LECTURE NOTES

FINANCIAL REPORTING & ANALYSIS

MBA I SEMESTER (VCE-R22)

G. RAMESH
ASSISTANT ROFESSOR

DEPARTMENT OF MANAGEMENT STUDIES

VARDHAMAN COLLEGE OF ENGINEERING
SHAMSHABAD (TS) - 501218
 UNIT-I

INTRODUCTION
Accounting has rightly been termed as the language of the business. The basic function of a
language is to serve as a means of communication Accounting also serves this function. It
communicates the results of business operations to various parties who have some stake in the
business viz., the proprietor, creditors, investors, Government and other agencies. Though
accounting is generally associated with business but it is not only business which makes use of
accounting. Persons like housewives, Government and other individuals also make use of a
accounting. For example, a housewife has to keep a record of the money received and spent by
her during a particular period. She can record her receipts of money on one page of her
"household diary" while payments for different items such as milk, food, clothing, house,
education etc. on some other page or pages of her diary in a chronological order. Such a record
will help her in knowing about :

(i) The sources from which she received cash and the purposes for which it was utilised.
(ii) Whether her receipts are more than her payments or vice-versa?
(iii) The balance of cash in hand or deficit, if any at the end of a period.

ORIGIN AND GROWTH OF ACCOUNTING

Accounting is as old as money itself. However, the act of accounting was not as eveloped as it is
today because in the early stages of civilisation, the number of transactions to be recorded
were so small that each businessman was able to record and check for himself all his
transactions. Accounting was practiced in India twenty three centuries ago as is clear from the
book named "Arthashastra"written by Kautilya, King Chandragupta's minister. This book not
only relates to politics and economics, but also explain the art of proper keeping of accounts.

However, the modern system of accounting based on the principles of double entry system
owes it origin to Luco Pacioli who first published the principles of Double Entry System in 1494
at Venice in Italy. Thus, the art of accounting has been practised for centuries but it is only in
the late thirties that the study of the subject 'accounting' has been taken up seriously.

MEANING OF ACCOUNTING
The main purpose of accounting is to ascertain profit or loss during a specified period, to show
financial condition of the business on a particular date and to have control over the firm's
property. Such accounting records are required to be maintained to measure the income of the
business and communicate the information so that it may be used by anagers, owners and
other interested parties. Accounting is a discipline which records, classifies, summarises and
interprets financial information about the activities of a concern so that intelligent decisions can
be made about the concern. The American Institute of Certified Public Accountants has defined
the Financial Accounting as "the art of recording,classifying and summarising in as significant
manner and in terms of money transactions and events which in part, at least of a financial
character, and interpreting the results thereof". American Accounting Association defines
accounting as "the process of identifying, measuring, and communicating economic information
to permit informed judgments’ and decisions by users of the information.

From the above the following attributes of accounting emerge:

(i) Recording : It is concerned with the recording of financial transactions in an orderly manner,
soon after their occurrence In the proper books of accounts.
(ii) Classifying : It Is concerned with the systematic analysis of the recorded data so as to
accumulate the transactions of similar type at one place. This function is performed by
maintaining the ledger in which different accounts are opened to which related transactions are
posted.
(iii) Summarising : It is concerned with the preparation and presentation of the classified data
in a manner useful to the users. This function involves the preparation of financial statements
such as Income Statement, Balance Sheet, Statement of Changes in Financial Position,
Statement of Cash Flow, Statement of Value Added.
(iv) Interpreting : Nowadays, the aforesaid three functions are performed by electronic data
processing devices and the accountant has to concentrate mainly on the nterpretation aspects
of accounting. The accountants should interpret the statements in a manner useful to action.
The accountant should explain not only what has happened but also (a) why it happened, and
(b) what is likely to happen under specified conditions.

DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

Book-keeping is a part of accounting and is concerned with the recording of transactions which
is often routine and clerical in nature, whereas accounting performs other functions as well,
viz., measurement and communication, besides recording. An accountant is required to have a
much higher level of knowledge, conceptual understanding and analytical skill than is required
of the book-keeper An accountant designs the accounting system, supervises and checks the
work of the book-keeper, prepares the reports based on the recorded data and interprets the
reports. Nowadays, he is required to take part in matters of management, control and planning
of economic resources.

NATURE OF ACCOUNTING

The various definitions and explanations of accounting has been propounded by different
accounting experts from time to time and the following aspects comprise the nature of
accounting:

i ) Accounting as a service activity

Accounting is a service activity. Its function is to provide quantitative information, primarily
financial in nature, about economic entities that is intended to be useful in making economic
decisions, in making reasoned choices among alternative courses of action. It means that
accounting collects financial information for the various users for taking decisions and tackling
business issues. Accounting in itself cannot create wealth though, if it produces information
which is useful to others, it may assist in wealth creation and maintenance.

(ii) Accounting as a profession

Accounting is very much a profession. A profession is a career that involve the acquiring of a
specialised formal education before rendering any service. Accounting is a systematized body of
knowledge developed with the development of trade and business over the past century. The
accounting education is being imparted to the examinees by national and international
recognised the bodies like The Institute of Chartered Accountants of India (ICAI), New Delhi in
India and American Institute of Certified Public Accountants (AICPA) in USA etc. The candidate
must pass a vigorous examination in Accounting Theory, Accounting Practice, Auditing and
Business Law. The members of the professional bodies usually have their own associations or
organisations, where in they are required to be enrolled compulsorily as Associate member of
the Institute of Chartered Accountants (A.C.A.) and fellow of the Institute of Chartered
Accountants (F.C.A.). In a way, accountancy as a profession has attained the stature comparable
with that of lawyer, medicine or architecture.

(iii) Accounting as a social force

In early days, accounting was only to serve the interest of the owners.Under the
changing business environment the discipline of accounting and the accountant both have to
watch and protect the interests of other people who are directly or indirectly linked with the
operation of modern business. The society is composed of people as customer, shareholders,
creditors and investors. The accounting information/data is to be used to solve the problems of
the public at large such as determination and controlling of prices. Therefore, safeguarding of
public interest can better be facilitated with the help of proper, adequate and reliable
accounting information and as a result of it the society at large is benefited.

(iv) Accounting as a language

Accounting is rightly referred the "language of business". It is one means of reporting and
communicating information about a business. As one has to learn a new language to converse
and communicate, so also accounting is to be learned and practised to communicate business
events. A language and accounting have common features as regards rules and symbols. Both
are based and propounded on fundamental rules and symbols. In language these are known as
grammatical rules and in accounting, these are termed as accounting rules. The expression,
exhibition and presentation of accounting data such as a numerals and words and debits and
credit are accepted as symbols which are unique to the discipline of accounting.

(v) Accounting as science or art

Science is a systematised body of knowledge. It establishes a relationship of cause and effect in
the various related phenomenon. It is also based on some fundamental principles. Accounting
has its own principles e.g. the double entry system, which explains that every transaction has
two fold aspect i.e. debit and credit. It also lays down rules of journalising. So we can say that
accounting is a science. Art requires a perfect knowledge, interest and experience to do a work
efficiently. Art also teaches us how to do a work in the best possible way by making the best use
of the available resources. Accounting is an art as it also requires knowledge, interest and
experience to maintain the books of accounts in a systematic manner. Everybody cannot
become a good accountant. It can be concluded from the above discussion that accounting is an
art as well as a science.

OBJECTIVES OF ACCOUNTING

The following are the main objectives of accounting :

1. To keep systematic records : Accounting is done to keep a systematic record of financial

transactions. In the absence of accounting there would have been terrific burden on human
memory which in most cases would have been impossible to bear.
2. To protect business properties : Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of accounting supplying the
following information to the manager or the proprietor:
(i) The amount of the proprietor's funds invested in the business.
(ii) How much the business have to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) cash
in hand, (c) cash at bank, (d) stock of raw materials, work-in-progress
and finished goods?
Information about the above matters helps the proprietor in assuring
that the funds of the business are not necessarily kept idle or underutilized .

3. To ascertain the operational profit or loss : Accounting helps in ascertaining the net
profit earned or loss suffered on account of carrying the business. This is done by keeping a
proper record of revenues and expense of a particular period. The Profit and Loss Account is
prepared at the end of a period and if the amount of revenue for the period is more than the
expenditure incurred in earning that revenue, there is said to be a profit. In case the
expenditure exceeds the revenue, there is said to be a loss.Profit and Loss Account will help the
management, investors, creditors, etc. in knowing whether the business has proved to be
remunerative or not. In case it has not proved to be remunerative or profitable, the cause of
such a state of affairs will be investigated and necessary remedial steps will be taken.

4. To ascertain the financial position of the business : The Profit and LossAccount gives the
amount of profit or loss made by the business during a particular period. However, it is not
enough. The businessman must know about his financial position i.e. where he stands ?, what
he owes and what he owns? This objective is served by the Balance Sheet or Position
Statement. The Balance Sheet is a statement of assets and liabilities of the business on a
particular date. It serves as barometer for ascertaining the financial health of the business.

5. To facilitate rational decision making : Accounting these days has taken upon itself the
task of collection, analysis and reporting of information at the required points of time to the
required levels of authority in order to facilitate rational decision-making. The American
Accounting Association has also stressed this point while defining the term accounting when it
says that accounting is the process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by users of the information. Of
course, this is by no means an easy task. However, the accounting bodies all over the world and
particularly the International Accounting Standards Committee, have been trying to grapple
with this problem and have achieved success in laying down some basic postulates on the basis
of which the accounting statements have to be prepared.

6. Information System : Accounting functions as an information system for collecting and

communicating economic information about the business enterprise.This information helps the
management in taking appropriate decisions. This function, as stated, is gaining tremendous
importance these days.

USERS OF ACCOUNTING INFORMATION

The basic objective of accounting is to provide information which is useful for persons inside
the organisation and for persons or groups outside the organisation. Accounting is the discipline
that provides information on which external and internal users of the information may base
decisions that result in the allocation of economic resources in society.

I. External Users of Accounting Information : External users are those groups or persons
who are outside the organisation for whom accounting function is performed. Following can be
the various external users of accounting information:
1. Investors, Those who are interested in investing money in an organization are interested in
knowing the financial health of the organisation of know how safe the investment already made
is and how safe their proposed investment will be. To know the financial health, they need
accounting information which will help them in evaluating the past performance and future
prospects of the organisation. Thus, investors for their investment decisions are dependent
upon accounting information included in the financial statements. They can know the
profitability and the financial position of the organisation in which they are interested to make
that investment by making a study of the accounting information given in the financial
statements of the organisation.
2. Creditors. Creditors (i.e. supplier of goods and services on credit, bankers and other lenders
of money) want to know the financial position of a concern before giving loans or granting
credit. They want to be sure that the concern will not experience difficulty in making their
payment in time i.e. liquid position of the concern is satisfactory. To know the liquid position,
they need accounting information relating to current assets, quick assets and current liabilities
which is available in the financial statements.
3. Members of Non-profit Organisations. Members of non-profit organisations such as schools,
colleges, hospitals, clubs, charitable institutions etc. need accounting information to know how
their contributed funds are being utilised and to ascertain if the organisation deserves
continued support or support should be withdrawn keeping in view the bad performance
depicted by the accounting information and diverted to another organisation. In knowing the
performance of such organisations, criterion will not be the profit made but the main criterion
will be the service provided to the society.
4. Government. Central and State Governments are interested in the accounting information
because they want to know earnings or sales for a particular period for purposes of taxation.
Income tax returns are examples of financial reports which are prepared with information taken
directly from accounting records. Governments also needs accounting information for
compiling statistics concerning business which, in turn helps in compiling national accounts.
5. Consumers. Consumers need accounting information for establishing good accounting
control so that cost of production may be reduced with the resultant reduction of the prices of
goods they buy. Sometimes, prices for some goods are fixed by the Government, so it needs
accounting information to fix reasonable prices so that consumers and manufacturers are not
exploited. Prices are fixed keeping in view fair return to manufacturers on their investments
shown in the accounting records.
6. Research Scholars. Accounting information, being a mirror of the financial performance of a
business organisation, is of immense value to the research scholars who wants to make a study
to the financial operations of a particular firm. To make a study into the financial operations of
a particular firm, the research scholar needs detailed accounting information relating to
purchases, sales, expenses, cost of materials used, current assets, current liabilities, fixed
assets, long term liabilities and shareholders' funds which is available in the accounting records
maintained by the firm.

II. Internal Users of Accounting Information. Internal users of accounting information are
those persons or groups which are within the organisation. Following are such internal users :
1. Owners. The owners provide funds for the operations of a business and they want to know
whether their funds are being properly used or not. They need accounting information to know
the profitability and the financial position of the concern in which they have invested their
funds. The financial statements prepared from time to time from accounting records depicts
them the profitability and the financial position.
2. Management. Management is the art of getting work done through others, the management
should ensure that the subordinates are doing work properly.Accounting information is an aid
in this respect because it helps a manager in appraising the performance of the subordinates.
Actual performance of the employees can be compared with the budgeted performance they
were expected to achieve and remedial action can be taken if the actual performance is not
upto the mark. Thus, accounting information provides "the eyes and ears to management". The
most important functions of management are planning and controlling. Preparation of various
budgets, such as sales budget, production budget, cash budget, capital expenditure budget etc.,
is an important part of planning function and the starting point for the preparation of the
budgets is the
accounting information for the previous year. Controlling is the function of seeing that
programmes laid down in various budgets are being actually achieved i.e. actual performance
ascertained from accounting is compared with the budgeted performance, enabling the
manager to exercise controlling case of weak performance. Accounting information is also
helpful to the management in fixing reasonable selling prices. In a competitive economy, a price
should be based on cost plus a reasonable rate of return. If a firm quotes a price which exceeds
cost plus a reasonable rate of return, it probably will not get the order. On the other hand, if
the firm quotes a price which is less than its cost, it will be given the order but will incur a loss
on account of price being lower than the cost. So, selling prices should always be fixed on the
basis of accounting data to get the
reasonable margin of profit on sales.
3. Employees. Employees are interested in the financial position of a concern they serve
particularly when payment of bonus depends upon the size of the profits earned. They seek
accounting information to know that the bonus being paid to them is correct.

BRANCHES OF ACCOUNTING
To meet the ever increasing demands made on accounting by different interested
parties such as owners, management, creditors, taxation authorities etc.,the various branches
have come into existence. There are as follows :
1. Financial accounting. The object of financial accounting is to ascertain the results (profit or
loss) of business operations during the particular period and to state the financial position
(balance sheet) as on a date at the end of the period.
2. Cost accounting. The object of cost accounting is to find out the cost of goods produced or
services rendered by a business. It also helps the business in controlling the costs by indicating
avoidable losses and wastes.
3. Management accounting. The object of management accounting is to supply relevant
information at appropriate time to the management to enable it to take decisions and effect
control.

LIMITATIONS OF FINANCIAL ACCOUNTING

Advantages of accounting discussed in this lesson do not suggest that accounting is free
from limitations. Anyone who is using accounting information should be well aware of
its limitations also. Following are the limitations:
(a) Financial accounting permits alternative treatments
No doubt accounting is based on concepts and it follows "generally accepted accounting
principles", but there exist more than one principle for the treatment of any one item. This
permits alternative treatments within the framework of generally accepted accounting
principles. For example, the closing stock of a business may be valued by any one of the
following methods : FIFO (First-in-first-out); LIFO (Last-in-first-out); Average price, Standard
price etc., Application of different methods will give different results but the methods are
generally accepted. So, the results are not comparable.
(b) Financial accounting is Influenced by personal judgements
Inspite of the fact that convention of objectivity is respected in accounting but to record certain
events estimates have to be made which requires personal judgement. It is very difficult to
expect accuracy in future estimates and objectivity suffers. For example, in order to determine
the amount of depreciation to be charged every year for the use of fixed asset it is required to
estimate (a) future life of the asset, and (b) scrap value of the asset. Thus in accounting we do
not determine but measure the income. In other words, the income disclosed by accounting is
not authoritative but approximation.
(c) Financial accounting ignores important non-monetary information Financial accounting
takes into consideration only those transactions and events which can be described in money.
The transactions and events, however important, if non-monetary in nature are ignored i.e., not
recorded. For example, extent of competition faced by the business, technical innovations
possessed by the business, loyalty and efficiency of the employees etc. are the important
matters in which management of the business is highly interested but accounting is not tailored
to take note of such matters. Thus any user of financial information is, naturally, deprived of
vital information which is of non-monetary character.(d) Financial accounting does not provide
timely information
Financial accounting is designed to supply information in the form of statements (Balance Sheet
and Profit and Loss Account) for a period, normally,one year. So the information is, at best, of
historical interest and only postmortem

ACCOUNTING PRINCIPLES
Accounting principles are two types i.e
1) Accounting Concepts 2) Accounting Conventions

ACCOUNTING CONCEPTS
 Separate Business Entity Concept
 Money Measurement Concept
 Dual Aspect Concept
 Going Concern Concept
 Accounting Period Concept
 Cost Concept
 The Matching Concept
  Accrual Concept
 Realization Concept
ACCOUNTING CONVENTIONS
 Convention of Materiality
 Convention of Conservatism
 Convention of consistency

ACCOUNTING CONCEPTS
The more important accounting concepts are briefly described as follows:
1. Separate Business Entity Concept. In accounting we make a distinction between business
and the owner. All the books of accounts records day to day financial transactions from the
view point of the business rather than from that of the owner. The proprietor is considered as a
creditor to the extent of the capital brought in business by him. For instance, when a person
invests Rs. 10 lakh into a business, it will be treated that the business has borrowed that much
money from the owner and it will be shown as a ‘liability’ in the books of accounts of business.
Similarly, if the owner of a shop were to take cash from the cash box for meeting certain
personal expenditure, the accounts would show that cash had been reduced even though it
does not make any difference to the owner himself. Thus, in recording a transaction the
important question is how does it affects the business ? For example, if the owner puts cash
into the business, he has a claim against the business for capital brought in. In sofar as a limited
company is concerned, this distinction can be easily maintained because a company has a legal
entity of its own. Like a natural person it can engage itself in economic activities of buying,
selling, producing, lending, borrowing and consuming of goods and services. However, it is
difficult to show this distinction in the case of sole proprietorship and partnership.
Nevertheless, accounting still maintains separation of business and owner. It may be noted that
it is only for accounting purpose that partnerships and sole proprietorship are treated as
separate from the owner (s), though law does not make such distinction. Infact, the business
entity concept is applied to make it possible for the owners to assess the performance of their
business and performance of those whose manage the enterprise.The managers are
responsible for the proper use of funds supplied by owners,banks and others.

2. Money Measurement Concept. In accounting, only those business transactions are recorded
which can be expressed in terms of money. In other words, a fact or transaction or happening
which cannot be expressed in terms of money is not recorded in the accounting books. As
money is accepted not only as a medium of exchange but also as a store of value, it has a very
important advantage since a number of assets and equities, which are otherwise different, can
be measured and expressed in terms of a common denominator. We must realize that this
concept imposes two limitations. Firstly, there are several facts which though very important to
the business, cannot be recorded in the books of accounts because they cannot be expressed in
money terms. For example, general health condition of the Managing Director of the company,
working conditions in which a worker has to work, sales policy pursued by the enterprise,
quality of product introduced by the enterprise, though exert a great influence on the
productivity and profitability of the enterprise, are not recorded in the books. Similarly, the fact
that a strike is about to begin because employees are dissatisfied with the poor working
conditions in the factory will not be recorded even though this event is of great concern to the
business. You will agree that all these have a bearing on the future profitability of the
company.Secondly, use of money implies that we assume stable or constant value of rupee.
Taking this assumption means that the changes in the money value in future dates are
conveniently ignored. For example, a piece of land purchased in 1990 for Rs. 2 lakh and another
bought for the same amount in 1998 are recorded at the same price, although the first
purchased in 1990 may be worth two times higher than the value recorded in the books
because of rise in land values. Infact, most accountants know fully well that purchasing power
of rupee does change but very few recognise this fact in accounting books and make allowance
for changing price level.

3. Dual Aspect Concept. Financial accounting records all the transactions and events involving
financial element. Each of such transactions requires two aspects to be recorded. The
recognition of these two aspects of every transaction is known as a dual aspect analysis.
According to this concept every business transactions has dual effect. For example, if a firm sells
goods of Rs. 10,000 this transaction involves two aspects. One aspect is the delivery of goods
and the other aspect is immediate receipt of cash (in the case of cash sales). Infact, the term
‘double entry’ book keeping has come into vogue because for every transaction two entries are
made. According to this system the total amount debited always equals the total amount
credited. It follows from ‘dual aspect concept’ that at any point in time owners’ equity and
liabilities for any accounting entity will be equal to assets owned by that entity. This idea is
fundamental to accounting and could be expressed as the following equalities:

Assets = Liabilities + Owners Equity ...............(1)

Owners Equity = Assets - Liabilities ...............(2)

The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’
denotes the resources supplied by the owners of the entity while the term ‘liabilities’ denotes
the claim of outside parties such as creditors, debenture-holders, bank against the assets of the
business. Assets are the resources owned by a business. The total of assets will be equal to total
of liabilities plus owners capital because all assets of the business are claimed by either owners
or outsiders.
4. Going Concern Concept. Accounting assumes that the business entity will continue to
operate for a long time in the future unless there is good evidence to the contrary. The
enterprise is viewed as a going concern, that is, as continuing in operations, at least in the
foreseeable future. In other words, there is neither the intention nor the necessity to liquidate
the particular business venture in the predictable future. Because of this assumption, the
accountant while valuing the assets do not take into account forced sale value of them. Infact,
the assumption that the business is not expected to be liquidated in the foreseeable future
establishes the basis for many of the valuations and allocations in accounting. For example, the
accountant charges depreciation of fixed assets values. It is this assumption which underlies the
decision of investors to commit capital to enterprise.

Only on the basis of this assumption can the accounting process remain stable and achieve the
objective of correctly reporting and recording on the capital invested, the efficiency of
management, and the position of the enterprise as a going concern. However, if the accountant
has good reasons to believe that the business, or some part of it is going to be liquidated or
that it will cease to operate (say within six-month or a year), then the resources could be
reported at their current values. If this concept is not followed, International Accounting
Standard requires the disclosure of the fact in the financial statements together with reasons.

5. Accounting Period Concept. This concept requires that the life of the business should be
divided into appropriate segments for studying the financial results shown by the enterprise
after each segment. Although the results of operations of a specific enterprise can be known
precisely only after the business has ceased to operate, its assets have been sold off and
liabilities paid off, the knowledge of the results periodically is also necessary. Those who are
interested in the operating results of business obviously cannot wait till the end. The
requirements of these parties force the businessman ‘to stop’ and ‘see back’ how things are
going on. Thus, the accountant must report for the changes in the wealth of a firm for short
time periods. A year is the most common interval on account of prevailingpractice, tradition
and government requirements. Some firms adopt financial year of the government, some other
calendar year.
.
6. Cost Concept. The term ‘assets’ denotes the resources land building, machinery etc. owned
by a business. The money values that are assigned to assets are derived from the cost concept.
According to this concept an asset is ordinarily entered on the accounting records at the price
paid to acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset would be
recorded in the books at Rs. 5 lakh, even if its market value at that time happens to be Rs. 6
lakh. Thus, assets are recorded at their original purchase price and this cost is the basis for all
subsequent accounting for the business. The assets shown in the financial statements do not
necessarily indicate their present market values. The term ‘book value’ is used for amount
shown in the accounting records.The cost concept does not mean that all assets remain on the
accounting records at their original cost for all times to come. The asset may systematically be
reduced in its value by charging ‘depreciation’.
.
7. The Matching concept. This concept is based on the accounting period concept. In reality we
match revenues and expenses during the accounting periods. Matching is the entire process of
periodic earnings measurement, often described as a process of matching expenses with
revenues. In other words, income made by the enterprise during a period can be measured only
when the revenue earned during a period is compared with the expenditure incurred for
earning that revenue.

8. Accrual Concept. It is generally accepted in accounting that the basis of reporting income is
accrual. Accrual concept makes a distinction between the receipt of cash and the right to
receive it, and the payment of cash and the legal obligation to pay it. This concept provides a
guideline to the accountant as to how he should treat the cash receipts and the right related
thereto. Accrual principle tries to evaluate every transaction in terms of its impact on the
owner’s equity. The essence of the accrual concept is that net income arises from events that
change the owner’s equity in a specified period and that these are not necessarily the same as
change in the cash position of the business. Thus it helps in proper measurement of income.

9. Realisation Concept. Realisation is technically understood as the process of converting non-

cash resources and rights into money. As accounting principle, it is used to identify precisely the
amount of revenue to be recognised and the amount of expense to be matched to such
revenue for the purpose of income measurement. According to realisation concept revenue is
recognised when sale is made. Sale is considered to be made at the point when the property in
goods passes to the buyer and he becomes legally liable to pay. This implies that revenue is
generally realised when goods are delivered or services are rendered. The rationale is that
delivery validates a claim against the customer.
ACCOUNTING CONVENTIONS

1. Convention of Materiality. Materiality concept states that items of small significance need
not be given strict theoretically correct treatment. Infact, there are many events in business
which are insignificant in nature. The cost of recording and showing in financial statement such
events may not be well justified by the utility derived from that information. For example, an
ordinary calculator costing Rs. 100 may last for ten years.However, the effort involved in
allocating its cost over the ten year period is not worth the benefit that can be derived from this
operation. The cost incurred on calculator may be treated as the expense of the period in which
it is purchased. Similarly, when a statement of outstanding debtors is prepared for sending to
top management, figures may be rounded to the nearest ten or hundred.

2. Convention of Conservatism. This concept requires that the accountants must follow the
policy of ‘’playing safe” while recording business transactions and events. That is why, the
accountant follow the rule anticipate no profit but provide for all possible losses, while
recording the business events. This rule means that an accountant should record lowest
possible value for assets and revenues, and the highest possible value for liabilities and
expenses. According to this concept, revenues or gains should be recognised only when they
are realised in the form of cash or assets (i.e. debts) the ultimate cash realisation of which can
be assessed with reasonable certainty. Further, provision must be made for all known liabilities,
expenses and losses, Probable losses regarding all contingencies should also be provided for.
‘Valuing the stock in trade at market price or cost price which ever is less’, ‘making the
provision for doubtful debts on debtors in anticipation of actual bad debts’, ‘adopting written
down value method of depreciation as against straight line method’, not providing for discount
on creditors but providing for discount on debtors’, are some of the examples of the application
of the convention of conservatism.

3. Convention of Consistency. The convention of consistency requires that once a firm decided
on certain accounting policies and methods and has used these for some time, it should
continue to follow the same methods or procedures for all subsequent similar events and
transactions unless it has a sound reason to do otherwise. In other worlds, accounting practices
should remain unchanged from one period to another. For example,if depreciation is charged
on fixed assets according to straight line method,this method should be followed year after
year.
Account
An account is a summary of the relevant transactions at one place relating to a particular head.
It records not only the amount of transaction but also their effect and direction.
Classification of Accounts
The classification of accounts is given as follows :
1. Personal Accounts : Accounts which are related to individuals, firms, companies, co-
operative societies, banks, financial institutions are known as personal accounts. The personal
accounts may further be classified into three categories :
(i) Natural Personal Accounts : Accounts of individuals (natural persons) such as Akhils' A/c,
Rajesh's A/c, Sohan's A/c are natural personal accounts.
(ii) Artificial Personal Accounts : Accounts of firms, companies, banks,financial institutions such
as Reliance Industries Ltd., Lions Club, M/s Sham &Sons, Punjab National Bank, National College
are artificial personal accounts.
iii) Representative Personal Accounts : The accounts recording transactions relating to limited
expenses and incomes are classified as nominal accounts. But in certain cases (due to the
matching concept of accounting) the amount on a particular date, is payable to the individuals
or recoverable from individuals. Such amount (i) relates to the particular head of expenditure or
income and (ii) represents persons to whom it is payable or from whom it is recoverable. Such
accounts are classified as representative personal account e.g., Wages outstanding account,
Pre-paid insurance account etc.
2. Real Accounts : Real accounts are the accounts related to assets/properties.These may be
classified into tangible real account and intangible real account.The accounts relating to
tangible assets (which can be touched, purchased and sold) such as building, plant, machinery,
cash, furniture etc. are classified as tangible real accounts. Intangible real accounts (which do
not have physical shape) are the accounts related to intangible assets such as goodwill,
trademarks,copyrights, patents etc.
3. Nominal Accounts : The accounts relating to income, expenses, losses and gains are classified
as nominal accounts. For example Wages Account, Rent Account, Interest Account, Salary
Account, Bad Debts Accounts, Purchases;Account etc. fall in the category of nominal accounts.

RULES OF DEBIT AND CREDIT

Basically, debit means to enter an amount to the left side of an account and credit means to
enter an amount to the right side of an account. In the abbreviated form Dr. stands for debit
and Cr. stands for credit. Both debit and credit may represent either increase or decrease
depending upon the nature of an account.

The Rules for Debit and Credit are given below :

Types of Accounts Rules for Debit Rules for Credit
(a) For Personal Accounts Debit the receiver Credit the giver
(b) For Real Accounts Debit what comes in Credit what goes out
(c) For Nominal Accounts Debit all expenses Credit all incomes and
and losses gains

MEANING AND FORMAT OF A JOURNAL

Journal is a historical record of business transactions or events. The word journal comes from
the French word "Jour" meaning "day". It is a book of original or prime entry written up from
the various source documents. Journal is a primary book for recording the day to day
transactions in a chronological order i.e. in the order in which they occur. The journal is a form
of diary for business transactions. This is also called the book of first entry since every
transaction is recorded firstly in the journal. The format of a journal is shown as follows :

Journal
Proforma (journal)

Date Particulars L.F no Debit(Rs.) Credit(Rs.)

(a) Date Column : This column shows the date on which the transaction is recorded. The year
and month is written once, till they change.
(b) Particular Column : Under this column, first the names of the accounts to be debited, then
the names of the accounts to be credited and lastly, the narration (i.e. a brief explanation of the
transaction) are entered.
(c) L.F., i.e. Ledger Folio Column : Under this column, the ledger page number containing the
relevant account is entered at the time of posting.
(d) Debit amount Column : Under this column, the amount to be debited is entered.
(e) Credit amount Column : Under this column, the amount to be credited is entered.

Meaning of Journalising

The process of recording a transaction in the journal is called journalising. The various steps to
be followed in journalising business transactions are given below :
Step 1 Ascertain what accounts are involved in a transaction.
Step 2 Ascertain what is the nature of the accounts involved.
Step 3 Ascertain which rule of debit and credit is applicable for each of the accounts involved.
Step 4 Ascertain which account is to be debited and which is to be credited.
Step 5 Record the date of transaction in the 'Date column'.
Step 6 Write the name of the account to be debited, very close to the left hand side i.e. the line
demarcating the 'Date column' and the 'Particulars column') along with the abbreviation 'Dr.'
on the same line against the name of the account in the 'Particulars column' and the amount to
be debited in the 'Debit Amount column' against the name of the account.
Step 7 Write the name of the account to be credited in the next line preceded by the word 'To'
at a few spaces towards right in the 'Particulars column' and the amount to be redited in the
'Credit Amount column' against the name of the account.
Step 8 Write 'Narration' (i.e. a brief description of the transaction) within brackets
in the next line in the 'Particulars column'.
Step 9 Draw a line across the entire 'Particulars column' to separate one Journal
Entry from the other.

Advantages of Journal
1. The transactions are recorded in journal as and when they occur so the chances of error is
minimized.
2. It help in preparation of ledger.
3. Any transfer from one account to another account is made through Journal.
4. The entry recorded in journal are self explanatory as it includes narration also.
5. It can record any such transaction which cannot be entered in any other books of account.
6. Every transaction is recorded in chronological order (date wise) so the chances of
manipulations are reduced.
7. Journal shows all information in respect of a transaction at one place.
8. The closing balances of previous year of accounts related to assets and liabilities can be
brought forward to the next year by passing journal entry in journal

Illustration 1 : From the following transactions of Nikhil, find out the nature of accounts and
also state which account should be debited and which should be credited :
i) Rent paid
ii) Interest received
iii) Purchased furniture for cash
iv) Machinery sold in cash
v) Outstanding salaries
vi) Paid to Surinder

Solution :
Analysis of Transactions Transaction Accounts Nature of Debit/Involved Accounts Credit
i) Rent paid Rent Account Nominal Account Debit Cash Account Real Account Credit
ii) Interest Received Cash Account Real Account Debit Interest Account Nominal Credit
iii) Purchased furniture for cash Furniture Account Real Account Debit Cash Account Real
Account Credit
iv) Machinery sold in cash Cash Account Real Account Debit Machinery Account Real Account
Credit
v) Outstanding Salary Salary Account Nominal Account Debit Outstanding Salary Personal
Account Credit Account
vi) Paid to Surinder Surinder's Account Personal Account Debit Cash Account Real Account
Credit

LEDGER

Journal is a daily record of all business transactions. In the journal all transactions relating to
persons, expenses, assets, liabilities and incomes are recorded. Journal does not give a
complete picture of the fundamental elements of book keeping i.e. properties, liabilities,
proprietorship accounts and expenses and incomes at a glance and at one place. Business
transactions being recurring in nature, a number of entries are made for a particular type of
transactions such as sales, purchases, receipts and payments of cash, expenses etc., through
out the accounting year. The entries are therefore scattered over in the Journal. In fact, the
whole Journal will have to be gone through to find out the combined effect of various
transactions on a particular account. In case, at any time, a businessman wants to now :

Relationship between Journal and Ledger

Journal and Ledger are the most useful books kept by a business entity. The points of
distinction between the two are given below :
1. The journal is a book of original entry where as the ledger is the main book of account.
2. In the journal business transactions are recorded as and when they occur i.e. date-wise.
However posting from the journal is done periodically, maybe weekly, fortnightly as per the
convenience of the business.
3. The journal does not disclose the complete position of an account. On the other hand, the
ledger indicates the position of each account debit wise or credit wise, as the case may be. In
this way, the net position of each account is known immediately.
4. The record of transactions in the journal is in the form of journal entries whereas the record
in the ledger is in the form of an account.
Utility of a Ledger
The main utilities of a ledger are summarised as under :
(a) It provides complete information about all accounts in one book.
(b) It enables the ascertainment of the main items of revenues and expenses
(c) It enables the ascertainment of the value of assets and liabilities.
(d) It facilitates the preparation of Final Accounts.

Format of a Ledger Account

Dr cr
Date Particulars J.f Amount Date Particulars J.f Amount

Posting
Posting refers to the process of transferring debit and credit amounts from the Journal or
subsidiary books to the respective heads of accounts in the ledger. Journal will have at a
minimum of one debit and one credit for each transaction. The ledger will have either a debit or
a credit for each account used in the Journal. Posting may be done daily, weekly fort nightly or
monthly according to the convenience and requirements of the business, but care should be
taken to complete it before the preparation of annual financial statements.

Procedure/Rules of Posting
The following rules should be followed while posting business transactions to respective
accounts in the ledger from the journal :
i) Enter the date and year of the transaction in the date column.
ii) Open separate account in the ledger for each person, asset, revenue, liability, expense,
income and loss appearing in the Journal.
iii) The appropriate/relevant account debited in the Journal will be debited in the ledger, but
the reference should be given of the other account which has been credited.
iv) Similarly, the account credited in the Journal should be credited in the ledger, but the
reference has to be given of the other account which has been debited in the Journal.
v) The debit posting should be prefixed by the word 'To' and credit posting should be prefixed
by the word 'By'.
vi) In the Journal Folio (J.F.) column the page number of the book of original entry (Journal) is
entered.

Trial Balance
A Trial Balance is a two-column schedule listing the titles and balances of all the ccounts in the
order in which they appear in the ledger. The debit balances are listed in the left-hand column
and the credit balances in the right-hand column. In the case of the General
Ledger, the totals of the two columns should agree. We, now, know the fundamental principle
of double entry system of accounting where for every debit, there must be a corresponding
credit. Therefore, for every debit or a series of debits given to one or
several accounts, there is a corresponding credit or a series of credits of an equal amount given
to some other account or accounts and viceversa.Hence, according to this principle, the sum
total of debit amounts must equal the credit amounts of the ledger at any date. If the various
accounts in the ledger are balanced, then the total of all debit balances
must be equal to the total of all credit balances. If the same is not true then the books of
accounts are arithmetically inaccurate. It is, therefore, at the end of the financial year or at any
other time, the balances of all the ledger accounts are extracted and are recorded in a
statement known as Trial Balance and finally totalled up to see whether the total of debit
balances is equal to the total of credit balances. to each other, it shows that there are some
errors, which must be detected and rectified if the correct final accounts are to be
prepared.Thus, Trial Balance forms a connecting link between the ledger accounts and the final
accounts.

METHODS OF PREPARATION OF TRIAL BALANCE

A trial balance can be prepared by the following two methods:

1. Total method: In this method, the debit and credit totals of each account are shown in
the two amount columns (onefor the debit total and the other for the credit total).

2. Balance Method: In this method, the difference of each amount is extracted. If debit side of
an account is bigger in amount than the credit side, the difference is put in the
debit column of the Trial Balance and if the credit side is bigger, the difference is written in the
credit column of the Trial Balance.

A specimen of the Trial Balance is given as follows:

TRIAL BALANCE OF …………… AS ON ……………..
Serial Name of the Account Dr.BalanceRs. Cr.BalanceRs.
No.

Of the two methods of the trial balance preparation, the second is usually used in practice
because it facilitates the preparation of the final accounts.

ACCOUNTING ERRORS

If the two sides of a trial balance agree it is a prima facie evidence of the arithmetical accuracy
of the entries made in the Ledger. But even if the trial balance agrees, it does not necessarily
mean that the accounting records are free from all errors, because there are certain types of
errors, which are not revealed by a Trial Balance. Therefore a Trial Balance should not be
regarded as a conclusive proof of accuracy of accounts. In accounting an error is a mistake
committed by the book-keeper (Accountant/Accounts Clerk) while recording or maintaining the
books of accounts. An error is an innocent and non-deliberate act or lapse on the part of the
persons involved in recording business transactions. It may occur while the transactions are
originally recorded in the books of
original entries i.e. Journal, Purchase Book, Sales Book, Purchase Return Book, Sales Return
Book, Bills Receivable Book, Bills Payable Book and Cash Book, or while the ledger accounts are
posted or balanced or even when the trial balance is prepared. These errors may affect the
arithmetical accuracy of the trial balance or may defeat the very purpose of accounting. These
errors can be classified as follows:
1. Clerical errors
2. Errors of Principle
A brief description of the above errors is given below:
(a) Clerical errors
Clerical errors are those errors, which are committed by the clerical staff during the course of
recording business transactions in the books of accounts. These errors are:
1. Errors of omission
2. Errors of commission
3. Compensating errors
4. Errors of duplication

Errors of omission: When business transaction is either completely or partly omitted to be

recorded in the books of prime entry it is called an ‘error of omission’. When a business
transaction is omitted completely, it is called a ‘complete error of omission”, and when a
business transaction is partly omitted, it is called a “partial error of mission”. A complete error
of omission does not affect the agreement of trial balance whereas a partial error of omission
may or may not affect the agreement of trial balance. Omission of recording a business
transaction either completely or partly, omission of ledger posting, omission of casting and
balancing of an account and omission of carrying forward are some examples of the errors of
omission.An example of a complete error of omission is goods purchased or sold may not be
recorded in the purchase book or sales book at all. This error will not affect the trial balance. An
example of a partial error of omission is goods purchased for Rs. 5,500 recorded in Purchase
Book for Rs. 550. This is a partial error of omission. This error will also not affect the agreement
of trial balance. Another example of a partial error of omission is that if goods purchased for Rs.
5,500 is recorded in the Purchase Book for Rs. 5,500 but the personal account of the supplier is
not posted with any amount on the credit side in the ledger, it is a partial error of omission and
it will affect the agreement of trial balance.

Error of commission: Such errors are generally committed by the clerical staff due to their
negligence during the course of recording business transactions in the books of accounts.
Though, the rules of debit and credit are followed properly yet some mistakes are committed.
These mistakes may be due to wrong posting of a business transaction either to a wrong
account or on the wrong side of an account, or due to wrong casting (addition) i.e. over-casting
or under-casting or due to wrong balancing of the accounts in the ledger.

Compensating errors: Compensating errors are those errors,which cancel or compensate

themselves. These errors arise when an error is either compensated or counter-balanced by
another error or errors so that of the other on the debit or credit side neutralizes the adverse
effect of one on credit side or debit side. For example, overposting on one side may be
compensated by under posting of an equal amount on the same side of the same account or
over posting of one side of an account may be compensated by an equal overprinting on the
opposite side of some other account. But these errors do not affect the trial balance.

Errors of duplication: When a business transaction is recorded twice in the prime books and
posted in the Ledger in the respective accounts twice, the error is known as the ‘Error of
Duplication’. These errors do not affect the trial balance.

(b) Errors of principle

When a business transaction is recorded in the books of original entries by violating the
basic/fundamental principles of accountancy it is called an error of principle. Some examples of
these errors are:
(i) When revenue expenditure is treated as capital expenditure or vice-versa, e.g. building
purchased is debited to the purchase account instead of the building account.
(ii) Revenue expenses debited to the personal account instead of the expenses account, e.g.
salary paid to Mr. Ashok, a clerk, for the month of June, debited to Ashok’s account
instead of salary account. These errors do not affect the Trial Balance.

Final accounts
INTRODUCTION

The transactions of a business enterprise for the accounting period are first recorded in the
books of original entry, then posted there from into the ledger and lastly tested as to their
arithmetical accuracy with the help of trial balance. After the preparation of the trial balance,
every businessman is interested in knowing about two more facts. They are : (i) Whether he has
earned a profit or suffered a loss during the period covered by the trial balance, and (ii) Where
does he stand now? In other words, what is his financial position?

For the above said purposes, the businessman prepares financial statements for his business
i.e. he prepares the Trading and Profit and Loss Account and Balance Sheet at the end of the
accounting period. These financial statements are popularly known as final accounts. The
preparation of financial statements depends upon whether the business concern is a trading
concern or manufacturing concern. If the business concern is a trading concern, it has to
prepare the following accounts along with the Balance Sheet :
(i) Trading Account; and
(ii) Profit and Loss Account.

But, if the business concern is a manufacturing concern, it has to prepare the following
accounts along with the Balance Sheet:
(i) Manufacturing Account;
(ii) Trading Account ; and
(iii) Profit and Loss Account.

Basically, two types of statements are prepared namely "Income Statement" and 'Position
Statement". The Income Statement is generally known as Profit and Loss Account. This Profit
and Loss Account is further sub-divided either into three parts or two parts according to the
nature of the business. As stated above, if the concern is a manufacturing one, the Profit and
Loss Account is divided into three sub-sections viz, Manufacturing Account, Trading Account
and Profit and Loss Account. On the other hand, if it is a trading concern, then this account is
divided into two sub-sections, namely Trading Account and Profit and Loss Account.The second
statement i.e. the "Position Statement" which is popularly known as the "Balance Sheet" is
prepared by every type of business concern.

The Balance Sheet is a statement which shows the position of the assets,liabilities and capital in
money terms, of an accounting entity as on a given date. A Balance Sheet is a formal
representation of the accounting equation indicating that the assets are always equal, in value,
to the liabilities plus capital.Trading Account is prepared to know the Gross Profit or Gross Loss.
Profit and Loss Account discloses net profit or net loss of the business.Balance sheet shows the
financial position of the business on a given date.For preparing final accounts, certain accounts
representing incomes or expenses are closed either by transferring to Trading Account or Profit
and Loss Account. Any Account which cannot find a place in any of these two accounts goes to
the Balance Sheet.

TRADING ACCOUNT

After the preparation of trial balance, the next step is to prepare Trading Account. Trading
Account is one of the financial statements which shows the result of buying and selling of goods
and/or services during an accounting period. The main objective of preparing the Trading
Account is to ascertain gross profit or gross loss during the accounting period. Gross Profit is
said to have been made when the sale proceeds exceed the cost of goods sold. Conversely,
when sale proceeds are less than the cost of goods.

sold, gross loss is incurred. For the purpose of calculating cost of goods sold, we have to take
into consideration opening stock, purchases, direct expenses on purchasing or manufacturing
the goods and closing stock. The balance of this account i.e. gross profit or gross loss is
transferred to the Profit and Loss Account.

MANUFACTURING ACCOUNT
Manufacturing Account is prepared by an enterprise engaged in manufacturing activities. It is
prepared to ascertain the cost of goods manufactured during an accounting period. This
account is closed by transferring its balance to the debit of the Trading Account. A general
format of a Manufacturing Account is shown below :

PROFIT AND LOSS ACCOUNT

Trading Account results in the gross profit/loss made by a businessman on purchasing and
selling of goods. It does not take into consideration the other operating expenses incurred by
him during the course of running the business. Besides this, a businessman may have other
sources of income. In order to ascertain the true profit or loss which the business has made
during a particular period, it is necessary that all such expenses and incomes should be
considered. Profit and Loss Account considers all such expenses and incomes and gives the net
profit made or net loss suffered by a business during a particular period. All the indirect
revenue expenses and losses are shown on the debit side of the Profit and Loss Account, where
as all indirect revenue incomes are shown on the credit side of the Profit and Loss Account.

Profit and Loss Account measures net income by matching revenues and expenses according to
the accounting principles. Net income is the difference between total revenues and total
expenses. In this connection, we must remember that all the expenses, for the period are to be
debited to this account - whether paid or not. If it is paid in advance or outstanding, proper
adjustments are to be made (Discussed later). Likewise all revenues, whether received or not
are to be credited. Revenue if received in advance or accrued but not received, proper
adjustment is required. A proforma of the Profit and Loss Account showing probable items
therein is as follows :

BALANCE SHEET

A Balance Sheet is a statement of financial position of a business concern at a given date. It is

called a Balance Sheet because it is a sheet of balances of those ledger accounts which have not
been closed till the preparation of Trading and Profit and Loss Account. After the preparation of
Trading and Profit and Loss Account the balances left in the trial balance represent either
personal or real accounts. In other words, they either represent assets or liabilities existing on a
particular date. Excess of assets over liabilities represent the capital and is indicative of the
financial soundness of a company.
A Balance Sheet is also described as a "Statement showing the Sources and Applications of
Capital". It is a statement and not an account and prepared from real and personal accounts.
The left hand side of the Balance Sheet may be viewed as description of the sources from which
the business has obtained the capital with which it currently operates and the right hand side as
a description of the form in which that capital is invested on a specified date.

CHARACTERISTICS OF A BALANCE SHEET

The characteristics of a Balance Sheet are summarised as under:

(a) A Balance Sheet is only a statement and not an account. It has no debit side or credit side.
The headings of the two sides are 'Assets'and 'Liabilities'.
(b) A Balance Sheet is prepared at a particular point of time and not for a particular period. The
information contained in the Balance Sheet is true only at that particular point of time at which
it is prepared.
(c) A Balance Sheet is a summary of balances of those ledger accounts which have not been
closed by transfer to Trading and Profit and Loss Account.
(d) A Balance Sheet shows the nature and value of assets and the nature and the amount of
liabilities at a given date.

UNIT-II
MEANING OF DEPRECIATION
Generally, the term depreciation is used to denote decrease in value but in accounting, this
term is used to denote decrease in the book value of fixed asset. Depreciation is the permanent
and continuous decrease in the book value of a fixed asset due to use, afflux ion of time,
obsolescence, expiration of legal rights or any other cause. According to the Institute of
Chartered Accountants of England and Wales, “Depreciation represents that part of the cost of
a fixed asset to its owner which is not recoverable when the asset is finally out of use by him.
Provision against this loss of capital is an integral cost of conducting the business during the
effective commercial life of the asset and is not dependent on the amount of profit earned”.

Depreciation is not the result of fluctuations in the value of fixed assets since, the fluctuation is
concerned with the market price of the fixed asset whereas the depreciation is concerned with
the historical cost.An analysis of the definition given above highlights the characteristics of
depreciation as follows :
(a) It is related to fixed assets only.
(b) It is a fall in the book value of an asset.
(c) The fall in the book value of an asset is due to the use of the asset in business operations,
effluxion of time, obsolescence, expiration of legal rights or any other cause.
(d) It is a permanent decrease in the book value of an asset.
(e) It is a continuous decrease in the book value of an asset.

Depreciation, Depletion and Amortisation

The terms depreciation, depletion and amortisation are used often interchangeably.
However, these different terms have been developed in accounting usage for describing this
process for different types of assets. These terms have been described as follows:

Depreciation
Depreciation is concerned with charging the cost of man made fixed assets to operation (and
not with determination of asset value for the balance sheet). In other words, the term
'depreciation' is used when expired utility of physical asset (building,machinery, or equipment)
is to be recorded.

Depletion
This term is applied to the process of removing an available but irreplaceable resource such as
extracting coal from a coal miner or oil out of an oil well.Depletion differs from depreciation in
that the former implies removal of a natural resource, while the latter implies a reduction in the
service capacity of an asset.
Amortisation
The process of writing off intangible assets is termed as amortisation. The intangible assets like
patents, copyrights, leaseholds and goodwill are recorded at cost in the books of account, Many
of these assets have a limited useful life and are, therefore,written off.

Obsolescence
It refers to the decline in the useful life of an asset because of factors like (i)technological
advancements, (ii) changes in the market demand of the product, (iii)legal or other restrictions,
or (iv) improvement in production process.

Meaning of Depreciation Accounting

According to the American Institute of Certified Public Accountants (AICPA), “Depreciation
Accounting is a system of accounting which aims to distribute cost or the basic value of tangible
capital assets less salvage (if any), over the estimated useful life of the unit (which may be
group of assets) in a systematic and rational manner. It is a process of allocation and not of
valuation.

CAUSES OF DEPRECIATION

The main causes of depreciation include the following :

(a) Physical wear and tear : When the fixed assets are put to use, the value of such assets may
decrease. Such decrease in the value of assets is said to be due to physical wear and tear.
(b) With the passage of time : When the assets are exposed to the forces of nature like
whether, winds, rains, etc., the value of such assets may decrease even if they are not put to
any use.
(c) Changes in economic environment : The value of an asset may decrease due to decrease in
the demand of the asset. The demand of the asset may decrease due to technological changes,
changes in the habits of consumers etc.
(d) Expiration of legal rights : When the use of an asset (e.g., patents, leases) is governed by the
time bound arrangement, the value of such assets may decrease with the passage of time.

NEED FOR PROVIDING DEPRECIATION

The need for providing depreciation in accounting records arises due to any one or more of the
following objectives to be achieved :
(a) To ascertain true results of operations : For proper matching of costs with revenues, it is
necessary to charge the depreciation (cost) against income (revenue) ineach accounting period.
Unless the depreciation is charged against income, the result of operations would stand
overstated. As a result the Income Statement would fail to present a true and fair view of the
result of operations of an accounting entity.

(b) To present true and fair view of the financial position : For presenting a true and fair view
of the financial position, it is necessary to charge the depreciation. If the depreciation is not
charged, the unexpired cost of the asset concerned would be
overstated. As a result, the Position Statement (i.e. the Balance Sheet) would not present
a true and fair view of the financial position of an accounting entity.
(c) To ascertain the true cost of production : For ascertaining the cost of production, it is
necessary to charge depreciation as an item of cost of production. If the depreciation on fixed
assets is not charged, the cost records, would not present a true and fair view of the cost of
production.
(d) To comply with legal requirements: In case of companies, it is compulsory to charge
depreciation on fixed assets before it declares dividend [Sec. 205(1) of the Companies Act,
1956].
(e) To accumulate funds for replacement of assets : A portion of profits is set aside in the form
of depreciation and accumulated each year to provide a definite amount at a certain future
date for the specific purpose of replacement of the asset at the end of its useful life.

METHODS OF CALCULATING DEPRECIATION

The following are various methods of allocating depreciation in use :

1. Fixed installment method or straight line method.
2. Machine hour rate method.
3. Diminishing Balance method.
4. Sum of years digits method
5. Annuity method
6. Depreciation Fund Method
7. Insurance Policy Method
8. Depletion Method.

1. Straight Line Method: This is also known as fixed installment method. Under this
method the depreciation is charged on the uniform basis year after year. When the
 amount of depreciation charged yearly under this method is plotted on a graph paper,
we shall get a straight line. Thus, the straight line method assumes that depreciations is
a function, of time rather than use in the sense that each accounting period received the
same benefit from using the asset as every other period.

The formula for calculating depreciation charge for each accounting period is :amount of
annual Depreciation =For example, if an asset cost Rs. 50,000 and it will have a residual
value of Rs.2000 at the end of its useful life of 10 years, the amount of annual
depreciation will be Rs. 4800 and it will be calculated as follow :Depreciation =This
method has many shortcomings. First, it does not take into consideration the seasonal
fluctuations, booms and depression. The amount of depreciation is the same in that
year in which the machine is used day and night to that in the another year in which it is
used for some months. Second, it ignores the interest on the money spent on the
acquisition of that asset. Third, the total charge for use of asset (i.e., depreciation and
repairs) goes on increasing form year to year though the assets might have been use
uniformly from year to year. For example, repairs cost together with depreciation
charge in the beginning years is much less than what it is in the later year. Thus, each
subsequent year is burdened with grater charge for the use of asset on account of
increasing cost of repairs.

2. Machine Hour Rate Method: In case of this method, the running time of the asset is
taken into account for the purpose of calculating the amount of depreciation. It is
suitable for charging depreciation on plant and machinery, air-crafts, gliders, etc. The
amount of depreciation is calculated as follows :

For example, if machinery has been purchased for Rs. 20000 and it will have a scrap
value of Rs. 1000 at the end of its useful life of 1900 hours, the amount of depreciation
per hour will be computed as follows : Depreciation =Rs. 10 per hour If in a particular
year, the machine runs for 490 hours, the amount of depreciation will be Rs. 4900 (i.e.,
Rs. 10x490). It is obvious from this example that under machine hour rate method the
amount of depreciation is closely related with the frequency of use of an asset. The
simplicity in calculations and understanding is the main advantage of this method.
However, it can be used only in case of those assets whose life can be measured in
terms of working time.

3. Written down Value Method: This is also known as Diminishing Balance method. Under the
diminishing balance method depreciation is charged at fixed rate on the reducing balance (i.e.,
cost less depreciation) every year. Thus, the amount of depreciation goes on decreasing every
year. Under this method also the amount of depreciation is transferred to profit and loss
account in each of the year and in the balance sheet the asset is shown at book value after
reducing depreciation from it. For example, if an asset is purchased for Rs. 10,000 and
depreciation is to be charged at 20% p.a. on reducing balance system then the depreciation for
the first year will be Rs. 2000. In the second year, it will Rs. 1600 (i.e. 20% of 8000),in the third
year Rs. 1280 (i.e. 20% of 6400) and so on. The rate of depreciation under this method can be
computed by using the following formula: Depreciation rate = -1

4. Sum of Years digits (SYD) Method: Under this method also the amount of depreciation goes
on diminishing in the future years similar to that under diminishing Balance method.For
calculating the amount of depreciation to be charged to the profit and loss account this method
takes into account cost, scrape value, and life of the asset. The following formula is used for
determining depreciation :For example, an asset having an effective life of 5 years is purchased
at a cost of Rs. 20,000. It is estimated that its scrap value at the end of its effective life will be
Rs. 2000. The depreciation on this asset, if SYD method is followed, will be calculated as follows
from one to five years : Year Depreciation Amount

5. Annuity Method: Sofar we have described such methods of charging depreciation which
ignore the interest factor. Also, sometimes it becomes inconvenient for a company to follow
any of the methods discussed earlier. Under such circumstances the company may use some
special depreciation systems. Annuity method is one of these special systems of depreciation.
Under this system, the depreciation is charged on the basis that besides losing the acquisition
cost of the asset the business also loses interest on the amount used for purchasing the asset.
Here, interest refers to that income which the business would have earnedotherwise if the
money used in buying the asset would have been committed in some other profitable
investment. Therefore, under the annuity method the amount of total depreciation is
determined by adding the cost of the and interest thereon at an expected rate. The annuity
table is used to help in the determination of the amount of depreciation.

6. Depreciation Fund Method : Business assets become useless at the expiry of their life and,
therefore, need replacement. However, all the methods of depreciation discussed above do not
help in accumulating the amount which can be readily available for the replacement of the
asset its useful life comes to an end Depreciation fund method takes care of such a contingency
as it incorporates the benefits of depreciating the asset as well as accumulating the necessary
amount for its replacement. Under this method, the amount of depreciation charged from the
profit and loss account is invested in certain securities carrying a particular rate of interest. The
interest received on the investment in such securities is also invested every year together with
the amount of annual depreciation. In the last of the life of asset the depreciation amount is set
aside interest is received as usual. But the amount is not invested because the amount is
immediately needed for the purchase of new asset. Rather all the investments so far
accumulated are sold away. Cash realised on the sale of investments is utilised for the purchase
of new asset. The following accounting entries are generally made in order to work out this
system of depreciation.

7. Insurance Policy Method : Under this method, instead of investing the money in securities an
insurance policy for the required amount is taken. The amount of the policy is such that it is
adequate to replace the asset when it is worn out. A fixed sum equal to the amount do
depreciation is paid as premium every year.Company receiving premium allows a small rate of
interest on compound basis. At the maturity of the policy, the insurance company pays the
agreed amount with which the new asset can be purchased. Accounting entries will be made as
follows.

8. Depletion Method : This is also known as productive output method.In this method it is
essential to make an estimate of the units of output the asset will produce in its life time. This
method is suitable in case of mines, queries, etc.,where it is possible to make an estimate of the
total output likely to be available.Depreciation is calculated per unit of output. Formula for
calculating the depreciation rate is as under: r =
Example : If a mine is purchased for 50,000 and it is estimated that the total quantity of mineral
in the mine is 1,00,000 tonnes, the rate of depreciation would be :r =Rs. 50,000 = Rs. 0.5
1,00,000

Hence, the rate of depreciation is 50 praise per tonne. In case output in a year is 20,000 tonnes,
the amount of depreciation to be charged to the profit and loss account would be Rs. 10,000
(i.e., 20,000 tonnes X Rs. 0.50).
This method is useful where the output can be measured effectively, and the utility of the asset
is directly related to its production use. Thus, the method provides thebenefit of correlating the
amount of depreciation with the productive use of asset.

INVENTORY VALUATION
INTRODUCTION

The literary meaning of the word inventory is stock of goods. To the finance manager, inventory
connotes the value of raw materials, consumable, spares, work-in-progress, finished goods and
scrap in which a company’s funds have been invested. It constitutes the second largest items
after fixed assets in the financial statements, particularly of manufacturing organisation. It is
why that inventory valuation and inventory control have become very important functions of
the accountants and finance managers. The persons interested in the accounting information
assume that the financial statements contain accurate information. However, it is often
observed that the financial statements don’t provide actual information about some of the
items,e.g. inventory and depreciation. This may be because of the variety of inventory valuation
methods available with the accountant.

According to the International Accounting Standard-2 (IAS-2), ‘Inventories’ mean tangible

property held;
(a) for sale in the ordinary course of business,
(b) in the process of production for such sale, or
(c) for consumption in the production of goods or services for sale.
Hence, the term inventory includes stock of (i) raw material and components, (ii) work-in-
progress and finished goods. In case of manufacturing concern, inventory consists of raw
materials, components, stores, semi-finished products and finished goods in case of
a trading concern inventory primarily consists of finished goods.

OBJECTIVES OF INVENTORY VALUATION

Following are the objectives of inventory valuation:
a) Determination of Income: A major objective of inventory valuation is the proper
determination of income through the process of matching appropriate cost against revenues.
Gross profit is found out by deducting cost of goods sold from sales. Cost of goods sold is
purchases plus opening stock minus closing stock. Hence, closing stock must be properly valued
and brought into accounts. Over valuation of closing stock leads to inflation of the current year
profits and deflation of the profits of succeeding years. Similarly, undervaluation leads to
deflation of current year’s profit and inflation of the profit of the succeeding years.

b) Determination of financial position: In the balance sheet, “inventory’ is a very important

item. It is to be shown as current asset in the balance sheet at the end of the year. If the
inventory is not properly and correctly valued, to that extent the balance sheet does not give
true and fair view of the financial position of the business. Keeping in view the above objectives
the auditor’s duty in relation to the verification and valuation of inventories becomes more
important. Therefore, while verifying he should ensure that stock taking is done by responsible
a officer, stock figures match with that of stock registers, and the basis of valuation has been
consistently the same from year to year. Moreover, he should carry out test checks to ensure
the accuracy of valuation.

METHODS OF VALUATION OF INVENTORIES

The basic methods of valuation of inventories are as follows:
(a) Historical cost based method
(b) Sale price based method
(c) Lower of cost or sale price

Methods based on Historical cost

According to AS-2 historical cost is the aggregate of costs of purchases, costs of conversion and
other costs incurred in the normal course of business in bringing the inventories to their
present locations and condition. Cost of purchase comprises purchase price, duties and taxes,
freight inwards and other expenditure directly attributable to acquisitions. However, selling
expenses such as advertisement expenses or storage cost should not be included.

The valuation of inventory at cost price will be in consonance with the realisation concept.
According to this concept, revenue is not realised until the sale is complete and the inventory is
converted into either cash or accounts receivable. There can thus be no recognition of revenue
accretion except at the point of sale. This is a method with very high objectivity since the
inventory valuer has to base it on a transaction which is completely verifiable. The main
limitation of this method is its inability to distinguish operational gains from holding gains
during period of inflation. (Note:Holding gain refers to profits which arises as a result of holding
inventories during inflation). They may be attributed to the fact that this method matches the
past inventories against revenues which have current relations. Thus, this system will result in
the inclusion of “inventory profits” (i.e. holding gain) in the income statements during periods
of rising prices.Now, we shall describe the various methods for assigning historical costs to
inventory and goods sold.

1. First In First Out Method (FIFO): This method is based on the assumption that the materials
which are purchased first are issued first. Issues of inventory are priced in order of their
purchases. Inventory issues/sales are priced on the same basis until the first lot of material of
goods purchased is exhausted. Thus, units issued are priced at the oldest cost price listed on
the stock ledger sheets. Under this system it is not necessary that the material which were
longest in stock are exhausted first. But the use of FIFO necessarily mean that the oldest costs
are first used for accounting purposes. In practice, an endeavour is made by most business
houses to sell of oldest merchandise or materials first. Hence when this system is followed the
closing stock does not consist of most recently purchased goods.

Advantages. The following are the advantages of this method:

(i) This method is easy to operate, provided the prices of materials do not fluctuate frequently.
(ii) It gives such a value of closing stock which is vary near to current market prices since closing
inventory is made of most recently purchased goods.
(iii) It is a realistic method because it takes into account the normal procedure of issuing
goods/inventory, i.e. the materials are issued to production in the order of their receipts.
(iv) As it is based on historical cost, no unrealised profit enters into the financial statements for
the period.

Disadvantages: This method suffers from the following limitations:

(i) Because of violent changes in prices of materials, it involves somewhat complicated
calculations and, therefore, it involves somewhat complicated calculations and, therefore,
increase the changes of clerical errors.
(ii) The prices of issues of materials may not reflect current market prices and, therefore, during
the period of inflation, the charge to production is unreasonably low.
(iii) Comparison between different jobs executed by the firm becomes sometimes difficult. A
job commenced a few minutes before another job might have consumes the supply of lower
priced stock. This is particularly because of that the fact the first job might have completely
exhausted the supply of materials of a particular lot.

Suitability: FIFO method is considered more suitable during the periods of falling prices. The
reason is that the higher price at which the purchase of materials was made earlier stands
recovered in cost. This method is suitable when the size of purchases is large but not much
frequent. The moderate fluctuations in the prices of materials and easy comparison between
different jobs are also the important conditions for the use of this method.

2. Last in First out Method (LIFO): Under this method, it is assumed that the material/goods
purchased in the last are issued first for production and those received first issued/sold last. In
case a new delivery is received before the first lot is fully used, price become the ‘last-in’ price
and is used for pricing issued until either the lot is exhausted or a new delivery is received.
Stated above, materials are issued to production at cost which may be very near to current
market price. However, inventories at the end will be valued at old prices which may be out of
tune with the current market price.

Advantages
(i) This method takes into account the current market circumstances while valuing materials
issued to various jobs or ascertaining the cost of goods sold.
(ii) No unrealized profit or loss is usually made in case this method is followed.

Disadvantages
(i) The stock in hand is valued at a price which have become out-of-date when compared with
the current inventory prices.
(ii) This method may not be acceptable for taxation purposes since the value of closing
inventory may be quite different from the current market value.
(iii) Comparison among similar jobs is very difficult because they may bear different issue prices
for materials consumed.

Suitability: This method is most suitable for materials which are of a bulky and non-perishable
type.

3. Highest-in-First-our (HIFO): According to this method, the highest priced materials are
treated as being issued first irrespective of the date of purchase. In fact, the inventory of
materials or goods are kept at the lowest possible price. In periods of rising prices the closing
inventory is undervalued and thus secret reserves are created. However, the highest cost of
materials is recovered first. Consequently, the closing inventory amount remains at the
minimum value. Hence, this method is very appropriate when the prices are frequently
fluctuating. As this method involves calculation more than that of LIFO and FIFO methods, it has
not been adopted widely.

4. Base stock method: The base stock method assume that each business firm whether small or
large must held a minimum quantity of materials finished foods at all times in order to carry on
business smoothly. These minimum quantity of inventories are valued
at the cost at which the base stock was acquired. It is assumed that the base stock is created
out of the lot purchased. Inventories over and above the base stock are valued according to
some other appropriate method such as FIFO, LIFO, etc.

5. Specific Identification Method: Under this method, each item of inventory is identified with
its cost. The value of inventory will be constituted by the aggregate of various cost so identified.
This method is very suitable for job order industries which carry out individual or goods have
been purchased for a specific job or customer.In other words, this method can be applied only
where materials used can be specifically and big items such as high quality furniture,paintings,
metal jewellery, cars, etc.However, this method is not appropriate in most industries because
of practical problems. For instance, in case of manufacturing company having numerous items
of inventory, the task of identifying the cost of every individual item of inventory becomes very
cumbersome. Also, it promotes the chances of manipulating the cost of goods sold. It can be
done by selecting items that have a relatively high cost or a relatively low cost, as he desires.

6. Simple average Price (SAP): This is the average of prices of different lots of urchase. Under
this method no consideration is given to the quantity of purchases in various lots. For example
the purchases of 500 units of materials at Rs. 10 per unit are made as on 5th January, 1995 and
800 units of materials at Rs. 14 per unit on 10 th January. If at the end 200 units remains
unissued/unsold, these will be valued at Rs. 12 = [(10 + 14)/2]per unit and hence, the closing
inventory will be shown at Rs. 2400 (200 × 12 = 2400). Infact, this method operated on the
principle that when items of materials are purchased in big lots and are put in godown, their
identity is lost and, therefore, issues should be priced at the average price of the lots in
godown.

7. Weighted Average Price (WAP): Under this method, the quantity of material purchased in
various lots of purchases is considered as weight while pricing the materials. Weighted average
price is calculated by dividing the total cost of material in stock by the
total quantity of material at the end. When this method is adopted, the question of profit or
loss out of varying prices does not arise because it evens out the effect of widely fluctuating
prices of different lots of purchases. This method is very popular because it reduces calculations
and is based on quantity and value of material purchased.

Unit-III
Shares
Shares are units of equity ownership interest in a corporation that exist as a financial asset
providing for an equal distribution in any residual profits, if any are declared, in the form
of dividends. Shareholders may also enjoy capital gains if the value of the company rises.

Shares represent equity stock in a firm, with the two main types of shares being common
shares and preferred shares. As a result, "shares" and "stock" are commonly used
interchangeably.

There are majorly two kinds of shares i.e. equity shares and preference shares.

Some of the most important types of preference shares of a company are as follows:

 Cumulative preference shares:

 Non-cumulative preference shares:
 Participating preference shares:
 Non-participating preference shares:
 Convertible preference shares:
 Non-Convertible preference shares:
 Redeemable preference shares
 Guaranteed preference shares

(i) Cumulative preference shares:

A preference share is said to be cumulative when the arrears of dividend are cumulative and
such arrears are paid before paying any dividend to equity shareholders. Suppose a company
has 10,000 8% preference shares of Rs. 100 each. The dividends for 1987 and 1988 have not
been paid so far. The directors before they can pay the dividend to equity shareholders for the
year 1989, must pay the pref. dividends of Rs. 2, 40,000 i.e. for the year 1987, 1988 and 1989
before making any payment of dividend to equity shareholders for the year 1989.

(ii) Non-cumulative preference shares:

In the case of non-cumulative preference shares, the dividend is only payable out of the net
profits of each year. If there are no profits in any year, the arrears of dividend cannot be
claimed in the subsequent years. If the dividend on the preference shares is not paid by the
company during a particular year, it lapses. Preference shares are presumed to be cumulative
unless expressly described as non-cumulative.

(iii) Participating preference shares:

Participating preference shares are those shares which are entitled in addition to preference
dividend at a fixed rate, to participate in the balance of profits with equity shareholders after
they get a fixed rate of dividend on their shares. The participating preference shares may also
have the right to share in the surplus assets of the company on its winding up. Such a right may
be expressly provided in the memorandum or articles of association of the company.

(iv) Non-participating preference shares:

Non- participating preference shares are entitled only to a fixed rate of dividend and do not
share in the surplus profits. The preference shares are presumed to be non-participating, unless
expressly provided in the memorandum or the articles or the terms of issue.

(v) Convertible preference shares:

Convertible preference shares are those shares which can be converted into equity shares
within a certain period.

(vi) Non-Convertible preference shares:

These are those shares which do not carry the right of conversion into equity shares.

(vii) Redeemable preference shares:

A company limited by shares, may if so authorized by its articles issue preference shares which
are redeemable as per the provisions laid down in Section 80. Shares may be redeemed either
after a fixed period or earlier at the option of the company.

(viii) Guaranteed preference shares:

These shares carry the right of a fixed dividend even if the company makes no or insufficient
profits.

Issue of Shares with Entries

Issue of shares involves the following steps:

 Issue of prospectus including people to take up shares

 Receiving applications along with application money.
 Allotment of shares
 Making calls on shares as decided by the Board of Directors.
 Issue and dispatch of share certificate.

Journal Entries for issue of Shares

1) On receipt of application money:

Bank A/c Dr.

To Share Application A/c [No. of shares applied ‘×’ Rate]

2) On allotment of shares:

Share Application A/c [No. of shares applied ‘×’ Rate] Dr.

To Share capital A/c

3) For rejection of some applications:

Share Application A/c Dr.

To Share Capital A/c [No. of shares rejected ‘×’ Rate]

Note: Shares can be issued at premium which may be receivable either at the time of
application or allotment; the Journal Entries then will be:

 When Premium is receivable along with application:

o Bank A/c [Total receipt including premium] Dr.
To Share Application
o Share Application A/c [No. of shares issued '×’ Rate] Dr.
To Share Capital [No. of shares issued '×’ Rate towards face value]
To Share Premium [premium / share ‘×’ No. of shares issued]
 When premium is receivable at the time of allotment.
o Share Allotment A/c Dr.
To Share Capital
To Share Premium.
o Bank A/c Dr.
To Share Allotment

4) Making and Receipt of Calls: The Balance due towards face value of shares after receiving
application and allotment money can be recovered by making as many calls as the directors
decide. The entries should be :
  For Call Money due:
Share Call A/c [No. of shares Issued '[No. of shares issued ‘×’ Rate]’ Rate.] Dr.
To Share Capital.
 For Call money received
Bank A/c Dr.
To Share Call A/c

5) Treatment of calls-in-arrear: The term denotes failure on part of some shareholders to make
payment of any call due on the shares taken up by him. The following entry should be passed in
every case of such default.

Call-in-arrear A/c [No. of defaulted shares ‘×’ Rate] Dr.

To (Respective) Call A/c.

Redemption
Redemption comes from the Latin word redimere, a combination of re(d)-, meaning “back,” and
emere, meaning “buy.” Redemption is what some people claim happens to your soul when
you're saved from evil forces. You might pray for redemption — to the tooth fairy, to Zeus, or to
some other kind of invisible being — in the hopes that an all-powerful being can save your soul.
Redemption can also refer to the repayment of a debt.

METHODS OF REDEMPTION OF DEBENTURES

1st Method of Redemption of Debentures - Redemption Out of Profit

In this method, we repay the money of debentures out of profit. Now, understand, how is it
possible? Suppose, you have estimated that you will get $ 1,00,0000 profit in march 2011 and in
same month, you have to redeem $ 10,000 debentures. Now, one side, you will pay $ 10000
through your cash or bank account and other side, you will deduct same $ 10000 from your
profit and loss account by making redemption reserve account. Following entry will be passed :

A) Transfer of Profit to debenture redemption reserve account

Profit and loss appropriation account Dr. 10000

Debentures Redemption account Cr. 10000

B) Redemption of Debentures

Debentures account Dr. 10000

Bank account Cr. 10000

2nd Method of Redemption of Debentures - Redemption Out of Capital

It means we directly repay the debentures out of capital. We just pass following entry after
repay of debentures by cheque.

Debentures account Dr.

Bank account Cr.

This entry's effect on our capital and it will reduce by same amount. There is no need to
transfer of profit to redemption reserves in this method.

3rd Method of Redemption of Debentures - Redemption by Conversion

Company can also redeem the old debentures by conversion these into new debentures or
equity or pref. shares. At that time, we will pass following entry

Old Debentures account Dr.

New Debentures account Cr

or

Equity Share capital account Cr.

or

Pref. Share capital account Cr.

4th Method of Redemption of Debentures - Redemption by Buying Own Debentures

In this method, directors go to debenture market and for redemption of debentures, they have
bought own debentures. For this, following entry will be passed.

Own Debenture or investment in own debentures account Dr.

Bank account Cr.

Investment in own debentures account or simply own debentures account will be shown on the
assets side of the balance sheet. Debentures will continue to be shown on the liabilities side of
the balance sheet. Here, it is assumed that the debentures are purchased immediately after the
payment of interest.

As and when the company wants to cancel investment in own debentures, the following entry
is done.

Debentures account Dr.

Loss on redemption of debentures account Dr.

Own debentures account Cr.

Profit on redemption of debentures account Cr.

5th Method of Redemption of Debentures - Redemption by Making Provision

In this method, we create provision for redemption of debentures when we issue debentures.
To making provision for redemption is good method to repay the amount of debenture on the
time. We keep a small amount of provision and invest in good scheme. At the time of
redemption, we liquidate our provision and repay the amount of debentures, it has two sub-
methods.

(A) Sinking Fund for Redemption Method

(B) Insurance Policy Method

In this method, we invest provision for redemption of debentures in insurance company, we

pay premium of insurance annual. When we have to redeem the debentures, we collect all the
money of insurance policy. After this, we repay the debenture amount.

Following entry will be passed in this method

First year

a) For amount of premium appropriated from profit and loss account

Profit and loss account appropriated account Dr.

Debenture redemption fund account Cr.

b) For amount of premium paid to insurance company

Debenture redemption fund policy account Dr.

Bank account Cr.

( Note : these entries will be passed every year including the last year also )

The following entries will also be passed at the end of the specific period on realization of the
policy:

a) For the amount received from insurance company

Bank account Dr.

Debenture redemption fund policy account Cr.

b) For the balance of debenture redemption fund policy account, excess amount received is
transferred to debenture redemption fund account.

Debenture redemption fund policy account Dr.

Debenture redemption fund account Cr.

c) For amount paid to debentures

debentures account D Cr.

 UNIT-IV
FINANCIAL ANALYSIS
INTRODUCTION
The term financial statements generally refers to two basic statements : (i) The Income
Statement, and (ii) The Balance Sheet. Of course, a business may also prepare a Statement of
Retained Earnings, and a Statement of Changes in financial Position in addition to the above
two statements.Financial statements are prepared primarily for decision-making. They play a
dominant role in setting the framework of managerial decisions. But the information provided
in the financial statements is not an end in itself as no meaningful conclusions can be drawn
from these statements alone. However, the information provided in the financial statements is
of immense use in making decisions through analysis and interpretation of financial statements.
Financial analysis is the process of identifying the financial strengths and weaknesses of the firm
by properly establishing relationship between the items of the balance sheet and the profit and
loss account. There are various methods or techniques used in analysing financial statements,
such as comparative statements, common-size statements, trend analysis, schedule of changes
in working capital, funds flow,cash flow analysis and ratio analysis.

MEANING OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

An analysis of financial statements is the process of critically examining in detail accounting

information given in the financial statements. For the purpose of analysis, individual items are
studied, their interrelationships with other related figures are established, the data is
sometimes rearranged to have better understanding of the information with the help of
different techniques or tools for the purpose. Analysing financial statements is a process of
evaluating relationship between component parts of financial statements to obtain a better
understanding of firm's position and performance. The analysis of financial statements thus
refers to the treatment of the information contained in the financial statements in a way so as
to afford a full diagnosis of the profitability and financial position of the firm concerned. For this
purpose financial statements are classified methodically, analysed and compared with the
figures of previous years or other similar firms.
The term 'Analysis' and 'interpretation' though are closely related,but distinction can be made
between the two. Analysis means evaluating relationship between components of financial
statements to understand firm's performance in a better way. Various account balances appear
in the financial statements. These account balances do not represent homogeneous data so it is
difficult to interpret them and draw some conclusions. This requires an analysis of the data in
the financial statements so as to bring some homogeneity to the figures shown in the financial
statements. Interpretation is thus drawing of inference and stating what the figures in the
financial statements really mean. Interpretation is dependent on interpreter himself.
Interpreter must have experience, understanding and intelligence to draw correct conclusions
from the analysed data.

OBJECTIVES OF FINANCIAL ANALYSIS

Analysis of financial statements is made to assess the financial position and profitability of a
concern. Analysis can be made through accounting ratios, fitting trend line, common size
statements, etc. Accounting ratios calculated for a number of years show the trend of the
change of position, i.e., whether the trend is upward or downward or static. The ascertainment
of trend helps us in making estimates for the future. Keeping in view the importance of
accounting ratios the accountant should calculate the ratios in appropriate form, as early as
possible, for presentation to management for managerial control. The main objectives of
analysis of financial statements are :

(i) to assess the profitability of the concern;

(ii) to examine the operational efficiency of the concern as a whole and of its various parts or
departments;
(iii) to measure the short-term and long-term solvency of the concern for the benefit of the
debenture holders and trade creditors;
(iv) to undertake a comparative study in regard to one firm with another firm or one
department with another department; and
(v) to assess the financial stability of a business concern.

TOOLS OF FINANCIAL ANALYSIS

Financial Analyst can use a variety of tools for the purposes of analysis and interpretation of
financial statements particularly with a view to suit the requirements of the specific enterprise.
The principal tools are as under :
1. Comparative Financial Statements
2. Common-size Statements
3. Trend Analysis
4. Cash Flow Statement
5. Ratio Analysis
6. Funds Flow statements
1. Comparative Financial Statements: Comparative financial statements are those statements
which have been designed in a way so as to provide time perspective to the consideration of
various elements of financial position embodied in such statements. In these statements figures
for two or more periods are placed side by side to facilitate comparison. Both the Income
Statement and Balance Sheet can be prepared in the form of Comparative Financial
Statements.

a) Comparative Income Statement

The comparative Income Statement is the study of the trend of the same items/group of items
in two or more Income Statements of the firm for different periods. The changes in the Income
Statement items over the period would help in forming opinion about the performance of the
enterprise in its business operations. The Interpretation of omparative Income Statement
would be as follows:
(i) The changes in sales should be compared with the changes in cost of goods
sold. If increase in sales is more than the increase in the cost of goods sold,then the profitability
will improve.
ii) An increase in operating expenses or decrease in sales would imply decreasein operating
profit and a decrease in operating expenses or increase in sales would imply increase in
operating profit.
iii) The increase or decrease in net profit will give an idea about the overall profitability of the
concern.

b) Comparative Balance Sheet

The comparative Balance Sheet analysis would highlight the trend of various items and groups
of items appearing in two or more Balance Sheets of a firm on different dates. The changes in
periodic balance sheet items would reflect the changes in the financial position at two or more
periods. The Interpretation of Comparative Balance Sheets are as follows :
i) The increase in working capital would imply increase in the liquidity position of the firm over
the period and the decrease in working capital would imply deterioration in the liquidity
position of the firm.
(ii) An assessment about the long-term financial position can be made by studying
the changes in fixed assets, capital and long-term liabilities. If the increase in capital and long-
term liabilities is more than the increase in fixed assets, it implies that a part of capital and long-
term liabilities has been used for financing a part of working capital as well. This will be a
reflection of the good financial policy. The reverse situation will be a signal towards increasing
degree of risk to which the long-term solvency of the concern would be exposed to.
iii) The changes in retained earnings, reserves and surpluses will give an indication about the
trend in profitability of the concern. An increase in reserve and surplus and the Profit and Loss
Account is an indication of improvement in profitability of the concern. The decrease in these
accounts may imply payment of dividends, issue of bonus shares or deterioration in profitability
of the concern.
2. Common-size Financial Statements : Common-size Financial Statements are those in which
figures reported are converted into percentages to some common base. In the Income
Statement the sale figure is assumed to be 100 and all figures are expressed as a percentage of
sales. Similarly in the Balance sheet the total of assets or liabilities is taken as 100 and all the
figures are expressed as a percentage of this total.

a) Common Size Income Statement

In the case of Income Statement, the sales figure is assumed to be equal to 100 and all other
figures are expressed as percentage of sales. The relationship between items of Income
Statement and volume of sales is quite significant since it would be helpful in evaluating
operational activities of the concern. The selling expenses will certainly go up with increase in
sales. The administrative and financial expenses may go up or may remain at the same level. In
case of decline in sale, selling expenses should definitely decrease.

b) Common Size Balance Sheet

For the purpose of common size Balance Sheet, the total of assets or liabilities is taken as 100
and all the figures are expressed as percentage of the total. In other words, each asset is
expressed as percentage to total assets/liabilities and each liability is expressed as percentage
to total assets/liabilities. This statement will throw light on the solvency position of the concern
by providing an analysis of pattern of financing both long-term and working capital needs of the
concern.

3. Trend Analysis
The third tool of financial analysis is trend analysis. This is immensely helpful in making a
comparative study of the financial statements of several years. Under this method trend
percentages are calculated for each item of the financial statement taking the figure of base
year as 100. The starting year is usually taken as the base year. The trend percentages show the
relationship of each item with its preceding year's percentages. These percentages can also be
presented in the form of index numbers showing relative change in the financial data of certain
period.This will exhibit the direction, (i.e., upward or downward trend) to which the concern is
proceeding. These trend ratios may be compared with industry ratios in order to know the
strong or weak points of a concern. These are calculated only for major items instead of
calculating for all items in the financial statements.
While calculating trend percentages, the following precautions may be taken :
(a) The accounting principles and practices must be followed constantly over the period for
which the analysis is made. This is necessary to maintain consistency and comparability.
(b) The base year selected should be normal and representative year.
(c) Trend percentages should be calculated only for those items which have logical relationship
with one another.
(d) Trend percentages should also be carefully studied after considering the absolute figures on
which these are based. Otherwise, they may give misleading conclusions.
(e) To make the comparison meaningful, trend percentages of the current year should be
adjusted in the light of price level changes as compared to base year.

4. Cash Flow Statement

A cash flow statement shows an entity's cash receipts classified by major sources and its cash
payments classified by major uses during a period. It provides useful information about an
entity's activities in generating cash from operations to repay debt, distribute dividends or
reinvest to maintain or expand its operating capacity; about its financing activities, both debt
and equity; and about its investment in fixed assets or current assets other than cash. In other
words, a cash flow statement lists down various items and their respective magnitude which
bring about changes in the cash balance between two balance sheet dates. All the items
whether current or non-current which increase or decrease the balance of cash are included in
the cash flow statement. Therefore, the effect of changes in the current assets and current
liabilities during an accounting period on cash position, which is not shown in a fund flow
statement, is depicted in a cash flow statement.
The depiction of all possible sources and application of cash in the cash flow statement helps
the financial manager in short term financial planning in a significant manner because the short
term business obligations such as trade creditors, bank loans, interest on debentures and
dividend to shareholders can be met out of cash only. The preparation of cash flow statement is
also consistent with the basic objective of financial reporting which is to provide information to
investors, creditors and others which would be useful in making rational decisions. The basic
objective is to enable the users of information to make prediction about cash flows in an
organization since the ultimate success or failure of the business depends upon the amount of
cash generated. This objective is sought to be met by preparing a cash flow statement.

DISTINCTION BETWEEN FUND FLOW STATEMENT AND CASH FLOW STATEMENT

Some of the main difference between a fund flow statement and a cash flow statement are
described below :
1. Concept of funds : A fund flow statement is prepared on the basis of a wider concept of
funds i.e., net working capital (excess of current assets over current liabilities) whereas cash
flow statement is based upon narrower concept of funds i.e., cash only.
2. Basis of accounting : A fund flow statement can also be distinguished from a cash flow
statement from the point of view of the basis of accounting used for preparing these
statements. A fund flow statement is prepared on the basis of accrual basis of accounting,
whereas a cash flow statement is based upon cash basis of accounting. Due to this reason,
adjustments for incomes received in advance, incomes outstanding, prepaid expenses and
outstanding expenses are made to compute cash earned from operations of the business (refer
to computation of cash from operations). No such adjustments are made while computing
funds from operations in the funds flow statement.

3. Mode of preparation : A fund flow statement depicts the sources and application of funds. If
the total of sources is more than that of applications then it represents increase in net working
capital. On the other hand if the total of applications of funds is more than that of sources then
the difference represents decrease in net working capital. A cash flow statement depicts
opening and closing balance of cash, and inflows and outflows of cash. In a cash flow
statement, to the opening balance of cash all the inflows of cash are added and from the
resultant total all the outflows of cash are deducted. The resultant balance is the closing
balance of cash. A cash flow statement is just like a cash account which starts with opening
balance of cash on the debit side to which receipts of cash are added and
from the resultant total, the total of all the payments of cash (shown on the credit side) is
deducted to find out the closing balance of cash.

4. Treatment of current assets and current liabilities : While preparing a funds flow statement
the changes in current assets and current liabilities are not disclosed in the funds flow
statement rather these changes are shown in a separate statement known as schedule of
changes in working capital. In a cash flow statement no distinction is made between current
assets and fixed assets, and current liabilities and long-term liabilities. All changes are
summarised in the cash flow statements.

5. Usefulness in planning : A cash flow statement aims at helping the management in the
process of short term financial planning. A cash flow statement is useful to the management in
assessing its ability to meet its short term obligation such as trade creditors, bank loans,
interest on debentures, dividend to shareholders and so on. A fund flow statement on the
other hand is very helpful in intermediate and long-term planning, because though it is difficult
to plan cash resources for two, three or more years ahead yet one can plan adequate working
capital for future periods.
Uses and Importance of Cash Flow Statements

Cash flow statements are of great importance to a financial manager.

The information contained in cash flow statement can help the management in the field of
short-run financial planning and cash control. Some of the important advantages of cash flow
statements are discussed below :
1) The projected cash flow statements if prepared in a business disclose surplus or shortage of
cash well in advance. This helps in arranging utilisation of surplus cash as bank deposits or
investment in marketable securities for short periods. Should there be shortage of cash,
arrangement can be mode for raising the bank loan or sell marketable securities.
2. Cash flow statements are of extreme help in planning liquidation of debt,replacement of
plant and fixed assets and similar other decisions requiring outflow of cash from the business as
they provide information about the cash generating ability of the business.
3. The cash flow statement pertaining to a particular year compared with the budget for that
year reveals the extent to which the actual sources and applications of cash were in consonance
with the budget. This exercise helps in refining the planning process in future.
4. The inter-firm and temporal comparison of cash flow statements reveals the trend in the
liquidity position of a firm in comparison to other firms in the industry. It can serve as a pointer
to the need for taking corrective action if it is observed that the management of cash in the firm
is not effective.
5. Cash flows statements are more useful in short term financial analysis as compared to fund
flow statements since in the short run it is cash which is more important for executing plans
rather than working capital.

Limitations of Cash flow Statements

1. The possibility of window dressing in cash position is more than in the case of working capital
position of a business. The cash balance can easily be maneuvered by deferring purchases and
other payments, and speeding up collections from debtors before the balance sheet date. The
possibility of such maneuvering is lesser in respect of working capital position. Therefore a fund
flow statement which shows reasons responsible for the changes in the working capital
presents a more realistic picture than cash flow statement.
2. The liquidity position of a business does not depend upon cash position only.In addition to
cash it is also dependent upon those assets also, which can be converted into cash. Exclusion of
these assets while assessing the liquidity of a business obscures the true reporting of the ability
of the business in meeting it liabilities on becoming due for payment.
3. Equating of cash generated from the operations of the business with the net operating
income of the business is not fair because while computing cash generated from business
operations, depreciation on fixed assets is excluded. This treatment leads to mismatch between
the expenses and revenue while determining the business results as no charge is made in the
profit and Loss account for the use of fixed assets.
4. Relatively larger amount of cash generated from business operations vis-avis net profit
earned may prompt the management to pay higher rate of dividend, which in turn may affect
the financial health of the firm adversely.

PROCEDURE FOR PREPARING A CASH FLOW STATEMENT

Cash flow statement shows the impact of various transactions on cash position of a firm. It is
prepared with the help of financial statements, i.e., balance sheet and profit and loss account
and some additional information. A cash flow statement starts with the opening balance of cash
and balance at bank, all the inflows of cash are added to the opening balance and the outflows
of cash are deducted from the total. The balance, i.e, opening balance of cash and bank balance
plus inflows of cash minus outflows of cash is reconciled with the closing balance of cash. The
preparation of cash flow statement involves the determining of :

(a) Inflows of cash.

(b) Outflows of cash.

(a) Sources of Cash Inflows :

The main sources of cash inflows are:
(1) Cash flow from operations.
(2) Increase in existing liabilities or creation of new liabilities.
(3) Reduction in or Sale of Assets.
(4) Non-trading Receipts.

(b) Application of Cash

(1) Cash lost in operation.
(2) Decrease in or discharge of liabilities.
(3) Increase in or purchase of assets.
(4) Non-trading payments.
Generally, cash flow statement is prepared in two forms:
(a) Report form
(b) T Form or an Account Form or Self Balancing Type
APPLICATIONS OF CASH OR CASH OUTFLOWS

1. Cash Lost in Operations: Sometimes the net result of trading in a particular period is a loss
and some cash may be lost during that period in trading operations. Such loss of ash in trading
in called cash lost in operations and is shown as an outflow of cash in Cash Flow Statement.
2. Decrease in or Discharge of Liabilities: Decrease in or discharge of any liability, fixed or
current results in outflow of cash either actual or notional. For example, when redeemable
preference shares are redeemed and loans are repaid, it will amount to an outflow of actual
cash. But when a liability is converted into another, such as issue of shares for debentures,
there will be a notional flow of cash into the business.
3. Increase in or Purchase of Assets: Just like decrease in or sale of assets is a source or inflow
of cash, increase or purchase of any assets is a outflow or application of cash.
4. Non Trading Payments: Payment of any non-trading expenses also constitute outflow of
cash. For example, payment of dividends, payment of income tax, etc.

Funds flow statement

The basic financial statements, i.e., the Balance Sheet and Profit and Loss Account or Income
Statement of business, reveal the net effect of the various transactions on the operational and
financial position of the company. The Balance Sheet gives a summary of the assets and
liabilities of an undertaking at a particular point of time. It reveals the financial status of the
company. The assets side of a Balance Sheet shows the deployment of resources of an
undertaking while the liabilities side indicates its obligations, i.e., the manner in which these
resources were obtained. The Profit and Loss Account reflects the results of the business
operations for a period of time. It contains a summary of expenses incurred and the revenue
realised in an accounting period. Both these statements provide the essential basic information
on the financial activities of a business, but their usefulness is limited for analysis and planning
purposes.
The Balance Sheet gives a static view of the resources (liabilities) of a business and the uses
(assets) to which these resources have been put at a certain point of time. It does not disclose
the causes for changes in the assets and liabilities between two different points of time. The
Profit and Loss Account, in a general way, indicates the sources provided by operations. But
there are many transactions that take place in an undertaking and which do not operate
through Profit and Loss Account. Thus, another statement has to be prepared to show the
change in the assets and liabilities from the end of one period of time to the end of another
period of time. The statement is called a Statement of Changes in Financial Position or a Funds
Flow Statement. The Funds Flow Statement is a statement which shows the movement of
funds and is a report of the financial operations of the business undertaking. It indicates various
means by which funds were obtained during particular period and the ways in which these
funds were employed. In simple words, it is a statement of sources and applications of funds.

MEANING OF FUNDS
The term 'funds' has been defined in a number of ways :

(a) In a narrow sense, it means cash and a Funds Flow Statement prepared on this basis is
called a cash flow statement. Such a statement enumerates net effects of the various business
transactions on cash and takes into account receipts and disbursements of cash.

(b) In a broader sense, the term 'funds' refers to money values in whatever form it may exist.
Here funds means all financial resources, used in business whether in the form of men,
material, money, machinery and others.

(c) In a popular sense, the term 'funds' means working capital, i.e., the excess of current
assets over current liabilities. The working capital concept of funds has emerged due to the fact
that total resources of a business are invested partly in fixed assets in the form of fixed capital
and partly kept in form of liquid or near liquid form as working capital.The concept of funds as
working capital is the most popular one and in this lesson we shall refer to 'funds' as working
capital.

MEANING OF FLOW OF FUNDS

The term 'flow' means movement and includes both 'inflow' and 'outflow’. The term 'flow of
funds' means transfer of economic values from one asset or equity to another. Flow of funds is
said to have taken place when any transaction makes changes in the amount of funds available
before happening of the transaction. If the effect of transaction results in the increase of funds,
it is called a source of funds and if it results in the decrease of funds, it is known as an
application of funds. Further, in case the transaction does not change funds, it is said to have
not resulted in the flow of funds. According to the working capital concept of funds, the term
'flow of funds' refers to the movement of funds in the working capital. If any transaction results
in the increase in working capital, it is said to be a source or inflow of funds and if it results in
the decrease of working capital, it is said to be an application or outflow of funds.
Rule of Flow of Funds
The flow of funds occurs when a transaction changes on the one hand a non-current account
and on the other a current account and vice-versa.When a change in a non-current account
e.g., fixed assets, long-term liabilities, reserves and surplus, fictitious assets, etc., is followed by
a change in another non-current account, it does not amount to flow of funds. This is because
of the fact that in such cases neither the working capital increases nor decreases. Similar, when
a change in one current account results in a change in another current account, it does not
affect funds. Funds move from non-current to current transactions or vice-versa only. In simple
language funds move when a transaction affects (i) current asset and a fixed asset, or (ii) a fixed
and a current liability, or (iii) a current asset and a fixed liability, or (iv) a fixed liability and
current liability; and funds do not move when the transaction affects fixed assets and fixed
liability or current assets and current liabilities.

Examples
(a) Transactions which involve only the current accounts and hence do not result in the flow
of funds
1. Cash collected from debtors.
2. Bills receivables realised.
3. Cash paid to creditors.
4. Payment or discharge of bills payable.
5. Issued bills payable to trade creditors.
6. Received acceptances from customers.
7. Raising of short-term loans.
8. Sale of purchased for cash or credit.
9. Goods purchased for cash or credit.

(b) Transactions which involve only non-current accounts and hence do not result in the flow
of funds
1. Purchase of one new machine in exchange of two old machines.
2. Purchase of building or furniture in exchange of land.
3. Conversion of debentures into shares.
4. Redemption of preference shares in exchange of debentures.
5. Transfers to General Reserves, etc.
6. Payment of bonus in the form of shares.
7. Purchase of fixed assets in exchange of shares, debentures, bonds or long-term loans.
8. Writing off of fictitious assets.
9. Writing off a accumulated losses or discount on issue of shares, etc.
(c) Transactions which involve both current and non-current accounts and hence result in the
flow of funds
1. Issue of shares for cash.
2. Issue of debentures for cash.
3. Raising of long-term loans.
4. Sale of fixed assets on cash or credit.
5. Sale of trade investments.
6. Redemption of Preference shares.
7. Redemption of debentures.
8. Purchase of fixed assets on cash or credit.
9. Purchase of long-term/trade investments.
10. Payment of bonus in cash.
11. Repayment of long-term loans.
12. Issue of shares against purchase of stock-in-trade.

FUNDS FLOW STATEMENT

The Funds Flow Statement is a financial statement which reveals the methods by which the
business has been financed and how it has used its funds between the opening and closing
Balance Sheet dates. According to Anthony, "The Funds Flow Statement describe the sources
from which additional funds were derived and the uses to which these funds were put". The
analysis of such statements over periods of time clearly shows the sources from which past
activities have been financed and brings to highlight the uses to which such funds have been
put. The statement is known by various titles, such as, Statement of Sources and Applications of
Funds, Statement of Changes in Working Capital, Where Got and Gone Statement and
Statement of Resources Provided and Applied.

Objectives of Funds Flow Statement

Generally a business prepares two financial statements i.e., Balance Sheet and Profit and Loss
Account. The former reflects the state of assets and liabilities of a company on a particular date
whereas the latter tells about the result of operations of the company over a period of a year.
These financial statements have great utility but they do not reveal the movement of funds
during the year and their consequent effect on its financial position. For example, a company
which has made substantial profits during the year, may discover to its surprise that there are
not enough liquid funds to pay dividend and income tax because of profits tied up in other
assets, and is always after the bank authorities to get the cash credit or bank overdraft facility.
In order to remove this defect, another statement known as Funds Flow Statement is prepared.
The main purposes of such statement are :
(i) To help to understand the changes in assets and asset sources which are not readily evident
in the Income Statement or the financial position statement. (ii) To inform as at how the loans
to the business have been used, and (iii) To point out the financial strengths and weaknesses of
the business.

Procedure for Preparing a Funds Flow Statement

Funds flow statement is a method by which we study changes in the financial position of a
business enterprise between beginning and ending financial statements dates. Hence, the
Funds Flow Statement is prepared by comparing two Balance Sheets and with the help of such
other information derived from the accounts as may be needed. Broadly speaking, the
preparation of a Funds Flow Statement consists of following two parts :
1. Statement or Schedule of Changes in Working Capital
2. Statement of Sources and Application of Funds

1. Statement or Schedule of Changes in Working Capital

Working Capital means the excess of current assets over current liabilities. Statement of
changes in working capital is prepared to show the changes in the working capital between the
two Balance Sheet dates. This statement is prepared with the help of current assets and current
liabilities derived from the two Balance Sheets. The changes in the amount of any current asset
or current liability in the current Balance Sheet as compared to that of the previous Balance
Sheet either results in increase or decrease in working capital. The difference is recorded for
each individual current asset and current liability. In case a current asset in the current period is
more than in the previous period, the effect is an increase in working capital and it is recorded
in the increase column. But if a current liability in the current period is more than in the
previous period, the effect is decrease in working capital and it is recorded in the decrease
column or vice versa. The total increase and the total decrease are compared and the
difference shows the net increase or net decrease in working capital. It is worth noting that
schedule of changes in working capital is prepared only from current assets and current
liabilities and the other information is not of any use for preparing this statement.
 UNIT - V
RATIO ANALYSIS

INTRODUCTION
An analysis of financial statements is the process of critically examining in detail accounting
information given in the financial statements. For the purpose of analysis,individual items are
studied, their interrelationships with other related figures are established, the data is
sometimes rearranged to have better understanding of the information with the help of
different techniques or tools for the purpose. Analysing financial statements is a process of
evaluating relationship between component parts of financial statements to obtain a better
understanding of firm’s position and performance. The analysis of financial statements thus
refers to the treatment of the information contained in the financial statements in a way so as
to afford a full diagnosis of the profitability and financial position of the firm concerned.For this
purpose financial statements are classified methodically, analysed and compared with the
figures of previous years or other similar firms.The term ‘Analysis’ and ‘interpretation’ though
are closely related, but distinction can be made between the two. Analysis means evaluating
relationship between components of financial statements to understand firm’s performance in
a better way.Various account balances appear in the financial statements. These account
balances do not represent homogeneous data so it is difficult to interpret them and draw some
conclusions. This requires an analysis of the data in the financial statements so as to bring some
homogeneity to the figures shown in the financial statements.Interpretation is thus drawing of
inference and stating what the figures in the financial statements really mean. Interpretation is
dependent on interpreter himself.
.
INTERPRETATION OF RATIOS

The interpretation of ratios is an important factor. Though calculation is also important

but it is only a clerical task whereas interpretation needs skills, intelligence and foresightedness.
The interpretation of the ratios can be done in the following ways :
1. Single Absolute Ratio: Generally speaking one cannot draw meaningful conclusions when a
single ratio is considered in isolation. But single ratios may be studied in relation to certain rules
of thumb which are based upon well proven contentions as for example 2:1 is considered to be
a good ratio for current assets to current liabilities.
2. Groups of Ratio : Ratios may be interpreted by calculating a group of related ratios. A single
ratio supported by related additional ratios becomes more understandable and meaningful.
3. Historical Comparisons : One of the easiest and most popular ways of evaluating the
performance of the firm is to compare its present ratios with the past ratios called comparison
over time.
4. Projected Ratios : Ratios can also be calculated for future standard based upon the projected
financial statements. Ratio calculation on actual financial statements can be used for
comparison with the standard ratios to find out variance, if any. Such variance helps in
interpreting and taking corrective action for improvement in future.
5. Inter-firm Comparison : Ratios of one firm can also be compared with the ratios of some
other selected firms in the same industry at the same point of time.

MANAGERIAL USES OF RATIO ANALYSIS

The following are the important managerial uses of ratio analysis –

1. Helps in Financial Forecasting : Ratio analysis is very helfpful in financial forecasting. Ratios
relating to past sales, profits and financial position form the basis for setting future trends.
2. Helps in Comparison : With the help of ratio analysis, ideal ratios can be composed and they
can be used for comparing a firm's progress and performance. Inter-firm comparison or
comparison with industry averages is made possible by the ratio analysis.
3. Financial Solvency of the Firm : Ratio analysis indicates the trends in financial solvency of the
firm. Solvency has two dimensions-long-term solvency and short-term solvency. Long-term
solvency refers to the financial viability of a firm and it is closely related with the existing
financial structure. On the other hand, short-term solvency is the liquidity position of the firm.
With the help of ratio analysis conclusions can be drawn regarding the firm's liquidity and
longterm solvency position.
4. Evaluation of Operating Efficiency : Ratio analysis throws light on the degree of efficiency in
the management and utilisation of its assets and resources. Various activity ratios measure this
kind of operational efficiency and indicate the guidelines for economy in costs, operations and
time.
5. Communication Value : Different financial ratios communicate the strength and financial
standing of the firm to the internal and external parties. They indicate the over-all profitability
of the firm.
6. Others Uses : Financial ratios are very helpful in the diagnosis of financial health of a firm.
They highlight the liquidity, solvency, profitability and capital gearing etc. of the firm.

DRAW BACKS OF RATIO ANALYSIS

1. Limited use of a single ratio : Ratio can be useful only when they are computed in a sufficient
large number. A single ratio would not be able to convey anything. A the same time, if too many
ratios are calculated, they are likely to confuse instead of revealing any meaningful conclusion.
2. Effect of inherent limitations of accounting : Because ratios are computed from historical
accounting records, so they also possess those limitations and weaknesses as accounting
records possess.
4. Lack of proper standards : While making comparisons, it is always a challenging job to find
out an adequate standard. It is not possible to calculate exact and well accepted absolute
standard, so a quality range is used for this purpose. If actual performance is within this range,
it may be regarded as satisfactory.
5. Past is not indicator of future : It is not always possible to make future estimates on the basis
of the past as it always does not come true.
6. No allowance for change in price level : While making comparisons of ratios, no allowance
for changes in general price level is made. A change in price level can seriously affect the
validity of comparisons of ratios computed for different time periods.
7. Difference in definitions : Comparisons are also made difficult due to differences in
definitions of various financial terms. The terms like gross profit, net profit, operating profit etc.
have not precise definitions and an established procedure for their computation.
8. Window Dressing : Financial statements can easily be window dressed to present a better
picture of its financial and profitability position to outsiders. Hence one has to be careful while
making decision on the basis of ratios calculated from such window dressing made by a firm.
9. Personal Bias : Ratios are only means of financial analysis and is not an end in itself. Ratios
have to be Interpreted carefully because the same ratio can be looked at, in different ways.

CLASSIFICATION OF RATIOS

Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity ratios (iii)
Leverage/Capital structure ratios (iv) Coverage ratios (v) Profitability ratios.

(i) Liquidity Ratios : Liquidity refers to the ability of a firm to meet its current obligations as and
when they become due. The importance of adequate liquidity in

the sense of the ability of a firm to meet current/short-term obligations when they become due
for payment can hardly be overstressed. In fact, liquidity is a prerequisite for the very survival
of a firm. The ratios which indicate the liquidity of a firm are (i) net working capital, (ii)current
ratio, (iii) acid test/quick ratio, (iv) super quick ratio, (v) basic defensive interval.
1. Net Working Capital : The first measurement of liquidity of a firm is to compute its Net
Working capital (NWC). NWC is really not a ratio, it is frequently employed as a measure of a
company's liquidity position. NWC represents the excess of current assets over current
liabilities. A firm should have sufficient NWC in order to be able to meet the claims of the
creditors and the day-to-day needs of business. The greater the amount of NWC, the greater
the liquidity of the firm. Inadequate working capital is the first sign of financial problems for a
firm. It is useful for purposes of internal control also.
NWC = Total Current Assets – Total Current Liabilities

2. Current Ratio : Current ratio is the most common ratio for measuring liquidity. Being related
to working capital analysis, it is also called the working capital ratio. The current ratio is the
ratio of total current assets to total current liabilities.
Current Ratio =Current Assets/Current Liabilities

As a measure of short-term financial liquidity, it indicates the rupees of current assets available
for each rupee of current liability. The higher the current ratio, the larger the amount of rupees
available per rupee of current liability, the more the firm's ability to meet current obligations
and the greater the safety of funds of short-term creditors. If the result is greater than 1, the
firm presumably has sufficient current assets to meet its current liabilities. A ratio of 2:1 (two
times current assets of current liabilities) is considered satisfactory as a rule of thumb. Thus, a
good current ratio, in a way, provides a margin of safety to the creditors.

3. Acid-Test/Quick Ratio : One defect of the current ratio is that it fails to convey any
information on the composition of the current assets of a firm. A rupee of cash is considered
equivalent to a rupee of inventory or receivables. But it is not so. A rupee of cash is more
readily available to meet current obligations than a rupee of, say, inventory. This impairs the
usefulness of the current ratio. The acidtest ratio is a measure of liquidity designed to
overcome this defect of the current ratio. It is often referred to as quick ratio because it is a
measurement of a firm's ability to convert its current assets quickly into cash in order to meet
its current liabilities. Thus, it is a measure of quick or acid liquidity.
Acid-test ratio =The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Included in this category of
current assets are (i) cash and bank balances; (ii) short-term marketable securities and (iii)
debtors/receivables. Thus, the current assets which are excludedare: prepaid expenses and
inventory. The exclusion of inventory is based on the reasoning that it is not easily and readily
convertible into cash. Prepaid expenses by their very nature are not available to pay off current
debts. An acid-test ratio of 1:1 or greater is recommended.

4. Cash-Position Ratio or Super-Quick Ratio : It is a variant of Quick ratio. When liquidity is

highly restricted in terms of cash and cash equivalents, this ratio should be calculated. It is
calculated by dividing the super-quick current assets by the current liabilities of a firm. The
super-quick current assets are cash and marketable securities. It can be calculated as
below :Cash-Position Ratio =Quick assets Current liabilities Cash + Marketable Securities
Current Liabilities
(ii) Activity Ratios
Activity ratios which are also called efficiency ratio or asset utilization ratios are concerned with
measuring the efficiency in asset management. The efficiency with which the assets are used
would be reflected in the speed and rapidity with which assets are converted into sales. The
greater is the rate of turnover or conversion, the more efficient is the utilisation/management,
other things being equal. For this reason, such ratios are also designated as turnover ratios.
1. Inventory Turnover Ratio : It is computed as follows :
Inventory turnover ratio =Current Assets The cost of goods sold means sales minus gross profit.
The average inventory refers to the simple average of the opening and closing inventory. The
ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity
and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf
or in the warehouse for a loan time.

2. Debtors Turnover Ratio : This ratio is determined by dividing the net credit
sales by average debtors outstanding during the year. Thus,
Debtors turnover ratio =Net credit sales consist of gross credit sales minus sales returns, if any,
from customers. Average debtors is the simple average of debtors at the beginning and at the
end of year. The ratio measures how rapidly debts are collected. A high ratio is
indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that
debts are not being collected rapidly.
3. Creditors Turnover Ratio : It is a ratio between net credit purchases and the average amount
of creditors outstanding during the year. It is calculated as follows:
Creditors turnover ratio =Net credit purchases = Gross credit purchases less returns to suppliers
Average creditors = Average of creditors outstanding at the beginning and at
the end of the year.
A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows
that accounts are to be settled rapidly.
4. Average Age of Sundry Debtors : The average age of sundry debtors (or accounts receivable),
or average collection period is more meaningful figure to use in evaluating the firm's credit and
collection policies. The main objective of calculating average collection period is to find out cash
inflow rate from realisation from debtors.It is found by a simple transformation of the firm's
accounts receivable turnover :
Average Age of Debtors =
It can be calculated as follows also : Average Collection Period = × No. of working days
The average of collection period should not exceed the standard or stated credit period in sales
terms plus 1/3 of such days. If it happens, it will indicate either liberal credit policy or slackness
of management in realising debts or accounts receivable.
5. Assets Turnover Ratio : This ratio is also known as the investment turnover ratio. It is based
on the relationship between the cost of goods sold and assets/investments of a firm. A
reference to this was made while working out the overall profitability of a firm as reflected in
its earning power. Depending upon the different concepts of assets employed, there are many
variants of this ratio.

(iii) Leverage/Capital Structure Ratios : The second category of financial ratios is leverage
ratios. The long-term creditors would judge the soundness of a firm on the basis of the long-
term financial strength measured in terms of its ability to pay the interest regularly as well as
repay the instalment of the principal on due dates or in lump sum at the time of maturity. The
long-term solvency of a firm can be examined by using leverage or capital structure ratios. The
leverage ratios may be defined as financial ratios which throw light on the long-term solvency
of a firm as reflected in its ability to assure the long-term creditors with regard to (i) periodic
payment of interest during the period of the loan and (ii) repayment of principal on maturity or
in predetermined installments at due dates.
1. The Debt-equity Ratio – This ratio establishes the relationship between the long-term funds
provided by creditors and those provided by the firm's owners.It is commonly used to measure
the degree of financial leverage of the firm. It is calculated as follows :
Debt-equity Ratio =Some experts use the following formula to calculate this ratio :
Debt-equity Ratio =Generally, a ratio of 2:1 is considered satisfactory.
2. Proprietary Ratio : This ratio is also known as Shareholders' Equity to Total Equities Ratio or
Net Worth to Total Assets Ratio. It indicates the relationship of Shareholders' equity to total
assets or total equities. As per formula : Proprietary Ratio =Higher the ratio, better the financial
position of the firm.
3. The Solvency Ratio – It is also known as Debt Ratio. It is a difference of 100 and proprietary
ratio. It measures the proportion of total assets provided by the firm's creditors. This ratio is
calculated as follows :
Solvency Ratio (or Debt Ratio) =
Interpretation :
Generally, lower the rate of total liabilities to total assets; more satisfactory or stable is the
long-term solvency position of a firm.
4. Fixed Assets to Net Worth Ratio – One of the important aspects of sound financial position
of a firm is that its fixed assets are totally financed out of shareholders' funds. If aggregate of
fixed assets exceeds the net worth (or proprietors' funds), it proves that fixed assets have been
financed with outsiders' funds (or creditors' funds). It may create difficulty in the long-run. This
ratio is calculated as follows :
Fixed Assets-Net Worth Ratio =This ratio should not exceed 1:1. On the contrary, lower the
ratio, better the position.
Usually, a ratio of 0.67 : 1 is considered satisfactory.
5. Proprietors' Liabilities Ratio : This ratio indicates the relationship of proprietors' funds to
total liabilities. It is calculated as follows :
Proprietors' Liabilities Ratio = Higher the ratio, better is the position of creditors.
6. Fixed Assets Ratio
A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to all long-term
funds which is calculated as :Fixed Assets Ratio = Fixed Assets (After depreciation)
Total long-term funds
Interpretation :
This ratio indicates the extent to which the total of fixed assets are financed by logterm
funds of the firm. Generally, the total of the fixed assets should be equal to total of the long-
term funds or say the ratio should be 100%. And if total long-term funds are more than total
fixed assets, it means that part of working capital requirement is met out.
7. Ratio of Current Assets to Proprietary's Funds
The ratio is calculated by dividing the total of current assets by the amount of shareholder's
funds. For example, if current assets are Rs. 2,00,000 and shareholder's
Funds are Rs. 4,00,000 the ratio of current assets to proprietors funds in terms of percentage
would be = × 100
Interpretation :
This ratio indicates the extent to which proprietors funds are invested in current assets. There is
no rule of thumb for this ratio and depending upon the nature of the business there may be
different ratios of different firms.
8. Debt-Service Ratio
Net income to debt service ratio or simply debt service ratio is used to test the debt-servicing
capacity of a firm. The ratio is also known as interest coverage ratio or fixed charges cover or
times interest earned. This ratio is calculated by dividing the net profit before interest and taxes
by fixed interest charges. Debt Service or Interest Coverage Ratio =
Interpretation
Interest coverage ratio indicates the number of times interest is covered by the profits available
to pay the interest charges. Long-term creditors of a firm are interested in knowing the firm's
ability to pay interest on their long-term borrowings. Generally, higher the ratio, more safe are
long term creditors because even if earnings of the firm fall, the firm shall be able to meet its
commitment of fixed interest changes. But a too high interest coverage ratio may not be good
for the firm because it may imply that firm is not using debt as a source of finance so as to
increase the earnings per share.
(iv) Coverage Ratios : The another category of leverage ratios are coverage ratios. These ratios
are computed from information available in the profit and loss account. The coverage ratios
measure the relationship between what is normally available from operations of the firms and
the claims of the outsiders. The important coverage ratios are as follows :
1. Interest Coverage Ratio : This ratio measures the debt servicing capacity of a firm insofar as
fixed interest on long-term loan is concerned. It is determined by dividing the operating profits
or earnings before interest and taxes (EBIT) by the fixed interest charges on loans. Thus,Interest
coverage =From the point of view of the creditors, the larger the coverage, the greater is the
ability of the firm to handle fixed-charge capabilities and the more assured is the payment of
interest to the creditors. However, too high a ratio may imply unused debt capacity.
2. Dividend Coverage Ratio : It measures the ability of a firm to pay dividend on preference
shares which carry a stated rate of return. This ratio is computed as under :
Dividend coverage =The ratio, like the interest coverage ratio, reveals the safety margin
available to the preference shareholders. As a rule, the higher the coverage, the better it is
from their point of view.
3. Total Coverage Ratio : The total coverage ratio has a wider scope and takes into account all
the fixed obligations of a firm, that is, (i) interest on loan, (ii)preference dividend, (iii) Lease
payments, and (iv) repayment of principal.
4. Debt-Services Coverage Ratio (DSCR) : This ratio is considered more comprehensive and apt
measure to compute debt service capacity of a business

(v) Profitability Ratios : Apart from the creditors, also interested in the financial soundness of a
firm are the owners and management or the company itself.The management of the firm is
naturally eager to measure its operating efficiency Similarly, the owners invest their funds in
the expectation of reasonable returns.Profitability ratios can be determined on the basis of
either sales or investments.
1. Profitability Ratios Related to Sales : These ratios are based on the premise that a firm
should earn sufficient profit on each rupee of sales. These ratios consist of (1) profit margin,
and (2) expenses ratio.
(i) Gross Profit Margin :
A high ratio of gross profit to sales is a sign of good management as it implies that the cost of
production of the firm is relatively low. It may also be indicative of a higher sales price without a
corresponding increase in the cost of goods sold. EATt + Interestt + Depreciationt +
OAtInstalmentt
(ii) Net profit margin is also known as net margin. This measures the relationship
between net profits and sales of a firm. Depending on the concept of net profit employed, this
ratio can be computed in two ways :
1. Operating profit ratio =
2. Net profit ratio =
This ratio is indicative of management's ability to operate the business with sufficient
success not only to recover from revenues of the period, the cost of merchandise or services,
the expenses of operating the business (including depreciation) and the cost of the borrowed
funds, but also to leave a margin of reasonable compensation to the owners for providing their
capital at risk. The ratio of net profit (after interest and taxes) to sales essentially expresses the
cost price effectiveness of the operation. A high net profit margin would ensure adequate
return to the owners.
2. Expenses Ratio : Another profitability ratio related to sales is the expenses ratio. It is
computed by dividing expenses by sales.
1. Cost of goods sold ratio = × 100
2. Administrative expenses ratio = × 100
3. Selling expenses ratio = × 100
4. Operating ratio = × 100
The expenses ratio should be compared over a period of time with the industry average as well
as firms of similar type. As a working proposition, a low ratio is favourable, while a high one is
unfavourable.
3. Rate of Return on Equity Share Capital : This ratio is calculated by dividing the net profits
(after deducing income-tax and dividend on preference share capital) by the paid up amount of
equity share capital. It is usually expressed in percentage as below :Rate of Return of Equity
Share Capital = Earnings before interest and taxes (EBIT)Sales Earnings after interest and taxes
(EAT)
.
4. Return on Proprietors Funds on Return on Net Worth : Some experts suggest to calculate
return on net worth instead of calculating return on equity share capital. The proprietors funds
or net worth represents the total interest of shareholders which include share capital (whether
equity or preference) and all accumulated profits. Alternatively, proprietors' funds may be
taken equal to fixed assets plus current assets minus all outside liabilities both long-term and
current. This ratio may be calculated as under :
Return on Proprietors' Funds =This ratio helps the proprietors and potential investors to judge
the earning of the company in relation to others and the adequacy of the return on proprietors'
funds.
5. Return on Investment (ROI) Ratio : This is one of the key profitability ratios. It examines the
overall operating efficiency or earning power of the company in relation to total investment in
business. It indicates the percentage of return on the capital employed in the business. It is
calculated on the basis of the following formula : × 100
The term capital employed has been given different meanings by different accountants.
Some of the popular meanings are as follows :
(i) Sum-total of all assets whether fixed or current.
(ii) Sum-total of fixed assets
(iii) Sum-total of long-term funds employed in the business, i.e.,Share Capital + Reserves and
Surplus + Long term Loans + Non-business Assets + Fictitious Assets
In management accounting the term capital employed is generally used in the meaning
given in the point third above.
The term Operating Profit means Profit before Interest and Tax. The term Interest means
Interest on long-term Borrowings. Interest on short-term borrowings will be deducted for
computing operating profit. Non-trading incomes such as interest on Government securities or
non-trading losses or expenses such as loss on accountof fire, etc. will also be excluded.
6. Return on Capital Employed (ROCE) : The ROCE is the second type of ROI. It is similar to the
ROA except in one respect. Here the profits are related to the total capital employed. The term
capital employed refers to long-tern funds supplied by the creditors and owners of the firm.
The higher the ratio, the more efficient is the use of capital employed. The ROCE can be
computed in different ways as shown below :
1. ROCE = × 100
2. ROCE = × 100
(7) Earning Per Share (EPS) measures the profit available to the equity shareholders on a per
share basis, that is, the amount that they can get on every share held. It is calculated by dividing
the profits available to the shareholders by the number of the outstanding shares. The profits
available to be the ordinary shareholders are represented by net profits after taxes and
preference dividend.
8. Divided Per Share (DPS) is the dividends paid to shareholders on a per share basis. In other
words, DPS is the net distributed profit belonging to the shareholders divided by the number of
ordinary shares outstanding. That is, Net profit after taxes/EBIT
The DPS would be a better indicator than EPS as the former shows what exactly is
received by the owners.
9. Divided-Pay Out (D/P) Ratio : This is also known as pay-out ratio. It measures the
relationship between the earnings belonging to the ordinary shareholders and the dividend
paid to them. In other words, the D/P ratio shows what percentage share of the net profits
after taxes and preference dividend is paid out as dividend to the equity holders. D/P = × 100
If the D/P ratio is subtracted from 100, it will give that percentage share of the net
profits which are retained in the business.
10. Earnings and Dividend Yield : This ratio is closely related to the EPS and DPS. While the EPS
and DPS are based on the book value per share, the yield is expressed in terms of the market
value per share.This ratio is calculated as follows :
1. Earning yield = × 100
2. Dividend yield = × 100
The earning yield is also called the earning-price ratio
Price Earnings (P/E) Ratio is closely related to the earnings yield/earnings price
ratio. It is actually the reciprocal of the latter. This ratio is computed by dividing the market
price of the shares by the EPS. Thus,P/E ratio =
The P/E ratio reflects the price currently being paid by the market for each rupee of currently
reported EPS. In other words, the P/E ratio measures investors' expectations and the market
appraisal of the performance of a firm.

ACCOUNTING STANDARDS

Indian Accounting Standards, (abbreviated as Ind AS) are a set of accounting standards
notified by the Ministry of Corporate Affairs which are converged with International Financial
Reporting Standards (IFRS). These accounting standards are formulated by Accounting
Standards Board of Institute of Chartered Accountants of India. Now India will have two sets of
accounting standards viz. existing accounting standards under Companies (Accounting
Standard) Rules, 2006 and IFRS converged Indian Accounting Standards (Ind AS). The Ind AS are
named and numbered in the same way as the corresponding IFRS. NACAS recommend these
standards to the Ministry of Corporate Affairs. The Ministry of Corporate Affairs has to spell out
the accounting standards applicable for companies in India. As on date the Ministry of
Corporate Affairs notified 35 Indian Accounting Standards (Ind AS). But it has not notified the
date of implementation of the same.

Advantages and Disadvantages of Accounting Standards

Advantages:

 They reduce or eliminate confusing variations in the methods used to prepare accounts.
 They provide a focal point for debate and discussions about accounting practice.
 They oblige companies to disclose the accounting policies used in the preparation of
accounts.
 They are a less rigid alternative to enforcing conformity by means of legislation.
 They have obliged companies to disclose more accounting information than they would
otherwise have done if standards did not exist.
 The development of IFRS involves a full consultative process in which user groups are
directly involved.
Disadvantages:

 A set of rules which give backing to one method of preparing accounts might be
inappropriate in some circumstances.
 Standards may be subject to lobbying or government pressure.
 Earlier standards were not based on a conceptual framework of accounting but the IASB
is committed to rectifying this.
 There may be a trend towards rigidity, and away from flexibility in applying the rules.
Some commentators feel that professional judgment should be used on technical
matters.

A principle that guides and standardizes accounting practices. The Generally Accepted
accounting Principles (GAAP) are a group of accounting standards that are widely accepted as
appropriate to the field of accounting. Accounting standards are necessary so that financial
statements are meaningful across a wide variety of businesses; otherwise, the accounting rules
of different companies would make comparative analysis almost impossible..
These are the converged Indian Accounting Standards (Ind ASs) hosted by MCA on its website.
The date on which these will come into force is yet to be notified. Any changes in the Ind AS vis.
a vis. corresponding IAS/IFRS are given in Appendix 1 appearing at the end of each Ind AS.
1. Framework for the Preparation and Presentation of Financial Statements in accordance
with Indian Accounting Standards
2. Ind AS 101 First-time Adoption of Indian Accounting Standards
3. Ind AS 102 Share based Payment
4. Ind AS 103 Business Combinations
5. Ind AS 104 Insurance Contracts
6. Ind AS 105 Noncurrent Assets Held for Sale and Discontinued Operations
7. Ind AS 106 Exploration for and Evaluation of Mineral Resources
8. Ind AS 107 Financial Instruments: Disclosures
9. Ind AS 108 Operating Segments
10. Ind AS 1 Presentation of Financial Statements
11. Ind AS 2 Inventories
12. Ind AS 7 Statement of Cash Flows
13. Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors
14. Ind AS 10 Events after the Reporting Period
15. Ind AS 11 Construction Contracts
16. Ind AS 12 Income Taxes
17. Ind AS 16 Property, Plant and Equipment
18. Ind AS 17 Leases
19. Ind AS 18 Revenue
20. Ind AS 19 Employee Benefits
21. Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance
22. Ind AS 21 The Effects of Changes in Foreign Exchange Rates
23. Ind AS 23 Borrowing Costs
24. Ind AS 24 Related Party Disclosures
25. Ind AS 27 Consolidated and Separate Financial Statements
26. Ind AS 28 Investments in Associates
27. Ind AS 29 Financial Reporting in Hyperinflationary Economies
28. Ind AS 31 Interests in Joint Ventures
29. Ind AS 32 Financial Instruments: Presentation
30. Ind AS 33 Earnings per Share
31. Ind AS 34 Interim Financial Reporting
32. Ind AS 36 Impairment of Assets
33. Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets
34. Ind AS 38 Intangible Assets
35. Ind AS 39 Financial Instruments: Recognition and Measurement
36. Ind AS 40 Investment Property
37. Comparison of IFRS as applicable on 1st April 2011 with Ind AS placed at MCA’s website
Following accounting standards are mandatory from july 2012

AS 1disclosure of accounting policies

AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occuring after the Balance Sheet Date
AS 5 Net Profit or Loss for the period,Prior Period Items and Changes in Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts (revised 2002)
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003),
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
 AS 14 Accounting for Amalgamations
AS 15 Employee Benefits (revised 2005)
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income.
AS 23 Accounting for Investments in Associates in Consolidated Financial Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Joint Ventures
AS 28 Impairment of Assets
AS 29 Provisions,Contingent` Liabilities and Contingent Assets

Limitations of financial statements

1. The financial position of a business concern is affected by several factors-economic, social

and financial, but financial factors are being recorded in these financial statements. Economic
and social factors are left out. Thus the financial position disclosed by these statements is not
correct and accurate.

2. The profit revealed by the Profit and Loss Account and the financial position disclosed by the
Balance Sheet cannot be exact. They are essentially interim reports.

3. Facts which have not been recorded in the financial books are not depicted in the financial
statement. Only quantitative factors are taken into account. But qualitative factors such as
reputation and prestige of the business with the public, the efficiency and loyalty of its
employees, integrity of management etc. do not appear in the financial statement.

4. The rupee of 1995, as for example, does not mean the same as the rupee of 2010. The
existing historical accounting is based on the assumption that the value of monetary unit, say
rupee, remains constant and accordingly assets are recorded by the business at the price at
which they are required and the liabilities are recorded at the amounts at which they are
contracted for. But monetary unit is never stable under inflationary condition. This instability
has resulted in a number of distortions in the financial statements and is the most serious
limitation of historical accounting.

5. Many items are left to the personal judgment of the accountant. For example; provision of
depreciation, stock valuation, bad debts provision etc. depend on the personal judgment of
accountant.

6. On account of convention of conservation the income statement may not disclose true
income of the business since probable losses are considered while probable incomes are
ignored.

7. The fixed assets are shown at cost less depreciation on the basis of "going concern concept"
(one of the accounting concept). But the value placed on the fixed assets may not be the same
which may be realized on their sale.

8. The data contained in the financial statements are dumb; they do not speak themselves.
The human judgment is always involved in the interpretation of statement. It is the analyst or
user who provides tongue to those data and make them to speak.

Other Limitations of financial statements

 Past financial performance, good or bad, is not necessarily an accurate predictor of

future performance.
 Financial statements do not tell you about changes in senior management.
 Financial statements do not tell you about the loss of major customers.
 Financial statements do not tell you about the competitive environment in which the
company operates.
 Financial statements do not disclose the companys future prospects, or the results of its
expenditures on Research and Development, or new product introductions, or new
marketing campaigns, or new pricing strategies, or the customers recent decision to
enter or exit a particular market segment.
 The more out-of-date a customers financial statements are, the less reliable they are as
a risk management tool.
 Without reading the Notes to the financial statements, credit managers cannot get a
clear idea of the risk they are evaluating.
 Unaudited statements may or may not follow Generally Accepted Accounting Principles,
and if they do not follow GAAP relying on them could be a serious mistake.
 Financial statements can be altered legally by adjusting certain types of reserves.
 Financial results can be improved by reducing or eliminating discretionary expenditures
- even if this cost cutting is at the expense of long term growth and profits.
 Foreign financial statements do not follow GAAP. In some cases, local accounting rules
are so different from GAAP accounting rules that it is easy to make the wrong decision
after reviewing the foreign financial data.
 Unaudited statements may be inaccurate, misleading, or even deliberately fraudulent -
and if they seem too good be true, they may be just that.
 To see the big picture, it is necessary to have at least two consecutive periods of
financial statements for comparison. Trends will only become apparent this way. The
corollary is that it is not enough to know a customers financial weaknesses. It is also
important to know whether the customers financial performance is weak but improving
or weak and deteriorating.
 Audited statements do not guarantee accuracy.
 Even audited financial statements are subject to a degree of manipulation.
 Off balance sheet financing is lawful, but can have a devastating effect on a customers
financial health.
 The fact that a company is publicly traded and its financial statements are readily
available does not guarantee that the company in question is financially stable and
creditworthy.