KMB103 Financial Accounting
So it is said the accounting is ‘a means to
for Managers
UNIT 1
Scope and Nature of Accounting
Nature of Accounting
We know Accounting is the systematic recording of financial
transactions and presentation of the related information of the
appropriate persons. The basic features of accounting are as follows:
1. Accounting is a process: A process refers to the method of
performing any specific job step by step according to the objectives, or
target. Accounting is identified as a process as it performs the specific
task of collecting, processing and communicating financial
information. In doing so, it follows some definite steps like collection
of data recording, classification summarization, finalization and
reporting.
2. Accounting is an art: Accounting is an art of recording, classifying,
summarizing and finalizing the financial data. The word ‘art’ refers to
the way of performing something. It is a behavioral knowledge
involving certain creativity and skill that may help us to attain some
specific objectives. Accounting is a systematic method consisting of
definite techniques and its proper application requires applied skill and
expertise. So, by nature accounting is an art.
3. Accounting is means and not an end: Accounting finds out the
financial results and position of an entity and the same time, it
communicates this information to its users. The users then take their
own decisions on the basis of such information. So, it can be said that
mere keeping of accounts can be the primary objective of any person or
entity. On the other hand, the main objective may be identified as
taking decisions on the basis of financial information supplied by
accounting. Thus, accounting itself is not an objective, it helps
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attaining a specific objective.
an end’ and it is not ‘an end in itself.’
4. Accounting deals with financial information and
transactions; Accounting records the financial transactions and date
after classifying the same and finalizes their result for a definite period
for conveying them to their users. So, from starting to the end, at every
stage, accounting deals with financial information. Only financial
information is its subject matter. It does not deal with non-monetary
information of non-financial aspect.
5. Accounting is an information system: Accounting is recognized
and characterized as a storehouse of information. As a service function,
it collects processes and communicates financial information of any
entity. This discipline of knowledge has been evolved out to meet the
need of financial information required by different interested groups.
Scope of Accounting
Accounting has got a very wide scope and area of application. Its use is
not confined to the business world alone, but spread over in all the
spheres of the society and in all professions. Now-a-days, in any social
institution or professional activity, whether that is profit earning or not,
financial transactions must take place. So there arises the need for
recording and summarizing these transactions when they occur and the
necessity of finding out the net result of the same after the expiry of a
certain fixed period. Besides, the is also the need for interpretation and
communication of those information to the appropriate persons. Only
accounting use can help overcome these problems.
In the modern world, accounting system is practiced no only in all the
business institutions but also in many non-trading institutions like
Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative
Society etc.and also Government and Local Self-Government in the
form of Municipality, Panchayat.
The professional persons like Medical practitioners, practicing
Lawyers, Chartered Accountants etc.also adopt some suitable types of
accounting methods. As a matter of fact, accounting methods are used
 by all who are involved in a series of financial transactions.
The scope of accounting as it was in earlier days has undergone lots of
changes in recent times. As accounting is a dynamic subject, its scope
and area of operation have been always increasing keeping pace with
the changes in socio-economic changes. As a result of continuous 4.
research in this field the new areas of application of accounting
principles and policies are emerged. National accounting, human
resources accounting and social Accounting are examples of the new
areas of application of accounting systems.
Objectives and Nature
of Accounting
Objectives of Accounting
The following are the main objectives of accounting
1. To maintain full and systematic records of business transactions
1. Accounting is a process: A process refers to the method of performing any
Accounting is the language of business transactions. Given the
limitations of human memory, the main objective of accounting is to
maintain ‘a full and systematic record of all business transactions.
2. To ascertain profit or loss of the business
2. Accounting is an art: Accounting is an art of recording, classifying,
Business is run to earn profits. Whether the business earned profit or
incurred loss is ascertained by accounting by preparing Profit & Loss
Account or Income Statement. A comparison of income and
expenditure gives either profit or loss.
3. To depict financial position of the business
3. Accounting is means and not an end: Accounting finds out the financial
A businessman is also interested in ascertaining his financial position
at the end of a given period. For this purpose, a position statement
called Balance Sheet is prepared in which assets and liabilities are
shown.
Just as a doctor will feel the pulse of his patient and know whether he
is enjoying good health or not, in the same way by looking at the
Balance Sheet one will know the financial health of an enterprise. If the
assets exceed liabilities, it is financially healthy, i.e., solvent. In the
other case, it would be insolvent, i.e., financially weak.
To provide accounting information to the interested parties
Apart from owner of the business enterprise, there are various parties
who are interested in accounting information. These are bankers,
creditors, tax authorities, prospective investors, researchers, etc. Hence,
one of the objectives of accounting is to make the accounting
information available to these interested parties to enable them to take
sound and realistic decisions. The accounting information is made
available to them in the form of annual report.
Nature of Accounting
We know Accounting is the systematic recording of financial
transactions and presentation of the related information of the
appropriate persons. The basic features of accounting are as follows:
specific job step by step according to the objectives, or target. Accounting is
identified as a process as it performs the specific task of collecting,
processing and communicating financial information. In doing so, it follows
some definite steps like collection of data recording, classification
summarization, finalization and reporting.
summarizing and finalizing the financial data. The word ‘art’ refers to the
way of performing something. It is a behavioral knowledge involving certain
creativity and skill that may help us to attain some specific objectives.
Accounting is a systematic method consisting of definite techniques and its
proper application requires applied skill and expertise. So, by nature
accounting is an art.
results and position of an entity and the same time, it communicates this
information to its users. The users then take their own decisions on the basis
of such information. So, it can be said that mere keeping of accounts can be
the primary objective of any person or entity. On the other hand, the main
objective may be identified as taking decisions on the basis of financial
information supplied by accounting. Thus, accounting itself is not an
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 objective, it helps attaining a specific objective. So it is said the accounting is 8 Users of Accounting
‘a means to an end’ and it is not ‘an end in itself.’
4. Accounting deals with financial information and transactions; Accounting1. Owners:
records the financial transactions and date after classifying the same and
finalizes their result for a definite period for conveying them to their users. The primary objective of accounting is to provide necessary
So, from starting to the end, at every stage, accounting deals with financial information to the owners relating to their business. For example, the
information. Only financial information is its subject matter. It does not deal shareholders of a company are interested in the accounting information
with non-monetary information of non-financial aspect. with a view to ascertaining the profitability and financial strength of
5. Accounting is an information system: Accounting is recognized and the company.
characterized as a storehouse of information. As a service function, it
collects processes and communicates financial information of any entity.
2. Management:
This discipline of knowledge has been evolved out to meet the need of
financial information required by different interested groups.
In large business organizations there is a separation of the ownership
and management functions. The managements of such concerns are
Users of Accounting more concerned with the accounting information because of their
accountability to the owners for better performance of their concerns.
Internal users of Accounting information
3. Creditors:
Internal users are that individual who runs, manages and operates the
daily activities of the inside area of an organization. Trade creditors, debenture holders, bankers, and other lending
institutions are interested in knowing the short-term as well as long-
1. Owners and Stockholders. term position of the company. The financial statements provide the
2. Directors, required information for ascertaining such position.
3. Managers,
4. Officers 4. Regulatory Agencies:
5. Internal Departments.
6. Employees Various governments and other agencies use accounting reports not
7. Internal Auditor. only as a basis for tax assessment but also in evaluating how well
various business concerns are operating under regulatory framework.
External users of accounting information are:
5. Government:
 Creditors
 Invstors Governments all over the world are using financial statements for
 Government compiling statistics concerning business units, which, in turn help in
 Trading partners. compiling national accounts.
 Regulatory agencies.
 International standardization agencies. 6. Potential Investors:


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 Investors use the information in accounting reports to a greater extent
in order to determine the relative merits of various investment
opportunities.
7. Employees:
Employees are interested in the earnings of the enterprise because their
pay hike and payment of bonus depend on the size of profits earned.
8. Researchers:
The research scholars in their research in accounting theory as well as
business affairs and practices also use accounting data. In addition,
those with indirect concern about business enterprise include financial
analysts and advisors, financial press and reporting, trade associations,
labour unions, consumers, and public at large. Thus, the list of actual
and potential users of accounting information is large.
Book Keeping and Accounting
Book Keeping
Bookkeeping is the recording of financial transactions, and is part of
the process of accounting in business. Transactions include purchases,
sales, receipts, and payments by an individual person or an
organization/corporation. There are several standard methods of
bookkeeping, including the single-entry and double-entry bookkeeping
systems. While these may be viewed as “real” bookkeeping, any
process for recording financial transactions is a bookkeeping process.
Bookkeeping is the work of a bookkeeper (or book-keeper), who
records the day-to-day financial transactions of a business. They
usually write the daybooks (which contain records of sales, purchases,
receipts, and payments), and document each financial transaction,
whether cash or credit, into the correct daybook—that is, petty cash
book, suppliers ledger, customer ledger, etc.—and the general ledger.
Thereafter, an accountant can create financial reports from the
information recorded by the bookkeeper.
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Bookkeeping refers mainly to the record-keeping aspects of financial
accounting, and involves preparing source documents for all
transactions, operations, and other events of a business.
The bookkeeper brings the books to the trial balance stage: an
accountant may prepare the income statement and balance sheet using
the trial balance and ledgers prepared by the bookkeeper.
Book Keeping and Accounting
Recording of financial transactions in a proper manner related to the
business operation of an entity is known as bookkeeping. Bookkeeping
is the permanent recording of financial transactions in a proper manner
in the books of accounts of an entity so that their financial effect on the
business of entity can be seen. There is a difference between the two
terms bookkeeping and accounting.
Book-keeping and accounting are different from each other.
Bookkeeping is an important part of accounting. Accounting is broader
than book-keeping. Accounting includes a design of accounting
systems which book-keepers use for the preparation of financial
statements, audits, cost studies, income-tax statements, etc.
It also facilitates the interpretation of accounting information for both
internal and external users for business decisions making. It requires
skills and experience of an accountant.
There is a difference between the two terms bookkeeping and
accounting, let us understand what is bookkeeping and accounting,
their processes and difference between the two.
While doing Bookkeeping, we need to follow the basic accounting
concepts and accounting conventions.
Bookkeeping is clerical in nature. Book-keeping is usually done by
junior employees of the entity. Most of the entities nowadays use
computers for bookkeeping rather than recording them manually.
Accounting of an entity depends on its book-keeping system.
 Book-keeping is the basis for accounting. It is because it is responsible This accounting principle assumes that it is possible to report the
for the proper recording of financial transactions. Whereas, Accounting complex and ongoing activities of a business in relatively short, distinct
involves classification, summarizing and reporting of financial time intervals such as the five months ended May 31, 2018, or the 5
transactions. It involves the preparation of source documents for all the weeks ended May 1, 2018. The shorter the time interval, the more
financial transactions of the entity. likely the need for the accountant to estimate amounts relevant to that
period. For example, the property tax bill is received on December 15
Process of Bookkeeping of each year. On the income statement for the year ended December
31, 2017, the amount is known; but for the income statement for the
1. Identifying financial transactions three months ended March 31, 2018, the amount was not known and an
2. Recording of financial transactions estimate had to be used.
3. Preparation of ledger accounts
4. Preparation of trial balance It is imperative that the time interval (or period of time) be shown in
the heading of each income statement, statement of stockholders’

Accounting Principles equity, and statement of cash flows. Labeling one of these financial
statements with “December 31” is not good enough–the reader needs to
know if the statement covers the one week ended December 31, 2018
The following is a list of the ten main accounting principles and the month ended December 31, 2018 the three months ended December
guidelines together with a highly condensed explanation of each. 31, 2018 or the year ended December 31, 2018.
1. Economic Entity Assumption
4. Cost Principle

The accountant keeps all of the business transactions of a sole
proprietorship separate from the business owner’s personal
transactions. For legal purposes, a sole proprietorship and its owner are
considered to be one entity, but for accounting purposes they are
considered to be two separate entities.
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only transactions
that can be expressed in U.S. dollars are recorded.
Because of this basic accounting principle, it is assumed that the
dollar’s purchasing power has not changed over time. As a result
accountants ignore the effect of inflation on recorded amounts. For
example, dollars from a 1960 transaction are combined (or shown) with
dollars from a 2018 transaction.
3. Time Period Assumption
5.
From an accountant’s point of view, the term “cost” refers to the
amount spent (cash or the cash equivalent) when an item was originally
obtained, whether that purchase happened last year or thirty years ago.
For this reason, the amounts shown on financial statements are referred
to as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted
upward for inflation. In fact, as a general rule, asset amounts are not
adjusted to reflect any type of increase in value. Hence, an asset
amount does not reflect the amount of money a company would receive
if it were to sell the asset at today’s market value. (An exception is
certain investments in stocks and bonds that are actively traded on a
stock exchange.) If you want to know the current value of a company’s
long-term assets, you will not get this information from a company’s
financial statements–you need to look elsewhere, perhaps to a third-
party appraiser.
Full Disclosure Principle

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 If certain information is important to an investor or lender using the expense in 2018 and the amount unpaid at December 31, 2018 as a
financial statements, that information should be disclosed within the liability. (The expense is occurring as the sales are occurring.)
statement or in the notes to the statement. It is because of this basic
accounting principle that numerous pages of “footnotes” are often Because we cannot measure the future economic benefit of things such
attached to financial statements. as advertisements (and thereby we cannot match the ad expense with
related future revenues), the accountant charges the ad amount to
As an example, let’s say a company is named in a lawsuit that demands expense in the period that the ad is run.
a significant amount of money. When the financial statements are
prepared it is not clear whether the company will be able to defend 8. Revenue Recognition Principle
itself or whether it might lose the lawsuit. As a result of these
conditions and because of the full disclosure principle the lawsuit will Under the accrual basis of accounting (as opposed to the cash basis of
be described in the notes to the financial statements. accounting), revenues are recognized as soon as a product has been
sold or a service has been performed, regardless of when the money is
A company usually lists its significant accounting policies as the first actually received. Under this basic accounting principle, a company
note to its financial statements. could earn and report $20,000 of revenue in its first month of operation
but receive $0 in actual cash in that month.
6. Going Concern Principle
For example, if ABC Consulting completes its service at an agreed
This accounting principle assumes that a company will continue to price of $1,000, ABC should recognize $1,000 of revenue as soon as its
exist long enough to carry out its objectives and commitments and will work is done—it does not matter whether the client pays the $1,000
not liquidate in the foreseeable future. If the company’s financial immediately or in 30 days. Do not confuse revenue with a cash receipt.
situation is such that the accountant believes the company will not be
able to continue on, the accountant is required to disclose this 9. Materiality
assessment.
Because of this basic accounting principle or guideline, an accountant
The going concern principle allows the company to defer some of its might be allowed to violate another accounting principle if an amount
prepaid expenses until future accounting periods. is insignificant. Professional judgement is needed to decide whether an
amount is insignificant or immaterial.
7. Matching Principle
An example of an obviously immaterial item is the purchase of a $150
This accounting principle requires companies to use the accrual basis printer by a highly profitable multi-million dollar company. Because
of accounting. The matching principle requires that expenses be the printer will be used for five years, the matching principle directs the
matched with revenues. For example, sales commissions expense accountant to expense the cost over the five-year period. The
should be reported in the period when the sales were made (and not materiality guideline allows this company to violate the matching
reported in the period when the commissions were paid). Wages to principle and to expense the entire cost of $150 in the year it is
employees are reported as an expense in the week when the employees purchased. The justification is that no one would consider it misleading
worked and not in the week when the employees are paid. If a if $150 is expensed in the first year instead of $30 being expensed in
company agrees to give its employees 1% of its 2018 revenues as a each of the five years that it is used.
bonus on January 15, 2019, the company should report the bonus as an

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 Because of materiality, financial statements usually show amounts
rounded to the nearest dollar, to the nearest thousand, or to the nearest
million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for
reporting an item, conservatism directs the accountant to choose the
alternative that will result in less net income and/or less asset amount.
Conservatism helps the accountant to “break a tie.” It does not direct
accountants to be conservative. Accountants are expected to be
unbiased and objective.
The basic accounting principle of conservatism leads accountants to
anticipate or disclose losses, but it does not allow a similar action for
gains. For example, potential losses from lawsuits will be reported on
the financial statements or in the notes, but potential gains will not be
reported. Also, an accountant may write inventory down to an amount
that is lower than the original cost, but will not write inventory up to an
amount higher than the original cost.
Basic Accounting Terminologies
1. Accounts receivable (AR)
Accounts receivable (AR) definition: The amount of money owed by
customers or clients to a business after goods or services have been
delivered and/or used.
2. Accounting (ACCG)
Accounting (ACCG) definition: A systematic way of recording and
reporting financial transactions for a business or organization.
3. Accounts payable (AP)
Accounts payable (AP) definition: The amount of money a company
owes creditors (suppliers, etc.) in return for goods and/or services they
have delivered.
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4. Assets (fixed and current) (FA, CA)
Assets (fixed and current) definition: Current assets (CA) are those
that will be converted to cash within one year. Typically, this could be
cash, inventory or accounts receivable. Fixed assets (FA) are long-
term and will likely provide benefits to a company for more than one
year, such as a real estate, land or major machinery.
5. Asset classes
Asset class definition: An asset class is a group of securities that
behaves similarly in the marketplace. The three main asset classes are
equities or stocks, fixed income or bonds, and cash equivalents or
money market instruments.
6. Balance sheet (BS)
Balance sheet (BS) definition: A financial report that summarizes a
company’s assets (what it owns), liabilities (what it owes) and owner
or shareholder equity ;at a given time.
7. Capital (CAP)
Capital (CAP) definition: A financial asset or the value of a financial
asset, such as cash or goods. Working capital is calculated by taking
your current assets subtracted from current liabilities—basically the
money or assets an organization can put to work.
8. Cash flow (CF)
Cash flow (CF) definition: The revenue or expense expected to be
generated through business activities (sales, manufacturing, etc.) over a
period of time.
9. Certified public accountant (CPA)
Certified public accountant (CPA) definition: A designation given
to an accountant who has passed a standardized CPA exam and met
government-mandated work experience and educational requirements
to become a CPA.
 10. Cost of goods sold (COGS)
Cost of goods sold (COGS) definition: The direct expenses related to
producing the goods sold by a business. The formula for calculating 
this will depend on what is being produced, but as an example this may
include the cost of the raw materials (parts) and the amount of
employee labor used in production.
11. Credit (CR)
Credit (CR) definition: An accounting entry that may
either decrease assets or increase liabilities and equity on the
company’s balance sheet, depending on the transaction. When using
the double-entry accounting method there will be two recorded
entries for every transaction: A credit and a debit.
12. Debit (DR)
Debit (DR) definition: An accounting entry where there is either
an increase in assets or a decrease in liabilities on a company’s balance
sheet.
13. Diversification
Diversification definition: The process of allocating or spreading
capital investments into varied assets to avoid over-exposure to risk.
14. Enrolled agent (EA)
Enrolled agent (EA) definition: A tax professional who represents
taxpayers in matters where they are dealing with the Internal Revenue
Service (IRS).
15. Expenses (fixed, variable, accrued, operation) (FE, VE, AE, OE)
Expenses (FE, VE, AE, OE) definition: The fixed, variable, accrued
or day-to-day costs that a business may incur through its operations.
 Fixed expenses (FE): payments like rent that will happen in a regularly
scheduled cadence.
 Variable expenses (VE): expenses, like labor costs, that may change in a
given time period.
Accrued expense (AE): an incurred expense that hasn’t been paid yet.
Operation expenses (OE): business expenditures not directly associated with
the production of goods or services—for example, advertising costs,
property taxes or insurance expenditures.
16. Equity and owner’s equity (OE)
Equity and owner’s equity (OE) definition: In the most general
sense, equity is assets minus liabilities. An owner’s equity is typically
explained in terms of the percentage of stock a person has ownership
interest in the company. The owners of the stock are known as
shareholders.
17. Insolvency
Insolvency definition: A state where an individual or organization can
no longer meet financial obligations with lender(s) when their debts
come due.
18. Generally accepted accounting principles (GAAP)
Generally accepted accounting principles (GAAP) definition: A set
of rules and guidelines developed by the accounting industry for
companies to follow when reporting financial data. Following these
rules is especially critical for all publicly traded companies.
19. General ledger (GL)
General ledger (GL) definition: A complete record of the financial
transactions over the life of a company.
20. Trial balance
Trial balance definition: A business document in which all ledgers
are compiled into debit and credit columns in order to ensure a
company’s bookkeeping system is mathematically correct.
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21. Liabilities (current and long-term) (CL, LTL)
Liabilities (current and long-term) definition: A company’s debts or
financial obligations incurred during business operations. Current
liabilities (CL) are those debts that are payable within a year, such as a
debt to suppliers. Long-term liabilities (LTL) are typically payable
over a period of time greater than one year. An example of a long-term
liability would be a multi-year mortgage for office space.
22. Limited liability company (LLC)
Limited liability company (LLC) definition: An LLC is a corporate
structure where members cannot be held accountable for the
company’s debts or liabilities. This can shield business owners from
losing their entire life savings if, for example, someone were to sue the
company.
23. Net income (NI)
Net income (NI) definition: A company’s total earnings, also called
net profit. Net income is calculated by subtracting total expenses from
total revenues.
24. Present value (PV)
Present value (PV) definition: The current value of a future sum of
money based on a specific rate of return. Present value helps us
understand how receiving $100 now is worth more than receiving $100
a year from now, as money in hand now has the ability to be invested
at a higher rate of return.
25. Profit and loss statement (P&L)
Profit and loss statement (P&L) definition: A financial statement
that is used to summarize a company’s performance and financial
position by reviewing revenues, costs and expenses during a specific
period of time, such as quarterly or annually.
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26. Return on investment (ROI)
Return on investment (ROI) definition: A measure used to evaluate
the financial performance relative to the amount of money that was
invested. The ROI is calculated by dividing the net profit by the cost of
the investment. The result is often expressed as a percentage.
27. Individual retirement account (IRA, Roth IRA)
Individual retirement account (IRA) definition: IRAs are savings
vehicles for retirement. A traditional IRA allows individuals to direct
pre-tax dollars toward investments that can grow tax-deferred, meaning
no capital gains or dividend income is taxed until it is withdrawn, and,
in most cases, it’s tax deductible. Roth IRAs are not tax-deductible;
however, eligible distributions are tax-free, so as the money grows, it is
not subject to taxes upon with-drawls.
28. 401K & Roth 401K
401k & Roth 401k definition: A 401K is a savings vehicle that allows
an employee to defer some of their compensation into an investment-
based retirement account. The deferred money is usually not subject to
tax until it is withdrawn; however, an employee with a Roth 401K can
make contributions after taxes. Additionally, some employers chose to
match the contributions made by their employees up to a certain
percentage.
29. Subchapter S corporation (S-CORP)
Subchapter S corporation (S-CORP) definition: A form of
corporation (that meets specific IRS requirements) and has the benefit
of being taxed as a partnership versus being subject to the “double
taxation” of dividends with public companies.
30. Bonds and coupons (B&C)
Bonds and coupons (B&C) definition: A bond is a form of debt
investment and is considered a fixed income security. An investor,
whether an individual, company, municipality or government, loans
money to an entity with the promise of receiving their money back plus
interest. The “coupon” is the annual interest rate paid on a bond.
 Accounting Equation
The accounting equation is a basic principle of accounting and a
fundamental element of the balance sheet. The equation is as follows:
Total Assets = Current Assets + Non-Current Assets
Total Liabilities = Current Liabilities + Non-Current Liabilities
Total Shareholders’ Equity = Share Capital + Retained Earning
Assets = Liabilities + Shareholder’s Equity
This equation sets the foundation of double-entry accounting and
highlights the structure of the balance sheet. Double-entry accounting
is a system where every transaction affects both sides of the accounting
equation. For every change to an asset account, there must be an equal
change to a related liability or shareholder’s equity account. It is
important to keep the accounting equation in mind when
performing journal entries.
The balance sheet is broken down into three major sections and its
various underlying items: Assets, Liabilities, and Shareholder’s Equity.
Below are some examples of items that fall under each section:
 Assets: Cash, Accounts Receivable, Inventory, Equipment
 Liabilities: Accounts Payable, Short-term borrowings, Long-term Debt
 Shareholder’s Equity: Share Capital, Retained Earnings
The accounting equation shows the relationship between these items.
Rearranging the Accounting Equation
The accounting equation can also be rearranged into the following
form:
Shareholder’s Equity = Assets – Liabilities
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In this form, it is easier to highlight the relationship between
shareholder’s equity and debt (liabilities). As you can see,
shareholder’s equity is the remainder after liabilities has been
subtracted from assets. This is because creditors – parties that lend
money – have the first claim to a company’s assets.
For example, if a company becomes bankrupt, its assets are sold and
these funds are used to settle debts first. Only after debts are settled are
shareholders entitled to any of the company’s assets to attempt to
recover their investments.
Overview to Depreciation
(Straight Line and
Diminishing Method)
Depreciation is the systematic reduction of the recorded cost of a fixed
asset. Examples of fixed assets that can be depreciated are buildings,
furniture, and office equipment. The only exception is land, which is
not depreciated (since land is not depleted over time, with the
exception of natural resources). The reason for using depreciation is to
match a portion of the cost of a fixed asset to the revenue that it
generates; this is mandated under the matching principle, where you
record revenues with their associated expenses in the same reporting
period in order to give a complete picture of the results of a revenue-
generating transaction. The net effect of depreciation is a gradual
decline in the reported carrying amount of fixed assets on the balance
sheet.
It is very difficult to directly link a fixed asset with a revenue-
generating activity, so we do not try – instead, we incur a steady
amount of depreciation over the useful life of each fixed asset, so that
the remaining cost of the asset in the company’s records at the end of
its useful life is only its salvage value.
Inputs to Depreciation Accounting
 There are three factors to consider when you calculate depreciation,
which are:
 Useful life. This is the time period over which the company expects that the
asset will be productive. Past its useful life, it is no longer cost-effective to
continue operating the asset, so it is expected that the company will dispose
of it. Depreciation is recognized over the useful life of an asset.
 Salvage value. When a company eventually disposes of an asset, it may be
able to sell it for some reduced amount, which is the salvage value.
Depreciation is calculated based on the asset cost, less any estimated
salvage value. If salvage value is expected to be quite small, then it is
generally ignored for the purpose of calculating depreciation.
 Depreciation method. You can calculate depreciation expense using an
accelerated depreciation method, or evenly over the useful life of the asset.
The advantage of using an accelerated method is that you can recognize
more depreciation early in the life of a fixed asset, which defers some
income tax expense recognition into a later period. The advantage of using a
steady depreciation rate is the ease of calculation. Examples of accelerated
depreciation methods are the double declining balance and sum-of-the-
years digits methods. The primary method for steady depreciation is the
straight-line method. The units of production method is also available if you
want to depreciate an asset based on its actual usage level, as is commonly
done with airplane engines that have specific life spans tied to their usage
levels.
If, midway through the useful life of an asset, you expect its useful life
or the salvage value to change, you should incorporate the alteration
into the calculation of depreciation over the remaining life of the asset;
do not retrospectively change any depreciation that has already been
recorded.
Depreciation Journal Entries
When you record depreciation, it is a debit to the Depreciation Expense
account and a credit to the Accumulated Depreciation account. The
Accumulated Depreciation account is a contra account, which means
that it appears on the balance sheet as a deduction from the original
purchase price of an asset.
11
Once you dispose of an asset, you credit the Fixed Asset account in
which the asset was originally recorded, and debit the Accumulated
Depreciation account, thereby flushing the asset out of the balance
sheet. If an asset was not fully depreciated at the time of its disposal, it
will also be necessary to record a loss on the undepreciated portion.
This loss will be reduced by any proceeds from sale of the asset.
Other Depreciation Issues
Depreciation has nothing to do with the market value of a fixed asset,
which may vary considerably from the net cost of the asset at any given
time.
Depreciation is a major issue in the calculation of a company’s cash
flows, because it is included in the calculation of net income, but does
not involve any cash flow. Thus, a cash flow analysis calls for the
inclusion of net income, with an add-back for any depreciation
recognized as expense during the period.
Depreciation is not applied to intangible assets. Instead, amortization is
used to reduce the carrying amount of these assets. Amortization is
almost always calculated using the straight-line method.
Straight Line Method (SLM)
According to the Straight line method, the cost of the asset is written
off equally during its useful life. Therefore, an equal amount of
depreciation is charged every year throughout the useful life of an
asset. After the useful life of the asset, its value becomes nil or equal to
its residual value. Thus, this method is also called Fixed Installment
Method or Fixed percentage on original cost method.
When the amount of depreciation and the corresponding period are
plotted on a graph it results in a straight line. Hence, it is known as the
Straight line method (SLM).
This method is more suitable in case of leases and where the useful life
and the residual value of the asset can be calculated accurately.
However, where the repairs are low in the initial years and increase in
subsequent years, this method will increase the charge on profit.
Also, while applying this method, the period of use of the asset should
be considered. If an asset is used only for 3 months in a year then
depreciation will be charged only for 3 months. However, for the
Income Tax purposes, if an asset is used for more than 180 days full
years’ depreciation will be charged.
Formulae:
Amount of Depreciation = (Cost of Asset – Net Residual Value) /
Useful Life
The rate of Depreciation = (Annual Depreciation x 100) / Cost of Asset
Diminishing Balance Method
According to the Diminishing Balance Method, depreciation is charged
at a fixed percentage on the book value of the asset. As the book value
reduces every year, it is also known as the Reducing Balance Method
or Written-down Value Method.
Since the book value reduces every year, hence the amount of
depreciation also reduces every year. Under this method, the value of
the asset never reduces to zero.
When the amount of depreciation charged under this method and the
corresponding period are plotted on a graph it results in a line moving
downwards.
This method is based on the assumption that in the earlier years the
cost of repairs to the assets is low and hence more amount of
depreciation should be charged. Also, in the later years, the cost of
repairs will increase and therefore less amount of depreciation shall be
provided. Hence, this method results in an equal burden on the profit
every year during the life of the asset.
However, under this method, if the rate of depreciation applied is not
appropriate it may happen that at the end of the useful life of the asset
full depreciation is not provided.
12
Also, while applying this method, the period of use of the asset should
be considered. If an asset is used only for 2 months in a year then
depreciation will be charged only for 2 months.
UNIT - 2
Accounting Standards and IFRS
Meaning of Accounting Standards: In order to ensure transparency
consistency, comparability, adequacy and reliability of financial reporting, it
is essential to standardize the accounting principles and policies, Accounting
Standards provide framework and standard accounting polices so that the
financial statements of different enterprises become comparable.
Accounting Standards are selected set of accounting policies or broad
guidelines regarding the principles and methods to be chosen out of
several alternatives. The Accounting Standards Board (ASB) of
the Institute of Chartered Accountants of India (ICAI) formulas
Accounting Standards to be established by the Council of the ICAI.
Objective of Accounting Standards: Objective of Accounting
Standards is to standarize the diverse accounting policies and practices
with a view to eliminate to the extent possible the non-comparability of
financial statements and the reliability to the financial statements.
The institute of Chartered Accountants of India, recognizing the need
to harmonize the diverse accounting policies and practices, constituted
at Accounting Standard Board (ASB) on 21st April, 1977.
IFRS:
IFRS is a set of international accounting standards stating how
particular types of transactions and other events should be reported in
financial statements.
IFRS are generally principles-based standards and seek to avoid a rule-
book mentality. Application of IFRS requires exercise of judgment by
the preparer and the auditor in applying principles of accounting on the
basis of the economic substance of transactions.
IFRS are issued by the International Accounting Standards Board
(IASB).
The term IFRS comprises IFRS issued by IASB; IAS issued by IASC;
and Interpretations issued by the Standing Interpretations Committee
(SIC) and the International Financial Reporting Interpretations
Committee (IFRIC) of the IASB.
“FOR THE EFFECTIVE STUDY OF ACCOUNTING
STANDARDS AND IFRS THERE IS A STRONG NEED TO
STUDY THE LINKAGE BETWEEN THESE TWO TERMS
THAT MEANS CONVERGENCE.”
MEANING of convergence: The convergence of accounting
standards refers to the goal of establishing a single set of accounting
standards that will be used internationally, and in particular the effort
to reduce the differences between the US generally accepted
accounting principles (USGAAP) and the International financial
reporting standards (IFRS)
Convergence of Indian accounting standards with International
financial reporting standards (IFRS):
Meaning of convergence with IFRS: Convergence means to achieve
harmony with IFRSs; in precise terms convergence can be considered
“to design and maintain national accounting standards in a way that
financial statements prepared in accordance with national accounting
standards draw unreserved statement of compliance with IFRSs”, i.e.,
when the national accounting standards will comply with all the
requirements of IFRS.
13
But convergence doesn’t mean that IFRS should be adopted word by
word, e.g., replacing the term ‘true & fair’ for ‘present fairly’, in IAS
1, ‘Presentation of Financial Statements’. Such changes do not lead to
non-convergence with IFRS.
The reason behind convergence is:
As, Availability of essential financial information about a company
to its shareholders and other stakeholders in accordance with
internationally accepted financial norms is considered as an integral
and important part of good corporate governance. To ensure this and to
implement the G-20 commitment to achieve a single set of high quality
global accounting standards, the Government has taken decision to
achieve convergence of Indian accounting standards with International
financial reporting standards (IFRS) in a phased manner in accordance
with the roadmap suggested by the Government.
Convergence in Indian Scenario:
With regard to India, the Ministry of Corporate Affairs (MCA) has
committed to converge the Indian Accounting Standards with the IFRS
effective 1st April 2011. The convergence process is picking up
momentum with the credit going to the Ministry of Corporate Affairs.
The Ministry has extended its unstinted support and guidance to the
various regulatory and legal bodies that are spearheading a smooth
transition process. Laudably, the highest authorities of the Indian
Government have concluded that convergence of Indian Accounting
Standards with IFRS is very vital for the country to take a lead role in
the global foray.
Entities covered under convergence;
Keeping in view the complex nature of IFRSs and the extent of
differences between the existing ASs and the corresponding IFRSs and
the reasons therefore, the ICAI is of the view that IFRSs should be
adopted for the public interest entities from the accounting periods
beginning on or after 1st April, 2011.
Public interest entities:
With a view to determine which entities should be considered as public
interest entities for the purpose of application of IFRSs, the criteria for
Level I enterprises as laid down by the Institute of Chartered
Accountants of India and the definition of ‘small and mediumsized
company’ as per Clause 2(f) of the Companies (Accounting Standards)
Rules, 2006, as notified by the Ministry of Company Affairs (now
Ministry of Corporate Affairs) in the Official Gazette dated December
7, 2006, were considered. The ICAI is of the view that in view of the
complexity of recognition and measurement principles and the extent
of disclosures required in various IFRSs, and the fact that about four
years have elapsed since the ICAI laid down the criteria for Level I
enterprises, as far as the size is concerned, it needs a revision.
Accordingly, the ICAI is of the view that a public interest entity should
be an entity:
(i) Whose equity or debt securities are listed or are in the process of
listing on any stock exchange, whether in India or outside India; or
(ii) Which is a bank (including a cooperative bank), financial
institution, a mutual fund, or an insurance entity; or
 International Accounting Standards were replaced in 2001 by International
(iii) Whose turnover (excluding other income) exceeds rupees one
hundred crore in the immediately preceding accounting year; or  Currently, the U.S., Japan, and China are the only major capital markets
(iv) Which has public deposits and/or borrowings from banks and 
financial institutions in excess of rupees twenty five crore at any time
during the immediately preceding accounting year; or
(v) which is a holding or a subsidiary of an entity which is covered in
(i) to (iv) above.
International Accounting
Principles and Standards
International Accounting Standards (IAS) are older accounting
standards that were replaced in 2001 by International Financial
Reporting Standards (IFRS), issued by the International Accounting
14
Standards Board (IASB), an independent international standard-setting
body based in London.
Understanding International Accounting Standards (IAS)
International Accounting Standards (IAS) were the first international
accounting standards that were issued by the International Accounting
Standards Committee (IASC), formed in 1973. The goal then, as it
remains today, was to make it easier to compare businesses around the
world, increase transparency and trust in financial reporting, and foster
global trade and investment.
Globally comparable accounting standards promote transparency,
accountability, and efficiency in financial markets around the world.
This enables investors and other market participants to make informed
economic decisions about investment opportunities and risks, and
improves capital allocation. Universal standards also significantly
reduce reporting and regulatory costs, especially for companies with
international operations and subsidiaries in multiple countries.
Financial Reporting Standards (IFRS)
without an IFRS mandate
The U.S. accounting standards body has been collaborating with the
Financial Accounting Standards Board since 2002 to improve and converge
American accounting principles (GAAP) and IFRS
Moving Toward New Global Accounting Standards
There has been significant progress towards developing a single set of
high-quality global accounting standards since the IASC was replaced
by the IASB. IFRS have been adopted by the European Union, leaving
the U.S., Japan (where voluntary adoption is allowed), and China
(which says it is working towards IFRS) as the only major capital
markets without an IFRS mandate. As of 2018, 144 jurisdictions
require the use of IFRS for all or most publicly listed companies and a
further 12 jurisdictions permit its use.
Globally comparable accounting standards promote transparency,
accountability, and efficiency in financial markets around the world.
The U.S. is exploring adopting international accounting standards.
Since 2002, America’s accounting-standards body, the Financial
Accounting Standards Board (FASB) and the IASB have been
collaborating on a project to improve and converge U.S. generally
accepted accounting principles (GAAP) and IFRS. However, while the
FASB and IASB have issued norms together, the convergence process
is taking much longer than was expected—in part because of the
complexity of implementing the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
The Securities and Exchange Commission (SEC), which regulates U.S.
securities markets, has long supported high-quality global accounting
standards in principle and continues to do so. In the meantime, because
U.S. investors and companies routinely invest trillions of dollars
abroad, fully understanding the similarities and differences between
U.S. GAAP and IFRS is crucial. One conceptual difference: IFRS is
thought to be a more principles-based accounting system, while GAAP
is more rules-based.
Matching of Indian Accounting
Standards with International
Accounting Standards
The London based group namely the International Accounting
Standards Committee (IASC), responsible for developing International
Accounting Standards, was established in June, 1973.
It is presently known as International Accounting Standards Board
(IASB), The IASC comprises the professional accountancy bodies of
over 75 countries (including the Institute of Chartered Accountants of
India). Primarily, the IASC was established, in the public interest, to
formulate and publish, International Accounting Standards to be
followed in the presentation of financial statements. International
Accounting Standards were issued to promote acceptance and
15
observance of International Accounting Standards worldwide. The
members of IASC have undertaken a responsibility to support the
standards promulgated by IASC and to propagate those standards in
their respective countries.
Between 1973 and 2001, the International Accounting Standards
Committee (IASC) released International Accounting Standards.
Between 1997 and 1999, the IASC restructured their organisation,
which resulted in formation of International Accounting Standards
Board (IASB). These changes came into effect on 1st April, 2001.
Subsequently, IASB issued statements about current and future
standards; IASB publishes its Standards in a series of pronouncements
called International Financial Reporting Standards (IFRS). However,
IASB has not rejected the standards issued by the ISAC. Those
pronouncements continue to be designated as “International
Accounting Standards” (IAS).
INTERNATIONAL FINANCIAL REPORTING STANDARDS AS
GLOBAL STANDARDS
The term International Financial Reporting Standards (IFRS)
comprises IFRS issued by IASB; IAS issued by International
Accounting Standards Committee (IASC); Interpretations issued by the
Standard Interpretations Committee (SIC) and the IFRS Interpretations
Committee of the IASB. International Financial Reporting Standards
(IFRSs) are considered a “principles based” set of standards. In fact,
they establish broad rules rather than dictating specific treatments.
Every major nation is moving toward adopting them to some extent.
WHAT ARE INDIAN ACCOUNTING STANDARDS (IND AS)?
In India, the Institute of Chartered Accountants of India (ICAI) has
worked towards convergence by considering the application of IFRS in
Indian corporate environment of Indian Accounting Standards with
Global Standards. Recognising the growing need of full convergence
of Indian Accounting Standards with IFRS, ICAI constituted a Task
Force to examine various issues involved. Full convergence involves
adoption of IFRS in the same form as that issued by the IASB. While
formulating the Accounting Standards, ICAI recognises the legal and
 other conditions prevailing in India and makes deviations from the rate. On the other hand, Indian GAAP doesn’t require an exchange rate since
corresponding IFRS. For convergence of Indian Accounting Standards it’s only applicable for Indian companies.
with International Financial Reporting Standards (IFRS), the
Accounting Standard Board in consultation with the Ministry of  There are many differences between IFRS and Indian GAAP. Let’s have a look
Corporate Affairs (MCA)), has decided that there will be two separate at the chief differences between these two –
sets of Accounting Standards viz. (i) Indian Accounting Standards
converged with the IFRS – standards which are being converged by Basis for
eliminating the differences of the Indian Accounting Standards vis-à- comparison
vis IFRS (known as Ind AS) and (ii) Existing Notified Accounting between IFRS IFRS Indian GAAP
Standards. vs Indian
GAAP
Indian Accounting Standards (Ind AS) are IFRS converged
standards issued by the Central Government of India under the
Meaning of The Indian version of
supervision and control of Accounting Standards Board (ASB) of International Financial
ICAI and in consultation with National Advisory Committee on the Generally Accepted
Reporting Standards
Accounting Standards (NACAS). abbreviation Accounting Principles

Ind AS are named and numbered in the same way as the International Accounting Ministry of Corporate
corresponding International Financial Reporting Standards Developed by
Standards Board (IASB) Affairs (MCA)
(IFRS).
When a company is said
The most important differences between IFRS and Indian
GAAP are mentioned: A company that is complying to follow the Indian
with IFRS needs to disclose GAAP, it’s presumed that
 IFRS is a much broader accounting standard in terms of scope and Disclosure as a note that their financial it’s complying with it and
application. IFRS has been used by 110 countries already. Indian GAAP is statements comply with the showing a true & fair
quite narrow and is only applicable for the Indian IFRS. view of its financial
 For IFRS, the companies may need to prepare consolidated financial affairs.
statements if they don’t fall under the exemption of IAS-27 (Para 10). As per
Indian GAAP, a company doesn’t need to prepare consolidated statements.
 As per IFRS, the companies need to disclose as a note that they’re complying Companies in 110+ countries
Indian GAAP is only
with the IFRS. But in the case of Indian GAAP, there’s no need to a statement have adopted IFRS. More
Adopted by adopted by Indian
disclosing that the company is complying with Indian GAAP. and more countries are
companies.
 Revenue is always considered as the fair value of consideration receivable or making the shift as well.
received in the case of IFRS. As per Indian GAAP on the other hand, revenue
is considered when the companies charge for products/services and also the
How to adopt it IFRS 1 provides clear Indian GAAP doesn’t give
benefits companies receive by using their resources.
 As per IFRS, if the company isn’t using the functional currency, then the for the first instruction on how to adopt any clear instruction on
assets and liabilities of the company would be converted by the exchange time? IFRS for the first time. the first time adoption.

16
 When the financial The American Association of Accountants (AAA) defines HRA as
statements are not follows: ‘HRA is a process of identifying and measuring data about
There’s no question of human resources and communicating this information to interested
Usage of presented in the functional
using exchange rate since parties’.
currency in the currency, then the assets
Indian GAAP is only used
presentation and liabilities of the balance Flamhoitz defines HRA as ‘accounting for people as an organizational
in the Indian context.
sheet are transmuted by the resource. It involves measuring the costs incurred by organizations to
exchange rate. recruit, select, hire, train, and develop human assets. It also involves
measuring the economic value of people to the organization’.
If the companies don’t come As per the Indian GAAP,
under the exemption criteria the companies should According to Stephen Knauf, ‘ HRA is the measurement and
quantification of human organizational inputs such as recruiting,
Consolidated mentioned under IAS 27 prepare individual
training, experience and commitment’.
Financial (Para 10), the companies financial statements.
Statements need to There’s no requirement Objectives of Human Resource Accounting (HRA)
prepare consolidated of preparing consolidated
financial statements. statements. 1. Providing cost value information about acquiring, developing, allocating and
maintaining human resources.
The companies 2. Enabling management to monitor the use of human resources.
Indian companies
following IFRS needs to 3. Finding depreciation or appreciation among human resources.
What financial following Indian4. Assisting in developing effective management practices.
prepare the balance sheet GAAP needs to prepare5.
statements Increasing managerial awareness of the value of human resources.
(statement of financial the balance sheet, profit6. For better human resource planning.
need to be
position) and the income & loss account,7. For better decisions about people, based on improved information system.
prepared? and cash flow8.
statement (statement of Assisting in effective utilization of manpower.
comprehensive income). statement.
Need for Human Resource Accounting (HRA)
The money charged for The need for human asset valuation arose as a result of growing
As per IFRS, the revenue is the products/services to concern for human relations management in the industry.
the customers and the
How is revenue shown at the fair value of
rewards received by Behavioural scientists concerned with management of organizations
shown? the money received or
using the resources pointed out the following reasons for HRA:
receivable. come under revenue as
per Indian GAAP. 1. Under conventional accounting, no information is made available about the
human resources employed in an organization, and without people the

Human Resource Accounting financial and physical resources cannot be operationally effective.
2. The expenses related to the human organization are charged to current
revenue instead of being treated as investments, to be amortized over a
period of time, with the result that magnitude of net income is significantly
17
 distorted. This makes the assessment of firm and inter-firm comparison to be used in legal proceedings. Forensic accountants are trained to
difficult. look beyond the numbers and deal with the business reality of a
3. The productivity and profitability of a firm largely depends on the situation. Forensic accounting is frequently used in fraud and
contribution of human assets. Two firms having identical physical assets and embezzlement cases to explain the nature of a financial crime in court.
operating in the same market may have different returns due to differences
in human assets. If the value of human assets is ignored, the total valuation Understanding Forensic Accounting
of the firm becomes difficult.
4. If the value of human resources is not duly reported in profit and loss Forensic accountants analyze, interpret and summarize complex
account and balance sheet, the important act of management on human financial and business matters. They may be employed by insurance
assets cannot be perceived. companies, banks, police forces, government agencies or public
5. Expenses on recruitment, training, etc. are treated as expenses and written accounting firms. Forensic accountants compile financial evidence,
off against revenue under conventional accounting. All expenses on human develop computer applications to manage the information collected and
resources are to be treated as investments, since the benefits are accrued communicate their findings in the form of reports or presentations.
over a period of time.
Along with testifying in court, a forensic accountant may be asked to
Limitations of Human Resource Accounting (HRA) prepare visual aids to support trial evidence. For business
investigations, forensic accounting entails the use of tracing funds,
HRA is yet to gain momentum in India due to certain difficulties: asset identification, asset recovery and due diligence reviews. Forensic
accountants may seek out additional training in alternative dispute
1. The valuation methods have certain disadvantages as well as advantages; resolution (ADR) due to their high level of involvement in legal issues
therefore, there is always a bone of contention among the firms that which and familiarity with the judicial system.
method is an ideal one.
2. There are no standardized procedures developed so far. So, firms are TAKEAWAYS
providing only as additional information.
3. Under conventional accounting, certain standards are accepted commonly,
 Forensic accounting is a combination accounting and investigative
which is not possible under this method.
techniques used to discover financial crimes.
4. All the methods of accounting for human assets are based on certain
 One of the key functions of forensic accounting is to explain the nature of a
assumptions, which can go wrong at any time. For example, it is assumed
financial crime to the courts.
that all workers continue to work with the same organization till retirement,
 Forensic accounting is used by the insurance industry to establish damages
which is far from possible.
from claims.
5. It is believed that human resources do not suffer depreciation, and in fact
they always appreciate, which can also prove otherwise in certain firms.
Forensic Accounting for Litigation Support
6. The lifespan of human resources cannot be estimated. So, the valuation
seems to be unrealistic.
Forensic accounting is utilized in litigation when quantification of
damages is needed. Parties involved in legal disputes use the
Forensic Accounting quantifications to assist in resolving disputes via settlements or court
decisions. For example, this may arise due to compensation and benefit
Forensic accounting utilizes accounting, auditing and investigative disputes. The forensic accountant may be utilized as an expert witness
skills to conduct an examination into the finances of an individual or if the dispute escalates to a court decision.
business. Forensic accounting provides an accounting analysis suitable
18
Forensic Accounting in the Insurance Industry
Forensic accounting is routinely used by the insurance industry. In this
capacity, a forensic accountant may be asked to quantify the economic
damages arising from a vehicle accident, a case of medical malpractice
or some other claim. One of the concerns about taking a forensic
accounting approach to insurance claims as opposed to an adjuster
approach is that forensic accounting is mainly concerned with
historical data and may miss relevant current information that changes
the assumptions around the claim.
Forensic Accounting for Criminal Investigation
Forensic accounting is also used to discover whether a crime occurred
and assess the likelihood of criminal intent. Such crimes may include
employee theft, securities fraud, falsification of financial statement
information, identify theft or insurance fraud. Forensic accounting is
often brought to bear in complex and high profile financial crimes. The 1.
reason we understand the nature of Bernie Madoff’s Ponzi scheme2.
today is because forensic accountants dissected the scheme and made it 3.
understandable for the court case.
Forensic accountants may also assist in searching for hidden assets in
divorce cases or provide their services for other civil matters such as
breach of contracts, tort, disagreements relating to company
acquisitions, breaches of warranty or business valuation disputes.
Forensic accounting assignments can include investigating construction
claims, expropriations, product liability claims or trademark or patent
infringements. And, if all that wasn’t enough, forensic accounting may
also be used to determine the economic results of the breach of a
nondisclosure or noncompete agreement.
UNIT 3 Mechanics of Accounting:
Double Entry System
of Accounting
12346512 AUG 2019 1 COMMENT
19
The double entry system of accounting or bookkeeping is based on the
fact that each business transaction essentially brings two financial
changes in business. These changes are recorded as debits or credits in
two or more different accounts using certain rules known as ‘rules of
debit and credit’. In double entry system, every debit entry must have a
corresponding credit entry and every credit entry must have a
corresponding debit entry. It is the basic principle of double entry
system and there is no exception to it. For example if a business
purchases furniture for $500 cash, the value of total furniture is
increased by $500 and at the same time the cash amounting to $500 is
decreased. If the business is using double entry system of accounting, it
must debit the furniture account by $500 and credit the cash account by
$500. See the rules of debit and credit.
The double entry system of accounting can be broadly divided into the
following three stages:
Original records (journal or subdivision of journal)
Classification (ledger accounts)
Summary (final accounts)
Original records (journal and subdivision of journal): The
transactions are first recorded in a book called journal which is further
divided into various subsidiary books such as cash journal, purchases
journal and sales journal etc. The number of subsidiary books to be
maintained by a business depends on its nature and size.
Classification (ledger accounts): In the second stage, all transactions
relating to the same person or thing are collected and stored in one
statement called account. The book in which these classified accounts
are kept is known as ledger.
Summary (profit and loss account and balance sheet): After certain
periods, the ledger accounts are balanced and a statement called trial
balance is prepared which is further used for calculating profit or loss
and determining the financial position of the business.
Advantages/Merits of Double Entry system
 The major advantages of employing a double entry system of
accounting are given below:
1. Under double entry system of accounting, the two aspects of each
transaction are recorded (i.e., for every debit there must be a credit and vice
versa). It creates an equilibrium within the records which helps in detecting
errors, omissions and frauds.
2. Under this system, a trial balance can be prepared to check arithmetical
accuracy of all accounting entries. The trial balance can be further used for1.
finding out operating results by preparing income statement and
determining the financial position of the business by preparing a balance
sheet.
3. Double entry system is the most advanced and useful form of maintaining 2.
accounting records and is extensively used by companies worldwide.
Without this system, a company would not be able to compare its financial
statements with that of other companies.
4. Double entry system is highly systematic that follows certain rules and
principles so it is easy to find information about a particular transaction or3.
account quickly when needed by owners, management, accountants or
other employees.
5. Almost all accounting standards and laws in the world require the use of
double entry system of accounting. If a company fails to comply with this
requirement, the auditors will not accept the financial statements of that
company.
6. The financial reports and results generated by double entry system is
reliable to great extent for decision making purpose.
Disadvantages/Demerits of Double Entry system
The double entry system is complex enough to require skilled and
qualified employees to handle the whole process of maintaining
accounting records. Therefore, its employment may be costly and time
consuming for small businesses.
The advantages of double entry system far outweigh its disadvantages.
Double entry system has, therefore, become the standard and in many
cases a requirement for maintaining accounting records of medium and
large size businesses. Most of the manual as well as
computerized accounting systems are based on it.
20
Journalisation
1234651 DEC 2018 2
Journalizing is the process of recording a business transaction in
the accounting records. This activity only applies to the double-entry
bookkeeping system. The steps involved in journalizing are as follows:
Examine each business transaction to determine the nature of the
transaction. For example, the receipt of a supplier invoice means that an
obligation has been incurred. Or, throwing out obsolete inventory means
that the inventory asset will be reduced.
Determine which accounts will be affected. This calls for the identification
of the general ledger accounts that will be altered as a result of the
transaction. For example, recording a supplier invoice could mean that the
office supplies expense account will be increased, as well as the
offsetting accounts payable
Prepare a journal entry. This involves not just entering the transaction in
the accounting system, but also documenting it sufficiently so that someone
reviewing the entry later will understand why it was created. Ideally, the
entry should note the impacted accounts, the debits and credits entered, a
journal entry number, and a narrative comment.
Journalizing can result in entries to the general ledger or to subsidiary
ledgers. An entry is made to a subsidiary ledger when it involves a
high-volume transaction that management has decided to summarize
separately from the general ledger.
As an example of the journalizing process, ABC International has just
signed a contract with a maintenance contractor to pay it $1,000 per
month in exchange for routine preventive maintenance services. The
nature of the transaction is a recurring obligation. The affected
accounts will be a debit of $1,000 to the maintenance expense account,
and a credit of $1,000 to the accounts payable account. This will be a
recurring monthly entry. The journal entry is created as just noted, and
flagged to recur automatically at the beginning of each subsequent
month.
Ledger Posting and Trial Balance
 12346523 JUN 2019 4
page very easily. Same way, any number of accounts heads can be
Ledger Posting opened.

Ledger posting is very important part of accounting system. As we2. As we know that the ledger contains the columns like date, particulars,
know that to reach to any financial result, we have to go through so ledger folio, amount Dr., amount Cr. and balance Dr. or Cr. There is simple
many process. For example, first of all, we must know to maintain procedure of posting the entries from day book to ledger. All entries relating
proper account records. To maintain proper account records, one must to the accounts heads, which are debited, should be posted to debit side of
know proper accounting system. And proper accounting system ledger account. Similarly, the credit entries of any account head should be
includes following important steps to be followed:- posted in to credit side of that particular ledger account. We can understand
this system easily with the following example:-
1. To prepare the vouchers.
2. To enter the vouchers in to different type of day books. Example:- Suppose, we prepared one Cash Payment Voucher like
3. Posting the entries from day books to ledger. this:-
4. Totaling and balancing of ledgers.
5. To prepare the trial balance Date: 15.07.2012
6. To prepare Trading Account, Profit & Loss Account and Balance Sheet.
Debit: Conveyance Expenses Account Rs.800/=
What is ledger?:- In brief, Ledger is a summary of all accounts heads
maintained by the business firm. Credit:- Cash Account Rs.800/=

How to post the entries from day book to ledger:- Following are the (Being cash paid to Mr. Vinod for conveyance for the m/o
procedures of posting of entries from day books to ledger:- June,2012)

1. First of all, we have to open the accounts heads in ledger books. Ledger First of all, the above voucher will be written in Cash Day Book in
books contains similar type of pages having serial numbers. It also contains payment side.
an index in beginning of ledger books. The name of account head is written
in index of ledger and the same account head is written on any page of From the above entry, we find that the Conveyance Expenses Account
ledger. Then, the page number of that particular account head is written is being debited. Therefore, In ledger, under Conveyance Expenses
against that account head in index. Account head, we shall write this amount in debit side. In other words,
the amount of above entries will be shown in debit side of Conveyance
For Example:- Suppose, we want to open a Conveyance Expenses expenses Account.
Account head in ledger. In this case, first, we shall write Conveyance
Expenses Account in Index of ledger under ‘C’ alphabet and then we Trial Balance
shall choose any page in ledger and on that page also, we shall write
A trial balance is a bookkeeping worksheet in which the balances of all
Conveyance Expenses Account. The page number, on which this
ledgers are compiled into debit and credit account column totals that
Conveyance Expenses Account is written, should be written in index
are equal. A company prepares a trial balance periodically, usually at
of ledger against Conveyance Expenses Account. So, when ever, we
the end of every reporting period. The general purpose of producing a
want to see the details of conveyance expenses account in ledger, first
trial balance is to ensure the entries in a company’s bookkeeping
we shall open the index under alphabet ‘C’ then we will find out the
system are mathematically correct.
page number of Conveyance Expenses Account and reach to particular
21
 Preparing a trial balance for a company serves to detect any
mathematical errors that have occurred in the double-entry accounting
system. If the total debits equal the total credits, the trial balance is
considered to be balanced, and there should be no mathematical errors
in the ledgers. However, this does not mean there are no errors in a
company’s accounting system. For example, transactions classified
improperly or those simply missing from the system could still be
material accounting errors that would not be detected by the trial
balance procedure.
specified period, usually a fiscal quarter or year. The P&L statement is
synonymous with the income statement. These records provide
information about a company’s ability or inability to generate profit by
increasing revenue, reducing costs or both. Some refer to the P&L
statement as a statement of profit and loss, income statement, statement
of operations, statement of financial results or income, earnings
statement or expense statement.
The particulars required for the preparation of profit and loss account
are available from the trial balance. Only indirect expenses and indirect

Preparations of Final Accounts revenues are considered in it. This account starts from the result of
trading account (gross profit or gross loss). Gross profit is shown on
1234651 DEC 2018 2
the credit side of the profit and loss account and gross loss is shown on
the debit side of this account. All indirect expenses are transferred on
Final account is the combination of income statement and balance the debit side of this account and all indirect revenues on credit side. If
sheet. The final account is prepared at the end of every year which may the total of the credit side exceeds the debit side, the result is “net
be a calendar year or other also. profit” and if the total of the debit side exceeds the total of the credit
side, the result is net loss. As the net profit or net loss of a certain
Normally final account includes the following items. accounting period is determined through profit and loss account, so its
heading is:
1. Trading Account
2. Profit and loss Account Name of Business
3. Profit and loss Appropriation Account
4. Balance Sheet Profit and Loss Account for the year ended
31.12.2005

Profit & Loss Account (if accounting period ends on 31.12.2019)

12346523 JUN 2019 3
Features of Profit and Loss Account
The account through which annual net profit or loss of a business is
ascertained, is called profit and loss account. Gross profit or loss of a 1.
This account is prepared on the last day of an account year in order to
business is ascertained through trading account and net profit is determine the net result of the business.
determined by deducting all indirect expenses (business operating2. It is second stage of the final accounts.
expenses) from the gross profit through profit and loss account. Thus 3.
Only indirect expenses and indirect revenues are shown in this account.
profit and loss account starts with the result provided by trading 4. It starts with the closing balance of the trading account i.e. gross profit or
account. gross loss.
5. All items of revenue concerning current year – whether received in cash or
The profit and loss (P&L) statement is a financial statement that not – and all items of expenses – whether paid in cash or not – are
summarizes the revenues, costs and expenses incurred during a considered in this account. But no item relating to past or next year is
included in it.
22
 TAKEAWAYS Time of Creation

 The P&L statement is a financial statement that summarizes the revenues, A firm prepares it after the preparation of profit and loss account at the
costs and expenses incurred during a specified period. end of every Financial Year, in short on 31st March every year. It is
 The P&L statement is one of three financial statements every public prepared just like many other ledger accounts.
company issues quarterly and annually, along with the balance sheet and
the cash flow statement. Debit Items
 It is important to compare P&L statements from different accounting
It’s Debit items include:
periods, as the changes in revenues, operating costs, R&D spending and net
earnings over time are more meaningful than the numbers themselves.
1. Net Loss transferred from P&L account,
 Together with the balance sheet and cash flow statement, the P&L
2. Transfer of profit to Reserves,
statement provides an in-depth look at a company’s financial performance.
3. Salary to Partners,
4. Interest on Capital,
Profit & Loss 5.
6.
Commission to Partners,
Payments designated for dividend payments.
Appropriation Account Credit Items
12346512 AUG 2019 1 COMMENT
It’s Credit items include:
Profits are an important part of a business so as its allocation. That is
why the Profit and Loss Appropriation Account is an important part of 1. Net Profit Transferred to the account from the Profit and Loss Account,
an organization. Profit and Loss Appropriation Account is necessary 2. Money was taken out from the general reserve,
for businesses, especially partnerships because they help to allocate the 3. Drawing by the partners and the interest thereupon.
net of expenditures and incomes among the various partners.
Balance of Profit and Loss Appropriation Account
It is a special account that a firm prepares to show the distribution of
profits/losses among the partners or partner’s capital. The balance of the account (Credit – Debit) is transferred as the
remaining profit either to the Capital accounts or to the Current
This account should not be confused with the typical Profit and Loss accounts of the partners in their respective pre-decided profit
Account but rather seen as an extension of it as it is made after making distribution ratio or shares.
the Profit and Loss Account.
But in the case of deficiency of profits, adjust the allocation of profits
Purpose to salary, commission, etc. keeping in view the availability of profit.

Overall the firm uses it to show the allocation and distribution of Net
Profit among the partners, reserves, and dividends. Balance Sheet
1234651 DEC 2018 3

The balance sheet is one of the three fundamental financial statements

and is key to both financial modeling and accounting. The balance
23
 sheet displays the company’s total assets, and how these assets are This account includes the balance of all sales revenue still on credit, net
financed, through either debt or equity. It can also sometimes be of any allowances for doubtful accounts (which generates a bad debt
referred to as a statement of net worth, or a statement of financial expense). As companies recover accounts receivables, this account
position. The balance sheet is based on the fundamental equation: decreases and cash increases by the same amount.

Assets = Liabilities + Equity. Inventory

As such, the balance sheet is divided into two sides (or sections). The Inventory includes amounts for raw materials, work-in-progress goods
left side of the balance sheet outlines all a company’s assets. On the and finished goods. The company uses this account when it reports
right side, the balance sheet outlines the companies liabilities and sales of goods, generally under cost of goods sold in the income
shareholders’ equity. On either side, the main line items are generally statement.
classified by liquidity. More liquid accounts like Inventory, Cash, and
Trades Payables are placed before illiquid accounts such as Plant, 2. Non-Current Assets
Property, and Equipment (PP&E) and Long-Term Debt. The assets and
Plant, Property and Equipment (PP&E)
liabilities are also separated into two categories: current asset/liabilities
and non-current (long-term) assets/liabilities.
Property, Plant and Equipment (also known as PP&E) capture the
company’s tangible fixed assets. This line item is noted net of
How the Balance Sheet is Structured?
depreciation. Some companies will class out their PP&E by the
Balance sheets, like all financial statements, will have minor different types of assets, such as Land, Building, and various types of
differences between organizations and industries. However, there are Equipment. All PP&E is depreciable except for Land.
several “buckets” and line items that are almost always included in
Intangible Assets
common balance sheets. We briefly go through commonly found line
items under Current Assets, Long-Term Assets, Current Liabilities,
This line item will include all of the companies intangible fixed assets,
Long-Term Liabilities and Equity.
which may or may not be identifiable. Identifiable intangible assets
include patents, licenses, and secret formulas. Unidentifiable intangible
Learn the basics in CFI’s Free Accounting Fundamentals Course
assets include brand and goodwill.
1. Current Assets
3. Current Liabilities
Cash and Equivalents
Accounts Payable
The most liquid of all assets, cash, appears on the first line of the
Accounts Payables, or AP, is the amount a company owes suppliers for
balance sheet. Cash Equivalents are also lumped under this line item
items or services purchased on credit. As the company pays off their
and include assets that have short-term maturities under three months
AP, it decreases along with an equal amount decrease to the cash
or assets that the company can liquidate on short notice, such as
account.
marketable securities. Companies will generally disclose what
equivalents it includes in the footnotes to the balance sheet.
Current Debt/Notes Payable
Accounts Receivable
24
 Includes non-AP obligations that are due within one year time or This is the total amount of net income the company decides to keep.
within one operating cycle for the company (whichever is longest). Every period, a company may pay out dividends from its net income.
Notes payable may also have a long-term version, which includes notes Any amount remaining (or exceeding) is added to (deducted from)
with a maturity of more than one year. retained earnings.

Current Portion of Long-Term Debt

Excel Application to Make
This account may or may not be lumped together with the above
account, Current Debt. While they may seem similar, the current Business Sheet
portion of long-term debt is specifically the portion due within this year 12346512 AUG 2019 1 COMMENT
of a piece of debt that has a maturity of more than one year. For
example, if a company takes on a bank loan to be paid off in 5-years, Find Template Through Excel
this account will include the portion of that loan due in the next year.
Step 1
4. Non-Current Liabilities Open Excel and click “New” from the “File” tab at the top of the
screen, then scroll through the “Templates” list at the left of the screen
Bonds Payable to view templates that came pre-loaded with your program and
available on the Office website.
This account includes the amortized amount of any bonds the company
has issued. Step 2
Click “I Accept” on the right hand side of the page to accept the terms
Long-Term Debt and conditions, if necessary. Browse under the “Budget,” “Expense
Reports” and “forms” categories to locate different kinds of balance
This account includes the total amount of long-term debt (Excluding sheet templates.
the current portion, if that account is present under current liabilities).
This account is derived from the debt schedule, which outlines all the Step 3
companies outstanding debt, the interest expense and the principal Click “Download” to download and open a desired template in Excel.
repayment for every period.
Step 4
5. Shareholders’ Equity Fill out your balance sheet.
Share Capital Find Template Online

This is the value of funds that shareholders have invested in the Step 1
company. When a company is first formed, shareholders will typically Visit the Microsoft Office Templates site, and enter “balance sheet” in
put in cash. For example, an investor starts a company and seeds it with the text box.
$10M. Cash (an asset) rises by $10M, and Share Capital (an equity
account) rises by $10M, balancing out the balance sheet. Step 2
Choose “Excel” from the product drop-down and then click “Search.”
Retained Earnings

25
Step 3
Browse templates until you find one that fits your requirements for a
balance sheet, and click “Download.”

Step 4
Validate your version of Excel, if prompted to do so, then indicate
where to save the template (your desktop, hard drive or a memory
device), then click “Save.”

Step 5 The debt-equity ratio holds a lot of significance. Firstly it is a great

Open Excel, click “Open” under the Office button, navigate to where way for the company to measure its leverage or indebtedness. A low
you saved the template, and click “Open.” Fill out your balance sheet. ratio means the firm is more financially secure, but it also means that
the equity is diluted.
UNIT 4 Analysis of Financial Statement In contrast, a high ratio indicates a risky business where there are more
creditors of the firm than there are investors. In fact, a high debt to
Solvency Ratios equity ratio may deter more investors from investing in the firm, and
even deter creditors from lending money.
12346515 AUG 2019 1 COMMENT

While there is no industry standard as such it is best to keep this ratio

Solvency Ratios also known as leverage ratios determine an entity’s
ability to service its debt. So these ratios calculate if the company can
meet its long-term debt. It is important since the investors would like to
know about the solvency of the firm to meet their interest payments
and to ensure that their investments are safe. Hence solvency ratios
compare the levels of debt with equity, fixed assets, earnings of the
company etc.
One thing to make note of is the difference between solvency ratios
and liquidity ratios. These two are often confused for the other.
Liquidity ratios compare current assets with current liabilities, i.e.
short-term debt. Whereas solvency ratios analyze the ability to pay
long-term debt.
as low as possible. The maximum a company should maintain is the
ratio of 2:1, i.e. twice the amount of debt to equity.
2) Debt Ratio
Next, we learn about debt ratio. This ratio measures the long-term debt
of a firm in comparison to its total capital employed. Alternatively,
instead of capital employed, we can use net fixed assets. So the debt
ratio will measure the liabilities (long-term) of a firm as a percent of its
long-term assets. The formula is as follows:

1) Debt to Equity Ratio

The debt to equity ratio measures the relationship between long-

term debt of a firm and its total equity. Since both these figures are
obtained from the balance sheet itself, this is a balance sheet ratio. Let
us take a look at the formula:

26
This is one of the more important solvency ratios. It indicates the
financial leverage of the firm. A low ratio points to a more financially
stable business, better for the creditors. A higher ratio points to doubts
about the firms long-term financial stability. But a higher ratio helps
the management with trading on equity, i.e. earn more income for the
shareholders. Again there is no industry standard for this ratio.
3) Proprietary Ratio
The third of the solvency ratios is the proprietary ratio or equity ratio.
It expresses the relationship between the proprietor’s funds, i.e. the
funds of all the shareholders and the capital employed or the net assets.
Like the debt ratio shows us the comparison between debt and capital,
this ratio shows the comparison between owners funds and total capital
or net assets. The ratio is as follows:
A high ratio is a good indication of the financial health of the firm. It
means that a larger portion of the total capital comes from equity. Or
that a larger portion of net assets is financed by equity rather than debt.
One point to note, that when both ratios are calculated with the same
denominator, the sum of debt ratio and the proprietary ratio will be 1.
4) Interest Coverage Ratio
All debt has a cost, which we normally term as an interest. Debentures,
loans, deposits etc all have an interest cost. This ratio will measure the
security of this interest payable on long-term debt. It is the ratio
between the profits of a firm available and the interest payable on debt
instruments. The formula is:
27
Profitability Ratios
12346515 AUG 2019 1 COMMENT
The management of a company cannot wait for the year to end to
analyze their financial performance and their profits. This must be done
year round. These profitability ratios help the management determine
an entity’s ability to use its assets and create earnings. The most useful
comparisons for these ratios is to the performance of the previous
years.
Profitability ratios are both revenue statement ratios and balance sheet
ratios. They compare the revenue of a firm to different types of
expense accounts within the Profit and Loss Statement. And then some
profitability ratios also compare revenue to aspects of the balance sheet
such as assets and equity.
There are a variety of profitability ratios calculated with the help of the
Income Statement and the Balance Sheet.
Gross Profit Ratio
This ratio simply compares the gross profit of a company to its net
sales. Both of these figures are obtained from the Income Statement.
The ratio is also known as Margin ratio or the Rate of Gross Profit. The
ratio is represented as a percentage of sales.
This ratio basically signifies the basic profitability of the firm. This is
why it is one of the most important profitability ratios. It shows the
margin in the selling price before the company will incur losses from
operations. The formula is
Gross Profit Ratio = (Gross Profits/Net Revenue from
Operations) × 100
Net Revenue from Operations = Net Sales = Sales – Sale Returns
Gross Profit = Sales – Cost of Sales
Operating Ratio
The second one of the profitability ratios is the operating ratio. This
ratio measures the equation between the cost of operating activities and
the net sales, or revenue from operations. This ratio expresses the cost
of goods sold as a percentage of the net sales.
Operating ratio also takes into account operating expenses such as
administration and office expenses, selling and distribution costs,
salaries paid, depreciation expenses etc. Also, it ignores the non-
operating incomes such as interests, commisions, dividends etc.
Operating Ratio = (COGS + Operating Expenses/Net Revenue
from Operations) × 100
This ratio can actually help ascertain the efficiency of the organization
along with its profitability. There is no standard ratio, but a trend
analysis must be done on year on year basis to check the progress of
the firm.
Net Profit Ratio
Unlike the operating ratio, the net profit ratio includes the total revenue
of the firm. It takes into account both the operating income as well as
the non-operating income. Then it compares net profit to these
incomes. This ratio too is represented as a percentage. The formula for
Net Profit ratio is,
Net Profit Ratio = (Net Profit/Net Revenue) × 100
Net Profit = Net Profit after Tax (NPAT)
This ratio helps measure the overall profitability of the firm. It
indicates the portion of the net revenue that is available to the
proprietors. It also reflects on the efficiency of the business and is a
very important ratio for investors and financiers.
Return on Capital Employed
This ratio is one of the important ones of the profitability ratios. It
measures the overall efficiency of the utilization of the firm’s funds.
The ratio explores the relationship between the total income/profit
28
earned by a firm and the total capital employed by the firm, or the total
investment made. The formula is as follows,
Return on Capital Employed = (PBIT/Capital Employed)× 100
PBIT = Profit Before Income and Tax
This ratio measures the efficiency with which the capital is being
utilized and it indicates the productivity of the capital employed. It is a
good tool to measure the overall profitability of the firm as well.
Earnings Per Share
This ratio represents the profit or the earnings of a company in the
context of one share. It represents the earnings of a firm whether or not
dividends were actually declared on such shares. The formula for this
ratio is
Earnings Per Share (EPS) = (Profit available to Equity
Shareholders/Number of equity Shareholders) × 100
Profit available to Equity Shareholders = NPAT – Preference
Dividend
This is an important ratio for the shareholders, it helps them decide
whether to hold onto the shares or sell them. It also is a good indicator
of the dividends to be declared and/or bonus issues.
Activity Ratios
12346515 AUG 2019 1 COMMENT
These ratios basically measure the efficiency with which assets are
being utilized or managed. This is why they are also known as
productivity ratio, efficiency ratio or more famously as turnover ratios.
These ratios show the relationship between sales and any given asset. It
will indicate the ratio between how much a company has invested in
one particular type of group of assets and the revenue such asset is
producing for the company.
 The following are the different kinds of activity ratios that measure the
effectiveness of the funds invested and the efficiency of their
performance
 Stock Turnover Ratio
 Debtors Turnover Ratio
 Creditors Turnover Ratio
 Stock to Working Capital Ratio
1) Stock Turnover Ratio
One of the most important of the activity ratios is the stock turnover
ratio. This ratio focuses on the relationship between the cost of goods
sold and average stock. So it is also known as Inventory Turnover
Ratio or Stock Velocity Ratio.
It basically counts the number of times a stock rotates (completes a
cycle) in one given accounting period and the sales it effects in the
same period. So it calculates the speed with which the company
converts stock (lying about) to sales, i.e. revenue. The formula for the
ratio is as follows,
Quick Ratio = COGS / Average Stock
COGS = Sales – Gross Profit
Average Stock = (Opening Stock + Closing Stock)/2
From a managerial standpoint, this is an important ratio to calculate. It
allows them to figure out their inventory reordering schedule, by
indicating when all the stock will run out. It also helps them analyze
how efficiently the stock and its reordering is being managed by the
purchasing department.
2) Debtors Turnover Ratio
This ratio measures the efficiency with which Accounts Receivable are
being managed, hence it is also known as ‘Accounts Receivable
Turnover ratio’. The ratio shows the equation between credit sales
(cash sales are not taken into consideration) and the average debtors of
a firm. The formula is as below
29
Debtors Turnover ratio = Credit Sales/Average Debtors OR
Debtors Turnover ratio = Credit Sales/Debtors + Bills Receivable
And with a slight modification, we also derive the average collection
period. This will indicate the average number of days/weeks/months in
which the payment from the debtor is collected by a firm. The formula
for this formula is as below,
Average Collection Period = (Number of
days/weeks/months)/Debtors T/O Ratio
Both of these ratios are significant in managing the debtors and bills
receivables of a company. Not only do they calculate the velocity with
which debtors pay up, they help shape the credit policy of the firm as
well.
3) Creditors Turnover Ratio
This ratio shows the relation between credit purchases (cash purchases
are ignored in this context) and the average creditors of a company at
any given time of the accounting year. This ratio is also the ‘accounts
payable turnover ratio’. While calculating the net purchases we will
minus any purchase return. The formula is as below,
Creditors Turnover ratio = Credit Purchases/Average
Creditors OR
Creditors Turnover ratio = Credit Purchases / (Creditors+ Bills
Payable)
Average Creditors = (Opening Creditors + Closing Creditors)/2
Now using the same ratio, we can also calculate the average payment
period in the number of days/weeks/months. We only have to modify
the ratio a little, and remember this will be expressed as a function of
time (days, moths etc)
Average Payment Period = (Number of days/weeks/months)/
(Creditors T/O Ratio)
Again creditors turnover ratio has great importance. It calculates the
velocity with which creditors are paid off during the year. It helps the
management judge how efficiently the accounts payables are being The current ratio is also known as the working capital ratio. It will
handled. measure the relationship between current assets and current liabilities.
It measures the firm’s ability to pay for all its current liabilities, due
4) Working Capital Turnover Ratio within the next one year by selling off all their current assets. The
formula for is as follows
This one of the activity ratios will measure the efficiency with which
the firm is using their Working Capital to support their sale volumes. Current Ratio = Current Assets/Current Liabilities
So any excess of current assets over the current liabilities of a firm is Current Assets include,
their working capital. The formula for the ratio is
 Stock
Working Capital Turnover ratio = Total Sales / Working Capital  Debtors
 Cash and Bank Balances
Working Capital = Current Assets – Current Liabilities  Bills receivable
A high Working Capital Turnover ratio means that the working capital  Accruals
is being very efficiently utilized. But sometimes it could mean that the  Short term loans that are given
creditors of the company are excessive (bringing down the working  Short term Securities
capital) and this could be a problem in the future. Conversely, a low
ratio could mean that there are too many debtors or a very big Current Liabilities include
inventory which is not an efficient use of resources.
 Creditors

Liquidity Ratios 

12346515 AUG 2019 1 COMMENT  Bank Overdrafts
 Provision for taxation
A firm has assets and liabilities to its name. Some are fixed in nature 
and then there are current assets and current liabilities. These are short-
term in nature and easily convertible into cash. The liquidity ratios deal
with the relationship between such current assets and current liabilities.
Liquidity ratios evaluate the firm’s ability to pay its short-term
liabilities, i.e. current liabilities. It shows the liquidity levels, i.e. how
many of their assets can be quickly converted to cash to pay of their
obligations when they become due.
It is not only a measure of how much cash there is but also how easily
current assets can be converted to cash or marketable securities. Now
let us look at some of the important liquidity ratios.
Current Ratio
Outstanding Expenses
Short Term Loans that are taken
Proposed Dividend
The ideal current ratio, according to the industry standard is 2:1. That
means that a firm should hold at least twice the amount of current
assets than it has current liabilities. However, if the ratio is very high it
may indicate that certain current assets are lying idle and not being
utilized properly. So maintaining the correct balance between the two
is crucial.
Quick Ratio
The other important one of the liquidity ratios is Quick Ratio, also
known as a liquid ratio or acid test ratio. This ratio will measure a
firm’s ability to pay off its current liabilities (minus a few) with only
selling off their quick assets.

30
Now Quick assets are those which can be easily converted to cash with
only 90 days notice. Not all current assets are quick assets. Quick
assets generally include cash, cash equivalents, and marketable
securities. The formula is
Quick Ratio = Quick Assets/(Current Liabilities/Quick Liabilities)
Quick Assets = All Current Assets – Stock – Prepaid Expenses
Quick Liabilities = All Current Liabilities – Bank Overdraft –
Cash Credit
The ideal quick ratio is considered to be 1:1, so that the firm is able to
pay off all quick assets with no liquidity problems, i.e. without selling
fixed assets or investments. Since it does not take into consideration
stock (which is one of the biggest current assets for most firms) it is a
stringent test of liquidity. Many firms believe it is a better test of
liquidity than the current ratio since it is more practical.
Absolute Cash Ratio
This is an even more rigorous liquidity ratio than quick ratio. Here we
measure the availability of cash and cash equivalents to meet the short-
term commitment of the firm. We do not consider all current assets,
only cash. Let us see the formula,
Absolute Cash ratio = (Cash+ Bank Balance + Marketable
Securities) /Current Liabilities
As you can see, this ratio measures the cash availability of the firm to
meet the current liabilities. There is no ideal ratio, it helps the
management understand the level of cash availability of the firm and
make any changes required.
However, if the ratio is greater than 1 it indicates poor resource
management and very high liquidity. And high liquidity may mean low
profitability.
Market Capitalization Ratios
12346515 AUG 2019 1 COMMENT
31
Capitalization ratio describes to investors the extent to which a
company is using debt to fund its business and expansion plans.
Generally, debt is considered riskier than equity (from company’s point
of view). Hence the higher the ratio, the riskier the company is.
Companies with higher capitalization ratio run higher risk of
insolvency or bankruptcy in case they are not able to repay the debt as
per the predetermined schedule. However, higher debt on the books
could also be earnings accretive if the business is growing in a
profitable manner (more on this in the analysis section).
The company uses this ratio to manage its capital structure and
determine the debt capacity. Investors use it to gauge the riskiness of
investment and form an important component of asset valuation (higher
risk implies higher expected return). Lenders use it to determine if the
company is within the predetermined limits and if there is more
headroom to lend more money.
Formula
The capitalization ratio formula is calculated by dividing total debt into
total debt plus shareholders’ equity. Here’s an example:
Total Debt to Capitalization = Total Debt / (Total Debt +
Shareholders’ Equity)
You can also calculate the capitalization ratio equation by dividing the
total debt by the shareholders’ equity.
Debt-Equity ratio = Total Debt / Shareholders’ Equity
Total debt refers to both long-term and short-term debts of a company
Shareholder’s equity refers to the book value of equity investment Trend Analysis
made by the investors
Trend analysis is analysis which entails comparison with the
The debt-to-equity investment is calculated by simply dividing the company’s own past performance. The problem in conducting this
two values. For total debt to cap ratio, we simply divide total debt with analysis is that all the numbers keep changing and there is no fixed
the sum or equity and debt (i.e. the total capital of a company) base. With the help of common size statements, the base gets fixed at
100% and all the numbers can be compared across years. Thus with the
help of this trend analysis, a company can figure out whether its
Common Size Statement advertising costs have gone up compared to last year and if so why?
12346515 AUG 2019 1 COMMENT
Sample of a typical common size income statement:
Common size statements are not financial ratios. Rather they are a
way of presenting financial statements that makes them more suitable Particulars Percentage
for analysis. However, analysts always use them in conjunction with
ratio analysis. In fact, financial analysts use common size statements as
the starting point to help them dig deeper. Common size statements tell Sales 100%
them what particular group of ratios deserves more attention for any
given set of financial statements.
Less: COGS 38%
Common size statements are financial statements expressed in
percentage form. Therefore a common size income statement
Gross Profit 62%
would consider the sales figure as 100%. Every expense in the
income statement will then be expressed as a percentage of the sales
figure. Similarly in common size balance sheet the total assets figure is Less: SG&A 14%
considered to be 100%. Everything else is expressed as a percentage of
the same.
EBIDTA 48%
Standardized for Comparison

The logic behind creating common size financial statements is that Less: Depreciation 10%
they are easily comparable. Analysts can compare the COGS across
two companies and state which one has lower COGS without any
calculation! Thus, using the common size statements the analysts look EBIT 38%
step by step at the financial statements and compare them with other
companies. This helps them understand how the company has a
different asset structure and cost structure in comparison to its Less Interest 6%
competitors and whether it is favorable or unfavorable for the
organization.
PBT 32%

32
 ABC International Statement of Financial Position

As of As of As of
Less: Taxes 11% 12/31/20X3 12/31/20X2 12/31/20X1

Current Assets
PAT 21%

Cash $1,200,000 $900,000 $750,000

Comparative Balance Sheet Accounts receivable 4,800,000 3,600,000 3,000,000

12346515 AUG 2019 1 COMMENT

A comparative balance sheet presents side-by-side information about Inventory 3,600,000 2,700,000 2,300,000
an entity’s assets, liabilities, and shareholders’ equity as of multiple
points in time. For example, a comparative balance sheet could present Total current assets $9,600,000 $7,200,000 $6,050,000
the balance sheet as of the end of each year for the past three years.
Another variation is to present the balance sheet as of the end of each Total fixed assets 6,200,000 5,500,000 5,000,000
month for the past 12 months on a rolling basis. In both cases, the
intent is to provide the reader with a series of snapshots of a company’s
Total Assets $15,800,000 $12,700,000 $11,050,000
financial condition over time, which is useful for developing trend line
analyses (though this works better when the reader has the entire set
of financial statements to work with and not just the balance sheet). Current Liabilities

The comparative balance sheet is not required under GAAP for Accounts payable $2,400,000 $1,800,000 $1,500,000
a privately-held company or a nonprofit entity, but the SEC does
require it in numerous circumstances for the reports issued by publicly- Accrued expenses 480,000 360,000 300,000
held companies, particularly the annual Form 10-K and the
quarterly Form 10-Q. The usual SEC requirement is to report a
comparative balance sheet for the past two years (with additional Short-term debt 800,000 600,000 400,000
requirements for quarterly reporting).
Total Current Liabilities $3,680,000 $2,760,000 $2,200,000
There is no standard format for a comparative balance sheet. It is
somewhat more common to report the balance sheet as of the least Long-term debt 9,020,000 7,740,000 7,350,000
recent period furthest to the right, though the reverse is the case when
you are reporting balance sheets in a trailing Twelve Months format.
Total Liabilities 12,700,000 10,500,000 9,550,000
Here is an example of a comparative balance sheet that contains the
balance sheet as of the end of a company’s fiscal year for each of the Shareholders’ Equity 3,100,000 2,200,000 1,500,000
past three years:
33
 Total Liabilities and Equity $15,800,000 $12,700,000 $11,050,000 Concept of Working Capital:

The funds invested in current assets are termed as working capital. It is

UNIT – 5 the fund that is needed to run the day-to-day operations. It circulates in
the business like the blood circulates in a living body. Generally,
working capital refers to the current assets of a company that are

Nature, Scope and Definition of changed from one form to another in the ordinary course of business,
i.e. from cash to inventory, inventory to work in progress (WIP), WIP
to finished goods, finished goods to receivables and from receivables to
Working Capital cash.
12346513 MAR 2019 2
There are two concepts in respect of working capital:
Meaning:
(i) Gross working capital and
In an ordinary sense, working capital denotes the amount of funds
needed for meeting day-to-day operations of a concern. (ii) Networking capital.

This is related to short-term assets and short-term sources of financing. Gross Working Capital:
Hence it deals with both, assets and liabilities—in the sense of
managing working capital it is the excess of current assets over current The sum total of all current assets of a business concern is termed as
liabilities. In this article we will discuss about the various aspects of gross working capital. So,
working capital.
Gross working capital = Stock + Debtors + Receivables + Cash.
The nature of working capital is as discussed below:
Net Working Capital:
1. It is used for purchase of raw materials, payment of wages and expenses.
2. It changes form constantly to keep the wheels of business moving. The difference between current assets and current liabilities of a
3. Working capital enhances liquidity, solvency, creditworthiness and business concern is termed as the Net working capital.
reputation of the enterprise.
Hence,
1. It generates the elements of cost namely: Materials, wages and expenses.
2. It enables the enterprise to avail the cash discount facilities offered by its Net Working Capital = Stock + Debtors + Receivables + Cash –
suppliers. Creditors – Payables.
3. It helps improve the morale of business executives and their efficiency
reaches at the highest climax. Need for Working Capital:
4. It facilitates expansion programmes of the enterprise and helps in Working capital plays a vital role in business. This capital remains
maintaining operational efficiency of fixed assets. blocked in raw materials, work in progress, finished products and with
customers.

The needs for working capital are as given below:

34
1. Adequate working capital is needed to maintain a regular supply of raw
materials, which in turn facilitates smoother running of production process. Types of Working Capital,
2. Working capital ensures the regular and timely payment of wages and
salaries, thereby improving the morale and efficiency of employees. Determinants of Working Capital
3. Working capital is needed for the efficient use of fixed assets.
12346513 MAR 2019 2
4. In order to enhance goodwill a healthy level of working capital is needed. It
is necessary to build a good reputation and to make payments to creditors in Types of working Capital
time.
5. Working capital helps avoid the possibility of under-capitalization. (a) Gross Working Capital:
6. It is needed to pick up stock of raw materials even during economic
depression. Gross working capital refers to the amount of funds invested in various
components of current assets. It consists of raw materials, work in
vii. Working capital is needed in order to pay fair rate of dividend and progress, debtors, finished goods, etc.
interest in time, which increases the confidence of the investors in the
firm. (b) Net Working Capital:

Importance of Working Capital: The excess of current assets over current liabilities is known as Net
working capital. The principal objective here is to learn the
It is said that working capital is the lifeblood of a business. Every composition and magnitude of current assets required to meet current
business needs funds in order to run its day-to-day activities. liabilities.

The importance of working capital can be better understood by the (c) Positive Working Capital:
following:
This refers to the surplus of current assets over current liabilities.
1. It helps measure profitability of an enterprise. In its absence, there would be
neither production nor profit. (d) Negative Working Capital:
2. Without adequate working capital an entity cannot meet its short-term
liabilities in time. Negative working capital refers to the excess of current liabilities over
3. A firm having a healthy working capital position can get loans easily from the current assets.
market due to its high reputation or goodwill.
4. Sufficient working capital helps maintain an uninterrupted flow of (e) Permanent Working Capital:
production by supplying raw materials and payment of wages.
5. Sound working capital helps maintain optimum level of investment in The minimum amount of working capital which even required during
current assets. the dullest season of the year is known as Permanent working capital.
6. It enhances liquidity, solvency, credit worthiness and reputation of
enterprise. (f) Temporary or Variable Working Capital:

vii. It provides necessary funds to meet unforeseen contingencies and It represents the additional current assets required at different times
thus helps the enterprise run successfully during periods of crisis. during the operating year to meet additional inventory, extra cash, etc.

35
It can be said that Permanent working capital represents minimum
amount of the current assets required throughout the year for normal
production whereas Temporary working capital is the additional capital
required at different time of the year to finance the fluctuations in
production due to seasonal change. A firm having constant annual
production will also have constant Permanent working capital and only
Variable working capital changes due to change in production caused
by seasonal changes. (See Figure 7.1.)

Determinants of Working Capital

(A) Current Assets:

These assets are generally realized within a short period of time, i.e.
within one year.

Current assets include:

(a) Inventories or Stocks

Similarly, a growth firm is the firm having unutilized capacity, (i) Raw materials
however, production and operation continues to grow naturally. As its
volume of production rises with the passage of time so also does the (ii) Work in progress
quantum of the Permanent working capital. (See Figure 7.2.)
(iii) Consumable Stores

(iv) Finished goods

(b) Sundry Debtors

(c) Bills Receivable

(d) Pre-payments

(e) Short-term Investments

36
(f) Accrued Income and increase sales volume, the enterprise needs to maintain its current
assets. In the course of period, the enterprise becomes in the position to
(g) Cash and Bank Balances keep a steady ratio of its current assets to annual sales. As a result, the
turnover ratio, i.e., current assets to turnover increases reducing the
(B) Current Liabilities: length of operating cycle. Thus, less the operating cycle period, less
will be requirements for working capital and vice versa.
Current liabilities are those which are generally paid in the ordinary
course of business within a short period of time, i.e. one year. 2. Length of Operating Cycle:

Current liabilities include: Conversion of cash through various stages viz., raw material, semi-
processed goods, finished goods, sales, debtors and bills receivables
(a) Sundry Creditors into cash takes a certain period of time that is known as ‘length of
operating cycle’. Longer the operating cycle time, the more is the
(b) Bills Payable working capital required.

(c) Accrued Expenses For example, heavy engineering needs relatively more working capital
than a rice mill or cotton spinning mill or a steel rolling mill. Thus, it
(d) Bank Overdrafts follows that depending upon the length of working cycle, the
requirement for working capital varies from enterprise to enterprise.
(e) Bank Loans (short-term)
3. Nature of Business
(f) Proposed Dividends
The requirement of working capital also varies among the enterprises
(g) Short-term Loans depending upon the nature of the business. For instance, trading
companies require more working capital than manufacturing
(h) Tax Payments Due companies. This is because that the trading business requires large
quantities of goods to be held in stock and also carry large amounts of
working capital than manufacturing concerns.
Assessment and Computation of
In both these types of businesses, the value of current assets is 80% to
Working Capital Requirement 90% of the value of total assets. The investment in current assets is
relatively smaller in the case of hotels and restaurants because they
12346513 MAR 2019 2
mostly have cash sales, and only small amounts of debtors’ balances.
In case of a small-scale enterprise, the important factors determining
the requirements of working capital are as follows: 4. Terms of Credit

1. Sales:
Among the various factors, size of the sales is one of the important
factors in determining the amount of working capital. In order to
Another important factor that determines the amount of working capital
requirements relates to the terms of credit allowed to the customers.
For instance, an enterprise may allow only 15 days credit, while
another may allow 90 days credit to its customers. Besides, an

37
 enterprise may extend credit facilities to its all customers, while
another enterprise in the same business may extend credit only to select
and those too reliable customers only.
Then, the requirements for working capital will naturally be more if the
credit period is longer and credit facilities are extended to all
customers, no matter reliable or non-reliable they are. This is because
there will be longer balance of debtors and that too for a relatively
longer period which will obviously demand for more capital.
On the contrary, if supplies of raw materials are available on
favourable conditions or terms of credit i.e., the payment will be made
after a relatively longer period of time, the requirement for working
capital will be correspondingly smaller.
5. Seasonal Variations
The seasonal enterprises, i.e., the enterprise whose operations pick up
seasonally may require more working capital to meet their increased
operations during the particular season. A popular example of seasonal
enterprise may be sugar factory whose operations are highly seasonal.
6. Turnover of Inventories
If inventories are large in size but turnover is slow, the small-scale
enterprise will need more working capital. On the contrary, if
inventories are small but their turnover is quick, the enterprise will
need a small amount of working capital.
7. Nature of Production Technology
In case of labour intensive technology, the unit will need more amount
to pay the wages and, therefore, will require more working capital. On
the other hand, if the production technology is capital- intensive, the
enterprise will have to make less payment for expenses like wages. As
a result, enterprise will require less working capital.
8. Contingencies
If the demand for and price of the products of small- scale enterprises
are subject to wide variations or fluctuations, the contingency
38
provisions will have to be made for meeting the fluctuations. This will
obviously increase the requirements for working capital of the small
enterprises. While one can add certain other factors to this list, the said
factors appear to be the major ones in determining the requirement of
working capital of a small-scale enterprise.
Assessment of Working Capital:
The requirement for working capital of a small-scale enterprise needs
to be assessed correctly as far as possible. Because, as we mentioned
earlier both under and over working capitals are harmful for the
enterprise. For example, over-estimation of working capital would
result in blockage of scarce funds in idle assets.
On the other hand, under-assessment of working capital would deprive
the enterprise of profitable opportunities. It is here that the concept of
operating cycle of working capital reveals its sharpness. Let us explain
it with an example.
Suppose the operating cycle of a small-scale enterprise is of four
months. It means that the cycle of operations is repeated three times in
a year. This further means that the enterprise would need an amount of
working capital equal to one-third of the operating expenses of the
whole last year.
This is best expressed by the following formula:
Total Working Capital Requirement = Total Operating Expenses in the
Last Year/Number of Operating Cycles in the Year
In addition, if the prices go up in the coming year, a certain percentage
for such contingencies will also be added to above working capital
calculated so.
Method # 1. Percentage of Sales Method:
This method of estimating working capital requirements is based on the
assumption that the level of working capital for any firm is directly
related to its sales value. If past experience indicates a stable
relationship between the amount of sales and working capital, then this
basis may be used to determine the requirements of working capital for
future period.
Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working
capital required was Rs 6,00,000; the requirement of working capital
for the year 2008 on an estimated sales of Rs 40,00,000 shall be Rs
8,00,000; i.e. 20% of Rs 40,00,000.
The individual items of current assets and current liabilities can also be
estimated on the basis of the past experience as a percentage of sales.
This method is simple to understand and easy to operate but it cannot
be applied in all cases because the direct relationship between sales and
working capital may not be established.
It involves purchase of raw materials and stores, its conversion into
stock of finished goods through work-in-process with progressive
increment of labour and service costs, conversion of finished stock into
sales, debtors and receivables, realization of cash and this cycle
continues again from cash to purchase of raw material and so on. The
speed/time duration required to complete one cycle determines the
requirement of working capital – longer the period of cycle, larger is
the requirement of working capital and vice-versa.
The requirements of working capital be estimated as follows:

Method # 2. Regression Analysis Method (Average Relationship between Sales and

Working Capital)
This method of forecasting working capital requirements is based upon
the statistical technique of estimating or predicting the unknown value
of a dependent variable from the known value of an independent
variable. It is the measure of the average relationship between two or
more variables, i.e.; sales and working capital, in terms of the original
units of the data.

Method # 3. Cash Forecasting Method

This method of estimating working capital requirements involves
forecasting of cash receipts and disbursements during a future period of
time. Cash forecast will include all possible sources from which cash
Need and Objectives of Financing
will be received and the channels in which payments are to be made so
that a consolidated cash position is determined.
of Working Capital, Short
This method is similar to the preparation of a cash budget. The excess
Term Credit
of receipts over payments represents surplus of cash and the excess of 12346519 MAR 2019 3

payments over receipts causes deficit of cash or the amount of working The primary objective of working capital management is to ensure
capital required. smooth operating cycle of the business. Secondary objectives are to
Method # 4. Operating Cycle Method
optimize the level of working capital and minimize the cost of such
funds.
This method of estimating working capital requirements is based upon
the operating cycle concept of working capital. The cycle starts with
The superior objective of financial management is wealth
the purchase of raw material and other resources and ends with the
maximization and that can be gained by profit maximization
realization of cash from the sale of finished goods.
39
 accompanied with sustainable growth and development. For
sustainable growth and development, the objectives of all the
stakeholders including customers, suppliers, employees, etc should be
aligned to the growth of the organization.
This implies that the operating cycle i.e. the cycle starting from the
acquisition of raw material to its conversion to cash should be smooth.
It is Objectives of Working Capital Management not easy; it is as good
as circulating 5 balls with two hands without dropping a single one. If
following 6 points can be managed, this operating cycle can be
management well.
 It means raw material should be present on the requirement and it should
not be a cause to stoppages of production.
 All other requirements of production should be in place before time.
 The finished goods should be sold as early as possible once they are
produced and inventoried.
 The accounts receivable should be collected on time.
 Accounts payable should be paid when due without any delay.
 Cash should be available as and when required along with some cushion.
LOWEST WORKING CAPITAL
Working capital here refers to the current assets less current liabilities
(net working capital). It should be optimized because higher working
capital means higher interest cost and lower working capital means a
risk of disturbance of operating cycle.
1.
MINIMIZE RATE OF INTEREST OR COST OF CAPITAL
The cost of capital utilized on working capital should be minimized so
as to achieve higher profitability. If the investment in working capital
involves bank finance, interest rates should be negotiated with the
bank.
Cost can be minimized by utilizing long-term funds but in a proper
mix. While deciding the mix of working capital, the fundamental
principle of financial management should be kept in mind that fixed
assets and permanent assets should be financed by long term sources of
40
finance of approximately same maturity and short-term or temporary
assets should be financed by short-term sources of finance.
OPTIMAL RETURN ON CURRENT ASSET INVESTMENT
The return on the investment made in current assets should be more
than the weighted average cost of capital so as to ensure wealth
maximization of the owners. In other words, the rate of return earned
due to investment in current assets should be more than the rate of
interest or cost of capital used for financing the current assets.
SHORT TERM CREDIT
Short-term loans are usually extended by financial institutions
generally for a period of 1-2 years. These are mostly unsecured, which
means you don’t have to pledge a collateral as security to avail them.
Though funds can be extended quickly, the reason why they are labeled
“short-term” is the associated repayment tenor (to be paid off in full
within 6-18 months) rather than the speed of funding.
What differentiates such a loan from the other conventional ones in the
market is the ease of availing one. However, there are many short
terms loan in India offering you the funds you need to meet any short-
term financial need. Here, we try to cover the ins and outs of the 5 most
popular sources of short-term loans, to help you make an informed
decision when it comes to availing short-term finance.
Trade Credit
Possibly one of the most affordable sources of obtaining interest-free
funds, you can avail a trade credit where the lender would give you the
time to pay for a purchase without incurring any additional cost. A
trade credit is usually extended for a period of 30 days.
However, you can consider asking for a longer tenor that would easily
fit into your plan.
A flexible repayment tenor will allow you to leverage the additional
time and funds to finance other initiatives.
2. Bridge Loans
A bridge loan will help to tide you over till the time you get another
loan, usually of a bigger value, approved. In India, such a loan assumes
importance in case of transactions relating to property. For example, if
you want to buy a new house but don’t have sufficient funds because
the old one hasn’t been sold off yet. You might want to wait for the
funds to come through once you get a potential buyer for the old
property, but this will have its own downsides, including the price of
the new property shooting up.
use a personal loan to meet a medical emergency or consolidate all
your existing into one.
Many lenders offer a personal loan on the basis of your income level,
employment and credit history, and perceived capacity to repay. Unlike
a home or car loan, a personal loan isn’t a secured one. This simply
means that the lender will not have anything to auction in case you
default on repaying the loan amount. What differentiates a personal
loan from all the above loans is that it gives you a substantial loan
amount with flexible tenor to facilitate repayment.

It is during this waiting time that you can avail a bridge loan, that
offers two-pronged benefits- it helps you with the funds to buy the Cash flow Statement: Various cash
property while giving you ample time to wait and get a good deal on
the old one. and Non-cash Transactions
3. Demand Loans The Statement of Cash Flows (also referred to as the cash flow
statement) is one of the three key financial statements that reports the
A demand loan can help you meet any urgent financial obligation. You cash generated and spent during a specific period of time (i.e., a month,
can pledge your insurance policies and other savings instruments such quarter, or year). The statement of cash flows acts as a bridge between
as NSCs in lieu of the loan. A certain percentage of the maturity value the income statement and balance sheet by showing how money moved
on such savings instruments will determine the extent to which you in and out of the business.
will be eligible to borrow as the loan amount.
Three Sections of the Statement of Cash Flows:
4. Bank overdraft
This is a facility that you can avail on your current account. With an 1.
Operating Activities: The principal revenue-generating activities of an
overdraft facility at your disposal, you will be able to withdraw money organization and other activities that are not investing or financing; any cash
despite your account not having sufficient cash to cover such flows from current assets and current liabilities
withdrawals. Essentially, it helps you to borrow money within a2. Investing Activities: Any cash flows from the acquisition and disposal of
sanctioned overdraft limit. long-term assets and other investments not included in cash equivalents
3. Financing Activities: Any cash flows that result in changes in the size and
Much like any other loan, an interest rate (often lower than that on composition of the contributed equity capital or borrowings of the entity
credit cards) is levied on the outstanding overdraft balance. Having (i.e., bonds, stock, dividends)
said that be wary of certain additional costs that might be attached with
such a facility, including fees per withdrawal. Cash Flow: Inflows and outflows of cash and cash equivalents (learn
more in CFI’s Ultimate Cash Flow Guide)
5. Personal loans
You can avail a personal loan to meet a variety of needs like home Cash Balance: Cash on hand and demand deposits (cash balance on
renovation, wedding, higher education or travel costs. You could also the balance sheet)

41
 Cash Equivalents: Cash equivalents include cash held as bank
deposits, short-term investments, and any very easily cash-convertible
assets – includes overdrafts and cash equivalents with short-term
maturities (less than three months).
Cash Flow Classifications
1. Operating Cash Flow
The items in the cash flow statement are not all actual cash flows, but
“reasons why cash flow is different from profit.”
Depreciation expense reduces profit but does not impact cash flow (it is
a non-cash expense). Hence, it is added back. Similarly, if the starting
point profit is above interest and tax in the income statement, then
interest and tax cash flows will need to be deducted if they are to be
treated as operating cash flows.

Operating activities are the principal revenue-producing activities of
the entity. Cash Flow from Operations typically include the cash flows
associated with sales, purchases, and other expenses.
The company’s chief finance officer (CFO) chooses between the direct
and indirect presentation of operating cash flow:
2. Investing Cash Flow
Direct Presentation: Operating cash flows are presented as a list of cash
flows; cash in from sales, cash out for capital expenditures, etc. Simple
but rarely used method, as the indirect presentation is more common.
Indirect Presentation: Operating cash flows are presented as a
reconciliation from profit to cash flow:
There is no specific guidance on which the profit amount should be
used in the reconciliation. Different companies use operating profit,
profit before tax, profit after tax, or net income. Clearly, the exact
starting point for the reconciliation will determine the exact
adjustments made to get down to an operating cash flow number.
Cash Flow from Investing Activities includes the acquisition and
disposal of non-current assets and other investments not included in
cash equivalents. Investing cash flows typically include the cash flows
associated with buying or selling property, plant, and equipment
(PP&E), other non-current assets, and other financial assets.

Profit P Cash spent on purchasing PP&E is called capital expenditures (or

CapEx for short).
Depreciation D
3. Financing Cash Flow
Amortization A
Cash Flow from Financing Activities are activities that result in
Impairment expense I changes in the size and composition of the equity capital or borrowings
of the entity. Financing cash flows typically include cash flows
Change in working capital ΔWC associated with borrowing and repaying bank loans, and issuing and
buying back shares. The payment of a dividend is also treated as a
Change in provisions ΔP financing cash flow.
Interest Tax (I)

Tax (T)

Operating cash flow OCF

42
 Cash Flow
Cash Flow (CF) is the increase or decrease in the amount of money a
business, institution, or individual has. In finance, the term is used to
describe the amount of cash (currency) that is generated or consumed in a
given time period. There are many types of CF, with various important uses
for running a business and performing financial analysis.

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid
understanding of what each of them is. When someone refers to CF,
they could mean any of the types listed below, so be sure to clarify
which cash flow term is being used.

Types of cash flow include:

Cash from Operating Activities: Cash that is generated by a

company’s core business activities – does not include cash flow from
investing. This is found on the company’s Statement of Cash Flows
(the first section).
Interest and Cash Flow
Free Cash Flow to Equity (FCFE): FCFE represents the cash that’s
Under IFRS, there are two ways of presenting interest expense in the
available after reinvestment back into the business (capital
cash flow statement. Many companies present both the interest
expenditures). Read more about FCFE.
received and interest paid as operating cash flows. Others treat interest
received as investing cash flow and interest paid as a financing cash
Free Cash Flow to the Firm (FCFF): This is a measure that assumes
flow. The method used is the choice of the finance director.
a company has no leverage (debt). It is used in financial modeling and
valuation. Read more about FCFF.
Under U.S. GAAP, interest paid and received are always treated as
operating cash flows.
Net Change in Cash: The change in the amount of cash flow from one
accounting period to the next. This is found at the bottom of the Cash
Free Cash Flow
Flow Statement.
Investment bankers and finance professionals use different cash flow
Uses of Cash Flow
measures for different purposes. Free cash flow is a common measure
used typically for DCF valuation. However, free cash flow has no
Cash Flow has many uses in both operating a business and in
definitive definition and can be calculated and used in different ways.
performing financial analysis. In fact, it’s one of the most important
metrics in all of finance and accounting.
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 The most common cash metrics and uses of cash flow are the FUND
following: BASIS CASH FLOW
FLOW

 Net Present Value: Calculating the value of a business by building a DCF

Model and calculating the net present value (NPV) A cash flow
 Internal Rate of Return: determining the IRR an investor achieves for making statement
an investment
is a
 Liquidity: Assessing how well a company can meet its short-term financial A fund flow
obligations statement
statement is a
 Cash Flow Yield: Measuring how much cash a business generates per share, showing
statement showing
relative to its share price, expressed as a percentage the inflows
the changes in the
 Cash Flow Per Share (CFPS): Cash from operating activities divided by the Meaning and
number of shares outstanding financial position
outflows of
 P/CF Ratio: The price of a stock divided by the CFPS (see above), sometimes of the entity in
cash and
used as an alternative to the Price-Earnings or P/E ratio different
cash
 Cash Conversion Ratio: The amount of time between when a business pays accounting years.
for its inventory (cost of goods sold) and receives payment from its equivalents
customers is the cash conversion ratio over a
 Funding Gap: A measure of the shortfall a company has to overcome (how period.
much more cash it needs)
 Dividend Payments: CF can be used to fund dividend payments to investors
 Capital Expenditures: CF can also be used to fund reinvestment and growth To show the
To show the reasons
in the business reasons for
for the changes in
movements in
the financial
Difference between Cash flow and Purpose of
Preparation
the cash at the
beginning and at
position, with
respect to previous
Fund flow the end of the
accounting
year and current
accounting year.
Cash Flow statement shows the changes in the cash position (Inflows and period.
outflows) of a firm. It is an analytical reconciliation statement which explains
the reasons for the differences between the opening and closing cash
Accrual
balances over a period. On the other hand, Fund Flow statement is a Cash Basis of
Basis Basis of
statement that shows the ups and downs of the financial position or the Accounting.
Accounting.
changes in working capital of the entity between the two financial years.

The financial position of any company can be better understood with

Analysis Short Term Long Term
the help of a cash flow statement and fund flow statement, along with
the Balance Sheet and Income statement. These two statements helps Analysis of cash Analysis of
stakeholders to know the sources and application of cash or funds. planning. financial
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 planning

Sources and
Inflows and
Discloses applications
Outflows of Cash
of funds

Contains opening
Opening and closing Does not contains opening
and closing balance of cash
balance and cash balance of cash and cash equivalents.
equivalents.

Part of
Financial Yes No The second method is to be followed particularly when the amount of
Statement purchases, sales, and expenses are not given. This will be similar to
Fund Flow Statement. The only difference is that the total changes in
working capital are to be considered in Fund Flow Statement, but here,
Preparation of Cash flow net increase or decrease of each component of current assets and
current liabilities is to be recognized.
Statement and it’s Analysis
There are two methods of its preparation. The first one is that it will
commence with opening Cash and Bank balances and with this, certain
amounts are to be added on account of issue of Shares and Debentures,
Cash received from Debtors, selling fixed assets etc.

The following items are to be deducted from the above total: payment
to Creditors, payment for liabilities and expenses, purchases of assets,
payments for dividend and taxation etc. the balance will represents the
closing balance of Cash and Bank.

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