Chapter 2

Financial Statements
2.1 Introduction
The basis for financial planning, analysis and decision making is the financial
information. Financial information is needed to predict, compare and evaluate the
firm’s earning ability. It is also required to aid in economic decision-making-
investment and financial decision making. The financial information of an
enterprise is contained in the financial statements.

A firm communicates financial information to the users through financial

statements and reports. Financial statements contain summarized information of
the firm’s financial affairs, organized systematically. They are the means to presents
the firm’s financial situations to the users. Preparation of the financial statements is
the responsibility of the top management. As these statements are used by investors
and financial analysts to examine the firm’s performance in order to make
investment decisions, they should be prepared very carefully contain as much
information as possible.

Managers, shareholders, creditors and others interested groups seeks answers to the
following questions about firms:

1. What is the financial position of the firm at a given point of time?

2. How has the firm performed financially over a given period of time?
3. What have been the sources and uses of cash over a given period of time?
To answer the above questions, the accountant prepares two statements, these two
basis financial statements prepared for the purpose of external reporting to owners,
investors and creditors.

1. Balance sheet or Statement of Financial Position

2. Profit and Loss Accounts or Income Statement
The balance sheet shows the financial positions (or conditions) of the firm at a given
point of time. It provides a snapshot and may be regarded as a static picture.

The profit and loss account reflects the performance of the firm over a period of
time.

In addition to the above two statements, a cash flow statement is also prepared
which shows the inflows and outflows of cash from operating, investing and
financing activities and it shows displays the sources and used of cash during the
period.

12
Financial statements are often an important sources of information for financial
decisions.

These financial statements are contained in a company annual’s report. A typical

annual report also includes the chairman’s speech, the director’s report, the
auditor’s report and accounting policy changes. For internal management purpose,
i.e. planning and controlling, much more information than that contained in the
published financial statements is needed. Therefore, the financial accounting
information is presented in different and report in such a way as to serve the
internal needs of the management.

2.2 Objective of Financial Statements

Financial statements are prepared from the accounting records maintained by the
firm. The objectives of the financial statements are:

1. Resources and obligations: to provide reliable information about

economic resources and obligations of a business enterprise.
2. Changes in the net resources: to provide reliable information about
change in net resources (resources mines obligations) of an enterprise
that results from the profit-directed and other activities.
3. Earning potential: to provide financial information that assists in
estimating the earnings potential of the enterprise.
4. Full disclosure: To disclose, to the extent possible, other information
related to the financial statement that is relevant to statement users.

Annual Report

The annual report of a company provides a lot of useful information.

1. Statement of the Chairman

2. Report of the board of Directors,
3. Auditor’s report,
4. Balance Sheet and Profit and Loss account,
5. Schedule of accounting ,
6. Schedule of accounting policies and
7. Financial statement of subsidiaries.
1. Chairman’s Statement: It is an important source of information on a
company’s internal and external environment, challenge of competition,
major changes, future opportunities and direction. The chairman’s statement
also contains information on a company’s mission, objectives, products,
organization philosophy etc.
2. Report of the board of Directors: Directors’ report provides a summary of
profit made and appropriate by the company and other relevant information

13
 such as industrial relations, investments, financing, reorganization,
appointment of auditors and directors etc.
3. Auditors’ Report: Auditors’ report to shareholders verifies whether the
balance sheet and profit and loss account provide a true and fair view of the
state of a company’s affairs. Auditors should obtain all necessary
information and explanation and ensure that proper books of accounts as
required by law have been prepared by the company. They bring out any
deviation or distortion to the notice of the shareholders.
4. Accounting polices: Companies adopt different accounting policies for
preparing their balance sheet and profit and loss account. Annual reports
incorporate major accounting policies as well as changes made in current
year.
5. Balance Sheet: Balance sheet shows the financial condition of a business at a
given point of time.
6. Profit and Loss Account: Profit and loss account presents the summary of
revenue, expenses and net income (or net loss) of a firm.

2.3 Need for Analysis of Financial Statements

The users of the financial statements like shareholders, employees, customers,
general public and lenders want to know different things from the financial
statements. Employees are interested in profitability of the business so that they can
get bonus, shareholders are interested in growth so that the value of their shares
goes up. Lenders are interested in knowing the capability of the company to pay
back the principle amount of loan along with interest. Customers are interested in
the product pricing and quality. As it is, the financial statements do not provide the
readymade answer or all these questions. They need to be analyzed properly
keeping this objective in view.

The analysis of the financial statements, therefore, is aimed at ascertaining financial

weaknesses and strength of the company in terms of its activity, liquidity, solvency
and profitability.

2.4 Significance of Financial analysis

1. Investors: Both potential future investors and existing investors are
interested in the analysis of the financial statements. The present investors
want to decide whether they should hold the securities of the company or
they should sell them. On the other hand investors want to know whether
they should invest in the shares of the company or not.
2. Creditor: They want to know the liquidity position of the company. Their
concern is whether the company will be able to pay them or not. They try to
focus on liquidity ratio.

14
 3. Lenders: The long term lenders want to know whether the company is
earning enough profits to able to pay interest to them regularly and also the
principle amount will be paid them as and when due. They are also
interested to know as to know as to how the money, lent by them, has been
used by the company. It is good if the company invests the long term funds in
Fixed Assets and Working Capital.
4. Management: The management always wants to ensure that the financial
stability is maintained. From time to the management wants to judge its
short and long term solvency, and efficiency in utilization of available
resources. It wants to know the return on investment or profit margin on the
sales. This information helps the management in decision making and
planning.

For any analysis we need (i) Subject matter and (ii) Tools to work on the subject
matter. Financial statement i.e. Balance Sheet and Income Statement are the subject
matter or raw material for conducting an analysis. The financial statements have to
be analyzed in order to reach some conclusion. These statements merely contain
absolute figure pertaining to assets, liabilities, revenues earned and expenses
incurred. As it is, they do not reveal anything about earning capacity, the extant to
which the resources have been utilized and liquidity and solvency position. In order
to make an opinion on these issues, the Balance Sheet and Profit and Loss Account
have to be analyzed systematically and conclusion have to be drawn to take proper
decisions.

2.5 Management Discussion and Analysis of Performance

This part of document is describes the concepts on which the Board relied in
recommending standards for Management's Discussion and Analysis (MD&A) to be
included in general purpose federal financial reports (GPFFR). Concepts
Statements are not authoritative in the sense that they do not establish standards or
principles. Preparers may find them useful, but these concepts are not "prescribed
guidelines" for required supplementary information as discussed in of the
Codification of Statements on Auditing Standards published by the American
Institute of Certified Public Accountants. No standards or prescribed guidelines for
MD&A are presented in this statement of concepts.

MD&A is an important vehicle for (1) communicating managers' insights about the
reporting entity, (2) increasing the understandability and usefulness of the GPFFR,
and (3) providing accessible information about the entity and its operations, service
levels, successes, challenges, and future. Some federal agencies also refer to MD&A
as the "overview." The basic concept that underlies the standards for MD&A is:

15
Each general purpose federal financial report (GPFFR) should include a section
devoted to management's discussion and analysis (MD&A). It should address the
reporting entity's performance measures, financial statements, systems and
controls, compliance with laws and regulations, and actions taken or planned to
address problems. The discussion and analysis of these subjects may be based partly
on information contained in reports other than the GPFFR. MD&A also should
address significant events, conditions, trends and contingencies that may affect
future operations. A separate document titled Standards for Management's
Discussion and Analysis presents the standards for MD&A. The standards for
MD&A say that MD&A should address:

-- the entity's mission and organizational structure;

-- the entity's performance goals and results;

-- the entity's financial statements;

-- the entity's systems, controls, and legal compliance; and

-- the possible future effects on the entity of existing, currently-known demands,

risks, uncertainties, events, conditions and trends.

The term general purpose federal financial report, abbreviated "GPFFR," is used as a
generic term to refer to the report that contains the entity's financial statements that
are prepared pursuant to federal accounting principles.

2.6 SIGNIFICANT ACCOUNTING POLICIES (with example of Edith

Cowan University)

The following accounting policies have been adopted in the preparation of the
financial statements. These policies have been consistently applied to all the years
presented, unless otherwise stated.

General statement

The financial statements constitute a general purpose financial report which has
been prepared in accordance with Australian Accounting Standards, Statements of
Accounting Concepts and other authoritative pronouncements of the Australian
Accounting Standards Board, and Urgent Issues Group (UIG) Consensus Views as
applied by the Treasurer's Instructions. Several of these are modified by the
Treasurer's Instructions to vary the application, disclosure, format and wording.
The Financial Administration and Audit Act 1985 and the Treasurer's Instructions

16
are legislative provisions governing the preparation of financial statements and take
precedence over Australian Accounting Standards, Statements of Accounting
Concepts and other authoritative pronouncements of the Australian Accounting
Standards Board, and UIG Consensus Views. The modifications are intended to
fulfil the requirements of general application to the public sector, together with the
need for greater disclosure and also to satisfy accountability requirements.

If any such modification has a material or significant financial effect upon the
reported results, details of that modification and where practicable, the resulting
financial effect, are disclosed in individual notes to these financial statements.

Reporting Entity

The reporting entity is Edith Cowan University and its controlled entity; ECU
Resources for Learning Ltd.

Control is taken to exist where:

• the entity is accountable to the University;

• the University has a residual financial interest in the net assets of the entity; and

• the University has the power to govern the financial and operating policies of an
entity so as to obtain benefits from its activities.

Basis of Preparation

The financial report has been prepared in accordance with applicable Australian
Accounting Standards which includes Australian equivalents to International
Financial Reporting

Standards, Urgent Issues Group Interpretations and other authoritative

pronouncements of the Australian Accounting Standards Board.

The Balance Sheet and Income Statement have been prepared on an accrual basis
and are in accordance with historical cost convention, modified by the revaluation
of land and buildings which have been measured at fair value.

The accounting policies applied in the preparation of the financial statements have
been consistently applied throughout all periods presented except that AASB 132
and AASB 139 have been applied from 1 January 2005, with the option provided by
AASB 1 paragraph 36A.

17
Assets and liabilities are recognised in the Balance Sheet when, and only when, it is
probable that future economic benefits will flow and the amounts of the assets or
liabilities can be reliably measured.

Contingent liabilities and contingent assets are not recognised in the Balance Sheet,
but are discussed in the relevant Notes to the Financial Statements. They may arise
from uncertainty as to the existence of a liability or asset, or represent an existing
liability or asset in respect of which settlement is not probable or the amount cannot
be reliably measured. Where settlement becomes probable, a liability or asset is
recognised.

The consolidated financial report is presented in Australian dollars and all amounts
are rounded to the nearest thousand dollars ($’000).

The judgements that have been made in the process of applying accounting policies
that have the most significant effect on the amounts recognised in the financial
report are included at note 4.

The key assumptions made concerning the future, and other key sources of
estimation uncertainty at the reporting date that have a significant risk of causing a
material adjustment to the carrying amounts of assets and liabilities within the next
financial year, are included at note 5.

Basis of Accounting

The consolidated financial statements have been prepared on the accrual basis of
accounting using the historical cost convention, except for certain assets and
liabilities which, as noted are measured at fair value.

(a) Principles of consolidation

Subsidiary
The consolidated financial statements incorporate the financial statements of Edith
Cowan University (the parent entity) and entities controlled by the University (its
subsidiary) made up to 31 December each year. Control is achieved where the
University has the power to govern the financial and operating policies of an
investee entity so as to obtain benefits from its activities. A list of controlled entities
appears in note 27. Consistent accounting policies have been employed in the
preparation and presentation of the consolidated financial statements.

The consolidated financial statements include the information and results of each
controlled entity from the date on which the University obtains control and until
such time as the University ceases to control such entities.

Inter-company transactions, balances and unrealised gains on transactions between

the University and controlled entities are eliminated in full on consolidation.

18
Unrealised losses are also eliminated unless the transaction provides evidence of an
impairment of the asset transferred.

Accounting policies of the subsidiary have been changed on consolidation where

necessary to ensure consistency with the accounting policies adopted by the
University.

(b) Grants and other Contributions

Government Grants

Grant contributions from the Commonwealth Government and Western Australia

State Government for financial assistance for operational purposes are recognised
as revenue when the University obtains control over the asset comprising the
contributions. When the University does not have control of the contribution or does
not have the right to receive the contribution or has not fulfilled grant conditions,
the grant contribution is treated as deferred income.

Grant contributions from the Commonwealth Government and Western Australia

State Government for financial assistance for the acquisition of non-current assets
are recognised as revenue when the University obtains control over the asset
comprising the contributions. When the University does not have control of the
contribution or does not have the right to receive the contribution or has not
fulfilled grant conditions, the grant contribution is treated as deferred income.

Sponsored Research

Research funds provide the opportunity for graduate and undergraduate students
to work with the faculty in research as part of their educational experience.
Research grant contributions from various sources of sponsored research, including
corporations, foundations, Commonwealth, State and local governments and
research institutes are recognised as revenue when the University obtains control
over the asset comprising the contributions. When the University does not have
control of the contribution or does not have the right to receive the contribution or
has not fulfilled grant conditions, the grant contribution is treated as deferred
income.

Donations
Donations, gifts and other non-reciprocal contributions are recognised as revenue
when the University obtains control over the assets comprising the contributions.
Control is normally obtained upon their receipt.

Endowment and Bequest Contributions

The University receives restricted funds from donors who wish to fund specific
programs or initiatives in the University. Endowments and bequests are invested to

19
create a source of income which is used for scholarships, research, prizes and special
lecture programs. Endowment contributions are recognised as revenue when the
University obtains control over the assets comprising the contributions. Control is
normally obtained upon their receipt.

(c) Revenue Recognition

Revenue is measured at the fair value of the consideration received or receivable

and represents amounts receivable for goods and services provided in the normal
course of business, net of discounts and Goods and Services Taxes (GST). Revenue
is recognised as follows:

Sale of Goods

Revenue from sales of goods and disposal of other assets is recognised when goods
are delivered and title has passed.

Fees and Charges

Revenue from fees and charges is recognised in the accounting period in which the
services are rendered, by reference to completion of the specific transaction assessed
on the basis of the actual service provided as a proportion of the total services to be
provided.

Revenue from students studying at the English language centre (ELICOS), is

recognised on a cash basis. This is because students who have been offered an
ELICOS course are issued with an invoice; payment of the invoice is a condition of
acceptance.

Interest Income

Interest income is accrued on a time-proportion basis, by reference to the principal

outstanding and at the effective interest rate applicable.

Parking and Library Fines

Revenue from parking and library fines is recognised on a cash basis, as the purpose
of the fine is to act as a deterrent not strictly for raising revenue. Non-payment of
these fines are not actively pursued.

Royalty, Trademark and Licenses Income

Royalties, trademark and licenses income is recognized on an accrual basis in

accordance with the substance of the relevant agreements.

20
Gains
Gains may be realized or unrealized. Realized gains are determined on a net basis as
the difference between the sale proceeds received or receivable and the carrying
amount of the non-current asset. Unrealized gains are determined on a net basis as
the difference between the fair value and the carrying amount of an asset.

The policies adopted for the recognition of significant categories of gains are as
follows:

Realized gains on disposal of non-current assets

Gains arising on the disposal or retirement of a non-current asset are recognized

when control of the asset and the significant risks and rewards of ownership have
passed to the buyer. Net gains are included in revenue for the period in which they
arise.

Unrealised gains associated with investment property at fair value

Gains arising from changes in the fair value of an investment property are included
in revenue for the period in which they arise.

(d) Expense Recognition

Expenses are recognized when incurred and are reported in the year to which they
relate.

The policies adopted for the recognition of significant categories of expenses are as
follows:

Depreciation, amortization and impairment losses

Depreciation of non-financial physical assets (excluding inventories) is provided on

a straight-line basis at rates based on the expected useful lives of those assets. The
expected useful lives for each class of depreciable asset are provided under
property, plant and equipment.

Amortization is provided on leasehold improvements, intangible assets and on assets

held under finance leases and is calculated on a straight-line basis, generally over
the expected useful lives on the same basis as owned assets.

Impairment losses are recognized as an expense when an asset’s carrying amount

exceeds its recoverable amount (unless it is related to a re-valued assets where the
value changes are recognized directly in equity).

Superannuation expense

21
The University receives Commonwealth Government superannuation
supplementary funding for employer contributions of the Pension Scheme and Gold
State Superannuation (GSS). These contributions where paid to state-administered
GESB during the year. The University also receives Commonwealth Government
general operating funding for employer contributions of the various UniSuper
superannuation plans.

The University includes the following elements in calculating a superannuation

expense:

(a) Defined benefit plan – change in the unfunded employer’s liability in respect of
current employees who are members of the Pension Scheme and current
employees who accrued a benefit on transfer from that Scheme to the Gold
State Superannuation Scheme; and

(b) Defined benefit plan – emerging cost in respect of current employees who are
members of the Pension Scheme and current employees who accrued a benefit
on transfer from that Scheme to the Gold State Superannuation Scheme; and

(c) Defined contribution plan – employer contributions paid to the Gold State
Superannuation Scheme and all of the Unisuper superannuation plans.

A revenue ‘Superannuation – deferred government contributions’ equivalent to (b)

is recognised under Revenue in the Income Statement as emerging cost
superannuation for which they are fully recouped by the Commonwealth
superannuation supplementary grant.

(d) Property, Plant and Equipment

Land and buildings held for use in the production or supply of goods or services, for
investment, and for administrative purposes, are stated in the Balance Sheet at their
revalued amounts, being the fair value at the date of revaluation, determined from
market-based evidence by appraisal undertaken by independent professional
valuers, less any subsequent accumulated depreciation and subsequent accumulated
recoverable amount write-down. Revaluations are performed with sufficient
regularity such that the carrying amount does not differ materially from that which
would be determined using fair values at the reporting date.

Any revaluation increase arising on the revaluation of such land and buildings is
credited to the asset revaluation reserve, except to the extent that it reverses a
revaluation decrease for the same asset class previously recognized as an expense, in
which case the increase is credited to the Income Statement to the extent of the
decrease previously charged on a asset class basis. A decrease in carrying amount
arising on the revaluation of such land and buildings is charged as an expense to the

22
extent that it exceeds the balance, if any, held in the asset revaluation reserve
relating to a previous revaluation of that asset class.

Depreciation on revalued assets is charged to the Income Statement. On the

subsequent sale or retirement of a revalued asset, the attributable revaluation
surplus remaining in the asset revaluation reserve is transferred directly to the
Income Statement.

Properties in the course of construction for production, rental or administrative

purposes, or for purposes not yet determined, are carried at cost, less any
recognized recoverable amount write down. Cost includes professional fees and, for
qualifying assets, borrowing costs are capitalized. Depreciation of these assets, on
the same basis as other property assets, commences when the assets are ready for
their intended use. Fixtures and computer equipment are stated at cost less
accumulated depreciation and any recognized recoverable amount write-down.
Purchases of fixtures and computer equipment which individually cost less than
$5,000 are expensed in the Income Statement in the year of acquisition.

Depreciation is charged so as to write off the cost or valuation of assets, other than
land and properties under construction, over their useful lives, using the straight-
line method.

Expected useful lives for each class of depreciable asset are:

Asset Category Life

Land Not depreciated

Buildings 50 years

Computing equipment 4 years

Other equipment &

6 years
furniture

Motor vehicles 6 years

Leased Motor vehicles 6 years

Art Works Not depreciated

Depreciated at 100% in the fourth

Library Collections
year after acquisition

23
Assets held under finance leases are depreciated over their expected useful lives on
the same basis as owned assets or, where shorter, over the term of the relevant lease.

Library Collections are stated at cost of the last three years’ acquisition of library
books. In each year, that year’s cost of acquisition is added to the carrying value
and the earliest year’s cost of acquisition within the carrying value is written off.

Works of art are classified as heritage assets. These artifacts are protected and
preserved for public exhibition, education, research and the furtherance of public
service. They are neither disposed of for financial gain nor encumbered in any
manner. Accordingly, such collections are capitalized, irrespective of value and are
not depreciated as it is anticipated that they have indefinite useful lives. Their
service potential has not, in any material sense, been consumed during the reporting
period.

Investment Property

Investment property comprises land and buildings which are held to earn rentals
and/or capital appreciation Initial recognition and measurement Investment
property assets are initially recognized at cost.

Subsequent measurement after recognition after recognition, the University uses the
revaluation model for measurement of investment land and buildings. Land and
buildings are carried at fair value and no depreciation is
provided in respect of freehold land and building.

The fair value of land has been determined on a continuing basis, determined from
market-based evidence.

Revaluations are performed with sufficient regularity such that the carrying
amount does not differ materially from that which would be determined using fair
values at the reporting date. The last revaluation of investment land and buildings
was conducted in December 2004 by an independent professional valuer.

The gain arising from changes in the fair value of the investment property are
included in the income statement for the period in which they arise.

(e) Leases

Leases are classified as finance leases whenever the terms of the lease transfer
substantially all the risks and rewards of ownership to the lessee. All other leases are
classified as operating leases.

Assets held under finance leases are recognized as assets of the University at their
fair value or, if lower, at the present value of the minimum lease payments, each
determined at the inception of the lease. The corresponding liability to the lessor is

24
included in the Balance Sheet as a finance lease obligation. Lease payments are
apportioned between finance charges and reduction of the lease obligation so as to
achieve a constant rate of interest on the remaining balance of the liability. Finance
charges are charged directly against income, unless they are directly attributable to
qualifying assets, in which case they are capitalized.

Rentals payable under operating leases are charged to expense on a straight-line

basis over the term of the relevant lease.

(f) Impairment

The University is required to assess property, plant and equipment and intangible
assets for any indication of impairment at each reporting date. Where there is an
indication of impairment, the recoverable amount must be estimated. As the
University is a not-for-profit entity, unless an asset has been identified as surplus
asset, AASB 136 prescribes the recoverable amount is the higher of an asset’s fair
value less selling costs and depreciated replacement cost. Consequently, the risk of
impairment is generally limited to circumstances where an asset’s depreciation is
materially understated or where the replacement cost is falling.

The University reviews each relevant class of assets annually to verify that the
accumulated depreciation/amortization reflects the level of consumption or
expiration of asset’s future economic benefits and to evaluate any impairment risk
from falling replacement costs.

For assets identified as surplus assets, the recoverable amount is the higher of fair
value less selling costs and the present value of future cash flows expected to be
derived from the asset.

(g) Cash

For the purposes of the Cash flow Statement, cash includes cash assets and
restricted cash assets. These include short-term deposits that are readily convertible
to cash on hand and are subject to insignificant risk of changes in value.

(h) Restricted Cash

Endowment and bequest funds are classified as restricted cash assets. Endowment
and bequest funds have been received from benefactors who, by the terms of their
conveying instruments, have stipulated that the use of funds is limited in future
years to the purposes designated by the benefactors.

(i) Inventories

Inventories are valued at the lower of cost and net realizable value. Cost comprises
direct materials and where applicable, import duties, transport and handling costs

25
that have been incurred to bring the inventories to their present location and
condition. Cost is calculated using the weighted average method. Net realizable
value represents the estimated selling price less all estimated costs of completion and
costs to be incurred in marketing, selling and distribution.

(j) Receivables

Accounts receivable include amounts due from students for tuition fees, housing and
other enrolment related services and reimbursements due from sponsors of
externally funded research. Accounts receivables are recognised at the amounts
receivable as they are due for settlement no more than 30 days from the date of
recognition. Accounts receivables do not carry any interest and are stated at their
nominal value as reduced by appropriate allowances for estimated irrecoverable
amounts.

(k) Intangibles

The University’s intangibles comprise externally acquired software for internal use
and have been customised by ECU. These assets are carried at cost. Software is
amortised on a straight-line basis over its anticipated useful life. The useful life of
the University’s currently amortised software is 5 years.

(l) Other financial assets

Investments are recorded at their fair value. In the case of Investments that
represent shares held in publicly listed companies – the fair value is measured at
balance date as the last sale price quoted on the Australian Stock Exchange.

(m) Payables

Payables, including accruals not yet billed, are recognized when the University
becomes obliged to make future payments as a result of a purchase of assets or
services. Accounts payable are not interest bearing and are stated at their nominal
value.

(n) Interest bearing liabilities

Interest-bearing loans and overdrafts are recorded as the proceeds received, net of
direct issued costs. Finance charges, including premiums payable on settlement or
redemption and direct issue costs, are accounted for on an accrual basis using the
effective interest method and are added to the carrying amount of the instrument to
the extent that they are not settled in the period in which they arise.

(o) Employee Benefits

Annual Leave

26
The liability for annual leave that will fall due within 12 months after the end of the
reporting date is recognized in the provision for employee benefits and is measured
at the undiscounted amounts expected to be paid. The liability for annual leave that
will fall due more than 12 months after the end of the reporting date is recognised in
the provision for employee benefits and is measured at the present value of amounts
expected to be paid in the future in respect of services provided by employees up to
the reporting date. Consideration is given, when assessing expected future
payments, to expected future wage and salary levels including superannuation on-
costs. Expected future payments are discounted using market yields at the reporting
date on national government bonds with terms to maturity that match, as closely as
possible, the estimated future cash flows.

Long Service Leave

The liability for long service leave that will fall due within 12 months after the end
of the reporting date is recognized in the provision for employee benefits and is
measured at the undiscounted amounts expected to be paid. The liability for long
service leave that will fall due more than 12 months after the end of the reporting
date is recognized in the provision for employee benefits and is measured at the
present value of amounts expected to be paid in the future in respect of services
provided by employees up to the reporting date. Consideration is given, when
assessing expected future payments, to expected future wage and salary levels
including superannuation on-costs. Expected future payments are discounted using
market yields at the reporting date on national government bonds with terms to
maturity that match, as closely as possible, the estimated future cash flows.

Leave benefits are calculated at remuneration rates expected to be paid when

liabilities are settled. A liability for long service leave is recognized after an
employee has completed four years of service. An actuarial assessment of long
service leave undertaken in-house in 2005 and determined that the liability
measured using the short-hand method was not materially different from the
liability measured using the present value of expected future payments. All
unconditional long service leave is classified as a current liability.

Provisions – Other

Employee On-Costs

Employee on-costs, including workers’ compensation insurance and payroll tax, are
not employee benefits and are recognized as liabilities and expenses when the
employee benefits to which they relate has occurred. Employee on-costs are not
included as part of the University’s ‘Employee benefits expense’ and the related
liability is included in Employee on-costs provision.

Other Compensated Absences

27
Employees accrue and accumulate sick leave and study leave in accordance with
University policies. It is the policy of the University to recognise the cost of sick leave
and study leave when paid. Employees who leave University employment are not
entitled to be paid for accrued sick leave or study leave. Therefore, no liability is
shown in the financial statements.

Superannuation
The University contributes to the GESB Pension Scheme, GESB Gold State
Superannuation Scheme and various UniSuper superannuation schemes on behalf
of its employees. The contributions made to these schemes by the University, and
emerging costs from unfunded schemes, are expensed in the Income Statement.
Refer to Note 26 for details relating to the individual schemes.

GESB Scheme Information

Pension Scheme members receive pension benefits on retirement, death or

invalidity. The Fund Share of the pension benefit, which is based on the member’s
contributions plus investment earnings, may be commuted to a lump sum benefit.
The State Share of the pension benefit, which is employer financed, cannot be
commuted to a lump sum benefit.

Some former Pension Scheme members have transferred to the Gold State Scheme.
In respect of their transferred benefit the members receive a lump sum benefit at
retirement, death or invalidity which is related to their salary during their
employment and indexed during any deferral period after leaving public sector
employment.

(p) Foreign currency translation and Hedges

Transactions in currencies other than Australian dollars are recorded at the rates of
exchange prevailing on the dates of the transactions. At each reporting date,
monetary assets and liabilities that are denominated in foreign currencies are
retranslated at the rates prevailing on the reporting date. Nonmonetary assets and
liabilities carried at fair value that are denominated in foreign currencies are
translated at the rates prevailing at the date when the fair value was determined.
Gains and losses arising on retranslation are included in the Income Statement for
the period.

In order to hedge its exposure to certain foreign exchange risks, the University
enters into forward contracts and options.

(q) Joint ventures

Joint Venture Operations

28
The University participates in a number of joint venture operations. The University
uses its own property, plant and equipment and incurs its own expenses and
liabilities. The joint venture agreements provide that ventures will fund the costs of
the joint venture in specific proportions and the revenue generated from the activity
is pooled and distributed based on the level of contribution by each venturer.

Joint Venture Entities

The University has no material interest in joint venture entities and does not include
any amounts in the financial statements for its interest in joint venture entities.

(r) Desegregation Information

The University has determined reportable segment information on the basis of

business segments and geographical segments.

A business segment is a group of assets and operations engaged in providing

products or services that are subject to risks and returns that are different from
those of other business segments. A geographic segment is engaged in providing
services within a particular economic environment that are subject to risks and
returns that are different from those of segments operating in other economic
environments.

The University and its subsidiary have two reportable business segments consisting
of higher education and technical and further education (TAFE). The higher
education segment is an aggregation of operations that deliver progressive
university degree programs for the modern workplace and focus on the service
professions. The TAFE segment primarily delivers nationally accredited flexible
training solutions designed to meet the varied needs of businesses and individuals
activities.

Geographically, these activities are conducted and operated predominantly in

Australia. Off-shore activities are analyzed as a separate geographical segment.

Segment revenues, expenses, assets and liabilities are allocated to business and
geographic segments on the basis of direct attribution and reasonable estimates of
usage. Income tax has not been included in assets and liabilities.

(s) Special reserves

The special reserve represents restricted funds, whose use is limited in future years
to the purposes designated by the benefactors, donors or sponsors such as research
financial assistance, scholarships and capital equipment replacement.

No funds are currently held in special reserves at the reporting date.

29
(t) Taxation

The controlled entity, E.C.U. Resources for Learning Ltd. (ECURL) trading as
Steps Professional Development, is subject to income tax in Australia under the
Income Tax Assessment Act 1997. Authority has been granted to ECURL to adopt a
calendar tax year.

The overseas branches are subject to income tax relating to income and expenditure
items attributable to permanent establishments in the UK and the US. The taxation
expense represents the sum of tax currently payable and is measured at 31
December each year.

Taxable profit differs from net profit as reported in the Income Statement because
it excludes items of income or expense that are taxable or deductible in other years
and it further excludes items that are never taxable or deductible. The liability for
current tax is calculated using tax rates that have been enacted by the reporting
date.

(u) Deferred Tax

The University adopts an income statement liability method to account for expected
income tax consequences inherent in the financial statements. The provision for
deferred income tax liability and the deferred tax assets includes the tax effect (at
current tax rates) of differences between income and expense items recognised in
different accounting periods for book and tax purposes. The benefit arising from
estimated carry-forward tax losses, has also been recorded as a deferred tax asset
only where realization of the asset is considered to be virtually certain. The carrying
amount of deferred tax assets is reviewed at each reporting date and reduced to the
extent that it is no longer virtually certain that sufficient taxable profits will be
available to allow all or part of the asset to be recovered.

(v) Comparative figures

Comparative figures have been restated on the AIFRS basis except for financial
instruments information which has been prepared under the previous AGAAP
Accounting Standard AAS 33 as permitted by AASB 1.36A. The transition to
AIFRS for data prepared under AASB 132 and AASB 139 will be 1 January 2005.

(w) Rounding

Amounts in the financial statements have been rounded to the nearest thousand
dollars.

30
2.7 Generally Accepted Accounting Principles – GAAP

Generally Accepted Accounting Principles (GAAP) is the standard framework of

guidelines for financial accounting. It includes the standards, conventions, and rules
accountants follow in recording and summarizing transactions, and in the
preparation of financial statements.

Financial accounting information must be assembled and reported objectively.

Third-parties who must rely on such information have a right to be assured that the
data are free from bias and inconsistency, whether deliberate or not. For this
reason, financial accounting relies on certain standards or guides that are called
"General Accepted Accounting Principles" (GAAP).

Principles also derive from tradition, such as the concept of matching. In any report
of financial statements (audit, compilation, review, etc.), the preparer/auditor/
Certified Public Accountant must indicate to the reader whether or not the
information contained within the statements complies with GAAP.

Basic objective

Financial reporting should provide information that is:

• Useful to present to potential investors and creditors and other users in

making rational investment, credit, and other financial decisions.
• Helpful to present to potential investors and creditors and other users in
assessing the amounts, timing, and uncertainty of prospective cash receipts.
• About economic resources, the claims to those resources, and the changes in
them.

Fundamental qualities

To be useful and helpful to users, financial statements must be:

• Relevant: relevant information makes a difference in a decision. It also helps

users make predictions about past, present and future events (it has
predictive value). Relevant information helps users confirm or correct prior
expectations (it has feedback value). It must also be available on time, that is
before decisions are made.
• Reliable: reliable information is verifiable (when independent auditors using
the same methods get similar results), neutral (free from bias), and
demonstrate representational faithfulness (what really happened or existed).
• Comparable: information must be measured and reported in a similar
manner for different enterprises (allows financial statements to be compared
between different companies).
• Consistent: the same accounting methods should be applied from period to
period and all changes in methods should be well explained and justified.

31
Basic concepts

To achieve basic objectives and implement fundamental qualities GAAP has four
basic assumptions, four basic principles, and four basic constraints.

Assumptions

• Economic Entity Assumption assumes that the business is separate from its
owners or other businesses. Revenues and expenses should be kept separate
from personal expenses. This applies even for partnerships and sole
proprietorships. as corporates they are considered separate legal entities
• Going Concern Assumption assumes that the business will be in operation
for a long time. This validates the methods of asset capitalization,
depreciation, and amortization. Only when liquidation is certain is this
assumption not applicable.
• Monetary Unit Assumption assumes a stable currency is going to be the unit
of record. The FASB accepts the nominal value of the US Dollar as the
monetary unit of record unadjusted for inflation.
• Periodic Reporting Assumption assumes that the business operations can be
recorded and separated into different periods (most common periods are
months, quarters and years). This is required for comparison between
present and past performance.

Principles

• The historical cost principle requires companies to account and report based
on acquisition costs rather than fair market value for most assets and
liabilities. This principle provides information that is reliable (removing
opportunity to provide subjective and potentially biased market values), but
not very relevant. Thus there is a trend to use fair values. Most debts and
securities are now reported at market values.
• The revenue recognition principle requires companies to record when
revenue is (1) realized or realizable and (2) earned, not when cash is received.
This way of accounting is called accrual basis accounting.
• The matching principle. Expenses have to be matched with revenues as long
as it is reasonable to do so. Expenses are recognized not when the work is
performed, or when a product is produced, but when the work or the
product actually makes its contribution to revenue. Only if no connection
with revenue can be established, cost can be charged as expenses to the
current period (e.g. office salaries and other administrative expenses). This
principle allows greater evaluation of actual profitability and performance
(shows how much was spent to earn revenue). Depreciation and Cost of
Goods Sold are good examples of application of this principle.
• The full disclosure principle. Amount and kinds of information disclosed
should be decided based on trade-off analysis as a larger amount of
information costs more to prepare and use. Information disclosed should be

32
 enough to make a judgment while keeping costs reasonable. Information is
presented in the main body of financial statements, in the notes or as
supplementary information.

Constraints

• Cost-benefit relationship states that the benefit of providing the financial

information should also be weighed against the cost of providing it.
• Materiality states that the significance of an item should be considered when
it is reported. An item is considered significant when it would affect the
decision of a reasonable individual.
• Industry practices states that accounting procedures should follow industry
practices.
• Conservatism states that when choosing between two solutions, the one that
will be least likely to overstate assets and income should be picked.

Principle of regularity

Regularity can be defined as conformity to enforced rules and laws.

Principle of sincerity

According to this principle, the accounting unit should reflect in good faith the
reality of the company's financial status.

Principle of the permanence of methods

This principle aims at allowing the coherence and comparison of the financial
information published by the company.

Principle of non-compensation

One should show the full details of the financial information and not seek to
compensate a debt with an asset, revenue with an expense, etc.

Principle of prudence

This principle aims at showing the reality "as is”: one should not try to make things
look prettier than they are. Typically, revenue should be recorded only when it is
certain and a provision should be entered for an expense which is probable.

Principle of continuity

When stating financial information, one should assume that the business will not be
interrupted. This principle is mitigating the previous one about prudence: assets do

33
not have to be accounted at their disposable value, but it is accepted that they are at
their historical value.

Principle of periodicity

Each accounting entry should be allocated to a given period, and split accordingly if
it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given
revenue should be split to the entire time-span and not counted for entirely on the
date of the transaction.

The common set of accounting principles, standards and procedures that companies
use to compile their financial statements. GAAP are a combination of authoritative
standards (set by policy boards) and simply the commonly accepted ways of
recording and reporting accounting information.

GAAP are imposed on companies so that investors have a minimum level of

consistency in the financial statements they use when analyzing companies for
investment purposes. GAAP cover such things as revenue recognition, balance sheet
item classification and outstanding share measurements. Companies are expected to
follow GAAP rules when reporting their financial data via financial statements. If a
financial statement is not prepared using GAAP principles, be very wary!

That said, keep in mind that GAAP is only a set of standards. There is plenty of
room within GAAP for unscrupulous accountants to distort figures. So, even when a
company uses GAAP, you still need to scrutinize its financial statements.

2.8 EXPLANATORY NOTES ON ACCOUNT CLASSIFICATIONS

OPERATING EXPENSES

Consolidated Revenue Fund operating expenses are presented in the Estimates and
the Supplement to the Estimates on the basis of a group account classification system.
Each group account represents a broad category of expenses and is comprised of
several specific components termed standard objects of expense. These specific
components are presented in the Supplement to the Estimates, and are then
aggregated into the group account totals shown in the Estimates. This group account
classification system is described below.

SALARIES AND BENEFITS

Base Salaries — includes the cost of the base salaries, overtime pay and lump sum
payments for all permanent and temporary direct employees of the government.

Supplementary Salary Costs — includes the cost of extra pay for certain types of
work such as shift differentials, premiums and allowances.

34
Employee Benefits — includes the cost of employer contributions to employee
benefit plans and pensions. Other benefits paid by the employer such as relocation
and transfer expenses are also included.

Legislative Salaries and Indemnities — includes the cost of the annual M.L.A.
indemnity and supplementary salaries as authorized under Section 4 of the
Legislative Assembly Allowances and Pension Act. Salaries for the Executive Council
and Officers of the Legislature are also included.

OPERATING COSTS

Boards, Commissions and Courts — Fees and Expenses — includes fees paid to
board and commission members, juries and witnesses, and related travel and out-of-
pocket expenses.

Public Servant Travel — includes travel expenses of government employees and

officials on government business including prescribed allowances.

Professional Services — includes fees and expenses for professional services

rendered directly to government for: the provision of goods and services in the
delivery of government programs; the provision of goods or services that are
required by statute or legislation and are billed directly to the government; and the
provision of goods or services that will assist in the development of policy and/or
programs or improve/change the delivery of programs, such as management
consulting services.

Information Systems — Operating — includes all contract fees and costs related to
data, voice, image and text processing operations and services such as data and
word processing, data communications charges, supplies, repairs, maintenance and
short-term rentals of information processing equipment.

Office and Business Expenses — includes supplies and services required for the
operation of offices.

Advertising and Publications — includes costs associated with non-statutory

advertising and general publications.

Statutory Advertising and Publications — includes costs associated with special

notices and publications required by statute and regulations.

Utilities, Materials, and Supplies — includes the cost of services such as the supply of
water and electricity, materials and supplies required for normal operation of
government services and food for institutions.

Operating Equipment and Vehicles — includes the costs associated with the repair
and maintenance of government vehicles, and operating machinery and equipment.

35
Non-Capital Roads and Bridges — includes highway costs recovered from the BC
Transportation Financing Authority, costs for minor enhancements to capitalized
infrastructure, as well as non-highway road costs.

Amortization — includes the amortization of the cost of capital assets and prepaid
capital advances over their useful lives.

Building Occupancy Charges — includes payments to the British Columbia

Buildings Corporation or the private sector, for the rental and maintenance of
buildings and office accommodation, including tenant improvements that do not
meet the criteria for capitalization.

GOVERNMENT TRANSFERS

Transfers — Grants — includes discretionary grants to individuals, businesses, non-

profit associations and others, where there are no contractual requirements.

Transfers — Entitlements/Agreements — includes payments and reimbursements

under contract, formula driven agreement, shared cost or other agreement, statute
or regulation, to individuals for defined benefits; or to individuals, public bodies
and organizations for the provision of goods and/or services to the public.

OTHER EXPENSES

Transfers Between Votes and Special Accounts — includes transfers (payments)

between a vote and a Special Account.

Interest on the Public Debt — includes only interest payments on the direct
provincial debt borrowed for government purposes.

Other Expenses — includes expenses such as financing costs and valuation

allowances and other expenses which cannot be reasonably allocated to another
standard object of expense.

INTERNAL RECOVERIES

Recoveries Between Votes and Special Accounts — includes recoveries between a vote
and a Special Account.

Recoveries Within the Consolidated Revenue Fund — includes recoveries for the use
of equipment or the provision of goods and services between ministries of the
provincial government.

Recoveries External to the Consolidated Revenue Fund — includes costs and amounts
recovered from government corporations, other governments, and non-government

36
organizations; the offset for commissions paid for the collection of government
revenues and accounts; and the write-off of uncollectible revenue related accounts.

CAPITAL EXPENDITURES

Consolidated Revenue Fund capital expenditures are presented on the basis of the
category of asset acquired. The categorization of assets is described below.

Land — includes the purchased or acquired value for parks and other recreation
land and land directly associated with capitalized infrastructure (buildings, ferries
and bridges); but does not include land held for resale.

Land Improvement — includes the capital cost of improvements to dams and water
management systems and recreation areas.

Buildings — includes the purchase, construction or major improvement of buildings

owned by the Consolidated Revenue Fund.

Specialized Equipment — includes the purchase or capital lease cost of heavy

equipment such as tractors, trailers and ambulances, as well as telecommunications
relay towers and switching equipment.

Office Furniture and Equipment — includes the cost or capital lease cost of office
furniture and equipment.

Vehicles — includes the purchase or capital lease cost of passenger, light truck and
utility vehicles.

Information Systems — includes the purchase or capital lease cost of mainframe and
other systems hardware, software and related equipment.

Tenant Improvements — includes the cost or capital lease cost of improvements to

leased space.

Roads — includes the capital costs for construction or major improvements of

roads, highways and bridges.

Other — includes capital expenditures which cannot be reasonably allocated to

another standard object of expense.

37
2.9 Subject matter
1. Balance Sheet

The balance sheet is a significant financial of a firm. In fact, it is called a

fundamental accounting report. Other terms to describe this financial statement are
statement of financial positions or position statement. As the name suggestions, the
balance sheet provides information about the financial standing or position of a firm
at a particular point of time, say as on March 31, 2006 (i.e. Balance sheet of L&T
Limited as on March 31, 2006). The financial position of a firm as disclosed by the
balance sheet refers to its recourses and obligations and the interest of its owners in
the business. In operation terms, the balance sheet contains information in respects
of assets, liabilities, and owners’ equity.

The balance sheet shows the financial condition of a given point of time. As per the
Company Act, the balance sheet of a company shall be in either the Account Form
(Horizontal Form) or the Report Form (Vertical Form). The Report Form (Vertical
Form is most commonly used by companies, but it is more convenient to explain the
contents of the balance in the Account Form (Horizontal Form).

Before discussing various account categories found on the balance sheet, we must
know about some basic concepts underlying financial accounting.

Basic concepts underlying financial accounting

The framework of financial accounting is based on several concepts which have

received widespread, through not universal, acceptance by accountants. The
important concepts have been briefly described below.

1. Entity Concept – For purposes of accounting, the business firm is regarded

as a separate entity. Accounts are maintained for the entity as distinct from
the persons who are connected with it. The accountant records transactions
as they affect this entity and regards owners, creditors, suppliers, employees,
customers and the government as parties transacting with this entity.
2. Money Measurement Concept – Accounting is concerned with only those
facts are expressible in monetary terms. The yardstick provides a means by
which heterogeneous elements, such as land, Plant and equipment,
inventories, securities and goodwill may be expressed may be expressed in a
common denominator.
3. Stable Monetary Unit Concept – An implicit assumption in accounting, as it
is practiced, is that the monetary unit remains stable and values recorded at
the time that events occur are not changed. Put differently, in the purchasing
power of money are not considered. This principle has been challenged and

38
 forceful arguments have been advanced for making adjustment for price
level changes. Despite the great plausibility of these arguments, the practice
of accounting is still based on the stable monetary unit assumption.
4. Going Concern Concept – Accounting is normally based on the premise that
the business entity will remain a going concern for an indefinitely long
period.
5. Cost Concept – Assets acquired by a business are generally recorded at their
cost and this is used for all subsequent accounting purposes. For example,
depreciation is charged on the basis of the original cost. It is evidence that
this concept is related to the stable monetary unit concept.
6. Conservatism Concept – This concept modifies the cost concept in the case of
current assets. It is usually stated as follows: “Anticipate no profit but
provide for all possible losses”. In accordance with this concept, current
assets are generally valued at cost or market value, whichever is lower.
7. Dual Aspect Concept – Regarded as the most distinctive and fundamental
concept of accounting, the dual aspect concept provides the basis for
accounting mechanics.
Assets are resources owned by a firm. I) Fixed Assets and II) Current Assets

Liabilities are the claims of various parties against the assets owned by a firm. I)
Owners’ Equity represents the claims of the owners. II) Outside liabilities, on the
other hand, reflect the claims of the creditors of the firm.

Since the resources owned by the firm are equal to its liabilities the basic
accounting identity is:

ASSETS = LIABILITIES

Now according to the dual aspect concept, each event has two aspects. These
are such that the accounting identity is always preserved.

8. Accounting Period Concept – In order to know the results of business

operations and financial position of the firm periodically, time is dividend
into segments referred to as accounting period. Income is measured for these
periods and the financial position is assessed at the end of an accounting
period.
9. Accrual Concept – Income is measured by changes in the owners’ equity
arising from the operations of the business. An increase in owners’ equity
arising from the business operations is called revenue and a decrease an
expenses. When revenues exceed expenses, the difference is known as income,
when expenses exceed revenues the difference is called loss.
10. Realization Concept – According to the realization concept, revenue is
deemed to be earned only when it is realized. When is revenue realized? It is
normally deemed realized when goods are shipping or delivered to the
customers, and not when a sales order is received or a contract signed or
goods manufactured.

39
 11. Matching – Once revenues for an accounting period are recognized, expenses
incurred in generating these revenues are matched them. This ensures that
sales and cost of goods sold in the income statements refer to the same
products. Note that expenses are matched to revenues and not vice versa.

Liabilities

Liabilities defined very broadly represent what the business entity owes others. The
Companies Act classified them as follows:

• Share Capital
• Reserves and Surplus
• Secured Loans
• Unsecured Loans
• Current Liabilities and Provisions
1. Share Capital: This is divided into two types: equity capital and preference
capital.

The first represents the contribution of equity shareholders who are theoretical the
owner to the firm. Equity capital, being risk capital, carries no fixed rate of
dividend. Preference capital represents the contribution of preference shareholders
and the dividend rate on it is fixed.

2. Reserves and Surplus: Reserves and surplus are profits which have been retained
in the firm. There are two types of reserves: revenue and capital reserves. Revenue
reserves represent accumulated retained earning from the profits of normal
business operations. These are held in various forms: general reserve, investment
allowance reserve, capital redemption reserves, dividend equalization reserve, and
so on. Capital reserves arise out of gains which are not related to normal business
operations. Examples of such gains are the premium on issue of shares or gain on
revaluation of assets.

Surplus is the balance in the profit and loss account which has not been
appropriated to any particular reserve account. Note that reserves and surplus
along with equity capital represents owners’ equity.

3. Secured Loans: These denote borrowing of the firm against which specific
collateral have been provided. The important components of secured loans are:
debentures, loans from financial institutions, and loans from commercial banks.

4. Unsecured Loans: These are the borrowings of the firm against which no specific
security has been provided. The major components of unsecured loans are: fixed

40
deposit, loans and advances from promoters, inter-corporate borrowings, and
unsecured loans from banks.

5. Current Liabilities and Provisions: Current liabilities and provisions, as per the
classification under the Companies Act, consist of the amounts due to the suppliers
of goods and services bought on credit, advance payments received, accrued
expenses, unclaimed dividend, provisions for taxes, dividends, gratuity, pension, etc.

Currents liabilities for managerial purposes (as distinct from their definition in the
Companies Act) are obligation which are expected to mature in the next twelve
months. So defined, they include the following:

(i). Loans which are payable within one year from the date of balance sheet,

(ii). Account payable (creditors) on account of goods and services purchased

on credit for which payment has to be made within one year,

(iii). Provisions for taxation,

(iv). Accrual for wages, salaries, rentals, interest and other expenses

(v). Advance payments received for goods and services to be suppliers in the
future.

Assets

Broadly speaking, asserts represents resources which are of some value to the firm.
They have been acquired at a specific monetary cost by the firm for the conduct of
its operations. Assets are classified as follows under the companies Act:

• Fixed assets
• Investments
• Current assets, loans and advances
• Miscellaneous expenditures and losses
1. Fixed Assets: These assets have two characterizes: they are acquired for use over
relatively long periods for carrying on the operations of the firm and they are
ordinarily not meant for resale. Examples of fixed assets are land, buildings, plant,
machinery, patents, and copy rights.

2. Investment: These are financial securities owned by the firm. Some investment
represents long-term commitment of funds. (Usually these are the equity shares of
other firms held for income and control purposes). Other investments are short-
term in nature and may rightly be classified under current assets for managerial
purpose. (Under requirement of the Companies Act, however, short-term holding of

41
financial securities also has to be shown under investment and not under current
assets).

3. Current Assets, Loans and Advances: This category consists of cash and other
resources which get converted into cash during the operating cycle of the firm.
Current assets are held for a short period of time as against fixed assets which are
held for relatively longer periods. The major components of currents assets are:
cash, debtors (also called accounts receivable), inventories (also called stocks), loans,
and advances and pre-paid expanses. Cash denotes funds readily disbursable by the
firm. The bulk of it is usually in the form bank balance and rest in currency held by
the firm. Debtors represent the amounts owned to the firm by the customers who
have bought goods and services on credit. Debtors are shown in the balance sheet at
the amount owned, less an allowance for bad debts. Inventories consists of raw
materials, work-in-progress, finished goods, and stores and spares. They are usually
reported at the lower of the cost or market value. Loans and advances are the
amounts loaned to employees, advances given to suppliers and contractors,
advanced tax paid, and deposits made with governmental and other agencies. They
are shown at the actual amount. Pre-paid expenses are expenditure incurred for
services to be rendered in the future. These are shown at the cost of unexpired
services.

4. Miscellaneous Expenditure and Losses: This category consists of two: (i)

miscellaneous expenditures and (ii) losses. Miscellaneous expenditure certain
outlays such as preliminary expenses and pre-operations expenses which have not
been written off. From the accounting point of view, a loss represents a decrease in
owner’s equity. Hence, when a loss occurs, the owners’ equity should be reduced by
that amount. However, as per company law requirements, the share capital
(represents owner’ equity) cannot be reduced when loss occurs. So the share capital
is kept intact on the left hand side (the liabilities side) of the balance sheet and the
loss is shown on the right hand side (the assets side) of the balance sheet.

Structure of the Balance Sheet as per Companies Act

A. Account Form (Horizontal Form)

Liabilities Assets
Share capital Fixed Assets
Reserves and Surplus Investments
Secured loans Current Assets, Loans and Advances
Unsecured Loans Current Assets
Current liabilities and Provision Loans and Advances
Current liabilities Miscellaneous Expenditure and losses
Provision
B Report Form( Vertical Form)

42
I Sources of Funds
1. Shareholders’ Funds
(a) Share Capital
(b) Reserves & Surplus
2. Loans Funds
(a) Secured Loans
(b) Unsecured Loans
II Application of Funds
1. Fixed Assets
2. Investments
3. Current Assets, loans, Advances
less: Current Liabilities and Provision
Net Current Assets
4. Miscellaneous Expenditure and losses

2. Profit and Loss Accounts

The second major statement of financial information is the profit and loss account
(P/L Account). It is also known by several other titles such as income statement,
statement of earning, statement of operations and profit and loss statement. While
the balance sheet, as a stock/position statement, reveals the financial condition of a
business at a particular point of time (date), the P/L account portrays, as a
statement, the operations over/during a particular period of time. The period of
time is an accounting period/year, April-March (i.e. Balance sheet of L&T Limited
for the Year ending on March 31, 2006). Since the purpose of every business firm is
to earn profit, the operations of a firm in given period of time will truly be reflected
in the profit earned by it. Thus the income statement P/L account of a firm reports
the result of operations in term of income/net profit by it.

The statement is prepared annually by every company. It shows the profit earned or
loss suffered by the company during the financial year. It discloses the true and fair
view of the profitability of the company.

The companies Act has prescribed a standard form for the balance sheet, but none
for the P/L account. However, the Companies Act does requires that the
information that the information provided should be adequate a true and fair
picture of the operations of the company for the accounting period.

The P/L account, like the balance sheet, may be presented in the account form or
the report form. Typically, companies employ the report form. The report form
statement may be a single-step statement or a multi-step statement. In a single-step
statement, all revenue items are recorded first, then the expense items are finally the
net profit is given.

43
While a single step profit and loss account aggregates all revenues and expanses, a
multi-step profit and loss account provides disaggregated. Further, instead of
showing only the final profit measures, viz. the profit after tax figure, it presents
profit measurers as intermediate stages as well. The highlights in the P/L account
are given below.

• Net sales
• Cost of goods sold
• Gross Profit
• Operating expenses
• Operating Profit
• Non-Operating Surplus/deficit
• Profit before interest and tax
• Interest
• Profit before tax
• Tax
• Profit after tax

Revenues

One group of items listed on the P/L account is revenue. It is defined as the income
that accrues to the firm by the sale of goods/services/assets or by the supply of the
firm’s resources to others. Alternatively, revenues mean the value that a firm
receives from its customers. The value/income can arise from other sources:

1. sale of products/goods/services and

2. supply of firm’s resources to others
Sales income:- The sales revenues equals net sales, that is, gross sales less (i) return
and allowance, and (ii) sales discount. Gross sales are the total invoice price of the
goods sold/services rendered plus the cash sales during the year. Sales return
represents the sale value of goods that were returned by the customers. Sales
discount is the amount of cash discount taken by customers for prompt payment.

Use of Economic Resources Outside:- the second sources of revenue is obtained by

investing a firm’s resources outside, and earning interest, rent, dividend, royalty,
commission, fee, and so on.

Expenses

The cost of earning revenue is called expenses. An important item of expanses

appearing in the P/L account is the cost of goods sold. Include in this expanse are
material cost, labour cost and other manufacturing expanses such as fuel and
power, repair, and maintenance, consumable stores, insurance of goods, and so on.

44
The general administrative expanses include salary, managerial remuneration, rent,
rate and taxes, staff welfare expanses, and so on. Other items are self-explanatory.

Net Income/Profit

The difference between revenues and expanses is net profit. The profit and loss
account may also show the appropriate of the net profits between dividends paid to
the shareholders and retained earning/amount transferred to reserves and surplus.
This last item is transferred to the balance sheet in the owner’s equity. Thus, it is a
link, in a way, between the profit and loss account and the balance sheet.

To conclude the two financial statements, namely, the balance sheet and profit and
loss account of a business firm contain useful information. The balance sheet shows
the sources from funds currently used to operate the business have been obtained,
that is, liabilities and owners’ equity, and the type of property rights in which these
funds are currently locked up, that is, assets. The profit and loss account represents
the score-board of the performance of the firm in term of the profitability of its
operations.

Net sales are obtained as follows:

Sales-Sales inwards-Excise duty

Sales are the sum of the invoice price of goods sold and services rendered during the
period. Sales inwards represent the invoice value of goods returned by the
customers. Excise duty refers to the amount paid to the government.

1. Cost of goods: - is the sum of costs incurred for manufacturing the goods sold
during the accounting period. It consists of direct material cost, labour cost,
and factory overheads. It should be distinguished from the cost of
production. The latter represents the cost of goods produced in the
accounting year, not the cost of goods sold during the same period.
2. Gross profit: - is the difference between net sales and cost of cost of goods
sold. Most companies show this amount as a separate item. Some companies,
however, show all the expanses at one place without making gross profit a
separate item.
3. Operating expanses: - consists of general administrative expanses, selling and
distribution expenses, and depreciation. (Many accountants include
depreciation under cost of goods sold as a manufacturing overhead rather
than under operating expanses. This treatment is also quite reasonable).
4. Operating profit: - is difference between gross profit and operating expanses.
As a measure of profit it reflects operating performance and is not affected
by non-operating gains/losses, financial leverage, and tax factor.
5. Non-operating surplus: - represents gains arising from sources other than
normal operations of the business. Its major components are income from

45
 investment and gain from disposal of assets. Likewise, non-operating deficit
losses from activities unrelated to the normal operations of the firm.
6. Profit before interest and taxes (PBIT): - is the sum of operating profit and
non-operating surplus deficit. Referred to also as Earning before interest and
taxes (EBIT), this represents a measure of profit which is not influenced by
financial leverage and the tax factor. Hence, it is preeminently suitable for
inter-firm comparison.
7. Interest: - is the expanses incurred for borrowed funds, such as term loans
debentures, public deposits, and working capital advances.
8. Profit before tax (PBT): - is obtained by deducting interest from profit before
interest and taxes.
9. Tax: - represents the income tax payable on the taxable profit of the year.
10. Profit after tax (PAT): - is the difference between the profit before tax and
tax for the year.
11. Dividends: - represents the amount earmarked for distribution to
shareholders.
12. Retaining earnings: - are the difference between profit after tax and
dividends.
Structure of the Profit and Loss accounts of Horizon Limited for the Year Ending
on March 31, 2001

(Rs in Million)

Items 2001
Net sales 701
Cost of goods sold 552
Stocks 421
Wages and salaries 68
Other manufacturing expanses 63
Gross profit 149
Operating expanses 60
Depression 30
General administration 12
Selling 14
Operating profit 89
Non- operating surplus/deficit -
Profit before interest and tax (PBIT) 89
Interest 21
Profit before tax (PBT) 68
Tax 34
Profit after tax 34
Dividends 28
Retained earnings 6
Per share data(in rupees)
Earning per share 2.27
Dividend per share 1.87

46
 Market per share 21.00
Book value per share 17.46

3. Cash flow statement

A cash flow statement is a financial report that shows incoming and outgoing money
during a particular period (often monthly or quarterly). The statement shows how
changes in balance sheet and income accounts affected cash and cash equivalents
and breaks the analysis down according to operating, investing, and financing
activities. As an analytical tool the statement of cash flows is useful in determining
the short-term viability of a company, particularly its ability to pay bills.

People and groups interested in cash flow statements include:

• Accounting personnel, who need to know whether the organization will be

able to cover payroll and other immediate expenses
• Potential lenders/creditors, who want a clear picture of a company's ability
to repay
• Potential investors who need to judge whether the company is financially
sound
• Potential employees or contractors who need to know whether the company
will be able to afford compensation

The cash flow statement may be prepared on the basis of actual or estimated data.
In the later case, it is termed as “Projected Cash Flow Statement”, which is
synonymous with the term ‘Cash Budget’.

The cash flow statement is a statement depicting change in cash position from one
period to another. The cash flow statement explains the reasons for inflows or
outflows of cash, as the case may be. It also helps management in making plans for
the immediate future. A Projected Cash Flow Statement or the Cash Budget will be
help the management in ascertaining how much cash will be available to meet
obligations to trade creditors, to pay bank loans and to pay dividend to the
shareholders. A proper planning of the cash recourses will enable the management
to have cash available whenever needed and put it to some profitable or productive
use in case there is surplus cash available.

The change in the cash position from one period to another is computed by taking
into account ‘Sources’ and ‘Applications’ of cash.

The Structure of the CFS

47
The cash flow statement is distinct from the income statement and balance sheet
because it does not include the amount of future incoming and outgoing cash that
has been recorded on credit. Therefore, cash is not the same as net income, which,
on the income statement and balance sheet, includes cash sales and sales made on
credit.

Cash flow is determined by looking at three components by which cash enters and
leaves a company: core operations, investing and financing,

Operations
Measuring the cash inflows and outflows caused by core business operations, the
operations component of cash flow reflects how much cash is generated from a
company's products or services. Generally, changes made in cash, accounts
receivable, depreciation, inventory and accounts payable are reflected in cash from
operations.

Cash flow is calculated by making certain adjustments to net income by adding or

subtracting differences in revenue, expenses and credit transactions (appearing on
the balance sheet and income statement) resulting from transactions that occur
from one period to the next. These adjustments are made because non-cash items
are calculated into net income (income statement) and total assets and liabilities
(balance sheet). So, because not all transactions involve actual cash items, many
items have to be reevaluated when calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an amount that is

deducted from the total value of an asset that has previously been accounted for.
That is why it is added back into net sales for calculating cash flow. The only time
income from an asset is accounted for in CFS calculations is when the asset is sold.

Changes in accounts receivable on the balance sheet from one accounting period to
the next must also be reflected in cash flow. If accounts receivable decrease, this
implies that more cash has entered the company from customers paying off their
credit accounts - the amount by which AR has decreased is then added to net sales.
If accounts receivable increase from one accounting period to the next, the amount
of the increase must be deducted from net sales because, although the amounts
represented in AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company has spent more
money to purchase more raw materials. If the inventory was paid with cash, the
increase in the value of inventory is deducted from net sales. A decrease in inventory
would be added to net sales. If inventory was purchased on credit, an increase in

48
accounts payable would occur on the balance sheet, and the amount of the increase
from one year to the other would be deducted from net sales.

The same logic holds true for taxes payable, salaries payable and prepaid insurance.
If something has been paid off, then the difference in the value owed from one year
to the next has to be subtracted from net income. If there is an amount that is still
owed, then any differences will have to be added to net earnings.

Investing
Changes in equipment, assets or investments relate to cash from investing. Usually
cash changes from investing are a "cash out" item, because cash is used to buy new
equipment, buildings or short-term assets such as marketable securities. However,
when a company divests of an asset, the transaction is considered "cash in" for
calculating cash from investing.

Financing
Changes in debt, loans or dividends are accounted for in cash from financing.
Changes in cash from financing are "cash in" when capital is raised, and they're
"cash out" when dividends are paid. Thus, if a company issues a bond to the public,
the company receives cash financing. However, when interest is paid to
bondholders, the company is reducing its cash.

Analyzing an Example of a CFS

49
From this CFS, we can see that the cash flow for FY 2003 was $1,492,000. The bulk
of the positive cash flow stems from cash earned from operations, which is a good
sign for investors. It means that core operations are generating business and that
there is enough money to buy new inventory. The purchasing of new equipment
shows that the company has cash to invest in inventory for growth. Finally, the
amount of cash available to the company should ease investors' minds regarding the
notes payable, as cash is plentiful to cover that future loan expense.

Of course, not all cash flow statements look this healthy, exhibiting a positive cash
flow. But a negative cash flow should not automatically raise a red flag without
some further analysis. Sometimes, a negative cash flow is a result of a company's
decision to expand its business at a certain point in time, which in fact would be a
good thing for the future. This is why analyzing changes in cash flow from one
period to the next gives the investor a better idea of how the company is performing,
and whether or not a company may be on the brink of bankruptcy or success.

Balance Sheet as at 31st March, 2006

As At As At
31st March, 2006 31st March, 2005
(Rs. in Crores) (Rs. in Crores)
I. SOURCES OF FUNDS

1. Shareholders' Funds

a)Capital 375.52 248.22

b)Share Capital Suspense - 1.21

c)Reserves & Surplus 8685.96 9061.48 7646.18 7895.61

2. Loan Funds

a)Secured Loans 33.67 88.69

50
 b)Unsecured Loans 86.06 119.73 156.67 245.36

3. Deferred Tax - Net 324.76 376.09

Total 9505.97 8517.06

II. APPLICATION OF FUNDS

1.Fixed Assets

a)Gross Block 6227.17 5746.27

b)Less: Depreciation 2065.44 1795.51

c)Net Block 4161.73 3950.76

d)Capital Work-in-Progress 243.40 4405.13 186.15 4136.91

2.Investments 3517.01 3874.68

3.Current Assets, Loans and Advances

a)Inventories 2636.29 2002.99

b)Sundry Debtors 547.96 527.76

c)Cash and Bank Balances 855.82 55.66

d)Other Current Assets 146.80 142.52

e)Loans and Advances 975.03 810.36

5161.90 3539.29

Less :

4.Current Liabilities and Provisions

a)Liabilities 2189.03 1925.64

51
 b)Provisions 1389.04 1108.18

3578.07 3033.82

Net Current Assets 1583.83 505.47

Total 9505.97 8517.06

Profit & Loss Account for the year ended 31st March, 2006

For the year For the year

ended ended
31st March, 31st March,
2006 2005

IA. GROSS INCOME 16510.51 13585.39

IB. NET INCOME

Gross Sales 16224.43 13349.58

Less: Excise Duties and Taxes on Sales of Products 6433.90 5710.13

and Services.

Net Sales [after considering provision for Taxes of 9790.53 52

7639.45
Rs. Nil (2005 - 214.75 Crores); also see
Schedule 19(i)]
Other Income 286.08 235.81

10076.61 7875.26

II. OTHER EXPENDITURE

Raw Materials etc. 3983.23 2769.55

Manufacturing, Selling etc. Expenses 2491.85 2119.77

Depreciation 332.34 312.87

6807.42 5202.19

III. PROFIT

Profit before Taxation and Exceptional items 3269.19 2673.07

Provision for Taxation 988.82 836.00

Profit after Taxation before Exceptional items 2280.37 1837.07

Exceptional items (net of tax) (45.02) 354.33

Profit after Taxation 2235.65 2191.40

Profit brought forward 611.41 387.84

2846.76 2579.24

Release from Hotel Foreign Exchange Earnings - 15.14

Reserve

53
 Available for appropriation 2846.76 2594.38

IV. APPROPRIATIONS

General Reserve 1150.00 1100.00

Proposed Dividend 995.12 773.25

Income Tax on Proposed Dividend [Including Rs. 139.58 109.72

0.02 Crore (2005 - Rs. 1.27 Crores) for earlier years]

Profit Carried Forward 562.06 611.41

2846.76 2594.38

Earnings Per Share (Face Value Rs. 1.00 each)

On Profit after Taxation before Exceptional items

Basic Rs. 6.08 Rs. 4.91

Diluted Rs. 6.05 Rs. 4.91

On Profit after Taxation

Basic Rs. 5.96 Rs. 5.85

Diluted Rs. 5.93 Rs. 5.85

Cash Flow Statement for the year ended 31st March, 2006
(Figures for the previous year have been rearranged to conform with the revised presentation)

54
 For the year ended For the year ended
31st March, 2006 31st March, 2005
(Rs. in Crores) (Rs. in Crores)
3269.1 2673.07
A. NET PROFIT BEFORE TAX AND
9
EXCEPTIONAL ITEMS

ADJUSTMENTS FOR :

Depreciation 332.34 312.87

Interest etc. (Net) 2.83 5.91

Income from Long Term Investments (8.69) (27.04)

Income from Current Investments (155.47) (119.72)

Fixed Assets - Loss on Sale/Write off - Net 19.63 1.89

(Profit)/Loss on Sale of Current Investments - Net (3.43) 0.34

Excess of Cost over Fair Value of Current 12.76 -

Investments

Unrealised Loss on Exchange -Net 0.01 0.04

Write off of Long Term Investment - 0.05

Liability no longer required written back (7.38) 192.60 (15.39) 158.95

OPERATING PROFIT BEFORE WORKING 3461.7 2832.02

CAPITAL CHANGES 9

ADJUSTMENTS FOR :

Trade and Other Receivables (160.51) (109.07)

55
Inventories (633.30) (506.09)

328.79 (465.02 418.11 (197.05)

Trade Payables
)

2996.7 2634.97
CASH GENERATED FROM OPERATIONS
7

(999.22 (783.77)
Income Tax Paid
)

1997.5 1851.20
Cash Flow before Exceptional items
5

Exceptional items paid/received [see Schedule (67.87) -

19(i)]

1929.6 1851.20
NET CASH FROM OPERATING ACTIVITIES
8

B. CASH FLOW FROM INVESTING ACTIVITIES :

Purchase of Fixed Assets (709.19) (517.20)

Sale of Fixed Assets 5.89 21.51

Purchase of Business (see Note 2 below) (38.83) (38.83)

(32734.10 (24462.88
Purchase of Current Investments
) )

Sale/Redemption of Current Investments 33215.54 23446.79

Purchase of Long Term Investments - (3.01)

Sale of Long Term Investments - 0.05

Income from Long Term Investments Received 8.37 27.04

56
Income from Current Investments Received 20.92 22.17

Interest Received 7.92 16.76

Refund of Deposits towards Property Options 46.50 77.01

Loans Given (55.24) (186.34)

Loans Realised 56.91 157.98

(175.31 (1438.95
NET CASH USED IN INVESTING ACTIVITIES
) )

C. CASH FLOW FROM FINANCING ACTIVITIES :

Proceeds from issue of Share Capital 65.95 37.32

Proceeds from Long Term Borrowings 17.01 11.31

Net increase / (decrease) in Cash/Export Credit (142.64) 113.12

Facilities and other Short Term Loan

Interest etc. Paid (16.28) (18.68)

Dividends Paid (769.78) (494.65)

Income Tax on Dividend Paid (108.47) (65.51)

NET CASH FLOW USED IN FINANCING (954.21 (417.09)

ACTIVITIES )

NET (DECREASE)/INCREASE IN CASH AND 800.16 (4.84)

CASH EQUIVALENTS

OPENING CASH AND CASH EQUIVALENTS 55.66 34.00

CASH AND CASH EQUIVALENTS TAKEN OVER - 26.50

ON AMALGAMATION (N 1)

57
ON AMALGAMATION (Note 1)

CLOSING CASH AND CASH EQUIVALENTS 855.82 55.66

CASH AND CASH EQUIVALENTS COMPRISE :

Cash and Bank Balances 855.82 55.66

Notes :

1. Cash and cash equivalents include Rs. Nil

(2005 - Rs. 26.50 Crores) of erstwhile ITC Hotels
Limited and Ansal Hotels Limited taken over on
amalgamation.

2. Purchase consideration of Rs.232.99 Crores

(net of liability of Rs.15.03 Crores towards sales
tax deferment loans assumed) on acquisition of
business in 2004, payable to M/s BILT Industrial
Packaging Company Limited. 232.99 232.99

Cash paid [Including Rs.38.83 Crores (2005 -

Rs.38.83 Crores) during the year as per scheme of
repayment] 116.49 77.66

Balance Payable 116.50 155.33

For analysis of these financial statements, the following tools are used:-

1. Ration analysis
2. Cash Flow Statement
3. Statement of Change in Financial Position on Working Capital basis and
Cash basis
4. Comparative Statement and,
5. Common size Statement.

58
2.10 Statement of Change in Financial Position (SCFP)
The balance sheet and income statement are traditional basic financial statement of
business enterprises. While they do furnish useful financial data regarding its
operations, a serious limitation of these statements is that they do not provide
information regarding changes in the firm’s financial position during a particular
period of time. In operational terms, they fail responsible to answer questions such
as:

• What have been factors responsible for the difference in owner’s

equity, assets and liabilities of the firm at two dates of consecutive
balance sheet?
• What have been the premier financing and investment activities of the
firm during this period?
• How long-term sources been adequate to finance fixed assets
purchase?
• Does the firm possess adequate working capital and cash?
• Why did the firm not pay dividends in spite of adequate profits?
• How much funds have been generated from operations/operating
activities?
• How much funds have been generated (or spent) from (or on)
investment and financing activities?
• Has the liquidity position of the firm improved?
The SCFP overcomes these limitations of basic financial statements. In other words,
the SCFP throws light on the above aspects which are of considerable interest to the
financial managers and outside investors.

Meaning of SCFP

The SCFP is a statement of flows, that is, it measures the changes that taken place in
the financial position of a firm between two balance sheet dates. It summarizes the
sources from which funds have been obtained and the uses to which they have been
applied. As a statement of sources and uses of funds, drawing on the information
contained in the basic financial statement, it shows the source of funds and
application of funds during the period. The changes in financial position could be
related to several different concepts of funds. The two most common usages of the
term funds are cash and working capital. Viewed in this sense. The SCFP would
explain the change in cash or working capital. Accordingly, there are two
statements, that is, statement of changes in cash (popularly called cash statement)
and statement of changes in words capital (popularly known as sources and uses
statements or funds flow statements).

SCFP-Working Capital basis

59
The net working capital (NWC) of a firm is the amount by which its current assets
(CA) exceed its current liabilities, (CL). The magnitude of working capital is a
measure of the safety margin that exists for the protection of short-term creditors.
Working capital may also be viewed as funds available for acquisition of non-
current assets/fixed assets as well as to repay non-current liabilities/ long-term
liabilities. Any transaction that results in an increase in working capital is a source
of WC; any transaction that causes a decrease in WC is an application of WC. Some
transactions merely change the form of working capital, without altering the
amount of working capital; such items neither constitute a source nor the use of
working capital.

General Rules

Let us formulate some general rules to ascertain transaction give rise to a use of
working capital and which do not. This exercise is useful for the preparation of the
funds flow statement. Symbolically,

WC=CA-CL

From the above, the following may be deduced:

1. Transactions affecting WC:

(a) An increase in CA (without affecting CL) causes an increase in WC. –

Issue of equity shares causes an increase in cash (CA) and increases in non-current
liability (NCL).

(b) A decrease in CA (without affecting CL) causes a decrease in WC. –

Purchase of non-current assets (NCA) causes decrease in cash (CA) and increase in
(NCA).

© An increase in CL (without affecting CA) causes a decrease in WC. – Bank

overdraft to repay long-term loans causes an increase in CL and decrease in NCL.

(d) A decrease in CL (without affecting CA) causes an increase in WC. –

Bank overdraft paid by issue of debentures causes a decrease in bank overdraft
(CL) and an increase in NCL.

2. Transactions not affecting WC:

(e) A simultaneous increase in CA and CL does not affect WC. – Purchase of

inventories on credit causes an increase in inventory (CA) and an increase in
creditors (CL).

60
 (f) A simultaneous decrease in CA and CL does not affect WC. – Payment of
creditors in cash (CA) and decrease in creditors (CL).

(g) A simultaneous increase/decrease in NCA and NCL does not affect WC. –
Purchase of machine by issue of debentures causes an increase in NCA and an
increase in debentures (NCL).

A close examination of the above rules and illustrations that a transaction which
gives rise to a source or use of working capital should affect both the current
account (CA or CL), and the non-current account (NCA or NCL) simultaneously.
However, if a transaction occurs where either only current accounts [as shown in
rules (e) and (f)] are affected, working capital is not changed. Likewise, if both non-
current assets (g) are affected as a result of the transaction, it does not bring about
any change in working capital.

The major sources and uses of working capital are

1. Sources of Working Capital

o Funds from business operations

o Other incomes
o Sales of non-current assets
o Long-Term borrowings
o Issue of additional equity capital or preferences shares capital
2. Uses of Working Capital

o Loses from business operations

o Purchase of non-current assets
o Redemption of debentures and/or preference shares
o Dividends to shareholders

SCFP-Cash basis

The statement of change in financial position based on working capital is of

immense use in long-range financial planning. The long-term financing and
investment activities are specifically portrayed. The net working capital
requirements (in one lump sum amount) are shown as a residual figure. However,
the working capital concept may conceal or exclude too much. It treats increase in
inventories and accounts receivable as equivalent to increase in cash. Likewise, an
increase in accounts payable and accrued expenses are treated as equivalent to an
increase in bank overdraft. This is not a correct treatment. In fact, accrued expanses
like wages and salaries may become payable in next 10 days or so; sundry creditors
bills may fall due for payment during the next one month, whereas bank overdraft
may be for a longer period of, say, three months or even more. Similarly, inventories

61
and accounts receivable undergo a transformation before they become money assets
(cash).

It is possible that there is sufficient net working capital as revealed by the statement
of changes in financial position and yet the firm may be unable to meet its current
liabilities as and when they fall due. It may be due to a sizeable piling up of
inventories and an increase in debtors caused by a slow-down in collections. The
firm’s failure to meet its short-term commitments, in spite of its sound long-range
financial position and adequate profitability, may plunge it into technical
insolvency. Therefore, in making plans for the more immediate future (short-range
financial position), the management is vitally concerned with a statement of cash
flows which provides more detailed information. Such a statement is useful for the
management to assess its ability to meet obligations to trade creditors, to pay bank
loans, to pay interest to debenture holders and dividend to the shareholders.

Furthermore, the projected cash flow statement prepared month-wise or so (which

are constructed like the funds statement) can be useful in presenting information of
excess cash in some months and shortage of cash in others. By making available
such information in advances, the statement of cash flows enables the management
to revise its plans. In the months when cash receipts are expected to be greater than
cash payment, bank overdraft can be repaid, short-term government securities can
be purchased, and cash discount can be availed of and so on. Likewise, in the
months when cash payments are expected to exceed receipts, the firm would be
required to arrange for bank overdraft or sell its marketable securities.

In essence, cash flow statements are SCFP on the basis of funds defined as cash-
equivalent. In short, cash flow statement summaries sources of cash inflow and uses
of outflows of the firm during a particular period of time.

62