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1) Realization Concept

"Revenues are recognized when goods and services are delivered and in an amount that is reasonably certain to be realized"

There are two important dimensions to this principle, i.e. when revenue is recognized, and whether it is certain that all revenue will eventually be collected.

If the accountant believes that based on past experience only 90% of revenues will be collected, then the accountant will create an "allowance for doubtful accounts".

2) Money measurement concept

The money measurement concept underlines the fact that in accounting, every recorded event or transaction is measured in terms of money. Using this principle, a fact or a happening which cannot be expressed in terms of money is not recorded in the accounting books.

One of the basic principles in accounting is "The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements." [1]

3) Personal Account, Nominal Account, Real Account with their rules and proper examples:










Nominal Account


Revenue or expense account that is a subdivision of the owners' equity account, and which is closed to a zero balance at the end of each accounting period. It starts with a zero balance at the beginning of a new accounting period, accumulates balances during the period, and returns to zero at the yearend by means of closing entries. Nominal accounts are income statement accounts and are also called 'temporary accounts' in contrast to balance sheet (asset, liability, and owners' equity) accounts which are called 'permanent accounts' or 'real accounts.'


The effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.


Accounting is the language of business and it is used to communicate financial information. In order for that information to make sense, accounting is based on 12 fundamental concepts. These fundamental concepts then form the basis for all of the Generally Accepted Accounting Principles (GAAP). By using these concepts as the foundation, readers of financial statements and other accounting information do not need to make assumptions about what the numbers mean.

For instance, the difference between reading that a truck has a value of $9000 on the balance sheet and understanding what that $9000 represents is huge. Can you turn around

and sell the truck for $9000? If you had to buy the truck today, would you pay $9000? Or,

perhaps the original purchase price of the truck was $9000.

All of these assumptions lead

to very different evaluations of the worth of that asset and how it contributes to the company’s financial situation.

For this reason it is imperative to know and understand the eleven key concepts.


Entity Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate

from those of the owner(s).


For an accounting record to be made it must be able to be expressed in monetary terms. For this reason, financial statements show only a limited picture of the business. Consider a situation where there is a labor strike pending or the business owner’s health is failing; these situations have a huge impact on the operations and financial security of the company but this information is not reflected in the financial statements.

Going Concern Accounting assumes that an entity will continue to operate indefinitely. This concept implies that financial statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets will be used in future operations. This concept also allows businesses to spread (amortize) the cost of an asset over its expected useful life.

Cost An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.) Look at the following example:



purchase price of the truck

Less depreciation $ 1,000

amount deducted as a depreciation expense

Net Truck:

$ 9,000

net book-value of the truck

The $9000 simply represents the book value of the truck after depreciation has been accounted for. This figure says nothing about other aspects that affect the value of an item and is not considered a market price.

Dual Aspect This concept is the basis of the fundamental accounting equation:

Assets = Liabilities + Equity

  • 1. Assets are what the company owns.

  • 2. Liabilities are what the company owes to creditors against those assets

  • 3. Equity is the difference between the two and represents what the company owes to its investors/owners.

All accounting transactions must keep this equation balanced so when there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side.


6) Trading a/c, profit and loss a/c and balance sheet with proper format.

Trading Account:

An account similar to a traditional bank account, holding cash and securities, and is administered by an investment dealer.

An account held at a financial institution and administered by an investment dealer that the account holder uses to employ a trading strategy rather than a buy-and-hold investment strategy.

Profit And Loss A/c

An income statement, also called a profit and loss statement, shows the revenues from business operations, expenses of operating the business, and the resulting net profit or loss of a company over a specific period of time.

In assessing the overall financial condition of a company, you'll want to look at the income statement and the balance sheet together, as the income statement captures the company's operating performance and the balance sheet shows its net worth.

Balance Sheet

A balance sheet is a statement of the total assets and liabilities of an organization at a particular date - usually the last date of an accounting period.

The balance sheet is split into two parts:

(1) A statement of fixed assets, current assets and the liabilities (sometimes referred to as "Net Assets")

(2) A statement showing how the Net Assets have been financed, for example through share capital and retained profits.

The Companies Act requires the balance sheet to be included in the published financial accounts of all limited companies. In reality, all other organizations that need to prepare accounting information for external users (e.g. charities, clubs, and partnerships) will also product a balance sheet since it is an important statement of the financial affairs of the organization.

A balance sheet does not necessary "value" a company, since assets and liabilities are shown at "historical cost" and some intangible assets (e.g. brands, quality of management, market leadership) are not included.

7) Memorandum of association

Document that regulates a firm's external activities and must be drawn up on the formation of a registered or incorporated firm. As the firm's charter it (together with the firm's articles of association) forms the firm's constitution. Also called 'memorandum,' it gives the firm's name, names of its members (shareholders) and number of shares held by them, and location of its registered office. It also states the firm's (1) objectives, (2) amount of authorized share capital, (3) whether liability of its members is limited by shares or by guaranty, and (4) what type of contracts the firm is allowed to enter into. Almost all of its provisions (except those mandated by corporate legislation) can be altered by the firm's members by following the prescribed procedures. The memorandum is a public document and may be inspected (normally on payment of a fee) by anyone, usually at the public office where it is lodged (such as the registrar of companies office). Called articles of incorporation in the US

8) Articles of association

The internal 'rule book' that, according to corporate legislation, every incorporated firm must have and work by. And which, along with memorandum of association, forms the constitution of a firm. Also called articles, it is a contract (1) between the members (stockholders, subscribers) and the firm and (2) among the members themselves. It sets out the rights and duties of directors and stockholders individually and in meetings. Certain statutory (obligatory) clauses (such as those dealing with allotment, transfer, and forfeiture of shares) must be included; the other (non-obligatory) clauses are chosen by the stockholders to make up the bylaws of the firm. A court, however, may declare a clause ultra virus if it is deemed unfair, unlawful, or unreasonable. A copy of the articles is lodged with the appropriate authority such as the registrar of companies. Articles are public documents and may be inspected by anyone (usually on payment of a fee) either at the premises of the firm and/or at the registrar's office. Lenders to the firm take special interest in its provisions that impose a ceiling on the borrowings beyond which the firm's management must get stockholders' approval before taking on more debt.

9) Types of companies

In India, the following types of business entities are available:

Private Limited Company

Public Limited Company

Unlimited Company

Limited Liability Partnership (LLP)


Sole Proprietorship

Liaison Office/Representative Office

Project Office

Branch Office

Joint Venture Company

Subsidiary Company

10) Preliminary expanses

Professional and other expenses involved in establishing a business. Also called formation expenses.

11) Share capital & types of share capital

Types of shares: Shares in the company may be similar i.e. they may carry the same rights and liabilities and confer on their holders the same rights, liabilities and duties. There are two types of shares under Indian Company Law:-

  • 1. Equity shares means that part of the share capital of the company which are not preference


  • 2. Preference Shares means shares which fulfill the following 2 conditions. Therefore, a share

which is does not fulfill both these conditions is an equity share.

  • a. It carries Preferential rights in respect of Dividend at fixed amount or at fixed rate i.e. dividend payable is payable on fixed figure or percent and this dividend must paid before the holders of the equity shares can be paid dividend.

  • b. It also carries preferential right in regard to payment of capital on winding up or otherwise.

It means the amount paid on preference share must be paid back to preference shareholders before anything in paid to the equity shareholders. In other words, preference share capital has priority both in repayment of dividend as well as capital.

Types of Preference Shares 1.Cumulative or Non-cumulative: A non-cumulative or simple preference shares gives right to fixed percentage dividend of profit of each year. In case no dividend thereon is declared in any year because of absence of profit, the holders of preference shares get nothing nor can they claim unpaid dividend in the subsequent year or years in respect of that year. Cumulative preference shares however give the right to the preference shareholders to demand the unpaid dividend in any year during the subsequent year or years when the profits are available for distribution. In this case dividends which are not paid in any year are accumulated and are paid out when the profits are available.

  • 2. Redeemable and Non- Redeemable: Redeemable Preference shares are preference shares

which have to be repaid by the company after the term of which for which the preference shares have been issued. Irredeemable Preference shares means preference shares need not repaid by the company except on winding up of the company. However, under the Indian Companies Act, a company cannot issue irredeemable preference shares. In fact, a company limited by shares cannot issue preference shares which are redeemable after more than 10 years from the date of issue. In other words the maximum tenure of preference shares is 10 years. If a company is unable to redeem any preference shares within the specified period, it may, with consent of the Company Law Board, issue further redeemable preference shares equal to redeem the old preference shares including dividend thereon. A company can issue the

preference shares which from the very beginning are redeemable on a fixed date or after certain period of time not exceeding 10 years provided it comprises of following conditions :-

  • 1. It must be authorized by the articles of association to make such an issue.

  • 2. The shares will be only redeemable if they are fully paid up.

  • 3. The shares may be redeemed out of profits of the company which otherwise would be

available for dividends or out of proceeds of new issue of shares made for the purpose of

redeem shares.

  • 4. If there is premium payable on redemption it must have provided out of profits or out of

shares premium account before the shares are redeemed.

  • 5. When shares are redeemed out of profits a sum equal to nominal amount of shares redeemed

is to be transferred out of profits to the capital redemption reserve account. This amount should then be utilized for the purpose of redemption of redeemable preference shares. This reserve can be used to issue of fully paid bonus shares to the members of the company.

  • 3. Participating Preference Share or non-participating preference shares: Participating

Preference shares are entitled to a preferential dividend at a fixed rate with the right to participate further in the profits either along with or after payment of certain rate of dividend on equity shares. A non-participating share is one which does not such right to participate in the profits of the company after the dividend and capital has been paid to the preference shareholders.

12) Qualitative characteristic of financial statement


Accounting information should be readily understandable to the intended users of the information.

This is a function of both the intended users and the intended uses of the information. Accounting systems that define either the users or uses narrowly may justify more complex information requirements and standards. Accounting systems that envision a broad body of users and/or uses would tend towards less complexity in published information and standards.

Typically the belief that, for information to be understandable, information contained in the various financial disclosures and reporting must be transparent (i.e., clearly disclosed and readily discernable).


The information should be relevant to the decision-making users of the information. It should make a difference in their decisions. Typically, this means the information must



Have predictive value

Provide useful feedback on past decisions


The information should be reliable and dependable. This usually includes the concepts of:

Representational faithfulness – the information represents what it claims to represent. For example, if the reported value of a common stock holding purports to be the current market value, that value should be approximately what the stock could be sold for by the company holding it.

Verifiability - another person or entity should be able to recreate the reported value using the same information that the reporting entity had.

Completeness - the reported information should not be missing a material fact or consideration that would make the reported information misleading.

The concept of neutrality is sometimes incorporated into the concept of reliability.


For accounting information to be usable, it must allow for comparisons across time and across competing interests (such as competing companies or industries).

This leads to a need for some consistency, wherever such comparisons are to be expected. For example, comparisons of two companies would be very difficult and potentially misleading if one discounts all its liabilities while the other discounts none of its liabilities.


Information that is biased can be misleading.

Biased information is not useful unless the users understand the bias, any bias is consistently applied across years/firms/industries, and the users can adjust the reported results to reflect their own desired bias.

When faced with uncertainty, there is a need to either require reporting of unbiased values accompanied with sufficient disclosure, or require the reporting of biased

(prudent or conservative) values with the bias determined in a predictable, consistent fashion.


General understanding that the development of accounting information consumes resources.

As such, the cost of producing such information should be reasonable in relation to the expected benefit.

Use the materiality accounting rule – may not have to be fully followed for immaterial items if full compliance would result in unwarranted higher costs.

13) GAAP (Generally Accepted Accounting Principal)

What Does Generally Accepted Accounting Principles - GAAP Mean? 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.

Investopedia explains generally Accepted Accounting Principles - GAAP 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.

15) CBDT (Central Board of Direct Taxes)

Since 1 January 1964 the Central Board of Direct Taxes (CBDT) has been charged with all matters relating to various direct taxes in India and it derives its authority from Central Board of Revenue Act 1963. The CBDT is a part of Department of Revenue in the Ministry of Finance. On one hand, CBDT provides essential inputs for policy and planning of direct taxes

in India, at same time it is also responsible for administration of direct tax laws through Income Tax Department.

The Chairman, who is also an ex-officio Special Secretary to Government of India, heads the CBDT. In addition, CBDT has six Members, who are ex-officio Additional Secretaries to Government of India. The Chairman and Members of CBDT are selected from Indian Revenue Service (IRS), a premier civil service of India, whose members constitute the top management of Income Tax Department. The support staff for CBDT is drawn from IRS as well as other premier civil services of the country and is assisted by several attached offices.

16) ASB (Accounting Standard Board)

UK organization (similar to the US Financial Accounting Standards Board) responsible for drafting and establishing accounting standards. ASB is a subsidiary of Financial Reporting Council; one of its committees publishes the International Accounting Standards.

17) Auditors’ Report: -

A section of an annual report that includes the auditor's opinion about the veracity of the financial statements.

18) Directors’ Report

In the UK and commonwealth countries, the part of a large firm's annual report package that (among other items of information) states (1) names of directors that served during the reporting year, (2) summary of the firm's trading activities and its future prospects, (3) principal activities of the firm and its subsidiaries, and any changes therein, (4) recommended dividend for the reporting year, (5) post-balance sheet date events that may materially affect the firm's finances, and (6) significant changes in the value of fixed assets. Called Form 10-k in the US, a director’s report must be independently audited like the accompanying financial statements.

19) Corporate Governance Report

The system of checks and balances designed to ensure that corporate managers are just as vigilant on behalf of long-term shareholder value as they would be if it was their own money at risk. It is also the process whereby shareholders-the actual owners of any publicly traded firm- assert their ownership rights, through an elected board of directors and the CEO and other officers and managers they appoint and oversee. In the heels of corporate scandals including the Enron debacle in 2002, a series of sweeping changes are being sought, such as forcing boards to have a majority of independent directors, granting audit committees power to hire and fire accountants, banning sweetheart loans to officers and directors, and requiring shareholder's approval for stock option plans. More specifically, the following principles constitute good governance:


To avoid conflicts of interest, a company's board of directors should include a substantial

majority of independent directors-independent meaning that directors don't have financial or

close personal ties to the company or its executives.

  • 2. a company's audit, nominating, and compensation committees should consist entirely of

independent directors.

  • 3. a board should obtain shareholder approval for any actions that could significantly affect

the relationship between the board and shareholders, including the adoption of anti-takeover

measures such as "poison pills."

  • 4. Companies should base executive compensation plans on pay for performance and should

provide full disclosure of these plans.

  • 5. To avoid abuse in the use of stock options (and executive perquisites), all employee stock

option plans should be submitted to shareholders for approval.

20) Quality of earning

A condition describing how earnings are recognized. Earnings of high quality are attributable to conservative accounting standards and/or strong cash flows. Low quality earnings come from artificial sources, such as inflation or aggressive accounting. For example, in the early 2000s, Krispy Kreme doughnuts had strong earnings and consequently a high stock price. However, the company had low cash flow from operations and the strong earnings came mainly from the accounting structures it used. Therefore, its stock was overvalued. Quality of earnings ratings is subjective, but they take into account matters such as corporate governance, inventory-to-sales ratios, and other factors.

21) Window Dressing

The deceptive practice of some mutual funds, in which recently weak stocks are sold and recently strong stocks are bought just before the fund's holdings are made public, in order to give the appearance that they've been holding good stocks all along.

25) Foreign Currency Accounting

Paper (unrealized) gain or loss (as on a balance sheet date) resulting from an appreciation or devaluation of the non-local currency in which the assets and/or liabilities of a firm are denominated in its account books.

26) Inflation Accounting,

Adjusting financial statements to show a firm's real financial position in inflationary times. It aims to indicate how rising prices and lower purchasing power of the currency affect a firm's cost of refinancing its productive assets, and of its ability to maintain an adequate level of profit on the capital employed. One method is to adjust every figure in the balance sheet on the basis of a price index (such as consumer price index) which reflects the current purchasing

power of the currency. Another method suggests revaluing tangible assets at their replacement cost. In valuation of an inventory, inflation accounting treatment can affect the firm's taxable income, cash position, and reported earnings, depending on whether the firm uses FIFO or LIFO methods. FIFO method, shows a higher profit, therefore higher tax burden and a decrease in net cash flow. LIFO method lowers the profit and tax burden and increases the net cash flow.

27) Human Resource Accounting

Method that recognizes a variety of human resources and shows them on a company's balance sheet. Under human resource accounting, a value is placed on people based on such factors as experience, education, and psychological traits, and, most importantly, future earning power (benefit) to the company. The idea has been well received by human-resource-oriented firms, such as those engaged in accounting, law, and consulting. Practical application is limited, however, primarily because of difficulty and the lack of uniform, consistent methods of quantifying the values of human resources.

28) Environment accounting

He practices of including the indirect costs and benefits of a product or activity, for example, its environmental effects on health and the economy, along with its direct costs when making business decisions.

29) Responsibility Accounting

Collection, summarization, and reporting of financial information about various decision centers (responsibility centers) throughout an organization; also called activity accounting or profitability accounting. It traces costs, revenues, or profits to the individual managers who are primarily responsible for making decisions about the costs, revenues, or profits in question and taking action about them. Responsibility accounting is appropriate where top management has delegated authority to make decisions. The idea behind responsibility accounting is that each manager's performance should be judged by how well he or she manages those items under his or her control.

Q. 2 Which are the financial statement & reports presented in the annual report? What are the objectives of financial statements & who are the users of financial information?

Financial statements (or financial reports) are formal records of the financial activities of a business, person, or other entity. In British English, including United Kingdom company law, financial statements are often referred to as accounts, although the term financial statements is also used, particularly by accountants.

Financial statements provide an overview of a business or person's financial condition in both short and long term. All the relevant financial information of a business enterprise presented in a structured manner and in a form easy to understand, is called the financial statements. There are four basic financial statements: [1]

  • 1. Balance sheet: also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and Ownership equity at a given point in time.

  • 2. Income statement: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state.

  • 3. Statement of retained earnings: explains the changes in a company's retained earnings over the reporting period.

  • 4. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.


Purpose of financial statements

"The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions." [2] Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization's financial position. Reported income and expenses are directly related to an organization's financial performance.

Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently." [2] Financial statements may be used by users for different purposes:

Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.

Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.

Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long- term bank loan or debentures) to finance expansion and other significant expenditures.

Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.

Vendors who extend credit to a business require financial statements to assess the creditworthiness of the business.

Media and the general public are also interested in financial statements for a variety of reasons.

Government financial statements See also: Fund accounting

The rules for the recording, measurement and presentation of government financial statements may be different from those required for business and even for non-profit organizations. They may use either of two accounting methods: accrual accounting, or cash accounting, or a combination of the two (OCBOA). A complete set of chart of accounts is also used that is substantially different from the chart of a profit-oriented business

Audit and legal implications

Although laws differ from country to country, an audit of the financial statements of a public company is usually required for investment, financing, and tax purposes. These are usually performed by independent accountants or auditing firms. Results of the audit are summarized in an audit report that either provides an unqualified opinion on the financial statements or qualifications as to its fairness and accuracy. The audit opinion on the financial statements is usually included in the annual report.

There has been much legal debate over who an auditor is liable to. Since audit reports tend to be addressed to the current shareholders, it is commonly thought that they owe a legal duty of care to them. But this may not be the case as determined by common law precedent. In Canada, auditors are liable only to investors using a prospectus to buy shares in the primary market. In the United Kingdom, they have been held liable to potential investors when the auditor was aware of the potential investor and how they would use the information in the financial statements. Nowadays auditors tend to include in their report liability restricting language, discouraging anyone other than the addressees of their report from relying on it. Liability is an important issue: in the UK, for example, auditors have unlimited liability.

In the United States, especially in the post-Enron era there has been substantial concern about the accuracy of financial statements. Corporate officers (the chief executive officer (CEO) and chief financial officer (CFO)) are personally liable for attesting that financial statements "do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the[e] report." Making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability. For example Bernie Embers (former CEO of WorldCom) was sentenced to 25 years in federal prison for allowing WorldCom's revenues to be overstated by $11 billion over five years.

Standards and regulations

Different countries have developed their own accounting principles over time, making international comparisons of companies difficult. To ensure uniformity and comparability between financial statements prepared by different companies, a set of guidelines and rules are

used. Commonly referred to as Generally Accepted Accounting Principles (GAAP), these set of guidelines provide the basis in the preparation of financial statements.

Recently there has been a push towards standardizing accounting rules made by the International Accounting Standards Board ("IASB"). IASB develops International Financial Reporting Standards that have been adopted by Australia, Canada and the European Union (for publicly quoted companies only), are under consideration in South Africa and other countries. The United States Financial Accounting Standards Board has made a commitment to converge the U.S. GAAP and IFRS over time.

Inclusion in annual reports

To entice new investors, most public companies assemble their financial statements on fine paper with pleasing graphics and photos in an annual report to shareholders, attempting to capture the excitement and culture of the organization in a "marketing brochure" of sorts. Usually the company's chief executive will write a letter to shareholders, describing management's performance and the company's financial highlights.

In the United States, prior to the advent of the internet, the annual report was considered the most effective way for corporations to communicate with individual shareholders. Blue chip companies went to great expense to produce and mail out attractive annual reports to every shareholder. The annual report was often prepared in the style of a coffee table book.

Q.3 Prepare the vertical format of balance sheet and income statement.


Happy Travel Court Income Statement For the Month Ended March 31, 2005

Revenues Rental Revenue


Operating Expenses Advertising
















Total Operating Expenses:


Net Income:


Q. 4 what is cash-flow statement? Explain the three different activities of cash flow statement and non cash items. Prepare the format of cash flow statement.


Summary of the actual or anticipated incomings and outgoings of cash in a firm over an accounting period (month, quarter, year). It answers the questions Where the money came (will come) from? And where it went (will go)? cash flow statements assess the amount, timing, and predictability of cash-inflows and cash-outflows, and are used as the basis for budgeting and business-planning. The accounting data is presented usually in three main sections: (1) Operating-activities (sales of goods or services), (2) Investing-activities (sale or purchase of an asset, for example), and (3) Financing-activities (borrowings, or sale of common stock, for example). Together, these sections show the overall (net) change in the firm's cash-flow for the period the statement is prepared. Lenders and potential investors closely examine the cash flow resulting from the operating activities. This section represents after-tax net income plus depreciation and amortization and, therefore, the ability of the firm to service its debt and pay dividends. With balance sheet and income statement (profit and loss account), cash flow statement constitutes the critical set of financial information required to manage a business.

A cash flow statement is a financial report that describes the source of a company's cash and how it was spent over a specified time period. Because of the varied accrual accounting methods companies may employ, it is possible for a company to show profits while not having enough cash to sustain operations. A cash flow statement neutralizes the impact of the accrual entries on the other financial statements. It also categorizes the sources and uses of cash to provide the reader with an understanding of the amount of cash a company generates and uses in its operations, as opposed to the amount of cash provided by sources outside the company, such as borrowed funds or funds from stockholders. The cash flow statement also tells the reader how much money was spent for items that do not appear on the income statement, such as loan repayments, long-term asset purchases, and payment of cash dividends.

Cash flow statements classify cash receipts and payments according to whether they stem from operating, investing, or financing activities. It also provides that the statement of cash flows may be prepared under either the direct or indirect method, and provides illustrative examples for the preparation of statements of cash flows under both the direct and the indirect methods.

CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS. At the beginning of a company's life cycle, a person or group of people comes up with an idea for a new company. The initial money comes from the owners, or could be borrowed. This is how the new company is "financed." The money owners put into the company, or money the company borrows, is classified as a financing activity. Generally, any item that would be classified on the balance sheet as either a long-term liability or equity would be a candidate for classification as a financing activity.

The owners or managers of the business use the initial funds to buy equipment or other assets they need to run the business. In other words, they invest it. The purchase of property, plant, equipment, and other productive assets is classified as an investing activity. Sometimes a

company has enough cash of its own that it can lend money to another enterprise. This, too, would be classified as an investing activity. Generally, any item that would be classified on the balance sheet as a long-term asset would be a candidate for classification as an investing activity.

Now the company can start doing business. It has procured the funds and purchased the equipment and other assets it needs to operate. It starts to sell merchandise or services and make payments for rent, supplies, taxes, and all of the other costs of doing business. All of the cash inflows and outflows associated with doing the work for which the company was established would be classified as an operating activity. In general, if an activity appears on the company's income statement, it is a candidate for the operating section of the cash flow statement.

ACCRUAL AND ITS EFFECT ON FINANCIAL STATEMENTS. Generally accepted accounting principles (GAAP) require that financial statements are prepared on the accrual basis. For example, revenues that were earned during an accounting period may not have been collected during that period, and appear on the balance sheet as accounts receivable. Similarly, some of the collections of that period may have been from sales made in prior periods. Cash may have been collected in a period prior to the services rendered or goods delivered, resulting in deferred recognition of the revenue. This would appear on the balance sheet as unearned revenue.

Sometimes goods or services are paid for prior to the period in which the benefit is matched to revenue (recognized). This results in a deferred expense, or a prepaid expense. Items such as insurance premiums that are paid in advance of the coverage period are classified as prepaid. Sometimes goods or services are received and used by the company before they are paid for, such as telephone service or merchandise inventory. These items are called accrued expenses, or payables, and are recognized on the income statement as an expense before the cash flow occurs. When buildings or equipment are purchased for cash, the cash flow precedes the recognition of the expense by many years. The expense is recognized over the life of the asset as depreciation. One of the main benefits of the cash flow statement is that it removes the effect of any such accruals or deferrals.

METHODS OF PREPARING THE CASH FLOW STATEMENT. Small business owners preparing a cash flow statement Chan choose either the direct or the indirect method of cash flow statement presentation. The operating section of a cash flow statement prepared using either method converts the income statement from the accrual to the cash basis, and reclassifies any activity not directly associated with the basic business activity of the firm. The difference lies in the presentation of the information.

Companies that use the direct method are required, at a minimum, to report separately the following classes of operating cash receipts and payments:

RECEIPTS. Companies are encouraged to provide further breakdown of operating cash receipts and payments that they consider meaningful.

Companies using either method to prepare the cash flow statement are also required to separately disclose changes in inventory, receivables, and payables to reconcile net income (the result of the income statement) to net cash flow from operating activities. In addition, interest paid (net of amount capitalized) and income taxes paid must be disclosed elsewhere in the

financial statements or accompanying notes. An acceptable alternative presentation of the indirect method is to report net cash flow from operating activities as a single line item in the statement of cash flows and to present the reconciliation details elsewhere in the financial statements.

The reconciliation of the operating section of a cash flow statement using the indirect method always begins with net income or loss, and is followed by an "adjustments" section to reconcile net income to net cash provided by operating activities.

Regardless of whether the direct or the indirect method is used, the operating section of the cash flow statement ends with net cash provided (used) by operating activities. This is the most important line item on the cash flow statement. A company has to generate enough cash from operations to sustain its business activity. If a company continually needs to borrow or obtain additional investor capitalization to survive, the company's long-term existence is in jeopardy.

The presentation of the investing and financing sections is the same regardless of whether the statement is prepared using the direct or indirect method. The final section of the cash flow statement is always a reconciliation of the net increase or decrease in cash for the period for which the statement is prepared, with the beginning and ending balances in cash for the period.

Analyzing and Classifying Common Transactions

Transactions on the balance sheet also must be analyzed and converted from the accrual to the cash basis in preparation of the cash flow statement. Every balance sheet account reflects specific activity. There are only a few distinctive transactions that affect each account. Following are examples of some of the common transactions affecting balance sheet items:

Accounts receivable increases when the company sells merchandise or does a service on credit, and decreases when the customer pays its bill. Accounts receivable is associated with the income statement account Sales or Revenue. The change in accounts receivable or the cash collected from customers is classified as an operating activity.

Inventory increases when the company buys merchandise for resale or use in its manufacturing process, and decreases when the merchandise is sold. Inventory is associated with the income statement account Cost of Goods Sold. The change in inventory or the cash paid for inventory purchases is classified as an operating activity.

Prepaid insurance increases when the company pays insurance premiums covering future periods and decreases when the time period of coverage expires. Prepaid insurance is associated with the income statement account Insurance Expense. The change in prepaid or the amount paid for insurance is classified as an operating activity.

The Land, Building, and Equipment accounts increase when the company purchases additional assets. They also undergo a corresponding decrease when the assets are sold. The only time the income statement is affected is when the asset is sold at a price higher or lower than book value, at which time a gain or loss on sale of assets appears on the income statement. The amount of cash used or received from the purchase or sale of such assets is classified as an investing activity. The gain or loss is classified as an adjustment in the operating section on a cash flow statement prepared using the indirect method.

Accumulated depreciation increases as the building and equipment depreciates and decreases when building and equipment is sold. Accumulated depreciation is associated with depreciation expense on the income statement. Depreciation expense does not appear on a cash flow statement presented using the direct method. Depreciation expense is added back to net income on a cash flow statement presented using the indirect method, since the depreciation caused net income to decrease during the period but did not affect cash.

Goodwill increases when the parent company acquires a subsidiary for more than the fair market value of its net assets. Goodwill amortizes over a time period not to exceed 40 years. Goodwill is associated with amortization expense on the income statement. Amortization expense appears in the operating section of a cash flow statement prepared using the indirect method. Amortization expense does not appear on a cash flow statement prepared using the direct method.

Notes payable increases when the company borrows money, and decreases when the company repays the funds borrowed. Since only the principal appears on the balance sheet, there is no impact on the income statement for repaying the principal component of the note. Notes payable appear in the financing section of a cash flow section.

Premiums and discounts on bonds are amortized through bond interest expense. There is no cash flow associated with the amortization of bond discounts or premiums. Therefore, there will always be an adjustment in the operating section of the cash flow statement prepared using the indirect method for premium or discount amortization. Premium or discount amortization will not appear on a cash flow statement prepared using the direct method.

Common stock and preferred stock with their associated paid in capital accounts increase when additional stock is sold to investors and decrease when stock is retired. There is no income statement impact for stock transactions. The cash flow associated with stock sales and repurchases appears in the financing section.

Retained earnings increases when the company earns profits and decreases when the company suffers a loss or declares dividends. The profit or loss appears as the first line of the operating section of the cash flow statement. The dividends appear in the financing section when they are paid.

CASH INFLOWS OR RECEIPTS. When preparing the cash flow statement using the direct method, the cash collected from customers may be found by analyzing accounts receivable, as follows: Beginning balance of accounts receivable, plus sales for the period (from the income statement), less ending balance of accounts receivable, equals cash received from customers. This is an extremely simplified formula, and does not take into account written off receivables or other noncash adjustments to customer accounts. If there is no accounts receivable on the balance sheet, the company does cash business and cash collected from customers will equal sales or revenue on the income statement.

If the cash flow statement is prepared using the indirect method, the adjustment to net income may be found in a similar manner. If the cash received from customers is more than the sales shown on the income statement, causing accounts receivable to decrease, the difference is added to net income. If cash received from customers is less than the sales shown on the income statement, causing accounts receivable to increase, the difference is subtracted from net income.

The amounts borrowed during the period may be found by analyzing the Liability Accounts. The amounts received from investors during the period may be found by doing a similar analysis on the Equity Accounts. Both of these types of transactions will be classified as financing activities.

If any land, buildings, or equipment were sold during the period, the information will be found in the Land, Building, and Equipment Accounts and their associated accumulated depreciation. One simple way to properly categorize the transaction is to reconstruct the journal entry. For example, assume that equipment that had cost $8,000 and had accumulated depreciation of $6,000 was sold during the period for $2,500. The journal entry for this transaction should indicate:



Accumulated depreciation $6,000



Gain on sale of equipment $500

The cash received from the sale of the equipment is classified as an investing activity. If the statement is prepared using the direct method, no other part of the journal entry is used. If the statement is prepared using the indirect method, the gain on sale of equipment is subtracted from net income. When the gain was recorded, net income increased. However, since the company is not in the business of buying and selling equipment, the gain needs to be subtracted from net income to arrive at the adjusted total related only to the proceeds from the company's direct business activities. If the sale had resulted in a loss, the loss is added back to net income.

CASH PAYMENTS. Cash payments are found using similar methods to those used for determining cash received. Cash payments for the purchase of inventory are found by analyzing accounts payable. The following formula can be used to find the cash paid for inventory purchases: beginning balance of accounts payable, plus inventory purchases during the period, less ending balance of accounts payable equals payments made for inventory during the period. This is a simplified formula and does not take into account any noncash adjustments.

If the cash paid for inventory is greater than the inventory purchased during the period, the difference between the amount purchased and the amount paid is deducted from net income if preparing the cash flow statement using the indirect method. If cash paid for inventory is less than the inventory purchased during the period, the difference between the amount purchased and the amount paid is added to net income if preparing the cash flow statement using the indirect method. Cash payments for land, building, and equipment purchases, repayments of loans, purchases of treasury stock, and payment of dividends may be found by performing similar analysis on the appropriate accounts.

SIGNIFICANT NONCASH TRANSACTIONS. Noncash transactions are not to be incorporated in the statement of cash flows. Examples of these types of transactions include conversion of bonds to stock and the acquisition of assets by assuming liabilities. If there are only a few such transactions, it may be convenient to include them on the same page as the statement of cash flows, in a separate schedule at the bottom of the statement. Otherwise, the transactions may be reported elsewhere in the financial statements, clearly referenced to the statement of cash flows.

Other events that are generally not reported in conjunction with the statement of cash flows include stock dividends, stock splits, and appropriation of retained earnings. These items are generally reported in conjunction with the statement of retained earnings or schedules and notes pertaining to changes in capital accounts.

Statement of Cash Flows Cash Flow from Operating Activities Net Income Adjustments to reconcile net income to net cash provided by operating activities:


Depreciation and amortization Changes in other accounts affecting operations:


(Increase)/decrease in accounts receivable


(Increase)/decrease in inventories


(Increase)/decrease in prepaid expenses


Increase/(decrease) in accounts payable


Increase/(decrease) in taxes payable


Net cash provided by operating activities


Cash Flow from Investing Activities Capital expenditures


Proceeds from sales of equipment


Proceeds from sales of investments


Investments in subsidiary


Net cash provided by investing activities


Cash Flow from Financing Activities Payments of long-term debt


Proceeds from issuance of long-term debt


Proceeds from issuance of common stock


Dividends paid


Purchase of treasury stock


Net cash provided by financing activities


Increase (Decrease) in Cash


Q. 5 what are the main objectives of accounting standards in global context?

An in-depth knowledge of global accounting regulations is becoming ever more critical, as many countries, including all 25 members of the European Union, will require the adoption of International Financial Reporting Standards (IFRS) for the first time in 2005. For example, approximately 2,000 companies in the United Kingdom alone will need to convert from U.K. GAAP to IFRS this year using special transition rules covering past transactions and opening balances.

Adding to this challenge, approximately 10 percent of the companies listed on the NYSE and NASDAQ are non-U.S. companies, and the U.S. Securities and Exchange Commission requires these companies to submit either financial statements that conform to U.S. GAAP or financial

statements prepared using other GAAP, like IFRS, accompanied by a reconciliation of earnings and net assets to U.S. GAAP figures.

As more and more companies are becoming global rather than just national entities, cross- border accounting compliance will remain a key element of doing business. American subsidiaries of foreign entities must follow the same accounting standards as their corporate parents, and for many, that means IFRS. Likewise, U.S. multinational entities seeking to enter new markets or to expand operations abroad may need to provide IFRS financial statements in order to obtain an operating permit or to raise capital.

In 2002, the FASB and the International Accounting Standards Board (IASB) reached agreement on a project to eliminate major differences between IFRS and U.S. GAAP. Although considerable progress has been made thus far, convergence of IFRS and U.S. GAAP is far from complete. Some of the differences still under review include accounting policies, construction contracts, investments in joint ventures, interim financial reporting, and research and development costs.

Beginning in 2005, all 7,000 EU publicly traded companies are required to apply IFRS in the preparation of their consolidated financial statements. In preparation for this sweeping change, the IASB completed its “stable platform” of standards in March 2004. New and revised standards included five new IFRSs and 17 amended IASs, resulting from the IASB’s Improvements Project and Phase I of its Business Combinations Project.

Since completion of the stable platform, the IASB has issued IFRS 6, Exploration for and Evaluation of Mineral Resources, and several interpretations of IFRS and amendments to current standards, including regulations on insurance contracts, financial reporting by small and medium-sized entities, disclosures for financial instruments, and financial guarantees and credit insurance, among others.