UNIT - VII

INTRODUCTION TO FINANCIAL ACCOUNTING CONCEPTS 1. INTRODUCITON

As you are aware, every trader generally starts business for purpose of earning profit. While establishing business, he brings own capital, borrows money from relatives, friends, outsiders or financial institutions. Then he purchases machinery, plant , furniture, raw materials and other assets. He starts buying and selling of goods, paying for salaries, rent and other expenses, depositing and withdrawing cash from bank. Like this he undertakes innumerable transactions in business. bserve the following transactions of small trader for one week during the month of !uly, "##$. "##$ %s. !uly &' (urchase of goods from )ree %am "&,*** !uly &+ ,oods sold for cash +,*** !uly &+ )old gods to )yam on credit $,*** !uly &Advertising expenses +,&** !uly &. )tationary expenses -** !uly &. Withdrawal for personal use &,+** !uly &$ %ent paid through che/ue ",*** !uly 0" )alaries paid #,*** !uly 0" %eceived cash from )yam +,*** The number of transactions in an organi1ation depends upon the si1e of the organi1ation. 2n small organi1ations, the transactions generally will be in thousand and in big organi1ations they may be in lakhs. As such it is humanly impossible to remember all these transactions. 3urther, it may not by possible to find out the final result of the business without recording and analy1ing these transactions. Accounting came into practice as an aid to human memory by maintaining a systematic record of business transactions. 1.1 History of Accountin ! Accounting is as old as civili1ation itself. 3rom the ancient relics of 4abylon, it can be will proved that accounting did exist as long as &-** 4.5. However, in modern form accounting based on the principles of 6ouble 7ntry )ystem came into existence in ". th 5entury. 3ra Luka (aciolo, a 3ransiscan monk and mathematician published a book De computic et scripturies in "'#' at 8enice in 2talyl. This book was translated into 7nglish in "+'0. 2n this book he covered a brief section on 9book:keeping;. Ori in of Accountin in In#i$! Accounting was practiced in 2ndia thousand years ago and there is a clear evidence for this. 2n his famous book Arthashastra <autilya dealt with not only politics and economics but also the art of proper keeping of accounts. However, the accounting on modern lines was introduced in 2ndia after "$+* with the formation =oint stock companies in 2ndia. Accounting in 2ndia is now a fast developing discipline. The two premier Accounting 2nstitutes in 2ndia vi1., chartered Accountants of 2ndia and the 2nstitute of 5ost and Works Accountants of 2ndia are making continuous and substantial contributions. The international Accounts )tandards 5ommittee >2A)5? was established as on &#th !une. 2n 2ndia the 9Accounting )tandards 4oard >A)4? is formulating 9Accounting )tandards; on the lines of standards framed by 2nternational Accounting )tandards 5ommittee.

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". %OO&-&EEPING AND ACCOUNTING According to ,.A. Lee the accounting system has two stages. ". The making of routine records in the prescribed from and according to set rules of all events with affect the financial state of the organi1ation@ and &. The summari1ation from time to time of the information contained in the records, its presentation in a significant form to interested parties and its interpretation as an aid to decision making by these parties. 3irst stage is called 4ook:<eeping and the second one is Accounting. %oo' ( &))*in ! 4ook A <eeping involves the chronological recording of financial transactions in a set of books in a systematic manner. Accountin ! Accounting is concerned with the maintenance of accounts giving stress to the design of the system of records, the preparation of reports based on the recorded date and the interpretation of the reports. Distinction +)t,))n %oo' ( &))*in $n# Account$ncy Thus, the terms, book:keeping and accounting are very closely related, through there is a subtle difference as mentioned below. 1. O+-)ct ! The ob=ect of book:keeping is to prepare original books of Accounts. 2t is restricted to =ournal, subsidiary book and ledge accounts only. n the other hand, the main ob=ect of accounting is to record analyse and interpret the business transactions. ". L).)/ of 0or'! 4ook:keeping is restricted to level of work. 5lerical work is mainly involved in it. Accountancy on the other hand, is concerned with all level of management. 1. Princi*/)s of Account$ncy! 2n 4ook:keeping Accounting concepts and conventions will be followed by all without any difference. n the other hand, various firms follow various methods of reporting and interpretation in accounting. 1. Fin$/ R)su/t! 2n 4ook:<eeping it is not possible to know the final result of business every year, ".1 2)$nin of Accountin Thus, book:keeping is an art of recording the business transactions in the books of original entry and the ledges. Accountancy begins where 4ook:keeping ends. Accountancy means the compiliation of accounts in such a way that one is in a position to know the state of affairs of the business. The work of an accountant is to analyse, interpret and review the accounts and draw conclusion with a view to guide the management in chalking out the future policy of the business. "." D)finition of Accountin ! S3it4 $n# As4+urn)! BAccounting is a means of measuring and reporting the results of economic activities.C R.N. Ant4ony! BAccounting system is a means of collecting summari1ing, analy1ing and reporting in monetary terms, the information about the business. A3)ric$n Institut) of C)rtifi)# Pu+/ic Account$nts 5AICPA6! BThe art of recording, classifying and summari1ing in a significant manner and in terms of money transactions and events, which are in part at least, of a financial character and interpreting the results thereof.C Thus, accounting is an art of identifying, recording, summari1ing and interpreting business transactions of financial nature. Hence accounting is the L$n u$ ) of %usin)ss. ".1 %r$nc4)s of Accountin ! The important branches of accounting areD 1. Fin$nci$/ Accountin ! The purpose of Accounting is to ascertain the financial results i.e. profit or loass in the operations during a specific period. 2t is also aimed at knowing the financial position, i.e. assets, liabilities and e/uity position at the end of the period. 2t also provides other relevant information to the management as a basic for decision:making for planning and controlling the operations of the business.

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Cost Accountin ! The purpose of this branch of accounting is to ascertain the cost of a product E operation E pro=ect and the costs incurred for carrying out various activities. 2t also assist the management in controlling the costs. The necessary data and information are gatherr'ed form financial and other sources. 1. 2$n$ )3)nt Accountin ! 2ts aim to assist the management in taking correct policy decision and to evaluate the impact of its decisions and actions. The data re/uired for this purpose are drawn accounting and cost:accounting. 7. USERS OF ACCOUNTING INFOR2ATION 6ifferent categories of users need different kinds of information for making decisions. The users of accounting can be divided in two board groups >"?. 2nternal users and >&?. 7xternal users. 7.1 Int)rn$/ Us)rs! 2$n$ )rs ! These are the persons who manage the business, i.e. management at he top, middle and lower levels. Their re/uirements of information are different because they make different types of decisions. Accounting reports are important to managers for evaluating the results of their decisions. 2n additions to external financial statements, managers need detailed internal reports either branch division or department or product:wise. Accounting reports for managers are prepared much more fre/uently than external reports. Accounting information also helps the managers in appraising the performance of subordinates. As such Accounting is termed as B the eyes and ears of management.C 7." E8t)rn$/ Us)rs ! In.)stors ! Those who are interested in buying the shares of company are naturally interested in the financial statements to know how safe the investment already made is and how safe the proposed investments will be. Cr)#itors! Lenders are interested to know whether their load, principal and interest, will be paid when due. )uppliers and other creditors are also interested to know the ability of the firm to pay their dues in time. 0or')rs! 2n our country, workers are entitled to payment of bonus which depends on the si1e of profit earned. Hence, they would like to be satisfied that he bonus being paid to them is correct. This knowledge also helps them in conducting negotiations for wages. Custo3)rs! They are also concerned with the stability and profitability of the enterprise. They may be interested in knowing the financial strength of the company to rent it for further decisions relating to purchase of goods. Go.)rn3)nt! ,overnments all over the world are using financial statements for compiling statistics concerning business which, in turn, helps in compiling national accounts. The financial statements are useful for tax authorities for calculating taxes. Pu+/ic! The public at large interested in the functioning of the enterprises because it may make a substantial contribution to the local economy in many ways including the number of people employed and their patronage to local suppliers. R)s)$rc4)rs! The financial statements, being a mirror of business conditions, is of great interest to scholars undertaking research in accounting theory as well as business affairs and practices. 9. ADVANTAGES FRO2 ACCOUNTING The role of accounting has changed from that of a mere record keeping during the " st decade of &*th century of the present stage, which it is accepted as information system and decision making activity. The following are the advantages of accounting. 1. Pro.i#)s for syst)3$tic r)cor#s! )ince all the financial transactions are recorded in the books, one need not rely on memory. Any information re/uired is readily available from these records.

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F$ci/it$t)s t4) *r)*$r$tion of fin$nci$/ st$t)3)nts! (rofit and loss accountant 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 >i.e. profit E loss? during the accounting period and the financial position of the business at the end of the accounting period. 1. Pro.i#)s contro/ o.)r $ss)ts! 4ook:keeping provides information regarding cash in had, cash at bank, stock of goods, accounts receivables from various parties and the amounts invested in various other assets. As the trader knows the values of the assets he will have control over them. 7. Pro.i#)s t4) r):uir)# infor3$tion! 2nterested parties such as owners, lenders, creditors etc., get necessary information at fre/uent intervals. 9. Co3*$r$ti.) stu#y! ne can compare the present performance of the organi1ation with that of its past. This enables the managers to draw useful conclusion and make proper decisions. ;. L)ss Sco*) for fr$u# or t4)ft! 2t 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. <. T$8 3$tt)rs! (roperly maintained book:keeping records will help in the settlement of all tax matters with the tax authorities. =. Asc)rt$inin V$/u) of %usin)ss! The accounting records will help in ascertaining the correct value of the business. This helps in the event of sale or purchase of a business. >. Docu3)nt$ry ).i#)nc)! Accounting records can also be used as an evidence in the court to substantiate the claim of the business. These records are based on documentary proof. 7very entry is supported by authentic vouchers. As such, 5ourts accept these records as evidence. 1?. H)/*fu/ to 3$n$ )3)nt! Accounting is useful to the management in various ways. 2t enables the management to asses the achievement of its performance. The weakness of the business can be identified and corrective measures can be applied to remove them with the helps accounting. ;. LI2ITATIONS OF ACCOUNTING The following are the limitations of accounting. 1. Do)s not r)cor# $// ).)nts! nly the transactions of a financial character will be recorded under book:keeping. )o it does not reveal a complete picture about the /uality of human resources, locational advantage, business contacts etc. ". Do)s not r)f/)ct curr)nt .$/u)s! The data available under book:keeping is historical in nature. )o they do not reflect current values. 3or instance, we record the value of stock at cost price or market price, which ever is less. 2n case of, building, machinery etc., we adopt historical cost as the basis. 2nfact, the current values of buildings, plant and machinery may be much more than what is recorded in the balance sheet. 1. Esti3$t)s +$s)# on P)rson$/ @u# 3)nt! The estimate used for determining the values of various items may not be correct. 3or example, debtor are estimated in terms of collectibility, inventories are based on marketability, and fixed assets are based on useful working life. These estimates are based on personal =udgment and hence sometimes may not be correct. 7. In$#):u$t) infor3$tion on costs $n# Profits! 4ook:keeping only provides information about the overall profitability of the business. Fo information is given about the cost and profitability of different activities of products or divisions. <. %ASIC ACCOUNTING CONCEPTS Accounting has been evolved over a period of several centuries. 6uring this period, certain rules and conventions have been adopted. They serve as guidelines in identifying the events and transactions to be accounted for measuring, recording, summari1ing and reporting them to the interested parties. These rules and conventions are termed as G)n)r$//y Acc)*t)# Accountin Princi*/)s. These principles are also referred as standards, assumptions, concepts, conventions doctrines, etc. Thus, the accounting concepts are the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting. They are the broad working rules for all accounting activities developed and accepted by the accounting profession. 4asic accounting concepts may be classified into two broad categories. ". 5oncept to be observed at the time of recording transactions.>%ecording )tage?. &. 5oncept to be observed at the time of preparing the financial accounts >%eporting )tage?

FINAL ACCOUNTS INTRODUCTIOND The main ob=ect of any 4usiness is to make profit. 7very trader generally starts business for the purpose of earning profit. While establishing 4usiness, he brings his own capital, borrows money from relatives, friends, outsiders or financial institutions, then purchases machinery, plant, furniture, raw materials and other assets. He starts buying and selling of goods, paying for salaries, rent and other expenses, depositing and withdrawing cash from 4ank. Like this he undertakes innumerable transactions in 4usiness. The number of 4usiness transactions in an organi1ation depends up on the si1e of the organi1ation. 2n small organi1ations the transactions generally will be in thousands and in big organi1ations they may be in lacks. As such it is humanly impossible to remember all these transactions. 3urther it may not be possible to find out the final result of the 4usiness with out recording and analy1ing these transactions. Accounting came in practice as an aid to human memory by maintaining a systematic record of 4usiness transactions. BOOK KEEPING AND ACCOUNTING: According to ,.A.Lee the Accounting system has two stages. 3irst stage is 4ook keeping and the second stage is accounting. GAH. BOOK KEEPINGD 4ook keeping involves the chronological recording of financial transactions in a set of books in a systematic manner B4ook keeping is the system of recording 4usiness transactions for the purpose of providing reliable information to the owners and managers about the state and prospect of the 4usiness conceptsC. Thus 4ook keeping is an art of recording business transactions in the books of original entry and the ledges. G4H. A55 IFT2F,D Accounting begins where the 4ookkeeping ends ". )J2TH AF6 A)H4IFF7D Accounting means Bmeasuring and reporting the results of economic activitiesC. &. %.F AFTH FKD Accounting is a system of Bcollecting, summari1ing, Analy1ing and reporting in monster terms, the information about the 4usinessC. 0. 25(AD %ecording, classifying and summari1ing is 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 there. Thus accounting is an art of recording, classifying, summari1ing and interpreting business transactions of financial nature. Hence accounting is the BLanguage of 4usinessC. A68AFTA,7 3 A55 IFT2F, The following are the advantages of AccountingLLLL
1. ".

1.

7. 9.

PROVIDES FOR S STE!ATIC RECORDSD )ince all the financial transactions are recorded in the books, one need not rely on memory. Any information re/uired is readily available from these records. FACI"ITATES T#E PRPARATION OF FINANCIA" STATE!ENTS D (rofit 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 4usiness operations >i.e. profitEloss? during the accounting period and the financial position of the business at the end of the accounting period. PROVIDES CONTRO" OVER ASSETSD 4ook keeping provides information regarding cash in hand, cash at hand, stack of goods, accounts receivable 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. PROVIES T#E RE$UIRED INFOR!ATIOND 2nterested parties such as owners, lenders, creditors etc, get necessary information at fre/uent intervals. CO!PARITIVE STUD D ne can compare present performance of the organi1ation with that of its past. This enables the managers to draw useful conclusions and make proper decisions.

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"ESS SCOPE FOR FRAUD OR T#EFT D 2t 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. TAM JALT7%)D (roperly maintained 4ook keeping records will help in the settlement of all tax matters with the tax authorities. ASCERTAINING VA"UE OF BUSINESSD The accounting records will help in ascertaining the correct value of the 4usiness. This helps in the event of sale or purchase of a business. DOCU!ENTAR EVIDENCED Accounting records can also be used as evidence in the court of substantial the claim of the 4usiness. Thus records are based on documentary proof. Authentic vouchers support every entry. As such, courts accept these records as evidence. #E"PFU" TO !ANAGE!ENTD Accounting is useful to the management in various ways. 2t enables the management to assess the achievement of its performance. The weaknesses of the business can be identified and corrective measures can be applied to remove them with the help of accounting. 3 A55 IFT2F,

L2J2TAT2 F)

The following are the limitations of accountingLLLL.. ". DOES NOT RECORD A"" EVENTS D nly the transactions of a financial character will be recorded under book keeping. )o it does not reveal a complete picture about the /uality of human resources, locational advantages, business contacts etc. &. DOES NOT REF"ECT CURRENT V"AUESD The data available under book keeping is historical in nature. )o they do not reflect current values. 3or instance we record the values of stock at cost price or market price, which ever is less. 2n case of building, machinery etc., we adapt historical case as the basis. 2nfact, the current values of 4uildings, plant and machinery may be much more than what is recorded in the balance sheet. 0. ESTI!ATES BASED ON PERSONA" %UDGE!ENT D The estimates used for determining the values of various items may not be correct. 3or example, debtors are estimated in terms of collectibles, inventories are based on marketability and fixed assets are based on useful working life. These estimates are based on personal =udgment and hence sometimes may not be correct. '. INADE$UATE INFOR!ATION ON COSTS AND PROFITS D 4ook keeping only provides information about over all profitability of the business. Fo information is given about the cost and profitability of different activities of products or divisions. %ASIC ACCOUNTING CONCEPTS Accounting is a system evolved to achieve a set of ob=ectives. 2n order to achieve the goals, we need a set of rules or guidelines. These guidelines are termed here as B4A)25 A55 IFT2F, F57(T)C. The term concept means an idea or thought. 4asic accounting concepts are the fundamental ideas or basic assumptions underlying the theory and profit of 32FAF52AL A55 IFT2F,. These concepts help in bringing about uniformity in the practice of accounting. 2n accountancy following concepts are /uite popular. ". BUSINESS ENTIT CONEPTD 2n this concept B4usiness is treated as separate from the proprietorC. All the Transactions recorded in the book of 4usiness and not in the books of proprietor. The proprietor is also treated as a creditor for the 4usiness. &. GOING CONCERN CONCEPTD This concept relates with the long life of 4usiness. The assumption is that business will continue to exist for unlimited period unless it is dissolved due to some reasons or the other. 0. !ONE !EASURE!ENT CONCEPTD 2n this concept B nly those transactions are recorded in accounting which can be expressed in terms of money, those transactions which can not be expressed in terms of money are not recorded in the books of accountingC. '. COST CONCEPTD Accounting to this concept, can asset is recorded at its cost in the books of account. i.e., the price, which is paid at the time of ac/uiring it. 2n balance sheet, these assets appear not at cost

price every year, but depreciation is deducted and they appear at the amount, which is cost, less classification. +. ACCOUNTING PERIOD CONCEPTD every 4usinessman wants to know the result of his investment and efforts after a certain period. Isually one:year period is regarded as an ideal for this purpose. This period is called Accounting (eriod. 2t depends on the nature of the business and ob=ect of the proprietor of business. -. DUA" ASCEPT CONCEPTD According to this concept B7very business transactions has two aspectsC, one is the receiving benefit aspect another one is giving benefit aspect. The receiving benefit aspect is termed as B6742TC, where as the giving benefit aspect is termed as B5%762TC. Therefore, for every debit, there will be corresponding credit. .. !ATC#ING COST CONCEPTD According to this concept BThe expenses incurred during an accounting period, e.g., if revenue is recogni1ed on all goods sold during a period, cost of those good sole should also 4e charged to that period. $. REA"ISATION CONCEPTD According to this concept revenue is recogni1ed when a sale is made. )ale is 5onsidered to be made at the point when the property in goods posses to the buyer and he becomes legally liable to pay. ACCOUNTING CONVENTIONS Accounting is based on some customs or usages. Faturally accountants here to adopt that usage or custom. They are termed as convert conventions in accounting. The following are some of the important accounting conventions. ". FU"" DISC"OSURED According to this convention accounting reports should disclose fully and fairly the information. They purport to represent. They should be prepared honestly and sufficiently disclose information which is if material interest to proprietors, present and potential creditors and investors. The companies A5T, "#+- makes it compulsory to provide all the information in the prescribed form. &. !ATERIA"IT D Inder this convention the trader records important factor about the commercial activities. 2n the form of financial statements if any unimportant information is to be given for the sake of clarity it will be given as footnotes. 0. CONSISTENC D 2t means that accounting method adopted should not be changed from year to year. 2t means that there should be consistent in the methods or principles followed. r else the results of a year 5annot be conveniently compared with that of another. '. CONSERVATIS!D This convention warns the trader not to take unreali1ed income in to account. That is why the practice of valuing stock at cost or market price, which ever is lower is in vague. This is the policy of Bplaying safeC@ it takes in to consideration all prospective losses but leaves all prospective profits. &EA 0ORDS IN %OO&-&EEPING &' TRANSACTIONS: A() sa*e or purchase o+ ,oo-s o+ ser.ices is ca**e- the tra(sactio(' Tra(sactio(s are t/o t)pes' 0a1' Cash tra(sactio(: cash tra(sactio( is o(e /here cash receipt or pa)me(t is i(.o*.e- i( the e2cha(,e' 031' Cre-it tra(sactio(: Cre-it tra(sactio( /i** (ot ha.e cash4 either recei.e- or pai-4 +or somethi(, ,i.e( or recei.e- respecti.e*)' &. GOODSD 3ill those things which a firm purchases for resale are called goods. 0. PURC#ASESD (urchases means purchase of goods, unless it is stated otherwise it also represents the ,oods purchased. '. SA"ESD )ales means sale of goods, unless it is stated otherwise it also represents these goods sold. +. E5PENSESD (ayments for the purchase of goods as services are known as expenses. -. REVENUED %evenue is the amount reali1ed or receivable from the sale of goods or services. .. ASSETSD The valuable things owned by the business are known as assets. These are the properties wned by the business.

$. "IABI"ITIESD Liabilities are the obligations or debts payable by the enterprise in future in the term f money or goods. #' DEBTORSD 6ebtors means a person who owes money to the trader. "*. CREDITORSD A creditor is a person to whom something is owned by the business. "". DRA6INGSD cash or goods withdrawn by the proprietor from the 4usiness for his personal or Household is termed to as BdrawingC. "&. RESERVED An amount set aside out of profits or other surplus and designed to meet contingencies. "0. ACCOUNTD A summari1ed statements of transactions relating to a particular person, thing, 7xpense or income. "'. DISCOUNTD There are two types of discounts.. a. cash discountD An allowable made to encourage frame payment or before the expiration of the period allowed for credit. b. Trade discountD A deduction from the gross or catalogue price allowed to traders who buys them for resale. CLASSIFICATION OF %USINESS TRANSACTIONS All business transactions are classified into three categoriesD ".Those relating to persons &.Those relating to property>Assets? 0.Those relating to income N expenses Thus, three classes of accounts are maintained for recording all business transactions. They areD ".(ersonal accounts &.%eal accounts 0.Fominal accounts "'Perso(a* Accou(ts DAccounts which are transactions with persons are called B(ersonal AccountsC . A separate account is kept on the name of each person for recording the benefits received from ,or given to the person in the course of dealings with him. 7.g.D <rishna;s AE5, ,opal;s AE5, )42 AE5, Fagar=una 3inanace Ltd.AE5, bul%eddy N )ons AE5 , HJT Ltd. AE5, 5apital AE5, 6rawings AE5 etc. &.Rea* Accou(tsD The accounts relating to properties or assets are known as B%eal AccountsC .7very business needs assets such as machinery , furniture etc, for running its activities .A separate account is maintained for each asset owned by the business . 7.g.D cash AE5, furniture AE5, building AE5, machinery AE5 etc. 0.Nomi(a*Accou(tsDAccounts relating to expenses, losses, incomes and gains are known as BFominal AccountsC. A separate account is maintained for each item of expenses, losses, income or gain. 7.g.D )alaries AE5, stationery AE5, wages AE5, postage AE5, commission AE5, interest AE5, purchases AE5, rent AE5, discount AE5, commission received AE5, interest received AE5, rent received AE5, discount received AE5. 4efore recording a transaction, it is necessary to find out which of the accounts is to be debited and which is to be credited. The following three different rules have been laid down for the three classes of accountsL. ".Perso(a* Accou(tsD The account of the person receiving benefit >receiver? is to be debited and the account of the person giving the benefit >given? is to be credited.

Rule: Debit----The Receiver, Credit---The Giver

&.Rea* Accou(tsD When an asset is coming into the business, account of that asset is to be debited .When an asset is going out of the business, the account of that asset is to be credited.

Rule: Debit----What comes in, Credit---What goes out

0. Nomi(a* Accou(tsD When an expense is incurred or loss encountered, the account representing the expense or loss is to be debited . When any income is earned or gain made, the account representing the income of gain is to be credited.

@OURNAL The first step in accounting therefore is the record of all the transactions in the books of original entry vi1., !ournal and then posting into ledges. %OURNA": The word !ournal is derived from the Latin word 9=ourn; which means a day. Therefore, =ournal means a 9day 4ook; in day:to:day business transactions are recorded in chronological order. !ournal is treated as the book of original entry or first entry or prime entry. All the business transactions are recorded in this book before they are posted in the ledges. The =ournal is a complete and chronological>in order of dates? record of business transactions. 2t is recorded in a systematic manner. The process of recording a transaction in the =ournal is called B! I%FAL2)2F,C. The entries made in the book are called B!ournal 7ntriesC. The proforma of !ournal is given below. D$t) P$rticu/$rs L.F. no D)+it
5Rs.6

Rule: Debit----All expenses and losses Credit---All incomes and gains

Cr)#it
5Rs.6

"##$ !an (urchases AOc " 6r. To cash AOc >4eing goods purchased for cash?

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LEDGER All the transactions in a =ournal are recorded in a chronological order. After a certain period, if we want to know whether a particular account is showing a debit or credit balance it becomes very difficult. )o, the ledger is designed to accommodate the various accounts maintained the trader. 2t contains the final or permanent record of all the transactions in duly classified form. BA ledger is a book which contains various accounts.C The process of transferring entries from =ournal to ledger is called B( )T2F,C. (osting is the process of entering in the ledger the entries given in the =ournal. (osting into ledger is done periodically, may be weekly or fortnightly as per the convenience of the business. The following are the guidelines for posting transactions in the ledger. ". &. 0. '. +. -. After the completion of !ournal entries only posting is to be made in the ledger. 3or each item in the !ournal a separate account is to be opened. 3urther, for each new item a new account is to be opened. 6epending upon the number of transactions space for each account is to be determined in the ledger. 3or each account there must be a name. This should be written in the top of the table. At the end of the name, the word BAccountC is to be added. The debit side of the !ournal entry is to be posted on the debit side of the account, by starting with BT C. The credit side of the !ournal entry is to be posted on the debit side of the account, by starting with B4KC. S$/)s $ccount

Pro+orma +or *e-,er: LEDGER BOOK

6ate

(articulars

Lfn o

Amoun t

6ate

(articular s

Lfn o

amount

6ate

(articulars

Lfn o

C$s4 $ccount Amoun 6ate t

(articular s

Lfn o

amount

TRAIL %ALANCE The first step in the preparation of final accounts is the preparation of trail balance. 2n the double entry system of book keeping, there will be credit for every debit and there will not be any debit without credit. When this principle is followed in writing =ournal entries, the total amount of all debits is e/ual to the total amount all credits. A trail balance is a statement of debit and credit balances. 2t is prepared on a particular date with the ob=ect of checking the accuracy of the books of accounts. 2t indicates that all the transactions for a particular period have been duly entered in the book, properly posted and balanced. The trail balance doesn;t include stock in hand at the end of the period. All ad=ustments re/uired to be done at the end of the period including closing stock are generally given under the trail balance. DEFINITIONS: SPICER AND POG"AR : A trail balance is a list of all the balances standing on the ledger accounts and cash book of a concern at any given date. %'R'BAT"IBOI: A trail balance is a statement of debit and credit balances extracted from the ledger with a view to test the arithmetical accuracy of the books. Thus a trail balance is a list of balances of the ledger accounts; and cash book of a business concern at any given date. PROFOR!A FOR TRAI" BA"ANCED Trail balance for J%LLLLLLLLLLLLLL as on LLLL F FAJ7 3 A55 IFT >(A%T25ILA%)? 6742T AJ IFT>% ).? 5%762T AJ IFT>%) .?

FINAL ACCOUNTS 2n every business, the business man is interested in knowing whether the business has resulted in profit or loss and what the financial position of the business is at a given time. 2n brief, he wants to know >i?The profitability of the business and >ii? The soundness of the business.

The trader can ascertain this by preparing the final accounts. The final accounts are prepared from the trial balance. Hence the trial balance is said to be the link between the ledger accounts and the final accounts. The final accounts of a firm can be divided into two stages. The first stage is preparing the trading and profit and loss account and the second stage is preparing the balance sheet.

TRADING ACCOUNT The first step in the preparation of final account is the preparation of trading account. The main purpose of preparing the trading account is to ascertain gross profit or gross loss as a result of buying and selling the goods. Tra-i(, accou(t o+ !R77777777' +or the )ear e(-e- 77777777 (articulars Amoun (articulars Amount t To opening stock Mxxx 4y sales xxxx To purchases xxxx LessD returns xxx Mxxx LessD returns xx Mxxx 4y closing stock Mxxx To carriage inwards To wages To freight To customs duty, octroi To gas, fuel, coal, Water To factory expenses To other man. 7xpenses To productive expenses To gross profit cEd Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx

3inally, a ledger 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. The up:to:date state of any account can be easily known by referring to the ledger. PROFIT AND LOSS ACCOUNT The business man is always interested in knowing his net income or net profit.Fet profit represents the excess of gross profit plus the other revenue incomes over administrative, sales, 3inancial and other expenses. The debit side of profit and loss account shows the expenses and the credit side the incomes. 2f the total of the credit side is more, it will be the net profit. And if the debit side is more, it will be net loss.
(% 32T AF6 L )) AE5 (A%T25ILA%) T office salaries T rent,rates,taxes T (rinting and stationery T Legal charges Audit fee T 2nsurance T ,eneral expenses T Advertisements T 4ad debts T 5arriage outwards T %epairs T 6epreciation T interest paid T 2nterest on capital T 2nterest on loans T 6iscount allowed T 5ommission T Fet profit::::::: >transferred to capital aEc? 3 J%LLLLLLLL.3 % TH7 K7A% 7F676LLLL AJ IFT (A%T25ILA%) AJ IFT Mxxxxx Mxxxx Mxxxx Mxxx Mxxx Mxxx Mxxxx Mxxx Mxxx Mxxx Mxxxx Mxxxx Mxxxx Mxxx Mxxxx Mxxxx Mxxxx xxxxxx 4y gross profit bEd 2nterest received 6iscount received 5ommission received 2ncome from investments 6ividend on shares Jiscellaneous investments %ent received Mxxxx Mxxxx Mxxx Mxxxx Mxxx Mxxx Mxxx Mxxx Mxxx

Mxxxxx

%ALANCE SHEET The second point of final accounts is the preparation of balance sheet. 2t is prepared often in the trading and profit, loss accounts have been compiled and closed. A balance sheet may be considered as a statement of the financial position of the concern at a given date. DEFINITION: A balance sheet is an item wise list of assets, liabilities and proprietorship of a business at a certain state. %'R'3ot*i3oi: A balance sheet is a statement with a view to measure exact financial position of a business at a particular date. Thus, 4alance sheet is defined as a statement which sets out the assets and liabilities of a business firm and which serves to as certain the financial position of the same on any particular date. n the left:hand side of this statement, the liabilities and the capital are shown. n the right:hand side all the assets are shown. Therefore, the two sides of the balance sheet should be e/ual. therwise, there is an error somewhere. 4ALAF57 )H77T 3 LLLLLLLLLL A) Liabilities and capital Amount 5reditors 4ills payable 4ank overdraft Loans Jortgage %eserve fund 5apital xxxxxx AddD Fet (rofit xxxx ::::::: xxxxxxx :::::::: LessD 6rawings xxxx Mxxx MMMM Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx F LLLLLLLLLLLLLL. Assets Amount Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx Mxxx MMMM

5ash in hand 5ash at bank 4ills receivable 6ebtors 5losing stock 2nvestments 3urniture and fittings (lants N Jachinery Land N buildings (atents, tm ,copyrights ,oodwill (repaid expenses utstanding incomes

A-.a(ta,es: The following are the advantages of final balance . ". 2t helps in checking the arithmetical accuracy of books of accounts. &. 2t helps in the preparation of financial statements. 0. 2t helps in detecting errors. '. 2t serves as an instrument for carrying out the =ob of rectification of entries. +. 2t is possible to find out the balances of various accounts at one place. FINAL ACCOUNTS -- AD@UST2ENTS We know that business is a going concern. 2t has to be carried on indefinitely. At the end of every accounting year. The trader prepares the trading and profit and loss account and balance sheet. While preparing these financial statements, sometimes the trader may come across certain problems .The expenses of the current year may be still payable or the expenses of the next year have been prepaid during the current year. 2n the same way, the income of the current year still receivable and the income of the next year have been received during the current year. Without these ad=ustments, the profit figures

arrived at or the financial position of the concern may not be correct. As such these ad=ustments are to be made while preparing the final accounts. The ad=ustments to be made to final accounts will be given under the Trial 4alance. While making the ad=ustment in the final accounts, the student should remember that Bevery ad=ustment is to be made in the final accounts twice i.e. once in trading, profit and loss account and later in balance sheet generallyC. The following are some of the important ad=ustments to be made at the time of preparing of final accountsD: ". C"OSING STOCK D: >i?I+ c*osi(, stoc8 is ,i.e( i( Trai* Ba*a(ceD 2t should be shown only in the balance sheet BAssets )ideC. >ii?I+ c*osi(, stoc8 is ,i.e( as a-9ustme(t D 1. 3irst, it should be posted at the credit side of BTrading AccountC. . Fext, shown at the asset side of the B4alance )heetC. &.OUTSTANDING E5PENSES D: >i?I+ outsta(-i(, e2pe(ses ,i.e( i( Trai* Ba*a(ce D 2t should be only on the liability side of 4alance )heet. >ii?I+ outsta(-i(, e2pe(ses ,i.e( as a-9ustme(t D ". 3irst, it should be added to the debit side of profit and loss account or Trading Account. &. Fext, it should be added at the liabilities side of the 4alance )heet. 0.PREAPID E5PENSES D: >i?I+ prepai- e2pe(ses ,i.e( i( Tria* Ba*a(ce D 2t should be shown only in assets side of the 4alance )heet. >ii?I+ prepai- e2pe(se ,i.e( as a-9ustme(t D ". 3irst, it should be deducted from the concerned expenses at the debit side of profit and loss account or Trading Account. &. Fext, it should be shown at the assets side of the 4alance )heet. '.INCO!E EARNED BUT NOT RECEIVED 0OR1 OUTSTANDING INCO!E 0OR1 ACCURED INCO!E D: >i?I+ i(comes ,i.e( i( Tria* Ba*a(ceD 2t should be shown only on the assets side of the 4alance )heet. >ii?I+ i(comes outsta(-i(, ,i.e( as a-9ustme(t D ". 3irst, it should be added to the concerned income at the credit side of profit and loss account. &. Fext, it should be shown at the assets side of the 4alance sheet. +. INCO!E RECEIVED IN ADVANCE: UNEARNED INCO!ED: >i?I+ u(ear(e- i(comes ,i.e( i( Trai* Ba*a(ce D 2t should be shown only on the liabilities side of the 4alance )heet. >ii?I+ u(ear(e- i(come ,i.e( as a-9ustme(t D ". 3irst, it should be deducted from the concerned income in the credit side of the profit and loss account. &. )econdly, it should be shown in the liabilities side of the 4alance )heet. -.DEPRECIATIOND: concerned expense at the

>i?I+ Depreciatio( ,i.e( i( Trai* Ba*a(ce D 2t should be shown only on the debit side of the profit and loss account. >ii?I+ Depreciatio( ,i.e( as a-9ustme(t ". 3irst, it should be shown on the debit side of the profit and loss account. &. )econdly, it should be deduced from the concerned asset in the 4alance sheet assets side. ..INTEREST ON "OAN 0OR1 CAPITA" D: >i?I+ i(terest o( *oa( :or; capita* ,i.e( i( Trai* 3a*a(ce and loss account. >ii?I+ i(terest o( *oa( :or;capita* ,i.e( as a-9ustme(t D 1. 3irst, it should be shown on debit side of the profit and loss account. . )econdly, it should added to the loan or capital in the liabilities side of the 4alance )heet. $.BAD DEBTSD: >i?I+ 3a- -e3ts ,i.e( i( Trai* 3a*a(ce D2t should be shown on the debit side of the profit and loss account. >ii?I+ 3a- -e3ts ,i.e( as a-9ustme(tD ". 3irst, it should be shown on the debit side of the profit and loss account. &. )econdly, it should be deducted from debtors in the assets side of the 4alance )heet. #.INTEREST ON DRA6INGS D: >i?I+ i(terest o( -ra/i(,s ,i.e( i( Trai* 3a*a(ce D 2t should be shown on the credit side of the profit and loss account. >ii?I+ i(terest o( -ra/i(,s ,i.e( as a-9ustme(ts D ". 3irst, it should be shown on the credit side of the profit and loss account. &. )econdly, it should be deducted from capital on liabilities side of the 4alance )heet. "*.INTEREST ON INVEST!ENTS D: >i?I+ i(terest o( the i(.estme(ts ,i.e( i( Trai* 3a*a(ce D2t should be shown on the credit side of the profit and loss account. >ii?I+ i(terest o( i(.estme(ts ,i.e( as a-9ustme(ts D D2t should be shown only on debit side of the profit

". 3irst, it should be shown on the credit side of the profit and loss account. &. )econdly, it should be added to the investments on assets side of the 4alance )heet. Note: Problems to be solved on final acco nts SU%SIDIARA %OO&S 2n a small business concern, the numbers of transactions are limited. These transactions are first recorded in the =ournal as and when they take place. )ubse/uently, these transactions are posted in the appropriate accounts of the ledger. Therefore, the =ournal is known as B4ook f riginal 7ntryC or B4ook of (rime 7ntryC while the ledger is known as main book of accounts.

n the other hand, the transactions in big concern are numerous and sometimes even run into thousands and lakhs. 2t is inconvenient and time wasting process if all the transactions are going to be managed with a =ournal. Therefore, a convenient device is made. )maller account books known as subsidiary books or subsidiary =ournals are disturbed to various sections of the business house. As and when transactions take place, they are recorded in these subsidiary books simultaneously without delay. The original =ournal >which is known as !ournal (roper? is used only occasionally to record those transactions which cannot be recorded in any of the subsidiary books. T PES OF SUBSIDIAR BOOKSD:: )ubsidiary books are divided into eight types. They are, ".(urchases 4ook &.)ales 4ook 0.(urchase %eturns 4ook '.)ales %eturns 4ook +.5ash 4ook -.4ills %eceivable 4ook ..4ills (ayable 4ook $.!ournal (roper ". PURC#ASES BOOK D: This book records all credit purchases only. (urchase of goods for cash and purchase of assets for cash. 5redit will not be recorded in this book. (urchases book is otherwise called (urchases 6ay 4ook, (urchases !ournal or (urchases %egister. &. SA"ES BOOK D:This book is used to record credit sales only. ,oods are sold for cash and sale of assets for cash or credit will not be recorded in this book. This book is otherwise called )ales 6ay 4ook, )ales !ournal or )ales %egister. 0.PURC#ASE RETURNS BOOK D: This book is used to record the particulars of goods returned to the suppliers .This book is otherwise called %eturns utward 4ook. '.SA"ES RETURNS BOOK D: This book is used to record the particulars of goods returned by the customers. This book is otherwise called %eturns 2nward 4ook. +.CAS# BOOK D: All cash transactions , receipts and payments are recorded in this book. 5ash includes che/ues, money orders etc. -.BI""S REECEIVAB"E BOOK received from the customers. D: This book is used to record all the bills and promissory notes are

..BI""S PA AB"E BOOK D: This book is used to record all the bills or promissory notes accepted to the suppliers. $.%OURNA" PROPER D: This is used to record all the transactions that cannot be recorded in any of the above mentioned subsidiary books. FOR!AT FOR PURC#ASE BOOK 6ate Fame of supplier 2nvoic e Fo Lf no 6etails Amount>%s .?

FOR!AT FOR SA"ES BOOK 6ate Fame of customer 2nvoic e Fo Lf no 6etails Amount>%s .?

FOR!AT FOR PURC#ASE RETURNS BOOK 6ate Fame of supplier 6ebit note Fo Lf no 6etails Amount>%s .?

6ate

FOR!AT FOR SA"ES RETURNS BOOK Fame of supplier 5redit Lf 6etails note no Fo

Amount>%s.?

CASH %OO& 5ash book plays an important role in accounting. Whether transactions made are in the form of cash or credit, final statement will be in the form of receipt or payment of cash. )o, every transaction finds place in the cash book finally. 5ash book is a principal book as well as the subsidiary book. 2t is a book of original entry since the transactions are recorded for the first time from the source of documents. 2t is a ledger in a sense it is designed in the form of cash account and records cash receipts on the debit side and the cash payments on the credit side. Thus, a cash book fulfils the functions of both a ledger account and a =ournal. 5ash book is divided into two sides. %eceipt side >debit side? and payment side >credit side?. The method of recording cash sample is very simple. All cash receipts will be posted on the debit side and all the payments will be recorded on the credit side. T)pes o+ cash 3oo8: cash book may be of the following types according to the needs of the business. )imple cash book 6ouble column or two column cash book Three column cash book (etty cash book

SING"E CO"U!N CAS# BOOK: The simple cash book is a record of only cash transactions. The model of the cash book is given below. CAS# BOOK 6at e (articul ars Lf no Amount 6at e (articulars Lf no A m o u n t

T6O CO"U!N CAS# BOOK: This book has two columns on each side one for discount and the other for cash. 6iscount column on debit side represents loss being discount allowed to customers. )imilarly, discount column on credit side represents gain being discount received. 6iscount may be two types. >i?Trade discount >ii?cash discount TRADE DISCOUNT: when a retailer purchases goods from the wholesaler, he allows some discount on the catalogue price. This discount is called as Trade discount. Trade discount is ad=usted in the invoice and the net amount is recorded in the purchase book. As such it will not appear in the book of accounts. CAS# DISCOUNT: When the goods are purchased on credit, payment will be made in the future as agreed by the parties. 2f the amount is paid early as promptly a discount by a way of incentive will be allowed by the seller to the buyer. This discount is called as cash discount. )o cash discount is the discount allowed by the seller to encourage prompt payment from the buyer. 5ash discount is entered in the discount column of the cash book. The discount recorded in the debit side of the cash book is discount allowed. The discount recorded in the credit side of the cash book is discount received. CAS# DISCOUNT CO"U!N CAS# BOOK 6ate particulars Lf n o 6isc. Allo wed cash 6ate (articulars Lf Fo 6isc %ecei 8ed. cash

PETT CAS# BOOK: We have seen that all the cash receipts and payments will be recorded in the cash book. 4ut in the case of big concerns if all transactions like postage, cleaning charges, etc., are recorded

in the cash book, the cash book becomes bulky and un wieldy. )o, all petty disbursement of cash is recorded in a separate cash book called petty cash book.

UNIT - VIII FINANCIAL ANALASIS THROUGH RATIOS

R$tio An$/ysis Absolute figures are valuable but they standing alone convey no meaning unless compared with another. Accounting ratio show inter:relationships which exist among various accounting data. When relationships among various accounting data supplied by financial statements are worked out, they are known as accounting ratios. Accounting ratios can be expressed in various ways such asD ". a pure ratio says ratio of current assets to current liabilities is &D" or &. a rate say current assets are two times of current liabilities or 0. a percentage say current assets are &**P of current liabilities. 7ach method of expression has a distinct advantage over the other the analyst will selected that mode which will best suit his convenience and purpose. Ises or Advantages or 2mportance of %atio Analysis %atio Analysis stands for the process of determining and presenting the relationship of items and groups of items in the financial statements. 2t is an important techni/ue of financial analysis. 2t is a way by which financial stability and health of a concern can be =udged. The following are the main uses of %atio analysisD >a? Iseful in financial position analysisD Accounting reveals the financial position of the concern. This helps banks, insurance companies and other financial institution in lending and making investment decisions. >ii? Iseful in simplifying accounting figuresD Accounting ratios simplify, summaries and systematic the accounting figures in order to make them more understandable and in lucid form. >iii? Iseful in assessing the operational efficiencyD Accounting ratios helps to have an idea of the working of a concern. The efficiency of the firm becomes evident when analysis is based on accounting ratio. This helps the management to assess financial re/uirements and the capabilities of various business units. >iv? Iseful in forecasting purposesD 2f accounting ratios are calculated for number of years, then a trend is established. This trend helps in setting up future plans and forecasting. >v? Iseful in locating the weak spots of the businessD Accounting ratios are of great assistance in locating the weak spots in the business even through the overall performance may be efficient. >vi? Iseful in comparison of performanceD Janagers are usually interested to know which department performance is good and for that he compare one department with the another department of the same firm. %atios also help him to make any change in the organisation structure. Li3it$tions of R$tio An$/ysis! These limitations should be kept in mind while making use of ratio analyses for interpreting the financial statements. The following are the main limitations of ratio analysis. ". 3alse results if based on incorrect accounting dataD Accounting ratios can be correct only if the data >on which they are based? is correct. )ometimes, the information given in the financial statements is affected by window dressing, i. e. showing position better than what actually is.

&. Fo idea of probable happenings in futureD %atios are an attempt to make an analysis of the past financial statements@ so they are historical documents. Fow:a:days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future. 0. 8ariation in accounting methodsD The two firms; results are comparable with the help of accounting ratios only if they follow the some accounting methods or bases. 5omparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock. '. (rice level changeD 5hange in price levels make comparison for various years difficult. +. nly one method of analysisD %atio analysis is only a beginning and gives =ust a fraction of information needed for decision:making so, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis. -. Fo common standardsD 2t is very difficult to by down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. .. 6ifferent meanings assigned to the some termD 6ifferent firms, in order to calculate ratio may assign different meanings. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions. $. 2gnores /ualitative factorsD Accounting ratios are tools of /uantitative analysis only. 4ut sometimes /ualitative factors may surmount the /uantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted. #. Fo use if ratios are worked out for insignificant and unrelated figureD Accounting ratios should be calculated on the basis of cause and effect relationship. ne should be clear as to what cause is and what effect is before calculating a ratio between two figures. %atio AnalysisD %atio is an expression of one number is relation to another. 2t is one of the methods of analy1ing financial statement. %atio analysis facilities the presentation of the information of the financial statements in simplified and summari1ed from. %atio is a measuring of two numerical positions. 2t expresses the relation between two numeric figures. 2t can be found by dividing one figure by another ratios are expressed in three ways. ". !ines method &. %atio Jethod 0. (ercentage Jethod 5lassification of ratiosD All the ratios broadly classified into four types due to the interest of different parties for different purposes. They areD ". &. 0. '. (rofitability ratios Turn over ratios 3inancial ratios Leverage ratios

". (rofitability ratiosD These ratios are calculated to understand the profit positions of the business. These ratios measure the profit earning capacity of an enterprise. These ratios can be related its save or capital to a certain margin on sales or profitability of capital employ. These ratios are of interest to management. Who are responsible for success and growth of enterpriseQ wners as well as financiers are interested in profitability ratios as these reflect ability of enterprises to generate return on capital employ important profitability ratios areD (rofitability ratios in relation to salesD (rofitability ratios are almost importance of concern. These ratios are calculated is focus the end results of the business activities which are the sole eritesiour of overall efficiency of gross pro"it organisation. ". ,ross profit ratioD x
!est sales

"**

FoteD Higher the ratio the better it is &. Fet profit ratioD M
!et pro"it a"ter interest # Tax !et sales

"**

FoteD Higher the ratio the better it is 0.

$ost o" goods sold + operating exenses !et sales M "** %perating pro"it !et sales M "** R "** operating ratio perating profit ratioD

perating ratio > perating expenses ratio?

FetD Lower the ratio the better it is '.

FoteD Higher the ratio the better it is cost of goods soldR opening stock S purchase S wages S other direct expenses: closing stock >or? sales A gross profit. perating expensesD R administration expenses S setting, distribution expenses operating profitR gross profit A operating expense. 7xpenses ratio R
concern expense M "** !et sales

FoteD Lower the ratio the better it is (rofitability ratios in relation to investmentsD !et pro"it a"ter tax # latest depreciation ". %eturn on investmentsD
share holders "unds

M "**

)hare holders funds R e/uity share capital S preference share capital S receives N surpluses Sundistributed profits. FoteD Higher the ratio the better it is &. %eturn on e/uity capitalD
!et (ro"it a"ter tax # interest - pre"erence divident e&uit' share capital

M "**

FoteD Higher the ratio the better it is 0. 7arnings per shareR

!et pro"it a"ter tax - pre"erecne divident !o. o" e&uit' shares
operating pro"it capital emplo'ed x "**

'. %eturn on capital employed R +. %eturn on total assets R

!. (. a"ter tax and interest Total Assets

Here, capital employed R e/uity share capital S preference share capital S reserves N surpluses S undistributed profits S debenturesS public deposit S securities S long term loan S other long term liability A factious assets >preliminary expressed N profit N loss account debt balance? 22. Turn over ratios or activity ratiosD These ratios measure how efficiency the enterprise employees the resources of assets at its command. They indicate the performance of the business. The performance if an enterprise is =udged with its save. 2t means ratios are also laced efficiency ratios.

These ratios are used to know the turn over position of various things in the TTTTTTTTTTT. The turnover ratios are measured to help the management in taking the decisions regarding the levels maintained in the assets, and raw materials and in the funds. These ratio s are measured in ratio method.
cost o" goods sold ". )tock turnover ratio average stoc)

Here, Average stockR opening stoc) + closing stoc) FoteD Higher the ratio, the better it is &. Working capital turnover ratio R
sales *or)ing capital

FoteD Higher the ratio the better it is working capital R current assets A essential liabilities. 0. 3ixed assets turnover ratio R
sales "ixed assets sales total assets

FoteD Higher the ratio the better it is. 0 >i? Total assets turnover ratio is D FoteD Higher the ratio the better it is. '. 5apital turnover ratioR FoteD Higher the ratio the better it is +. 6ebtors turnover ratioR +>i?R 6ebtors collection periodR

+ales $apital emplo'ed

credits sales or sales average de,tors

/01 -or. 1 Turnove ratio

Here, Average debtors R

opening de,itors + closing ,e,tors

6ebtors R debtors S bills receivable FoteD Higher the ratio the better it is. -. 5reditors turnover ratio R
opening + closing credetors

credit purchasers or purchases average credetors

- >i? creditors collection periodR Here, Average creditorR 5reditors R creditors S bills payable. FoteD lower the ratio the better it is.

/01 -or. 1 $reditor turnover ratio

1. Fin$nci$/ r$tios or /i:ui#ity r$tios!

Li/uidity refers to ability of organisation to meet its current obligation. These ratios are used to measure the financial status of an organisation. These ratios help to the management to make the decisions about the maintained level of current assets N current libraries of the business. The main purpose to calculate these ratios is to know the short terms solvency of the concern. These ratios are useful to various parties having interest in the enterprise over a short period A such parties include banks. Lenders, suppliers, employees and other. The li/uidity ratios assess the capacity of the company to repay its short term liabilities. These ratios are calculated in ratio method. 5urrent ratio R
current assets current lia,ilities

FoteD The ideal ratio is &D" i. e., current assets should be twice. The current liabilities. Uuick ratio or li/uid ratio or acid test ratioD
&uic) assets current lia,ilities

Uuick assets R cash in hand S cash at bank S short term investments S debtors S bills receivables short term investments are also known as marketable securities. Here the ideal ratio is "D" is, /uick assets should be e/ual to the current liabilities. Absolute li/uid ratioR
a,solute li&uid assets current lia,ilities

Here, Absolute li/uid assetsRcash in hand S cash at bank S short term investments S marketable securities. Here, the ideal ratio is *,*D" or "D& it, absolute li/uid assets must be half of current liabilities. Leverage ratio of solvency ratiosD )olvency refers to the ability of a business to honour long item obligations like interest and installments associated with long term debts. )olvency ratios indicate long term stability of an enterprise. These ratios are used to understand the yield rate if the organisation. Lenders like financial institutions, debenture, holders, banks are interested in ascertaining solvency of the enterprise. The important solvency ratios areD ". 6ebt A e/uity ratioR
outsiders "unds share holders "unds

Here, utsiders funds R 6ebentures, public deposits, securities, long term bank loans S other long term liabilities. )hare holders funds R e/uity share capital S preference share capital S reserves N surpluses S undistributed pro=ects. The ideal ratio is &D" share holder "unds &. (reprimary ratio or e/uity ratioR The ideal ratio is "D0 or *.00D" total assets 0. 5apital A greasing ratioD R Here,
-e&uit' share capital + reserves # surplusses + undistri,uted pro2ects. -%utsiders "unds + pre"erence share capital .

higher gearing ratio is not good for a new company or the company in which future earnings are uncertain. "". 6ebt to total fund ratioR
outsiders "unds capital emplo'ed

5apital employedR outsiders funds S share holders funds R debt S e/uity. The ideal ratio is *.-.. D" or &D0

CAPITAL %UDGETING
C$*it$/ %u# )tin ! 5apital budgeting is the process of making investment decision in long:term assets or courses of action. 5apital expenditure incurred today is expected to bring its benefits over a period of time. These expenditures are related to the ac/uisition N improvement of fixes assets. 5apital budgeting is the planning of expenditure and the benefit, which spread over a number of years. 2t is the process of deciding whether or not to invest in a particular pro=ect, as the investment possibilities may not be rewarding. The manager has to choose a pro=ect, which gives a rate of return, which is more than the cost of financing the pro=ect. 3or this the manager has to evaluate the worth of the pro=ects in:terms of cost and benefits. The benefits are the expected cash inflows from the pro=ect, which are discounted against a standard, generally the cost of capital. C$*it$/ %u# )tin Proc)ss! The capital budgeting process involves generation of investment, proposal estimation of cash:flows for the proposals, evaluation of cash:flows, selection of pro=ects based on acceptance criterion and finally the

continues revaluation of investment after their acceptance the steps involved in capital budgeting process are as follows. ". (ro=ect generation &. (ro=ect evaluation 0. (ro=ect selection '. (ro=ect execution 1. Pro-)ct )n)r$tion! 2n the pro=ect generation, the company has to identify the proposal to be undertaken depending upon its future plans of activity. After identification of the proposals they can be grouped according to the following categoriesD a. R)*/$c)3)nt of ):ui*3)nt! 2n this case the existing outdated e/uipment and machinery may be replaced by purchasing new and modern e/uipment. b. E8*$nsion! The 5ompany can go for increasing additional capacity in the existing product line by purchasing additional e/uipment. c. 6iversificationD The 5ompany can diversify its product line by way of producing various products and entering into different markets. 3or this purpose, it has to ac/uire the fixed assets to enable producing new products. d. %esearch and 6evelopmentD Where the company can go for installation of research and development suing by incurring heavy expenditure with a view to innovate new methods of production new products etc., ". Pro-)ct ).$/u$tionD 2n involves two steps. a. 7stimation of benefits and costsD These must be measured in terms of cash flows. 4enefits to be received are measured in terms of cash flows. 4enefits to be received are measured in terms of cash in flows, and costs to be incurred are measured in terms of cash flows. b. )election of an appropriate criterion to =udge the desirability of the pro=ect. 1. Pro-)ct s)/)ction! There is no standard administrative procedure for approving the investment decisions. The screening and selection procedure would differ from firm to firm. 6ue to lot of importance of capital budgeting decision, the final approval of the pro=ect may generally rest on the top management of the company. However the proposals are scrutini1ed at multiple levels. )ome times top management may delegate authority to approve certain types of investment proposals. The top management may do so by limiting the amount of cash out lay. (rescribing the selection criteria and holding the lower management levels accountable for the results. 7. Pro-)ct E8)cution! 2n the pro=ect execution the top management or the pro=ect execution committee is responsible for effective utili1ation of funds allocated for the pro=ects. 2t must see that the funds are spent in accordance with the appropriation made in the capital budgeting plan. The funds for the purpose of the pro=ect execution must be spent only after obtaining the approval of the finance controller. 3urther to have an effective cont. 2t is necessary to prepare monthly budget reports to show clearly the total amount appropriated, amount spent and to amount unspent C$*it$/ +u# )tin T)c4ni:u)s! The capital budgeting appraisal methods are techni/ues of evaluation of investment proposal will help the company to decide upon the desirability of an investment proposal depending upon their@ relative income generating capacity and rank them in order of their desirability. These methods provide the company a set of norms on the basis of which either it has to accept or re=ect the investment proposal. The most widely accepted techni/ues used in estimating the cost:returns of investment pro=ects can be grouped under two categories. ". Traditional methods &. 6iscounted 5ash flow methods 1. Tr$#ition$/ 3)t4o#s These methods are based on the principles to determine the desirability of an investment pro=ect on the basis of its useful life and expected returns. These methods depend upon the accounting information

available from the books of accounts of the company. These will not take into account the concept of 9time value of money;, which is a significant factor to determine the desirability of a pro=ect in terms of present value. A. P$y-+$c' *)rio# 3)t4o#D 2t is the most popular and widely recogni1ed traditional method of evaluating the investment proposals. 2t can be defined, as 9the number of years re/uired to recover the original cash out lay invested in a pro=ect;. According to Weston N 4righam, BThe pay back period is the number of years it takes the firm to recover its original investment by net returns before depreciation, but after taxesC. According to !ames. 5. 8anhorne, BThe payback period is the number of years re/uired to recover initial cash investment. The pay back period is also called payout or payoff period. This period is calculated by dividing the cost of the pro=ect by the annual earnings after tax but before depreciation under this method the pro=ects are ranked on the basis of the length of the payback period. A pro=ect with the shortest payback period will be given the highest rank and taken as the best investment. The shorter the payback period, the less risky the investment is the formula for payback period is (ay:back period R 5ash outlay >or? original cost of pro=ect ::::::::::::::::::::::::::::::::::::::::::: Annual cash inflow

2)rits! ". 2t is one of the earliest methods of evaluating the investment pro=ects. &. 2t is simple to understand and to compute. 0. 2t dose not involve any cost for computation of the payback period. '. 2t is one of the widely used methods in small scale industry sector. +. 2t can be computed on the basis of accounting information available from the books. D)3)rits! ". This method fails to take into account the cash flows received by the company after the pay back period. &. 2t doesn;t take into account the interest factor involved in an investment outlay. 0. 2t doesn;t take into account the interest factor involved in an investment outlay. '. 2t is not consistent with the ob=ective of maximi1ing the market value of the company;s share. +. 2t fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows. %. Accountin 5or6 A.)r$ ) r$t) of r)turn 3)t4o# 5ARR6! 2t is an accounting method, which uses the accounting information repeated by the financial statements to measure the probability of an investment proposal. 2t can be determine by dividing the average income after taxes by the average investment i.e., the average book value after depreciation. According to 9)oloman;, accounting rate of return on an investment can be calculated as the ratio of accounting net income to the initial investment, i.e., Average net income after taxes A%%R ::::::::::::::::::::::::::::::::::::::::::: M "** Average 2nvestment Total 2ncome after Taxes Average net income after taxes R ::::::::::::::::::::::::::::: Fo. f Kears Total 2nvestment ::::::::::::::::::::::::: & n the basis of this method, the company can select all those pro=ects whose A%% is higher than the minimum rate established by the company. 2t can re=ect the pro=ects with an A%% lower than the expected Average investment R

rate of return. This method can also help the management to rank the proposal on the basis of A%%. A highest rank will be given to a pro=ect with highest A%%, where as a lowest rank to a pro=ect with lowest A%%. 2)rits! ". 2t is very simple to understand and calculate. &. 2t can be readily computed with the help of the available accounting data. 0. 2t uses the entire stream of earning to calculate the A%%. D)3)rits! ". 2t is not based on cash flows generated by a pro=ect. &. This method does not consider the ob=ective of wealth maximi1ation 0. 2T ignores the length of the pro=ects useful life. '. 2t does not take into account the fact that the profits can be re:invested. II! Discount)# c$s4 f/o, 3)t4o#s! The traditional method does not take into consideration the time value of money. They give e/ual weight age to the present and future flow of incomes. The 653 methods are based on the concept that a rupee earned today is more worth than a rupee earned tomorrow. These methods take into consideration the profitability and also time value of money. A. N)t *r)s)nt .$/u) 3)t4o# 5NPV6 The F(8 takes into consideration the time value of money. The cash flows of different years and valued differently and made comparable in terms of present values for this the net cash inflows of various period are discounted using re/uired rate of return which is predetermined. According to 71ra )olomon, B2t is a present value of future returns, discounted at the re/uired rate of return minus the present value of the cost of the investment.C F(8 is the difference between the present value of cash inflows of a pro=ect and the initial cost of the pro=ect. According the F(8 techni/ue, only one pro=ect will be selected whose F(8 is positive or above 1ero. 2f a pro=ect>s? F(8 is less than 9Vero;. 2t gives negative F(8 hence. 2t must be re=ected. 2f there is more than one pro=ect with positive F(8;s the pro=ect is selected whose F(8 is the highest. The formula for F(8 is F(8R (resent value of cash inflows A investment. 5" 5& 50 5n F(8 R :::::: S ::::::: S :::::::: S ::::::: >"S<? 5o: investment 5", 5&, 50L 5nR cash inflows in different years. <R 5ost of the 5apital >or? 6iscounting rate 6R Kears. 2)rits! ". 2t recogni1es the time value of money. &. 2t is based on the entire cash flows generated during the useful life of the asset. 0. 2t is consistent with the ob=ective of maximi1ation of wealth of the owners. '. The ranking of pro=ects is independent of the discount rate used for determining the present value. D)3)rits! ". 2t is different to understand and use. &. The F(8 is calculated by using the cost of capital as a discount rate. 4ut the concept of cost of capital. 2f self is difficult to understood and determine. 0. 2t does not give solutions when the comparable pro=ects are involved in different amounts of investment. '. 2t does not give correct answer to a /uestion whether alternative pro=ects or limited funds are available with une/ual lines

%. Int)rn$/ R$t) of R)turn 2)t4o# 5IRR6 The 2%% for an investment proposal is that discount rate which e/uates the present value of cash inflows with the present value of cash out flows of an investment. The 2%% is also known as cutoff or handle rate. 2t is usually the concern;s cost of capital. According to Weston and 4righam BThe internal rate is the interest rate that e/uates the present value of the expected future receipts to the cost of the investment outlay. When compared the 2%% with the re/uired rate of return >%%%?, if the 2%% is more than %%% then the pro=ect is accepted else re=ected. 2n case of more than one pro=ect with 2%% more than %%%, the one, which gives the highest 2%%, is selected. The 2%% is not a predetermine rate, rather it is to be trial and error method. 2t implies that one has to start with a discounting rate to calculate the present value of cash inflows. 2f the obtained present value is higher than the initial cost of the pro=ect one has to try with a higher rate. Like wise if the present value of expected cash inflows obtained is lower than the present value of cash flow. Lower rate is to be taken up. The process is continued till the net present value becomes Vero. As this discount rate is determined internally, this method is called internal rate of return method. (" : U 2%% R LS ::::::::: M 6 (" A(& L: Lower discount rate (" : (resent value of cash inflows at lower rate. (& : (resent value of cash inflows at higher rate. U: Actual investment 6: 6ifference in 6iscount rates.

2)rits! ". 2t consider the time value of money &. 2t takes into account the cash flows over the entire useful life of the asset. 0. 2t has a psychological appear to the user because when the highest rate of return pro=ects are selected, it satisfies the investors in terms of the rate of return an capital '. 2t always suggests accepting to pro=ects with maximum rate of return. +. 2t is inconformity with the firm;s ob=ective of maximum owner;s welfare. D)3)rits! ". 2t is very difficult to understand and use. &. 2t involves a very complicated computational work. 0. 2t may not give uni/ue answer in all situations. C. Pro+$+i/ity In#)8 2)t4o# 5PI6 The method is also called benefit cost ration. This method is obtained cloth a slight modification of the F(8 method. 2n case of F(8 the present value of cash out flows are profitability index >(2?, the present value of cash inflows are divide by the present value of cash out flows, while F(8 is a absolute measure, the (2 is a relative measure. 2t the (2 is more than one >W"?, the proposal is accepted else re=ected. 2f there are more than one investment proposal with the more than one (2 the one with the highest (2 will be selected. This method is more useful incase of pro=ects with different cash outlays cash outlays and hence is superior to the F(8 method. The formula for (2 is (resent 8alue of 3uture 5ash 2nflow (robability index R :::::::::::::::::::::::::::::::::::::::::::::::: 2nvestment 2)rits! ". 2t re/uires less computational work then 2%% method &. 2t helps to accept E re=ect investment proposal on the basis of value of the index. 0. 2t is useful to rank the proposals on the basis of the highestElowest value of the index. '. 2t is useful to tank the proposals on the basis of the highestElowest value of the index. +. 2t takes into consideration the entire stream of cash flows generated during the useful life of the asset. D)3)rits! ". 2t is some what difficult to understand &. )ome people may feel no limitation for index number due to several limitation involved in their competitions 0. 2t is very difficult to understand the analytical part of the decision on the basis of probability index.