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i. Balance Sheet its elements, uses and limitations

ii. Income Statement its elements, and uses

iii. The statement of cash flows, its categories and uses. Understand how
the primary financial statements tie together
iv. Why is the financial statement and notes needed? What are the types of
information included in the notes? How does a financial statement show
how a business is doing and what its successes and failures are?
v. The fundamental concepts and assumptions that underlie financial

Imagine a hardware seller who wants to buy a retail space to display his wares. He approaches a local
bank for loan. The bank hands out several forms and asks him to provide documents to assess his
financial status and his ability to repay the loan. Without proper documentation, the bank cannot judge if
the seller is eligible for loan. And in the absence of his financial status and his credit ratings, they cannot
decide what interest rate to charge him. If he does not provide all the information, the bank may charge
him a higher rate of interest. So for his own benefit, the seller should give the bank accounts of his
financial earnings and expenses.
Primary financial
statements are used by
This same logic applies to a company seeking to generate funds. It is external groups to
important for a company to make financial disclosures so that lenders and assess a companys
investors can evaluate the past performance and future prospects of a economic standing.
company. The financial statements are used by several groups like creditors,
banks, lenders and investors; hence they are very important for any company. Financial statements are
also called general purpose financial statements. There are three primary financial statements Balance
Sheet, Income statement, and Statement of Cash flows. These statements help determine the companys
current financial status, companys operating results for the period, and how did the company obtain and
used cash during the period.
Balance Sheet is the financial The balance sheet reports the resources of a company called its assets,
statement reports a companys
assets, liabilities, and owners the companys obligations called its liabilities, and the difference
equity at a particular date. between what it owns and what it owes which is called owners equity.
Income statement is the financial
statement that reports the amount The income statement or statement of earnings reports the net income
of net income earned by a company
during a period.
earned by a company during a period. Annual and quarterly income
Statement of cash flows is the statements are the most common. The income statement measures the
financial statement that reports the financial performance of a company.
amount of cash collected and paid
out by a company during a period The statement of cash flows reports the amount of cash collected and
of time
paid out by a company during a period of time.

The first question that potential creditors and lenders ask a business is what are your existing assets and
liabilities? The balance sheet provides these details.

Assets Assets are financial resource owned by the company. Each asst is to be assigned a value in terms
of money. Without the assets being represented in monetary terms, these items may not serve any
purpose. The accountants must exercise their judgment well before attaching monetary value to the assets.
See below







Liabilities - The liabilities of a company are obligation to pay, transfer asset or supply goods to someone
buyer. It could also mean unpaid bill and dues or load installments.





Just like Assets, liabilities also need to be converted into monetary value. And here also the accountants
must properly evaluate a companys liabilities. It is one of the biggest challenges that an accountant faces.
A simple example is of a company fighting a legal dispute in court of law over retrograde taxes charged
by the government.
Owners equity after deducting liabilities from assets what remains is Owners equity. It represents the
residual amount called the Net Assets available after all liabilities have been paid for.






If there are no liabilities which is unlikely except when a business is starting,then the total assets are
exactly equal to the owners claims against those assetsthe owners equity.

To get a company started, investors make investments, usually in cash, and are offered shares in the
company against this investment. Ownership of a company can be restricted to one person (a sole
proprietorship), to a small group (a partnership), or to a diverse group of owners who often dont even
know one another (a corporation). When the owners initially invest money in a company, they receive
shares of stock. These shares of stock may then be privately traded among existing owners of the
business, privately sold to new owners, or traded publicly on an organized stock exchange like the
Bombay Stock Exchange (BSE).
Primary financial
The owners of a company are called stockholders or shareholders, and the statements are used by
external groups to
owners equity section of a companys balance sheet is referred to as assess a companys
stockholders equity. Owners equity increases when owners make additional economic standing.
investments in a business or when the business generates profits that are
ploughed back into the business. Owners equity decreases when the owners take back part of their
investment. If the business is a company, distributions to the owners (stockholders) are called dividends.
Owners equity is also reduced if the company generates losses instead of profit. In the extreme, a poor
performance can lead to the loss of all the investment made by the owners. For a company, the
accumulated earnings of the business that has not been given to owners is called retained earnings. The
portion of owners equity contributed by owners in exchange for shares of stock is called capital stock.
The amount of retained earnings plus the amount of capital stock equals the companys total owners

The basic accounting equation used to represent the balance sheet

Assets = Liabilities + Owners' Equity

In fact, the name balance sheet comes from the fact that a correct balance sheet must always balance
total assets must be equal to the total of liabilities and owners equity.
The accounting equation is not some magic; but it is true by definition. Liabilities and owners equity are
ways to finance the acquisition of assets; that is, they are the creditors claims and owners claims against
the assets. The total resources, therefore, equal the claims against those resources. This is illustrated in
Exhibit 4.4

Assets=Liabilities+Owners Equity

Sources of Funding

Resources Creditors claims against resources Owners claims against resources

= +

Decreased by distributions to owners (dividends) & unprofitable

Increased operations
by investments by owners and profitable operations

The balance sheet of a company is divided into its assets, liabilities, and owners equity. The asset section
identifies the types of assets owned by a company like cash and the amount associated with those assets.
The liability section defines the extent and nature of its debts like taxes & dues not yet paid.

The Exhibit 4.5 shows the balance sheet of a hypothetical Grocery Chain A. This section identifies the
portion of Grocery Chain As resources that were contributed by owners, either in exchange for shares of
stock or as undistributed earnings since its inception. Together with liabilities, owners equity indicates
how a company is financed (whether by borrowing or by owner contributions and operating profits). You
can see that Grocery Chain A has been financed primarily through liabilities. Because total liabilities are
over 61% of Grocery Chain As total assets, we can say that most of Grocery Chain As assets are financed
using some form of liabilities.


Lets begin with an example. There are two companies A & B which owe company C, Rs.10, 00,000.
Company C asks the balance sheets of both company A & company B. Company A has assets of Rs.10,
00,000 in the form of cash. Company B has assets of Rs.10, 00,000 in the form of undeveloped land. If
company C needs to collect the loan in the next two weeks, which borrower would be more likely to pay
you back? Company A, whose assets are liquid, meaning that they are in CLASSIFIED BALANCE SHEET
the form of cash or can be easily converted into cash, is more likely to A balance sheet in which assets
repay you faster. Assets like undeveloped land, which takes time and effort and liabilities are further into
to convert into cash, are called illiquid. This illustration above shows that current and long term categories
not all assets are the same. CURRENT ASSETS - Cash and
For such purposes, it is very important to distinguish between current other assets that can be
assets, which are generally more liquid and long-term assets. A balance converted to cash within a year.
sheet that distinguishes between current and long term assets is called a LIQUIDITY The ability of a
classified balance sheet. company to pay its debts in the
short run
In the balance sheet in Exhibit 4.5, Grocery Chain As assets are classified
as current, or short term, and long term. Current assets include cash and
that a company needs to be able
other assets that are expected to be converted to cash within a year. They operate its business over an
usually are listed in decreasing order of liquidity; cash is first, followed extended period of time
by the other current assets, like accounts receivable. A company needs
long-term assets, like land, buildings, and equipment, in order to operate its -Liabilities are likely to be
business over an extended period of time. Like assets, liabilities usually are satisfied within a year or the
classified as either current liabilities which are expected to be satisfied current operating cycle,
within a year or long-term liabilities. Accounts payable, for example, whichever is longer
usually would be paid within 30 to 60 days, whereas a mortgage may LONG-TERM LIABILITIES -
remain on the books for 20 to 30 years before it is fully paid. Liabilities that are not expected
to be satisfied within a year
Grocery Chain As balance sheet in Exhibit 4.5 includes financial
information for both the year 1996 & 1995. Most companies prepare STATEMENTS
financial statements that compare the performance in the current year and Financial statements in which
the previous year so that readers can identify any significant changes in data for two or more years are
particular items. For example, notice that Grocery Chain As total assets shown together
decreased by Rs.166.3 million (Rs.17,484.7 Rs.17,651.0) from 1995 to 1996. In addition, notice that
Grocery Chain As total liabilities decreased by Rs.250.7 million. Even though the companys assets
decreased, its liabilities decreased by a larger amount, and the fact that the company reported net income
of Rs.965.3 million confirms that the company is successful.

Exhibit 4.5 Balance Sheet of Grocery Chain A

1996 1995
Current assets:
Cash and equivalents 382.8 277.8
Receivables 515.1 577.9
Merchandise inventories, net of LIFO reserve of Rs.98.3 and Rs. 63.4 2,591.40 2,797.80
Prepaid expenses and other current assets 486.9 354
Total current assets 3,976.20 4,007.50

Property, plant & equipment: 1,588.60 1,597.10

Land 18,103.70 17,827.10
Total Land, Plant and equipment 19,692.30 19,424.20

Less accumulated depreciation and amortization -9,049.20 -8,802.20

Total property, net 10,643.10 10,622.00

Goodwill 2,390.20 2,406.30

Other assets 475.20 615.20
Total assets 17,484.70 17,651.00


Current liabilities:
Current portion of long-term debt 799.00 997.40
Accounts payable 2,448.50 2,825.40
Accrued salaries and wages 450.30 506.70
Deferred income taxes 107.20 88.00
Other accrued liabilities 694.2 718.9

Total current liabilities 4,499.20 5,136.40

Long-term debt:
Notes and debentures 4,184.20 4,093.50
Obligations under capital leases 516.60 564.20
Total long-term debt 4,700.80 4,657.70
Deferred income taxes 249.60 254.70
Pension and postretirement benefit obligations 597.20 236.70
Accrued claims and other liabilities 651.70 663.70
Total liabilities 10,698.50 10,949.20

Stockholders equity:
Common stock: par value Rs.0.01 per share; 1,500 shares authorized; 590.7 and
589.3 shares outstanding 5.90 5.90
Additional capital stock 4,128.30 4,038.20
Treasury stock at cost; 161.8 and 149.2 shares -4,776.80 -4,418.00
Accumulated other comprehensive (loss) income -228.70 246.20
Retained earnings 7,657.50 6,829.50
Total stockholders equity 6,780.30 6,695.90
Total liabilities and stockholders equity 17,484.70 17,651.00


The balance sheet is useful in showing the financial status of a company, however it has many limitations.
Primarily, it does not reflect the current market value of a company. If the balance sheet were perfect, meaning
that it included all economic assets reported at their current market values, then the amount of owners equity
would be equal to the market value of the company.

The discrepancy between recorded balance sheet value and actual market value is the result of the following

1. Accountants record many assets at their purchase cost, not at their current market value. Market value is
the price that would have to be paid to buy the same asset today . For example, if land was bought ten years
ago, it would still be reported on the balance sheet at its original cost, even though its market value may have
increased dramatically.
Market value is the
number of shares of
2. Not all economic assets are included in the balance sheet. For example, some of the stock outstanding
most important economic assets of any grocery chain like Spencers Retail are its multiplied by the
distribution channels, its name recognition, and its reputation for low prices. These current market price
intangible factors are all very valuable economic assets. In fact, they are by far the most of the stock; the
valuable assets that Spencers has. Nevertheless, these important economic assets are current value of a
outside the normal accounting process. business
Because the balance sheet can underreport the value of some long-term assets, and not Book value The
report other important economic assets, the accounting book value of a company value of a company
(measured by the amount of owners equity) is usually less than the companys market as measured by the
value, measured by the market price per share times the number of shares of stock. amount of owners
equity; that is, assets
less liabilities.
Despite its deficiencies, the balance sheet is a useful source of information regarding
the financial position of a business. A lender would never loan a company any money
without knowing what assets the company has and what other loans the company is already obligated to repay.
An investor shouldnt pay money in exchange for ownership in a company without knowing something about
the companys existing resources and obligations. When a balance sheet is classified, and when comparative
data are provided, the balance sheet provides an informative picture of a companys financial position.

Balance sheet is a summary of the financial position of a company at a particular time

Asset are economic resource controlled by a company

Liability is the economic obligation to deliver assets or provide a service

Equity is equal to total assets minus total liabilities; represents the book value of the owners
assets after the liability obligations have been satisfied; stems from direct owner investment
and past profits retained in the business

Accounting equation - Assets = Liabilities + Owners Equity

Format In the balance sheet, assets and liabilities are typically separated into current and
long-term items with data for both the current and the preceding year reported for comparison

Limitations In the balance sheet reflects assets acquired at their historical cost, thus
frequently ignoring changes in value and gradual development of intangible assets

Almost every day, The Economic Times includes articles which carry the income forecasts of many
publicly traded companies. The stock prices of companies go up or down depending on whether
information disclosed about a company has a positive or negative impact on the firms expected earnings.

Investors find information about revenue and income numbers useful in evaluating the health and
performance of a business. Net income is reported in the income statement. The income statement shows
the results of a companys operations for a period of time (a month, a quarter, or a year). The income
statement summarizes the revenues generated and the costs incurred (expenses) to generate those
revenues. The bottom line of an income statement is net income (or net loss), the difference between
revenues and expenses. To help you understand an income statement, we must first define its elements
revenues, expenses, and net income (or net loss).


Revenue is the amount of assets created through the sale of goods and services. Think of revenue as
another way for a company to acquire assets. Just as assets can be acquired by borrowing or by owners
investment, assets can also be acquired by providing a product or service for which customers are willing
to pay. Manufacturing and merchandising companies receive revenues from the sale of merchandise. For
example, Grocery Chain As revenue is the cash that customers pay in exchange for groceries.

A service enterprise generates revenues from the fees it charges for the services it performs. Companies
might also earn revenues from other activities, such as charging interest or collecting rent. When goods
are sold or services performed, the resulting revenue is in the form of cash or accounts receivable (a
promise from the buyer to pay for the goods or services by a given date in the future). Revenues thus
generally represent an rise in total assets. These new assets are not tied to any liability obligation;
therefore, the assets belong to the owners and thus represent an increase in owners equity.


increase in a
Expenses are the amount of assets consumed through business operations. Expenses companys assets
from the sale of
are the costs incurred in normal business operations to generate revenues. Employee goods or services.
salaries and utilities used during a period are two common examples of expenses. For
Grocery Chain A, the primary expense is the wholesale cost of the groceries that it EXPENSES are the
sells to its customers at retail. Just as revenues represent an increase in assets and costs incurred in the
normal course of
equity, expenses generally represent a decrease in assets and in equity. business to generate
Net Income (or Net Loss) Net income, sometimes called earnings or profit, is an revenues.
overall measure of a companys performance. Net income reflects the companys
accomplishments (revenues) in relation to its efforts (expenses) during a particular NET INCOME is an
overall measure of
period of time:
the performance of a
company; equal to
Revenues Expenses = Net Income revenues minus
expenses for the
If revenues exceed expenses, the result is called net income. If expenses exceed period
revenues, the difference is called net loss. Because net income results in an increase
in resources from operations, owners equity is also increased; a net loss decreases owners equity.
It is important to note the difference between revenues and net income. Both concepts represent an
increase in the net assets (assets liabilities) of a firm. However, revenues represent total resource
increases; expenses are subtracted from revenues to derive net income or net loss. Thus, whereas revenue
is a gross concept, income (or loss) is a net concept.
It is also important to note the difference between revenues and assets. Revenues are one activity of a
company that generates assets. For example, selling a product (which is revenue) results in an asset
(either cash or an accounts receivable). Assets can also be generated by other activities. For example,
borrowing money from a bank would not be considered a revenue-generating activity, but it would result
in an assetcash. To summarize, activities involving revenue result in assets, but assets can result from
many different activities. The Format of Income Statement & Comparative income statements for
Grocery Chain A are presented in Exhibit 4.6.


1996 1995
Sales 44104.0 42286.0
Cost of goods sold -31589.2 -30133.1
Gross profit 12514.8 12152.9

Operating and administrative expense -10662.1 -10380.8

Operating profit 1852.7 1772.1
Interest expense -358.7 -388.9
Other income, net 10.6 20.4
Income from continuing operations before income taxes 1504.6 1403.6
Income taxes -539.3 -515.2
Net income 965.3 888.4

In contrast to the balance sheet, which is as of a particular date, the income statement refers to the year
ended. Remember, the income statement covers a period of time; the balance sheet is a report at a point
in time. The multistep format illustrated here highlights several profit measurements including gross
profit, operating income, and net income.
GAINS - Money
made on activities
outside the normal
In considering revenues and expenses, do remember that not all the inflows of
operation of a assets are revenues; nor are all outflows of assets considered to be expenses. For
company. example, cash may be received by borrowing from a bank, which is an increase in
liability, not a source of revenue. Similarly, cash may be paid for supplies, which is
LOSSES - Money
an exchange of one asset for another asset, not an expense.
lost on activities
outside the normal
operation of a The income statement usually shows two main categories, revenues and expenses,
company. although several subcategories may also be presented (as illustrated). Revenues are
listed first. Typical operating expenses for most businesses are employee salaries,
LOSS) PER SHARE utilities, and advertising. For Grocery Chain A, as with any retail firm, the largest
The amount of net expense is for cost of goods sold. The difference between sales and cost of goods
income (earnings) sold represents the difference between the retail price Grocery Chain A receives
related to each share
of stock; computed
from a grocery sale and the wholesale cost of the groceries that are sold. This
by dividing net difference is called gross profit or gross margin:
income by the
number of shares of
stock outstanding
during the period.
Sales Cost of Goods Sold = Gross Profit (Gross Margin)

Expenses can be divided into operating and non-operating categories. The primary non-operating
expenses are interest and income taxes. These expenses are called non-operating because they have no
connection with the specific nature of the operation of the business. Two other items that frequently
appear in the income statement are gains and losses. Gains and losses refer to money made or lost on
activities outside the normal business of a company. For example, when Grocery Chain A receives cash
for selling groceries, it is called revenue. But when it makes money by selling an old delivery truck, the
amount is called a gain, not revenue, because Grocery Chain A is not in the business of selling trucks.
One final bit of information required on the income statements of companies is earnings (loss) per share
(EPS). This EPS amount is computed by dividing the net income (earnings or loss) for the current period
by the number of shares of stock outstanding during the period:

Net Income or the Outstanding Number of Shares of Stock = Earnings (Loss) per Share

Earnings per share information tells the owner of a single share of stock how much of the net income for
the year belongs to him or her. Often, two EPS figures are disclosedbasic and diluted.

Basic EPS is based on transactions in the past and involves dividing net income by actual average shares
outstanding during the period. Diluted EPS is a bit more complicated and involves estimating what EPS
would be if certain stock transactions (to be discussed later) had occurred. Like the balance sheet, the
income statement usually shows the comparative results for two or more periods, allowing investors and
creditors to evaluate profitability over time. For example, examination of Grocery Chain As comparative
income statements in Exhibit 4.6 shows that net income in 1996 was Rs.76.9 million higher (Rs.965.3
Rs.888.4) than in 1995. Further analysis of the income statement is reinforced throughout the text.

The Statement of Retained Earnings

In addition to an income statement, companies sometimes prepare a statement of retained earnings. This
statement identifies changes in retained earnings from one accounting period to the next.
It is important to understand Retained Earnings and what it is not. Retained Earnings is the amount of a
businesss earnings that have been retained in the business. The earnings that have not been retained in the
business have been distributed to owners in the form of a dividend. The earnings that have been retained
have been reinvested back into the business to become inventory and equipment and to pay down debt. To
see where a company has reinvested the earnings it has retained would require you to examine the assets
on the firms balance sheet. Odds are that many of those assets will have been provided by the earnings
that have been reinvested in the business. Now, what isnt Retained Earnings? Retained Earnings is not
cash. Some of the earnings that have been retained in a business may be retained in the form of cash, but
it is more likely that the cash has been used to purchase other assets or to pay off liabilities . Dont make
the mistake of assuming that if a company has Retained Earnings, the company has cash. That is not true.
To determine how much cash a company has, you would examine the balance in the companys cash
accountnot the balance in the companys retained earnings account.

Points to remember

Income statementa report of a companys performance for a particular period of time

Revenuean INCREASE in a companys resources through a normal business transaction

Expensea DECREASE in a companys resources through a normal business transaction

Net incomeequal to revenues minus expenses; represents the net amount of assets created
through business operations during a particular period of time

Formatusually several years of income statement data are reported side by side for

Retained earningsthe total earnings that have been retained in the company; equals
beginning retained earnings plus net income minus dividends; accumulates each year

Net income is the single best measure of a companys economic performance. However, anyone who has
paid rent or college tuition knows that bills must be paid with cash, not with economic performance.
Accordingly, in addition to net income, investors and creditors also desire to know how much actual cash
a companys operations generate during a period and how that cash is used. The statement of cash flows
shows the cash inflows (receipts) and cash outflows (payments) of an entity during a period of time.

Selling goods or providing services

Selling other assets
Receiving cash from investments by owners

Companies use cash to

Pay current operating expenses such as wages, utilities, and taxes
Purchase additional buildings, land, and otherwise expand operations
Repay loans
Pay their owners a return on the investments that have been made

In the statement of cash flows, individual cash flow items are classified according to three main activities:


Operating Activities - Operating activities are those activities that are part of the day-to-day business of a
company. Major operating cash inflow results from selling goods or providing services, while major
operating cash outflows include payments to purchase inventory and to pay wages, taxes, interest,
utilities, rent, and similar expenses.

Investing Activities - Investing activities are those activities associated with buying and selling long-term
assetsprimarily the purchase and sale of land, buildings, and equipment.

Financing Activities - Financing activities are those activities whereby cash is obtained from or repaid to
owners and creditors. For example, cash received from owners investments, cash proceeds from a loan,
or cash payments to repay loans would all be financing activities.

Conceptually, the statement of cash flows is the easiest to prepare of the three primary financial
statements. Imagine examining every check and deposit slip you have written in the past year and sorting
them into three pilesoperating, investing, and financing. You would have to exercise some judgment in
deciding which pile some items go into (for example, is the payment of interest an operating or a
financing activity?). But overall, the three-way categorization of cash flows is not that difficult. In
essence, this is all that is involved in the preparation of a statement of cash flows. Exhibit 4.7 contains the
adapted statement of cash flows for Grocery Chain A for 1996 and 1995. As with balance sheets and
income statements, companies usually provide comparative statements of cash flows

1996 1995
Cash collected from customers 44166.8 42169.3
Cash paid for
Inventory -31759.7 -29927.4
Operating and administrative expenses -9312.1 -9252.1
Interest -379.7 -406.3
Taxes -464.4 -393.0
2250.9 2190.5
Cash paid for property additions -1595.7 -1768.7
Proceeds from sale of property 97.8 140.0
Other -48.1 -57.7
-1546.0 -1686.4
Additions to short-term borrowings 0.0 285.0
Payments on short-term borrowings -95.0 -190.0
Additions to long-term borrowings 2130.0 1864.6
Payments on long-term borrowing -2165.0 -2220.9
Purchase of treasury stock -359.5 -226.1
Dividends paid -132.1 -111.5
Other 21.7 156.0
-599.9 -442.9

How can Grocery Chain A report such a small amount of income on the income statement and yet be
generating over Rs.2.25 billion in cash flow from operating activities? The simple answer is that it
reported a large number of noncash expenses on its 1996 income statement.


Although we have introduced the primary financial statements as if they were independent of one another,
they are interrelated and tie together. In accounting language, they articulate. Articulation refers to the
relationship between an operating statement (the income statement or the statement of cash flows) and
comparative balance sheets, whereby an item on the operating statement helps explain the change in an
item on the balance sheet from one period to the next.

Statement of cash flowsa report of a companys cash inflows and outflows categorized into
operating, investing, and financing activities

Operating activitiesactivities that are part of a companys day-to-day business; examples

include collecting cash from customers, paying employees, and purchasing inventory

Investing activitiesactivities involving the purchase and sale of long-term assets such as
buildings, trucks, and equipment

Financing activitiesactivities surrounding acquiring the capital needed to purchase the

companys assets; examples include getting cash from loans, repaying loans, receiving invested
cash from owners, and paying dividends

Formatusually several years of cash flow data are reported side by side for comparison

Articulationthe three primary financial statements tie together as follows:

The income statement explains the change in the retained earnings balance in the balance
The statement of cash flows explains the change in the cash balance in the balance sheet

While the three primary financial statements contain a lot of information, they cannot possibly tell
financial statement users everything they want to know about a company. Additional information is given
in the notes to the financial statements, which give information about the assumptions and methods used
in preparing the financial statements and more detail about specific items. In a typical annual report, the
notes go on for 20 pages or more, whereas the primary financial statements fill only three pages.

Financial statement notes fall into four general categories:

1. Summary of significant accounting policies.

2. Additional information about the summary totals found in the financial NOTES TO THE
statements. FINANCIAL
3. Disclosure of important information that is not recognized in the financial STATEMENTS
statements. These are
4. Supplementary information required by the Securities and Exchange Board of information
India (SEBI). considered an
integral part of the
Summary of Significant Accounting Policies financial statements

Accounting involves making assumptions, estimates, and judgments. In addition, in some settings, there
is more than one acceptable method of accounting for certain items. For example, there are a variety of
acceptable ways of estimating how much a building depreciates (wears out) in a year.
In order for financial statement users to properly interpret the three primary financial statements, they
must know what procedures were used in preparing those statements. This information about accounting
policies and practices is given in the financial statement notes.

Disclosure of Information Not Recognized

One way to report financial information is to include the estimates and judgments in the financial
statements. This is called recognition. The key assumptions and estimates are then described in a note to
the financial statements. Another approach is to not include estimates and judgments in
the financial statements but instead to explain them in the notes to the financial statements. This is called
disclosure. Disclosure is the accepted way to convey information to users when the information
is too uncertain to be recognized.

Supplementary Information

SEBI requires supplementary information that must be reported in the financial statement notes. For
example, the SEBI requires the disclosure of quarterly financial information and of business segment
Points to Remember

The notes to the financial statements

Contain additional information not included in the financial statements themselves

Explain the companys accounting assumptions and practices

Provide details of financial statement summary numbers and additional disclosure about
complex events

Report supplementary information required by the SEBI


Certain fundamental concepts and assumptions underlie financial accounting practice and the resulting
financial statements. These ideas are so fundamental to any economic activity that they usually are taken
for granted in conducting business. Nevertheless, it is important to be aware of them
because these assumptions, together with certain basic concepts and procedures, SEPARATE
determine the rules and set the boundaries of accounting practice. They indicate which ENTITY
events will be accounted for and in what manner. In total, they provide the essential The idea that the
characteristics of the traditional accounting model. activities of an
entity are to be
separated from those
Because business involves the exchange of goods or services between entities, it follows
that accounting records should be kept for those entities. For accounting purposes, an Exchange of goods
entity is defined as the organizational unit for which accounting records are maintained. It or services between
is a focal point for identifying, measuring, and communicating accounting data. In the entities, as well as
other events having
separate entity concept, an entity is considered to be separate from its individual owners. an economic impact
on a business
The Assumption of Arms-Length Transactions Accounting is based on the recording of
economic transactions. Viewed broadly, transactions include not only exchanges of TRANSACTIONS
economic resources between separate entities, but also events that have an economic Business dealings
impact on a business independently. The borrowing and lending of money and the sale independent and
and purchase of goods or services are examples of the former. The loss in value of rational parties who
equipment due to obsolescence or fire is an example of the latter. Collectively, are looking out for
their own interests.
transactions provide the data that are included in accounting records and reports.
The dollar amount
exchanged in an
Accounting for economic transactions enables us to measure the success of an entity. arms-length
However, the data for a transaction will not accurately represent that transaction if any transaction; assumed
to reflect the fair
bias is involved. Therefore, unless there is evidence to the contrary, accountants assume market value of an
arms-length transactions. That is, they make the assumption that both partiesfor item at the
example, a buyer and a sellerare rational and free to act independently; each trying to transaction date.
make the best deal possible in establishing the terms of the transaction. COST PRINCIPLE
The idea that
The Cost Principle transactions are
recorded at their
historical costs or
To further ensure objective measurements, accountants record transactions at historical exchange prices at
cost, the amount originally paid or received for goods and services in arms-length the transaction date
transactions. The historical cost is assumed to represent the fair market value of the item
at the date of the transaction because it reflects the actual use of resources by independent
parties. In accounting, this convention of recording transactions at cost is often referred to as the cost
principle. The historical cost figure may be modified in the future to reflect new information. While
historical cost is a reliable number in that it results from an arms-length transaction, it may not always
provide information that is as relevant as financial statement users would like.
The Monetary Measurement Concept

Accountants do not record all the activities of economic entities. They record only those that can be
measured in monetary terms. Thus, the concept of monetary measurement becomes another important
characteristic of the accounting model. For example, employee morale cannot be measured directly in
monetary terms and is not reported in the accounting records. Wages paid or owed, however, are
quantifiable in terms of money and are reported. In accounting, all transactions are recorded in monetary
amounts, whether or not cash is involved. In India, the Rs is the unit of exchange and is thus the
measuring unit for accounting purposes.

The Going Concern Assumption

The Grocery Chain A balance sheet in Exhibit 4.5 was prepared under the assumption that it would
continue in business for the foreseeable future. This is called the going concern assumption. Without this
assumption, preparation of the balance sheet would be much more difficult. For example, the Rs.2.6
billion inventory for the Grocery Chain A in 1996 is reported at the cost originally paid to purchase the
inventory. This is a reasonable figure because, in the normal course of business, it can expect to sell the
inventory for this amount, plus some profit. But if it were assumed that it would go out of business
tomorrow, the inventory would suddenly be worth a lot less. The going concern assumption allows the
accountant to record assets at what they are worth to a company in normal use, rather than what they
would sell for in a liquidation sale

Points to Remember

Entity conceptFinancial statements are prepared for a specific economic entity; the private
affairs of the owners are not to be mixed in with the business transactions.

Arms-length transactionA market price accurately reflects underlying value when the
transaction occurs between two unrelated parties, each bargaining for his or her own interests.

Cost principleIn general, financial statement items are measured at their cost on the original
transaction date.

Monetary measurement conceptIn order to be included in the financial statements, the value
of an item must be measurable in terms of dollars.

Going concern assumptionWhen preparing the financial statements, the accountant

assumes that the business will survive for the foreseeable future. Without this assumption,
balance sheet items would be recorded at emergency liquidation amounts.

1. As an investor or creditor, what type of accounting information do you need?

2. Describe the purpose of

a. A balance sheet?

b. An income statement?

c. A statement of cash flows?

3. Why should you research a companys financial statements before investing in its stock?

4. Why do annual reports for shareholders have classified and comparative financial statements?

5. Why are owners equity and liabilities considered the sources of assets?

6. What is the nature of owners equity?

7. What are the limitations of the balance sheet? Why should we review them when evaluating a
companys growth potential?

8. Why is the income statement sometimes considered more important than the balance sheet? Do you
agree? Why or why not?

9. How can the bottom line (the net income or EPS number) on an income statement be misleading?

10. Why should we classify cash flows according to operating, investing, and financing activities?

11. What are the four general types of financial statement notes typically included in annual reports to

12. Describe why each of the following is important in accounting:

a. The separate entity concept
b. The assumption of arms-length transactions

c. The cost principle

d. The monetary measurement concept
e. The going concern assumption
Other Questions
Question 4.1

Total Assets
Please use following information to compute total assets.
Equipment Rs.15, 000
Accounts payable 1,800
Capital stock 2,800
Cash 1,400
Wages payable Rs. 900
Accounts receivable 3, 000
Retained earnings 5,400
Inventory 4,500
Loan payable 13,000

Question 4.2
Total Liabilities - Refer to the data in the Question above. Compute total liabilities.

Question 4.3
Total Owners Equity - Refer to the data in Question 4.1. Compute total owners equity.

Question 4.4
The Accounting Equation - For the following four cases, use the accounting equation to compute the
missing quantity.
Assets Liabilities Owners Equity
Case A Rs.10,000 Rs. 4,000 A
Case B 8,000 B Rs. 3,500
Case C C 5,500 7,000
Case D 13,000 15,000 D

Question 4.5
Balance Sheet - Using the data in Question 4.1, prepare a balance sheet.

Question 4.6
Book Value and Market Value of Equity - For the following four cases, compute (1) the book value of
equity and (2) the market value of
Assets Liabilities Number of Shares of Market
Price per
Stock Outstanding Share
Case A Rs. 10,000 Rs. 4,000 1,000 Rs.15
Case B 8,000 7,000 500 10
Case C 13,500 5,500 300 20
Case D 100,000 150,000 1,000 7
Question 4.7

Computation of Net Income - For the following four cases, compute net income (or net loss). Caution:
Not all of the items listed should be included in the computation of net income.
Case A Case B Case C Case D
Cost of goods sold Rs. 60,000 Rs. 30,000 Rs.60,000 Rs.110,000
Interest expense 18,000 47,000 25,000 31,000
Cash 3,000 4,500 2,100 6
Retained earnings 50,000 15,000 31,000 70,000
Sales 100,000 150,000 70,000 200,000
Accounts payable 12,000 20,000 5,000 38 ,000
Rent revenue 5,000 1,000 12,000 10 ,000
Machinery 175,000 60,000 50,000 185,000

Question 4.8
Computing Elements of Owners Equity

From the information provided, determine:

1. The amount of retained earnings at December 31.
2. The amount of revenues for the period.

Totals January 1 December 31

Current assets Rs. 15,000 Rs. 25, 000
All other assets Rs.240,000 220,000
Liabilities Rs. 125,000 85,000
Capital stock 70,000 ?
Retained earnings 60,000 ?

Additional data:
Expenses for the period were Rs.55,000.
Dividends paid were Rs. 9,000.
Capital stock increased by Rs.20, 000 during the period .

Question 4.9
Articulation: Relationships between a Balance Sheet and an Income Statement
The total assets and liabilities of Jain Company at January 1 and December 31, 2012, are presented
January 1 December 31
Assets Rs. 103,000 Rs.167,000
Liabilities Rs.72,000 88,000
Determine the amount of net income or loss for 2012, applying each of the following assumptions concerning
the additional issuance of stock and dividends paid by the fi rm. Each case is independent of the others.
1. Dividends of Rs.12,100 were paid and no additional stock was issued during the year.
2. Additional stock of Rs.18,000 was issued and no dividends were paid during the year.
3. Additional stock of Rs.72,000 was issued and dividends of Rs.12,400 were paid during the year

Question 4.10
Balance Sheet Relationships - Correct the following balance sheet.

BPA Corporation Balance Sheet

December 31, 2012
Assets Liabilities & Owners Equity
Cash Rs. 55,000
Buildings Rs. 325,000
Accounts payable 65,000
Accounts receivable 75,000
Interest receivable 20,000
Mortgage payable 150,000
Capital stock 200,000
Sales revenue 350,000
Rent expense 60,000
Equipment 85,000
Retained earnings 145,000
Utilities expense 5,000
Total assets Rs.545, 000
Total liabilities and owners equity Rs.990, 000

Question 4.11

Cash Flow Classifications

For each of the following items, indicate whether it would be classified and reported under the operating
activities (OA), investing activities (IA), or financing activities (FA) section of a statement of cash flows:
a. Cash receipts from selling merchandise
b. Cash payments for wages and salaries
c. Cash proceeds from sale of stock
d. Cash purchase of equipment
e. Cash dividends paid
f. Cash received from bank loan
g. Cash payments for inventory
h. Cash receipts from services rendered
i. Cash payments for taxes
j. Cash proceeds from sale of property no longer needed as expansion site

Question 4.12

The Cost Principle

On January 1, 2012, Vast Development Company paid Rs.325,000 in cash for a piece of land to be used
as the new office building site. During March, the company petitioned the Delhi Development Authority
to classify the area for professional office buildings. DDA refused, preferring to maintain the area as a
residential zone. After nine months of negotiation, Vast Development convinced the DDA to classify the
property for commercial use, thus raising its value to Rs.475, 000. For accounting purposes, what value
should be used to record the transaction on January 1, 2012? At what value would the property be
reported at year-end, after the DDA classifies it for commercial use? Explain why accountants use
historical costs to record transactions.

Question 4.13

The Monetary Measurement Concept

Many successful companies, like f, readily acknowledge the importance and value of their employees. In
fact, the employees of a company are often viewed as the most valued asset of the company. Yet in the
asset section of the balance sheets of these companies there is no mention of the asset Employees. What is
the reason for this oversight and apparent inconsistency?
Question 4.14

The Going Concern Assumption

Assume that you open an auto repair business. You purchase a building and buy new equipment.
What difference does the going concern assumption make with regard to how you would account for
these assets?

Question 4.15
Preparation of a Classified Balance Sheet
Following are the December 31, 2012, account balances for Brisca Company.
Cash Rs.1,950
Accounts receivable 2,500
Supplies 1,800
Equipment 11,275
Accounts payable 3,450
Wages payable 250
Dividends paid 1,500

1. Prepare a classified balance sheet as of December 31, 2012.
2. Interpretive Question: On the basis of its 2012 earnings, was this companys decision to
pay dividends of Rs.1,500 a sound one?

Question 4.16
Balance Sheet Preparation with a Missing Element
The following data are available for Schubert Products Inc. as of December 31, 2012.
Cash 7,500
Accounts payable 24,000
Capital stock 42,000
Accounts receivable 20,000
Building 49,500
Supplies 2,000
Retained earnings ?
Land 20,000
1. Prepare a balance sheet for Schubert Products Inc.
2. Determine the amount of retained earnings at December 31, 2012.
3. Interpretive Question: In what way is a balance sheet a depiction of the basic accounting

Question 4.17

Income Statement Preparation

Listed below are the results of Serif Tyre operations for 2011 and 2012.
(Assume 5,000 shares of outstanding stock for both years.)
2012 2011
Sales Rs.530,000 Rs.625,000
Utilities expenses 18,000 12,500
Employee salaries 185,000 170,000
Advertising expenses 25,000 40,000
Income tax expense 20,100 72,750
Interest expense 45,000 25,000
Cost of goods sold 210,000 155,000
Interest revenue 20,000 20,000

1. Prepare a comparative income statement for Serif Tyre for the years ended December 31, 2012, and
2011. Be sure to include figures for gross margin, operating income, income before taxes, net income, and
earnings per share.

2. Interpretive Question: What advice would you give Serif Tyre to improve its profitability for the year

Question 4.18
Income Statement Preparation
The following information is taken from the records of a Pearson Pipes for the year ended
December 31, 2012.
Income taxes Rs.45,000
Service revenues 210,000
Rent expense 6,000
Salaries expense 41,000
Prepare an income statement for Pearson Pipes for the year ended December 31, 2012. (Assume
that 3,000 shares of stock are outstanding.)

Question 4.19
The following report is supplied by M/S Aggarwal Sons Company.

M/S Aggarwal Sons Company

Comparative Balance Sheets
As of December 31, 2012 and 2011

Assets 2012 2011

Cash 28,000 19,000

Receivable 21,000 14,000
Notes receivable 10,000 12,000
Land 43,000 43,000

Liabilities and
Owners Equity 2012 2011
Accounts payable Rs.9,000 Rs.8,000
Salaries and commissions
Payable 11,000 12,000
Notes payable 32,000 35,000
Capital stock. . . . . . . . . . 15,000 15,000
Retained earnings . . . . . . 35,000 18,000
Total assets. . . . . . Rs.102,000 Rs.88,000
Total liabilities and
owners equity . . . . . Rs.102,000 Rs.88,000

Operating expenses for the year included utilities of Rs.5,700, salaries and commissions of Rs.38,700,
and miscellaneous expenses of Rs.2,200. Income taxes for the year were Rs.4,500, and the company
paid dividends of Rs.8,000.
1. Compute the total expenses, including taxes, incurred in 2012.
2. Compute the net income or net loss for 2012.
3. Compute the total revenue for 2012.
4. Interpretive Question: Why are comparative financial statements generally of more value to users
than statements for a single period?

Question 4.20

Statement of Cash Flows

Binder Company, builds homes and offices and sells them to customers. The financial information shown
below was gathered from its accounting records for 2012. Assume any increase or decrease in the
balances from 1/1/12 to 12/31/12 resulted from either receiving or paying cash in the transaction. For
example, during 2012 the balance on loans for land holdings increased Rs.55,000 because the company
received Rs.55,000 in cash by taking out an additional loan on the land.

Items Balance as of Balance as of

1/1/12 12/31/12
Cash Rs.220,000 Rs.264,000
Cash receipts from customers - 910,000
Loans on land holdings 220,000 275,000
Cash distributions to owners - 95,000
Loan on building 175,000 75,000
Investments in securities 560,000 720,000
Cash payments for other expenses - 44,000
Cash payments for taxes - 57,000
Cash payments for operating expenses - 270,000
Cash payments for wages and salaries - 195,000
1. Prepare a statement of cash flows for Binder Company, for the year ended
December 31, 2012.
2. Interpretive Question: Does Binder Company, appear to be in good shape from a cash flow
standpoint? What other information would help you analyze the situation?