FRA NOTES (QUESTIONS AND ANSWERS FORMAT)

Financial Reporting: Meaning, Objectives and Importance

UNIT-1
In any industry, whether manufacturing or service, we have multiple departments, which function day in
day out to achieve organizational goals. The functioning of these departments may or may not be
interdependent, but at the end of day they are linked together by one common thread – Accounting &
Finance department. Financial Reporting involves the disclosure of financial information to the various
stakeholders about the financial performance and financial position of the organization over a specified
period of time. These stakeholders include – investors, creditors, public, debt providers, governments &
government agencies. In case of listed companies the frequency of financial reporting is quarterly &
annual.

Financial Reporting is usually considered as end product of Accounting. The typical components of
financial reporting are:

1. The financial statements – Balance Sheet, Profit & loss account, Cash flow statement &
Statement of changes in stock holder’s equity
2. The notes to financial statements
3. Quarterly & Annual reports (in case of listed companies)
4. Prospectus (In case of companies going for IPOs)
5. Management Discussion & Analysis (In case of public companies)

Objectives of Financial Reporting

The following points sum up the objectives & purposes of financial reporting –

1. Providing information to management of an organization which is used for the purpose of

planning, analysis, benchmarking and decision making.
2. Providing information to investors, promoters, debt provider and creditors which is used to
enable them to male rational and prudent decisions regarding investment, credit etc.
3. Providing information to shareholders & public at large in case of listed companies about
various aspects of an organization.
4. Providing information about the economic resources of an organization, claims to those
resources (liabilities & owner’s equity) and how these resources and claims have undergone
change over a period of time.
5. Providing information as to how an organization is procuring & using various resources.
6. Providing information to various stakeholders regarding performance management of an
organization as to how diligently & ethically they are discharging their fiduciary duties &
responsibilities.
7. Providing information to the statutory auditors which in turn facilitates audit.
 8. Enhancing social welfare by looking into the interest of employees, trade union & Government.

Importance of Financial Reporting

The importance of financial reporting cannot be over emphasized. It is required by each and every
stakeholder for multiple reasons & purposes. The following points highlights why financial reporting
framework is important –

1. In helps and organization to comply with various statues and regulatory requirements. The
organizations are required to file financial statements to ROC, Government Agencies. In case of
listed companies, quarterly as well as annual results are required to be filed to stock exchanges
and published.
2. It facilitates statutory audit. The Statutory auditors are required to audit the financial
statements of an organization to express their opinion.
3. Financial Reports forms backbone for financial planning, analysis, bench marking and decision
making. These are used for above purposes by various stakeholders.
4. Financial reporting helps organizations to raise capital both domestic as well as overseas.
5. On the basis of financials, the public in large can analyze the performance of the organization as
well as of its management.
6. For the purpose of bidding, labor contract, government supplies etc., organizations are required
to furnish their financial reports & statements.

Annual Report
What is an Annual Report?

The single source of getting information about any company whether it is the past or present
performance or for that matter, the future outlook, detailed financial performance through the financial
statements, corporate governance or CSR activities, all is compiled in the Annual Report of the company.
Key constituents of Annual Report:
The major components of the annual report mirror the psyche of the company, giving a fair idea on the
sustainability of business and how sound the business is.

Letter from the Chairman: This part of the annual report mainly tells you how the company has
performed during the year. It’s a place to find apologies and reasons if the performance doesn’t meet
the expectations. The goals and strategies for the future are also laid down by the leading hands in this
section of the annual report.

Ten-year financial summary: Assuming that a company is at least ten years old, many annual reports
contain a snapshot of the financial results over that period of time. This helps in seeing the growth / de-
growth trend of revenues and profits and other leading indicators of a company’s financial success.
List of directors and other officers: All the data regarding the leading managers like the president, chief
executive officer (CEO), vice presidents, chief financial officer (CFO) is provided here. Also, information
pertaining to the other seniors who may not be a part of the organization, but are present on the board
of the company, to help and guide the organization is available in this section of the annual report.

Directors’ report: The director’s report comprises of all the key events that happened during the
reporting period. It contains all the information like summary of financials, operational performance
analysis, and details of new ventures, partnerships and businesses, performance of subsidiaries, details
of change in share capital and details of dividends. In short, it provides a recap of the fiscal year under
consideration.

Corporate information: Subsidiaries, brands, addresses: This section has all the information regarding
company locations (domestic and foreign), contact information, as well as brand names and product
lines.

General shareholders’ information and corporate governance: The report on corporate governance
covers all the aspects that are essential to the shareholder of a company and are not a part of the daily
operations of the company. It provides all the details regarding the directors and management of the
company, for e.g. their background and remuneration. It also provides data regarding board meetings as
to how many directors attended how many meetings. It also provides general shareholder information
such as correspondence details, details of annual general meetings, dividend payment details, stock
performance (stock history, stock price trends, listing stock exchanges), details of registrar and transfer
agents and the shareholding pattern.

Financial statements and schedules: This section includes the financial performance data of the
company. It provides details regarding the operational performance and financial strength of a company
during the reporting period through the income statement, balance sheet and cash flow statement. The
footnotes are equally important as they provide information about the organization’s structure and
financial status that has not been covered anywhere else in the report.

a) Profit and Loss statement: It is the financial statement that summarizes the revenues, costs and
expenses incurred during a specific period of time. It clearly indicates how much was earned and what
went into getting those earnings.

b) Balance Sheet: This provides the summary of the assets and liabilities of a company. It gives a fair
idea of what the company owns and what it owes.

c) Cash Flow: Cash Flow Statement is the accounting statement that provides the details of how much
cash is generated and used by the company over a specific period of time.

The purpose of financial statements

The general purpose of the financial statements is to provide information about the results of
operations, financial position, and cash flows of an organization. This information is used by the readers
of financial statements to make decisions regarding the allocation of resources. At a more refined level,
there is a different purpose associated with each of the financial statements.

As a group, the entire set of financial statements can also be assigned several additional purposes, which
are:

1. Credit decisions. Lenders use the entire set of information in the financials to determine
whether they should extend credit to a business, or restrict the amount of credit already
extended.
2. Investment decisions. Investors use the information to decide whether to invest, and the price
per share at which they want to invest. An acquirer uses the information to develop a price at
which to offer to buy a business.
3. Taxation decisions. Government entities may tax a business based on its assets or income, and
can derive this information from the financials.
4. Union bargaining decisions. A union can base its bargaining positions on the perceived ability of
a business to pay; this information can be gleaned from the financial statements.
5. In addition, financial statements can be presented for individual subsidiaries or business
segments, to determine their results at a more refined level of detail.

In short, the financial statements have a number of purposes, depending upon who is reading the
information and which financial statements are being perused.

Types of financial statements

Financial statements provide a picture of the performance, financial position, and cash flows of a
business. These documents are used by the investment community, lenders, creditors, and management
to evaluate an entity. There are four main types of financial statements, which are as follows:

1. Income statement. This report reveals the financial performance of an organization for the
entire reporting period. It begins with sales, and then subtracts out all expenses incurred during
the period to arrive at a net profit or loss. Earnings per share figure may also be added if the
financial statements are being issued by a publicly-held company. This is usually considered the
most important financial statement, since it describes performance.
2. Balance sheet. This report shows the financial position of a business as of the report date (so it
covers a specific point in time). The information is aggregated into the general classifications of
assets, liabilities, and equity. Line items within the asset and liability classification are presented
in their order of liquidity, so that the most liquid items are stated first. This is a key document,
and so is included in most issuances of the financial statements.
3. Statement of cash flows. This report reveals the cash inflows and outflows experienced by an
organization during the reporting period. These cash flows are broken down into three
classifications, which are operating activities, investing activities, and financing activities. This
document can be difficult to assemble, and so is more commonly issued only to outside parties.
 4. Statement of changes in equity. This report documents all changes in equity during the
reporting period. These changes include the issuance or purchase of shares, dividends issued,
and profits or losses. This document is not usually included when the financial statements are
issued internally, as the information in it is not overly useful to the management team.

When issued to users, the preceding types of financial statements may have a number of footnote
disclosures attached to them. These additional notes clarify certain summary-level information
presented in the financial statements, and may be quite extensive. Their exact contents are defined by
the applicable accounting standards.

Limitations of financial statements

The limitations of financial statements are those factors that a user should be aware of before relying on
them to an excessive extent. Knowledge of these factors could result in a reduction of invested funds in
a business, or actions taken to investigate further. The following are all limitations of financial
statements:

 Dependence on historical costs. Transactions are initially recorded at their cost. This is a concern
when reviewing the balance sheet, where the values of assets and liabilities may change over
time. Some items, such as marketable securities, are altered to match changes in their market
values, but other items, such as fixed assets, do not change.

 Inflationary effects. If the inflation rate is relatively high, the amounts associated with assets
and liabilities in the balance sheet will appear inordinately low, since they are not being
adjusted for inflation. This mostly applies to long-term assets.

 Intangible assets not recorded. Many intangible assets are not recorded as assets. Instead,
any expenditure made to create an intangible asset is immediately charged to expense. This
policy can drastically underestimate the value of a business, especially one that has spent a large
amount to build up a brand image or to develop new products. It is a particular problem for
startup companies that have created intellectual property, but which have so far generated
minimal sales.

 Based on specific time period. A user of financial statements can gain an incorrect view of the
financial results or cash flows of a business by only looking at one reporting period. Any one
period may vary from the normal operating results of a business, perhaps due to a sudden spike
in sales or seasonality effects.

 Not always comparable across companies. If a user wants to compare the results of different
companies, their financial statements are not always comparable, because the entities use
different accounting practices. These issues can be located by examining the disclosures that
accompany the financial statements.
  Subject to fraud. The management team of a company may deliberately skew the results
presented. This situation can arise when there is undue pressure to report excellent results,
such as when a bonus plan calls for payouts only if the reported sales level increases. One might
suspect the presence of this issue when the reported results spike to a level exceeding the
industry norm.

 No discussion of non-financial issues. The financial statements do not address non-financial

issues, such as the environmental attentiveness of a company's operations, or how well it works
with the local community.

 Not verified. If the financial statements have not been audited, this means that no one has
examined the accounting policies, practices, and controls of the issuer to ensure that it has
created accurate financial statements.

 No predictive value. The information in a set of financial statements provides information about
either historical results or the financial status of a business as of a specific date. The statements
do not necessarily provide any value in predicting what will happen in the future.

Assessment of performance of a business is based on financial

statement analysis.” Explain
One of the major aspects while taking a right investment decision is to analyze the financial statements
of any company. Financial Statement analysis is a process to select, evaluate and interpret financial data
in order to assess a company’s past, present and future financial performance. Various questions about
the company like whether it has debt repaying capacity, is it financially sound or stressed, does it have
an apt financial mix, is it rightly placed to provide returns to shareholders, revenue generating efficiency,
working capital management being among the major ones which can be analyzed to a larger extent
through financial reports. Although the information used is historical, the purpose is to arrive to future
forecasts and an estimated performance of the company.

Methods of Financial Statement Analysis:

Academically, we are all aware of common size analysis which is restating the financial information in a
standardized format. This could be done by horizontal analysis which compares two or more years of
financial data in both Rupee and percentage form and vertical where each category of accounts on the
balance sheet is shown as a percentage of the total accounts. This can be complimented with the
DuPont model and also ratio analysis. Furthermore, we then use relationships among financial
statement accounts, forecasting the company’s future income statements and balance sheets, to see
how the company’s performance is likely to evolve. This step is normally based on the guidance given by
the company management.

Users of Analysis:
Financial analysis is carried out by investors, regulators, lenders and suppliers to decide whether to
invest in a particular company, whether to extend credit to it or no. The management of the company
also carries out financial analysis to evaluate the current performance and implement strategies for the
future. A thorough financial analysis of a company is examining its efficiency in putting its assets to
work, its liquidity position, its solvency and its profitability.

To start off, the annual report of the past 3-5 years of the company is to be acquired. The various
components of the annual report add to the conclusion drawn on the company. The different parts of
the financial statements need to be scanned for abnormalities, and if any found, reasons for the same
are to be chalked.

6 Steps to an Effective Financial Statement Analysis

For any financial professional, it is important to know how to effectively analyze the financial statements
of a firm. This requires an understanding of three key areas:

1. The structure of the financial statements

2. The economic characteristics of the industry in which the firm operates and
3. The strategies the firm pursues to differentiate itself from its competitors.

There are generally six steps to developing an effective analysis of financial statements.

1. Identify the industry economic characteristics.

First, determine a value chain analysis for the industry—the chain of activities involved in the creation,
manufacture and distribution of the firm’s products and/or services. Techniques such as Porter’s Five
Forces or analysis of economic attributes are typically used in this step.

2. Identify company strategies.

Next, look at the nature of the product/service being offered by the firm, including the uniqueness of
product, level of profit margins, creation of brand loyalty and control of costs. Additionally, factors such
as supply chain integration, geographic diversification and industry diversification should be considered.

3. Assess the quality of the firm’s financial statements.

Review the key financial statements within the context of the relevant accounting standards. In
examining balance sheet accounts, issues such as recognition, valuation and classification are keys to
proper evaluation. The main question should be whether this balance sheet is a complete
representation of the firm’s economic position. When evaluating the income statement, the main point
is to properly assess the quality of earnings as a complete representation of the firm’s economic
performance.

4. Analyze current profitability and risk.

This is the step where financial professionals can really add value in the evaluation of the firm and its
financial statements. The most common analysis tools are key financial statement ratios relating to
liquidity, asset management, profitability, debt management/coverage and risk/market valuation. With
respect to profitability, there are two broad questions to be asked: how profitable are the operations of
the firm relative to its assets—independent of how the firm finances those assets—and how profitable is
the firm from the perspective of the equity shareholders. It is also important to learn how to
disaggregate return measures into primary impact factors. Lastly, it is critical to analyze any financial
statement ratios in a comparative manner, looking at the current ratios in relation to those from earlier
periods or relative to other firms or industry averages.

5. Prepare forecasted financial statements.

Although often challenging, financial professionals must make reasonable assumptions about the future
of the firm (and its industry) and determine how these assumptions will impact both the cash flows and
the funding. This often takes the form of pro-forma financial statements, based on techniques such as
the percent of sales approach.

6. Value the firm.

While there are many valuation approaches, the most common is a type of discounted cash flow
methodology. These cash flows could be in the form of projected dividends, or more detailed techniques
such as free cash flows to either the equity holders or on enterprise basis. Other approaches may
include using relative valuation or accounting-based measures such as economic value added.

The next steps

Once the analysis of the firm and its financial statements are completed, there are further questions
that must be answered. One of the most critical is: “Can we really trust the numbers that are being
provided?” There are many reported instances of accounting irregularities. Whether it is called
aggressive accounting, earnings management, or outright fraudulent financial reporting, it is important
for the financial professional to understand how these types of manipulations are perpetrated and more
importantly, how to detect them.

Accounting Standards: Concept, Meaning, Nature and Objectives

Concept of Accounting Standards:

We know that Generally Accepted Accounting Principles (GAAP) aims at bringing uniformity and
comparability in the financial statements. It can be seen that at many places, GAAP permits a variety of
alternative accounting treatments for the same item. For example, different methods for valuation of
stock give different results in financial statements.

Such practices sometimes can misguide intended users in taking decision relating to their field. Keeping
in view the problems faced by many users of accounting, a need for the development of common
accounting standards was aroused.
Meaning of Accounting Standards:

Accounting standards are the written statements consisting of rules and guidelines, issued by the
accounting institutions, for the preparation of uniform and consistent financial statements and also for
other disclosures affecting the different users of accounting information.

Accounting standards lay down the terms and conditions of accounting policies and practices by way of
codes, guidelines and adjustments for making the interpretation of the items appearing in the financial
statements easy and even their treatment in the books of account.

Nature of Accounting Standards:

On the basis of forgoing discussion we can say that accounting standards are guide, dictator, service
provider and harmonizer in the field of accounting process.

(i) Serve as a guide to the accountants:

Accounting standards serve the accountants as a guide in the accounting process. They provide basis on
which accounts are prepared. For example, they provide the method of valuation of inventories.

(ii) Act as a dictator:

Accounting standards act as a dictator in the field of accounting. Like a dictator, in some areas
accountants have no choice of their own but to opt for practices other than those stated in the
accounting standards. For example, Cash Flow Statement should be prepared in the format prescribed
by accounting standard.

(iii) Serve as a service provider:

Accounting standards comprise the scope of accounting by defining certain terms, presenting the
accounting issues, specifying standards, explaining numerous disclosures and implementation date.
Thus, accounting standards are descriptive in nature and serve as a service provider.

(iv) Act as a harmonizer:

Accounting standards are not biased and bring uniformity in accounting methods. They remove the
effect of diverse accounting practices and policies. On many occasions, accounting standards develop
and provide solutions to specific accounting issues. It is thus clear that whenever there is any conflict on
accounting issues, accounting standards act as harmonizer and facilitate solutions for accountants.

Objectives of Accounting Standards:

In earlier days, accounting was just used for recording business transactions of financial nature. Its main
emphasis now lies on providing accounting information in the process of decision making.

For the following purposes, accounting standards are needed:

(i) For bringing uniformity in accounting methods:

Accounting standards are required to bring uniformity in accounting methods by proposing standard
treatments to the accounting issue. For example, AS-6(Revised) states the methods for depreciation
accounting.

(ii) For improving the reliability of the financial statements:

Accounting is a language of business. There are many users of the information provided by accountants
who take various decisions relating to their field just on the basis of information contained in financial
statements. In this connection, it is necessary that the financial statements should show true and fair
view of the business concern. Accounting standards when used give a sense of faith and reliability to
various users.

They also help the potential users of the information contained in the financial statements by disclosure
norms which make it easy even for a layman to interpret the data. Accounting standards provide a
concrete theory base to the process of accounting.

(iii) Simplify the accounting information:

Accounting standards prevent the users from reaching any misleading conclusions and make the
financial data simpler for everyone. For example, AS-3 (Revised) clearly classifies the flows of cash in
terms of ‘operating activities’, ‘investing activities’ and ‘financing activities’.

(iv) Prevents frauds and manipulations:

Accounting standards prevent manipulation of data by the management and others. By codifying the
accounting methods, frauds and manipulations can be minimized.

(v) Helps auditors:

Accounting standards lay down the terms and conditions for accounting policies and practices by way of
codes, guidelines and adjustments for making and interpreting the items appearing in the financial
statements. Thus, these terms, policies and guidelines etc. become the basis for auditing the books of
accounts.

Accounting Principles: (Accounting Concepts and conventions) GAAP

Accounting concepts are also basic assumptions or truths which are accepted by people without further
proof. They are conceptual guidelines for application in the financial accounting process.

Principles/Concept

According to AICPA (USA) principles means “a general law or rule adopted or professed as a guide to
action, a settled ground or basis of conduct or practice". Thus principles are general guidelines for action
or conduct.
Conventions

The term 'convention' includes those customs and traditions which guide the accountant while
preparing the accounting statements. Conventions have their origin in the various accounting practices
followed by the accountant.

Separate Entity Concept

In separate entity concept the business is treated as a separate entity from the owner event though
statutes recognize no such distinct entity. In accounting the concept of separate entity is applicable in
the case of all organizations. This concept is very much relevant in the case of sole proprietorship
entities and partnerships. In the case of a company it is recognized as a separate entity by statutes as
well as from the accounting point of view.The separate entity concept helps to keep the affairs of the
business separate from the private affairs of the proprietor.

Going Concern Concept

This concept assumes that the business will continue for a fairly long period of time in future. There is no
need of forced sale of the assets of the entity. Otherwise every time the annual financial statements are
prepared the probable losses on account of the possible sale of assets should be accounted. This would
distort the operating result as revealed by the profit and loss account and the financial position depicted
in the balance sheet. On the basis of this principle depreciation is charged on fixed assets on the basis of
expected life rather than its market value and intangible assets are amortized over a period of time .The
annual financial statements are considered to be interrelated series of statements.

Money Measurement Concept

Money is the unit in which economic events affecting a business entity are measured. The money
measurement concept implies that accounting could measure and report only those transactions and
events which could be measured in terms of money. It cannot account for qualitative aspects like
employee relations, competitive market, advantages of the entity over others etc. This concept imposes
a restriction on the ability of the financial statements to present a correct picture of the entity as those
events which are unable to be quantified in money terms are left out.

Cost Concept

The basis on which assets are recorded in the books of accounts is the cost- that is the price paid to
acquire them. Cost will form the basis of which further accounting will be done as regards the asset. No
adjustment is made in the cost to reflect the market value of the asset. The cost concept does not imply
that asset will always appear at cost in the balance sheet. It only means that cost will be the basis for
further accounting treatment. The cost of the asset may be reduced gradually by the process of charging
depreciation.

Further the cost concept means that if nothing is paid for the acquisition of an asset it cannot be shown
as an asset in the books of account.
Dual Aspect Concept

The basic equation of accounting is

Assets = Liabilities + Capital

Every transaction affecting an entity has dual aspect on the accounting records. Both aspects are
recorded in the books of accounts. Hence accounting is called ' double entry system'. The two aspects
are expressed as 'debit' and 'credit '.In other words ' for every debit there is an equivalent credit'.

The term 'assets' denotes the resources owned by a business while equities denote the claims of various
parties against the assets. Equities are two types

i) Owners' Equity and

ii) Outsiders' Equity

Owners' equity otherwise called 'capital' denotes the claims of the owners against the assets of the
entity whereas outsiders' equity denotes the claims of creditors, debenture holders, lenders etc against
the assets of the entity.

Accounting Period Concept

As per the going concern concept, the life of a business is indefinite. The actual working result of the
entity and its real financial position could be ascertained only after a very long period of time. This will
be of not much help to various interested parties who have to take decisions considering the operating
results and financial position of the entity. In order to overcome these practical difficulties the life of an
entity is divided into segments known as accounting period. Usually accounting period is a period of one
year. The accounting period concept facilitates the preparation of income statement and statement of
financial position at the end of each accounting year and ascertains the operating results (profit/loss)
and the financial position of the entity.

Periodic Matching of Cost and Revenue Concepts

The concept is based on the accounting period concept. The objective of maintaining accounts is to
prepare the income statement to ascertain the profit/loss of the entity. In order to fulfill this objective
the 'revenues' of the period for which income statement is prepared should be matched with costs.
'Matching' means the appropriate association of related 'revenues' and 'costs'. Profit/loss could be
ascertained only when the revenue earned during the period is compared with the expenditure incurred
during the same period.

Realization Concept

According to the realization concept 'revenue' should be recognized only when the entity is legally
entitled to receive payment. Thus revenue is an inflow of assets resulting from the sale of goods and
rendering of services to the customers in the ordinary course of business. For the purpose of preparing
the annual financial statements business entities have to recognize revenue. What is revenue
recognition? It is the process of identifying the items of revenue receipts, which are to be considered for
the matching of costs and revenues. When is revenue recognized? Under accrual system of accounting,
revenue is recognized at the time of sale or rendering of services whether cash is received or not,
provided that at the time of performance it is not unreasonable to expect ultimate collection.

The accounting conventions followed in the preparation of accounting statements are

Conservatism

The rule of the accountant is 'anticipate no profit but provide for all possible losses' at the time of
recording the business transactions and preparation of annual financial statements. The accountant
wants to be on the safer side by not taking some profits which may be received but which are not yet
received and providing for losses which he thinks may happen but which has not yet happened. This is
because he thinks the chances of non-receipt of anticipated profit and the incurring of losses anticipated
are higher. If he is very optimistic regarding receipt of profits and non –incurring of losses, the financial
statements may present a very rosy picture of the state of affairs of the entity which may not
subsequently materialize. So he acts conservatively by not taking anticipated profits and but taking
anticipated losses in the preparation of the financial statements.

Materiality

The convention of materiality advocates that the accountant should give importance to transactions and
events which are material in the preparation of accounts and presentation of financial statements. He
should ignore those items in the recording of transactions and preparation of financial statements, items
which are immaterial or not having much bearing in giving a true and fair view of the state of affairs of
the entity. It is very difficult to fix a threshold limit in deciding materiality or non-materiality of events. It
is left to the discretion and best judgment of the accountant to decide upon the materiality and non-
materiality of events.

Consistency

According to the convention of consistency the accounting practices employed should be consistent,
that is, applied without change in the coming periods also. In other words the practices should not be
changed without sufficient reason. For example if stock is valued on the basis of 'cost or market price
whichever is lower' the same method should be employed year after year. If depreciation is charged on
straight line method, the same method of computing depreciation should be used thereafter.
Consistency of the methods employed should be maintained due to various reasons. First of all it will
help the users to make comparative study of financial statements by employing methods of intra-firm
and inter-firm comparison.

Full disclosure

The very purpose of accounting is to facilitate the preparation of the income statement and the
statement of financial position so that the operating results of the entity and the financial position could
be ascertained. This is done at periodic intervals usually on an annual basis. The business enterprise
should provide through the financial statements all the relevant information required, so as to enable
the external parties to make sound economic and investment decisions. Any information which is
relevant and likely to influence the decision making process of the user should not be left out.

Top 10 Differences between IFRS and GAAP Accounting

International Financial Reporting Standards (IFRS) is the accounting method that’s used in many
countries across the world. It has some key differences from the Generally Accepted Accounting
Principles (GAAP) implemented in the United States.

As an accounting professional or business owner, it’s vital to know the variations of these accounting
methods, in order to successfully manage your company globally, as well as domestically. Here are the
top 10 differences between IFRS and GAAP accounting:

1. Locally vs. Globally

As mentioned, the IFRS is a globally accepted standard for accounting, and is used in more than 110
countries. On the other hand, GAAP is exclusively used within the United States and has a different set
of rules for accounting than most of the world. This can make it more complicated when doing business
internationally.

2. Rules vs. Principles

A major difference between IFRS and GAAP accounting is the methodology used to assess the
accounting process. GAAP focuses on research and is rule-based, whereas IFRS looks at the overall
patterns and is based on principle.

With GAAP accounting, there’s little room for exceptions or interpretation, as all transactions must
abide by a specific set of rules. With a principle-based accounting method, such as the IFRS, there’s
potential for different interpretations of the same tax-related situations.

3. Inventory Methods

Under GAAP, a company is allowed to use the Last In, First Out (LIFO) method for inventory estimates.
However, under IFRS, the LIFO method for inventory is not allowed. The Last In, First Out valuation for
inventory does not reflect an accurate flow of inventory in most cases, and thus results in reports of
unusually low income levels.

4. Inventory Reversal

In addition to having different methods for tracking inventory, IFRS and GAAP accounting also differ
when it comes to inventory write-down reversals. GAAP specifies that if the market value of the asset
increases, the amount of the write-down cannot be reversed. Under IFRS, however, in this same
situation, the amount of the write-down can be reversed. In other words, GAAP is overly cautious of
inventory reversal and does not reflect any positive changes in the marketplace.

5. Development Costs

A company’s development costs can be capitalized under IFRS, as long as certain criteria are met. This
allows a business to leverage depreciation on fixed assets. With GAAP, development costs must be
expensed the year they occur and are not allowed to be capitalized.

6. Intangible Assets

When it comes to intangible assets, such as research and development or advertising costs, IFRS
accounting really shines as a principle-based method. It takes into account whether an asset will have a
future economic benefit as a way of assessing the value. Intangible assets measured under GAAP are
recognized at the fair market value and nothing more.

7. Income Statements

Under IFRS, extraordinary or unusual items are included in the income statement and not segregated.
Meanwhile, under GAAP, they are separated and shown below the net income portion of the income
statement.

8. Classification of Liabilities

The classification of debts under GAAP is split between current liabilities, where a company expects to
settle a debt within 12 months, and noncurrent liabilities, which are debts that will not be repaid within
12 months. With IFRS, there is no differentiation made between the classifications of liabilities, as all
debts are considered noncurrent on the balance sheet.

9. Fixed Assets

When it comes to fixed assets, such as property, furniture and equipment, companies using GAAP
accounting must value these assets using the cost model. The cost model takes into account the
historical value of an asset minus any accumulated depreciation. IFRS allows a different model for fixed
assets called the revaluation model, which is based on the fair value at the current date minus any
accumulated depreciation and impairment losses.

10. Quality Characteristics

Finally, one of the main differentiating factors between IFRS and GAAP is the qualitative characteristics
to how the accounting methods function. GAAP works within a hierarchy of characteristics, such as
relevance, reliability, comparability and understandability, to make informed decisions based on user-
specific circumstances. IFRS also works with the same characteristics, with the exception that decisions
cannot be made on the specific circumstances of an individual.

Types of assets
The two main types of assets are current assets and non-current assets. These classifications are used to
aggregate assets into different blocks on the balance sheet, so that one can discern the
relative liquidity of the assets of an organization.

Current assets are expected to be consumed within one year, and commonly include the following line
items:

 Cash and cash equivalents

 Marketable securities

 Prepaid expenses

 Accounts receivable

 Inventory

Non-current assets are also known as long-term assets, and are expected to continue to be productive
for a business for more than one year. The line items usually included in this classification are:

 Tangible fixed assets

 Intangible fixed assets

 Goodwill

The classifications used to define assets change when viewed from an investment perspective. In this
situation, there are growth assets and defensive assets. These types are used to differentiate between
the manners in which investment income is generated from different types of assets.

Growth assets generate income for the holder from rents, appreciation in value, or dividends. The
values of these assets can rise in value to generate a return for the holder, but there is a risk that their
valuations can also decline. Examples of growth assets are:

 Equity securities

 Rental property

 Antiques

Defensive assets generate income for the holder primarily from interest. The values of these assets tend
to hold steady or can decline after the effects of inflation are considered, and so tend to be a more
conservative form of investment. Examples of defensive assets are:

 Debt securities

 Savings accounts
  Certificates of deposit

Assets may also be classified as tangible or intangible assets. Intangible assets lack physical substance,
while tangible assets have the reverse characteristic. Most of an organization's assets are usually
classified as tangible assets. Examples of intangible assets are copyrights, patents, and trademarks.
Examples of tangible assets are vehicles, buildings, and inventory.

What are Fictitious Assets?

Fictitious Assets

The best way to understand fictitious assets is to memorize the meaning of the word “fictitious” which
means “not true” or “fake”.

Fictitious assets are not assets at all, however, they are shown as assets in the financial statements only
for the time being. In fact, they are expenses & losses which for some reason couldn’t be written off
during the accounting period of their incidence.

They are written off against the firm’s earnings in more than one accounting period. Basically, they
are amortized over a period of time. They are recorded as assets in financial statements only to be
written off in a future period.

Examples of Fictitious Assets

 Promotional expenses of a business

 Preliminary expenses

 Discount allowed on issue of shares

 Loss incurred on issue of debentures

They are shown in the balance sheet on the asset side under the head “Miscellaneous Expenditure”. (To
the extent not written off or adjusted)

Types of Liabilities: Non-current Liabilities

Non-current liabilities, also known as long-term liabilities, are debts or obligations that are due in over a
year’s time. Long-term liabilities are an important source of a company’s long-term financing.
Companies take on long-term debt to acquire immediate capital to fund the purchase of capital assets
or invest in new capital projects.

Long-term liabilities are crucial in determining a company’s long-term solvency. If companies are unable
to repay their long-term liabilities as they become due, then the company will face a solvency crisis.

List of non-current liabilities:

  Bonds payable

 Long-term notes payable

 Deferred tax liabilities

 Mortgage payable

 Capital lease

Types of Liabilities: Contingent Liabilities

Contingent liabilities are liabilities that may occur depending on the outcome of a future event.
Therefore, contingent liabilities are potential liabilities. For example, when a company is facing a lawsuit
of $100,000, the company would face a liability if the lawsuit proves successful. However, if the lawsuit
is not successful, the company would not face a liability. In accounting standards, a contingent liability is
only recorded if the liability is probable and the amount can be reasonably estimated.

List of contingent liabilities:

 Lawsuits

 Product warranties

Balance Sheet Definition and Examples

Definition:

A Balance Sheet is a statement of the financial position of a business which states the assets, liabilities,
and owners' equity at a particular point in time. In other words, the balance sheet illustrates your
business's net worth.

The balance sheet is the most important of the three main financial statements used to illustrate the
financial health of a business. The others are:

 The Income Statement, which shows net income for a specific period of time, such as a month,
quarter, or year. Net income equals revenue minus expenses for the period.

 The Cash Flow Statement, which shows the movements of cash and cash equivalents in and out
of the business. Chronic negative cash flow is symptomatic of troubled businesses.

Incorporated businesses are required to include balance sheets, income statements, and cash flow
statements in financial reports to shareholders and tax and regulatory authorities. Preparing balance
sheets is optional for sole proprietorships and partnerships, but is useful for monitoring the health of
the business.
An up-to-date and accurate balance sheet is essential for a business owner that is looking for
additional debt or equity financing or wishes to sell the business and needs to determine how much it is
worth.

All accounts in your General Ledger are categorized as an asset, a liability, or equity. The relationship
between them is expressed in this equation:

Assets = Liabilities + Equity

The items listed on balance sheets vary from business to business depending on the industry, but in
general the balance sheet is divided into the following three sections:

Assets

As in the balance sheet example shown below, assets are typically organized into liquid assets—those
that are cash or can be easily converted into cash—and non-liquid assets that cannot quickly be
converted to cash, such as land, buildings, and equipment.

The list of assets may also include intangible assets, which are much more difficult to value.

Generally accepted accounting principles (GAAP) guidelines only allow intangible assets to be listed on a
balance sheet if they are acquired assets that have a lifespan and a clearly identifiable fair market
value (the probable price at which a willing buyer would buy the asset from a willing seller) that can be
amortized. These are reported on the balance sheet at the original cost minus depreciation. This
includes items such as:

 Franchise agreements

 Copyrights

 Patents

Liabilities

Liabilities are funds owed by the business, and are broken down into current and long-term categories.
Current liabilities are those due within one year and include items such as:

 Accounts payable (supplier invoices)

 Wages

 Income tax deductions

 Pension plan contributions

 Medical plan payments

 Building and equipment rents

  Customer deposits (advance payments for goods or services to be delivered)

 Utilities

 Temporary loans, lines of credit, or overdrafts

 Interest

 Maturing debt

 Sales tax and/or goods and services tax charged on purchases

Equity/Earnings

Equity, also known as shareholders' equity, is that which remains after subtracting the liabilities from
the assets. Retained earnings are earnings retained by the corporation—that is, not paid to shareholders
in the form of dividends.

Retained earnings are used to pay down debt or are otherwise reinvested in the business to take
advantage of growth opportunities. While a business is in a growth phase, retained earnings are typically
used to fund expansion rather than paid out as dividends to shareholders.

SAMPLE BALACE SHEET

Sample profit & loss statement

A Profit & Loss Statement (P&L) measures the activity of a business over a period of time – usually a
month, a quarter, or a year. This financial report may have several different names: profit & loss, P&L,
income statement, statement of revenues and expenses, or even the operating statement. The P&L
basically tells you revenue, expenses, profit, and loss. Keep in mind that in almost all circumstances,
profit is not the same thing as cash flow.

The basic formula for the profit-and-loss statement is:

Revenues – expenses = net profit.

P&L statements generally follow this format:

Revenues
– Operating (variable) expenses
= Gross profit (operating) margin
– Overhead (fixed expenses)
= Operating income
+/– Other income or expense (non-operating)
= Pre-tax income
– Income taxes
= Net income (after taxes)

Here are definitions of these categories:

Revenue is the money you receive in payment for your products or services.

Operating, or variable, expenses are the expenses that rise or fall based on your sales volume.
Gross profit margin or operating margin is the amount left when you subtract operating expenses from
revenues.

Overhead, or fixed, expenses are costs that don’t vary much month-to-month and don’t rise or fall with
the number of sales you make. Examples might include salaries of office staff, rent, or insurance.

Operating income is income after deducting operating and overhead expense.

Other income or expenses (non-operating) generally don’t relate to the operating side of the business,
rather to how the management finances the business. Other income might include interest or dividends
from company investments, for example. Other expenses might include interest paid on loans.

Pre-tax income is income before federal and state governments take their share.

Income taxes How income tax is shown on the P&L varies based on the type of legal entity. For
example, a C corporation almost always shows income tax expense, but S corporations, partnerships,
LLCs, and sole proprietorships rarely show income tax expense on the P&L.

Net income (after taxes) is the final amount on most profit-and-loss statements. It represents the net
total profit earned by the business during the period, above and beyond all related costs and expenses.

Accounting equation
Accounting equation describes that the total value of assets of a business is always equal to its liabilities
plus owner’s equity. This equation is the foundation of modern double entry system of accounting being
used by small proprietors to large multinational corporations. Other names used for
accounting equation are balance sheet equation and fundamental or basic accounting equation.

Definition and explanation

We know that every business owns some properties known as assets. The claims to the assets owned by
a business entity are primarily divided into two types – the claims of creditors and the claims of owner.
In accounting, the claims of creditors are referred to as liabilities and the claims of owner are referred to
as owner’s equity.

Accounting equation is simply an expression of the relationship among assets, liabilities and owner’s
equity in a business. The general form of this equation is given below:

Assets = Liabilities + Owner’s Equity

EXAMPLE

Mr. John started a T-shirts business to be known as “John T-shirts”. He performed following transactions
during the first month of operations:

1. Mr. John invested a capital of $15,000 into his business.

 2. He purchased a building for $5,000 cash for business use.

3. He purchased furniture for $1,500 cash for business use.

4. He purchased T-shirts from a manufacturer for $3,000 cash.

5. He sold T- shirts for $1,000 cash, the cost of those T-shirts were $700.

6. He purchased T-shirts for $2,000 on credit.

7. He sold T-shirts for $800 on credit, the cost of those shirts were $550.

8. He paid $1,000 cash to his payables.

9. He collected $800 cash from his receivables.

10. The shirts costing $100 were stolen by someone.

11. Mr. John paid $150 cash for telephone bill.

12. He borrowed money amounting to $5,000 from City Bank for business purpose.

Required: Explain how each of the above transactions impacts the accounting equation of John T-shirts.

Solution

Transaction 1: The investment of capital by John is the first transaction of John T-shirts which creates
very initial accounting equation of the business. At this point, the cash is the only asset of business and
owner has the sole claim to this asset. Therefore, the equation would look like the following:

Equation element(s) impacted as a result of transaction 1: “Assets” & “Owner’s equity”.

Transaction 2: The second transaction is the purchase of building which brings two changes. First, it
reduces cash by $5,000 and second, the building valuing $5,000 comes into the business. In other words
cash amounting to $5,000 is converted into building. The impact of this transaction on accounting
equation is shown below:

Equation element(s) impacted as a result of transaction 2: “Assets”

Transaction 3: The impact of this transaction is similar to that of transaction number 2. Cash goes out of
and furniture comes in to the business. On asset side, The reduction of $1,500 in cash is balanced by the
addition of furniture with a value of $1,500.

Equation element(s) impacted as a result of transaction 3: “Assets”

Transaction 4: The impact of this transaction is similar to transactions 2 and 3. One asset (i.e, cash) goes
out and another asset (i.e, inventory) comes in. The cash would decrease by $3,000 and at the same
time the inventory valuing $3,000 would be recorded on the asset side.

Equation element(s) impacted as a result of transaction 4: “Assets”

Transaction 5: In this transaction, shirts costing $700 are sold for $1,000 cash. It increases cash by
$1,000 and reduces inventory by $700. The difference of $300 is the profit of the business that would be
added to the capital. The whole impact of this transaction on accounting equation is shown below:

Equation element(s) impacted as a result of transaction 5: “Assets” & “Owner’s equity”

Transaction 6: In this transaction, T-shirts costing $2,000 are purchased on credit. It increases inventory
on asset side and creates a liability of $2,000 known as accounts payable (abbreviated as A/C P.A) on the
equity side of the equation. Since it is a credit transaction, it has no impact on cash.

Equation element(s) impacted as a result of transaction 6: “Assets” & “liabilities”

Transaction 7: In this transaction, the business sells T-shirts costing $550 for $800 on credit. It reduces
inventory by $550 and creates a new asset known as accounts receivable (abbreviated as A/C R.A)
valuing $800. The difference of $250 is profit of the business and would be added to capital under the
head owner’s equity.

Equation element(s) impacted as a result of transaction 7: “Assets” & “Owner’s equity”

Transaction 8: In this transaction, business pays cash amounting to $1,000 for a previous credit
purchase. It will reduce cash and accounts payable liability both with $1,000.

Equation element(s) impacted as a result of transaction 8: “Assets” & “Liabilities”

Transaction 9: In this transaction, the business collects cash amounting to $800 for a previous credit
sale. On asset side, it increases cash by $800 and reduces accounts receivable by the same amount.

Equation element(s) impacted as a result of transaction 9: “Assets”

Transaction 10: The loss of shirts by theft reduces inventory on asset side and capital on equity side
both by $100. All expenses and losses reduce owner’s equity or capital.

Equation element(s) impacted as a result of transaction 10: “Assets” & “Owner’s equity”

Transaction 11: The payment of telephone and electricity bills are business expenses that reduce cash
on asset side and capital on equity side both by $150.
Equation element(s) impacted as a result of transaction 11: “Assets” & “Owner’s equity”

Transaction 12: The loan is a liability because the John T-shirts will have to repay it to the City Bank. This
transaction increases cash by $5,000 on asset side and creates a “bank loan” liability of $5,000 on equity
side.

Equation element(s) impacted as a result of transaction 12: “Assets” & “Liabilities”

In above example, we have observed the impact of twelve different transactions on accounting
equation. Notice that each transaction changes the dollar value of at least one of the basic elements of
equation (i.e., assets, liabilities and owner’s equity) but the equation as a whole does not lose its
balance.

The difference between capital expenditures and revenue

expenditures
Capital expenditures are for fixed assets, which are expected to be productive assets for a long period of
time. Revenue expenditures are for costs that are related to specific revenue transactions or operating
periods, such as the cost of goods sold or repairs and maintenance expense. Thus, the differences
between these two types of expenditures are as follows:

 Timing. Capital expenditures are charged to expense gradually via depreciation, and over a long
period of time. Revenue expenditures are charged to expense in the current period, or shortly
thereafter.

 Consumption. A capital expenditure is assumed to be consumed over the useful life of the
related fixed asset. Revenue expenditure is assumed to be consumed within a very short period
of time.

 Size. A more questionable difference is that capital expenditures tend to involve larger
monetary amounts than revenue expenditures. This is because expenditure is only classified as a
capital expenditure if it exceeds a certain threshold value; if not, it is automatically designated
as revenue expenditure. However, certain quite large expenditures can still be classified as
 revenue expenditures, as long they are directly associated with sale transactions or are period
costs

SOLVED EXAMPLE

State with reasons whether the fallowing items of expenditure are

capital or revenue?
(i) Wages paid on the purchase of goods.

(ii) Carriage paid on goods purchased.

(iii) Transportation paid on machinery purchased.

(iv) Octroi duty paid on machinery.

(v) Octroi duty paid on goods.

(vi) A second-hand car was purchased for $7,000 and $5,000 was spent for its repairs and overhauling.

(vii) Office building was whitewashed at a cost of $3,000.

(viii) A new machinery was purchased for Rs.80, 000 and a sum of Rs.1, 000 was spent on its installation
and erection.

(ix) Books were purchased for $50,000 and $1,000 was paid for carrying books to the library.

(x) Land was purchased for $1, 00,000 and $5,000 were paid for legal expenses.

(xi) $50,000 was paid for customs duty and freight on machinery purchased from Japan.

(xii) Old furniture was repaired at a cost of $500.

(xiii) An additional room was constructed at a cost of $15,000.

(xiv) Damages paid on account of the breach of contract to supply certain goods.

(xv) Cost of replacement of an old and worn out part of machinery.

(xvi) Repairs to a motor car met with an accident.

(xvii) $10,000 paid for improving machinery.

(xviii) Cost of removing plant and machinery to a new site.

(xix) Cost of acquiring the goodwill of an old firm.

(xx) Cost of redecorating a cinema hall.

(xxi) Cost of putting up a. gallery in a cinema hall.

(xxii) Compensation paid to a director for loss of his office.

(xxiii) Premium paid on the redemption of debentures.

(xxiv) Costs of attending a mortgage.

(xxv) Commission paid on issue of debentures.

(xxvi) Cost of air-conditioning the office of the director of a company.

(xxvii) Repairs and renewal of machinery.

(xxviii) Cost of acquiring patent rights and trademarks.

(xxix) Compensation paid to workers for termination of their services.

(xxx) Compensation paid to a person injured by company's car.

(xxxi) Expenditures incurred on alteration in windows ordered by municipal authorities.

(xxxii) Painting expenditures of a newly-constructed factory.

(xxxiii) Expenditures incurred on renewal of patent.

(xxxiv) Expenditures on replacement of a slate roof by a glass roof.

(xxxv) $10,000 spent on dismantling, removing and reinstalling machinery and fixtures.

(xxxvi) Legal expenses incurred in an income tax appeal.

Solution:

Sr. No. Nature of Reasons

Wages A/C is (i)
debited.
Carriage A/c is (ii)
debited.
Machinery A/c is (iii)
debited instead of
transportation A/c.
Machinery A/c is (iv)
debited instead of
octroi duty A/c
Octroi duty A/c is (v)
debited.
For both (vi)
expenditures motor
car A/C is debited
White washing A/c (vii)
is debited.
Machinery A/c (viii)
debited for all
expenditure.
For both (ix)
expenditures Books
A/c is debited.
Land A/c is (x)
Expenditure
Revenue Wages paid on goods purchased and a revenue
expenditure expenditure because goods purchased are meant for
resale. It is recurring by nature as goods are purchased
repeatedly in a business.
Revenue The carriage paid on purchases is revenue expenditure
expenditure. because goods purchased are meant for resale and
whenever goods are purchased carriage is paid to bring
the goods to the godown of the business.
Capital Machinery purchased is useless until it is brought to the
expenditure. business. As machinery is a fixed asset and
transportation paid is an additional cost to the
machinery, so it is a capital expenditure.
Capital Octroi duty paid on machinery is also an additional cost
expenditure. to the machinery, If it is not paid, the machinery cannot
be taken to the business, so it is a capital expenditure.
Revenue Octroi duty paid on goods is a revenue expenditure
expenditure. because goods mean saleable goods. It is recurring and
is paid repeatedly whenever goods are purchased.
Capital A second-hand car is a fixed asset as it "can be used for
expenditure. many years and its utility does not diminish in one year,
so it is a capital expenditure. But it is useless if it is not
made good to work, so the amount spent on its repair
and overhauling is also a capital expenditure.
Revenue Whitewashing of a building is necessary for its
expenditure. maintenance and because of this expenditure the profit
earning capacity of the business has not increased, so it
is revenue expenditure.
Capital Machinery is a permanent asset of the business and can
expenditure. be used for many years but it will benefit to the business
until it is installed and erected at a proper place. So
amount spent on purchase of machinery, on its
installation and erection is capital expenditure.
Capital Fixed asset "Books" has been acquired and can be used
expenditure. for many years. Cost of carrying books is regarded as a
part of purchase price of the books, so it is a capital
expenditure.
Capital Land purchased is a fixed asset. All expenses'
debited. expenditure. connected with its acquisition are regarded as a part of
its purchase price.
Machinery A/c is (xi) Capital Machinery is a fixed asset. All expenses connected with
debited. expenditure. its import from Japan are regarded as a part of its
purchase price, So it is capital expenditure.
Repair A/c is (xii) Revenue Value of furniture does not increase as a result of
debited. expenditure. its repair -- it is simply kept in a proper working
condition.
Building A/c is (xiii) Capital This is an addition to a fixed asset and as a result of this
debited. expenditure. expenditure the value of the building has increased, so it
is a capital expenditure.
Damages A/c or (xiv) Revenue In this case the goods have not been supplied by the
general expenses expenditure. business to the customer according to the contract
are debited. between them. The customer claimed damages which
the business paid. It is a usual thing that happens in
ordinary course of trading, so it is revenue expenditure.
Repair and (xv) Revenue A worn out part of the machinery is simply the cost of
maintenance A/c Expenditure. repair and maintenance of fixed asset. The value and
is debited. profit earning capacity of the machinery has not
increased in any way, so it is revenue expenditure.
Repair to car A/c is (xvi) Revenue Cost of repair to a motor car does not increase
debited. Expenditure the value of the car; it is simply incurred to put back the
car into working condition, so it is Revenue
expenditure.
Machinery A/c is (xvii) Capital Cost has been incurred to 'improve (h machinery. It
debited. expenditure. increases the value and profit earning capacity of the
machinery, so it is capital expenditure.
Plant and , (xviii) Capital Plant and machinery have been removed to a new site in
Machinery A/c is expenditure. order to increase their profit-earning capacity, so cost of
debited. removal is a capital expenditure.
Goodwill A/c is (xix) Capital Goodwill is an intangible asset and it will benefit to the
debited. expenditure. business for many years. So cost of acquiring goodwill
(using the name of an old firm) is always a capital
expenditure.
Re-decoration 'A/c (xx) Revenue Generally a cinema hall is decorated regular and re-
or Maintenance A/c expenditure. decorating cost is a recurring expenditure Moreover, it
is debited. will not add to the capacity of the hall, so it is revenue
expenditure.
Cinema hall A/c or (xxi) Capital As a gallery has been put up in the cinema hall, it
Building ' debited. expenditure. increases the capacity of the hall, which in turns
enhances the profit-earning capacity of the business;
therefore, the cost is treated as a capital expenditure.
Expense A/c is (xxii) Revenue Compensation paid to the director of a company, for the
debited. expenditure. loss of his office is revenue expenditure because the
company will get the benefit of this expenditure only
for one year.
(xxiii) Capital By issuing debentures, money is borrowed from the
 expenditure. public for a long period of time and is used in the
purchase of fixed assets or on the expansion of the
business; therefore, premium paid is a capital
expenditure.
(xxiv) Capital Mortgage means a deed showing that the money has
expenditure. been borrowed (loan raised) by mortgaging assets as
collateral security. The assets will remain mortgaged
with the lender until the loan has been repaid. So the
assets have been utilized for raising loan and the costs
attending the mortgage are, therefore, a capital
expenditure.
(xxv) Capital Debentures are considered as borrowed capital and are
expenditure. used for the acquisition of fixed assets such as
machinery etc., therefore, commission paid on issue of
debentures is a capital expenditure.
(xxvi) Capital By making the office of the director, air-conditioned,
expenditure. the efficiency of the director will increase and it will
last for many years, so cost of air-conditioning is a
capital expenditure.
Repair A/c is (xxvii) Revenue Annual repair and renewal of machinery is necessary to
debited. expenditure. keep it in a proper working condition, therefore, this
expenditure is considered as revenue expenditure.
(xxviii) Capital Patents and trademarks are intangible assets, the benefit
expenditure. of, which is received for many years, so cost of
acquiring these assets is a capital expenditure.
(xxix) Capital By terminating inefficient workers, the business will
expenditure. run more economically and profit-earning capacity of
the business will increase, so compensation paid to
them is a capital expenditure.
(xxx) Revenue It happened in the ordinary course of business, so,
expenditure. compensation paid to the injured person is revenue
expenditure.
(xxxi) Revenue This expenditure will add nothing to the value of the
expenditure. building and will have no effect on the profit-earning
capacity of the business, so it is a revenue expenditure.
(xxxii) Capital Amount spent on painting a new factory is regarded as a
expenditure. part of the cost of factory building; therefore, it is a
capital expenditure.
(xxxiii) Revenue If patent is renewed annually, then it is revenue
Expenditure. expenditure as it has been incurred in the ordinary
course of business.
(xxxiv) Capital As a slate roof is replaced by a glass roof, it will
expenditure. increase the efficiency of the building and therefore, it
is a capital expenditure.
(xxxv) Revenue Amount of $10,000 spent on dismantling removing and
Expenditure re-installing machinery an fixtures will be treated as
revenue expenditure. may be treated as deferred
 revenue expenditure item and spread over a number of
years.
(xxxvi) Revenue This expenditure has been incurred in the ordinary
Expenditure course of the business being expense of carrying on the
business; therefore, it is revenue expenditure.

Deferred Revenue Expenditure

It will be easier to understand the meaning of deferred revenue expenditure if you know the
word deferred, which means “Holding something back for a later time”.

Deferred Revenue Expenditure is an expenditure which is revenue in nature and incurred during an
accounting period, but its benefits are to be derived in multiple future accounting periods.

These expenses are unusually large in amount and, essentially, the benefits are not consumed within the
same accounting period.

Part of the amount which is charged to profit and loss account in the current accounting period is
reduced from total expenditure and rest is shown in the balance sheet as an asset (fictitious asset,
i.e. it is not really an asset).

Related Topic – What is Capital Expenditure and Operational Expenditure?

Example

Let’s suppose that a company is introducing a new product to the market and decides to spend a large
amount on its advertising in the current accounting period. This marketing spend is supposed to draw
benefits beyond the current accounting period.

It is a better idea not to charge the entire amount in the current year’s P&L Account and amortize it over
multiple periods.

The image shows a company spending 150K on advertising, which is unusually large as compared to the
size of their business.

The company decides to divide the expense over 3 yearly payments of 50K each as the benefits from
them spend are expected to be derived for 3 years.

Difference between Capital Receipt and Revenue Receipt

Capital Receipt Vs Revenue Receipt. In general, two types of receipts occur during the course of
business. Capital Receipts are described as the money brought to the business from non-operating
sources like proceeds from the sale of long-term assets, capital brought by the proprietor, sum received
as a loan or from debenture holders etc. In contrast revenue receipts are the result of firm’s routine
activities during the financial year, which includes sales, commission, interest on investment.

Capital receipts differ from revenue receipts, in the sense that the former has no bearing on profit or
loss for the financial year, whereas the latter is set off against the revenue expenses for the period. Read
the article provided to you, so as to understand the difference between capital receipt and revenue
receipt.

BASIS FOR
CAPITAL RECEIPT REVENUE RECEIPT
COMPARISON

Meaning Capital Receipts are the income generated Revenue Receipts are the income
from investment and financing activities generated from the operating
of the business. activities of the business.

Nature Non-Recurring Recurring

Term Long Term Short Term

Shown in Balance Sheet Income Statement

Received in Source of income Income

exchange of

Value of asset or Decreases the value of asset or increases Increases or decreases the value of
liability the value of liability. asset or liability.

What is Diluted Earnings per Share (EPS)?

Definition: Diluted earnings per share, also called diluted EPS, is a profitability calculation that measures
the amount of income each share will receive if all of the dilutive securities are realized. In other words,
it shows the effect of dilutive securities like stock options, rights to purchase common shares, bond and
preferred stock that can be converted to common shares on the basic earnings per share.

The basic earnings per share formula take the difference between net income and preferred dividends
and divide it by the average outstanding common stock. This calculates the amount of income that is
available to the current common shareholders of the company. The key word in that sentence is current.
It only reflects the current outstanding shares.
What Does Diluted EPS Mean?

What is the definition of diluted earnings per share? Diluted EPS is more detailed than EPS as it portrays
the true shareholder value based on which the earnings per share are allocated. Furthermore, the
diluted EPS affects a firm price to earnings (P/E) ratio as well other valuation measures. To calculate the
diluted EPS, we need to know the net income, the preferred dividends, the convertible preferred
dividend, the tax rate, the weighted average of dilutive common shares, the convertible preferred
shares, the convertible debt and the unexercised employee stock options. Compared to the EPS, the
diluted EPS is always lower.

SAMPLE SOLVED QUESTIONS ON FINAL ACCOUNTS

Illustration:

From the following Trial Balance of Radhe Shyam Trading and Profit and Loss A/c for the year ending
31st December, 2010 and Balance Sheet as on that date. The Closing Stock on 31st December, 2010 was
valued at Rs. 2, 50,000.

Debit Balances Amount Credit Balance Amount

(Rs.) (Rs.)

Stock (1-1-2010) 2,00,000 Sundry Creditors 1,50,000

Purchases 7,50,000 Purchases Return 30,000

Sales Return 80,000 Sales 25,00,000

Freight and Carriage 75,000 Commission 33,000

Wages 3,65,000 Capital 17,00,000

Salaries 1,20,000 Interest on Bank Deposit 20,000

Repairs 12,000 B/P 62,000

Trade Expenses 40,000

Rent and Taxes 2,40,000

Cash in Hand 57,000

B/R 40,000

5,50,000

Plant and Machinery 16,00,000

Withdrawals (Drawings) 1,66,000

Bank Deposit 2,00,000

44,95,000 44,95,000

Solution:

TRADING AND PROFIT & LOSS ACCOUNT for the year ending 31st December, 2010

Liabilities Amount Assets Amount

Rs. Rs.

To Opening Stock 2,00,000 By Sales 25,00,000

To Purchases 7,50,000 Less: Sales Return 80,000 24,20,000

Less:Purchases Return By Closing Stock 2,50,000

30,000 7,20,000

To Freight & Carriage 75,000

To Wages 3,65,000

To Gross Profit c/d 13,10,000

26,70,000 26,70,000

To Salaries 1,20,000 By Gross Profit b/d 13,10,000

To Repairs 12,000 By Commission 33,000

To Trade Expenses 40,000 By Interest on 20,000

Bank

Deposit

To Rent & Taxes 2,40,000

To Net
profit transferred
to Capital A/c
 9,51,000

13,63,000 13,63,000

BALANCE SHEET as on 31st December, 2010

Liabilities Amount Assets Amount

Rs. Rs.

B/P 62,000 Cash in Hand 57,000

Sundry Creditors 1,50,000 B/R 40,000

Capital 17,00,000 Sundry Debtors 5,50,000

Add: Net Profit 9,50,000 Closing Stock 2,50,000

26,51,000 Bank Deposit 2,00,000

Less:Drawings 1,66,000 24,85,000 Plant & Machinery 16,00,000

26,97,000 26,97,000

Note: The heading of Trading A/c and Profit & Loss A/c is put collectively as ‘Trading and Profit & Loss
A/c’. The first part of this Account is Trading A/c, whereas the second part is Profit & Loss A/c. Trading
Account, in fact, is a part of Profit & Loss Account.

Illustration:

From the following balances prepare a Trading, Profit & Loss Account and Balance Sheet.

Rs. Rs.

Carriage on Goods Purchased 80,000 Cash in Hand 25,000

Carriage on Goods Sold 35,000 Banker’s A/c (Cr.) 3,00,000

Manufacturing Expenses 4,20,000 Motor Car 6,00,000

Advertisement 70,000 Drawings 80,000

Freight and Octroi 44,000 Audit Fees 27,000

Lighting 60,000 Plant 15,39,000

Customer’s A/c 8,00,000 Repairs to Plant 22,000

Supplier’s A/c 6,10,000 Stock at the end 7,60,000

Duty and Clearing Charges 52,000 Purchase Less Returns 16,00,000

Postage and Telegram 8,000 Commission on Purchases 20,000

Fire Insurance Premium 36,000 Incidental Trade Exp. 32,000

Patents 1,20,000 Investments 3,00,000

Income Tax 2,40,000 Interest on Investments 45,000

Office Expenses 72,000 Capital A/c 10,00,000

Sales Less Returns 52,00,000

Rent 1,20,000

Discount Paid 27,000

Discount on Purchases 34,000

Solution:

TRADING AND PROFIT & LOSS ACCOUNT for the year ending ……………………

Rs. Rs.

To Purchases Less Returns 16,00,000 By Sales Less Returns 52,00,000

To Commission on Purchases 20,000

To Carriage on goods Purchased 80,000

To Manufacturing Expenses 4,20,000

To Freight and Octroi 44,000

To Duty & Clearing Charges 52,000

To Gross Profit c/d 29,84,000

52,00,000 52,00,000

To Carriage on Goods Sold 35,000 By Gross Profit b/d 29,84,000

To Advertisement 70,000 By Interest on Investments 45,000

To Lighting 60,000 By Discount on Purchases 34,000

To Postage & Telegram 8,000

To Fire Insurance Premium 36,000

To Office Expenses 72,000

To Audit Fees 27,000

To Repair to Plant 22,000

To Incidental Trade Expenses 32,000

To Rent 1,20,000

To Discount Paid 27,000

To Net Profit Transferred to

Capital A/c 25,54,000

30,63,000 30,63,000

UNIT -3
Shareholders' funds
Shareholders' funds are the balance sheet value of the shareholders' interest in a company. For
company (as opposed to group) accounts it is simply all assets less all liabilities. For
consolidated group accounts the value of minority interests should also be excluded.
The addition of minority interests gives us “shareholders' fund including minority interests”.
Further adjustments give us total equity.

The balance sheet value of assets does have some significance for valuation (see NAV).
However, changes in shareholders' funds are also important. The most obvious reason for
shareholders' funds to change is that profits have been made and retained, however changes
can also be caused by gains or losses that do not go through the P & L, such as revaluations.

This is why both the statement of total recognized gains and losses (STRGL) and the note to the
accounts reconciling beginning and ending shareholders' funds are important, the more so
because looking at changes that have not gone through the P & L can alert investors to some
manipulations of the accounts. For example, a consistent accumulation of unrealised losses on
investments may be a cause for concern.

The items within shareholders' funds (share capital, reserves and retained profit) are usually of
little importance, although the amount of distributable reserves might matter to shareholders if
it is too low, and (even more rarely) to creditors if it is too high.

What Is the Formula to Calculate the Net Worth of a Company?

There are multiple metrics that people use to determine a company's value. Here's the formula
that explains exactly what the company's net assets are worth.

Investors look at a lot of metrics and measures when valuing a company. Not only is it
important to help inform your understanding of the company and its prospects, but it can also
help you identify potential opportunities, as well as companies that may be overvalued and
should be avoided.

But knowing a company's market value is only part of the equation, as that only describes what
the company is worth to investors today. It's also important to understand the company's net
worth, or the net value of all of its assets after liabilities like debt has been paid. Here's a closer
look at some metrics, what they mean, and how you calculate a company's net worth

Common "market value" metrics

Metrics such as market capitalization, and enterprise value are handy ways to know what a
company is "worth" to investors today. While market cap is simply the value of a company's
stock, enterprise value is more of a "total value" measure: It takes the market capitalization,
subtracts cash, and then adds in total debt. Enterprise value is sort of a "price to buy" the whole
company, since you would get the cash it has with the rest of the assets, but you'd also have to
take on its debt.
How to calculate a company's net worth
Understanding a company's market value is one thing, but in isolation, it may not tell the whole
story in terms of a company's value. This can be especially true for industries that require major
investments in equipment, property, and other high-cost or high-value assets. With this in
mind, it's very important to understand how to calculate the net value of those assets. It's
actually pretty straightforward how to calculate a company's net worth:

Total assets minus total liabilities = net worth.

This is also known as "shareholders' equity" and is the same formula one would use to calculate
one's own net worth. This simple formula essentially calculates what would be left over and
divided among all shareholders, if a company were to be liquidated and sold off at the carrying
value of all of its assets after liabilities were paid.

This differs slightly from "tangible book value," which subtracts the value of intangible assets
such as goodwill. You can find the financial information to calculate these measures in a
company's annual 10-K and quarterly 10-Q SEC filings.

Foolish bottom line

calculating a company's net worth, or any of the other various market value and asset value
measures, is only a starting point to valuing a company. It's also worth mentioning that since
industries can vary greatly, comparing the per-share asset value of a high-tech, asset-light
company to a steelmaker isn't a good idea. Better to use these metrics in comparing companies
in the same or very similar industries, and always with a grain of salt and an eye on the
company's business prospects as well.

In summary, using net worth or book value as a way to determine if the company's market
value is trading at a fair premium or even occasionally a discount can be a useful way to identify
great value opportunities, as well as help you avoid stocks that may be selling for more than
they are worth. Just don't forget to consider the company's long-term opportunities as a
business, as well as the liquidation value of its assets.

Note on reformulation of balance sheet/

What is reformulation of financial statements?/
Advantages of reformulation of financial statement
One of the primary reasons that businesses choose to reformulate financial statements is for
readers, both inside and outside companies. Normal statements are created using generally
accepted accounting principles, but these do not always show the most accurate
representation for analysis. The business may be able to make the statements much easier to
read and highlight the most important information by reformulating them for specific readers,
creating their custom versions.

Liability Separation

When it comes to the balance sheet, many businesses will reformulate to further divide
liabilities and assets. Liabilities especially can benefit from being divided in detailed categories
like financial liabilities and operating liabilities. This shows what expenses are associated with
operation and which are more oriented toward investment, future plans and expansion. Some
businesses may also want to separate assets to show which have come to the business in
recent years.

Identify Surpluses and Deficits

In the income statement, reformulating can help highlight recent changes that led to extra
income or a lower income than previously reported. This is often connected with shareholder
changes. For instance, if shareholder equity changes or if a dividend distribution has been
made, the business may reformulate the income statement to incorporate the change and
produce a new net income, giving readers a more accurate picture of the period.

Equity Changes

Equity can also change for the business. When dealing with the state of shareholders' equity, it
may be easier to show beginning and ending equity balances with a reformulation, taking into
account any major share changes and showing clearly the earnings available to stockholders
together with net distributions.

What is the difference between Income Statement and Reformulated

Income Statement?
In the broadest sense a reformulated income statement is the act of taking a standard income
statement, typically one prepared in accordance with GAAP or IFRS and reclassifying the line
items based on some other standard or criteria.

You might reformulate an income statement for the purpose of making it easier to compare the
income statements of two or more different companies that use different formats for their
income statements.
One of the more common reasons for a reformulated income statement is to break the income
statement of a company into results from financial activity and results from operating activity.
This is commonly done for valuation analysis of a business.

We would have to know the context in which your question was asked to know why someone
may want a reformulated income statement in your particular situation.

What are the benefits of reformulations of income statement?

Reformulated income statement

– The income statement reports profits and losses that NOA and NFA have
produced over a given period

– The reformulated statement groups these items into operating and financing
categories

– Includes dirty-surplus items from the statement of shareholders’ equity

Notes to Accounts
Also known notes to financial statements, footnotes, notes to accounts are supporting
information that is usually provided along with a company’s final accounts or financial
statements. Many such notes are required to be provided by law, including details related to
provisions, reserves, depreciation, investments, inventory, share capital, employee benefits,
contingencies, etc.

Other information supplied along with the financial statements may be a product of the
accounting standards being followed by the business. Notes to accounts help users of
accounting information to understand the current financial position of a company and act as a
support for its estimated future performance.

Significance of notes to accounts/ What is the significance of

preparing notes to accounts in the annual report of an
organization?/ Which accounting policies are normally
disclosed in notes to accounts?
Notes, also known as footnotes, are important in accounting because they provide additional
information regarding methodology, valuation, time period and myriad other calculation
nuances. Financial statements and reports provide a uniform framework for evaluating sales,
net income, cash flow, assets, liabilities and stockholder equity. There are many different ways
these accounts can be interpreted and valued based on both the business and industry. Notes
provide an explanation for how the numbers in the financial statement, or report, are
calculated. Notes provide information about accounting policies, the use of accounting
principles, accounting changes, non-monetary transactions, fair value, business combinations,
revenue recognition, commitments and contingencies of a legal and financial nature, risks and
uncertainties. Accountants use estimates to determine many of these amounts. These
estimates are based on reasonable assumptions. The financial statements themselves are filled
with assumptions, however. Part of accounting is being able to tell a financial story, and the
notes provide the accountant with the level of detail needed to communicate the full story.

Explaining Accrual-Based Accounting

Financial accounting is primarily concerned with matching revenues and costs to the period in
which they were incurred, not tracking for net income for tax purposes. As a result, there are
often differences between the cash flow statement and the income statement. An accrual is the
accounting name for a revenue or cost adjustment into another time period. These adjustments
can manipulate earnings and are critical for analysts, bankers and investors to fully understand
how earnings are calculated, which is why explanations are often provided in the notes.

Cash Taxes Vs. Income Tax Expense

Income tax expense is a line item on the income statement. Like much of accounting, income
tax expense is only a provision or an estimate based on the calculation of net income. Net
income itself is calculated by deducting a host of estimated expenses from revenues. As a
result, the actual cash paid for taxes may differ from the income tax provision companies report
on their income statement. The footnotes provide a way for the company to reconcile the
difference between the two.

Auditors Use Footnotes Too

Most companies must be audited at some point. It is up to the auditor to provide a legal
statement of validity for financial statements. One resource the auditor will use are the notes
to the financial statements. For this reason, the information in the footnotes is just as
important as the information contained within the statements, particularly from a regulatory
perspective. If the financial statements are error free, but there are errors within the notes, the
auditor should issue negative remarks.

Note on different types of capital expenditure, Income

expenditure, capital income and revenue income
Capital and Revenue Expenditure

Capital Expenditure

Capital expenditure includes costs incurred on the acquisition of a fixed asset and any
subsequent expenditure that increases the earning capacity of an existing fixed asset.

The cost of acquisition not only includes the cost of purchases but also any additional costs
incurred in bringing the fixed asset into its present location and condition (e.g. delivery costs).

Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its
benefit is derived over several accounting periods. Capital Expenditure may include the
following:

Purchase costs (less any discount received), Delivery costs, Legal charges, Installation costs, Up
gradation costs, Replacement costs

Revenue expenditure incurred on fixed assets include costs that are aimed at 'maintaining'
rather than enhancing the earning capacity of the assets. These are costs that are incurred on a
regular basis and the benefit from these costs is obtained over a relatively short period of time.
For example, a company buys a machine for the production of biscuits. Whereas the initial
purchase and installation costs would be classified as capital expenditure, any subsequent
repair and maintenance charges incurred in the future will be classified as revenue expenditure.
This is so because repair and maintenance costs do not increase the earning capacity of the
machine but only maintains it (i.e. machine will produce the same quantity of biscuits as it did
when it was first put to use).

Revenue costs therefore comprise of the following:

 Repair costs, Maintenance charges, Repainting costs, Renewal expenses

Revenue Income and Capital Income

Capital income

Income arises from non -Recurring Transactions by certain or a certain event is called capital
income.

Capital income includes:

Price received on investments in small saving schemes, The premium on letting out shop or
houses, Bonus shares on investment, Hidden treasures found on the dismantling of the old
house.
Revenue income

Income arose from Recurring transactions in the ordinary course of business is called revenue
income.

Revenue income includes:

Commission received, discount received, interest from debtors, fees and room rent from
patients, donations and charities received by the charitable institution, Fright received by
transport companies.

Note on journal, ledger and trial balance with relevant

proforma statements
A journal is a chronological (arranged in order of time) record of business
transactions. A journal entry is the recording of a business transaction in the journal. A journal
entry shows all the effects of a business transaction as expressed in debit(s) and credit(s) and
may include an explanation of the transaction. A transaction is entered in a journal before it is
entered in ledger accounts. Because each transaction is initially recorded in a journal rather
than directly in the ledger, a journal is called a book of original entry.

A ledger (general ledger) is the complete collection of all the accounts and transactions of a
company. The ledger may be in loose-leaf form, in a bound volume, or in computer
memory. The chart of accounts is a listing of the titles and numbers of all the accounts in the
ledger. The chart of accounts can be compared to a table of contents. The groups of accounts
usually appear in this order: assets, liabilities, equity, dividends, revenues, and expenses. Think
of the chart of accounts as a table of contents of a textbook. It provides direction as to what
exactly will be found in the financial statement preparation.

A trial balance is a listing of all accounts (in this order: asset, liability, equity, revenue, expense)
with the ending account balance. It is called a trial balance because the information on the
form must balance.

PROFORMA- JOURNAL (THESE ARE JUST EXAMPLES)

Date Account Debit Credit

03-Sep-20YY 125 Supplies Inventory 1,180

200 Accounts Payable 1,80
PROFORMA – LEDGER

PROFORMA-TRIAL BALANCE

Define shareholder’s funds and retained earnings.

Shareholders' funds is the balance sheet value of the shareholders' interest in a company. For
company (as opposed to group) accounts it is simply all assets less all liabilities. For
consolidated group accounts the value of minority interests should also be excluded.

Retained earnings are the profits that a company has earned to date, less any dividends or
other distributions paid to investors. This amount is adjusted whenever there is an entry to the
accounting records that impacts a revenue or expense account

As a business owner, you need to measure performance. If you don’t, how do you know if the
decisions you make for your business are working? Looking at a comparative income statement
helps you analyze profitability over time.
 UNIT -4
What is the importance of comparative statements? Illustrate your
answer
A comparative income statement combines information from several income statements as
columns in a single statement. It helps you identify financial trends and measure performance
over time. You can compare different accounting periods from your records. Or, you can
compare your income statement to other companies.

Usually, you organize a comparative income statement into two or three columns. Each column
represents an accounting period. Amounts are listed in rows that correspond to a specific
account. Put the most current year closest to the accounts on the left.

For example, you might have columns for 2017, 2016, and 2015 (reading from left to right). Or,
you could compare months, such as July, June, and May. The column furthest to the left lists
the names of your accounts.

A comparative income statement helps you with many accounting tasks. Here are just a few
ways the statement benefits your business:

 Compare current amounts to past years

 See if performance has improved over time

 Figure out patterns in high and low sales months

 Calculate percentages of changes

 Show how your company compares to others when securing outside capital

Information on a comparative income statement helps you make smart business decisions. For
example, you notice sales dip every May. The pattern tells you to step up your marketing
efforts next May.

Looking at several references to compare financial figures takes time. Trying to locate
information on different statements can be confusing and frustrating. A comparative income
statement makes it easy to point out trends in performance. You don’t have to flip back and
forth between individual documents.

You can use a comparative income statement to look at important financial figures. Patterns in
past figures can guide you in the future. For example, you compare last year’s return on
investment (ROI) to the current year. This tells you if the money you put into your business
brings in a greater amount of income.

Comparative income statements can also reveal if your costs and revenues are consistent. Let’s
say in three years your cost of goods sold (COGS) goes from 25% of sales to 40% of sales. By
recognizing the increase, you can find solutions to reduce COGS.

Business investors use comparative income statements to look at different companies. The
comparison helps them decide which business is a better investment.

Common-Size Statement: Advantages

Advantages of Common-Size Statement:

The advantages of Common-Size Statement are:

(a) Easy to Understand:

Common-size Statement helps the users of financial statement to make clear about the ratio or
percentage of each individual item to total assets/liabilities of a firm. For example, if an analyst
wants to know the working capital position he may ascertain the percentage of each individual
component of current assets against total assets of a firm and also the percentage share of
each individual component of current liabilities.

(b) Helpful for Time Series Analysis:

A Common-Size Statement helps an analyst to find out a trend relating to percentage share of
each asset in total assets and percentage share of each liability in total liabilities.

(c) Comparison at a Glance:

An analyst can compare the financial performances at a glance since percentage of increase or
decrease of each individual component of cost, assets, liabilities etc. are available and he can
easily ascertain his required ratio.

(d) Helpful in analysing Structural Composition:

A Common-Size Statement helps the analyst to ascertain the structural relations of various
components of cost/expenses/assets/liabilities etc. to the required total of assets/liabilities and
capital.

Limitations of Common-Size Statement:

Common-Size Statement is not free from snags.

Some of them are:

(a) Standard Ratio:

Common-Size Statement does not help to take decisions since there is no standard
ratio/percentage regarding the change of percentage in the various component of assets,
liabilities, sales etc.

(b) Change in Price-level:

Common-Size statement does riot recognise the change in price level i.e. inflationary effect. So,
it supplies misleading information’s since it is based on historical cost.

(c) Following Consistency:

If consistency in the accounting principle, concepts, conventions is not maintained then

Common Size Statement becomes useless.

(d) Seasonal Fluctuation:

Common-Size Statement fails to convey proper records during seasonal fluctuations in various
components of sales, assets liabilities etc. e.g. sales and closing stock significantly vary. Thus,
the statement fails to supply the real information to the users of financial statements.

(e) Window Dressing:

Effect of window dressing in financial statements cannot be ignored and Common-Size

Statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects
of window dressing appearing in the financial statements.

(f) Qualitative Element:

Common-Size Statement fails to recognise the qualitative elements, e.g. quality of works,
customer relations etc. while measuring the performance of a firm although the same should
not be ignored.

(g) Liquidity and Solvency Position:

Liquidity and solvency position cannot be measured by Common-Size Statement. It considers

the percentage of increase or decrease in various components of sales, assets, liabilities etc. In
other words it does not help to ascertain the Current Ratio, Liquid Ratio, Debt Equity Capital
Ratio, Capital Gearing Ratio etc. which are applied in testing liquidity and solvency position of a
firm.
 What is the meaning and importance of comparative financial
statement? Explain specifically with reference to balance sheet.
Meaning of Comparative Statements :

The comparative financial statements are statements of the financial position at different periods; of
time. The elements of financial position are shown in a comparative form so as to give an idea of
financial position at two or more periods. Any statement prepared in a comparative form will be
covered in comparative statements.

From practical point of view, generally, two financial statements (balance sheet and income statement)
are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures
of two periods but also be relationship between balance sheet and income statement enables an in
depth study of financial position and operative results.

The comparative statement may show:

(i) Absolute figures (rupee amounts).

(ii) Changes in absolute figures i.e., increase or decrease in absolute figures.

(iii) Absolute data in terms of percentages.

(iv) Increase or decrease in terms of percentages.

The analyst is able to draw useful conclusions when figures are given in a comparative position. The
figures of sales for a quarter, half -year or one year may tell only the present position of sales efforts.
When sales figures of previous periods are given along with the figures of current periods then the
analyst will be able to study the trends of sales over different periods of time. Similarly, comparative
figures will indicate the trend and direction of financial position and operating results.

The financial data will be comparative only when same accounting principles are used in preparing these
statements. In case of any deviation in the use of accounting principles this fact must be mentioned at
the foot of financial statements and the analyst should be careful in using these statements.

(i) Comparative Balance Sheet:

The comparative balance sheet analysis is the study of the trend of the same items, group of items and
computed items in two or more balance sheets of the same business enterprise on different dates.’ The
changes in periodic balance sheet items reflect the conduct of a business.

The changes can be observed by comparison of the balance sheet at the beginning and at the end of a
period and these changes can help in forming an opinion about the progress of an enterprise. The
comparative balance sheet has two columns for the data of original balance sheets. A third column is
used to show increases in figures. The fourth column may be added for giving percentages of increases
or decreases.

What are the ways to conduct financial statement analysis?

A number of useful techniques involving simple math and a bit of research can help you perform some
qualitative and quantitative financial statement analysis for your business, depending on the type of
information you want to investigate.

Trend Analysis

Trend analysis is also called time-series analysis. Trend analysis helps a firm's financial manager
determine how the firm is likely to perform over time, based on trends shown by past history.

Common-size financial statement analysis involves analyzing the balance sheet and income statement
using percentages. All income statement line items are stated as a percentage of sales. All balance sheet
line items are stated as a percentage of total assets.

Percentage Change Financial Statement Analysis

Percentage change financial statement analysis gets a little more complicated. When you use this form
of analysis, you calculate growth rates for all income statement items and balance sheet accounts
relative to a base year.

Benchmarking

Benchmarking is also called industry analysis. Benchmarking involves comparing a company to other
companies in the same industry to see how one company is doing financially compared to others in the
industry.

What are the ways to conduct financial statement analysis?

The common-size statements, balance sheet and income statement are shown in analytical percentages.
The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are
taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities
are taken as a part of total liabilities.

These statements are also known as component percentage or 100 per cent statements because every
individual item is stated as a percentage of the total 100.

The common-size statements may be prepared in the following way:

(1) The totals of assets or liabilities are taken as 100.

(2) The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities
are calculated in relation to total liabilities. For example, if total assets are Rs 5 lakhs and inventory value
is Rs 50,000, then it will be 10% of total assets (50,000×100/5,00,000)

Types of Common-Size Statements:

(i) Common-Size Balance Sheet:

A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the
ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet.

(ii) Common Size Income Statement:

The items in income statement can be shown as percentages of sales to show the relation of each item
to sales. A significant relationship can be established between items of income statement and volume of
sales. The increase in sales will certainly increase selling expenses and not administrative or financial
expenses.

In case the volume of sales increases to a considerable extent, administrative and financial expenses
may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a
relationship is established between sales and other items in income statement and this relationship is
helpful in evaluating operational activities of the enterprise.

Difference between Comparative and Common Size

Statement
Comparative vs Common Size Statement

Comparative financial statements
present financial information for
several years side by side in the form of
absolute values, percentages or both.
Common size financial statements present all items in
percentage terms where balance sheet items are
presented as percentages of assets and income
statement items are presented as percentages of
sales.

Purpose

Comparative statements are prepared Common size statements prepared for reference
for internal decision making purpose. purpose for stakeholders.

Usefulness

Comparative statements become more Common size statements can be used to compare
useful when comparing company
 results with previous financial years. company results with similar companies.

Discuss the uses and application of trend analysis in the financial

performance measurement of a company./ How trend analysis can be
applied for the analysis of financial statements? Differentiate it from
comparative statement analysis(Difference answer Given in above
notes)
Since there is recurring need to evaluate the past performance, present financial position, the position
of liquidity and to assist in forecasting the future prospects of the organization, various financial
statements are to be examined in order that the forecast on the earnings may be made and the progress
of the company be ascertained.

There are various types of Financial analysis. They are briefly mentioned herein:

External analysis: The external analysis is done on the basis of published financial statements by those
who do not have access to the accounting information, such as, stock holders, banks, creditors, and the
general public.

Internal Analysis: This type of analysis is done by finance and accounting department. The objective of
such analysis is to provide the information to the top management, while assisting in the decision
making process.

Short term Analysis: It is concerned with the working capital analysis. It involves the analysis of both
current assets and current liabilities, so that the cash position (liquidity) may be determined.

Horizontal Analysis: The comparative financial statements are an example of horizontal analysis, as it
involves analysis of financial statements for a number of years. Horizontal analysis is also regarded as
Dynamic Analysis.

Vertical Analysis: it is performed when financial ratios are to be calculated for one year only. It is also
called as static analysis.

An assortment of techniques is employed in analyzing financial statements. They are: Comparative

Financial Statements, statement of changes in working capital, common size balance sheets and income
statements, trend analysis and ratio analysis.

Comparative Financial Statements: It is an important method of analysis which is used to make

comparison between two financial statements. Being a technique of horizontal analysis and applicable
to both financial statements, income statement and balance sheet, it provides meaningful information
when compared to the similar data of prior periods. The comparative statement of income statements
enables to review the operational performance and to draw conclusions, whereas the balance sheets,
presenting a change in the financial position during the period, show the effects of operations on the
assets and liabilities. Thus, the absolute change from one period to another may be determined.

Statement of Changes in Working Capital: The objective of this analysis is to extract the information
relating to working capital. The amount of net working capital is determined by deducting the total of
current liabilities from the total of current assets. The statement of changes in working capital provides
the information in relation to working capital between two financial periods.

Common Size Statements: The figures of financial statements are converted to percentages. It is
performed by taking the total balance sheet as 100. The balance sheet items are expressed as the ratio
of each asset to total assets and the ratio of each liability to total liabilities. Thus, it shows the relation of
each component to the whole - Hence, the name common size.

Trend Analysis: It is an important tool of horizontal analysis. Under this analysis, ratios of different items
of the financial statements for various periods are calculated and the comparison is made accordingly.
The analysis over the prior year’s indicates the trend or direction. Trend analysis is a useful tool to know
whether the financial health of a business entity is improving in the course of time or it is deteriorating.

It must be noted that Financial analysis is a continuous process being applicable to every business to
evaluate its past performance and current financial position. It is useful in various situations to provide
managers the information that is needed for critical decisions. The process of financial analysis provides
the information about the ability of a business entity to earn income while sustaining both short term
and long term growth.

How is horizontal trend analysis used in accounting?

Horizontal analysis (also known as trend analysis) is a financial statement analysis technique that shows
changes in the amounts of corresponding financial statement items over a period of time. It is a useful
tool to evaluate the trend situations.

The statements for two or more periods are used in horizontal analysis. The earliest period is usually
used as the base period and the items on the statements for all later periods are compared with items
on the statements of the base period. The changes are generally shown both in dollars and percentage.

Dollar and percentage changes are computed by using the following formulas:
 Trend Analysis: Advantages and Disadvantages
Advantages of Trend Analysis:

(a) Possibility of making Inter-firm Comparison:

Trend analysis helps the analyst to make a proper comparison between the two or more firms over a
period of time. It can also be compared with industry average. That is, it helps to understand the
strength or weakness of a particular firm in comparison with other related firm in the industry

(b) Usefulness:

Trend analysis (in terms of percentage) is found to be more effective in comparison with the absolutes
figures/data on the basis of which the management can take the decisions.

(c) Useful for Comparative Analysis:

Trend analyses is very useful for comparative analysis of date in order to measure the financial
performances of firm over a period of time and which helps the management to take decisions for the
future i.e. it helps to predict the future.

(d) Measuring Liquidity and Solvency:

Trend analysis helps the analyst/and the management to understand the short-term liquidity position as
well as the long-term solvency position of a firm over the years with the help of related financial Trend
ratios.

(e) Measuring Profitability Position:

Trend analysis also helps to measure the profitability positions of an enterprise or a firm over the years
with the help of some related financial trend ratios (e.g. Operating Ratio, Net Profit Ratio, Gross Profit
Ratio etc.).

Disadvantages of Trend Analysis:

The trend analysis is not free from snags.

Some of them are:

(a) Selection of Base Year:

It is not so easy to select the base year. Usually, a normal year is taken as the base year. But it is very
difficult to select such a base year for the propose of ascertaining the trend. Otherwise, comparison or
trend analyses will be of no value.

(b) Consistency:
 UNIT -5
What is the Current Ratio?
The current ratio, also known as the working capital ratio, measures the capability of a business
to meet its short-term obligations that are due within a year. The ratio considers the weight of
the total current assets versus the total current liabilities. It indicates the financial health of the
company, and how it can maximize the liquidity of its current assets to settle debt and
payables. The Current Ratio formula (below) can be used to easily measure a company’s
liquidity.

What is the significance of P/E ratio?

The P/E ratio can be calculated as: Market Value per Share / Earnings per Share

PE ratio is one of the most widely used tools for stock selection. It is calculated by dividing the
current market price of the stock by its earning per share (EPS). It shows the sum of money you
are ready to pay for each rupee worth of the earnings of the company

The price-to-earnings ratio helps investors determine the market value of a stock compared to
the company's earnings. ... The P/E ratio is important because it provides a measuring stick for
comparing whether a stock is overvalued or undervalued.

Types of Profitability Ratio

I. Return on Equity

II. Earnings Per Share

III. Dividend Per Share

IV. Price Earnings Ratio

V. Return on Capital Employed

VI. Return on Assets

VII. Gross Profit

VIII. Net Profit

I. Return on Equity
This ratio measures Profitability of equity fund invested the company. It also measures how
profitably owner’s funds have been utilized to generate company’s revenues. A high ratio
represents better the company is.

Formula: Profit after Tax ÷ Net worth

Where,

Net worth = Equity share capital, and Reserve and Surplus

II. Earnings Per Share

This ratio measures profitability from the point of view of the ordinary shareholder. A high ratio
represents better the company is.

Formula: Net Profit ÷ Total no of shares outstanding

III. Dividend Per Share

This ratio measures the amount of dividend distributed by the company to its shareholders. The
high ratio represents that the company is having surplus cash.

Formula: Amount Distributed to Shareholders ÷ No of Shares outstanding

IV. Price Earnings Ratio

This ratio is used by the investor to check the undervalued and overvalued share price of the
company. This ratio also indicates Expectation about the earning of the company and payback
period to the investors.

Formula: Market Price of Share ÷ Earnings per share

V. Return on Capital Employed

This ratio computes percentage return in the company on the funds invested in the business by
its owners. A high ratio represents better the company is.

Formula: Net Operating Profit ÷ Capital Employed × 100

Capital Employed = Equity share capital, Reserve and Surplus,

Debentures and long-term Loans

Capital Employed = Total Assets – Current Liability

VI. Return on Assets

This ratio measures the earning per rupee of assets invested in the company. A high ratio
represents better the company is.

Formula: Net Profit ÷ Total Assets

VII. Gross Profit

This ratio measures the marginal profit of the company. This ratio is also used to measure the
segment revenue. A high ratio represents the greater profit margin and it’s good for the
company.

Formula: Gross Profit ÷ Sales × 100

Gross Profit= Sales + Closing Stock – op stock – Purchases – Direct Expenses

VIII. Net Profit

This ratio measures the overall profitability of company considering all direct as well as indirect
cost. A high ratio represents a positive return in the company and better the company is.

Formula: Net Profit ÷ Sales × 100

Net Profit = Gross Profit + Indirect Income – Indirect Expenses

What do you understand by cash flow statement?

A cash flow statement typically breaks out a company's cash sources and uses for the period
into three categories: cash flow from operating activities, cash flow from investing activities,
and cash flow from financing activities. It is important to note that cash flow is not the same as
net income, which includes transactions that did not involve actual transfers of money
(depreciation is common example of a noncash expense that is included in net income
calculations but not in cash flow calculations).

Cash flow from operating activities is generally calculated according to the following formula:

Cash Flows from Operations = Net income + Noncash Expenses + Changes in Working Capital

How the cash from operating activity calculated? Explain with suitable
example?
Cash Flow from Operating Activities
Cash flow from operating activities is a section of the cash flow statement that provides
information regarding the cash-generating abilities of a company's core activities.

Cash flow from operating activities is generally calculated according to the following formula:

Cash Flow from Operating Activities = Net income + Noncash Expenses + Changes in Working
Capital

The noncash expenses are usually the depreciation and/or amortization expenses listed on the
firm's income statement.

A statement of cash flows typically breaks out a company's cash sources and uses for the period
into three categories: cash flows from operations, cash flows from investing activities, and cash
flows from financing activities. Cash flows from operations primarily measures the cash-
generating abilities of the company's core operations rather than from its ability to raise capital
or purchase assets.

Because working capital is a component of cash flow from operations, investors should be
aware that companies can influence cash flow from operating activities by lengthening the time
they take to pay the bills (thus preserving their cash), shortening the time it takes to collect
what’s owed to them (thus accelerating the receipt of cash), and putting off buying inventory
(again thus preserving cash). It is also important to note that companies also have some leeway
about what items are or are not considered capital expenditures, and the investor should be
aware of this when comparing the cash flow of different companies.

Prepare a cash flow statement of ---------------company with

Imaginary figure?
What is 'Corporate Social Responsibility’ (CSR)?
Corporate social responsibility (CSR) is a self-regulating business model that helps a company be
socially accountable — to itself, its stakeholders, and the public. By practicing corporate social
responsibility, also called corporate citizenship, companies can be conscious of the kind of
impact they are having on all aspects of society including economic, social, and environmental.
To engage in CSR means that, in the normal course of business, a company are operating in
ways those enhance society and the environment, instead of contributing negatively to it.

Importance of Vision, Mission, and Values

The importance of an organization to develop a vision, mission, and values is important for
strategic direction. Without the individual foundations of strong values illustrated by a vision to
be undertaken by a mission, an organization cannot become an overly successful organization.
Without developing a mission, vision, and values to assist in developing a strategy, an
organization cannot identify, distinguish or explain itself to its employees and customers alike.
This paper will discuss the importance of developing a vision, mission, and values for the
business of water turbine induction systems.

What is the 'Management Discussion and Analysis - MD&A?'

Management discussion and analysis (MD&A) is the portion of a public company's annual
report in which management addresses the company’s performance over the previous twelve
months. In this section, the company’s high-ranking officers analyze the company’s
performance using qualitative and quantitative performance measures. In the MD&A section,
management will also provide commentary on financial statements, systems and controls,
compliance with laws and regulations, and actions it has planned or has taken to address any
challenges the company is facing. Management also discusses the upcoming year by outlining
future goals and approaches to new projects. The Management Discussion and Analysis is an
important source of information for analysts and investors who want to review the company’s
financial fundamentals and management performance.

What is Corporate Governance?

Corporate Governance refers to the way a corporation is governed. It is the technique by which
companies are directed and managed. It means carrying the business as per the stakeholders’
desires. It is actually conducted by the board of Directors and the concerned committees for
the company’s stakeholder’s benefit. It is all about balancing individual and societal goals, as
well as, economic and social goals.
Corporate Governance is the interaction between various participants (shareholders, board of
directors, and company’s management) in shaping corporation’s performance and the way it is
proceeding towards. The relationship between the owners and the managers in an organization
must be healthy and there should be no conflict between the two. The owners must see that
individual’s actual performance is according to the standard performance. These dimensions of
corporate governance should not be overlooked.

Corporate Governance deals with the manner the providers of finance guarantee themselves of
getting a fair return on their investment. Corporate Governance clearly distinguishes between
the owners and the managers. The managers are the deciding authority. In modern
corporations, the functions/ tasks of owners and managers should be clearly defined, rather,
harmonizing.

10 important things to analyse while reading an annual report are as

follows:
1) Vision and mission statements of the company

In this section, you will get to read vision and mission statement, values and goals of the
company. These statements are general in nature. Take a look at vision and mission statements
of Infosys:

Vision: "We will be a globally respected corporation."

Mission: "Strategic Partnerships for Building Tomorrow’s Enterprise.

2) Corporate information

3) Products overview and financial highlights in last 5 to 10 years

Get details of products being manufactured by a company, segment wise performance in last
two years, key raw materials consumed, etc. Some companies publish financial highlights of 5
to 10 years in annual reports. You will get to analyse trend of revenue, earnings before interest,
tax, depreciation and amortization (EBITDA), profit after tax (PAT/Net income / loss) from
income (profit and loss) statement and also get a glimpse on shareholders equity, assets,
debtors, liability and total debt from balance sheet over the years. Important ratios are also
presented in charts over 5 to 7 years time line.

4) Director’s report
This section provides brief summary on financials, explanation of the financial results, key
developments in the company. Key things to look in here are operational parameters of the
company such as capacity additions, capex plan / executed during the year, order book as on
financial year end, average length of stay, occupancy rates, average revenue per occupied bed,
average revenue per user, etc.

5) Management discussion and analysis (MDA)

This section provides information on trends in the industry, SWOT analysis of the company,
insights on key line items of financial statements and risk factors/concerns affecting the
company performance. You will get relevant information to understand the industry while
reading this section. It’s appreciated to read at least 3-5 years of MDA to understand trends of
the company in different economy scenario.

6) Report on Corporate governance

This section gives insight on corporate governance followed by a company, composition of

board of directors, brief background information on directors and independent directors of the
company, attendance of directors in board meetings and annual general meetings,
remuneration of directors, re-appointment of directors after completing the term, composition
of sub-committees, etc.

7) Information on shares of the company

This section provides information on historical performance of share price, share holding
pattern of the company, pledging of shares by promoters during the year, split of shares, bonus
shares distributed, etc.

8) Auditors report

This section gives information on comments by auditors on the financials of the company. You
look out who are the auditors for the company and any qualifications by the auditors on
internal processes. The information on change in accounting policy if any will be highlighted in
this section.

9) Financial statements

This section provides detailed information on profit and loss accounts (income statement),
balance sheet as on year end, cash flow statement and schedules of the financials for two
years. Analyzing numbers from this section help us to check financial health of the company.
We will explain in other article key things to look in financial statements for fundamental
analysis of a company.
10) Notes to accounts

In this section you will get information on accounting policy followed by a company,
depreciation method, forex losses / gains, segmental reporting, inventories, liabilities, leases,
etc. It will be helpful if you read notes to account section of last 3 to 5 years. This will help to
get information on any change in accounting year or accounting policy which can inflate
revenues or profits of the company, trend in segmental revenues / profitability, contingent
liabilities over the years, related party transactions, etc.

Classification of financial ratios on the basis of function:

On the basis of function or test, the ratios are classified as liquidity ratios, profitability ratios,
activity ratios and solvency ratios.

Liquidity Ratios:

Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the ability
of the business to pay its short-term debts. The ability of a business to pay its short-term debts
is frequently referred to as short-term solvency position or liquidity position of the business.

Four commonly used liquidity ratios are given below:

1. Current ratio or working capital ratio

2. Quick ratio or acid test ratio
3. Absolute liquid ratio
4. Current cash debt coverage ratio

Profitability ratios:

Profit is the primary objective of all businesses. All businesses need a consistent improvement
in profit to survive and prosper. A business that continually suffers losses cannot survive for a
long period.

Profitability ratios measure the efficiency of management in the employment of business

resources to earn profits. These ratios indicate the success or failure of a business enterprise for
a particular period of time.

Some important profitability ratios are given below:

1. Net profit (NP) ratio

2. Gross profit (GP) ratio
3. Price earnings ratio (P/E ratio)
 4. Operating ratio
5. Expense ratio
6. Dividend yield ratio
7. Dividend payout ratio
8. Return on capital employed ratio
9. Earnings per share (EPS) ratio
10. Return on shareholder’s investment/Return on equity
11. Return on common stockholders’ equity ratio

Activity ratios:

Activity ratios (also known as turnover ratios) measure the efficiency of a firm or company in
generating revenues by converting its production into cash or sales. Generally a fast conversion
increases revenues and profits.

Some important activity ratios are:

1. Inventory turnover ratio

2. Receivables turnover ratio
3. Average collection period
4. Accounts payable turnover ratio
5. Average payment period
6. Asset turnover ratio
7. Working capital turnover ratio
8. Fixed assets turnover ratio

Solvency ratios:

Solvency ratios (also known as long-term solvency ratios) measure the ability of a business to
survive for a long period of time. These ratios are very important for stockholders and creditors.

Some frequently used long-term solvency ratios are given below:

1. Debt to equity ratio

2. Times interest earned (TIE) ratio
3. Proprietary ratio
4. Fixed assets to equity ratio
5. Current assets to equity ratio
6. Capital gearing ratio

What are the uses of liquidity ratios?

Liquidity ratio only measures ability to pay short term obligations at a particular point in time.
This ratio or any other ratios that are derived from the Balance Sheet is good at that particular
point. Nonetheless it does give some indications of the ability to meet short term obligations.

It is therefore wise to look at trends as well as understand the prevailing economic climate at
which those trends occur before deciding on an entity's ability to meet its short term
obligations.

Importance / need of Cash Flow Statement:

Needless to say that Cash Flow Statement is particularly useful in short-term planning. In order
to meet the various obligations, a firm needs sufficient amount of cash (e.g., payment for
expenses, purchase of fixed assets, payments for dividend and taxes etc.). It helps the financial
manager to make a cash flow projection for immediate future taking the data relating to cash
from the past records.

As such, it becomes easy for him to know the cash position which may either result in a surplus
or a deficit one. However, Cash Flow Statement is an important financial tool for the
management to make an estimate relating to cash for the near future.

The importance of Cash Flow Statement is presented below:

(a) Helps to make Cash Forecast:

Cash Flow Statement, no doubt, helps the management to make a cash forecast for the near
future. A projected Cash Flow Statement helps the management about the cash position which
is the basis for all operations and thus, the management finds the light relating to cash position,
viz., how much cash is needed for a specific purpose, sources of internal and external issues etc.

(b) Helps to the Internal Management:

It helps the internal management to determine the financial policy to be adopted in future
since it supplies information relating to funds, e.g., taking decision about the replacement of
fixed assets or repayment of long- term liabilities etc.

(c) Reveals the cash position:

It is a significant pointer about the movement of cash, i.e., whether there is any increase in cash
or decrease in cash and the reasons thereof which helps the management. Moreover, it
explains the reasons for a small cash balance even though there is sufficient profit or vice-versa.
Besides, the management can compare the original forecast with the actual one in order to
understand the trend of movement of cash and the variation thereof.

(d) Reveals the result of Cash Planning:

How far and to what extent, the cash planning becomes successful, that story is told by the
analysis of Cash Flow Statement. The same is possible by making a comparison between the
projected Cash Flow Statement/Cash budget and the actual one and the measures to be taken
accordingly.

Objectives of Cash Flow Statement

(a) Measurement of Cash:

Inflows of cash and outflows of cash can be measured annually which arise from operating
activities, investing activities and financial activities.

(b) Generating Inflow of Cash:

Timing and certainty of generating the inflow of cash can be known which directly helps the
management to take financing decisions in future.

(c) Classification of Activities :

All the activities are classified into: operating activities, investing activities and financial
activities which help a firm to analyze and interpret its various inflows and outflows of cash.

(d) Prediction of Future:

A Cash Flow Statement, no doubt, forecasts the future cash flows which helps the management
to take various financing decisions since synchronization of cash is possible.

(e) Assessing Liquidity and Solvency Position:

Both the inflows and outflows of cash and cash equivalent can be known, and, as such, liquidity
and solvency position of a firm can also be maintained as timing and certainty of cash
generation is known, i.e. it helps to assess the ability of a firm to generate cash.

(f) Evaluation of Future Cash Flows:

Whether the cash flow from operating activities are quite sufficient in future to meet the
various payments e.g. payment of expenses/debts/dividends/taxes.
(g) Supply Necessary Information to the Users:

A Cash Flow Statement supplies various information relating to inflows and outflows of cash to
the users of accounting information in the following ways:

(i) To assess the ability of a firm to pay its obligations as soon as it becomes due;

(ii) To analyze and interpret the various transactions for future courses of action;

(iii) To see the cash generation ability of a firm;

(iv) To ascertain the cash and cash equivalent at the end of the period.

(h) Helps the Management to Ascertain Cash Planning:

No doubt a cash flow statement helps the management to prepare its cash planning for the
future and thereby avoid any unnecessary trouble.

What is the purpose/contents of a directors’ report?

The information provided by the directors’ report helps shareholders understand:

 Whether the company’s finances are in good health;

 Whether the company has the capacity to expand and grow;

 How well the company is performing within its market, and how well the market is
performing in general;

 How well the company is complying with financial regulations, accounting standards and
social responsibility requirements.

By knowing this information, shareholders can make better informed decisions and can hold
the directors of the company to greater account.

What is included in a directors’ report?

As a minimum, a directors report should always state:

 The names of each director who served during the reporting year;

 A summary of the company’s trading activities;

 A summary of future prospects;

  The principle activities of the company and, if relevant, the principle activities of its
subsidiaries;

 Recommendations for dividends for the reporting year;

 Any financial events that occurred after the date on the balance sheet, if these events
could affect the company’s finances;

 Significant changes to the company’s fixed assets.

Importance of Corporate Social Responsibility

Corporate social responsibility allows organizations to do their bit for the society, environment,
and customers or for those matter stake holders.

The term corporate social responsibility gives a chance to all the employees of an organization
to contribute towards the society, environment, country and so on. We all live for ourselves but
trust me living for others and doing something for them is a different feeling altogether.
Bringing a smile to people’s life just because your organization has pledged to educate the poor
children of a particular village not only gives a sense of inner satisfaction but also pride and
contentment.

Corporate social responsibility goes a long way in creating a positive word of mouth for the
organization on the whole. Doing something for your society, stake holders, customers would
not only take your business to a higher level but also ensure long term growth and success.
Corporate social responsibility plays a crucial role in making your brand popular not only among
your competitors but also media, other organizations and most importantly people who are
your direct customers.

Corporate social responsibility also gives employees a feeling of unparalleled happiness. Believe
me, employees take pride in educating poor people or children who cannot afford to go to
regular schools and receive formal education. CSR activities strengthen the bond among
employees. People develop a habit of working together as a single unit to help others.Infact
they start enjoying work together and also become good friends in due course of time. They
also develop a sense of loyalty and attachment towards their organization which is at least
thinking for the society.

In today’s scenario of cut throat competition, everyone is so occupied in chasing targets and
handling the pressure at workplace that we actually forget that there is a world around us as
well. Corporate social responsibility in a way also plays a crucial role in the progress of the
society, which would at the end of the day benefit us only.
 PROFITABILITY AND SOLVENCY/LIQUIDITY RATIOS
I. Return on Equity

This ratio measures Profitability of equity fund invested the company. It also measures how
profitably owner’s funds have been utilized to generate company’s revenues. A high ratio
represents better the company is.

Formula: Profit after Tax ÷ Net worth

Where,

Net worth = Equity share capital, and Reserve and Surplus

II. Earnings Per Share

This ratio measures profitability from the point of view of the ordinary shareholder. A high ratio
represents better the company is.

Formula: Net Profit ÷ Total no of shares outstanding

III. Dividend Per Share

This ratio measures the amount of dividend distributed by the company to its shareholders. The
high ratio represents that the company is having surplus cash.

Formula: Amount Distributed to Shareholders ÷ No of Shares outstanding

IV. Price Earnings Ratio

This ratio is used by the investor to check the undervalued and overvalued share price of the
company. This ratio also indicates Expectation about the earning of the company and payback
period to the investors.

Formula: Market Price of Share ÷ Earnings per share

V. Return on Capital Employed

This ratio computes percentage return in the company on the funds invested in the business by
its owners. A high ratio represents better the company is.

Formula: Net Operating Profit ÷ Capital Employed × 100

Capital Employed = Equity share capital, Reserve and Surplus,

Debentures and long-term Loans
Capital Employed = Total Assets – Current Liability

VI. Return on Assets

This ratio measures the earning per rupee of assets invested in the company. A high ratio
represents better the company is.

Formula: Net Profit ÷ Total Assets

VII. Gross Profit

This ratio measures the marginal profit of the company. This ratio is also used to measure the
segment revenue. A high ratio represents the greater profit margin and it’s good for the
company.

Formula: Gross Profit ÷ Sales × 100

Gross Profit= Sales + Closing Stock – op stock – Purchases – Direct Expenses

VIII. Net Profit

This ratio measures the overall profitability of company considering all direct as well as indirect
cost. A high ratio represents a positive return in the company and better the company is.

Formula: Net Profit ÷ Sales × 100

Net Profit = Gross Profit + Indirect Income – Indirect Expenses

Under liquidity ratio there are several more ratios, which come into the picture for checking
how financially, sound a company is:

I. Current Ratio

II. Acid Test Ratio or Quick Ratio

III. Absolute Liquidity Ratio

I. Current Ratio

This ratio measures the financial strength of the company. Generally 2:1 is treated as the ideal
ratio, but it depends on industry to industry.

Formula: Current Assets/ Current Liability

Where,
A. Current Assets = Stock, Debtor, Cash and bank, receivables, loan and advances, and other
current assets.

B. Current Liability = Creditor, Short-term loan, bank overdraft, outstanding expenses, and
other current liability

II. Acid Test Ratio or Quick Ratio:

This ratio is the best measure of the liquidity in the company. This ratio is more conservative
than the current ratio. The quick asset is computed by adjusting current assets to eliminate
those assets which are not in cash. Generally 1:1 is treated as an ideal ratio.

Formula: Quick Assets/ Current Liability

Where,

Quick Assets = Current Assets – Inventory – Prepaid Expenses

III. Absolute liquidity ratio:

This ratio measures the total liquidity available to the company. This ratio only considers
marketable securities and cash available to the company. This ratio only tests short-term
liquidity in terms of cash, marketable securities, and current investment.

Formula: Cash + Marketable Securities / Current Liability

Calculating Cash Flow from Operating Activities

Different reporting standards are followed by companies as well as the different reporting
entities which may lead to different methods of calculations. Depending upon the available
figures, CFO value can be calculated by one of the following methods, and both yield the same
result:

1. Cash Flow from Operating Activities = Funds from Operations + Changes in Working
Capital

where, Funds from Operations = (Net Income + Depreciation, Depletion & Amortization +
Deferred Taxes & Investment Tax Credit + Other Funds)

This format is used for reporting Cash Flow details by finance portals like Market Watch.

Or
 2. Cash Flow from Operating Activities = Net Income + Depreciation + Adjustments To
Net Income + Changes In Accounts Receivables + Changes In Liabilities + Changes In
Inventories + Changes In Other Operating Activities

This format is used for reporting Cash Flow details by finance portals like Yahoo! Finance.

All the above mentioned figures included in the above mentioned versions are available as
standard line items in the cash flow statements of the companies.

The net income figure comes from the income statement. Since it is prepared on an accrual
basis, the noncash expenses, such as depreciation and amortization, are added back to the net
income. In addition, any changes to the working capital, such as an increase and/or decrease in
current assets and current liabilities are also added to the net income to account for the overall
cash flow.

Inventories, tax assets (deferred and credits), accounts receivable, accrued revenue and
deferred revenue are common items of assets for which a change in value will be reflected in
cash flow from operating activities. Accounts payable, tax liabilities and accrued expenses are
common examples of liabilities for which a change in value is reflected in cash flow from
operations. From one reporting period to the next, any positive change in assets is recorded as
a cash outflow for calculations, while a positive change in liabilities is recorded as a cash inflow.

In essence, the calculation for Cash Flow from Operating Activities adjusts for receivables,
liabilities, taxes and depreciation, and more accurately measures the amount of cash a
company has generated (or utilized).

Cash Flow from Financing Activities

It’s important for accountants, financial analysts, and investors to understand what makes up
this section of the cash flow statement and what financing activities include. Since this is the
section of the statement of cash flows that indicates how a company funds its operation, it
generally includes changes in all accounts related to debt and equity.

Financing activities include:

 Issuance of equity

 Repayment of equity

 Payment of dividends

 Issuance of debt
  Repayment of debt

 Capital/finance lease payments

Example of Cash Flow from Financing Activities

Below is an example from Amazon’s 2017 annual report and form 10-k. In the bottom area of
the statement, you will see the cash inflow and outflow related to financing.

Activities in financing are:

 Inflow: proceeds from issuing long-term debt

 Outflow: repayment of long-term debt

 Outflow: principal repayments of capital lease obligations

 Outflow: principal repayments of finance lease obligations