Preparation of Financial Statements of Limited Companies

P. GURU PRASAD FACULTY MEMBER INC GUNTUR

General requirements of the companies act

The joint stock companies, are legally required to prepare a set of financial statements to periodically assess the profits earned and to know the financial position of the company as on a specified date. In the case of companies registered under the companies act the act specified the books of accounts to be maintained and also prescribes the format and content of the financial statements.

General requirements of the companies act

The legal requirement laid down by the companies act, there fore assumes a great importance in the preparation of the financial statements of a join stock company. In addition , the accounts must be statutorily audited by an external person called the auditor and it is the duty of the auditor to submit a report in the prescribed format to the shareholders

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Books of Accounts Section 209 of the companies act specifies the books of accounts to be maintained by a company All sums of money received and expended by the company and the matters in respect of which the receipts and expenditure take place All sales and purchases of goods by the company The assets and liabilities of the company Companies have to compulsorily maintain their accounts only on the accrual basis . Cash basis of accounting cannot be followed. Also double entry system of accounting should be followed.

Books of Accounts

The books of accounts for a period of eight years preceding the current year together with the vouchers relating to any entry in such books of accounts should be preserved in good condition The books of accounts and other books and papers of a company must be open to inspection during business hours , by the registrar or such authorized government officer to carry out such inspections

Legal requirements regarding annual accounts

The annual accounts of the company must be submitted in an annual general meeting within six months counted from the last day of the accounting period to which the accounts relate. The period to which the accounts relate is known as the financial year and it may be less than, equal to or greater than 12 months but cannot exceed 15 months. Where special permission has been granted by the registrar the financial year may extend to eighteen months

Format of Balance sheet
 The balance sheet should be in the form

set out in part I of schedule VI of the companies act,1956. However this format does not apply to banking companies , insurance companies and companies engaged in the generation or supply of electricity.

Requirement of the companies Act with Respect to Profit and loss a/c
 Part II of schedule VI of the companies act

1956 does not prescribe any format for the profit and loss account but only outlines the information to be included. The various items of receipts ad expenses should be arranged under the most convenient heads

Revenues
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The following are the revenues which must be disclosed in the P&L The turnover or the aggregate amount of sales effected by the company The gross income derived from services rendered or supplied. Incomes from trade investments and other investments Incomes by way of interests Profit on investments Profits of non recurring nature Miscellaneous income Dividends from subsidiary companies

Expenses
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The following are the expenses which must be disclosed in the profit and loss a/c The value of raw material consumes, item wise break up and quantity consumed. Opening & closing stock of raw material Opening & closing work-in-progress The amount provided for depreciation, Consumption of stores and spare parts Power and fuel Rent Repairs to buildings Repairs to machinery Salaries and wages and bonus Miscellaneous expenses

Expenses
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Contribution to provident fund an other funds Staff welfare expenses Insurance Income tax payable Dividend paid Provision for losses of subsidiary companies Amounts reserved for repayment of share capital Amounts set aside for reserves Amounts set aside for provisions Expenses related to sales, trade discounts

According to part II schedule VI , certain information has to be provided by way of notes to P&L account. payments made to directors Managerial remuneration paid or payable under section 198 Other allowances & commission Any other perquisites or benefits in cash or in kind Pensions Gratuities Payment to provident fund Compensation for loss of office Retirement benefits Auditors fees Value of imports calculate on C.I.F basis Expenditure in foreign currency on account of royalty, etc., Export of goods calculated on F.O.B basis Other incomes indicating the nature there of

Notes to profit and loss a/c

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Profit and loss appropriation account

It shows in detail the appropriations made from the profits in respect of dividends and transfer to reserves etc., The balance in the P&L appropriation account ,if it is a credit balance will be shown on the liability side of the balance sheet heading “reserves and surplus”. If there is a closing debit balance in the profit and loss appropriation account (that is, a loss), then such balance will be shown on the asset side under the heading “miscellaneous expenditure”

Requirements of the companies act with respect to Balance Sheet
 The assets of the limited company should

be classified into  Fixed assets and investments,  Current assets,  Loans and advances and  Miscellaneous expenditure

 Goodwill  Land  Buildings  Lease hold

Fixed assets

 Railway sidings  Plant and machinery  Furniture and fittings  Development of property  Patents, trademarks and designs  Live stocks  Vehicles etc.,

Current assets
 Interest accrued on investment  Stores and spare parts  Loose tools  Stock-in-trade  Work-in-progress  Sundry debtors  Cash balance on hand  Bank balances

Sundry debtors
 Broadly classified into  Debits outstanding for a period exceeding

6 months  Other debits  The provision for doubtful debits should be shown as deduction from the debtors

Miscellaneous expenditure
 Preliminary expenses  Expenses including commission or

brokerage on un writing or subscription of share or debentures  Discount allowed on the issue of share or debentures  Interest paid out of capital during construction  Development expenditure (not adjusted)  Other items

Liabilities
 Share capital  Reserves and surplus  Secured loans  Unsecured loans

current liabilities  provisions

Share capital
 Authorized capital  Issued capital  Subscribed capital  Called up capital  Calls in arrears  Any forfeited shares  Classes of preferences  Paid up capital  Bonus shares have been issued

Forfeiture
 Definition  A loss of money, property, or privileges

due to a breach of legal obligation, which serves as compensation for resulting losses.

Preference shares
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Definition Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than common stockholders. In the event the company goes bankrupt, preferred shareholders are paid off before common stockholders.

Book building

Definition The process of determining the price at which an Initial Public Offering will be offered. The book is filled with the prices that investors indicate they are willing to pay per share, and when the book is closed, the issue price is determined by an underwriter by analyzing these values.

Reserves and surplus
 Capital reserves  Capital redemption reserve  Share premium  Other reserves  Surplus, balance after providing for

account

dividend, bonus or reserves  Proposed additions to reserves  Sinking fund

Sinking fund
 Definition  Reserves created by periodically setting

aside certain sums in a custodial account (as cash or investment in marketable securities) for future replacement of an asset or repayment of a liability.

Secured loans
 Debentures  Loans and advances from

the banks  Loans and advances from subsidiaries  Other loans and advances

Debenture
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Definition 1:Charge, claim, or lien on asset or property, usually as a result of a loan. Definition 2:Promissory note or a corporate bond which (in the US) is backed generally only by the reputation and integrity of the borrower and (in the UK) by the borrower's specific assets. When unsecured, it is called a bare debenture or naked debenture; when secured by a charge on a specific property, it is called a mortgage debenture.

Unsecured loans
 Fixed deposits  Short term loans from  Loans from

banks

others

Current liabilities
 Bills payable (accounts payable)  Sundry creditors  Amount due to subsidiary companies  Advance payment received  Unclaimed dividend  Other’s liabilities 

interest accrued but not due on loans

Accounts payable (A/P)
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Definition Unpaid bills. Accounts that are owed to suppliers (trade creditors) as distinguished from accrued interest, rent, salaries, taxes, and other such accounts. Accounts payable are shown under current (short-term) liabilities in the balance sheet. Lenders and investors examine the relationship of these accounts to the firm's purchases in order to judge the soundness of its day to day financial management.

Accrued interest
 Definition  Interest earned but not received (realized).

For example, bonds usually pay interest every six months, therefore interest accrues between one interest payment and the next. The buyer of a bond pays its market value plus the interest earned up to the settlement date.

Sundry creditors
 Definition  Miscellaneous small or infrequent

suppliers that are not assigned individual ledger accounts but are classified as a group.

capital reserve
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Definition Resource created by the accumulated capital surplus (not revenue surplus) of a firm, such as by an upward revaluation of its assets to reflect their current market value after appreciation. Allocating such sums to capital reserve means they are permanently invested and will not be paid as dividends.

Provisions
 Provision for taxation  Proposed dividends  Provision for contingencies  Provision for provident fund and to their

schemes  Provisions for insurance, pension and similar staff benefit schemes  Other provisions

Provision
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Provision: A present obligation which satisfies the rest of the definition of a liability, even if the amount of the obligation has to be estimated. In financial accounting, provisions are liabilities similar to accruals, for which the amount or probability of occurrence are not known. Typical examples are provisions for warranty costs and provision for taxes, or for the results of court ruling. Sometimes, the term reserve is used instead of term provision; such a use, however, is inconsistent with the terminology suggested by International Accounting Standards Board.

Reserves

In financial accounting, the term reserve is most commonly used to describe any part of shareholders' equity, except for basic share capital. Sometimes, the term is used instead of the term provision; such a use, however, is inconsistent with the terminology suggested by International Accounting Standards Board. Reserve - ACCOUNT used to earmark a portion of EQUITY or fund balance to indicate that it is not available for expenditure. An obsolete term in the United States. More commonly used in Europe.

Reserves
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Equity reserves are created from several possible sources: Reserves created from shareholders' contributions, the most common examples of which are:  legal reserve fund - it is required in many legislations and it must be paid as a percentage of share capital  share premium - amount paid by shareholders for shares in excess of their nominal value

Reserves

Reserves created from profit, especially retained earnings, i.e. accumulated accounting profits. However, profits may be distributed also to other types of reserves, for example:
legal reserve fund from profit - many legislations require creation of the fund as a percentage of profits  remuneration reserve - will be used later to pay bonuses to employees or management  translation reserve - arises during consolidation of entities with different reporting currencies

Difference Between Provision & Reserve

The Provisions are charged on profit and loss account, even though there were no profits for the current financial year. It is mandatory to create the Provisions according to conservatism concept. Where as the Reserves are apportioned from the profits only. If there are no profits, then the management can not create Reserve. They are not mandatory. It can be used to write off capital losses. Later they will form the part of owners net worth.

Share premium account
Share Premium account is shown on liability side of balance sheet under the head reserves and surplus. Section 78 of the companies act restricts the use of the amount collected as premium on securities for the following purpose alone. 2. Issuing fully paid bonus shares to the members 3. Writing off preliminary expenses

Share premium account
1.

2.

3. 4.

Writing off the expenses of issue or the commission paid of or discount allowed on any issue of shares or debentures of the company. Providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company, In purchasing its own shares (buy back) [section 77A] Otherwise called as “Securities Premium Account. (Shares, Bonds, or debentures)

Notes to the balance sheet
 Claims against the company not

acknowledged as debts  Uncalled liability on shares partly paid  Arrears of fixed cumulative dividends  Estimated amount of contracts remaining to be executed on capital account and not provided for.  Other money for which the company is contingently liable.

Form of balance sheet
 A company may prepare its balance sheet

either in the horizontal form specified in part I of schedule VI or may prepare it in a statement form, stating the liabilities as sources of funds in the first part and listing the assets as applications of funds in the second part

Depreciation
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The companies act requires the provision of adequate depreciation for the following purpose For determination of the profits out of which dividends can be declared for determination of the profits for the purpose of calculation of managerial remuneration. The depreciation to be written off to profit and loss account is the amount of depreciation chargeable for the calculation of devisable profits

Interest on debentures
 When a company has raised funds by

floating debenture, the profit and loss account must be charged with interest on debentures for the financial year or where the debentures had been floated only in the current financial year , for the period for which they have been out standing.  Interest accrued but not due should be shown in the balance sheet as a current liability

Income tax

Dividends to both the equity and the preference share holders can paid only out of profits available after taking into account the income tax. the profits on which income tax is payable is termed as taxable profits and the calculation of taxable profits is based on the provisions as per the income tax act. Though the actual amount of tax can be calculated only when the books of accounts are closed for the accounting period and profits are ascertained, the income tax act requires a business to pay advance tax by forecasting the likely profits that would accrue during the year

Income tax

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The process of assessment may take quite some time to be completed and until such completion, the exact tax liability will not be known to the company. Thus the accounting treatment of income tax must take into account the following three stages. Payment of advance income tax Determination of the tax liability by the company from its books of accounts, making a provision for such liability and payment of difference, if any, between advance tax and tax now computed Completion of the assessment by the income tax officer.

Dividends

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Dividends may be defined as the share of profits that is payable to each share holder of the company. The companies act lays down that dividends can be paid out of profits only and prohibits the payment of any dividend out of capital .also , dividends should be paid in cash only. a company may pay dividends from any or all of the three sources. Profits of the current year Undistributed profits of previous year Money provided by the central or any state government for the payment of dividends

Dividends

The directors generally recommended the percentage of dividend payable on the equity shares . The share holders in the annual general meeting may pass a resolution adopting the recommendation or may lower the percentage recommended. The share holders don’t have the power to enhance the dividend recommended by the directors. The percentage adopted must be applied only on the paid up capital. Calls in arrears do not qualify for the dividends.

Dividends
 The dividend recommended by the

directors is termed as proposed dividend till such time it is adopted by the share holders in the annual general meeting.  The proposed dividend will be classified as a provision and shown on the liability side of the balance sheet . The dividend finally decided by the share holders in the annual general meeting as a payable is termed as declared dividend.

Dividends
 Any dividend declared must be paid with

in 42 days from the date of declaration. Hence a declared dividend must be classified current liability in the balance sheet of the company. Though the dividends can be declared only by a resolution of the share holders , if the articles of the company permit , the directors can declare and interim dividend between two annual general meetings.

Dividends
 As per the companies act , no dividend

shall be declared or paid by a company for any financial year out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of he sec 205 (2), except after the transfer to the reserves of the company a percentage for its profits of that year as specified below

Dividends
 Where the dividend proposed exceeds

10% but not 12.5% of the paid up capital , the amount to be transferred to the reserves shall not be less than 2.5% of the current profits  Where the dividends proposed exceeds 12.5% but does not exceed 15% paid up capital , the amount to be transferred to the reserves shall not be less than 5% of the current profits

Dividends
 Where the dividend proposed 15% but

does not exceed 20% of the paid up capital the amount to be transferred to the reserves shall not be less than 7.5% of the current profits.  Where the dividend exceeds 20% of the paid up capital the amount to be transferred to reserves shall not be less than 10% of the current profits.

Dividends

Any dividend declared by the company reaming un paid with in 30 days of declaration , shall be transfer by the company to a special account with in 7 days of the expiry of the aforesaid 30days. If the dividend is not claimed for a period of 7 years from the date of transfer to the special bank account , then the unclaimed amount must be transferred by the company to the fund established under sec 205C. After such transfer , any share holder entitled to claim such dividend may claim it from the government.

Profit on revaluation of fixed assets

When a company revalues its fixed assets and if there is profit on revaluation it should be transfer to capital reserve account. Capital Reserve- Reserve created by the accumulated capital surplus( not the revenue surplus) of the firm e.g. an upward revaluation of assets by a firm to reflect its assets at the current market values after appreciation. Capital reserve is created from the capital gains Capital reserve is that reserve which is created out of profit of capital nature such as: revaluation, business purchase, forfeiture, etc.

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Interest out of capital

Though the companies act provides that the dividends to share holders are payable only out of profits , in certain circumstances with the previous sanction of central government interest may be paid to share holders out of capital . The circumstances classified by sec 208 of the companies act are as below:-

Interest out of capital
 Where any shares in a company are

issued for the purpose of raising money to defray the expenses of the construction of any work or building or the provision of any plant  Such construction or provision of plant cannot be made profitable for a lengthy period. ( notified rate of interest 12%)

Suspense account
 Some times suspense account is shown in

the trial balance because some items which cannot be posted to the correct account for some reason or the other is shown as suspense account which is rectified or adjusted while preparing the final accounts

Managerial remuneration

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Calculating of managerial remuneration payable to directors , mangers , managing director is base on net profit which is calculated as follows. The net profit for this purpose is calculate after making the four adjustment to gross profit Credit shall be given for the following sums Credit shall not be given for the following sums The following sums shall be deducted The following sums shall not be deducted

Credit shall be given for the following sums
 Bounties and subsidies received from

any government or any public authority should be added with the gross profit.

 Bounty:- rewards, generosity  Subsidies:- gift of supporting funds

Credit shall not be given for the following sums
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Profits, by way of premium, on shares or debentures of the company Profits on sales by the company of forfeited shares Profits of capital nature including profits from sale of undertaking Profits from the sale of immovable property However, credit shall be given for revenue profit( difference between original cost and written down value) on the sale of fixed asset

The following sums shall be deducted
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All the usual working charges Directors remuneration Bonus or commission paid to any member of the staff Any tax on excess or abnormal profits Interest on debentures Interest on mortgage Expenses on repairs Outgoings , inclusive of contributions Depreciation toa the extent specified in sec 350

The following sums shall be deducted
 The excess of expenditure over income  Any compensation or damages to be paid

in virtue of any legal liability  Any sum paid by way of insurance  Debts considering bad and written-off  Amount paid as cess u/s441 A

The following sums shall not be deducted
 The remuneration payable to the

managing agent (not in force)  Income tax and super tax payable  Any compensation, damages or payments made voluntarily  Loss of capital nature including loss on sale of the undertaking. sec 350

Commission after charging such commission
 :-

as per the provision of the companies act, commission to managerial staff should be calculated before charging such commission . However, a company may enter into an agreement to pay commission as a percentage of profit after charging such commission. In this case, commission is calculated as follows

commission is calculated as follows

Commission =
rate of commission
100+rate of commission

profit before commission

*

Commission payable to more than one member of managerial staff
 There

may be an agreement that the whole time directors will get commission at a fixed rate on net profits after the commission of the part time directors. Again the part time directors will get commission at a fixed rate on net profit after the commission of the whole time directors. In this situation, the commission of each group is calculated with the help of simultaneous equations.( refer 7.3)

Thank you
 "When people say to me: "How do you do

so many things?" I often answer them without meaning to be cruel: "How do you do so little?" It seems to me that people have vast potential. Most people can do extraordinary things if they have the confidence or take the risks. Yet most people sit in front of the TV and treat life as if it goes on forever." -- Phillip Adams

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