types:
 Intra-Firm: It is the comparison of the firm’s profits for the current year and the
previous year, and may also be known as Trend Analysis.
 Inter-Firm: It is also termed Cross-Sectional Analysis, and is the comparison of one
company to the other in the market.
4. Efficiency of management: The trend of the profits and losses of a business allows us to
judge if the business is being managed efficiently or not, which means that the resources of a
business are being utilised effectively or not.
5. Useful to the management: An insight into the business helps the management to make
very important decisions about the business.
6. Analyse the short-term and long-term solvency: It also helps to analyse whether a
business will be able to clear its short-term and long-term debts or not.
7. Reasons for deviation: To identify the reasons for any change in the profitability/financial
position of the firm.

Types of Financial Analysis:

Financial Analysis of 4 types:

1. External Analysis: This type of analysis is carried out by investors, stakeholders,
researchers, etc., who rely upon the information published in various reports, such as Statement
of Profit and Loss, Balance Sheet, etc., as they do not have access to the internal and
confidential business information.
2. Internal Analysis: As compared to external analysis, this type of analysis is performed by
the internal management who have complete access to the confidential business information
and can perform an extensive analysis to get detailed and accurate information.
3. Horizontal Analysis: In this type of analysis, the financial statements of several years are
compared with each other in order to understand the profitability of the business and its
growth. It is also termed Dynamic analysis or Time series analysis.
4. Vertical Analysis: Analysis of the financial statement of a single year is known as Vertical
analysis or Static analysis or Cross-Sectional analysis. It involves the study of the relationship
between various items of Statement of Profit and Loss, balance sheet, etc., in a single financial
year.
Limitations of Financial Analysis:

Though financial analysis is of great importance to an organisation, it still has various

limitations, which are as follows:
1. Current changes in the prices in the economy are not taken into consideration in the financial
statement analysis.
2. Since the analysis is done by humans, it is prone to personal bias, and may lead to conflicts
between the interpretation of the data by various experts.
3. Financial analysis is quantitative in nature and can only analyse those aspects that are related
to money, and fails to analyse the non-monetary aspects.
4. Different firms may use different accounting policies, and it may not be possible to compare
the two businesses in terms of financial analysis due to this.

Difference between Horizontal and Vertical Analysis:

Horizontal Analysis Vertical Analysis

In this, financial statements of several years In this, various aspects of the financial
are compared against the financial statement statement of a single year or current year are
of a base year. analysed or compared.

Same items of different years are compared. Different items of the same year are compared.

It is also called Time Series Analysis or It is also called Static Analysis or Cross-
Dynamic Analysis. Sectional analysis.

It compares a company’s financial status over It compares the financial status of a company
a period of time. to the other in the same financial year.

Uses of Financial Analysis:

1. Security analysis: Securities are defined as tradeable financial instruments used by

corporations to raise funds. These include shares, debentures, bonds, derivatives, hybrids, etc.
Security analysis deals with the determination of the exact value of these securities for the
corporation, as well as the costs to the company in raising funds from these securities.
Financial analysis helps in ascertaining all such values by way of comprehensive scrutiny of all
transactions related to securities, like the floating costs, brokerage, dividend and interest
percentages, etc.
2. Credit analysis: Credit analysis is used by the lenders of an organisation to determine the
level of security of their lending. In other words, credit analysis is used to check whether the
firm would be able to repay its debts or go bankrupt in the near future. It is done using
solvency ratio analysis such as debt-equity ratio, proprietary ratio, etc.
3. Debt analysis: Debt analysis is the calculation of the proportion of debt to the assets owned
by an organisation. It is used to determine if the given assets would be sufficient in order to
repay the debt taken. Ratio analysis is the most commonly used parameter for debt analysis.
Matrices like solvency ratios are employed to compute the proportion of assets to debt and
interpreted accordingly.

Importance of Financial Analysis:

1. Assessing the Financial Performance and Position: Financial data does not make any
meaningful contribution unless it is analysed. Financial performance over the years can be
analysed with the help of comparative statements of profit and loss, wherein the revenues and
expenses of the current year and previous year are recorded side-by-side to calculate the
percentage shift between the two. Similarly, the financial position is analysed using
comparative balance sheets.
2. Operational Efficiency: Financial analysis consists of ratio analysis and other techniques
used to study the financial statements of a business and to draw conclusions thereof. Ratio
analysis, especially the activity ratios help to determine the operational efficiency of the
business. Operational efficiency can be judged with the help of inventory turnover ratio,
working capital turnover ratio, operating ratio, operating profit ratio, etc.
3. Indicating Growth Trends: Comparative statements of profit and loss and balance sheets
are used to reflect the percentage changes in the facts and figures recorded in those statements.
This helps the users of financial statements judge how the organisation has grown or faced
losses over the years. Moreover, ratio analysis such as net profit ratio, return on investment,
etc., also facilitates disclosing the growth pattern over the years.
4. Trend Forecasting: This method examines patterns in the operating efficiency and financial
standing of the company over a long period of time. In this study, a single year is used as the
base year, with the remaining years’ results given as a percentage of the base year. Along with
determining the firm’s operational effectiveness and financial status, it aids in problem
identification and inefficiency detection.
5. Facilitates Comparison: Another important advantage of financial analysis is that it
facilitates comparison both inter and intra-firm. Inter-firm comparison means comparing two
or more business units that are similar in nature in order to derive a competitive position to
facilitate improvement in performance and productivity, ultimately improving profitability.
Intra-firm comparison means comparison among different units or products of the same
business with the purpose of competitive and meaningful analysis to improve the efficiency of
all departments in the business.
6. Provides Information to Stakeholders: Financial data does not make any meaningful
contribution unless it is analysed. The figures recorded in financial statements only provide
useful info when compared with other years’ figures and are analysed and interpreted
thereafter to communicate the results to the users of such information. Without financial
 analysis techniques, numbers are just numbers. They are studied and scrutinized to make the
results comprehensible and comparable.

Limitations of Financial Analysis:

Since financial analysis relies entirely upon the data recorded in the financial statements, it
suffers from the limitations inherent in financial statements. These are:
1. Financial analysis ignores price level changes since it is based on the historical cost concept
of accounting.
2. Qualitative aspects, such as the quality of employees and management, etc., are overlooked
since financial statements only keep records of quantitative aspects of the transactions.
3. Financial statements often involve personal bias, judgments, and prejudices of the
accountant. Hence, the results of the analysis of such biased statements are not fair.

Trend Analysis

Trend analysis is an analysis of the trend of the company by comparing its financial statements
to analyze the trend of the market or analysis of the future based on past performance results,
and it’s an attempt to make the best decisions based on the results of the analysis done.

 Trend analysis helps companies make informed decisions by comparing financial

statements to understand market trends and predict future performance.
 There are three types of trends: uptrend, downtrend, and sideways/horizontal trend.
 This tool serves the purpose of accounting and technical analysis for traders. It enables
them to earn profits by observing market trends. However, to make the most of it, traders must
pay attention to detail and understand the market well. Additionally, it can assist in projecting
future financial statements.

Types
1 – Uptrend

An uptrend or bull market is when financial markets and assets – as with the broader economy-
level – move upward and keep increasing prices of the stock or the assets or even the size of the
economy over the period. It is a booming time where jobs get created, the economy moves into a
positive market, sentiments in the markets are favorable, and the investment cycle has started.

2 – Downtrend

Companies shut down their operation or shrank the production due to a slump in sales. A
downtrend or bear market in a stock market trend analysis is when financial markets and asset
prices – as with the broader economy-level – move downward, and prices of the stock or the
assets or even the size of the economy keep decreasing over time. Jobs are lost, asset prices start
declining, sentiment in the market is not favorable for further investment, and investors run for
the haven of the investment.

3 – Sideways / horizontal Trend

A sideways/horizontal trend means asset prices or share prices – as with the broader economy
level – are not moving in any direction; they are moving sideways, up for some time, then down
for some time. The direction of the trend cannot be decided. It is the trend where investors are
worried about their investment, and the government is trying to push the economy in an uptrend.

Uses

It is used by both – Accounting analysis and technical analysis.

#1 – Use in Accounting

Sales and cost information of the organization’s profit and loss statement can be arranged on a
horizontal line for multiple periods and examine trends and data inconsistencies. For instance,
take the example of a sudden spike in the expenses in a particular quarter followed by a sharp
decline in the next period, which is an indicator of expenses booked twice in the first quarter.
Thus, the trend analysis in accounting is essential for examining the financial statements for
inaccuracies to see whether certain heads should be adjusted before the conclusion is drawn from
the financial statements.

2 – Use in Technical Analysis

An investor can create his trend line from the historical stock prices in case of stock
market trend analysis, and he can use this information to predict the future movement of the
stock price. The trend can be associated with the given information. Cause and effect
relationships must be studied before concluding the trend analysis.
 Trend analysis also involves finding patterns occurring over time, like a cup and handle
pattern, head and shoulder pattern, or reverse head and shoulder pattern.
 It can be used in the foreign exchange market, stock market, or derivative market in
technical analysis. With slight changes, the same analysis can be used in all markets.

Benefits

 The trend is the best friend of the traders is a well-known quote in the market. Trend
analysis tries to find a trend like a bull market run and profit from that trend unless and until
data shows a trend reversal can happen, such as a bull to bear market. It is most helpful for the
traders because moving with trends and not going against them will make a profit for an investor.
 Trends can be both growing and decreasing, relating to bearish and bullish market.
 A trend is nothing but the general direction the market is heading during a specific
period. There are no criteria to decide how much time is required to determine the trend;
generally, the longer the direction, the more is reliably considered. Based on the experience and
some empirical analysis, some indicators are designed, and standard time is kept for such
indicators like 14 days moving average, 50 days moving average, and 200 days moving average.
 While no specified minimum amount of time is required for a direction to be considered a
trend, the longer the direction is maintained, the more notable the trend.

Limitations

Some limitations of the method are as follows:

 It assumes that the trends identified from the historical data will continue in future, which
may not be the real case. Trends keep changing in every field.
 The data used may not be authentic or reliable enough to interpret correctly. The quality
issues lead to incorrect conclusion and decision making.
 In case of trend analysis in accounting or any other field predictions are limited to a
particular extent. If there are some unforeseen contingencies, the predictions will be useless.
 The analysis just provides some conclusion based in numerical form. It does not provide
the reason of the particular trend which may be on the upside or downside. To understand the
reason, further analysis is needed.
 Trends are not always in a linear form. It may have a seasonal pattern or cyclical pattern,
which is again difficult to interpret and analyse.
 There is always a risk of biasness in the trend analysis methods. Analysts may
sometimes interpret the data based on their own assumptions or expectations.

Trend Analysis Vs Ratio Analysis

Let us look at the differences between the two above financial and statistical concepts in detail.
 The former focuses on identifying and analysing historical patterns in data and
understand the changes. But the latter focusses on establishing the relation between different
variables.
 The trend analysis methods use data for deriving conclusion regarding changes in
revenue, sales etc, but the latter uses data for calculating ratios.
 The main purpose of the former is the analyses the trend to understand the improvement
or downfall of a situation but the latter helps in evaluation of the financial health of business or
economy.
 There is the use of charts or graphs in the former, but this is not the case for the latter.
 The former predicts the future and provides insight into future developments but the latter
provides information and analysis for the present or a particular point of time.

Human Resource Accounting

Human resources accounting is the process of identifying and measuring your organisation’s
Human Resources (HR) budget. The term can be slightly misleading, as it implies that HR
spending is something to be tracked and analysed like financial or operational expenses.
Human Resource Accounting is a broad term that refers to collecting, analysing, and reporting
data about employee benefits, compensation practices, and benefits in general.

HRA involves quantifying the value of human resources in financial terms, which can be used
to make informed decisions regarding investments in the workforce, talent retention, and talent
development. It recognizes that the value of human resources is not only based on the cost of
hiring and training but also their knowledge, skills, abilities, and experience. These intangible
assets of human resources are often the key factors that contribute to an organization’s success.
HRA involves a systematic approach to measure the value of human resources, which includes
identifying the relevant costs and benefits associated with human resources, estimating the
value of human resources, and presenting this information in a way that can be used to make
informed decisions.
Features of Human Resource Accounting(HRA)

The features of Human Resource Accounting (HRA) are as follows:

 Valuing human resources: HRA involves identifying and quantifying the value of the
knowledge, skills, and experience of an organization’s employees. This can be done using a
variety of methods, such as estimating the cost of replacing employees or calculating the
economic value of their contributions.
 Tracking costs: HRA involves tracking the costs associated with managing human
resources, such as recruiting, training, and compensation expenses. This can help
organizations to identify areas where they can reduce costs and improve efficiency.
 Investment analysis: HRA can be used to analyze the return on investment of human
resource management practices, such as training and development programs. This can help
organizations to determine the effectiveness of these practices and to make decisions about
where to allocate resources.
 Decision-making: HRA can provide valuable information to support decision-making
about human resource management practices, such as determining the optimal level of
staffing, identifying areas for improvement in employee performance, and assessing the
impact of changes in compensation and benefits.
 Reporting: HRA involves creating reports that summarize the value of human
resources and the costs associated with managing them. These reports can be used to
inform decision-making by managers and executives.
 Performance evaluation: HRA can be used to evaluate the performance of employees
and to determine the impact of human resource management practices on employee
productivity and performance. This can help organizations to identify areas where they can
improve employee performance and develop strategies to enhance productivity.
 Strategic planning: HRA can be used to support strategic planning by providing
information about the organization’s human resource capabilities and constraints. This can
help organizations to identify potential gaps in their human resource capacity and to
develop strategies to address these gaps.
 Risk management: HRA can be used to identify potential risks associated with human
resource management practices, such as high turnover rates or a lack of skilled workers.
This can help organizations to develop strategies to mitigate these risks and ensure the
availability of the necessary human resources to achieve organizational goals.

Objectives of Human Resource Accounting(HRA)

The main objectives of human resource accounting (HRA) are as follows:

 To assign a monetary value to an organization’s human resources: It helps
organizations estimate the value of their human resources by quantifying the cost of
recruiting, training and retaining employees, as well as the economic value of their skills,
knowledge, and experience. This information can help organizations to better allocate
resources and to make informed decisions about HR investments.
 To track the costs associated with managing human resources: It can help
organizations track the costs associated with managing their human resources, such as
 recruitment costs, training expenses, and salaries and benefits. By analyzing this
information, organizations can identify areas where they can reduce costs and increase
efficiency.
 To evaluate the effectiveness of human resource management practices: HRA
provides a framework for evaluating the effectiveness of HR practices such as training and
development programs, employee retention strategies, and compensation and benefits
policies. By analyzing HR data, organizations can identify areas where they can improve
their HR practices and better support employee productivity and performance.
 To support decision-making: HRA provides valuable information to support decision-
making about HR management practices, such as determining the optimal level of staffing,
identifying areas for improvement in employee performance, and assessing the impact of
changes in compensation and benefits.
 To comply with legal and regulatory requirements: HRA can help organizations to
comply with legal and regulatory requirements related to HR management, such as equal
employment opportunity regulations, minimum wage laws, and workplace safety
regulations. By tracking and reporting on compliance-related data, HRA can help
organizations to avoid penalties and legal disputes.

Process of Human Resource Accounting

Advantages of Human Resource Accounting

o Better human resources planning - Through HRA, organizations can plan their human
resources in a better way. This helps to provide maximum results. Human resource
accounting helps record every detail about the employees through all these records, the
organization can provide more and better working conditions. Also, training as per the
requirement of the employee is provided.
 o Proper utilization of human resources - When the organization is fully aware of the
cost and value of the employees and their contribution towards achieving the
organization's goal, then the organization can make better decisions in utilizing the
human resources in a better way as and when it is needed.
o Increases employee motivation - One of the advantages of Human Resource
accounting is that it recognizes the value of the employee's contribution. Then the
company compensates them accordingly. So when the organization values the employees,
they feel motivated to work much more effectively.
o Designs training and development programmes - Human resource accounting records
the value of the employees. It also records the strengths and weaknesses. As the
organization is fully aware of the strengths and weaknesses of the employee, it will be
able to develop proper training modules. These development programs are for the
employees to improve their contribution towards the organization.
o Formulates better personal policies - Another advantage of Human Resource
accounting is that it helps in formulating better personal policies for the company.
According to the data available from HRA, the organization's management can formulate
personal policies like promotion, transfer, favourable working conditions and improving
the job satisfaction level of the employees.
o Attracts the best human resources - Through the implementation of Human Resource
Accounting in an organization, the goodwill, the image of the company improves among
the competitors. Also, the benefits provided by human resource accounting will attract
many more talented and Competent employees to be part of the organization. Through
this process, human resource accounting helps attract and retain the organization's best
and most skilled employees.
o Communicate information to investors - The employees' skills, knowledge and
productivity are communicated through the information provided by human resource
accounting. This information reveals that the employees are competent and working in a
productive manner to achieve the organization's goals. So the profitability and
productivity of the employees will lead to the future growth of the business, which can be
determined by the investors so that the investors can make better and more informed
investment decisions in the company.
o Improve financial reporting - Another advantage of Human Resource accounting is that
it helps and provides more accurate and reliable information about the value of the human
capital of the organization. This helps in depicting an accurate and fair view of the
organization's financial statements, which ultimately helps the investors and the
stakeholders after the company to make better investing decisions.

Disadvantages of Human Resource Accounting

o No clear-cut guidelines - It is not easy to value the organization's human resources

because human behaviours are uncertain and cannot be predicted. Like any other physical
assets, the organization's human resources cannot be owned, retained and used as per the
organization's requirements. In many cases, employees may leave the organization after
 getting valued. So it isn't easy to set proper guidelines to value the organization's human
resources.
o Cost - One of the disadvantages of human resource accounting is that sometimes it
might be costly for the organization. Implementing HRA requires a lot of resources to
develop and maintain the process. Maintaining HRA might not be possible for small and
medium-sized organizations.
o Continuous process - Human resource accounting is a continuous process. It needs the
data to be updated continuously. If the data recorded in Human Resource accounting is
not updated, it will not provide the correct information about the organization. Ultimately
the organization's financial statements will need to show the proper value of the
organization's human capital.
o Complexity - Implementing human resource accounting is a very complex process. It
requires specialized knowledge and skills to record the data correctly. In many cases, the
organization must hire external consultants to complete the work.
o Absence of standardized procedure - To value the organization's human resources,
there is no standardized procedure. In most cases, the procedures are different from
organization to organization. But for this particular reason, the procedures of valuing
human capital do not maintain uniformity. And also, in many cases, human resource
accounting needs wider acceptance.
o Dehumanize human resources - Sometimes, value in the organization's human capital is
regarded as dehumanization because valuing the human resources as the organization's
assets that are used for a completing the organization's goals might be manipulated. On
the other hand, a person who gets low values might be demotivated and jealous because
of the differences.
o No evidence - As human resource accounting is an emerging concept. It still needs
proper evidence to prove its utility.
o The idea may not be accepted - Due to different valuations of different employees, the
group system might emerge, and employees who are low-valued may feel discouraged.
There also exist the chances of non-acceptance of ideas by trade unions and employees.
o Legal issues - The valuation of different employees might create certain kinds of legal
issues. Issues relating to discrimination, confidentiality and relating to privacy of the
valuation process.
o Subjectivity - Evaluation of employees in the organization is done on the basis of the
skills, knowledge and experience that are provided by the employee. Many a times it is
difficult to value all human resources accurately. On the other hand, the valuation process
might be influenced by the personal biases and opinions of the evaluator.

Forensic Accounting

Forensic accounting is a type of accounting where you investigate financial information for
potential evidence of crimes. Forensic accountants use accounting, auditing, and investigative
skills to understand whether a person or company has committed financial misconduct, such as
embezzlement or fraud.

Forensic accounting is the area of accounting practice wherein the accounts are examined by
independent accounts with the prenotion objective of determining financial misconduct and
reporting fraud. It is usually conducted by an independent accounting and auditing firms
appointed by regulators, the management, or sometimes the government agencies to check
alleged wrongdoing in the financial accounting system of the organisation under scrutiny of
misconduct.

Application for Forensic Accounting

There is different dimensions of businesses where the concept of forensic accounting is used to
detect financial frauds and misreporting. Following are a few dimensions -

Business Fraud
Business fraud includes misappropriation of assets, laundering of money, and other forms of
fraud. Using analytical and investigating skills, accounts uncover business frauds through the
application of forensic accounting.

Tax Fraud
Businesses usually understate their profits or falsify their financial statements to evade taxes.
Forensic accounts use their skills to catch tax evasion.

Securities Frauds
Financial industry participants are usually rushed to make short-term money. This causes them to
enter into risky ventures and sometimes commit wire fraud to gain insight into stock moves.
Regulators often appoint forensic accountants to look into such matters.

Insurance Claims
Forensic accountants analysis of the economic damages in accidents and medical negligence
cases for the claims lodged. They review the insurance policies and coverage issues and calculate
the potential damages that could have been made if irregularities did not exist. They also
investigate property losses, business losses, and claims in lawsuits.

Money Laundering
Regulators often appoint forensic accountants to look into money laundering matters. Forensic
auditors unfold any possible disputes and linkages into such matters through their investigative
skills. The same could be seen in the case when the government appointed appointed Forensic
accountants to look into the matter of the Satyam Computer Services scandal .

Best Forensic Accounting Firms

Often big independent audit firms have also deep roots in forensic accounting due to their long
expertise and experience in financial matters. As per the Firsthand report in 2022, some of the
best forensic accounting firms in India and overseas are -

 PWC LLP (PricewaterhouseCoopers)

 Deloitte
 Ernst & Young LLP (EY)
 KPMG LLP
 Grant Thornton LLP

Issues in Forensic Accounting

Forensic accounts face the following challenges in carrying out their work -

 Forensic procedures require a lot of analytical and investigative skills

 Investigations may potentially leak confidential documents
 Even mere speculation of an alleged felony generates unwanted negative publicity around
the company
 Depending on the scope of forensic accounting, it may become costly to conduct a
forensic audit into the fraudulent reporting
 Even after proving suspects not guilty, employees remain suspicious.

What Does a Forensic Accountant Do?

Forensic accountants work on a range of activities to investigate financial crime, from analyzing
documents to actually speaking in court. If you’re looking for a career path in finance that also
requires work in the legal sector, forensic accounting might be the right career path for you.

Some everyday responsibilities of a forensic accountant include:

 Statement review: reviewing financial statements for inconsistencies or signs of fraud

 Document review: examining financial documents, contracts, invoices, and bank records
for investigations
 Fraud detection: identifying fraud activities like embezzlement or money laundering
 Asset tracing: tracing assets to determine who and where they came from and whether
they were involved in illegal activity
 Data analysis: applying data analysis to look at large amounts of financial data and
spotting any anomalies that might indicate misconduct
 Interviewing: speaking with individuals involved in a case to gather statements
 Expert witness testimony: presenting expert testimony in legal proceedings, usually
explaining complex financial concepts
  Due diligence: conducting financial due diligence to assess financial health of a business,
investment, or individual
 Litigation support: helping legal teams prepare for trial by providing financial expertise

Types of Forensic Accounting

There are various types of forensic auditing that can take place, and they are typically grouped
by the types of legal proceedings that they fall under. Below are some of the most common
examples:

 Financial theft (customers, employees, or outsiders)

 Securities fraud
 Bankruptcy
 Defaulting on debt
 Economic damages (various types of lawsuits to recover damages)
 M&A related lawsuits
 Tax evasion or fraud
 Corporate valuation disputes
 Professional negligence claims
 Money laundering
 Privacy information
 Divorce proceedings
 Process of forensic accounting

Differences Between Audit and Forensic Accounting

Auditing and forensic accounting are two entirely different streams—the terms cannot be used
interchangeably. The significant differences are as follows:

Basis Auditing Forensic Accounting

It checks books of accounts It analyzes the financial documents to

compliance with Generally detect illegal activity within an
Purpose
Accepted Accounting Principles organization, specifically white-collar
(GAAP). crime.

Error identification and

Objective Detecting frauds and felonies.
prevention.
Basis Auditing Forensic Accounting

A predefined and systematic

The Investigative process looks for
Process process of reviewing accounts as
outliers and specific patterns.
per GAAP.

Auditors analyze the financial Forensic Accountants scrutinize every

Investigation
transaction samples. detail.

Litigation The investigation is documented and

No
Perspective presented in a court of law.

Requires skills beyond accounting—

Skills Set Requires accounting knowledge. criminalistics, advanced data analytics,
information technology, and law.

Regular—companies are
Uncommon—done only when
Frequency mandated by law to appoint an
suspected of fraud.
auditor.

Carried Out Certified Public Accountant Professional team of experts, including

By (CPA) CPAs.

Directors, owners, third parties, and

Appointed By Company shareholders
counsels.

Accounting for corporate social responsibility

Corporate social responsibility (CSR) is a self-regulating business model that helps a company
be socially accountable to itself, its stakeholders, and the public. By practicing corporate social
responsibility, also called corporate citizenship, companies can be conscious of the kind of
impact they are having on all aspects of society, including economic, social, and environmental.
 Corporate social responsibility is a business model by which companies make a
concerted effort to operate in ways that enhance rather than degrade society and the
environment.
  CSR can help improve various aspects of society as well as promote a positive brand
image for companies.
 Corporate responsibility programs can also raise morale in the workplace.
 CSR is often broken into four categories: environmental impacts, ethical responsibility,
philanthropic endeavors, and financial responsibilities.

Which company need to constitute a Corporate Social Responsibility Committee

If a company satisfied any of the following condition during any financial year shall constitute a
Corporate Social Responsibility Committee of the Board consisting of three or more directors,
out of which at least one director shall be an independent director.

The conditions are as follows:

 net worth of Rs500crore or more,

 turnover of Rs1000crore or more
 net profit of Rs5crore or more
Minimum amount of expenditure on Corporate Social Responsibility

The board shall ensure that the company spends, in every financial year at least 2% of the
average net profits of the company made during the three immediately preceding financial years,
in pursuance of its corporate social responsibility policy.

What activities should be included by companies in their Corporate Social Responsibility?

 Encouraging education under poor sections of society

 Promoting gender equality
 Promoting women empowerment
 Eradicating extreme hunger and poverty
 Reducing child mortality and improving maternal health
 Combating human immunodeficiency virus, acquired immune deficiency syndrome,
malaria and other diseases
 Ensuring environmental sustainability
 Employment enhancing vocational skills
 Social business projects
 Contribution to Prime Minister’s National Relief Fund
Accounting treatment of Corporate Social Responsibility expenditure

Schedule VII to the company’s bill, 2013 specifies a list of CSR activities. The accounting of
CSR activities will be done as under:

 In case a contribution is made to a fund specified in Schedule VII to the Act, the same
would be treated as an expense for the year and charged to the statement of profit and loss.
 In case the company incurs any expenditure on any of the activities as per schedule VII
on its own, the company needs to analyse the nature of the expenditure keeping in mind the
“Framework for Preparation and Presentation of Financial Statements issued by ICAI.
 In case the company incurs any expenditure on any of the activities as per schedule VII is
of revenue nature, the same should be charged as an expense to the statement of profit or loss.
 In case the company incurs any expenditure which give rise to an asset, the company
need to analyse whether the expenditure qualifies the definition of the term asset as per the
Framework i.e. whether it has control over the asset and derives future economic benefits
from it.