Complete Theory

Accountancy class 12th

Fundamentals of Partnership

Partnership as defined by Indian Partnership Act, 1932, Section 4:

It is relation between persons who have agreed to share the profits of a business
carried on by all or any of them acting for all.

The owners individually are called Partners and collectively is called firm. The name of
business is called firm name.

Nature of partnership- From accounting point of view, business and partners are
different but from legal point of view they are same.

Features of Partnership

 Two or more partners- at least two partners who are competent to contract
(Minor, Persons of unsound mind and persons disqualified by law).
Minimum partners- 2
Maximum partners- 50 (as per central government)
 Agreement- Either written or oral. Written agreement is called partnership
deed.
 Lawful Business
 Profit-sharing- agreement to share profits and losses.
 Business can be carried on by all any of them acting for all- A partner is agent
as well as principal. A partner binds through his acts and is also bounded by act
of other partners.

Partnership Deed

Agreement between partners can be oral or written (however written agreement is

advisable). The written agreement is called partnership deed. It is a legal document
signed by all partners and contains information like Description of the partners,
description of firm, nature of business, place business, etc.

Partnership deed helps in settlement of disputes among partners. In absence of

partnership deed, provisions of Indian Partnership Act, 1932 applies.

Matters Provision of Partnership Act

Sharing of profits/losses Shared Equally
Interest on capital Not Allowed
Interest on drawings Not Charged
Interest on Loan by Partner Paid at 6% p.a. and it is a charge against profit.
Remuneration to partner Not paid
Admission of partner New Partner cannot be admitted unless all the partners
agree.
Interest on loan to partner Not charged

Other Provisions

 Minor may only be admitted for benefits of partnership only if all partners
agree. (Sec 30)
 Registration of Partnership is optional and not compulsory. (Sec 69)
 Firm gets dissolved on death of partner unless otherwise agreed. (Sec 35)

Limited Liability Partnership (LLP):

An LLP is a corporate business vehicle that enables professional expertise and entrepreneurial
initiative to combine and operate in flexible, innovative and efficient manner, providing benefits of
limited liability while allowing its members the flexibility for organizing their internal structure as a
partnership.

Characteristics:

i. Separate Legal Entity: An LLP has a separate legal entity and therefore, LLP and its partners are
distinct from each other.

ii. Minimum Capital: Such minimum capital of an LLP is not specified and therefore, the partners of
the LLP decide how much capital will be contributed by each partner.

iii. Minimum Number of Members: A minimum of 2 members are required to establish an LLP who
shall also be the Designated Partners and shall have Director Identification Number (DIN). There is
no limit on the maximum number of partners.

iv. Audit is not mandatory: Audit of an LLP is not compulsory except for the following:

a. If the contributions of the LLP exceeds Rs.25lakhs or

b. If the annual turnover of the LLP exceeds Rs.40lakhs.

Reasons for Interest on capital
  When capitals of partners are different but profit share is equal.
 When capitals of partners are not same and profit share is also not equal.
 Capital increases the earning capacity of the firm.

Case
When No partnership deed or it is silent about
Interest on capital
When Partnership Deed provides for Interest on
Capital but does not mention whether it is charge or
appropriation (it is assumed to be appropriation)
When Partnership deed provides for interest on
capital and also mentions that it is charge.
Provision
Not Allowed
Interest is allowed as per following:
a) Allowed up to full amount only if there are
enough profits
b) Not allowed in case of loss
c) Allowed in appropriation ratio with other
appropriations (if there) if profit is less than
appropriation.
Interest on capital is allowed to full even if there is
loss, less profit or more profits.

Calculation of opening Capital

Interest on capital is calculated on allowed on opening capital. If no additional capital or withdrawing

against capital is there, then Last year’s closing will be same as opening capital of current year.

If Opening capital is not given, then it is calculated by adding things which were subtracted in
opening capital account and subtracting thing which were added in opening capital.

(A) When Capital is fixed

Opening Capital = Closing Capital + Drawings against capital – Additional capital

(B) When Capital is fluctuating

Opening Capital = Closing capital + Drawings (both against capital and profits) + Interest on drawings
+ Share of loss – Additional Capital – Salary/commission – Interest on capital – Share of profit

There are two methods to rectify the errors or omission:

(A) When a single adjustment entry is to made- In this case, net effect of errors is
determined and a single adjustment entry is passed by debiting and crediting the Partner’s
capital/current account.

(B) When multiple adjustment entries are passed- In this, Journal entry is passed for each
error or omission through P/L adjustment A/c and at last profit or loss is distributed among
partners.

Guarantee of profits works in following order:

(A) Guarantee by partner to firm

(B) Guarantee by firm to partner

(C) Guarantee by partner to partner

GOODWILL

WHAT IS THE NEED FOR VALUING GOODWILL

 Change in PSR
 Admission of new partner
 Partner retires or dies
 Business is sold
 Two or more firms are amalgated
 Partnership is converted into company

FACTORS AFFECTING GOODWILL

 Efficient Management
 Favorable location
 Favorable contracts
 Longer establishment of business
 Advantage of patents
 Access to supplies
 Quality
 Market situation
 Market situation
 Risks associated with business
 Nature of business
 Past performance
 Other factors (like after sale services, good customer relations, etc)

Classification of Goodwill

There are two types of goodwill

 Purchased Goodwill: When a business is purchased and purchase

consideration is more than the value of net assets. The goodwill for
which consideration has been paid. It appears in the books of account.

 Self-generated goodwill: It is goodwill made by efforts through various

factors like favorable location, efficient management, etc. It never
appears in books of account.
NOTE: AS-26 says that goodwill should not be recognized in the books of account unless
consideration is paid for it.
Number of years' purchase is the number of years' for which the firm will expect to
earn the same amount of profit because of the past efforts of the firm after change of
ownership.

CHANGE IN PSR

Following are the reasons for reconstitution of firm:

 Change in profit sharing ratio among partners

 Admission of a partner
 Retirement of a partner
 Death of a partner
 Amalgamation of two or more partnership firm

Workmen Compensation Reserve

It is a reserve for a possible liability on account of compensation to employees

Investment Fluctuation Reserve

It is the reserve to meet fall in the market value of investments.

ADMISSION

The new Partner on joining becomes liable for liabilities of business and
entitled to have share in assets and future profits of the firm.

Sec 31 of Indian Partnership Act, 1932, a person can be admitted ad partner

only if:

 If agreed in Partnership Deed

 If all partners agree for the admission, if there is no partnership deed.

Rights of partner after admission:

 Right to share future profits of the firm

 Right to share in assets of firm.

RETIREMENT

According to section 32(1) of the Indian Partnership Act, 1932:

A partner may retire in any of the following ways:

1. With the consent of all the partners.

2. In accordance with an express agreement by the partners.

3. Where the partnership is at will, by giving notice in writing to all the other partners
of his intention to retire.
Liability of retiring Partner

He is liable for all the acts of firm before retirement. But he may be discharged from
his liability by an agreement between himself, third party and continuing partners.

A retiring partner will also be liable for the acts after his retirement if public notice has
not been given of his retirement.

Amount to be credited to the Retiring Partner’s Capital Account/Amount to be paid

 Balance of his/her capital account

 Balance of his/her current account

 Share of goodwill

 Share in Revaluation profits

 Share in Accumulated profits and Reserves

 Interest on Capital

 Salary/Commission etc.

 Share in the profit of current year.

Amount to be debited to the Retiring Partner’s Capital Account/Amount to be

recovered

 Drawings

 Interest on drawings

 Share in Revaluation Loss

 Written off portion of goodwill appearing in the books

 Written off of fictitious assets

Interest on loan amount of retiring partner

Unless otherwise agreed, A partner gets interest of 6% p.a. till the time his due is paid
or at his option he may take share of profits that have been earned by him on amount
due to him. It is calculated by ratio of his capital to total capital employed.

DEATH
In case of death of the partner, partnership will come to an end immediately. In such a
case remaining partners may continue the business. All amounts due to the deceased
partner will be paid to his legal representative/Executor.
Executor is the person named in a Will or appointed by a court to wind up the
deceased partner’s financial affairs after death. He is entitled to all the amounts due
to the deceased partner.

Sec 35 says that unless agreed, death of a partner brings end to partnership business.

Executor of deceased partner gets interest of 6% p.a. till the time his due is paid or at
his option he may take share of profits that have been earned by him on amount due
to him. It is calculated by ratio of his capital to total capital employed.

DISSOLUTION
According to Section 39 of the Indian Partnership Act, 1932, the dissolution of
partnership between all the partners of a firm is called “Dissolution of the Firm”. A firm
may be dissolved with the consent of all the partners or in accordance with a contract
between the partners.

Modes of Dissolution of a Firm

By Agreement (Section 40)

According to Section 40 of the Indian Partnership Act, 1932, partners can dissolve the
partnership by agreement and with the consent of all the partners. Partners can also
dissolve the partnership based on a contract that has already been made

Compulsory Dissolution (Section 41)

An event can make it unlawful for the firm to carry on its business. In such cases, it is
compulsory for the firm to dissolve. However, if a firm carries on more than one
undertakings and one of them becomes illegal, then it is not compulsory for the firm
to dissolve. It can continue carrying out the legal undertakings. Section 41 of the
Indian Partnership Act, 1932, specifies this type of voluntary dissolution.

On the happening of certain contingencies (Section 42)

According to Section 42 of the Indian Partnership Act, 1932, the happening of any of
the following contingencies can lead to the dissolution of the firm:  Some firms are
constituted for a fixed term. Such firms will dissolve on the expiry of that term.  Some
firms are constituted to carry out one or more undertaking. Such firms are dissolved
when the undertaking is completed.  Death of a partner.  Insolvency of a partner.

By notice of partnership at will (Section 43)

According to Section 43 of the Indian Partnership Act, 1932, if the partnership is at

will, then any partner can give notice in writing to all other partners informing them
about his intention to dissolve the firm. In such cases, the firm is dissolved on the date
mentioned in the notice. If no date is mentioned, then the date of dissolution of the
firm is the date of communication of the notice.

Dissolution of the Firm by the Court (Section 44)

 Insanity/Unsound mind
 Permanent Incapability
 Misconduct
 Persistent Breach of the Agreement
 Transfer of Interest
 Continuous/Perpetual losses.
 Just and equitable grounds
SHARE CAPITAL
Company is an artificial person incorporated under Companies Act 2013 or any previous
company law.

The capital of company is divided into small units called shares, owners of which are known
as members or shareholders.

Features of Company

 Incorporation (formed by law under companies Act)

 Separate Legal Entity (separate from shareholders)
 Artificial Person (can own property, enter into contract, conduct business, sue or be
sued)
 Perpetual Existence (existence is not affected by the death, lunacy or bankruptcy of its
members. Can come to end only by winding up through process of law)
 Limited Liability (liability of members is limited to face value or nominal value of shares
or amount of guarantee. In case of companies registered with unlimited liability,
members have unlimited liability)
 Transferability of shares (free transfer in case of public company and in case of private
company is regulated by Articles of Association)
 Management and ownership (managed by elected representatives called Directors
elected by members)
 Common seal (may or may not have common seal, affixed to important documents)

Kinds of companies

 One Person Company (Section 2(62))

 Only natural person being Indian Citizen and resident of India can form OPC.
 One Person can form or be nominee of only one OPC.
 Cannot be formed for Charitable Purpose or Non-banking Financial Investment
 Paid share capital cannot be more than 50 lakhs.
 Average annual turnover of three overs should not exceed 2 crore.
 Should have at least 1 director and max 15.
 Private company
 Restricts right to transfer its shares and cannot invite applications from public
 Maximum number of members-200 (excluding past and present employees) and
Minimum number of members- 2
 Minimum directors-2 and maximum-15
 “Private limited” words mandatory after name of company
 Public Company
 Minimum members- 7 and maximum- infinite
  Minimum directors- 3 and maximum directors-15
 “Limited” word mandatory after name
 Can invite applications from public.
 A private company which is subsidiary of public company becomes public company.

Incorporation of company

 Promotion 1st stage

 Incorporation or registration 2nd stage (certificate of incorporation is called birth
certificate)
 Capital Subscription and Commencement of business (need to get certificate of
commencement with 180 days of incorporation)

Prospectus- document in which terms and conditions of the issue are stated along with
purpose for which securities are being issued.

 Deemed prospectus- any document which offers sale of security

 Red Herring Prospectus- does not contain all details like price and quantity and just
issued for registration.
 Shelf Prospectus- prospectus issued for more than one offers of securities to public.
 Abridged Prospectus- containing all salient features of prospectus in summary form.

Minimum Subscription

Minimum number of applications that should be subscribed by public. According to SEBI,

90% is minimum subscription.

If Minimum subscription is not received, then application money shall be refunded in 15

days from date of closure of Issue.

Preliminary Expenses (expenses incurred for incorporation before incorporation)

Kinds of Shares

 Preference share (two preferential rights- receive dividend before equity shareholders
and receive repayment of capital at winding up before equity shares. No voting rights.
 Cumulative and Non-cumulative (cumulative have right to receive arrears of
dividend before equity shareholders and non-cumulative don’t have that right)
 Participating and Non-participating (Participating have right to enjoy remaining
profit after given to equity shareholders. Non-participating have no such right.)
 Convertible and non-convertible (convertible have right to convert into equity
shares and no such right to non-convertible)
 Redeemable and irredeemable (redeemable get paid back after specified period not
exceeding 20 years and irredeemable shares do get paid back). Irredeemable
preference shares are not allowed to Issue.
 Equity Shares contains voting rights. Contains maximum risk and reward. Enjoy
appreciation of market vale

Types of Share Capital

 Authorized Capital (also known as Nominal Capital, maximum amount that can be raised
through shares, mentioned in memorandum of Association).
 Issued capital (part of authorized capital issued for subscription. Includes shares issued
for other than cash, shares taken by directors and shares subscribed by signatories of
MOA). Cannot be more than Authorized capital.
Issued Capital ≤ Authorized capital
 Subscribed Capital (part of issued capital company issued for cash or other than cash).
Subscribed capital ≤ Issued capital
 Subscribed and Fully Paid-up (Fully called and fully paid- both should be fulfilled)
 Subscribed but not fully paid up (other than fully paid up)
 Called-up capital (which has been called for payment)
 Paid-up capital (amount received with respect to shares issued)

Reserve Capital ( part of capital which will be called only at time of winding up. Shown as
subscribed but not fully paid up)

Capital Reserve (reserve created out of capital and profits and can be used for writing off
capital loss but cannot be used for distribution of dividend.

Issue of shares

 Public issue of shares (offer made by company to public)

 Private placement of shares (issue and allotment of shares to a small number of
investors privately and not publically. Investors are generally banks, mutual funds and
insurance companies.)
 Preferential allotment (allotment to pre identified people at pre-determined price such
as promoters, venture capitalists etc.)
 ESOP (employee stock option Plan) shares offered to employees and employee director
at a price lower than market price. Sweat Equity is wider than ESOP as it also includes
shares to promoters.
 Right Issue- A rights issue is an invitation to existing shareholders to purchase
additional new shares in the company. This type of issue gives existing
shareholders securities called rights. With the rights, the shareholder can purchase
new shares at a discount to the market price on a stated future date.
 Sweat Equity (shares offered to employee for their efforts and also includes shares given
to promoters).
 IPO (Initial public offer) (inviting public for first time to subscribe for shares
 Issue of share at par (1st and only installment is known as share application and
allotment)
 Issue of shares in installments (1st installment- Share application, 2nd installment- share
allotment and remaining part of share money, when called up is called Call money)
 Minimum application should be 5% of nominal value of share and SEBI prescribes that
application money should not be less than 25% of the issue price
 word final is added to last installment.
 Calls are made as provided in Article of Association
 Table F to be followed by company if it doesn’t have Article of Association.

Table Form

Table F AOA of a company limited by shares

Table G AOA of a company limited by guarantee and having

share capital

Table H AOA of a company limited by guarantee and not having

share capital

Table I AOA of an unlimited company and having share capital

Table J AOA of an unlimited company and not having share

capital

Sec 53 of the companies act, 2013 does not allow issue of shares at discount. However, sec
54 allows issue of shares at a discount, when they are issued as Sweat Equity Shares.

Utilization of securities premium reserve (Sec 52 (2))

 Issuing FULLY PAID bonus shares.

 Writing off preliminary expenses
 Writing off expenses or commission paid or discount allowed on any issue of securities
or debentures
 Providing for premium on redemption of any redeemable preference shares or
debentures
 Purchasing its own shares (buy-back)

Calls-in-arrears (amount not paid by shareholder on allotment or calls according to terms).

 Amount unpaid is transferred to Calls-in-arrears account only if question says so.

 Company can only charge interest on calls-in-arrears if mentioned in Articles of
Association. If not mentioned in Articles, table F is followed and interest rate is 10%
p.a. Directors have right to waive interest on calls-in-arrears.
 Shown as deducted from share capital in Balance sheet.
Calls-in-advance (if AOA allows company may accept in advance amount of calls or calls not
yet made).

 Shown as other current liabilities under main head current liabilities.

 Interest if AOA allows and if not mentioned, then Table F is followed which says 12%
p.a.
DEBENTURES
Meaning of Debentures as per Section 2(30) of the Companies Act, 2013: Debenture
includes debenture stock, bonds and any other instrument of the company evidencing
a debt, whether constituting a charge on the assets of the company or not.

Meaning of a Bond: Bond is similar to debenture, both in terms of contents and

texture. It is an acknowledgment of debt issued by the company and signed by an
authorized signatory. Traditionally, bonds were issued by the Government. But these
days, bonds are also being issued by semi-government and non-government
organisations as an acknowledgement of debt.

Types of Debentures

Following are the different kinds of debentures classified based on:

i. Security point of view:

a. Secured: Such debentures are secured by either a fixed charge or a floating charge
on the assets of the company. Such charge is to be registered with the Registrar of
the Companies.

b. Unsecured: Such debentures are not secured by any charge on assets of the
company

ii. Redemption/Permanence point of view:

a. Redeemable: Such debentures are repayable by the company at the end of a

specified period or by instalments during the existence of the company.

b. Irredeemable: Such debentures are not repayable during the lifetime of the
company and are repayable only when the company is liquidated

iii. Records/Negotiability point of view:

a. Registered: Such debentures are registered in the company’s records in the holder’s
name. All amounts towards principal and interest are to be paid to the registered
debentureholder only. Any transfer of such debentures requires execution of transfer
deed.

b. Bearer: Such debentures are not registered in the records of the company in the
name of the holder. They are easily transferable by mere delivery. Interest is paid to
the person who produces coupons attached to the debenture.
iv. Priority point of view:

a. First Debentures: Such debentures are to be repaid before the other debentures.

b. Second Debentures: Such debentures are to be repaid after the first debentures are
redeemed.

v. Coupon rate point of view:

a. Specific Coupon Rate: Such debentures are issued with a specified rate of interest,
called the coupon rate. This rate may be either fixed or floating. If it’s a floating rate, it
is usually linked with the bank rate.

b. Zero Coupon Rate (Bonds): Such debentures do not carry a specific rate of interest.
They are issued at a substantial discount. Such difference between the face value and
issue price is the total amount of interest related to the duration of debentures.

vi. Convertibility point of view:

a. Convertible: Such debentures are convertible into shares. Where only a part of the
debentures amount is convertible into Equity Shares, they are known as Partly
Convertible Debentures. However, when full amount of debentures is convertible into
Equity Shares, they are known as Fully Convertible Debentures.

b. Non-Convertible: Such debentures are not convertible into shares.

Disclosure of debentures in balance sheet

Non-Current Liability: This is done when Debentures are due for redemption after 12
months from the reporting date i.e., the date of Balance Sheet or after the period of
Operating Cycle. The date of issue of debentures determines whether these
debentures are Long-term borrowings or Short-term Borrowings.

Current Liability:

i. Short-term Borrowings: This is done when Debentures are due for redemption within
12 months from the reporting date i.e., the date of Balance Sheet or within the period
of Operating Cycle.

ii. Current Maturities of Long term debt: shown as other current liabilities.

Concept of Minimum Subscription with respect to Debentures

As per SEBI, 75% of the issue should be subscribed before a company allots
debentures.

Writing off Discount or loss on Issue of Debentures:

i. Discount or loss on Issue of Debentures is a Capital Loss for the company and is
therefore, written off in the first year itself
 It may be written off from Capital Reserve and/or from Securities Premium Reserve
and/or from Statement of Profit and Loss.

Analysis of financial statements

As per section 129 of Companies Act, 2013, Balance Sheet and statement of profit and loss
account are prepared in form prescribed in Schedule III of companies Act, 2013.

Financial Statements provide summary of accounts reflecting its Assets, Liabilities and Capital as
on certain date and income statement for certain period.

 Balance Sheet (Position Statement) statement showing Assets and Liabilities (financial
position) at a given date.
 Profit and Loss Account (Income statement) shows financial performance about profit
or loss in Part II of Schedule III of Companies Act, 2013.
 Notes to Account balance sheet and profit and loss account is supported by notes and
accounts giving details of items in Balance sheet and statement of profit and loss.
 Cash Flow statement (statement prepared in accordance with AS 3, cash flow statement
shows inflow and outflow of cash and cash equivalents.

Features of financial statements-a) Relate to past period and are historical documents,

b) Expressed in monetary terms

Nature of financial Statements

 Recorded facts
 Based on conventions
 Accounting concepts
 Accounting standards
 Selection of accounting policies
 Estimates
 Source of financial information

Balance Sheet and its components

 EQUITY AND LIABILITIES

 Shareholder’s Funds
 Share Capital- authorised capital, issued capital, subscribed capital, called up
capital (amount of nominal value called by company) and paid-up capital
(amount received by company as against share capital). Calls-in-arrears shown as
deduction in subscribed but not fully paid up and Calls-in-advance shown as
other current Liabilities.
 Reserve and surplus
Capital Reserve Securities Premium Reserve Capital redemption reserve
Debenture redemption revaluation reserve shares option outstanding
reserve account
Surplus
 Money received against share warrants
 Share application money pending allotment
Share application money against which shares are not be allotted, then it is shown as
“Other current liabilities” under current liability.
 Non-current liability
 Long-term borrowings
Debentures Bonds Term Loans
Public deposits other loans and advances
(only current maturity)
 Deferred Tax Liability
 
Other Long term liability- Trade payables (beyond operating period or 12
months), others (premium payable on redemption of debentures or preference
shares).
 Long-term provisions (provision for gratuity, provision for earned leave and
provision for warranty)
 Current liabilities (Liabilities which are expected to be settled within normal
operating cycle of business or 12 Months from balance sheet date, whichever is
higher) or held primarily for the purpose of trading or there is no unconditional
right to defer settlement for at least 12 months after the reporting date.
Operating cycle- Time period between acquisition of asset for processing and its
realisation into cash and cash equivalents. Where operating cycle can’t be
identified, then it is assumed to be 12 months.
Particulars Operating Expected period Current or non-current liability
cycle of payment
i) Trade payable 10 Months 8 Current (as expected period less than operating cycle)
ii) Trade Payable 10 months 12 Current (as expected within 12 months even if more than operating
cycle)
iii) Trade Payable 10 months 15 Non-current (expected more than both 12 and operating cycle)
iv) Trade Payable 18 months 15 Current (expected more than 12 but less than operating)
v) Trade Payable 18 months 24 Non-current (expected more than both 12 and operating cycle)

Note: Liability is Non-Current only If Expected Period of payment is more than Both
operating cycle or 12 Months.
 Short-term borrowings
loans repayable on demand Bank overdraft Cash Credit from banks
Loans from other parties Deposits other loans and advances
 Trade Payables- creditors and bills payable
 Other current liabilities
current maturities of long- Interest Accrued but not due interest accrued and due
term debts
income received in advance unpaid dividends Application money received
for allotment and due for
refund and interest on it
Unpaid Matured deposits Unpaid matured debentures Calls-in-advance

Outstanding expenses Other Payables

 Short-term Provisions
Provision for Employee Provision for Expenses Provision for Tax
Benefits
Other provisions

 ASSETS
 Non-current Assets
  Fixed Assets- Tangible (furniture, machinery, plant, vehicles, building etc.),
Intangible (Goodwill, Trademarks, Copyrights, Patents, etc.), Capital Work in
Progress, Intangible Assets under development.
 Non-current Investments- Trade Investments (investment in shares and
debentures of other company to promote its own business) and Other
investments (Non-trade). Eg: Investment in Property, Equity, preference shares,
government or trust securities, debentures or bonds, mutual funds, partnership
firms.
 Deferred Tax Assets
 Long-term loans and advances
Capital Advances Security deposits Other loans and advances
 Other Non-current Assets- Long-term trade receivables and others (unamortised
expenses/losses, insurance claim receivable or amount due for asset sold etc.)
 Current Assets (Follow same formula as in current liabilities to calculate what is
Current Asset and What is Non-Current Asset)
 Current Investments (investments to be converted into cash within 12 months or
within operating cycle)
Investment in Equity Investments in Preference Investment in government or
instruments shares trust securities
Investments in Debentures or Investments in Mutual Funds Investments in Partnership
Bonds firms
Other investments

 Inventories (stock)- held for the purpose of trade for ordinary course of business.
Raw Materials Work-in-progress Finished goods
Stock-in-trade Stores or Spares Loose Tools

 Trade Receivables (amounts receivable for sale of goods or services rendered.

They are current assets if they are receivable with 12 months or operating cycle)
Only 2 items- Debtors and Bills Receivables
Provision for Doubtful debts can be shown in Balance Sheet by 2 approaches:
a) Under Long-term or Short-term provision depending whether trade
receivables are long-term or short-term respectively.
b) As a deduction from amount of Trade Receivables.
However, SECOND APPROACH IS MORE APPROPRIATE AND SHOULD BE
FOLLOWED.
 Cash and Cash Equivalents- schedule III classify it into following:
Balances with banks Cheques, drafts Cash in hand
Others Earmarked balances with Balance with bank held as
banks like, unpaid dividend margin money
Bank deposits with more than
12 months maturity
 Short-term Loans and advances- expected to realise with 12 months from date of
Balance sheet or operating cycle.
  Other current Assets- All current assets which do not fall in any category fall
under this category.
Unamortized expenses/losses Prepaid expenses Dividend receivable
(to be written off within 12
months or operating cycle)
Advance taxes
 Contingent Liability and Commitments
 Contingent Liability- liability which may or may not arise depends upon future event.
Example: consumer filed a case in court against company which yet to be adjudged.
Proposed dividend for current year is also shown as contingent liability as it is
subject to approval from shareholders (according to AS-4 revised)
CONTINGENT LIABILITY IS NOT RECORDED IN BOOKS BUT SHOWN IN NOTES TO
ACCOUNTS.
a) Claims against company not acknowledged as debts
b) Bills Receivables discounted from Bank not yet due for payment
c) Proposed Dividend (Current Year)
d) Other money for which company in contingent liable.
 Commitments- financial commitments due to activities agreed to by the company to
be under taken in future.
a) Estimated amounts of contracts remaining to be executed on capital account and
not provided for
b) Uncalled liability on shares and other investments partly paid
c) Other commitments
Not Shown in books but in Notes to Accounts.

STATEMENT OF PROFIT AND LOSSES

 Revenue
 Revenue from operations- revenue earned by company from its operating activities.
(Net sales which is Sales – Sales return) and fee earned by service company and
dividend earned by financial company.
Eg: Beatall Sports Ltd. (a cricket equipment manufacturer) sold waste from wood
used in making cricket bats for 1,00,000. This is revenue from operations.
 Other Income- income earned by company from non-operating activities. Like gain
on sale of Fixed Assets, excess provision written back, bad debts recovered, interest
earned on FD by non-financing company, dividend earned by non-finance company
etc.
In case of financing company, interest and dividend are Revenue from operations
because they deal in investing and financing money.
 Expenses
 Cost of Material consumed- materials are raw materials and other materials used in
manufacturing of goods. (Opening Inventory/stock of materials + Purchases of
materials – closing inventory/stock of materials)
 Purchases of stock-in-trade – goods purchased for reselling. Eg: if company wood for
reselling, then it is shown as Purchases of stock-in-trade but if company purchases
wood for making furniture, then purchase of wood is shown as purchase of raw
materials in cost of material consumed.
 Changes in Inventories of finished goods, Work-in-progress and stock in Trade-
Difference between opening inventory/stock and Closing inventory/stock. (Opening
– Closing )

 Employee benefits expenses- payment for benefit of employees. e.g.: Wages,

Salaries, bonus, leave encashment, staff welfare expenses, etc.
 Finance costs- cost incurred on the borrowings e.g.: interest paid, loan processing
fee, discount on issue of debentures and premium payable on redemption, etc.
Bank Charges are not finance cost as they are not paid for borrowings but for
services by bank.
 Depreciation and Amortisation Expenses- Depreciation is fall in value of Fixed Asset
due to usage, passage/efflux of time, obsolescence etc.
Amortisation is fall in the value of Asset on Intangible Assets.
 Other Expenses- Carriage inwards (direct expense), carriage outwards (indirect
expense), etc.

Objectives of Financial Statements- Provide financial data on economic resources and

obligation of enterprise, show implications of operating profit, provide information for
cash flow to investors, present true and fair view of business, etc.

Parties interested in financial statements or users

 Internal Users- Shareholders (for return as they are exposed to risk),
management (to arrive at informed decisions) and Employees (for bonus and
salary hikes)
 External users- Banks and financial institutions, Investors and potential investors,
Creditors, government and its authorities, SEBI, researchers, Tax authorities,
customers, etc.

Limitations of Financial statements

 Historical Records
 Affected by estimates
 Different accounting practices
  Qualitative elements are ignored
 Price level changes are ignored
 Cannot meet the purpose of all parties
 Aggregate information

Analysis of financial statements is a systematic process of analysing the financial

information in financial statements to understand and take economic decisions. It is a study
of relationships among the various financial factors in a business, as discussed by a single set
of statements, and a study of trends.

Tools of financial statements

 Comparative statements- In comparative Balance sheet and comparative statement of

profit and loss, amounts of two or more years is placed side by side to ascertain change
in amounts and percentage change. This analysis is known as horizontal Analysis.
 Common size statements- common size balance sheet and common size profit and loss,
percentage is calculated of different values in statements taking a common base. In
Balance sheet, Total of balance sheet is taken as common base and in profit and loss,
Revenue from operations (sales) is taken as common base. It is Vertical analysis.
 Ratio analysis- arithmetical expression of relationship between two related or
interdependent components of financial statements of an accounting period.

Types of financial statements

 External Analysis- done by those (outsiders) who do not have access to detailed records
of company and depend on published documents like profit and loss, balance sheet,
notes to accounts etc. done by researchers, customers, creditors, lenders, etc.
 Internal analysis- done by management. It is more detailed, extensive and accurate as
compared to internal.
 Horizontal Analysis- also known as Time-series analysis. Shows comparison of several
years against a chosen base year. All comparative statements.
 Vertical Analysis- also known as Cross-section analysis. Analysis statements of one year
only. Ratio analysis and common size statements are example.
 Inter-firm comparison: a comparison of two or more firms. Also known as cross-
sectional.
 Intra-firm Analysis: comparison of different years or financial variables of a single firm.
Also known as Time series or trend analysis.

ACCOUNTING RATIOS
It is an arithmetical expression of relationship between two interdependent or related
items.
Forms of Expressing Ratios:

i. Pure: As per this form, ratio is expressed as a quotient.

ii. Percentage: As per this form, ratio is expressed as a percentage.

iii. Times: As per this form, ratio is expressed in number of times a particular figure is
when compared to another figure.

iv. Fraction: As per this form, ratio is expressed in fraction.

Advantages of Ratio Analysis:

i. Tool for analysis of Financial Statements: It helps the users of financial statements to
analyse the financial position of an enterprise. Such users can be bankers, investors,
creditors, etc. who are concerned about the performance of an enterprise.

ii. Simplifies Accounting Data: It simplifies understanding of accounting information

presented in the financial statement. Calculation of ratios summarises briefly the
results of detailed and complicated information.

iii. Assessment of Operating Efficiency of Business: Operating efficiency can be

determined by assessing and evaluating liquidity, solvency and profitability of an
enterprise.

iv. Assists in Forecasting: Calculation, analysis and comparison of ratios helps in

business planning and forecasting. This is because the trend of ratios being calculated
acts as a guide for future planning.

v. Identifies Weak Areas: Calculation and analysis of various ratios help to identify and
interpret the favourable and unfavourable ratios which can are used to identify the
weak areas or unfavourable factors in the enterprise. Enterprise can then work upon
such areas or factors to improve the performance.

vi. Facilitates Inter-firm and Intra-firm Comparison: When a firm compares its
performance with that of other firms or with its industry standards in general, it is
known as Inter-firm Comparison or Cross Sectional Analysis. On the other hand, if the
performance of different units is belonging to the same firm is to be compared, it is
known as Intra-firm Comparison.

Limitations of Ratio Analysis:

i. Reliability of Ratios: Since, ratios are calculated based on the financial information, if
the information available is not correct ratios calculated using such information will
also be incorrect. Therefore, such ratios are not completely reliable to make any future
decisions for an enterprise.

ii. Only Quantitative Factors considered: Calculation of ratios takes into consideration
only quantitative factors and all the related qualitative factors are ignored, which may
be important for future decision making of an enterprise.
iii. No Standard Ratio: In order to determine whether a ratio is favourable or adverse,
there should be a standard with which the ratio can be compared. However, there is
no single standard against which the ratio can be compared.

iv. Non Comparable: It is possible that different firms belonging to the same industry
may follow different policies and procedures for the purpose of accounting. The
amounts computed using such different policies and procedures will also be different.
Therefore, ratios calculated by such firms will not be comparable as the information
used in calculating such ratios by the different firms is not the same.

v. Price Level Changes Ignored: It is necessary to understand that comparability of the

ratios depends upon the change in the price levels. However, such change in price
levels is not considered in accounting variables from which ratios are computed.

vi. Window Dressing: If the accounts are manipulated in order to window dress the
financial performance and position of the business, the information available for
computing ratios will not be accurate. This will lead to incorrect ratios being
computed which in turn will affect the decisions taken based on analysis of such
incorrect ratios.

vii. Personal Bias: Since, preparation of financial statements is highly influenced by

personal judgments, accounting ratios computed based on such information is also
not free from such limitation.

CASH FLOW STATEMENT

A cash flow is the inflow (receipt) and the outflow (payment) of Cash and Cash
equivalents, where cash and cash equivalents include Cash, Bank Balance, Marketable
Securities, etc.(unless specified otherwise, Current Investments are considered as
Marketable Securities)

Objectives of Cash Flow Statement:

i. to determine the sources of Cash and Cash Equivalents under operating, investing
and financing activities of the enterprise.

ii. to determine the applications of Cash and Cash Equivalents for operating, investing
and financing activities of the enterprise.

iii. to determine the net change in Cash and Cash Equivalents due to cash inflows and
outflows for operating, investing and financing activities of the enterprise that take
place between the 2 balance sheet dates.

Importance or Uses of Cash Flow Statement:

i. To facilitate Short-term Planning.

ii. To assess Liquidity and Solvency

iii. To manage Cash Efficiently

iv. To facilitate Comparative Study

v. To justify Cash Position

vi. To evaluate Management Decisions

vii. To take dividend decisions

Limitations of Cash Flow Statement:

i. Non-cash transactions are not shown

ii. Not a substitute for an Income Statement

iii. Not a substitute for Balance Sheet

iv. Historical in Nature

v. Assessment of Liquidity

Operating Activities

Following is the list of operating activities for:

 Financial Companies:

a. purchase of securities;

b. sale of securities;

c. interest on loans granted;

d. interest on loans taken;

e. dividends on securities;

f. salaries, bonus and other employee benefits paid to employees;

g. income tax paid and income tax refund received (unless such amounts are
identified with investing or financing activities).

Non-Financial Companies

a. purchase of goods and/or availing of services;

b. sale of goods and/or rendering of services;

c. amounts received from trade receivables;

d. amounts paid to trade payables;

e. royalties, fees and commission, etc.;

f. wages, salaries and other employee benefits paid to the workers and employees;
g. payment of claims and receipt of premium (in case of Insurance Companies) h.
income tax paid and income tax refund received (unless such amounts are identified
with investing or financing activities).

Transactions not regarded as Cash Flow: These are the transactions that are mere
movements in between the items of Cash and Cash Equivalents. This includes cash
deposited in bank, cash withdrawn from the bank and purchase or sale of marketable
securities.

Non-cash transactions: These are the transactions in which the inflow or outflow of
Cash or Cash Equivalent does not take place. Therefore, these non-cash transactions
are not considered while preparing the Cash Flow Statements. These transactions
include depreciation, amortisation, issue of bonus, etc.