21E00104 FINANCIAL ACCOUNTING FOR MANAGERS

Semester I
Course Objectives:
• To introduce accounting , accounting rules, accounting process and preparation of financial
statements.
• To explain methods of valuation of assets,
• To explore the meaning and interpretation of financial statements through ratio analysis
technique.
Course Outcomes (CO): Student will be able to
• Prepare the financial statements with accounting knowledge
• Value the assets of the business organizations under different methods
• Analyse the financial performance and position of the business organization and interpret the
results from the point of company and investor
UNIT - I
Introduction to Accounting: Definition, Importance, Objectives and principles of accounting, uses of
accounting and book keeping Vs Accounting, Single entry and Double entry systems, classification of
accounts – rules of debit & credit. (Only theory)
UNIT - II
The Accounting Process: Overview, Books of Original Record; Journal and Subsidiary books, ledger,
Trial Balance, Final accounts: Trading accounts- Profit & loss accounts- Balance sheets with
adjustments. (Problems on Only Final Accounts)
UNIT - III
Valuation of Assets: Introduction to Depreciation- Methods (Simple problems from Straight line
method, Diminishing balance method and Annuity method). Inventory Valuation: Methods of
inventory valuation (Simple problems from LIFO, FIFO).
UNIT - IV
Financial Analysis -I Analysis and interpretation of financial statements from investor and company
point of view, Liquidity, leverage, solvency and profitability ratios – Du Pont Chart (A Case study on
Ratio Analysis).
UNIT - V
Financial Analysis-II: Objectives of fund flow statement - Steps in preparation of fund flow statement,
Objectives of Cash flow statement- Steps in Preparation of Cash flow statement – Analysis of Cash
flow and Funds flow statements - Funds flow statement Vs Cash flow statement. (Only theory).
Textbooks:
1. Financial Accounting, Dr.S.N. Maheshwari and Dr.S.K. Maheshwari, Vikas
PublishingHouse Pvt. Ltd.,
2. Accountancy .M P Gupta &Agarwal ,S.Chand
Reference Books:
1. Financial Accounting ,P.C.Tulisan ,S.Chand
2. Financial Accounting for Business Managers, Asish K. Bhattacharyya, PHI
3. Financial Accounting Management An Analytical Perspective, Ambrish Gupta, Pearson
Education
4. Accounting and Financial Management, Thukaram Rao, New Age Internationals.
5. Financial Accounting Reporting & Analysis, Stice&Stice, Thomson
6. Accounting for Management, Vijaya Kumar,TMH
7. Accounting for Managers, Made Gowda, Himalaya
 UNIT-1
INTRODUCTION TO ACCOUNTING
1. Account:
Def: The term account may means
• Purchase or sale of goods or an asset on credit.
• Receipt or payment of money in part settlement of an existing account.
• Receipt or payment of money on account of previous due or receivable or payables.

DEFINITION OF ACCOUNTING: “The American Institute of Certified Public

Accountants has defined “Accounting is a recording classifying summarizing& reporting to
the business transaction”.
“Accounting is a means of measuring and reporting the results of economic activities”
- Smith and Ashburne –
“Accounting systems is a means of collecting, summarizing, analyzing and reporting
in monetary terms, the information about the business”.
- R.N.Anthony –

“The art of recording, classifying and summarizing in a significant manner and in

terms of money transactions and events, which are, in part at least, of a financial character
and interpreting the results thereof”.
- American Institute of Certified Public
Accountants (AICPA) – 1.1Accounting: American
Institute of Certified Public Accountant (AICPA)
Accounting is the art of recording business transactions classify and summarizing in a
significant manner and in terms of money transactions and events with in part at least of a
financial and interpreting the results thereof.
Ex:
1. B has paid Rs.1,00,000/- to X
2. N has paid Rs. 25,000/- to Business
3. Puneth today is leave
4. A has received Rs.1000

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 Meaning of accounting:Accounting is a language of business.
“The art of recording, classifying and summarizing in a significant manner in terms
of money transactions”.
1.3Introductions:
• The main aim of a business is to earn profit. For earning profit, the businessman will
either purchase the goods in one market at certain price and sell it in another market at
higher price or will convert the raw materials into finished products and sell it to the
different customers at a price which will give him some percentage of profit on cost of
production. But this may not be true in all cases.
• Sometimes it may happen that the goods purchased or produced may go out of fashion
and may be saleable simply because of depression in the market or keen competition.
• He may be able to sell the goods either at a loss or at a very small margin. However,
he will be anxious at the end of the year to find out whether his goods taken together
have been sold at a profit or at a loss and what is financial condition on a particular
date. Moreover in big business information is required for planning, control,
evaluation of performance and decision making.
• This information can be provided only when business transactions are record,
classified and summarized properly.
• In order to achieve the above purposes it would be necessary to record business
transactions according to well devised system. Accounting name given to such a
system.
History of Accounting:
• Accounting is as old as civilization itself. From the ancient relies of Babylon, it can be
well proved that accounting did exist as long as 2600 B.C.
• However, in modern form accounting based on the principles of Double Entry
System, which came into existence in 15 th century.
• Fra Luka Paciolo, a mathematician published a book De competence scriptures in
1494 at Venice in Italy. This book was translated in to English in 1543. In this book
he covered a brief section on ‘book-keeping’.

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 • Paciolo used the terms ‘debito’ and ‘credito’ these words came from latic words
debeo and credo. The terms debit and credit used to day have its origin from debito
and credito.
Origin of Accounting in India:
• Accounting was practiced in India thousand years ago and there is a clear evidence for
this. In his famous book Arthashastra ‘Kautilya’ dealt with not only politics and
economics but also the art of proper keeping of accounts.
• However, the accounting on modern lines was introduced in India after 1850 with the
formation of joint stock companies in India.
• Accounting in India is now a fast developing discipline.
• The two premier accounting institutes in India viz., chartered Accountants o India and
the Institute of Cost and Works Accountants of India are making continuous and
substantial contributions

2. IMPORTANCE OF ACCOUNTING:

i)Replacement of Human Memory:as the human’s memory is limited and short, it is

difficult to remember all the transactions of the business. Therefore, all the financial
transactions of the business are recorded in the books. By this way the businessmen
cannot only see the records at the required time but can also remember them for a
long time. Thus, recording of the transactions is the replacement of human’s memory.
ii) Helpful In The Determination Of Financial Results And Presentation Of
Financial Position: accounting is very useful in the determination of the profit and loss of
a business and showing the financial position of the business.
iii) Helpful in assessing the tax liability: generally,: a businessman has to pay corporate
tax, VAT and excise duty, etc. therefore, it is necessary that proper accounts should
be maintained to compute the tax liability of the business.
iv) Helpful in the case of insolvency: sometimes the businessman becomes the
insolvent. If he has properly maintained the accounts, he will not face the problems in
explaining few things in the court.

v) Helpful in the valuation of business: if the business is shut down and sold,
accounting helps the businessman to determine the value of business. It would be
possible only in that case when the accounts of the business are properly maintained.

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 vi) Helpful in the valuation of goodwill and shares: if accounts of the business are
properly maintained, it would be quite convenient to determine the value of goodwill.
Goodwill is very important for the determination of the value of shares of the
company.
vii) Accounting makes comparative statement possible: proper and adequate
accounting helps in comparing the income, expenditure, purchase, sale of the current
year with that of the previous years. And then future plans, policies and forecasting
may be possible.
viii) It helps to make inter period and interfirm comparison. Accounting information
recorded properly can be used to compare the results of one year with those of
previous years and with those of their other enterprises.
ix) It is an aid to the management. The information recorded properly can be used for
meaning full analysis, so as to assist the management in decision making.
x) It is needed for legal reasons:. Accounting information as recorded can be produced
as a firm, evidence in a court of law. It helps in taxation matters and finalizing other
contract details, etc.
3. OBJECTIVES OF ACCOUNTING:
1. Designing Work: It includes the designing of the accounting system, basis for
identification and classification of financial transactions and events, forms, methods,
procedures etc.,
2. To maintain records of business: One of the important objectives of accounting is
the systematic maintenance of all monetary aspects of business transactions. This Is known
as book-keeping.
3. To calculate Profit or Loss: The profit earned or the loss suffered during a specific
period can be calculated easily from the accounting books.
4. To ascertain financial position: By preparing the financial statements profit and loss
account and balance sheet, the financial position of the business can be found out. From
these statements it is possible to know the resources owned by the firm. These statements
also provide information about the obligations of business. Thus accounting aims at
depicting the true and fair financial position of a concern.
5. TO communicate financial information: Accounting is called language of business.
It aims at communicating financial information to various interested parties.
6. Preparation of Budget: The management must be able to reasonably estimate the

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future requirements and opportunities. As an aid to this process, the accountant has to
prepare budgets, like cash budget,capital budget, purchases budget, sales budget etc. this is
known as ‘Budgeting’.
7. Taxation work: The accountant has to prepare various statements and returns
pertaining to income-tax, sales-tax, excise or customs duties etc., ant file that returns with
the authorities concerned.
8. Auditing: It involves a critical review and verification of the books of accounts
statements and reports with a view to verifying their accuracy. This is ‘Auditing’.
ACCOUNTING PRINCIPLES

ACCOUNTING
PRINCIPLES

a) ACCOUNTING CONCEPTS b) ACCOUNTING CONVENTIONS

a) ACCOUNTING CONCEPTS:
1. Money measurement Concept: This means that the accounting record is made
only of those transactions, which can be measured and expressed in terms of
money.
2. Business Entity Concept: Accounting assumes that business is a separate entity
distinct forms its owner under this concept. Business is treated like a legal person
owing is assets, liabilities without such restrictions the affairs of the business will
be mixed with the private affairs and entire picture of the business.
3. Going Concern Concept: It means that in accounting a concern that will
continue to operate for an indefinite long period of time.
4. Cost Concept: This concept states that assets are recorded at the actual cost to
the business and not the market values or some other imaginary values.
5. Dual Aspects Concept: Every business transaction involves dual or double
aspect of equal value is called dual aspect concept. The accounting equation is
Assets –Liabilities + Capital
6. Accounting Period Concept: It means that measuring the financial results of a
business periodically. The business working life is split into convenient short
period of time is called accounting period. Financial position of the business is
ascertained at the end of the accounting period by preparing financial statements.
7. Objective Evidence Concept: It means that all accounting entities should be

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 evidenced and supported by source documents such as invoice, vouchers etc.,
8. Revenue Realization Concept: It means that revenue is earned by sales of goods
or from provisions of services to customers and revenue is to be recognized or
considered to be realized only when goods or services transferred to a customer
and the customer becomes legally liable to pay for it.
9. Accrual Concept: This concept means that when a transaction has been entered
in to its consequences will certainly follow so all transaction must be brought into
record whether they are settled in cash or not.
10. Matching Concept: Expenses incurred in the accounting period should be
matched with revenue realized in that period. Thus if revenue is realized on goods
sold in a period all expensed attributable to that sales should be recorded in that
period.

b) ACCOUNTING CONVENTIONS:
1. Full disclosure concept: This concept deals with the convention that all
information which is of material importance should be disclosed in the accounting
statements. The companies act, 1956 makes it compulsory to provide all the
information in the prescribed form. The accounting reports should disclose full
and fair information to the proprietors, creditors, investors and others. This
convention is specially significant in case of big business like Joint Stock
Company where there is divorce between the owners and the managers.

2. Materiality concept: Under this concept the trader records important facts about
the commercial activities in the form of financial statements. If any unimportant
information is to be given for the sake of clarity, it will be given as footnotes.

3. Consistency concepts: The methods or principles followed in the preparation of

various accounts should be followed in the years to come. It means that there
should be consistency in the methods or principles followed. Or else, the results
of one year cannot be conveniently compared with that of another. For example, a
company may adopt straight line method, written down value method, or any
other method of providing depreciation on fixed assets. But it is expected that the
company follows a particular method of depreciation consistently.

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 4. Conservatism concept: This convention warns the trader not to take unrealized
income into account. That is why the practice of valuing stock at cost or market
price, whichever is lower is in vogue. This is the policy of “playing safe”. It takes
into consideration all prospective losses to leaves all prospective profits. The
convention of conservatism should be applied cautiously so that the results
reported are not distorted. Some degree of conservatism is inevitable where
objective data is not available.

Uses of Accounting Information

Accounting reports are designed to meet the common information needs of most
decision makers. These decisions include when to buy, hold or sell the enterprise
shares. It assesses the ability of the enterprise to pay its employees, determine
distributable profits and regulate the activities of the enterprise. Investors and
lenders are the most obvious users of accounting information.
a) Investors: Investors may be broadly classified as retail investors, high net worth
individuals, Institutional investors both domestic and foreign. As chief provider of risk
capital, investors are keen to know both the return from their investments and the
associated risk. Potential investors need information to judge prospects for their
investments.
b) Lenders: Banks, Financial Institutions and debenture holders are the main lenders and
they need information about the financial stability of the borrower enterprise. They are
interested in information that would enable them to determine whether their borrower
has the capability to repay the loans along with the interest due on it. They also use the
information for monitoring the financial condition of the borrowers. They may stipulate
certain restrictions (known as covenants) such as upper limit on the total debt borrowed
from all sources or ask for additional security etc. Short term lenders (trade creditors)
who provide short term financial support need information to determine whether the
amount owing to them will be paid when due and whether they should extend, maintain
or restrict the flow of credit.
c) Regulators, Rating Agencies and Security Analyst: Investors and creditors seek the
assistance of information specialist in assessing prospective returns. Equity analyst,
bond analyst and credit rating agencies offer a wide range of information in the form of

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 answering queries on television shows, providing trends in business newspapers on a
particular stock, offer valuable information in seminars, discussion groups, meetings and
interviews. Security analyst obtain valuable information including insider information
by means of face-to-face meetings with the company officials, visit their premises and
make constant enquiry using e-mails, teleconference and video conference. Firms build a
good rapport with such type of information seekers to gain visibility in the market.
d) Management: Management needs information to review the firm’s short term solvency
and long term solvency. It has to ensure effective utilization of its resources, profitability
in terms of turnover and investment. It has to decide upon the course of action to be
taken in future. Management may also be interested in acquiring other business which is
undervalued. When managers receive a commission or bonus related to profit or other
accounting measures, they have a natural interest in understanding how those numbers
are computed. Further when faced with a hostile takeover attempt, they communicate
additional financial information with a view to boosting the firm’s stock price.
e) Employees, Trade Union and Tax authorities: Employees are keen to know about the
general health of the organization in terms of stability and profitability. Current
employees have a natural interest in the financial condition of the firm as their
compensation will depend on the financial performance of the firm. Potential employees
may use financial information to find out the future prospects of the firm. Trade unions
use financial reports for negotiating wage package, declaration of bonus and other
benefits. Tax authorities need information to assess the tax liability of the firm.
f) Customers: Customers have an interest in the accounting information about the
continuation of company especially when they have established a long term involvement
with or are dependent on the company. For Eg. Car owners, buyers of white goods,
electronic gadgets, depend on the manufacturer for warranty service support, continued
supply of spare parts. The sales of Matiz car was badly affected due to the abrupt closure
of Daewoo Motors.
g) Government and regulatory agencies: Government and the regulatory agencies
require information to obtain timely and correct information, to regulate the activities of
the enterprise if any. They seek information when tax laws need to be amended, to
provide institutional support to the lagging industries. The regulatory agencies use
financial reports to take action against the firm when appropriate returns are not filed in
time or when the returns fails to provide true and fair position of the business or to take
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appropriate action against the firm when complaints / misappropriation are being lodged.
Stock exchange has a legitimate interest in financial reports of publicly held enterprise to
ensure efficient operation of capital market.
h) The Public: Every firm has a social responsibility. Firms depend on local economy to
meet their varied needs. They may get patronage from local government in the form of
capital subsidy, cheap land or tax sops in the form of tax holidays for certain period of time.
Prosperity of the enterprise may lead to prosperity of the economy both directly and
indirectly. Growth in software industry in Bangalore, Karnataka State, led to boom in
housing sector, education sector, entertainment sector, travel sector and tourism sector in
and around Bangalore. Published financial statement assist public by providing information
about the trends and recent developments of the firm.

4. NATURE,FUNCTIONS AND SCOPE OF ACCOUNTING

1) Recording:This is the basic function of accounting. It is essentially concerned not
only with ensuring that all business transactions of financial character are recorded, but also
that they are recorded in an orderly manner. Recording is done in the book “journal”. This
may be further subdivided into various subsidiary books such as cash journal, purchases
journal, sales journal etc. the number if subsidiary books to be maintained will be according
to the nature and size of the business.
2) Classifying: classification is concerned with the systematic analysis of the recorded
data, with a view to group transactions or entries of one nature at one place. The work of
classification is done in the book termed as “Ledger”. This book contains on different pages,
individual account heads under which, all financial transactions of similar nature are
collected. For example, there may be separate account heads for traveling expenses, printing
and stationery, advertising etc. all expenses under these heads, after being recorded in the
journal, will be classified under separate heads in the ledger. This will help in finding out the
total expenditure incurred under each of the above heads.
3) Summarizing: this involves presenting the classified data in a manner which is
understandable and useful to the internal as well as external end-users of accounting
statements. This process leads to the preparation of the following statements:

i) trial balance

ii) income statement

iii) Balance sheet

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4) Dealing with financial transactions: accounting records only those transactions and
events in terms of money which are of a financial character. other transactions are not
recorded in the books of account. For example, if a company has a team of dedicated and
trusted employees, it is of great use to the business; but since it is not of a financial character
and not capable of being expressed in terms of money, it will not be recorded in the books of
business.
5) Analyzing and interpreting: this is the final function of accounting. The recorded
financial data is analyzed and interpreted in a manner that will enable the end-users to make a
meaningful judgment about the financial condition and profitability of the business
operations. The data is also used for preparing future plans and framing the policies for
executing such plans.
6) Communicating: the accounting information after being meaningfully analyzed and
interpreted has to be communicated in a proper form and manner, to the proper person. This
is done through preparation and distribution of accounting reports, which include – besides
the usual income statement and the balance sheet economists the marginal cost refers to the
cost of producing one additional unit. Such cost per unit may increase or decrease depending
upon the law of returns. For example in the case of law of increasing returns, the cost per unit
BOOK-KEEPING Vs ACCOUNTING
Points of
Sl.No Difference Book-Keeping Accounting

The main object of accounting is to

The Object of Book-Keeping is to prepare
1 Object record, analyze and interpret the
original books of Accounts.
business transactions.

Book-Keeping is restricted to level of Accountancy on the other hand, is

level of work. Clerical work is mainly involved in concerned with all levels of
2
work it. management
On the other hand, various firms
Principles of follow various methods of reporting
3 All without any difference.
Accountancy and interpretation in accounting.
In Book-Keeping it is not possible to know
the final result of business every year. Accounting gives the net results of the
4 Final Result
business every year.

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 Objects of book-keeping at a glance

Sub-Objects Ancillary Objects

PRIMARY OBJECTS

 To Know  To review the progress

 To know Creditors  To prevent errors &
Profit/Loss  To Know Debtors Frauds
 To know  To keep a check on
 To know capital property
Financial Invested  To provide
Position  To understand valuable
 To have a cash and information for
systematic stock decision-making

6. SINGLE ENTRY SYSTEM

• transactions.
• It is the system, which has no fixed set of rules to record the financial transactions of
the business. Single entry system records only one aspect of transaction.
• Thus, single entry system is not a proper system of recording financial transactions,
which fails to present complete information required by the management.
• Single entry system mainly maintains cash book and personal accounts of debtors and
creditors.
• Single entry system ignores nominal account and real account except cash account.
• Hence, it is incomplete form of double entry system, which fails to disclose true profit
or loss and financial position of a business organization.

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6.1 Features of single entry system

1. No Fixed Rules: Single entry system is not guided by fixed set of accounting rules
for determining the amount of profit and preparing the financial statements.
2. Incomplete System: Single entry system is an incomplete system of accounting,
which does not record all the aspects of financial transactions of the business.
3. Cash Book: Single entry system maintains cash book for recording cash receipts and
payments of the business organization during a given period of time.
4. Personal Account: Single entry system maintains personal accounts of all the debtors
and creditors for determining the amount of credit sales and credit purchases during a given
period of time.
5. Variations in Application: Single entry system has no fixed set of principles for
recording financial transactions and preparing different financial statements. Hence, it has
variations in its application from one business to another.
Single Entry vs. Double Entry Accounting
The single entry approach contrasts with double entry accounting, in which every financial
event brings at least two equal and offsetting entries. One is a debit (DR) and the other a
credit (CR). As a result:
 Firms using the double entry approach report financial results with an accrual
reporting system.
 Firms using single entry approach are effectively limited to reporting on a cash basis.
7. DOUBLE ENTRY SYSTEM
• Every transaction as two aspects when you received some thing we give something
else in written. “Rule Double entry system. Purchase goods for cash. “Every debit
they must be a corresponding credit”.
• In these business transaction we receive goods and give cash in return similarly when
we sale goods on credit goods are given another customer becomes debtors these
method of writing may transaction divided into two types debt and credit.
• One account is to be debt and another account is credit for every transaction in order
to have a complete record of the same.
• Every transaction effects two accounts in opposite direction a transaction is to be
recorded in two different accounts in opposite side for annual value both the accounts

cannot be debted and another account is to be credit the basic principle of double
entry systems is to every debt they must be corresponding credit of equal value.
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 • Double entry system is a scientific way of presenting accounts. As such all the
business concerns feel it convenient to prepare the accounts under double entry
system. The taxation authorities also compel the businessmen to prepare the accounts
under double entry system.
• Under dual aspect concept the Accountant deals with the two aspects of business
transaction. i.e.
1. Receiving aspect (Debit Aspect)
2. Giving aspect(Credit Aspect)
In double entry system book-keeping system these two aspects are recorded facilitating
the preparation of trail balance and the final accounts there from.
Principle of double entry system
 The systematically way of presenting the accounts is duly under the
double entry system. Single entry system is in fact not a system at all.
It is nothing but an incomplete form of double entry.
 Every business transaction has got two accounts, where one account
is debited and other account is credited.
 If own account receives a benefit, there should be another account
to part the benefit.
 The principle of double entry is based on the fact that there can be no
giving without receiving nor can there be receiving without something
giving.

Advantages double entry system:

1. Scientific System: Double entry system records, classifies and summarizes business
transactions in a systematic manner and, thus, produces useful information for decision
makers.
2. Full Information: Full and authentic information can be had about all transactions as the
trader maintains the ledger with all types of account.
3. Assessment of Profit and Loss: The business man/trader will be able to known correctly
whether he had earned profit or sustained loss. It facilitates the trade to take such steps so as
to increase the efficiency of the firm.

4. Knowledge of debtors: The trader will be able to know exactly what amounts are owed by
different customers to the firm. If any amount is pending for a long time from any customer,
he may stop credit facility to that customer.

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5. Knowledge of Creditors: The trader also knows the exact amounts owed by the firm to
others and he will be able to arrange prompt payment to obtain cash discount.
6. Arithmetical accuracy: The arithmetical accuracy of the books can be proved by
preparing trail balance.
7. Assessment of Financial Position: The trader will be able to prepare the balance sheet
which will help the interested parties to know fully about the financial position of the firm.
8. Comparison of results: It facilitates the comparison of current year’s results with of
previous years.
9. Maintenance according to Income Tax Rules: Proper maintenance of books will satisfy
the tax authorities and facilitates accurate assessment. In India joint stock companies should
maintain accounts under double entry system.
10. Detection of frauds: The systematic and scientific recording of business transaction on
the basis of this system minimizes the chances of embezzlement and frauds. The frauds or
errors can be easily detected by vouching. Verification and auditing of accounts.
7.3Disadvantage double entry systems:
1. Errors of Omission: In case the entire transaction is not recorded in the double of
accounts the mistake cannot be detected by accounting. The Trail Balance will tally in spite
of the mistakes.
2. Errors o principle: Double entry is based upon the fact that every debit has to
corresponding credit. It will not be able to detect the mistake such as debiting Ram’s
account instead of Rao’s account or building account in place of repairs account.
3. Compensating errors: If Rahim’s account is by mistake debited with Rs.15 lesser and
Mohan’s account is also by mistake credited with Rs.15 lesser, the Trail balance will tally
but mistake will remain in accounts.
8. CLASSIFICATIONS OF ACCOUNTS (OR) TYPES OF ACCOUNTS

PERSONAL ACCOUNTS IMPERSONAL ACCOUNTS

Natural Artificial Representative Real Nominal

Personal A/C Personal A/C Personal A/C Accounts Accounts

Tangible Intangible
Accounts Accounts
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9. RULES OF THE DOUBLE ENTRY SYSTEMS
I. personal accounts: these accounts record a business’s dealings with persons or firms. The
person receiving something is given debited and the person giving something is given credit.
a) Natural Personal A/C: An account recording transactions with and individual human
being is known as natural personal accounts.
Ex:Ramu A/C, Sindhu A/C, Nagendra A/C.
b) Artificial Personal A/C: An account recording financial transactions with an artificial
person created by law are called as artificial personal accounts.
Ex: SBI Bank A/C, Satyam InfoTech Ltd A/C
c) Representative personal A/C: An account indirectly representing a person or group of
persons is known as representative personal A/C.

Rule: Debit the receiver

Credit the giver
II.Real Accounts: Real accounts means the business transactions deal with assets. these are
the accounts of assets, asset entering the business is given credit. Real accounts again
classified into two types i.e.,
1. Tangible real A/C
2. Intangible Real A/C
a) Tangible Real A/C: It relates to an asset which can be touchable felt sun and
measured.
Ex: machinery A/C, Cash A/C
b) Intangible Real A/C: It relates to an asset which can be touched physically but can
be measured in valued.
Ex:Goodwill A/C, Patents A/C
Rule: Debit what comes in
Credit what goes out
IIINominal Accounts: It means the business transaction deals with an expenses, loss
incomes, and gains. Accounts of expenses and losses are debited and accounts of incomes
and gains are credited.

Rule: Debit all expenses and losses,

Credit all incomes and gains

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 Advantages of accounting:
1. Provides fro systematic records: since all the financial transactions are recorded in
the books, one need not rely on memory. Any information required is readily
available from these records.
2. Facilitate the preparation of financial statements: Profit and loss account and
balance sheet can be easily prepared with the help of the information in the records.
This enables the trader to know the net result of business operations during the
accounting period and the financial position of the business at the end of the
accounting period.
3. Provides control over assets: Book-keeping provides information regarding cash in
hand, cash at bank, stock of good, accounts receivables from various parties and the
amounts invested in various other assets. As the trader knows the values of the assets
he will have control over them.
4. Provides the required information: Interested parties such as owners, lenders,
creditors etc., get necessary information of frequent intervals.
5. Comparative study: One can compare the present performance of the organization
with that of its past. This enables the managers to draw useful conclusions and make
proper decisions.
6. Less scope for fraud or theft: It is difficult to conceal fraud or theft etc., because of
the balancing of the books of accounts periodically. As the work is divided among
many persons, there will be check and counter check.
7. Tax matters:Properly maintained book0keeping records will help in the settlement of
all tax matters with the tax authorities.
8. Ascertaining value of business: The accounting records will help in ascertaining the
correct value of the business. This helps in the even of sale or puchase of a business.
9. Documentary evidence: Accounting records can also be used as evidence in the court
to substantiate the claim of the business. These records are base on documentary
proof. Every entry is supported by authentic vouchers. As such, courts accept these
records as evidence.

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 10. Helpful to management: Accounting is useful to the management in various ways. It
enables the management to find the achievement of its performance. The weakness of
the business can be identified and corrective measures can be applied to remove them
with help of accounting.

Limitations of accounting:
1. Does not record all events: Only the transactions of a financial character will be
recorded under bookkeeping. So it does not reveal a complete picture about the
quality of human resources, location advantage, business contacts.
2. Does not reflect current values: The data available under book-keeping is historical
in nature. So they do not reflect current values. For instance, we record the value of
stock at cost price or market price, whichever is less.
3. Estimates based on Personal Judgment: The estimates used for determining the
values of various items May not be correct.
4. Inadequate information on costs and profits: Book-keeping only provides
information about the overall profitability of the business. No information given about
the cost and profitability of different activities of products or divisions.
Accounting terms
1. Business: It is an activity involves exchange of goods or services with the intention of
earning income and profit.
2. Business transaction: Business transaction an exchange of more aspects as goods and
services between two parties.
Ex:
a) Goods purchase to Mr. X
b) Goods sold to Ms. Y
c) Cash received
d) Cash Paid
e) Land sold – The types business transaction are classified in three
f) Machinery Purchased

3. Trail Balance:A list of debit and credit balances of all the ledger account is prepared on
any particular date in order to certify in arithmetically.
4. Expenses:

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 2 types
 Direct: – wages (Factory related), fuel, power etc.
 Indirect: - Salary etc.

5. Difference between Debtors and Creditors:

a. A debtor is a person who owes money to business, but a creditor is a person to whom
the business owes money.

b. A person becomes a debtor of a business where he has received some benefit from the
business but a person becomes a creditor of a business when he has given some
benefit to the business.

c. Debtor constitutes assets for the business. Creditors constitute liabilities for a
business.

d. Account of a debtor shows debit balances and account of creditors shows credit
balances.

6. Equity:All claims against the assets of business are called equity the claim of outsiders
is creditor’s equity or liability the claim of the properties is called owner equity or capital.

7. Revenue or Income: Revenue refers to the earning of a business it include the sale
process of goods, receipts for services rendered and earning from interest,
commission.Thisreefers to earnings of the business. It includes the sales proceeds of
goods, receipts for services rendered.
Eg: Earnings from interest, dividend, rent, commission, discount etc.
8. Expense:It is amount spend in conducting business action. It is the expenditure in
return for some benefits. An expense refers to expenditure in return for some benefit is
received and the benefit received is enjoyed and exhausted immediately.
Eg: Salary paid to staff, rent paid to land lord, transportation paid, and electricity charges
paid. An expense refers to expenditure in return for some benefit is received and the
benefit received is enjoyed and exhausted immediately.
Eg: Cost of goods sold, salaries, printing and stationery, and telegram etc.,

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 9. Loss:Loss refers to money or monies worth given up without or benefit in return it is
an expenditure in return for which no benefit is received
Eg: Loss of goods fire, damages paid to others loss difference for expense an expense
brings some benefit whereas loss does not bring my benefit rent paid is an expense but
goods destroy fire is loss. It refers to money or money worth given up without any benefit
in return.
Eg: Loss of goods by fire, be theft, damage paid to others etc.,

KEY WORDS
1. Assets: The valuable things owned by the business are known as assets. These are the
properties owned by the business.
a. Fixed Assets: These assets are acquired for long-term use in the business. They are
not met for resale. Land and Building, plant and machinery, vehicles and furniture
etc., are some of the examples of fixed assets.
b. Liquid Assets: These assets also known as circulating, fluctuating or current assets.
These assets can be converted into cash as early as possible. Current assets are cash,
bank balance, debtors, stock, and investments.
c. Fictitious assets: Fictitious assets are those assets, which do not have physical form.
They do not have any real value. The example of these assets are loss on issue of
shares, preliminary expenses etc.,
d. Intangible assets: Intangible assets are those having no physical existence goodwill,
patents, trademarks are the examples.
e. Wasting Assets: Wasting assets are those assets which are consumed through being
worked or used. Mines are the examples of wasting assets.

2. Capital: It is the part of wealth which is used for further production and thus capital
costs of all current assets and fixed assets. Cash in hand, cash at bank, buildings, plant and
furniture etc., are the capital of the business. Capital is classified as
a. fixed capital
b. Working Capital
a. Fixed Capital: The amount invested in acquiring fixed assets is called fixed capital.
Plant and machinery, vehicles, furniture and buildings etc., are some the examples of fixed
capital.

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b. Working Capital: The part of capital available with the firm for day0to-day working
of the business is known as working capital. Working capital can also be expressed as under.
Working Capital = Current Assets – Current Liabilities

3. Liabilities: Liabilities are the obligations or debts payable by the enterprise in the
future in the form of money or goods. Liabilities can be classified as
a. Fixed Liabilities
b. Current Liabilities
c. Contingent Liabilities
a. Fixed Liabilities: These liabilities are payable generally, after a long period.
Capital, Loans, debentures, mortgage etc., is its examples.
b. Current Liabilities: Liabilities payable within a year are termed as current
liabilities. The value of these liabilities goes on changing. Creditors, bills payable
and outstanding expenses etc., are current liabilities.
c. Contingent Liabilities: These are not the real liabilities. Future events can only
decide whether it is really a liability or not. Due to their uncertainty, these
liabilities are termed as contingent liabilities.

4. Transaction: It refers to any happening event which is measurable in terms of money

and which changes the financial position of the business concern. Types of transaction.
Any sale or purchase of goods or services is called the transaction. Transactions are of
three types.
a. Cash Transaction
b. Credit Transaction
c. Non-cash Transaction

a. Cash Transaction: Cash transaction is one where cash receipt or payment is involved in
the exchange.
b. Credit Transaction: Credit transaction will not have cash, either received or paid, for
something given or received,, respectively. Credit transactions give rise to debtor and
creditor relationship.
c. Non-cash Transaction: It is a transaction where the question of receipt or payment
of cash does not arise at all.

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Ex: Depreciation, return of goods, and bad debts etc.

5. Account: A summarized statement of transactions relating to a particular person, thing,

expense or income.

6. Proprietor: Proprietor is the person, who owns the business. He invests capital in the
business with the object of earning profits. Proprietor is an individual in case of sole
trading, partner in case of partnership firms and shareholder in case of companies.

7. Drawings: Cash or goods withdrawn by the proprietor from business for his personal or
household use are termed as ‘drawings’.

8. Solvent: One who is able to pay one’s debts when they become due.

9. Insolvent: The inability of a person to pay his debts when they become due. The
condition in which the liabilities exceed assets.

10. Debtors: Debtor means a person who owes money to the trader.

11. Creditor: A creditor is a person to whom something is owned by the business. He is a

person to whom some amount is payable for loan taken, services obtained or goods
bought.

12. Equity: A claim which can be enforced against the assets of a firm is called equity. The
equities of a firm are of two types
a. Owner’s equity or capital &
b. Creditor’s equity

13. Goods: All those things which a firm purchases for resale are called goods.Goods refers
to commodities, articles, services or things in which trader deals goods refers to
commodities or things intended to resale unsold goods, lying in a business concern on any
given date are called stock
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14. Purchases: Purchases means purchase of goods, unless it is stated otherwise. It also
represents the goods purchased.

15. Sales: Sales means sale of goods, unless it is stated otherwise. It also represents the goods
sold.

16. Revenue: Revenue in accounting means the amount released or receivable from the sale
of goods.

17. Discount: There are two types of discount.

a. Cash Discount: An allowance made to encourage prompt payment or before the
expiration of the period allowed for credit.
b. Trade discount: A deduction from the gross or catalogue price allowed to traders who
buys them for resale.

18. Voucher: Accounting transactions must be supported by documents. These documentary

proofs in support of the transactions are termed as vouchers.

19. Reserve: An amount set aside out of profits or other surplus and designed to meet
contingencies.

20. Losses: It is to be distinguished from expense. An expense is supposed to bring some

benefit to the firm, whereas a loss will not. Loss by fire or theft is an example.

21. Revenue or Income: Revenue refers to the earning of a business it include the sale
process of goods, receipts for services rendered and earning from interest, commission.
This refers to earnings of the business. It includes the sales proceeds of goods, receipts
for services rendered.

Eg: Earnings from interest, dividend, rent, commission, discount etc.

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22. Accounting period: A period of 12 months for which the accounts are usually kept. It
may be calendar year (Jan 1 st to Dec 31st) or financial year(April 1st to March 31st).

23. Gross profit: The difference between the selling price and the cost price of goods, before
the deduction of any expenses incurred in selling goods.

24. Net profit: The profit that remains after deducting all the expenses from the gross profit.
It represents the real gain of the business.

25. Profit and Loss account: It is a statement prepared by the businessman for the
ascertainment of profit or loss during the accounting period.

26. Balance Sheet: It is a statement of assets and liabilities prepared with a view to measure
the exact financial position of a business on particular date, generally the last of the
accounting period.

ACCOUNTING EQUATION:
American accountants have derived the rules of debit and credit through accounting equation
which is given below:
Assets = Equities
The equation is based on the principle that accounting deals with property and rights to
property and the sum of the properties owned is equal to the sum of the rights to the
properties. The properties owned by a business are called assets and the rights to properties
are known as liabilities or equities of the business.
Equities may be divided into equities of creditors representing debts of the business known as
liabilities and equity of the owner known as capital. Keeping in view the two types of equities
the equation given above can be stated as below:
Assets = liabilities + capital
Or Capital = assets-liabilities
Or Liabilities = Assets – capital

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UNIT-1 IMPORTANT QUESTIONS
1. Define accounting? Importance of accounting &Book keeping Vs accounting?
2. Advantages & Dis-Advantages of Single& double entry system?
3. Classification of accountings with rules &examples?
4. Accounting principles

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 21E00104 FINANCIAL ACCOUNTING FOR MANAGERS

Semester I
Course Objectives:
• To introduce accounting , accounting rules, accounting process and preparation of financial
statements.
• To explain methods of valuation of assets,
• To explore the meaning and interpretation of financial statements through ratio analysis
technique.
Course Outcomes (CO): Student will be able to
• Prepare the financial statements with accounting knowledge
• Value the assets of the business organizations under different methods
• Analyse the financial performance and position of the business organization and interpret the
results from the point of company and investor
UNIT - I
Introduction to Accounting: Definition, Importance, Objectives and principles of accounting, uses of
accounting and book keeping Vs Accounting, Single entry and Double entry systems, classification of
accounts – rules of debit & credit. (Only theory)
UNIT - II
The Accounting Process: Overview, Books of Original Record; Journal and Subsidiary books, ledger,
Trial Balance, Final accounts: Trading accounts- Profit & loss accounts- Balance sheets with
adjustments. (Problems on Only Final Accounts)
UNIT - III
Valuation of Assets: Introduction to Depreciation- Methods (Simple problems from Straight line
method, Diminishing balance method and Annuity method). Inventory Valuation: Methods of
inventory valuation (Simple problems from LIFO, FIFO).
UNIT - IV
Financial Analysis -I Analysis and interpretation of financial statements from investor and company
point of view, Liquidity, leverage, solvency and profitability ratios – Du Pont Chart (A Case study on
Ratio Analysis).
UNIT - V
Financial Analysis-II: Objectives of fund flow statement - Steps in preparation of fund flow statement,
Objectives of Cash flow statement- Steps in Preparation of Cash flow statement – Analysis of Cash flow
and Funds flow statements - Funds flow statement Vs Cash flow statement. (Only theory).
Textbooks:
3. Financial Accounting, Dr.S.N. Maheshwari and Dr.S.K. Maheshwari, Vikas Publishing
House Pvt. Ltd.,
4. Accountancy .M P Gupta &Agarwal ,S.Chand
Reference Books:
8. Financial Accounting ,P.C.Tulisan ,S.Chand
9. Financial Accounting for Business Managers, Asish K. Bhattacharyya, PHI
10. Financial Accounting Management An Analytical Perspective, Ambrish Gupta, Pearson
Education
11. Accounting and Financial Management, Thukaram Rao, New Age Internationals.
12. Financial Accounting Reporting & Analysis, Stice&Stice, Thomson
13. Accounting for Management, Vijaya Kumar,TMH
14. Accounting for Managers, Made Gowda, Himalaya
 UNIT-2
THE ACCOUNTING PROCESS

1. ACCOUNTING OVERVIEW
 Every company has an accounts department that looks after the accounting details of the
company.
 An accounting department is the backbone of every business. It records all the business
transactions and keeps a track of the incomes and expenses of the business.
 The business depends on these incomes for its profits and should know all the expenses
that are incurred to keep it going.
 They also determine the correct financial position and financial standing of the business.
 All this makes the recording of transactions important.
 For the systematic and accurate recording of the transactions, accounting is important. Let
us understand the accounting process in detail.
 The purpose of accounting is recording all the transactions honestly and accurately in the
books of accounts.
 The accounting process can be defined as "the process that begins when the transaction
takes place and ends when the transaction is recorded in the books of accounts". It is a
series of procedures that are used to analyze and record the business transactions for a
particular period of time.

 The accounting process, also known as the accounting cycle process, includes thesteps
mentioned below. In order to follow these steps, you will need to know all theaccounting
principles and concepts well.

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  The first step involves identifying the transaction and finding the source documents of the
transaction.
 Analyze which accounts is the transaction affecting and what is the amount of the
transaction.
 Record the entry into the journal as a credit or debit, according to its nature.
 Transfer the journal entries into the appropriate accounts in the ledger.
 A trial balance is then created which sees to it that the debit amount equals the credit
amounts.
 Correct the discrepancies in the trial balance and balance the debit side with the credit
side.
 Make adjusting entries in order to record the accrued and deferred amounts.
 Next, prepare the adjusted trial balance on the basis of the deferred amounts.
 Prepare the financial statements like the income statements, the balance sheet, retained
earnings statements and finally the cash flow statements.
 Close the temporary accounts like revenues, expenses, gains, etc. by closing journal
entries. These accounts are transferred to the income summary account and later posted
into the capital accounts.
 Prepare the final trial balance on the basis of the closing journal entries.

2. BOOKS OF ORIGINAL RECORD

JOURNAL: Journal is derived from the French word ‘jour’ which means a day.
Journal, therefore, means a daily record of business transactions. Journal is a book of
original entry because transaction is first written in the journal from which it is posted
to the ledger at any convenient time. The ruling of the journal is as follows:
Journal
Date Particulars L.F. Dr.Amount Cr. Amount
Rs. Rs.
Year Name of account to be debited
Month To Name of Account to be credited
Date (Narration)

(A) (B)
Column 1 (date):the date of the transaction on which it takes place is written in this column.
The year is written only in the first entry appearing on each page. This column is divided into
two parts: the first part is used for writing the month and the second part is used for writing
the date.
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Column2 _ (particulars): in this column, the name of the account to be debited is written
first and is written close to the line marked (A). The word Dr. is written near the line marked
(B). In the next line, the account to be credited is written preceded by the word “To” leaving
a few spaces away from the (A). an explanation of the entry known as “narration” is also
recorded in this column below the line giving credit to the account.

Column 3 – (L.F.) L.F. stands for ledger folio which means page of the ledger. In this column are
entered the page numbers on which the various accounts appear in the ledger.

Column 4 _ (Dr. Amount): in this column, the amount to be debited against the ‘Dr’. Account is
written along with nature of currency.
Column 5_ (Cr. Amount)in this column the amount to be credited against the ‘Cr’. Account is
written along with the nature of currency.
We may define a few more items relating to the journal.
Journalizing means recording a transaction in the journal and the form in which it is recorded is
known as journal entry.
If two or more transactions of the same nature occur on the same day and either the debit
account or credit account is common, such transactions can be conveniently entered in the
journal in the form of a combined journal entry instead of making a separate entry for each
transaction. Such type of entry is known as a compound journal entry.

In a going concern, the balances of the previous year appearing in various accounts are
brought forward at the beginning of the new accounting year by means of a journal entry
known as opening entry to incorporate the previous balances in a new set of accounts. All the
assets accounts are debited and liabilities is credited to capital account.

Steps in journalizing:
1. Ascertain the accounts involved in the transactions.
2. Ascertain the nature of account involved i.e., personal A/c (or) Real A/c (or) Nominal A/c.

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 3. Ascertain which rule of debit and credit is applicable for each of the accounts involved.
4. Ascertain which account is to be debited and which account is to be credited.
5. Record the date of transactions in the date column.
6. Write the name of account to be debited very close to left hand side with the abbreviation
‘Dr.” on the same line in the extreme right hand side of particulars column. The amount to
be debited is written in the debit amount column on the same line against the name of
account.
7. Write the name of account to be credited in the next line. It should be precise by word
‘To’ at a few spaces towards right in the particulars column and the amount to be credited
in the credit amount column against the name of account.
8. Write the narration ( a brief explanation of the transactions) with in the brackets and in the
next line in the particulars column.
9. Draw a line across the entire ‘particulars column’ to separate one entry from the other
entry. The line should be drawn only in the particulars columns.
Note: the word account should be suffered to both debit and credit aspects of journal entry.

Points to be noted before journalizing:

1. Capital account: if the proprietor has introduced cash or goods or property in
business, it is known as capital. It should be debited to cash/stock of goods/property account
and credited to the proprietor’s capital account. It must be clearly understood that the entity
of the proprietor is totally different from the business.
2. Drawings account:if the proprietor has withdrawn cash or goods from the business
for his personal or domestic use, it is called drawings. It should be debited to drawings
account and credited to cash/ purchases account.
3. Cash/credit transactions: when goods are purchased or sold for cash, it is known as
cash transaction. If the goods are purchased or sold on credit i.e., the payment will be made
or received after sometime, it will be a credit transaction. If nothing is mentioned whether it
is a credit or cash transaction, then it should be treated as a credit transaction. For example,
goods sold to X for Rs.2,000 or goods purchased form Y for Rs. 1,000 etc.
4. Casts and Carry forwards: when journal entries extend to several pages of the
journal, the totals are cast at the end of each page. At the end of each page the words ‘ Total
C/f stands for carried forward are written in the particulars column against the debit and
credit totals. On the next page, in the beginning the words
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Total b/f” is written in the particulars column against the debit and credit totals. At the end of a
specified period or on the last page, the grand total is cast.
5. Goods given away as Charity: if some goods from the business are given away as
charity to a particular person or institution, it should be debited to charity account and
credited to purchases account.
6. Compound journal entry: if there are two or more transactions of a similar nature
occurring on the same day and either Dr. or Cr. Account is common, such transactions can be
conveniently recorded in the form of one journal entry instead of making a separate entry for
each transaction. Such entry is known as compound journal entry.
7. Opening entry: the balances of the previous year are brought forward in the
beginning of the year by means of an entry in a going concern. Such entry is made on the
basis of accounting equation i.e., by debiting all assets and crediting liabilities and capital
account.
8. Cash Discount: This discount is allowed by a creditor to a debtor when the latter
pays the amount of goods purchased by him either immediately or within a specified period.
It is an incentive given to a debtor for making an early payment. Thus if the seller allows 2%
discount for payment within month. On a bill of Rs. 20,000, the customer would pay Rs.
19,600 if the payment is made within a month otherwise he would have to pay Rs. 20.000
i.e., full amount of the bill. This discount is recorded in the books of accounts and a separate
account is opened in the ledger. Being a nominal account discount allowed is debited and
discount received credited. For examples:

i) cash received from Mahesh Rs. 1900 and allowed him discount Rs.100
Cash A/c Dr. 1,900
Discount A/c Dr. 100
To Mahesh’s A/c 2,000

ii) Paid to Suresh Rs. 20,000 less 2% cash discount.

Suresh A/c Dr. 20,000
To Cash A/c 19,600
To discount A/c 400
(Cash paid and discount received)

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9. Trade discount: it is a deduction on the gross value or list price of goods allowed by
the manufacturer to the wholesaler or a wholesaler to a retailer in order to enable them to sell
the goods further at list price to the consumer and yet earn a profit. Suppose, a manufacturer
produced an article for Rs. 40 may fix Rs,100 as list price and allows 35% discount to the
wholesaler. The wholesaler will thus get it at Rs.65 and may sell to the retailer at 20% trade
discount. The retailer would thus get it for Rs. 80 and sell to the consumer at Rs. 100. Thus,
the manufacturer earns a profit of Rs.25, the wholesaler Rs. 15 and the retailer Rs.20. it is
deducted from the invoice or cash memo itself from gross value of goods and is not recorded
at all in the books of account. The journal entry will be passed with the net value of goods.
For example, bought goods worth Rs.6,000 from Ram less 20% trade discount.
Purchases A/c Dr. 4,800
To Ram’s A/c 4,800
(For goods purchased from Ram)

Sometimes the purchaser may get the benefit of both discounts. In such a case, firstly
trade discount is calculated on the gross value of goods sold and then cash discount is
calculated on the net value of goods. For example, bought goods worth Rs.6,000 from
Ram less 29% trade discount and paid in cash full less 2% cash discount.
Purchases Account Dr. 4,800
To Cash 4,704
To Discount A/c 96
(For goods purchased for cash and discount received)
If the payment is made in part then cash discount is calculated only on the amou nt paid
and not on the total value of goods bought or sold. For example – Bought goods worth
Rs.6,000 less 20% trade discount and 2% cash discount and paid half the amount in cash
Purchases A/c Dr. 4,800
To Supplier’s A/c 2,400
To Cash A/c 2,352
To Discount A/c 48
( For goods purchased and half the amount paid in cash less 2% cash discount)

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 2.1.2. Difference between Trade Discount and Cash Discount
The following are the main differences between trade discount and cash discount

Basis of Distinction Trade Discount Cash discount

1. When allowed It is allowed on a certain It is allowed when

quantity being purchased payment is made before a
or as trade practice. certain date.
2. Purpose It is given to promote It is allowed to encourage
sales. early cash payment.
3. Vary with It may vary with the It may vary with the
quantity of goods period within which the
purchased. payment is to be made.
4. Entry in books It is not recorded in the A separate account in the
books of account. ledger is maintained for
such discount.
5. Deduction It is deducted from the It is not deducted from the
Invoice. invoice.
6. When offered It is offered at the time of It is offered at the time of
sale or purchase. getting quick payment.
7. Form It is usually given in It may be given in
percentage. it is given on percentage or in absolute
the list price or catalogue figure.
price or retail price.

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 SUBSIDIARY BOOKS:
• Subsidiary Books are those books of original entry in which transactions of similar nature
are recorded at one place and in chronological order.
• In a big concern, recording of all transactions in one Journal and posting them into
various ledger accounts will be very difficult and involve a lot of clerical work.
• This is avoided by sub-dividing the journal into various subsidiary journals or books.
• The subdivisions of journal into various subsidiary journals for recording transactions of
similar nature are called as ‘Subsidiary Books.’

TYPES OF SUBSIDIARY BOOKS

1. Purchases Day Book – for recording credit purchase of goods only. Cash purchase or assets
purchased on credit are not entered in this book.

2. Sales Day Book – for recording credit sales of goods only. Assets sold or cash sales are not
recorded in this book.

3. Purchases Returns Book – for recording the goods returned to the suppliers when purchased
on credit.

4. Sales Returns Books – for recording goods returned by the customers when sold on credit.

5. Bills Receivable Book – for recording the bills received [Bills Receivables] from customers
for credit sales.

6. Bills Payables Book – for recording the acceptances [Bills Payables] given to the suppliers for
credit purchases.

7. Cash Book – for all receipts and payments of cash.

8. Journal Proper – for recording any transaction which could not be recorded in the
abovementioned subsidiary books. For example, assets purchased or sold on credit and opening
entry etc., are entered in this book.

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LEDGER:
• As we know, journal records all business transactions separately and date wise.
• The transactions pertaining to a particular person, asset, expense or income are recorded at
different places in the journal as they occur on different dates.
• Hence, journal fails to bring the similar transactions together at one place.
• Thus, to have a consolidated view of the similar transactions different accounts are
prepared in the ledger.
• A ledger account may be defined as a summary statement of all the transactions relating to
a person, asset, expense or income which have taken place during a given period of time
and shows their net effect.
• Thus, a journal is maintained only to facilitate the passing of entries in the ledger, so every
entry recorded in the journal must be posted into the ledger.

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• Ledger is a register having a number of pages which are numbered consecutively.
• One account is usually assigned one page in the ledger.
• However, if the transactions, pertaining to a particular account are more, it may be
assigned more than one page in the ledger.
• An index of various accounts opened in the ledger is given at the beginning of the ledger
for the purpose of easy reference.
• It is the principal book of accounts because it helps us in achieving the objectives of
accounting. It gives answers to the following pertinent questions:
1. what are the total sales to an individual customer?
2. what are the total purchases from an individual supplier?
3. how much amount is owed by others?
4. how much amount is owed to others?
5. what is the amount of profit or loss made during a particular period?
Advantages or merits:
• It provides complete information about all accounts in one book.
• It is easy to ascertain how much money is due to suppliers (from creditors ledgers)and
how much money is one from customers (from debtors ledgers).
• It enables to ascertain, what are the main items of revenue or incomes (nominal account).
• It enables to ascertain what are the main items expenses (nominal account)
• It enables to know the kind of assets the company holds and their respective values (real
account)
• It facilitates preparation of trial balance and thereafter preparation of financial statements
i.e., P&L A/c and balance sheet.

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 Differences between Journal and Ledger:
S.NO Basis of difference Journal Leger
1. Nature of Book It is a book of original entry It is a book of final entry.

2. Object It is prepare to record all the It is prepare to know the

transactions in chronological order effect of various transactions
(date wise) affecting a particular account.

3. Basis of Preparation It is prepared on the basis of It is prepared on the basis of

transactions. journal.

4. Stage of recording Recording in the journal is the first Recording in the ledger is the
stage. second stage.

5. Balancing Journal is not balanced All ledger A/c are balanced.

6. Narration Narration is written for each entry. No narration is given

7. In ledger there are 4 columns

Format In journal there are 5 columns viz, on debit and credit side viz.
date, particulars, L.F. Dr and Cr. date, particulars, journal folio
and amount.

8. Name of the process The process of recording in journal The process of recording in
is called journalizing. ledger is called ledger posting.

9. Basis of preparation of Journal directly doesn’t serve as Ledger serves the basis for the
Final A/c basis for preparation of final preparation of final accounts.
account.

TRIAL BALANCE:
• The agreement of the trial balance reveals that both the aspects of each transaction have
been recorded and that the books are arithmetically accurate.
• If the trial balance does not agree, 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.

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 Preparation of trial balance:
1. Total method: in this method, the debit and credit totals of each account are shown in
the two amount columns against it.
2. Balance method: in this method, the difference of each account is extracted. If debit side
of an account is bigger in amount than the credit side, the differences is put in the debit
column of the trial balance and if the credit side is bigger, the difference is written in the
credit columns of the trial balance.
Trial balance can be prepared on a loose sheet having four columns. A specimen is given as
follows:
Trial balance of - - - -As on - - - -
Serial No. Name of the account Dr. Cr.
Balance (or Balance (or
Total ) Rs. Total) Rs.

Of the two methods of preparation, the second is usually used in practice because it facilitates
the preparation of the final accounts
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 (one for the debit total and the other for the credit total) against it.
2. Balance method: in this method, the difference of each account 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.
Of the two methods of preparation, the second is usually used in practice because it
facilitates the preparation of the final accounts.

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 Specimen of trial balance
Particulars Debit (Assets &Expenditure) Credit(Liabilities&Incomes)
Rs. Rs.

Capital XXX
Purchases XXX
Purchase returns XXX
Sales XXX
Sales returns XXX
Carriage XXX
Wages XXX
All expenses and losses XXX
Direct and indirect expenses
All incomes and gains
All assets XXX
Current assets, fixed assets,
intangible assets and fictious
assets.
All liabilities XXX
Current liabilities, long-term
liabilities etc.
Discount allowed XXX
Discount received XXX
Drawings XXX
Taxation paid XXX
Dividend paid XXX
Bad debts and reserves XXX
Suspense A/c XXX

XXX XXX

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3. FINAL ACCOUNTS

 Two main objectives of maintaining accounts are to find out the profit or loss made by the
business at the end of regular periodic intervals and to ascertain the financial position of
the business on a given date.
 Final accounts are prepared to achieve the objectives of accountancy.

 In order to know the profit or loss earned by a firm, Income Statement or Trading and
Profit and Loss account is prepared.

 Balance Sheet or Position Statement will portray the financial condition of the firm on
a particular date. These two statements, i.e., Trading and Profit & Loss Account and
Balance Sheet are prepare to give the final results of the business, that is why both
these are collectively called as final accounts.

Thus, final accounts include the preparation of :

I.Trading and Profit and Loss Account; and
II.Balance Sheet.
Final accounts are the means of conveying to management, owners and interested
outsiders a concise picture of profitability and financial position of the business. The
preparation of the final account sis not the first step in the accounting process but they are the
end products of the accounting process which give a concise accounting information of the
accounting period after the accounting period is over. These accounts summarize all the
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accounting information recorded in the subsidiary books and the ledger running into hundreds
or thousands of pages.

TRADING ACCOUNT
Amount Amount
Particulars Rs. Particulars Rs.
To Opening Stock By Sales
To Purchases Less: Sales Returns
Less: Purchase Returns
To Direct Expenses By Closing Balance
To Carriage Inward
To Wages By Gross Loss C/d
To Wage and Salaries
To Fuel and Power
To Manufacturing or
Production Expenses.
To Coal, Water and
Gas
To Motive Power
To Factory Lighting
To Octroi
To Import Duty
To Custom Duty
To Excise Duty
To Consumable Stores
To Foreman/Works
Manager’s
Salary
To Factory Rent, Rated an
To Royalty on
Manufactured Goods
To Gross Profit C/d

XXXX XXXX

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 PROFIT AND LOSS ACCOUNT:-
• This account is prepared to calculate the net profit of the business.
• There are certain items of incomes and expenses of the business which must be taken
into consideration for calculating net profit of the business.
• These are of indirect nature, i.e., concerning the whole business and relating to
various activities which are done by the business for the purpose of making the goods
available to the consumers.
• Indirect expenses may be selling and distribution expenses, management expenses,
financial expenses, extraordinary losses and expenses to maintain the assets into
working order.
• This account is prepared from nominal accounts and its balance is transferred to
capital account as the whole profit or loss will be that of the owner and it will increase
of decrease his capital.
The specimen proforma of this account is given as under.
PROFIT AND LOSS A/C,For the year ended 31 st March,2000
Particulars Amount Particulars Amount
Rs. Rs
To Gross Loss b/d By Gross Profit b/c
To Selling and Distribution By Interest Received
Expenses: By Discount Received
Advertisement By Commission Received
Travelers’ Salaries, By Rent From Tenants Received
Expenses & Commission By Income from Investments
Bad Debts By Apprenticeship Premium
Carriage Outward By Interest on Debentures
Bank charges By Income from any other Source
Agent’s Commission By Miscellaneous Revenue Receipts
Upkeep of Motor Lorries By Net Loss transferred to Capital A/c*
To Management Expenses:
Rent, Rates and Taxes
Heating and Lighting office
Salaries
Printing & Stationery
Postage & Telegrams
Telephone Charges
Legal Charges
Audit Fees
Insurance
General Expenses
To Depreciation and
Maintenance:
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 Depreciation
Repairs & Maintenance To
Financial Expenses:
Discount Allowed
Interest on Capital
Interest on Loans
Discount on Bills Discounted To
Extraordinary Expenses:
Loss by fire (not covered by
Insurance)
Cash Defalcations
To Net Profit transferred to
Capital A/c*

* Balancing figure will be either net profit or net loss.

BALANCE SHEET
• A balance sheet is a statement prepared with a view to measure the financial position of
a business on a certain fixed date.
• The financial position of a concern is indicated by its assets on a given date and its
liabilities and that 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 application 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 a 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.
• On the left hand side of the balance sheet, the several liability items described how much
capital was obtained from trade creditors, from banks, from bill holders and other
outside parties. The owner’s equity section shows the capital supplied by the owner.

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Grouping and Marshalling of Assets and Liabilities:
Liabilities Amount Assets Amount
Rs. Rs.
Current Liabilities: Liquid Assets:
Bills Payable Cash in Hand
Sundry Creditors Cash at Bank
Bank Overdraft Floating Assets:
Long Term Liabilities: Sundry Debtors
Loan from Bank Investments
Loan from Wife Bills Receivable
Fixed Liabilities: Stock in Trade
Capital Prepaid Expenses
Fixed Assets:
Machinery
Building
Furniture & Fixtures
Motor Car
Intangible Assets:
Goodwill
Patents
Copyright
Licenses
Fictitious Assets:
Advertisement
Misc. Expenses
(to the extent not written off)
Profit & Loss A/c

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 Treatment of items appearing in the trial balance:

Items Profit & loss account Balance sheet

1. closing stock Shown in the asset side of

balance sheet.
2. outstanding expenses or Shown in the liability side of
accured expenses balance sheet.

3. prepaid expenses Shown in the asset side of the

balance sheet

4. Accrued income Shown in the asset side of

balance sheet.

5. unearned income Shown in the liability side of

the balance sheet.

6. Depreciation Shown in the Dr side of

Profit & Loss account

7. Interest on capital Shown in the Dr side of Profit

& Loss account

8.drawings Less from capital on the

balance sheet liabilities side

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 4. FINAL ACCOUNTS WITH ADJUSTMENTS
• While preparing trading and profit and loss account one point that must be kept in mind is
that expenses and incomes for the full trading period are to be taken into consideration.
• This means that if an expense has been incurred but not paid during that period, a liability
for the unpaid amount should be created before the accounts can be said to show the profit
or loss.
• All expenses and incomes should properly be adjusted through entries.
• These entries which are passed at the end of the accounting period to make a record of the
transactions omitted to be entered in the books are called adjusting entries.
• Hence before preparing final accounts adjusting entries should be made to ensure that final
accounts exhibit a true and fair view.
• Some important adjustments which are to be made at the end of the accounting year are
discussed in the following pages one by one.
• Every adjustments item will come two times or three times. In the final accounts all trial
balance items will come only one time in the final accounts.
Treatment of adjustment items in the final accounts:
Adjustments Trading Profit & loss Balance sheet
account account
1. closing stock Shown in the Shown in the asset side
cr side of
trading
account.
2.outstanding Shown in the Dr side Liability side of balance sheet
expenses of trading or profit &
loss account by way of
addition to the concern
expenses.
3.unexpired or Shown in the Dr profit Shown on the asset side of the
prepaid expenses and loss account by the balance sheet.
way of deduction from
concern expenses.
4.Accrued income Showing in the Cr Shown on the addition to the asset
profit & loss account side balance sheet.
by the way of addition
concerning.
5. Income received in It is shown on the Shown on the liabilities side of
advance profit and loss account balance sheet.
by the way of
deduction from

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 concern income.
6. Depreciation Shown on the Dr side of Shown on the asset side by way of
Profit and loss account. deduction from the concern asset.

7. Interest on Shown in the Dr side Shown on the liabilities side of the

capital of profit & loss balance sheet by way of adding to
account the capital.
8.Interest on Shown on the “cr” side Shown on the liabilities side of the
drawings of profit & loss balance sheet by way of addition to
account the drawings which are ultimately
redacted from the capital

9.Provision of Shown on the “Dr” Shown on the assets side by way of

doubtful debts side of P/L account or deduction from the sundry debtors (
by way of addition to after deduction of further bad debts)
bad debts (old if any
provision for doubtful
debts at the beginning
of the year will be
deducted)
10.Provision for Shown on the “Dr” side o Shown by way of deduction from
discount debtors on account sundry debtors (after deduction of
further bad debts & provision for
doubtful debts) on the asset side of
the balance sheet
11.additional bad Shown on the “Dr” Shown the assets side by way of
debts side by way of deduction from the amount of
addition to the bad sundry debtors.
debts
12.Reserve for Shown on the Cr side of Shown on the liabilities side of the
discount on P/L account balance sheet by way of deduction
creditors from sundry creditors.
13.Deferred Shown on the “Dr” Shown on asset side by way of
Revenue side of P/L account deduction from capitalized
Expenditure (some proportionate expenditure.
amount on deferred
revenue expenses)

15. bad debts Shown on the debit Shown on the assets side of the B/S
side of Profit & loss by way of deduction from sundry
account. debtors.
16.(Interest On Shown on the Dr side Shown on the liabilities side of the
Loan)hidden of the P/L account by balance sheet by way of addition to
adjustments way of addition to the the loan account.
interest on loan.

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 UNIT-2- IMPORTANT QUESTIONS
 Explain Accounting process/cycle
 How to prepare ledger, trail balance & final accounts explain with steps?
 How to post adjustment items in final accounts: Outstanding expenses, prepaid expenses,
depreciation, interest on capital, drawings, discounts &other adjustments.

Problems: JOURNAL, LEDGER, TRAIL BALANCE & FINAL ACCOUNTS)

Trading & profit & loss A/C, Balance sheet)

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 UNIT-3
VALUATION OF ASSETS

1. INTRODUCTION TO DEPRECIATION

Valuation of fixed assets:The broad meaning of Valuation of fixed assets is Valuation of Land,
Building, Plant and Machinery, etc.

Valuation of Fixed Assets is undertaken as per the client’s requirement. Sometimes Financial
Institutions, Banks & Customs authorities also need valuation reports for certain specific
assets.

Definition of 'Asset Valuation'

A method of assessing the worth of a company, real property, security, antique or other item
of worth. Asset valuation is commonly performed prior to the sale of an asset or prior to
purchasing insurance for an asset.

What is the Difference Between Tangible and Intangible Assets?

• In the world of accounting, understanding the difference between tangible and

intangible assets is very important to keep track of a company's property. A tangible
asset is anything that has a physical existence, meaning that it can actually be seen or
felt by a person. An intangible asset is anything that a company owns that does not
have a physical existence, meaning things like information and company logos. Both
types of assets are very important parts of a company, and accountants need to be able
to recognize both types of these assets.
• One type of tangible assets are known as long-term assets. These are physical things
that a company owns and expects to have for a long period of time. The most
common examples of these types of assets include land, equipment, and buildings.
Over time, all of these assets, except for land, have to be depreciated by an accountant
working for the company. This means that they are not worth as much as time goes on
as they were originally purchased for.
• Buildings and equipment used by the company are depreciated as time passes.
Additionally, companies incur other costs that have to be factored in to their balance
sheet. For example, some building costs include the original price of the purchase of
the building, any taxes that the company had to pay when purchasing the building,
any kind of fees for attorneys and realtors, and any potential costs of having to fix up
or maintain the building. Some equipment costs include the original price that the
equipment was bought for, any taxes that had to be paid to purchase the equipment,
the costs incurred for installing the equipment, and if the item was delivered, the cost
for delivery.

UNIT-3 Valuation of assets DR K V SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

 • Land is different from other tangible assets in that it does not depreciate, but instead is
held to its historical cost. This means that it remains at the same price on the balance
sheet whether the appraisal value goes up or down. It also sees some of the same
additional costs as buildings and equipment do. For example, in addition to the price
that the land was purchased for, companies have to factor in any potential taxes and
any potential fees for people involved with the purchase.

Concept of Depreciation:

a) Depreciable asset. These are assets which

i) are expected to be used during more than one accounting period: and ii)have a limited
life ; and iii)are held by an enterprise for use in the production or supply of goods and
services for rental to others, or for administrative purposes and not for the purpose of sale
in the ordinary course of business.

b) Useful life. This is either (i) the period over which a depreciable asset is expected to be
used by the enterprise; or (ii) the number of production of similar units expected to be
obtained from the use of the asset by the enterprise.

The useful life of a depreciable asset is shorter than its physical life and is:

(i) pre-determined by legal or contractual limits such as the expiry dates of related lease
;

(ii) directly governed by extraction or consumption ;

(iii) dependent on the extent of use and physical deterioration on account of wear and tear
which again depends on operational factors, such as, the number of shifts for which
the asset is to be used, repairs and maintenance policy of the enterprise etc., and

(iv) Reduced by obsolescence arising from such factors as technological changes,

improvement in production methods, change in market demand for the product or
service, output of the asset or legal or other restrictions.

(c) Depreciable Amount. The amount of depreciable asset is its historical cost, or other
amount substituted for historical cost in financial statements, less the estimated residual
value.

(d) Residual Value. Determination of residual value of an asset is normally a difficult

matter. If such value is considered as insignificant, it is normally regarded as nil. On the
contrary, if the residual value is likely to be significant, it is estimated at the time of
acquisition/installation, or at the time of subsequent revaluation of the asset.
Cause of depreciation
UNIT-3 Valuation of assets DR K V SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT
 The following are the main causes of depreciation:

(i) Physical Deterioration. It is caused mainly from wear and tear when the
asset is in use and from erosion, rust, rot and decay from being exposed to
wind, rain sun and other elements of nature.

(ii) Economic Factors. These may be said to be those that cause the asset to
be put out of use even though it is in good physical condition. These arise
due to obsolescence and inadequacy. Obsolescence means the process of
becoming obsolete or out of date. An old machinery though in good
physical condition may be rendered obsolete by the introduction of a new
model which produces more than the old machinery.
(iii) Time factors. There are certain assets with a fixed period of legal life such
as lease, patents, and copyrights. For instance, a lease can be entered into
for any period while a patent’s life is for some years but on certain grounds
this can be extended. Provision for the consumption of these assets is
called amortization rather depreciation.

(iv) Depletion. Some assets are of a wasting character perhaps due to the
extraction of raw materials from them. These materials are then either used
by the firm to make something else or are sold in their raw state to other
firms. Natural resources such as mines, quarries and oil wells come under
this heading. To provide for the consumption of an asset of a wasting
character is called provision for depletion.

(v) Accident. An asset may reduce in value because of meeting of an accident.

Difference between Depreciation, Depletion, Amortization and Dilapidations

• Depreciation applies to fixed assets, depletion to wasting assets, amortizations to
intangible assets and dilapidation to damage due to a building or other property during
tenancy. AICPA has given the difference between these terms in the following words:
• “Depreciation can be distinguished from other terms, with specialized meaning used
by accountants to describe assets cost allocation procedures. Depreciation is
concerned with charging the cost of man-made fixed assets to operations (and not
with determination of asset value for the balance sheet). Depletion refers to cost
allocations for natural resources such as oil and mineral deposits.
• Amortization relates t cost allocation for intangible assets such as patent and
leaseholds. The use of the term depreciation should also be avoided in connection
with the valuation procedures for securities and investments.”

.
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 2. METHODS OF DEPRECIATION:
Different methods of calculating provision for depreciation are mainly accounting customs
which may be used by different concerns taking into consideration their individual
peculiarities. The following are the main methods of providing depreciation:

Fixed Installment (or Fixed Percentage on Original Cost or Straight Line) Method

Under method a fixed percentage of the original value of the asset is written off every
year so as to reduce the asset account to nil or to its scrap value at the end of the
estimated life of the asset. To ascertain the annual charge under this method all that is
necessary is to divide the original value of the asset (minus its residual value, if any) by
the number of years of its estimated life i.e.,

Depreciation = Cost price of asset – Scrap Value

Estimated life of asset

If, for example, a machine costing Rs. 11, 000/- is estimated to have a life of 10 years and the
scrap value is estimated Rs. 1, 000/- at the end of its life, the amount of depreciation would
be

Rs. 11,000-1,000 = Rs. 1,000

10
The amount of depreciation charged during each period of the asset’s life is constant. If the
charge of depreciation is plotted annually on a graph paper and the points joined together,
then the graph will reveal a straight line that is why it is also called as straight line method.
This method is suggested in case of assets where in the service value declines as a function
of time and that too at a uniform rate. The repairs, maintenance and revenue also remain
more or less constant.
It should be noted carefully that if depreciation is given as some percentage per annum and if
the asset is purchased during the accounting year, say on July 1st then depreciation for six
months is to be charged, if the accounting year closes on 31st December.

Merits of Fixed Installment Method

i. This method is simple to understand and easy to apply.
ii. It can write down an asset to zero at the end of its working life, if so desired.
iii. This method is very suitable for those assets which have a fixed life e.g., furniture,
fixtures, short leases, patents and copyright and other assets of a small intrinsic value,
repair charges are less and the possibility of obsolescence also less.

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Demerits of Fixed Installment Method
i. The charge for depreciation remains constant year after year. The expenses of
repairs and maintenance are increasing as the asset grows older. The profit and
loss account thus in the later years bears more than its share of valuation.
ii. It becomes difficult to calculate the depreciation on additions made during
year.
iii. Under this method the depreciation charge remains the same from year to year
irrespective of the use of the asset. Thus it does not take into consideration the
effective utilization of the asset.
iv. It is not take into consideration the interest on capital invested in fixed assets.
v. It does not provide funds replacement of assets.
vi. This method tends to report an increasing rate of return on investment in the
asset amount due to the fact that the net balance of the asset amount is
taken. In spite of these drawbacks, this method is mostly used by firms in
U.S.A Canada, U.K., and some firms in India.

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Diminishing Balance (or Reducing Installment or Written Down Value) Method

• Under this method, depreciation is calculated at a certain percentage each year on the balance
of the asset which is brought forward from the previous year;
• The amount of depreciation charged in each period is not fixed but it goes on decreasing
gradually as the beginning balance of the asset in each year will reduce.
• The charges in initial periods are higher than those in the later periods.
• Overall charges, i.e., amount of depreciation, repairs and maintenance taken together remains
equal throughout the life of the asset.
• This method is justified in the cases where 1. there is much uncertainty of revenue in later
years and 2.
• there is also increase in repairs and maintenance costs consequently decreasing efficiency and
revenues in every succeeding period. It is usually adopted for plant and machinery.
Merits of Diminishing Balance Method
i. It tends to give a fairly even charge of depreciation against revenue each year.
Depreciation is generally heavy during the first few years and is counter –
balanced by the repairs being light and in the later years when repairs are
heavy this is counter – balanced by the decreasing charge for depreciation.
This concept is based on the logic that as an asset grows order, the amount of
depreciation goes on decreasing.
ii. Fresh calculations of depreciation are not necessary as and when additions are
made.
iii. This method is recognized by the income tax authorities in India. iv. It
does not provide for replacement of asset on the expiry of its useful life.
v.This method is suitable for plant and machinery, building etc. Where the amount of
repairs and renewals increase as the asset grows older and the possibilities of
assets are more.
Demerits of Diminishing Balance Method
i.The original cost of the asset is altogether lost sight of in subsequent years and the
asset can never be reduced to zero. ii.This method does not take into consideration the
asset as an investment and interest is not taken into consideration.
iii. As compared to the first method, it is difficult to determine the suitable rate of
depreciation.

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 DISTINCTION BETWEEN STRAIGHT LINE METHODSAND DIMINISHING
BALANCE METHOD
Points of Diminishing Balance Method
Distinction Straight Line Method

Change in Throughout the life of the asset, the amount Amount of depreciation is more during
Depreciation for depreciation remains to be equal. earlier years of the life of asset than later
Amount years and therefore amount is never equal.

The amount never becomes nil.

Assets A/c at the expiry of the expected life
Balance in becomes nil.
Assets A/c Overall charge remains more or less same
for every year throughout the life of the
Overall The overall charge i.e., Depreciation and asset. Since depreciation goes on
Changes repairs taken together go on increasing decreasing and amount of repairs goes on
from year to year. In other words the increasing.
amount depreciation and repairs is
relatively less during the earlier years of the
life of the asset than later years become
repairs go on increasing with use of asset. Profits are less during earlier years than the
later years.
Profits Profits under this method are more during
the earlier years of the life of the asset.

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ANNUITY METHOD
1. The fixed Installment Method and the Reducing Balance method of charging
depreciation ignore the interest factor.
2. The Annuity Method takes care of this factor. Under this method, the depreciation is
charged on the basis that besides losing the original cost of asset, the business also losses
interest on the amount used for buying the asset.
3. The terms “Interest” here means the interest which the business could have earned
otherwise if the money used in purchasing the asset would have been invested in some
other form of investment.
4. Thus, according to this method, such an amount is charged by the way of depreciation
which taken into A/c not only the cost of the asset but also interest there on at an
accepted rate.
5. The amount of interest is calculated on the book value of the asset, in the beginning of
each year.
6. The amount of depreciation is uniform and is determined on the basis of annuity table.
Follows: Rs. 5,000 x 2.48685 = Rs 12,434 or (say) Rs 12,500.

UNIT-3 IMPORTANT QUESTIONS

 Explain Methods of Depreciation with merits &de-merits?
Depreciation problems:Straight Line, Diminishing Balance &annuity Method.
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 UNIT-3 VALUATION OF ASSETS
3. INVENTORY VALUATION
According to Kohler’s Dictionary for Accountants, inventory is defined as "Raw
materials and supplies, goods finished and in process of manufacture and merchandise on
hand, in transit and owned, in storage or consigned to other at the end of an accounting
period.
Inventory forms a significant portion of the total assets of many enterprises and a lot
of working capital is invested in this item. Inventories generally constitute the second largest
item after fixed assets, in the financial statements, particularly of manufacturing concerns.
This is why valuation of inventories has assumed significance in recent years. The values
attached to inventories can materially affect the operating results as shown by trading and
profit and loss account and the financial position of a business firm because closing inventory
(stock in trade) is shown on the credit side of the trading account and this amount is also
shown as current asset in the balance sheet. The closing inventory becomes the opening
inventory in the next accounting period and shown on the debit side of trading account. Thus,
the valuation of inventories does affect the operating results not only of the current
accounting period but also of the subsequent period. Inventory valuation is purely subjective
depending upon the policies and the different bases of valuing inventories used by different
business and even by different undertakings with in the same trade or industry.
According to Accounting Standards - A (AS - 2) 'inventories' mean tangible property held.
(1) for sale
(2) in the process of production for sale
(3) for computation in the production of goods or services for sale, inventories
are normally classified in the financial statements as current assets as under : i. Raw
materials and components ii. Work- in-process iii. Finished goods iv. Stores and
spares.
Thus, the term inventory includes stock of (I) finished goods, (ii) work in-progress and (iii) raw
materials and components. In case of a trading concern inventory primarily consists of finished
goods while in case of a manufacturing concern, inventory consists of raw materials,
components, stores, work-in-process and finished goods.

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OBJECTIVE OF INVENTORY VALUATION:
a) Determination of Correct Income: The major objectives of accounting for
inventories are the proper determination of income through the process of matching
appropriate cost against revenues. As we know that Gross Profit is determined by rig cost of
goods sold from sales revenue. Cost of goods sold does not mean purchase price, it takes
opening and closing stocks of goods. Cost of goods sold is equal to opening Stock +
Purchases - Closing Stock. Therefore, closing stock is valued and into account. The value of
Closing Stock is credited to Trading Account. The Closing Stock becomes the opening stock
of the next year. Thus, valuation of closing stock affects the profits for the current year as
well as for the next year. When we credit the Trading Account with the closing stock and
debit the Trading Account with the opening stock. The valuation of stock will affect the
Gross Profit. Overvaluation of closing stock means inflating the current year‟s profit and
deflating the profit of the succeeding year. Likewise undervaluation of Stock will decrease
the volume of current profit and increase the succeeding year profit. When Gross profit is
affected the net profit will automatically in the same direction.

b) Determination of Financial Position: In a concern, Balance Sheet is a statement

which shows the financial position of the business on a particular date. Inventory is an
important item of current asset which is shown on the asset side of the Balance Sheet. If this
figure is not shown correctly, the balance sheet, to that extent, will be misleading. Decision
making by Management: Inventory is an important asset of the business. The figure of
Inventory very useful to the management for decision making. Management calculate
inventory turnover ratio to know whether inventory has been efficient used or not External
Reporting: Various external group particularly the Investors are interested in the figure of
inventory to forecast the future cash Inflows of the enterprise.

METHODS OF VALUATION OF INVENTORIES: The purchase prices of materials

fluctuate on account of changes in the product prices, buying from different suppliers and on
account of quality discounts. Because of price fluctuations, the stock may include several lots
of the same material purchased at different prices. When these materials are issued to
production, it is important to consider the correct price at which these materials are charged

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to production. There are various methods in use. They are broadly classified under the
following categories:

First in First out (Commonly Called FIFO):

Under this method material is first issued from the earliest consignment on hand and
priced at the cost at which that consignment was placed in the stores. In other words,
materials received first are issued first. The units in the opening stock of materials are treated
as if they are issued first, the units from the first purchase issued next, and so on until the
units left in the closing stock of materials are valued at the latest cost of purchases. It follows
that unit costs are apportioned to cost of production according to their chronological order of
receipts in the store.
This method is most suitable in times of falling prices because the issue price of
materials to jobs or works orders will be high (materials issued from the earliest
consignments which were purchased at a higher rate) while the cost of replacement of
materials will be low. But in case of rising prices this method is not suitable because the issue
price of materials to production will be low while the cost of replacement of materials will be
high.

Advantages of FIFO Method:

1. The main advantage of FIFO method is that it is simple to understand and easy to operate.
2. It is a logical method because it takes into consideration the normal procedure of utilizing
first those materials which are received first. Materials are issued in order of purchases, so
materials received first are utilized first.
3. Under this method, materials are issued at the purchase price; so the cost of jobs or work
orders is correctly ascertained so far as cost of materials is concerned. Thus, the method
recovers the cost price of the materials.
4. This method is useful when prices are falling.
5. Closing stock of materials will be valued at the market price as the closing stock under
this method would consist of recent purchase of materials.
6. This method is also useful when transactions are not too many and prices of materials are
fairly steady.

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Disadvantages of FIFO Method:
1. This method increases the possibility of clerical errors, if consignments are received
frequently at fluctuating prices as every time an issue of materials in made, the store
ledger clerk will have to go through this record to ascertain the price to be charged.
2. In case of fluctuations in prices of materials, comparison between one job and the
other job becomes difficult because one job started a few minutes later than another of
the same nature may be issued materials at different prices, merely because the earlier
job exhausted the supply of the lower priced materials in stock.
3. For pricing one requisition more than one price has often to be taken.
4. When prices rise, the issue price does not reflect the market price as materials are
issued from the earliest consignments. Therefore, the charge to production is low
because the cost of replacing the material consumed will be higher than the price of
issue.

Last In First Out (Commonly Called LIFO) Method:-

As against the First In First Out method the issues under this method are priced in the
reverse order of purchase i.e., the price of the latest available consignment is taken. This
method is sometimes known as the replacement cost method because materials are issued at
the current cost to jobs or work orders except when purchases were made long ago. This
method is suitable in times of rising prices because material will be issued from the latest
consignment at a price which is closely related to the current price levels. Valuing material
issues at the price of the latest a available consignment will help the management in fixing the
competitive selling prices of the products. This method was first introduced in the U.S.A.
during the Second World War to get the advantages of rising prices.

Advantages of LIFO Method:

1. Like FIFO method, this is simple to operate and is useful when transactions are not
too many and the prices are fairly steady.
2. Like FIFO, this method recovers cost from production because actual cost of material
is charged to production.

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 3. Production is charged at the recent prices because materials are issued from the latest
consignment. Thus, effect of current market prices of materials is reflected in the cost
of sales provided the materials are recently purchased.
4. In times of rising prices, LIFO method of pricing issues is suitable because materials
are issued at the current market prices which are high. This method thus helps in
showing a lower profit because of increased charge to production during periods of
rising prices and lower profit reduces burden of income-tax.

Disadvantages of LIFO Method:

1. Like FIFO, this method may lead to clerical errors as every time an issue is made, the
store ledger clerk will have to go through the record to ascertain the price to be
charged.
2. Like FIFO, comparison between one job and the other job will become difficult
because one job started a few minutes after another of the same type may bear a
different charge for materials consumed, merely because the earlier job exhausted the
supply of the lower priced or higher priced materials in stock.
3. For pricing a single requisition, more than one price has often to be adopted.
The stock in hand is valued at price which does not reflect current market price.
Consequently, closing stock will be understated or overstated in the Balance Sheet.

Highest In First Out (HIFO) Method:

This method is based on the assumption that the closing stock of materials should
always remain at the minimum value; so the issues are priced at the highest value of the
available consignments in the store. The method is not popular as it always undervalues the
stock which amounts to creating a secret reserve. The method is mainly used in case of cost
plus contracts or monopoly products as it is helpful in increasing the price of the contract or
products.

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Average Cost Method:
The principle on which the average cost method is based is that all of the materials in
store are so mixed up that an issue cannot be made from any particular lot of purchases and,
therefore, it is proper if the materials are issued at the average cost of materials in store.

Average may be of two types:

(i) Simple Arithmetic Average
(ii) Weighted Arithmetic Average.

Simple Arithmetic Average: "A price which is calculated by dividing the total of the prices
of the materials in the stock from which the material to be priced could be drawn by the
number of the prices used in that total".
Simple average price is calculated by dividing the total of unit purchase prices of
different lots in stock on the date of issue by the number of prices used in the calculation and
quantity of different lots is ignored. This method may lead to over-recovery or underrecovery
of cost of materials from production because quantity purchased in each lot is ignored.
Simple average price is not to be followed because this method of calculating issue price
does not recover the cost price of the materials from the production.

Weighted Average Price:"A price which is calculated by dividing the total cost of materials
in the stock from which the materials to be priced could be drawn by the total quantity of
materials in that stock".
It is better to issue the material at weighted average price method because it recovers the
cost price of the materials from production.

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 UNIT-3 IMPORTANT QUESTIONS
 Explain Methods of Inventory Valuation? Merits & de-merits?
 Explain Methods of good will Valuation? Merits & de-merits?
Problems: LIFO, FIFO SIMPLE & WEIGHTED AVERAGE.

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 UNIT-4
FINANCIAL ANALYSIS – I

1. ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS FROM

INVESTOR AND COMPANY POINT OF VIEW

NATURE OF FINANCIAL STATEMENTS:

Financial statements are the basic and formal means through which the corporate
management communicates financial information to various external users. Financial
statements are primarily directed towards the needs of owners and incidentally to the needs of
other external parties which include investors, tax authorities, governments, employees etc.
the following definitions bring out the meaning of financial statements.
According to American Institute of Certified Public Accountants (AICPA), “Financial
statements are prepared for the purpose of presenting a periodical review or report on
progress made by the management and deal with the status of investment in the business and
the results achieved during the period under review.

TYPES OF FINANCIAL STATEMENTS:

Financial statements generally include two statements known as income statement and
balance sheet. The prime attention of accounting process is paid on distinguishing between
the revenue items from capital items. Revenue items include both revenue receipts as well as
revenue payments. They are of nominal nature, hence need to be matched and net results are
to be identified. The statement, which takes care of this process, is known as income
statement. After matching the revenue receipts with that of revenue payments, the remaining
balances are of capital nature. They include items, which have potential uses and future
obligations known as assets and liabilities. The statement, which shows total of assets and
liabilities, is known as balance sheet. As per generally accepted accounting principles
financial statements are as follows:
i) Balance sheet
ii)Income statement
iii) Statement changes in owners’ account
iv) Statement of changes in financial position

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

The two basic or major financial statements known as balance sheet and income statement are
required for external reporting and also for internal needs of the management like planning,
decision making and control. These two basic statements are supported by number schedules,
annexure, supplementing the data contained in the balance sheet and income statement. Apart
from these two basic financial statements, there is a need to know about movements of funds
and changes in the financial position of the company. A statement of retained earnings and
the statement of changes in financial position help in this direction.

USES AND IMPORTANCE OF FINANCIAL STATEMENTS:

Financial statements, which are prepared depicting true, relevant, easily understandable,
comparable, analytically represented and promptly presented financial position, help the
users in their economic decisions. The users of financial statements include management,
investors, shareholders, creditors, government, bankers, employees and public at large. They
provide not only information about the performance of the management to the various parties
interested in the organization but also help in taking appropriate decisions. The uses and
importance of financial statements are presented below:
a) Report on stewardship function: Financial statements report on the performance of
the policies of the management to the shareholders. The gaps in the management and
ownership can be understood with the help of financial statements.
b) Basis for fiscal policies: the fiscal policies particular taxation polices of the
government are related with the financial performance of corporate undertakings.
Thus financial statements provide basic input for industrial and taxation and other
socio-economic policies of the government.
c) Basis for dividend polices: the dividend policies of the corporate sector are linked
with the government regulations and financial performance of the undertaking. Hence,
financial statements form basis for dividend policies of companies.
d) Basis for granting of credit: corporate undertakings have to borrow funds from
banks and other financial institutions for different purposes. Credit granting
institutions take decisions based on the financial performance of the undertakings.
Thus financial statements form basis for granting of credit.
e) Basis for prospective investors: the investors include both short term and long term
investors. Their prime considerations in their investment decisions are security and
liquidity of their investment with reasonable profitability. Financial statements help

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 the investors to assess long term and short term solvency as well as the profitability of
the concern.
f) Guide to the value of the investment already made: shareholders of companies are
interested in knowing the status, safety and return on their investment. They may also
need information to take decision about continuation or discontinuation of their
investment in the business. Financial statements provide information to the
shareholders in taking such important decisions.
g) Aids government in policy framework: the government studies the financial
statements of corporate undertakings to assess the role of corporate undertakings in
the economic development of the country. It also studies the economic situation of the
country from these statements in terms of industrial production, employment,
technological development etc. these statements enable the government to know
whether business is following various rules and regulations or not. These statements
also form a base for framing and amending various laws for the regulation of the
business.
h) Helps trade associations in helping their members: trade associations may analyze
the financial statements for the purpose of providing service and protection to the
members. They may develop standard ratios and design uniform system of accounts.
i) Helps stock exchanges: financial statements help the stock exchanges to understand
the extent of transparency in reporting on financial performance and enables them to
call for required information to protect the interest of investors. The financial
statements enable the stock brokers to judge the financial position of different
concerns and take decisions about the prices to be quoted.

LIMITATIONS OF FINANCIAL STATEMENTS:

Though utmost care is taken in the preparation of financial statements to be useful to the
users, they suffer from the following limitations:
1) Net profit is ascertained on the basis of historical cost. If profits are adjusted to
changing price levels, it may lead to loss and consequently dividends may be paid out
of capital.
2) Accounting is done on the basis of certain conventions; eg: the assets are valued on
the going concern basis. Some of the assets may not realize the stated values, if the

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 liquidation is forced on the company. Assets shown in the balance sheet reflect merely
unexpired or unamortized cost.
3) The balance sheet is prepared at a point of time and the accounting year may be
deliberately chosen in such a manner that it gives favorable picture.
4) Financial statements are the outcome of recorded facts, concepts and conventions
used and value judgments made in different situations by the accountants. Hence,
bias may be observed in the results.
5) Financial statements show aggregate information but not specific information. Hence
they may not satisfy the users in decision making unless modified suitably.
6) Balance sheet does not disclose information relating to changes in management, loss
of markets and cessation of agreements, which have vital bearing on the enterprise.
7) Financial statements contain only monetary information but not qualitative
information like industrial relations, industrial climate, labor relations, quality of work
and labor etc.
8) Profit and loss account discloses only interim profits but not final profits. Final profits
can be known only when enterprise is liquidated.

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS:The process

of critical examination of the financial information contained in the financialstatements in
order to understand and make decisions regarding the operations of the firm iscalled
”financial statement analysis”. It is basically a study of the relationship among various
financial facts and figures as given in a set of financial statements.

OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS

1) To provide adequate information about the source of finance and obligations of the
finance firm.
2) To provide reliable information about the financial performance and financial
soundness of the concern.
3) To provide sufficient information about results of operations of business over a period
of time.
4) To provide useful information about the financial conditions of the business and
movement of resources in and out of business.

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 5) To provide necessary information to enable the users to evaluate the earning
performance of resources or managerial performance in forecasting the earning
potentials of business.

CHARACTERISTIC & FUNCTIONS OF FINANCIAL STATEMENT ANALYSIS

1) Understandability: The information must be readily understandable to users of the

financial statements. This means that information must be clearly presented, with
additional information supplied in the supporting footnotes as needed to assist in
clarification.
2) Relevance: The information must be relevant to the needs of the users, which is the
case when the information influences the economic decisions of users. This may
involve reporting particularly relevant information, or information whose omission or
misstatement could influence the economic decisions of users.
3) Reliability: The information must be free of material error and bias, and not
misleading. Thus, the information should faithfully represent transactions and other
events, reflect the underlying substance of events, and prudently represent estimates
and uncertainties through proper disclosure.
4) Comparability: The information must be comparable to the financial information
presented for other accounting periods, so that users can identify trends in the
performance and financial position of the reporting entity.

TYPES OF ANALYSIS AND INTERPRETATION:

As you have already learnt, various users of financial statements study them from different
angles for different purposes. However, the ‘modus operandi and the material used are
identified by Man Mohan and Goyal as two common bases used for classification.

I) Modus operandi: on the basis of number of years, financial statements used for analysis
and interpretation, the analysis may be classified into vertical and horizontal analysis.

a. Vertical analysis: when the analysis of financial statements of an organization is

made for only one accounting period, it is called as vertical analysis. For instance, analyzing
and interpreting the performance of a company for the year 2004 with the help of profit and

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 loss account of that company for the year ending 31st December, 2004 and the balance sheet
of that company so on that date.

Balance sheet of XYZ Company as on 31.12.2004

Amount Amount
Uses of Funds Rs Rs
Fixed Assets
Land & Building XXX
Plant & Machinery XXX
Furniture & Fixtures XXX XXX

Current Assets
Stock-in-trade XXX
Sundry Debtors XXX
Bills Receivables XXX
Cash at bank XXX
Cash in hand XXX

XXX

Current Liabilities
Sundry Creditors XXX
Bills payable XXX
Outstanding Expenses XXX

XXX XXXXX
XXXXXX
Net working capital (CA-CL)
Total net Assets

Sources of funds
Owners Funds
Equity Share Capital
Reserves & Surplus
Long Term liabilities

Total XXXXX

b. Horizontal analysis:When the analysis of financial statements of an organization is

made for two or more years, it is called as `horizontal analysis’. Since the data for more than

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one year are used, it is possible to compare the performance of the company during a year with
that of the previous year. This helps to identify the trend in various indicators of performance
such as improved profitability of an organization, its solvency, liquidity, etc., over the years.
For instance, comparison of performance of an undertaking for the year 2004 with that of
2
Capital & Liabilities Amount Assets &Property Amount
0
0
Capital: Fixed Assets
3
Equity share capital Good will
,
Preference share capital Land & Building
Reserves & Surplus Plant & Machinery
c
LONG TERM Furniture & Fixtures
a
LAIBILITIES Investments
Debentures n
Loan
Mortgage Current Assets b
Stock in trade e
Current Liabilities’ Debtors
Creditors Bills Receivable t
Bills Payables Cash at bank a
Bank Loan Cash in hand k
Outstanding Expenses e
n
XXXX XXXX

as horizontal analysis.

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II) Material used:

Analysis and interpretation of Financial Statement maybe external or internal depending upon
the material or information used.

a. External Analysis: The financial statements are prepared and presented to out sides
including shareholders and employees. Normally, external people do not have an easy access
to the detailed accounting records of the organization. The outsiders have to rely on the
figures in the financial statements and other supplement in the annual reports of the purpose
of analysis and interpretation to form an idea about the financial health of the company and to
take appropriate decisions. Such type of analysis by the people external to the organization is
called ‘external analysis. Due to this reason of non-availability of detailed information, this
type of analysis serves only a very limited purpose.

b. Internal analysis:when the financial statements of an organization are analyzed and

interpreted by the people internal to the organization and who have an easy access to the
detailed accounting records for the purpose of assisting the material personal to take correct
measures and appropriate decisions, is called “internal analysis”. As complete set of
information is available to the analyst, he can analyze the performance of the organization
clearly stating the reasons for improvements or decreasing trends in various indicators of
performance.

TECHNIQUES OF FINANCIAL ANALYSIS:

Financial statement analysis is done to emphasize the comparative and relative importance of
data presented and at the same time evaluate the position of the firm. This purpose of
financial data analysis is satisfied by using various suitable techniques. The techniques show
the relationships and changes. Most widely known techniques of financial statement analysis
are:

1) Comparative statements
2) Common size statements
3) Trend analysis
4) Funds flow statement
5) Cash flow analysis 6)Ratio analysis

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1) Comparative financial statement analysis: Here, both the profit and loss account and
balance sheet are prepared by providing columns to the figures for both, the current year as
well as for the previous year and for the changes during the year both, in absolute and relative
terms. As a result, it is possible to find out not only the balances of account as on different
dates and summarized of different operational activities of different periods, but also the
extent of their increase or decrease between these dates. The figures in the comparative
statements can be used for identifying the direction of changes and also the trends in different
indicators of performance of an organization.

2) Common size financial statement analysis: Common size statement is a financial

tool for studying the key changes and trends in the financial position (balance sheet) and
financial result (profit and loss account) of a company. Here each item in the statement is
stated as a percentage of totals of which that item is a part. Thus, each percentage exhibits the
relation of the individual item to its respective total.
First, state the total of the statement 100% and then compute the ratio of each statement item
to the statement total.
Inter-firm comparison or comparison of the company’s position with the related industry as a
whole is possible with the help of vertical common size statement analysis. Horizontal
common size statement analysis facilitates trend analysis of the financial result and financial
position of the statement of the company over the past several years.

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3) Trend analysis: The financial statements may be analyzed by computing trends of series of
information. Trend analysis determines the direction upwards or downwards and involves the
computation of the percentage relationship that each statements item bears to the same item in
the base year.

Procedure for calculating trends:

One year is taken as base year. Generally the first or the last year is taken as base year. The
figures of base year are taken as 100. The trend percentages are calculated in relation to base
year. If a figure in other year is less than the figure in base year, the trend percentage will be
less than 100 and it will be more than 100 if figure is more than the base year figure. Each
year’s figure is divided by the base year figure.

Trend ratio = present year value/base year value*100

The base period should be carefully selected. The base period should be a normal period. The
accounting procedures and conventions used for collecting data and preparation of financial
statements should be similar; otherwise the figures will not be comparable.

The interpretation of trend analysis involves a cautious study. The mere increase or decrease in
trend percentage may give misleading results. For example, an increase of 20% in current
assets may be treated favorable. If this increase in current assets is accompanied by an
equivalent increase in current liabilities, then this increase will be unsatisfactory. The increase
in sales may not increase profits if cost of production has gone up.

4) Funds flow statement:As the name implies statement of sources and uses of funds
depicts the sources from which funds are obtained and uses to which they are put.
According to Foulke defined funds flow statement as “A statement of sources and application
of funds is a technical device designed to analyze the changes in the financial conditions of a
business enterprise between two dates”.
Preparation of funds flow statement:
The preparation of funds flow statement is divided into two parts viz.,
a)Statement of changes in working capital and
b)Statement of Sources and Uses of funds.

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

12
5) Cash Flow Statement: A statement of changes in the financial position of firm on
cash basis is called a cash flow statement ..A cash flow statement summarizes the causes of
changes in cash position of business enterprises between dates of two balance sheets. It is
called a cash flow out flow (uses) of cash.
Preparation of cash Flow statement:
The cash flows shown in the statement are grouped in to three main categories of
cash inflows and cash outflows viz., Cash flows from operating activities , cash flows
investing activities and cash flows from financing activities. A brief description of these
items is discussed below:
A) Cash flows from operating activities
B) Cash flows from investing activities
C) Cash flows from financing activities
6) Ratio Analysis:Single most important techniqueof financial analysisin which
quantitiesare converted into ratios for meaningful comparisons, with past ratios and ratios of
other firms in the same or different industries. Ratio analysis determines trendsand exposes
strengthsor weaknesses of a firm.-Bust Noon

2. RATIO ANALYSIS:
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick
indication of a firm's financial performance in several key areas. The ratios are categorized as
Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios,
Profitability Ratios, and Market Value Ratios.

Ratio Analysis as a tool possesses several important features. The data, which are provided
by financial statements, are readily available. The computation of ratios facilitates the
comparison of firms which differ in size. Ratios can be used to compare a firm's financial
performance with industry averages. In addition, ratios can be used in a form of trend
analysis to identify areas where performance has improved or deteriorated over time.

Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by
the distortions which arise in financial statements due to such things as Historical Cost
Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

financial analysis, to obtain a quick indication of a firm's performance and to identify areas
which need to be investigated further.

OBJECTIVES OF RATIO ANALYSIS:

(1) Measuring the profitability: Profitability is the profit earning capacity of the
business. This can be measured by Gross Profit, Net Profit, Expenses and Other Ratios. If
these ratios fall we can take corrective measures.

(2) Determining operational efficiency: Operational efficiency of the business can be

determined by calculating operating / activity ratios.

(3) Measuring financial position: Short-term and long-term financial position of the
business can be measured by calculating liquidity and solvency ratios. In case of unhealthy
short or long-term position, corrective measures can be taken.

(4) Facilitating comparative analysis: Present performance can be compared with past
performance to discover the plus and minus points. Comparison with the performance of
other competitive firms can also be made.

(5) Indicating overall efficiency: Profit and Loss Account shows the amount of net profit
and Balance Sheet shows the amount of various assets, liabilities and capital. But the
profitability can be known by calculating the financial ratios.

(6) Budgeting and forecasting: Ratio analysis is of much help in financial forecasting
and planning. Ratios calculated for a number of years work as a guide for the future.
Meaningful conclusions can be drawn for future from these ratios.

ADVANTAGES OF RATIO ANALYSIS

1. Performance over time: Ratio analysis is a strong indicator of the financial
performance of a company over time. An analyst can calculate the same ratio across
different time periods to identify particular components of a company’s financial
performance that may be improving or declining. Ratio analysis uses relative
percentages rather than dollar amounts, allowing for ease of comparison across
periods. Ratio analysis may help distinguish between firms that may fail and firms
UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT
14
 that are profitable. Through the careful use of financial ratio analysis, an analyst may
be able to detect financial troubles up to five years before a firm fails.

2. Performance against competitors: Ratio analysis can be used to assess the

performance of a company against other competitors that operate within the same
industry. Companies that operate in the same industry generally exhibit similar
financial profiles. Thus, a calculated ratio that is significantly above or below the
industry average may indicate a particularly strong or particularly weak performance
by the company in certain areas.

DISADVANTAGES OF RATIO ANALYSIS

1. Narrow Focus: Ratio analysis may lead to a narrow focus on certain elements of a
company’s financial performance. It is important to consider all ratios in relation to
one another.
2. Accounting Methodologies: Certain ratios may be adversely affected by a
company’s accounting methodologies.

TOOLS FOR RATIO ANALYSIS (OR) TYPES RATIO :

1) Liquidity Ratios: They measure the firm’s ability to meet current obligations.
Current ratio, cash ratio, quick ratio, net working capital ratio it measures the firm’s
ability to meet current obligations

2) Leverage Ratios: These ratios show the proportion of debt and equity in financing
thefirm’s assets. Debt ratio, debt equity ratio capital employed to net worth ratio it
shows the proportions of debt and equity in financing the firm’s assets

3) Activity Ratios: They reflect the firm’s efficiency in utilizing the assets.Inventory
turnover ratio, debt turnover ratio, collection period, total assets turnover ratio, fixed
and current assets turnover ratio, creditor turnover ratio, working capital ratio etc,
Activity ratio reflect the firms efficiency in utilizing its assets

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

 4) Profitability Ratios: These ratios measure overall performance and effectiveness of
thefirm. Gross profit, net profit, operating, return on equity, return on investment .it
measures overall performance and effectiveness of the firm.

3. DUPONT CHART
The DuPont analysis also called the DuPont model is a financial ratio based on the return on
equity ratio that is used to analyze a company’s ability to increase its return on equity. In
other words, this model breaks down the return on equity ratio to explain how companies can
increase their return for investors.
The DuPont analysis looks at three main components of the ROE ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage
The DuPont Corporation developed this analysis in the 1920s. The name has stuck with it
ever since
Based on these three performances measures the model concludes that a company can raise
its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets
more effectively.
Formula
The Dupont Model equates ROE to profit margin, asset turnover, and financial leverage. The
basic formula looks like this.

Since each one of these factors is a calculation in and of itself, a more explanatory formula
for this analysis looks like this.

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

16
Every one of these accounts can easily be found on the financial statements. Net income and
sales appear on the income statement, while total assets and total equity appear on the
balance sheet.

USE OF DUPONT ANALYSIS

Using the modified equation of Return on Equity, one can make a more informed decision
and understand the company position better. If the Return on Equity either increases due to
increase in operating efficiency or improved asset utilization, it is a good sign for investors. It
would imply that either company is making higher margins on its sales or the company is
making better use of its assets or both.
On the other hand, if the Return on Equity increases on account of financial leverage, it
would imply that the profit is due to the financial strategy of the company rather than good
operations of it. Too higher a debt ratio also makes a company riskier proposal for
investment.
In essence, a manager should try increasing the ROE by way of either higher operating
efficiency or better asset utilization. There is no reservation for using the third parameter also
i.e. financial leverage, but it will increase the risk of bankruptcy in case the lenders asks for
the large sum of money.

Example Explaining DuPont Analysis

Consider a hypothetical scenario of companies X and Y with below numbers.
X Y
1. Operating profit margin ratio 0.20 0.12
2. Asset turnover ratio 0.30 0.30
3. Financial Leverage or Equity multiplier 2.00 3.33
ROE (1*2*3) 0.12 0.12

UNIT-4 Financial Analysis -I | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

 135000

135000
d
 d

d
 d
Type

d
 d

IMPORTANT QUESTIONS
UNIT-4
 What is ratio analysis? Explain types of ratio with formulas?
 Importance (or) Advantages & disadvantages of Ratio analysis?
 What is financial analysis? Explain Du Pont chart analysis ?
Problems: RATIO ANALYSIS MOST IMPORTANT.

UNIT-4 Financial Analysis -I DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANA

UNIT-5 FINANICAL ANALYSIS – II | DR K.V.SUBBA REDDY SCHOOL OF BUSINESS MANAGEMENT

 Unit-5
OBJECTIVE
After studying this lesson, you will be able to know :
(a) Meaning of Funds, Flow of Funds and Funds Flow Statement.
(b) Preparation of Funds Flow Statement.
(c) Uses and Limitations of Funds Flow Statement.

INTRODUCTION

The basic financial statements, i.e., the Balance Sheet and Profit and LossAccount 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 BalanceSheet 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 onthe 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 takeplace 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 liabilitiesfrom 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 disbursementsof 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 currentassets over current
liabilities. The working capital concept of funds has emerged dueto thefact that total resources of a business are
invested partly in fixed assets in the form of fixedcapital 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.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 MEANING OF FLOW OF FUNDS 2
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 anothernon-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 notresult 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 notresult 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 orlong-term loans.
8. Writing off of fictitious assets.
9. Writing off a accumulated losses or discount on issue of shares, etc.

KVSB Dr. K .V . Subba Reddy School Of Business Management

(c) Transactions which involve both current and non-current accounts andhence result in3
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 FLOWSTATEMENT
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
consistsof following two parts :
1. Statement or Schedule of Changes in Working Capital

2. Statement of Sources and Application of Funds

KVSB Dr. K .V . Subba Reddy School Of Business Management

1. Statement or Schedule of Changes in Working Capital 4
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.
Statement or Schedule of Changes in Working Capital
Effect on
Particulars Previous Current Working Capital
Year Year Increase Decrease
Current Assets :
Cash in hand
Cash at bank
Bills Receivable
Sundry Debtors
Temporary Investments
Stock/Inventories
Prepaid Expenses
Accrued Incomes

Total Current Assets

Current Liabilities :
Bills Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term advances
Dividends Payable
Proposed dividends*
Provision for taxation*
Total Current Liabilities

Working Capital (CA-CL)

Net Increase or Decrease in

Working Capital
* May or may not be a current liability

KVSB Dr. K .V . Subba Reddy School Of Business Management

 5
Illustration 1. Prepare a Statement of changes in Working Capital from the followingBalance Sheets of
Manjit and Company Limited.
BALANCESHEETS
as on 31st March
Liabilities 2001 2002 Assets 2001 2002
Rs. Rs. Rs. Rs
EquityCapital 5,00,000 5,00,000 Fixed Assets 6,00,000 7,00,000
Debentures 3,70,000 4,50,000 Long-term
TaxPayable 77,000 43,000 Investments 2,00,000 1,00,000
AccountsPayable 96,000 1,92,000 Work-in-Progress 80,000 90,000
Interest Payable 37,000 45,000 Stock-in-trade 1,50,000 2,25,000
Dividend Payable 50,000 35,000 AccountsReceivable 70,000 1,40,000
Cash 30,000 10,000
11,30,000 12,65,000 11,30,000 12,65,000
Solution :

Statement of Changes in Working Capital

Effect on
Working Capital
Particulars 2001 2002
Rs. Rs. Increase Decrease
Rs. Rs.
Current Assets :
Cash 30,000 10,000 20,000
Accounts Receivable 70,000 1,40,000 70,000
Stock-in-trade 1,50,000 2,25,000 75,000
Work-in-progress 80,000 90,000 10,000
3,30,000 4,65,000
Current Liabilities :
Tax Payable 77,000 43,000 34,000
Accounts Payable 96,000 1,92,000 96,000
Interest Payable 37,000 45,000 8,000
Dividend Payable 50,000 35,000 15,000
2,60,000 3,15,0000
Working Capital (CA-CL) 70,000 1,50,000
Net Increase in Working Capital 80,000 80,000
1,50,000 1,50,000 2,04,000 2,04,000

KVSB Dr. K .V . Subba Reddy School Of Business Management

 6
2. Statement of Sources and Application of Funds
Funds flow statement is statement which indicates various sources from which funds
(working capital) have been obtained during certain period and the uses or applications to which these
funds have been put during that period. Generally, this statement is prepared in two formats :
(a) Report Form
(b) T Form or An Account Form or Self Balancing Type.
Specimen of Report Form of Funds Flow Statement

Sources of Funds : Rs.

Funds from Operations Issue
of Share Capital Raising of
long-term loans
Receipts from partly paid shares, called upSales of
non current (fixed) assets
Non-trading receipts, such as dividends receivedSale of
Investments (long-term)
Decrease in working capital (as per Schedule ofChanges in
Working Capital)
Total
Applications or Uses of Funds :
Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of long-term loans Purchase
of non-current (fixed) assetsPurchase of
long-term Investments Non-trading
payments
Payments of dividends*
Payment of tax*
Increase in Working Capital (as per Schedule ofChanges in
Working Capital)
Total

KVSB Dr. K .V . Subba Reddy School Of Business Management

 T Form or An Account Form or Self Balancing TypeFunds Flow 7
Statement

Sources Rs. Applications Rs.

Funds from Operations Issue Funds lost in Operations
of Share Capital Issue of Redemption of Preference
Debentures Raising of long- Share Capital Redemption
term loansReceipts from of DebenturesRepayment of
partly paid long-term
shares, called up loans
Sale of non-current (fixed) Purchase of non-current
assets Investments
Sale of long-term Investments Net Non-trading payments
Decrease in Working Capital Payment of Dividends
Net Increase in Working Capital

* Note : Payment of dividend and tax will appear as an application of funds only whenthese items are
appropriations of profits and not current liabilities.
Sources of Funds : The following are the sources from which funds generally flow(come), into the
business :
1. Funds from operation or Trading Profits
Trading profits or the profits from operations of the business are the most important and
major source of funds. Sales are the main source of inflow of funds into the business as they increase
current assets (cash, debtors or bills receivable) but at the same time funds flow out of business for
expenses and cost of goods sold. Thus, the net effect of operations will be a source of funds if inflow from
sales exceedsthe outflow for expenses and cost of goods sold and vice-versa. But it must be
remembered that funds from operations do not necessarily mean the profit as shown by the Profit and
Loss Account of a firm, because there are many non-fund or non- operating items which may have been
either debited or credited to Profit and Loss Account. The examples of such items on the debit side of a
Profit and Loss Accounts are amortization of fictitious and intangible assets such as goodwill,
preliminary expenses and discount on issue of shares and debentures written off, appropriation of retained
earnings, such as transfers to reserves, etc., depreciation and depletion, loss on sale of fixed assets,
payment of dividend, etc. The non-fund items are those which may be operational expenses but they do
not affect funds of the business, e.g., in case of depreciation charged to Profit and Loss Account, funds
really do not move out of business. Non-operating items are those which although may result in the
outflow of funds but are not related to the trading operations of the business, such as loss on sale of
machinery or payment of dividends. There are two methods of calculating funds from operations which
are as follows :
(a) The first method is to prepaid the Profit and Loss Account afresh by taking into consideration only
fund and operational items which involve funds and are related to the normal operations of the business.
The balancing figure in this case will be either funds generated from operations or funds lost in
operations depending upon whether the income or credit side or Profit and Loss Account exceeds the
expense or debitside of Profit and Loss Account or vice-versa.

KVSB Dr. K .V . Subba Reddy School Of Business Management

(b) The second method (which is generally used) is to proceed from the figure of net profit or ne8t loss
as arrived at from the Profit and Loss Account already prepared. Funds from operations by this method
can be calculate as under :
(a) Calculation of Funds from Operation

Rs.
Closing BalanceofProfit and Loss Account (asgiven inthe Balance Sheet)
Add :Non-fund and Non-operating items which have beenalreadydebited to Profi and
Loss Account :
(i) Depreciationand Depletion
(ii) Amortizationoffictitiousand Intangible Assetssuch as :
Goodwill/ Patents/Trade marks/Preliminary Expenses/
Discount onIssueofShares, etc.
(iii) AppropriationofRetained Earnings, suchas :
Transfer to GeneralReserve/ Dividend Equalisation Fund/
Transferto Sinking Fund/ ContingencyReserveetc.
(iv) Loss on the Sale of anynon-current (fixed) assets such as :
Lossonsaleofland and building/Lossonsaleofmachinery/
Lossonsaleof furniture/Lossonsaleof long-terminvestmentsetc.

(v) Dividendsincluding:
InterimDividend/ Proposed Dividend(if it is anappropriationofprofits
and not taken as current liability)

(vi) Provisionfor Taxation(if it is not takenas Current Liability)

(vii) Anyothernon-fund/non-operatingitems whichhave beendebitedto Profit and
Loss Account
Total(A)
Less Non-fundor Non-operating items which havealreadybeencreditedto
Profit and Loss Account
(i) Profit or Gain fromthesaleofnon-current (fixed) assets such as :
Saleoflandandbuilding/Saleofplant& machinery/
Saleoflong-terminvestments, etc.
(ii) Appreciation inthe valueoffixedassets, such as increase in the
valueofland if it hasbeencreditedto Profit and Loss Account
(iii) DividendsReceived
(iv) Excess Provisionretransferred to Profit and Loss Account orwrittenoff
(v) Anyother non-operating itemwhich has beencreditedto Profit and Loss Account
(vi) OpeningbalanceofProfit and Loss Account or Retained Earnings
(as given in the Balance Sheet)
Total(B)
Total(A) – Total(B) = Funds generated byoperations

KVSB Dr. K .V . Subba Reddy School Of Business Management

 9
(b) Funds from operations can also be calculated by preparing Adjusted Profit andLoss Account as
follows :
Adjusted Profit and Loss Account

Rs. Rs.
To Depreciation & Depletion ByOpening Balance(of
or amortization of fictitious and P&L A/c)
intangible assets, such as : By Transfers from excess
Goodwill, Patents, Trade Marks, provisions
Preliminary Expenses etc. By Appreciation in the
To Appropriationof Retained value of fixed assets
Earnings, such as : By Dividends received By
Transfersto General Profit on sale of fixed
Reserve, Dividend Equalisation or non-current assets By
Fund, Sinking Fund, etc. Funds fromOperations
To Loss on Sales of any non-currentor (balancing figure in case
fixed assets debit side exceeds credit
To Dividends(includinginterim side)
dividend)
To Proposed Dividend (if nottaken as
a current liability)
To Provision for taxation (ifnot
taken as a current liability)
To Closing balance (of P&LA/c)
To Funds lost in Operations
(balancing figure, in case
credit side exceeds the debit
side)

KVSB Dr. K .V . Subba Reddy School Of Business Management

 10
Illustration 2 : Nikhil Company presents the following information and you arerequired to calculate
funds from operations :
Profit and Loss Account

Particulars Rs. Particulars Rs.

To Expenses : By Gross Profit 2,00,000
Operation 1,00,000 By Gain on Sale of Plant 20,000
Depreciation 40,000
To Loss on Sale of building 10,000
To Advertisement written off 5,000
To Discount allowed to customers 500
To Discount on Issue of Shares
written off 500
To Goodwill 12,000
To Net Profit 52,000
2,20,000 2,20,000
Solution :
Calculation of Funds From Operations

Rs.
Net Profit (as given) 52,000
Add : Non-fund or non -operating items which have been
debited to Profit and Loss Account
Depreciation 40,000
Loss on sale of Building 10,000
Advertisement written off 5,000
Discount on issue of shares written off 500
Goodwill written off 12,000 67,500
1,19,500
Less : Non-fund or non-operating items which
have been credit to Profit and Loss Account :
Gain on sale of Plant 20,000 20,000
Funds from Operations
99,500

KVSB Dr. K .V . Subba Reddy School Of Business Management

 11
Alternatively :
Adjusted Profit and Loss Account

Rs. Rs.
To Depreciation 40,000 By Opening balance –
By Gain on sale of plant By
To Loss on sale of building 10,000 20,000
Funds from Operations
To Advertisement written off 5,000 (balancing figure)
To Discount on Issue of Shares 500 99,500
To Goodwill 12,000
To Closing balance 52,000

1,19,500 1,19,500

2. Issue of Share Capital and Debentures

If during the year there is any increase in the share capital, whether preference or equity, it
means capital has been raised during the year. Issue of shares/ debentures is a source of funds as it
constitutes inflow of funds. Even the calls received from partly paid shares/debentures constitutes an
inflow of funds. It should also be remembered that it is the net proceeds from the issue of share capital
which amounts to a source of funds and hence in case shares are issued at premium, even the amount of
premium collected shall become a source of funds. The same is true when shares are issued at discount;
it will not be the nominal value of shares but the actual realisationafter deducting discount that shall amount
to inflow of funds. But sometimes shares are issued otherwise than in cash, the following rules must be
followed :
(i) Issue of shares or making of partly paid shares as fully paid out of accumulated profits in the form
of bonus shares is not a source of funds.
(ii) Issues of shares for consideration other than current assets such as against purchase of land,
machines, etc. does not amount to inflow of funds.
(iii) Conversion of debentures or loans into shares also does not amount to inflowof funds.
In all the three cases mentioned above, both the accounts involved arenon-current and
do not involve any current assets or funds.
3. Sale of Fixed (non-current assets) and Long-term or Trade investments
When any fixed or non-current asset like land, building, plant and machinery, furniture,
long-term investments, etc. are sold it generates funds and becomes a source of funds. However, it must
be remembered that if one fixed asset is exchanged for another fixed asset, it does not constitute an
inflow of funds because nocurrent assets are involved.
4. Non-Trading Receipts
Any non-trading receipt like dividend received, refund of tax, rent received, etc. also
increases funds and is treated as a sources of funds because such an income is not included in the funds
from operations.
5. Decrease in Working Capital
If the working capital decreases during the current period as compared to the previous
period, it means that there has been a release of funds from working capital and it constitutes a source of
funds.

KVSB Dr. K .V . Subba Reddy School Of Business Management

Application or Uses of Funds 12

1. Funds lost in operations

Sometimes the result of trading in a certain year is a loss and some fundsare lost during that
period in trading operations. Such loss of funds in trading amounts to an outflow of funds and is treated as
an application of funds.
2. Purchase of fixed assets
Purchase of fixed assets such as land, building, plant, machinery, long- term investments,
etc., results in decrease of current assets without any decrease in current liabilities. Hence, there will be a
flow of fund. But in case shares or debentures are issued for acquisition of fixed assets, there will be no
flow of funds.
3. Payment of dividend
Payment of dividend results in decrease of a fixed liability and, therefore, it affects funds.
Generally, recommendation of directors regarding declaration of dividend (i.e., proposed dividends) is
simply taken as an appropriation of profits and not as an item affecting the working capital.
4. Payment of fixed liabilities
Payment of a long-term liability, such as redemption of debentures or redemption of
redeemable preference shares, results in reduction of working capital and hence it is taken as an
application of funds.
5. Payment of tax liability
Provision for taxation is generally taken as an appropriation of profits and not as
application of funds. But if the tax has been paid, it will be taken as an application of funds.
HIDDENTRANSACTIONS
While preparing a Funds Flow Statement, one has to analyse the given balance sheets.
Items relating to current accounts, i.e., current assets and current liabilities have to be shown in the
Schedule of Changes in Working Capital. But the non-current assets and non-current liabilities have to
be further analysed to find out the hidden information with regard to sale or purchase of non-current
assets, issue or redemption of share capital, raising or repayment of long-term loans, transfer to reserveand
provisions, etc. The following items require special care while preparing a Funds Flow Statement :
1. Fixed Assets
Sometimes there are certain adjustments or transactions of sale andpurchase of fixed assets
which are given after two Balance Sheets. Under such circumstances, it is desirable to prepare accounts
relating to such fixed assets and provisions or reserve for depreciation. The working of these accounts will
be as follows:
Fixed Asset Account

Particulars Rs. Particulars

Rs.
To Opening Balance b/d By Adjusted Profit & Loss
To Bank (Purchase of an (Dep.)
Asset : Bal. fig.) By Bank (Sale of an Asset)
To Adjusted Profit & Loss A/c By Adjusted Profit & Loss A/c
(Profit on Sale) (Loss on Sale)

By Balance c/d

KVSB Dr. K .V . Subba Reddy School Of Business Management

 Depreciation Account 13

Particulars Rs. Particulars Rs.

To Fixed Asset A/c By Opening Balance b/d
(Accumulated depreciation relating By Adjusted Profit & Loss A/c
to asset transferred or sold) (New provision or reserve)
To Closing Balance c/d

Illustration 3 : The following figures are available from the records of a Company :

2001 2002
Rs. Rs.

Plant and Machinery 80,000 1,20,000

Additional Information :
(i) Depreciation charged during the year 50,000
(ii) A part of the plant whose written down value is Rs. 12,000 has been sold for Rs. 7,000
Prepare Plant and Machinery A/c.

Solution :

Plant and Machinery Account

Rs. Rs.
To Balance b/d 80,000 By Adjusted Profit & Loss A/c (Dep.) 50,000
To Bank A/c ByBank A/c (Sale) 7,000
ByAdjusted P/LA/c (Losson Sale
(PurchaseofPlant &Machinery) ofMachinery) 5,000
(Bal. Fig.) 1,02,000 ByBalance c/d

1,20,000

1,82,000 1,82,000
Thus depreciation of Rs. 50,000 and loss on sale of machinery Rs. 5,000 will be shown on
the debit side of Adjusted Profit and Loss Account. Rs. 7,000 realised from the sale of plant will be shown
as source and Rs. 1,02,000 i.e. purchased of plant and machinery as application in the Funds Flow
Statement.
2. Proposed Dividend : It can be treated as an item of current liability or non- current liability but
preferably it should be treated as non-current liability. For knowing hidden transactions relating to
dividend, it is desirable to prepare proposed dividend account as follows (in case treated as non-current
liability) :

KVSB Dr. K .V . Subba Reddy School Of Business Management

 14
Proposed Dividend Account

Rs. Rs.
To Bank(Payment ofdividendof ByOpening Balance b/d
last year) By Adjusted Profit & Loss A/c
To Closing Balancec/d (Provisionmade for thecurrent year)
(Bal.fig.)

If dividend paid during the year is not given, then it is assumed that last year balance must
have been paid during the year and provision made during the year must be equal to the closing balance.
Interim dividend has nothing to do with proposed dividend account. If interim dividend is paid it will be
shown on the debit side of Adjusted Profit and Loss Account and on the application side of Funds Flow
Statement. If treated as current liability it will be shown in Schedule of Changes in Working Capital and
dividend paid will be shown on the debit side of Profit and Loss Account and as an application in the
Funds Flow Statement.
3. Provision for Income tax. Like proposed dividend it can be treated as current liabilities or non-
current Liability. But preferably it should be treated as non-current liability. If income tax paid during the
year is not given, then it is assumed that last year balance must have been paid during the year and will be
shown as an application in the Funds Flow Statement. Provision made during the year must be the closing
balance ofsuch account and will be shown on the debit side of Adjusted Profit and Loss A/c.
Income Tax payable is a current liability. The provision for income tax account is prepared as under (if
treated as non-current liability) :
Provision for Taxation Account

Rs. Rs.
To Bank (Taxpaid) By Opening Balance c/d
To Closing Balance c/d By Profit & Loss A/c
(Provision made) (Bal. fig.)

If treated as a current liability, it will be shown in the Schedule of Changes in Working

Capital and tax paid will be shown as an application in the Funds Flow Statement and on the debit side of
Profit and Loss Account.
4. Fictitious Assets : If there are certain fictitious assets shown in the Balance Sheet such as discount
on issue of shares or debentures, preliminary expenses, underwriting commission, etc., then the balance to
be written off to the Adjusted Profit and Loss Account can be calculated by preparing the fictitious asset
account. It will beprepared as follows :
Fictitious Asset Account

Rs. Rs.
To Opening Balance c/d By Adjusted Profit & Loss A/c
(Bal. fig.) (written off)
By Balance c/d

KVSB Dr. K .V . Subba Reddy School Of Business Management

5. Undistributed Reserves and Funds : If there are any undistributed profits in the form of res1e5r ves
and funds the difference of these reserves and funds will be shown on the debit or credit side of Adjusted
Profit and Loss Account. If it increases, it will be shown on the debit side, if it decreases, will be shown on
the credit side. The accountis shown as under :
Reserve Account

Rs. Rs.
To Adjusted Profit & Loss A/c(reserve By Balance c/d
utilised) By Adjusted Profit and Loss A/c
To Balance c/d (new reserve)

Illustration 4 : From the following balances extracted from XYZ Company Ltd. as on 31st March, 2001
and 2002, you are required to prepare a schedule of changes in Working Capital and a Funds Flow
Statement.
As on As on
Liabilities 31st March Assets 31st March

2001 2002 2001 2002

Share Capital 1,00,000 1,10,000 Building 40,000 38,000

GeneralReserve 14,000 18,000 PlantandMachinery 37,000 36,000

P & L A/c 16,000 13,000 Investment(L.T.) 10,000 21,000
Creditors 8,000 5,400 Stock 30,000 23,400
B/P 1,200 800 B/R 2,000 3,200
Provisionfor Tax 16,000 18,000 Debtors 18,000 19,000
Provisionfor DoubtfulDebt 400 600 Cashat Bank 6,600 15,200
PreliminaryExpenses 12,000 10,000

1,55,600 1,65,800 1,55,600 1,65,800

Additional Information :

(i) Depreciation charged on Plant was Rs. 4,000.

(ii) Provision for taxation Rs. 19,000 was made during the year 2001-02.

(iii) Interim dividend of Rs. 8,000 was paid during the year.

(iv) A piece of machinery was sold for Rs. 8,000 during the year 2001-02. It hadcosted Rs. 12,000,
depreciation of Rs. 7,000 has been provided on it.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 16
Solution :
Schedule of Changes in Working Capital

2001 2002 Increase Decrease

Rs. Rs. Rs. Rs.
Current Assets :
Stock 30,000 23,400 6,600
B/R 2,000 3,200 1,200
Debtors 18,000 19,000 1,000
Cash at Bank 6,600 15,200 8,600
Current Liabilities :
Creditors 8,000 5,400 2,600
B/P 1,200 800 400
Provisionfor DoubtfulDebts 400 600 200
13,800 6,800
7,000
13,800 13,800
Funds Flow Statement for the year ended 31.03.2002
Sources Rs. Uses Rs.
Funds fromOperation(a) 33,000 Purchaseof Machinery(b) 8,000
SaleofMachinery 8,000 PaymentofInterimDivided 8,000
IssueofShare Capital 10,000 PurchaseofInvestment 11,000
PaymentofTax(c) 17,000
Increase in Working Capital 7,000
51,000 51,000
Working Notes :
(a) Adjusted Profit and Loss Account

Rs. Rs.
ToInterimDivided 8,000 ByNet Profit b/d 16,000
ToDepreciationofBuilding 2,000 ByProfit on Sale ofMachinery 3,000
ToPreliminaryExpenses 2,000 ByFund fromOperations 33,000
To GeneralReserves 4,000
To DepreciationonPlant and Machinery 4,000
To Provisionfor TaxA/c 19,000
To Net Profit c/d 13,000
52,000 52,000

KVSB Dr. K .V . Subba Reddy School Of Business Management

 17
(b) Plant and MachineryAccount

Rs. Rs.
To Balance b/d 37,000 By Adjusted P & L A/c(Dep.) 4,000
To Adjusted P&LA/c (Profit) 3,000 By Bank A/c 8,000
To Bank(PurchaseofMachinery) 8,000 ByBalance c/d 36,000
(Bal.figure)

48,000 48,000
(c) Provision for Tax Account

Rs. Rs.
To Bank A/c (Bal. Fig.) 17,000 ByBalance b/d 16,000
To Balance c/d 18,000 By Adjusted P&LA/c 19,000

35,000 35,000

6. Net Profit or Drawings. Sometimes in case of sole trader or partnership concerns, capital of the
proprietor or partners is given but figures of drawings or net profit may be missing. In order to find out
these figures, capital account may preparedas follows :
Capital Account

Rs. Rs
To Bank(Drawings) ByBalance b/d
(Bal.fig.) By Adjusted P & L A/c
To Balance c/d (NetProfit)(Bal. fig.)

7. Intangible Assets. Intangible assets as goodwill, patents, copyrights, licences are also written off
from the Adjusted Profit and Loss Account. Till these assets are completely written off their balances will
be shown in the Balance Sheet. Sometimes additions are also made to these assets. Balance to be written
off will be the balancing figure. Such assets accounts are prepared as follows :

Intangible Asset Account

Rs. Rs
To Balance b/d ByAdjusted Profit & Loss A/c
To Bank Share Capital A/c (writtenoff)
(purchase for cashor issue ByBalance c/d
ofsharecapital

KVSB Dr. K .V . Subba Reddy School Of Business Management

8. Redemption of Debentures : When debentures are to be redeemed during a specified peri1o8d, it
must be seen whether the total payment to be made is more or less than the face value of debentures. If it
is more than the face value, the excess will be charged to Adjusted Profit and Loss Account as loss on
redemption and if less than the face value, the difference will be profit on redemption and will be shown
on the credit side of Adjusted Profit and Loss Account. Actual amount paid will be shown an application
in the Funds Flow Statement. The account will be prepared as under :
Debentures Account
Rs. Rs.
To Bank(Actualamount paid) ByOpening Balance
To Adjusted Profit and LossA/c By Adjusted Profit and Loss A/c
(Bal. Fig.) (lossonredemption)
(Profit onredemption) (Bal. Fig.)

9. Redemption of reference Share : Like redeemable debentures, the redeemable preference shares
can be redeemed by the company either at premium or at discount. Excess amount of premium paid
alongwith the face value of the shares will be a chargeto Adjusted Profit and Loss Account while discount
gained on redemption will be credited to Adjusted Profit and Loss Account. The account of redeemable
shares will be prepared as under :
RedeemablePreference ShareCapitalAccount
Rs. Rs.
To Bank ByOpening Balance b/d
To Profit and Loss A/c ByProfit and Loss A/c
(GainonRedemption) (PremiumonRedemption)

10. Bonus Shares : Bonus shares are those shares which are issued to the existing shareholders in
certain proportion without receiving anything in cash from them. Such shares are issued from existing
balances of various accounts such as capital redemption reserve, shares premium, general reserve or Profit
and Loss Account. If indication to this respect is given, then that account is prepared in order to see the
net effect of the account to be taken to Adjusted Profit and Loss Account.
Is depreciation a source of funds?
Depreciation means decrease in the value of an asset due to wear and tear, lapse of time,
obsolescence, exhaustion and accident. Depreciation is taken as an operating expense while calculating
funds from operations. The accounting entries are:
(i) Depreciation A/c Dr.
To Fixed Asset A/c
(ii) Profit and Loss A/c Dr. To
Depreciation A/c
Thus, effectively the Profit and Loss Account is debited while the Fixed Asset Account is
credited with the amount of depreciation. Since, both Profit and Loss Account and the Fixed Asset
Account are non-current accounts, depreciation is a non- fund item. It is neither a source nor an application
of funds. It is added back to Operating Profit to find out funds from operations since it has already been
charged to profit but it does not decrease funds from operations. Depreciation should not, therefore,
be taken as a 'Source of Funds'. If depreciation were really a source of funds by itself, anyenterprise could
have improved its funds position at will by merely increasing the periodical depreciation charge.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 However, depreciation can be taken as a source of funds in a limited sense becau1s9e of
three reasons :
(i) In case of manufacturing concern, when current assets include closing inventoryis and the value of
closing inventories includes the depreciation on fixed assets as an element of cost, depreciation acts as a
source of funds in such a case.
(ii) Depreciation does not generate funds but it definitely save funds. For example, if the business had
taken the fixed assets on hire, it would have been required to pay rent for them. Since it owns fixed
assets, it saves outflow of funds which would have otherwise gone out in the form of rent.
(iii) Depreciation reduces taxable income and therefore, income-tax liability for the period is
reduced. This will be clear with the following example.
Case I Case II
Income before depreciation Rs. 75,000 Rs. 75,000
Depreciation provided (A) Nil 15,000
Taxable income 75,000 60,000
Income tax say at 50 per cent 37,500 30,000
Net Income after (B) 37,500 30,000
Net flow of funds after tax (A) + (B) 37,500 45,000
The above example shows that in case II, the net flow of funds is more by Rs. 7,500 as
compared to case I. This is because on account of depreciation charge being claimed as an expense, tax
liability has been reduced by Rs. 7,500 in case of case II. It may therefore be said that true funds flow from
depreciation is the opportunitysaving of cash outflow through taxation.
Illustration 5 : From the following details relating to the accounts of Kapil & Co.Ltd., prepare Statement
of Sources and Applications of Funds :

Liabilities 31.03.2002 31.03.2001 Assets 31.03.2002 31.03.2001

Share Capital 4,00,000 3,00,000 Goodwill 90,000 1,00,000
Reserve 1,00,000 80,000 Plant&Machinery 4,29,250 2,98,000
Profit & Loss A/c 50,000 30,000 DebenturesDiscount 5,000 8,000
Debentures 1,00,000 1,50,000 Prepaid Expenses 5,750 4,000
IncomeTaxProvision 40,000 50,000 Investments 60,000 1,00,000
Trade Creditors 70,000 90,000 SundryDebtors 1,10,000 1,60,000
Proposed Dividend 40,000 30,000 Stock 80,000 50,000
Cash and Bank balances 10,000
20,000
8,00,000 7,30,000 8,00,000 7,30,000
(i) 15% depreciation has been charged in the accounts on Plant and Machinery
(ii) Old machines costing Rs. 50,000 (W.D.V. Rs. 20,000) have been sold for Rs.35,000.
(iii) A machine costing Rs. 10,000 (W.D.V. Rs. 3,000) have been discarded.
(iv) Rs. 10,000 profit has been earned by sale of investments.
(v) Debentures have been redeemed at 5% premium.
(vi) Rs. 45,000 income tax has been paid and adjusted against Income-tax ProvisionAccount.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 Solution : 20
Funds Flow Statement
Rs. Rs.
SaleofMachine 35,000 PurchaseofMachine (3) 2,30,000
SaleofInvestments(4) 50,000 PaymentofDebentures 52,500
IssueofShares 1,00,000 PaymentofIncomeTax 45,000
Funds fromOperations(2) 1,84,250 PaymentofDividend 30,000
Increase in workingcapital(1) 11,750
3,69,250 3,69,250

KVSB Dr. K .V . Subba Reddy School Of Business Management

 21
Working Notes :
(1) Schedule of Changes in Working Capital

Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets :
Stock 50,000 80,000 30,000
SundryDebtors 1,60,000 1,10,000 50,000
Cashand Bank Balances 10,000 20,000 10,000
Prepaid Expenses 4,000 5,750 1,750
Current Liabilities :
Trade Creditors 90,000 70,000 20,000
Working Capital (CA-CL) 134000 145750 61,750 50,000
Increase in Working Capital 11750 11,750

145750 145750 61,750 61,750

(2) Adjusted Profit and Loss Account

Rs. Rs.
ToGoodwill 10,000 ByBalance b/d 30,000
To Losson Machine Discarded 3,000 ByProfit on SaleofMachine 15,000
To DebentureDiscount 3,000 ByProfit onSaleofInvestment 10,000
To GeneralReserve 20,000 ByFunds fromOperations 1,84,250
To Debentures(Premium) 2,500
To Income-tax Provision(5) 35,000
To Proposed Dividend 40,000
To Depreciationon Plant &
Machinery(3) 75,750
To Balance c/d 50,000
2,39,250 2,39,250

KVSB Dr. K .V . Subba Reddy School Of Business Management

 22
(3) Plant and Machinery Account

Rs. Rs.
To Balance b/d 2,98,000 ByBank A/c 35,000
ByProfit and Loss A/cBy
To Profit and Loss A/c 15,000 Depreciation A/c 3,000
15% on Rs. 2,75,000
To Bank (Purchase ofMachinery)
15% on Rs. 2,30,000
(Bal. fig.) 2,30,000 ByBalance c/d 41,250
34,500
4,29,250
5,43,000 5,43,000

* Closing Balance 4,29,250

Less : W.D.V. of Old Machine (2,75,000-41,250) 2,33,750
W.D.V. of additions 1,95,500
So Depreciation charged onaddition within the year = 15
85
× 1,95,5000
= Rs. 34,500

(4) Investment Account

Rs. Rs.

To Balance b/d 1,00,000 ByBank 50,000

To Profit & Loss A/c 10,000 ByBalance c/d 60,000
1,10,000 1,10,000

(5) Income Tax Provision Account

Rs. Rs.
To Bank A/c 45,000 ByBalance b/d 50,000
To Bankc/d 40,000 ByProfit and Loss A/c 35,000

85,000 85,000

KVSB Dr. K .V . Subba Reddy School Of Business Management

 USES OFFUNDS FLOW STATEMENT 23
The various uses of Funds Flow Statement are summarised as under :
(a) As a tool of historical analysis, it provides an answer to some of the importantfinancial questions
such as :
(i) How was it possible to distribute dividend in excess of current earnings or in the presence
of a net loss for the period? (i.e. the firm might have raised funds from other sources
also in addition to funds from operations).
(ii) Why has the net working capital decreased although the net income for the period has
gone up? (i.e. the firm might have applied the funds morethan the sources of funds).
(iii) Why has the net working capital increased even though there has been a net loss for the
period? (i.e., the firm might have raised the funds more than the application of funds).
(iv) What happened to the proceeds of the sale of plant and equipment? (e.g., the firm might have
purchased some fixed assets or it might have redeemed the redeemable debentures or
preference shares)
(v) Why did the firm resort to long-term borrowings inspite of large profits?
(vi) Why did the firm issue new equity or preference shares?
(vii) How was the retirement of long-term debts or redemption of redeemable preference shares
accomplished? (e.g. the firm might have issued new shares).
(b) As a tool of planning, the Projected Fund Flow Statement enables the management to plan its
future investments, operating and financial activities such as the repayment of long-term loans
and interest thereon, modernisationor expansion of plant, payment of cash dividend etc.
(c) Alongwith a Schedule of Changes in Working Capital, the Funds Flow Statement helps in managing
and utilizing the working capital. The management can know
the adequacy or otherwise of the working capital and can plan for the effective use of surplus
working capital or can make arrangement in case of inadequacy of working capital. Besides this,
the management can identify the magnitude and directions of changes in various components of
working capital and if there is any undesired situation such as heavy inventory accumulations,
heavy funds locked up in receivables than normally required, the necessary action may be taken
so as to achieve the desired level thereof.
LIMITATIONS OFFUNDS FLOWSTATEMENT
The major limitations of Funds Flow Statement are summarised below :
(a) It ignores the non-fund transactions. In other words, it does not take into consideration
those transactions which do not affect the working capital e.g., issue of shares against the
purchase of fixed assets, conversion of debentures into equity shares.
(b) It is a secondary data based statement. It merely rearranges the primary data already appearing in
other statements viz. Income Statement and Balance Sheet.
(c) It is basically historical in nature, unless Projected Funds Flow Statements are prepared to plan for
the future.
KEYWORDS
Fund: It refers to all financial resources or purchasing power or economic valuepossessed by a firm at
a point of time.
Fund flow statement: It is a technical device designed to analyse the changes in thefinancial condition of a
business enterprise between two dates.
Flow of funds: The flow of fund refers to the changes in the existing financial positionof a business
caused by inflow of resources owing to receipts and payments.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 Cash Flow Statement 24
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 statementhelps 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 organisation 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 STATEMENTAND 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 statementno distinction is made between current assets and fixed assets,
and current liabilities and long-term liabilities. All changes are summarised in the cash flow

KVSB Dr. K .V . Subba Reddy School Of Business Management

statements. 25
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 obligations 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 futureperiods.
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 helpsin 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-a- vis 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.

KVSB Dr. K .V . Subba Reddy School Of Business Management

PROCEDURE FOR PREPARINGACASH FLOW STATEMENT 26
Cash flow statement shows the impact of various transactions on cashposition 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
SPECIMEN OFREPORT FORM OFCASH FLOW STATEMENT
Cash balance in the beginningRs.

Add : Cash inflows :

Cash flow from operations

Sale of assets
Issue of shares
Issue of debentures
Raising of loans
Collection from debtors
Non trading receipts such as :
Dividend received Income tax
refund

Less : Applications or Outflows of cash :

Redemption of Preference shares Redemption of
debentures

Repayment of loans

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 27
Purchase of assets Payment of
dividendPayment of taxes

Cash lost in operations Cash Balance at

the end

SPECIMEN OF T FORM OR AN ACCOUNT OF CASH FLOWSTATEMENT

Rs. Rs.
Cash balance in the beginning Outflow of Cash :
Add : Cash inflows : Redemption of Preference
Cash flow from operation Shares
Sale of Assets Redemption of Debentures
Issue of Shares Repayment of Loans
Issue of Debentures Purchase of Assets
Raising of Loans Payment of Dividends
Collection from Debtors Payment of Tax
Dividends Received Cash lost in Operations
Refund of tax Cash Balance at the end

SOURCEOF CASH INFLOWS

1. Cash from Operations or Cash Operating Profit
Cash from trading operations during the year is a very important source of cash inflows.
The net effect of various transactions in a business during a particular period is either net profit or net
loss. Usually, net profit results in inflow of cash and net loss in outflow of cash. But it does not mean
that cash generated from trading operations in a year shall be equal to the net profit or that cash lost in
operations shall be identical with net loss. It may either be more or less. Even, there may be a net
loss in a business, but yet there may be a cash inflow from operations. It is so because of certain non-
operating (expenses or incomes) chargedto the income statement, i.e., Profit and Loss Account.
How to Calculate Cash from Operations or Cash Operating Profit ?
There are three methods of determining cash from operations :
(a) From Cash Sales : Cash from operations can be calculated by deductingcash purchases
and cash operating expenses from cash sales, i.e. Cash from
Operations= (Cash Sales) – (Cash Purchases + Cash Operating Expenses).
Cash sales are calculated by deducting credit sales or increase in receivables from the
total sales. From the cash sales, the cash purchases and cash operating expenses are to be deducted. In
the absence of any information, all expenses may be assumed to be cash expenses. In case outstanding
and prepaid expenses are known/given, any decrease in outstanding expenses or increase in prepaid
expenses should be deducted from the corresponding figure.

(b) From Net Profit/Net Loss

Cash from operations can also be calculated with the help of net profitor net loss. Under
this method, net profit or net loss is adjusted for non-cash and non-operating expenses and incomes as
follows :

KVSB Dr. K .V . Subba Reddy School Of Business Management

 Calculation of Cash From Trading Operations 28
Amount
Net Profit (as given)
Add : Non cash and Non-operating items which havealready been
debited to P & L A/c :
Depreciation Transfer to Reserves
Transfer to ProvisionsGoodwill
written off
Preliminary expenses written off Other intangible
assets written off
Loss on sale or disposal of fixed assetsIncrease in Accounts
Payable
Increase in outstanding expensesDecrease in
prepaid expenses
Less : Non-cash and Non-operating items which have alreadybeen credited to P &
L A/c :
Increase in Accounts Receivables Decrease in
Outstanding ExpensesIncrease in Prepaid
Expenses Cash from Operations

(C) Cash Operating Profit

Cash operating profit is also calculated with the help of net profit or net loss. The
difference in this method as compared to the above discussed method is that increase or decrease in
accounts payable and accounts receivable is not adjusted while finding cash from operations and it is
directly shown in the cash flow statement as an inflow or outflow of cash as the cash may be. The
cash from operations so calculated is generally called operating profit.

Calculation of Cash Operating Profit

Amount
Net Profit (as given) or Closing Balance of Profit and Loss A/c
Add : Non-cash and non-operating items which havealready
been debited to P& L A/c :
Depreciation
Transfers to Reserves and Provisions
Writing off intangible assets
Outstanding Expenses (current year)
Prepaid Expenses (previous year) Loss
on Sale of fixed Assets Dividend Paid,
etc.
Less : Non-cash and non-operating items which have alreadybeen
credited to P& L A/c :
Profit on Sale or disposal of fixed assets
Non-trading receipts such as dividend received, rent received, etc.
Re-transfers from provisions (excess
provisions charged back) Outstanding
income (current year)
Pre-received income (in previous year)Opening
balance of P&L A/c
Cash Operating Profit
Note: Generally the cash operating profit method has to be followed because of its similarity with

KVSB Dr. K .V . Subba Reddy School Of Business Management

calculating funds from operations. However, if this method is followed the following two points2n9eed
particular care :
(i) Outstanding/Accrued Expenses : The outstanding/accrued expenses represent those
expenses which are although charged to profit and loss account but no cash in paid during the year.
For this reason, outstanding/accrued expenses of the current year are added back while calculating
cash operating profit. However if some outstanding expenses of the previous year are also given, these
may be assumed to have been paid during the year and hence shown as an outflow of cash in the cash
flow statement.
(ii) Prepaid Expenses : Prepaid expenses are those expenses which are paid in advance and
hence result in the outflow of cash but are not charged to profit and loss account because they do not
relate to the current period of profit and loss account. For this reason, prepaid expenses of the current
year should be taken as anoutflow of cash in the cash flow statement. But the expenses, if any, paid in
the previous year do not involve outflow of cash in the current year but are charged to profit and loss
account. Therefore, prepaid expenses of the previous year (related to the current year) should be
added back while calculating cash operating profit. In the similar way, we can deal with outstanding
and pre-received incomes.
Illustration 5. Calculate Cash from operations from the following informations :
Rs.
Sales 70,000
Purchases 40,000
Expenses 8,000
Creditors at the end of the year 15,000
Creditors in the beginning of the year 12,000
Solution :
Rs. Rs.

Sales 70,000
Less : Purchases 40,000
Expenses 8,000 48,000
Profit for the year 22,000
Add : Creditors a the end of the year 15,000
37,000
Less : Creditors at the beginning of the year 12,000
Cash from operations 25,000
2. Increase in Existing Liabilities or Creation of new Liabilities
If there is an increase in existing liabilities or a new liability is createdduring the year, it
results in the flow of cash into the business. The liability may be either a fixed long-term liability
such as equity share capital, preference share capital, debentures, long-term loans, etc. or a
current liability such as sundrycreditors, bills payable, etc.
The inflow of cash may be either Actual of Notional
There is an actual inflow of cash when cash is actually received andgenerally long-term
liabilities result into actual inflow of cash, e.g.
For issue of Shares, during the year, the journal entry shall beCash A/c Dr.
To Share Capital A/c
So, actual cash flows into the business. In the same manner, issue of debentures,
raising of loans for cash, etc. result into actual inflows of cash. But when the fixed liabilities are
created in consideration of purchase of assets, i.e., other than cash, there is no inflow of actual cash.
The journal entry for the issue of debentures in lieu of purchase of machinery is :

KVSB Dr. K .V . Subba Reddy School Of Business Management

 Plant and Machinery A/c Dr. 30
To Debentures A/c
Usually, current liabilities result into inflow of notional cash. For example,
increase in sundry creditors implies purchase of goods on credit. In this case although no cash in
actually received but we may say that creditors have given us loans which have been utilised in
purchasing goods from them. Hence, increase in the current liabilities may be taken as a source of
inflow of cash and decrease in current liabilities as an outflow of cash.
3. Reduction in or Sale of Assets
Whenever a reduction in or sale of any asset-fixed or current-takes place (otherwise
than depreciation) it results into inflow of actual or notional cash. There is an actual inflow of cash
when assets are sold for cash and notional cash flows in when assets are sold or disposed off on
credit. Thus, sale of building, machinery or even reduction in current assets like stocks, debtors, etc.
result in inflow of actual notional cash.
4. Non-Trading Receipts
Sometimes, there may be non-trading receipts like dividend received, rent received,
refund of tax, etc. Such receipts or incomes are although non-trading
in nature but they result into inflow of cash and hence taken in the cash flow statement.
APPLICATIONS OFCASH OR CASH OUTFLOWS
1. Cash Lost in Operations : Sometimes the net result of trading in a particularperiod is a loss and
some cash may be lost during that period in trading operations. Such loss of cash 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 ofcash 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.
Illustration 6 : The following details are available from a company.

Liabilities 31-12-98 31-12-99 Assets 31-12-98 31-12-99

Rs Rs. Rs. Rs.
Share Capital 70,000 74,000 Cash 9,000 7,800
Debentures 12,000 6,000 Debtors 14,900 17,700
Reserve for doubtful 700 800 Stock 49,200 42,700
debts
Trade Creditors 10,360 11,840 Land 20,000 30,000
P & L A/c Goodwill
1,03,10 1,03,200 1,03,100 1,03,200
0
Additional Information :(i) Dividend paid total Rs. 3,500, (ii) Land was purchased for Rs. 10,000.
Amount provided for amortisation of goodwill Rs. 5,000 and (iii) Debentures paid off Rs. 6,000
Prepare Cash Flow Statement.

KVSB Dr. K .V . Subba Reddy School Of Business Management

 31
Solution :
Cash Flow Statement
(for the year ended 31.12.1999)
Rs. Rs.
Opening balance of cash Cash Outflows
on 1.1.1999 9,000 Purchase of Land 10,000
Add : Cash Inflows : Increase in Debtors 2,800
Issue of Share Capital 4,000 Redemption of Debentures 6,000
Increase in trade creditors 1,480 Dividends Paid 3,500
Cash inflow from operations 9,120 Closing balance of cash on
Decrease in stock 6,500 31.12.1999 7,800
30,100 30,100
Workings :
1. Cash inflow from operations
Adjusted Profit And Loss A/c

Rs. Rs.
To Dividend (non-operating) 3,500 ByBalance b/d 10,040
To Goodwill(non-fund/cash) 5,000 ByCash inflow fromoperation 9,120
To Reserve for doubtful debts 100
To Balancec/d 10,560
19,160 19,160

Alternatively Rs.
Balance of P & L A/c on 31.12.1999 10,560
Add : non-fund/cash and non-operating items which
have already been debited to P & L A/c :
Dividend paid 3,500
Goodwill written off 5,000
Reserve for doubtful debts 100
19,160
Less : Opening balance of P & L A/c and non-operating
incomes :
Opening balance of P/L A/c
(on 31.12.1998) 10,040 10,040
Cash Inflow from operations 9,120

KVSB Dr. K .V . Subba Reddy School Of Business Management

KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
KVSB Dr. K .V . Subba Reddy School Of Business Management
 DIFFERENCE BETWEEN FUNDS FLOW STATEMENT & CASH FLOW STATEMENT
Basis of difference Funds flow statement Cash flow statement
1.Basis of concept It is based on a wider concept of It is based on a narrow concept of
funds, i.e., working capital. funds, i.e., cash.
It is based on accrual basis of It is based on cash basis of
2.Basis of accounting accounting. accounting.

3.Schedule of Schedule of changes in No such schedule of changes in

changes in working working capital is prepared to working capital is prepared.
capital show the changes in current
assets and current liabilities.
Funds flow statement reveals the It is prepared by talking the
sources and applications of funds. opening balance of cash, adding
The net difference between sources to this all the inflows of cash
4.Method of preparing. and applications of funds represents deducting the outflows of cash
net increase or decrease in working from the total, the difference
capital. represents the closing balance of
cash.
It is useful in planning intermediate It is more useful for short-term
5.Basis of usefulness. and long –term financing. analysis and cash planning of the
business.

UNIT-5 –IMPORTANT QUESTIONS

 Objectives & uses of funds flow & cash flow statement?
 How to prepare funds flow & cash flow statement steps in preparation of funds flow
statement?
 Funds flow statement Vs cash flow statement?
Problems: FUNDS FLOW AND CASH FLOW ANALYSIS.