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Introduction to Accounting

By Prof. Harvinder S. Chawla

Accounting was born before writing or numbers existed, some 10,000 years ago in Mesopotamia later know as Persia (Iran and Iraq). This area contains the Tigris river valley, fertile area with a large population and active trading being done between towns and cities up and down the river valley. And what happens next will directly lead to the invention of both writing and number systems.

Before shipping their goods, a merchant would take one token for each item in the shipment, and encase the tokens in a ball of clay, called a "BOLLAE" (pronounced "bowl-eye") - meaning ball. This ball would be dried in the sun, given to the boatman, and then broken by the buyer on the other end of the transaction. The buyer would match the tokens with the items, to verify that everything sent was accounted for. This is the function of protection of assets, and is a major function of all modern accounting systems. It was important 10,000 years ago and is just as important now.

Written accounting records are some of the oldest writings that have been excavated across the world. These early records were simple single-entry listings of wages paid, temple assets, taxes and tributes to the king or Pharaoh.

Picture in the Tomb of Chnemhotep, pharaoh of Egypt dated 1950 BC. Minute care is not only taken in the case of large amounts, but even the smallest quantities of corn or dates are conscientiously entered." In ancient Egypt, the accountants literally counted food, beer, clothing and everything else. Ancient Egyptians were paid in kind as the concept of money was not invented till then.

Marble tablet: Account of Disbursements of the Athenian State c. 418-415 BC By the time Christopher Columbus was trying to sail west, a new form of accounting was in use by merchants in Venice . Luca Pacioli set down in writing for the first time a description of the double-entry system of accounting, which we still use today in the same form. Although he didn't actually invent the system he is called "The Father Of Accounting" for his contributions and for documenting the system in his fifth book on mathematics Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion).

Important Concepts & Necessity of Accounting


By Prof. Harvinder S. Chawla

Why should managers and other decisionmakers know accounting? If Finance is the language of business, then Accounting is its grammar. Accounting is an information system Accounting provides information for making decisions Accounting and economic decisions

Are the companys share good for medium to long term investment horizon? Investor

Can the borrower repay its obligation on time & what should be the collateral? Lender

How is our company performing As compared to our competitors? Can we improve? Manager

Assess whether the employer can meet the future obligations i.e. Bonus, Salary.etc? Employee & Trade Unions

Can the company pay on time for purchases? Can the borrower pay interest on time? Suppliers & Trade Financiers

The supplier will be able to provide spare parts? Can supplier meets warranty obligations? Customers

Is the company evading income tax, excise duty and other government levies? Government & Regulatory Authorities

Is the company exploiting its customers, labour, natural resources, suppliers, etc? The Public

Accounting entity Business is distinct from owner Going concern Business is a continuing enterprise Periodicity Business activities divided into periods Money measurement Money is a stable measurement unit Accrual Concept Record business transaction when they occur not when the cash is received

Importance of GAAP
What is GAAP?

Institutions that influence GAAP


Government Accounting profession Securities regulators Other regulators International organizations

FORMS OF BUSINESS ORGANIZATION

SOLE PROPRIETORSHIP

PARTNERSHIP

TYPICAL SIZE

Single Owner

Few Individuals (Min 2 - Max20)

DECISION MAKING

Completely Flexible

Largely Flexible but Partners may disagree

GOVT. REGULATION

None

Virtually None

SUITABILITY

Small Business

Small to Medium

FORMS OF BUSINESS ORGANIZATION

LIMITED COMPANY (Private)

LIMITED CO. PUBLIC (Not listed)

LIMITED CO. PUBLIC (Listed)

TYPICAL SIZE

Few Individuals (Min 2 Max50)

Min 7 to Unlimited Shareholders Very Rigid (Shareholders approval needed at every stage)

Min 7 to Unlimited Shareholders Very Rigid (Shareholders approval needed at every stage) Companied Act & SEBI Act (applies to full extent Filing of Documents, Disclosure, etc.)

DECISION MAKING

Largely Flexible but Directors may disagree

GOVT. REGULATION

Companies Act (applies but to very less extent)

SUITABILITY

Small to Medium (often due to legal restriction Permit, Licence, Loan, etc.)

Companied Act (applies to full extent Filing of Documents, Disclosure, etc.)

Medium to Larger

Large to Very Large Business (especially ones which need huge Capital Investment)

Overview of Income Statement & Balance Sheet


By Prof. Harvinder S. Chawla

15

Measurement: Past & Current Performance

Forecasting: Future Financial Position


Decision Making: Relevant information to users Comparison & Evaluation: Targets vs. Actual

Control: Identify Weakness & offer Feedback


Government Regulation & Taxation

Profit and loss account Statement of financial performance Revenues; Expenses (Profitability) Balance sheet Statement of financial position Assets; Liabilities; Equity (Solvency) Cash flow statement Statement of cash receipts and cash payments Activities: Operating;Investing;Financing (Changes in Financial Position)

THE DOUBLE ENTRY SYSTEM

&
ACCOUNTING EQUATION

Sources of Funds = Uses of Funds

Equities = Asset

Assets=Liabilities + Equity
Capital+ RevenuesExpensesDrawingsDividends
Can be rewritten as (Assets + Expenses + Drawings + Dividends = Liabilities + Capital + Revenues

Probable future economic benefits (Cash or something that can generate cash for business) Assets = what a business owns Examples Cash, Cash at Bank, Bills Receivables, Prepaid Expenses, Debtors or Account Receivable, Stock (of Raw Material, Work in Progress, Finished Goods, etc.) Land, Buildings, Plant & Machinery, Patents, Copyrights, Loose Tools, Goodwill, etc.

Probable future sacrifices of economic benefits Liabilities = what a business owes (Contractual, statutory, or constructive) Examples
Bank Overdraft, Outstanding Expenses, Bills Payable, Creditors on accounts, Loan short term as well as long term, Debentures, etc.

Equity represent the claims of those who supplied or invested the money to start the business. Difference between Asset Liabilities. Equity is the residual interest in the asset of the business after deducting all its liabilities. Example
Money supplied by the Proprietor for business or seed money (less withdrawals) Reserve & surplus of profit (accumulated profit)

Increase in one Asset Increase in one Liability Increase in one item of Proprietor's Equity Increase in Proprietor's Equity Increase in Liability Decrease in Asset Increase in Asset Increase in Asset Decrease in Asset

Decrease in another Asset Decrease in another Liability Decrease in one item of Proprietor's Equity Decrease in Liability Decrease in Proprietor's Equity Decrease in Proprietor's Equity Increase in Proprietor's Equity Increase in Liability Decrease in Liability

The account is the basic building block of any accounting system. An accounting system classifies transactions into meaningful categories to prepare financial statements & reports. Accounts facilitates easy & quick retrieval of companys financial data. An account is used to record increase & decrease in these item (assets, liabilities, capital, revenue, drawings, dividends & expenses) resulting from business transactions. No matter whether a company uses either a manual or electronic accounting system, it is essential to have a proper system of classification of transaction into various accounts.

The T account
Debit = Left Credit = Right

Debits = Credits
We need to record each transaction in two accounts so that the accounting equation is always in balance. Double Entry System records every transaction with equal debits & credits. As a result, the total of all Debits must equal total of all Credits

The terms Debit (Dr.) & Credit (Cr.) are used to describe the left hand side & right hand side of an account. To debit means to make an entry in the left hand side of an account & to credit means to make an entry on the right hand side.
(Any type of Account)

Debit Always the left side

Credit Always the right side

The term debit & credit has no other meaning in accounting. All accounts show entries recording increase & decrease. In some accounts increase are recorded on the left side & decrease on right side whereas in other accounts the reverse is true. It means debits & credits by themselves do not indicate increase & decrease unless reference is made to a specific account to determine the debits & credits represent increases & decreases.

Asset Accounts Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit Expenses Account Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit Drawings Account Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit

Assets, Required Expenses, Effect Drawings, Dividends

Liabilities, Equity, Revenues

Debit Credit

Credit Debit

Owners' Equity Account Debit Side Credit Side Revenue Account Shows Decreases Shows Increases Debit Side Credit Side Normal Balance - Credit Shows Decreases Shows Increase Normal Balance - Credit

Liabilities Account Debit Side Credit Side Shows Decreases Shows Increases Normal Balance - Credit

The accounts maintained by the business organization can be classified into three types. Personal Account: It deals with accounts of individuals like Creditors, Debtors, Bank etc. It give you an idea about the balance due to these individuals or due from them on a particular date. Real Account: It relates to assets of the firm but not debts. Eg: Machinery, Land, Buildings, Fixed Deposits Goodwill etc. This account shows the worth of an asset on a particular date. Nominal Account: It consists of different types of expenses or losses and income or profit. The account shows the amount of income earned or expenses incurred for a particular period.

PERSONAL ACCOUNT Debit the receiver, Credit the giver. REAL ACCOUNT Debit what comes in, Credit what goes out. NOMINAL ACCOUNT Debit all expenses & losses, Credit all incomes & gains.
Assets, Required Expenses, Effect Drawings, Dividends Liabilities, Equity, Revenues

Debit Credit

Credit Debit

Sr. No Title of Account Equation Approach Traditional Approach


1 2 3 4 5 6 7 BUILDING STOCK BANK DEPOSIT RENT CASH DEBTORS LOAN ASSET ASSET ASSET EXPENSES

REAL
REAL PERSONAL NOMINAL

ASSET
ASSET LIABILITY DRAWINGS

REAL
PERSONAL PERSONAL PERSONAL

8
9

DRAWINGS
FURNITURE

ASSET

REAL

JOURNAL ENTRIES, LEDGER & TRIAL BALANCE

The Journal is a chronological record of transaction entered into by the business. It is called the Book of Original entry or primary book because we record all the business transaction first in this book.
The process of recording transaction in Journal is called Journalizing.

JOURNAL Date (1) Description (2) Post. Ref (3) NARRATION (6) Debit (Dr.) (4) Credit (Cr.) (5)

The procedure for recording transactions in the journal is as follows: Enter the year, month & date of the transaction on the Date Column Write the account titles under the Description Column Enter the account to debit on the first line. Enter the account to credit under the debited account & indent it to set the account apart from the debited account. If there are several accounts enter them one after another.

Enter the amount of the debit in the Debit Column alongside the account to debit & the amount of the credit in the Credit Column alongside the account to credit. Write a brief explanation of the transaction The Post. Ref. (Posting Reference) is left blank at the time of making the journal entry.

After recording transaction in the Journals, all entries are classified & grouped into set of accounts. Transferring information from Journal to Ledger is called Posting. A ledger account has two sides debit side & credit side. Each of this sides has four columns: Date, Particulars, Journal Folio, Amount.
ACCOUNT NAME Particulars
To Vijays A\c

Dr. Date
1/6/10

Cr. Particulars
By Machinery A\c

J.F.

Amount
1,000

Date
10/6/10

J.F.

Amount
500

Separate account is opened in ledger book for each account & entries from ledger posted to respective account accordingly. It is a practice to use words TO & BY while posting debit & credit entries respectively. To ascertain the balance, total both the sides and find out the difference. Cr. > Dr. The account has a credit balance. Dr. > Cr. The account has a debit balance.

Dr.

CASH ACCOUNT

Cr.

Date
1/6/10

Particulars
To Vijays A\c

J.F.

Amount
1,000 1,000

Date
10/6/10 31/6/10

Particulars
By Machinery A\c By Balance

J.F.

Amount
500 500 1,000

1/7/10

To Balance b\d

500

We know that under double entry system, the debit & credit amounts must be equal.

The TRIAL BALANCE is a device for verifying the equality of debits & credits. The TRIAL balance list each account in the ledger, with the debit balance in the left column, & credit balance in the right column.
Each column has a total & the two total must be equal. When this happens, the accounts are said to be in balances.
TRIAL BALANCE as on 31 March, 2010 Account Name Debit Credit

The equality of the debit & credit totals of the TRIAL balance proves that we have recorded equal debits & credits in the accounts. However, we could have made errors that do not affect the equality of debits & credits: Errors of principle: Posting a journal entry to a wrong account will not affect the Trial Balance. Eg: Suppose that for payment of RENT we debited Office Furniture instead of Rent expense. The Trial Balance will still balance. Errors of omission & repetition: The trial balance will not reveal either the complete omission of a transaction from the ledger or the recording of the same transaction more than once.

Compensatory errors: The recording of the same erroneous amount for both the debit & credit of a transaction will not show up in the trial balance.

LOCATING ERRORS: Posting a debit as a credit or a credit as a debit. Computing an account balance incorrectly. Copying the amount of an account balance to the trial balance incorrectly. Copying a debit balance in an account as a credit balance or a credit balance as an debit balance. Omitting an account balance from the trial balance Totaling the trial balance incorrectly.

Correcting Errors: If you discover an error in a journal entry before posting, you can cross out the wrong amount & insert the correct amount immediately. However, erasing errors may give a wrong impression of misappropriation or misuse. We should avoid the above situation. In order to rectify wrong posting of journal entries, a useful way is to determine the correcting entry & compare it with the incorrect entry. Eg: Electricity Expenses Paid Rs. 4,000. Incorrect Entry: Rent Expenses A\c To Cash A\c

Dr.

Rs.4000 Rs. 4000

Correct Entry: Electricity Bills A\c To Cash A\c

Dr.

Rs. 4000 Rs. 4000

To correct the error, pass the below entry: Electricity Bills A\c Dr. Rs. 4000 To Rent A\c Rs. 4000 Please note that credit to Cash A\c is correct & does not need correction. When the trial balance is not in Balance, the normal practice is to place the difference initially in a Suspense Account. Then the accounting records are verified to locate the errors. Finally, the correct entry is passed to debit or credit Suspense A\c & the relevant account.

The following are the transactions for Pulp & Paper Co. Ltd.(printing press) for October 10 are as follows: 1st - Mr. Kapoor began business by investing Rs. 10,000 3rd Paid cash for two months office rent in advance Rs. 2,000 4th Bought machine for cash Rs. 1,200 6th Bought raw material for cash Rs. 700 9th Received cash for printing work completed Rs. 8,600 11th Paid cash for an advertisement done for business promotion Rs. 1,400

13th Received cash for printing text books Rs. 11,200 17th Bill of Rs. 13,100, send to customer for work done. 20th Paid cash as salary to marketing manager Rs. 1,500 23rd Cash paid for telephone bill Rs. 240 28th Received cash as part payment from customer billed on 17th Oct, 2010, Rs. 4,800 29th Declared & Paid cash dividend of Rs. 2,500 Pass Journal Entries for all the transaction, Post them into Ledger & prepare Trial Balance.

Journal Entries in the books Pulp & Paper Co. Ltd.

POSTING JOURNALS ENTRIES INTO LEDGER ACCOUNTS

CAPITAL & REVENUE

All the transaction of a business enterprise can be classified into Current Period Transaction & Futuristic Transaction. All the expenses & receipts can be classified as revenue expenditure, capital expenditure, deferred expenditure, revenue receipts & capital receipts.
This classification in necessary in order to provide appropriate treatment to these items under financial statement.

Expenses are classifies as revenue expenses, capital expenses & deferred revenue expenses.
EXPENDITURE REVENUE EXPENSES

CAPITAL EXPENSES

DEFERRED REVENUE EXPENSES

REVENUE EXPENSES These are the expenses, the benefits of which are not available for more than one accounting year. Such expense nether lead to addition into any of the assets nor increase the earning capacity of the business. They are incurred to enable enterprise to carry out the day to day business activities such as payment of salary, wages, rent, etc.

Features of Revenue Expenses: Recurring in nature. Benefit exhaust within one accounting year. These are generally routine expenses. Find place in trading or Profit & Loss Account. CAPITAL EXPENSES These are the expenses, the benefit of which is not exhausted within one accounting year. Such expense either lead to addition into any of the assets or increase the earning capacity of the business. They are non recurring in nature. In the financial statements these expense are shown on asset side of Balance Sheet. Expenditure incurred for construction, acquisition, purchase, installation charges, freight charges incurred on fixed asset.

Features of Capital Expenses: Non - recurring in nature. Benefits are provided for long period of time. Lead to increase in the earning capacity of the business. Find place in Balance Sheet of the firm. DEFERRED REVENUE EXPENSES These are the expenses which are basically revenue in nature but their benefit is not exhausted within one accounting year. Hence the amount of such expenditure is written off over a certain period of time. The written off portion is debited to the Profit & Loss Account and balance is shown on the asset side of Balance Sheet.

Feature of Deferred Revenue Expenses: Non recurring in nature Benefits are provided for long period of time. Does not lead to addition in the fixed assets. Generally heavy amount of expenditure. Find place in Profit & Loss Account (of the extent written off) as well as Balance Sheet (balance amount).

The receipts are classified as revenue receipts & capital receipts for the purpose of ensuring appropriate treatment in the books of account & financial statement.
RECEIPTS CAPITAL RECEIPTS

REVENUE RECEIPTS

CAPITAL RECEIPTS Receipts which are generated out of capital transactions like sale of fixed assets or taking the loan. Thus, when a capital receipts takes place then it is the consequence of either decrease in fixed asset (by way of sale) or increase in liability like collecting public deposits, etc.

REVENUE RECEIPTS Receipts generated out of routine business transaction or operating transaction. Amount of sales proceeds received, interest received, commission received, dividend received, etc. When a amount is received under revenue receipts then there is no impact or change in the amount of asset or liability. EXAMPLES: Customs duty paid Rs. 5,000 on import of machinery.
Capital Expenditure: Because the import duty paid in connection with the purchase of new fixed asset & hence it is also to be included in capital expenditure.

Wages paid for formation of the production plant Rs. 3,000. Capital Expenditure Because wages are paid in connection with erecting new plant which itself is a capital expenditure Repairing expenses Rs. 5,000 before putting to use a second hand delivery van. Capital Expenditure Because any repairs made to any asset immediately on purchase & before it is put to use are considered as capital expenditure & added in the value of assets.

Rs. 3,400 paid for replacing a worn out part of a machine with the new part.

Revenue Expenditure Because it is incurred for keeping the asset in working condition. It does not lead to any addition in fixed assets nor does it enhances the earning capacity above the existing level.

Amount of Rs. 500 paid for repairs of existing plant.


Revenue Expenditure Any expenditure for repairs on the existing asset is considered as revenue expenditure.

Rs. 8,00,000 paid for advertisement for launching a new product into the market. The benefit of such advertisement will be accrued for 4 to 5 years.

Deferred Revenue Expenditure Heavy advertisement made for launching of a new product will benefit for long period of time but it does not lead to addition in value of fixed assets.

Collection from debtors Rs. 20,000.


Revenue Receipt Collection from the debtors is against credit sales made to them, hence such collection is considered as revenue receipts.

Loan taken Rs. 15,000.


Capital Receipt Loan taken leads to increase in liability, hence such receipts is capital receipts.

DEPRICIATION

In any business, fixed assets are used for a long period of time. Hence certain proportion of its cost is required to be measured & charged against periodic revenue of the business. Such an appropriate proportion of cost to be charged against annual revenue is called as DEPRECIATION. In other words depreciation means reduction in the value of fixed assets due to its wear and tear. Depreciation is charged on fixed assets only and it is termed as loss to the business. Depreciation is also termed as provision for the replacement of asset at the end of its useful life.

Features of Depreciation

Depreciation is charged on fixed assets only. Depreciation is a gradual process. Depreciation is a permanent decrease in the value of fixed asset. Depreciation takes place continuously. It is basically a fall in the value of depreciable fixed asset.

Need for Providing Depreciation


To show the fixed asset at reasonable value. To find out the true amount of profit or loss of business. To show the correct financial position. To spread the cost of fixed asset over its useful life. To meet the legal requirements.

On the basis of maintaining the accounts for depreciation, there are two systems which are as follows. Charging depreciation directly to asset - Under this system a separate asset account is maintained and the amount of annual depreciation is credited directly to asset account. Under this method at the end of every accounting year, the balance in asset account is considered as written down value of that asset.

Creating provision for depreciation account- Under this system asset account is maintained at cost through out its life and a separate account called provision for deprecation account is prepared for crediting the amount of annual depreciation. Over a period of time the amount of depreciation gets accumulated in this account.

METHODS OF CHARGING DEPRECIATION Fixed installment method- It is also known as straight line method or original cost method. Under this method every year during the useful life of asset, depreciation is calculated as certain fixed percentage of original cost of asset.

Therefore, the amount of depreciation remains constant over the useful life of asset. In this method annual installment of depreciation can also be calculated by the following formula.
Depreciation (p.a.) = Cost of Fixed Asset Scrap Value of Asset Estimated useful life

Reducing balance method- also known as diminishing balance method or written down value method. Under this method depreciation is charged at certain % on original cost in the first year and subsequently on opening written down value of an asset every year. Due to this an amount of depreciation changes every year and it goes on reducing.

Change of method - It is not a separate method of depreciation as such. After charging depreciation under particular method for few years a businessman may decide to change the method. A businessman may either shift from fixed installment method to reducing balance method or reducing balance method to fixed installment method. There are two ways of implementing such change which are as follows. Prospective change- Under such change the method of providing depreciation changes from the current year only that is the change is effective from the year in which it is implemented.

Retrospective change- Under this method a change is implemented in the current year with effect from the very beginning that is from the first year of an asset. Under such change there may be a profit or a loss arising from the change of method which is transferred to the profit and loss account of the year in which such a change is implemented. EXAMPLE 1: APJ Traders Pvt. Ltd. Purchased Machinery costing Rs. 30,000 on 1st July, 2000. They purchased additional Machinery of Rs. 15,000 on 1st April, 2001. It was decided to depreciate it @ 10% on 31st March every year under Straight line Method.

Machinery Purchased on 1st July, 2000 was sold for Rs. 25,000 on 31st March, 2002. Prepare Machinery A/c, Depreciation A/c & Ascertain the Profit or Loss on the sale of machinery. EXAMPLE 2: Chill Fruit Juice Pvt. Ltd. Purchased equipment costing Rs. 3,00,000 on 1st July, 2000. They purchased additional equipment of Rs. 1,50,000 on 1st April, 2001. It was decided to depreciate it @ 15% on 31st March every year under Reducing Balance Method. Equipment Purchased on 1st July 2000 were sold for Rs. 1,60,000 on 31st March, 2002.

EXAMPLE 3: ACL Ltd. Purchased building worth Rs. 20,000 on 1st Jan 2002 & started depreciating it @ 10% p.a. on RBM on every 31st Dec. In the year 2004 it was decided to change the method to FIM @ 8% with retrospective effect. Prepare Building A/c for 4 years from the beginning.

IMPORTANT: If the answer of total depreciation as per old method minus total depreciation as per new method comes positive then it is considered as profit and if it come negative it is considered as loss on change of method

The final-accounts are the group of three different accounts viz. Trading Account, Profit and Loss Account and Balance Sheet. This group of three accounts is called final accounts because it gives final results of the business done in the accounting year. In other words, final accounts generally refer to two important accounting statements prepared by the business unit at the end of the financial year and those accounting statements are:
Income statements and Statement of financial position.

It is a part of final accounts which is prepared on the basis of direct expenses and direct incomes of business to ascertain the gross result of the business, done in the accounting year. On the debit side of trading account, direct expenses, opening stock and purchases are recorded and on the credit side of account direct income, closing stock and sales are recorded. Debit balance of this account indicates gross loss and credit balance of this account indicates gross profit. Results shown by this account i.e. either gross profit or gross loss is carried forward to the profit and loss account.

Profit and Loss account is a part of final accounts which is prepared on the basis of indirect expenses and indirect incomes of the business to ascertain the net result of the business done in the accounting year. Expenses and incomes which have no direct relation with production and whose absence do not affect production, are called indirect expenses and indirect incomes.

An accounting statement which shows the financial position of all assets and liabilities of the business as on particular date is called the Balance Sheet. Balance sheet is not an account but a positional statement showing financial position of a business concern as on a particular date.

Additional business information provided after completion of trial balance for preparation of final accounts are known as adjustments. To get a clear view and real results of business done in the trading year, some other business information, which do not find place in the trial balance, are required to be considered, while preparing final accounts. It has 2 or more effects.

EXAMPLE 1: 04.

The TRIAL Balance of Shree Traders as on 31st Mar

Particular To Opening Stock To Purchases Less: Purchase Return To Carriage Inward To Wages Add: Outstanding To Gross Profit c\f To Commission To Rent & Insurance Add: Outstanding To Bad Debt Add: New R.D.D. Less: Old R.D.D. To Discount To Printing & Stationery To Depreciation Plant & Machinery Furniture To Salaries To Trade Expenses To Postage & Telegram To Interest on Loan To Interest on Capital To Loss by Fire To Net Profit c\f

Trading and P&L A\c for the year ended 31st Mar '04 Rs. Rs. Particular 11,000 By Sales 47,500 Less: Sales Returns 1,000 46,500 By Good destroyed by Fire 350 By Drawing 6,000 By Closing Stock 600 6,600 29,800 94,250 500 By Gross Profit b\d 400 By Discount Earned 700 1,100 250 880 1,130 750 380 100 700 600 250

Rs. 75,500 1,500

Rs. 74,000 5,000 250 15,000

94,250 29,800 50

850 2,500 300 200 165 1,250 800 21,005 29,850

29,850

Balance Sheet as on 31st Mar '04


Liabilities Capital Less: Drawing Less: More Drawings Add: Interest on Capital Add: Net Profit Outstanding Wages Outstanding Rent Sundry Creditors Outstanding Salaries Loan Add: Interest for 3 months 11,000 165 11,165 Rs. 25,000 750 250 1,250 21,005 46,255 600 700 12,600 100 Sundry Debtors Less: R.D.D. @ 5% Furniture Less: Dep @ 5% Prepaid Insurance Cash in Hand Patents Insurance claims receivables Closing Stock 71,420 17,600 880 5,000 250 4,750 300 2,000 2,500 4,200 15,000 71,420 16,720 Rs. Assets Land Plant & Machinery Less: Dep @ 10% Cash @ Bank 6,000 600 5,400 550 Rs. Rs. 20,000

Example 2 - The following is the trial balance of RJ & Co. at 31st March, 2008 and it is desired to prepare final statements of account showing the results of the transaction for the year:
Cr (Rs.) Particulars 8,000 Sales Bills Receivable Bills Payable Sundry Creditors Returns Inwards Provision for Doubtful Debts Drawing Returns Outwards Rent Factory lighting and heating Telephone Dr (Rs.) 1,440 1,120 10,400 1,860 500 1,400 1,100 1,200 160 70
Bad Debts Discount allowed Discount Received TOTAL 117,860 500 840 740 117,860 Advertising General Expenses 1,130 200

Dr (Rs.) Particulars Capital Account 10,000 Plant & Machinery Office Furniture & Fittings Stock 01/04/2007 Motor Vans Sundry Debtors Cash in hand Cash at bank Wages: Factory Wages: Office Purchases 520 9,600 2,400 9,600 80 1,300 30,000 2,800 42,700

Cr (Rs.) 96,000

Particulars Insurance

Dr (Rs.) 60

Cr (Rs.)

The following adjustments are to be made. Stock on 31st March 2008 Rs. 10,400. Rent due but not paid up to 31st March 2008 Rs. 400. Three months factory lighting and heating due but not paid Rs. 60. Insurance paid in advance Rs. 20. Depreciate Plant and Machinery by 1O%, Furniture by5% and Motor vans by 25%. Write off further bad debts Rs.140 and increase the provision for doubtful debts for Rs. 600. Discount of 2 % on debtors and creditors are to be anticipated.

Trading and Profit & Lass A\c. of RJ & Co. For the year ended 31st Mar 08.

Particulars

Rs.

Particulars

Rs.

EXAMPLE 3: From the following trial balance prepare the Trading and Profit & Loss Account & Balance Sheet after taking into considerations all the following adjustments. Trial Balance as on 31st March, 2003.
DEBIT BALANCES OPENING STOCK SUNDRY DEBTORS PURCHASE WAGES SALARIES OFFICE EXPENSES INSURANCE PLANT & MACHINERY RENT TRAVELLING EXPENES RETURN INWARD LAND & BUILDING BILLS RECEIVABLES BANK BALANCE FURNITURE SUNDRY EXPENSES BAD DEBTS ADVERTISEMENT Rs. 20,000 28,000 40,000 8,500 2,700 2,445 1,300 30,000 1,800 1,400 3,500 44,800 4,000 6,655 2,400 800 600 700 199,600 CREDIT BALANCES BILLS PAYABLE RETURN OUTWARDS SUNDRY CREDITORS SALES R.D.D. CAPITAL 10% LOAN (TAKEN ON 1ST OCT '02) COMMISSION DISCOUNT RECEIVED RENT RECEIVED Rs. 10,000 2,500 21,500 70,000 400 90,000 3,000 1,000 500 700

199,600

ADJUSTMENTS: CLOSING STOCK VALUED AT RS. 15,000 OUTSTANDING: WAGES RS. 500 & SALARIES RS. 300 PREPAID INSURANCE RS. 300 DEPRECIATE PLANT & MACHINERY @ 10%, LAND & BUILDING @ 15% AND FURNITURE @ 5% PROVIDE RS. 500 FOR FUTHER BAD DEBTS & MAINTAIN RESERVE FOR DOUBTFUL DEBTS @ 5% PROVIDE 5 % INTEREST ON CAPITAL

Trading and P&L A\c for the year ended 31st Mar '03 Particular TO OPENING STOCK TO PURCHASES LESS: RETURN OUTWARDS TO WAGES TO GROSS PROFIT c\f 40,000 Rs. Rs. Particular Rs. 70,000 66,500 3,500 15,000 Rs.

20,000 BY SALES LESS: RETURN INWARD BY CLOSING 2,500 37,500 STOCK 8,500 9,000 15,000 81,500

Liabilities

Balance Sheet as on 31st Mar '04 Rs. Rs. Assets


SUNDRY DEBTORS
83,990 LESS: FURTHER B.D. 10,000 21,500 LESS: NEW R.D.D. PLANT & MACHINERY 3,150 LESS: DEP @ 10% 500 LAND & BUILDING 300 LESS: DEP @ 15% BILLS RECEIVABLES BANK BALANCE FURNITURE LESS: DEP @ 5% CLOSING STOCK PREPAID INSURANCE 119,440

Rs.
28,000
500 27,500 1,375 30,000 3,000 44,800 6,720

Rs.

ADD: OUTSTANGING 500

81,500 15,000 1,000 500

TO SALARIES

2,700

ADD: OUTSTANGING 300 TO OFFICE EXPENSES

BY GROSS PROFIT b\d 3,000 BY COMMISSION 2,445 BY DISCOUNT RECEIVED

CAPITAL 90,000 ADD: INTEREST ON 4,500 CAPITAL LESS: NET LOSS 10,510 BILLS PAYABLE SUNDRY CREDITORS LOAN TAKEN 3,000 ADD: INTEREST @ 10 150 (FOR 6 MONTHS) OUTSTANDING WAGES OUTSTANDING SALARIES

26,125 27,000

TO INSURNCE
LESS: PREPAID TO RENT TO TRAVELLING EXPENES TO SUNDRY EXPENSES TO DEPRECIATION PLANT & MACHINERY LAND & BUILDING FURNITURE TO BAD DEBTS ADD: NEW R.D.D.

1,300
300 1,800 1,400 800

BY RENT RECEIVED
1,000 BY NET LOSS c\f

700
10,510

38,080 4,000 6,655 2,280 15,000 300 119,440

2,400 120

3,000 6,720 120 600 1,375 2,475 2,075 700 4,500 150 27,710 27,710 9,840

ADD: FURTHER B.D. 500

LESS: OLD R.D.D. 400 TO ADVERTISEMENT TO INTEREST ON CAPITAL TO INTEREST ON LOAN

RATIO ANALYSIS

RATIO ANALYSIS
Ratio Analysis - is the process by which the relationship of different variables in financial accounting (& especially of financial statements) are computed, established and presented. It is a mathematical tool that measures the relationship between two figures, which are interrelated to each other and mutually interdependent. It is an attempt to derive quantitative measures concerning the financial position & profitability of a business enterprise. It can be used in understanding the future trend as well as for static & comparative analysis.

There are ratios for different purposes, for different types of users and for different types of analysis. Ratios can be expressed under the following the heads: Traditional Classification Functional Classification TRADITIONAL CLASSIFICATION Balance Sheet Ratio or Financial Ratios: they deal with relationship between two item and group of items, which are together found in the balance sheet for e.g. Ratio of Current Assets and Current Liabilities, Ratio of Stock to Working Capital etc

Revenue Statement Ratio or Income Statement Ratio: These ratios deal with the relationship between two items or two groups of items which are both found in the income statement for e.g. Ratio of Net Profit to Sales, Ratio of Expense to Sales etc. Composite Ratio or Inter-Statement Ratio or Combined Ratio: These ratios indicate the relationship between two items or two groups of items of which one is found in the Balance Sheet and other in the Income Statement for e.g. 'Ratio of Return on Capital Employed, Ratio of Return on Proprietors' Fund etc.

Functional Classification - The ratio may be classified in accordance with the purposes that it serves for the different users of accounting information. On this basis the ratio are categorized as follows.

Liquidity ratio: these ratios analyze short time & immediate financial status of a business organization and indicate the ability of the firm to meet its short-term current liabilities out if its available short term resources. They are also known as solvency ratios. Leverage ratio: these ratios measure the relationship between proprietors' funds & borrowed funds. They indicate the degree of the debt financing in the capital structure of a firm.

Activity ratio: these ratios are designed to indicate the efficiency of a firm in utilizing its monetary resources, its degree of productivity, effectiveness & its standards of performance. Hence they are also known as "efficiency & performance ratios.
Profitability ratios: these ratios are intended to reflect the overall efficiency of the management of the organization, its ability to earn a handsome return on capital employed or on shares issued and the effectiveness of its investment strategies.

Balance Sheet Ratios Current Ratio - also known as solvency ratio or 'Working Capital Ratio'. Standard current ratio is 2:1. Current ratio indicates the short-term financial position of the firm. It is expressed as pure ratio.
CURRENT ASSETS CURRENT LIABILITIES

Current assets consists of Debtors, Cash & Bank Balance, Bills Receivable, Stock, Prepaid Expenses Current liabilities consist of Creditors, Bills Payable, Outstanding Expenses, Bank Overdraft

Liquid Ratio - also known as quick ratio or acid test ratio. Standard quick ratio is 1:1.Greater the ratio, stronger the financial position. It indicates the solvency & financial soundness of the business. It is expressed as pure ratio.
Quick Assets Quick liabilities

Quick assets consist of Debtors, Cash, Bank Balance, Bills Receivable. Quick liabilities consist of Creditor, Bills Payable, Outstanding Expenses.

Debt Asset Ratio - This ratio indicates the percentage or the proportion of the total assets created by the company through short-term & long-term debt.
DEBT ASSETS

Debt - all liabilities including the short term or long term & Assets = all assets, i.e., fixed and current

Debt equity ratio - It shows the proportion of debt to equity. It is expressed pure ratio.
DEBT EQUITY

Debt - all liabilities including long term and short term Equity= Net Worth + Preference Capital

Proprietary Ratio This ratio indicates the proportion of proprietors' funds to the total assets of the firm.
Proprietors fund Total assets

Stock to working capital ratio: it expresses the relationship between closing stock & working capital.
Closing stock Working capital x 100

Capital Gearing Ratio it indicates the relation between fixed income bearing securities to funds on which no fixed returns are to be paid.

Capital gearing ratio = Fixed income bearing securities Non fixed income bearing securities

Revenue Statement Ratio Gross Profit Ratio: Gross profit ratio indicates the efficiency of production and trading operations. It is expressed as percentage
Gross profit ratio= Gross Profit x 100

Net Sales

Operating Ratio: It is index of managerial operation to control operating expenses.


Operating ratio: Cost of Goods Sold + Operating Expenses x 100 Net sales

Expenses Ratio: The ratio of each item of expense or each group of expenses to Net Sales is known as an Expenses Ratio expressed as a percentage in relation to net sales.
Administrative Expenses Ratio = Administrative Expenses x 100 Net Sales Selling & Distribution Expenses Ratio = S&D Expenses x 100 Net Sales

Financial Expenses Ratio = Financial Expenses x 100 Net Sales Material Consumed Ratio = Material Consumed x 100 Net Sales

Net Profit Ratio: Net Profit Ratio indicated the relationship between net profit and net sales. Net Profit can be either operating net profit or net profit after tax or net profit before tax.
Net Profit before Tax Ratio = Net Profit before Tax x 100 Net Sales
Net Profit after Tax Ratio = Net Profit after Tax x 100 Net Sales

Net Operating Profit Ratio: It is a relationship between net operating profit and net sales which is express in percentage. Net operating profit is equal to gross profit minus all operating expenses.
Net Operating Profit Ratio = Net Operating Profit x 100 Net Sales

Stock Turnover Ratio: Stock Turnover Ratio is also known as Inventory Ratio" or "Inventory Turnover Ratio or Stock Velocity Ratio. This ratio measure the number of times stock turns or flows or rotates in an accounting period compared to the sales effected during the period.
Stock Turnover Ratio = Cost of Goods Sold x 100 Average Stock

Average Stock is calculated by adding inventory in the beginning of the period to the inventory at the close of the period and the product is divided by two. When the opening stock figure is not available, closing stock can be considered as the average stock
Average Stock = Opening stock + Closing Stock 2

Combined Ratios - Combined Ratios or InterStatement Ratios shows relationship between two items or two groups of item of which one is from Balance Sheet and one of the revenue statements.
Return on Capital Employed - This ratio explains the relationship between total profits earned by the business and total investment made or total assets employed. This ratio, thus measures the overall efficiency of the business operations. This ratio is also known as "Return on Total Resources". Return on Total Resources is calculated by dividing Net Profit before interest on loans and debentures by total assets (fixed assets and current assets). This is always expressed as a percentage.
Return on Capital Employed Ratio = Net Profit before Interest and Tax x 100 Capital Employed Capital Employed = Owned Funds + Borrowed Funds (OR) Capital Employed = Fixed Assets + Current Assets -Current Liabilities

Return on Proprietor's Funds - It is also known as "Return on Proprietors Equity" or "Return on Shareholders Investment". The above ratio indicates the relationship between net profit earned and total Proprietors' Funds.
Return on Proprietors' Ratio = Net Profit Tax x 100 Proprietors Fund Proprietors Funds = Equity Share Capital + Preference Share Capital + Reserve and Surplus - Miscellaneous Expenses

Return on Equity Share Capital - This ratio indicates the rate of earning on the equity or ordinary share capital.
Return on Eq. Share Capital Ratio = Net profit after Tax- Preference Dividend x 100 Equity Share Capital

Earning per Share - Earning per Share is calculated to find out overall profitability of the organization. It is indicated by the following formula.
Earning per Share = Net profit after Tax - Preference Dividend x 100 Number of Equity Shares

Dividend Payout Ratio - The purpose of this ratio is to find out the proportion of earning used for payment of dividend and the proportion of earning retained. The ratio is a relationship between earning per equity share and dividend per equity share.
Dividend Payout Ratio = Dividend per Equity share x 100 Earning per Equity Share

Debtors Turnover Ratio (Debtors Velocity) - Debtors Turnover Ratio is also known as "Accounts Receivable Turnover Ratio" or "Average Collection Period". It attempts to measure the collectability of debtor's and other account receivable. It shows the rate at which the trade debtors are being collected.
Debtors Turnover Ratio = Credit Sales x 100 Avg. Debtors + Avg. Bills Receivable

Debt Collection Period - Debt Collection Period indicates the extent to which the debts have been collected in time.
Debt Collection period = No. of days in a year Debtors Turnover

Creditors turnover ratio - Creditors' turnover shows the speed with which payments are made to the supplier for purchases made from them. It is a relationship between net credit purchases and average creditors.

Creditors turnover ratio = Credit Sales x 100 Avg. Creditors+ Avg. Bills Payable

Credit Collection Period - Creditors Turnover Ratio is further used to find out the average rate of payables by using the following formula.
Credit Collection period= No. of days in a year Creditors Turnover

FINANCIAL RATIO ANALYSIS

EXAMPLE - Following is the Balance Sheet of XYZ Ltd. Balance Sheet as on 31st March, 2007

You are required to calculate Balance Sheet ratios.

In the Books of XYZ Ltd. Vertical Balance Sheet as on 31st Mar 07

Following is the Profit and Loss A/c of SAM JAM Ltd. For the year ended 31st Mar 06. You are required to prepare Vertical Income Statement for the purpose of calculation of Gross Profit Ratio, Operating Cost Ratio, Stock Turnover Ratio

Financial Statements are prepared with a view to exhibit the true and fair financial position of the concern. But in the real scenario, inflationary trends affects, the position as shown in the financial statements thereby not depicting the true and fair value of financial position of the company.

Under the conditions of inflation, the prices of all the factors and inputs of the production are on a constant rise.
The value of money declines in real term as the same quantity of goods is purchased at higher costs.

Limitations of Historical costs-based Financial Statements: Undercharging depreciation & higher value of inventories. Unreliable results shown by financial statements leading to wrong decision making by the users of financial accounting information. Payment of heavy dividends and taxes as the profits are inflated Insufficient funds for replacement of fixed assets after the end of useful life. Inefficient working capital management. Comparison of financial figures becomes difficult and misleading. Gains from the appreciation of assets are not accounted for.

MERITS OF INFLATION ACCOUNTING The objective of inflation accounting is to embraces the true and fair value view of accounts & following are the merits of Inflation accounting: Correlation of current cost with the current revenue leading to more realistic profitability position of the business.

Prevents heavy payment of dividend & taxes. Depreciation is charged on current values of the assets

It facilitates meaningful comparison of the records of the different period.


Guides decision making of investors and public, as it depicts true profitability and financial position of the organization .

DEMERITS OF INFLATION ACCOUNTING

Implementation and follow up has many obstacles in it. Makes financial statements more complicated as change to price level needs to be given adjusted. Valuation at current prices takes different views. Income tax department does not except the accounts prepared & profits shown under the inflation accounting system. In deflation, complex calculation are required there by further complicating the accounting process.

Charging of the depreciation more than the cost of the asset not allowed by standard accounting principles.

METHODS OF MAINTAINING INFLATION ACCOUNTING There are two methods of maintaining the books of accounts as per inflation accounting. Current Purchasing Power (CPP): Under CCP the historical costs are adjusted with the general price index. The items in the financial statement are adjusted & revalued at the general price level.

For e.g. an asset purchased at Rs. 15000 in 1981-82 has to have X value in 2009-10. This X value is found out by dividing purchase price of asset by general index value of the year of purchase and then multiplying it with the general price index value of the current year. General Price index value of 1980 is 100 whereas its current years value is 551. So the value of asset in 2009-10 is 15000/100 x 551 = 82650. The depreciation will be charged on this current value of asset.

Current Cost Accounting (CCA): The CCA method is more realistic as it reflects more correct impact of inflation by measuring the current cost of individual asset by applying specific index value instead of general index value. This method attempts to show the assets at current cost instead of showing the changes in general purchasing power of the money.

Fund Flow & Cash Flow Statements

A statement which summaries the changes in the amount of the funds of a firm, indicating the sources from which the funds have come in the pool of Working Capital and the uses to which the funds have been put. A Funds Flow Statement concentrates on the inflows and outflows in the Working Capital. It shows the sources The term 'Funds' may denote working capital or cash. Working Capital: A statement of inflow & outflow of Working Capital (Current Assets - Current Liabilities) is known as a Funds Flow Statement. Cash: A statement of inflow and outflow of cash is called Cash Flow Statement

Limitations of Balance Sheet: A Balance Sheet shows the amounts of Funds Available and the Funds Employed on a particular date. Balance Sheet: Funds Available = Funds Employed The Funds Available during a year change due to inflow of funds from various sources such as issue of shares, issue of debentures, obtaining new loan, sale of assets and above all the profits made by the concern during the year. The Funds Employed during a year change due to outflow of funds for various uses such as repayment of loan, purchase of assets, redemption of debentures etc. Funds Flow: Change in Funds Available = Change in Funds Employed Since the Balance Sheet does not show the flow of funds of a concern during a year, a separate statement has to be prepared for this purpose. Such statement is called the Funds Flow Statement.

Limitations of Profit & Loss Account: The net profit shown in the Profit and Loss Account does not show the actual increase in the funds of a concern during a year. This is because, the book profit is arrived at after debiting depreciation, or preliminary expenses written off etc. which do not involve any actual outflow of funds. A separate statement called statement of funds from operations has to be prepared to work out the amount of increase in funds due to operations. This statement, it should be noted, is a part of the Funds Flow Statement, as operating profits is an important and regular source of funds for a concern.

Funds Flow Statement treats working capital as a fund. Let us understand how the working capital of a concern constitutes a Fund. Cash is the basic 'Fund' of an enterprise. The cash balance in the cash box can be said to be a fund-an amount set aside to meet the immediate cash payments. However, not all business transactions involve immediate receipt or payment of cash. For example, in credit sales cash is receivable or credit purchases cash is payable only after certain period. When cash is receivable or payable in future, the transaction gives rise to Debtors or Creditors. Thus, credit sales give rise Current Assets & credit purchases give rise to Current Liabilities. Current Assets show the Cash Receivable and Current Liabilities show the Cash payable. The difference between Current Assets (CA) and Current Liabilities (CL) shows the amount of Working Capital (WC). Working Capital is thus Cash Receivable less Cash Payable. It is the net Cash Receivable by a concern in near future. Working Capital = Current Assets - Current Liabilities [WC = CA - CL] Working Capital = Net Cash Receivable So, Working Capital is like the cash balance in the cash box. Cash balance shows excess of cash received over cash paid. Working Capital shows the excess of cash receivable over cash payable. Just as a concern should always have enough cash in the cash box to be able to make cash payments whenever required, it should always have sufficient Working Capital to be able to meet short term liabilities. Thus, Working Capital (Net Cash Receivable) is a fund: an amount set aside out of Cash Receivables to meet liabilities on account of Cash Payables.

Flow of funds means increase or decrease in the fund of Working Capital. Increase in funds is due to inflow of funds from various sources. Decrease in funds is due to outflow of funds for various purposes. There is a flow of funds when any transaction changes the amount of Working Capital. Working Capital is a Fund which increases when Current Assets increase or Current Liabilities decrease or Working Capital decreases when Current Assets decrease or Current Liabilities increase. An Increase in CA causes an Increase in Working Capital An decrease in CA causes an decrease in Working Capital An Increase in CL causes an decrease in Working Capital An decrease in CL causes an Increase in Working Capital

The cash flow statement is more useful when cash flows are classified into meaningful groups. A typical classification has been to separate sources from uses of cash. The disadvantage of such a classification is that it does not focus on categories of related cash flows. Investors, creditors, & managers consider the relationships among certain components of cash flows to be important to their analysis of financial performance. Besides, the sources and uses classification often ends up as a listing of changes in balance sheet amounts, providing little explanation about an enterprise's ability to meet obligations and pay dividends, or about its needs for external financing. The cash flow statement will reflect the cash flow effects of each of the major activities of the enterprise when cash flows are classified according to whether they stem from operating, investing, or financing activities. Such a classification enables significant relationships within and among the three kinds of activities to be evaluated. Grouping of cash flows into these categories will also assist investors, creditors, and managers in understanding trends in the cash flows of an enterprise as well as in making comparisons with other enterprises. The classification of cash flows into operating, investing and financing categories will depend on the nature of the business.

Operating activities. These involve producing and delivering goods and providing services. Cash inflows from operating activities. Examples:: Cash sales of goods and services, Advances from customers, Collections of debtors. Cash outflows from operating activities. Examples: Payments to suppliers for materials and for services, Payments to employees for services, Payments to governments for taxes and duties. Investing activities. These involve making and collecting loans, acquiring & disposing of debt and equity instruments, and fixed assets. Cash inflows from investing activities. Examples: Sales of fixed assets, Collections of loans, Sales of shares and bonds of other enterprises, Interest and dividends received on loans and investments. Cash outflows from investing activities. Examples: Payments (including advance or down payments) to buy fixed assets, Disbursements of loans, Payments to buy shares and bonds of other enterprises. Financing activities. These involve obtaining resources from owners and providing them with a return on, and return of, their investment, borrowing money and repaying amounts borrowed, and obtaining and paying for other resources obtained from long term creditors. Cash inflows from financing activities. Examples: Proceeds from issuing shares and bonds, Proceeds from loans. Cash outflows from financing activities. Examples: Payments to buy back or redeem own shares, Principal payments of bonds and loans, Payments of interest, Payments of dividends.

Non-cash investing and financing activities: These are transactions that affect assets or liabilities but do not result in cash inflows or outflows. Examples: Converting debt into equity, Acquiring assets by assuming directly related liabilities such as purchasing a building incurring a mortgage to the seller, Obtaining an asset by entering into a hire purchase or a finance lease, Exchanging non-cash assets or liabilities for other non-cash assets or liabilities. Although non-cash transactions do not result in cash inflows or outflows in the period in which they occur, they generally have a significant effect on the prospective cash flows of a company. For example, conversion of debt into equity will eliminate payment of interest on the debt. Again, entering into a finance lease obligation requires future lease payments in cash. An enterprise should provide information about all noncash investing and financing activities in a note or schedule to the cash flow statement.

Net Cash Flow from Operating Activities - The profit and loss account shows whether an enterprise's operations have resulted in a profit or loss but does not indicate cash inflows and outflows from the operations. This is because net profit is based on accrual: we record revenues and expenses when earned or incurred although we may not have received or paid all of them. Further, depreciation, amortization, and provision for doubtful debts do not reflect cash outflows in both current and future periods. Thus, the net profit will not indicate the net cash flow from operations. In order to arrive at net cash flow from operating activities, we have to restate revenues and expenses on a cash basis. We do this by undoing the accrual accounting adjustments.
Starting with net profit, we eliminate the effect of revenues not received and expenses not paid in order to arrive at net cash flow from operating activities.

There are two alternatives for reporting net cash flow from operating activities(i) direct method & (ii) indirect method. The direct method shows major classes of operating cash receipts and payments, such as cash received from customers, cash paid to suppliers and employees, and income tax paid, the sum of which is the net cash flow from operating activities, as shown now:

The indirect method starts with net profit and adjusts it for revenue and expense items that did not involve operating cash receipts or cash payments in the current period to arrive at net cash flow from operating activities as follows:

FORMAT OF THE CASH FLOW STATEMENT - The statement reports cash flows from operating, investing and financing activities, usually in that order. Within each category, cash inflows and outflows are reported separately. For example, cash outflows for acquisition of fixed assets are shown separately from proceeds from sale of fixed assets, and not offset. Similarly, cash inflows from borrowings are shown separately from cash outflows to repay loans. Net cash provided by refers to net cash inflow, and net cash used in refers to net cash outflow. A supplemental schedule of noncash investing and financing activities appears at the end of the statement.

We need to make the following three types of adjustments in order to convert net profit into net cash flow from operating activities:

Non-cash items: Provision for doubtful debts, depreciation, depletion, and

amortization do not require cash outflows in the current period. Hence, we add them back to net profit to arrive at net cash flow from operating activities. Non-operating items: We remove non-operating items, such as gains and losses on disposal of fixed assets and investments, interest income, and interest expense from the operating activities section and take them to the investing or financing activities section, as appropriate.

Changes in working capital items: We adjust net profit for changes in working

capital items, such as debtors, inventory, prepaid expenses, creditors, and bills payable. For example, if debtors increased during the current period, cash received from customers will be less than sales reported in the profit and loss account. Similarly, if inventories increased during the current period, purchases will be more than cost of goods sold. Thus, to convert net profit into net cash flow from operating activities, we deduct increase (add decrease) in debtors, inventory, and prepaid expenses from (to) the net profit. On the contrary, we add increase (deduct decrease) in creditors and bills payable to (from) the net profit. We should consider change in income tax payable if the starting point of the computation is profit after tax. Note that the adjustments for changes in current assets and current liabilities are exactly the same as discussed under the direct method.

Adjustments to Convert Net Profit into Net Cash Flow from Operating ActivitiesIndirect Method. Converting net profit into operating cash flow requires three kinds of adjustments.

PREPARING THE CASH FLOW STATEMENT: We now see how to prepare the cash flow statement. The data for the example given below consist of a balance sheet at two consecutive dates, a profit and loss account, and details of selected transactions.

Additional information: Purchased machinery costing Rs 173,000; Sold machinery with cost of Rs 67,000 and accumulated depreciation of Rs 51,000 for Rs 22,000; Purchased investments for Rs 26,000; Sold investments costing Rs 51,000 for Rs 42,000; Purchased machinery for Rs 49,000 on unsecured credit; Issued at par shares for Rs 100,000; Converted secured debentures of Rs 50,000 to equity shares of Rs 10 at par; Paid dividends of Rs 25,000; Repaid unsecured loans of Rs 1,000; Redeemed secured debentures of Rs 27,000 at par; Wrote off Rs 10,000 of debtors when a customer became insolvent and provided Rs 12,000 for doubtful debts included in Selling and Administrative Expenses; Received Rs 3,000 from an insurance claim for loss suffered in an earthquake.

EXAMPLE 2: In the above balance sheet, the CA & CL items are related to working capital. The working capital on the balance sheet date (i.e., 1st Jan 06) is: Current assets - Current liabilities = Working capital Assuming that after the balance sheet date, the following transactions take place: Obtained a further unsecured loan of Rs. 1,00,000 in cash. Sold Rs.2,00,000 worth of inventories (at cost) for a price of Rs.3,00,000 on credit. Sold investments costing Rs. 1,00,000 for Rs. 1,20,000. Purchased fixed assets for Rs.1,00,000. The amount being payable after 10 yearsthe loan is secured by the property. Collected Rs. 2,00,000 from book debts.

Sr. No. 1 2

Transaction Unsecured Loan Obtained Sale of Inventories

Working Capital Affected Item Increase Decrease (Rs.) (Rs.) Bank & Cash 100,000 Book Debts Inventory 300,000 200,000 120,000

Working Capital Not Affected Item Increase Decrease (Rs.) (Rs.) Unsecured Loan 100,000 Accumulated Profit Invesement Profit on Investment Fixed Assets Secured Loans 20,000 100,000 100,000 100,000

Sale of Investment

Bank

100,000

Purchase of Fixed Assets through Loan Collection of Money from Debtors

No Affect

Bank & Cash 200,000 Book Debts 200,000 320,000 720,000 720,000

Net Increase in Working Capital

Example 3: The following is the Balance Sheet of B.S. Industries as on 31st Mar '2003 with the corresponding figures
Particulars Fixed Asset Land & Building Plant & Machinery Current Assets, Loans & Advances Stock in Trade Sundry Debtors Bills Receivables Advances paid to Contractors Cash in Bank Liabilities Issued Share Capital 3500 Equity Shares of Rs. 100 each Recerves & Surplus Secured Laons from Banks Current Liabilities Sundry Creditors 350,000 254,000 16,000 190,000 60,000 870,000 350,000 180,000 187,280 46,000 763,280 31-3-2003 370,000 50,000 220,000 166,000 34,000 10,000 20,000 Previous Years 394,600 29,680 152,500 156,000 18,500 2,000 10,000

870,000

763,280

Bills Payables

You are required to prepare the Statement of Changes in Working Capital

Example 4: Following are the Balance Sheet of Shree Traders for two years: Particulars 31-3-2003 31-3-2002 Liabilities 201,500 162,000 Capital 45,000 30,000 Creditors Accured Expenses 5,000 251,500 192,000 Assets Machineries Furniture Stock Debtors Cash on hand Cash at Bank 90,000 10,000 35,000 108,000 7,500 1,000 251,500 Prepare the statement of changes in working capital 40,000 10,000 35,000 90,000 6,000 11,000 192,000