Financial Accounting and Analysis Book PDF

Financial Accounting & Analysis
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COURSE DESIGN COMMITTEE
TOC Reviewer Content Reviewer

Mr. Ashok Bhansali Mr. Ashok Bhansali
Visiting Faculty, NMIMS Global Visiting Faculty, NMIMS Global
Access - School for Continuing Education Access - School for Continuing Education
Specialization: Finance Specialization: Finance
Content Reviewer
Ms. Purva Shah
Assistant Professor, NMIMS Global
Access - School of Continuing Education
Specialization: Finance
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Author : Dr. Ajay Kumar Chauhan

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Reviewed By: Mr. Ashok Bhansali & Ms. Purva Shah
Copyright:
2018 Publisher
ISBN:
978-93-5119-748-5
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
NMIMS Global Access - School for Continuing Education School Address
V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India.
NMIMS Global Access - School for Continuing Education

CONT E NTS
CHAPTER NO. CHAPTER NAME PAGE NO.
1 Introduction to Financial Accounting 1
2 Accounting Process 29
3 Trial Balance to Final Accounts 69
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4 Accounting Standards I 105
5 Accounting Standards II 127

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6 Generally Accepted Accounting Principles 157
7 Corporate Accounts 177

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8 Cash Flow Statement 213

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9 Financial Statement Analysis I 245
10 Financial Statement Analysis II 273
11 Financial Statement Analysis III 315
12 Case Studies 347

F i n a n c i a l A cco u n tin g & A n a ly sis
c u rr i c u l u m
Introduction to Financial Accounting: Nature and Scope of Financial Accounting, Difference be-
tween Financial and Management Accounting ,Basic Accounting Concepts ,Advantages and Lim-
itations of Financial Accounting
Accounting Process: Accounting Process, Journal, Ledger, Meaning of Subsidiary Books, Bills of
Exchange
Trial Balance to Final Accounts: Preparing a Trial Balance ,Rectifying Errors, Final Accounts
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Accounting Standards I: Accounting , Constitution of Accounting Standards Board in India, Pro-
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cedure of Issuing Accounting Standards, Compliance with Accounting Standards
Accounting Standards II: Implementation of Accounting Standards, Financial Statements

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Generally Accepted Accounting Principles (GAAP): Generally accepted Accounting Principles,

International Financial Reporting Standards (IFRS) , Indian Accounting Standards (AS), Differ-
ence between IGAAP& IFRS in following areas ( with Examples)
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Corporate Accounts: Schedule III of the Companies Act, 2013
Cash Flow Statement: Cash Flow Statement , Cash Flow Statements ( AS-3)
Financial Statement Analysis I: Financial Statements, Profit and Loss Account, Balance Sheet
Financial Statement Analysis II: Ratio Analysis, Types of Ratio, The DuPont Equation
Financial Statement Analysis III: Common Size Analysis, Trend Analysis, Percentage Change
Analysis, Management’s Analysis and Discussion: Thinking beyond Numbers

Ch a
1 p t er
Introduction to Financial Accounting
CONTENTS
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1.1 Introduction
1.2 Nature and Scope of Financial Accounting
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1.2.1 Objectives of Accounting
Self Assessment Questions
Activity
1.3 Financial Accounting, Management Accounting and Cost Accounting
Activity
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1.4 Basic Accounting Concepts

1.4.1 Entity Concept
1.4.2 Cash and Accrual Concept
1.4.3 Matching Concept
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1.4.4 Double Entry Accounting System

1.4.5 Money Measurement
1.4.6 Going Concern
1.4.7 Historical Cost
1.4.8 Accounting Period
1.4.9 Conservatism
1.4.10 Realisation
1.4.11 Consistency
1.4.12 Materiality
Activity
1.5 Advantages and Limitations of Financial Accounting
Activity
1.6 Summary
1.7 Descriptive Questions
1.8 Answers and Hints
1.9 Suggested Readings & References

2 Financial Accounting & Analysis
Introductory Caselet
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FINANCIAL POSITION OF LAXMI DAS Ltd
Mr. Laxmi Das is the owner of Laxmi Das Ltd., which was set up
in 1975. The company is into various business operations, such
as construction, hotel, entertainment and media business. There-
fore, consolidating the various business transactions into one
book of accounts was a major challenge for the company.
Mehra Associates, a firm of Chartered Accountants, audited the

financial statements of Laxmi Das Ltd. In 2010, many entries were
made in the following manner:
Credit sales were not shown in the trading account
Land and building were shown at their market price
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Withdrawals by Mr. Laxmi Das for personal use were shown at
their market price
Depreciation on assets were charged at their market value
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General reserve maintained by the organisation was not
shown in the balance sheet
The financial statements were biased and do not provide a full

disclosure of the facts. This restrained the framing of the true fi-
nancial position of the organisation and reflecting the business
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realities.
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Introduction to Financial Accounting 3
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learning objectives
After studying this chapter, you will be able to:

> Describe the nature and scope of financial accounting
> Differentiate between financial accounting and manage-
ment accounting
> Explain the basic accounting concepts
> Discuss the advantages and limitations of financial
accounting
1.1 INTRODUCTION
Accounting is an important and an old concept in business manage-
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ment. The concept of accounting came into existence with the growth
of business, economics and banking. Accounting has become synon-
ymous with the “language of business”. However, there have been
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several modifications in the concepts, conventions, policies and stan-
dards of accounting over the years.
Accounting can be defined as the practice of recording financial trans-

actions pertaining to a business in a systematic and comprehensive
manner based on a set of rules. It can also be defined as the process of
summarising, analysing and reporting the financial transactions per-
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taining to an organisation for tax collection and oversight entities.
The concept of accounting is very essential for managers as it can

be applied to all day-to-day activities of an organisation. Therefore,
managers need to be well-versed with the basic accounting concepts
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in order to understand costs, revenue and profit. The concept of ac-

counting helps in understanding various financial transactions, the
methods of recording them, and evaluating them to get the desired
results. With the expansion of the market and the size of the business
organisations, the shareholders, creditors, suppliers, potential buyers
and various government agencies seek to get the financial disclosure
of the organisation. In addition, accounting is required to ensure func-
tional transparencies in organisations. Therefore, accounting is the
basic requirement for the smooth working and growth of an organi-
sation.
There are three major branches of accounting viz. financial account-

ing, management accounting and cost accounting. Apart from these,
there are some other branches of accounting too. These include au-
diting, taxation, Accounting Information System (AIS), fiduciary, and
forensic accounting. This chapter deals specifically with the concept
of Financial Accounting.
Financial Accounting is that branch of accounting that involves re-

cording, classifying and summarising business transactions. Infor-

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mation generated by financial accounting is usually aimed at internal

and external stakeholders but primarily for external ones. External
stakeholders include investors, creditors, competitors, customers,
stock market analysts, etc. Therefore, in other words, we can say that
financial accounting records and reports information about the finan-
cial position and performance of a company, primarily for use by the
business entity’s external stakeholders. Financial accounting involves
preparation of financial statements that must be made in strict com-
pliance with the Generally Accepted Accounting Principles (GAAP).
The same financial accounting information can be of use to different

users at a time. For example, a finance manager makes use of account-
ing data in the management of an organisation. The same information
is used by investors to analyse the success of a business by evaluating
the financial statements of the past and present.
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Organisations conduct their activities by acquiring resources – man-
power, materials and various services, land, buildings, plant and ma-
chinery and equipment. These resources have to be financed or paid
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for. The main purpose of financial accounting is to record the finan-
cial transactions occurring in an organisation at a given time peri-
od to prepare financial statements and present this information in a
comprehensive manner. The importance of accounting to a business
is to provide information about an organisation’s financial result or
position.
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In this chapter, you will study about the nature and scope of financial
accounting. Thereafter, the difference between financial and manage-
ment accounting has been discussed. In addition, the unit discusses
the basic accounting concepts. Towards the end, the advantages and
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limitations of financial accounting have been explained in the chapter.
NATURE AND SCOPE OF FINANCIAL

1.2
ACCOUNTING
In simple words, accounting refers to the process of identifying, clas-
sifying, summarising and analysing the financial transactions of an
organisation in a systematic manner. In addition, accounting involves
interpreting the business results to various interested users such as
proprietor, creditor, managers, shareholders and investors.
According to the American Accounting Association (AAA), Account-

ing is the process of identifying, measuring, and communicating eco-
nomic information to permit informed judgments and decisions by users
of the information.
Financial accounting is the field of accounting involving the prepara-

tion of financial statements for decision makers, such as stockholders,
suppliers, banks, employees, government agencies, owners and other

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stakeholders. Figure 1.1 shows the various aspects that comprise the
nature and scope of financial accounting:
Financial Accounting as a Service Activity
Financial Accounting as a Profession
Financial Accounting as Language of Business
Financial Accounting as Science and Art
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Financial Accounting as Information System
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Figure 1.1: Nature and Scope of Financial Accounting
Let us discuss these aspects in detail in the following section:

Financial accounting as a service activity: Financial accounting
is a service activity because of its intangible nature. It is an im-
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portant service activity of any organisation because it supports

economic decision making and it helps in choosing the best al-
ternative course of action. It also enables management with the
all-important financial information required to get desired results.
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Financial accounting as a profession: As a profession financial

accounting provides good opportunity to finance students who
want to pursue their careers as finance managers, charted accoun-
tants, financial accountants, etc. As per India’s scenario, Institute
of Charted Accountants of India, Institute of Cost Accountants of
India, National Institute of Financial Management, etc. are the
apex bodies in this field.
Financial accounting as language of business: It is a means of
reporting and communicating information about a business. The
expression, exhibition and presentation of accounting data known
as accounting principles or rules (such as numerals and words and
debits and credit) are accepted as symbols which are unique to the
discipline of accounting. Irrespective of a business being located in
any part of the world, financial information is analysed in a similar
manner. For instance financial experts use data in financial state-
ments such as balance sheet, profit and loss accounts to interpret
and establish whether a business is performing well or not.

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Financial accounting as science and art: Financial accounting fol-

lows a principle of double entry system, is based on various rules,
concepts, conventions and assumptions. Therefore, financial ac-
counting is regarded as a science. However, financial accounting
requires interest and experience apart from the knowledge of ac-
counting and can be learnt only by practice. An individual having
greater experience in accounting would be able to understand a
new transaction, new developments and changes in accounting
easily compared to a less experienced individual. Thus, financial
accounting is also an art.
Financial accounting as an information system: Accounting in-
formation is used for forecasting, comparing and evaluating the
earning capability and the financial position of a business entity.
Therefore, distribution of information is a vital function of ac-
counting. Figure1.2 shows the flow of accounting information:
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Business Output
Input (Data) Processing To the Users
Activities (Information)
Figure1.2: Financial Accounting as an Information System

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Figure 1.2 depicts the role of financial accounting as an information

system in an organisation. The input data is collected from different
business activities and later processed to make it comprehensible.
The resultant output (interpretation) provides information to various
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users such as government, suppliers, researchers, investors, manag-

ers, creditors, etc.
Some of the major objectives of financial accounting as information

system are as follows:
Financial accounting provides information that helps in making
financial decisions.
Itfulfils the requirements of the users who rely on financial state-
ments as their standard source of information for decision making.
It provides information, for judging managerial efficiency to use
the resources effectively for attaining the business goals and ob-
jectives.
It provides accurate and interpretive information regarding as-
sumptions taken for evaluation, forecast and assessment.
It provides historical information to the management to reveal his-
torical events.

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1.2.1 Objectives of Accounting
Some of the major objectives of accounting are as follows:

Permanent and systematic records of transactions: Every orga-
nization needs to maintain a permanent and systematic record for
all of its transactions. These records are necessary for both exter-
nal (taxation, annual reports, etc.) and internal purposes (examin-
ing current business position) and these records can be produced
as per the requirement.
To identify operational profit or loss: A business organization is
involved in various activities on a daily basis and out of these ac-
tivities some may result in profit and some other in loss. Account-
ing shares daily, weekly, monthly, quarterly and annual reports to
measure all these activities in terms of good and bad outcomes, i.e.
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profit and loss. These reports further enable a firm to take correc-
tive actions as and when required.
Proper utilization of financial resources: Accounting data is also
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useful to conduct internal analysis of various resources and it pro-
vides clear picture regarding usage of resources. After conducting
this analysis an organisation can minimise wastage by assigning
budget to various activities and this budget limits the usage of re-
sources in various resources and hence, efficiency in resource util-
isation can be achieved.
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To identify the financial position of a business: By analysing

Profit and Loss A/c, Balance Sheet and Final Statements, and a
business organisation can project its financial position in compar-
ison with its competitors.
Logical decision making: Accounting process can explore, identi-
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fy and measure accounting and economic information and this in-

formation can be used by the managers to ensure the development
of rational and logical decision making.
Corporate governance (CG): An organisation can practice good
CG by ensuring transparency in recording of accounting events
and this can also enable top decision makers to ensure sustainable
growth of the business.
self assessment Questions
1. The expression, exhibition and presentation of accounting

data in financial statements are called _______________.
a. Accounting basics
b. Accounting principles
c. Recording techniques
d. Only (b) and (c)

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2. Accounting is the process of identifying, measuring, and

communicating economic information to permit informed
judgments and decisions by users of the information. This
definition of accounting is given by___________.
a. Global Accounting Principles
b. Institute of Charted Accountants of India
c. Indian Accounting Association
d. American Accounting Association
Activity
Using the Internet, make a list of various career options available

after studying financial accounting.
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FINANCIAL Accounting, MANAGEMENT
1.3
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ACCOUNTING ANd cost accounting
Although management accounting and financial accounting are often
used interchangeably, it should be noted that management account-
ing is simply an off-shoot of financial accounting. In simple terms,
management accounting uses the financial data provided by financial
accounting by the management of an organisation to improve the ef-
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ficiency.
According to Institute of Management Accountants (IMA), Manage-

ment accounting is a profession that involves partnering in manage-
ment decision making, devising planning and performance manage-
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ment systems, and providing expertise in financial reporting and

control to assist management in the formulation and implementation
of an organization’s strategy.
However, in spite of the interrelationship between financial and man-

agement accounting, there are certain points of difference between
the two, which are summarised in Table 1.1:
Table 1.1: Points of Difference between

Financial Accounting and Management
Accounting
Points Financial Accounting Management Accounting
Primary users of External users (such as Internal users (such as
information creditors, stockholders, and managers) are the prima-
government regulators) are ry users of the informa-
the primary users of the tion.
information.

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Accounting
Focus It focuses on historical It focuses on the future
information. Only external projections and focuses
party transactions are con- on internal transactions
sidered. with a detailed view of
analysis.
Accounting It follows the Generally It can use any accounting
principles Accepted Accounting Prin- standard or technique to
ciples (GAAP) or Interna- generate useful informa-
tional Financial Reporting tion as there is no limita-
Standards (IFRS) to create tion to follow any of the
a sense of confidence as accounting standards.
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the data is used by external
users.
Time span In this, reports are pre- In this, reports are pre-
pared annually, semi-an- pared depending on man-
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nually & quarterly on a agement’s need. Some are
regular basis. daily while others may
be prepared only when
needed.
Audit Independent certified pub- There are no independent
lic accountants audit the audits verifying the infor-
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annual financial statements mation and organisation’s

of publicly traded compa- internal audit
nies. Team examines the pro-
They also express an opin- cedures used in preparing
ion on the fairness of the reports.
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financial information.
Unit of The financial information is Besides, monetary units,
measurement usually expressed in mon- management accounting
etary terms. This is to help uses measures such as
in making comparisons machine hours, labour
between different data. hours, product units, etc.
for the purpose of analy-
sis and decision making.
Reporting Report is about the com- Management determines
purpose pany’s performance at a the contents and format
whole, which is consolidat- of a report according
ed in financial statements. to company’s products,
The standards to use for customers, geographical
financial reporting are de- regions, departments,
termined IFRS or GAAP. divisions. Reports are
generally prepared only
when management
believes the benefit of
using the report exceeds
the cost of preparing the
report.

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Accounting
Subject It produces information and It identifies, collects,
matter and reports for external users measures, classifies and
scope such as researchers, gov- reports information that
ernment, etc. is useful to managers in
planning, control and
decision making.
The Chartered Institute of Management Accountants (CIMA), Lon-

don, defines Management Accounting as the process of identification,
measurement, accumulation, analysis, preparation, interpretation, and
communication of information used by management to plan, evaluate
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and control within an entity and to assure appropriate use of and ac-
countability for its resources. Management accounting also comprises
the preparation of financial reports for non-management groups such as
shareholders, creditors, regulatory agencies and tax authorities.
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Cost accounting is a part of financial accounting used to calculate
and control the cost of different business operations. Cost account-
ing involves the analysis of variable cost, fixed cost, overheads and
capital cost in business operations. However, there are certain points
of difference between the two, which are summarised in Table 1.2:
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Financial Accounting and Cost Accounting
Points Financial Accounting Cost Accounting
Primary users of It involves the preparation It involves the prepara-
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information of a standard set of reports tion of a broad range of

for an outside audience, reports that management
which may include inves- needs to run a business.
tors, creditors, credit rating
agencies and regulatory
agencies.
Objective It provides information It provides information
about the financial perfor- about the determination
mance and financial posi- of cost in order to control
tion of an organisation. cost and take relevant
decisions.
Format Reports prepared under In this, reports are pre-
financial accounting are pared using the format
highly specific in their specified by manage-
format and content, as ment with the intention
mandated by either GAAP of including only that
or IFRS. information pertinent
to a specific decision or
situation.

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Financial Accounting and Cost Accounting
Points Financial Accounting Cost Accounting
Unit of Financial accounting clas- Cost accounting classi-
measurement sifies records and presents fies records and presents
interpreted data in mone- the material, labour and
tary terms. overheads costs.
Focus Financial accounting pri- Cost accounting usual-
marily focuses on reporting ly results in reports at
the results and financial a much higher level of
position of an entire busi- detail within the compa-
ness entity. ny, such as for individual
products, product lines,
geographical areas, cus-
tomers, or subsidiaries.
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Regulatory The structure of financial There is no regulatory
framework accounting reports is tightly framework governing
governed by either gener- cost accounting reports.
ally accepted accounting
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principles or international
financial reporting stand-
ards.
Content of It contains an aggregation It contains both financial
report of the financial informa- and operational informa-
tion recorded through the tion. Operational infor-
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accounting system. mation is collected from

a variety of sources that
are not under the direct
control of the accounting
department.
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Time span Financial accounting per- Cost accounting issues re-

sonnel issue reports only ports at any time and with
at the end of a reporting any degree of frequency,
period. depending upon manage-
ment’s requirement.
Analysis of costs It presents the profit/loss It provides detail of
and profits incurred by an organisation cost incurred and profit
as a whole. earned from each job,
product, process, con-
tracts, etc. separately.
Recording of It records historical data. Cost accounting collects
data and presents the budget-
ed data. It includes both
historical and estimated
cost data.

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3. Who among the following are primary users of the management

accounting data?
a. Creditors
b. Management
c. Government
d. Shareholders
4. Which of the following represents International Accounting
Standards?
a. IFRS
b. IMA
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c. AAA
d. Indian GAAP
5. Which of the following involves the analysis of variable cost, fixed
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cost, overheads and capital cost in business operations?
a. Financial costing
b. Cost accounting
c. Management accounting
d. Fundamentals of costing
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Activity
Make a group of your friends and discuss the difference between

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management accounting and financial accounting.
1.4 BASIC ACCOUNTING CONCEPTS

In accounting, financial transactions are recorded and communicat-
ed to various stakeholders and other users in the form of financial
statements. If users of accounting information do not follow any stan-
dard or rule, it would be difficult for organisations and accountants to
communicate the required data as different people would interpret
it differently. Therefore, it is essential to have Accounting Standards,
Accounting Principles and Accounting Concepts to bring uniformity
in understanding the accounting records. Consequently, several ac-
counting concepts have been introduced to make accounting more
consistent and easy to comprehend by different users.
In simple words, the accounting concepts refer to the general rules
and assumptions that are made while preparing the financial state-
ments. Accounting concepts help various users of accounting infor-
mation in understanding and interpreting the accounts in a similar
manner.

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The major accounting concepts are shown in Figure 1.3:
Entity Concept
Cash and Accrual Concept
Matching Concept
Double Entry Accounting System
Money Measurement Concept
Going Concern Concept
Historical Cost Concept
Accounting Period Concept
Conservatism
Realisation
Consistency
Materiality
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Figure 1.3 Accounting Concepts
Let us discuss these accounting concepts in detail in the following
section:
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1.4.1 ENTITY CONCEPT
According to this concept, a business is treated as a separate unit or

entity from the owners, creditors, managers and stakeholders. In oth-
er words, according to the business entity concept, the business and
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its owners are two separate entities. Therefore, even the owner is re-
garded as a creditor of business. Accounting is done for entities, rath-
er than for the persons who own or are associated with them.
For instance, when an owner invests money in the business; it is as-

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sumed that the owner has given the money and the business has re-
ceived the money. Similarly, cash or goods withdrawn by the owner
from business for his/her personal use are considered as the personal
expense instead of a business expense. In such a case, the personal
expense of the owner is debited from the withdrawal account. There-
fore, all the transactions of the business are recorded in the account-
ing books of an organisation from the point of view of the business
unit and not that of the owner. The concept of separate entity is appli-
cable in all forms of business organisations.
Let us understand the concept of a business entity with the help of

an example. Suppose Mr. Gupta started a business with an amount of
`50,000. He purchased furniture and machinery for `30,000, and goods
for `10,000. The rest of the amount of `10,000 is deposited in the bank.
According to the business entity concept, `50,000 is treated as capital
and is considered as the liability of the business to the owners of the
business. In addition, if Mr. Gupta withdraws `5,000 from the bank for
personal use, then it comes under the personal expenses and not the
business expenses and is shown as drawings.

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1.4.2 CASH AND ACCRUAL CONCEPT
Cash basis of accounting recognises inflow and outflow of cash only

when account is received or bills are paid, respectively. In other
words, in cash basis of accounting, revenue is recognised when cash
is received, whereas the expense is recognised when cash is paid. On
the other hand, in the accrual concept of accounting, revenues or ex-
penses are recorded when they are earned or incurred, and not when
cash is paid or received by an organisation. In such cases, we can cal-
culate the profit, by matching expenses with the revenue when they
are earned or incurred, instead of the cash received or paid for them.
For example, an organisation sells goods on credit worth `50,000 in
November, 2012 and receives the payment in January, 2013. According
to the cash accounting method, the payment would be recorded in the
month of January, 2013 when cash was actually received. However,
under the accrual basis of accounting the income is recorded in the
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November, 2012 books of account.
Let us consider another example. If an organisation purchases a new

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printing machine on credit in May, 2013 and pays `1,00,000 for it in
July, 2013 two months later. According to the cash method, `1,00,000 is
recorded as expense for the month of July, 2013. However, according
to the accrual method, `1,00,000 is recorded as payment in May, 2013
when the organisation became obligated to pay for the printer.
1.4.3 MATCHING CONCEPT

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It is a well-accepted fact that the desire to make profit is an important

trigger that engages owners in business activities. This is one reason
why a major share of an accountant’s attention is consumed in evolv-
ing the various techniques of measuring income.
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The profit earned by an organisation can be calculated by matching

revenues received, at the cost incurred during a specific duration.
The net income of a period can be determined by deducting total ex-
penses from total revenues. On the basis of this concept, adjustments
are made in the final accounts for all the prepaid expenses, outstand-
ing expenses, accrued incomes and unearned incomes. According to
the matching concept, the expenses incurred on earning the revenues
should be recognised during the accounting period in that time period
and not in the next or previous time period in order to reach accurate
net income figure. For example, a hospital pays `2,00,000 per month
as salaries to five doctors. Monthly revenues are worth `80,00,000.
In this case, `10,00,000 worth of monthly salaries should be matched
with `80,00,000 of revenue generated to reach the accurate net income
figure.
1.4.4 DOUBLE ENTRY ACCOUNTING SYSTEM
The double entry concept is a basic principle of accounting, which

is considered as the foundation of accounting. According to this con-

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cept, every transaction has a two-fold effect, namely receiving and giv-
ing. These are the two aspects of every business transaction. These
are known as Debit (Dr) and Credit (Cr) entries. This implies that for
every debit entry, there will always be an equal credit entry. This is
known as the duality principal of accounting. It implies that a single
transaction would affect at least two accounts.
For example, an organisation bought machinery worth `80,000 in

cash. In such a case, the fixed asset account would be debited while
the cash account is credited. Therefore, one transaction is affecting
two accounts, which is represented as follows:
Asset (machinery) = Liability (cost)
80,000 80,000
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Some of the common rules of debit and credit entries are as follows:
Debit Entries Credit Entries

Increase in assets Decrease in assets
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Increase in expense Decrease in expense
Decrease in liability Increase in liability
Decrease in equity Increase in equity
Decrease in income Increase in income
Let us illustrate this further.

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Illustration 1: Transaction type: Purchase of machine by cash.

In this case, debit entry would include Machine (increase in asset),
while credit entry would be Cash (decrease in asset).
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Illustration 2: Transaction type: Interest received on bank deposit ac-

count. In this case, debit entry would include Cash (increase in asset),
while credit entry would be Finance Income (increase in income).
Apart from this, the dual aspect concept is called the double entry
system of book keeping, which implies that the total assets and total
liabilities of an organisation should be equal. The equality between
assets and liabilities represents the balance sheet equation or the
accounting equation, which is discussed in detail in the subsequent
chapters.
1.4.5 MONEY MEASUREMENT
The money measurement concept underlines the fact that only those
transactions and events would be recorded in the books of account-
ing that are financial or monetary in nature. The financial statements
report only those transactions which can be measured in terms of
money or can be accounted as monetary amounts. For example, an
organisation has a cash balance of `10,000, a building containing 10
rooms, a piece of land of 1000 meters, and 10 tables. In such a case, it

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would be difficult for the organisation to determine the total assets or

obtain any information, as not all of them are represented in monetary
terms. Therefore, the transactions that cannot be expressed in mon-
etary terms are not recorded in the books of accounts. For example,
although goodwill, loyalty, and honesty of employees affect the profits
of an organisation, these are not recorded in the accounting books, as
they cannot be expressed in monetary terms.
1.4.6 GOING CONCERN
Going concern concept is based upon the assumption that an organi-

sation would not be ceased or liquidated in the immediate future, and
continues to operate for an indefinite period.
According to Kohler’s Dictionary for accountants, the going concern
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concept is defined as, any enterprise which is expected to continue op-
erating indefinitely in the future.
The going concern concept states that organisations should be treated

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as though they would continue to operate for an indefinite time period
or at least long enough to accomplish their objectives. In simple words,
the going concern concept states that organisations would have a long
life and not close or become bankrupt in the immediate future. For
example, in the early 2000s, General Motors (GM) experienced major
financial difficulties and decided on declaring bankruptcy and close
operations throughout the world. Later, the Federal Government of
M
USA stepped forward to provide GM with a bailout as well as a guar-

antee. This helped GM to continue with its operations. According to
this concept, organisation would be able to achieve its predetermined
goals and contractual obligations from available resources. The go-
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ing concern concept is extremely important to generally accepted ac-

counting principles or GAAP, the most significant contribution being
in the area of assets. The concept of depreciation and amortisation
of assets is based on the notion that organisations would continue to
operate indefinitely.
For example, organisation purchases machinery worth `45,000 with

the life span of 10 years. As per the concept of going concern, some
amount of the cost incurred on machinery would be shown as an ex-
pense every year and the balance amount would be represented as
an asset. In accounting books, representing the whole expense on an
asset in a single year is inappropriate. This concept provides the basis
for showing value of assets on the balance sheet and determining their
depreciation.
1.4.7 HISTORICAL COST
According to the historical cost concept, the assets are measured as

per the price paid (cost incurred) to acquire them. This cost would
include the cost of acquisition, transportation and installation. This

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concept of asset measurement does not change with the passage of

time, if there is a change in the current value of assets. For example,
if a piece of land is purchased for `1,00,000 and its market price is
`1,50,000, then while preparing financial statements, its purchase val-
ue would be considered. Therefore, the balance sheet is prepared on a
particular date on the basis of the cost concept. It does not specify the
market price of the asset.
The cost concept is historical in nature as the prices recorded for the
assets are the past prices, the prices paid at the time of acquisition.
One of the important aspects of the cost concept is that if the organi-
sation does not pay anything for acquiring the asset, it is not record-
ed in the books of accounts. The cost assumption does not mean that
the assets would always be shown at the same cost price every year,
but the cost price of the asset would reduce systematically using the
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process of depreciation. Therefore, after a certain period, these assets
disappear from the balance sheet as their economic tenure completes,
which signifies that they have fully depreciated and would be sold as
scrap.
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1.4.8 ACCOUNTING PERIOD
Accounting period refers to the period for which an organisation eval-

uates its financial position. It covers the profit earned or loss incurred
by the organisation for a particular duration that is represented in the
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income statement.
According to accounting period concept, the entire business tenure

should be divided into equal segments to study and analyse the results
properly. For example, the accounting period for publishing financial
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statements is usually a quarter (e.g. January 1st, 2013 through March

31st, 2013), while the accounting period for tax reporting is usually a
year (e.g. January 1st, 2013 – December 31st, 2013).
At the end of each accounting period, various financial statements,

such as income statement/profit and loss account and balance sheet,
are prepared. The income statement represents the profits earned
and losses incurred by the organisation during the accounting period.
On the other hand, balance sheet signifies the financial position of
organisation in terms of assets and liabilities as of the last day of the
accounting period.
1.4.9 CONSERVATISM
According to the conservatism concept, financial transactions are re-

corded in the books of accounting by taking into consideration all pro-
spective losses and ignoring all prospective profits.
Kohler defines the concept of conservatism as a guideline which

chooses between acceptable accounting alternatives for recording events

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or transactions so that the least favourable immediate effect on assets,

income, and owner’s equity is reported.
This concept is based on the conservative approach, which allows the

determination of future income in such a manner that the profits are
not overstated and losses are not understated. For example, if an or-
ganisation ABC is in the middle of a patent lawsuit, and expects to lose
the suit; it would record the loss in the footnotes of its financial state-
ments as per the concept of conservatism. This approach emphasises
on recognising the revenues and income gradually, whereas the losses
or expenses are acknowledged quickly.
1.4.10 REALISATION
This concept states that an organisation should determine the time

when revenues are earned and expenses are incurred. The accoun-
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tant should record the business transactions only when it is realised.
Revenue is realised when goods or services produced or rendered by

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the business entity are transferred to a customer either for cash, some
other assets, or for future payment. It follows the legal principle relat-
ed to transfer of property. However, it is not related to the actual re-
ceipt of cash or receipt of an order to supply goods. For example, if an
organisation receives an order in April to supply goods in June, then
revenue would be earned in June, when the actual sales take place.
This concept prevents an organisation from inflating their incomes or
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profits by recording sales and incomes that occur in future.
1.4.11 CONSISTENCY
According to this concept, the practices and methods of accounting

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remain constant in different accounting periods. Therefore, the finan-

cial information of one period can be compared to another period or
another entity if the consistency approach is followed.
However, the idea of consistency also facilitates the introduction of

improvement in the techniques of accounting.
The principle of consistency plays its role particularly when an alter-

native accounting method is equally acceptable. For example, in ap-
plying the principle “that fixed assets are depreciated over its useful
tenure” an organisation may adopt any of the several methods of de-
preciation. However, as per the concept of consistency, it is accepted
that the organisation would consistently follow the method of depre-
ciation once chosen. Any change from one method to another would
result in inconsistency.
1.4.12 MATERIALITY
According to this concept, the main basis of accounting should be ma-

terial facts. This concept states that only the significant details of a

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material will be included as these are required for accounting. Howev-

er, all the insignificant details of a material can be ignored.
The American Accounting Association defines the term materi-

ality as, an item should be regarded as material if there is reason to
believe that knowledge of it would influence the decision of the informed
investor.
According to the principle of materiality, unimportant items are either

left out or merged with other items. It should be noted that an item
that is significant for one might be insignificant for the other. Similar-
ly, an item that is of significance in one year may not be significant in
the next year.
For instance, suppose the profit and loss account has been affected
due to a change in the basis of accounting, such as the depreciation
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methods and basis of valuation of stock. In such a case, the changed
amount must be disclosed if it is material in relation to the total amount
charged and have an impact on the profit or loss of the organisation.
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Materiality is relative to the size and particular circumstances of indi-
vidual organisations.
For example, default by a customer owing `1000 to an organisation

with net assets of worth `100 crores is insignificant to the financial
statements of the organisation. However, if the amount of default was
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worth `10,00,000, the information would result in major problems in

the financial statements of the organisation leading users to make in-
correct business decisions.
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6. According to the ________concept, a business is treated as a

separate unit or entity from the owners, creditors, managers
and stakeholders.
a. Matching
b. Materiality
c. Economic Entity
d. None of the above
7. According to the________________, revenue expenses should
be recorded in the same period in which revenue was realized.
a. Matching concept
b. Materiality concept
c. Economic Entity concept
d. Conservation concept

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8. According to the ____________concept, financial transactions

are recorded in the books of accounting by taking into
consideration all prospective losses and ignoring all
prospective profits.
a. Matching concept
b. Materiality concept
c. Economic Entity concept
d. Conservation concept
Activity
Make a group of your friends and discuss the basic accounting con-
cepts. Present your discussion points in a short note.
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Advantages and Limitations of
1.5
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Financial Accounting
We have previously discussed that accounting is the art and science of
recording business transactions. It records data and further analyses
it to reduce it to accounting reports. These reports help in facilitat-
ing the dissemination of important information among the different
groups of users to take the appropriate decisions. Following are some
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of the other advantages of accounting:

Maintaining business records: Accounting helps in recording
all financial transactions in the books of accounts in a systematic
manner. Therefore, we do not need to rely on human memory.
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Preparing the financial statement: Accounting helps in deter-

mining the profit or loss as well as the financial position of the
business during a particular period. Accounting records and clas-
sification provide the relevant information to the accountant for
preparing financial statements.
Comparing results: Accounting involves comparing the profits or
loss in a given year with those of previous years. The comparison
helps in gathering important information and planning for the fu-
ture operations.
Helping in decision making: It implies that accounting assists
the management decision-making by providing significant infor-
mation for solving numerous problems, such as deciding the sell-
ing price of goods produced, or deciding whether a part should be
manufactured in the industrial unit or procured from outside.
Providing information to interested groups: It implies that the
accounting process provides appropriate information to various

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interested parties, such as owners, creditors and management

who are concerned about the accounting information related to
various aspects, such as, sales, production and profit.
Providing legal evidences: This refers to the documentary evi-
dence of the accounting information for legal requirements. This
helps to prevent any misconduct or threats from rival organisa-
tions.
Apart from the advantages of accounting, it has some disadvantages.

Some of the limitatmions of accounting are as follows:
Itfocuses only on financial transactions or events while ignoring
the non-monetary items.
Itleads to wrong conclusions if the assumptions of accounting
data are inaccurate.
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Itobtains biased information from the accountant if he/she will-
ingly makes inappropriate estimations.
Itshows fixed asset at a particular cost, which would depreciate
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over time. Hence, there is a significant difference between the
original cost at which assets were purchased and the current re-
placement cost.
Itprovides accounting information on a yearly basis only, while
the information can also be required for a shorter duration.
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9. Accounting process provides appropriate information to

various interested parties, who among the following are the
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interested parties?
a. Owners
b. Creditors
c. Management
d. All of the above
10. Financial accounting focuses only on _________transactions
or events while ignoring the non-monetary items.
a. Barter
b. Financial
c. Valuable
d. Only (a) and (b)

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Activity
Form a group and discuss the advantages and disadvantages of

accounting.
1.6 Summary
Accounting is a very important and old concept in business man-
agement.
Accounting has become synonymous with the “language of busi-
ness”.
With the expansion of the market and the size of the business or-
ganisations, the shareholders, creditors, suppliers, potential buy-
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ers and various government agencies seek to get the financial dis-
closure of the organisation.
In simple words, accounting refers to the process of identifying,
IMclassifying, summarising and analysing the financial transactions
of an organisation in a systematic manner.
In today’s business world, accounting plays the crucial role of pro-
viding important financial information to the interested parties.
Financial accounting refers to the process of systematic record-
ing of financial transactions aimed at preparing profit and loss ac-
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count and balance sheet.

Management accounting refers to the process of designing the ac-
counting system for the management.
The accounting concepts refer to the general rules and assump-
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tions that are made while preparing the financial statements.

Major accounting concepts are entity concept, cash and accrual
concept, matching concept, double entry accounting system, mon-
ey measurement concept, going concern concept, historical cost
concept, accounting period concept, conservatism concept, reali-
sation concept, consistency concept and materiality concept.
Some of the advantages of accounting are maintaining the busi-
ness records, preparing financial statements, helping in decision
making, and providing information to interested groups.
The limitations of financial accounting are that it focuses only on
financial transactions or events while ignoring the non-monetary
items, leads to wrong conclusions if the assumptions of accounting
data are inaccurate, obtains biased information from the accountant
if he/she willingly makes inappropriate estimations, shows fixed as-
set at a particular cost, which would depreciate over time, etc.

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key words
Accounting principles: General rules and concepts that govern

the field of accounting.
Accrued income: Income which has been earned but not yet
received.
Assets: Resources owned by a firm having economic value.
Creditors: Persons or organisations to whom one owes money.
Debtors: Persons or entities that owe money to the organisa-
tion.
Depreciation: The method of allocating the cost of a tangible
asset over its useful life.
Duality: An accounting principle according to which for each
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debit entry, there will always be an equal credit entry.
Expenses: The total money spent by an organisation for reve-
nue generation.
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Income: The excess of revenue over expenses which is also
known as earnings or profits.
Liability: The financial debt or obligation which arises as a re-
sult of regular business operations.
Overheads: All ongoing expenses in a business, which are not
included or related to direct labour, direct materials or third-par-
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ty expenses.
Owner’s equity: The total investment made in the company
which is calculated by deducting liabilities from assets.
Revenue: The amount of money received by a company by sell-
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ing goods and services.

Sales: The total amount generated by an organisation for sell-
ing its products and services.
Shareholders: Individuals or institutions that legally own a
share of stock in a public or private corporation.
Stakeholder: A person who has an interest or concern about
something, especially business.
Suppliers: Persons or organisations that provide goods or ser-
vices to another organisation or individuals.
1.7 DESCRIPTIVE QUESTIONS

1. Discuss the nature and scope of financial accounting.
2. Distinguish between financial accounting and management
accounting.

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3. What do you mean by accounting concepts? Mention the basic

accounting concepts.
4. Distinguish between financial accounting and cost accounting.
5. What are the major advantages and limitations of financial
accounting?
1.8 ANSWERS and hints
answers for Self Assessment Questions
Topic Q. No. Answers

Nature and Scope of Finan- 1. b. Accounting principles
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cial Accounting
2. d. American Accounting Asso-
ciation
Financial Accounting, Man- 3. b. Management
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agement Accounting and
Cost Accounting
4. a. IFRS
5. b. Cost accounting
Basic Accounting Concepts 6. c. Entity Concept
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7. a. Matching concept

8. d. Conservation concept
Advantages and Limitations 9. d. All of the above
of Financial Accounting
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10. b. Financial
hints for descriptive Questions

1. Accounting refers to the process of identifying, classifying,
summarising and analysing the financial transactions of an
organisation in a systematic manner. Refer to Section 1.2 Nature
and Scope of Financial Accounting.
2. Financial accounting refers to the process of systematic
recording of financial transactions aimed at preparing profit
and loss account and balance sheet. Management accounting
refers to the process of designing the accounting system for
the management. Refer to Section 1.3 Financial Accounting,
Management Accounting and Cost Accounting.
3. The accounting concepts refer to the general rules and
assumptions that are made while preparing the financial
statements. Refer to Section 1.4 Basic Accounting Concepts.

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4. Financial accounting refers to the process of systematic

recording of financial transactions aimed at preparing profit and
loss account and balance sheet while cost accounting is a part
of financial accounting used to calculate and control the cost
of different business operations. Refer to Section 1.3 Financial
Accounting, Management Accounting and Cost Accounting.
5. It records data and further analyses it to reduce it to accounting
reports. These reports help in facilitating the dissemination of
important information among the different groups of users to take
the appropriate decisions. The limitations of financial accounting
are that it focuses only on financial transactions or events while
ignoring the non-monetary items, leads to wrong conclusions
if the assumptions of accounting data are inaccurate, obtains
biased information from the accountant if he/she willingly makes
inappropriate estimations, shows fixed asset at a particular
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cost, which would depreciate over time, etc. Refer to Section
1.5 Advantages and Limitations of Financial Accounting.
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1.9 SUGGESTED READINGs & REFERENCEs
Suggested Readings
Debarshi, B. (2011). Management Accounting (pp. 1-10). Noida:
Dorling Kindersley India Pvt. Ltd.
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Pingle,M. (2013). Basic Accounting Concepts: A Beginner’s Guide

to Understanding Accounting (pp. 58-62). United States of Ameri-
ca: Michael Pingle.
Weygandt, J., & E. Kieso, D. (2011). Financial Accounting: IFRS
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Edition (pp. 4-12). United States of America: WorldColour, Inc.
E-REFERENCES
Icaiknowledgegateway.org. (2014). ICAI Knowledge Gateway. Re-
trieved from, http://www.icaiknowledgegateway.org/
AccountingCoach.com. (2014). Accounting Basics | Explanation |
Accounting Coach. Retrieved from, http://www.accountingcoach.
com/accounting-basics/explanation
Accounting-simplified.com.(2014). Accounting Concepts & Prin-
ciples | Accounting-Simplified.com. Retrieved from, http://ac-
counting-simplified.com/financial-accounting/accounting-con-
cepts-and-principles/

Case study
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TURNAROUND BY IMPLEMENTING FINANCIAL

ACCOUNTING
Mr. Rakesh Goyal, owns a small road side food stall in the out-
skirts of Delhi in Najafgarh. Initially 1994, at the time of starting
up, his business was quite small and he does not practice record-
ing transactions. Then in 2000, he bought a shop in a semi urban
locality and started providing 3 time meals for minimal charges
per plate. With this move he opened a small family restaurant
named ‘Goyal Rasoi’ with a serving capacity of 25 customers at
once. He also allowed some customers to buy on credit basis. Due
to lack of recording and book keeping Mr. Rakesh Goyal mostly
forgot many transactions and started suffering losses. He used to
forget to whom he had to pay (Lender) and from whom he had to
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take (borrower). On the other hand, there are many other factors,
such as underestimation and overestimation of demand, wastage
of food, number of cooks employed, etc. due to which he suffered
losses.
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By the year 2002, the losses were too high and he started thinking
about winding up. One day, one of the friends of Mr. Goyal named
Rahul Sheety came to meet him. Mr. Goyal made his friend aware
about the conditions of ‘Goyal Rasoi’ and Mr. Sheety suggested
him to start recording all the transactions on the daily basis. How-
M
ever, Mr. Goyal was not financially literate and therefore he hired
a commerce graduate as clerk for recording transactions.
The clerk recorded all the accounting transaction by maintain-

ing various subsidiary books, such as Journal, Ledger, Cashbook,
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Purchase book, etc. Then, within just 3-4 months of recording, Mr.
Goyal got clear picture of his restaurant and now it was easy to
track borrowers and lenders of the business. With the help of his
clerk, he further identified many loopholes such as, wastage of
resources, actual requirement of labour, inventory level to meet
regular and seasonal demand, etc. As all the data was available in
recorded form, so it became more convenient to analyse various
costs, their components and methods to control them.
In 2005, at the end of third year of recording, Mr. Goyal got finan-
cial statements of ‘Goyal Rasoi’ for three years. By analysing these
statements, Mr. Goyal was now able to do comparative analysis of
his restaurant with past position and as well as with competitors.
They also identified many new investment opportunities in the
related field. As a result by 2015, ‘Goyal Rasoi’ established its 20
‘Chain Restaurants’ in Delhi NCR and became a prominent lead-
er in small restaurant industry.

Case study
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questions
1. Explain, how record keeping and accounting helped

‘Goyal Rasoi’ in increasing their client base?
(Hint: Mr. Rakesh Goyal had done many transactions
on credit basis and due to the lack of recording and
book keeping Mr. Rakesh Goyal used to forgot many
transactions and started suffering losses.)
2. Write a summary on the case of this case in 200 words and
also share a new heading for the summary.
(Hint: Analyse the case and write a summary focusing on
the importance of accounting.)
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Ch a
2 p t er
Accounting Process
CONTENTS
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2.1 Introduction
2.2 Accounting Process
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2.2.1 Stages in Accounting Process
2.2.2 Traditional Approach for Recording Transactions
2.2.3 Transaction Analysis
2.2.4 Debit and Credit Rules
Activity
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2.3 Journal
2.3.1 Format of Journal
2.3.2 Process of Journalising
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Activity
2.4 Ledger
2.4.1 Format of Ledger
2.4.2 Ledger Balancing
Activity
2.5 Meaning of Subsidiary Books
2.5.1 Cash book
2.5.2 Purchases Book
2.5.3 Sales Book
2.5.4 Purchases Return Book
2.5.5 Sales Return Book
Activity
2.6 Summary

CONTENTS

2.9 Solved Numerical Illustrations
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Accounting Process 31
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NEW VENTURE FINDS ACCOUNTING

SOLUTION THROUGH DELOITTE
Deloitte provides audit, consulting, financial advisory, risk man-

agement and tax services to selected clients that are members of
Deloitte Touche Tohmatsu Limited (DTTL), a UK private com-
pany limited by guarantee. It provides technical assistance to its
clients by developing powerful business solutions tailored as per
the clients’ needs. One of its clients was a newly created venture
providing an internet based reinsurance trading platform. The
company was based in the United Kingdom and had outsourced
its accounting process to a shareholder. This created several prob-
lems as the accountants had no exposure to the actual operations
and functioning of the company. Therefore, the management had
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the challenge to overcome the problems faced in its accounts de-
partment. The company hired a new Finance Director who decid-
ed to focus his attention to the issues in the accounts department.
The findings were as follows:
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Financial statements did not reflect the correct or actual fi-
nancial figures.
The financial reports lacked accuracy and consistency.
Tax information lacked details.
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The finance director decided to meet with the consultants at De-

loitte and consider their advice. Based on the issues, Deloitte con-
sultant deduced that the accounting procedure of the new firm
was faulty and lacked a proper flow of recording and book keep-
ing. As a result, the figures on financial statements and books of
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account were inconsistent. The consultant later developed the fol-

lowing accounting process for the firm to rectify the problems in
the accounting method of the new firm:
1. Keep a record of source documents for each transaction
2. Records transactions in journals
3. From the debits and credits in journals, prepare a ledger
4. Prepare a trial balance from all accounts
5. Prepare financial statements from the information in the
trial balance.

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learning objectives

> Describe the accounting process
> Explain the stages of the accounting process
> Describe the meaning and format of journal
> Describe the meaning and format of ledger
> Discuss subsidiary books
> Explain Bills of Exchange
2.1 INTRODUCTION
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Accounting process constitutes one of the most fundamental con-
cepts of accounting. The accounting process helps in maintaining
systematic records of all financial transactions to avoid any possible
errors. In simple words, accounting process determines the economic
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impact of the transactions on the business. The accounting process
contains identifying, measuring and communicating financial infor-
mation to the interested parties. The accounting process needs to be
followed properly to avoid any confusion or errors while recording
financial transactions. Therefore, deployment of a proper accounting
process helps in the efficient functioning of financial activities of an
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organisation.
Accounting process consists of various steps. In the first step, the

transactions are recorded. This process is known as journalising. The
second phase is the ledger posting phase in which the accounts are
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classified and the balance of each account is determined. In the next

phase, the trial balance is prepared. In the trial balance, the ledger ac-
counts are arranged and aggregated into debit and credit balances in
such a way that both sides become equal. Therefore, you can say that
the trial balance helps in verifying the arithmetic accuracy of the re-
corded accounts. In the fourth and the last phase, financial statements
are recorded at the end of the accounting period. It includes profit and
loss statement and the balance sheet.
The chapter begins with a detailed discussion of the process of

accounting. Next, you will study the stages in the accounting process.
In addition, the chapter also discusses the meaning and format of the
Journal. Next, the chapter describes the meaning and format of the
ledger. Some of the other topics discussed in the chapter include sub-
sidiary books and bills of exchange.

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2.2 ACCOUNTING PROCESS

The accounting process starts when any financial transaction is made
in an organisation. The accounting process results in various financial
statements, such as balance sheet, profit and loss account and other
statements. Therefore, you can say that the main objective of this pro-
cess is recording financial transactions systematically and accurately
in the journal and process them to prepare the financial statements.
The process of financial accounting involves a number of steps. Let

us understand the accounting process with the help of an example.
Figure 2.1 represents the process of accounting:
Prime Document }
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Invoices for Purchases }
Invoices of Sales }
Credit and Debit Notes } Sources of Accounting
Bank Pay-in-Slips } Information
Cheques Issued
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}
Cash Payments for Expenses
Invoices for Fixed Assets Purchases
Primary Accounting Records

Day Books
Journal Books
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Cash Book and Petty Cash Book Recording the business

Sales Book transactions in the
Purchase Book accounting system
Sales Return Book according to the dual aspect
Purchase Return Book concept and classifying the
Bills Receivable Book accounting information
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Bills Payable Book

Journal Proper
Ledger
Trial Balance
Arithmetic checking of
A summary of all the balances at the
double entry book keeping
end of the accounting period
Final Account Statement measuring

Trading and Profit and Loss Account the profit or loss for an
Balance Sheet accounting period, statement
of assets, liabilities, and
capital at the end of the
accounting period
Figure 2.1: Accounting Process

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2.2.1 STAGES IN ACCOUNTING PROCESS
The process of accounting starts with the identification of financial

transactions. Next, it records the transactions in the books of accounts.
Then the process classifies and summarises the information and pre-
pares a trial balance and financial statements. The steps involved in
the process are shown in Figure 2.2:
Identification of Financial
Transactions
Preparation of Vouchers
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Recording Entries in the Books of
Original Entry
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Posting to the Ledger
Preparation of Trial Balance and

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Financial Statements
Figure 2.2: Steps in the Accounting Process

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A brief description of the steps involved in the accounting process (as

depicted in Figure-2.2) is as follows:
1. Identification of financial transactions: In this step, the
business transactions that are financial in nature are identified.
It should be noted that the financial transactions should have
documentary evidence, such as invoices of purchases and sales,
credit and debit notes, cash memo, pay-in-slips and payment
vouchers. Financial transactions result in monetary changes
in the assets and liabilities of an organisation. Therefore, these
changes are recorded in the journal, books of accounts.
2. Preparation of vouchers: In this step, documentary evidences
are prepared. This helps in notifying the business transactions.
A voucher refers to an authorised consent of the payments made
and provides information about the accounts that are to be
debited or credited. After recording the payment entries in the
voucher, they are next recorded in the journal.
3. Recording entries in the books of original entry: In this step,
the financial transactions are recorded from the vouchers to the
books of accounts or journals. You must note that the financial

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transactions are recorded in chronological order in these books.

If the same type of transaction takes place a large number of
times, then a subsidiary book can be maintained to record the
credits. Subsidiary books are specialised books of original entry,
and are discussed later in the chapter.
4. Posting to the ledger: In this step, the recorded transactions are
transferred from the journal books to the ledger. This process
is called the ledger posting. Same type of entries of financial
transaction collectively forms an account. In other words, in
an account we put financial transactions that are classified as
per their type. For example, sales account contains entries
of the product/services sold. The book in which the accounts
are maintained is known as a ledger. Therefore, a ledger is
a collection of accounts and also the principal book in double
entry bookkeeping. Classification of transactions enables the
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organisation to get information related to total purchases, total
sales, total expenses, creditors and debtors.
5. Preparation of trial balance and financial statements: In this
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step, a balance in each ledger account is determined and the trial
balance is prepared. In the trial balance, the debit and credit
balances of each account are put in their respective columns. The
total of the debit balance and the credit balance must tally. This
would indicate arithmetic accuracy. The financial statements are
prepared with the help of the trial balance.
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2.2.2 TRADITIONAL APPROACH FOR RECORDING

TRANSACTIONS
According to the traditional approach, various accounts are classified

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as personal account, real account and nominal account.
Personal accounts are accounts that are related to persons, compa-

ny, firms or organisations, with which the business is engaging in fi-
nancial transactions. Personal account will mainly consist of accounts
of debtors and creditors. Some examples for personal accounts are
Rakesh account, ABC Pvt. Ltd. Account, creditors account, debtors
account, etc. Personal accounts are further divided into the following
three sub-categories:
Natural personal accounts are those accounts which are related
to individual persons or human beings. For example, Rakesh ac-
count, Ramesh Account, Sohail account, etc.
Artificial personal accounts are those accounts which are relat-
ed to corporate bodies, institutions created by the law and these
accounts are not related to living persons. For e.g. Private limited
companies (Pvt. Ltd.), Limited liability partnerships (LLPs), limit-
ed liability companies (LLCs), banks, educational institutions, etc.

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Representative personal accounts are those accounts which rep-

resent an individual or a group of certain individuals directly or
indirectly. For example, outstanding expenses account, advance
expenses account, outstanding income account and advance in-
come account.
Golden rule for personal accounts: Debit the receiver and credit the
giver.
Real accounts refer to the accounts related to the assets and liabilities
including capital accounts of owners. These accounts may be tangible
or intangible in nature. Real accounts are further divided into the fol-
lowing two sub categories:
Tangible real accounts are those accounts which are related to
those items that can be touch and feel. For example, building, plant
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and machinery, land, stock, etc.
Intangible real accounts are those accounts which are related to
intangible things that cannot be touch or feel. For example, good-
IMwill, patents, trademarks, copyrights, etc.
Golden rule for real accounts: Debit what comes in and credit what
goes out.
Nominal accounts are those accounts which exist in name only and
do not have any physical form. Monetary transaction is involved be-
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hind every transaction in a nominal account. For e.g. sales account,

purchase account, commission account, salary account, discount ac-
count, rent account, etc.
Golden rule for nominal accounts: Debit all expenses and losses and
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credit all incomes and gains.
2.2.3 TRANSACTION ANALYSIS
Every business organisation involves a large number of transactions

on a daily basis, for example issue of shares, purchase of raw materi-
al, rent paid, wages paid, salary paid, sale of finished goods, etc. All
these transactions lead to changes in three basic elements, which are
assets, liabilities and share capital. Transaction analysis provides a
clear view of owner’s original investment by applying an accounting
equation. Accounting equation shows the relationship between assets
(valuable resources owned by organisation), liabilities (present obli-
gations of organisation) and share capital (owners’ equity required to
operate a business). This relationship can be expressed by a mathe-
matical equation, i.e. Assets = Liabilities + Capital. This mathemati-
cal equation must be balanced to match the assets and liabilities side
of a balance sheet. Any transaction from accounting operations can be
divided into the following parts:

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We will further describe transaction analysis with the help of a series

of transaction given below:
Transaction 1: ABC Ltd. Company starts business by issuing
shares of ` 10 lakh.
Impact on Balance Sheet
Assets side will increase with cash of `10 lakh.
Liability side will increase with share capital of ` 10 lakh.
Transaction 2: Purchased machinery of ` 1 lakh for cash.
Assets side will decrease with a cash of ` 1 lakh.
Assets side will increase with the purchase of machinery of
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` 1 lakh.
Transaction 3: Purchased raw material inventory on credit worth
` 1 lakh.
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Assets side will increase with the inventory of ` 1 lakh.
Liabilities side will increase with creditors of ` 1 lakh.
Transaction 4: Sold finished goods inventory for cash ` 1 lakh.
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Assets side will increase with cash of ` 1 lakh.

Assets side will decrease with inventory of finished goods sold
for ` 1 lakh.
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Transaction 5: Advance payment of ` 1 lakh received from cus-

tomer.
Liability
side will increase with Advance income ` 1 lakh (in-
come received but not earned).
Transaction 6: Cash payment made to creditors ` 1 lakh.
Assets side will decrease with cash of ` 1 lakh - Liability side
(Creditors) will decrease with ` 1 lakh.
Transaction 7: Patents amortise with ` 1 lakh.
On Assets side, patents will decrease with the amount of ` 1
lakh.
On Liability side, retained earnings will decrease with ` 1 lakh.

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Transaction 8: 10% Loan of ` 1 lakh acquired from bank.

Impact on Balance sheet
Liability side will increase with ` 1 lakh as loan received from
bank.
Transaction 9: Cash dividend of ` 10 thousand paid to sharehold-
ers.
On Assets side cash will decrease with ` 10 thousand.
On liability side retained earnings will decrease with ` 10 thou-
sand.
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2.2.4 Debit and Credit Rules
The debit and credit are the most fundamental concepts of account-
IM
ing, which represent two sides of each individual transaction recorded
in the books of accounts. Business processes in organisations include
numerous business processes. As explained earlier, every transaction
has receiving and giving aspects. The aspect of receiving is known as
the debit aspect and the aspect of giving is known as the credit aspect.
The debit and credit aspects of a transaction form the basis of the dou-
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ble entry bookkeeping system and are two opposite actions. The debit
is recorded at the left side of the account and the credit is recorded at
the right side, as depicted in Table 2.1:
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Table 2.1: Pattern Of Recording The Debit And

Credit In An Account
(Any Account Title)
Left side Right Side
Debit Credit
There are three types of accounts, namely personal account, real ac-
count and nominal account. Let us now study how the rules of debit
and credit are used in these different types of accounts, which is de-
scribed as follows:
In case of personal accounts: A debit in the personal account im-
plies that the person whose account is debited becomes a debtor.
Thus, when goods are sold on credit to a customer, then he/she
becomes the debtor of the business. If the account of a creditor is
debited, then the debit would be regarded as the amount due to
that person has decreased.
A credit in the personal accounts implies that the person whose
account is credited becomes a creditor. Whenever goods are pur-
chased on credit from suppliers, then he/she becomes the creditor

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of the business. If the account of a debtor is credited, then the cred-

it would be regarded as the decrease in the debt of the customers.
In short:
Debit: the receiver
Credit: the giver
In case of real accounts: Debit in the real account implies that an
asset is purchased. Any further debit in the real account means
more acquisition of the asset and this would increase the value of
an asset. Any credit in the real account implies that some part or
whole of the asset is sold off and this would reduce the value of the
asset.
In short:
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Debit: what comes in
Credit: what goes out
In
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case of nominal account: A debit in a nominal account implies
that either an expenditure has been incurred, some loss has taken
place, or some income has diminished by the amount of the debit.
Whenever any expenditure on account of salary, rent, and interest,
is incurred, the nominal accounts would be debited. Credit in a
nominal account signifies that income or profit is earned.
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In short:
Debit: all expenses and losses
Credit: all incomes and gains
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Let us summarise the rules of debit and credit in different types of ac-
counts. These rules are also termed as three golden rules of account-
ing, which are shown in Table 2.2:
Table 2.2: Three Golden Rules of Accounting

Accounts Debit Credit
Personal The receiver The giver
Real What comes in What goes out
Nominal All expenses and losses All gains and incomes
Let us discuss the application of the three golden rules with the help
of examples. These examples would help in understanding a single
transaction to be recorded in the account separately.
Illustration 1: Deepak started a business entitled Galaxy Co. Ltd. and

performed the following transactions:
a. Started the business with cash, amounting `4,00,000
b. Deposited amount of `1,00,000 in the Bank

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c. Purchased Furniture of `80,000 in cash

d. Company purchased goods on credit from Rohit, worth `50,000
and they are sold for `65,000 in cash
e. Paid salary of `40,000 to employees by issuing the cheque
f. Paid cash for `10,000 as rent
g. A machine is depreciated by `8,000
h. Analyse each of the transactions separately and represent the
entry in the books of accounts.
Solution:
a. The transaction that involves in starting a business increases the
cash and capital of the organisation. The increase in cash (asset)
is debited while the increase in the capital (liability) is credited.
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The entries can be made as follows:
Cash Account Capital Account
Debit Credit Debit Credit
IM
4,00,000 4,00,000
b. When cash is deposited in banks, the amount in the bank
increases and the cash account decreases. The increase in the
asset is debited and the decrease in the asset is credited, which
can be represented as follows:
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Cash Account Bank Account

1,00,000 1,00,000
c. Purchase of furniture would increase the money in furniture
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account while it would decrease in the bank account. The

increase in the furniture (asset) is debited and the decrease in
the cash (asset) is credited. The entries can be made as follows:
Furniture Account Cash Account
80,000 80,000
d. Purchase of goods from Rohit on credit would increase the
purchases and also increases the liability (Rohit as creditor). The
increase in the purchase is the increase in the expense and thus,
it would be debited. The increase in the liability is credited. On
the other hand, sales of the goods increase the revenue and also
increase the cash. Therefore, the increase in the sales (revenue)
is credited and the increase in the cash (asset) is debited. The
entries in the different accounts can be represented as follows:
Purchase Account Rohit Account
50,000 50,000

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Cash Account Sales Account

65,000 65,000
e. When salary is paid by issuing cheque it would increase the
expense. Payment of salaries from the bank account decreases
the bank balance. The increase in the expense is debited i.e., the
salary account is debited and the decrease in the bank balance
(asset) is credited, which is shown as follows:
Salary Account Bank Account
40,000 40,000
f. Payment of rent in cash would increase expenses, which decrease
the cash amount. The increase in the expense is debited and the
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decrease in the cash (asset) is credited, which is shown as follows:
Rent Account Cash Account
10,000
IM 10,000
g. Depreciation of an asset would increase the non-cash expense.
So a depreciation account would be opened up and debited with
the depreciated value of asset. As a result, the value of asset
would be diminished. Therefore, the depreciated value would be
credited to the asset account.
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Depreciation Account Asset Account

8000 8000
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1. ‘Debit the receiver and credit the giver’ is the accounting rule
for___________.
(a) Real account
(b) Personal account
(c) Nominal account
(d) Both (a) and (c)
2. XYZ Ltd. purchased goods for credit. What will be the impact
of this transaction on the balance sheet?
(a) Assets decrease and liabilities increase
(b) Assets increase and liabilities also increase
(c) Assets increase and liabilities decrease
(d) Assets decrease and liabilities also decrease

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3. __________ are those accounts which represent an individual

or a group of certain individuals directly or indirectly. For
example, outstanding expenses account, advance expenses
account, outstanding income account and advance income
account.
(a) Natural personal account
(b) Representative personal accounts
(c) Tangible real account
(d) Artificial personal accounts
Activity
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Ram commenced his computer business on 1st Apr, 2009 with a
capital of `3,00,000. On 31st March, 2010, the cost of assets were
worth `5,00,000 and the liabilities were worth `1,00,000. Calculate
his closing capital and profit gain during this year.
IM
2.3 Journal
A journal refers to a primary book of accounts in which all transac-
tions of a business are recorded. A journal can also be defined as a
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chronological record of the business transactions. The process of re-

cording a transaction in a journal is known as journalising.
2.3.1 FORMAT OF JOURNAL

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The format of a journal is shown in Table 2.3:
Table 2.3: Format of a Journal

Date Particulars L.F. Debit Credit
Amount(`) Amount(`)
Name of the debited account Dr.

To Name of the credited account
(Narration)
The following is a brief description of the columns used in the preced-

ing journal:
Date: It records the date when a transaction is made.
Particulars: It records the names of the debit and credit accounts
affected by a transaction. The debit account is written at the left
side of the Particulars column (Dr. is written at the right side) and
the credit account is written in the next line with a prefix To. Nar-
ration is a brief description of the transaction.

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Ledger Folio (L.F.): It records the page number of the ledger on

which the debit and credit accounts are posted.
Debit Amount: It records the debited amount.
Credit Amount: It records the credited amount.
Consider the following transactions:

July 5- Purchased furniture for cash ` 60000.
July 5- Sold goods for ` 130000 on cash.
July 5- Sold goods for ` 150000 to Yash on credit.
July 9- Cash payment of ` 80000 to Raj.
July 11- Cash received from Yash ` 100000.
July 11- Purchased goods for cash ` 75000.
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July 15- Purchased goods on credit for ` 50000 from Rajesh.
July 15- Sold Goods for Cash ` 126000.
July 21- Sold goods for ` 70000 to Mohan on credit.
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July 23- Purchased machinery for cash ` 80000.
July 23- Cash withdraw for personal use ` 25000.
July 27- Rent paid in cash ` 4000.
July 31- Wages paid in cash ` 4500.
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July 31- Salary paid in cash ` 12000.

July 31- Commission received in cash ` 2000.
Table 2.4 shows the journal entries corresponding to the above men-
tioned transactions:
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Table 2.4: A sample journal

Amount(`) Amount(`)
July 5 Furniture A/c Dr. 60,000
To Cash A/c 60,000
(Being the furniture purchased
for cash)
Cash A/c Dr. 1,30,000
To Sales A/c 1,30,000
(Being goods sold for cash)
Yash Dr. 1,50,000
(Being goods sold to Yash on
credit)
Raj Dr. 80,000
To Cash A/c 80,000
(Being cash paid to Raj)

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Amount(`) Amount(`)
Cash A/c Dr. 1,00,000
To Yash 1,00,000
(Being cash received from Yash)
Purchase A/c Dr. 75,000
To Cash A/c 75,000
(Being goods purchased on cash)
Purchase A/c Dr. 50,000
To Rajesh (Being goods pur- 50,000
chased from Rajesh on credit)
Cash A/c Dr. 1,26,000
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Mohan Dr. 70,000
To Sales A/c 70,000
(Being goods sold to Mohan on
IM credit)
Machinery A/c Dr. 80,000
To Cash A/c 80,000
(Being machinery purchased for
cash)
Drawings A/c Dr. 25,000
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To Cash A/c 25,000

(Being cash withdrew for person-
al use)
Rent A/c Dr. 4,000
To Cash A/c 4,000
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(Being rent paid)

Wages A/c Dr. 4,500
To Cash A/c 4,500
(Being wages paid)
Salary A/c Dr. 12,000
To Cash A/c 12,000
(Being Salary paid)
Cash A/c Dr. 2,000
To Commission A/c 2,000
(Being commission received)
Grand Total 17,88,500 17,88,500
2.3.2 Process of Journalising
We have mentioned that a journal entry is the basic record of business

transactions. It becomes very easy to journalise business transactions
when you understand the rules of debit and credit. When we jour-
nalise a transaction, one account receives the benefits and another

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account gives the benefits. The following steps are performed to enter
a transaction in the journal:
1. Ascertaining that the accounts are affected by the transaction.
2. Ascertaining the nature of the account which is affected.
3. Ascertaining the account to be debited and the account to be
credited by applying the rules of debit and credit.
4. Ascertaining the amount by which the accounts are to be debited
and credited.
5. Recording the date and month of the transaction in the date
column and the year at the top.
6. Recording in the particular column the name of the account to
be debited. Along with the name of the account, the abbreviation
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“Dr.” also should be written in the same line against the name of
the account. Write the amount to be debited in the debit amount
column.
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7. Recording in the “Particular” column the name of the account
to be credited. The name of the account to be credited should
be written in the next line preceded by the word “To”. The word
“To” is written towards the right after leaving a few spaces. Write
the amount to be credited in the credit amount column.
8. Recording a brief description of the transaction starting from the
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next line in the “Particulars” column. This brief description of

the transaction is termed as narration.
9. Drawing a line across the “Particulars” column to separate one
journal entry from the other.
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Let us look at the following illustrations:
Illustration 2
Transaction number 1: A new firm issues 1,000 shares of common
stock and receives `7,50,000 cash.
The journal entry steps are as follows:
Step 1: The firm raises capital by issuing shares of its stock on
January 6, 2013.
Accounts Affected:
Assets – Cash is increased.
Share capital – Common stock is increased.
Step 2: The journal entry would be as follows:
Cash `7, 50,000
Common Stock `7, 50,000

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Journal (No. 1)
Amount(`) Amount(`)
Jan 6, CashDr. 1 7, 50,000
2013 To Common Stock 7, 50,000
Transaction number 2: The firm pays salaries of `1, 00,000 to its

employees on January 31, 2013.
The journal entry steps are as follows:
Step 1: Salaries represent an expense of the accounting period.
The matching concept requires expenses to be recorded in the
period they are incurred to generate revenue.
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Accounts Affected:
Share Capital – Expense is increased
Assets – Cash is decreased
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Step 2: The journal entry would be as follows:
Salaries Expense `1, 00,000
Cash `1, 00,000
Journal (No. 2)
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Amount(`) Amount(`)
Jan Salary A/c Dr. 2 1, 00,000
31, To Cash A/c 1, 00,000
2013
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(Being paid salary)
Therefore, each journal entry follows a two-step process of balancing

every transaction for its debit and credit effect on financial position of
an organisation.
4. ___________ records the page number of the ledger on which

debit and credit accounts are posted.
(a) Ledger Folio
(b) Ledger Follower
(c) Journal Follower
(d) Journal Folio

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Activity
Make a group of your friends and discuss the concept of

journalising.
2.4 Ledger
A ledger refers to a book or register in which financial transactions
are permanently recorded after being summarised and classified. We
need to arrange the ledger accounts under particular headings. Led-
gers help in preparing a trial balance, after which the final statement
is prepared. A ledger is also known as the principal book. It is import-
ant to note here that although a journal provides a complete listing
of the daily transactions of a business, it does not provide informa-
S
tion about a specific account in one place. For example, if an accoun-
tant needed to know how much cash balance the organisation is left
with, he/she would have to check all the journal entries involving cash,
IM
which is a time consuming task involving numerous entries. To avoid
such instances, debit and credit entries from a journal are transferred
to a single ledger account.
Table 2.5 shows the format of a ledger account is as follows:
Table 2.5: Format of a Ledger Account

M
Dr. Name of Account Cr.

Date Particulars J.F. Amount (`) Date Particulars J.F. Amount (`)
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In a ledger, each account is divided into two sides, the debit side and
the credit side. The left side of the ledger is called the debit side;
whereas, the right side of the ledger is called the credit side. Each side
is further divided into four columns. The following is a brief descrip-
tion of these columns:
Date: It records the date on which a transaction is made.
Particulars: It records the names of the accounts to be credited
on the debit side and the accounts to be debited on the credit side.
Journal Folio (J.F.): It records the page number of the journal on
which the posting of the ledger takes place.
Amount: It records the amount of each transaction.
A ledger is often referred to as T-account due to its resemblance to
the letter T. The left side of the ledger is debit, whereas the right
side is credit.

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2.4.1 FORMAT OF LEDGER
Transactions are posted to a ledger periodically, such as weekly or

monthly, according to convenience.
Perform the following steps to post the transactions of a journal to a

ledger:
1. Creating the ledger accounts. These accounts are based on the
accounts recorded in the corresponding journal.
2. Entering the date of a transaction in the date column.
3. Posting the debited transaction of the journal entry on the credit
side of the account, this is credited in the journal entry.
4. Similarly, posting the credited transaction of the journal entry
on the debit side of the account which is debited in the journal
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entry.
5. Beginning the debit side with “To” and the credit side with “By”.
IM
6. Entering the page number of the journal from where the
transaction is transferred to the ledger in the J.F. column.
Illustration 3: Let’s suppose that on 2 April 2010, salary of `15,000

were paid, and you want to journalise this transaction and post it to
the ledger.
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The preceding transaction is recorded in the journal as follows:
Journal
Date Particulars L.F. Dr. Cr.
Amount (`) Amount (`)
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2010 Salary A/c Dr. 15,000

Apr 2 To Cash A/c 15,000
(Being paid salary)
The preceding entry can be posted to the ledger in the following way:
Dr. Cash Account Cr.

2010 By Salary 15,000
Apr 2 A/c
Dr. Salary Account Cr.

2010 To Cash A/c 15,000
Apr 2

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In the preceding example, two accounts are opened in the ledger, Sal-
ary account and Cash account. The Salary account, which is debited
in the journal entry, is credited in the ledger entry; whereas, the Cash
account, which is credited in the journal entry, is debited in the ledger
entry. The Salary account shows the debited amount and the Cash
account shows the credited amount in the ledger.
Let us look at another example for preparing a ledger from a journal:
Illustration 4: From the following transactions, prepare a journal and

post the entries into a ledger:
December, 2013
December 3. Ali started his small scale business with a cash of

`1, 00,000
S
December 5. He purchased furniture for `20,000
December 12. He purchased goods worth `60,000

IM
December 16. He sold goods worth `80,000 in cash
December 28. He paid salaries to his employees worth `10,000
Solution:
Ali’s Journal for December, 2013

M
Date Particulars L.F. Amount Amount

December, Debit (`) Credit (`)
2013
3 Cash A/C Dr. 9 100000 100000
N
To Capital 11
(Being capital brought in)
5 Furniture A/C Dr. 13 20000 20000
To Cash A/C 9
(Being furniture purchased
for cash)
12 Purchases A/C Dr. 15 60000 60000
To Cash A/C 9
(Goods purchased for cash)
16 Cash A/C Dr. 9 80000 80000
To Sales A/C 17
(Sold goods for cash)
28 Salaries A/C Dr. 19 10000 10000
To Cash A/C 9
(Salaries paid)

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The ledgers from the journal are prepared as follows:
Cash Account (No. 9)

Date Particulars J.R. Amount (`) Date Particulars J.R. Amount (`)
Dec Dec
2013 2013
3 To Capital 1 1,00,000 5 By Furniture 1 20,000
A/C A/C
16 To Sales A/C 1 80,000 12 By Purchases 1 60,000
A/C
28 By Salaries 1 10,000
A/C
By Balance c/d 90,000
Total 1,80,000 Total 1,80,000
S
Capital Account (No. 11)
Dec Dec
2013
IM 2013
28 To Balance 1,00,000 3 By Cash A/C 1 1,00,000
c/d
Total 1,00,000 Total 1,00,000
Furniture Account (No. 13)

M
Dec Dec
2013 2013
5 To Cash A/C 1 20,000 28 By Balance 20,000
c/d
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Total 20,000 Total 20,000
Purchases Account (No. 15)

Dec Dec
2013 2013
c/d
Sales Account (No. 17)

Dec Dec
2013 2013
28 To Balance 80,000 16 By Cash A/C 1 80,000
c/d

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Salaries Account (No. 19)
Dec Dec
2013 2013

c/d
2.4.2 Ledger Balancing
After we have posted and recorded the transactions, it is necessary to

balance each account prepared in a ledger. In simple words, ledger
balancing means totalling the amount of both sides (that is the credit
S
side and the debits side) of the account and writing the difference to
the side whose total is less. For example, if the credit side is greater
than the debits side, then the difference of both sides is recorded in
the debit side. On the other hand, on the debit side is greater than the
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credit side, the difference is recorded in the credit side.
The following steps need to be performed to balance an account:

1. Calculate the amount of both the debit and credit sides of the
account separately.
2. Calculate the difference of both sides. If there is no difference,
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it means that the balance is nil. If the total of the debit side is
greater than the total of the credit side, the difference is written
on the credit side; and if the total of the credit side is greater than
the total of the debit side, the difference is written on the debit
side.
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3. Type the balance as To Balance c/d, if the difference is on the

debit side. The word c/d means carried down to the next period.
Similarly, type the balance as To Balance b/d, if the difference is
on the credit side. The word b/d means brought down from an
earlier period. A period refers to any duration, such as a month
or three months (quarterly), according to convenience.
4. Calculate the credit and debit totals at their respective sides of
the accounts.
Note that the closing balance of the previous period of an account ap-
pears as the opening balance for the next period of the account. The
closing balance of the previous period is written in the opposite side of
the next period as To Balance b/d or By balance b/d.

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5. A _______ refers to a book or register in which financial

transactions are permanently recorded after being
summarised and classified.

(a)
Ledger (b)
Journal
(c) Subsidiary Book (d) Record Book
6. Ledgers help in preparing a _________.
(a) Trial balance (b) Balance sheet
(c) Cash book (d) Asset book
7. In ledger balancing, closing balance of the previous period is
written in the___________ side of the next period as To Balance
b/d or By balance b/d.
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(a) Debit side only (b) Credit side only
(c) Opposite side (d) On both sides
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Activity
Make a group of your friends and discuss the steps of ledger

balancing.
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2.5 Meaning of Subsidiary Books

It should be noted that in a real life scenario, a large number of busi-
ness transactions take place in an organisation. Therefore, it becomes
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difficult to record all the transactions in one prime book. Therefore,

for convenience a separate book is maintained for similar types of
transactions, such as one book for receipts and payments of cash and
another book for sales of goods and their purchases.
As the transactions are directly recorded in such books, there would

not be any requirement of the journal entry. These books of original
entry are called the subsidiary books and the ledger accounts are pre-
pared on their basis.
2.5.1 Cash Book
Cash Book includes the records of all the receipts and payments made
by cash and cheques. The Cash Book, which is used to record cash as
well as bank transactions, is known as Bank Book. The Cash Book has
two sides, namely the left side, which records all the cash receipts and
the right side, records all the cash payments. The special feature of the
Cash Book is that it functions as a Journal and a Ledger with regard
to the cash and bank transactions respectively.

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The format of the Cash Book is shown in Table 2.6:
Table 2.6: Format of the Cash Book

Dr Cash Book of Mohan & Co. Cr.
Date Receipts Cash(`) Bank(`) Date Payments Cash(`) Bank(`)
2011 2011
Apr 1 To balance b/d 1,500 12,000 Apr 2 By Wages 2,000
Apr 5 To Sales 1,000 Apr 4 By Rent 1,500
Apr 8 To Manoj Co. 4,000 Apr 9 By Electricity 3,000
Apr 12 To Sales 2,000 Apr 15 By Balance c/d 13,000
3,500 16,000 3,500 16,000
2.5.2 PurchaseS Book
Purchase Book involves the records of the credit purchases of goods.
S
However, the cash purchases of goods or the credit purchases of as-
sets are not recorded in this book. The format of the Purchase Book is
shown in Table 2.7:
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Table 2.7: Format of the Purchase Book
Purchase Book of Jagat & Co.
Date Name of Suppliers Ledger Folio Inward Amount (`)
Invoice No.
2011
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April 8 X Limited 3,500 1,25,000

April 10 Priya Enterprises 480 3,50,000
April 20 Earns & Co. 5,500 75,000
Total 5,50,000
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2.5.3 Sales Book
Sales Book involves the records of all the credit sales of goods. How-
ever, it does not record the cash sales of goods or credit sales of assets.
It is also known as Sales Journal.
The format of the Sales Book is shown in Table 2.8:
Table 2.8: Format of the Sales Book

Sales Book of Jagat & Co.
Date Name of Ledger Folio Outward Amount (`)
Customer Invoice No.
2011
April 3 Alpha Corporation 68 2,50,000
April 10 Vimal Traders 69 3,75,000
April 14 Star Dealers 70 2,20,000
Total 8,45,000

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2.5.4 Purchases Return Book
Purchase Returns Book includes the records of the return of goods

and materials sent back to the suppliers. It is also called to Return
Outward Book.
The format of the Purchase Returns Book is shown in Table 2.9:
Table 2.9: Format of the Purchase Returns Book

Purchase Returns Book of Jagat & Co.
Date Name of Suppliers Ledger Debit Note No. Amount `
Folio
2011
April 10 X Limited 62 70,000
April 22 Earns & Co. 80 45,000
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Total 1,15,000
2.5.5 Sales Return Book

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Sales Returns Book include the records of the returns of the credit
sales received back from the customers. It is also known as the Return
Inwards Book.
The format of Sales Return Book is shown in Table 2.10:
Table 2.10: Format of the Sales Return Book

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Sales Return Book of Jagat & Co.

Date Name of Customer Ledger Folio Credit Note No. Amount `
2011
April 5 Alpha Corporation 14 60,000
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April 14 Vimal Traders 15 85,000

Total 1,45,000
8. _________ includes the records of all receipts and payments

made by cash and cheques.
(a) Cash book
(b) Bank book
(c) Clearance book
(d) Receipts and payments book
9. _________ functions as a journal and a ledger with regard to
cash and bank transactions, respectively.
(a) Cash book (b) Bank book
(c) Clearance book (d) Receipts and Payments book

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10. _________ involves the records of credit purchases of goods.

(a) Purchase book (c) Sales book
(c) Journal (d) Both (a) and (c)
11. ____________ include the records of returns of credit sales
received back from customers.
(a) Sales returns book
(b) Return inwards book
(c) Both (a) and (b)
(d) None of the above
12. __________ refers to a financial statement that summarises
a company’s assets, liabilities and shareholders’ equity at a
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specific point in time.
(a) Profit and loss account
(b) Balance sheet
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(c) Trial balance
(d) Book of balancing
Activity
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Make a group of your friends and discuss the various subsidiary

books and how it relates to the monetary transactions in particular
and the business in general.
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2.6 Summary
Accounting process is one of the most fundamental concepts of ac-
counting. The accounting process helps in maintaining systematic
records of all financial transactions to avoid any possible errors.
The accounting process starts when any financial transaction is
made in an organisation. The accounting process results in var-
ious financial statements, such as balance sheet, profit and loss
account and other statements.
The steps involved in the accounting process are 1) Identification
of financial transactions. 2) Preparation of Vouchers 3) Posting to
the ledger and 4) Preparing the trial and financial statements.
The traditional approach is also known as the British approach. In
this approach, various accounts are classifies as personal account,
real account and nominal account.

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An accounting equation refers to a statement that states that a firm

has equal assets and liabilities. Dual entry concept is the basis of
the accounting equation.
The balance Sheet approach of recording a transaction is also
called the American approach. This approach records the transac-
tions on the basis of the accounting equation i.e. Assets= Liabili-
ties + Capital.
The debit and credit are the most fundamental concepts of ac-
counting, which represent two sides of each individual transaction
recorded in the books of accounts.
A journal refers to a primary book of accounts in which all transac-
tions of a business are recorded. A journal can also be defined as a
chronological record of the business transactions.
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A ledger refers to a book or register in which financial transactions
are permanently recorded after being summarised and classified.
After we have posted and recorded the transactions, it is necessary
IMto balance each account prepared in a ledger.
Some of the subsidiary books are cash book, petty cash book, pur-
chase book, sales book, purchase return book and sales return
book.
key words
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Balance sheet: A financial statement that summarises a com-

pany’s assets, liabilities and shareholders’ equity at a specific
point in time.
Depreciation: The systematic allocation of the cost of an asset
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to the periods that are expected to benefit from its use.

Equity:An ownership interest in a corporation in the form of
common stock or preferred stock.
Petty cash: Small amounts of cash kept at hand used for mak-
ing immediate payments for miscellaneous minor expenses.
Prime documents: The documents in a business used to initi-
ate and record the accounting entries in an accounting system
such as sales invoices, materials requisitions, materials returns
notes, etc.
Trial balance: A list of all the general ledger accounts (both
revenue and capital) that are contained in the ledger of a
business.
Vouchers: Internal documents in an organisation’s accounts
payable department used to collect and establish the necessary
documentation and approvals before paying a vendor invoice.

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1. Describe the stages of the accounting process.
2. What do you mean by transaction analysis? Explain.
3. Explain various types of subsidiary books.
4. Which book is called primary book in accounting? Explain the
process of recording under primary book.
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Accounting Process 1. b. Personal account
2. b. Assets increase and lia-
bilities also increase
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3. b. Representative personal
accounts
Journal 4. a. Ledger folio
Ledger 5. a. Ledger
Basic Accounting Concepts 6. a. Trial balance
7. c. Opposite side
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Meaning of Subsidiary Books 8. a. Cash book

9. a. Cash book
10. d. Both (a) and (c)
11. c. Both (a) and (b)
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12. b. Balance sheet
hints for Descriptive Questions

1. Steps involved in the accounting process are 1) identification of
financial transactions. 2) Preparation of vouchers 3) Posting to
the ledger and 4) preparing the trial and financial statements.
Refer to Section 2.2 Accounting Process.
2. Every business organisation involves a large number of
transactions on a daily basis, for example, issue of shares,
purchase of raw materials, rent paid, wages paid, salary
paid, sale of finished goods, etc. All these transactions lead to
changes in three basic elements, which are assets, liabilities
and share capital. Transaction analysis provides a clear view of
owner’s original investment by applying accounting equation.
Accounting equation shows a relationship between assets
(valuable resources owned by organisation), liabilities (present

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obligations of organisation) and share capital (owners’ equity

required to operate a business). Refer to Section 2.2 Transaction
Analysis.
3. Cash Book, Purchase Book, Sales Book, Purchase Return
Book and Sales Return Book. Refer to Section 2.5 Meaning of
Subsidiary Books.
4. A journal refers to a primary book of accounts in which all
transactions of a business are recorded. A journal can also be
defined as a chronological record of business transactions. Refer
to Section 2.3 Journal.

1. On January 04, 2017, Ram started a business with cash of
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` 100000. Make a journal entry for this transaction.
Solution:
Ram’s Journal for January 2017
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Debit (`) Credit (`)
January Cash A/C Dr. 9 100000 100000
04, 2017 To Capital 11
(Being capital brought in to
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start busniss)
2. On January 15, 2017, Ram draws ` 1000 for personal use make a
journal entry for this transaction.
Solution:
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Ram’s Journal for January 2017

January Drawings A/c Dr. 9 1000 1000
15, 2017 To Cash 11
(being cash drawn for per-
sonal use)
3. With reference of question No. 1, On January 10, 2017, Ram
purchased furniture for office. Elaborate its impact on balance
sheet using Transaction analysis.
Solution:
Initially Ram has,
Capital (`100000) + Liability (`0) =Assets (`100000)

n o t e s
Then on January 10, 2017, he bought furniture for office use and
its impact on balance sheet will be as follows:
Capital (`100000) + Liability (`0) = Assets (Cash= ` 90000 +
Furniture = `10000)
4. With reference of question No. 3, On April 15, 2017, Ram takes
loan from Bank for ` 50000. Elaborate its impact on balance sheet
using Transaction analysis.
Solution:
Initially Ram has,
Then on January 10, 2017, Capital (` 100000) + Liability (`0) =
Assets (Cash= ` 90000 + Furniture = `10000). Then on April
15, 2017, Ram takes loan from Bank for ` 50000. its impact on
balance sheet will be as follows:
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Capital (` 100000) + Liability (`1050000) = Assets (Cash=
` 140000 + Furniture = ` 10000)
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5. Consider the following Journal entry and post it into Ledger.
Ram’s January 2017
January Cash A/C Dr. 9 100000 100000
15, 2017 To Capital 11
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(Being capital brought in to

start busniss)
Solution:
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Cash Account
Date Particulars JF Amount Date Particulars JF Amount

Jan. To Capital 11 100000 Jan. By Balance 100000
15, A/c 15, b/d
2017 2017
Total 100000 Total 100000
Capital Account
Jan. To Balance 100000 Jan. By Cash A/c 11 100000
15, c/d 15,
2017 2017

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6. Journalise the following transactions; post them in a ledger

account.
Transactions in November 2017
1. Prateek commenced business with ` 2, 00,000.
2. Paid into bank ` 50,000.
3. Purchased Plant worth ` 1, 00,000 from Modi & Co.
4. Purchased goods worth ` 50000 form Anwar.
5. Goods worth ` 40,000 sold to Abu
6. Sold goods worth ` 20,000 for cash.
7. Goods returned by Abu ` 5,000.
8. Paid rent ` 4,500.
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9. Withdrawn from bank for office use ` 20,500.
10. Paid Salaries ` 18,000.
11. Withdrawn for personal use ` 2,500.
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12. Goods returned to Anwar ` 10,000.
13. Paid for office furniture ` 10,500 by cheque.
14. Received ` 34,500 cash from Abu and discount allowed ` 500.
15. Paid Anwar on account ` 39900 and discount allowed by him
`100.
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Solution:
Pratik’s Journal for November 2017

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November Debit (`) Credit (`)

2017
Cash A/C Dr. 200000 200000
To Capital
Bank A/C Dr. 50000
To Cash A/C 50000
(Being cash paid into bank)
Plant A/C Dr. 100000
To Modi and Company 100000
(Being plant purchased from
Modi and company)
Purchase A/c Dr. 50000 50000
To Anwar
(Being goods purchased from
Anwar)

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2017
Abu Dr. 40000 40000
To Sales A/c
(Being goods sold to Abu)
Cash A/c Dr. 20000 20000
To Sales A/c
Sales return A/c Dr. 5000 5000
To Abu
(Being goods returned by
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Abu)
Rent A/c Dr. 4500 4500
To Cash A/c
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(Being rent paid)
Cash A/c Dr. 20500 20500
To Bank A/c
(Being cash drawn for official
purposes)
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Salary A/c Dr. 18000 18000

To Cash A/c
(Being salary paid)
Drawings A/c Dr. 2500 2500
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To Cash A/c
(Being cash drawn for per-
sonal use)
Anwar Dr. 10000 10000
To Purchase Return A/c
(Being goods returned to
Anwar)
Furniture A/c Dr. 10500 10500
To Bank A/c
(Being furniture purchased
through cheque)
Cash A/c Dr. 34500 40000
Discount A/c Dr. 500
To Abu
(Being cash payment re-
ceived from Abu and dis-
count allowed ` 500)

n o t e s

2017
Anwar. Dr. 40000
To Cash A/c 39900
To Discount A/c 100
(Being cash paid to Anwar
and discount received `100)
Ledger of Pratik
Cash Account
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To Capital A/c 200000 By Bank 50000
To Sales A/c 20000 A/c 4500
To Bank A/c 20500 By Rent A/c 18000
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To Abu 34500 By Salary
A/c
2500
By Draw-
ings A/c 39900
By Anwar
By Balance 160100
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c/d
Capital Account
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Jan. To Balance 200000 Jan. By Cash A/c 200000
15, c/d 15,
2017 2017
Bank Account
To Cash A/c 50000 By Cash A/c 20500
By Balance
c/d 29500

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Plant Account
To Modi and 100000 By Balance 100000
Company c/d
Modi and Company Account

To Balance 100000 By Plant A/c 100000
c/d
Purchase Account
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To Anwar 50000 By Balance 50000
c/d
Total 50000
IM Total 50000
Anwar Account
To Purchase 10000 By Purchase 50000
Return A/c A/c
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To Cash A/c 39900

To Discount 100
A/c
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Sales Account
To Balance 60000 By Abu 40000
c/d By Cash 20000
A/c
Abu Account
To Sales A/c 40000 By Sales
Return A/c 5000
By Cash A/c 34500
By Discount
A/c
500

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Sales Return Account

To Abu 40000 By Balance 40000
c/d
Rent Account
To Cash A/c 4500 By Balance 4500
c/d
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Salary Account
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c/d
Drawings Account
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c/d

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Purchase Return Account

To Balance c/d 10000 By Anwar 10000
Furniture Account
To Bank A/c 10500 By Balance 10500
c/d

n o t e s
Discount Account
To Abu 500 By Anwar 100
By Balance 400
c/d
Total 500 Total 500
Sales Account
To Balance 40000 By Abu 40000
c/d
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SUGGESTED READINGS
IM
Agtarap, D., & Juan, S. (2007). Fundamentals of Accounting: Basic
Accounting Principles Simplified for Accounting Students (1st ed.,
pp. Ch 3-5). Bloomington: Author House.
Gilbertson, C., Lehman, M., & Gentene, D. (2014). Fundamentals of
Accounting: Course 1 (10th ed., pp. Ch. 3-4). Mason: South Western
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Cengage Learning.
Maheshwari, S., & Maheshwari, S. (2009). Fundamentals of Ac-
counting for Cpt, 2E (2nd ed., pp. 1.62 -1.106). Vikas Publishing
House: Noida.
N
E-references
AccountingCoach.com. (2014). Accounting Equation | Explanation
| Accounting Coach. Retrieved from, http://www.accountingcoach.
com/accounting-equation/explanation
AccountingCoach.com. (2014). What is a general ledger account? |
Accounting Coach. Retrieved from, http://www.accountingcoach.
com/blog/what-is-a-general-ledger-account
AccountingCoach.com. (2014). What is a journal? | Accounting
Coach. Retrieved from, http://www.accountingcoach.com/blog/
what-is-a-journal

Case study
n o t e s
ACCOUNTING PROCESS
Let’s start the case study with a brief introduction of the main
character of this case Mr. AK Shrivastava, an MBA graduate who
was working as an auditor in one of the prominent audit firms. Af-
ter working for more than 3 years in that auditing firm, Mr. Shri-
vastava decides to start his own venture as Business to Business
(B2B) software solutions provider, named as AKSI Enterprises.
He meets many venture capitalists and one of them finds his idea
profitable and agrees to invest in ‘AKSI’ by providing `10 lakh
as venture capital. On April 5, 2017, he got funds from venture
capitalists and following are some transactions done during the
month of April 2017:
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On April 7, 2017, Mr. Shrivastava started business with ven-
ture capital of `15 lakh and 5 lakhs from personal savings.
On 7, 2017, Mr. Shrivastava acquired commercial space on a
IMmonthly rental basis for `10 thousand.
On April 10, 2017, he spends `1 lakh for office furniture and
`1.5 lakh for computers and other essentials.
On April 12, 2017, ‘AKSI’ got their first order to develop a web-
site for a water park for the total cost of ` 10000 and receives `
5000 immediately in advance and remaining `5000 at the time
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of the completion of the project.

On April 20, 2017, paid electricity bills of `500.
On April 23, 2017, receives another order to develop ‘ware-
house management software’ for `20000 and receives `7000 in
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advance.
On April 26, 2017, the 1st project is completed and details re-
garding the same have been sent through invoice for the pay-
ment of remaining `5000.
On April 27, 2017, he receives payment of remaining of `5000.
On April 30, 2017, receives the remaining payment for the sec-
ond project.

Case study
n o t e s
Analyse the above information pertaining to transactions and an-

swer the questions that follow.
questions
1. Suppose you are accountant at ‘AKSI’. Prepare the

Journal of ‘AKSI’ for the month of April 2017.
(Hint: Apply golden rules of accountancy and record
every transaction as relevant journal entry, such as capital
invested, sales, purchases, advance income, utilities, etc.)
2. Examine the impact of above transactions on the balance
sheet.
(Hint: Identify and select all the items which belong to
the balance sheet. Analyse all journal entries by applying
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accounting equation, i.e. Assets = Liabilities + Share
Capital)
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M
N

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M
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Ch a
3 p t er
Trial Balance to Final Accounts
CONTENTS
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3.1 Introduction
3.2 Preparing a Trial Balance
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Activity
3.3 Rectifying Errors
3.3.1 Errors of Principle
3.3.2 Errors of Omission
3.3.3 Errors of Commission
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3.3.4 Errors of Compensation

Activity
3.4 Financial Statements
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3.4.1 Profit and Loss Account

3.4.2 Balance Sheet
3.4.3 Cash Flow Statement
3.4.4 Relationship between Profit and Loss Account and Balance Sheet
Activity
3.5 Summary

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New Age publishing
New Age publishing is a publishing company based in New Delhi.

The company has recently started its operations. Therefore, it fac-
es multiple problems in managing the various departments of the
organisation. One of the most challenging problems encountered
by the organisation is correctly recording its financial transac-
tions and preparing financial reports. Even though the company
has hired experienced accountants to take care of the account-
ing function, various accounting errors keep taking place. For ex-
ample, in one of the instances the purchases book of New Age
Publishing was overwritten by `10,000 resulting in excess debit
of `10,000 in purchases account. On the other hand, the compa-
ny’s sales returns book was underwritten by `10,000 resulting in a
S
short debit of `10,000 to sales returns account. Later, the company
realised that this incident was a case of two errors compensating
each other’s effect. Credit entry on one side was nullified by the
debit entry of equal amount on the other side which set off the net
IM
effect of these two errors without reflecting on the trial balance.
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Trial Balance to Final Accounts 71
n o t e s
learning objectives

> Describe how to prepare a trial balance
> Discuss the rectification of errors in trial balance
> Describe different types of Financial Statements
3.1 INTRODUCTION
Under the double-entry system of accounting, the Trial Balance is an
important statement. Trial Balance is a report which is a listing of all
the closing debit and credit balances at the end of a particular peri-
od-usually a month, quarter, half-year or year i.e. annual.
S
A trial balance is prepared when the accounts in the ledger are bal-
anced. You can say a trial balance to be a simple listing of all general
ledger accounts and their respective balances. Therefore, trial bal-
IM
ance includes the summary of all ledger balances outstanding on a
given date.
Financial Statements contain a structured, organised, and detailed

summary of the business processes. These determine the profits and
loss and the strengths and weaknesses of a business at the end of an
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accounting period. Financial Statements are prepared with the help

of trial balance, which is prepared with the help of ledgers. A complete
set of financial accounts includes the trading account, the profit and
loss account, and the balance sheet.
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In this chapter, you will study about the structure and preparation
of Trial Balance using the ledger accounts, the rectification of errors
while balancing of Trial Balance and the different types of Financial
Statements in an organisation.
3.2 PREPARING A TRIAL BALANCE

In the previous chapter, you studied about the recording of financial
transactions to prepare a journal from primary documents in an or-
ganisation. Later to make the procedure of referring to financial data,
ledgers are prepared from the journals. Trial Balance refers to a list
of closing balances of ledger accounts on a particular date and consti-
tutes the first step towards the preparation of financial statements of
an organisation. A trial balance is generally prepared at the end of the
accounting period for preparing the financial statements.
M.S. Gosav defines Trial Balance as “a statement containing the bal-

ance of all ledger accounts, at any given date, arranged in the form of
debit and credit columns placed side by side, and prepared with the ob-
ject of checking the arithmetic accuracy of ledger positions.”

n o t e s
The objectives of preparing a trial balance from a ledger account are

as follows:
a. For achieving arithmetical accuracy of the accounts (debits
must equal credits)
The Trial Balance is prepared after balancing the ledgers and
the Closing balances based on whether the closing balances are
debited or credited.
The total of all the debit balances must equal the total of credit
balances. This is quite a task when accounts are maintained
manually. Under computerised system of accounting there are
built-in checks to ensure the arithmetical accuracy.
b. For using as a worksheet
Trial Balance is prepared in various phases or stages. Depending
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upon the stage in which we generate the Trial Balance, it can be
used as a worksheet for planning and passing adjustment entries
which are basically Journal Entries.
IM
c. For serving as a source report for preparation of financial
statements
The Trial Balance is the source report for the preparation of the
Financial Statements i.e. both the Balance Sheet as well as The
Profit & Loss Account. It is important to note that the agreement of
credit and debit balances on a trial balance is not a conclusive proof
of the absence of errors. There is always a chance of hidden errors
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in a trial balance which need to be rectified. For example, an error

relating to a credit balance for `40,000 may be balanced by a debit
entry of an equal amount relating to a transaction and go unnoticed
by the accountant. Rectification of errors in a trial balance has been
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discussed in the subsequent section of this chapter.

The most commonly used format of a trial balance is as follows:
Trial Balance of M/S______ as on ____
Particulars L/F Debit Amount Credit Amount
Share Capital - -
Furniture - -
Building - -
Creditors - -
Debtors - -
Cash Balance - -
Sales - -
Cost of Sales - -
General and - -
Administration
Expanses
Total XXXXX XXXXX

n o t e s
Let us discuss the different contents in a trial balance format:

Headers: The heading in a trial balance consist of the details relat-
ed to the name of the organisation and the instance to which the
ledger account balance pertains.
Particulars: The name of the account head is written under the
‘particulars’ column of a trial balance.
Ledger Folio (L/F): Ledger folio provides detail about the page
number in the ledger from which the transactional information is
being extracted.
Debit amount: Financial transactions pertaining to assets and ex-
penses are recorded in the debit column of a trial balance.
Credit amount: Financial transactions pertaining to liabilities, eq-
uity and revenue is recorded in the debit column of a trial balance.
S
Modern method of preparing Trial Balance is as follows:
Modern method: This method is more widely used. The modern
IM
method has been derived from the traditional method. In this
method, instead of writing down the sub total of debit and cred-
it entries on the trial balance, these are set off and only the net
balance is indicated at the end of the trial balance. In this meth-
od, ledger accounts are balanced. The brought down balances are
then brought to a sheet as follows:
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XYZ Ltd.’s books

Trial Balance as on _________ 20___
S. Name of Account L.F. Debit Balance Credit Balance

No. ` `
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note
Assets, sundry debtors, losses, expenses and drawings are deb-

it balances while capital, liabilities, sundry creditors, gains, in-
comes and capital, revenues are credit balances.
Let us look at the following illustration to understand the prepara-

tion of a trial balance using the modern method by balancing the
ledger:
Illustration 1: Enter the following transactions into the ledger and
prepare the trial balance for Ravi’s books of accounts.
2013
Jan 1: Ravi started business with cash `8,00,000 and furniture
`2,00,000.
Jan 5: Purchased goods on credit worth `3,00,000 from Kartik.
Jan 8: Sold goods for cash `4,60,000.

n o t e s
Jan 16: Sold goods on credit to Vinay for 1,00,000

Jan 20: Cash received from Vinay `98,000 in full settlement of his
account.
Solution:
Ravi’s Ledger
Cash Account (No. 5)
Date References JF Debit (`) Credit (`) Balance (`)
2013 Dr. Cr.
Jan. 1 Capital A/C 5 8,00,000 8,00,000
Jan 8 Sales A/C 5 4,60,000 12,60,000
Jan 16 Vinay A/C 5 98,000 13,58,000
Furniture Account (No. 7)
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2013 Dr. Cr.
Jan 1 Capital A/C 5 2, 00,000 2, 00,000
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Capital Account (No. 9)
2013 Dr. Cr.
Jan 1 Cash A/C 5 8,00,000 8,00,000
Jan 1 Furniture A/C 5 2,00,000 10,00,000
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Purchases Account (No. 11)

2013 Dr. Cr.
Jan 5 Kartik A/C 5 3, 00,000 3, 00,000
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Kartik Account (No. 13)

2013 Dr. Cr.
Jan 5 Purchases A/C 5 3, 00,000 3, 00,000
Sales Account (No. 15)

2013 Dr. Cr.
Jan 8 Cash A/C 5 4, 60,000 4, 60,000
Jan 16 Vinay A/C 5 1, 00,000 5, 60,000
Vinay Account (No. 17)

2013 Dr. Cr.
Jan 16 Sales A/C 5 1,00,000 1,00,000
Jan 20 Cash A/C 5 98,000
Jan 20 Discount A/C 5 2000 Nil

n o t e s
Discount Account (No. 19)

2013 Dr. Cr.
Jan 20 Vinay A/C 5 2000 2000
From the above ledgers in Ravi’s books, the trial balance can be
prepared as follows:
Ravi’s books
Ravi’s Trial Balance as on January 31, 2013 (Amount in `)
S. No. Account Name A/C No. Debit (`) Credit (`)
1 Cash Account 5 13,58,000
2 Furniture Account 7 2, 00,000
3 Capital Account 9 10, 00,000
4 Purchases Account 11 3,00,000
S
5 Kartik Account 13 3, 00,000
6 Sales Account 15 5, 60,000
7 Vinay Account 17
8 Discount Account
IM 19 2000
Total 18, 60,000 18, 60,000
Illustration 2: Journalise the following transactions, post them into

ledger and prepare the trial balance for Rakesh’s books of accounts:
On January 01, 2017, Rakesh started business with cash `50000.

M
On January 02, 2017, Rakesh take bank loan for `20000.

On January 04, 2017, Purchase goods for cash `58000
On January 07, 2017, Purchased stationary and office supplies `6000
from Ankit on credit.
N
On January 10, 2017, Sold goods for cash ` 12000

On January 16, 2017, Pays `2000 to Ankit
On January 25, 2017, Salary paid `4000 and rent `1200
On January 30, 2017, Sold goods on credit `8000
On January 31, 2017, Rakesh withdraws `3500 for personal use.
Solution:
Rakesh’s Journal for January 2017

January Debit (`) Credit (`)
2017
1 Cash A/C Dr. 50000
To Capital 50000

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Rakesh’s Journal for January 2017

January Debit (`) Credit (`)
2017
2 Cash A/c Dr. 20000
To Bank Loan 20000
(Being loan taken from bank)
4 Purchase A/C Dr. 58000
To Cash A/C 58000
(Being goods purchased for cash)
4 Stationary and office supplies A/c Dr.
To Ankit 6000
(Being stationary and office supplies 6000
purchased on credit)
10 Cash A/c Dr. 12000
S
To Sales A/C 12000
16 Ankit Dr. 2000
IM
To Cash A/c 2000
(Being cash paid to Ankit)
25 Salary A/c Dr. 4000
Rent A/c Dr. 1200
To Cash A/c 5200
(Being salary and rent paid for cash)
M
30 Debtors A/c Dr. 8000

To Sales A/c 8000
(Being goods sold on credit)
31 Drawings A/c Dr. 3500
To Cash A/c 3500
N
(Being cash withdrawn for personal

use)
Rakesh’s Ledger for January 2017
Cash Account
Particulars JF Amount Particulars JF Amount
To Capital A/c 50000 By Purchase A/c 58000
To Bank Loan A/c 20000 By Ankit 2000
To Sales A/c 12000 By Salary A/c 4000
By Rent A/c 1200
By Drawings A/c 3500
By Balance c/d 13300

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Capital Account
To Capital A/c 50000 By Cash A/c 50000
Bank Loan Account

To Balance c/d 20000 By Cash A/c 20000
Purchase Account
S
To Cash A/c Dr. 58000 By Balance 58000
c/d
IM
Stationary and office Supplies Account
c/d
M
To Ankit 4000
Ankit Account
N

To Cash A/c 2000 By Stationary 6000
and office
Supplies A/c
To Balance c/d 4000
Sales Account
To Balance c/d 20000 By Cash A/c 12000
By Debtors 8000
A/c

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Salary Account
b/d
Rent Account
c/d
S
Debtors Account
To Sales A/c 8000 By Balance 8000
IM c/d
Drawings Account
M
Cash A/c 3500 By Balance 3500

c/d
Rakesh’s Ledger for January 2017

N
S. No. Name of Account Amount Amount

Dr. (`) Cr. (`)
1. Cash 13300
2. Debtors 8000
3. Stationary and office Supplies 6000
Account
4. Purchase 58000
5. Ankit 4000
6. Bank Loan 20000
7. Capital 50000
8. Sales 20000
9. Salaries 4000
10. Rent 1200
11. Drawings 3500
Total 94000 94000

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note
If an account has zero balance, it is not necessary to record it in the trial

balance.
1. ____________ refers to a list of closing balances of ledger

accounts on a particular date and constitutes the first
step towards the preparation of financial statements of an
organisation.
(a) Trial balance (b) Balance sheet
(c) Trading account (d) Cash book
S
2. The total of all the __________ balances in a trial balance must
always be equal to the total of __________balances.
(a) Assets; liabilities (b) Debit; credit
IM
(c) Income; expenditure (d) Both (b) and (c)
3. As per__________ approach, ledger accounts are not balanced
for each debit and credit entry and are simply summed up and
the total of debit side and credit side should be equal to each
other.
(a) Modern Approach (b) Miller model
M
(c) Traditional Approach (d) None of the above
Activity
N
Prepare a trial balance from the following balances extracted from

the books of Pawan Enterprises on 31st March 2013:
Particular Amount (`) Particular Amount (`)

Purchases 1,10,000 Drawings 14,700
Stock (April 1, 2009) 30,000 Return Inwards 11,000
Sales 2,05,000 Premises 5,00,000
Sundry Debtors 27,800 Sundry Creditors 22,100
Discount Received 13,500 Discount Allowed 2,800
Carriage Outwards 5,700 Carriage Inwards 1,400
Cash in Hand 8,500 Cash at Bank 45,500
Machinery 1,50,000 General Expenses 2,550
Depreciation on 30,200 Bad Debts Written Off 2,000
Machinery 8,380
Provision for Doubtful
Debts

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3.3 Rectifying Errors

We have already discussed that a trial balance is prepared to check
the arithmetical accuracy of transactions in a journal. In case of agree-
ment in a trial balance, it can be assumed that the recording, posting
and balancing are performed correctly. However, in case the trial bal-
ance does not agree, we need to locate the errors committed.
The errors in a trial balance may occur at the time of recording, clas-
sifying, or summarising a financial transaction.
It should be noted that even when the trial balance is correct, some
errors may remain in the accounting records. For example, if the cred-
it purchases are not recorded in the purchase book, it would not af-
fect the agreement of the trial balance because the entry is not made
S
in either sides of the book. Therefore, clearly two types of errors are
committed: errors that affect the trial balance and the errors that do
not affect the trial balance.
IM
However, we need to identify and rectify both types of errors. The pro-
cess of rectifying the errors and correcting the accounting records is
termed as rectification of errors.
The major types of accounting errors are as depicted in Figure 3.1:

M
Errors of Errors of
Omission Commission
N
Errors of Accounting Errors of

Principle Errors Compensation
Figure 3.1: Types of Accounting Errors
Let us discuss the major types of accounting errors in the following

section.
3.3.1 Errors of Principle
It is imperative to follow the Generally Accepted Accounting Princi-

ples (GAAP) to record accounting transactions. However, when finan-
cial transactions are recorded in violation of the accounting principles,
the error is referred to as the error of principle. It should be noted
that the errors of principles do not affect the trial balance. In any sit-
uation when there is wrong categorisation of receipts or expenditure

n o t e s
between capital and revenue, then it will lead to rise of the error of
principle. These errors may occur; when the entry of a transaction
is made on the wrong side of the related account or in the wrong ac-
count. However, the value of entry or the amount of the transaction
is correct. The rectification of such errors is very important as they
directly affect financial statements. Such errors may occur due to the
following reasons:
In case, there is lack of understanding, classification and hence the
distinction between the revenue and capital items. The revenue
receipt may be taken as capital receipt or vice versa.
In case, there is lack of distinction between the business expenses
and personal expenses.
In case, there is lack of distinction between the productive and
non-productive expenses.
S
Let us comprehend the process of rectification of errors of principle
with the help of an example.
IM
Illustration 3: Rectify the following errors:
1. Paid wages for the construction of office debited to wages account
`2,000.
2. Paid cartage for newly purchased furniture `500, is posted to
cartage account.
M
3. Paid `5,000 for the installation of machinery debited to wages

account.
Solution: The rectification of entries is shown as follows:

N
Date Particulars L.F. Dr. Cr.

Amount (`) Amount (`)
1. Building A/c Dr. 2,000
To Wages A/c 2,000
(Being wages paid for construction of
office wrongly debited to wages A/c, now
rectified)
2. Furniture A/c Dr. 500
To Cartage A/c 500
(Being cartage paid for newly purchased
furniture wrongly posted to cartage A/c,
now rectified)
3. Machinery A/c Dr. 5,000
To Wages A/c 5,000
(Being amount paid for installation of
machinery wrongly debited to wages A/c,
now rectified.

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3.3.2 ERRORS OF OMISSION

An error of omission occurs when any transaction is completely or
partially omitted to be recorded in the books of accounts. There is a
difference between the error of partial recording of transactions and
error of completely omitting transactions. These errors may occur
when the entry of a transaction is omitted from being recorded or it is
recorded only on one side (either debit or credit side) of the account.
When the transaction is completely omitted to be recorded in the books
of account, then it is called as error of complete omission. These types
of errors do not affect the trial balance. For instance, credit purchase
from vendor is not recorded in the purchase book. On the other hand,
when the transaction is recorded only on one side of account (either
debit or credit), then it is the case of partial omission. These types
of errors affect the trial balance. For example, discount allowed to a
customer not recorded in the discount account of ledger.
S
Let us understand the error of omission with the help of an example.
Suppose the recording of goods worth `1000 purchased on credit from
Arun Lal is omitted from the purchase book. In such a case, it would
IM
be omitted from being posted in the ledger as well. Consequently, the
transaction is not found in the trial balance. Besides this, now suppose
a particular transaction is recorded in relevant subsidiary book but
it was omitted to be recorded in ledger. This is the case of partial
omission. In this scenario, the agreement of trial balance also gets
affected and hence accuracy of accounts is also diminished.
M
3.3.3 ERRORS OF COMMISSION

An error of commission occurs when the transaction is recorded
with incorrect amount in the various books of account. Errors of
N
commission are also known as posting errors.

Generally, error of commission occurs in two cases:
Wrong amount: The transaction is recorded with wrong amount.
For example, goods purchased worth `5000 are recorded as `5500.
Wrong account: The transaction is recorded in the wrong account.
For example, purchases made for the personal use of owner are
recorded in the purchase account (i.e. which must be considered
as drawings).
For example, the recording of goods worth `1000 purchased on credit
from Arun Lal is recorded as `10000 in purchase book or credit
purchase worth `1000 from Arun Lal is recorded in the sales account.
This is called error of commission and majority of these types of errors
are reflected in the trial balance. This type of error affects the trial
balance and as a result, balances do not match due to an incorrect
amount recorded and accuracy of accounts also gets affected.

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Let us understand the rectification process of errors of omission with

the help of an illustration.
Illustration 4: Pass the journal entries to rectify the following errors:

1. A credit sale of `50,000 to Krish omitted to be recorded in the
books.
2. Goods (cost `20,000 and sales price `24,000) taken by the
proprietor were not recorded anywhere.
3. Goods worth `3,500 sold to Ravi on credit were omitted from the
accounts. Although, cash received subsequently from him stands
posted to his credit.
4. A credit sale of old furniture to Rajesh for `5,000 omitted to be
recorded.
S
5. On 31st March, 2007, the goods worth `30,000 were returned by
Ram and were taken into stock on the same date, but no entry
was passed in the books.
IM
Solution:
The journal entries after rectification of errors are shown as follows:
Date Particulars L.F. Dr. Amount Cr. Amount

2010 (`) (`)
1 Krish Dr. 50,000
M
To Sales A/c 50,000

(Being a credit sale omit-
ted to be recorded, now
recorded)
N
2 Drawing A/c Dr. 20000

To Purchase A/c 20000
(Being goods taken away
by the proprietor omit-
recorded)
3 Ravi Dr. 3500
To Sales A/c 3500
(Being the rectification
of goods sold to Ravi not
recorded in the books)
4 Rajesh Dr. 5000
To old furniture A/c 5000
(Being old furniture sold
to Rajesh on credit omit-
recorded)

n o t e s

2010 (`) (`)
5 Sales return A/c Dr. 30000
To Ram 30000
(Sales return received
from Ram omitted to be
recorded, now recorded)
3.3.4 Errors of Compensation
In case of errors of compensation, an error is nullified with errors of

equal proportion. In other words, it means one type of error is bal-
anced by another error. This is why these are called errors of com-
pensation. It may happen that when an error occurs in an account,
S
the same type of error may take place in another account. In such
a case, it is not easy to detect the error. For example, Amit’s A/c was
debited with `1000 instead of `10000 while Sandip’s A/c was debited
with `10000 instead of `1000. Therefore, Amit’s A/c, which was debited
IM
by `9000, was compensated by another error in Sandip’s A/c, whose
account was debited excess of `9000. Errors of compensation do not
affect the trial balance.

M
4. Which type of error can result in disparity in the agreement of

trial balance?
(a) Two sided error
(b) One sided error
N
(c) Errors of omission

(d) Both (b) and (c)
5. Trial balance can be defined as________.
(a) Statement
(b) Subsidiary Book
(c) Account
(d) Principle book
6. When financial transactions are recorded in violation of
accounting principles, the error is called the_________.
(a) Error of omission
(b) Error of commission
(c) Error of principle
(d) Error of compensation

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7. __________ may occur when there is a lack of discrepancy

between the revenue and capital items.
8. _______ occurs when any transaction is not completely or
partially recorded in the books of accounts.
S
9. In case of errors of _____, an error is nullified with errors of
equal proportion.
IM

(a)
Omission (b)
Commission

(c)
Principle (d)
Compensation
Activity
M
Make a group of your friends and discuss the various types of

errors. Present your discussion points in a short note.

N
The primary aim of investing money in a business is to earn profits.

An organisation needs to periodically evaluate the profits earned and
losses incurred and the financial standing of the organisation on a giv-
en date. The primary aim of investing money in a business is to earn
profits. An organisation needs to periodically evaluate profits earned
and losses incurred and the financial standing of the organisation on a
given date. In addition, different users of accounting information have
different requirements. These requirements can be fulfilled by pre-
paring final accounts also called financial statements, which provide
profit earned and the losses suffered by a business.
A financial statement is an official record of all financial transactions

of an organisation for a particular period of time. It reflects financial
position (or financial health) and performance of the organisation. Un-
der a financial statement, profit and loss account reflects the financial
performance of the organisation while balance sheet reflects financial
position or financial health of the organisation.

n o t e s
Section 2 (40) of Indian Companies Act. 2013, explains some man-

datory requirements for the presentation of financial statements of a
company. As per this section, a company’s financial statement must
include a balance sheet for the concerned financial year, statement
of disclosure pertaining equity changes, cash flow statement, profit
and loss account in the case of profitable organisations or income and
expenditure account in the case of non-profit organisations such as,
charitable trusts, hospitals, educational institutions, However, in the
case of one person company, small company and dormant company,
there is no requirement to include cash flow statement.
A business owner would be interested in knowing whether his/her

business is running at a profit or incurring loss, the actual financial
position of the business, etc. The main aim of Financial Statements
is to inform the owner about the progress of his/her business and the
S
financial position at the right time and in the right manner. There are
mainly three types of Financial Statements in an organisation which
are shown in Figure 3.2:
IM
Financial
Statements
Profit and Loss Cash Flow

Balance Sheet
Account Statement
M
Figure 3.2: Components of Financial Statements

Let us now discuss these financial statements in detail
N
3.4.1 PROFIT AND LOSS ACCOUNT

Profit and loss account is prepared so as to ascertain the net profit
earned and net loss suffered by a business over a given accounting
period. Therefore, this statement depicts the financial position of a
company. In other words, the profit and loss account is a statement that
shows expenditures, revenues and net income of an organisation. The
company’s profit and loss account is a brief description of company’s
revenue, expenses and net profit (or net loss) for any particular period
of time. It may be produced on a monthly, quarterly, half annually or
annual basis. In most cases, it is produced on an annual basis along
with other financial statements. It is the statement which reflects
company’s financial performance to its investors, management and
other interested parties. In simple words, the profit and loss account
is the explanation of company’s profitability over a particular period
of time.

n o t e s
Let us now discuss the components of the profit and loss account
which are given as follows:
Revenue: Revenue is the total amount of money received by a
business entity after selling its products or services. Generally,
revenue is also known as sales revenue or net sales and it can be
calculated by deducting sales return, discounts and allowances
from total sales. It is recorded at the top of the income statement
and because of this it is also known as ‘top line’.
Cost of goods sold (COGS): COGS includes all direct costs in-
volved in the process of production. For example, raw material, la-
bour, factory overheads, depreciation on plant and machinery, etc.
Gross profit or gross loss: It is the difference between the revenue
received and cost of goods sold for a particular period of time.
S
Operating expenses: Operating expenses are the amount of ex-
penses that a business entity has to bear in day-to-day business
operations. For example, amortisation of intangible assets, ad-
vertising and sales expenses, research and development, rent of
IM
building, etc.
Administrative expenses: Administrative expenses are those ex-
penses which are not directly related with the process of produc-
tion and these expenses are related to management and support-
ing activities of a business organisation. For example, depreciation
on corporate office building, salary of top level managers, legal
M
charges, functional cost of HR department, functional cost of IT

department, functional cost of finance department, etc.
Operating income: Operating income can be calculated by de-
ducting operating and administrative expenses from gross profit.
N
It is also known as earnings before interest and taxes (EBIT).

Other income: Other income is the income which is non-opera-
tional in nature and is not generated on the basis of core opera-
tions of a business. For example, rent received from the in-house
canteen contractor of a factory.
Other expenses: Other expenses are those expenses which are not
related to the core operations of a business enterprise and these
expenses do not contribute anything to the process of production.
For example, income tax paid to the government, interest paid for
borrowings, etc.
Net profit or net loss: It can be calculated by deducting all ex-
penses from revenue. It is recorded at the end of income statement
and because of this it is also known as ‘bottom line’. Net profit/loss
is also known as ‘accounting profit/loss’ because there are many
non-cash transactions such as amortisation, depreciation, etc. are
included under it.

n o t e s
All above items appear in debit or credit side of ‘profit and loss
account’. The items that appear on the debit side of the Profit and
Loss Account are as follows:
Expenses incurred in a business: This is divided into two parts:
Direct expenses: These are recorded in income statement.
Indirect expenses: These are recorded on the debit side. Indi-
rect expenses are further categorised as follows:
Selling expenses: These include all expenses relating to sales such
as carriage outwards, travelling expenses, advertising, distribution
costs, etc.
Office expenses: These include all expenses incurred on run-
ning an office such as office salaries, rent, tax, postage, statio-
S
nery etc.
Maintenance expenses: These include all expenses related to
the maintenance of assets such as repairs and renewals, depre-
IM
ciation, etc.
Financial expenses: These include all expenses related inter-
est paid on loan, discount allowed, etc.
The items that appear on the credit side of the profit and loss account
are as follows:
M
Gross profit
Other gains and incomes of the business such as interest received,
rent received, discounts earned and commission earned.
The format of a Profit and Loss Account is as follows:
N
PROFIT AND LOSS ACCOUNT

Company Name_____________
Profit and loss statement for the year ended March 31, 20XX
Particulars Amount
Revenue/ Net sales
(-) Cost of Goods Sales
= Gross Profit
+ Other incomes
(-) Operating expenses
(-) Administrative expenses
(-) Distribution costs
(-) Other expenses

n o t e s
Particulars Amount
= Operating income/Earnings before Interest and Tax (EBIT)
(-) Interest paid
=Profit before tax (PBT)
(-) Income tax
= Net profit
Apart from this, you will also study the components of the profit and
loss account in chapter 9. Let us understand the preparation of a Profit
and Loss Account with the help of the following illustrations:
Illustration 5: Prepare the profit and loss account from the following
particulars of ABC Limited for the year ending March 31, 2017:
S
Particulars Amount (`)
Net Sales 75000
Administrative expenses 4000
IM
Interest received 1200
Profit on sale of old machinery 1400
Operating expenses 14000
Income tax paid 0.00
M
Cost of goods sales 34000

Distribution costs 4800
Other expenses 1900
N
Interest paid 1700
Solution: The required profit and loss account is shown in the

following table:
PROFIT AND LOSS ACCOUNT
ABC Limited
Profit and loss statement for the year ended March 31, 2017
Particulars Amount in `
Revenue from operations / Net sales 75000
(-) Cost of Goods Sales 34000
= Gross Profit 41000
+ Other incomes

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Profit on sale of old machinery 1400 2600
(-) Operating expenses 14000
(-) Administrative expenses 4000
(-) Distribution costs 4800
(-) Other expenses 1900
= Operating income/ Earnings before Interest and Tax 18900
(EBIT)
(-) Interest paid 1700
=Profit before tax (PBT) 17200
(-) Income tax 0.00
= Net profit 17200
S
3.4.2 Balance Sheet
In simple words, a balance sheet refers to a statement that summaris-

es and presents the financial position of an organisation on any given
IM
date. It shows the assets and liabilities of an organisation. The main
aim of preparing a balance sheet is to determine the exact financial
position of a company. In a balance sheet, the debit balances are re-
flected by the assets and the liabilities are reflected by the credit bal-
ances. A number of steps are involved in preparing a balance sheet.
The first step is transferring all nominal accounts in the trial balance
M
to the trading and profit and loss account. Next, the personal accounts
of customers are grouped under the heading of sundry debtors, the
entities from whom the amounts of sold goods and services are due.
Similarly, we need to group all balances of the suppliers under the sin-
gle heading of sundry creditors, the entity to whom the organisation
N
owes money or payment. In the end, the real and personal accounts
are grouped as assets and liabilities and are arranged in a proper way.
The resultant statement obtained is called the balance sheet.
The American Institute of Certified Public Accountants defines bal-

ance sheet as, “A tabular statement of summary of balances (debits
and credits) carried forward after an actual constructive closing of
books of account and kept according to the principles of accounting.”
In the balance sheet, assets are represented on the right side and lia-
bilities are shown on the left side. It is also known as the statement of
sources of funds and application of funds. The financial position of the
organisation includes its economic resources (assets), economic obli-
gations (liabilities), and owner’s equity. As discussed in previous chap-
ters, a balance sheet is the detailed summary of the basic accounting
equation:
Assets = Liabilities + Owner’s Equity

n o t e s
The pro forma of the balance sheet is shown in the following table:
The proforma of the balance sheet in reverse order of liquidity is

shown in the following table:
PART I — BALANCE SHEET

Name of the Company…………………….
Balance Sheet as at ………………………
(Rupees in…………)
Particulars Note Figures as at the Figures as at the

No. end of current end of the previous
reporting period reporting period
1 2 3 4
I. EQUITY AND LIABILITIES
(1) Shareholders’ funds
S
(a) Share capital
(b) Reserves and surplus
(c) Money received against share
warrants
(2) Share application money pending
allotment
IM
(3) Non-current liabilities
(a) Long-term borrowings
(b) Deferred tax liabilities (Net)
(c) Other Long term liabilities
(d) Long-term provisions
(4) Current liabilities
(a) Short-term borrowings
M
(b) Trade payables

(c) Other current liabilities
(d) Short-term provisions
TOTAL
II. ASSETS
N
Non-current assets
(1) (a) Fixed assets
(i) Tangible assets
(ii) Intangible assets
(iii) Capital work-in-progress
(iv) Intangible assets under
development
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long-term loans and
advances
(e) Other non-current assets
(2) Current assets
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and
advances
(f) Other current assets
TOTAL

n o t e s
Illustration 6: Prepare the profit and loss account and the balance
sheet from the following particulars of Rajan Associates on 31st
March, 2017:

Net Sales 249000
Administrative expenses 12000
Gain on government bonds 3500
Operating expenses 48000
Income tax paid 8800
Cost of goods sales 134000
S
Distribution costs 14600
Other expenses 3800
Interest paid 6200
IM
Bills Receivable 16200
Creditors 23300
Machinery 52700
Plant 55600
Cash in Hand 22000
M
Net Debtors 40000

Drawings 6500
Capital 80000
N
Bills Payable 5000

Loan 9000
Solution:
STATEMENT OF PROFIT AND LOSS

Rajan Associates
Profit and loss statement for the year ended March 31, 2017
Revenue from operations / Net sales 294000
(-) Cost of Goods Sales 134000
= Gross Profit 160000
+ Other incomes
Gain on government bonds 3500 9100
(-) Operating expenses 48000
(-) Administrative expenses 12000

n o t e s
(-) Distribution costs 14600
(-) Other expenses 3800
= Operating income/ Earnings before Interest and Tax (EBIT) 90700
(-) Interest paid 6200
=Profit before tax (PBT) 84500
(-) Income tax 8800
= Net profit 75700
BALANCE SHEET
Rajan Associates
Balance sheet for the year ended March 31, 2017
S. No. Particulars Amount in `
Capital
S
Share capital 80000
Add: Net profit 75700
Less: Drawings 6500
IM
149200
Liabilities
Loan9000
Bills Payable 5000
Creditors23300
37300
M
TOTAL 186500
ASSETS
Plant55600
Machinery52700
N
Bills Receivable 16200

Debtors40000
Cash in Hand 22000
TOTAL 186500
3.4.3 CASH FLOW STATEMENT

Cash flow statement is one of the most significant financial statements
that are issued by any organisation. Cash flow statement measures the
actual cash generated by the organisation within a particular period of
time. Under this statement, the word ‘cash flow’ refers to the amount
of cash that comes into or goes out from the organisation. Cash flows
of any organisation are categorised into, cash inflow and cash outflow.
Cash inflow refers to the total amount of cash that comes into the
organisation through various activities. For example, cash received on
behalf of sales, cash received from the sale of assets, loan received,
issue of debentures, issue of shares, interest received, dividend
received, etc. On the other hand, cash outflow refers to the total
amount of cash that goes out from the organisation through various

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activities. For example, cash purchase of raw material, purchase of

assets, redemption of debentures, cash payment for wages, income
tax payment, repayment of loan, interest paid, dividend paid, etc.
The cash inflows and outflows of any organisation can further be
classified into three activities. These activities are operating activities,
investing activities and financing activities.
Operating activities are those activities which are related to core
business operations of the business and it includes all those activ-
ities which are related to the revenue generation of the organisa-
tion. For example, cash sale of goods, payment made to the suppli-
er, commission, cash payment of salaries, etc.
Investing activities are those activities which are related to the
purchase or sale of long-term investments and assets. For exam-
ple, cash purchase of plant and machinery, old machinery sold for
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cash, investment in government bonds, etc.
Financing activities are those activities which are related to the
financial transactions of a business and these activities provide the
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overview of cash used in business financing. For example, loan re-
ceived, issue of shares, payment of dividend, repayment of loan,
issue of debentures, etc. Apart from all, this you will study ‘cash
flow statement’ in detailed manner in chapter 8.
3.4.4 Relationship between Income Statement and

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Balance Sheet
The profit and loss account reflects the financial performance of the
company by analysing the overall profitability of the entity. It shows
how much amount of gain or loss has taken place during a particular
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time period. On the other hand, a balance sheet reflects the financial
health of an entity by providing a pathway to ratio analysis. In other
words, balance sheet shows owes (liabilities) and owns (assets) of the
entity.
However, both the financial health and financial performance are
interrelated via equity investment in the balance sheet and net profit
on the profit and loss account. The connection between the balance
sheet and profit and loss account can also be determined with changes
in the equity of the entity. For example, suppose ABC Enterprise has
owners’ equity of ` 1 crore at the year ending March 31, 2016 and `1.25
crore for the year ending March 31, 2017. During this time period the
owner did not brought in any new investment and nor he withdrew
anything for personal use. So in this case we can say that the company’s
owner equity has been raised by ` 25 lakh due to retained earnings or
net profit.

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Let us now discuss some important terms related to financial state-

ments:
Opening stock or opening inventory can be defined as per their
nature (i.e. raw material, work-in-progress and finished goods). In
the case of raw material opening, stock means the inventory of raw
material that is unused at the beginning of the accounting peri-
od. Work-in-progress opening stock is the inventory of semi-fin-
ished goods at the beginning of the accounting year. In the case of
finished goods, opening stock is the inventory of unsold finished
goods at the beginning of the accounting period.
Closing stock or ending inventory is the amount of inventory lies
with the organisation at the end of the accounting period. It may
be in the form of raw material, work-in-progress or finished goods.
At the end of the accounting year this closing stock became open-
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ing stock in the following accounting year.
Purchase can be defined as the overall cost of inventory, asset or
an item, that is possessed by an organisation to carry out its var-
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ious operations. In simple words, purchase is a transaction that
means exchange of money with goods or services.
Sales can be defined as the transfer of ownership of a particular
asset, item good or service to the buyer, for a certain amount of
money.
Direct expenses are those expenses which are directly related to
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core operations of the entity. Generally, direct expenses involve

costs related to the purchase of raw material and conversion of
raw material into finished goods. For example, raw material, la-
bour, factory overheads, etc.
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Indirect expenses are required to ensure smooth running of an

organisation and these expenses not directly related to the core
revenue generating operations of the entity. For example, station-
ary bills, telephone charges, printing of brochures, legal fees, pro-
fessional services, etc.
Income is the sum of money that an organisation receives from sell-
ing of goods and services. In accounting terms, it can be explained
as a surplus of revenue over expenditure for a given time frame.
10. ___________ is the final process for any accounting year.

(a) Preparation of principle book
(b) Preparation of financial statements
(c) Preparation of Journal
(d) Preparation of subsidiary books

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11. In a profit and loss account, all indirect revenue expenses are
shown in the __________side and the indirect revenue incomes
are shown in the ___________ side.
(a) Debit; credit (b) Credit; Debit
(c) Profit; loss (d) Both (b) and (c)
12. A _______ refers to a statement that summarises and presents
the financial position of an organisation on any given date.
(a) Profit and loss statement (b) Income statement
(c) Balance sheet (d) Principle book
13. In a balance sheet, the ______________ balances are reflected
by assets.

(a)
Credit (b)
Debit
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(c)
Positive (d)
Expenditure
14. As per the reverse order of liquidity format of balance sheet
which of the following comes under the heading of fixed asset?
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(a) Tangible assets (b) Intangible assets
(c) Capital work-in-progress (d) All of the above
Activity
From the following balances extracted from the books of Oxford on

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31st March, 2010, prepare the profit and loss account as well as the
balance sheet:
Debit Balances Amount (`) Credit Balances Amount (`)
Opening Stock 2,00,000 Sundry Creditors 1,50,000
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Purchase 7,50,000 Purchase Returns 30,000

Sales Return 80,000 Sales 25,00,000
Freight and Carriage 75,000 Commission 33,000
Wages 3,65,000 Capital 17,00,000
Salaries 1,20,000 Interest on Bank Deposit 20,000
Repair 12,000 Bills Payable 62,000
Trade Expenses 40,000
Rent and Taxes 2,40,000
Case in Hand 57,000
Bills Receivable 40,000
Debtors 5,50,000
Plant and Machinery 16,00,000
Drawing 1,66,000
Bank Deposit 2,00,000
Closing stock as at 31st March, 2010 was `2, 50,000.

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3.5 Summary
After we have posted transactions in a ledger account and bal-
anced the ledger, a statement is prepared to show the debit and
credit balances separately. This statement is called trial balance.
A trial balance tests the arithmetical accuracy of the posting of
transactions into the ledger.
The balance in an account refers to the difference between the
totals of the debit side and the credit side.
There are two methods of preparing a trial balance: total method
and balance method.
In case the trial balance does not agree, we need to locate the er-
rors committed.
When financial transactions are recorded in violation of the ac-
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counting principles, the error is called the error of principle.
Errors of omission occur when any transaction is not completely
or partially recorded in the books of accounts.
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In case of errors of compensation, an error is nullified with errors
of equal proportion. In other words, it means one type of error is
compensated by another error.
The profit and loss account is prepared to ascertain the net profit
earned and net loss suffered by a business over a given accounting
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period.
A balance sheet refers to a statement that summarises and pres-
ents the financial position of an organisation on any given date.
key words
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Bad debts: The borrowed amount debt that is not collectible

and therefore of no worth to the creditor.
Bills payable: A document showing the amount owed for goods
or services received on credit.
Billsreceivable: A document showing that your customer for-
mally agrees to pay at some future date.
Capital receipt: Receipts realised after sale of original assets.
Financial statements: Structured, organised and detailed sum-
mary of the business processes.
Generally Accepted Accounting Principles: A framework of
accounting standards, rules and procedures defined by the pro-
fessional accounting industry, which has been adopted by near-
ly all publicly traded U.S. companies.

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Revenue Items: The items which do not generate any asset of

business.
Sundry creditors: Individuals or businesses that supply goods
or services or consumable items to a business firm on credit
basis.
Sundry debtors: The account for individuals or businesses that
owe money to a business.

1. What do you understand by a trial balance? Discuss.
2. Describe the methods of preparing a trial balance.
3. What are errors of principle? Explain.
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4. What do you mean by errors of compensation?

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Preparing a Trial Balance 1. a. Trial balance
2. b. Debit; credit
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3. c. Traditional Approach
Rectifying Errors 4. b. One sided error
5. a. Statement
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6. c. Error of principle
7. c. Error of principle
8. a. Error of omission
9. a. Compensation
Final Accounts 10. b. Preparation of financial state-

ments
11. b. Credit; Debit
12. c. Balance Sheet
13. b. Debit
14. d. All of the above

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1. After we have posted transactions in a ledger account and
balanced the ledger, a statement is prepared to show the debit
and credit balances separately. This statement is called trial
balance. Refer to Section 3.2 Preparing a Trial Balance.
2. There are two methods of preparing a trial balance. These are
total method and balance method. Refer to Section 3.2 Preparing
a Trial Balance.
3. When financial transactions are recorded in violation of the
accounting principles, the error is called the error of principle.
Refer to Section 3.3 Rectifying Errors.
4. In case of errors of compensation, an error is nullified with errors
of equal proportion. Refer to Section 3.3 Rectifying Errors.
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1. Old machinery was sold for `10000 and credited to sales. Rectify
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the error from this information and also mention the type of
error.
Solution:
This is the error of principle and rectifying entry will be:
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(`) (`)
Sales A/c Dr. 10000
To Machinery A/c 10000
(Being old machinery sold
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for cash wrongly credited to

sales A/c, now rectified)
2. Return outward of `1000 was omitted to be recorded. Rectify the
error from this information and also mention the type of error.
Solution:
This is error of omission and rectifying entry will be:
(`) (`)
Accounts Payable Dr. 1000
To Return outward 1000
(Return outward omitted to
be recorded, now recorded)

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3. Amount of ` 10000 received from M/s Gupta and Co. was credited
to M/s Gopal and Co. Rectify the error from this information and
also mention the type of error.
Solution:
This is the error of commission and rectifying entry will be:
Date Particulars L.F. Dr. Amount Cr.
(`) Amount (`)
M/s Gopal and Co. A/c Dr.
To M/s Gupta and Co. A/c 1000
(Cash received from M/s Gupta
and Co. wrongly credited to M/s 1000
Gopal and Co., now rectified)
4. Wages of `2000 paid for the installation of machinery was debited
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to wages account. Rectify the error from this information and
also mention the type of error.
Solution:
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This is the error of principle and rectifying entry will be:
(`) (`)
Machinery A/c Dr. 2000
To Wages A/c 2000
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(Wages paid for installation of

machinery wrongly debited to
wages account, now rectified)
5. Calculate gross profit from the information given below:
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Opening stock 150000
Closing stock 60000
Purchases 210000
Sales 450000
Return inward 10000
Return outward 10000

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Solution:
For the calculation of gross profit, we need to calculate:
Cost of Goods Sold (CoGS) = Opening Stock + (Purchases –
Return outward) – Closing stock
= 150000 + (210000 - 10000) – 60000
= 290000
Now,
Gross Profit = Net Sales – CoGS

Or
= (Total Sales – Return inward) – CoGS
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= (450000 - 10000) – 290000
Gross Profit = `150000

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Suggested Readings
Debarshi, B. (2011). Management Accounting (1st ed., pp. 12-18).
Delhi: Dorling Kindersley India.
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Goyal, V., & Goyal, R. (2013). Corporate Accounting (1st ed., pp.
261-332). Delhi: Prentice Hall India.
Ramachandran, N., & Kakani, R. (2010). How to Read a Cash Flow
N
Statement (1st ed., pp. 35-97). Delhi: Tata McGraw Hill.
E-references
AccountingCoach.com. (2014). Balance Sheet | Explanation |
AccountingCoach. Retrieved from, http://www.accountingcoach.
com/balance-sheet/explanation/1
Zeepedia.com. (2014). Rectification of Error Financial Account-
ing Commerce Accounting. [Retrieved from, http://www.zeepe-
dia.com/read.php?rectification_of_error_financial_account-
ing&b=23&c=28

n o t e s
Letslearnfinance.com. (2014). Advantages and Disadvantages

of Cash Flow Statement | LetsLearnFinance. Retrieved from,
http://www.letslearnfinance.com/advantages-and-disadvantag-
es-of-cash-flow-statement.html
Studytesttime.com. (2014). Classification of Cash Flows as per Ac-
counting Standard-3 (Revised). Retrieved from, http://studytest-
time.com/all-topics/22-analysis-of-financial-statements/56-classifi-
cation-of-cash-flows-as-per-accounting-standard-3-revised
S
IM
M
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Case study
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Corn Soup Recipe
Amita inherited `50, 00,000 while her brother, Gaurav inherited

`45, 00,000 from their parents along with a secret recipe for prepa-
ration of a corn soup discovered a few generations earlier. Gaurav
was not interested in the recipe while his sister saw great poten-
tial in the recipe to start a new business. Amita decided to buy the
recipe from Gaurav, but he was reluctant to sell. However, later he
agreed to sell it for `10, 00,000 while Amita put the remaining `40,
00,000 to start the restaurant. Gaurav on the other hand spent his
money on purchasing a car worth `10, 00,000 and put the rest in
his bank account. The restaurant has since been in operation for
the last 5 years. The following information about Amita’s restau-
rant is provided:
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2013
Jan 1: Amita purchased the secret recipe from Gaurav for `10,
00,000
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Jan 12: Amita started the restaurant with cash `12, 00,000 and fur-
niture `4, 00,000.
Jan 15: She purchased utensils, crockery, gas stoves, etc. on credit
worth `6, 00,000 from Aggarwal Associates.
Jan 8: Sold soup for cash worth `60,000.
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Jan 16: Sold soup on credit to another small restaurant, Foodie

for `50,000
Jan 20: Cash received from the Foodie `49,000 in full settlement
of their account.
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questions
1. Suppose you are one of the accountants in the Amita’s

restaurant. Use the above information to prepare ledgers
and trial balance for January, 2013.
(Hint: Prepare ledgers for cash, furniture, purchase, sales,
etc. and from these prepare a trial balance by balancing
the debit entries against the credit entries.)
2. Given the income Amita has made out of her new
restaurant, do you think it is a good decision when
compared to her brother’s decision of spending the money
on a car and saving the rest in a bank.
(Hint: Prepare an income statement from the trial balance
and see the gross profit/loss to assess Amita’s situation. A
bank savings account would only provide a fixed return
of approximately 3.50% to 4 % p.a. while Amita has the
opportunity to grow and earn more from her new start-up.)

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M
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Ch a
4 p t er
Accounting Standards I
CONTENTS
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4.1 Introduction
4.2 Accounting Standards
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4.2.1 Types of Accounting Standards
4.2.2 Applicability of Accounting Standards
4.2.3 Objectives and Scope of Accounting Standards
Activity
4.3 Constitution of the Accounting Standards Board of India
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Activity
4.4 Procedure of Issuing Accounting Standards
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Activity
4.5 Compliance with Accounting Standards
Activity
4.6 Summary

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Supreme Court Highlights Accounting Standards
There has been a paradigm shift in the Indian economy in the last
two decades. This led to the announcement of several accounting
standards. Accounting standards were formulated with the view
of harmonising various accounting policies and treatment across
a section of business. The objective is to reduce flexibility in the
norms of preparation of financial accounts and ensure compara-
bility of financial statements.
In a landmark case, the Supreme Court in Challapalli Sugar’s case

approves adoption of accounting standards for interpretation of
terms not defined in the Income Tax Law. In 2008, the Supreme
Court upheld the constitutional validity of AS 22 (“Accounting for
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Taxes on Income”) on deferred tax accounting within the frame-
work of the Constitution. The apex court rendered the decision
that the deferred tax liability is nothing but accrual of tax due
to a divergence between accounting and taxable profits. In the
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Woodward Governor`s case, the apex court affirmed the decision
of the Delhi HC for deducting revenue expenditure resulting from
liability due to foreign exchange rates.
With the growing number of accounting standards in the past

years, the complexities are bound to grow in Indian companies as
the Indian accounting system commits itself to align to the inter-
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national standards. Most provisions of accounting standards are

being subject to a matter of controversy. There is a need of estab-
lishing consistency across accounting principles and various tax
laws.
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Accounting Standards I 107
n o t e s
learning objectives

> Describe the meaning, objectives and scope of accounting
standards
> Discuss the constitution of Accounting Standards Board in
India
> Describe the procedure of issuing accounting standards
> Explain the need for compliance with accounting standards
4.1 INTRODUCTION
In the previous chapter, you studied about trial balance, rectification
S
of errors and final accounts. Now, let us move forward and study about
accounting standards.
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The financial statements prepared by an organisation are accessed and
used by a diverse range of users. These users include various stake-
holders, such as the owners, investors and the government. There-
fore, it is absolutely essential that the different users of accounting
information interpret the accounting standards in the similar manner.
Therefore, uniformity needs to be maintained in the preparation of
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the financial statements. This necessitates the formulation and setting

up of the various standards. These standards make the accounting
information meaningful, reliable and comparable. The standards are
set by various regulatory bodies. Some of these bodies are Interna-
tional Accounting Standards Board (IASB), the Financial Accounting
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Standards Board (FASB), and the Institute of Chartered Accountant

of India (ICAI).
The main objective of setting accounting standards is to standardise

various diverse accounting policies and practices. A committee named
International Accounting Standards Committee is formed to formu-
late, publish and promote the use of accounting standards worldwide.
In India, the Companies Act, 2013 makes it compulsory for manage-
ment and auditors to explicitly state whether accounting standards
have been followed in preparing the statements or not.
4.2 ACCOUNTING STANDARDS

In simple words, we can define accounting standards as the written
statements regularly issued by accounting institutes. The standards
are used to consolidate the various accounting principles that are gen-
erally accepted. In addition, a set of guidelines are followed to prepare
and present the financial statements. This helps in bringing consis-

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tency in the reporting of accounting information. Under the Compa-

nies Act, 2013, the Central Government prescribed accounting stan-
dards along with the National Advisory Committee on Accounting
Standards (NACAS). NACAS was created as a body of experts which
include representatives of several regulatory groups and government
agencies. It was engaged in the practice of examining the Accounting
Standards prepared by the Institute of Chartered Accountants of In-
dia (ICAI) to be used by Indian corporates.
The Institute of Chartered Accountant of India (ICAI) established Ac-

counting Standards Board (ASB) in 1977 in order to develop account-
ing standards. They notified 28 Accounting Standards (AS 1 to 7 and
AS 9 to 29) in December 2006 in the form of Companies (Accounting
Standard) Rules, 2006 as per recommendations received from NACAS.
These Accounting Standards became applicable with effect from fi-
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nancial year 2007-08. The main purpose of ASB is to develop stan-
dards in the areas in which uniformity is required. The accounting
standards can be compared with a “lighthouse” which offers guidance
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and a disciplined path for the preparation of financial statements.
However, now that the NACAS is no longer in action after applicabil-

ity of section 132 of the Companies act 2013, which deals with NFRA.
National Financial Reporting Authority (NFRA) was constituted un-
der the Section 132 of Companies Act 2013 and it is a regulatory au-
thority (quasi- judicial body) that holds various regulatory powers
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such as providing recommendation, compliance and enforcement for

accounting standards, auditing standards and inspection of auditors.
As per the Section 133 of The Companies Act, 2013, the union gov-
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ernment prescribes that a company must follow accounting standards

recommended by The Institute of Charted Accountants of India in
consultation with National Financial Reporting Authority. These ac-
counting standards are mentioned in the Section 3 of The Chartered
Accountants Act, 1949.
A large group of individual accounting standards, accounting princi-

ples, fundamental accounting assumptions, common concepts, guid-
ance notes, the Companies Act and ICAI’s pronouncements are col-
lectively known as “The Generally Accepted Accounting Principles”
(popularly termed as “G.A.A.P.”) The common set of accounting stan-
dards and procedures that Indian corporates follow to compile their
financial statements is termed as ‘Indian GAAP’. Indian GAAP is an
arrangement of authoritative standards and commonly accepted ways
of recording and reporting accounting information by Indian corpo-
rates. You will study about the Indian GAAP and its inclusions in de-
tail in Chapter 6.

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It is important to follow Accounting Standards because of the follow-

ing reasons:
It acts as a framework to produce reliable and standardised finan-
cial statements.
It promotes proper and timely dissemination of financial infor-
mation to the management, investors and other interested parties
and creates a sense of confidence among them.
It ensures transparency, consistency and comparability of account-
ing information by providing uniformity in accounting practices as
the accountants and the auditors follow the same rules and proce-
dures.
It considers the business and legal environment of a country.
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It ensures uniformity in accounts in all types of businesses irre-
spective of their industry and size.
It provides flexibility by facilitating an organisation to freely adopt
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any of the practices with a suitable disclosure.
4.2.1 TYPES OF ACCOUNTING STANDARDS
So far, the ICAI has issued 31 accounting standards. These ac-

counting standards are mandatory for the preparation and mainte-
nance of accounts. These are obligatory for the members of all the
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institutes. The accounting standards are shown in the following

Table 4.1:
Table 4.1: Accounting Standards

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AS Number Title
AS-1 Disclosure of Accounting Policies
AS-2 Valuation of Inventories (revised )
AS-3 Cash Flow Statements (revised)
AS-4 Contingencies and Events Occurring After the Bal-
ance Sheet Date (revised)
AS-5 Net Profit or Loss for the period, Prior Period Items
and extraordinary items and changes in accounting
policies
AS-6 Depreciation Accounting (revised)
AS-7 Accounting for Construction Contracts
AS-9 Revenue Recognition
AS-10 Accounting for Fixed Assets
AS-11 Accounting for the Effect of Changes in Foreign Ex-
change Rates (revised)
AS-12 Accounting for Government Grants

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Table 4.1: Accounting Standards

AS Number Title
AS-13 Accounting for Investments
AS-14 Accounting for Amalgamations
AS-15 Accounting for Retirement Benefits in the Financial
Statements of Employers
AS-16 Borrowing Costs
AS-17 Segment Reporting
AS-18 Related Party Disclosure
AS-19 Leases
AS-20 Earnings Per Share
AS-21 Consolidated Financial Statements
AS-22 Accounting for Taxes on Income
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AS-23 Accounting for Investments in Associates in Consoli-
dated Financial Statements
AS-24 Discounting Operations
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AS-25 Interim Financial Reporting
AS-26 Intangible Assets
AS-27 Financial Reporting of Interests in Joint Ventures
AS-28 Impairment of Assets
AS-29 Provisions, Contingent Liabilities and Contingent
Assets
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Source: http://www.icai.org/post.html?post_id=474
note
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At present there are 29 accounting standards are applicable in In-

dia and these accounting standards (AS) are issued by ICAI.
4.2.2 APPLICABILITY of Accounting Standards
For the purpose of relaxation to the Small and Medium sized Enter-
prises (SMEs), the ICAI have notified in October, 2003 certain relax-
ation in the applicability of accounting standards after due consider-
ation of the representations from various professionals and advisors.
For the purpose of applicability of accounting standards, enterprises
are classified into the following:
Level I Enterprise: These include either of the following:
Enterprise whose equity or debt securities are listed whether
in India or outside India.
Enterprises, which are in the process of listing their equity or
debt securities as evidenced by the board of directors’ resolu-
tion in this regard.

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Banks including co-operative banks.

Financial institutions.
Enterprises carrying on insurance business
All commercial, industrial and business reporting enterpris-
es, whose turnover for the immediately preceding accounting
period on the basis of audited financial statements exceeds
`50 crores. Turnover does not include ‘other income’.
All commercial, industrial and business reporting enterprise
having borrowings, including public deposits, in excess of
`10 crores at any time during the accounting period.
Holding and subsidiary enterprise of any one of the above at
any time during the accounting period.
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Level II Enterprise: These include either of the following:
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es, whose turnover for the immediately preceding accounting
period on the basis of audited financial statements exceeds
`40 lakhs but does not exceed `50 crores. Turnover does not
include ‘other income’.
es having borrowings, including public deposits, in excess of
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`1 crore but not in excess of `10 crores at any time during the
accounting period.
Level III Enterprise: Enterprises, which are not covered under
Level I and Level II, are considered as Level III enterprises.
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4.2.3 OBJECTIVES AND SCOPE OF

ACCOUNTING STANDARDS
The main aim of accounting standards is to enhance the quality of

financial statements and remove various alternative methods and pol-
icies of accounting. Accounting standards enable uniformity in the
preparation and reporting of general purpose financial statements for
the benefit of shareholders, creditors, employees, etc.
Accounting standards are consistent with the provisions of the law

and are thus, extremely useful to the investors and other external par-
ties interested in assessing the progress of different companies for the
purpose of investment. In other words, the standards ensure unifor-
mity in accounting.
Some of the objectives of the accounting standards are as follows:

Improves the credibility and reliability of the financial state-
ments: Accounting standards improves the reliability of the finan-
cial statements by providing a common framework of accounting.

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Determines managerial accountability: It implies that the ac-

counting standards determine the regulations and corporate ac-
countability, which helps to assess the managerial skills in main-
taining and improving the profitability, liquidity and solvency.
Assists accountants and auditors: It refers to the instructions
that the accounting professionals get through these accounting
standards, which help them to prepare and audit the financial
statements appropriately. In case of financial reporting issues, an
accountant may refer to the published accounting standard to in-
terpret on how to record the transactions.
Enables ease of understanding: Accounting standards specify
the processes and formats to be followed by organisations in pre-
paring and reporting their financial statements. Users of financial
statements depend on the assumptions set forth by the accounting
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standards while interpreting the reported figures. Once users be-
come accustomed to these assumptions, they may use this knowl-
edge to interpret the financial statements of different organisa-
tions with ease.
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In its Preface to the Statements of Accounting Standards, the ASB
has outlined the scope of accounting standards. These are as follows:
Efforts will be made to issue Accounting Standards which are in
conformity with the provisions of the applicable laws, customs, us-
ages and business environment in India. However, if a particular
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Accounting Standard is found to be not in conformity with law, the

provisions of the said law will prevail and the financial statements
should be prepared in conformity with such law.
The Accounting Standards by their very nature cannot and do not
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override the local regulations which govern the preparation and

presentation of financial statements in the country. However, the
ICAI will determine the extent of disclosure to be made in finan-
cial statements and the auditor’s report thereon. Such disclosure
may be by way of appropriate notes explaining the treatment of
particular items. Such explanatory notes will be only in the nature
of clarification and therefore need not be treated as adverse com-
ments on the related financial statements.
The Accounting Standards are intended to apply only to items
which are material. Any limitations with regard to the applicability
of a specific Accounting Standard will be made clear by the ICAI
from time- to- time. The date on which a particular standard will
come into effect, as well as the class of enterprises to which it will
apply, will also be specified by the ICAI. However, no standard will
have retroactive application, unless otherwise stated.

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The Institute will use its best endeavours to persuade the govern-
ment, appropriate authorities, industrial and business community
to adopt the Accounting Standards in order to achieve uniformity
in preparation and presentation of financial statements.
In formulation of Accounting Standards, the emphasis would be
on laying down accounting principles and not detailed rules for
application and implementation thereof.
The standards formulated by the ASB include paragraphs in bold
italic type and plain type, which have equal authority. Paragraphs
in bold italic type indicate the main principles. An individual stan-
dard should be read in the context of the objective stated in that
standard and this preface.
The ASB may consider any issue requiring interpretation on any
Accounting Standard. Interpretations will be issued under the au-
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thority of the council. The authority of interpretation is the same
as that of Accounting Standard to which it relates.
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1. Under the Companies Act, 2013, __________ has been replaced

by National Financial Reporting Authority (NFRA)?
(a) National Advisory Committee on Accounting Standards
(NACAS)
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(b) Institute of Chartered Accountants of India (ICAI)

(c) Accounting Standards Board (ASB)
(d) Accounting Regulatory Board of India (ARBI)
N
2. Accounting standards are mentioned in the __________of The

Chartered Accountants Act, 1949.
(a) Section 10 (C)
(b) Schedule II of Section 10
(c) Section 3
(d) Section 23 (A)
3. According to the Companies Act, 2013, common set of
accounting standards and procedures that Indian corporates
follow to compile their financial statements is termed as
____________.
(a) Indian Accounting Standards (Ind AS)
(b) Accounting Standards (AS)
(c) International Financial Reporting Standards (IFRS)
(d) Generally Accepted Accounting Principles (GAAP)

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4. ASB has outlined the scope of accounting standards in its

______________.
(a) Preface to the Statements of Accounting Standards
Acknowledgement to the Statements of Accounting
(b)
Standards
(c) Bibliography to the Statements of Accounting Standards
(d) Abstract to the Statements of Accounting Standards
Activity
Make a list of countries that mandate the use of GAAP for prepa-
ration and reporting of the financial statements of their corporate
bodies.
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CONSTITUTION OF the ACCOUNTING
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4.3
STANDARDS BOARD of INDIA
In India, the Accounting Standards are issued by the Council of the
ICAI. ICAI set up the Accounting Standards Board in the year 1977.
The ASB has also been assigned with the responsibility to propagate
the Accounting Standards and persuade the corporations to adopt
M
them in the preparation and presentation of their financial state-

ments. The ASB provides guidance on issues arising from Accounting
Standards. The main objective of the ASB is to consolidate the diverse
accounting practices followed in the country. This takes into consid-
eration various applicable laws, customs, usages and the business en-
N
vironment.
Following are the main functions of the ASB:

To conceive of and suggest areas in which Accounting Standards
need to be developed.
To formulate Accounting Standards with a view to assisting the
Council of the ICAI in evolving and establishing Accounting Stan-
dards in India.
To examine how far the relevant International Accounting Stan-
dard/International Financial Reporting Standard can be adapted
while formulating the Accounting Standard and to adapt the same.
To review, at regular intervals, the Accounting Standards from the
point of view of acceptance or changed conditions, and, if neces-
sary, revise the same.
To provide, from time- to- time, interpretations and guidance on
Accounting Standards.

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To carry out such other functions relating to Accounting Stan-

dards.
The ICAI, being a member of the International Federation of Accoun-

tants (IFAC), is expected to promote the International Accounting
Standards Board’s (IASB) announcements in India in order to facil-
itate global harmonisation of accounting standards. Consequently,
while formulating the Accounting Standards, the ASB has given due
consideration to International Accounting Standards (IAS) issued
by the International Accounting Standards Committee and has inte-
grated them in the lights of the prevailing conditions and practices in
India.
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5. In India, the Accounting Standards are issued by the Council
of the_________.
(a) Institute of Chartered Accountants of India (ICAI)
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(b) National Advisory Committee on Accounting Standards
(NACAS)
(c) National Financial Reporting Authority (NFRA)
6. __________ formulates Accounting Standards with a view to
M
assist the Council of the ICAI in evolving and establishing

Accounting Standards in India.
(a) Ministry of Corporate Affairs (MCA)
(b) Accounting Standards Board (ASB)
N
(c) Finance secretory

7. ICAI is a member of the _______.
(a) The International Federation of Accountants (IFAC)
(b) South Asian Federation of Accountants (SAFA)
(c) Confederation of Asian and Pacific Accountants (CAPA)
(d) All of the above
Activity
The Accounting Standards of each country are different. Find out

and list the factors that are responsible for the variation in Account-
ing Standards followed by different countries.

n o t e s
PROCEDURE OF ISSUING ACCOUNTING

4.4
STANDARDS
Following are the steps involved in the formulation of accounting
standards of Accounting Standard Board (ASB):
Determining broad accounting standards and listing them accord-
ing to a priority.
Seeking helps from various professional groups for setting the
standards. These groups draft the preliminary standards as as-
signed to them. The draft is then reviewed by the ASB, which in
turn sends it to various associates and bodies. Some of these busi-
ness associates and bodies include Federation of Indian Chambers
of Commerce and Industry (FICCI), Company Law Board (CLB),
S
Institute of Cost and Works Accountants of India (ICWAI), Insti-
tute of Company Secretaries of India (ICSI), and Central Board of
Direct Taxes (CBDT). The representatives of these bodies are also
invited at a meeting of the ASB for discussion.
IM
Issuing the exposure draft in order to invite comments from the
members of institutes and public at large. Next, the draft is pub-
lished in the journal of the institute. Following are the basic points
of the exposure draft:
a. Comprises a statement of concepts and fundamental account-
M
ing principles related to the standards

b. Include the definition of the terms used in the standards
Involves the manner in which the accounting principles have been
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applied for formulating the standards

a. Include the presentation and disclosure requirements in
complying with the standards
b. Consist of the class of organisation to which the standards
would apply
c. Include the date from which the standards would be effective
Reviewing the comments of the exposure draft and prepare a final
draft to the council of institutes.
The council of the institute would consider the final draft of the
standards. The modification of the draft (if required) is done in
consultation with the ASB. After that, the council issues the stan-
dards in their final form, under its authority.

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Figure 4.1 shows the sequence of the procedure for issuing accounting
standards in India:
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Figure 4.1: Standard Setting Procedure of the Accounting

Standards Board
Source: http://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=194
8. National Financial Reporting Authority (NFRA) was

constituted under the _________of Companies Act 2013.
(a) Section 112 (C)
(b) Schedule II of Section 119
(c) Section 132
(d) Section 23 (A)

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9. The exposure draft is sent to more than _______institutes for

comments.
(a) 300
(b) 450
(c) 600
(d) 650
10. The modification of the draft is done in consultation with
the________.
(a) Accounting Standard Board
(b) National Financial Reporting Authority (NFRA)
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Activity
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Visit the website of ICAI and list the Accounting Standards that are
currently under revision status by the Accounting Standards Board.
COMPLIANCE WITH ACCOUNTING

4.5
STANDARDS
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On February 16, 2015, Ministry of Corporate Affairs (MCA) issued a

notification to prescribe that a company have to comply with Indian
Accounting Standards (Ind AS) mentioned under the Rule 4 of Com-
panies (Indian Accounting Standards) Rules, 2015 in preparation of
N
financial statements. Compliance with accounting standard is crucial

in financial and management accounting.
However, the Rule 4 mentioned above is obligatory and mandatory for

a company that falls under following criteria:
Any listed or non-listed company having net worth of more than
`500 crore.
Any company whose parent company, subsidiary, associates or
joint venture falls under the above criteria.
In case the standards are not followed, different stakeholders would

interpret the accounting statements in different ways. In addition, the
financial statements of different companies cannot be compared if the
statements are not in compliance with the accounting standards.
The Council of ICAI lays down the following points in its Preface to
the Statements of Accounting Standards:
The Accounting Standards would be mandatory from the respec-
tive dates stated in the Accounting Standards. The mandatory sta-

n o t e s
tus of an Accounting Standard indicates that while settling their

attest functions, it would be the duty of the members of the ICAI to
inspect whether the Accounting Standard conforms to the presen-
tation of financial statements enclosed in their audit. In the event
of any deviation from the Accounting Standard, it would be their
duty to prepare adequate disclosures in their audit reports so that
the users of financial statements may be aware of such deviation.
Ensuring compliance with the Accounting Standards while mak-
ing the financial statements is the responsibility of the manage-
ment of the corporate. Statutes governing certain enterprises re-
quire that the financial statements are prepared in compliance
with the Accounting Standards.
Financial Statements cannot be described as complying with the
Accounting Standards unless they comply with all the require-
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ments of each applicable standard.

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11. Indian Accounting Standards (Ind AS) mentioned under the
_________of Companies (Indian Accounting Standards) Rules,
2015
(a) Section 12
(b) Section 17
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(c) Rule 4
(d) Rule 7
12. The financial statements of different companies cannot
be compared if the statements are not in compliance with
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the_____________.
(a) Indian Accounting Standards
(b) Rules of Posting
(c) Financial Statement Preparation Rules
13. The mandate for compliance with Accounting Standards by
Indian corporates has been outlined by the ________________.
(a) Institute of Charted Accountants of India (ICAI)
(b) International Financial Reporting Standards (IFRS)
(c) National Financial Reporting Authority (NFRA)

n o t e s
14. Rule 4 is mandatory for any listed or non-listed company

having net worth of more than_________.
`2000 crore
(a)
`1500 crore
(b)
`1000 crore
(c)
(d)
`500 crore
Activity
Visit the website of ICAI and note the manner of making a disclo-
sure in the audit report in the case of non-compliance with any of
the accounting standards. Present your findings in a brief note.
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4.6 SUMMARY
The financial statements prepared by an organisation are accessed
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and used by a diverse range of users. The users include various
stakeholders, such as the owners, investors, and the government.
In simple words, we can define accounting standards as the writ-
ten statements regularly issued by accounting institutes. The stan-
dards are used to consolidate the various accounting principles
that are generally accepted.
M
The main aim of the accounting standards is improving the quality

of the financial statements and removing various alternative meth-
ods and policies of accounting.
So far, the ICAI has issued 31 accounting standards. These ac-
N
counting standards are mandatory for the preparation and main-

tenance of accounts.
The main aim of accounting standards is to improve the quality of
financial statements and remove various alternative methods and
policies of accounting.
Some of the important functions of the accounting standards are
improving the credibility and reliability of the financial statements,
determining managerial accountability, and assisting accountants
and auditors.
In any country, the accounting standards consist of a number of
set guidelines that provides a system of recording transactions and
preparing financial reports. In India, ICAI is the national account-
ing body that set accounting guidelines for companies. ICAI set up
the ASB in the year 1977.
The common set of accounting standards and procedures that
Indian corporates follow to compile their financial statements is
termed as ‘Indian GAAP’.

n o t e s
The participation of various interested professionals is very cru-

cial for the formulation of accounting standards.
Based on the received comments, draft for accounting standard
is prepared which is forwarded to the Council of ICAI for their
approval.
The Council of ICAI can modify the draft in consultation with ASB
and finally issue the accounting standard.
Compliance with the accounting standard is very important in fi-
nancial and management accounting.
The Council of ICAI lays down the points for compliance to Ac-
counting Standards in its Preface to the Statements of Accounting
Standards.
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key words
Consolidated Financial Statements: The financial statements

of a corporate group in which assets, liabilities, equity, income,
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expenses, cash flows of the parent organisation and its subsid-
iaries are presented as those of a single entity.
Disclosures: Additional information attached to an organisa-
tion’s financial statements generally as an explanation for ac-
tivities which have significantly influenced the organisation’s
financial results.
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Financial disclosure: The formal publishing of the financial in-

formation of a company in a standard form.
Turnover: An organisation’s annual sales volume net of all dis-
counts and sales taxes.
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1. What do you mean by accounting standards? Describe.
2. Describe the applicability of Accounting Standards.
3. Discuss the scope of Accounting Standards as outlined by ICAI
in its Preface to the Statements of Accounting Standards.
4. Write a note on the constitution of the Accounting Standards
Board in India.
5. What is the procedure of issuing Accounting Standards?
6. Discuss the provisions under compliance with accounting
standards laid down by ICAI.
7. What are the main objectives of issuing Accounting Standards?

n o t e s

Accounting Standards 1. a. National Advisory Commit-
tee on Accounting Standards
(NACAS)
2. c. Section 3
3. a. Indian Accounting Standards
(Ind AS)
4. a. Preface to the Statements of
Accounting Standards
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Constitution of the 5. True
Accounting Standards 5. d. Both (a) and (c)
Board of India
IM 6. b. Accounting Standards Board
(ASB)
Procedure of Issuing Ac- 8. c. Section 132
counting Standards
9. a. 300
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Compliance with 12. False
Accounting Standards 11. c. Rule 4
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12. a. Indian Accounting Standards

13. d. Both (a) and (b)
14. d. `500 crore

1. In simple words, we can define accounting standards as the
written statements regularly issue by accounting institutes.
Refer to Section 4.2 Accounting Standards.
2. For the purpose of applicability of accounting standards,
enterprises are classified into Level I, Level II and Level III
enterprises. Refer to Section 4.2 Accounting Standards.
3. In its Preface to the Statements of Accounting Standards, ASB
has outlined the scope of accounting standards. Refer to Section
4.2 Accounting Standards.
4. ICAI set up the Accounting Standards Board in the year 1977.

n o t e s
5. Suggestions in the form of drafts for accounting standard are

received from various professionals, etc. by the ICAI. The Council
of ICAI can modify the draft in consultation with ASB and finally
issue the accounting standard. Refer to Section 4.4 Procedure of
Issuing Accounting Standards.
6. The Council of ICAI lays down the points for compliance with
Accounting Standards in its Preface to the Statements of
Accounting Standards. Refer to Section 4.5 Compliance with
Accounting Standards.
7. Some of the main objectives of issuing accounting standards are
that they improve the credibility and reliability of the financial
statements, determine managerial accountability, assist
accountants and auditors and enable ease of understanding.
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4.9 SUGGESTED Readings & References
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SUGGESTED READINGS
Bhattacharyya, A. (2006). Indian Accounting Standards: Practices,
Comparisons, and Interpretations (2nd ed., pp. 4.1-4.5). Delhi: Tata
McGraw Hill.
Chowdhury, A. (2007). Fundamentals of Accounting and Financial
M
Analysis (For U.P.T.U.) (1st ed., pp. 31-39). Delhi: Dorling Kinders-
ley.
Rajasekaran, V., & Lalitha, R. (2011). Financial Accounting (1st ed.,
pp. 30-37). Delhi: Dorling Kindersley.
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E-REFERENCES
My Accounting Course. (2014). GAAP | Accounting Principles and
Objectives. Retrieved from, http://www.myaccountingcourse.com/
accounting-principles/generally-accepted-accounting-principles
Objectives of Accounting - The Accounting Concept. (2014).
Boundless. Retrieved from, https://www.boundless.com/account-
ing/textbooks/boundless-accounting-textbook/introduction-to-ac-
counting-1/the-accounting-concept-18/objectives-of-account-
ing-114-1525/
Rbi.org.in.
(2014). Reserve Bank of India. Retrieved from, http://
www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=194
Saralaccounts.com. (2014). Accounting Standards. Retrieved from,
http://www.saralaccounts.com/resources/accounting-std.php

Case study
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COLLAPSE OF LEHMAN BROTHERS
Lehman Brothers Holdings Incorporation was founded in 1850 by

Mr. Henry Lehman, Mr. Emanuel Lehman and Mayer Lehman in
Montgomery, Alabama, United States. At the time of Bankruptcy
in 2008 it was the fourth largest investment bank in the US. The
company has good market coverage with a diverse set of areas in
banking and financial services such as investment banking, mer-
chant banking, equity sales and trading, research, private equity,
etc. and it was a primary dealer of US Treasury securities market.
Before bankruptcy Lehman Brothers was a company that sur-
vived from big incidents in history, such as, The Great Depression
(1930), World War I, World War II, Capital shortage in 1994. At that
time Lehman Brothers’ had many subsidiaries such as, Lehman
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brothers to Aurora Loan Services Inc., SIB Mortgage. Its head-
quarters were in New York along with regional Headquarters in
London (UK) and Tokyo (Japan).
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During 2003 and 2004 (period of housing bubble), Lehman Broth-
ers received five mortgage lenders such as, BNC Mortgage and
Aurora Loan services, which provides loans without complete
documentation. Lehman brothers had invested huge amount of
funds in property market and the decline in real estate prices
pushes Lehman Brothers to bankruptcy. At the same time com-
pany had manipulated many of accounting principles.
M
The top executives and auditors (E & Y) at Lehman are the main
players in the scandal and they uses Repo 105 scheme to manip-
ulate various accounting rules. Repo 105 is an accounting trick
which works as repurchase agreement and this trick allows com-
N
panies to show its short term loans as sales. It is an exchange pro-

cess which is based on collateral and as per the agreement a com-
pany borrows funds with a promise to pay back within a given
period of time. In simple words, securities are sold with a promise
to buy back later. It was reported that Lehman accountants are
using this trick to reduce leverage liabilities in the balance sheet
before the earnings were announced. It created an image that
Lehman was less reliable on debts. By using Repo 105, they were
hiding debt of over UD $ 50 billion and showcase it as sales. Leh-
man sold toxic assets to Cayman Island banks under repurchase
agreement of Repo 105 schemes. In other words, Lehman showed
its toxic assets as sales instead of recording them as debt. In this
manner they are creating an impression that they had more than
US $ 50 billion in cash and equitant and at the same time US $ 50
billion less in toxic assets.
Lehman Brother’s filed Chapter 11 of the US bankruptcy code
on September 15, 2008 for the total amount of more than US $
639 billion in assets (largest in US history) and as a result Down

Case study
n o t e s
Jones Index closed with 500 points falls in a single day trading.
On the next day, September 16, 2008, Barclays, announced to ac-
quire Lehman Brothers Holdings. However, the Securities and
Exchange Commission did not initiate the process due to the lack
of evidence.
In March 2010, the committee appointed by the US Federal court
submitted its report. This report described that at the end of each
quarter Lehman’s top decision makers had used many fraud ac-
counting tricks to make its financial position more attractive. As
per the federal law, Lehman was not allowed to get lawyers in the
USA for the closing of the real deal with outsiders. So, they did it
through British Subsidiary, which comes under the British legal
system. The investigators commented that if Lehman remained
in the US only, using the US accounting laws, it would fail in the
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scheme. In the same manner if the firm had followed Internation-
al accounting rules, it would also fail.
questions
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1. Discuss some of the measures to reduce the risk of frauds
in context with financial accounting.
(Hint: Consider some measures such as, employee’s
backgrounds, set up reporting system and
communicate them to employees, internal controls, take
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recommendations from external expertise, etc.)

2. Suppose you are the manager at the company which
invested huge amount of funds in an investment bank,
then how would you measure its credit worthiness?
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(Hint: Analyse the information related to repayment

history and credit score.)
3. Discuss whether Repo 105 is offensive or not. Why?
(Hint: Search on the internet regarding the applicability
of Repo 105.)

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Ch a
5 p t er
Accounting Standards II
CONTENTS
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5.1 Introduction
5.2 Implementation of Accounting Standards
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Activity
5.3 Financial Statements Reporting
5.3.1 Accounting Standards: 1 and 2
5.3.2 Accounting Standards: 4 and 5
5.3.3 Accounting Standards: 9, 10, 16 and 26
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5.3.4 Accounting Standards: 13, 17 and 20

5.3.5 Situational Applicability of Accounting Standards
Activity
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5.4 Summary

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Budget 2014 proposes convergence of Indian

accounting standards with IFRS
The corporate sector in India applauded the suggestion of the

Indian Finance Minister to converge Indian Accounting (also re-
ferred to as “Ind AS”) Standards with International Accounting
Standards. This convergence has the potential to improve the fi-
nancial reporting by Indian companies. The convergence might
also help in attracting foreign capital by way of Foreign Direct
Investment (referred to as “FDI” for the sake of brevity) to the
Indian subcontinent. The possible convergence of Indian AS with
International Standards is an outcome of India’s longstanding
commitment to the G20 nations for convergence with Interna-
tional Financial Reporting Standard (IFRS). The new accounting
S
standards would be mandatory from the Financial Year 2016-17
(The word “Financial Year, hereinafter referred to as “FY” for the
sake of brevity). How
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ever, organisations may voluntarily adopt this by FY 2015-16. The
company law experts in India believe that the new accounting
standards would further strengthen the capital markets. Howev-
er, experts also assess the possibility of several challenges in the
implementation of the new accounting standards.
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IFRS would emphasise on fair value accounting, which would

make a favourable impact on a company’s profit. Although IFRS
would increase the volatility of reported earnings, it would make
the accounts of Indian companies consistent with accounting
norms followed globally.
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Source: http://economictimes.indiatimes.com/industry/services/consultancy-/-audit/
budget-2014-proposes-convergence-of-indian-accounting-standards-with-ifrs/article-
show/38140064.cms

Accounting Standards II 129
n o t e s
learning objectives

> Discuss the implementation of the Accounting Standards
> Describe various Accounting Standards
5.1 INTRODUCTION
In the previous chapter, you studied various accounting standards fol-
lowed in India. Now, let us move forward and study about these stan-
dards in detail.
In April 1977, Accounting Standard Board (ASB) was formed by the
S
Council of Institutes of Charted Accountants of India (ICAI). ASB is
responsible for the development of accounting standards in India.
The standards are formulated in consultation with the members and
various institutions.
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Accounting standards are those set of principles that work as a bench-
mark for accounting practices and financial reporting. Accounting
standards determine rules to record various events (or transactions)
occurred in organisations.
Recently, there have been efforts to conform the Indian Accounting

M
Standards to the international reporting standards. Implementing ac-

counting standards is a challenge for the ICAI. It constitutes a com-
mittee in order to facilitate implementation of the accounting stan-
dards. The committee provides feedback to the ICAI regarding the
N
implementation issues.
International Financial Reporting Standards (IFRS) standards are

maintained by the IFRS foundation and these standards provide var-
ious measures to increase global adaptation of generally accepted ac-
counting principles. IFRS also ensure transparency, accountability
and efficiency in financial markets across the globe.
On February 25, 2011, the Ministry of Corporate Affairs notified a

press release stating that the convergence of Indian accounting stan-
dard with IFRS in a phased manner to ensure smooth and effective
implementation. As per the process, 35 accounting standards were
converged with the IFRS. This was emerged because of the need of
having uniform accounting standards across the globe. Uniform ac-
counting standards are must in this era of globalisation when Indian
companies are acquiring companies across borders and on the other
hand foreign multinational companies are establishing subsidiaries in
India. So it will make financial reporting more transparent and com-

n o t e s
parable. The list of various Indian accounting standards (Ind AS) pre-
scribed by the ICAI given below:
1. Ind AS 101 First-time Adoption of Indian Accounting Standards
2. Ind AS 102 Share based Payment
3. Ind AS 103 Business Combinations
4. Ind AS 104 Insurance Contracts
5. Ind AS 105 Non current Assets Held for Sale and Discontinued
Operations
6. Ind AS 106 Exploration for and Evaluation of Mineral Resources
7. Ind AS 107 Financial Instruments: Disclosures
8. Ind AS 108 Operating Segments
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9. Ind AS 1 Presentation of Financial Statements
10. Ind AS 2 Inventories
11. Ind AS 7 Statement of Cash Flows
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12. Ind AS 8 Accounting Policies, Changes in Accounting Estimates
and Errors
13. Ind AS 10 Events after the Reporting Period
14. Ind AS 11 Construction Contracts
15. Ind AS 12 Income Taxes
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16. Ind AS 16 Property, Plant and Equipment

17. Ind AS 17 Leases
18. Ind AS 18 Revenue
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19. Ind AS 19 Employee Benefits

20. Ind AS 20 Accounting for Government Grants and Disclosure of
Government Assistance
21. Ind AS 21 The Effects of Changes in Foreign Exchange Rates
22. Ind AS 23 Borrowing Costs
23. Ind AS 24 Related Party Disclosures
24. Ind AS 27 Consolidated and Separate Financial Statements
25. Ind AS 28 Investments in Associates
26. Ind AS 29 Financial Reporting in Hyperinflationary Economies
27. Ind AS 31 Interests in Joint Ventures
28. Ind AS 32 Financial Instruments: Presentation
29. Ind AS 33 Earnings per Share
30. Ind AS 34 Interim Financial Reporting

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31. Ind AS 36 Impairment of Assets

32. Ind AS 37 Provisions, Contingent Liabilities and Contingent
Assets
33. Ind AS 38 Intangible Assets
34. Ind AS 39 Financial Instruments: Recognition and Measurement
35. Ind AS 40 Investment Property
Currently, the government and other parties involved are taking var-
ious measures to integrate the Indian accounting standards with the
global accounting standards and the International Financial Report-
ing Standards (IFRS). This will help in better aligning the Indian cap-
ital markets with the international markets. In addition, this will help
the market participants by way of giving them more reliable market
information.
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In this chapter, you will study the implementation of the accounting
standards in India. In addition, the unit discusses about the reporting
of financial statements based on various accounting standards.
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IMPLEMENTATION OF ACCOUNTING
5.2
STANDARDS
Proper implementation of accounting standards by Indian enterprises
implies that the financial statements and disclosures of the enterpris-
M
es are prepared by complying with the accounting standards issued

by the Council of ICAI. Implementation of accounting standards is the
responsibility of the Board of Directors in an enterprise. According to
the Clause (c) of Sub-section (3) of Companies Act, 2013, a Director’s
Responsibility Statement would state the following:
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a. That the annual accounts have been prepared in compliance with

the applicable accounting standards with proper explanation
regarding material departures.
b. That the directors had selected accounting policies and applied
them consistently. They made judgements and assessments that
are reasonable and prudent so as to provide a true and fair view
of the state of affairs of an enterprise at the end of the financial
year and of the profit or loss of the enterprise for that period.
c. That the directors had taken due care to maintain adequate
accounting records in accordance with the provisions of the
Companies Act to safeguard the assets of the enterprise and to
prevent and detect fraud and other irregularities.
d. That the directors had prepared the annual records of the
enterprise on a going concern basis.
This clause states that the entire responsibility for the implementa-
tion of accounting standards rests with the directors of an enterprise.
The auditor’s responsibility is restricted to form his opinion and to

n o t e s
report on the financial statements of the enterprise. Auditors need to

ensure that the accounting standards have been implemented while
preparing the financial statements. It is the auditor’s responsibility to
disclose the deviations from prescribed accounting standards in his/
her reports meant for the users.
For discharging its functions, the ASB will keep in view the purposes
and limitations of financial statements and the attest function of the
auditors.
The other functions of ASB are as follows:

The ASB will enumerate and describe the basic concept to which
accounting principles should be oriented and state the accounting
principles to which the practices and procedures should conform.
The ASB will clarify the terms commonly used in financial state-
S
ments and suggest improvements in the terminology wherever
necessary. The ASB will examine the various current alternative
practices in vogue and endeavour to eliminate or reduce alterna-
IMtives within the bounds of rationality.
Accounting Standards are designed to apply to the general pur-
pose financial statements and other financial reporting, which are
subject to the attest function of the members of the ICAI.
The term ‘General Purpose Financial Statements’ includes balance
sheet, statement of profit and loss, a cash flow statement (wherev-
M
er applicable) and statements and explanatory notes which form

part thereof, issued for the use of various stakeholders, Govern-
ments and their agencies and the public. References to financial
statements in this Preface and in the standards issued from time
to time will be construed to refer to General Purpose Financial
N
Statements.
Responsibility for the preparation of financial statements and for
adequate disclosure is that of the management of the enterprise.
The auditor’s responsibility is to form his opinion and report on
such financial statements.
One of the major developments in the implementation of accounting

standards in India is its convergence with International Financial Re-
porting Standards (IFRS). In order to accomplish these implementa-
tion objectives, an implementation committee has been constituted.
This committee would provide assistance to the members and other
stakeholders in the proper implementation of IFRS converged Indian
Accounting Standards (Ind AS). The issues faced by the committee in
the implementation of the accounting standards are forwarded to the
Council of ICAI for their consideration.

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Exhibit
Objectives of Ind AS (converged with IFRS) Implementation

Committee
To formulate Frequently Asked Questions on Indian Account-
ing Standards converged with IFRS in consultation with the
Accounting Standards Board.
To deal with industry-specific issues involved in implementa-
tion of Indian Accounting Standards converged with IFRS.
To interact with Central Government and State Governments
on issues related to implementation of Indian Accounting Stan-
dards converged with IFRS.
To interact with national and international bodies on issues in
S
implementation of Indian Accounting Standards converged
with IFRS.
To take adequate steps to enhance knowledge of the members
IM
and other stakeholders for proper implementation of Indian Ac-
counting Standards converged with IFRS by conducting work-
shops, seminars, IFRS Certificate Course in India and abroad,
and train the trainers programmes.
To develop course material for the Certificate Course and
e-learning.
M
To co-ordinate with Accounting Standards Board regarding

issues in IFRS/ Indian Accounting Standards converged with
IFRS.”
N
To co-ordinate with Direct Taxes Committee, Indirect Taxes

Committee and Corporate Laws and Corporate Governance
Committee and other committees of the Institute with regard
to various issues in IFRS/ Indian Accounting Standards con-
verged with IFRS.
To deal with any other tasks related to implementation of Indi-
an Accounting Standards converged with IFRS.
Source: http://www.icai.org/new_post.html?post_id=6985&c_id=330
1. IFRS standards are developed by the___________.

(a) IFRS Foundation
(b) IFRS Organisation
(c) International Federation of Accountants (IFAC)

n o t e s
2. The auditor’s responsibility is restricted to form his opinion

and report on the _________ of the enterprise.
(a) Balance sheet only
(b) Financial position
(c) Financial statements
(d) Financial performance
3. ___________ will enumerate and describe the basic concept
to which accounting principles should be oriented and state
accounting principles to which practices and procedures
should conform.
(a) Accounting Standards Board
(b) Accounting Standards Principles
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(c) Institute of Charted Accountants of India
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4. AS 1 deals in _____________ and is mandatory to be followed
by all enterprise.
(a) Valuation of inventories
(b) Net profit/loss for the period
(c) Disclosure of financial statements
M
(d) Depreciation accounting
Activity
N
Visit the website of ICAI. List the main items covered under the
Preface to the Statements of Accounting Standards (revised 2004).
5.3 Financial Statements Reporting

Reporting of financial statements is a major concern in accounting.
Different countries follow different standards of reporting financial
statements. The norms of financial statements reporting are manda-
torily followed by different companies in a country. Let us go through
some of the important accounting standards that deal with various
aspects of accounting and reporting of financial statements.
5.3.1 Accounting Standards: AS 1 and AS 2
Accounting Standard (AS 1): Disclosure

of Accounting Policies
The ICAI issued Accounting Standard (AS) 1 which deals with ‘Disclo-
sure of Accounting Policies’ and is a mandatory to be followed by all

n o t e s
enterprises. It mainly deals with disclosure of significant accounting

policies which are followed while preparing and presenting financial
statements.
In India, generally the accounting policies are not regularly and fully
disclosed in the financial statements. Many enterprises include some
notes in accounts, which provide a description of some of the sig-
nificant accounting policies. There is again a considerable variation
among the very few enterprise which includes a separate statement of
accounting policies on financial statements. The main objective of the
statement of accounting policies is promoting a better understanding
of the financial statements by disclosing significant accounting poli-
cies.
Following are the main aspects of AS1:
S
An enterprise should disclose all significant accounting policies
that are adopted while preparing and presenting the financial
statements: This is required because the accounting policies differ
across organisations which makes it inevitable to provide guide-
IM
lines and rules that are followed right from the recording of trans-
actions till their presentation on the financial statements. Such
disclosures should form a part of the financial statements and the
significant accounting policies should normally be disclosed in one
place.
An enterprise should disclose in case the fundamental account-
M
ing assumptions are not followed: The accounting assumptions

are Going Concern, Consistency and Accrual basis of accounting.
If all the fundamental accounting assumptions are followed while
preparing the financial statements, then specific disclosure is not
N
required. However, if any one of the fundamental accounting as-

sumptions is not followed then this fact requires a specific disclo-
sure.
An enterprise should give special consideration in selecting the
accounting policies: Some of the major considerations for the se-
lection and application of accounting policies are as follows:
Prudence: As per this concept, an enterprise should not over-
estimate the amount of revenues that are recorded nor under-
estimate the amount of expenses.
Substance over form: As per this concept, the information in
the financial statements and disclosures should reflect the un-
derlying realities of accounting transactions, rather than their
legal form.
Materiality: As per this concept, an enterprise is allowed to
ignore any accounting standard if the net impact has an insig-
nificant impact on the financial statements such that the user
of the financial statements is not misled.

n o t e s
Changes in accounting policies: As per this concept, any change

in accounting policies which might materially affect the current
period or which are expected to materially affect the later periods
are required to be disclosed.
Accounting Standard (AS 2): Valuation

of Inventories (revised 1999)
Accounting Standards (AS) 2 deal with the ‘Valuation of Inventories’.

This is a mandatory standard. Following are the main aspects of AS 2:
The objective of AS 2 is to recommend the accounting treatment

for inventories. A primary issue in accounting for inventories is the
amount of cost to be recognised as an asset and carried forward until
the related revenues are recognised. AS 2 deals with the determina-
tion of cost and its subsequent recognition as an expense, including
S
any write-down to net realisable value. It also deals with the cost for-
mulas that are used to assign costs to inventories. According to AS 2,
inventories should be measured and valued at the lower of cost and
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net realisable value.
As per AS 2 “ The cost of inventories should comprise all costs of

purchase, costs of conversion and other costs incurred in bringing the
inventories to their present location and condition “
Cost of inventories should comprise the costs shown in Figure 5.1:

M
Costs of Purchase
N
Costs of Conversion
Other Costs
Figure 5.1: Inventories Costs as per AS 2

Costs of purchase: These include the purchase price, import du-
ties and other taxes, transport, handling and other costs directly
attributable to the acquisition of finished goods, materials and ser-
vices.
Costs of conversion: The costs of conversion of inventories in-
clude costs directly related to the units of production, such as di-
rect labour. They also include a systematic allocation of fixed and
variable production overheads that are incurred in converting ma-
terials into finished goods.
Other costs: These include the cost incurred in bringing the inven-
tories to their present location and condition. For example, other

n o t e s
costs could be overheads other than production overheads or the

costs of designing products for specific customers, such costs are
included in inventories cost.
5.3.2 ACCOUNTING StandardS: as 4 and as 5
Accounting Standard 4 titled “Contingencies and Events Occurring

After the Balance Sheet Date” and Accounting Standard 5 titled “Net
Profit or Loss for the Period, Prior Period Items and Changes in Ac-
counting Policies “are mandatory standards.
Accounting Standard (AS 4): Contingencies and Events

Occurring After the Balance Sheet Date
Accounting Standard 4 (AS 4) deals with the treatment in financial
S
statements of
i. Contingencies
ii. Events occurring after the balance sheet date
IM
The following terms are used in AS 4:
Contingency: This refers to a condition or situation, the ultimate
outcome of which, gain or loss, will be known or determined only
on the occurrence, or non-occurrence, of one or more uncertain
future events.
M
Events occurring after the balance sheet date: These refer to sig-
nificant events, both favourable and unfavourable, that occur be-
tween the balance sheet date and the date on which the financial
statements are approved by the Board of Directors in the case of
N
a company, and, by the corresponding approving authority in the

case of any other entity.
Two types of events identified are as follows:

a. Events that provide further evidence of conditions that existed
at the balance sheet date; and
b. Events those are indicative of conditions that arose subsequent
to the balance sheet date.
Accounting Standard (AS 5): Net Profit/Loss for the

Period, Prior Period Items and Changes in Accounting
Policies
Accounting Standard 5 (AS 5) deals with “Net Profit/Loss for the Pe-
riod, Prior Period Items and Changes in Accounting Policies”. The
objective of AS 5 is to recommend the classification and disclosure of
certain items in the profit and loss statement so that all organisations
prepare and present the statement uniformly. This improves the com-
parability of the financial statements of an enterprise over time and

n o t e s
with the financial statements of other enterprises. The main aspects

of this standard are as follows:
a. AS 5 should be applied by an organisation in presenting profit
or loss from ordinary activities, extraordinary items and prior
period items in the statement of profit and loss, in accounting for
changes in accounting estimates and in disclosure of changes in
accounting policies.
b. It deals with the disclosure of certain items of net profit or loss
for the period. These disclosures should be made in addition to
any other disclosures required by other accounting standards.
c. It does not deal with the tax implications of extraordinary items,
prior period items, changes in accounting estimates, and changes
in accounting policies for which appropriate adjustments will
have to be made depending on the circumstances.
S
The definitions covered in AS 5 are as follows:
Ordinary activities: It refers to those activities which are under-
IM
taken by an organisation as part of its business and such related
activities in which the organisation engages in furtherance of, in-
cidental to, or arising from, these activities.
Extraordinary items: It refers to income or expenses arising from
events or transactions that are clearly distinct from the ordinary
activities of the enterprise and thus, do not recur frequently or
M
regularly.
Prior period items: It refers to income or expenses arising in the
current period as a result of errors or omissions in the preparation
of the financial statements of one or more prior periods.
N
Accounting policies: It refers to accounting principles and meth-

ods of applying these principles by an enterprise for preparing and
presenting their financial statements.
5.3.3 Accounting Standards: AS 9, AS 10,

AS 16 and AS 26
Accounting Standard (AS 9): Revenue Recognition
Accounting Standard 9 deals with the bases for ‘Revenue Recognition’

in the statement of profit and loss of an organisation. The standard
recommends the recognition of revenue arising in the course of the
ordinary activities of the organisation from the following:
Sale of goods,
Rendering of services, and
Use by others of enterprise resources yielding interest, royalties
and dividends.

n o t e s
It does not deal with the following modes of revenue recognition:

Revenue arising from construction contracts
Revenue arising from hire-purchase, lease agreements
The definitions covered under the AS 9 are as follows:

a. Revenue: It refers to the gross inflow of cash, receivables or other
consideration arising from the sale of goods, from the rendering
of services, and from the use by others of enterprise resources
yielding interest, royalties and dividends.
b. Completed service contract method: It refers to the method of
accounting for revenue recognition used by organisations in the
profit and loss statement only when the rendering of services
under a contract is completed or substantially completed.
S
c. Proportionate completion method: It refers to the method of
accounting which recognises revenue in the statement of profit
and loss in proportion to the degree of completion of services
under a contract.
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ACCOUNTING STANDARD (AS 10): PROPERTY, PLANT AND
EQUIPMENT
Accounting Standard (AS) 10 recommends accounting standards for

‘Property, Plant and Equipment’. The standard deals with accounting
for fixed assets grouped into various categories like land, buildings,
M
plant and machinery, vehicles, furniture, goodwill, patents, trade-

marks, etc. AS 10 does not deal with accounting for the following items:
a. Forests, plantations and similar regenerative natural resources
N
b. Wasting assets including mineral rights, expenditure on the

exploration for and extraction of minerals, oil, natural gas and
similar non-regenerative resources
c. Expenditure on real estate development
d. Livestock
Definitions covered under AS 10 are as follows:

Fixed asset: It refers to an asset held with the intention of being
used for the purpose of producing or providing goods or services
and not held for sale in the normal course of business.
Fair market value: It refers to the price agreed to in an open and
unrestricted market between knowledgeable and willing parties
that deal at arm’s length who are completely informed and not un-
der any compulsion to transact.
Gross book value of a fixed asset: It refers to the historical cost or
other amount substituted for historical cost in the account books
or financial statements. When this amount is shown net of accu-
mulated depreciation, it is termed as net book value.

n o t e s
note
Earlier AS 6 deals with depreciation accounting then in March

2016, as per ‘Companies Accounting Standards Amendment Rules
2016’ it has been withdrawn and merged with AS 10.
Accounting Standard (AS 16): Borrowing Costs
Accounting Standard (AS) 16 is applied in accounting for borrowing

costs and does not deal with the actual or imputed cost of owners’
equity, including preference share capital not classified as a liability.
Definitions covered under AS 16 are as follows:
Borrowing costs: It refers to interest and other costs incurred by
an organisation related to the borrowing of funds.
S
A qualifying asset: It refers to an asset that necessarily takes a con-
siderable amount of time to get ready for its intended use or sale
IM
Accounting Standard (AS 26): Intangible Assets
Accounting Standard (AS) 26 recommends the accounting treatment

for intangible assets not covered in another accounting standard. AS
26 require an organisation to recognise an intangible asset only if a
few criteria are met. AS 26 also specify how to measure the carrying
amount of intangible assets and requires certain disclosures about in-
M
tangible assets. If some accounting standard deals with a specific type

of intangible asset, an organisation adopts that accounting standard
instead of AS 26. For example, AS 26 does not apply to intangible as-
sets held by an organisation for sale in the ordinary course of business.
N
Some of the definitions covered by AS 26 are as follows:

Intangible asset: It is an identifiable non-monetary asset, without
physical substance, held for use in the production or supply of goods
or services, for rental to others, or for administrative purposes.
Monetary assets: It refers to the money held and assets to be re-
ceived in fixed or determinable amounts of money.
Non-monetary assets: It refers to assets other than monetary assets.
Amortisation: It refers to the systematic allocation of the depre-

ciable amount of an intangible asset over its useful life.
Depreciable Amount: It refers to the cost of an asset less its resid-
ual value.
Useful life of an asset: This refers to either the time period over
which an asset is expected to be used by the organisation or the
amount of production or identical units expected to be obtained
from the asset by the organisation.

n o t e s
5.3.4 Accounting Standards: As 13, AS 17 and AS 20
Accounting Standard (AS 13): Accounting

for Investments
Accounting Standard 13 deals with accounting for investments in the

financial statements of organisations and related disclosure require-
ments. The standard does not deal with:
The bases for recognition of interest, dividends and rentals earned on

investments which are covered by Accounting Standard 9 on Revenue
Recognition;
a. Operating for finance leases
b. Investments of retirement benefit plans and life insurance
enterprises; and
S
c. Mutual funds and venture capital funds and/or the related asset
management companies, banks and public financial institutions
formed under a central or state government ACT or so declared
IM
under the Companies Act, 1956.
Some of the definitions covered under AS 13 are as follows:

Investments: It refers to assets held by an organisation for earn-
ing income by way of dividends, interest, and rentals, for capital
appreciation, or for other benefits to the investing enterprise. As-
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sets held as stock-in-trade are not ‘investments’.

Current investment: It refers to an investment that is by its na-
ture readily realisable and is intended to be held for not more than
one year from the date on which such investment is made.
N
Long term investment: It refers to an investment other than a

current investment.
Investment property: It refers to an investment in land or build-
ings that is not intended to be occupied substantially for use by, or
in the operations of, the investing organisation.
Accounting Standard (AS 17): Segment Reporting
Accounting Standards 17 establish accounting principles for report-

ing financial information related to different types of products and
services that an organisation produces and the different geographical
areas in which it operates. Such information helps users of financial
statements in the following manner:
Understanding the performance of the enterprise
Assessing the risks and returns of the enterprise
Making more informed judgements about the enterprise as a whole

n o t e s

a. A business segment: It refers to a distinguishable component
of an organisation that is engaged in providing an individual
product or service or a group of related products or services and
that is subject to risks and returns that are different from those
of other business segments. Aspects that should be considered in
determining whether products or services are related include:
The nature of the products or services
The nature of the production processes
The type or class of customers for the products or services
If applicable, the nature of the regulatory environment, for
example, banking, insurance, or public utilities.
b. A geographical segment: It refers to a distinguishable component
S
of an organisation that is engaged in providing products or services
within a particular economic environment and that is subject to
risks and returns that are different from those of components
IM operating in other economic environments. Aspects that should
be considered in identifying geographical segments include:
Similarity of economic and political conditions
Relationships between operations in different geographical
areas
Proximity of operations
M
Special risks associated with operations in a particular area

Exchange control regulations
The underlying currency risks
N
Accounting Standard (AS 20): Earnings per share
Accounting Standard 20 prescribes accounting principles for the de-

termination and presentation of ‘Earnings Per Share’, which would
improve comparison of performance among different organisations
for the same period and among different accounting periods for the
same organisation. The focus, of AS 20 is on the denominator of the
earnings per share calculation. Even though earnings per share data
have limitations because of different accounting policies used for de-
termining ‘earnings’, a consistently determined denominator enhanc-
es the quality of financial reports.
Scope of AS 20: Although AS 20 is a mandatory Accounting Standard

(w.e.f. July 01, 2012 ), certain Small and Medium Sized non-corporate
entity falling in Level II or Level III enterprises may not disclose di-
luted earnings per share (both including and excluding extraordinary
items).

n o t e s

An equity share: It refers to a share other than a preference share.
A preference share: It refers to a share having preferential rights

to dividends and repayment of capital.
A financial instrument: It refers to any contract that gives rise to
both a financial asset of one enterprise and a financial liability or
equity shares of another enterprise.
A potential equity share: It refers to a financial instrument or oth-
er contract that entitles, or may entitle, its holder to equity shares.
Share warrants or options: It refers to financial instruments that
give the holder the right to acquire equity shares.
5.3.5 Situational Applicability of Accounting
S
Standards
To discuss situational applicability of accounting standards, we will

start with a brief story of Mr. Farid who started a new business as a
IM
trader and registered his business as a trading company. Now, we will
discuss all the accounting standards one by one as follows:
AS 1 - Disclosure of accounting plans and policies: Farid start-
ed trading business and established various accounting plans and
policies as per regulatory requirements and market conditions.
M
AS 2 - Inventory valuation: Now Farid started acquiring inven-

tory for trading. He further evaluated this inventory (valuation of
inventory) on the basis of various costs to be incurred, such as cost
of purchase and cost of conversion.
N
AS 3 - Cash flow statements: Inventory valuation and procure-

ment is essential because it ensures smooth cash flows in the busi-
ness.
AS 4 - Contingencies and events occurring after the balance
sheet: There occurred fire inside the warehouses and Farid suf-
fered huge losses because he did not recognise contingencies and
events occurring after the balance sheet. In simple words, he did
not anticipate various negative events such as accidents, fire, theft,
etc.
AS 5 - Net profit or Loss for the period, Prior Period Items and
Changes in Accounting Policies: He noticed that fire occurred
due to faulty electric wiring done in the prior period.
AS 7 - Construction Contracts: As the business loss was too high
so he considered the opportunity to construct a new business.
AS 9 - Revenue Recognition: Farid again started a new business
because he knew that he would recognise the revenue only after
constructing a new business.

n o t e s
AS 10 - Property, Plant and Equipment: In order to start this new

business Farid started acquiring many fixed assets such as proper-
ty, plant and equipment.
AS 11 - The Effects of Changes in Foreign Exchange Rates: To
start this new business he ordered some of the equipment from a
foreign supplier and followed proper regulatory guidelines to min-
imise the effects of changes in foreign exchange rates.
AS 12 - Government Grants: Farid was dealing in renewable ener-
gy business and he received some grants from government to start
his new venture.
AS 13 - Accounting for Investments: Now Farid has acquired suf-
ficient funds to start his venture and this time he recognised the
importance of accounting for investments and later on he wisely
disbursed his investments.
S
AS 14 - Accounting for Amalgamations: He made many good in-
vestments and his business started making a considerable amount
of profits. As a result, he got an offer of amalgamation from one of
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the reputed Multinational Corporations (MNCs).
AS 15 - Employee Benefits: When employees got information
about the said amalgamation deal, they started protesting for the
settlement of their outstanding employee benefits.
AS 16 - Borrowing Costs: For the settlement of employee benefits,
Farid borrowed some money from a bank and due to this his bor-
M
rowing costs also increased.

AS 17 - Segment Reporting: Before the process of amalgamation
he performed segment analysis for his business to understand the
performance of his business in various segments (such as geo-
N
graphic and business segments). He recorded all this data in seg-

ment report.
AS 18 - Related Party Disclosures: During the analysis of seg-
ment report, it was observed that one of the segments performed
negatively and he further identified that abnormal payments were
made to related parties.
AS 19 – Leases: It was found that all abnormal payments were
made in terms of high lease rentals and he closed that segment.
AS 20 - Earnings Per Share: After closing down of that segment
there was a substantial increase in earnings per share and all in-
vestors became more satisfied.
AS 21 - Consolidated Financial Statements: Then at the end of
the accounting year, he prepared consolidated financial state-
ments for the entity and shares all the financial information about
various economic activities.
AS 22 - Accounting for Taxes on Income: After the preparation
of consolidated financial statements he determined net profit and
paid applicable amount of taxes to the government.

n o t e s
AS 23 - Accounting for Investments in Associates: However, Far-

id made it clear that he did not pay any tax for its Associates busi-
ness.
AS 24 - Discontinuing Operations: He further clarified that all
operations under its associates business investment are now dis-
continued.
AS 25 - Interim Financial Reporting: The Income Tax Depart-
ment of Government appoints a committee to evaluate the authen-
ticity of closed associate business and this committee asks Farid to
submit an interim financial report regarding the issue.
AS 26 - Intangible Assets: The venture achieved many successful
remarks in terms of earnings (or profits) and acquired many intan-
gible assets such as goodwill, patents, copywriters, etc.
S
AS 27 - Financial Reporting of Interests in Joint Ventures: Due
to the goodwill of the business he got many offers from reputed
many MNCs to start a new project through joint venture.
IM
AS 28 - Impairment of Assets: After initiating the new project un-
der joint venture, he recognised that the book value of assets was
not justified and as a result there was an impairment of assets.
AS 29 - Provisions, Contingent Liabilities and Contingent As-
sets: Under the project of joint venture an accident took place and
one of the labour got injured and he filed a case for compensa-
M
tion against the business. This created a contingent liability on the

company in which it was not clear whether the liability would oc-
cur or not.

N
5. Indian Accounting Standard 10 recommends accounting

standards for____________.
(a) Events after Reporting Period
(b) Net Profit/Loss for the Period
(c) Depreciation Accounting
(d) Revenue Recognition
6. Indian Accounting Standard 8 deals with the bases for
____________ in the statement of profit and loss of an
organisation.
(a) Accounting for Fixed Assets
(b) Net Profit/Loss for the Period
(c) Depreciation Accounting
(d) Accounting Policies, Changes in Accounting Estimates
and Errors

n o t e s
7. __________ recommends accounting standards for ‘Statement

of Cash Flows’.
(a) Indian Accounting Standard 9
(b) Indian Accounting Standard 7
(c) Indian Accounting Standard 5
(d) Indian Accounting Standard 11
8. ____________ refers to an asset held with the intention of
being used for the purpose of producing or providing goods or
services and not held for sale in the normal course of business.
(a) Fixed asset
(b) Current asset
(c) Intangible asset
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9. _____________ is the systematic allocation of the depreciable
IM amount of an intangible asset over its useful life.
(a) Amortisation
(b) Depreciation
(c) Cost of usage
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10. ____________ deals with Accounting for Government Grants

and Disclosure of Government Assistance.
N

11. __________ refers to the method of accounting which recognises
revenue in the statement of profit and loss in proportional
with the degree of completion of services under a contract.
(a) Proportionate completion method
(b) Weighted average method
(c) Service completion method
12. ____________ recommends accounting principles for the
determination and presentation of ‘Earnings per Share’.

n o t e s

13. __________ recommends the accounting treatment for
intangible assets.
(a) Accounting Standard 26
(b) Accounting Standard 34
(c) Accounting Standard 36
(d) Accounting Standard 38
14. What is the total number of Accounting Standards notified by
the Ministry of Corporate Affairs?
(a) 33
(b) 37
(c) 41
(d) 45
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Activity
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Visit the website of Ministry of Corporate Affairs and make a list of
the mandatory and non-mandatory AS.
5.4 Summary
The Accounting Standard Board (ASB) is responsible for formu-
M
lating the accounting standards.

Proper implementation of accounting standards by Indian enter-
prises implies that the financial statements and disclosures of the
enterprises are prepared by complying with the accounting stan-
N
dards issued by the Council of ICAI.

Auditors
need to ensure that the accounting standards have been
implemented while preparing the financial statements.
One of the major developments in the implementation of account-
ing standards in India is its convergence with International Finan-
cial Reporting Standards (IFRS).
AS 1 deals in ‘Disclosure of Accounting Policies’ and is mandatory
to be followed by all enterprise.
Accounting Standards 2 deals in the ‘Valuation of Inventories’.
This is a mandatory standard.
Accounting Standard 4 is a mandatory standard and deals with
the treatment in financial statements of contingencies and events
occurring after the balance sheet date.
Accounting Standard 5 deals with “Net Profit/Loss for the Period,
Prior Period Items and Changes in Accounting Policies”.
Accounting Standard 9 deals with the bases for ‘Revenue Recogni-
tion’ in the statement of profit and loss of an organisation.

n o t e s
Accounting Standard 10 recommends accounting standards for

‘Accounting for Fixed Assets’.
Accounting Standard 13 deals with accounting for investments in
the financial statements of organisations and related disclosure re-
quirements.
Accounting Standards 17 establish accounting principles for re-
porting financial information related to different types of products
and services that an organisation produces and the different geo-
graphical areas in which it operates.
Accounting Standard 20 recommends accounting principles
for the determination and presentation of ‘Earnings Per Share’,
which would improve comparison of performance among different
organisations for the same period and among different accounting
periods for the same organisation.
S
key words
IM
Attest function: The independent review of an audit conducted
by a Certified Public Accountant (CPA).
Book value: The value at which an asset is carried on to a bal-
ance sheet.
Contingency: A future event or situation which is probable but
cannot be predicted with certainty.
M
Disclosures: Secondary information provided by the organisa-

tion for illuminating or interpreting certain published financial
information.
N
Fixed asset: An asset that is not expended during the normal

course of a business, such as land, buildings, equipment, ma-
chinery, etc.
General Purpose Financial Statements: A term that includes
balance sheet, statement of profit and loss, cash flow statement
and statements and explanatory notes which form part thereof.
(Reference: Paragraph 3 of “Preface to the Statements of Ac-
counting Standards “issued by the Institute of Chartered Ac-
countants of India)
Useful life: The period for which an asset remains useful to the
business.
Venture capital: The money provided by investors to start new
or small businesses with perceived long-term growth potential.

1. Explain the implementation of Accounting Standards in India.

n o t e s
2. Discuss the main recommendation under Accounting

Standards 1.
3. How are inventories valued and reported as per AS 2?
4. Discuss the main recommendation under Accounting Standards
9 and 10.
5. Discuss the main recommendation under Accounting Standards
16 and 26.
6. What is meant by business segment and geographical segment
as per AS 17?
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Implementation of Ac- 1. a. IFRS Foundation
counting Standards
2. c. Financial statements
3. a. Accounting Standards Board
4. c. Disclosure of Financial State-
ments
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Financial Statements Re- 5. a. Events after Reporting Period

porting
6. d. Accounting Policies, Changes
in Accounting Estimates and
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Errors
7. b. Indian Accounting Standard 7
8. a. Fixed asset
9. a. Amortisation
10. b. Indian Accounting Standard
20
11. a. Proportionate completion
method
12. b. Indian Accounting Standard
33
13. d. Accounting Standard 38
14. c. 41

1. Clause (c) of Sub-section (3) of Companies Act, 2013, states that
the entire responsibility of the implementation of accounting

n o t e s
standards rests with the directors of an enterprise. The auditor’s

responsibility is restricted to form his opinion and to report on
the financial statements of the enterprise. Refer to Section 5.2
Implementation of Accounting Standards.
2. AS 1 deal with ‘Disclosure of Accounting Policies’ and AS 2 deals
in the ‘Valuation of Inventories’. Refer to Section 5.3 Financial
Statements Reporting.
3. According to AS 2, cost of inventories comprises costs of
purchase, costs of conversion and other costs. They are measured
at the lower of cost and net realisable value. Refer to Section 5.3
Financial Statements Reporting.
4. AS 9 deals with the bases for ‘Revenue Recognition’ in the
statement of profit and loss of an organisation and AS 10
recommend accounting standards for ‘Accounting for Fixed
S
Assets’. Refer to Section 5.3 Financial Statements Reporting.
5. Accounting Standard 16 is applied in accounting for borrowing
costs and does not deal with the actual or imputed cost of owners’
IM
equity, including preference share capital not classified as a
liability. Accounting Standard 26 recommends the accounting
treatment for intangible assets not covered in another Accounting
Standard. Refer to Section 5.3 Financial Statements Reporting.
6. As per AS 17, a business segment is a distinguishable component
of an organisation engaged in providing an individual product
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or service or a group of related products or services and that is

subject to risks and returns that are different from those of other
business segments. On the other hand, a geographical segment is
a distinguishable component of an organisation that is engaged
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in providing products or services within a particular economic

environment and that is subject to risks and returns that are
different from those of components operating in other economic
environments. Refer to Section 5.3 Financial Statements
Reporting.

1. Suppose, on March 19, 2017, XYZ Ltd. has gross profit of `10 lakh,
then an earthquake occurred on March 21, 2017. Estimated loss
due to earthquake was ` 2 lakh. By considering AS 5 determine,
calculate profit before tax of XYZ Ltd. for the year ending March
31, 2017.
Solution:
Loss by earthquake is an extraordinary item and as per AS 5 it
should be deducted from gross profit before calculating income
tax. So in this case the profit before tax (PBT) for XYZ Ltd.
should be calculated as follows:
Gross profit = ` 1000000

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Loss due to earthquake = ` 200000

Therefore, PBT = 1000000 – 200000
PBT = ` 800000
2. Suppose XYZ Ltd. a four wheeler manufacturer inaugurates
a new road for test drive (RCC Structure) costing ` 1crore. By
considering the AS 10, calculate the total annual amount and
rate of depreciation.
Solution:
According to AS 10 and Schedule II of Section 123 of Companies
Act, 2013, the carpeted road with RCC structure should be
depreciated by the rate of 10 per cent per annum (life span
of 10 years). So in the above case the total annual amount of
depreciation will be `10 lakh and the rate of depreciation will be
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10 percent per annum.
3. Suppose, XYZ Ltd. has a net profit of `1 crore and preferred
dividends of `10 lakh. Calculate its basic and diluted EPS if the
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total number of outstanding shares is 900000.
Solution:
According to AS 20, Earning Per Share (EPS) should be
calculated as follows:
Diluted EPS = (Net profit-prefferred dividends)/(Weighted
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average common stock)

4. By applying accounting standard 2 calculate the cost of inventory
on the basis of the following data:
Invoice price of Purchases= `100000
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Excise Duty paid = `2000

Freight inward = `1500
Freight outward = `1000
Stationary = `1000
Wages paid = `2000
Customs duty paid = `1000
Trade discount = `5000
Subsidy = `3000
Solution:
Cost of Inventory = (Invoice price of purchases + Excise duty
paid + Freight inward + Customs duty) – (Trade discount +
Subsidy)
= (`100000 + `2000 + `1500 + `1000) - (`5000 + `3000)
= `96500

n o t e s
note
Cost of inventory does not include freight outward, stationary, wag-

es paid, factory overhead, selling cost, distribution cost, etc.
5. Suppose the ABC Ltd has an annual inventory of 1000 units and
the current market price of each unit is `20 and ABC limited sold
all 1000 units for `22 per unit. Calculate the net realisable value
and fair value of inventory per unit.
Solution:
In the above situation the net realisation value for inventory will
be `22 per unit and fair value will be `20 per unit.
6. In February 2016, a teller at the billing counter of XYZ Ltd. thefts
`5 lack from company’s wallet and it was not noticed until June
S
2016. Explain where this amount of `5 lakh will be adjusted at
the end of financial year in March 2016.
Solution:
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Para 13 of Accounting Standard 4 provides the provision of
‘Contingencies and Events Occurring after the Balance Sheet
Date’. It means in such a situation mentioned above the monetary
value of loss or theft occurred can be adjusted in the balance sheet
of the concerned year. However, there is one condition that the
financial statements of thee concerned year are not approved by
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the board of directors. So, in this case XYZ limited can adjust the
theft value of `5lakh if its financial statements are not approved
by the board of directors.
= (10000000 – 1000000)/90000
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= `100
Basis EPS = (Net profit) / (Weighted average common stock)
= (1000000)/90000
= `111.11
SUGGESTED READINGS
Bhattacharyya, A. (2006). Indian Accounting Standards: Practices,
Comparisons, and Interpretations (2nd ed., pp. 4.15-22.38). New
Delhi: Tata McGraw Hill.
Godfrey, J., & Chalmers, K. (2008). Globalisation of Accounting
Standards (2nd ed., pp. 253-256). Massachusetts: Edward Elgar
Publications.

n o t e s
V., R., & R., L. (2011). Financial Accounting (1st ed., pp. 30-39). Noi-
da: Dorling Kindersley (India).
E-REFERENCES
ICAI. (2014). ICAI - The Institute of Chartered Accountants of
India. Retrieved from, http://www.icai.org/new_post.html?post_
id=2805&c_id=221
Mca.gov.in. (2014). Ministry of Corporate Affairs - Standards. Re-
trieved from, http://www.mca.gov.in/MinistryV2/standards.html
Ey.com. (2014). Overview: IFRS becomes mandatory in India. Re-
trieved from, http://www.ey.com/IN/en/Issues/IFRS/Overview--IF-
RS-becomes-mandatory-in-India
India,P. (2014). Ready with updated Indian accounting standards:
S
ICAI. Business-standard.com. Retrieved from, http://www.busi-
ness-standard.com/article/economy-policy/ready-with-updat-
ed-indian-accounting-standards-icai-114071300140_1.html
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Case study
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Towards Global Accounting Standards
The rapid integration of capital markets over the past decade has
underlined the appeal of developing a single set of international
accounting standards. The growing acceptance of international
standards has provided momentum for the work of the Interna-
tional Accounting Standards Board (IASB) and has increased the
possibility that international standards might be the foundation
of global markets.
There are many compelling benefits of a global accounting stan-

dard. The use of one high quality accounting standard throughout
the world may offer following benefits:
Improving comparability and transparency of financial infor-
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mation
Reducing the costs of preparing financial statements
IM
Providing access to higher quality
Making better decisions owing to rigorous and consistent ap-
plication of the accounting standards
Allocating funds more efficiently
Achieving lower cost of capital
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Some of these arguments have been used to support the adop-

tion of the International Financial Reporting Standards (IFRS)
for financial reporting of the consolidated listed entities in the Eu-
ropean Union (EU) member states. Other arguments include the
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demands of high quality standards that would be able to improve

the quality and comparability of financial reporting and promote
the development of a national capital market and integration with
the international market.
However, the argument against the adoption of global accounting

standards states that the adoption of global accounting standards
bears the risk of severely restricting the different forms of capital-
ism in the world. It also privileges a particular way of conducting
business. The adoption of a single accounting standard might pre-
vent alternative and superior ways of conducting business. Major
factors that influence the development of a country’s accounting
system are:
The relationship between business and the providers of cap-
ital
Political and economic ties with other countries
Levels of inflation

Case study
n o t e s
The level of a country’s development

The prevailing culture in a country
As these are different for each nation across the globe, the critics
argue that accounting standards should be developed tailored to
the needs of particular economies.
questions
1. With the help of the case, discuss the benefits that arise
for the market participants in case companies use IFRS.
(Hint: Improving comparability and transparency of
financial information, reducing the costs of preparing
financial statements, providing access to higher quality,
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making better decisions owing to rigorous and consistent
application of the accounting standards, allocating funds
more efficiently, etc.)
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2. According to you, what are the possible disadvantages of
having a global accounting standard?
(Hint: The adoption of single form of accounting system
has the risk of severely restricting the different forms of
capitalism that might develop across the globe. It also
privileges one particular way of doing business over
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alternative forms.)
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Ch a
6 p t er
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
CONTENTS
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6.1 Introduction
6.2 Generally Accepted Accounting Principles (GAAP)
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6.2.1 Objectives of GAAP
6.2.2 Characteristics of GAAP
6.2.3 Difference between GAAP & International Accounting Standards
Activity
6.3 International Financial Reporting Standards (IFRS)
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Activity
6.4 Indian Accounting Standards (AS)
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Activity
6.5 Difference between IGAAP, IFRS and Ind AS
Activity
6.6 Summary

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WIPRO’s ACCOUNTING POLICIES
Wipro is one of the well-known software companies in India. The

financial statements of the company are prepared in accordance
with the Indian Generally Accepted Accounting principles (also
referred to as the “Indian GAAP”) as well as the US GAAP. The
company started as a producer of cooking oil in 1945.
The company had staged a strong comeback in 2003. Wipro’s senior

managers looked back with satisfaction at the company’s financial
performance. The company spends several years in restructuring
so that it could sell end-to-end solutions to customers, instead of
bidding for piecemeal projects. In short, the company built three
new businesses-enterprise solutions, infrastructure management,
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and Business Process Outsourcing (BPO) that together accounted
for more than 30% of the total revenue of the company. All these
businesses were expected to be the major growth drivers for the
company in the future. The company prepared its consolidated
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financial statements, under Indian GAAP in accordance with the
requirements of Accounting Standards AS 21, AS 23, and AS 27
issued by the Institute of Chartered Accountants of India (ICAI).
The company also prepared its consolidated financial statements
in accordance with the US GAAP to meet the requirements
of the Securities and Exchange Commission (SEC) in the US.
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The significant accounting policies of the company states:
“The condensed financial statements are prepared in accordance

with Indian Generally Accepted Accounting Principles under the
historical cost convention on the accrual basis. GAAP comprises
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accounting standards notified by the Central Government of India,

other pronouncements of the Institute of Chartered Accountants of
India, the provisions of the Companies Act, 1956 and guidelines is-
sued by the Securities and Exchange Board of India. The recogni-
tion, measurement and disclosure provisions of AS 25, Interim Fi-
nancial Reporting, have been followed for these condensed interim
financial statements.”

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 159
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learning objectives

> Discuss Generally Accepted Accounting Principles
> Describe the International Financial Reporting Standards
> Explain various Indian Accounting Standards
> Discuss the difference between Indian GAAP and IFRS
6.1 INTRODUCTION
In the previous chapter, you studied several accounting standards, the
recommendations and definitions under these accounting standards.
Now, let us discuss the accounting conventions under the Generally
S
Accepted Accounting Principles (hereinafter referred to as “GAAP”
for the sake of brevity).
Accounting statements are prepared to communicate the financial in-

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formation of a business entity to various interested parties. Therefore,
the accounting process and the accounting statements should be such
that various stakeholders can interpret the statements in the same
manner. For example, provisions of depreciation in the balance sheet
should be interpreted in the similar manner by the various stakehold-
ers. For this reason, organisations need to follow a common frame-
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work for recording their financial transactions in the books of accounts

and preparing the financial statements. GAAP refers to the standard
framework or guidelines for financial accounting used in any given
jurisdiction. The GAAP includes various standards, conventions and
rules that are followed by accountants for the purpose of recording,
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summarising and preparing financial statements. The GAAP are dif-

ferent across nations. However, with rapid increase in global transac-
tions and business affairs there is a need to follow a common account-
ing language, which is comparable across international borders. This
led to the adoption of International Financial Reporting Standards
(IFRS), which are set of international accounting standards prescrib-
ing how particular types of transactions and other events need to be
reported in the financial statements.
IFRS ensures that financial statements of an organisation are under-

standable by all users alike. The IFRS is the result of the growing
international shareholding and trade and very significant for compa-
nies which deal in multiple countries and have cross-border business
transactions.
In this chapter, you will study the significance and characteristics

of GAAP. You will also study the differences between GAAP and Ac-
counting Standards. In addition, the chapter discusses the meaning
and importance of IFRS. In the end, the chapter highlights the differ-
ences between Indian GAAP and IFRS.

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GENERALLY ACCEPTED ACCOUNTING

6.2
PRINCIPLES (GAAP)
There is a set of ground rules in financial accounting to present the fi-
nancial information. These rules are recognised as GAAP. We have al-
ready discussed that in order to be useful, financial information need
to be collected, classified, summarised and reported objectively. The
stakeholders who access this information have a right to ensure that
the information is reliable and free from biases and inconsistencies.
For this reason, accounting practices should be bound by certain rules
and guidelines. Financial accounting information can be useful only
when it follows these standards and guidelines.
It should be noted that GAAP are simple guidelines and principles for
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accounting. Therefore, it is subject to amendments. At times, certain
specific principles need to be altered and some new principles add-
ed to adapt to the changing economic circumstances and changing
business practices. Moreover, various accounting principles originate
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from changes in law, tax regulations, new business organisational ar-
rangements, or new financing or ownership techniques.
According to the Walgenbach, et al. Because no basic natural account-

ing law exists, accounting principles have developed on the basis of their
usefulness. Consequently, the growth of accounting is more closely re-
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lated to experience and practice than to the foundation provided by an

ultimate law. As such accounting principles tend to evolve rather than
to be discovered, to be flexible rather than precise and to be subject to
regular evaluation rather than be ultimate or final.
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Generally Accepted Accounting Principles (GAAP) are accounting

rules for standardising the preparation and reporting of financial
statements including balance sheets, income statements and cash
flow statements by organisations in a country. GAAP is required to
ensure that the information provided in the financial statements of an
organisation is useful for assessing the financial viability of the organ-
isation. For instance, investors and creditors often assess the financial
statements of an organisation to make economic decisions.
According to the American Institute of Certified Public Accoun-

tants (AICPA) Generally Accepted Accounting Principles incorporate
the consensus at any time as to which economic resources and obliga-
tions should be recorded as assets and liabilities, which changes in them
should be recorded, how the recorded assets and liabilities and changes
in them should be measured, what information should be disclosed and
which financial statements should be prepared.

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6.2.1 OBJECTIVES OF GAAP
Every organisation issuing financial statements to the public follows

an accounting system. This is important for maintaining consistency
in recording financial data over the years and across different organ-
isations. For example, an investor can compare the Balance Sheet of
one organisation to those of another organisation to take his/her in-
vesting decisions. Similarly, there are several important objectives of
the commonly used accounting system, GAAP. These are as follows:
Itprovides an accounting framework to the various companies
that follow these principles.
It brings uniformity to the various financial statements made by
different companies.
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It
helps various stakeholders in interpreting the financial state-
ments in the same manner.
Itprovides various stakeholders from different jurisdiction in un-
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derstanding the accounts prepared in other jurisdictions.
It clarifies issues and confusions regarding various accounting issues.
6.2.2 CHARACTERISTICS OF GAAP
GAAP includes principles as well as the procedures to apply these

principles. The main characteristics of GAAP are as depicted in the
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Figure 6.1:
Simple Guidelines
Characteristics of GAAP
Ensure Uniformity
Relevance
Objectivity
Feasibility
Figure 6.1: Characteristics of GAAP

Simple guidelines: This implies that the accounting principles are
simple and man-made guidelines, derived from past experiences.
Ensure uniformity: This implies that the accounting principles
are set for ensuring uniformity and meaningful presentation of the
accounting information, which can be understood by the users.

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Relevance: It depicts that the accounting principles are relevant

to the extent that the accounting information presented after fol-
lowing these principles is meaningful and useful to the users.
Objectivity: This implies that the accounting principles are not
influenced by the personal bias or judgment of those who have
formulated them. This ensures the reliability of the presented ac-
counting information.
Feasibility: It refers to the extent to which the accounting principles
can be implemented without the complexity and incurring any cost.
6.2.3 DIFFERENCE BETWEEN GAAP & International

ACCOUNTING STANDARDs
International Accounting Standards (IAS) is a set of standard guide-
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lines set by the International Accounting Standard Committee (IASC),
located in London. The International Accounting Standard Board
(IASB) is the standard-setting body of the IASC. GAAP on the other
hand, are accounting standards followed in any country. GAAP dic-
IM
tates the rules or standards, as well as the conventions to be followed
when organisations in a country, records, summarises, transact and
prepare their financial statements. Although IASC is a powerful com-
mittee, it has no direct control for setting the rules for GAAP. Howev-
er, GAAP are influenced by IAS e.g. the set of rules principles, con-
ventions and the Accounting Standards followed in India would be
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known as “Indian GAAP” .

Therefore, when IASC sets accounting standards, various countries
tend to adopt these standards or at least interpret these standards to
fit the accounting standards of various jurisdictions. These become
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the GAAP of the respective jurisdictions. For example, in the USA,

the Financial Accounting Standard Board (FASB) makes the rules
and regulations of accounting, which becomes US GAAP. Therefore,
GAAP of different countries varies.
1. _____________ are accounting rules for standardising the

preparation and reporting of financial statements including
balance sheets, income statements and cash flow statements
by organisations in a country.
(a) General Auditing and Accounting Principles
(b) Generally Accepted Accounting Philosophies
(c) Generally Accepted Accounting Principles
(d) General Accounting and Auditing Principles

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2. In the US, ____________ makes rules and regulations of

accounting, which becomes US GAAP.
(a) Financial Accounting Standard Board
(b) Financial Accounting Board
(c) Financial Accounting and Auditing Board
(d) Board for Financial Accounting Principles
Activity
With the help of the Internet, compare Indian GAAP with the US
GAAP. Present your findings in a short note.
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INTERNATIONAL FINANCIAL
6.3
REPORTING STANDARDS (IFRS)
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Accounting standards need to be established at the national and the
international level. However, different countries follow different ac-
counting standards. This presents a significant challenge in the global
business environment. Several standards setting bodies and organisa-
tions are engaged in standardising the accounting practices. For pro-
moting the standardisation of the accounting standards, the Interna-
M
tional Accounting Standards Board (IASB) emerged on 29th June 1973,

recognised by the professional accounting bodies in different coun-
tries. Some of the countries are Canada, Australia, France, Japan, Ger-
many, Mexico, Netherlands and United Kingdom. The headquarters
and secretariat of IASB is established in London, United Kingdom.
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The International Financial Reporting Standards (IFRS) are princi-

ple-based standards, interpretations and the framework (1989) adopt-
ed by the IASB. It is now being used in various countries of the world.
The adoption of IFRS globally would prove beneficial to investors,
management and other users of financial statements.
The IFRS includes the following:

International Financial Reporting Standards (IFRS)—standards
issued after 2001
International Accounting Standards (IAS)—standards issued be-
fore 2001
Interpretations originated from the International Financial Re-
porting Interpretations Committee (IFRIC)—issued after 2001
Standing Interpretations Committee (SIC)—issued before 2001
Framework for the Preparation and Presentation of a financial
statement (198)

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Exhibit
The Time-Frame of IFRS, according to American Institute of

Certified Public Accountants (AICPA)
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Source: “IFRS”, http://media.cpa2biz.com/Publications/IFRS/1924_IFRS_Background_v3_
web_FINAl_06-09-09.pdf,2008
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ICAI has announced that IFRS would be mandatory in India for pre-

paring and presenting financial statements from the financial year be-
ginning on April 1, 2015. It would apply to the companies whose worth
is above `1000 crores.
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According to the revised rules for IFRS, a financial statement needs to

involve the following after Jan 1, 2009:
The balance sheet is to be known as “ Statement of Financial Posi-
tion”
The income statement is to be known as “Statement of Compre-
hensive Income”
The cash flow statement is to be known as “ Statement of Cash
Flows”
The summary of significant accounting policies is to be involved
in the “Notes”
The “Statement of Changes in Equity (SOCE)”
The convergence of accounting standards towards IFRS has been in-
creasing. This system helps in providing more transparency, stability
and fairness to investors and meets the criteria of global maintenance
of accounting. Therefore, most of the countries tend to adopt these
standards.

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3. For promoting the standardisation of accounting standards,

the International Accounting Standards Board (IASB)
emerged on _______________.
(a) July 26, 1973
(b) January 26, 1973
(c) June 29, 1973
(d) April 8, 1973
Activity
With the help of the Internet, conduct research on the evolution of
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IFRS. Present your findings in a short note.
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6.4 INDIAN ACCOUNTING STANDARDS (AS)
In any country, the accounting standards comprise a system of mea-
surement and disclosure for the preparation and the presentation
of the financial statements. The Institute of Chartered Accountants
of India (ICAI) is the apex accounting body in India. ICAI set up the
ASB in April 1977 to formulate accounting standards. The board at-
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tempts to synchronise the diverse accounting policies and practices

in India and to take into account the applicable laws, customs, usages
and business environment. The ICAI is a member of the International
Accounting Standards Committee (IASC), and supports the objectives
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of the IASC. The ASB gives due consideration to the International Ac-
counting Standards (IAS) issued by IASC and tries to integrate them
to the maximum extent in the light of the conditions and practices
prevailing in India. The accounting standards are issued under the
authority of the council.
Firstly, the ASB finalises the procedure to be followed in the formula-

tion of standards. The “Preface to the Statements of Accounting Stan-
dards” was issued in January 1979. The preface outlines the scope
and functions of the ASB as well as the procedure it should follow
while formulating the standards. In addition, it helps in determining
the phased manner in which the compliance with the standard would
be encouraged by the institute. The constitution of the ASB provides
adequate representation to all the stakeholders. Currently, it consists
of members from the council and representatives of industry, banks,
Company Law Board (CLB), Central Board of Direct Taxes (CBDT),
Central Board of Excise and Customs (CBEC), Controller General of
Accounts (CGA), the Comptroller and Auditor General (CAG) of India,
Securities and Exchange Board of India (SEBI), University Grants
Commission (UGC), and educational and professional institutions.

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The functions of the ASB can be summarised as follows:

Formulating the accounting standards, which are established by
the Council of ICAI. It considers the applicable laws, customs and
usages, and the business environment.
Persuading the concerned parties for adopting the standards in
the preparation and presentation of the financial statements.
Issuing guidance notes are related to the accounting standards.
Clarifying the issues arising from the standards and the guidance
notes on the accounting standards.
Reviewing accounting standards at periodic intervals.
As per Section 132 of Companies Act, 2013, the Union Government has
constituted a financial regulatory authority named as National Finan-
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cial Reporting Authority (NFRA). NFRA is responsible for providing
recommendations to the central government on accounting standard,
accounting policies, auditing standard and inspection of auditors and
there are three committees under NFRA, namely accounting stan-
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dard committee, auditing standard Committee and enforcement com-
mittee. NFRA has its chairperson as the highest level of authority and
he should have expert knowledge of accounting, auditing, finance or
law. The authority comprises maximum 15 members from various de-
partments, such as Accounting, Auditing, Enforcement, Ministry of
Corporate Affairs (MCA), Reserve Bank of India (RBI), Securities and
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Exchange Board of India (SEBI), The Institute of Chartered Accoun-

tants of India (ICAI), The Institute of Cost and Works Accountants of
India (ICWAI), The Institute of Company Secretaries of India (ICSI),
Central Board of Direct Taxes (CBDT), etc.
The ICAI issues accounting standards that are recommended in the
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initial years. During this recommended period, it is expected that the

accounting practices of an organisation should be brought in line with
the standards. The process of transition should be easy and smooth
so that the organisation would have no difficulty in complying with
the accounting standards once they are made mandatory. After the
accounting standards become mandatory, it is applicable to all organ-
isations whose accounts are audited by qualified auditors as per the
mandatory standards. It is the duty of the auditors to make sure that
all the accounting standards are adhered to the standardised rules of
preparation and presentation of financial statements. If the organisa-
tion fails to comply with mandatory accounting standards, the auditor
is required to make a complete disclosure in his/her report. In such a
case, the users of financial statements become aware of non-compli-
ance deviations on the part of the organisations.
The accounting standards adopted by Indian companies are Indi-
an Accounting Standards (Ind AS). Till date there are 41 Account-
ing Standards notified by the Ministry of Corporate Affairs and these
standards are developed by ICAI’s Accounting Standard Board.
Ind AS was implemented as voluntary from 2015-16 fiscal and then

n o t e s
from 2016-17 it is mandatory for Indian companies to follow Ind AS

in accounting reporting. In the way of accepting global accounting
language Ind AS is now converged with International Financial Re-
porting Standards (IFRS) and Ind AS are named and numbered in
the same way they are in IFRS. Accounting standards under IFRS
are developed by the IFRS foundation and International Accounting
Standards Board (IASB). As of now, there are two types of accounting
standards issued by the IFRS, type one IFRS for large scale compa-
nies and IFRS for Small and Medium Enterprises (SMEs). We will fur-
ther discuss the need for the convergence of Ind AS with IFRS from
the following points:
Facilitation of capital inflows in the country
Global recognition of balance sheet
Smooth moment of accounting professional across the globe
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Consolidation of financial statements of foreign MNCs operating
in India and Indian MNCs operating in abroad.
It should be noted that accounting standards have a legal backing.
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The ICAI expects that its members should implement the account-
ing standards issued by it through their independent attest function.
Attest function includes independently reviewing the validity of data
through audits conducted by accountants. The ASB has been entrust-
ed with the responsibility of propagating the accounting standards
and persuading the concerned parties to adopt them in the prepara-
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tion and presentation of the financial statements. Guidance notes on

accounting standards may be issued by the ASB and clarification on
issues arising can be resolved by it. Even it may review the accounting
standards at periodic intervals.
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4. Which of the following is not a member of Accounting

Standards Board?
(a) Comptroller and Auditor General (CAG) of India
(b) Securities and Exchange Board of India (SEBI)
(c) University Grants Commission (UGC)
5. The ___________of the Companies (Amendment) Act, 1999
states that the central government is empowered to constitute
an advisory committee named as the National Advisory
Committee for various accounting standards.
(a) Section 23-A
(b) Section 43-C
(c) Section 210-A
(d) Section 217-C

n o t e s
Activity
Visit the website of Ministry of Corporate Affairs (http://www.mca.gov.

in/) and make a list of the accounting standards set by the ministry.
DIFFERENCE BETWEEN IGAAP, IFRS

6.5
and Ind AS
The International Financial Reporting Standards (IFRS) differ from
the Indian Generally Accepted Accounting Principles (IGAAP). On
the other hand, Indian Accounting Standards (Ind AS) is Indian ver-
sion of IFRS. At the conceptual level, IFRS is considered to be a ‘prin-
ciples based’ accounting standard and it is a base for Ind AS, whereas
IGAAP is considered to be a ‘rules ba sed’. IFRS offers more flexibility
S
as compare to Ind AS and IGAAP and also the terms used in IFRS are
different from Ind AS and IGAAP. For instance, Ind AS and IGAAP
uses the term ‘Balance Sheet’ while under IFRS it is known as ‘State-
ment of Financial Position’. As a principle based accounting system,
IM
IFRS represents and includes the economics of a transaction better
than IGAAP and Ind AS. There are several similarities between these
three accounting systems. For example, all three accounting systems
use the same reporting elements; assets, liabilities, equity, income
(revenues and gains) and expenses (losses). Ind AS is mostly inspired
from IFRS, which is a set of global accounting standards that are al-
M
ready adopted by 125 countries across the globe. It is accepted because

the flow of capital, mergers and acquisitions, smoothly consolidation
of financial statements. However, there are some differences between
IGAAP, IFRS and Ind AS. Let us discuss some differences between
these three accounting frameworks based on the following aspects:
N
Table 6.1: Difference between IGAAP, IFRS

and Ind AS
Point of IFRS IGAAP Ind AS
Difference
Financial ‘Balance sheet’ is Terms used under Terms used un-
Accounts known as ‘State- IGAAP are balance der Ind AS are
Components ment of Financial sheet and profit ‘Balance sheet’
Position’ and ‘State- and loss account and ‘Profit and
ment of Compre- Loss Account’
hensive Income’ or the ‘Income
is a term used for Statement’
‘profit and loss
account’.
Lease Lease rentals must Leases are men- Lease rentals to
rentals and be operating equat- tioned under AS be equated oth-
inflation ed as per IFRS 17. 19 but there is no er than inflation.
such provision for
lease rentals.

n o t e s
Point of IFRS IGAAP Ind AS

Difference
Breach of Deals with current There is no such No such defini-
Agreement liabilities and IFRS provision. tion on the type
1 and 10 are guid- of liability and
ing rules. as per Ind AS 1
and 10, liability
must be paid on
the reporting
date
Amalgama- Transfer to profit Transfer to capital Transfer to
tion and loss account reserve account as capital reserves
and IFRS 103 is per AS 14. and Ind AS 103
applicable. is applicable.
Associates Excess amount is Excess amount Excess amount
S
transferred to profit is transferred to is transferred to
and loss account capital reserves capital reserves
as per IFRS 28. and AS 23 is appli- and AS 28 is
Uniformity in ac- cable. applicable. It is
IM
counting policies is impracticable to
required for associ- change account-
ates. Retrospective ing policies
costs to be calculat- which are men-
ed as per IFRS 1. tioned under
Ind AS 101 and
book value in
M
declined cost to
be calculated as
per Ind AS 1.
Foreign Foreign currency No such definition. Foreign curren-
currency convertible bonds cy convertible
N
convertible are liability as per bonds are equity

bonds IFRS 32. as per Ind AS
32.
Penalties Penalties to be ad- Penalties are men- As per Ind AS
justed with revenue tioned under AS 115, a penalty
as per IFRS 15. 29 and it must be to be adjusted
considered as con- with revenue
tingent Liabilities. only if there is
direct relation.
Otherwise it will
be charged as
expense under
the profit and
loss account.

n o t e s
6. IFRS are accounting standards developed by the IFRS

foundation and _____________.
(a) International Accounting Board
(b) International Accounting Standards Board
(c) International Accounting and Auditing Board
(d)
Board for International Accounting Standards and
Principles
7. In which year were International Financial Reporting
Standards regarding disclosure of financial statements
originally issued?
(a) 1973
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(b) 1979
(c) 1983
IM
(d) 1989
Activity
Provide the name of five organisations following the GAAP

accounting standards and IFRS accounting standards in India.
M
6.6 SUMMARY
Accounting statements are prepared to communicate the finan-
N
cial information of a business entity to various interested parties.

Therefore, the accounting process should be executed and the ac-
counting statements should be prepared in such a manner that
various stakeholders can interpret the statements in the same
manner.
Itshould be noted that GAAP are simple guidance for accounting.
Therefore, it is subject to amendments.
GAAP provides an accounting framework to the various compa-
nies that follow these principles.
GAAP includes principles as well as the procedures to apply these
principles.
Accounting standards are a set of standard guidelines set by the
International Accounting Standard Committee (IASC), located in
London.
Accounting standards need to be established at the national and
the international level. However, different countries follow differ-

n o t e s
ent accounting standards. This poses a significant challenge in the

global business environment.
ICAI has announced that IFRS would be mandatory in India for
preparing and presenting financial statements from the financial
year beginning on April 1, 2015.
In any country, the accounting standards comprise a system of
measurement and disclosure for the preparation and the presen-
tation of the financial statements.
ICAI issues accounting standards that are recommended in the
initial years.
The International Financial Reporting Standards (IFRS) have
some key differences from the Indian Generally Accepted Ac-
counting Principles (IGAAP).
S
The requirements for the presentation of financial statements are
set out in Schedule IV of the Companies Act, 1956, Schedule III to
the Banking Regulation Act, 1949, the regulations issued by the
IM
Insurance Regulatory and Development Authority (IRDA) and the
SEBI guidelines together with the Accounting standards notified
under the Companies (Accounting Standards) Rules, 2006.
Inventory valuation refers to the cost associated with an organi-
sation’s inventory in hand at the end of a reporting period. Inven-
tories owned by a manufacturing company typically include raw
M
materials, work in progress and finished goods.

Anything tangible or intangible capable of being owned or con-
trolled to generate value is considered an asset. Fixed assets are
assets that last cannot be consumed or converted into cash before
one year.
N
Accounting policies refer to the specific policies and procedures

used by an organisation to prepare its financial statements.
The key differences between the two accounting frameworks based
on the presentation of financial statements, inventories valuation
and revenue recognition, fixed assets (tangible and intangible) and
disclosure of accounting policies.
key words
Accounting principles: General rules and concepts that govern

the field of accounting, both for the preparation and presenta-
tion of financial statements.
Accounting Standard (AS): Sets of principles that work as a
benchmark for accounting practices.

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Current assets: Assets such as accounts receivable, inventory,

marketable securities, prepaid expenses and other liquid assets
that can be readily converted to cash within the operating cycle
and are short-term in nature.
Illiquid assets: Assets that cannot be sold easily due to a lack
of ready and willing investors or speculators to purchase such
assets.
Ind AS: The accounting standards adopted by Indian compa-
nies are Indian Accounting Standards (Ind AS). Till date there
are 41 accounting standards notified by the Ministry of Corpo-
rate Affairs and these standards are developed by ICAI’s Ac-
counting Standard Board.
Indefinite useful life: The asset life where, based on an anal-
ysis, there is no foreseeable limit to the period over which the
S
asset is expected to generate net cash inflow for the entity such
as land.
International Financial Reporting Standards (IFRS): IFRS
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Accounting standards developed by the IFRS foundation and
International Accounting Standards Board (IASB). As of now,
there are two types of accounting standards issued by the IFRS,
type one IFRS for large scale companies and IFRS for Small
and Medium Enterprises (SMEs).
Non-current assets: An organisation’s assets such as plant,
M
property, machinery, long term investments, etc., which cannot

be converted to cash easily or whose value cannot be realised in
one financial year .These assets are held for obtaining long term
enduring benefit which lasts more than a year.
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Stakeholders: A person, group or organisation that has an in-

terest or concern in another organisation.

1. Explain the meaning and characteristics of GAAP.
2. Briefly describe the Indian accounting standards.
3. Discuss the main points of differentiation between IFRS and
GAAP based on the presentation of financial statements.

Generally Accepted 1. a. Generally Accepted Account-
Accounting Principles ing Principles
(GAAP)

n o t e s

2. b. Financial Accounting Stan-
dard Board
International Financial 3. c. June 29, 1973
Reporting Standards
(IFRS)
Indian Accounting Stan- 4. d. None of the above
dards (Ind-AS)
Financial Statements Re- 5. c. Section 210-A
porting
Difference between IG- 6. b. International Accounting
AAP and IFRS Standards Board
7. d. 1989
S
1. GAAP provides accounting frameworks to the various companies
that follow these principles. The main characteristics of GAAP are
IM
that it provides simple guidelines, ensures uniformity, relevance,
objectivity and feasibility in maintaining financial data. Refer to
Section 6.2 Generally Accepted Accounting Principles (GAAP).
2. ICAI issues accounting standards in India, recommended
in the initial years. These are applicable to all organisations
whose accounts are audited by qualified auditors as per the
M
mandatory standards. Refer to Section 6.4 Indian Accounting

Standards (AS).
3. The IFRS and GAAP differ in their system of presentation of
financial statements such as balance sheet, income statement,
N
exceptional items, statement of changes in shareholders’ equity,

cash flow statements and correction of errors. Refer to Section
6.5 Difference between IGAAP and IFRS.
Suggested Readings
Epstein,
B., Nach, R., & Bragg, S. (2009). Wiley GAAP codification
enhanced (1st ed. pp. 105-110). Hoboken, NJ: John Wiley & Sons.
Kuppapally, J. (2010). Accounting for managers (1st ed. pp. 20-23).
India: PHI Learning.
Everingham, G., Kleynhans, J., & Posthumus, L. (2007). Principles
of Generally Accepted Accounting Practice (3rd ed.,. pp. 1-18). Cape
Town, South Africa: Juta and Co.

n o t e s
E-REFERENCES
My Accounting Course. (2014). GAAP | Accounting Principles and
Objectives. Retrieved from, http://www.myaccountingcourse.com/
accounting-principles/generally-accepted-accounting-principles
Pkobp.pl. (2014). PKO BP Annual Report 2012 - Tangible fixed as-
sets and intangible assets. Retrieved from, http://www.pkobp.pl/
raportroczny2012/en/tangible-fixed-assets-and-intangible-assets.
html
Sage Fixed Assets. (2012). Explaining Tangible and Intangible
Fixed Asset Categorisations - Sage Fixed Assets. Retrieved from,
http://blog.sagefixedassets.com/fixed-asset-management/explain-
ing-tangible-and-intangible-fixed-asset-categorizations/
Usgaap.tripod.com. (2014). US GAAP vs Indian GAAP. Retrieved
S
IMfrom, http://usgaap.tripod.com/id6.html
M
N

Case study
n o t e s
Impact of IFRS and GAAP on Wipro’s

Financial Statements
Wipro Limited is a leading India based organisation that offers

products and services in IT business, consumer care and lighting
and also infrastructure engineering. IT business includes IT ser-
vices and products. It comprises software services, BPO services
and products. The consolidated financial statements as per GAAP
are compared with the consolidated financial statements under
IFRS. Some selected ratios have been analysed to indicate the dif-
ferences between two sets of statements. The figures in the Balance
Sheet and Profit and Loss statements are drawn from the annual
report of the company. The Balance Sheet of Wipro under GAAP
and IFRS for the period ending 31st March 2012 is as follows:
S
Shareholders’ funds As AS As IFRS % Diff
Share capital 4,915 4917 0.04%
IM
Reserves and surplus 2,65,258 281246 6.03%
2,70,173 286163 5.92%
Minority interest 849 -100.00%
Non-current liabilities
Long term borrowings 22,510 22817 1.36%
Deferred tax liabilities 275 353 28.36%
M
Other long term liabilities 778 8922 1046.79%

26,670 32153 20.56%
Current Liabilities
Short term borrowings 35,480 36448 2.73%
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Trade payables 47,736 47258 -1.00%

Other current liabilities 23,305 32858 40.99%
Short term provisions 28,368 1121 -96.05%
1,34,889 117685 -12.75%
TOTAL EQUITY AND LIABILITIES 4,32,581 4,36,001 0.79%
Non-current assests As AS As IFRS % Diff
Goodwill 67,961 67937 -0.04%
Fixed assets
Tangible assets 54,627 58988 7.98%
Intangible assets 1,767 4229 139.33%
Capital work-in-progress 3,466 3462 -0.12%
Non-current investments 3,232 3232 0.00%
Deferred tax assets 440 2597 490.23%
Long term loans and advances 22,893 10287 -55.06%
Other non-current assets 9,168 11781 28.50%
1,63,554 162513 -0.64%

Case study
n o t e s
Shareholders’ funds As AS As IFRS % Diff

Current assets As AS As IFRS % Diff
Current investments 41,483 41961 1.15%
Inventories 10,662 10662 0.00%
Trade receivables 80,387 80328 -0.07%
Case and bank balances 77,666 77666 0.00%
Short term loans and advances 23,263 37128 59.60%
Other current assets 35,566 25743 -27.62%
2,69,027 273488 1.66%
Total Assets 4,32,581 4,36,001 0.79%
Source: http://www.wipro.com/Documents/investors/pdf-files/IFRS_Financials_Q4_
FY_12_13.pdf
The amount of current assets and current liabilities as per IFRS
S
is different from the amount in GAAP. Also, the amounts of short
term loans and advances and that of other current assets are dif-
ferent. The reason behind this is the difference in recognition of
IM
certain items of loans and trade receivables. Under IFRS loans
and trade receivables are treated quite differently. The total of the
current assets is 1.66% more in the case of IFRS which shows that
AS are more conservative. Similarly short term loans and advanc-
es, prepaid expenses, advance to suppliers are accounted for dif-
ferently in IFRS and GAAP. The total of current liability varies by
M
12.75%. Other current liabilities include employee benefits, statu-

tory liabilities, advances from customers, derivative liabilities and
accrued interest varies by about 50% for IFRS and GAAP. This is
because the cost of leases and interest expenses is treated on fair
values in IFRS which are not the case in GAAP. Also, short term
N
provisions differ by 96%. Under IFRS the total current liabilities

are quite less as compared to GAAP.
questions
1. Do the above observations in WIPRO balance sheet

emphasise the fact that IFRS is a fair value principle than
GAAP?
(Hint: IFRS is based on fair accounting principles
which improve the quality of disclosures and enhance
international comparability and understanding of
financial statements.)
2. What are the major differences in the balance sheet
prepared using IFRS and GAAP?
(Hint: The total of the current assets is 1.66% more in the
case of IFRS, total of current liability varies by 12.75%,
and other current liabilities vary by about 50% for IFRS
and GAAP.)

Ch a
7 p t er
CORPORATE ACCOUNTS
CONTENTS
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7.1 Introduction
7.2 Schedule III of the Companies Act, 2013
IM
7.2.1 The Companies Act, 2013
7.2.2 Format of Balance Sheet
7.2.3 General Instructions, for the Preparation of a Balance Sheet
7.2.4 General Instructions for the Statement of Profit and Loss
Activity
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7.3 Summary
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OPERATING CYCLE OF RUBBER PLANTATION BUSINESS
To prepare financial statements as per the Revised Schedule VI

the accounts needs to be categorised as an asset or a liability. The
concept of operating cycle has been introduced in the Revised
Schedule VI. Operating cycle refers to the time interval between
the purchase and receipt of inventory and the date when cash is
collected from receivables. Typically the operating cycle would be
different for every industry and depending upon operating and
commercial negotiating efficiencies the operating cycle can be op-
timised. Like all industries, the rubber plantation business also
required deciding the term of their operating cycles. The rubber
plantation takes about six to seven years after which the plants
become mature for tapping. Therefore, the major problem in front
S
of the rubber plantation business was whether or not to include
these years in its operating cycles. With respect to this problem,
attention was drawn towards the opinion of the Expert Advisory
Committee who released their statement on this matter in their
IM
research dated 23-3-2007 ‘Accounting treatments of surplus re-
alised on the sale of rubber trees’. The Committee opined that
rubber plants are fixed assets for rubber planting organisations
and any expenditure incurred on rubber plantations should be
capitalised when the plants are mature for tapping. Consequently,
the cost capitalised in this way required to be amortised during
M
the useful life of the rubber plants. The Expert Advisory Commit-
tee stated that the rubber plants are fixed assets and are not pro-
cessed. Apart from this, the plants not kept for sale by the rubber
planting organisations. It was then decided that the time of six to
seven years taken for plantations should be considered as part of
N
the operating cycle of rubber plantation business.

CORPORATE ACCOUNTS 179
n o t e s
learning objectives

> Discuss the Revised Schedule III of the Companies Act, 2013
> Describe the format of the Balance Sheet as per the
Schedule III
> Explain the general instructions for preparing a Balance
Sheet
> Describe the format of the Profit and Loss Statement as per
the Schedule III
> Explain the general instructions for preparing a Profit and
Loss Statement
S
7.1 INTRODUCTION
The Ministry of Corporate Affairs (MCA) prescribed Schedule III (ap-
IM
plicable as per accounting standards) of Section 129 of Indian Compa-
nies Act, 2013, which specifies the new format for the preparation and
presentation of financial statements by Indian corporates. The Re-
vised Schedule lays down the new acceptable format and general in-
structions for the preparation of financial statements of corporations;
viz. the balance sheet and the profit and loss statement. A balance
sheet is a summary of financial balances of a corporate body stating
M
the position of its assets and liabilities. On the other hand, a profit and
loss statement summarises revenues, costs and expenses incurred by
an organisation during a specific period of time usually a financial
year. This schedule prescribes various mandatory requirements such
as disclosure of addition, substitution or deletion in the head or sub-
N
head of the financial statements of a company. As per Schedule III,

monetary figures in financial statements should be rounded off to the
nearest figure of hundred and its multiples.
Schedule III introduces some concrete conceptual changes such as

the uniformity of financial statements, minimum requirements of dis-
closures in financial statements, importance to abide by the specifica-
tions of the accounting standards and the concept of operating cycle
vis-à-vis financial statements, etc. Schedule III also embraces inter-
national standards on disclosures of financial statements and thus it
makes financial statements more relevant to international practices.
It is indeed a welcome step in the direction of converging the Indian
GAAP with the International Financial Reporting Standards (IFRS).
Altogether, the Schedule is largely successful in modernising and sim-
plifying the preparation and interpretation of financial statements by
making them more relevant to present needs.
In this chapter, you will study about Schedule III of Companies Act,
2013 and the format and general instructions laid down by the Act for
the preparation of financial statements, in detail.

n o t e s
7.2 SCHEDULE III OF COMPANIES ACT 2013

The instructions for the presentation of financial statements are pre-
scribed in the Schedule III of the Act and it is applicable to all corpora-
tions (except banking companies, insurance companies and NBFCs)
for the financial year commencing on or after April 1, 2014. Howev-
er, from April 1, 2018 banking companies, insurance companies and
NBFCs will come under this schedule. The Schedule III can consid-
ered to be a step towards the convergence of Indian Accounting Stan-
dards to International Financial Reporting Standards (IFRS) with
regard to the presentation of financial statements. Many features/dis-
closures as per Schedule III are in line with international standards.
For instance, the disclosure of foreign investment, foreign currency
investment, etc. In short, the purpose of schedule III is to:
S
Acquaint corporates with IGAAP/IFRS
Ensure effective presentation, disclosure of financial data to facili-
tate organised data for users of financial statement.
IM
The Schedule III of the Companies Act lays down general instructions
for the preparation of the Balance Sheet and the statement of the prof-
it and loss of a company in addition to the notes incorporated adjacent
to the heading of the Balance sheet. These are as follows:
1. Where compliance with the requirements of the Act including
accounting standards as applicable to corporations, require
M
any change in the treatment or disclosure including addition,

amendment, substitution or deletion in the head/sub-head or
any changes interest, in the financial statements or statements
forming part thereof, the same shall be made and the requirements
N
of the Schedule III shall stand modified accordingly.

2. The disclosure requirements specified in Part I and Part II of
this Schedule are in addition to and not in substitution of the
disclosures specified in the accounting standards prescribed
under the Companies Act, 2013. Additional disclosures specified
in the accounting standards shall be made in the notes to
accounts or by the way of additional statement unless required
to be disclosed on the face of financial statements. Similarly,
all other disclosures as required by the Companies Act shall be
made in the notes to accounts in addition to the requirements set
forth in the Schedule.
3. Notes to accounts shall contain information in addition to that
presented in the financial statements and shall provide where
required:
Narrative descriptions or disaggregation of items recognised
in those statements.

n o t e s
Information about items that do not qualify for recognition in

those statements.
Each item on the face of the Balance Sheet and Statement of Profit
and Loss shall be cross referenced to any related information
in the notes to accounts. In preparing the financial statements
including the notes to accounts, a balance shall be maintained
between providing excessive detail that may not assist users of
financial statements and not providing important information as
a result of too much aggregation.
4. Depending upon the turnover of the corporation, the figures
appearing in the financial statements may be rounded off as
follows:
Turnover Rounding off
S
Amount below one hundred rounded off to the nearest hundreds,
Crore rupees thousands, rupees Lakhs or Millions,
or decimals thereof
Amount equal to or above
IM
rounded off to the nearest, Lakhs,
one hundred Crore rupees Millions or Crores, more or decimals
thereof
Once a unit of measurement is used, it should be used uniformly

in the financial statements.
5. Except in the case of the first financial statements laid before the
M
corporation (after its incorporation) the corresponding amounts

(comparatives) for the immediately preceding reporting period
for all items shown in the financial statements including notes
shall also be given.
N
6. For the purpose of the Revised Schedule VI, the terms used
herein shall be as per the applicable accounting standards.
note
Apart from this, the Revised Schedule also specifies the require-
ment of notes by the corporations. Notes disclosed at the end of the
financial statements set out the minimum requirements for disclo-
sures on the face of the Balance Sheet, and the Statement of Profit
and Loss (hereinafter referred to as “Financial Statements” for the
purpose of this Schedule). Line items, sub-line items and sub-totals
shall be presented as an addition or substitution on the face of the
Financial Statements when such presentation is relevant to an un-
derstanding of the company’s financial position or performance or
to cater to industry/sector-specific disclosure or when required for
compliance with the amendments to the Companies Act or speci-
fied in the accounting standards.

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7.2.1 THE COMPANIES ACT, 2013
The Companies Act, 2013 is the same as the notified under the existing
Companies Act, 1956. The Act combines and amends the Companies
Act, 1956. The core changes of the new Act as compared to Companies
Act, 1956 are as follows:
Companies Act, 1956 defines the term “financial year” as the peri-
od in respect of which any profit and loss account of the body corpo-
rate laid before it in AGM is made up, whether that period is a year
or not. However, according to Companies Act, 2013, every company
shall follow uniform accounting year starting April 1 – March 31.
According to Companies Act, 2013, every Listed Company /Pub-
lic Company with paid up capital of `100 Crores or more / Public
Company with turnover of `300 Crores or more shall have at least
S
one Woman Director.
The Companies Act, 1956 does not define the term “financial
statements.” The Companies Act, 2013 defines the term “financial
IMstatements” to include:
a. Balance Sheet as at the end of the financial year
b. Profit and Loss account for the financial year
c. Cash flow Statement for the financial year
d. Statement of change in equity, if applicable
M
e. Any explanatory note forming part of the above statements

Apart from the addition of general instructions for preparation of
cash flow statement, the format of financial statements given in
the Companies Act, 2013 is the same as the Revised Schedule VI
N
notified under the existing Companies Act, 1956.

The Companies Act, 2013 requires both separate and consolidated
financial statements of all companies (including banking compa-
nies) to be signed at least by the Chairperson of the company if he
is authorised by the board, or by two directors out of which one
will be Managing Director and the Chief Executive Officer, if he
is a director in the company, the Chief Financial Officer, and the
Company Secretary, if appointed.
The Companies Act, 2013 requires companies with one or more
subsidiaries to place audited financial statements of each subsidi-
ary on its website, if any.
The Companies Act, 2013 requires that every company with net
worth of `500 crore or above or turnover of `1,000 crore or above
or a net profit of `5 crore or above in a financial year shall consti-
tute a Corporate Social Responsibility (CSR) committee.

n o t e s
Difference between Companies Act 1956 and Companies Act 2013
S. Points Companies Act 1956 Companies Act 2013

No. of differ-
ence
1. Structure Companies Act 1956 is Companies Act 2013 is

divided into 13 parts, 15 divided into 29 chapters, 7
schedule and 658 sec- schedules and 470 sections.
tions.
2. Financial Financial year is not Financial year from April 01

Year specified. to March 31 must be fol-
lowed by all companies.
3. Presenta- Schedule VI Schedule III

tion of
S
Financial
State-
ments
4. Share-
IM
Maximum limit for no. of Maximum limit for no. of
holding shareholders 50. shareholders 200.
in Pvt.
Company
5. One There is no such concept Company having only one

person member prescribed under
M
company Section 2 (62)
6. Charge There is no such defini- ‘Charge’ is defined under

tion Section 2 (16). It is an in-
terest or lien brings on the
assets of the company.
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7. Listed Defined under Section Defined under Section 2

company 23 A, as the public com- (52), as the company having
pany having stocks listed stocks listed on any recog-
on any recognised stock nised stock exchange.
exchange.
7.2.2 FORMAT OF BALANCE SHEET
‘The format of financial statement prescribed in Schedule III of the

Companies Act, 2013 is applicable for all companies’ voluntary from
April 1, 2015 and Mandatory from April 01, 2016. As per schedule III,
vertical format has now been permitted for balance sheet. The bal-
ance sheet should include the following items and in the order:

n o t e s
Part I — Form of Balance Sheet

Name of the Company…………………….
Balance Sheet as at ……………………… (Rupees in…………)
Particulars Note Figures as at Figures as at
No. the end of the the end of the
current report- previous re-
ing period porting period
2 3 4
I. Equity and Liabilities
1. Shareholders’ Funds
a. Share capital
b. Reserves and surplus
c. Money received against share
warrants
2. Share Application money pending
S
allotment
3. Non-current liabilities
a. long-term borrowings
IM
b. Deferred tax liabilities (Net)
c. Other Long term liabilities
d. Long-term provisions
4. Current liabilities
a. Short term borrowings
b. Trade payables
c. Other current liabilities
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d. Short-term provisions

Total:
II. Assets
1. Non-current assets
a. Fixed Assets
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i. Tangible assets

ii. Intangible Assets
iii. Capital work-in-progress
iv. Intangible assets under
development
b. Non-current investments
c. Deferred tax assets (net)
d. Long-term Loan and Advances
e. Other Non-current assets
2. Current Assets
a. Current investments
b. Inventories
c. Trade receivables
d. Cash and cash equivalents
e. Short-term loans and advances
f. Other current assets
Total:

n o t e s
7.2.3 GENERAL INSTRUCTIONS, FOR the PREPARATION

OF a BALANCE SHEET
According to the Section 129 of Schedule III of the Companies Act,

2013, companies need to follow certain guidelines for the preparation
of their balance sheet for each financial year. These guidelines (gener-
al instructions) are as follows:
An asset shall be classified as current when it satisfies any of the
following criteria:
it is expected to be realised in, or is intended for sale or con-
sumption in, the company’s normal operating cycle;
it is held primarily for the purpose of being traded;
it is expected to be realised within twelve months after the re-
porting date; or
S
it is the cash or cash equivalent unless it is restricted from be-
ing exchanged or used to settle a liability for at least twelve
IM
months after the reporting date.
All other assets shall be classified as non-current.
A receivable shall be classified as a ‘trade receivable’ if it is in re-
spect of the amount due on account of goods sold or services ren-
dered in the normal course of business.
An operating cycle refers to the time between the acquisition of an
M
asset for processing and its realisation in cash or cash equivalents.

Where the normal operating cycle cannot be identified, it is as-
sumed to have duration of 12 months.
N
A liability shall be classified as current when it satisfies any of the

following criteria:
it is expected to be settled in the company’s normal operating
cycle;
it is held primarily for the purpose of being traded;
it is due to be settled within twelve months after the reporting
date; or
the company does not have an unconditional right to defer
settlement of the liability for at least twelve months after the
reporting date. Terms of a liability that could, at the option of
the counterparty, result in its settlement by the issue of equity
instruments do not affect its classification.
All other liabilities shall be classified as non-current.
A payable shall be classified as a ‘trade payable’ if it is in respect
of the amount due on account of goods purchased or services re-
ceived in the normal course of business.

n o t e s
A corporation shall disclose the following items as depicted in

Figure 7.1 in the notes to accounts:
Share Capital
Reserves and Surplus
Non-current Liabilities
Long term loans and Short Term Loans
Current Liabilities
Non-Current Assets
Capital Work-in-Progress
Long term Investments & Current Investments
Current Assets
S
Other Current Assets
Contingent Liabilities and Commitments
IM
Figure 7.1: Different Items in a Balance Sheet
Let us discuss specifications made in the Schedule III of Companies

Act 2013 for each of these items as follows:
SHARE CAPITAL
M
For each class of share capital, the following disclosures are required
to be made by the corporations:
the number and amount of shares authorised;
the number of shares issued, subscribed and fully paid, and sub-
N
scribed but not fully paid;

par value per share;
a reconciliation of the number of shares outstanding at the begin-
ning and at the end of the reporting period;
the rights, preferences and restrictions attaching to that class in-
cluding restrictions on the distribution of dividends and the repay-
ment of capital;
shares in the company held by its holding corporation or by its
subsidiaries or associates;
shares in the company held by any shareholder holding more than
five per cent shares;
shares reserved for issue under options and contracts/commit-
ments for the sale of shares/disinvestment, including the terms
and amounts;

n o t e s
separate particulars for a period of five years immediately preced-

ing the date as at which the Balance Sheet is prepared:
Aggregate number and class of shares allotted as fully paid up
pursuant to contracts without payment being received in cash.
Aggregate number and class of shares allotted as fully paid up
by way of bonus shares.
Aggregate number and class of shares bought back.
Terms of any securities convertible into equity/preference shares
issued along with the earliest date of conversion in descending or-
der starting from the farthest date.
Calls unpaid ( showing aggregate value of calls unpaid by directors
and officers);
S
Forfeited shares ( amount originally paid up)
RESERVES AND SURPLUS

IM
As per the Schedule III of Companies Act, 2013, Reserves and Surplus
shall be categorised as:
a. Capital Reserves
b. Capital Redemption Reserves
c. Securities Premium Reserve
M
d. Debenture Redemption Reserve

e. Revaluation Reserve
f. Other Reserves
N
g. Surplus i.e. balance in the statement of Profit & Loss disclosing

allocations and appropriations such as dividend paid, bonus
shares and transfer to/from reserves, etc.
Additions and deductions since the last balance sheet need to be re-
vealed under each of the following heads:
A reserve specifically represented by earmarked investments shall
be termed as a ‘fund’.
Debit balance of Statement of Profit and Loss shall be shown as a
negative figure under the head ‘Surplus’.
The balance of ‘Reserves and Surplus’, after adjusting negative
balance of surplus, if any, shall be shown under the head ‘Reserves
and Surplus’ even if the resulting figure is in the negative.

n o t e s
LONG TERM borrowings AND SHORT TERM borrowings
As per the Schedule III of Companies Act, 2013, long-term loans shall
be categorised as:
a. Bonds/debentures
b. Term loans
from banks
from other parties
c. Deferred payment liabilities
d. Deposits
e. Loans and advances from related parties
S
f. Long-term maturities of finance lease obligations
g. Other loans and advances
The following important points should be kept in mind with respect to

IM
Long-term borrowings:
Borrowings shall further be sub-classified as secured and unse-
cured. Nature of security shall be specified separately for each
case.
Where loans have been guaranteed by directors or others, a men-
M
tion thereof shall be made and also the aggregate amount of such
loans under each head shall be disclosed.
Bonds/debentures (along with the rate of interest and particu-
lars of redemption or conversion, as the case may be) stated in
N
descending order of maturity or conversion, starting from the far-

thest redemption or conversion date, as the case may be. Where
bonds/debentures are redeemable by instalments, the date of ma-
turity for this purpose must be reckoned as the date on which the
first instalment becomes due.
Particularsof any redeemed bonds/debentures which the compa-
ny has power to reissue shall be disclosed.
Terms of repayment of term loans and other loans shall be stated.
Period and amount of default in repayment of dues, providing
break-up of principal and interest shall be specified separately for
each case.
As per the Schedule III of Companies Act, 2013, short term loans shall
be categorised as:
Loans repayable on demand
from banks
from other parties

n o t e s
Loans and advances from subsidiaries/holding company/associ-

ates/business ventures
Deposits
Other loans and advances

Borrowings shall further be sub categorised as secured and
unsecured. Nature of security shall be specified separately for
each case.
NON-CURRENT ASSETS
As per the Revised Schedule III of Companies Act, 2013, non-current

assets shall be categorised as:
Fixed Assets
S
Tangible assets
Intangible Assets
Capital work-in-progress
IM
Intangible assets under development
Non-current investments
Deferred tax assets
Long-term loans and advances
M
Other non-current assets

Assets under lease shall be separately specified under each class
of asset.
N
A reconciliation of gross and net carrying amounts of each asset

class at the beginning and end of the reporting period showing
additions, disposals, acquisitions and other movements and the
related depreciation and impairment losses/reversals shall be dis-
closed separately.
In case where sums have been written off on a reduction of cap-
ital or revaluation of assets or where sums have been added on
revaluation of assets, each balance sheet succeeding the write-off
date shall show the reduced or increased figures as applicable and
shall by way of a note also show the amount of the reduction or
increase as applicable together with the date therefore for the first
five years subsequent to the date of such reduction or increase.
CAPITAL WORK-IN-PROGRESS
As per Schedule III of the Companies Act 2013, capital work-in-prog-
ress (WIP) is treated as a non-current asset. In the balance sheet, cap-
ital WIP is treated as a different account which is shown after fixed
assets. Provisions for non-current assets shall apply in the same way
on capital work-in-progress.

n o t e s
LONG TERM INVESTMENTS AND CURRENT INVESTMENTS

As per the Schedule III of the Companies Act, 2013, long term invest-
ments shall be classified as trade investments and other investments
and further classified as:
Investment in Property
Investments in equity instruments
Investments in preference shares
Investments in government or trust securities
Investments in units, debentures or bonds
Investments in mutual funds
Investments in partnership firm
S
Other non –current investments (specify nature)
As per the Schedule III of the Companies Act, 2013, current invest-
ments shall be classified as:
IM
Investments in equity instruments
Investments in preference shares
Investments in government or trust securities
Investments in units, debentures or bonds
M
Investments in mutual funds

Investments in partnership firm
Other investments
N
i. Under each classification, details shall be given of names

of the corporate bodies, indicating separately whether such
bodies are:
99 subsidiaries
99 associates
99 joint ventures
99 controlled special purpose entities
ii. It should also include the details of the nature and extent of
the investment so made in each such corporate body.
iii. With respect to investments in the capital of partnership firms,
the names of the firms (with the names of all their partners,
total capital and the shares of each partner) shall be given.
iv. Investments carried at other than at cost should be separately
stated specifying the basis for the valuation thereof.

n o t e s
v. The following shall also be disclosed:

99 Aggregate amount of quoted investments and market
value thereof
99 Aggregate amount of unquoted investments
99 Aggregate provision for diminution in value of invest-
ments
99 Aggregate amount of partly paid-up investments
99 The names of corporate bodies in whose securities, in-
vestments have been made
CURRENT ASSETS
As per the Schedule III of the Companies Act, 2013, current assets,
S
loans and advances shall be categorised as follows:
Current investments
Inventories
IM
Trade receivables
Cash and cash equivalents
Short- term loans and advances
Other current assets
M
These shall also be separately sub-classified as follows:

To the extent secured, considered good
Others, considered good
N
Doubtful
i. Allowance for bad and doubtful loans and advances shall be
disclosed under the relevant heads separately.
ii. Loans and advances due by directors or other officers of
the corporate body either severally or jointly with any other
persons or amounts due by firms or private companies
respectively in which any director is a partner or a director or
a member should be stated separately.
CURRENT LIABILITIES AND PROVISIONS
As per the Schedule III of Companies Act, 2013, current liabilities and
provisions shall be categorised as:
Short term borrowings
Trade payables
Other current liabilities
Short-term provisions

n o t e s
Short-term borrowings shall be sub-classified as secured and unse-

cured. Nature of security shall be indicated separately in each case.
Where loans have been guaranteed by directors or others, a mention

thereof shall be made along with disclosures of the aggregate amount
of loans under each head.
Time period and amount of default in repayment of dues, providing

break-up of principal and interest shall be specified separately for
each case.
CONTINGENT LIABILITIES AND COMMITMENTS
As per the Schedule III of Companies Act, 2013, Contingent Liabilities

shall be categorised as:
S
Claims against the company not acknowledged as debt
Guarantees
Other money for which the company is contingently liable

IM
On the other hand, commitments shall be categorised as:
Estimated amount of contracts remaining to be executed on capi-
tal account and not provided for
Uncalled liability on shares and other investments partly paid
M
Other commitments
OTHER SIGNIFICANT DISCLOSURES
The amount of dividends proposed being distributed to equity holders

N
for the period and the related amount per share shall be disclosed sep-
arately. Arrears of fixed cumulative dividends shall also be disclosed
separately.
Where in respect of an issue of securities made for a specific purpose,
the whole or part of the amount has not been used for the specific
purpose at the balance sheet date, there shall be indications by way
of notes about how such unused amounts have been used or invested.
If in the opinion of the board, any of the assets other than fixed assets
and non-current assets do not have a value on realisation in the or-
dinary course of business (at least equal to the amount at which they
are stated) the fact that the board is of the opinion, shall be indicated.
Let us understand the preparation of a balance sheet as per Schedule
III of Companies Act, 2013, with the help of an example.
Illustration 1: From the following information extracted from the

books of XYZ Ltd., prepare a Balance Sheet of the company as at 31st
March, 2017 as per Schedule III of Companies Act, 2013.

n o t e s
Particulars Amount ( in `‘000’)

Long-Term Borrowings 500
Trade Payables 30
Share Capital 400
Reserve and Surplus 90
Fixed assets (tangible) 800
Inventories 20
Trade receivables 80
Cash and cash equivalents 120
The balance sheet of XYZ Ltd. will be as follows:

XYZ Ltd. Balance Sheet as at 31st March, 2012
(in `‘000’)
S
Particulars Note No. 2011-12
I. Equity and Liabilities
1. Shareholders’ Funds
IM
a. Share Capital
b. Reserves & Surplus 400
2. Non-current liabilities 90
Long-term borrowings 500
3. Current liabilities
Trade payables 30
M
Total 1020
II. Assets
1. Non-Current Assets
a. Fixed Assets
N
Tangible Assets 800

2. Current Assets
a. Inventories 20
b. Trade receivables 80
c. Cash & Cash Equivalents 120
Total 1020
7.2.4 GENERAL INSTRUCTIONS FOR THE STATEMENT OF

PROFIT AND LOSS
General instructions for the preparation of statement of profit and loss

statements as per the Schedule III of Companies Act, 2013, are as fol-
lows:
1. The Provisions of this Part shall apply to the Income and
Expenditure account referred to in sub-clause (ii) of clause (40)
of section 2 of the Act, in like manner as they apply to a statement
of profit and loss.

n o t e s
2. (A) In respect of a company other than finance company revenue

from operations shall disclose separately in the notes revenue
from
a. Sale of products
b. Sale of services
c. Other operating revenues
Less
i. Excise duty
(B) In respect of a finance company, revenue from operations
shall include revenue from
i. Interest
ii. Other financial services
S
Revenue under each of the above heads shall be disclosed
separately by way of notes to accounts to the extent applicable.
3. Finance costs shall be disclosed as:
IM
i. Interest expense
ii. Other borrowing costs
iii. Applicable net gain/loss on foreign currency transaction and
translation
4. Other Income shall be categorised as:
M
a. Interest Income
b. Dividend Income
c. Net gain/loss on sale of investments
N
d. Other non-operating income

5. Additional Information
A corporate body shall disclose by way of notes additional
information regarding aggregate expenditure and income on the
following items:
i. Employee benefits expense
ii. Depreciation and amortisation expense
iii. Any item of income or expenditure which exceeds one per
cent of revenue from operations or `1,00,000, whichever is
higher
iv. Interest income
v. Interest expense
vi. Dividend income
vii. Net gain/loss on sale of investments
viii. Adjustments to the carrying amount of investments

n o t e s
6. The P&L account shall also disclose by way of notes, the following
information:
i. Value of imports during the financial year in respect of the
following:
99 Raw material
99 Components and spare parts
99 Capital goods
ii. Expenditure in foreign currency during the financial year on
account of royalty, know-how, professional and consultation
fees, interest and other matters
iii. Total value if all imported raw materials, spare parts and
components consumed during the financial year and the
total value of all indigenous raw materials, spare parts and
S
components similarly consumed and the percentage of each
to the total consumptions
iv. Earnings in foreign exchange classified under the following:
IM
99 Exports of Goods
99 Royalty, know-how, professional and consultation fees
99 Interest and Dividends
99 Other Income
M
7. As per the Schedule III of Companies Act, 2013, the corporate

bodies shall disclose the expenditure incurred separately for the
following categories:
Consumption of stores and spare parts
N
Power and fuel

Rent
Repairs to building
Repairs to machinery
Insurance
Rates and taxes, excluding, taxes on income
Apart from the above the following would also need to be disclosed
separately:
items exceeding the higher of one per cent of revenue from opera-
tions or INR 1,00,000
net loss on sale of investments
provision for diminution in the value of investments/other adjust-
ments to carrying amount of investments

n o t e s
net loss on account of foreign exchange

provisions for losses of subsidiary companies
The Revised Schedule VI of the Companies Act, 1956 lays down a new
format for the presentation of Profit and Loss (P&L) account of cor-
porate bodies. It permits the use of the vertical format of presentation
only. The revised format of P&L account is as follows:
Part II – Form of Statement of Profit and Loss
Name of the company………………………
Profit and Loss statement for the year ended ……………………….
(Rupees in……………)
Particulars Note Figures as Figures as
No. at the end of at the end of
the current the previous
reporting reporting
S
period period
I. Revenue from operations XXX XXX
II. Other Income XXX XXX
III. Total Revenue (I+II) XXX XXX
IM
IV. Expenses:
Cost of materials con- XXX XXX
sumed
Purchases of Stock-In-
Trade
XXX XXX
Changes in inventories
M
of finished goods work-

in-progress and Stock-in-
Trade
Employee benefits
expense
Finance costs
N
Depreciation and amorti-

sation expense
Other expenses
Total Expenses XXX XXX
V. Profit before exceptional XXX XXX
and extraordinary items
and tax (III-IV)
VI. Exceptional Items XXX XXX
VII. Profit before extraordi- XXX XXX
nary items and tax (V-VI)
VIII. Extraordinary items XXX XXX
IX. Profit before tax (VII-VI- XXX XXX
II)
X. Tax Expense:
1. Current Tax XXX XXX XXX
2. Deferred Tax XXX XXX XXX

n o t e s
Particulars Note Figures as Figures as

No. at the end of at the end of
the current the previous
reporting reporting
period period
XI. Profit/(Loss) for the XXX XXX
period from continuing
operations
XII. Profit/(Loss) from dis- XXX XXX
continuing operations
XIII. Tax expense of discon- XXX XXX

tinuing operations
XIV. Profit/(Loss) from Dis- XXX XXX
continuing operations
(after tax)
XV. Profit/(Loss) for the XXX XXX
S
period
XVI. Earnings per equity
share:
1. Basic XXX XXX XXX
IM
2. Diluted XXX XXX XXX
1. The Schedule III of Companies Act, 2013, provides general

instructions for the preparation of_____________.
M
(a) Financial statements

(b) Balance sheet only
(c) Profit and loss statement only
(d) Cash book
N
2. The format of financial statements prescribed in Schedule

III of Companies Act, 2013, was voluntary applicable
from____________.
(a) April 2014
(b) April 2015
(c) April 2016
(d) April 2017
3. Schedule III of Companies Act, 2013, provides instructions for
the preparation of the ______________ and ____________________
of Indian corporations.
(a) Balance sheet and profit and loss statement
(b) Balance sheet, Profit and Loss Statement and cash flow
statement

n o t e s
(c) Balance sheet, Profit and Loss Statement and Consolidated

financial statement
4. If the turnover of the corporate body is below one hundred
crore rupees, then which of the following rounding off method
shall apply?
(a) Rounded off to the nearest, lakhs, millions or crores, more
or decimals thereof
(b) Rounded off to the nearest hundreds, thousands, rupees
lakhs or millions, or decimals thereof
S
5. Which of these is NOT included in current liabilities?
(a) Short term borrowings
(b) Capital work-in-progress
IM
(c) Other current liabilities
(d) Short-term provisions
6. As per Schedule III of Companies Act, 2013, which of the
following represents fixed assets?
(a) Capital work-in-progress
M
(b) Tangible and intangible

(c) Intangible assets under development
N
7. __________________ is the balance in the statement of Profit

& Loss disclosing allocations and appropriations such as
dividend paid, bonus shares and transfer to/from reserves.
(a) Surplus
(b) Reserves
(c) Transfer payments
8. Capital work-in-progress is a __________.
(a) Current asset
(b) Fixed asset
(c) Non-current asset

n o t e s
9. Repairs to building and machinery is categorised under which

of the following heads?
(a) Non-current liabilities
(b) Current liabilities
(c) Miscellaneous expenditures
(d) Contingent liabilities
10. As per general instructions for preparation of P&L account, in
respect of a finance company, revenue from operations shall
include revenue from ____________
(a) Interest
(b) Loans
(c) Other Financial services
S
11. Income generated from interest and dividends are categorised
as ____________ in the P&L account of a corporation as per
IM
the revised schedule.
(a) Interest income
(b) Other income
(c) Opportunity income
(d) Real income
M
12. Any item of income or expenditure which exceeds one per

cent of revenue from operations or `1,00,000, whichever is
higher is disclosed by the corporate by way of ______________.
(a) Financial operations
N
(b) Summarisation
(c) Notes
13. As per Revised Schedule VI, the value of imports is disclosed
in notes with respect to:
(a) Raw material
(b) Components and spare parts
(c) Capital goods
14. As per the new P&L format, tax expense of corporations is
classified further into:
(a) Current Tax
(b) Duties and Taxes

n o t e s
(c) Direct Taxes only

15. Uncalled liability on shares and other investments partly paid
are categorised under the head _____________________.
(a) Commitment
(b) Enjoy
(c) Capital goods
16. Debit balance of statement of profit and loss shall be reported
as a negative figure under the head __________________.
(a) Reserve
(b) Capital gains and losses
S
(c) Surplus
IM
17. ___________ refers to potential liabilities that occur due to an
unforeseen or uncertain future event such as a court case or
fire.
(a) Non-current liabilities
(b) Contingent liabilities
(c) Current liabilities
M
(d) Emergencies
18. As per the Schedule III of Companies Act, 2013, _________
format of the balance sheet is/are permitted to be used by
corporates.
N
(a) Horizontal
(b) Vertical
(c) Straight line
(d) Both (a) and (b)
19. ________ amounts due to a business from its customers in
exchange for the goods or services delivered to them in the
ordinary course of business.
(a) Trade receivable
(b) Trade payable
(c) Prepaid expenses
(d) Customer liability
20. Uncalled liability on shares and other investments partly paid
are categorised under the head _______________.
(a) On spot Liability
(b) Promised Liability

n o t e s
(c) Commitments
(d) Current liability
21. As per the Companies Act, 2013, financial year is defined as
the period from __________ to ___________.
(a) 1st April to 31st March
(b) 31st March 1st April
(c) 1st January to 31st December
Activity
Identify and list down the main points of differences between the
S
Old Schedule VI and Revise Schedule VI.
7.3 SUMMARY
IM
The Ministry of Corporate Affairs (MCA) vide Notification No.
1/19/2013-CL-V dated April 04, 2014, which provides the com-
mencement of provisions under Companies Act 2013 including the
maintaining books of accounts, auditors report board of directors
report, instructions for the preparation of the balance sheet, state-
ment of profit & loss of corporations and consolidated statement,
M
etc.
Old Revised Schedule VI to the Companies Act, 1956 has not been
able to keep pace with changes taking place in the international
arena.
N
The Schedule III of Companies Act, 2013, is applicable to all cor-

porations (except banking companies, insurance companies and
NBFCs) for the financial year commencing on or after April 1,
2014. However, from April 1, 2018 banking companies, insurance
companies and NBFCs will come under this schedule.
Major heads under which the assets are presented in the Balance
Sheet of the company as per Schedule III of Companies Act, 2013,
are (i) Non-current Assets and (ii) Current Assets.
The major heads under which the ‘Equity and Liabilities’ are pre-
sented in the Balance Sheet of a company as per Schedule III of
Companies Act, 2013, are (i) Shareholders’ Funds, (ii) Share Appli-
cation Money Pending Allotment, (iii)Non-Current liabilities and
(iv) Current Liabilities.
The sub-heads under ‘Shareholders’ Funds are (i) Share Capital,
(ii) Reserves and Surplus, (iii) Money received against Share War-
rants.
The sub-heads under ‘Non-current liabilities’ are (i) Long-term
Borrowings, (ii) Deferred Tax Liabilities (iii) Other Long-term Lia-
bilities and (iv) Long-term Provisions.

n o t e s
Notes provided at the end of financial statements as per Revised

Schedule VI set out the minimum requirements for disclosures by
the corporates.
In respect of a company other than finance company revenue from
operations shall disclose separately in the notes revenue from the
sale of products + sale of services + other operating revenues –
excise duty.
In respect of a finance company, revenue from operations shall in-
clude revenue from interest and other financial services.
Finance costs shall be disclosed as interest expense, other borrow-
ing costs and applicable net gain/loss on foreign currency transac-
tion and translation.
A corporate body shall disclose by way of notes additional infor-
S
mation regarding aggregate expenditure and income.
The P&L account shall also disclose by way of notes, the value
of imports, earnings in foreign exchange, expenditure in foreign
IMcurrency, total value if all imported raw materials, spare parts and
components consumed during the financial year, etc.
key words
Commitments: Pledges regarding a substantial expenditure at

a future date. Commitments are deemed liabilities and must be
M
disclosed in the firm’s balance sheet.

Contingent liabilities: Potential liabilities that occur due to an
unforeseen or uncertain future event such as a court case or
fire.
N
Intangible assets: The non-physical assets such as patents,

trademarks, copyrights, goodwill and brand recognition.
Operating cycle: The number of days or the time interval be-
tween the arrival of inventory and the realisation of cash from
receivables.
Tangible assets: Assets that have a physical form and include
both fixed assets, such as machinery, buildings and land and
current assets, such as inventory.
Trade payables: Amounts due by a business to its suppliers in
exchange of the goods or services consumed by the business in
the ordinary course of business.
Trade receivables: Amounts due to a business from its custom-
ers in exchange for the goods or services delivered to them in
the ordinary course of business.

n o t e s

1. Describe the Schedule III of the Companies Act, 2013.
2. Explain the format of the balance sheet as per the Revised
Schedule VI.
3. List the major heads under which the ‘Equity and Liabilities’ are
presented in the Balance Sheet of a company as per Schedule III
of the Companies Act, 2013.
4. Explain the format of profit and loss statement as per Schedule
III of the Companies Act, 2013.
5. List major heads under which ‘assets’ are presented in the
balance sheet of a company as per Schedule III of the Companies
Act, 2013.
S
6. Is it possible to round off the amount appearing in the financial
statements? Explain the method.
7. Describe the general instruction for preparing a balance sheet.
IM
8. Name sub-heads under the heads ‘Shareholders Funds’ and
‘Non-current liabilities as per Schedule VI Part 1 of the Balance
Sheet.
9. What were the main reasons for the revision of the old schedule
by the Ministry of Corporate Affairs?
M

N

Schedule III of the Compa- 1. a. Financial Statements
nies Act, 2013
2. b. April 2015
3. d. Both (b) and (c)
5. b. Capital Work in progress
7. a. surplus
8. b. Fixed Assets
9. c. Miscellaneous Expenditure

n o t e s

11. b. Other income
12. c. Notes
14. a. Current tax
15. a. Commitment
16. b. Capital Gains and Losses
17. b. Contingent Liabilities
18. b. Vertical
19. a. Trade receivable
S
20. c. Commitments
21. a. 1st April to 31st March
IM
1. Schedule III of Companies Act 2013 deals with the form of balance
sheet and profit and loss account and classified disclosure to be
made therein and it applies uniformly to all companies registered
under the Companies Act, 2013, for the preparation of financial
M
statements of an accounting year. Refer to Section 7.2 Schedule

III of Companies Act 2013.
2. Schedule III of Companies Act 2013 permits the use of only
vertical balance sheet formats with major heads as equity
and liabilities and assets. Refer to Section 7.2 Schedule III of
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Companies Act 2013.

3. Major heads under which the ‘Equity and Liabilities’ are
presented in the balance sheet of a company as per Schedule
III of Companies Act, 2013, are (i) Shareholders’ Funds, (ii)
Share Application Money Pending Allotment, (iii)Non-Current
liabilities and (iv) Current Liabilities. Refer to Section 7.2
Schedule III of Companies Act 2013.
4. Schedule III of Companies Act 2013 of Companies Act, 1956
permits the use of only vertical profit and loss statement formats.
Refer to Section 7.2 Schedule III of Companies Act 2013.
5. Major heads under which assets are presented in the balance
sheet of the company as per Schedule VI Part I of the Companies
Act 1956 are (i) Non-current Assets and (ii) Current Assets. Refer
to Section 7.2 Schedule III of Companies Act 2013.

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6. Depending upon the turnover of the company, figures appearing

in the financial statements may be rounded off as below:
Turnover Rounding Off
Amount below one hundred rounded off to the nearest hundreds,
crore rupees thousands, rupees lakhs or millions,
or decimals thereof
Amount equal to or above rounded off to the nearest, lakhs,
one hundred crore rupees millions or crores, more or decimals
thereof
Refer to Section 7.2 Schedule III of Companies Act 2013.
7. According to the Schedule III of Companies Act, 2013,
organisations need to follow certain guidelines for the preparation
of their balance sheet for each financial year. Section 7.2 Schedule
III of Companies Act 2013.
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8. Sub-heads under ‘Shareholders’ Funds are (i) Share Capital,
(ii) Reserves and Surplus, (iii) Money received against Share
Warrants. The sub-heads under ‘Non-current liabilities’ are (i)
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Long-term Borrowings, (ii) Deferred Tax Liabilities (iii) Other
Long-term Liabilities and (iv) Long-term Provisions. Refer to 7.2
Schedule III of Companies Act 2013.
9. Old Revised Schedule VI to the Companies Act, 1956 has not been
able to keep pace with changes taking place in the international
arena. Refer to Section 7.2 Schedule III of Companies Act 2013.
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1. From the following information extracted from the books of ZZ
Ltd., prepare a balance sheet of the company as at 31st March,
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2017 as per Schedule III of the Companies Act, 2013.

Long-Term Borrowings 240000
Trade Payables 30000
Share Capital 600000
Reserve and Surplus 90000
Fixed assets (tangible) 720000
Inventories 20000

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Solution:
ZZ Ltd. Balance Sheet as at 31stMarch, 2017
Particulars Note No. Amount (`)
I. EQUITY AND LIABILITIES
Shareholders’ funds
(a) Share capital 600000
(b) Reserves and surplus 90000
(a) Long-term borrowings 240000
Current liabilities
Trade payables 30000
TOTAL 960000
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II. ASSETS
Non-current assets
Fixed assets 720000
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Current assets
Inventories 20000
TOTAL 960000
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2. Suppose XYZ Ltd. purchased goods worth `100000 for cash.

What will be the impact of this transaction on the balance sheet?
Solution:
By applying transaction analysis, we will analyse the impact of
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above transaction (cash purchase of goods worth `100000) as

follows:
Asset (Cash) = decreases by `100000
Asset (Inventory) = increases by `100000
Increase in inventory will contribute to increase in assets for
`100000 and because purchase is done on a cash basis then assets
should be deducted by `100000 due to reduction in cash.
3. Calculate total fixed assets from the following information given
below:
Buildings 10000000
Goodwill 100000
Patents 50000
Capital work-in-progress 100000
Copyrights under development 75000

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Deferred tax assets 15000
Long-term loans and advances 100000
Other non-current asset 150000
Inventories 200000
Solution:
Total fixed assets can be calculated as follows:
Buildings 10000000
Goodwill 100000
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Patents 50000
Capital work-in-progress 100000
Copyrights under development
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Total Fixed Assets 10325000
note
Deferred tax assets are included in non-current investments and

cash and cash equivalents are part of current asset.
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4. Calculate total current assets from the following information

given below:
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Current investments 1000000

Inventories 100000
Mutual funds 50000
Cash 200000
Foreign exchange reserves 10000
Short term government bonds 20000
Bank overdraft 10000
Goodwill 100000
Patents 10000
Trademark 15000
Prepaid expenses 30000

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Solution:
Total current assets can be calculated as follows:
Current investments 1000000
Inventories 100000
Mutual funds 50000
Cash 200000
Foreign exchange reserves 10000
Short term government bonds 20000
Prepaid expenses 30000
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Total Current Assets 1460000
note
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Goodwill, Patents and Trademark are part of fixed assets.
5. Calculate total current liabilities from the following information

given below:
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Short term borrowings 100000

Customer deposits 10000
Short-term provisions 15000
Pension liabilities 17000
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Deferred revenue 20000
Deferred compensation 14000
Dividend payable 17000
Solution:
Total current liabilities can be calculated as follows:
Short term borrowings 100000
Customer deposits 10000
Short-term provisions 15000
Dividend payable 17000
Total Current Liabilities 154000

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6. Calculate other current liabilities from the following information

given below:
Total Assets 900000
Long term loan 200000
Share Capital 500000
Advance income 10000
Short-term borrowing 90000
Debtors 60000
Deferred revenue 30000
Other current liabilities ?
Solution:
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We know that,
Total Assets = Liabilities + Capital
Or
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Liabilities = Total Assets – Capital
= 900000 – 500000
Therefore, Liabilities = `400000
Other current liabilities = Liabilities – (Long term loan +
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Advance income + Short-term borrowing + Debtors + Deferred

revenue)
= 400000 – (200000+10000+90000+60000+30000)
= 400000 – 390000
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Other current liabilities = `10000
SUGGESTED READINGS
Bhattacharya,
A. (2014). Essentials of Financial Accounting:
BASED ON IFRS (3rd ed., pp. 151-152). Delhi: Prentice Hall India.
Khatri, D. (2011). Financial Accounting (1st ed., pp. 685-696). Delhi:
Tata McGraw Hill.
Kuppapally, J. (2008). Accounting for Managers (1st ed., pp. 19-23).
Delhi: Prentice Hall India.
Ramachandran, N., & Kakani, R. (2011). Financial Accounting for
Management (3rd ed., pp. 710-715). Delhi: Tata McGraw Hill.

n o t e s
E-REFERENCES
Abaobkn.org. (2014). SCHEDULE VI-1203971 Download www.
sebpdf.org. Retrieved from, http://www.abaobkn.org/down-
load/1203971.htm#.U8UdzJSSxb5
Chartered Club. (2011). Changes in Schedule VI – Old vs New (Re-
vised). Retrieved from, http://www.charteredclub.com/changes-in-
schedule-vi-old-vs-new-revised/
Wirc-icai.org. (2014). WIRC. Retrieved from, https://www.wirc-icai.
org
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Case study
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P&L STATEMENT OF GOODS PRIVATE LTD
Goods Private Ltd. is engaged in the manufacture and sale of tex-

tiles and has earned total revenue of `120 crores from its opera-
tions. The following heads are listed in its trial balance:
Rent paid `6.00 crores
Insurance of factory building `0.75 crores
Internal audit fees `0.10 crores
Legal fees `0.50 crores
Power and fuel `1.25 crores
ISO certification fee `0.25 crores
Property tax paid `0.60 crores
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Travelling & conveyance `1.40 crores
Income tax penalty `0.50 lakhs
As per Schedule III of Companies Act, 2013, following items are

disclosed separately by the organisation in the statement of P&L
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irrespective of its significance.
Rent paid – `6.00 crores
Insurance of factory building – `0.75 crores
Power and fuel – `1.25 crores
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Property tax paid – `0.60 crores

For the remaining items, the company prepares a separate disclo-
sure for items exceeding `1.20 crores. Accordingly, travelling and
conveyance amount of `1.40 crores (higher than `1.20 crores) are
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separately disclosed.
questions
1. As per Schedule III of Companies Act, 2013, how would

you treat the three fees (internal audit fees, legal fees and
ISO certification fees) and place them under which head
in the P&L account of Goods Private Ltd.?
(Hint: Internal audit fees, legal fees and ISO certification
fee shall be placed under ‘Other Expenses’ since their
values are below the threshold (`1.20 crores).)
2. Income tax penalty does not meet the threshold amount
of `1.20 crores. Would you also place it under ‘Other
Expenses’?
(Hint: As per Schedule III of Companies Act, 2013, income
tax shall qualify as an extraordinary / exceptional item.
Therefore, it is required to be disclosed separately as per
materiality.)

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Ch a
8 p t er
CASH FLOW STATEMENT
CONTENTS
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8.1 Introduction
8.2 Concept of Cash Flow Statement
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8.2.1 Meaning and Objectives of Cash Flow Statement
8.2.2 Limitations of Cash Flow Statement
Activity
8.3 Cash Flow Statements (AS-3)
8.3.1 Cash Flows from Operating Activities
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8.3.2 Cash Flows from Investing Activities

8.3.3 Cash Flows from Financing Activities
8.3.4 Treatment of Certain Items as per AS-3
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Activity
8.4 Summary

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Preparation of Cash Flow Statement at Shivay

Textiles
Shivay Textiles is a sole proprietorship firm that is owned by a

single individual. The firm is based in the union territory of Chan-
digarh and has a staff of 32 employees. It owns many clothing
stores of readymade garments in the state capital region of Chan-
digarh and it is a famous merchandise store among local people.
Shivay Textiles needs a cash flow statement to understand the

cash position of the business. There are three main activities
found in various recording books of any firm or a company name-
ly operating activities (core operations of the business), investing
activities (sale and purchase of assets) and financing activities
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(cash received from financing and cash paid to owners).
Preparing a cash flow statement required a proper format pre-

scribed by the Ministry of Corporate Affairs in the Companies Act
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2013. As per the format, the header of the statement should be
company name (Shivay Textiles in this case) and then below this
it must be stated that ‘Statement of Cash Flow’ for the accounting
period ending March 31, 20XX.
The first section is for ‘cash flow from operating activities’. So as

per the format we start with the net profit and then various ad-
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justments were made in the given order. Under this section, we

have to add non-cash expenses such as depreciation and amorti-
sation and then subtract non-operating incomes such as profit on
sale of fixed assets. In this case, if the firm has purchased invento-
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ry of merchandise on a cash basis then we need to subtract it from

and add it to supplies. If there is a decrease in creditors or account
payable, it means that the firm has paid of its debts. This event is
a cash flow and it should be deducted from cash. Same treatment
should be done with tax payable.
Then next section is for investing activities and any increase or

decrease in assets should be recorded under it. In this case, if
Shivay Textiles buys a new clothing store for cash then it will be
treated as cash outflow from investing activities.
The third and last section of cash flow statement is for cash flow
from financing activities. Under this section, any cash inflow or
outflow from financing activities (loans, issue of shares, issue of
debentures, so it is a cash inflow and it should etc.) are recorded
under this head. It also involves recording of various transactions
such as Interest received (Add), Sale of old machinery (Add), Div-
idend received (Add), repurchase of shares (Subtract), etc. In this
case, suppose Shivay Textiles buys a clothing store by borrowing

CASH FLOW STATEMENT 215
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loan from a bank. This activity is a cash inflow from financing

activities and should be considered cash inflow from financing
activities. On the other hand, payment of loan is considered to
be cash outflow from financing activities. Now suppose the pro-
prietor of Shivay Enterprise withdraws money for personal use.
Then in this case it is considered as cash outflow and it should be
deducted from financing activities.
In the last step the total of all three sections has to be calculated
by using formula, cash inflows minus cash outflow. After calcu-
lating this, suppose Shivay Enterprise shows a change in positive
cash balance with `250000 and the beginning cash balance was
`100000. Then the total cash balance at the end will be calculated
by adding `250000 and ` 100000. Which is equal to ` 350000 and
the ending cash in the balance sheet will be recorded as 350000.
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learning objectives

> Discuss the concept of Cash Flow Statement
> Explain the limitations of Cash Flow Statement
> Describe the proforma of Cash Flow Statement using direct
and indirect methods
> Explain the calculation of net cash flows from operating ac-
tivities, investing activities and financing activities
> Describe the treatment of certain items in Cash Flow State-
ment as per AS-3
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8.1 INTRODUCTION
Generally a reference to the financial statements of an organisation
means its balance sheet and profit and loss/income statements. The
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income/profit and loss statement of the organisation gives an account
of its financial performance due to its operations in a given financial
year. However, the income/P&L account does not disclose the cash
flows in the organisations made later (deferred payments to and by
suppliers and customers respectively).
Similarly, certain items such as amortisation, returns on taxes, non-

M
cash expenses are also not included in the cash flow statements. There-
fore, there is a need to maintain a separate record of the cash inflows
and outflows, non-cash expenses and deferred payments made by an
organisation from to its operating, investing and financing activities.
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The Cash Flow Statement allows the investors to assess the perfor-
mance of an organisation based on its sources and outflows of cash
and cash equivalents. As a result, a Cash Flow Statement is now con-
sidered as the third most important financial statement of an organi-
sation. The traditional method of preparation of the Cash Flow State-
ment has been replaced by the format specified as per Accounting
Standard 3 (AS-3).
In this chapter, you will study about how the Cash Flow Statement
is structured, the components of a Cash Flow Statement and the as-
sessment of net cash flows due to operating, investing and financing
activities of an organisation.
8.2 CONCEPT OF CASH FLOW STATEMENT

The Cash Flow Statement is a mandatory record of an organisation’s
financial reports. It records the amount of cash and cash equivalents
entering and leaving an organisation in a given time period. Thus it is
a statement which shows the change in cash balances during a spec-

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ified period. The Cash Flow Statement enables investors to compre-

hend how an organisation is performing in terms of its operations, the
source of its money resources and how the available cash is utilised.
A Cash Flow Statement combined with the other financial statements
provides information allowing investors to evaluate the changes in net
assets of an organisation, its financial structure, its liquidity and sol-
vency conditions and the organisation’s ability to affect the amounts
and timing of cash flows. Cash flow details help in assessing the ability
of the organisation to generate cash and cash equivalents to enable
users in comparing the present value of the future cash flows of dif-
ferent organisations. To gain a better understanding of the Cash Flow
Statement, let us discuss the concept of Cash Flow Statement and its
objectives in the next section.
8.2.1 MEANING AND OBJECTIVES OF CASH
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FLOW STATEMENT
A Cash Flow Statement is a summary of an organisation’s inflow and

outflows of cash or cash equivalents for a given reporting period. It
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provides with the information about the historical changes in cash
and cash equivalents of an organisation by classifying the cash flows
in a period owing to different activities as depicted in Figure 8.1:
Cash Flow
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Statement
Cash Flows due Cash Flows due Cash Flows due

to Operating to Investing to Financing
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Activities Activities Activities
Figure 8.1: Categorisation of a Cash Flow Statement
A Cash Flow Statement reports the cash flows during the period clas-
sified by operating, investing and financing activities.
Let us discuss the different terminologies associated with a Cash Flow

Statement:
Cash: This includes an organisation’s cash in hand and deposits
with banks.
Cash equivalents: These include the short-term highly liquid in-
vestments that can be easily converted into cash. Cash equivalents
have short maturity periods (about three months or less) from the
date of acquisition.
For example, treasury bills, liquid mutual funds.
Operating activities: Cash flows from operating activities include
the changes in cash due to major revenue producing activities such

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as sale of goods as well as major operating expenses for purchase

of goods and services, operating expenses. Therefore, cash flows
from operating activities accrue from the transactions and events
that determine the net profit or loss incurred by the organisation.
For example, cash receipts from sale of goods, cash receipts from
royalties, fees, commission, etc.
Investing activities: Cash flows from investing activities include
the changes in cash due to purchase or sale of long-term assets
(also known as non-current assets) not included in cash equiva-
lents. The disclosure is made separately to highlight the expendi-
tures made on resources intended to generate future income and
cash flows. For example, cash payments to purchase fixed assets,
cash receipts from sale of fixed assets, cash payments to acquire
shares, warrants, debt instruments, loans or advances made to
other organisations, etc.
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Financing activities: Cash flows from financing activities include
the changes in the size and composition of the share/owner’s cap-
ital and debt of the organisation. Financing activities of an organ-
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isation depict how a firm raises capital and pays back to investors
through the capital markets. For example, cash proceeds from is-
sue of shares and other market instruments, cash proceeds from
issue of loans, debentures, bonds etc., dividend/interest paid by
the organisation to its shareholders, etc. Hence this section of the
cash flow deals with the capital structure and major changes in the
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composition of the capital structure i.e. both equity and debt.
What are the objectives of a Cash Flow Statement?
A Cash Flow Statement fulfils several objectives of an enterprise. The

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objective of the Cash Flow Statement is to provide the information

about the cash inflows & cash outflows to all stakeholders. It depicts
the organisation’s liquidity position or its ability to meet current ex-
penses using the available resources. The main objectives of a Cash
Flow Statement are as follows:
Cash Flow Statements provides the knowledge of the cash posi-
tion. It indicates the changes in the cash position as well as the
reasons for the changes.
Cash Flow Statements are useful for providing a business with a
general idea of how it will make ends meet in the short term and
thereby maintain the short term and long term solvency. This as-
pect is also useful for external investors to analyse the liquidity
and solvency of an organisation.
Cash Flow Statements are useful to the management for prepar-
ing dividend and profit retention policies.
Cash Flow Statements guide the management to evaluate the
changes in cash position.

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Cash Flow Statements provide the management with details about

the performance of operational, financial and investment activities
for effective decision making.
Cash Flow Statements provide information about the factors caus-
ing the cash flows.
Cash Flow Statements guide the management to take a decision
about short-term obligations.
Cash Flow Statements provide the details about the sources of
cash and applications of cash during a given period.
Cash Flow Statements provide a base for the preparation of cash
budgets.
8.2.2 LIMITATIONS OF CASH FLOW STATEMENT
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The limitations of Cash Flow Statements are as follows:
Cash Flow Statements are based on cash flows and record the
movement of cash. Only cash transactions are recorded. Thus, it
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ignores the accrual concept of accounting.
Cash Flow Statements are not a complete substitute for the In-
come Statement or the Profit & Loss Account. The net cash flow
calculated in the Cash Flow Statement cannot be equal to the net
profit calculated under a profit and loss account. As it considers
only the inflows and outflows of cash, the Net Cash Flow of a cer-
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tain period does not necessarily mean the Net Profit of the busi-
ness, as Net Profit is determined using both cash as well as non-
cash transactions.
It ignores the non-cash transactions. For example, the purchase of
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fixed assets by the issue of shares or debentures.

The Cash Flow statement cannot substitute a Balance Sheet. It
cannot indicate the correct financial position of an organisation.
Cash Flow Statement does not provide a comprehensive detail of
the financial position of an organisation as non-cash items of ex-
penses and incomes are excluded from the statement.
The Cash Flow statement cannot substitute a Fund Flow State-
ment. The Fund Flow Statement depicts the changes in Working
Capital whereas the Cash Flow Statement depicts the changes in
the cash position and the reasons thereof.
1. The cash flow statement is a mandatory record of an

organisation’s financial reports.
(a)
Voluntary (b)
Mandatory
(c) Significant (d) Both (b) and (c)

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2. ________ enables investors to comprehend how an organisation

is performing in terms of its operations, the source of its money
resources and how the available cash is invested.
(a) Cash flow statement
(b) Cash book
(c) Principle book
(d) Balance sheet
3. _____________ includes short-term highly liquid investments
that can be easily converted into cash.
(a) Cash equivalents
(b) Cash alternatives
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(c) Current debtors
4. Cash flows from which of these activities include changes in
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cash due to major revenue producing activities?
(a) Operating activities (b) Investing activities
(c) Financing activities (d) Departmental activities
5. ________________ of an organisation depicts how a firm raises
capital and pays back to investors through capital markets.
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6. ___________ refer to highly liquid securities that can be
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converted into cash quickly at a reasonable price.

(a) Common stock (b) Certificates of deposit
(c) Debentures (d) All of the above
Activity
List some examples of non-cash items that affect the cash position
of an organisation.
8.3 CASH FLOW STATEMENTS (AS-3)

The Institute of Chartered Accountants of India (ICAI) has issued
the Accounting Standards (AS-3) for the preparation of Cash Flow
Statement for accounting periods starting on or after April 1, 2001.
The Cash Flow Statement as per AS-3 has some fundamental differ-
ences from the Cash Flow Statement as per the traditional method
which is shown in Table 8.1:

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Table 8.1: Difference between AS-3 and tradition-

al methods of Cash Flow Statement
Cash Flow Statement as per AS-3 Cash Flow Statement as per
traditional method
Cash includes not only cash in hand and Cash includes cash in hand
bank deposits but also short-term invest- and bank deposits only.
ments or marketable securities. Such
short term investments are classified as
cash equivalents.
Cash flows statement includes cash flows There is no such separation of
from operating, investing and financing cash flows.
activities.
Two separate approaches, direct and in- A single approach is followed
direct method are followed for the prepa- to prepare the Cash Flow
ration of a Cash Flow Statement. Statement.
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Procedure to Prepare Cash Flow Statement as Per AS-3
(Revised)
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Firstly, all the information relating to the cash flow statement is col-
lected from the Profit & Loss Account and the Balance Sheet. The
following steps are necessary to prepare the Cash Flow Statement:
1. Opening and closing balances of cash and cash equivalents are
determined. These balances are calculated by addition of the
following amounts:
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a. Cash in hand
b. Cash at bank
c. Marketable Securities
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d. Short term investments( Invested for 3 or less than 3 months)

2. Net Cash provided (or used) by the Operating Activities
3. Net Cash provided (or used) by the Investing Activities
4. Net Cash provided (or used) by the Financing Activities
5. Net increase or decrease in Cash and Cash equivalents is
determined by the aggregation of net cash provided (or used)
by the operating, investing and financing activities which are
calculated above in the 2nd, 3rd and 4th steps.
6. In the last step, the net increase or decrease in cash and cash
equivalents is reconciled with the opening and closing balance
of cash and cash equivalents. The difference of opening and
closing balance of cash and cash equivalents should be equal to
the net increase opening and closing balance of cash and cash
equivalents.
After preparation of the Cash Flow Statement, a note should be given

regarding the non-cash items and extra-ordinary items.

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The direct and indirect methods for presentation of Cash Flow State-
ment as per AS-3 are as follows:
Direct Method: As per the direct method, the net cash flows from
operating activities is calculated directly by deducting the cash
outflows from Operating Activities from cash inflows from Oper-
ating Activities.
Indirect Method: As per the indirect method, the net cash flows
from operating activities is calculated indirectly by adding all
non-operational and non-cash items debited to Profit and Loss Ac-
count and later deducting it from non-operational and non-cash
items credited to Profit and Loss Account for a financial year.
The proforma of Cash Flow Statement using direct and indirect meth-
ods are as follows:
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Proforma of Cash Flow Statement using direct method:
Cash Flow Statement of ____________for the period ended ____________.

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Particulars ` ` `
A. Cash flows from Operating Activities
Cash receipts from customers by sale of Goods and Ser-
vices, Debtors, Royalties, Fees and Commission
Less: Cash paid to suppliers and employees
Cash generated from operations
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Less: Income tax paid

Cash flows from Operation before extraordinary items
Add: Proceeds from any disaster settlement
Net cash flows from Operating Activities
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B. Cash flows from Investing Activities

Proceeds from sale of fixed assets including investments
Less: Purchase of fixed assets including investments
Add: Interest received
Dividend received
Net cash flows from Investing Activities
C. Cash flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayment of long-term borrowings including
redemption of preference shares
Less: Interest paid
Dividend paid
Net cash flows from Financing Activities
Net increase in cash and cash equivalents
Add: Cash and cash equivalents at the beginning of the
period
Less: Cash and cash equivalents at the end of the period

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Proforma of Cash Flow Statement using indirect method:
Cash Flow Statement of ______________for the period ended _______________.

Particulars ` ` `
A. Cash flows from Operating Activities
Net Profit for the period before Taxation and Extraordi-
nary items
Add: Adjustment for Non-cash and Non-operating
items charged to P&L
Depreciation
Interest paid
Foreign Exchange loss
Loss on sale of fixed assets and investments
Less: Adjustment for Non-current and Non-operating
items credited to P&L account
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Particulars ` ` `
Interest earned
Dividend earned
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Profit on sale of fixed assets and investments
Operating Profit before Working Capital changes
Add: Increase in operating current liabilities
Decrease in operating current assets
Less: Increase in operating current assets
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Decrease in operating current liabilities

Cash generated from operations
Less: Income tax paid
Add: Proceeds from any disaster settlement
Net cash flows from Operating Activities
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B. Cash flows from Investing Activities

Proceeds from sale of fixed assets including investments
Less: Purchase of fixed assets including investments
Add: Interest received
Dividend received
Net cash flows from Investing Activities
C. Cash flows from Financing Activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayment of long-term borrowings including
redemption of preference shares
Less: Interest paid
Dividend paid
Net cash flows from Financing Activities
Net increase in cash and cash equivalents
Add: Cash and cash equivalents at the beginning of the period
Less: Cash and cash equivalents at the end of the period

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8.3.1 CASH FLOWS FROM OPERATING ACTIVITIES
Cash flows from operating activities constitute the first part of a Cash
Flow Statement. Operating activities provide details about how much
cash an organisation has generated from its core business, as opposed
to peripheral activities such as investing or financing. These cash flows
are directly associated with production and sale of a firm’s products or
services. This is a key indicator of the extent to which the firm’s oper-
ation has generated adequate cash flows to maintain the operational
efficiency without having recourse to external sources of funds. Cash
flows from operating activities can be calculated using either of the
two methods as follows:
Direct method: In this method, gross cash receipts and gross cash
payments for the major items are disclosed such as cash receipts
from customers and cash payments to suppliers and employees.
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Under the direct method, information can be obtained from either
accounting records of the organisation or by adjusting the sales,
cost of sales and other items in the P&L statement of the organisa-
IMtion. These items are as follows:
Changes during the period in inventories and operating receiv-
ables and payables
Other non-cash items
Other items for which cash effects are shown either in invest-
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ing or financing activities

Indirect method: In this method, P&L account is adjusted for the
following heads:
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Effects of transactions of non-cash nature such as deprecia-

tion, amortisation, deferred taxes, loss on sale of fixed assets
and unrealised foreign exchange gains and losses
Changes during the period in inventories and operating receiv-
ables and payables
All other items for which cash effects are shown either in in-
vesting or financing activities
Cash inflows from operating activities include:
Cash receipts from sale of products or services
Cash receipts from royalties, fees, commissions and other rev-
enues
Cash receipts from an insurance enterprise for premiums and
claims, annuities and other benefits
Cash outflows from operating activities include:
Cash payments to suppliers for products and services

n o t e s
Cash payments to employees

Cash payments for income taxes unless specified in financing
or investing activities
Cash payments from an insurance enterprise for premiums
and claims, annuities and other benefits
note
As the focus is on cash from operating activities, non-operating

expenses and non-operating income is excluded from this head.
Therefore, dividends/interest income is excluded.
Let us understand the preparation of Cash Flow Statement using di-
S
rect and indirect methods with the help of the following illustrations.
Illustration 1: Analyse the profit and loss statement of Farid Enter-

prises given below and prepare its cash flow statement from operating
activities by using the indirect method.
IM
Farid Enterprises
Profit and loss account for the year ending March 31, 2017
as on March
31, 2017
M
Revenue from operation 165000

Profit from sale of old machinery 13000
Gains on Bond investments 10000
Total Revenue 188000
N
Purchases 80000
Direct Expenses 20000
Rent 8000
Salary 20000
Depreciation 15000
Provision for Bad Debts 5000
Lawsuit settlement expenses 11500
Taxes 2500
Total Expenses 162000
Net Profit after Tax 26000
Solution: By applying the indirect method, profit and loss account is

adjusted with the effect of non-cash transactions and the cash flow from
operating activities can be calculated in the following table:

n o t e s
Farid Enterprises
Cash flow from operating activities for the year ending March 31, 2017
Particulars Amount (`) as on March 31,
2017
Cash Flow from Operating Activities:
Net Profit as per profit and loss account 26000
Add: Non Cash transactions

Depreciation 15000
Total Non-Cash transactions 20000
Add: Non-operational expenses

Lawsuit settlement expenses 11500
S
Less: Non-operational income
Profit from sale of old machinery (13000)
Total Cash inflow from Operating Activities 44500
IM
Illustration 2: Analyse the profit and loss statement of Rahul Enter-
prises given below and prepare its cash flow statement from operating
activities by using the indirect method.
Rahul Enterprises
M
Profit and loss account for the year ending March 31, 2017
as on March
31, 2017
Revenue from operation 4 3100000
N
Profit on sale of land 300000

Gains on currency exchange 75000
Total Revenue 3475000
Purchases 1600000
Direct Expenses 200000
Rent 80000
Salary 200000
Depreciation Expenses 100000
Amortisation Expenses 125000
Utilities 25000
Legal Fees 15000
Proposed Dividends 160000
Preliminary expenses written off 17000
Taxes (@25%) 230250
Total Expenses 2784250
Net Profit after Tax 690750

n o t e s
Solution: By applying the indirect method, profit and loss account is

adjusted with the effect of non-cash transactions and the cash flow from
operating activities can be calculated in the following table:
Rahul Enterprises
Cash flow from operating activities for the year ending March 31, 2017
Particulars Amount (`) as on March
31, 2017
Cash Flow from Operating Activities:
Net Profit as per profit and loss account 690750

32000
Provision for Bad Debts
S
100000
Depreciation Expenses
125000
Amortisation Expenses
160000
Proposed Dividends
IM 17000
Preliminary expenses written off
434000
Total Non-Cash transactions

M
Profit from sale of land 300000
Gains on currency exchange 75000
Total Non-operational income 375000

Total cash inflow from operating activities 749750
N
8.3.2 CASH FLOWS FROM INVESTING ACTIVITIES
Cash flows from investing activities constitute the second part of a

Cash Flow Statement. It provides details of cash flows related to ac-
quisition and disposal of an organisation’s long-term investments
such as property, plant and equipment, (also termed as “Fixed As-
sets”) investment in subsidiaries and associates, etc. Cash flows from
investing activities are disclosed separately as these cash flows helps
users to assess whether the organisation is investing in such resources
that may result in increased profits in future or whether it is disposing
out cash on resources already owned. Cash flows typically reported as
cash flows from investing activities are as follows:
Cash inflows from investing activities include:

Proceeds from sale of property, plant and equipment
Proceeds from sale of debt or equity investments of other entities
Proceeds from collections of principal on loans to other entities

n o t e s
Cash outflows from investing activities include:

Payments for purchase of property, plant and equipment
Payments for purchase of debt or equity securities of other entities
Loans given to other entities
Let us consider an illustration to understand the calculation of net

cash flows due to investing activities:
Illustration 3: ABCD Ltd. is engaged in manufacture of chemicals

and fertilisers. For the year ended 30 June 2012, it installed a new
plant worth `150 lakhs (50% of which is financed by the issue of debt
instruments). The old plant is predisposed at a loss of `25 lakhs. The
closing written down value of the old plant was `100 lakhs. The com-
pany has used `20 lakhs on the construction of new plant building
S
and infrastructure. It has sold off its stake of `50 lakhs on EFG Ltd.,
a subsidiary engaged in food processing. In addition ABCD Ltd. has
received `10 lakhs on account of repayment of principal. It received
dividends of `5 lakhs during the year. Calculate the net cash flows of
IM
ABCD Ltd. from investing activities.
Net Cash Flows of ABCD Ltd. from Investing Activities

Particulars ` `
Cash flows from investing activities
Cash proceeds from sale of old plant 75,00,000
Cash proceeds from sale of investment in EFG Ltd. 50,00,000
M
Cash proceeds from payback of loan principal 10,00,000

5,00,000 140, 00,000
Less:
Cash paid to acquire new plant 75,00,000 95, 00,000
Cash paid to construct new buildings 20,00,000
N
45, 00,000
note
1. Only `75 lakhs is shown as cash outflow because 50% is paid

through the issue of a debt instrument which is reported in
the schedule of non-cash transactions.
2. Cash receipt from sale of plant equals written down value of
the plant of `100 lakhs minus the loss of `25 lakhs.
8.3.3 CASH FLOWS FROM FINANCING ACTIVITIES
Cash flows from financing activities constitute the third and last part
of a Cash Flow Statement. Financing activities of an organisation re-
sult in changes in the size and composition of the owner’s capital (in-
cluding preference share capital). It also results in changes in the bor-
rowings of the organisation. In other words, financing activities of an
organisation include total capital employed (equity shares, preference

n o t e s
shares and long-term loans). Any inflow or outflows of cash from these
activities are treated as cash flows from financing activities.
For example, cash inflow from financing activities includes proceeds

from the issue of equity and preference shares, debentures, etc. Cash
outflow from financing activities include redemption of preference
shares, debentures, repayment of long-term loans, etc.
Let us consider an illustration to understand the calculation of net

cash flow from financing activities:
Illustration 4: The following information for XYZ Ltd. has been given:
1. Proceeds from the issue of equity shares = `5, 00,000
2. Proceeds from issue of preference shares = `3, 00,000
S
3. Proceeds from long-term loans = `2, 50,000
4. Redemption of preference shares =`1, 50,000
5. Redemption of debentures = `1, 00,000
IM
6. Payment of dividend = `30,000
7. Payment of interest = `40,000
Calculate the net cash flows from financing activities of XYZ Ltd.
M
Net Cash Flows of XYZ Ltd. from the Financing Activities

Particulars ` `
Cash flows from financing activities:
Proceeds from the issue of equity shares 5, 00,000
N
Proceeds from issue of preference shares 3, 00,000

Proceeds from long-term loans 2, 50,000 10, 50,000
Particulars ` `
Less:
Redemption of preference shares 1, 50,000
Redemption of debentures 1, 00,000
Payment of dividend 30,000
Payment of interest 40,000
3, 20,000
7, 30,000
Illustration 5: The following information about A Ltd. is provided:

1. Cash from bonds issued = `15, 00,000
2. Cash from new stock issued = `20, 00,000
3. Repayment on existing loans = `2, 00,000
4. Dividends paid = `6, 00,000
5. Repurchase of existing stock = `1, 00,000

n o t e s
Calculate the net cash flow from financing activities.
Net Cash Flow of a Ltd. from Financing Activities

Particulars ` `
Cash from bonds issued 15, 00,000
Cash from new stock issued 20, 00,000 35, 00,000
Less:
Repayment on existing loans
Dividends paid 2, 00,000
Repurchase of existing stock
6, 00,000
1, 00,000 9, 00,000
26, 00,000
S
Format of Cash Flow Statement based on AS-3: The Cash Flow
Statement of an organisation as per AS-3 is prepared by combining
the cash flows from the three different activities in the following order:
IM
a. Operating activities
b. Investing activities
c. Financing activities
M
8.3.4 TREATMENT OF CERTAIN ITEMS AS PER AS-3
While most of the items in the Cash Flow Statement are self-explan-
atory, there are a few transactions/items that need more explanation.
In this section, you will study about these items (shown in Figure 8.2)
N
as per AS-3.
Extraordinary Items
Taxes on Income
Foreign Currency Cash Flows
Non-cash Transactions
Investments in Subsidiaries, Associates and Joint Ventures
Figure 8.2: Provisions of AS 3 on Treatment of Certain Items

n o t e s
Let us discuss these items and their treatment in Cash Flow State-
ment in the following section:
Extraordinary Items: Cash flows from extraordinary items are
classified as items arising out of operating, financing or investing
activities as applicable and disclosed separately. A few examples
of extraordinary items in the Cash Flow Statement are claim for
loss of stock (operating activity), claims for loss of assets (investing
activity), lottery (investing activity), etc.
Taxes on Income: Cash flows from taxes on income are disclosed
separately and classified as arising out of operating activities un-
less otherwise specified. A few examples of taxes on income are
provision for taxation for the current year (non-cash charge due to
operating activity), tax paid (cash outflow due to operating activi-
ty), tax refund (cash inflow due to operating activity), etc.
S
Foreign Currency Cash Flows: These should be converted at the
prevailing exchange rate. The gain or loss on cash and cash equiv-
alents are reported as part of reconciliation of change in cash and
IM
cash equivalents for the current period and therefore not reported
in the Cash Flow Statement.
Non-cash Transactions: Such transactions do not require the use
of cash or cash equivalents. Non-cash transactions such as depre-
ciation, amortisation, purchase of building by issuing shares, etc.
are not disclosed in cash flow statements because these transac-
M
tions are already eliminated during the calculation of net profits.

These transactions are accounting in nature and do not involve
any movement of cash. A few examples of non-cash transactions
are the issue of shares and debentures for a consideration other
than cash such as against building, machinery, etc., conversion of
N
debentures into equity shares (no cash is involved), etc.

Investments in Subsidiaries, Associates and Joint Ventures: Ac-
quisition of interest in a subsidiary, associate or a joint venture is
treated as ‘investing activity’ in the Cash Flow Statement. Also,
sale or disposal of such interest and receipt of interest or dividends
on such investments is included as ‘investing activity’ in the Cash
Flow Statement.
7. As per_________, two separate approaches, direct and indirect

method are followed for the preparation of a cash flow
statement, whereas as per the traditional method, a single
approach is followed to prepare the cash flow statement.
(a) AS-2 (b)
AS-3
(c) AS-5 (d)
AS-7

n o t e s
8. Cash flows in a period owing to different activities are

categorised into three categories. Which one of the following
is not a correct category?
9. Proceeds from the issuance of share capital are a part of which
of the following?
(a) Cash flows from operating activities
(b) Cash outflows from financing activities
(c) Cash inflows from financing activities
(d) Cash flows from investing activities
S
10. Cash paid in mergers and acquisitions and purchase of
marketable securities are examples of ___________.
(a) Cash outflow from investing activities
IM
(b) Cash inflow from investing activities
(c) Cash outflow from operating activities
(d) Cash inflow from investing activities
11. Depreciation and interest paid are treated as which of the
following in a cash flow statement?
M
(a) Cash inflow from investing activities

(b) Cash inflow from operating activities
(c) Non-cash item and is deducted from profit before taxes
N
(d) Non-cash item and is added to profit before taxes

12. Match the following:
Table 1 Table 2
I. Claim for loss of stock A. Financing activity
II. Tax refund B. Extraordinary items
III. Issue of shares and deben- C. Taxes on income
tures
IV. Acquisition of interest in a D. Investments in subsidiaries
subsidiary
(a) I(A), II(B), III(C), IV(D)
(b) I(C), II(D), III(A), IV(B)
(c) I(B), II(C), III(A), IV(D)
(d) I(D), 2(C), 3(D), 4(A)

n o t e s
13. Redemption of preference shares is treated as a cash

__________ from __________activities.
(a) Cash outflow; financing activities
(b) Cash outflow; investing activities
(c) Cash inflow; financing activities
(d) Cash outflow; investing activities
14. Foreign currency cash flows are reported as part of

reconciliation of change in cash and cash equivalents for
________ period and therefore not reported in the cash flow
statement.
(a)
Preceding (b) Following
(c) Current (d) Both (a) and (b)
S
Activity
IM
Using the Internet, download the cash flow of an automobile cor-
poration for the financial year 2012 and 2013 and compare the net
increase/decrease in its cash position.
8.4 SUMMARY
M
The Cash Flow Statement records the amount of cash and cash
equivalents entering and leaving an organisation in a given time
period.
A Cash Flow Statement consists of details about cash flows of an
N
organisation arising from its operating activities, investing activi-

ties and financing activities.
Cash includes an organisation’s cash in hand and deposits with
banks.
Cash equivalents include short-term highly liquid investments
that can be easily converted into cash.
Cash flows from operating activities include the changes in cash
due to major revenue producing activities such as sale of goods.
Cash flows from investing activities include the changes in cash
due to purchase or sale of long-term assets not included in cash
equivalents.
Cash flows from financing activities include the changes in the size
and composition of the share/owner’s capital and debt of the or-
ganisation.
Cash Flow Statement does not provide a comprehensive detail of
the financial position of an organisation as non-cash items of ex-
penses and incomes are excluded from the statement.

n o t e s
As per AS-3, two separate approaches, direct and indirect method

are followed for the preparation of a Cash Flow Statement; direct
method and indirect method.
Cash flows from extraordinary items are classified as arising out of
operating, financing or investing activities as applicable and dis-
closed separately.
Cash flows from taxes on income are disclosed separately and clas-
sified as arising out of operating activities unless otherwise spec-
ified.
Foreign currency cash flows are converted at the prevailing ex-
change rate. The gain or loss on cash and cash equivalents is re-
ported as part of reconciliation of change in cash and cash equiv-
alents.
S
Non-cash transactions do not require the use of cash or cash equiv-
alents and are not disclosed in the Cash Flow Statement.
Acquisition of interest in a subsidiary, associate or a joint venture
IMis treated as ‘investing activity’ in the Cash Flow Statement.
Sale or disposal of such interest and receipt of interest or divi-
dends on such investments is included as ‘investing activity’ in the
Cash Flow Statement.
key words
M
Accounting Standards-3: Accounting standards notified by the

Ministry of Corporate Affairs together with International Fi-
nancial Reporting Standards (IFRS) that lay down the standard
for preparation of Cash Flow Statements.
N
Cash proceeds: The cash received from a sale or as a loan after

the commissions, expenses, fees and taxes are excluded.
Dividends: The payment made by an organisation to its share-
holders, usually as a distribution of profits.
Marketable securities: The highly liquid securities that can be
converted into cash quickly at a reasonable price.
Non-cash transactions: The financial activities that involve
owner’s equity and liabilities but do not affect the inflows and
outflows of cash.
Owner’s capital: The capital invested in an organisation de-
rived by deducting the book value of liabilities from the book
value of assets.
Redemption of debentures: The repayment of the amount bor-
rowed by an organisation.

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Redemption of shares: The repayment of shares and other debt

securities on or before their maturity date.
Share capital: The part of an organisation’s equity obtained by
trading stock to a shareholder for cash.

1. Explain the concept and importance of the Cash Flow Statement
as per AS-3.
2. What are the limitations of a Cash Flow Statement? Discuss.
3. Describe the proforma of a Cash Flow Statement using:
a. direct method
S
b. indirect methods
4. Explain the treatment of the following items in the Cash Flow
Statement as per AS-3:
IM
a. Extraordinary items
b. Investments in subsidiaries
c. Non-cash transaction
d. Taxes on income
M
5. Explain the procedure to prepare cash flow statement as per

AS 3.
6. What are three activities under the head of cash flow statement?
Explain all components under these activities.
N

Concept of Cash Flow State- 1. d. Both (b) and (c)
ment
2. a. Cash flow Statement
3. a. Cash equivalents
4. a. Operating activities
5. c. Financing activities

n o t e s

Cash Flow Statements (AS-3) 7. b. AS-3
8. a. Operating activities
9. c. Cash inflow from financ-
ing activities
10. d. Cash outflow from invest-
ing activities
11. d. Non-cash item and is added
to profit before taxes
12. c. I(B), II(C), III(A), IV(D)
13. a. Cash outflow; Financing
activities
S
14. c. Current

IM
1. The Cash Flow Statement records the amount of cash and cash
equivalents entering and leaving an organisation in a given
time period. As per AS-3, two separate approaches, direct and
indirect method are followed for the preparation of a Cash Flow
Statement; direct method and indirect method. Refer to Section
8.2 Concept of Cash Flow Statement.
M
2. Cash Flow Statement does not provide a comprehensive detail

of the financial position of an organisation as non-cash items of
expenses and incomes are excluded from the statement. Refer to
Section 8.2 Concept of Cash Flow Statement.
N
3. In the direct format, gross cash receipts and gross cash payments
for the major items are disclosed such as cash receipts from
customers and cash payments to suppliers and employees. In
this method, P&L account is adjusted for the following heads,
effects of transactions of a non-cash nature such as depreciation,
amortisation, deferred taxes, loss on sale of fixed assets and
unrealised foreign exchange gains and losses. Refer to Section
8.3 Cash Flow Statement (AS-3).
4. Cash flows from extraordinary items are classified as arising
out of operating, financing or investing activities as applicable
and disclosed separately. Cash flows from taxes on income are
disclosed separately and classified as arising out of operating
activities unless otherwise specified. Refer to Section 8.3 Cash
Flow Statement (AS-3).
5. Consider the necessary steps to prepare the cash flow statement
as per AS 3. Refer to Section 8.3 Cash Flow Statements (AS-3).

n o t e s
6. There are three basic activities under the head of cash flow
statements namely, cash flow from operating activities, cash flow
from investing activities and cash flow from financing activities.
Operating activities provide details about how much cash an
organisation has generated from production and selling of its
products. Investing activities provide details of cash flows related
to the acquisition and disposal of an organisation’s long-term
investments such as property, plant and equipment. Financing
activities provides the structure of share capital and debt capital
employed within the entity. Refer to Section 8.3 Cash Flow
Statements (AS-3).

1. The following information about ABC Ltd. is provided:
S
Cash from bonds issued =`25,00,000
Cash from new stock issued = `30,00,000
IM
Repayment on existing loans = `1,00,000
Dividends paid =`8,00,000
Repurchase of existing stock = `2, 00,000.
Calculate the net cash flow from financing activities.
M
Solution:
Non-cash transactions do not require the use of cash or cash
equivalents and are not disclosed in the Cash Flow Statement.
Acquisition of interest in a subsidiary, associate or a joint venture
N
is treated as ‘investing activity’ in the Cash Flow Statement.

The net cash flow of A Ltd. from financing activities:
Particulars ` `
Cash from bonds issued 25, 00,000
Cash from new stock issued 30, 00,000 55, 00,000
Less:
Repayment on existing loans 1, 00,000
Dividends paid 8, 00,000
Repurchase of existing stock 2, 00,000 11, 00,000
44, 00,000
Refer to Section 8.3 Cash Flow Statement (AS-3).

2. The Profit and Loss Account of XYZ Ltd. for the year ended
31st March, 2012 is given. Calculate the cash generated from
operating activities using the direct method.

n o t e s
Profit and Loss Account for year ended 31st March, 2012
Particulars Amount Particulars Amount
(`) (`)
To opening stock 1,60,000 By sale 42,50,000
To purchases (cash) 31,00,000 By commission 40,000
To wages 4,40,000 accrued
Add: Outstanding 60,000 5,00,000 By dividend received

To salaries 2,20,000 By profit on sale of 60,000
plant
Add: Outstanding 20,000
(Sale proceeds 2,40,000
2,40,000 22,40,000 – Book
Less: Prepaid 10,000 2,30,000 value 20,00,000)
To office expenses 80,000 By Closing stock 2,20,000

48,10,000
S
To selling expenses 1,20,000
To depreciation 1,10,000 8,20,000
To income tax paid 20,000 48,10,000
To goodwill written off 44,000
IM
To preliminary expenses
written off 20,000
To office rent 4,26,000
To Net Profit
48,10,000 48,10,000
M
Solution:
The net cash flows of XYZ from operating activities using the
direct method would be calculated as follows:
Particulars `
N
A. Cash receipts from operating activities

Cash sales 42,50,000
Less:
B. Cash payments from operating activities
Purchases 31,00,000
Wages 4,40,000
Salaries 2,20,000
Office expenses 80,000
Selling expenses 1,20,000
39,60,000
Cash flow from operating activities before tax 2,90,000

Less: Income tax paid 20,000
Net cash flow from operating activities 2,70,000
Refer to Section 8.3 Cash Flow Statement (AS-3).

n o t e s
3. Analyse the following information and prepare a cash flow

statement from investing activities.
Machinery Purchased 200000
Sale of shares 325000
Dividend held 22000
Sale of old machinery 60000
Solution:
Cash Flow Statement from Investing Activities
Cash flow from investing activities
S
Sale of shares 325000
Sale of old machinery 60000
Dividend received
IM 22000
Less: Outflow for Machinery purchased 200000
Cash flow from investing activities 225000

statement from financing activities.
M

Bank loan 1000000
Interest paid 13000
N
Sale of bonds 200000

Issue of preference shares capital 225000
Stock repurchase 125000
Dividends paid 22000
Solution:
Cash Flow Statement from Financing Activities
Cash flow from financing activities
Bank loan 1000000
Sale of bonds 200000
Issue of preference shares capital 225000
Dividends paid 22000
Less Interest paid 13000
Less: Stock repurchase 125000
Cash flow from financing activities 1309000

n o t e s

statement from financing activities.
Long term borrowings 1500000
Interest paid -52000
Dividend Received 40000
Issue of debenture 450000
Preference shares redeemed -125000
Proceeds from forward contract 150000
Issue of equity share capital 200000
Cash used in discontinuation of operations -5000
Solution:
S
Cash Flow Statement from Financing Activities
IM Cash flow from financing activities
Long term borrowings 1500000
Dividend Received 40000
Issue of debenture 450000
Proceeds from forward contract 150000
Issue of equity share capital 200000
M
Less Interest paid 52000

Less: Cash used in discontinuation of operations 5000
Less: Preference shares redeemed 125000
N
Cash flow from financing activities 2158000
Suggested Readings
Debarshi, B. (2011). Management Accounting (1st ed., pp. 203-208).
Goyal, V., & Goyal, R. (2013). Corporate Accounting (1st ed., pp.
Ramachandran, N., & Kakani, R. (2010). How to Read a Cash Flow
Statement (1st ed., pp. 51-57). Delhi: Tata McGraw Hill.
Sinha, G. (2009). Financial Statement Analysis (1st ed., pp. 346-
445). Delhi: Prentice Hall India.

n o t e s
E-references
A,P., & A, P. (2013). Limitations of Cash Flow Analysis. BMS.co.in:
Bachelor of Management Studies. Retrieved from, http://www.
bms.co.in/limitations-of-cash-flow-analysis/
CA Results. (2014). Download All Accounting Standards for CA,
CWA/CMA, CS Exams -CA Results. Retrieved from, http://caulti-
mates.in/download-accounting-standards-cacwacmacs-exams/
Letslearnfinance.com. (2014). Advantages and Disadvantages
of Cash Flow Statement | LetsLearnFinance. Retrieved from,
http://www.letslearnfinance.com/advantages-and-disadvantag-
es-of-cash-flow-statement.html
Studytesttime.com. (2014). Classification of Cash Flows as per Ac-
counting Standard-3 (Revised). Retrieved from, http://studytest-
S
time.com/all-topics/22-analysis-of-financial-statements/56-classifi-
cation-of-cash-flows-as-per-accounting-standard-3-revised
IM
M
N

Case study
n o t e s
CASH FLOW STATEMENT OF PAL AND BOSE LTD.
Link Lever Limited is a manufacturer of industrial locks, fasten-

ers and holdfasts. It commenced its operation from Gorakhpur,
Uttar Pradesh in 2002. The organisation tasted considerable suc-
cess and acceptance among the customers. As a result, the own-
ers decided to expand their operations. The organisation grew
from a five-member association to 50 employees operating from
a small set-up in Kanpur, U.P. It was named as Pal and Bose (PB)
Ltd. after its founder Arunashu Pal and Tamal Bose. The CEO,
Arunashu Pal decided to open a modern manufacturing unit in
Jharkhand. He decided to diversify the business for better growth
prospects. He needed to meet the following requirements:
1. Set-up the proposed new plant outside U.P.
S
2. Purchase modern machinery
3. Train employees
IM
4. Advertise and promote business
5. Obtain license for advanced technology from foreign
collaborators
To achieve this, the management decided to obtain a loan of
`5000000 from the State Bank of India. The SBI visited Pal and
Bose (PB) Ltd. to assess the organisation’s credit worthiness. The
M
bank requested the financial statements of the organisation in-

cluding the balance sheet, P&L statement and Cash Flow State-
ment as per AS-3.
The Cash Flow Statement of Pal and Bose Ltd. is as follows:
N
Particulars Amount
(` in 000)
Cash flows from operating activities
Net income 2500
Depreciation and amortization 125
Gain on sale of facility (65)
Total Cash inflow from Operating Activities 2580
Cash flows from investing activities

Purchase of property, plant, and equipment 500
Less: Proceeds from sale of equipment 35
Net cash used in investing activities (465)

Case study
n o t e s
Particulars Amount
(` in 000)
Cash flows from financing activities
Proceeds from issue of common stock 150
Proceeds from issuance of long-term debt 175
Less: Dividends paid 45
Net cash used in financing activities (280)
Net increase in cash and cash equivalents 1835

Cash and cash equivalents at beginning of period 4824
Cash and cash equivalents at end of period 6659
The net cash flows from operating activities of Pal and Bose Ltd.
are `71, 35,000 which imply that the organisation can support div-
S
idend payments to shareholders. However, outflows from financ-
ing activities are `5, 54,000 which signify that the proceeds from
shares are less than the payments for interest and dividends. The
organisation is not strong enough to repay the loan and thus, the
IM
SBI declines the loan application made by Pal and Bose Ltd.
questions
1. Do you think SBI’s reason to not provide Pal and Bose

with loans is justified? Discuss.
M
(Hint: The outflows from financing activities are

`5,54,000 which signify that the proceeds from shares
are less than the payments for interest and dividends.
The organisation is not strong enough to repay the
loan.)
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2. From the net cash flows from each of the activities,

assess the financial position of Pal and Bose Ltd.
(Hint: Cash and cash an equivalent at the beginning is
an amount of `15, 60,000 while that at the end of the year
is an amount of `17, 30,000 suggesting an improvement
in the overall cash. However, outflows are more than
inflows from financing activities which shows that Pal
and Bose are not capable of giving out dividends to
repay loans.)
3. Do you think that SBI would find the payment of
dividend of `5, 00,000 as not being prudent since the
organisation has borrowed and has a negative cash
outflow from financing activities?
(Hint: The outflows from financing activities are
`5,54,000 which signify that the proceeds from shares
are less than the payments for interest and dividends.
The dividend payment is `5,00,000. The organisation
could perhaps conserve cash at this stage.)

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M
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Ch a
9 p t er
Financial Statement Analysis I
CONTENTS
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9.1 Introduction
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9.2.1 Meaning of Financial Statement
9.2.2 Characteristics of Financial Statement
9.2.3 Scope of Financial Statements
Activity
9.3 Profit and Loss Account
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9.3.1 Component Analysis of Profit and Loss Account

Activity
9.4 Balance Sheet
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9.4.1 Relationship between Profit and Loss Account and Balance Sheet
Activity
9.5 Financial statement analysis
9.5.1 Types of financial statement analysis
9.5.2 Techniques of financial statements analysis
9.5.3 Process of Financial Statement Analysis
9.6 Summary

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Chittaranjan Mills Financial Problems
Chittaranjan Mills Ltd is a Kolkata-based garments manufacturing

company. The company has been into operations for the last 35
years. Therefore, it has a good hold over the market of the eastern
parts of India. However, in the last few years the company is facing
certain financial problems. Therefore, the management and many
of the investors in the company are not particularly hopeful about
the future financial performance of the company. Some of the in-
vestors are even anticipating impending bankruptcy of the com-
pany. Some of the reasons that contributed to the sudden downfall
of the company are a decrease in demand due to better products
being offered by the competitors.
S
The management of the company hired a financial consultant to
evaluate the past performance and current situation in the com-
pany. The consultant recommended a financial statement analysis
in the company. According to the consultant, financial statement
IM
analysis would help in assessing the past performance and the cur-
rent position of the company. Past financial performance is a good
indicator of the future performance potential of a company. The
trend of past sales, expenses, net income and cash flow, and return
to investment reflects the future trends of these variables.
In addition, the consultants suggested that financial statement

M
analysis would help in predicting net income and growth pros-

pects. Some of the other benefits of financial statement analysis as
predicted by the consultant were predicting bankruptcy and fail-
ure and influencing the loan decisions by financial institutions and
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banks.

Financial Statement Analysis I 247
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learning objectives

>> Define financial statements
>> Describe Profit and Loss Account
>> Discuss the relationship between the Balance Sheet and the
Profit and Loss Account
9.1 Introduction
In the previous chapter, you studied cash flow statements. The chapter
included the concept of cash flow statement along with its objectives
and limitations. Now, let us move forward and discuss financial state-
S
ments, such as the Profit and Loss accounts and the Balance Sheet.
In simple words, a financial report refers to a formal record of the

financial activities of a business, person, or other entity. In a financial
IM
statement, relevant financial information is presented in a structured
and easy-to-understand manner.
The Profit and Loss account or the Income Statement refers to one of
the financial statements of a company that shows the revenues and
expenses during a particular period. The account indicates how reve-
M
nues are transferred into net income. The main objective of the Prof-
it and Loss statement is to show managers and investors, whether a
company has made or lost money during a reported period.
In financial accounting, the Balance Sheet refers to the summary of

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the fiscal balances of a business organisation. In a Balance Sheet, the

assets, liabilities and owners’ equity are listed as of a specific date,
such as the end of a fiscal year. Very often financial accounts describe
a Balance Sheet as a “snapshot of a company’s financial condition”.
The Balance Sheet is the only financial statement that applies to a

single point in time in the business’s calendar year.
Financial Statement Analysis provides a pathway to measure this el-

ement of risk and it is a technique that features past performance of
the organisation and it can be measured in terms of liquidity, profit-
ability, growth potential, efficiency, etc. It focuses on the significant re-
lationship between financial statements. Financial statement analysis
emphasise on the estimation of past performance of the organisation
in various aspects such as, profitability, growth potential, liquidity, sol-
vency and operational efficiency. Financial statement analysis incor-
porates the use of various techniques in evaluating and explaining the
consequences of past performance and current position of the organi-
sation. These techniques are exploited by managers to gain efficiency
in investment related decision making. Therefore financial statement

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analysis is an important means for evaluation of past performance,

forecasting and financial planning.
In this chapter, you will study the meaning, characteristics and scope
of financial statements. Next, you will study the Profit and Loss state-
ment along with its components.
In addition, the chapter explains the concept and format of a Balance

Sheet. Then study about the relationship of a Profit and Loss account
with a Balance Sheet.
Towards the end, you will study about the meaning, need, importance,
types, techniques, procedures of financial statement analysis.
9.2 FINANCIAL STATEMENTS
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In a business, the sole purpose of investing money is earning profits.
The financial position of an organisation is determined by evaluating
the profit earned or loss suffered by an organisation. In addition, dif-
IM
ferent users of accounting information need other accounting infor-
mation. Financial statements are created to fulfil these requirements.
Financial statements provide information regarding total profit earned
or loss suffered the net income and the distribution of income. Prepara-
tion of the financial statement is the final step in the accounting cycle.
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9.2.1 MEANING OF FINANCIAL STATEMENT
Financial statements act as an important source of information as

they provide a structured and an easy to understand information re-
garding the business activities of an organisation.
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According to John N. Myer, The financial statements provide a sum-

mary of the accounts of a business enterprise, the balance sheet reflect-
ing assets and liabilities and the income statement showing the results of
operations during a certain period.
We have already discussed that the users of various financial statements

have diverse information requirements. Therefore, instead of provid-
ing specific information to a particular group, financial statements are
prepared to satisfy the general information requirements of all users.
The objective of financial statements is to provide information such

as performance details, financial position, and the changes in the fi-
nancial position of the organisation. These help the users of financial
statements in making decisions. Various financial statements sum-
marise assets, liabilities, equity, income and expenses during a partic-
ular accounting period.

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9.2.2 CHARACTERISTICS OF FINANCIAL STATEMENT
We have discussed that various users of financial information need

financial statements for making economic decisions. Organisations
publish the financial statements to fulfil the information needs of the
users. Therefore, it can be seen that there is a great dependence of the
users on the financial statements. If the financial statements are not
accurate, true and fair, users may end up making decisions. Following
are some of the important characteristics of financial statements:
Understandability
Stakeholders cannot use financial information which they are unable

to comprehend. Problems in understanding financial information
may arise out of two reasons: the users incapability in understanding
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information and ambiguity in the information itself. An organisation
cannot do anything about the understanding level of the users. How-
ever, an organisation can present the financial information in such a
way that it helps in understanding the underlying information. There-
IM
fore adequate measures need to be taken on behalf of the organisa-
tion to follow standard guidelines so that the financial statements are
comprehensible. However, it does not mean that complex information
should be excluded from the financial statements just because these
are creating problems in overall understanding of the statements.
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Relevance
A set of information can only be considered relevant when the infor-

mation adds value to the decision-making process. Through relevant
information, users can evaluate whether they are making right eco-
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nomic decisions or not. Moreover, a set of information can also be con-

sidered to be relevant when it has the capability of correcting or con-
firming the existing thought process and information.
Reliability
Information is reliable when it is dependable and this is possible only

when it is:
Free from errors, especially material errors
Complete
Free from bias
Relevance does not suffice for reliability. A set of information must be

reliable as well as relevant in order to be useful in decision-making.
Comparability
In simple words, comparability refers to the ability of financial state-

ments to stand useful over time against financial information obtained

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from other sources. It is not possible for users to evaluate different

aspects of an organisation’s financial performance without comparing
the financial information of one period with another or the financial
information of one entity to another.
In order to attain comparability, organisations prepare financial state-

ments by following a uniform pattern or standards as instructed by
the international or local accounting standards board. Once a particu-
lar standard is adopted, it remains consistent in application.
9.2.3 SCOPE OF FINANCIAL STATEMENTS
Following are the main scopes of financial statements:

Providing information about the financial position: It refers to
the reporting of assets and liabilities of the organisation. It depicts
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the financial position of the organisation at a particular point in
time. This is like a snapshot of the company.
Providing information about the financial performance: It refers
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to the reporting of the expenses incurred and profits earned by the
organisation during an accounting period. It represents the organ-
isation’s ability to use the available economic resources in a profit-
able manner. This is like a video of the operations of the company.
Providing information about changes in the financial position:
It refers to the reporting of the effect of business activities on the
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stake of the investors in the organisation. It is presented in the

form of statement of cash flows and statement of changes in equity.
Providing notes and supplementary schedules: It refers to infor-
mation about the risks and uncertainties affecting the organisa-
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tion. In addition, it notices the item that has not been mentioned
in the balance sheet of an organisation.
1. Preparation of the financial statement is the ______step of the

accounting cycle.
(a) first (b) final
(c) continuous (d) None of the above
2. In order to achieve ___________, organisations prepare financial
statements by following a uniform pattern or standards as
instructed by the international or local accounting standards
board.
(a) transparency (b) affordability
(c) comparability (d) Both (a) and (c)

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Activity
Make a group of your friends and discuss the scope of financial

statements. Present your discussion points in a short note.
9.3 PROFIT AND LOSS ACCOUNT

The gross profit or gross loss calculated in a trading account is taken to
the second part of the account called the profit and loss account. The
profit and loss account is prepared to ascertain the net profit earned
or the net loss suffered by the business over an accounting period, de-
picting the financial performance of the organisation. In this account,
all indirect revenue expenses are shown on the debit side whereas all
the indirect revenue incomes are shown on the credit side. In other
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words, the profit and loss account is a statement that shows the expen-
ditures, revenues and net income of an organisation.
According to Carter, A profit and loss account is an account into which

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all the gains and the losses are collected in order to ascertain the excess
of the gains over the losses or vice-versa.
A profit and loss account can be prepared by considering the follow-

ing accounting rules:
Debiting all the expenses
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Crediting all the incomes

Considering the balance amount, if any, as profit or loss
Following is the commonly used pro forma of a trading account:

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Trading Account for the year ended 31st March _________

Dr. Cr.
Particulars Amount ` Amount ` Particulars Amount ` Amount `
To Opeining Stock XXX By Sales XXX
Less: XXX XXX

Returns
To Purchase XXX Inwards
Less: Returns XXX XXX By Closing XXX
Stock
Outwards XXX By Gross XXX
Loss (to be
transferred
to P&L A/c)
To Wages XXX
To Freight
To Carriage
Inwards XXX
To Clearing

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Trading Account for the year ended 31st March _________

Dr. Cr.
Particulars Amount ` Amount ` Particulars Amount ` Amount `
Charges XXX
To Packing charges XXX
To Dock dues XXX
To Power XXX
To Gross Profit (to be XXX
transferred to P&L
A/c)
XXX XXX
The general pro forma of the profit and loss account is shown as follows:
Profit & Loss Account for the year ended 31st March _________
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Particulars Amount (`) Particulars Amount (`)
To Trading A/c By Trading A/c
(Gross Loss) (Gross Profit)
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To Salaries By Commission
To Rent & Taxes earned
To Stationeries By Rent received
To Postage expenses By Interest received
To Insurance By Discounts received
To Repairs By Net Loss
To Trading expenses (Capital A/c)
M
To office expenses
To Interest
To Bank charges
To Establishment expenses
To Sunder expenses
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To Commission
To Discount
To Advertisement
To Carriage outwards
To Traveling expenses
To Distribution expenses
To Bad Debt provision
To Net Profit
(transferred to Capital A/c)
The profit and loss account plays an important role in the accounting
process as it helps in determining the net results of the business activ-
ities. The main objectives of the profit and loss account are as follows:
Determining the net gain or loss of an organisation
Controlling unnecessary expenses by providing information about
the effect of individual expense on the net profit or loss of the or-
ganisation
Assisting in analysing the progress of an organisation by compar-
ing the current and previous year’s net profit

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Helping in preparing the balance sheet, which would further indi-

cate the financial position of an organisation
9.3.1 COMPONENT ANALYSIS OF PROFIT AND LOSS

ACCOUNT
The principle components of a profit and loss account are expenses

and incomes. The expenses are shown on the debit side and the in-
comes are shown in the credit side of a P&L account. Following are
the components in the profit and loss account:
Administrative expenses: These refer to the expenses incurred by
an organisation but not directly tied to any specific function, such
as productions or sales. These expenses are related to the organi-
sation as a whole as opposed to any individual department. Some
of the administrative expenses are:
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Office Salaries
Postage & Telephone
Traveling & Conveyance
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Legal Charges
Office Rent
Depreciation
Audit Fees
Insurance
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Repairs & Renewals

Selling and distribution expenses: These are the expenses that
are associated with the process of selling and delivering goods and
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services to customers. This type of expense includes:

Salaries of marketing manager, sales director and sales man-
agement
Salaries and commission of salesmen
Travelling and entertainment expenses of salesmen
Marketing costs like advertising and sales promotion expenses
Costs of running and maintaining delivery vans
Discount allowed to customers for early payment of their debts
Bad debts written off
Allowances for bad debt provision
Cost of goods sold: Cost of sales represents the cost of goods sold
or services rendered during an accounting period. Hence, for a
retailer, cost of sales will be the sum of inventory at the start of
the period and purchases during the period minus any closing in-
ventory. In case of a manufacturer, however, cost of sales will also
include production costs incurred in the manufacture of goods
during a period such as the cost of direct labour, direct materi-

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al consumption, depreciation of plant and machinery and factory

overheads, etc.
Other income: Other income consists of income earned from ac-
tivities that are not related to the entity’s main business. For exam-
ple, other income of an entity that manufactures electronic appli-
ances may include:
Gain on disposal of fixed assets
Interest income on bank deposits
Exchange gain on translation of a foreign currency bank ac-
count
Administrative expenses: Administrative expenses generally
comprise of costs relating to the management and support func-
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tions within an organization that are not directly involved in the
production and supply of goods and services offered by the entity.
Examples of administrative expenses include:
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Salary cost of executive management
Legal and professional charges
Depreciation of head office building
Rent expense of offices used for administration and manage-
ment purposes
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Cost of functions / departments not directly involved in pro-

duction such as finance department, HR department and ad-
ministration department
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Other expenses: This is essentially a residual category in which

any expense that is not suitably classifiable elsewhere is included.
Finance charges: Finance charges usually comprise of interest
expense on loans and debentures. The effect of present value ad-
justments of discounted provisions are also included in finance
charges (e.g. unwinding of discount on provision for decommis-
sioning cost).
Income tax: Income tax expense recognized during a period is
generally comprised of the following three elements:
Current period’s estimated tax charge
Prior period’s tax adjustments
Deferred tax expense
Prior period comparatives: Prior period financial information is
presented alongside current period’s financial results to facilitate
comparison of performance over a period. It is therefore import-
ant that prior period comparative figures presented in the income
statement relate to a similar period. For example, if an organisa-

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tion is preparing an income statement for the year ending March

31, 2017, comparative figures of prior period should relate to the
year ending March 31, 2016.
Illustration 1: Prepare a profit and loss accounts from the following

information:

i. Gross Profit 75,000
ii. Salary 30,000
iii. Rent 15,000
iv. Interest Paid on Loan 5,000
v. Postage and Telegram 2,000
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vi. Advertising 6,000
vii. Commission paid 2,500
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v
iii. Bad debts 1,500
ix. Depreciation 1,000
x. Legal charges 3,000
xi. Interest Received 4,000
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Solution:
The required profit and loss account is as follows:

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Profit and Loss Account for the year ending on March 31, 2011
Particulars Amount (`) Particulars Amount (`)
To Salary 30,000 By Gross profit 75,000
To Rent 15,000 By Interest received 4,000
To Interest paid on loan 5,000
To Postage and telegram 2,000
To Advertising 6,000
To Commission paid 2,500
To Bad debts 1,500
To Depreciation 1,000
To Legal Charges 3,000
To net profit (transferred 13,000

to capital account)

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3. ___________ part of financial statements reflects the financial

performance of the organisation.
(a) Balance sheet (b) Cash book
(c) Cash flow statement (d) Profit and loss
4. ____________refers to the analysis of the percentage increase
or decrease in corresponding items in comparative financial
statements.
(a) Straight line (b) Vertical analysis
(c) Horizontal Analysis (d) Fundamental Analysis
S
Activity
Segregate the following list of expenses into administrative expens-

es and selling and distribution expenses:
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Costs of running and maintaining delivery vans
Legal Charges
Salaries and commission of salesmen
Office Rent
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Depreciation
Audit Fees
Bad Debts written off
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9.4 BALANCE SHEET

A balance sheet is the statement that summarises, and presents the fi-
nancial position of an organisation as on a particular date, by showing
the assets and liabilities of the organisation. It is prepared with an aim
to know the exact financial position of the business on the last date of
the financial year. Assets in the balance sheet reflect debit balances
whereas liabilities reflect credit balances.
A balance sheet can be prepared by performing a series of steps. Firstly,

all nominal accounts in the trial balance are transferred to the trading
and profit and loss accounts. After that, personal accounts of customers
are grouped under the heading of sundry debtors. These are the enti-
ties from whom the amounts of sold goods and services are due. Simi-
larly, all balances of the suppliers are grouped under the single heading
of sundry creditors, the entities to whom the organisation owes mon-
ey or payment. Finally, the balances of real and personal accounts are

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grouped as assets and liabilities and are arranged in a proper way. The
resultant statement obtained is called the balance sheet.
The American Institute of Certified Public Accountants defines bal-

ance sheet as, A tabular statement of summary of balances (debits and
credits) carried forward after an actual constructive closing of books of
account and kept according to the principles of accounting.
In the balance sheet, assets are represented on the right side and liabili-
ties are shown on the left side. It is also known as the statement of sources
of funds and application of funds. The financial position of the organisa-
tion includes its economic resources (assets), economic obligations (lia-
bilities), and owner’s equity. As discussed in previous chapters, a balance
sheet is the detailed summary of the basic accounting equation:
Assets = Liabilities + Owner’s Equity
S
The pro forma of the balance sheet:
Balance Sheet of _______ As at _______

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Liabilities Amount (`) Assets Amount (`)
Sundry creditors Cash in hand including
petty cash
Bills payable Cash at bank
Bank overdraft Bills receivables
Employees provident Sundry debtors
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fund
Loans (Cr.) Loan (Dr.)
Mortgage Closing stock
Reserves or reserve Loose tools
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funds
Capital Investment
Add: Interest on capital Furniture and fitting
Add: Net profit Plant and machinery
Less: Drawing Land and building
Less: Income tax Leasehold land
Less: Interest on Business premises
drawing
Less: Net loss Patent and trade mark
Goodwill
Total Total
Following are the main characteristics of a Balance Sheet:

A Balance Sheet plays a vital role in taking important financial
decisions by management and investors of the organisation. The
characteristics of a balance sheet are as follows:
It is prepared on a particular date and thus, shows the position
of the organisation at a point in time

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It is considered as a statement and not an account as it enlists

the assets and liabilities columns instead of showing the debit
and credit columns
It is prepared after the preparation of the trading account and
the profit and loss account
It provides a summarised information about the balances of
various assets and liabilities along with their values and nature
in a structured manner and on a particular date
It requires the total assets to be equal to total liabilities
Let us take the following trial balance and prepare a balance sheet:
From the following balances extracted from the books of Oxford on

31st March, 2010, let us prepare the balance sheet:
S
Debit Balances Amount (`) Credit Balances Amount (`)
Opening Stock 2,00,000 Sundry Creditors 1,50,000
IM
Purchase 7,50,000 Purchase Returns 30,000
Sales Return 80,000 Sales 25,00,000
Freight and Carriage 75,000 Commission 33,000
Wages 3,65,000 Capital 17,00,000
Salaries 1,20,000 Interest on Bank Deposit 20,000
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Repair 12,000 Bills Payable 62,000

Trade Expenses 40,000
Rent and Taxes 2,40,000
Cash in Hand 57,000
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Bills Receivable 40,000

Debtors 5,50,000
Plant and Machinery 16,00,000
Drawing 1,66,000
Bank Deposit 2,00,000
Total 44,95,000 Total 44,95,000
Balance Sheet of Oxford as on 31st March 2010

Liabilities Amount (`) Assets Amount (`)
Capital 17,00,000 Cash in Hand 57,000
Add: Net Profit 9,51,000 24,85,000 Plant and 16,00,000
26,51,000 Machinery
Sundry Debtors 5,50,000
40,000
Less: Drawing 1,66,000 62,000 Bills Receivable
2,00,000
Bills Payable 1,50,000 Bank Deposit
Closing Stock 2,50,000
Sundry Creditors
26,97,000 26,97,000

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9.4.1 RELATIONSHIP BETWEEN PROFIT AND LOSS

ACCOUNT AND BALANCE SHEET
Trading transactions of a company, such as income, sales and expen-

diture and the resulting profit or loss for a given period is summarised
in the profit and loss account. In comparison, the balance sheet pro-
vides a financial snapshot of a company at a given moment. The bal-
ance sheet does not show the day-to-day transactions or the current
profitability of a business.
Any profit that is not paid as dividend is shown in the retained profit
column of the Balance Sheet. The amount that will be shown as cash
or at the bank under current assets on the balance sheets will be de-
termined in part by the incomes and expenses recorded in the P&L.
For instance, if sales income exceeds spending in the immediately pre-
ceding period of the publication of the accounts; then, all other things
S
remaining equal, current assets will be higher in case expenses ex-
ceeded income in the same period.
IM
In case of short-term loans taken by a business, the loan will be shown
in the Balance Sheet under current liabilities but the loan will not be
recorded in the P&L account. However, the P&L account will include
interest payments on the loan in its expenditure column. These fig-
ures will affect the bottom line (net profit) of the company.
M
5. __________ can be defined as the difference between net total

sales and cost of goods sales.
(a) Gross profit
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(b) Gross loss

(c) Return on sales
(d) Both (a) and (b)
Activity
Make a group of friends and discuss the relationship between the

balance sheet and profit and loss account. Present your discussion
points in a short note.
9.5 FINANCIAL STATEMENT ANALYSIS
Financial statements provide detailed information about various items

of an organisation such as, assets, liabilities, equity, reserves, expens-
es, profit and loss, cash flows, funds flows, etc. This information is not
simple to understand for most of the stake holders and their analysis

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and interpretation is required to make them understandable. Hence,

financial statement analysis is a crucial process in which financial
information about an organisation is analysed. It is essential to un-
derstand this information for good operational decision making and
it provides a path to examine the relation between various financial
events of financial statements. In other words, financial statements
analysis is a process of interpretation of financial statements to under-
stand profitability, operational efficiency and financial health of the
organisation.
Financial statement analysis involves two activities namely analysis

and then interpretation. The term analysis is related to the mathemat-
ical representation of financial data by applying various techniques
and interpretation means explaining the meaning, importance and
consequences of various financial events. Both these activities are
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very essential to measure financial soundness and future prospects of
the business organisation.
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Need for Financial Statements Analysis
Financial statement analysis is the most significant technique that is

used to determine various trends and relationships between the ac-
counts of financial statements. This analysis can be used by internal
decision makers (finance manager) and external users (stakeholders)
M
or by anyone who wants to measure profitability, growth potential,

liquidity, solvency and operational efficiency. The most significant-
ly used techniques of financial statement analysis are ratio analysis,
common-size statements, comparative analysis, trend analysis, per-
centage change analysis and Management’s Discussion and Analysis.
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These techniques include various calculations and the connection be-

tween their outcomes. In simple words, the proper analysis and expla-
nation of financial statement can provide a clear picture of organisa-
tion’s financial health.
Objectives of financial statement analysis
The Objectives of financial statement analysis are as follows:

Estimation of past and current performance: Financial state-
ment analysis estimates past performance of the organisation.
Analysts use this past data to evaluate future performance of the
organisation because the past performance of the business is the
best measure to predict future performance. For example, a fi-
nance manager, analyst or an investor use trend of sales, net profit
or return on investment of any particular period to estimate future
performance of the organisation. Most importantly, future perfor-
mance is also depends on the analysis of current performance of

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the organisation and the analyst do not rely only on the past per-
formance. Current performance reflects that whether the business
is doing well or not in the current scenario. So, in order to predict
future performance more accurately an analyst must have to con-
sider both past performance as well as the current performance
and there must be a trade-off between the two.
Estimation of current position: As we know that performance
and position of an organisation are two different issues because
performance is related to earning capacity of the organisation
while position reflects the organisation’s ability to meet debt ob-
ligations. So the financial statement analyses helps to estimates
current position of the organisation with regard to, the type of as-
sets held with the organisation and its obligation to meet current
liabilities. In other words, it predicts bankruptcy related issues of
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the organisations before their occurrence.
Growth forecast: The growth rate of an organisation depends on
several components such as, earnings, sales, market price of share,
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etc. Financial statements analysis provides a pathway to forecast
future growth of the organisation. The decision makers of an or-
ganisation are futuristic and they can make future growth fore-
cast by scanning out the trend of the growth rate in past years. It
enables finance managers or investors in the process of efficient
decision making to minimise the risk and uncertainty factor.
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Loan decisions: Financial statement analyses are often used by

banks and other financial institutions to evaluate the credit wor-
thiness and the repayment capacity of the borrower. Financial
statement analysis assists in checking credit risk, solvency risk or
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the bankruptcy risk related to the borrower.
Importance of financial statement analysis
The Importance of financial statement analysis are as follows:

By analysing financial statements a company is able to evaluate
and compare its performance within a particular period of time.
Itenables the management, in forecasting on financial health of
the organisation and taking corrective actions to improve create a
healthy business environment.
It improves decision making of investors and after analysing finan-
cial statements they can efficiently decide that whether to deploy
their funds in a particular company.
By analysing financial statements various regulatory authorities
such as, MCA, NFRA, ICAI, etc. can ensure that corporations are
following relevant accounting standards.

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It helps employees to better negotiate their salary.

It also helps creditors or the lenders to evaluate financial position
and creditworthiness of the organisation.
It enables shareholders to identify that whether management is
utilising their funds efficiently or not.
9.5.1 TYPES OF FINANCIAL STATEMENT ANALYSIS
In a business environment there are various parties who analyse fi-

nancial for various purposes. Financial Statement Analysis are broad-
ly classified into two categories and these two categories are further
classified into two sub categories:
I. On the basis of Materials Used (Users)
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II. On the basis of Modus Operand (methods used and time period
of study)
These categories are shown in Figure 9.2 as follows:

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Types of Financial
Statement analysis
M
On the basis of On the basis of

Materials Used Modus Operand
External Internal Vertical Horizontal

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Analysis Analysis Analysis Analysis
Figure 9.2: Two Categories of Financial Statement Analysis
On the basis of Materials Used (Users)
On the basis of materials used, financial statement analysis can be fur-

ther divided into two sub-categories, which are given below:
(i) External Analysis is performed by the external stakeholders
of the organisation namely investors, customers, creditors,
government agencies, economists, vendors, etc. These external
stakeholders do not have access to internal organisational
records and they relies on financial statements published in
annual reports of the organisation.
(ii) Internal Analysis is performed by the management executives of
the organisation to examine financial and operating performance

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of the company. These are more reliable as compare to external

analysis because the concerned person is given access to all the
internal data and policies.
On the basis of Modus Operand (methods used and time

period of study)
On the basis of modus operand, financial statement analyses can be

further divided into two sub categories, which are given below:
(i) Horizontal analysis is also known as dynamic analysis and it
is that type of analysis in which financial statements of two or
more consecutive accounting period are analysed. The figures
of all accounting periods are written horizontally in a particular
column that represents years and these figures can represent
graphically also. Initial year will be taken as the base year and
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figures for every year is compared with that of the base year.
Horizontal analysis is most applicable when an organisation
examines the direction of trend for a period of several years
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several years. Comparative statements and trend analysis are
two main techniques under horizontal analysis.
(ii) Vertical analysis of financial analysis is also known as ‘Static
Analysis’ and it is that type of analysis in which study is conducted
only for one particular period. Under this analysis each item of
financial statement is expressed in terms of percentage of the
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same item in the base year. Common size statements and ratio
analysis are two important tools to perform vertical analysis.
9.5.2 TECHINIQUES OF FINANCIAL STATEMENT ANALYSIS

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Techniques of financial statement analysis are generally classified in

to three categories:
I. Cross-sectional analysis or inter firm analysis is one of the most
significant technique of financial statement analysis. Under this
technique, financial characteristics of a particular organisation
are analysed in with the pecuniary characteristics of another or-
ganisation. For example, if ABC Industries Ltd. has earned 20%
return on investment (RoI) in the FY year 2017 and another com-
pany named XYZ Industries Limited has earned 22% (RoI). This
data does not show that XYZ Industries Limited is more efficient
in generating profits and under this case, we need to analyse vari-
ous other components also.
II. Time series analyse is also known as intra firm comparison and
under this technique the relationship between two or more items
of financial statements for being examined. This comparison can
be done by using, financial statement of one organisation for dif-
ferent period of time or financial statement of two or more organi-
sations for a particular period of time.

n o t e s
III. Cross-sectional cum time series analysis a technique that is most

effective to analyse the financial statements and under this tech-
nique both the techniques cross-sectional and time series analy-
sis, are applied together to analyse financial statements. There are
many tools or methods that are used under this technique and fol-
lowing are the most commonly used methods for analysing finan-
cial statement:
Comparative financial statements: Under this method com-
parative financial accounts (comparative balance sheet, com-
parative profit and loss account and comparative cash flow
statement) are prepared for a number of years. It helps in iden-
tification of loopholes and suggests corrective measures. You
will study comparative financial statement in detailed manner
in chapter 11.
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Common size statements: Under this method figures of finan-
cial statements are shown in analytical percentage. The figures
of all items are shown as the percentage of their relevant head
(i.e. total assets and total liabilities in the balance sheet, total
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sales/revenue in the profit and loss account). The total percent-
age of each head is taken as 100. You will study common size
statement in detailed manner in chapter 11.
Fund Flow Analysis: It involves the analysis of funds flow
statement which acts as additional statement to the profit and
loss account and balance sheet. It shows the changes in finan-
M
cial position that are based on working capital and cash. It

also provides information about sources of funds and their use
during a particular period.
Ratio Analysis: It is one of the most significant methods to
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measure the interrelationship between two or more related

variables in the financial statements. Ratio analyses reduce
large figures in understandable relationship. An analyst can
draw meaningful conclusion by evaluating and relating various
ratios. Generally ratios are categorized into three major cate-
gories namely, Liquidity Ratios, Solvency Ratios, Profitability
Ratios and Activity Ratios. You will study the ratio analysis in
detailed manner in chapter 10.
Percentage change analysis: It explains the changes in ac-
counting figures of various variables of financial statements in
percentage terms. You will study percentage change analysis
in detailed manner in chapter 11.
Management’s Discussion and Analysis is that part of annual
report which provides the overview of preceding year’s opera-
tions and company performance. Under this section manage-
ment also explains their goals for the upcoming year. You will
study Management’s Discussion and Analysis (MD&A) in de-
tailed manner in chapter 11.

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9.5.3 PROCESS OF FINANCIAL STATEMENT ANALYSIS
Following is the process for conducting financial statement analysis:
S. No. Stages Source of Information Result

1. Purpose and The nature of the ana- Statement of the
framework of lyst’s function, such as purpose or objective
the analysis evaluating an equity or of analysis.
debt investment or issu- A list (written or
ing a credit rating. unwritten) of spe-
Institutional guidelines cific questions to
related to developing spe- be answered by the
cific work product. analysis.
Nature and content
of reports to be pro-
vided timetable and
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budgeted resources
for completion.
2. Data collection Financial statements, Organized financial
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other financial data, ques- statements and data
tionnaires, and industry tables.
data.
Discussions with manage-
ment, suppliers, custom-
ers, and competitors,
Company site visits (e.g.,
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to production facilities or
retails stores).
3. Data process- Data of collection stage. Adjusted financial
ing statements, com-
mon-size state-
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ments, comparative
statements, ratios
and graphs.
4. Analysis and Processed data Analytical results
interpretation with interpretation.
of data
5. Presentation of Data from stage 5 Financial analysis
report (con- report along with
clusions and answers of purpose
recommenda- established in stage
tions) 1 and recommen-
dation regarding
purpose.
6. Follow-up Information gathered by Final updated report
action periodically repeating and recommenda-
above steps as necessary tions.
to determine whether
changes to holdings or
recommendations are
necessary.

n o t e s
6. Which of the following is/are type of financial statement

analysis?
(a) Horizontal Analysis (b) Vertical Analysis
(c) External Analysis (d) All of the above
7. Which of the following is part of ratio analysis?
(a) Liquidity Ratios (b) Solvency Ratios
(c) Profitability Ratios (d) All of the above
9.6 SUMMARY
S
In a business, the sole purpose of investing money is earning prof-
its. The financial position of an organisation is determined by eval-
uating the profit earned or loss suffered by an organisation.
IM
Financial statements act as an important source of information as
they provide a structured and easy to understand information re-
garding the business activities of an organisation.
The objective of financial statements is to provide information that
would convey the performance details, financial position, and the
changes in the financial position of the organisation. These help
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users in making decisions.

Stakeholders cannot use financial information which they do not
understand. Problems in understanding financial information
may arise out of two reasons: user’s incapability in understanding
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information and ambiguity in the information itself.

A set of information can only be considered relevant when the in-
formation adds value to the decision-making process.
Information is reliable when it is dependable and this is possible
only when it is free from errors (especially material errors), com-
plete and free from bias.
It is not possible for users to evaluate different aspects of an organ-
isation’s financial performance without comparing the financial
information of one period with another or the financial informa-
tion of one entity to another.
Some of the main scopes of financial statements are providing
information about the financial position, providing information
about the financial performance, providing information about
changes in the financial position, and providing notes and supple-
mentary schedules.
The gross profit or gross loss calculated in a trading account is taken
to the second part of the account called the profit and loss account.

n o t e s
The profit and loss account is prepared to ascertain the net profit
earned or the net loss suffered by the business over an accounting
period, depicting the financial performance of the organisation.
The profit and loss account plays an important role in the account-
ing process as it helps in determining the net results of the busi-
ness activities.
The main components of a profit and loss account are expenses
and incomes. The expenses are shown on the debit side and the
incomes are shown on the credit side of the P&L account.
A balance sheet is the statement that summarises, and presents
the financial position of an organisation as on a particular date, by
showing the assets and liabilities of the organisation.
In the balance sheet, assets are represented on the right side and
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liabilities are shown on the left side.
A balance sheet plays a vital role in taking important financial de-
cisions by management and investors of the organisation.
IM
Trading transactions of a company, such as income, sales and
expenditure and the resulting profit or loss for a given period is
summarised in the profit and loss (P&L) account. In comparison,
the balance sheet provides a financial snapshot of a company at a
given moment.
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key words
Accounting standards board: The board consisting of account-

ing professionals to develop and implement various accounting
guidelines.
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Bad debt: A debt that is not collectible and therefore worthless

to the creditor.
Bottom line: The net profit of the organisation.
Carriage outward: The shipping and handling costs incurred
by a company that is shipping goods to a customer.
Depreciation: A reduction in the value of an asset over time due
to wear and tear.
Sales commission: The amount of commission received by a
person depending on the level of sales obtained by him/her.

1. What do you mean by financial statements? Discuss.
2. What are profit and loss accounts? Explain.

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3. Explain the relationship between a balance sheet and profit and

loss account.
9.8 Answers and hints

Scope of Financial State- 1. b. Final
ments
2. d. Both (a) and (c)
Profit and Loss 3. d. Profit and loss
Account
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4. c. Horizontal Analysis
Balance Sheet 5. a. Gross profit
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Financial statement anal- 6. d. All of the above
ysis

1. Financial statements provide information regarding total profit
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earned or loss suffered in the net income and the distribution of

income. Preparation of the financial statement is the last step in
the accounting cycle. Refer to Section 9.2 Financial Statements.
2. Profit and loss account is prepared to ascertain the net profit
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earned or the net loss suffered by the business over an accounting

period. Refer to Section 9.3 Profit and Loss Account.
3. Trading transactions of a company, such as income, sales and
expenditure and the resulting profit or loss for a given period is
summarised in the profit and loss (P&L) account. In comparison,
the balance sheet provides a financial snapshot of a company at
a given moment. Refer to Section 9.4 Balance Sheet.
Suggested Readings
Lal, J. (2009). Accounting for management. 5th Revised ed. (pages:

164-232) Mumbai: Himalaya Pub. House.
Sinha, G. (2009). Financial Statement Analysis (1st ed., pp. 97-133).

n o t e s
E-references
Accountingtools.com. (2014). What are the qualitative charac-

teristics of financial statements? - Questions & Answers - Ac-
counting Tools. Retrieved from, http://www.accountingtools.com/
questions-and-answers/what-are-the-qualitative-characteris-
tics-of-financial-statem.html
Nibusinessinfo.co.uk. (2014). Retrieved from, https://www.nibusi-
nessinfo.co.uk/content/relationship-between-balance-sheets-and-
profit-and-loss-accounts
Investopedia. (2010). Financial Statement Analysis Definition | In-
vestopedia. Retrieved from, http://www.investopedia.com/terms/f/
financial-statement-analysis.asp
Ltd,E. (2014). Components of profit and loss account, Account-
S
ing Basics. Expertsmind.com. Retrieved from, http://www.ex-
pertsmind.com/questions/components-of-profit-and-loss-ac-
count-30117983.aspx
IM
My Accounting Course. (2014). Balance Sheet | Example | Tem-
plate | Format. Retrieved from, http://www.myaccountingcourse.
com/financial-statements/balance-sheet
M
N

Case study
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PREPARATION OF FINANCIAL STATEMENTS
ABC Financial was started by first generation entrepreneur

named, Rohit Nagi. He started a business of manufacturing in-
dustrial equipments (Business to Business) namely ‘Rohit Indus-
tries Limited’ with a capital of `305 crore. Below given are the
transactions related with the commencement of business:
Transactions:
(I) On April 1, 2016, Rohit Started a business named ‘Rohit
Industries Limited’ with a capital of `305 crore. On the
same day he bought machinery worth `100 crore from Farid
Machinery Limited and half of the amount was made on the
same day. Rest half payment would have been made by the
S
end of the month (By April 30, 2016).
Other transactions during the year:
(II) Rohit took an interest free loan of `150 crore from one of his
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relative’s company which is in size equal to twice the capital
of his firm.
(III) The firm makes a credit sales of `70 crore during the year.
At the end of the year, total trade receivables were `15 crore
and it is expected that out of this 10% to be turned out as bad
debt.
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(IV) Market and distribution expenses for the year were `1 crore.
Salaries for the year stood at `50 lakh and Electricity charges
for the year at `1 crore. All these expenses have been paid
and there are no dues at the end of year (March 31, 2017).
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(V) The firm also made a cash purchase of raw material of worth
`15 crore and the firm made credit purchase of `15 crore. At
the end of year (March 31, 2017) balance remained in the
books was `4.5 crore.
(VI) At the end of the year (March 31, 2017) the firm had raw
materials of `10 lakh and no other inventory remained.
(VII) The machinery was to be depreciated @20 per cent per
annum. The applicable corporate income tax was 25%.
Fringe tax benefits were to be estimated as `3 lakh. However,
taxes had not been paid by the firm and provision had been
made for the same.
Now, you are required to prepare a balance sheet and a profit
and loss account at the end of the year and answer the following
questions:

Case study: STORTFORD YACHTS LIMITED 271
Case study
n o t e s
questions
1. What is the balance of cash and retained earnings in the

year end?
2. What is the value of total assets and net profit in the year
end?
3. What is the balance for current liabilities and provisions
in the year end?
(Hint: Prepare balance sheet and profit and loss
statement, as per the format prescribed in the Companies
Act, 2013 (reverse liquidity order). You can hypothetically
assume the value of current assets and current liabilities
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in order to match balance sheet but make sure that each
item is recorded under the correct head. Also consider
accounting year for the case is from April 1, 2016 to March
31, 2017 and you can assume dates of other transactions
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on your behalf.)
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Ch
10 a p t er
FINANCIAL STATEMENT ANALYSIS II
CONTENTS
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10.1 Introduction
10.2 Ratio Analysis
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10.2.1 Significance of Ratio and Ratio Analysis
10.2.2 Advantages and Limitations of Ratio Analysis
Activity
10.3 Types of Ratios
10.3.1 Liquidity Ratios
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10.3.2 Solvency Ratios

10.3.3 Profitability Ratios
10.3.4 Activity Ratios
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Activity
10.4 The DuPont Equation
Activity
10.5 Summary
10.8 Numerical Ability Questions

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The District Central Cooperative Bank Ltd.
The District Central Cooperative Bank Ltd., Rajnandgaon was es-

tablished on 3rd December 1974 as a central financing agency of
Poorest Areas Civil Society (PACS) with the purpose of address-
ing the agricultural credit needs of the farmers in the district. The
bank has its head office at Rajnandgaon, Chhattisgarh. The main
objective of the bank is to meet the short and medium-term cred-
it requirements of member societies, collect deposits and arrange
funds for the purpose of lending to farmers, implement the credit
policy and programmes of the government and to provide various
banking facilities to the member societies and the farmers. In or-
der to sanction funds for opening up more branches of the bank in
surrounding districts, the bank approached the government. The
S
balance sheet for the last five years was presented to the bank for
providing details about the financial position of the bank. However,
the government required finer details to assess the different finan-
cial aspects of the bank such as its liquidity, solvency, profitability,
IM
etc. To meet the government’s requirement, the District Central
Cooperative Bank Ltd. the bank decided to conduct a ratio anal-
ysis to depict its state of profitability, solvency, liquidity, indebted-
ness, etc. The financial position of this bank proved that the posi-
tion of solvency, liquidity and profitability are satisfactory. When
presented with the details, the Government of Chhattisgarh not
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only sanctioned funds for opening more branches but also award-
ed the bank for excellent service and contribution in cooperative
development for the year 2011. DCC bank obtained 79 Marks out
of 100 Marks and achieved grade “A” in Audit Report of Financial
Year 2010-2011.
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FINANCIAL STATEMENT ANALYSIS II 275
n o t e s
learning objectives

>> Discuss the concept of ratio analysis
>> Describe the different types of ratios and their significance
>> Explain the DuPont Chart
10.1 Introduction
In the past for an organisation to obtain loans and advances from fi-
nancial institutions, security from banks was a considered to be a suf-
ficient guarantee. However, in the present scenario the entire business
of lending is based on a thorough analysis and financial viability of a
S
business proposal and not on a mere security by a bank. In addition,
all business decisions related to credit have an element of risk. Various
quantitative methods help in the analysis and assessment of this risk.
IM
One of the commonly used techniques to assess this element of risk
and the financial health of organisations is ratio analysis.
Ratio analysis is a management tool to assess the financial results and

trends of an organisation over time, provide key indicators of organ-
isational performance and compare the financial performance of dif-
ferent organisations within an industry. Managers use ratio analysis to
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identify the strengths and weaknesses to form subsequent strategies

and initiatives in the future. In addition, investors use ratio analysis
to measure the results of different organisations and take investing
decisions.
N
Accounting ratios are mathematical comparisons of financial state-

ment that represent the relationships between the financial data and
help investors, creditors, and internal management to understand
how well a business is performing and trace down the areas that need
improvement. Ratios can be categorised on the basis of liquidity for
instance current ratio, solvency ratio like debt-equity ratio, profitabil-
ity ratio—gross profit ratio and activity ratio like inventory turnover
ratio.
In this chapter, you will study about the concept and significance of
ratio analysis and the advantages and limitations of ratio analysis. You
will also study the commonly used ratios, their interpretation and dis-
cuss the DuPont equation.
10.2 RATIO ANALYSIS

Ratio analysis is a method of analysing an organisation’s financial
statements. Financial statements provide investors with details about
an organisation’s expenses and incomes, capital, assets, liabilities etc.
but do not provide a comparative picture of the organisation’s finan-

n o t e s
cial health at a glance. Ratio analysis is a powerful tool of analysing

an organisation’s financial statements for determining the financial
strengths and weaknesses of the organisation. Ratio analysis is used
to represent the information from financial statements in comparative
form and helps in evaluating an organisation’s performance. Ratio
analysis provides vital information to investors, creditors apart from
internal management to understand about how well a business is per-
forming and what areas of business need to be improved.
Let us discuss the meaning of ratio and ratio analysis in the subse-
quent sections.
10.2.1 SIGNIFICANCE OF RATIO AND RATIO ANALYSIS
A ratio is a relationship between two or more values. A financial ra-
S
tio depicts the relationship between two or more accounting data
expressed in mathematical terms. Accounting or financial ratio are
based on information obtained from financial statements (Balance
Sheet and Profit and Loss Statement) and expressed in terms of ratio
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(for example, 2:1), in terms of number (for example 2 or 2 times) or
in terms of percentage (for example 50 per cent). A single accounting
data by itself does not communicate much information about an or-
ganisation’s position.
Accounting ratios are indicators of the financial strength, soundness,

position or weakness of an organisation.
M
Assume that an organisation’s sales figures for the given year are ` 80,
00,000 and its net profit is ` 5, 00,000. The ratio of profit to sales will be
N
5, 00, 000
= 1:16 or 6.25 %
80, 00, 000
Ratio analysis is a tool for determining and interpreting the relation-
ships between different items of financial statements for providing
understanding of the performance and financial position of an organi-
sation. Ratio analysis is an accounting tool to present accounting vari-
ables in a simple, concise and meaningful form.
DEFINITION
As per Myers (Professor of Financial Economics at the MIT Sloan

School of Management), “ratio analysis is a study of the relation-
ship among various financial factors in a business”.
The purpose of ratio analysis is to assess the earning capacity, finan-

cial soundness and operating efficiency of an organisation. Ratio anal-
ysis helps the management to know the profitability, financial posi-
tion, liquidity, solvency and operating efficiency of the organisation.

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10.2.2 ADVANTAGES AND LIMITATIONS OF RATIO

ANALYSIS
Ratio analysis is widely used in the analysis of financial well-being of

a business and is crucial to the understanding of the performance of
organisations against one another. It offers several benefits to organi-
sations which are as follows:
Ratio analysis is used for the analysis of financial statements:
The different stakeholders in a business such as bankers, inves-
tors, creditors, etc. use ratio analysis methods to analyse the differ-
ent financial statements of an organisation to assess its financial
well-being. For instance, fundamental analysis of an organisation
by investors involves analysis of balance sheet and profit and loss
statement of an organisation using ratio analysis.
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Ratio analysis helps in simplifying accounting figures: Ratio
analysis simplifies and organises a wide array of accounting fig-
ures to make them meaningful for the concerned parties. Finan-
cial ratios are used to summarise the results of the detailed and
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complicated computation which can lead to diagnosing the finan-
cial health of a firm.
Ratio analysis is used to evaluate the operating efficiency of a
business: Ratio analysis helps in the diagnosis of an organisation’s
financial health by evaluating its state of liquidity, solvency, prof-
itability etc. This enables the management to assess and compare
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the financial states and capabilities of various business units.

Ratio analysis helps in business forecasting: Ratio analysis can
also be used for forecasting the financial status and performance
of an organisation in the future. Therefore, ratio analysis enables
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planning the future activities based on the forecasts made using

ratio analysis. For instance, ratio analysis may help in planning
the course of action in the immediate future using ratio analysis to
determine business trends over the years.
Ratio analysis helps in identifying the weaknesses of an organ-
isation: In spite of satisfactory overall performance, an organisa-
tion may have certain drawbacks that need to be addressed by the
management. Ratio analysis helps in identifying these weak spots
in an organisation and taking remedial action. For example, if an
organisation discovers that the distribution expense is not propor-
tional to the sales, the management would attempt to examine the
situation and revise the distribution system.
Ratio analysis is used for making inter-firm or intra-firm com-
parisons: Organisations are interested in comparing their per-
formance against the competitors’ performance or against the in-
dustry in general. Such a comparison is referred to as inter-firm
comparison while comparing the performance of different in an
organisation is called intra-firm comparison. Both intra-firm as

n o t e s
well as inter-firm comparisons can be performed using ratio anal-

ysis.
However, ratio analysis has certain drawbacks that limit its use for
financial analysis. These limitations are as follows:
Incorrect or unauthenticated data may lead to wrong interpre-
tations: Ratio analysis depends on the data in the financial state-
ments, which if not accurate or authenticated may lead to incor-
rect interpretation of results.
Dependence on historical data may not help in proper forecasts:
Ratio analysis depends on the past data and thus, does not incor-
porate the current trends financial analysis. Forecasts based on
historical data may not always lead to accurate trend prediction.
A single ratio does not provide sufficient information: A single
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ratio computed for a specific area is insufficient to interpret a sig-
nificant conclusion thus, a series of ratios need to be calculated to
ascertain the situation of a particular business area.
IM
Different firms follow different accounting principles: Organi-
sations may follow different accounting principles, which limit the
use of inter-firm comparisons. Inter-firm comparisons are possible
only when the organisations being compared follow uniform ac-
counting principles and policies.
Price level changes may affect the forecasting: Changes in price
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level often distort the trend analysis process, which is carried out
by computing a series of ratios for making forecasts.
Qualitative factors may get ignored: Financial Ratios are based
on quantitative analysis of financial statements. Often qualitative
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facts need to be considered for making business decisions, which

are ignored in ratio analysis. For example, organisations give cred-
it based on ratio analysis and ignore qualitative aspects such as
character and managerial ability of the borrower. Under such cir-
cumstances, the conclusions derived from ratio analysis may prove
to be misleading.
Window dressing may affect interpretations based on ratio
analysis: Window dressing or manipulations of data in financial
statements affects the results of ratio analysis.
Personal biases may affect the way the ratios are interpreted:
Different people may interpret the same ratio in different ways.
Personal judgment of the analyst affects the interpretation of re-
sults using ratio analysis. If an analyst does not possess the re-
quired qualifications or is biased in interpreting the ratios, the
conclusion drawn may prove to be misleading.

n o t e s
1. Profitability of an organisation depends upon its__________.

(a) Investment in fixed assets
(b) Return on investment
(c) Net sales
2.
_____________ comparisons are possible only when
organisations being compared follow uniform accounting
principles and policies.
(a) Inter firm (b) Departmental
(c) Intra firm (d) Transactional
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Activity
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With the help of an organisation’s financial statements, assess how
window dressing (manipulation of figures) can affect the computa-
tion of various ratios. Present your assessment in a short note.
10.3 TYPES OF RATIOS

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Financial ratios are categorised based on the financial aspect of a

business that they are used to measure. For example, ratios that are
used to measure the liquidity position of a business are categorised as
liquidity ratios. Financial ratios help as analytical tools for comparing
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different organisations, industries or different departments of a single

organisation and financial data of an organisation at time periods, etc.
While analysing the financial statements of an organisation, it is advis-
able to have a complete understanding of the different types of ratios,
their calculation, and interpretation. Financial ratios can be classified
as depicted in Figure 10.1:
Types of Ratios
Liquidity Leverage Profitability

Activity Ratios
Ratios Ratios Ratios
Figure 10.1: Classification of Ratios
Now, let us discuss the different ratios in detail in the following

section.

n o t e s
10.3.1 LIQUIDITY RATIOS
Liquidity refers to an organisation’s ability to convert its assets into

cash quickly without reducing its price significantly. Liquidity ratios
help in assessing an organisation’s ability to meet its current liabilities
using its current assets. The current liabilities are the short-term ob-
ligations to be met within one financial year. For example, short term
debt, accounts payable, sundry creditors, etc. Current assets refer
to the short-term assets that can be converted to cash within a year.
For example, cash, marketable securities, short-term investments, ac-
counts receivable, prepaid expenses, inventory, etc. There are three
important liquidity ratios, which are as follows:
CURRENT RATIO
S
The current ratio (CR) is equal to total current assets divided by total
current liabilities. It indicates the extent to which current assets can
be used to pay off current liabilities. Mathematically, it is expressed as
follows:
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Current Assets
Current Ratio =
Current Liabilities
Let us understand this with the help of the following illustrations:
Illustration 1: The balance sheet of XYZ Ltd. is as shown below. Com-

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pute the current ratio from its balance sheet:
Liabilities (`) Assets (`)

Share capital (fully paid up) 10,00,000 Land and building 10,00,000
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General reserve 8,00,000 Plant and machinery 4,00,000

Profit and loss account 3,00,000 Inventory 3,00,000
Accounts payable 4,00,000 Accounts receivables 5,00,000
Cash and bank balances 3,00,000
25,00,000 25,00,000
Solution:
Current Assets = Inventory + Accounts receivables + Cash and bank

balances = 11, 00,000
Current Liabilities = Accounts payable = 4, 00,000
Current Assets 11, 00, 000

Therefore, Current Ratio = = = 2.75
Current Liabilities 4, 00, 000
A current ratio of 2:1 or higher is considered good for almost all organ-
isations but investors and analyst need to be careful while assessing
an organisation’s liquidity based on this ratio. This because an organ-
isation with a high current ratio may not always be in a position to

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pay off its liabilities if the major part of its assets is composed of slow
moving or obsolete inventories. Similarly, an organisation with a low
current ratio may be strong enough to pay its current liabilities if the
major part of its current assets is composed of highly liquid assets i.e.,
cash, bank balance, marketable securities and fast moving invento-
ries. Let us understand this with the help of the following illustration:
Illustration 2: Calculate the current ratio from the data given below:
Cash in hand 170000
Bank balance 65000
Goodwill 130000
Trademarks 172000
Inventory 90000
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Accounts Receivable 185000
Accounts payables 135000
Income tax payables 35000
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Capital Work in progress 42000
Long term loan 250000
Deferred tax payable 32000
Solution:
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Current Assets
Current Ratio =
Current Liabilities
Where,
Current Assets = Cash in Hand + Bank Balance + Inventory + Ac-

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counts Receivable
= 170000 + 65000 + 90000 + 185000
= 510000
Current Liabilities = Accounts Payable + Income Tax payables
= 135000 + 35000
= 170000
Therefore,
Current Assets
Current Ratio =
Current Liabilities

510000
=
170000
= 3:1

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QUICK RATIO
One of the limitations of the current ratio is that it assumes that all
current assets of an organisation can be easily converted to cash in
order to meet its current liabilities. This assumption may not always
be true. There are current assets such as inventory and pre-paid ex-
penses which cannot be readily converted into cash. To overcome this
limitation, there is another ratio called the quick ratio, which removes
from current assets, the less liquid current assets such as inventory
and pre-paid expenses. The quick ratio is also referred to as the acid
test ratio. Quick ratio is equal to liquid current assets divided by cur-
rent liabilities. Mathematically, it can be expressed as follows:
Cash in hand + Cash at Bank + Receivables + Marketable Securities
Quick Ratio =
Current Liabilities
Alternatively, quick ratio can also be calculated as follows:
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Current Assets − Inventory − Advances − Prepayments
Quick Ratio =
Current Liabilities
IM
It indicates the extent to which an organisation’s current liabilities
can be paid off using its liquid current assets including cash, market-
able securities, and accounts receivables. Ideally, a quick ratio of 1:1 is
considered financially viable.
Let us look at the following illustration to understand Quick Ratio:

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Illustration 3: ABC Ltd. has the following assets and liabilities as at

31st December 2013:
Particulars ` lakhs Total

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Non-current Assets
Goodwill 75
Fixed Assets 75 150
Current Assets
Cash in hand 25
Cash in bank 50
Short term investments 75
Inventory 25
Receivable 100 275
Current Liabilities
Trade payables 100
Income tax payables 60 160
Non-current Liabilities

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Particulars ` lakhs Total

Bank Loan 50
Deferred tax payable 25 75
note
Short term investments comprise treasury bills worth `45, 00,000

and investment in unlisted shares worth `30, 00,000.
Solution:
Quick ratio will be calculated as follows:

Cash in hand + Cash at Bank + Receivables + Marketable Securities
Quick Ratio =
S
Current Liabilities
25 + 50 + 45
= = 120/160 = 0.75
160
IM
CASH RATIO
It is the ratio of cash and cash equivalents of an organisation to its

current liabilities. It assesses the capability of an organisation to repay
its current liabilities by using its cash and cash equivalents only. The
formula of cash ratio is as follows:
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Cash + Cash Equivalents

Cash Ratio =
Current liabilities
A cash ratio of 1 or above implies that the organisation is capable of
repaying its current liabilities in the immediate short term.
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10.3.2 SOLVENCY RATIOS
Solvency ratios are used to measure the ability of an organisation to

pay its long term debt and the interest on that debt. Solvency ratios
are different from liquidity ratios although both are used to measure
the ability of an organisation to pay off its obligations. Solvency ratios
are a measure of the long-term sustainability of an organisation while
liquidity ratios are a measure of the current liabilities of the organisa-
tion. Solvency ratios are particularly of interest to long-term creditors
and shareholders as these ratios give a clear picture of the long-term
health and survival of business firms.
In other words, solvency ratios are tools to assess if organisations can

pay off their debt and interest on debt on maturity. The ideal or ac-
ceptable level of solvency ratio varies from industry to industry. How-
ever, a solvency ratio higher than 20% is considered to be satisfactory.
Usually, a lower solvency ratio reveals a greater probability of the or-
ganisation’s insufficiency to pay off its debt obligations. There are four
important solvency ratios, which are as follows:

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DEBT-EQUITY RATIO
The debt-equity ratio is a financial ratio that is used to compare an or-

ganisation’s total debt against its total equity. In other words, this ratio
reveals the relationship between external equities and internal equities.
Therefore, it is also called the external-internal equity ratio. Total equi-
ty includes all ordinary capital, reserves, preferences and minorities.
It is an organisation’s net assets (total assets less total liabilities). This
ratio measures how much of an organisation’s asset base is financed
using debt. For example, if the debt-equity is 50%, it implies that half of
the organisation’s assets are financed using debt and the other half are
financed using equity. Solvency ratios help the business owner to track
down a possible bankruptcy. As the debt-equity ratio grows higher, the
possibility of bankruptcy significantly increases as the organisation is
financed more and more with debt as against equity. The debt to equity
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ratio Debt-Equity ratio measures the ratio of long-term or total debt to
shareholders’ equity. Mathematically, it can be expressed as follows:
Total Liabilities
Debt-Equity Ratio =
IM
Shareholder 's Equity
In the above formula, two variables debt and equity are discussed and
their meaning is as follows:
Debt is a borrowed capital and includes those funds which are owed
by the firm from external sources of finance. These funds are obligato-
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ry in nature and sources can be defined as lender, for example, banks,

NBFC, debenture holders, etc.
Equity is an owned capital of the entity and it can be raised by issuing

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new shares or equity. These funds are ownership based in nature and
belong to shareholders, proprietors or the owner of the entity.
The debt considered is exclusive of current liabilities. The sharehold-

ers’ equity includes the following:
i. Equity and preference share capital
ii. Past accumulated profits
iii. Discounts on issue of shares
iv. Common stock, treasury stock
v. Retained earnings
vi. Capital surplus.
The D/E ratio can also be computed as follows:
Total debt
Debt-Equity Ratio =
Shareholders 'equity

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Therefore, the D/E ratio is the ratio of total external liabilities to own-
ers’ total funds. In other words, it is the ratio of the amount invested
by outsiders (shareholders) to the amount invested by the owners of
an organisation. For example, a D/E ratio of 1:2 implies that for every
rupee of shareholders’ liability, the organisation two rupees of internal
capital. Conversely, a ratio of 2:1 would imply that the safety margin is
one-third for the investors.
Let us look at the following illustration to understand the debt-equity

ratio calculation:
Illustration 4: The information of XYZ Ltd. is as follows:
Short term debt 500000
Long term debt 1000000
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Common equity 50000
Preferred equity 25000
Additional paid in capital 600000
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Retained earnings 325000
Solution:
XYZ Ltd.’s debt-to-equity ratio can be calculated as follows:
Total Liabilities
M
Debt-Equity Ratio =
Where,
Total Liabilities = Short term debt + Long term debt

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= 500000 + 1000000
= 1500000
Shareholder’s equity = Common equity + Preferred equity + Addi-

tional paid in capital + Retained earnings
= 50000 + 25000 + 600000 + 325000
= 1000000
Total Liabilities
Therefore D/E ratio of XYZ Ltd. = =
1500000
=
1000000
= 1.5 times or 150%
This implies that for every `1 of XYZ Ltd. owned by the shareholders,
XYZ Ltd. owes ` 1.50 to creditors.

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Illustration 5: The ABX Pvt. Ltd. has total shareholder’s equity of

800000 and the D/E ratio of 150%. Calculate total liabilities of ABX
Pvt. Ltd.
Solution:
Total Liabilities
Debt-Equity Ratio =
Or
Total liabilities = D/E ratio total shareholder’s equity
= 1.5 800000
Total liabilities ABX Pvt. Ltd. = `1200000
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DEBT TO TOTAL ASSETS RATIOS
This ratio also represents an organisation’s ability to meet all its finan-
cial obligations. It is a measure of the organisation’s financial position
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as it represents the percentage of an organisation’s assets financed
through loans and other financial liabilities (total debt). A ratio great-
er than 1 implies that a significant proportion of assets are being fi-
nanced using debt whereas a ratio below 1 implies that most of the
assets are financed through equity. Debt to Total Assets Ratio can be
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Long Term Debt

Debt to Total Assets Ratio =
Total Assets
For example, total assets of an organisation are worth `90,00,000 and
its long term debt amounts to `40,00,000. The debt to total asset ratio
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is calculated as follows:
Debt to Total Assets Ratio = 40,00,000/90,00,000 = 0.44 times
This implies that the organisation has `0.44 in long term debt for every
`1 it has in assets.
PROPRIETARY RATIO
It is also referred to as Capital Ratio or Net Worth to Total Asset Ratio.

This ratio is used to establish the relationship between shareholders’
fund and total assets of an organisation. It indicates the proportion of
total assets financed by the owners of a firm. Mathematically, it can be
expressed as follows:
Proprietary Ratio = Shareholders’ Funds/ Total Assets × 100
Suppose, a firm has total assets worth `40, 00,000 and proprietary
funds worth `30, 00,000, then the Proprietary Ratio of the firm would
be calculated as follows:

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30, 00, 000

Proprietary Ratio = = 0.75 or 75%
40, 00, 000
This implies that 25% of the firm’s funds are financed by outside cred-
itors.
note
Shareholders’ Funds is also termed as “ Net Worth ”
INTEREST COVERAGE RATIO
Interest Coverage Ratio denotes the relationship between the net profit
before the deduction of interest and tax and the fixed interest charges.
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It is used as a measure for the stakeholders to gain an insight that the
concerned enterprise would be able to pay its interest periodically.
Interest Coverage Ratio = Net profit before Interest & Taxes / Fixed
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Interest Charges
For example, details of XYZ Ltd. are as follows:
Net Income `3, 50,000

Interest `4, 00,000
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Taxes `50,000
Interest Coverage Ratio= (3, 50,000 +4, 00,000 + 50,000)/4, 00,000 = 2.0
From the viewpoint of investors, the higher the coverage, the greater
would be the ability of the firm to handle fixed charge liabilities and
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the more assured would be the payment of interest to them. Howev-

er, a very high ratio may also imply unused debt capacity of the firm.
Conversely, a very low ratio might raise an alarm that the firm is using
excessive debt and lacks the ability to offer assured interest payment
to the creditors.
DIVIDEND COVERAGE RATIO
This ratio is used to measure the ability of a firm to pay dividend on

preference shares carrying a specific rate of return. For example, div-
idend coverage of 3 implies that a firm has sufficient earnings to pay
dividends amounting to 3 times of the present dividend payout during
the period. The dividend coverage ratio is expressed as follows:
Dividend Coverage Ratio = EAT (Earnings After Taxes)/ Preference

Dividend
Let us look at an illustration to understand the ratio:

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Following information relates to the financial statements of ABC Ltd.

for the year ended 31st March 2013:
Particulars ` (in lakhs)

Net profit 220
Dividend paid on ordinary shares 50
Dividend paid on redeemable preference shares 30
Dividend paid on irredeemable preference shares 20
Dividend Coverage ratio would be calculated as follows:
Dividend Coverage Ratio = (220 – 20)/ 50 = 4 times
This implies that ABC Ltd. earnings to pay dividends amounting to 4

times of the dividend payout in the period.
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SOLVENCY RATIO
This ratio measures an organisation’s ability to meet its long term

IM
debt and other obligations. The solvency ratio measures whether an
organisation’s cash flows are sufficient to meet its short and long-term
liabilities. A lower solvency ratio indicates a firm’s probability for de-
fault. Solvency ratio measures the size of a firm’s income after tax less
depreciation expenses against the total debt obligations of the firm.
Mathematically, Solvency ratio = (Profit After Tax + Depreciation)
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/ Total liabilities
A firm which is completely insolvent and unable to pay its debts would
be forced into bankruptcy. Investors need to examine all the financial
statements of a firm to make sure that the firm is solvent as well as
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profitable.
FIXED ASSETS RATIO
This ratio measures a firm’s ability to generate net sales from fixed as-
sets specially property, plant and equipment less depreciation. Math-
ematically,
Net Sales
Fixed Assets Ratio =
Net Property, Plant and Equipment
A higher Fixed-Asset ratio indicates that the firm has been effectively
using the investment in fixed assets to generate revenues. Lower ra-
tios are indicative of underutilisation of resources and presence of idle
capacity.
CAPITAL GEARING RATIO
Capital gearing is the relation of equity shares to preference share

capital and loan capital. Capital gearing describes the relative share of

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fixed interest and/or fixed dividend bearing and the equity sharehold-
ers’ fund. Mathematically, it can be calculated as follows:
Capital Gearing Ratio = Common Stockholders Equity/Fixed Cost

Bearing Funds
Fixed Interest Bearing = Debentures + Preference Share Capital +

Other Long-term Loans
High Capital Gearing ratio indicates that an organisation has large

fund bearing fixed interest and/or fixed dividend bearing compared to
equity share capital. A lower ratio indicates that the preference share
capital and other fixed interest bearing loans in the organisation are
less than the equity share capital. An ideal capital gearing ratio is 2:1.
Let us understand the ratio with the help of an illustration:
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The capital structure of XYZ Ltd. is as follows:
Particulars Amount (in `)

IM
Preference Share Capital 5,00,000
Equity Share Capital 6,00,000
Capital Reserve 3,00,000
Profit and Loss Account 1,00,000
12% Debentures 3,00,000
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Secured Loan 1,00,000
The Capital Gearing ratio of XYZ Ltd. would be calculated as follows:
Capital Gearing Ratio = Common Stockholders Equity/Fixed Cost

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Bearing Funds
Common Stockholders Equity = Equity Share Capital + Capital Re-

serve + Profit and Loss Account
= 6, 00,000 + 3, 00,000 + 1, 00,000 = 10, 00,000
Fixed Cost Bearing Funds = Debentures + Preference Share Capital

+ Secured Loans
= 3, 00,000 + 5, 00,000 + 1, 00,000 = 9, 00,000
Capital Gearing Ratio = 10, 00,000/9, 00,000 = 10:9
This is a low Capital Gearing Ratio indicating that XYZ Ltd.’s prefer-
ence share capital and other fixed interest bearing loans in the organ-
isation are less than the equity share capital.

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10.3.3 PROFITABILITY RATIOS
A profitability ratio is used to measure an organisation’s profitability

in order to assess its performance. In other words, Profitability ratios
measure an organisation’s performance in generating earnings over
related expenses over a specified time period. Profit includes the in-
come earned after an organisation has deducted the costs and expens-
es incurred in the process. The three main types of profitability ratios
are gross profit ratio, net profit ratio and operating profit ratios. Let us
discuss each of these in detail:
GROSS PROFIT RATIO
This ratio shows the relationship between an organisation’s gross

profit and total net sales revenue. Gross profit ratio is a tool to assess
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the operational performance of the organisation. It is calculated by
dividing the gross profit figure by the net sales in a given time period.
Mathematically, gross profit ratio can be expressed as follows:
IM
Gross Profit Ratio = Gross Profit or
Net Sales
Sales – ( Direct materials + Direct Labour + Overhead )
Sales
M
When expressed in percentage form, gross profit ratio is known as

gross profit margin or gross profit percentage.
Gross Profit
Gross Profit Margin = × 100
Net Sales
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Higher ratios are considered favourable as they imply that the organ-
isation is selling its products at a higher profit percentage. Let us un-
derstand this with the help of an illustration:
Illustration 6: The following data relate to a small scale company A

Ltd. Find the gross profit ratio of the company.
Particulars `
Gross sales 10,00,000
Sales returns 90,000
Opening stock 2,00,000
Purchases 5,90,000
Purchases returns 70,000
Closing stock 45,000

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Solution: Computation of gross profit:
Particulars Amount
Sales 10,00,000
Less sales returns 90,000
Net sales 9,10,000
Less cost of goods sold (COGS):
Opening inventory 2, 00,000
Purchases 5, 90,000
Purchases returns 70,000 5, 20,000
Available for sale 7, 20,000
Less closing inventory 45,000 6, 75,000
Gross profit (Net Sales – COGS) 2, 35,000
S
Gross Profit 2, 35, 000
Therefore, Gross Profit Ratio = = = 0.26
Net Sales 9,10, 000
IM
2, 35, 000
Gross Profit Margin = × 100 = 26%
9,10, 000
This implies that A Ltd. earns a gross profit ` 0.26 on each ` 1 of sales.
NET PROFIT RATIO

M
This ratio indicates the relationship between an organisation’s net

profit after tax and net sales. Net profit is determined by adjusting the
operating and non-operating incomes and expenses and loss in the
gross profit. It is calculated by dividing the net profit (after tax) figure
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by the net sales in a given time period. Net profit is equal to gross
profit minus operating expenses and income tax. Mathematically, net
profit ratio can be expressed as follows:
Net Profit after Tax

Net Profit Ratio =
Net Sales
When expressed in percentage form, net profit ratio is known as net
profit margin or net profit percentage.
Net Profit after Tax

Net Profit Margin = × 100
Net Sales
Let us understand this with the help of the illustration:
Illustration 7: The following data relate to a small scale company B

Ltd. Find the net profit ratio of the company.

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Particulars `
Sales 2,10,000
Returns inwards 10,000
Gross profit 80,000
Administrative expenses 15,000
Selling expenses 15,000
Interest on investment 10,000
Loss on account of fire 6,000
Income tax 5,000
Solution:
S
a. Computation of net operating profit after tax:
Gross profit 80,000
IM
Less operating expenses:
Administrative expenses 15,000
Selling expenses 15,000
Net operating profit before tax 50,000
Less income tax 5,000
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Net operating profit after tax 45,000
b. Computation of net sales:

Net sales = Sales – return inwards = 2, 10,000 – 10,000 = 2, 00,000
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Net Profit after tax 45, 000

Therefore, Net Profit Ratio = = = 0.225%
Net Sales 2, 00, 000
45, 000
Net Profit Margin = × 100 = 22.5%
2, 00, 000
This implies that B Ltd. earns a net profit `0.225 on each `1 of
sales.
OPERATING PROFIT RATIO
This ratio indicates the relationship between operating income of an

organisation and its sales revenue. Operating profit ratio shows oper-
ating income as a percentage of revenue from sales. It is calculated by
dividing operating income by sales revenue. Mathematically, it can be
expressed as follows:
Operating Income
Operating Profit Ratio =
Sales Revenue

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When expressed as a percentage, operating profit ratio is known as

operating margin:
Operating Income
Operating Margin = x 100
Sales Revenue
Operating income is also referred to as earnings before income and
taxes or EBIT. EBIT includes the income that remains on the income
statement after all operating and overhead costs are deducted.
Let us understand this with the help of the illustration:
Illustration 8: The financial information for PQR Ltd. is as follows.
Compute the operating profit ratio.
Particulars Amount
S
Net Sales `10,00,000
Cost of Goods Sold `5,00,000
Rent `15,000
Wages
IM `1,00,000
Other Operating Expenses `25,000
Solution: Operating income = Net sales – operating expenses

Therefore, Operating income = 10, 00,000 – (5, 00,000 + 15,000 +
1,00,000 + 25,000)
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10, 00,000 – 6, 40,000) = ` 3, 60,000
Operating Income 3, 60, 000

Operating Profit Ratio = = = 0.36
Sales Revenue 10, 00, 000
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This implies that PQR Ltd. earns `0.36 as operating income from ev-
ery `1 of sales revenue. It is important to note that this ratio does not
take into account the organisation’s capital and tax structure.
RETURN ON INVESTMENT (ROI)
This ratio used to evaluate the competence of an investment or to com-

pare the competence of different investments. To calculate ROI, the
return expected from an investment is divided by the cost of the invest-
ment. ROI is expressed as a percentage and the formula is as follows:
Return from Investment − Cost of Investment

ROI =
Cost of Investment
RETURN ON EQUITY (ROE)
This ratio measures an organisation’s profitability by revealing how

much profit organisation yields with the shareholders’ money. ROE is
expressed as a percentage and the formula is as follows:
ROE = Net Income/Shareholder’s Equity

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Let us look at an example for a better understanding:
Let us assume that XYZ earned `10 lakhs of net income last year.
Shareholders’ equity is `20 lakh. The ROE of XYZ can be calculated
as follows:
ROE = 10, 00,000/20, 00,000 = 0.5 or 50%
This implies that Company XYZ earned `0.50 for every `1 of share-
holders’ equity.
RETURN ON ASSETS (ROA)
This ratio measures how profitable an organisation is relative to its

total assets. ROA assesses how efficiently the management of an or-
ganisation is utilising its assets to generate profits. ROA is expressed
S
as a percentage and the formula is as follows:
Net Income
ROA =
Total Assets
IM
10.3.4 ACTIVITY RATIOS
Activity ratios also referred to as operating or management ratios are

used to measure an organisation’s efficiency to use its assets such as
inventories, accounts receivable, working capital and fixed assets.
The commonly used activity ratios are inventory turnover, debtors
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turnover and working capital turnover ratios. Before discussing the

different types of activity ratios, let us first understand the concept of
the average collection period. Average collection period refers to the
average number of days between the date that a credit sale is made
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and the date that receivables are collected from the customer. It is
computed as follows:
365
Average collection period =
Average Receivables Turnover Ratio
Let us discuss the activity ratios in detail:
INVENTORY TURNOVER RATIO
It is the ratio of cost of goods sold by an organisation to its average

inventory during a given accounting period. Inventory turnover ratio
measures the number of times average inventory is “turned” or sold
during a given period. In other words, the inventory turnover ratio
measures the number of times an organisation sold its total average
inventory during a financial year. For example, an organisation with
an average inventory and net sales of worth `10, 00,000 and `50, 00,000
effectively sold its inventory 5 times over. Inventory turnover ratio is
calculated using the following formula:

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Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory
COGS = Opening Inventory + Purchases - Closing Inventory
Average inventory refers to the average of beginning and closing in-

ventory:
Opening inventory + Closing Inventory

Average Inventory =
2
365
Average Selling period:
Inventory Turnover
Illustration 9: Compute the inventory turnover ratio and average sell-
ing period from the following data of EFG Ltd:
S
Particulars `
Sales 75, 00,000
IM
Purchases 20, 00,000
Opening inventory 9, 00,000
Closing inventory 7, 00,000
Solution: Computation of COGS and average inventory:

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COGS = 9, 00,000 + 20, 00,000 – 7, 00,000 = `22, 00,000
Average inventory = 9, 00,000 + 7, 00,000) / 2 = `8, 00,000
Cost of Goods Sold 22, 00, 000

Inventory Turnover Ratio = = = 2.75 times
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Average Inventory 8, 00, 000
365
Average Selling Period = = 132.7
2.75
This implies that EFG Ltd. will take 132.7 days to sell the average in-
ventory.
DEBTORS TURNOVER RATIO
This ratio measures the number of times average debtors are turned
over during a financial year. Debtors turnover ratio is also referred to
as accounts receivable turnover ratio. It indicates the frequency with
which the sundry debtors in an organisation are converted into cash.
A higher value of debtors turnover ratio reflects an efficient manage-
ment of debtors by an organisation. On the other hand, lower value of
debtors turnover ratio reflects an inefficient management of debtors
by the organisation. Accounts receivable turnover is calculated by di-

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viding net credit sales by average accounts receivable for that period.
Mathematically, it can be expressed as follows:
Net Credit Sales

Debtors Turnover Ratio =
Average Accounts Receivables
Let us understand this with the help of the following illustration:
Illustration 10: Net credit sales of PQR Ltd. for the year ended March
31, 2013 were worth ` 6, 44,790. It received ` 43,300 on July 1, 2012 and
` 51,730 on January, 2013. Calculate the debtors turnover ratio.
Solution: Average account receivables = (43,300 + 51,730)/2 = ` 47,515

6, 44, 790
Debtors Turnover Ratio = = 13.57
47,515
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Debtors collection period: 365/ Debtors Turnover = approximately 27
days
This implies that PQR Ltd. collects its due on credit sales in a financial
IM
year with a frequency of 13.57 times. The debts are collected every
27th day of the year.
CREDITORS TURNOVER RATIO
This is the ratio between net credit purchases and the average amount of
creditors outstanding during a financial year. It is computed as follows:
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Net Credit Purchases

Creditors Turnover Ratio =
Average Accounts Payable
Net Credit Purchases = Gross credit purchases – Returns to suppliers
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Average Accounts Payable = Average of bills payable at the beginning

and end of the year
Low turnover implies liberal credit terms provided by suppliers. On

the other hand, a higher ratio is indicative of a rapid account settle-
ment. This ratio helps in analysing whether a firm can reduce its re-
quirement of current assets by relying on the suppliers’ credit. Let us
understand this with the help of an illustration:
A firm makes a credit purchase of `1, 80,000. Accounts payable at the

beginning and end of year are `42,500 and `47,500 respectively. The
Creditors Turnover Ratio of the firm would be calculated as follows:
1,80, 000
Creditors Turnover Ratio = =4 times a year
(42,500 + 47,500) / 2
Creditors Payment Period = 365/ Creditors Turnover Ratio = 91.25 days
This implies that the firm repays its credit purchases after every 91.25
days. It signifies healthy credit terms between the firm and its suppliers.

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WORKING CAPITAL TURNOVER RATIO

Working capital measures the operating liquidity available to an or-
ganisation. It is current assets less current liabilities in a given time
period. A high ratio indicates efficient utilisation of working capital
and vice versa. However, a very high working capital turnover ratio
implies that an organisation does not have enough capital to support
it sales. Commonly used formula for the calculation of working capital
turnover ratio is as follows:
Net Sales
Working Capital Turnover Ratio =
Average Working Capital
Let us understand this with the help of the following illustration:
Illustration 11: Compute the working capital turnover ratio from the
following data of HIJ Ltd:
S
Particulars `
Net Sales 75, 00,000
Current Assets 20, 00,000
IM
Current Liabilities 10, 00,000
Solution: Working Capital = Current Assets – Current Liabilities
Therefore WC = 20, 00,000 – 10, 00, 000 = `10, 00, 000
Net Sales
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75, 00, 000
= = 7.5 times
10, 00, 000
Illustration 12: ABC Ltd. has `12, 00,000 worth of net sales for the
N
period ending March 31, 2013. Its closing working capital is `2, 00,000
and opening working capital is worth `4, 50,000. Calculate its working
capital turnover ratio.
Solution: Average Working Capital =
Opening working capital + Closing working capital

2
Therefore, Average Working Capital = 2, 00, 000 + 4,50, 000 =

`3, 25,000 2
Net Sales
12, 00, 000
= = 3.7 times
3, 25, 000

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Exhibit
Market Ratios-The Investors’ Ratio

Market ratios assess the economic status of an organisation in the
wider marketplace. These include the earnings per share, price
earnings ratio, dividend yield, book value per share, etc. Market
value ratios provide investors with an idea about an organisation’s
performance and future prospects.
Types of Market Calculation Uses

Ratios
Earnings Per Net Income Measures earnings ca-

Share No of Ordinary Shares pability of an ordinary
Outstanding share
S
Price Earnings Market Price Per Share Measures the amount
Ratio (P/E Ratio) Earnings Per Share the investors are
willing to pay for each
IM dollar of earnings.
Earnings Yield Earnings Per Share Measures the earnings

Market Price Per Share capability of an ordi-
nary share relative its
market value.
Dividend Per Cash Dividend Measures the dividend

M
Share No of Ordinary Shares return earned by a

Outstanding share
Dividend Yield Dividend Per Share Measures the dividend

earned by a share rela-
N
Market Price Per Share

tive its market value.
Dividend Pay- Dividend Per Share Indicates the percent-

out Ratio Earnings Per Share age of earnings paid
out as dividend.
Book Value Per Total Shareholders’ Equity Measures equity on

Share Total No. of Ordinary per share basis.
Shares
Price to Book Market Price Per Share Measures market price

Value Ratio Book Value Per Share of share relative to
book value.
Source: http://www.gulfbase.com/InvestmentTutorial/SubSection?id=61&SectId=107

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3. _____________________ helps in assessing an organisation’s

ability to meet its current liabilities using its current assets.
(a) Liquidity ratio (b) Solvency ratio
(c) Profitability ratio (d) Quick ratio
4. _________ shows the ability of an organisation to meet its
short-term financial liabilities.
5. Which of the following ratios is used to compare an
organisation’s total debt against its shareholders’ equity?
S
(a) Debt-equity ratio
(b) Debt to total assets ratios
(c) Quick ratio
IM
(d) Debtors turnover ratio
6. __________ measures an organisation’s performance in
generating earnings over related expenses over a specified
time period.
M

7. __________ measures an organisation’s ability to meet its long-
term obligations.
N

8. __________ includes income that remains on the income
statement after all operating and overhead costs are deducted.
(a) EBIT (b) PAT
(c) Gross profit (d) Net profit
9. Operating ratio is used to examine the profitability from
__________.
(a) Sale of core products (b) Investments
(c) Sale of old machinery (d) Both (a) and (c)
10. A higher value of debtors’ turnover ratio can ________the
average collection period of the organisation.
(a) Increase (b) Lowers
(c) Not affect (d) Either (a) or (b)

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Activity
Find out (a) debtors turnover and (b) average collection period of
the organisation whose annual credit sales are `5,00,000, debtors in
the beginning `80, 000, debtors at the end are ` 1,00,000 and debt is
taken for a year (360 days).
10.4 THE DUPONT EQUATION

DuPont equation is named after the U.S. chemical company, The Du-
Pont Corporation in the 1920s. The equation is a financial ratio used
to analyse an organisation’s ability to increase its return on equity.
Return on equity (ROE) measures the ratio between an organisation’s
net income and its stockholders’ equity during a given time period. In
S
other words, the DuPont equation breaks down the return on equity
ratio to explain how organisations can increase their return for inves-
tors. Return on equity is a relevant measure of how well an organisa-
IM
tion’s management creates value for its shareholders.
The DuPont equation is also referred to as the DuPont model, DuPont

analysis or DuPont method. The DuPont model breaks down the re-
turn on equity ratio into three components; the net profit margin, as-
set turnover and the equity multiplier. Evaluating each of these com-
ponents helps in assessing the sources of an organisation’s return on
M
equity and compare with its competitors.
The DuPont model concludes that an organisation can raise its ROE
by maintaining a high profit margin, increasing asset turnover or le-
veraging assets more effectively.
N
In a DuPont analysis, the formula for Return on Equity is:
ROE = Profit margin × Total asset turnover × Financial leverage
The formula can be further broken down as follows:
Net Income Revenues Total Assets

ROE = × ×
Revenues Total Assets Shareholders' Equity
Let us understand the calculation of ROE using DuPont analysis with
the help of the following illustration:
Illustration 13: The following information from XYZ Ltd.’s balance

sheet and income statement is given. Calculate the ROE using DuPont
model.

n o t e s
Balance Sheet:
Particulars ` ’000
Total Assets 250
Shareholders’ equity 50
Income Statement
Particulars ` ’000
Revenue 100
Net income 20
Net Income Revenues Total Assets

Solution: ROE = × ×
Shareholders' Equity
S
Revenues Total Assets
Therefore, ROE of XYZ Ltd. is calculated as follows:
20000 100000 250000

IM
ROE = × × = 40%
100000 250000 50000
ROE is an effective tool for measuring the profitability of an organisa-
tion. Higher values of ROE represent a favourable picture of the finan-
cial health of an organisation implying that the organisation is efficient
in generating income on new investment. Investors usually compare
M
the ROE of different organisations and ROE values of an organisation

over a period of years. However, ROE analysis for investment is not
sufficient to make a decision and it is advisable to be combined with
other financial ratios. This is because ROE can be manipulated by the
management of an organisation. For example, if debt financing is used
N
to decrease the share capital, ROE can be increased even when the
income remains constant.
Let us further understand the concept of three factor DuPont analysis

with the help of the following illustration:
Illustration 14: Company P Ltd. and Q Ltd. operate in the same mar-
ket and have the same size. Both companies earn the same return on
equity of 15%. The respective net profit margin, asset turnover and
financial leverage of both organisations are as follows:
Company P Company Q
Net Profit Margin 10% 10%
Asset Turnover 1 1.5
Financial Leverage 1.5 1
As per the information, both organisations have similar ROE of 15%.

However, the underlying strengths and weaknesses of P Ltd. and Q
Ltd are quite opposite. Q Ltd. is at a better position than P Ltd. in ex-

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pending its assets to generate revenues, but it is unable to capitalise

the same advantage for achieving a higher return on equity owing to
its lower financial leverage. P Ltd. can improve its financial position
by expending its total assets more effectively to generate sales while Q
Ltd. can improve its condition by raising some debt.
11. The DuPont model breaks down the return on equity ratio
into three components, which are:
(a) Net profit margin, asset turnover and equity multiplier
(b) Net profit margin, sales turnover and equity multiplier
(c) Net profit margin, earning per share and equity multiplier
S
(d) Net profit margin, gross profit margin and equity multi-
plier
12. __________ measures the ratio between an organisation’s
IM net income and its stockholders’ equity during a given time
period.
(a) Return on Asset (b) Return on Investment
(c) Return on equity (d) Net profit margin
13. Which of the following indicates the proportion of total assets
financed by the owners of a firm?
M
(a) Owner’s equity ratio (b) Equity to asset ratio

(c) Acid test ratio (d) Proprietary Ratio
14. ___________ model concludes that an organisation can raise
N
its ROE by maintaining a high profit margin, increasing asset

turnover or leveraging assets more effectively.
(a) Boumol’s (b) Miller-Orr
(c) DuPont (d) Modigilani
Activity
From the given information, calculate the ROE of Z Ltd. and assess
its profitability:
(` in lakhs)
Year 2011 2012 2013
Net Income 20 22 21
Revenue 100 105 120
Equity 68 70 80
Assets 120 140 200

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The ratios and their interpretation are summarised in the Table 10.1:
Types of Ratios Calculation Interpretation

Liquidity Ratios
Current Ratio (Current Assets)/(Cur- Indicates the extent to
rent Liabilities) which current assets can
be used to pay off current
liabilities.
Quick Ratio (Current Assets - In- Indicates the extent to
ventory - Advances - which an organisation’s
Prepayments)/(Current current liabilities can be
Liabilities) paid off using its liquid
current assets.
Cash Ratio (Cash + Cash Equiva- Indicates the capability of
lents)/(Current liabili- an organisation to repay
ties) its current liabilities by
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using its cash and cash
equivalents only.
Solvency Ratios
Debt-Equity Ratio
IM
(Total Liabilities)/ Indicates the extent to
(Shareholders’ equity) which an organisation’s
assets are financed using
debt.
Debt to Total Assets (Long Term Debt )/ Indicates the percentage of
Ratio (Total Assets) an organisation’s assets fi-
nanced through loans and
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other long term liabilities.

Proprietary Ratio (Proprietor’s Funds/ Indicates the proportion of
Total Assets) × 100 total assets financed by the
owners of a firm.
Interest Coverage Net profit before In- Indicates the ability of the
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Ratio terest & Taxes / Fixed firm to handle fixed charge

Interest Charges liabilities.
Dividend Coverage EAT (Earnings After Indicates the ability of a
Ratio Taxes)/ Preference firm to pay dividend on
Dividend preference shares carrying
a specific rate of return.
Solvency Ratio (Profit After Tax + Indicates whether an or-
Depreciation) / Total ganisation’s cash flows are
liabilities sufficient to meet its short
and long-term liabilities.
Fixed Assets Ratio (Net Sales)/(Net Prop- Indicates a firm’s ability
erty, Plant and Equip- to generate net sales from
ment) fixed assets specially prop-
erty, plant and equipment
less depreciation.
Capital Gearing Ratio Common Stockhold- Indicates whether an
ers Equity/Fixed Cost organisation has sufficient
Bearing Funds fund bearing fixed interest
and/or fixed dividend bear-
ing compared to its equity
share capital.

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Types of Ratios Calculation Interpretation

Profitability Ratios
Gross Profit Ratio (Sales – (Direct materi- Indicates the relationship
als + Direct Labour + between an organisation’s
Overhead))/Sales gross profit and total net
sales revenue.
Net Profit Ratio (Net Profit after Tax )/ Indicates the relationship
(Net Sales) between an organisation’s
net profit after tax and net
sales.
Operating Profit Ratio (Operating Income)/ Indicates the relationship
(Sales Revenue) between operating income
of an organisation and its
sales revenue.
Return on Investment (Return from Invest- Evaluates the competence
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(ROI) ment-Cost of Invest- of an investment or to
ment)/(Cost of Invest- compare the competence
ment) of different investments.
Return on Equity Net Income/Sharehold- Indicates an organisa-
IM
(ROE) er’s Equity tion’s profitability by
revealing how much profit
organisation yields with
the shareholders’ money.
Return on Assets (Net Income)/(Total Indicates how profitable
(ROA) Assets) an organisation is relative
to its total assets.
M
Activity Ratios
Inventory Turnover (Cost of Goods Sold)/ Measures the number of
Ratio (Average Inventory) times average inventory is
“turned” or sold during a
given period.
N
Debtors Turnover (Net Credit Sales)/(Av-

Ratio erage Accounts Receiv- Measures the number of
ables) times an organisation can
turn its accounts receiv-
Creditors Turnover (Net Credit Purchas- able into cash during a
Ratio es)/(Average Accounts financial year.
Payable) Shows the relationship
Working Capital Turn- (Net Sales)/(Average between net credit pur-
over Ratio Working Capital) chases and the average
amount of creditors out-
standing during a finan-
cial year.
Measures the operating
liquidity available to an
organisation.
10.5 SUMMARY
A financial ratio depicts the relationship between two or more ac-
counting data expressed in mathematical terms.

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Accounting ratios are indicators of the financial strength, sound-

ness, position or weakness of an organisation.
Ratio analysis is a tool for determining and interpreting the rela-
tionships between different items of financial statements for pro-
viding understanding of the performance and financial position of
an organisation.
Financial ratios can be divided into liquidity ratios, solvency ra-
tios, profitability ratios and activity ratios.
Liquidity ratios help in assessing an organisation’s ability to meet
its current liabilities using its current assets. These are the current
ratio and quick ratio.
Solvency ratios also referred to as leverage ratios are used to mea-
sure the ability of an organisation to pay its long term debt and the
interest on that debt. For example, debt-equity and debt to total
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assets ratios.
Profitability
ratios measure an organisation’s performance in gen-
erating earnings over related expenses over a specified time peri-
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od. For example, gross profit, net profit and operating profit ratios.
Activity ratios also referred to as operating or management ratios
are used to measure an organisation’s efficiency to use its assets
such as inventories, accounts receivable, working capital and fixed
assets. The most commonly used activity ratios are inventory turn-
over, debtors turnover, working capital turnover ratios.
M
The DuPont equation is a financial ratio used to analyse an organ-

isation’s ability to increase its return on equity.
Return on equity measures the ratio between an organisation’s net
income and its stockholders’ equity during a given time period.
N
The DuPont model breaks down the return on equity ratio into
three components; the net profit margin, asset turnover and the
equity multiplier.
In a DuPont analysis, the formula for Return on Equity is:
Net Income Revenues
The formula for ROE is ROE = ×
Revenues Total Assets
Total Assets
×
Shareholders' Equity
key words
Accounts payable: The amount owed by an organisation to its

suppliers for goods purchased on credit and is considered a lia-
bility on the balance sheet.
Accounts receivable: The amount owed to an organisation by
its customers for the products and services provided on credit.
It is considered as an asset on the balance sheet.

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Debentures: The long-term securities that yield a fixed rate of

interest, issued by an organisation and secured against assets.
Debt: The amount owed to an individual or organisation for
funds borrowed.
Equity: The value of the shares issued by an organisation.
Marketable securities: The highly liquid securities that are
easily converted into cash.
Shareholders’ equity: The total assets minus total liabilities
(net worth) of an organisation.
Window dressing: The act of manipulating the information in
the taken or not taken prior to issuing financial statements in
order to enhance their appearance.
S
Working capital: The capital used by an organisation to per-
form its day-to-day operations and is obtained by deducting the
current liabilities from the current assets.
IM
1. What is a quick ratio? What does it signify?
2. What do you mean by profitability ratios? Explain the following
profitability ratios:
M
a. Net profit ratio

b. Operating profit ratio
3 What are solvency matrices? Explain its various types and their
N
uses.
4. What are the advantages and limitations of ratio analysis?
Discuss.
5. Discuss the composition of Return on Equity based on the
DuPont Model.
6. What are various types of activity matrices? Explain with relevant
examples.
10.7 Answers and hints

Ratio Analysis 1. d. Both (b) and (c)
2. a. Inter firm
Types of Ratios 3. a. Liquidity ratio

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4. d. Quick ratio
5. a. Debt-equity ratio
6. c. Profitability ratio
7. a. Solvency ratio
8. a. EBIT
9. a. Sale of core products
10. b. Lowers
The DuPont 11. a. Net profit margin, asset turnover
Equation and equity multiplier
S
12. c. Return on equity
13. d. Proprietary ratio
14.
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c. DuPont

1. Quick ratio is equal to liquid current assets divided by current
liabilities. Quick ratio is significant as all assets in an organisation
cannot be readily converted into cash. Quick ratio removes from
M
current assets, the less liquid current assets such as inventory

and pre-paid expenses. Refer to Section 10.3 Types of Ratios.
2. Profitability ratios measure an organisation’s use of assets and
its control on expenses to generate an acceptable profit. Net
N
Profit ratio shows the relationship between an organisation’s net

profit after tax and net sales. Operating Profit ratio shows the
relationship between operating income of an organisation and
its sales revenue. Refer to Section 10.3 Types of Ratios.
3. Solvency matrices indicates organisations overall ability to
meet its short term and long term obligations. Debt-to-equity
ratio, debt to total asset ratio, proprietary ratio, interest coverage
ratio, dividend coverage ratio, solvency ratio, fixed assets ratio
and capital gearing ratio are some of the important types of
solvency ratios. Refer to Section 10.4 The Dupont Equation.
4. There are many advantages of ratio analysis like ratio analysis
helps in simplifying accounting figures, it simplifies and organises
a wide array of accounting figures to make them meaningful
for the concerned parties, ratio analysis is used to evaluate the
operating efficiency of a business, it helps in the diagnosis of an
organisation’s financial health by evaluating its state of liquidity,
solvency, profitability etc., it helps in business forecasting. Refer
to Section 10.2 Ratio Analysis.

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5. The DuPont model breaks down the return on equity ratio into
three components; the net profit margin, asset turnover and the
equity multiplier. Refer to Section 10.4 The DuPont Equation.
6. Activity matrices indicates organisations overall ability to
convert various heads of balance sheet into cash and it can
be expressed in number of days. Inventory turnover, debtors
turnover, creditors turnover and working capital turnover ratio
are some important types of activity ratio. Refer to Section 10.4
The Dupont Equation.

1. Calculate the current ratio from the data given below:
Accounts payable: ` 20 crore
S
Notes Payable: `10 crore
Long term debt: ` 50 crore
Cash: ` 60 crore
IM
Accounts receivable: ` 50 crore
Inventory: ` 70 crore
Solution:
Current Ratio = (Current Assets)/(Current Liabilities)
M
=180/30
Current Ratio = 6 times
2. Calculate the quick ratio from the data given below:
N
Accounts payable: ` 20 crore

Notes Payable: ` 10 crore
Long term debt: `50 crore
Cash: ` 60 crore
Accounts receivable: `50 crore
Inventory: ` 70 crore
Solution :
Quick Ratio = (Cash in hand+Cash at
bank+Receivables+Marketable securities)/ (Current
Liabilities)
= (60+50)/30
= 110/30
Quick Ratio= 3.67 times (approx.)

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3. Calculate debt to equity ratio from the data given below:

Common stock: `40crore
Capital surplus: `50crore
Accounts payable: 20
Notes Payable: 10
Retained earnings: `70 crore
Long-term debt: `30 crore
Solution :
Debt to equity ratio = (Total Liability)/(Total equity)
= 80/180
S
Debt to equity ratio = 0.44 times (approx.)
4. Calculate the inventory turnover ratio from the data given below:
Cost of goods sold: `70 crore
IM
Administrative expenses: `10 crore
Depreciation: `30 crore
Beginning inventory: `40 crore
Ending inventory: `30 crore
M
Solution :
Inventory turnover ratio = (Cost of goods sold)/(Average
Inventory)
Average inventory = (Begining Inventory+Ending Inventory)/2
N
=70/2
=35
Therefore,
Inventory turnover ratio = 70/35
= 2
Inventory turnover ratio =2 times
5. The following information about ABCZ Ltd. is given:

Revenue: `29, 00,000
Net Income: `6, 00,000
Assets: `27, 00,000

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Shareholders’ equity: `13, 00,000

Calculate the ROE of ABCZ Ltd.
Solution:
Return on Investment = (Net income)/Revenue × Revenues/
(Total Assets) × (Total Assets)/(Shareholder^’ sequity)
= 600000/2900000 × 2900000/2700000 × 2700000/1300000
= 0.462 times (approx.)
10.8 SUGGESTED READINGS & REFERENCES
Suggested Readings
S
Debarshi, B. (2011). Management Accounting. (1st ed., pp. 57-79).
Bhat, S. (2008). Financial Management. (2nd ed.). New Delhi: Excel
IMBooks, pp.27-52.
Goyal, V. & Goyal, R. (2013). Corporate Accounting (1st ed., pp.
Sinha, G. (2009). Financial Statement Analysis (1st ed., pp. 97-133).
M
E-references
Accounting Coach.com. (2014). Financial Ratios and Analysis |
Explanation | Accounting Coach. Retrieved from, http://www.ac-
countingcoach.com/financial-ratios/explanation
N
Cliffsnotes.com.(2014). Accounting Principles II: Ratio Analysis.

Retrieved from, http://www.cliffsnotes.com/more-subjects/ac-
counting/accounting-principles-ii/financial-statement-analysis/ra-
tio-analysis
My Accounting Course. (2014). Financial Ratio Analysis | Example
| My Accounting Course. Retrieved from, http://www.myaccount-
ingcourse.com/financial-ratios/
Prenhall.com. (2014). Ratio Analysis. Retrieved from, http://www.
prenhall.com/divisions/bp/app/cfl/RA/RatioAnalysis.html

Case study
n o t e s
STORTFORD YACHTS LIMITED
Stortford Yachts Ltd. was established in 1983 and provides com-

plete service for cruise holidays in various destinations of Greece
and Turkey. It deals in yacht chartering, yacht management and
yacht brokerage business. The company manages a fully equipped
fleet of yachts and has a team of qualified and trained staff. In the
past, the company has achieved good levels of growth and return
on capital which is gradually changing. The company has failed to
introduce new product lines and relies on the traditional yachts
with little investment in research or product development. The
director of Stortford Yachts Ltd. Paul Marriot decides to address
the problem and introduce new ideas to their product line. Paul
meets up with the Director of Management Consultants group
S
stating that he wishes to introduce a stronger management con-
trol within the company. The director receives a file containing
a summary of Stortford Yachts Ltd. Profit and Loss and Balance
Sheet statements for the past three years which is as follows:
IM
Profit and Loss Account summary:
Particulars (` in lakhs)
2011 2012 2013
Sales turnover 4.90 5.30 6.60
M
Operating costs 4.17 4.43 5.82

Profit before tax 0.73 0.87 0.78
Taxes 0.24 0.30 0.27
Profit after tax 0.49 0.57 0.51
N
Dividends 0.12 0.16 0.16

Net profit 0.37 0.41 0.35
Balance Sheet summary:
2011 2012 2013
Fixed assets 2.40 2.77 2.88
Current assets
Stocks:
Raw materials 0.09 0.12 0.15
Finished goods 0.40 0.43 0.45
Debtors 1.14 1.32 1.84
Bank 0.03 0.04 0.05
1.66 1.91 2.49
Less Current liabilities 1.35 1.56 1.90

Case study
n o t e s
2011 2012 2013
Net current assets 0.31 0.35 0.59
2.71 3.12 3.47
Capital and reserves 0.5 0.91 1.26

Bank loans 2.21 2.21 2.21
2.71 3.12 3.47
Financial ratios of Stortford Yacht Ltd. for the year 2013 were also
provided to the consultants:
Average ratios for 2013
S
Ratio 2013
Return on Equity 27.78%
Asset turnover 1.9 times
IM
Net profit margin 5.3%
Current ratio 1.31 times
Quick ratio 0.995 times
Debtors collection period 28 days
M
questions
Suppose you are planning assistant of the Management Con-

sultants group and are required to analyse the company’s fi-
nancial state over the last three years.
N
1. Prepare a detailed report on the company’s performance

in terms of profitability and liquidity.
(Hint: Analyse the other liquidity and profitability ratios
for the years 2011 and 2012 of Stortford Yacht Ltd. given
the below table below
Ratio 2011 2012
Return on Equity 74% 45%
Asset turnover 1.79 times 1.69 times
Net profit margin 7.6% 7.73%
Current ratio 1.3 times 1.22 times
Quick ratio 0.867 times 0.872 times
Debtors collection period 85 23

Case study
n o t e s
2. Suggest changes in the financial structure to improve the

profitability and liquidity position of the company.
(Hint: Based on the ratio trends, suggest structural
changes to the company. For e.g. the reduction in overall
performance is highlighted through the reduction of the
net profit figures on the P&L statement. The company
needs to control costs and analyse the reason behind the
sharp fall in net profit figures.)
S
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M
N

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M
IM
S
Ch
11 a p t er
FINANCIAL STATEMENT ANALYSIS III
CONTENTS
S
11.1 Introduction
11.2 Components of Financial Statement Analysis
IM
11.2.1 Common Size Analysis
11.2.2 Comparative Statement
Activity
11.3 Trend Analysis
M
Activity
11.4 Percentage Change Analysis
Activity
N
11.5 Management’s Discussion and Analysis: Thinking beyond Numbers

Activity
11.6 Summary

n o t e s
AMAZON OR WAL-MART?
An organisation’s balance sheet often reflects its business model.

Excel Investments Inc. helps its clients in analysing the financial
health of different organisations. It uses fundamental analysis
techniques to provide the required insights to its customers. Late-
ly, group members of its Portfolio Analysis Team were analysing
the Balance Sheets of Wal-Mart and Amazon.com Inc. However,
the team forgot to prepare separate files for the two organisations
and placed all its papers in one file. The problem arose when the
team members found out that the Balance Sheets were not titled
by the corresponding company names. When the matter was re-
ported to the chief, he asked his team members to run a vertical
analysis on the balance sheet of the two companies to distinguish
S
between them.
The percentages of items in the balance sheet of the two companies

were compared against total assets of the two companies, which
IM
are as follows:
Particulars Company A Company B

Cash and cash equivalents 33.3% 4.4%
Accounts receivable 9.9% 2.4%
Inventories 16.8% 21.1%
M
Fixed assets 10.3% 58.5%
Based on this, the team members drew the following interpreta-

tions:
N
Both Amazon and Wal-Mart are in the business of selling inventory,

but their business models are different. Wal-Mart follows the tradi-
tional brick-and-mortar model, while Amazon is a dot com company
selling its inventory through the web. Therefore, Wal-Mart should
be under a greater percentage of its total assets in fixed assets and
inventories. Company B has 58.5% and 21.1% of fixed assets and in-
ventories respectively. Therefore, the team members could success-
fully distinguish the balance sheets of the two companies.

FINANCIAL STATEMENT ANALYSIS III 317
n o t e s
learning objectives

>> Describe common size analysis
>> Discuss trend analysis
>> Explain percentage change analysis
>> Discuss the importance and benefits of Management discus-
sion and analysis
11.1 Introduction
In the previous chapter, you studied about the concept and signifi-
cance of ratio analysis using financial statements of an organisation
S
for assessing its financial health. In this chapter, you will study about
the other common financial analysis method used by organisations,
the common size analysis.
IM
Generally speaking analysis of any kind and especially financial anal-
ysis can be broadly categorised into two segments.
1. Time Series Comparison or Trend Analysis: The performance
of the firm is compared with the past performance to analyse
how to improve the productivity and achieve sustainable growth.
M
While doing such an analysis, we compare the figures and ratios

for a firm for many years.
2. Cross-sectional Comparison or Industry Benchmarking: The
firm’s performance is compared with the other firms in the
industry. The performance has to be benchmarked with the best
N
in the industry both in the domestic as well as the global arena.
A common size financial statement is created to display line items of a

financial statement as a percentage of a base figure. Common size fi-
nancial statements make it convenient to assess an organisation’s per-
formance over a time period and compare its performance with other
organisations of different scale and size. Most importantly, common
size financial statements help investors to observe trends, which can-
not be made out of a simple financial statement. The comparison as
well as analysis, when absolute figures are converted into percentag-
es, are easier to comprehend and understand for most persons wheth-
er from a non-finance or finance background.
All three of the primary financial statements are analysed using com-
mon size analysis. The amounts included in financial statements of
an organisation can be converted to common size statements, which
could be used to compare organisations belonging to different indus-
tries and having different sizes. The main advantage of common size
analysis is that it allows for a vertical analysis over a single time peri-

n o t e s
od, such as a quarterly or annual period, and also a horizontal analysis

over a time period such as three years or more. Common size analysis
allows investors to identify significant changes in a firm’s financial po-
sition over a time period. Sudden increases or decreases can be read-
ily observed in an organisation’s financial statements. In a nutshell,
common size analysis is used to compare an organisation’s statements
from different years to detect trends not evident from the comparison
of absolute amounts.
In this chapter, you will study about the different kinds of common
size analysis used for comparing organisation’s performance. The
chapter explains vertical and horizontal common size analysis. Later,
the chapter describes the trend analysis and percentage change anal-
ysis of financial statements. Towards the end, the chapter discusses
the significance of Management’s Discussion and Analysis.
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Components of Financial
11.2
Statement Analysis
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You have studied earlier that the financial statements of an organisa-
tion are used for reporting the financial position of the company for
public use. The financial statement analysis are categorised majorly
into two parts:
Let us now study about these components in detail as follows:

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11.2.1 COMMON SIZE ANALYSIS
You have studied earlier that the traditional financial statements of an

organisation are used for reporting the financial position of the com-
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pany for public use. Whenever an investor intends to compare the fi-
nancial statements of two organisations, there is a need for a common
scale in order to match the two distinct businesses for investment pur-
poses. As organisations are different in size, growth, etc. comparing
the traditional financial statements might lead to misleading interpre-
tations affecting the investors.
For example, A Ltd. has liabilities worth `10, 00,000 while B Ltd. has
liabilities worth `100, 00,000. Does this information from their balance
sheets imply that A Ltd. is less risky than B Ltd.?
In reality, it depends in part on the size of the companies, their asset

size, the industries that the two companies belong to, etc. This led to
the use of common size analysis for decision-making purposes. Com-
mon size analysis is a popular method of financial statement analysis,
which makes use of common size financial statements. These finan-
cial statements display all items as percentages of a common base fig-
ure. Each item in the financial statement is reported in the form of a
percentage. This percentage is arrived at by using a base figure. For

n o t e s
example, every item on the income statement of an organisation is

reported as a percentage of sales.
There are three reasons to use common-size analysis:

Comparing financial information of an organisation from one pe-
riod to the next.
Comparing financial information of an organisation relative to its
competitors.
Comparing financial information of various companies in different
parts of the world when the reporting currency is different.
e.g., A Company like Uniliver plc. which has operations in several
countries and the financials are in different currencies like Great
British Pound (GBP), United States Dollars (USD), and Indian Ru-
pee (INR) etc. The use of Common size analysis which translates
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absolute amounts in different currencies into percentages makes
comparisons and financial analysis more meaningful and simpler.
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The most widely used common size analysis methods are as follows:
i. Horizontal Common Size Analysis
ii. Vertical Common Size Analysis
Although both methods are similar considering that the figures in fi-
nancial statements are converted to percentages however, they differ
in the base used to compute the percentages. Let us discuss the two
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methods in detail in the subsequent sections.
HORIZONTAL COMMON SIZE ANALYSIS

Horizontal common-size analysis uses one type of financial statement
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at a time. However, instead of using only a year’s financial statement,

horizontal common analysis makes use of the same type of financial
statement over several consecutive years. Usually, three years of in-
formation is used for horizontal analyses, although it is common to
extend the evaluation for measuring long-term trends in the organi-
sation’s performance. For instance, if an organisation performs a hori-
zontal analysis on its income statement, it would use the income state-
ments for 2011, 2012 and 2013. The figures in each succeeding period
are expressed as a percentage of the amount in the baseline year, with
the baseline amount being listed as 100%.
Consider the following illustration:
Income statement information of Dell Inc. as ended March, 2013 is as

follows:
2011 2012 2013

Revenue 61,494 62,071 56,940
Cost of goods sold 50,098 48,260 44,754

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2011 2012 2013

Gross profit 11,396 13,811 12,186
Operating expenses 7,963 9,380 9,174
Operating income 3,433 4,431 3,012
Interest expenses (83) (191) (171)
Income Before income tax 3,350 4,240 2,841
Income tax provision 715 748 469
Net income 2,635 3,492 2,372
Source: http://valueinvestingbasics.com
Assuming 2011 is the base year, 2012 and 2013 revenues will be calcu-
lated as follows, respectively:
note
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(Revenue of 2012/Revenue of 2011) × 100 = 62,071/61,494 × 100 = 101%
(COGS of 2012/ COGS of 2011) × 100 = 56,940/61,494 × 100 = 93%
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Thus, the horizontal analysis of Dell’s Income Statement would be as
follows:
2011 2012 2013

Revenue 61,494 100% 62,071 101% 56,940 93%
Cost of goods sold 50,098 100% 48,260 96% 44,754 89%
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Gross profit 11,396 100% 13,811 121% 12,186 107%

Operating expenses 7,963 100% 9,380 118% 9,174 115%
Operating income 3,433 100% 4,431 129% 3,012 88%
Interest expenses (83) 100% (191) 230% (171) 206%
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Income Before in- 3,350 100% 4,240 127% 2,841 85%

come tax
Income tax provision 715 100% 748 105% 469 66%
Net income 2,635 100% 3,492 133% 2,372 90%
Source: http://valueinvestingbasics.com
This analysis shows that the percentages of revenue for 2012 and 2013
first increased and later decreased the 100% benchmark of 2011. The
financial statement user would interpret this as an increase and later
decrease in Dell Inc.’s sales performance. Revenue for 2013 may be
misleading at first glance, however, further analysis reveals that the
decrease in 2013 represents only 7% fall compared to the 100% bench-
mark of revenue in 2011. In reality, the COGS in 2013 have come down
by 11% compared to the benchmark COGS in 2011. Thus, the compa-
ny is in a better position in managing its resources.
VERTICAL COMMON SIZE ANALYSIS
Another type of common size analysis is the vertical analysis meth-

od. Vertical analysis refers to the proportional analysis of a financial

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statement, where each item on a financial statement is recorded as a

percentage of another item. This implies that each item on the income
statement of an organisation is recorded as a percentage of the gross
sales. On the other hand, each item on the balance sheet of an organ-
isation is recorded as a percentage of the total assets. For example, if
the cost of goods sold has consistently been recorded as 40% of sales
in the past four years for an organisation, a percentage of 48% in the
fifth year would raise an alarm for further analysis. Moreover, vertical
analysis is helpful for timeline analysis. An example of vertical analy-
sis of an income statement as follows:
Particulars Amount (`) Percentage

Sales 10,00,000 100%
Cost of goods sold 4,00,000 40%
Gross margin 6,00,000 60%
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Salaries and wages 2,50,000 25%
Office rent 50,000 5%
Supplies 10,000 1%
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Utilities 20,000 2%
Other expenses 90,000 9%
Total expenses 4,20,000 42%
Net profit 1,80,000 18%
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note
Vertical analysis of the income statement not only helps in spotting

steep rise in expenses but also helps in determining the minor ex-
penses that may not be worthy of much management attention.
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Vertical analysis of a balance sheet uses the common base as the total
assets of an organisation. However, for a deeper analysis, users tend
to use the total of all liabilities as the base for calculating line item li-
abilities in a balance sheet and the total of all equity accounts as base
when calculating all equity line item percentages.
This has been illustrated in the following example:
Cash 1,00,000 10%

Accounts receivable 2,50,000 25%
Inventory 1,50,000 15%
Total current assets 2,00,000 20%
Fixed assets 3,00,000 30%
Total assets 10,00,000 100%
Accounts payable 1,00,000 10%

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Accrued liabilities 70,000 7%

Total current liabilities 2,00,000 20%
Notes payable 30,000 3%
Total liabilities 2,00,000 20%
Capital stock 1,00,000 10%
Retained earnings 1,50,000 15%
Total equity 1,50,000 15%
Total liabilities and equity 10,00,000 100%
From the above analysis it can be interpreted that:

The relative investment in fixed assets is 30% of total assets
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Total current liabilities are 20% of total liabilities and equity
Current assets account for 20% of the total assets
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Exhibit
Vertical Common Size Analysis of Balance Sheet

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N
Interpretation:
The relative investment in fixed assets (currently around 52%
of assets), when compared with current assets, has increased
since 2008.
The proportions of assets that are current assets have decreased
slightly over time.
Source: CFA Institute

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11.2.2 Comparative Financial Statement Analysis
Comparative financial statements are those statements which provide

all the desired financial information for two or more financial years.
This statement is use to compare results of current financial statement
with previous accounting period of the firm or with that of the compet-
itors. Under this method, the components of financial statement (i.e.
Balance sheet and Income statement) are used for comparative pur-
poses and all the items are presented in terms of figures and as well
as in percentage. Comparative statements determines any increase,
decrease and percentage change in the corresponding amount of two
or more than two years and this analysis is used by various stakehold-
ers such as, managers, investors, creditors, analyst, etc. It reflects or-
ganisation’s ability to deal with solvency, liquidity, profitability related
issues.
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The methods used under the comparative statements are as follows:
Comparative Income Statement

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Comparative Income Statement shows the financial performance of
the firm in comparison of prior period data of the firm or of compet-
itors. It provides information regarding expenses and income of the
firm for two or more than two years. It also provides the information
about various changes in absolute figure and in the form of percent-
age. It provides a view of business performance over a time and sup-
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ports financial manager in decision making practices.
Comparative Income Statement of Infosys for year ended March 31,

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2017 is as follows:
MAR’17 MAR’16
Parameter Change %
(` Cr.) (` Cr.)
Operating Income 59,289.00 53,983.00 9.83%
Less: Inter divisional
0.00 0.00 0.00%
transfers
Less: Excise 0.00 0.00 0.00%
Net Sales 59,289.00 53,983.00 9.83%
EXPENDITURE:
Stock Adjustments 0.00 0.00 0.00%
Raw Materials Con-
0.00 0.00 0.00%
sumed
Power & Fuel Cost 180.00 179.00 0.56%

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MAR’17 MAR’16
Parameter Change %
(` Cr.) (` Cr.)
Employee Cost 30,944.00 28,207.00 9.70%
Cost of Software de-
6,044.00 5,466.00 10.57%
velopments
Operating Expenses 399.00 221.00 80.54%
General and Adminis-
3,884.00 3,666.00 5.95%
tration Expenses
Selling and Marketing
276.00 229.00 20.52%
Expenses
Miscellaneous Ex-
355.00 351.00 1.14%
penses
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Expenses Capitalised 0.00 0.00 0.00%
Total Expenditure 42,082.00 38,319.00 9.82%
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PBIDT (Excl OI) 17,207.00 15,664.00 9.85%
Other Income 3,062.00 3,051.00 0.36%
Operating Profit 20,269.00 18,715.00 8.30%
Interest 0.00 0.00 0.00%
PBDT 20,269.00 18,715.00 8.30%
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Depreciation 1,331.00 1,115.00 19.37%

Profit Before Taxation
18,938.00 17,600.00 7.60%
& Exceptional Items
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Exceptional Income /
0.00 0.00 0.00%
Expenses
Profit Before Tax 18,938.00 17,600.00 7.60%

Provision for Tax 5,120.00 4,907.00 4.34%
PAT 13,818.00 12,693.00 8.86%
Extraordinary Items 0.00 0.00 0.00%
Adj to Profit After Tax 0.00 0.00 0.00%
Profit Balance B/F 44,698.00 40,065.00 11.56%
Appropriations 58,516.00 52,758.00 10.91%
Equity Dividend 515.00 485.00 6.19%
Earnings Per Share 60.18 55.28 8.86%
Book Value 295.72 266.00 11.17%
Source: http://profit.ndtv.com/stock/infosys-ltd_infy/financials-profit-loss

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Comparative Balance Sheet
Comparative Balance Sheet shows the current financial position of the

firm in comparison to prior period data. Comparative balance sheet
records all the items of balance sheet side by side under relevant head
of three main components (i.e. Assets, Liabilities and Share capital)
of balance sheet. Generally it is presented at the end of financial year
for the past 3 years data. While some firms like financial institutions
use other versions which shows all the data at the month end or at the
quarter end. However, in both versions it provides a clear picture of
firm’s financial position to the analyst.
Comparative Balance Sheet of Infosys for year ended March 31, 2017
is as follows:
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Parameter MAR’17 MAR’16 YoY
(` Cr.) (` Cr.) %Change
EQUITY AND LIABILITIES

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Share Capital 1,148.00 1,148.00 0.00%
Share Warrants & Outstanding
Total Reserves 66,749.00 59,925.00 11.39%
Shareholder’s Funds 68,017.00 61,082.00 11.35%

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Long-Term Borrowings 0.00 0.00 0.00%
Secured Loans 0.00 0.00 0.00%

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Unsecured Loans 0.00 0.00 0.00%
Deferred Tax Assets / Liabilities -346.00 -405.00 -14.57%
Other Long Term Liabilities 82.00 62.00 32.26%
Long Term Trade Payables 0.00 0.00 0.00%
Long Term Provisions 0.00 0.00 0.00%
Total Non-Current Liabilities -264.00 -343.00 -23.03%
Current Liabilities
Trade Payables 269.00 623.00 -56.82%
Other Current Liabilities 7,405.00 7,225.00 2.49%
Short Term Borrowings 0.00 0.00 0.00%
Short Term Provisions 4,112.00 3,740.00 9.95%

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Total Current Liabilities 11,786.00 11,588.00 1.71%
Total Liabilities 79,539.00 72,327.00 9.97%
ASSETS
Non-Current Assets 0.00 0.00 0.00%
Gross Block 16,240.00 14,739.00 10.18%
Less: Accumulated
7,635.00 6,491.00 17.62%
Depreciation
Less: Impairment of Assets 0.00 0.00 0.00%
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Net Block 8,605.00 8,248.00 4.33%
Lease Adjustment A/c 0.00 0.00 0.00%
Capital Work in Progress 1,247.00 934.00 33.51%

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Intangible assets under
0.00 0.00 0.00%
development
Pre-operative Expenses
0.00 0.00 0.00%
pending
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Assets in transit 0.00 0.00 0.00%
Non Current Investments 15,334.00 11,076.00 38.44%
Long Term Loans & Advances 6,237.00 5,550.00 12.38%

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Other Non Current Assets 434.00 422.00 2.84%
Total Non-Current Assets 31,857.00 26,230.00 21.45%
Current Assets Loans &

Advances
Currents Investments 9,643.00 2.00 482050.00%
Inventories 0.00 0.00 0.00%
Sundry Debtors 10,960.00 9,798.00 11.86%
Cash and Bank 19,153.00 29,176.00 -34.35%
Other Current Assets 4,443.00 3,735.00 18.96%
Short Term Loans and

3,483.00 3,386.00 2.86%
Advances

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Total Current Assets 47,682.00 46,097.00 3.44%
Net Current Assets (Including

35,896.00 34,509.00 4.02%
Current Investments)
Total Current Assets Excluding

38,039.00 46,095.00 -17.48%
Current Investments
Miscellaneous Expenses not

0.00 0.00 0.00%
written off
Total Assets 79,539.00 72,327.00 9.97%
Contingent Liabilities 1,902.00 188.00 911.70%
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Total Debt 0.00 0.00 0.00%
Book Value 295.72 266.00 11.17%
Adjusted Book Value

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295.72 266.00 11.17%
Source: http://profit.ndtv.com/stock/infosys-ltd_infy/financials
1. ___________analysis uses one type of financial statement at a

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time over several consecutive years.

(a) Vertical common size
(b) Horizontal common size
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(c) Downward common size

(d) In line common size
2. Common size financial statements display all items as
___________ of a common base figure.
(a) Percentile (b) Ratio
(c) Percentage (d) Fraction
3. ___________ refers to the proportional analysis of a financial
statement, where each item on a financial statement is
recorded as a percentage of another item.
(a) Vertical common size analysis
(b) Horizontal common size analysis
(c) Downward common size analysis
(d) In line common size analysis

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4. In _____________, each item on the income statement of an

organisation is recorded as a percentage of the gross sales.
(a) Vertical analysis
(b) Horizontal analysis
(c) Downward analysis
(d) In line analysis
5. Vertical analysis of a balance sheet uses the common base as
the _______ of an organisation.
(a) Total assets
(b) Total liabilities
(c) Total equity
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(d) Total Sales
6. Which of the following financial statements can be analysed
using common size statements?
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(a) Balance sheet
(b) Profit and loss account
(c) Consolidated financial statement
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7. Which of the following shows the current financial position of

the firm in comparison to prior period data?
(a) Comparative balance sheet
(b) Comparative income statement
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(c) Downward comparative income statement

(d) Vertical comparative statement
Activity
List the main points of difference between horizontal common size

analysis and vertical common size analysis.
11.3 TREND ANALYSIS

Trend analysis is another tool for the analysis of an organisation’s fi-
nancial statements by investors. Investors use trend analysis to ascer-
tain the financial position of an organisation for decision making. In
this method, the financial statements of an organisation are compared
with each other over a period of years after converting them into a
percentage. Therefore, trend analysis evaluates an organisation’s fi-
nancial information over a period of time. These periods could be sev-

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eral months, quarters, or years, depending on the requirements. The

objective is to calculate and evaluate the change in the amount and
per cent from one period to the next.
For instance, an investor wants to observe the trend of an organisa-

tion’s sales in 2006-2012. In this case, year 2006 would act as the base
year and the sales figure in 2006 would be restated as 100. Next, the
sales amounts for the years 2007 - 2012 would be presented as percent-
ages of the 2006 figure. This is done by dividing each year’s figures for
the 2006 figure to arrive at a percentage. This has been illustrated as
follows:
Year 2006 2007 2008 2009 2010 2011 2012
Sales (`) 31,69,100 40,93,000 50,70,400 63,89,100 79,34,100 101,15,400 120,20,000
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% 100 129 160 202 250 319 379
note
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Trend analysis percentage = (figure of the concerned year / figure
of the base year) × 100
From the above illustrated trend analysis, it can be observed that sales
in 2012 were 379% of the 2006 sales achieved by the organisation. Using
information from trend analysis makes it much convenient to see how
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effectively and efficiently an organisation has performed over the years.
Exhibit
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Advantages and Disadvantages of Trend Analysis
The advantages of trend analysis are that it can:

Reveal potentially fruitful areas of audit investigation
Detect significant variations over time
Be easily understood and communicated
Be readily accepted due to its widespread use
The disadvantages of trend analysis are that it can:

Provide little insight into the root causes of variations
Fail to indicate what the entity’s normal or benchmark position
is
Be undermined by frequent changes in financial reporting for-
mats
Be heavily influenced by the choice of the base fiscal period
Source: http://www.preciousheart.net/chaplaincy/Auditor_Manual/16trendd.pdf

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8. Which of the following is a technique used in comparative

analysis of financial analysis?
(a) Trend analysis (b) Graph method
(c) Preference analysis (d) All of the above
Activity
Make a list of the limitations of using trend analysis for financial

assessment of organisations.
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11.4 PERCENTAGE CHANGE ANALYSIS
A percentage change analysis illustrates how two items in a financial
statement changed as a percentage from one period to another period.
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For example, percentage change analysis of items in a balance sheet
illustrates how a balance sheet account changes from year- to- year, or
quarter- to- quarter. The balance sheet accounts are assets, liabilities
and stockholders’ equity. Percentage change analysis helps managers
and investors to assess how an organisation is performing over a time
period. Consider the following illustration:
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Suppose an investor is required to evaluate the balance sheet of an

organisation using percentage change analysis. Balance sheet infor-
mation of A Ltd. is as follows:
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Items 2012 2013

Cash `4, 00,000 `7, 00,000
Fixed Assets `20, 00,000 `22, 00,000
Accounts receivable `2, 00,000 `2, 50,000
For this purpose he/she would follow these steps:

Step 1: Identify the balance sheet items that the investor needs to
analyse. Note the figures of the selected items for the beginning
and ending periods. For example, cash account of A Ltd.’s balance
sheet for the year 2012 had `4,00,000 and in 2013, it had `7,00,000.
Step 2: Subtract the current account from the previous account
to determine the change in the account. In the above example,
`7,00,000 - `4, 00,000 = `3,00,000.
Step 3: Divide the change in the account by the old account bal-
ance to determine the percentage change. In the above example,
`3, 00,000/`4, 00,000 equals to a percentage change of 75%.

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Step 4: Repeat these steps for other balance sheet items for per-
centage change analysis.
Let us look at another illustration of percentage change analysis:
Income Statement of ABC Pvt. Ltd.

Items 2013 2012 Difference % Change
Revenue `18,00,000 `15,00,000 `3,00,000 20
Cost of Goods Sold `10,00,000 `8,50,000 `1,50,000 17.6
Depreciation and `1,50,000 `1,50,000 0 0
amortization
Selling and adminis- 2,25,000 `1,50,000 75,000 50.0
trative expenses
Interest expense 50,000 25,000 25,000 100.0
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Taxes 1,00,000 75,000 25,000 33.3
Percentage analysis of the income statement of ABC Pvt. Ltd. shows

that cost of sales have increased by 17.6% in 2013 compared to 2012.
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When analysed further, it can be assessed that the increase in COGS
is in the favourable direction as revenue (sales) percentage has also
increased by 20% in the year 2013. Similarly, the percentage change in
items in 2013 from 2012 is computed and assessed.
Percentage change analysis helps investors in comparing and evalu-

ating the relative size of items or the relative change in items of an or-
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ganisation’s financial statements. Moreover, conversion of monetary

figures into percentages also facilitates the comparison between dif-
ferent organisations.
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9. _____________analysis illustrates how two items in a financial

statement changed as a percentage from one period to another
period.
(a) Percentage change analysis
(b) Revenue analysis
(c) Organisational analysis
(d) Seasonal analysis
Activity
XYZ, Inc. has `5,00,000 in inventory on its balance sheet in 2012

and `7,00,000 in inventory on its balance sheet in 2013. What is the
percentage of growth in inventory in 2013?

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Management’s Discussion and

11.5 Analysis: Thinking beyond
Numbers
Financial statements are not sufficient to provide information on the
overall performance of an organisation. Senior managements, boards
of directors also make an attempt to explain and evaluate the overall
performance and prospects of an organisation. Therefore, in addition
to financial statements, the annual reports of an organisation consist
of a section called Management’s Discussion and Analysis (MD&A).
Management’s Discussion and Analysis is a discussion and analysis
of the financial activities of an organisation by its Management’. The
MD&A usually precedes the financial statements in the annual report
of an organisation and contains, among other things, comments on
the organisation’s operational outcome, its ability to satisfy its existing
S
obligations and expansion plans, if any.
In other words, MD&A provides an overview of the previous year’s

IM
operations and how the organisation progressed. Management usual-
ly also throws some light on the upcoming year, outlining its forthcom-
ing goals and new projects.
There are six disclosure principles that guide the preparation of

MD&A in the annual report of an organisation. These principles are
depicted in Table 11.1:
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Table 11.1: Principles of MD&A

Principle Implication
1. Through the An entity should disclose information in the
Eyes of the MD&A that enables readers to view it through
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Management. the eyes of the Management.

2. Integration with MD&A should complement as well as supplement
Financial financial statements.
Statements
3. Completeness and MD&A should be complete, fair and balanced,
Materiality and provide information that is material to the
decision-making needs of users.
4. Forward-looking A forward-looking orientation is fundamental to
Orientation useful MD&A reporting.
5. Strategic MD&A should focus on Management’s strategy
Perspective for generating value for investors over time.
6. Usefulness MD&A should be understandable, relevant, and
comparable
MD&A offers various advantages, some of which are as follows:

Management is better placed than others to provide information
about an organisation. The MD&A is a powerful tool for the Man-
agement to communicate how the organisation has performed and
how it plans to expand in future.

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The MD&A along with the financial statements offers the oppor-
tunity for an organisation to communicate the effectiveness of its
resources and progress towards its defined strategic objectives.
The MD&A is helpful in integrating and accumulating material in-
formation about the organisation that investors are interested in.
Apart from imparting information to investors, many organisa-
tions use the MD&A to help new directors in orienting themselves
to an organisation’s performance and prospects.
The internal processes, systems and control required in the prepa-
ration of an effective MD&A deliver significant advantages to or-
ganisations by improving organisational focus, giving new insights
into key performance indicators, encouraging accountability and
control and enabling performance benchmarking.
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Exhibit
An Excerpt from the MD&A of Tata Motors, 72nd Annual

Report, 2016-17 Tata Motors Business
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Automobile sales in India
Indian automobile industry shows a growth of 8.2% in FY 2016-17.
Sale of commercial vehicles and passenger vehicles has significant-
ly increased by 3.2 % and 9.6% during the financial year 2016-17.
The overall performance of Indian automobile industry during

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FY 2016-17 and the Tata Motors market share are given in the
following table:
Category Industry Sales Company Sales Market Share
Fiscal 2017 Fiscal 2016 Growth Fiscal 2017 Fiscal 2016 Growth Fiscal 2017 Fiscal 2016
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Units % Units % %
Commercial Vehicles1 7,29,360 7,06,819 3.2% 3,24,175 3,26,755 (0.8)% 44.4% 46.2%
Passenger Vehicles2 30,34,670 27,68,290 9.6% 1,57,020 1,27,118 23.5% 5.2% 4.6%
Total 37,64,030 34,75,109 8.3% 4,81,195 4,53,879 6.0% 12.8% 13.1%
Source:
Society of India Automobile manufacturers report and Company Analysis
1
Commercial vehicles include V2 van sales
2
Passenger vehicles include Flat and Jaguar Land Rover-branded cars.
The company registers the overall growth of 6 % to 481195 units in

FY 2016-17 it is because the slow growth 0.8% in company’s com-
mercial vehicles segment. However, the growth in company’s pas-
senger car sales sees a significant growth of 23.5%.
The domestic industry performance during FY 2016-17 and the

Company’s market share is given below:
Category Industry Sales Company Sales Market Share
Fiscal 2017 Fiscal 2016 Growth Fiscal 2017 Fiscal 2016 Growth Fiscal 2017 Fiscal 2016
Units % Units % %
M&HCV 3,02,402 3,02,556 (0.1)% 1,48,774 1,57,120 (5.3)% 49.2% 51.9%
LCVs1 4,26,958 4,04,263 5.6% 1,75,401 1,69,635 3.4% 41.1% 42.2%
Total 7,29,360 7,06,819 3.2% 3,24,175 3,26,755 (0.8)% 44.4% 46.2%
Source:
Society of India Automobile manufacturers report and Company Analysis
1
LCVs include V2 van sales

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10. ________________ is a discussion and analysis of the financial

activities of an organisation by its Management.
(a) Management Growth Analysis
(b) Management Discussion and Analysis
(c) Management Development Programme
(d) Management Efficiency Analysis
11. Match the following:
i. Forward-looking A. Understandable, rele-

Orientation vant and comparable
ii. Completeness and B. Complete, fair and
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Materiality balanced
iii. Strategic Perspective C. Fundamental to use-
ful Management Dis-
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(MD&A) reporting
iv. Usefulness D. Focus on Manage-
ment’s strategy
(a) I(A), II(B), III(D), IV(C) (b) I(C), II(A), III(D), IV(B)
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(c) I(B), II(C), III(D), IV(A) (d) I(C), II(B), III(D), IV(A)
12. _________________________ principle implies that MD&A
should complement as well as supplement financial statements.
(a) Diversification of investments
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(b) Integration with financial statements

(c) Learning by doing
(d) Aggregation with financial statements
13. Which of the following is a principle of MD&A?
(a) Through the eyes of the management.
(b) Completeness and materiality
(c) Strategic perspective
14. An entity should disclose information in the MD&A that
enables readers to view it through the eyes of Management.
This is included in which of these MD&A principles?
(a) Strategic perspective
(b) Through the eyes of the management
(c) Integration with financial statements
(d) Forward-looking orientation

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Activity
Using the Internet, download the annual report of an organisation

of your choice. Note down the main points of Management’s Dis-
cussion and Analysis of the company’s Annual Report.
11.6 SUMMARY
Common size analysis is a popular method of financial statement
analysis, which makes use of common size financial statements.
Horizontal common-size analysis uses one type of financial state-
ment at a time over several consecutive years.
Verticalanalysis refers to the proportional analysis of a financial
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statement, where each item on a financial statement is recorded as
a percentage of another item.
Invertical analysis, each item on the income statement of an or-
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ganisation is recorded as a percentage of the gross sales.
Similarly,each item on the balance sheet of an organisation is re-
corded as a percentage of the total assets.
Investorsuse trend analysis to determine the financial position of
an organisation for decision making.
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Trend analysis evaluates an organisation’s financial information

over a period of time. These periods could be several months,
quarters, or years, depending on the requirements.
A percentage change analysis illustrates how two items in a finan-
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cial statement changed as a percentage from one period to another

period.
Percentage change analysis helps investors in comparing and
evaluating the relative size of items or the relative change in items
of an organisation’s financial statements.
In addition to financial statements, the annual reports of an or-
ganisation consist of a section called Management Discussion and
Analysis (MD&A).
Management Discussion and Analysis are a discussion and analy-
sis of the financial activities of an organisation by its Management.
The MD&A usually precedes the financial statements in the annu-
al report of an organisation.
MD&A contains, among other things, comments on the organisa-
tion’s operational outcome, its ability to satisfy its existing obliga-
tions and expansion plans.

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Thereare six disclosure principles that guide the preparation of

MD&A in the annual report of an organisation.
These principles are through the eyes of Management, integration
with financial statements, completeness and materiality, forward
looking orientation, strategic perspective and usefulness.
key words
Equity accounts: The accounts that represent the owners’ in-

terest in the assets of a business.
Key performance indicators: Measurable values used to deter-
mine how effectively an organisation is achieving its key busi-
ness objectives.
Line item: An item included on a financial statement, financial
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report or other documents in a list format.
Performance benchmarking: The process of comparing an or-
ganisation’s processes and performance metrics to best practic-
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es from other industries and organisations.
Stockholders’ equity: The equity currently held on the books
by an organisation’s equity investors.
Timeline analysis: A tool used by analysts to identify changes
that impacted the performance of an organisation over a time
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period.

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1. Explain the need for Common Size Analysis. What are its main
uses?
2. What do you understand by comparative analysis and what are
its types?
3. Explain trend analysis and various steps under it.
4. Explain the use of Percentage Change Analysis in comparing
and evaluating an organisation’s financial statements.
5. Explain management discussion and analysis and its main
principles.
6. Explain the principles and advantages of Management Discussion
and Analysis.

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Common Size Analysis 1. b. Horizontal common size
2. c. Percentage
3. a. Vertical common size analysis
4. a. Vertical analysis
5. a. Total assets
Comparative statement 7. a. Comparative balance sheet
Trend analysis 8. a. Trend analysis
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Percentage Change Analysis 9. a. Percentage change analysis
Management Discussion and 10. b. Management Discussion and
Analysis: Thinking Beyond Analysis
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Numbers
11. d. I(C), II(B), III(D), IV(A)
12. b. Integration with Financial
Statements
14. b. Through the Eyes of the Man-
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agement

1. Common size analysis is a popular method of financial statement
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analysis, which makes use of common size financial statements

Refer to Section 11.2 Components of Financial Statement
Analysis.
2. Comparative Balance Sheet shows the current financial position
of the firm in comparison to prior period data. Comparative
balance sheet records all the items of balance sheet side by
side under relevant head of three main components (i.e.
Assets, Liabilities and Share capital) of balance sheet There
are two types of trend analysis (i.e. Comparative Balance Sheet
and Comparative Income statement. Refer to Section 11.2
Comparative Statements.
3. Trend analysis is another tool for the analysis of an organisation’s
financial statements by investors. Investors use trend analysis to
ascertain the financial position of an organisation for decision
making. Refer to Section 11.3 Trend Analysis.

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4. Percentage change analysis helps investors in comparing and

evaluating the relative size of items or the relative change in
items of an organisation’s financial statements. Refer to Section
11.4 Percentage Change Analysis.
5. Management’s discussion and analysis is a discussion and
analysis of the financial activities of an organisation by its
management and it is a part of company’s annual report. It has six
main principles namely, Through the Eyes of the Management,
Integration with Financial Statements, Integration with
Financial Statements, , Completeness and Materiality, Forward-
looking Orientation, Strategic Perspective and Usefuless. Refer
to Section 11.5 Management Discussion and Analysis.
6. Management Discussion and Analysis is a discussion and analysis
of the financial activities of an organisation by its Management
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and the managerial perspective about the past performance,
challenges and the plans for the future. There are six disclosure
principles that guide the preparation of MD&A in the annual
report of an organisation. Refer to Section 11.5 Management’s
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Discussion and Analysis: Thinking beyond Numbers.

1. ABC Ltd. had the following net sales and operating income for
each of the past four years. Assuming 2010 is the base year;
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calculate the trend percentage for each year.

Particulars 2017 2016 2015 2014
(Amount (Amount (Amount (Amount
in `) in `) in `) in `)
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Net sales `3500000 `3000000 `3100000 `2800000

Operating `890000 `820000 `840000 `700000
income
Solution:
The base year is 2014; therefore percentage of net sales for 2014
is 100. Similarly, operating income for 2014 is 100. Calculate
percentage for other years using the formula:
Trend analysis percentage = (figure of the concerned year /
figure of the base year) × 100
Trend analysis percentage for net sales in 2017
= (3500000/2800000) ×100
=125%
= (3000000/2800000) ×100
=107.14%

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= (3100000/2800000) ×100
= 110.71%
Trend analysis percentage for Operating income in 2017
= (890000/700000) ×100
= 127.14%
= (820000/700000) ×100
= 117.14%
= (840000/700000) ×100
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= 120%
2. The Income Statement of PQR Private Ltd. is as follows:
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Income Statement of PQR Private. Ltd.
Particulars 2017 (Amount in `) 2016 (Amount in `)
Revenue `3000000 `2500000
Cost of goods sold `2200000 `1850000
Depreciation and `350000 `350000
Amortisation
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Selling and `650000 `450000

Administrative Expenses
Interest Expenses `100000 `75000
Taxes `240000 `100000
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Use percentage change analysis to assess the relative change in

items in the two years.
Solution:
Percentage change in Revenue = [(New amount – Old amount)/
Old Amount] ×100
= [(3000000-2500000)/2500000] ×100
= 20%
Cost of goods sold = [(New amount – Old amount)/ Old Amount]
×100
= [(2200000-1850000)/1850000] ×100
= 18.91%
Depreciation and Amortisation = [(New amount – Old amount)/
Old Amount] ×100
= [(350000-350000)350000] ×100
= 0%

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Selling and Administrative Expenses = [(New amount – Old

amount)/ Old Amount] ×100
= [(650000-450000)450000] ×100
= 44.44%
Interest Expenses = [(New amount – Old amount)/ Old Amount]
×100
= [(100000-75000)75000] ×100
= 33.33%
Taxes = [(New amount – Old amount)/ Old Amount] ×100
= [(240000-100000)100000] ×100
= 140%
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3. Prepare vertical common size analysis on the balance sheet XYZ
Ltd. given below.
Particulars (Amount in `)
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Cash 1000000
Accounts receivable 350000
Inventory 250000
Fixed assets 800000
Total assets 3000000
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Accounts payable 400000

Accrued liabilities 270000
Total current liabilities 200000
Notes payable 130000
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Total liabilities 400000

Capital stock 400000
Retained earnings 650000
Total equity 550000
Total liabilities and equity 3000000
Solution:
In case of vertical common size analysis on the balance sheet,
use the total of all liabilities and equity as the base for calculating
line item liabilities and equity in a balance sheet and the total of
all assets accounts as base when calculating all assets line item
percentages.
Particulars (Amount in `) Percentage
Cash 1000000 33.33%
Accounts receivable 350000 11.66%
Inventory 250000 8.33%
Total current assets 600000 20%

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Particulars (Amount in `) Percentage

Fixed assets 800000 26.67%
Total assets 3000000 100%
Accounts payable 400000 13.33%
Accrued liabilities 270000 9%
Total current liabilities 200000 6.67
Notes payable 130000 4.44%
Total liabilities 400000 13.33%
Capital stock 400000 13.33%
Retained earnings 650000 21.67%
Total equity 550000 18.33%
Total liabilities and equity 3000000 100%
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4. Prepare horizontal common size analysis on the balance sheet
Bharat Enterprises given below.
Particulars 2015 2016 2017
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(Amount (Amount (Amount
in `) in `) in `)
Revenue 15000000 18000000 17400000
Cost of goods sold 11000000 13000000 13200000
Gross profit 4000000 5000000 4200000
Operating expenses 1500000 1800000 1700000
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Operating income 2500000 3200000 2500000

Interest expenses 250000 200000 200000
Income Before income tax 2250000 3000000 2300000
Income tax provision 562500 750000 575000
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Net income 1687500 2250000 1725000

Solution:
For preparation of horizontal common size statement for Bharat
Enterprises, we have to take figures of year 2015 as base figure
and percentage base for all figures in 2015 will be equal to 100%.
We will calculate percentage for all the items for the year 2016
and 2017 by using below formula:
Common Size Percentage = (figure of the concerned year / figure
of the base year) × 100
(Amount Per- (Amount Per- (Amount Per-
in `) cent- in `) centage in `) centage
age
Revenue 15000000 100% 18000000 120% 17400000 116%
Cost of goods 11000000 100% 13000000 118.18% 13200000 120%
sold

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(Amount Per- (Amount Per- (Amount Per-
in `) cent- in `) centage in `) centage
age
Gross profit 4000000 100% 5000000 125% 4200000 105%
Operating 1500000 100% 1800000 120% 1700000 113.33%
expenses
Operating 2500000 100% 3200000 128% 2500000 100%
income
Interest 250000 100% 200000 80% 200000 80%
expenses
Income Be- 2250000 100% 3000000 133.33% 2300000 102%
fore income
tax
Income tax 562500 100% 750000 133.33% 575000 102%
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paid
Net income 1687500 100% 2250000 133.33% 1725000 102%
5. Prepare a percentage change analysis for the data given below:

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Particulars 2016 (Amount 2017 (Amount
in `) in `)
Revenue 50000000 65000000
Cost of goods sold 42800000 54200000
Gross profit 7200000 10800000
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Operating expenses 3250000 5200000

Operating income 2950000 5600000
Interest expenses 250000 400000
Income Before income tax 2700000 5200000
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Income tax paid 675000 1300000

Net income 2025000 3900000
Solution:
For conducting percentage change analysis of given data,
we have to take figures of year 2016 as base figure and then
calculate difference between figures of 2016 and 2017 to calculate
percentage change.
We will calculate percentage change analysis for all the items in
the year 2017 by using below formula:
Percentage Change for year n= [(figure of the n year – figure of
base year)/ figure of the base year] × 100
Particulars 2016 2017 Difference Percentage
(Amount (Amount (Amount Change
in `) in `) in `)
Revenue 50000000 65000000 15000000 30%

Cost of goods sold 42800000 54200000 11400000 26.63%

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Particulars 2016 2017 Difference Percentage

(Amount (Amount (Amount Change
in `) in `) in `)
Gross profit 7200000 10800000 3600000 50%

Operating expenses 3250000 5200000 1950000 60%
Operating income 2950000 5600000 2650000 89.83%
Interest expenses 250000 400000 150000 60%
Income Before 2700000 5200000 2500000 92.6%
income tax
Income tax paid 675000 1300000 625000 92.6%
Net income 2025000 3900000 1875000 92.6%
SUGGESTED READINGs &

11.10
REFERENCES
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SUGGESTED READINGS
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Norman, H., Alderman, W., & Godwin, C. (2010). Financial ACCT
2010 (1st ed., p. 38). Mason, USA: Cengage Learning.
Peterson Drake, P., & J. Fabozzi, F. (2012). Analysis of Financial
Statements (3rd ed., pp. 127-129). Hoboken, New Jersey: Wiley
Publishers.
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Weil, R., Francis, J., & Schipper, K. (2014). Financial Accounting:

An Introduction to Concepts, Methods and Uses (1st ed., pp. 239-
245). Mason, USA: Cengage Learning.
E-REFERENCES
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Wiley.com. (2014). Financial Analysis Primer - Introduction. Re-

trieved from, http://www.wiley.com/college/kieso/0471363049/dt/
analysttool/faprimer/fap11.htm
Fuhrmann, R. (2013). The Common-Size Analysis of Financial
Statements (IBM). Investopedia. Retrieved from, http://www.in-
vestopedia.com/articles/investing/111413/commonsize-analysis-fi-
nancial-statements.asp
Readyratios.com. (2014). Horizontal Analysis of Financial State-
ments. Retrieved from, http://www.readyratios.com/reference/
analysis/horizontal_analysis_of_financial_statements.html

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FINANCIAL STATEMENT OF BANK AND A

MANUFACTURING COMPANY
You are being given the balance sheets of two well-known organ-
isations, namely, XYZ Bank Ltd. and ABC Industries Ltd. While
one is a large state owned bank and other is a large manufactur-
ing company.
XYZ Bank Limited
Consolidated Balance Sheet as on March 31, 2017
Particulars Amount (` in Crore)
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Equity and Liabilities
Capital 9720
Reserves and Surplus 17800
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Deposits 245000
Borrowings 16000
Other Liabilities and Provisions 12000
TOTAL 300520
Assets
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Cash and other reserves with Central Bank 16050

Balances with other Banks (Call and short
notice) 14900
Investments 71950
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Gross Block 176400

Revaluation Reserves 2600
Advances 12500
Fixed Assets 3800
Other Assets 2320
TOTAL 300520
ABC Industries Limited
Consolidated Balance Sheet as on March 31, 2017

Sources of funds
Shareholder’s fund 16490
Share Capital 1172
Reserves and Surplus 15230
Secured loans 11530

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Unsecured loans 1430
Accounts Payable 1030
TOTAL 46882
Application of funds
Fixed Assets 12610
Goodwill 523
Patents and Trademarks 565
Capital work in progress 1112
Net deferred tax assets 389
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Investments 9830
Current assets 2561
Inventories 817
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Accounts Receivable 2252
Cash and Bank Balances 828
Short term loans and advances 4719
Other current assets 8153
Loans and Advances 2523
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TOTAL 46882
questions
1. From the above given data you are required to prepare

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common size statements for both the organisations.

(Hint: Prepare common size statements as per the format
discussed in chapter 11 and consider all the items as per
cent of relevant head. For instance, suppose total liabilities
are 10000 and share capital is 100, then as per the common
size statement share capital is 10% of liabilities.)
2. Explain the difference between the nature of various
items in balance sheet of a bank and a manufacturing
company.
(Hint: Analyse both the balance sheets and try to
understand the nature of assets, liabilities and share
capital of bank and a manufacturing company. For
instance, Net loan is a liability item in a ABC Industries
Limited’s balance sheet but if this loan has been borrowed
from XYZ Bank limited then it should be recorded as an
asset item in a balance sheet of a bank.)

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Ch
12 a p t er
CASE STUDIES
CONTENTS
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Case Study 1 Assessment of Business Expenses
Case Study 2 Transactional Analysis and Balance Sheet
Case Study 3 Sanjeev’s Delicious Bites
Case Study 4
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Satyam Computers Limited- Business Accounting Fraud
Case Study 5 Reporting the Depreciation of Assets at Abyss Inc.
Case Study 6 Voilation of Accounting Standards by Xerox
Case Study 7 Flymates Reports Accounting Data as per Schedule III of
Companies Act, 2013
Case Study 8 Tata Motors- Cash Flow Analysis
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Case Study 9 Tata Motors-Financial Analysis on a standalone basis

Case Study 10 Ratio Analysis of ITC Limited
Case Study 11 Common Size Analysis for Interpreting Notion Graphics Ltd.
Case Study 12 Management Discussion and Analysis at Marico India
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Case study 1
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ASSESSMENT OF BUSINESS EXPENSES
This Case Study discusses the recording concepts of accounting and

it is with respect to Chapter 1 of the book.
In 2015, Mr. Amit Khanna started working as a driver of Mr. Abdul

Khan of M/s Khan and Sons. In April 2016, he decided to operate
his own cab business and he bought a car costing `785000. This
included `30000 annual insurance, `60000 on 15 year road tax and
`3000 on expenses for registration. He paid `285000 as the down
payment and took a mortgage loan for remaining amount. This
mortgage was structured as 36 EMI of `18000 each.
His only source of income was the fare money collected from cab
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and during the first year, he had all the information on money
spent by him that he had noted in his pocket diary.
Particulars Amount (in `)

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Groceries Purchased for personal use 48275
Clothes bought for his son 2850
Books and school fee for son 850
Uniform for himself and driver’s badge 2765
Food and drinks while driving 18000
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Sari bought for his mother 1250

Diesel and oil 157500
Paid electricity bill for his house 11000
EMI paid 198000
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Paid in savings bank account 7490
At the end of year, he organised a small party for his family. His
wife pointed out that he had put in all his savings in the cab. ‘Did
you make any profit?’ He did some mental calculations and re-
plied, ‘as of now, I made a loss of ` 277510.
However, his wife decided to consult her cousin Mrs. Diksha, a

charted accountant. Mrs. Diksha told her that the accounts need
to be prepared taking accounting concepts into consideration.

Case study 1: AASSESSMENT OF BUSINESS EXPENSES 349
Case study 1
n o t e s
questions
1. Did you agree with Amit’s loss calculation? Why or Why

not?
(Hint Amit has calculated loss by adding all the expenses
incurred in the year. He does not consider the nature
of expenses incurred. He does not specify whether the
expenses are related with the business or personal.)
2. Suggest some measures to calculate actual profit (or loss)
earned by Amit.
(Hint As discussed in previous hint, Amit needs to analyse
all the expenses incurred during the year. For example,
school fee paid, grocery purchased for personal use, etc.
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are personal expenses and should not be considered as
business expenses. On the other hand, his uniform and
driver’s badge, food and drinks while driving, diesel and
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oil, etc. should be considered as business expenses.)
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N

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Case study 2
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TRANSACTIONAL ANALYSIS AND BALANCE SHEET
This Case Study discusses the transactional analysis of Rider.com.

It is with respect to Chapter 2 of the book.
Mr. Arvind Rohilla, owns an old bikes’ showroom in Delhi and in

May 2016 started a bike rental venture named ‘rider.com’ with a
capital of ` 5 lakh, which he contributed from his personal sav-
ings. His father also arranged a commercial space for his office.
Initially, nobody was convinced with his idea while Arvind saw a
great potential in this business opportunity. The following are the
transactions for his business for the month of May, 2016:
On May 01, 2016, Arvind started business with cash of `5 lakh.
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On May 06, 2016, Arvind purchased a laptop for cash `40 thou-
sand.
On May 07, 2016, full advance payment of `25 thousand, was
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made to the website developer for developing a customized
website for ‘rider.com’.
On May 08, 2016, `20 thousand had been spend for office fur-
niture.
On May 09, 2016, Arvind received rights for fully customized
website of ‘rider.com’.
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On May 10, 2016, Arvind purchased 3 old motorcycles worth

`25000 each, to initiate rental services.
On May 11, 2016, ‘rider.com’ received their 1 order for all 3
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bikes for 5 days bike rental and full payment of `7500 had been
received.
On May 15, 2016, paid `2200 for electricity charges.
On May 20, 2017, Arvind purchased 10 more motorcycles for
`25000 each.
On May 22, 2016, got another order for 12 bikes for 6 days and
full payment of `36000 has been received.
On May 27, 2016, salary of `20000 paid to employees.
On May 30, 2016, Arvind withdrew `6000 for personal use.
On May 31, 2016, Additional capital of `1 lakh brought in by
Arvind.

Case study 2
n o t e s
questions
1. Prepare a Journal of ‘Rider.com’ for above transactions

and then post them in ledger.
(Hint: Pass all the journal entries by applying the golden
rules of accountancy and maintain separate ledger
accounts for all items such as Cash Account, Capital
Account, Laptop Account, Furniture Account, Motorcycle
Account, Salary Account, etc.)
2. Analyse the impact of above transactions on the balance
sheet of ‘Rider.com’ by using transactional analysis.
(Hint: Identify and select all the items according to the
account to which they belong in balance sheet. Analyse
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all the journal entries by applying accounting equation,
i.e. Assets = Liabilities + Share Capital)
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Case study 3
n o t e s
SANJEEV’S DELICIOUS BITES
This Case Study discusses the preparation of Trial Balance and rec-
tification of errors in the Trial Balance for Sanjeev’s new restau-
rant, ‘Delicious Bites’. It is with respect to Chapter-3 of the book.
Sanjeev is a chef at a major five star hotel with a work experience

comprising culinary work of popular Delhi restaurants. Sanjeev
decided to open up his own restaurant, ‘Delicious Bites’ as he
believed in his skills and counted on his customer base. Sanjeev
has his own bank balance to use, which is worth `8, 00,000 but he
would still require to take a term loan from a bank.
However, to apply for loans, Sanjeev would need to create Fi-

nancial Statements pertaining to the first year of operation to be
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presented to the lending bank. The bank would assess Sanjeev
and his restaurant’s credibility to repay the loan. For this purpose,
Sanjeev hired a book keeper who kept a record of all the trans-
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actions that took place and forwarded them to Sanjeev’s accoun-
tant. The book keeper recorded the following transactions:
Jan 1: Sanjeev started business with cash `8, 00,000 and furni-
ture `2, 00,000.
Jan5: Purchased goods on credit worth `3, 00,000 from Taste-
makers Inc.
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Jan 8: Sold food items for cash `4, 60,000.

Jan 16: Sold food items on credit to customers for `1, 00,000
Jan 20: Cash received from customers worth `98, 000 in full
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settlement of his account.
Sanjeev’s Ledger
Cash Account (No.5)
Date References J.F Debit (`) Credit (`) Balance (`)
2013 Dr. Cr.
Jan. 1 Capital A/C 5 8,00,000 8,00,000
Jan 8 Sales A/C 5 4,60,000 12,60,000
Jan 16 Customer’s A/C 5 98,000 13,58,000
Furniture Account (No.7)

2013 Dr. Cr.
Jan 1 Capital A/C 5 2, 00,000 2, 00,000

Case study 3
n o t e s
Capital Account (No.9)

2013 Dr. Cr.
Jan 1 Cash A/C 5 8,00,000 8,00,000
Jan 1 Furniture A/C 5 2,00,000 10,00,000
Purchases Account (No.11)

2013 Dr. Cr.
Jan 5 Tastemakers Inc. 5 3, 00,000 3, 00,000
A/C
Tastemakers Inc. Account (No.13)
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Date References J.F Debit (`) Credit Balance (`)
2013 (`) Dr. Cr.
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Jan 5 Purchases A/C 5 3, 00,000 3, 00,000
Sales Account (No.15)
Date References J.F Debit (`) Credit Balance (`)

2013 (`) Dr. Cr.
Jan 8 Cash A/C 5 4, 60,000 4, 60,000
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Jan 16 Customers A/C 5 1, 00,000 5, 60,000
Customers Account (No.17)

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2013 Dr. Cr.

Jan 16 Sales A/C 5 1,00,000 1,00,000
Jan 20 Cash A/C 5 98,000
Jan 20 Discount A/C 5 2000 Nil
Discount Account (No.19)

2013 Dr. Cr.
Jan 20 Customers A/C 5 2000 2000
The next step in the preparation of financial statements was the

preparation of trial balance using the above ledgers in Sanjeev’s
books. His accountant prepared the following trial balance and
ended up short of `2000 in the debit balance:

Case study 3: SANJEEV’S DELICIOUS BITES 355
Case study 3
n o t e s
Sanjeev’s Trial Balance as on January 31, 2013 (Amount in `)
S. No. Account Name L.F Debit (`) Credit (`)

1 Cash Account 5 13,58,000
2 Furniture Account 7 2, 00,000
3 Capital Account 9 10, 00,000
4 Purchases Account 11 3,00,000
5 Tastemakers Inc. Account 13 3, 00,000
6 Sales Account 15 5, 60,000
7 Customers Account 17
Total 18, 58,000 18, 60,000
Sanjeev asked his accountant to rectify the error; however his ac-
countant was unable to find out the reason for his unbalanced
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entries.
questions
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1. Suppose you are an accountant at Sanjeev’s old restaurant.
He seeks your help in the rectification of his trial balance
entries. Analyse the reason for the mismatched entries.
(Hint: Cash received from customers worth `98, 000,
which means a discount worth `2000, which has not been
M
recorded in the debit column.)

2. Under which category would you classify the error which
occurred in the books of account of Sanjeev`s restaurant?
Justify.
N
(Hint: Errors of Omission: This type of error occurs when

a transaction is not completely or partially recorded in
the books of accounts)

N
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Case study 4
n o t e s
SATYAM COMPUTERS LIMITED- BUSINESS

ACCOUNTING FRAUD
This Case Study discusses the Fraudulent Financial Reporting by

Satyam Computer Services Limited due to weak internal control,
non-compliance with Accounting Standards and poor auditing by
the Audit Committee. It is with respect to Chapter-4 of the book.
Fraudulent financial reporting has a significant impact on an or-

ganisation and its stakeholders. It also affects public’s confidence
in the capital markets. Often high-profile fraudulent cases relat-
ed to deceitful financial reporting raise apprehensions about the
credibility of the financial reporting process in a nation. It also
raises concern about the roles of management, auditors, regula-
S
tors and analysts, among others to check fraudulent financial re-
porting.
Satyam Computer Services Limited was among the leading or-

IM
ganisations in outsourced IT-services industries in India. The or-
ganisation was established in 1987 in Hyderabad by Ramalinga
Raju. Satyam Computer Services Limited began with 20 employ-
ees and developed rapidly as a global IT company. The company
was engaged in providing IT and Business Process Outsourcing
services across various sectors. In 2003-2008, Satyam Computer
M
grew considerably and generated USD $467 million from its total
sales. By March 2008, Satyam Computer had grown to USD $2.1
billion. It booked an annual compound growth rate of 35% in that
time period.
N
Satyam is a Level I enterprise as it has a turnover above ` 50

crores. This implies that all Accounting Standards are compulso-
ry to be complied with by Satyam Computers. These Accounting
Standards improve the credibility and reliability of the financial
statements, determine managerial accountability, assist accoun-
tants and auditors, and enable ease of understanding. However,
there have been several frauds in India’s corporate history due
to lack of compliance to these standards and inefficient corporate
governance.
On January 7, 2009, Ramalinga Raju revealed in a letter ad-

dressed to Satyam Computers Limited’s Board of Directors dis-
closing that he had been involved in manipulating the company’s
accounting figures for several years. Ramalinga Raju declared
that he had overstated the company’s assets on Satyam’s balance
sheet by $1.47 billion. He revealed that about $1.04 billion worth
of bank loans and cash that Satyam claimed to own did not exist.

Case study 4
n o t e s
Besides, Satyam Computers had underreported its liabilities on

the balance sheet and had been involved in overstating its income
almost every quarter over the course of several years in order to
meet the expectations of the critics. Satyam overstated quarterly
revenues by 75 per cent and profits by 97 per cent on October 17,
2009. It was also found out that the bank accounts were falsified
for inflating the balance sheet with balances that actually never
existed. In addition, income statement was exaggerated by declar-
ing interest income from the fake bank accounts. It was also ex-
posed that company owner made 6000 fake salary accounts over
the past several years and withdrew the money after the company
deposited it.
The result of the fraudulent accounting and financial reporting

affected the company’s stockholders and creditors. Besides, the
S
investors’ confidence in the capital market was shaken consider-
ably. The fraud also had an adverse impact on Satyam’s employ-
ees who lost their jobs and diminished pension fund value. The
IM
others that were affected were depositors in Satyam Computers,
the company’s underwriters, auditors, attorneys, and insurers
and even trustworthy competitors whose reputations suffered
owing to their association with Satyam.
Some of the main points that organisations must remember after

the Satyam Scandal are:
M
Investigation of all inaccuracies: The fraud at Satyam start-

ed at a small scale initially and grew up to $276 million. Most
accounting frauds start out small with the offender assuming
that minute changes in the financial statements would go un-
N
noticed. Thus, organisations should be aware when the ac-

counts do not balance or if something seems inaccurate even
if it is insignificant.
Adherence to accounting standards: Organisations should
follow a set of guidelines to prepare and present the financial
statements. This helps in bringing consistency in the report-
ing of accounting information. It also ensures transparency,
consistency and comparability of accounting information by
providing uniformity in accounting practices as the accoun-
tants and the auditors follow the same rules and procedures.
Role division: Dividing responsibilities across a team of indi-
viduals would help in detecting irregularities or misappropri-
ated funds.

Case study 4: SATYAM COMPUTERS LIMITED- BUSINESS ACCOUNTING FRAUD 359
Case study 4
n o t e s
questions
1. Suppose you are the finance manager at an MNC, in such

a scenario, what measures will you take to avoid financial
frauds?
(Hint: Periodically tally books of accounts, check for bank
balance, investigate the unexpected cash inflows and
outflows, and check the unbalanced accounts for small
and big changes alike.)
2. Briefly explain the Satyam Scam and the role played by
the audit committee.
(Hint: Prepare a summary by analysing various loopholes
in the scandal.)
S
IM
M
N

N
M
IM
S
Case study 5
n o t e s
REPORTING THE DEPRECIATION OF ASSETS

AT ABYSS INC.
This Case Study discusses the accounting standards followed in In-

dia and how depreciation is reported by Abyss Inc. that follows the
Indian GAAP for preparing its financial statements. It is with re-
spect to Chapter-5 of the book.
Abyss Inc. was incorporated in April, 2008 and deals in the pro-
cessing and distribution of dried fruits. The company also car-
ries out research and development activities related to different
varieties of dry fruits. It follows the Indian Generally Accepted
Accounting principles (i-GAAP) for preparing and reporting its
financial statements. In preparing its financial statements for fi-
S
nancial year ending 31st March, 2012, Abyss Inc. used the follow-
ing useful lives for its property, plant and equipment:
Land and building

IM 15 years
Plant and machinery 10 years
Furniture and fixtures 9 years
The book value of Abyss Inc.’s property, plant and equipment are
as follows:
M
Land and building `15,00,000

Plant and machinery `10,00,000
Furniture and fixtures ` 3,50,000
N
On April, 2013, the company decided to review the useful lives of

its property, plant and equipment. However, the company lacked
the required expertise for the same and hired a group of exter-
nal valuation experts for this purpose. These external valuation
experts certified that the remaining useful lives of Abyss Inc.’s
property, plant and equipment at the beginning of year 2013 were
as follows:
Land and building 10 years

Plant and machinery 7 years
Furniture and fixtures 6 years
Abyss Inc. follows the straight line method of depreciation. There-

fore, depreciation is charged uniformly over the life of an asset.
After five years of using the assets, the company derived at the
following residual value of its assets:

Case study 5
n o t e s
Land and building `10,00,000

Plant and machinery ` 7,00,000
Furniture and fixtures ` 1,50,000
questions
1. Suppose you are one of the valuation experts, help Abyss

Inc. in computing its revised annual depreciation for the
year 2013.
(Hint: Revised annual depreciation = (book value –
residual value)/ remaining useful life).
2. Abyss Inc. has patents and research articles as assets in
its balance sheet. Should depreciation on these assets be
S
reported in the same way?
(Hint: AS 6 does not apply on intangible assets, patents,
goodwill, research and development, etc.)
IM
M
N

Case study 6
n o t e s
VOILATION OF ACCOUNTING STANDARDS BY XEROX
This Case Study discusses the effect of wrong treatment of account-

ing standards done by Xerox in the preparation of financial state-
ments. It is with respect to Chapter 6 of the book.
Xerox Corporation was founded on April 16, 1906 by Mr. Joseph

C. Wilson in Rochester, New York. At that time it was known as
‘The Haloid Photographic Company’ which deals in photographic
paper and equipment. In 1938, Mr. Chester Carlson who was also
a cofounder of Xerox has invented a dry photocopying technique
named ‘electrophotography’ and later on electrophotography
came to be known as ‘Xerography’.
S
Then in 1959, Carlson introduced ‘Xerox 914’ the first plain pho-
tocopier of that time which became so popular and resulted as a
game changer for Xerox. This product brought substantial chang-
es in company’s revenue and it jumped to over US $ 500 million by
IM
1965 from US $ 60 million in 1961. During 1960s, Xerox acquired
many companies such as, University Microfilms International,
Electro-Optical Systems, Scientific Data Systems, etc.
In late 1970s, Xerox faced high competitive pressure and their

market share in United States copying market reduced to 14%
M
which was 100% during early 1970s. Then in 1981, ‘Memory writ-
er’ (an electronic memory typewriter) was launched by Xerox and
good response has been received from market. By the year end
of its launched, around 20 % market share was captured by this
product. In mid 1980s, during the time of computing revolution,
N
most of the market share was loosed to other major players such
as, Apple, IBM, Microsoft, etc. However, from that time to till date
Xerox has achieved many milestones and today it is a well-known
brand in Document solutions and services provider company with
global reach of 180 countries.
In early 2000s the financial reporting and accounting related is-

sues in Xerox became unreliable. It seems like, the management
of Xerox has manipulated its financial statements to maintain
good image among investors in stock market. This scam comes
into light in 2002, when Securities and Exchange Commission
(SEC), identifies that the company is recording false profit trans-
actions in their financial statements. According to SEC, the prin-
ciple of revenue recognition has been violated by Xerox. In order
to make it work, Xerox was using two illegal accounting practices,
namely Cookie Jar Reserves and inappropriate recording for long
term leases. Cookie Jar Accounting (or Reserves) is a practice in
which a company uses surplus profits of successful years to com-
pensate with current losses.

Case study 6
n o t e s
During the investigation it was found out that Xerox was engaged
in such practices from past many years. For instance, during the
financial year 1996-1997 the expected return of investment (ROI)
recorded was US $ 2.02 per share while the actual ROI per share
was US $ 1.65 per share. By using Cookie Jar Reserves (or Ac-
counting) false profits were recorded by Xerox and to carry out
such practice it was using past profits of successful years to cover
up losses. In many cases, Xerox was recording future revenue in
order to compensate with current revenue. In this scenario, ‘In-
ternational Financial Reporting Standard (IFRS) 15’ or ‘Interna-
tional Accounting Standard (IAS) 18’ of revenue recognition has
been violated by the company. As per the Indian context, ‘Indian
Accounting Standard (Ind AS) 18’ deals with Revenue Recogni-
tion.
S
On the other hand, many times long-term leases have been re-
corded as short term rentals in order to delay the revenue recog-
nition process. While the G.A.A.P states that the revenues for long
IM
term leases are supposed to be recorded immediately. It also spec-
ifies that the revenues from short-term equipment rentals are to
be spread over the duration of the contract. In spite of this, Xerox
sometimes purposely classifies its long-term leases as short-term
rentals in an effort to postpone revenue recording. In this man-
ner, Xerox was also violating, ‘International Financial Reporting
Standard (IFRS) 16’ or ‘International Accounting Standard (IAS)
M
17’ of lease recording. As per Indian scenario, ‘Indian Accounting

Standard (Ind AS) 17’ deals with recording of lease.
questions
N
1. Explain, what was the main reason for which big

organisations commit fraudulent activities by relating it
to Xerox.
(Hint: Xerox has manipulated its financial statements to
maintain good image among investors in stock market.)
2. Discuss the main illegal accounting practices done by the
Xerox.
(Hint: Study about ‘International Accounting Standard
(IAS) 18’, ‘Indian Accounting Standard (Ind AS) 18’ of
Revenue Recognition. and ‘International Accounting
Standard (IAS) 17’, ‘Indian Accounting Standard (Ind
AS) 17’ of lease recording. Also study about cookie jar
reserves.)

Case study 7
n o t e s
FLYMATES REPORTS ACCOUNTING DATA AS PER

SCHEDULE III OF COMPANIES ACT, 2013
This Case Study discusses the Schedule III of Companies Act, 2013,
adopted by Indian corporates w.e.f. April 1, 2016 for preparing and
presenting their financial statements. It explains the way the assets
and liabilities are reported in the balance sheet of Flymates Pvt.
Ltd. as per Schedule III of Companies Act, 2013. It is with respect to
Chapter 7 of the book.
Flymates Pvt. Ltd. is a supplier of aviation spare parts, component

repair and overhaul services for civil and military, fixed and rotary
wing aircraft operators across the world. Flymates Pvt. Ltd. has
earned itself a reputation for total support and quality assurance
S
for its worldwide customers. The organisation has developed a
technical support team to serve airlines that adhere to document-
ed safety standards. Flymates Pvt. Ltd. prepares and presents its
financial statements as per Schedule III of Companies Act, 2013.
IM
Although the organisation is performing fairly satisfactorily for
the last two decades, there are a few problems in its accounting
procedures owing to the adoption of the Schedule III of Compa-
nies Act, 2013. The following information has been provided by
the Accounts Manager to the consultants of the organisation:
M
The time period from the initial purchase of raw materials till the
completion of final production of the spares and their delivery
after quality certification is approximately 10 months on an av-
erage. Once the spares are sold to the buyers, the credit terms
of Flymates provides for payment of the amount due within six
N
months from the delivery date.
There is a group of spare parts manufactured by Flymates that

have become obsolete now and are lying in Flymates’ inventory
for the past two years. The management has no hopes of these
spare parts being disposed-off in the near future either.
Flymates Pvt. Ltd. has acquired a 7 year term loan from a public
sector bank against security of its plant & machinery. The com-
pany has already paid principal and interest amount of the loan
for the first 3 years and the opening balance of the loan as on
1st April, 2016 is `5.50 crore. The principal repayment per year
is nearly `2 crore. However, for the last 2 months Flymates’ loan
instalments are unpaid as at 31st March, 2017. As per the bank’s
terms and conditions, the loan would be liable to be recalled in
case of failure to adhere to loan terms which include submission
of quarterly performance indicators. During 2016-2017, Flymates
Pvt. Ltd. failed to submit any statements. Until now, the bank has
not issued any notice for recalling the loan.

Case study 7
n o t e s
questions
1. Assuming you are one of the consultants, how will

Flymates Pvt. Ltd. show the inventory in its balance sheet
as per Schedule III of Companies Act, 2013?
(Hint: Normal operating cycle = 10 + 6 months. Inventory
is classified as a current asset since it is realised within
an operating cycle. Also obsolete spare parts would be
included.)
2. Explain how the loan would be disclosed as per Schedule
III of Companies Act, 2013.
(Hint: Term loan is basically a non-current liability.
Therefore, classification as at reporting date would be
S
IMNon-current Liabilities → Long term borrowings.)
M
N

Case study 8
n o t e s
TATA MOTORS- CASH FLOW ANALYSIS
This Case Study discusses the analysis of the Cash Flow Statement
of Tata Motors Limited to assess the financial performance of the
organisation in the FY 2016-17. It is with respect to Chapter 8 of the
book.
Tata Motors Limited (previously known as TELCO, short form for

Tata Engineering and Locomotive Company) is an Indian automo-
tive manufacturing company having its headquarters in Mumbai,
Maharashtra. Tata Motors has manufacturing plants in Jamshed-
pur, Pantnagar, Lucknow, Sanand, Dharwad and Pune in India.
Outside India, it has presence in Argentina, South Africa, Thai-
land and the United Kingdom. Tata Motors’ has several subsidiar-
ies including Jaguar, Land Rover and Tata Daewoo. Tata Motors
S
runs a joint venture for manufacturing buses with Marcopolo S.A.
Besides, Tata Motors also runs a joint venture with Hitachi for
manufacturing construction machinery. Fiat-Tata is another India
IM
based joint venture between Tata and Fiat for manufacturing Fiat
and Tata passenger cars, engines and transmissions.
Tata Motors is listed in the Bombay Stock Exchange (BSE), the

National Stock Exchange (NSE) of India and the New York Stock
Exchange (NYSE) in the USA.
M
The following table shows the consolidated cash flow statement

of Tata
Motors Limited:
N
Tata Motors Ltd. Cash Flow Statement for FY 2016-17:

Parameter M A R ’ 1 7 MAR’16 Change %
(` Cr.) (` Cr.)
Net Profit (Loss) Before Taxes -2,479.99 -62.30 -3880.72%
Adjustments for Expenses & 4,028.96 3,564.72 13.02%
Provisions
Adjustments for Liabilities & -73.75 -775.94 90.50%
Assets
Cash Flow from operating 1,381.47 2,702.98 -48.89%
activities
Cash Flow from investing -2,737.98 -3,264.22 16.12%
activities
Cash Flow from financing 1,119.21 -78.87 1519.06%
activities
Effect of exchange fluctuation on 0.00 0.00 0.00%
translation reserve
Net increase/(decrease) in cash -237.30 -640.11 62.93%
and cash equivalents

Case study 8
n o t e s
Parameter M A R ’ 1 7 MAR’16 Change %

(` Cr.) (` Cr.)
Opening Cash & Cash Equivalents 427.07 1,066.47 -59.95%
Cash & Cash Equivalent on 0.00 0.00 0.00%
Amalgamation / Take over /
Merger
Cash & Cash Equivalent of 0.00 0.00 0.00%
Subsidiaries under liquidations
Translation adjustment on 0.00 0.00 0.00%
reserves / op cash balances
foreign subsidiaries
Effect of Foreign Exchange -1.38 0.71 -294.37%
Fluctuations
Closing Cash & Cash Equivalent 188.39 427.07 -55.89
S
Source: http://profit.ndtv.com/stock/tata-motors-ltd_tatamotors/financials-cash-flow
questions
IM
1. You are required to prepare the summary of cash flow
statement of Tata motors in less than 400 words.
(Hint: Analyse the cash flow statement and prepare a
summary in a way that it shows comparative summary of
year 2015-16 and 2017-18. For instance, Net cash flow from
M
operating activities before changes in working capital

and finance receivable was `1,381.47 crores in FY 2016-17
as compare to 2,702.98 crores in FY 20115-16, signifying
a decrease in cash generated through operations. Cash
Flow from investing activities was `-2,737.98 crore in FY
N
2016-17 as compare to `-3,264.22 crore in 2015-16. Cash

Flow from financing activities was `1,119.21 crore in 2016-
17 as compare to `-78.87 crore in 2015-16.)
2. Analyse the overall financial performance of Tata Motors
in FY 2016-17 against FY 2015-16.
(Hint: Analyse the financial performance of Tata Motors
compared to the previous year using the summary
prepared for the 1st question and comment on company’s
performance.)

Case study 9
n o t e s
TATA MOTORS-FINANCIAL ANALYSIS ON A STAND-

ALONE BASIS
This Case Study discusses the analysis of profit and loss of Tata
Motors Limited on a basis to assess the financial performance of the
organisation in the Financial Year (FY) 2016-17. It is with respect to
Chapter 9 of the book.
Tata Motors Limited is India’s leading automobile manufacturer,

with Total combined income of `50079.25 crores in FY 2016-17 as
compared to `48785.92 in 2015-16. It is the leading manufacturer
of commercial and passenger vehicles including compact, mid-
sized car and utility vehicle segments. Tata Motors Limited is the
fifth largest truck manufacturer and the fourth largest bus manu-
S
facturer in the world.
The acquisition of Jaguar Land Rover (JLR) enabled Tata Motors

Limited to enter the premium car market. Tata Motors continues
IM
to focus on profitable growth opportunities in the global automo-
tive world by manufacturing through market expansion.
Tata Motors Limited and Jaguar Land Rover continue to focus

on integration and synergy through resource sharing for product
development and manufacturing automobiles.
M
The major business segments can be divided into automotive op-

erations and all other operations. Automotive operations include
business activities relating to development, design, manufacture,
assembly and sale of vehicles.
N
The automotive operations segment of the Tata Motors Group

is further divided into Tata Motors and other brand vehicles (in-
cluding spares and vehicle financing) and Jaguar Land Rover.
Standalone Profit and Loss Account of Tata Motors for 2016-17 is

given below:

Case study 9
n o t e s
Source: http://www.tatamotors.com/investors/financials/72-ar-html/profit-loss.html
questions
1. What conclusions can be drawn from the financial
S
statement analysis of Tata Motors Limited?
(Hint: Analyse the profit and loss account of Tata Motors
and summarise all the significant changes.)
IM
2. Prepare a comparative profit and loss account of Tata
motors for the year 2016-17.
(Hint: Prepare comparative profit and loss as per the
format and instructions mentioned in chapter 11. Also note
that, in comparative profit and loss account percentage
M
change has to be shown in all the figures of corresponding

years.)
N

Case study 10
n o t e s
RATIO ANALYSIS OF ITC LIMITED
This Case Study discusses the ratio analysis of ITC Limited using
its financial statements for the year ending 31st March, 2014. It is
with respect to Chapter-10 of the book.
ITC Limited was incorporated on August 24, 1910 under the name
of ‘Imperial Tobacco Company of India Limited’ in a leased office
on Radha Bazar Lane, Kolkata. ITC Limited’s principal activities
are to manufacture cigarettes and tobacco. The Group operates in
retailing business such as garments, greeting, gift and stationery,
packaged foods and export of agricultural products. ITC provides
a range of branded packaged and convenience food for its cus-
tomers in its operations all over India. Some of the brands under
S
ITC are India Kings, Wills, Gold Flake, Checkers, Hi-Val, Wills
Sport, Expressions, etc. The company’s financial statements for
the year 2013-2014 are as follows:
IM
Balance Sheet of the ITC for year ended 31.03.2014
Note As at 31st As at 31st

March 2014 March 2013
(` in Crores) (` in Crores)
EQUITY AND LIABILITIES
M
Share capital 1 795.32 790.18

Reserves and surplus 2 26441.64 27236.96 22367.72 23157.90
Minority Interests 203.03 179.89
Long-term borrowings 3 76.40
N
Deferred tax liabilities (Net) 4A 1306.99

Other Long term liabilities 5 42.74
Long-term provisions 6 131.75 1557.88 144.75 1489.61
Current liabilities
Short-term borrowings 7 150.24 -
Trade payables 2106.25 1771.56
(Includes share of Joint Ventures
` 30.36 Crores (2013-` 23.94
Crores))
Other current liabilities 8 3673.10 3560.03
Short-term provisions 9 5956.47 11886.06 5194.39 10525.98
Total 40886.93 35353.38
ASSETS
Non-current assets
Fixed assets 10
Tangible assets 12556.00 11728.45

Case study 10
n o t e s
Intangible assets 73.83 100.54

Capital work-in-progress-Tangible assets 3081.29 2041.37
Intangible assets under development 36.08 20.66
15747.20 13891.02
Less; Provision for assets given on lease 5.67 13891.02
15747.20 13885.35
Goodwill on consolidation 297.14 316.51
Non-current investments 11 798.52 814.17
Deferred tax assets (Net) 48 35.52 24.11
Long-term loans and advances 12 1428.92 1246.30
Other non-current assets 12A 1.24 18302.87 1.24 1687.68
Current assets
Current investments 13 6485.50 51167.11
S
Inventories 14 8255.24 7522.09
Trade receivables 15 2439.21 1395.76
Cash and bank balance 16 3490.19 3828.30
IM
Short-term loans and advances 17 816.20 529.61
Other current assets 18 1094.72 22581.06 622.83 19065.70
Total 40883.93 35353.38
Profit and Loss Statement for year ended 31.03.2014
Note For the year For the year

M
ended 31st ended 31st

Gross Income 19 5050.61 45102.45
Gross Revenue from sale of products and 49247.28 43920.76
N
services
Less: Excise Duty 14262.58 12597.31
Net Revenue from sale of products and 34984.70 31323.45
services
Other operating revenue 332.38 304.09
Revenue from operations 20 35317.08 31627.54
Other income 21 970.95 877.60
Total Revenue 36288.03 32505.14
Expenses
Cost of materials consumed 10376.05 9069.82
` 108.30 Crores (2013- ` 83.62 Crores))
Purchases of Stock-in- Trade and Interme- 2976.96 3305.23
diates
Changes in inventories of finished goods, 22 (112.74) (256.84)
work-in-progress, Stock-in-Trade and Inter-
mediate
Employee benefits expense 23 2504.24 2145.63

Case study 10: RATIO ANALYSIS OF ITC LIMITED 373
Case study 10
n o t e s
Note For the year For the year

ended 31st ended 31st
Finance costs 24 6.37 87.18
Depreciation and amortization expense 964.92 859.11
` 1.91 Crores (2013-`1.45 Crores))
Other expenses 25 6520.66 6189.36
Total Expenses 23236.48 21399.49
Profit before tax 13051.55 11105.65
Tax expense:
Current tax 26 3988.87 3088.05
Deferred tax 27 72.06 324.02
S
Profit after tax before share of results of 8990.62 7693.58
associates and minority interests
Less: Minority interests 109.81 96.38
Share of net profit of associates
IM 10.57 10.87
Profit for the year 8891.38 7608.07
Earnings per share (Face Value ` 1.00 each) 28(i)
Basic ` 11.22 ` 9.69
Diluted ` 11.09 ` 9.56
Source: http://www.itcportal.com/about-itc/shareholder-value/annual-reports/itc-annu-
al-report-2014/pdf/ITC-Consolidated-Financials-Statement.pdf
M
Some investors were interested to assess the financial perfor-

mance of ITC Limited before making an investment in the organi-
sation. They decided to use the company’s financial statements to
calculate the financial ratios for revealing how ITC was financed,
N
how it used its resources, its ability to pay its liabilities and gen-
erate profit. These investors used the following financial ratios to
compare ITC Limited across different time periods.
Ratios:
i. Current Ratio = Current Assets/Current Liabilities =
22581.06/11886.06 = 1.9
ii. Quick Ratio = (Current Assets-Inventories-Prepaid
Expenses)/ Current Liabilities = (22581.06 – 8255.24)/
11886.06 = 1.2
iii. Cash Ratio = Cash and Cash equivalents/ Current Liabilities
= 3490.19/11886.06 = 0.3
iv. Debt-Total Assets Ratio = (Long term debt)/(Total Assets)
= 1577.88/40883.93 = 0.03
v. Gross Profit Ratio = (Gross Profit )/(Net Sales) = 50550.61/
34984.70= 1.44

Case study 10
n o t e s
vi. Net Profit Ratio = (Net Profit after Tax )/(Net Sales) =
8990.62/34984.70 = 0.25
vii. Return on Assets = (Net Income)/(Total Assets) =
8891.38/40883.93 = 0.21
viii. Working Capital Turnover Ratio = (Net Sales)/(Average
Working Capital) = 34984.70/10695 = 3.27
(Working capital = Current Assets-Current Liabilities)
questions
1. Suppose you are one of the investors interested in

knowing ITC Limited’s performance. Using the above
ratios, analyse the financial status of ITC Limited.
S
(Hint: assess the liquidity, profitability and activity status
of ITC on the basis of its ratio against the ideal ratios and
give your analysis.)
IM
2. Has the financial position of ITC Limited improved
compared to its 2013 results?
(Hint: calculate the given ratios for year 2013 using the
data on the balance sheet and P&L account of ITC,
compare against 2014 results to give your analysis.)
M
N

Case study 11
n o t e s
COMMON SIZE ANALYSIS FOR INTERPRETING

NOTION GRAPHICS LTD.
This Case Study discusses the common size analysis for interpreting
Notion Graphics Ltd.’s financial position for investment purposes
by a group of venture capitalists. It is with respect to Chapter-11 of
the book.
Notion Graphics Ltd. is a graphics, multimedia solution and An-

imation company. The company has about 3000 employees. No-
tion Graphics Ltd. provides other organisations with enterprise
as well as open-source multimedia solution. The organisation has
created numerous animated features and has about 3000 employ-
ees. The income statement of the company for the year ended 31st
S
March, 2014 is as follows:
Income statement for the year ended 31st March, 2014 (Amount
in lakh of `)
IM
Particulars 2013 2014
Gross sales 370 480
Less: Returns 20 30
Net Sales 350 450
M
Less: Cost of Goods Sold 190 215

Gross Profit 160 235
Less: Selling and Administrative Costs 50 72
Operating Profit 110 163
N
Less: Interest and Expenses 20 17

Earnings before Taxes 90 146
Less: Taxes 31.5 51.5
Earnings after Taxes 58.5 94.5
A group of venture capitalists were interested to know the finan-

cial position of Notion Graphics Ltd. for investing their finances
in the organisation. They converted the income statement of the
company into a common size income statement. The common
size income statement of Notion Graphics was as follows:

Case study 11
n o t e s
Common Size Income statement for the year ended 31st March,
2014 (Percentages)
Particulars 2013 2014

Net Sales 100.0 100
Cost of Goods Sold 54.3 47.8
Gross Profit 45.7 52.2
Selling and Administrative Costs 14.3 16.0
Operating Profit 31.4 36.2
Interest 5.7 3.8
Earnings before Taxes 25.7 32.4
Taxes 9.0 11.4
S
Earnings after Taxes (EAT) 16.7 21.0
The venture capitalists arrived at the following conclusions from

the common size analysis of Notion Graphics’ Income Statement:
IM
The EAT of 2014 has increased to 21 per cent from 16.7 per cent
in 2013. This improvement in profitability is owing to the de-
crease of 6.5 per cent in the COGS, which reflects the improve-
ment in animation efficiency of Notion Graphics Limited.
There is a decrease in the financial overheads (Interest) by 1.9
per cent in 2014 which can be traced back to the repayment of
M
a part of long-term borrowings.

Further analysis of the common size income statement shows
that profitability would have been more, but the increase in
operating expenses (Selling and Administrative costs) of 1.7
N
per cent in 2014 has reduced the profits.
questions
1. According to you, should the venture capitalists invest

their money in Notion Graphics Ltd.? Explain and provide
reasons.
(Hint: EAT of 2014 has increased to 21 per cent from 16.7
per cent in 2013, decrease in the financial overheads by
1.9 per cent suggests a favourable picture for investors.)
2. What could be the limitations of using common size
analysis of financial statements for assessing a company’s
financial health?
(Hint: The relation between the components of different
financial statements cannot be compared, income statement
and balance sheets are analysed independently of each
other, inter-period comparison could be misleading, etc.)

Case study 12
n o t e s
Management Discussion and Analysis at Marico India
This Case Study discusses the Management Discussion and Anal-

ysis at Marico India in their annual report for the financial year
2016-17. It is with respect to Chapter 11 of the book.
Marico was found in 1988 and it is one of the leading FMCG brand
in India. It is registered in Mumbai and as of now it is the 7th larg-
est FMCG Company with a customer base of around 130 million.
Marico has very effective distribution channel with over 2.5 mil-
lion outlets in India and overseas. Its PE ratio was 52.15 against
the industry PE ratio of 56.5. With a total debt of `108 crore, it has
a Debt-to-Equity ratio of just 0.1 and this makes a Marico almost a
debt free company. As per the current shareholding pattern of the
S
company includes 59.7 % in promoter’s holdings and 7% non-in-
stitutional public holding while Foreign Institutional Investors
(FIIs) and (Direct Institutional Investors) DIIs have 29% holding.
IM
Analyse the below data regarding Marico’s Standalone perfor-
mance in stock market as of November 2017:
Particulars Amount/ Particulars Amount/ Per-

Percentage centage
Market Cap ` 39,658.95 Eps (Travelling 6.10 times
crore Twelve Months -
M
TTTM)
Price To Earn- 50.37 times Put-Call Ratio 45.46 times
ings Ratio (PE
Ratio)
N
Book Value ` 22.66 Price - Book 13.56 times

Ratio
Dividend 350% Dividend Yield 1.14 %
Market Lot 1 Face Value `1
Industry P/E 60.40% Deliverables 50.73 %
Ratio
Marico has significant market share in many products such as,

coconut oil, hair oil, wash hair care, anti-lice treatment, edible oil,
fabric care, etc. Marico has established many brands like, Para-
chute, Safola, Revive, Startz, Medicare, Hair & Care, Livon, Set
Wet, Zatak, Fiancee, etc. under its consumer products segment.
Given below are some key highlights of Management Discussion

and Analysis report released under Marico India’s annual report
for FY 2016-17:
Totalrevenue from operations in Marico was ` 5935.9 crore,
as compared to `6024.5 it is decreased by 1%. While other in-

Case study 12
n o t e s
comes were measured to `97.3 crore against them 3 in the fi-

nancial year 2016.
Volume has grown by 4% and operating margin was at 19.5%.
In the last five years, the profit after tax (at compounded an-
nual growth rate) has increased with 18%.
To expand its distribution system capacity, Marico has added
86000 outlets in the last three years.
In international business operations, Bangladesh and South-
East Asia are the largest contributor for with a share of 44%
and 28% respectively. While Middle East and North Africa
(MENA) and, South Africa contributes 13% and 7% respec-
tively.
S
To provide maximum return to shareholders, the company
has increased its dividend pay-out to 350% in 2017 as com-
pared to 337% in 2016.
IM
Total expenses have risen by 4% to 863.9 crore from 829.3 in
the last year.
Group Company’s Debt to Equity, ratio (DE Ratio) was signifi-
cantly decreased from 0.2% in 2016 to 0.13% in 2017.
Some other key comparison highlights of Marico’s Annual state-

M
ments are mentioned in the table given below.
Particular Amount for Percent- Amount Percent-

2017 (`) age of for 2016 age of
revenue (`) revenue
N
Revenue from 5935.96 crore 6024.5

operations crore
Cost of Materials 2,849.1 crore 48% 3119 51%
Employees Cost 404.2 6.8% 373.4 6.2
Advertisements
and Sales Pro-
motion 659.5 11.1 692.7 11.5
Other Expendi- 863.9 14.6 829.3 19.5
ture 1159.3 19.5 1051.4 17.5
PBIDT margins
Depreciation, 90.3 1.5 94.9 1.6
Amortisation 16.6 0.3 20.6 0.3
and Impairment
337.75 5.7 305.4 5.1
Finance Charges
Tax
Profit After Tax 798.6 13.5 711.5 11.8

Case study 12: Management Discussion and Analysis at Marico India 379
Case study 12
n o t e s
questions
1. Marico’s Debts are decreasing at a very fast pace. Do you

think that debt is a bad and costly source of finance? Why
and Why not?
(Hint: Consider all the pros and cons of debt financing
such as, tax shield or tax rebate, opportunity cost of
owners money, healthy debt equity ratio, collateral, cost
of interest, limited cash flow, etc.)
2. Suppose you are the Finance Manager of Marico at the
time of GST implementation, then how would you take a
decision to minimise any risk?
(Hint: Examine the principle of ‘Completeness and
S
Materiality’ in Management Discussion and Analysis. So
first of all you need to have complete and fair information
about the issue. Then analyse that whether the effect is
positive, negative or no effect).
IM
M
N

N
M
IM
S

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Financial Accounting & Analysis

TOC Reviewer Content Reviewer

Author : Dr. Ajay Kumar Chauhan

Reviewed By: Mr. Ashok Bhansali & Ms. Purva Shah

NMIMS Global Access - School for Continuing Education

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Introduction to Financial Accounting 1

3 Trial Balance to Final Accounts 69

5 Accounting Standards II 127

7 Corporate Accounts 177

8 Cash Flow Statement 213

9 Financial Statement Analysis I 245

10 Financial Statement Analysis II 273

11 Financial Statement Analysis III 315

12 Case Studies 347

NMIMS Global Access - School for Continuing Education

Accounting Standards II: Implementation of Accounting Standards, Financial Statements

Generally Accepted Accounting Principles (GAAP): Generally accepted Accounting Principles,

Corporate Accounts: Schedule III of the Companies Act, 2013

NMIMS Global Access - School for Continuing Education

Introduction to Financial Accounting

1.4 Basic Accounting Concepts

1.4.4 Double Entry Accounting System

NMIMS Global Access - School for Continuing Education

FINANCIAL POSITION OF LAXMI DAS Ltd

Mehra Associates, a firm of Chartered Accountants, audited the

The financial statements were biased and do not provide a full

NMIMS Global Access - School for Continuing Education

After studying this chapter, you will be able to:

Accounting can be defined as the practice of recording financial trans-

taining to an organisation for tax collection and oversight entities.

The concept of accounting is very essential for managers as it can

in order to understand costs, revenue and profit. The concept of ac-

There are three major branches of accounting viz. financial account-

Financial Accounting is that branch of accounting that involves re-

NMIMS Global Access - School for Continuing Education

mation generated by financial accounting is usually aimed at internal

The same financial accounting information can be of use to different

limitations of financial accounting have been explained in the chapter.

NATURE AND SCOPE OF FINANCIAL

According to the American Accounting Association (AAA), Account-

Financial accounting is the field of accounting involving the prepara-

NMIMS Global Access - School for Continuing Education

Financial Accounting as a Service Activity

Financial Accounting as a Profession

Financial Accounting as Language of Business

Financial Accounting as Science and Art

Let us discuss these aspects in detail in the following section:

portant service activity of any organisation because it supports

 Financial accounting as a profession: As a profession financial

NMIMS Global Access - School for Continuing Education

 Financial accounting as science and art: Financial accounting fol-

Figure1.2: Financial Accounting as an Information System

Figure 1.2 depicts the role of financial accounting as an information

users such as government, suppliers, researchers, investors, manag-

Some of the major objectives of financial accounting as information

NMIMS Global Access - School for Continuing Education

Some of the major objectives of accounting are as follows:

 To identify the financial position of a business: By analysing

fy and measure accounting and economic information and this in-

self assessment Questions

1. The expression, exhibition and presentation of accounting

NMIMS Global Access - School for Continuing Education

Financial accounting as a profession: As a profession financial

Financial accounting as science and art: Financial accounting fol-

To identify the financial position of a business: By analysing