PreParation of financial Statement

Introduction
Whether you watch analysts on CNBC or read articles in the Economic Times, you'll hear
experts insisting on the importance of "doing your homework" before investing in a company.
In other words, investors should dig deep into the company's financial statements and analyze
everything from the auditor's report to the footnotes. But what does this advice really mean,
and how does an investor follow it?

A firm's financial statements are the primary source of information used by investors and
creditors for making investment decisions. Firm management is obligated to provide accurate
information and motivated to provide financial results that meet the expectations of BSE
participants. Much of the time both results can be obtained simultaneously. However, there are
times where the accurate information will not support the expectations of the investing
community. What is management to do?

The requirement for management is to accurately report the firm's financial position. However,
in the late 1990s and early 2000s there were instances where the desire to meet investors
expectations dominated the obligation to provide accurate information. Therefore it is
necessary to understand financial statements and it’s component.

The Balance Sheet

BALANCE SHEET A financial statement reflecting the recorded values of all assets,
liabilities, and owners’ equity at a point in time. The balance sheet is a summary of the assets,
liabilities, and equity of a business at a particular point in time—usually the end of the firm’s
fiscal year. The balance sheet is also known as the statement of financial condition or the
statement of financial position. The values shown for the different accounts on the balance
sheet are not purported to reflect current market values; rather, they reflect historical costs.

In essence, the balance sheet presents the details of the so-called accounting equation:
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
This equation recognizes that a company has assets and there are claims on the assets by
creditors (measured in terms of the company’s liabilities) and company owners (measured in
terms of stockholders’ equity).

ASSET A physical or intangible item of value to a company or an individual. Assets are the
resources of the business enterprise, such as plant and equipment, that are used to generate
future benefits. If a company owns plant and equipment that will be used to produce goods for
sale in the future, the company can expect these assets (the plant and equipment) to generate
cash inflows in the future.
There are three major categories of assets: current assets , non current assets and investments.
Noncurrent assets include plant assets, intangibles.

FIXED ASSETS - include machinery and equipment, buildings, and land. Some businesses
are more capital-intensive than others; for example, a manufacturer would typically be more
capital-intensive than a wholesale operation and, therefore, have and more fixed assets.
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ACCUMULATED DEPRECIATION The total of past periodic depreciation charges

applicable to depreciable assets carried on a company’s balance sheet, shown as a deduction
from gross fixed assets.

GROSS BLOCK - Gross fixed assets mean the original cost of the fixed assets. Cumulative
depreciation in the books is as per the provisions of The Companies Act, 1956. It is last
cumulative depreciation till last year + depreciation claimed during the current year. Net block
= Gross Block – Provision for Depreciation.

INTANGIBLE ASSETS are the current value of nonphysical assets that represent long-term
investments of the company. Such intangible assets include patents, copyrights, and goodwill.
The cost of some intangible assets is amortized (“spread out”) over the life of the asset.

AMORTIZATION is akin to depreciation: The asset’s cost is allocated over the life of the
asset; the reported value is the original cost of the asset, less whatever has been amortized. The
number of years over which an intangible asset is amortized depends on the particular asset
and its perceived useful

CAPITAL WORK-IN-PROGRESS – This represents advances, if any, given to building

contractors, value of building yet to be completed, advances, if any, given to equipment
suppliers etc. Once the equipment is received and the building is complete, the fixed assets are
capitalised in the books, for claiming depreciation from that year onwards.Till then, it is
reflected in the form of capital work in progress.

INVESTMENTS These are assets that are purchased with the intention of holding them for a
long term, but which do not generate revenue or are not used to manufacture a product.
Examples of investments include equity securities of another company and shares/bonds/units
of Unit Trust of India etc for speculative purposes.
This type of investment should be ideally from the profits of the organisation and not from any
other funds, which are required either for working capital or capital expenditure. They are
bifurcated in the schedule, into “quoted and traded” and “unquoted and not traded” depending
upon the nature of the investment, as to whether they can be liquidiated in the secondary market
or not.

CURRENT ASSETS (also referred to as circulating capital or working assets or gross

working capital)
Current assets are assets that could reasonably be converted into cash within one operating
cycle or one year, whichever takes longer. An operating cycle begins when the firm invests
cash in the raw materials used to produce its goods or services and ends with the collection of
cash for the sale of those same goods or services. For example, if Fictitious manufactures and
sells candy products, its operating cycle begins when it purchases the raw materials for the
products (e.g., sugar) and ends when it receives cash for selling the candy to retailers. Because
the operating cycle of most businesses is less than one year, we tend to think of current assets
as those assets that can be converted into cash in one year. E.g. cash, marketable securities,
accounts receivable, inventories, and prepaid expenses.

CASH comprises both currency—bills and coins—and assets that are immediately
transformable into cash, such as
deposits in bank accounts.
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Every firm must have cash for current business operations. A reservoir of cash is needed
because of the unequal flow of funds into (cash receipts) and out of (cash expenditures) the
business. The amount of the cash balance is determined not only by the volume of sales, but
also by the predictability of cash receipts and cash payments.

MARKETABLE SECURITIES are securities that can be readily sold when cash is needed.
Every company needs to have a certain amount of cash to fulfill immediate needs, and any cash
in excess of immediate needs is usually invested temporarily in marketable securities.
Investments in marketable securities are simply viewed as a short term place to store funds;
marketable securities do not include those investments in other companies’ stock that are
intended to be long term. Some financial reports combine cash and marketable securities into
one account referred to as cash and cash equivalents or cash and marketable securities.

ACCOUNTS RECEIVABLE are amounts due from customers who have purchased the
firm’s goods or services but haven’t yet paid for them. To encourage sales, many firms allow
their customers to “buy now and pay later,” perhaps at the end of the month or within 30 days
of the sale.
Accounts receivable therefore represents money that the firm expects to collect soon. Because
not all accounts are ultimately collected, the gross amount of accounts receivable is adjusted
by an estimate of the uncollectible
accounts, the allowance for doubtful accounts, resulting in a net accounts receivable figure.

INVENTORIES represent the total value of the firm’s raw materials, work-in-process, and
finished (but as yet unsold) goods. A manufacturer of toy trucks would likely have plastic and
steel on hand as raw materials, work-in-process consisting of truck parts and partly completed
trucks, and finished goods consisting of trucks packaged and ready for shipping.

PREPAID EXPENSES The portion of any expenses paid during a stated period but applicable
to future periods. A company often needs to prepay some of its expenses. For example,
insurance premiums may be due before coverage begins, or rent may have to be paid in
advance. Thus, prepaid expenses are those cash payments recorded on the balance sheet as
current assets and then shown as an expense in the income statement as they are used.
PreParation of financial Statement

Format of the Balance Sheet in vertical form

Balance Sheet of ..... as on .....

Particulars

I. Source of Funds:
1. Shareholder’s Funds:
(a) Share capital
Equity
Preference
Less: Calls Unpaid:
Add: Forfeited Shares

(b) Reserves and Surplus

Capital Reserve
Capital Redemption Reserve
Securities Premium
Other Reserves
Profit and Loss Account
Less: Deferred Revenue expenditure to the extent
not written-off.
Preliminary Expenses
Discount on Issue of Shares
Profit and Loss account
(debit balance, if any)
2. Loan Funds:
(a) Secured loans
Debentures
Loans and Advance from Banks
Loans from subsidiary Companies

(b) Unsecured loans

Public Deposits
Total (Capital Employed)

II. Application of Funds

1. Non Current Assets:
Tangible Assets
Land
Building
Leasehold Premises
Railway Sidings
Plant and Machinery
Furniture
Vehicles
Less: Provision for Depreciation

Intangible Assets
Goodwill
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Patents and Trademarks

Less: Amortisation

2. Investments:
Government or Trust Securities, Shares,
Debentures, Bonds

3. Current Assets, Loans and Advances:

Quick
Sundry Debtors
Cash and Bank balances
Bills Receivable
Interest Accrued on investments
Other Current Assets
Short term Loans and Advances
Non Quick
Loose Tools / Stock in Trade, Inventories
Prepaid Expenses

Less: Current Liabilities and Provisions:

Quick liabilities & Provisions
Bills payables
Sundry Creditors
Outstanding Expenses
Provisions for Taxation
Proposed Dividends
Non Quick
Bank Overdraft / Cash Credit
Pre received Income
TOTAL
Note: A footnote to the Balance Sheet may be added to show the contingent liabilities.

LIABILITY is defined as a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources embodying
economic benefits.

RESERVES AND SURPLUS represent the profit retained in business since inception of
business. “Surplus” indicates the figure carried forward from the profit and loss appropriation
account to the balance sheet, without allocating the same to any specific reserve. Hence, it is
mostly called “unallocated surplus”. The company wants to keep a portion of profit in the free
form so that it is available during the next year for appropriation without any problem.

SINKING FUND A separate pool of cash, often held in trust, into which periodic payments
are made for the future redemption of an obligation.

SECURED LOANS represent loans taken from banks, financial institutions, debentures
(either from public or through private placement), bonds etc. for which the company has
mortgaged immovable fixed assets (land and building) and/or hypothecated movable fixed
PreParation of financial Statement

assets (at times even working capital assets with the explicit permission of the working capital
banks)

Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while loans
from banks for working capital, i.e., current assets are secured by current assets. These
loans enjoy priority over unsecured loans for settlement of claims against the company.

UNSECURED LOANS represent fixed deposits taken from public (if any) as per the
provisions of Section 58 (A) of The Companies Act, 1956 and in accordance with the
provisions of Acceptance of Deposit Rules, 1975 and loans, if any, from promoters, friends,
relatives etc. for which no security has been offered.
Such unsecured loans rank second and subsequent to secured loans for settlement of claims
against the company. There are other unsecured creditors also, forming part of current
liabilities, like, creditors for purchase of materials, provisions etc.

EQUITY, also called shareholders’ equity or net worth or owners fund, reflects ownership.
The equity of a firm represents the part of its value that is not owed to creditors and therefore
is left over for the owners. In the most basic accounting terms, equity is the difference between
what the firm owns—its assets—and what it owes its creditors—its liabilities. Net worth means
total of share capital and reserves and surplus.

CURRENT LIABILITIES are obligations that must be paid within one operating cycle or
one year, whichever is longer. It include:
■ Accounts payable, which are obligations to pay suppliers. They arise from goods and
services that have been purchased but not yet paid.
■ Accrued expenses, which are obligations such as wages and salaries payable to the
employees of the business, rent, and insurance.
■ Short-term loans from a bank or notes payable within a year.

INCOME STATEMENT

An income statement is a summary of the revenues and expenses of a business over a period
of time, usually either one month, three months, or one year. This statement is also referred to
as the profit and lossstatement. It shows the results of the firm’s operating and financing
decisions during that time.

Income is defined as increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in increases in equity,
other than those relating to contributions from equity participants.

Expenses are defined as decreases in economic benefits during the accounting period in the
form of outflows or depletions of assets or incurrence’s of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.

Cost of goods sold - Whenever a product is manufactured or sold, certain direct costs are
incurred. These costs are designated on the income statement as cost of goods sold, or COGS.
For a retail company, direct costs are simply the cost of materials purchased for resale. For a
manufacturing company, direct costs can also include labor costs, manufacturing overhead, and
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depreciation expenses associated with production. Since service companies incur few direct
costs, their income statements usually do not include cost of goods sold.

Operating expenses - Operating expenses are expenses other than cost of goods sold that a
company incurs in the normal course of business. These include items such as management
salaries, advertising expenditures, repairs and maintenance costs, research and development
expenditures, lease payments, and general and administrative expenses.

Interest expense - Interest expense is the cost to the firm of borrowing money. It depends on
the overall level of firm indebtedness and the interest rate associated with this debt. Interest
expense is generally a small fraction of total firm expenses, however, this expense as a percent
of revenue can fluctuate dramatically with changes in the firm’s borrowing requirements or
with the general level of interest rates in the economy.

The operating decisions of the company—those that apply to production and marketing—
generate sales or revenues and incur the cost of goods sold (also referred to as the cost of sales
or the cost of products sold). The difference between sales and cost of goods sold is gross
profit. Operating decisions also result in administrative and general
expenses, such as advertising fees and office salaries. Deducting these expenses from gross
profit leaves operating profit, which is also referred to as operating income, or operating
earnings.

Non Operating includes income from dividend on share investment made in other companies,
interest on fixed deposits/debentures, sale proceeds of special import licenses, profit on sale of
fixed assets and any other sundry receipts.

Operating and Non Operating decisions take the firm from sales to earnings before interest
and taxes (EBIT) on the income statement. The results of financing decisions are reflected in
the remainder of the income statement. When interest expenses and taxes, which are both
influenced by financing decisions, are subtracted from EBIT, the result is net income. Net
income is, in a sense, the amount available to owners of the firm. If the firm has preferred stock,
the preferred stock dividends are deducted from net income to arrive at earnings available to
equity shareholders. If the firm does not have preferred stock, net income is equivalent to
earnings available for equity shareholders.

VERTICAL FORMAT
Financial statements should be rearranged for proper analysis and interpretations of these
statements. It enables to measure the performance of operational efficiency and profitability of
a concern during particular period. The items of operating revenues, non-operating revenues,
operating expenses and nonoperating expenses are rearranged into different heads and sub-
heads are given below:
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FORMAT OF INCOME STATEMENT

PARTICULARS Amt. (Rs.) Amt. (Rs.) Amt. (Rs.)

Gross Sales X

Less : Returns & Allowances X XX

Less: Cost of Goods Sold

Opening stock of goods X

Add: Purchases X

Less: Purchases Returns X X

Add: Freight and Carriage X

Less:Closing Stock of Raw Materials X

Direct wages (Factory) X

Other Factory Exp

Factory Rent and Rates X

Power and Coal X

Depreciation of Plant and Machinery X

Depreciation of Factory Building X

Work Manager's Salary X

Other Factory Expenses X XX XXX

Gross Profit XXX

Less: Operating Expense

(a) General & Administrative Expense X

(b) Selling Expense X

(c) Finance Expenses X X

Operating Profit XX
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Add: Non Operating Income

Discount Received X

Dividend Received X

Income from Investment X XX

Less: Non Operating Expenses

Loss on Sale of Fixed Assets X

Loss by fire / Earthquake X XX

Net Profit before Interest and Tax (EBIT) XXX

Less: Interest X

Net Profit before Tax X

Less: Provision for Income taxes X

a) Current Tax

b) Deferred tax asset / liability

Net Profit after Tax X

Less: Appropriations X

Closing balance ( to be transferred to balance sheet ) XXX

Income Statement Equations

From the above rearrangement of operating statements, the following accounting equations
may be given:
(1) Net sales = Gross sales - (Returns and Allowances)

(2) Gross Profit = Net Sales - Cost of Goods Sold

(3) Operating Expenses = Office and Administrative Expenses + Selling and Distribution
Expenses + Finance Expenses

(4) Net Profit Before Interest and Tax = Operating Profit + Non-Operating Income - Non-
Operating Expenses