Financial Accounting A Managerial Perspective 1259004880, 9781259004889

Table of contents :
Cover
Contents
1. Introduction to Financial Accounting
Accounting as an Information System
Financial, Cost and Management Accounting and their Interrelationships
Finance Function and Accounting
Accounting as an Academic Discipline
Accounting as a Career and Profession
Place of Accounting Officers in the Organisation
Auditing and Internal Control
Ethical Issues in Accounting
Forms of Organisations and Their Effect on Accounting
Accounting and Corporate Governance
Summary
Multiple Choice Questions
Theory Questions
2. Accounting Concepts, Standards and IFRS
Introduction
Accounting Concepts and Convention
Accounting Policies
Generally Accepted Accounting Principles (GAAP)
International Financial Reporting Standards (IFRS)
Indian Accounting Standards (Ind AS)
India’s Road Map to Convergence with IFRS
Indian Government Accounting Standards (IGAS)
Summary
Multiple Choice Questions
Theory Questions
Research Assignments
Interpreting Financial Reports
Business Case
3. Presentation of Financial Statements: Balance Sheet
Conceptual Basis of a Balance Sheet
Capital and Revenue Expenditure and Receipts
Classification of Items on a Balance Sheet
Format of Balance Sheet
Balance Sheet Equation
Preparing Balance Sheet
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignment
Interpreting Financial Reports
Business Cases
4. Preparation of Final Accounts: The Income Statements
Introduction
Format of Profit and Loss Account
Profit and Loss Account of a Manufacturing Concern
Appropriation of Profit
Advantages of Profit and Loss Account
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Case
5. Mechanics of Accounting
Introduction
Classification of Accounts
Double Entry System
Overview of Accounting Cycle
Preparing Journals
Subsidiary Books
Ledger
Preparation of Trial Balance
Accounting Errors and Their Rectification
Bank Reconciliation Statement (BRS)
Computerised Accounting
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Cases
6. Fixed Assets and Depreciation Accounting
Introduction
Cost of Fixed Assets
Depreciation
Method of Computing Depreciation
Accounting Treatments for Transactions
Impairment of Assets
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Cases
7. Inventory Valuation
Introduction
Record Keeping for Inventory
Perpetual Inventory System
Inventory Valuation/Measurement
Methods of Valuation of Inventories
Analysis of Inventories
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Cases
8. Corporate Accounts
Introduction to Companies
Types of Companies
Shares and Share Capital
Issue of Shares
Share Issue: Payments in Instalment
Buyback of Shares
Debentures and Bonds
Income Statement/Profit and Loss Account
Balance Sheet
Company Annual Report
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Case
9. Cash Flow Statement
Introduction to Cash Flow Statement
Cash and Cash Equivalents
Cash Flow Activities
Operating Activities
Some Special Items
Free Cash Flow
Fund Flow Statement
Analysis of Cash Flow Statement
Preparation of Cash Flow Statement
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Cases
10. Financial Statement Analysis
Introduction
Techniques for Financial Statement Analysis
Horizontal Analysis: Comparative and Trend Statements
Vertical Analysis: Common Size
Liquidity Ratios: Current and Quick Ratio
Solvency Ratios: D/E, Interest Coverage
Profitability Ratios: GP, NP, EBIT, EBDITA, EPS
Return Ratios: ROI, ROE
Turnover Ratios
Analysis of Stock and Debtors
Working Capital Management
Stock Prices and Financial Data: P/E
Summary
Multiple Choice Questions
Theory Questions
Practical Problems
Research Assignments
Interpreting Financial Reports
Business Cases
11. Investments
Introduction
Financial Instrument, Assets and Liabilities
Joint Ventures
Subsidiaries and Associates
Consolidated Financial Statement
Business Combinations
Accounting for Investments
Summary
Multiple Choice Questions
Theory Questions
Research Assignments
Interpreting Financial Reports
Business Case
12. Contemporary Issues in Accounting
Introduction
Foreign Currency Accounting
Creative Accounting
Forensic Accounting
Environmental Accounting
Lean Accounting
Human Resource Accounting
Objectives of Human Resource Accounting
HRA in India
Inflation Accounting
Responsibility Accounting
Transfer Pricing
Segment Reporting
eXtensible Business Reporting Language (XBRL)
Summary
Multiple Choice Questions
Theory Questions
Research Assignment
Business Cases
Reading an Annual Report
Glossary
Index

Citation preview

Financial Accounting A Managerial Perspective

ABOUT THE AUTHORS Varadraj B. Bapat M.Com., F.C.A., D.I.S.A., Ph.D. Dr. CA. Varadraj B. Bapat has consulting and teaching experience of 19 years in Accounting, Audit and Finance. He has obtained professional qualifications in Chartered Accountancy, Cost Accountancy and Information System Audit before obtaining Ph.D. from Indian Institute of Technology (IIT), Bombay. Dr. Bapat was All India Rank-holder at both CA Intermediate and Final examinations. He is at present a faculty member at Shailesh J. Mehta School of Management, IIT, Bombay. He has been a faculty at Somaiya Vidyavihar, Mumbai and NITIE, Mumbai. He has published a book titled Investment Analysis and Portfolio Management and has also presented/published papers in a number of national and international conferences/journals. He has spent a term at Cornell University, New York, USA under the Faculty Exchange Program. His areas of research are Accounting Standards, Corporate Governance, Portfolio Management and Financial Inclusion and teaching interests include Financial Accounting and Reporting and Managerial Accounting. He has conducted and taught in numerous MDPs in the areas of Accounting and Finance. Dr. Bapat has a keen interest in spirituality and social work as well.

Mehul Raithatha M.Com., CFA He is a Chartered Financial Analyst and has over six years of teaching experience. He is at present a faculty member at Smt. MMK College of Commerce and Economics, University of Mumbai. He is also a Ph.D. Research Scholar at Shailesh J. Mehta School of Management, IIT, Bombay. He is visiting faculty at many reputed institutions like BSE Training Institute, Russell Square International College and Mittal Institute of Management Studies. He has published and presented several research papers and peer reviewed Indian and international journals. His areas of research are Accounting Standards, Corporate Governance, Corporate Finance and Financial Management and teaching interests include Financial Accounting, Corporate Finance and Mergers and Acquisitions.

Financial Accounting A Managerial Perspective

Varadraj B. Bapat Faculty, Shailesh Mehta School of Management Indian Institute of Technology, Bombay Mehul Raithatha Faculty, Smt. MMK College of Commerce and Economics University of Mumbai

Tata McGraw Hill Education Private Limited NEW DELHI McGraw-Hill Offices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto

Tata McGraw-Hill Published by the Tata McGraw Hill Education Private Limited, 7 West Patel Nagar, New Delhi 110 008.

Financial Accounting: A Managerial Perspective Copyright © 2012, by Tata McGraw Hill Education Private Limited. No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, Tata McGraw Hill Education Private Limited ISBN-13: 978-1-25-900488-9 ISBN-10: 1-25-900488-0 Vice President and Managing Director: Ajay Shukla Head—Higher Education Publishing and Marketing: Vibha Mahajan Publishing Manager—B&E/HSSL: Tapas K Maji Deputy Manager (Sponsoring): Surabhi Khare Development Editor: Anirudh Sharan Senior Production Manager: Manohar Lal Senior Production Executive: Atul Gupta Marketing Manager: Vijay Sarathi Assistant Product Manager: Daisy Sachdeva Graphic Designer (Cover Design): Meenu Raghav General Manager—Production: Rajender P Ghansela Manager—Production: Reji Kumar Information contained in this work has been obtained by Tata McGraw-Hill, from sources believed to be reliable. However, neither Tata McGraw-Hill nor its authors guarantee the accuracy or completeness of any information published herein, and neither Tata McGraw-Hill nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that Tata McGraw-Hill and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Typeset at The Composers, 260, C.A. Apt., Paschim Vihar, New Delhi 110 063 and printed at

Cover Printer:

The book is dedicated to Lord Shri Krishna [Lord Krishna is one of the greatest Management Gurus, the Mentor of Mentors, a philosopher, thinker, yogi and warrior. The teachings of Lord Krishna are known all over the world through the famous Bhagavad Gita. The age old teachings in the Bhagavad Gita are equally relevant in the present day where knowledge is power.]

Preface

This book aims at acquainting the students with fundamentals of financial accounting keeping in mind the management function. We emphasize on bringing out the managerial view through an eye of accountant using a variety of cases, illustrations and examples. The book has been specially designed for post-graduate management students. It has a comprehensive coverage of financial accounting concepts and its application in practical life. The book contains numerous real life business cases which would help the management students (aspiring mangers) have ample exposure to the real business scenarios. The book is also helpful to the professional students pursuing courses like CA, CS, CWA and CFA. Executives with non-accounting background will find this book extremely useful to deal with the finance function in the organisation.

METHODOLOGY Each chapter is prepared with articulated structure to make the contents not only easy to understand but also interesting to learn. Each chapter begins with learning objectives followed by introductory case i.e. “Let us set stage………….” to bring out the basic need to study the chapter. The text of the chapter contains explanation of concepts supported by tables, figures, exhibits and solved illustrations. We have also provided exercises, business cases, financial report interpretations and research assignments at the end of each chapter to enable student to think of a real life situation and apply the knowledge in business-like scenario. Exercises given at the end of the chapter include MCQs, Conceptual Questions and Practical Questions (divided in three levels—Easy, Standard and Expert) to create a ladder in the minds of students to grasp each and every aspect of a particular concept.

viii Preface

Our book provides real life cases based on data of listed companies. You will find cases from Indian as well as international companies.

WEB-BASED RESOURCES The online companion website comes with a strong suite of resources for instructors as well as students. These resources would help the instructors to facilitate the learning process whereas the students would be able to strengthen their learning and explore more on the subject. All the below mentioned resources can be accessed at www.mhhe.com/bapat-raithatha.

Resources for students include: ■ ■ ■

Student PowerPoint Presentations Solutions to exercise questions/cases Useful web links

Resources for instructors: ■ ■ ■

Teachers’ PowerPoint Presentations Solutions Manual Video lectures

Acknowledgements

We first thank our students who have been a constant motivation for us. We are grateful to our colleagues at IIT Bombay and fellow Chartered Accountants for their valuable suggestions. We acknowledge the constant support and encouragement provided by our family members. The insightful comments and suggestions provided by reviewers have been of important help for the comprehensive coverage of book. We, along with the publishers, would like to thank the following reviewers for their insightful comments and suggestions in bringing out this text: Sandeep Goyal, Management Development Institute, Gurgaon; Jacqueline Symss, Indian Institute of Foreign Trade, New Delhi; Satyendra P Singh, Jaipuria Institute of Management, Lucknow; Saroj Kumar Routray, KIIT University, Bhubaneswar. The publishers, Tata McGraw-Hill have contributed significantly in bringing out this text. VARADRAJ B. BAPAT MEHUL RAITHATHA

Teaching Plan

While bringing out this book, we have kept in mind management students who may not have any previous knowledge in accounting. Conceptual basis of accounting along with its contemporary approach has been the key objective of this book and have presented each chapter as a tool for self-study. To teach the subject of Financial Accounting two different approaches can be adopted – traditional and modern. Traditional approach generally gives preference to teach students about accounting records and process whereas modern approach aims at understanding the ultimate impact of accounting on financial statements. Since each faculty has its own way of handling the course, it becomes difficult to adopt one common approach. Management students are not so keen to learn, “how to record”, they are more interested in reading, understanding and interpreting financial statements. Since they have limited time, they need to focus on “how to read” financial statements. In modern era recording part has been computerised, and hence its importance has diminished a little. Considering the need of management education, we prefer to present our book in the sequence of modern approach which is as follows:

xii Teaching Plan

Teaching Plan xiii

However faculty can choose to adopt traditional approach and may follow following sequence:

Contents

Preface Acknowledgements Teaching Plan 1. Introduction to Financial Accounting Accounting as an Information System 3 Financial, Cost and Management Accounting and their Interrelationships 8 Finance Function and Accounting 9 Accounting as an Academic Discipline 10 Accounting as a Career and Profession 11 Place of Accounting Officers in the Organisation 13 Auditing and Internal Control 13 Ethical Issues in Accounting 15 Forms of Organisations and Their Effect on Accounting 17 Accounting and Corporate Governance 18 Summary 20 Multiple Choice Questions 21 Theory Questions 22 2. Accounting Concepts, Standards and IFRS Introduction 25 Accounting Concepts and Convention 25 Accounting Policies 29 Generally Accepted Accounting Principles (GAAP) 30 International Financial Reporting Standards (IFRS) 33 Indian Accounting Standards (Ind AS) 38 India’s Road Map to Convergence with IFRS 41 Indian Government Accounting Standards (IGAS) 43 Summary 44

vii ix xi 2

24

xvi Contents

Multiple Choice Questions 45 Theory Questions 48 Research Assignments 49 Interpreting Financial Reports 49 Business Case 50 3. Presentation of Financial Statements: Balance Sheet Conceptual Basis of a Balance Sheet 55 Capital and Revenue Expenditure and Receipts 56 Classification of Items on a Balance Sheet 57 Format of Balance Sheet 62 Balance Sheet Equation 65 Preparing Balance Sheet 66 Summary 69 Multiple Choice Questions 69 Theory Questions 70 Practical Problems 71 Research Assignment 74 Interpreting Financial Reports 74 Business Cases 75

54

4. Preparation of Final Accounts: The Income Statements Introduction 78 Format of Profit and Loss Account 79 Profit and Loss Account of a Manufacturing Concern 81 Appropriation of Profit 83 Advantages of Profit and Loss Account 84 Summary 86 Multiple Choice Questions 87 Theory Questions 89 Practical Problems 89 Research Assignments 92 Interpreting Financial Reports 93 Business Case 98

76

5. Mechanics of Accounting Introduction 101 Classification of Accounts 101 Double Entry System 103 Overview of Accounting Cycle 104 Preparing Journals 105 Subsidiary Books 108 Ledger 115 Preparation of Trial Balance 120 Accounting Errors and Their Rectification 123 Bank Reconciliation Statement (BRS) 125

100

Contents xvii

Computerised Accounting 128 Summary 131 Multiple Choice Questions 132 Theory Questions 134 Practical Problems 135 Research Assignments 143 Interpreting Financial Reports 144 Business Cases 145 6. Fixed Assets and Depreciation Accounting Introduction 149 Cost of Fixed Assets 150 Depreciation 153 Method of Computing Depreciation 155 Accounting Treatments for Transactions 161 Impairment of Assets 166 Summary 167 Multiple Choice Questions 168 Theory Questions 169 Practical Problems 170 Research Assignments 174 Interpreting Financial Reports 174 Business Cases 178

148

7. Inventory Valuation Introduction 192 Record Keeping for Inventory 193 Perpetual Inventory System 193 Inventory Valuation/Measurement 194 Methods of Valuation of Inventories 196 Analysis of Inventories 204 Summary 206 Multiple Choice Questions 206 Theory Questions 208 Practical Problems 208 Research Assignments 212 Interpreting Financial Reports 212 Business Cases 214

190

8. Corporate Accounts Introduction to Companies 217 Types of Companies 218 Shares and Share Capital 220 Issue of Shares 223 Share Issue: Payments in Instalment 226 Buyback of Shares 233

216

xviii Contents

Debentures and Bonds 234 Income Statement/Profit and Loss Account 235 Balance Sheet 239 Company Annual Report 253 Summary 254 Multiple Choice Questions 256 Theory Questions 258 Practical Problems 258 Research Assignments 264 Interpreting Financial Reports 264 Business Case 265 9. Cash Flow Statement Introduction to Cash Flow Statement 271 Cash and Cash Equivalents 273 Cash Flow Activities 276 Operating Activities 276 Some Special Items 282 Free Cash Flow 284 Fund Flow Statement 285 Analysis of Cash Flow Statement 288 Preparation of Cash Flow Statement 289 Summary 296 Multiple Choice Questions 297 Theory Questions 299 Practical Problems 300 Research Assignments 306 Interpreting Financial Reports 307 Business Cases 309

270

10. Financial Statement Analysis Introduction 321 Techniques for Financial Statement Analysis 321 Horizontal Analysis: Comparative and Trend Statements 325 Vertical Analysis: Common Size 330 Liquidity Ratios: Current and Quick Ratio 332 Solvency Ratios: D/E, Interest Coverage 335 Profitability Ratios: GP, NP, EBIT, EBDITA, EPS 339 Return Ratios: ROI, ROE 341 Turnover Ratios 343 Analysis of Stock and Debtors 345 Working Capital Management 346 Stock Prices and Financial Data: P/E 348 Summary 350 Multiple Choice Questions 351

320

Contents xix

Theory Questions 355 Practical Problems 355 Research Assignments 363 Interpreting Financial Reports Business Cases 367

363

11. Investments Introduction 373 Financial Instrument, Assets and Liabilities Joint Ventures 376 Subsidiaries and Associates 379 Consolidated Financial Statement 383 Business Combinations 385 Accounting for Investments 386 Summary 390 Multiple Choice Questions 391 Theory Questions 393 Research Assignments 393 Interpreting Financial Reports 393 Business Case 394

372 374

12. Contemporary Issues in Accounting Introduction 405 Foreign Currency Accounting 406 Creative Accounting 409 Forensic Accounting 411 Environmental Accounting 413 Lean Accounting 416 Human Resource Accounting 419 Objectives of Human Resource Accounting 419 HRA in India 422 Inflation Accounting 423 Responsibility Accounting 427 Transfer Pricing 428 Segment Reporting 430 eXtensible Business Reporting Language (XBRL) Summary 437 Multiple Choice Questions 439 Theory Questions 441 Research Assignment 442 Business Cases 442

404

434

Reading an Annual Report

448

Glossary

451

Index

464

VISUAL Each chapter is specifically designed to make journey of understanding comfortable, interesting and innovative for the reader. Following is the quick overview of sequence followed to explain topic in each chapter:

Learning Objectives Each chapter opens with a set of learning objectives, summarizing what one should learn from each chapter.

1 Learning Objectives After studying this chapter, you will be able to ❖

Define accounting and realise its importance

❖

Distinguish between financial, cost and management accounting

❖

Relate finance function and accounting

❖

Understand accounting as an academic discipline and as a profession

❖

Get an overview of auditing and internal control

❖

Know ethical issues in accounting

❖

Relate accounting and corporate governance

LET US SET THE STAGE . . . Mr Mayank started general in Mumbai on 1st April 2012. He invested Rs 1,00,000 in his busi . He purchased furniture worth Rs 80,000. The ise which he was was on rental basis, requiring him to pay refundable deposi of Rs 70,000 nd rent of Rs 10,000 pm. He also purchased a refrigerator for Rs . After making these he acquired stock of grocery items, cold drinks ice cream from Mr Raghu and paid Rs 1,00,000 out of which he paid Rs n cash. He recorded these transactions on the same day in a simple di He started recording all his aily transactions in the same diary on different dates. month he thought of calculating t rom his new business. When he opened his diary he got confused looking at the various transactions. He approached his friend Mr Jatin with this diary. Mr Jatin intaining accounts with double entry system told him to follo to avoid such confusions in future. What is an accounting process? What i How can one maintain systemati

■ ■

All such questions can be answered by studyi (This case is continued in Business Cases provi

ine hi

nancial position?

is chapter he end of the ch

)

INTRODUCTION We have seen the structure of financial statements in earlier discloses various assets and liabilities while an income expenses. The balance sheet equation is as follows:

. A balance sheet shows incomes and

Owner’s Fund + External Liabilities = Assets or Owner’s Fund = Assets – External Liabilities It shows that total assets are equal to total liabilities. This equality ari due o the ions. specific process of maintaining books of accounts to record various ic We shall discuss the entire process of recording various transactions in a manner to arrive at financial statements.

CLASSIFICATION OF ACCOUNTS An account is a statement which shows all transactions related to a particular party, asset, liability, income or expense. The types of accounts are personal, real and nominal (Figure 5.1).

Introductory Case [Let us set the stage……] Each chapter opens with an introductory case which sets the scene and introduces the issues that will be addressed in the chapter. It brings out how learning this chapter is important for overall understanding of the business.

WALKTHROUGH Introduction LET US SET THE STAGE . . . Mr Mayank started a general store in Mumbai on 1st April 2012. He invested Rs 1,00,000 iture in his business and borrowed a sum of Rs 2,00,000 from bank. worth Rs 80,000. The premise which he was using was on rental is, requiring him . He also purchased to pay refundable deposit of Rs 70,000 and rent of Rs 10,000 a refrigerator for Rs 30,000. After making these he acquired stock of and paid m Rs ,00,000 grocery items, cold drinks and ice cream from Mr out of which he paid Rs 30,000 in cash. He recorded all these transactions carefully on the same day in a simple diary. He started ing ll his daily transactions in he thought of calculating t from the same diary on different dates. After a his new business. When he opened his di he got co looking he rious transactions. He approached his friend Mr Jatin with this diary. Mr Jatin intaining accounts with double entry system told him to follo to avoid such confusions in future What is an account How can one mainta

■ ■

What is double entry system? ic records to determine hi nancial position? ing this chapter

All such questi (This case i

It provides brief discussion on the main theme of the chapter and gives an overview of the chapter.

inued in Business Cases pr

he end of the chapter.)

INTRODUCTION We have seen the structure of financial statements in earlier chapters. A balance sheet discloses various assets and liabilities while an income statement shows incomes and expenses. The balance sheet equation is as follows: Owner’s Fund + External Liabilities = Assets or Owner’s Fund = Assets – External Liabilities It shows that total assets are equal to total liabilities. This equality arises due to the specific process of maintaining books of accounts to record various transactions. We shall discuss the entire process of recording various transactions in a systematic manner to arrive at financial statements.

CLASSIFICATION OF ACCOUNTS An account is a statement which shows all transactions related to a particular party, asset, liability, income or expense. The types of accounts are personal, real and nominal (Figure 5.1).

Diminishing/Reducing Balance Method or Written Down Value Method (RBM) Under this method, the depreciation is charged at a fixed annual rate on the reducing balance, i.e. cost less depreciation. The amount of depreciation charged in each year is not fixed but it goes on decreasing gradually every year. Thus, the amount of depreciation is higher in earlier periods and lower in subsequent periods when repairs and maintenance cost of the asset increases. The formula for calculating the rate of depreciation under diminishing balance method is as follows: Rate of Depreciation = 1 - n

Net Residual Value Cost of Acquisition

If residual value is zero, assume as 1. Here, n = life of the asset (in year)

ILLUSTRATION 6.3 The cost of the asset is Rs 20,000, residual value is Rs 2,000 and the life of the asset is 3 years. Compute the annual rate of depreciation. Solution: The rate of depreciation would be calculated as follows: Rate of Depreciation = 1 - 3

2,000 20,000

= 53.6%

ILLUSTRATION 6.4 A company buys equipment at a cost of Rs 10,000. It decides to depreciate the asset at the cost of 20% per annum based on the reducing balance method (RBM). Calculate the amount of depreciation and WDV for 5 years. Show how equipment will appear in the balance sheet at the end of years 1, 2 and 3. Solution:

Illustrations Each chapter provides a number of solved problems/cases helping you to apply theory to accounting practice.

Year

Cost

1st

10,000

Depreciation = Cost * 20% 2,000

WDV = Cost – Depreciation 8,000

Accumulated Depreciation 2,000

2nd

8,000

1,600

6,400

3,600

3rd

6,400

1,280

5,120

4th

5,120

1,024

4,096

5,904

5th

4,096

819.2

3,276.8

6,723.2

4,880

VISUAL EXHIBIT 5.1 Bank Reconciliation Statement (Starting with Cash Book Balance) Rs

Rs

Bank Balance as per Cash Book

xxxx

Add: Cheques Issued but not Presented for Payment Direct Collections by Bank

xxxx

Direct Deposits by Debtors/Collection Agents

xxxx

Interest Credited by Bank

xxxx

Less: Cheques Deposited but not Cleared

xxxx

xxxx

Direct Payment by Bank

xxxx

Dishonoured Cheques and Related Charges

xxxx

Interest and Bank Charges

xxxx

xxxx

Balance as per Pass Book

xxxx

BRS can also be prepared starting with pass book balance as per the following exhibit: c ation

XHIBIT

Tables, Exhibits

atemen s

Rs

Bank Balance as per Current Account Statement

Sufficient tables and exhibits have been inserted to make the text easier to grasp and to depict information.

xxxx

: xxxx 1 xxx

xed ges

E ges

ayment —Net Block Di

8,000 xxxx

ions by Banks

its Direct Deposits by Debtors/Collection Agents The char iation reduces every year, wh ill remai wn in WDV is li i i ing LLUSTR

is approv i Brijesh, a le-trader, found on 31st March that bank balance as per cash book i

T

Cash and Cash Equivalents

Opening Balance

Cash

15,000

Bank Short-Term Investments

5,000

5,800

9,050 15,000

50,800

29,050

Workings Fixed Asset A/c Particulars

Rs

Balance B/d

6,00,000

Purchase of Fixed Assets*

1,75,000

Particulars Bank A/c (Sale Value) Loss on Sale of Fixed Assets

is likely

xxxx

. .

.2 compares SLM and RBM.

Straight Line Method

Reducing Balance Method

It remains the same throughout the life of the asset. he book value of the asset can be zero. his method is not acceptable.

It goes on decreasing every year. The book value of the asset cannot be reduced to zero. This method is acceptable.

Under the Companies Act, company s free to either of the two methods: SLM or RBM. However, rates of epreciation are prescribed in Table 6.3 as per the ompanies Act and 6.4 as per the Income T Act T

BLE

6.3 Rates of depreciation as per Compani

Pr isions of Companies Act (Schedule XIV) Assets ildings Furniture Plant and Machinery (Single Shift) V i

Act Rate of Depr iation WDV SLM 10% .34% 18.1% 6.33% 13.91% 4.75% 40% 16.21% 25.89% 9.5%

Rs 1,50,000 50,000

Depreciation

75,000

Balance C/d

5,00,000

7,75,000

3,600 6400

its fair v . xxxx i years li

Depreciation

Closing Balance

30,000

xxxx

i

Basis

Income T

2

some a ance will always be is av ilable:

i

Book V

Y

xx

7,75,000

SUMMARY ➤

The purpose of a statement of cash flo s to provide i the cash receipts and cash payments of the enti and how they relate to the ntity’s operating, investing and financing activities. f nancial statements use this information to assess the solvency of a bus and to evaluate its ability to generate positive cash flows in future peri vi nance gro th

➤

Cash flows are classified as operating, investing and fi ing activities. Receipts and payments of interest are classified as operating activi es.

➤

The major operating cash flows are cash received from cash paid o suppliers and employees, interest and dividends received, paid and income taxes paid. These cash flows are computed by converting the statement amounts for revenue, cost of goods sold and expenses from the basis to the cash basis. This is done by adjusting the income statement amounts changes occurring over the period in related balance sheet accounts.

➤

The direct and indirect methods are alternative formats for reporting net cash ws from operating activities. The direct method shows the specific cash inflows outflows comprising the operating activities of the business. Under the indi method, the computation begins with accrual-based net income and then shows adjustments necessary to arrive at net cash flows from operating activities. Both methods result in the same amount of net cash flows from operating activities.

Summary This briefly reviews and reinforces the main topics one has covered in each chapter. This would ensure that one has acquired an understanding of the key topics.

WALKTHROUGH Exercises Exercises encourage you to review and apply the knowledge you have acquired from each chapter and can be undertaken to test your understanding. Exercises are divided into following categories:

MULTIPLE CHOICE QUESTIONS* 1. Accounting concepts refer to (a) The basic assumptions (b) Rules and regulations (c) Procedures (d) None of the above 2. The business entity concept assumes that, for accounti ities (a) The business enterprise and its owner are two separate i (b) The business enterprise and its owner are same entities (c) Business is continued forever (d) None of the above 3. This money measurement concept assumes that (a) All business transactions should be expressed in non-monetary terms (b) All business transactions should be expressed in non-monetary terms (c) Either in monetary or non-monetary terms (d) None of the above 4. In accordance with which of the following basic accounting concepts, during lifetime of an entity, financial statements are prepared periodically? (a) Conservation (b) Matching (c) Accounting period (d) None of the above 5. When information about two different entities have been prepared and presented in a similar manner the information shows the characteristic of (a) Verifiability (b) Relevance (c) Reliability (d) None of the above 6. A concept that a business organisation will not be closed down in the near future is known as (a) Going concern (b) Economic entity (c) Monetary (d) None of the above 7. The primary qualities that make accounting information useful for decisionmaking are (a) Relevance and freedom from bias *

Multiple Choice Questions These questions are conceptual questions with four alternative choices given. It helps for quick revision of the concepts explained in the chapter.

Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

THEORY QUESTIONS

Theory Questions These are conceptual questions which involve recollecting and theoretically narrating the issue. It includes short notes, ‘distinguish between’ and essay-type questions.

1. The ietor of a firm withdrew Rs 56,000 for his personal use. This was shown as xpense the firm. Profits were reduced to pay a lower tax. Is this right from accounti int of view? Justify your answer. 2. The CE y is killed in a plane crash. To the extent “an organisation is the shadow of a man”, the real value of the company will change immedi and this will be reflected in the market price of the company shares. ill this have any effect as far as the accounts of the company are concerned? Give iate reasons. 3. A y revalues its buildings, which were purchased at a cost of Rs 10, in 1995 to Rs 90, 00,000 in 2010, and records the difference of Rs 80, it for the year 2003. Is this practice right? Give reasons. 4. accounting year of a firm closes on 31st December each year. The rent for siness premises of Rs 45,000 for the last quarter could not be paid to the owner on account of his being away in a foreign country. Should the rent payable be taken into account for computing the firm’s profit for the accounting year? Give reasons. 5. A government contractor supplies stationery to various government offices. Some bills amounting to Rs 10,000 were still pending with various offices at the close of the accounting year on 31st March. Should the businessman take the revenue of Rs 10,000 into account for computing the net profit of the period? 6. A company had been charging depreciation on a machine at Rs 10,000 per year for the first three years. Then it began charging Rs 9,000 for the fourth year and Rs 7,800 for the fifth year and so on. Is this practice justified? Give reasons for your answer. 7. Indicate which of the following transactions relate to Mr Keshav’s business as news agent and which are his personal transactions: (a) Rs 50,000 won from a lottery ticket (b) Rs 10,000 for placing advertisement on a local cricket ground regarding his up to date news service (c) Sale of unsold newspaper to local stationary shop (d) Payment to newspaper wholesaler Rs 20,000 (e) Purchase of new car for family use although it was used in each morning to collect newspapers from suppliers 8. At the end of the year 2012, an organisation had a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials. All these assets were disclosed as mentioned above in the balance sheet. Using accounting concepts, you are required to comment on this approach.

VISUAL Practical problems 3. Distinguish between SLM and RBM. 4. What is an asset impairment? Why is it necessary to provide for the same?

Practical problems are divided into 3 layers i.e. Easy, Standard and Expert.

Level 1 – Easy

PRACTICAL PROBLEMS Level 1: Easy 1. Amteck Ltd. bought a machine on 1.1.2012 costing Rs 5,00,000 with a useful life of 10 years. It is expected to have a scrap value of Rs 20,000 at the end of its useful life. The rate of depreciation applicable to RBM is 10%. You are required to calculate depreciation for the year 2013 and 2014 and also WDV as on 31.12.2013 and 31.12.2014 as per SLM and RBM and offer your comments. 2. Mr Omprakash purchased machinery costing Rs 1,80,000 on 1st April, 2012 having a useful life of 15 years, with no salvage value at the end. He decides to provide depreciation @ 10% pa as per RBM. You are required to pass necessary journal entries using provision for depreciation method for 3 years. 3. Complete the following fixed assets schedule: Rs in lacs

These are simple problems to understand the basic calculations of relevant concepts of the chapter.

Level 2 – Standard

Particulars

These are problems that require deep understanding of concepts and issues.

Level 3 – Expert

Gross Block Cost as on 1/4/2011

Goodwill

Additions

Depreciation

Net Block

Cost as on Accu- Current AccuAs on As on 31/3/2012 mulated Year mulated 1/4/2011 31/03/2012 as on as on 1/4/2011 31/3/2012

50,000

—

—

Land and Building

1,80,000

5,000

50,000

Plant and Machinery

4,50,000 15,000

60,000

Furniture

1,55,000

10,000

5,000

You are informed that:

These are practical problem at higher level which aims at testing the grasping power of the reader and thorough understanding of the chapter.

Rate of depreciation for land and building is 10%, plant and machinery is 15% and furniture is 20% ■ Full depreciation is provided on assets purchased during the year ■ WDV is used for providing depreciation 4. The following information is available for Bharat Ceramic Ltd: ■

Particulars Cost of the Machine (Rs)

26,00,000

Useful Life (Years)

5

Scrap Value (Rs)

rate of depreciation as 11. Suman Ltd purchased the following assets during the year 2012. ird year

Asset

ird year ils of which are as under. Using ine. Amount

iculars

25,00,000 50,000 24,50,000 3,00,000 actory Site Visit

Scrap

Amount

27,50,000 12,500 37,500 40,000 20,000

icals Ltd purchased on 1.1.1997, a divisible plant for . The plant had estimated useful life of 5 years. It was depreciated SLM. A major extension was carried out for Rs 4,00,000 which was ional from 1.1.1999. Prepare the machinery account for all the years ing: (a) the extension will last only till the life of the existing asset (b) the extension is capable of being used independently of existing plant and is expected to last 5 years from its installation

6 Aparna Rs

Deductions

Additions

Deductions

As at 31/3/2012

As at 31/3/2011

As at 31/3/2012

Net Block

Additions

Net Block

Depreciation/Amortisation/ Impairment

As at 31/3/2011

Depreciation

Gross Block

4,00,000

—

—

4,00,000 1,00,000

30,000

—

1,30,000

3,00,000

2,70,000

5,00,000

—

—

5,00,000 2,50,000

50,000

—

3,00,000

2,50,000

2,00,000

2,00,000

—

—

2,00,000 1,00,000

30,000

—

1,30,000

1,00,000

70,000

1,55,000

—

—

1,55,000

77,500

15,500

—

93,000

77,500

62,000

3,00,000

—

—

3,00,000 1,50,000

60,000

—

2,10,000

1,50,000

90,000

15,55,000

—

—

15,55,000 6,77,500 1,85,500

—

8,63,000

8,77,500

6,92,000

Rs in lakhs Gross Block

10 20

Building

7. Complete the following fixed assets schedule:

Cost Add- Cost as Accu- Current AccuAs on As on as on itions on 31/3/ mulated Year mulated 1/4/2011 31/3/2012 1/4/2011 2012 as on as on 1/4/2011 31/3/2012

Useful Life

1,60,000 1,80,000

Particulars

Level 2: Standard

Particulars

Residual Value

24,00,000 30,00,000

Company used SLM for providing depreciation from the year of purchase. However from year 5, company decided to change depreciation method to WDV and decided to apply rate of 10%. Assuming company earning a profit of Rs 6,50,000 before depreciation which grows @ 10% pa, you are required to: Compute profit after depreciation for 5 years. Show the impact of change in method of depreciation in year 5 (assuming it is done retrospectively from year 1). 12. Carriage Transport Company purchased 5 trucks at the cost of Rs 2,00,000 each on 1 April 2001. The company writes off depreciation @ 20% p a on the original cost and closes its books on 31 December, every year. On 1st October, 2003, one of the trucks is involved in an accident and is completely destroyed. Insurance company has agreed to pay Rs 70,000 in full settlement of the claim. On the same date the company purchased a second hand truck for Rs 1,00,000 and spent Rs 20,000 on its overhauling. Prepare a truck account and provision for depreciation account for the three years ended on 31 December 2003. Also give truck account if truck disposal account is prepared. 13. The following is the schedule of fixed assets of Amtech Ltd for 2011–12:

vo ce Price List Price Less: T iscount Balance Add: Sales T Exci ion Char Installation Char es avelling Char

Cost

Plant Building

Land and Building

3,50,000

25,000

Plant and Machinery

1,85,000

24,000

Furniture

1,20,000

16,500

Plant and Machinery Furniture and Fixtures Computer Systems Vehicles

Computer

2,25,000

59,000

Total

As at 31/3/2011

P

years

As at 31/3/2012

ired to: rmine nnual depreciation for per SLM 2 determine accumulated depreciati 3. how disclosure of machine i 5. mkar Silk Ltd. purchased machinery, the the given informati

Level 3: Expert

Y

1

1,30,000

WALKTHROUGH

BUSINESS CASE India’s largest power company, NTPC was set up in 1975 o accelerate power development in India. NTPC is emerging as a diversi ed power major with presence n the entire value chain of the power generation business Apart from power generation, which is the mainstay of the company, NTPC has ventured into onsultancy, power trading, ash utilisation and coal mining. NTPC 341st in the ‘2010, Forbes Global 2000’ ranking of the world’s biggest companies. became a Maharatn company in May 2010, one of the only four companies to be a arded this status. The total installed capacity of the company is 36,014 MW (i ing JVs) with 15 coal based and 7 gas based stations, located across the country. ition under JVs, 5 stations are coal based and another station uses naphtha/LNG as fuel. The company has set a target to have an installed power generating capacity of MW by the year 2032. The capacity will have a diversified fuel mix comprising coal, 16% gas, 11% nuclear and 17% renewable energy sources (RES), including . By 2032, non-fossil fuel-based generation capacity shall make up nearly 28% of ’s portfolio. NTPC has been operating its plants at high efficiency levels. Although the compan has 17.75% of the total national capacity, it contributes 27.40% of the total power generation due to its focus on high efficiency. The following information is available regarding its incomes and expenses in Rs Cr for the years ending 31st March 2010 and 2011. Particulars Sales Turnover Excise Duty Other Income Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Admin Expenses Miscellaneous Expenses Interest Depreciation Tax Preference Dividend Equity Dividend

March 2011 55,216.69 278.01

March 2010 46,623.60 245.9

2,525.48 31.33 35,796.37 3,395.27 1,273.14 2,264.01 525.63 2,027.21 2,485.69 2,630.54 0 3,133.26

2,872.80 31.1 29,689.10 2,946.80 1,096.60 578.5 436.4 1,861.90 2,650.10 2,682.70 0 3,133.20

Business Cases Business cases are designed in such a way that reader can understand real business scenarios. Cases are developed with interesting situations and real life data. Application of knowledge will be the key requirement of solving the cases.

You are required to prepare income statement and calculate profit at various levels.

Research Assignments Each chapter ends with research assignments which are given as guidelines to collect and analyse specific information. They are home assignments to serve the purpose of selfstudy and improve research skills.

Using the following information you are required to prepare fixed assets schedule for 2012–13. Company follows RBM to provide depreciation On 1st July, 2012 company acquired new vehicle worth Rs 50,000 and sold out old vehicle for Rs 50,000 (WDV Rs 50,000 and cost Rs 1,00,000) ■ On 1st September, 2012 company acquired new building worth Rs 1,00,000 ■ On 1st January, 2012 company acquired furniture worth Rs 40,000 14. A company provides depreciation on plant and machinery at 20% per annum on diminishing balance method. On 1 April 2013, the balance in the plant and machinery account was Rs10,00,000, It was discovered during 2013–14 that: (a) Rs 50,000 being ordinary repairs to machinery incurred on 30 June 2011 had been wrongly capitalised. (b) Rs 1,00,000 being the cost of a generator purchased on 1 October 2010 had been wrongly treated as revenue expenditure and written off to stores. plant which cost Rs 80,000 on 30 September 2012 was scrapped and replaced with more sophisticated one on 31 December 2013 by spending Rs 1,20,000. . the plant and machinery account as would appear on 31 March 2014 after provi ing depreciation for that year. Also show the detailed working notes maki ion. ■ ■

RESEARCH ASSIGNMENTS

Interpreting Financial Reports Financial reports published by corporates are an important source of data for the company information. It provides financial statements and/or a specific corporate issue to be analysed and interpreted.

1. Study annual report of Coal India Ltd, TCS Ltd and Infosys Ltd for 3 years and answer the following questions: (a) Compare depreciation method followed by companies. (b) Find out if assets are revalued and how revaluation effect has been reflected in the financial statements. (c) Suppose company wants to charge depreciation on revalued amount, explain how it would affect the profit. (d) Analyse intangible assets shown in financial statements of the company and comment on accounting policies adopted for the valuation. (e) Comment on assets impairment policy of the company and reflect whether it has affected companies profit or not.

INTERPRETING FINANCIAL REPORTS 1. Following details have been extracted from the Annual Report of Reliance Industries Limited. for the year 2010–11.

Financial Accounting

Introduction to Financial Accounting

Learning Objectives After studying this chapter, you will be able to ❖

Define accounting and realise its importance

❖

Distinguish between financial, cost and management accounting

❖

Relate finance function and accounting

❖

Understand accounting as an academic discipline and as a profession

❖

Get an overview of auditing and internal control

❖

Know ethical issues in accounting

❖

Relate accounting and corporate governance

1

Introduction to Financial Accounting

3

LET US SET THE STAGE . . . Krishna needs to buy a book urgently. She asks her father for the money. “But”, the father says, “what happened to the money I gave you last week?” She tries to recollect how she spent it but could not remember exact amount of money she spent on various occasions. Her father advises her to record all her expenses in a diary. Recording all incomes and expenses systematically is ‘accounting’ for the money. Mr Ram Singh is a retail fruit vendor. He records his daily sale and purchase of fruits in a diary. At the end of the day, he counts his stock and plans for next day’s purchase. As his fruit business was doing well, he plans to start a retail shop of fruits in the market. He approaches a microfinance institution in his area and asks for a loan. They ask Mr Ram Singh to produce financial statements. Mr Ram Singh produces a diary stating all daily purchases, sales and stock records. A volunteer explains him that such a dairy is not enough and he has to get proper profit and loss account (stating all expenses and incomes) and balance sheet (stating all assets and liabilities) to obtain a loan. Accounting plays a very important role in determining the profitability and financial position. This chapter will introduce you to various concepts and set a background for you to get acquainted with the accounting terminologies.

ACCOUNTING AS AN INFORMATION SYSTEM Decision-making in respect of major business functions, including production, administration and marketing, depends on availability of timely and accurate financial information. All types of organisations, whether business, non-profit or governmental, are required to provide information to outsiders. Thus, financial information is demanded by both external and internal users. Accounting establishes a standardised and systematic process for recording and processing of data, giving out information in the form of financial statements.

Meaning In simple words, ‘accounting’ refers to recording. Whenever any organisation is operating, one would like to know its performance. In order to be able to do so, it is necessary that as far as possible all the transactions that have taken place should be recorded systematically in monetary terms. The process of accounting involves recording, classifying and summarising past events and transactions of financial nature, with a view to enabling the users of accounting data to interpret the resulting summary. Accounting is one of the most widely used information processing systems in business. The utility of accounting information increases when this information is compiled in a systematic manner and financial statements are prepared at periodic

4 Financial Accounting

intervals. For the purpose of compilation, all monetary events are recognised as ‘transactions’ and are classified into various ‘account’ heads. An account is a statement that shows all transactions related to a particular asset, liability, income or expense, for instance Cash Account (Cash A/C). The ‘account’ heads are then summarised under related groups so that interpretation becomes possible. For example, when a travel agent purchases stationery for office use, it is recorded as Stationary A/C, grouped under office expenses. All such expenses are compared with business income to arrive at profit. There is a small difference between the terms ‘accounting’ and ‘book keeping’. Book keeping is a part of accounting that is concerned with recording; a book keeper normally needs lower academic qualification. Accounting, in its broad sense, extends to financial reporting, taxation compliance, cost analysis, interpretation, and estimation. It is the process of identifying, measuring, recording and communicating economic transactions. “Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.” —The American Institute of Certified Public Accountants (AICPA) Financial accounting consists of creation of financial information and the subsequent use of such information. Accounting entails various steps, namely, recording, classifying and summarising, which are dealt below: 1. What to record? All financial transactions affecting the business have to be recorded in accordance with the principles of accountancy. As money is the common unit of measurement, all events that are expressed in monetary terms will be recorded. 2. When to record? Accounting is historical in nature because of which the recording is to be effected only after the occurrence of a transaction. Therefore, sale of goods cannot be recorded when the goods are merely intended to be sold but only after such sale is complete and the property in the goods has been transferred to the buyer. 3. How to record? Whenever a transaction occurs, it is decided in which account/s it is to be recorded. Accounting concepts, policies guide recording procedure. This will be covered in-depth in Chapter 5, Mechanics of Accounting. 4. Value at which it is to be recorded: All the ingredients of the financial statements are to be assigned appropriate values. Money is the scale of measurement in accounting and we can measure only those which can be translated into monetary terms. Different valuation bases are used in accounting, of which, the frequently used are historical cost, current cost, realisable value and present value. Value is determined at the time of recording and at the time of preparation of financial statements.

Introduction to Financial Accounting

5

5. Preparing statements: Income statement is prepared to calculate profit or loss during a particular year by summarising all incomes and expenses. Balance sheet is prepared to record assets and liabilities stating financial position of the concern at the end of a particular period. Cash flow statement shows inflow and outflow of cash. The financial statements are prepared at the end of certain period, usually yearly or quarterly.

Evolution of Accounting Both merchants and governments have been using accounting for keeping records of transactions since times immemorial. India has a very long tradition of maintaining books of accounts known as chopadis. These chopadis were closed at the end of the year and new set of books were opened. Lakshmi Poojan (Diwali) is considered as an auspicious day for worshipping new books (chopadis), which are to be started from the next day (Bali Pratipada). The concept of accounting period is firmly rooted to the Indian tradition. We also see mention of financial instruments like hundis in ancient India. Kautilya, also known as Chanakya or Vishnugupta, a well-known statesman, economist and spiritual guru wrote Arthshastra in the fourth century BC, where he has recognised the importance of accounting. He realised that a proper measurement of economic performance was absolutely essential for efficient allocation of resources. He specified a very broad scope for accounting and considered explanation and prediction as its proper objectives. Kautilya developed book-keeping rules to record and classify economic data. He emphasised the critical role of independent periodic audits and proposed the establishment of two important but separate offices—the Treasurer and Comptroller-Auditor—to increase accountability, specialisation, and, above all, to reduce the scope for conflicts of interest. Clarity, consistency and completeness of rules are keys to such enforcement. Kautilya believed that such measures were necessary but not sufficient to eliminate fraudulent accounting. He also emphasised the role of ethics, considering ethical values as the glue which binds society and promotes economic development. The origin of the organised forms of accounting that we use today can be traced back to Italy. The recognition in record keeping, of the fact of the duality of values— that is, the benefit to the entity on the one hand, and its sacrifice on the other—can be considered to be the crux of the modern accounting system. Luca Pacioli (1445– 1515) is usually recognised as the father of modern accounting as he published first text on accounting. Though accounting systems were used much prior to Pacioli’s book, the system became a standard for merchants, especially in Europe, only after Pacioli structured and organised it in his book. Accounting methodology, which was developed and used in trade and commerce during the Middle Ages, faced its first serious challenge with the introduction of the modern manufacturing industry, as a result of the Industrial Revolution.

6 Financial Accounting

In today’s information technology intensive environment, we see that accounting is getting increasingly adapted to the new situation and getting integrated into new software packages. Computerised accounting systems have taken the place of traditional book keeping. They are designed to automate and integrate all the business operations, such as sales, finance, purchase, inventory and manufacturing.

Importance of Accounting

Objective 1 To Define Accounting and Realise its Importance

Accounting plays an important role in the success of any business, social or regulatory organisation. The following are the major points showing importance of accounting: ■ ■

■

■

■

■ ■

It ensures systematic recording of financial transactions. It records income and expenses in such a manner that net result of any period can be determined. It records assets and liability in such a way that financial position of the entity can be judged. It makes tax assessment easy and benefits both business organisations and tax authorities. It helps share holders, management and other stakeholders to monitor and evaluate organisations performance. It provides reliable and timely information for decision-making. It acts as a basis for estimation and projection of financial figures and hence enables preparation of budgets.

Users of Financial Statements Financial statements are prepared by following proper accounting process. Such financial statements are used by various users for different purposes as follows (see Figure 1.1).

Owners/Investors The major users of financial statements of business include sole proprietor or partners or shareholders. The financial position of the company is communicated to the shareholders through the financial statements which state the profit gained or loss suffered and the value of its assets and liabilities. Prospective investors also use such information to take decisions about their investments in companies. In case of listed companies, groups like analysts, mutual funds, investment bankers, institutional investors become interested in financial statements.

Management/Board of Directors In a company form of organisation the owners or the shareholders elect a group of people to manage the day-to-day affairs of the company. Since these directors/managers are

Introduction to Financial Accounting

FIGURE 1.1

7

Users of Financial Statements

ultimately responsible for the financial performance, they must periodically compile and report the financial statements. Financial information are also useful for decisionmaking function.

Lenders/Bankers Banks, financial institutions and other lenders would willingly part with their money only if they are assured of the repayment capacity, profitability and long-term solvency of the business to which they are asked to lend. Financial statements are normally used by the lenders to judge for the financial health of the business and to assure themselves of the security available for the monies lent. The financial statements are also used to monitor company’s performance on regular basis.

Suppliers/Creditors Suppliers of raw material or services are primarily interested in the short-term liquidity of the company. The financial statements facilitate the creditors in ascertaining the capacity of the organisation, to pay on time the consideration for the goods/services to be supplied.

Customers They can determine the strength and reliability of an organisation based on financial performance. Legal obligations associated with guarantees, warranties and after sales

8 Financial Accounting

service contracts tend to establish long-term relationships between a business and its customers. The financial statements are used by the customers to draw inferences about the long-term viability of the firm.

Employees Employees have an interest in the continued and profitable operations of the organisation in which they work. Financial statements can be used as an important source for obtaining information regarding the current and future profitability and solvency. Sometimes, contracts tying remunerations to profits or payment of incentives based on certain financial measure would tend to magnify this interest.

Government and Regulatory Agencies The correct assessment of taxes—income tax, sales tax, excise duty, etc.—takes inputs from the financial statements of an organisation especially to detect tax evasion, if any. Government, as the guardian of public interest, must also keep a close watch over the various business firms to detect profiteering and creation of monopolies. Vital information in this regard can be gathered from a scrutiny of the financial statements of business enterprises. National income accounting used in macroeconomic analysis derives its fundamental inputs from financial statements. The tax payable by the enterprises as well as the compilation of countrywide statistics is discerned using the financial statements. Regulatory authorities like Securities Exchange Board of India (SEBI), Reserve Bank of India (RBI), Registrar of Companies (ROC) also uses the financial information to keep vigilance on the companies.

FINANCIAL, COST AND MANAGEMENT ACCOUNTING AND THEIR INTERRELATIONSHIPS Financial accounting deals with recording and preparation of the statements revealing the income and financial position of the business on the basis of events which have happened in a particular period.

Objective 2 To distinguish between financial, cost and management accounting

The major purpose of financial accounting is to report the position of the entity as on the reporting date, as well as the performance of the entity during the period covered by the previous reporting date and the present reporting date. This reporting is done through various financial statements, important ones being income statement and balance sheet. Financial statements present information on revenues, profits, cash flows, assets, liabilities and so on. Though this information is very important, it does not adequately aid the management in planning, controlling, organising and efficiently conducting the course of the business as a result of which cost accounting and management accounting have emerged.

Introduction to Financial Accounting

9

Cost accounting records, analyses and estimates cost. It also deals with cost computation, cost saving, cost reduction, etc. The costing function provides information that is crucial for profit measurement in financial accounting. The cost of products/ services to be considered with respect to the revenues earned is provided by the cost accounting system. Cost accounting is primarily targeted to inside users. Management accounting deals with the processing of data generated in financial accounting and cost accounting for managerial decision-making. It also uses managerial economic concepts for decision-making. Management accounts facilitate planning and control of activities of organisation to assist in decision-making process. Cost accounting is indistinguishable from management accounting as the major purposes of providing information for control purpose and for formulating plans and policies, is common to both (see Table 1.1). It should, however, be noted that traditionally, cost accounting was concerned with the determination of product costs and inventory valuation and in this respect; it was an extension of financial accounting. The function of management involves taking decision with respect to day-to-day operations of the entity and strategic planning. Managers depend on the accounting data for guiding their decisions. Management accounting provides relevant information to facilitate decision-making. TABLE 1.1

Managerial Accounting and Financial Accounting

Managerial Accounting

Financial Accounting

1.

It is generally targeted to managers within the organisation

It is targeted to various stakeholders including outside the organisation.

2.

Preparing managerial accounting is not mandatory

Maintaining financial accounting records is statutory requirements

3.

It is not regulated as it is intended only for management

It is closely regulated by GAAP, accounting bodies and government authorities

4.

It uses historical data along with projections and estimations

It primarily uses historical data

FINANCE FUNCTION AND ACCOUNTING Objective 3 Accounting involves the creation of financial To relate finance function and records of business transactions, flows of accounting finance, the process of creating wealth in an organisation, and the financial position of a business at a particular moment in time.

10 Financial Accounting

Finance is the lifeblood of economy without which business cannot run successfully. Sufficient funds at the required time are the key to success. In terms of Husband and Dockery, “Finance is the agent that directs the flow of economic activity and facilitates its smooth operation.” John J Hampton defined it as the management of the flow of money through an organisation. It involves the proper custody and authorised utilisation of available funds. It is related to procurement of funds as well as their effective utilisation. It covers not only financial planning, financial forecasting, raising finance but optimum use of funds.

ACCOUNTING AS AN ACADEMIC DISCIPLINE Objective 4 An academic discipline, or field of study, To understand accounting as is a branch of knowledge that is taught and an academic discipline and as a researched. Disciplines are defined and profession recognised by the academic journals in which research is published, and the learned societies and academic departments or faculties to which their practitioners belong. Accounting has generally been oriented towards practical knowledge as opposed to theoretical abstractions.

Accounting and Economics Economics is concerned with rational decision-making regarding efficient use of scarce resources for satisfying human wants and needs. Accounting and economics are related to each other. Both of them consider the effective and efficient use of resources. Accounting deals with provision of accurate, timely and adequate information to the stakeholders, while economics deals with production, distribution, and consumption of goods and services. Accounting and finance are related to each other as accounting is a part of finance. Accounting deals with recording financial transactions on daily basis whereas raising and utilising funds are focus areas in finance activity.

Accounting and Statistics Statistics is the science of numbers. It is concerned with numerical data as well as various statistical techniques which are used for collection, classification, analysis and interpretation of such data. Accounting has close relation with statistics as numbers of statistical techniques are used for analysis and interpretation of accounting data.

Introduction to Financial Accounting

11

Accounting and Law A business entity operates within a legal framework. There are laws governing specific entity for instance Companies Act is applicable to Joint Stock Companies and it provides detailed guidelines for preparing accounting statements, the Banking Regulation Act is applicable to banking companies and so on. Table 1.2 shows some of the major Indian and international research journals in the areas of accounting. TABLE 1.2

Accounting Research Journals No. Name of Journal

Published by

1

Accounting, Auditing, & Accountability Journal

Emerald

2

The Accounting Review

American Accounting Association

3

The Chartered Accountant

ICAI

4

Journal of Accounting and Economics

Elsevier

5

Journal of Accounting Research

Wiley

6

Abacus

Wiley

ACCOUNTING AS A CAREER AND PROFESSION Accounting is considered as a profession as it requires specialised knowledge. Each country has its own accounting bodies to regulate the accounting profession. In India, a qualified accountant must have passed examinations conducted by the Institute of Chartered Accountants of India (ICAI) and should be a member of that Institute. The ICAI is a statutory body established under the Chartered Accountants Act, 1949 for the regulation of the profession of Chartered Accountants in India. During its 63 years of existence, the ICAI has achieved recognition as a premier accounting body not only in the country but also globally, for its contribution in the fields of education, professional development, maintenance of high accounting, auditing and ethical standards. Apart from the ICAI following professional bodies offer professional qualifications which are also widely accepted in India. ■ ■

Institute of Cost and Works Accountants of India (ICWAI) (Established in 1944) Institute of Company Secretaries of India (ICSI) (Established in 1980) Table 1.3 lists out some recognised accounting bodies in some other countries.

12 Financial Accounting TABLE 1.3

List of Recognised Bodies in other Countries

Institute

Country

No. of Members

American Institute of Certified Public Accountant (AICPA)

USA

3,70,000

The Institute of Chartered Accountants of India (ICAI)

India

1,61,516

The Chinese Institute of Certified Public Accountants (CICPA)

China

1,40,000

The Institute of Chartered Accountants in England and Wales (ICAEW)

UK

1,36,000

Canada Institute of Chartered Accountants (CICA)

Canada

78,000

The Institute of Chartered Accountants of Australia (ICAA)

Australia

50,000

The Institute of Professional Accountants of Russia (IPAR)

Russia

50,000

These accounting bodies contribute to accounting profession by identifying opportunities for accountants in audit and assurance function, performance measurement services, strategic management, general practice specialisation and servicing global organisations. Such institutes plays important role in providing high quality education and in maintaining professional ethics. Some other international accounting bodies are discussed below. The Association of Chartered Certified Accountants (ACCA) is a British accountancy body that offers the Chartered Certified Accountant qualification worldwide. It is one of the world’s largest and fastest-growing accountancy bodies with 1,40,000 members in 170 countries. The International Federation of Accountants (IFAC) is the global organisation for the accountancy profession. The IFAC has 164 members and associates in 124 countries and jurisdictions, representing more than 2.5 million accountants employed in public practice, industry and commerce, government, and academe. The organisation, through its independent standard-setting boards, establishes international standards on ethics, auditing and assurance, accounting education, and public sector accounting. It also issues guidance to encourage high quality performance by professional accountants in business. The Association of International Accountants (AIA) is a professional accountancy body. It was founded in the UK in 1928 and since then has promoted the concept of “international accounting” to create a global network of accountants in over 85 countries worldwide. Accounting profession is done by individual accountants or by their partnership firms. Global consultancy business is dominated by certain accounting firms. Table 1.4 provides information about top international accounting/consulting firms for 2011.

Introduction to Financial Accounting

TABLE 1.4

13

Information about Top International Audit Firms Audit Firm

Revenue

Employees

Headquarters

Deloitte

$26.578 bn

1,82,000

USA

PwC

$26.569 bn

1,69,000

UK

Ernst & Young

$21.255 bn

1,52,964

UK

KPMG

$20.630 bn

1,38,000

The Netherlands

Source: http://en.wikipedia.org/wiki/Big_Four_%28audit_firms%29, accessed on 17 January 2012

PLACE OF ACCOUNTING OFFICERS IN THE ORGANISATION In the large organisations, professionals with accounting and finance background are placed at all levels, i.e. higher, middle and lower level. Figure 1.2 shows a sample organisational chart.

FIGURE 1.2

Sample Organisational Chart

AUDITING AND INTERNAL CONTROL Objective 5 The final accounts of business concern are used To get an overview of auditing by various persons such as owners, shareholders, and internal control investors, creditors, banks, government, etc., for different purposes. All these users need to be sure that such accounting statements prepared by the management are reliable. An auditor is an independent expert who examines the accounts of business concern and reports whether they present ‘true and fair view’.

14 Financial Accounting

As per the Standards on Auditing (SA) 200 issued by the ICAI, “Auditing is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.” As per the Standards on Auditing (SA) 200 issued by the ICAI, basic principles governing auditing include Integrity, Objectivity and Independence, Confidentiality, Skill and Competence, Planning, Audit evidence, etc. As per the Indian Companies Act a qualified Chartered Accountant (CA) holding certificate of practice issued by the ICAI is authorised to be appointed as an auditor of the company. Audit report issued by an auditor is opinion of the auditor mainly regarding true and fair view of financial position of the company and compliance with Accounting Standards issued by the ICAI. Internal control is a process affected by an organisation to provide reasonable assurance regarding the effectiveness and efficiency of operations, reliability of financial reporting and compliance with related rules and regulations. Internal control system comprises accounting controls as well as administrative controls. Accounting controls mainly aim at safeguarding assets and ensuring reliability of financial records. It provides reasonable assurance that all the transactions authorised by the management are promptly and properly recorded. Administrative controls are basically regarding improving operational efficiency and adherence to management policies for instance Stores Department can issue materials only against a requisition slip duly authorised. A system of internal control comprises the following five elements: Control environment, Entity’s risk assessment process, Information system and communication, Control activities, and Monitoring of controls. —Standard on Internal Audit (SIA) 11-ICAI Large organisations are required to set up a system of internal audit within the organisation as an integral part of the internal control. Internal audit is review of various operations and records of the company by staff/professionals specifically appointed for this purpose. Internal audit is an independent appraisal activity within an enterprise for the review of accounting, financial and other operational controls as basis to service for management. —Guidelines on Internal Audit by ICAI Internal audit has always been of immense significance to the corporate world. From being a cross check over the accounts of the organisation, internal audit has, over the years moved to being a strong indispensable control tool in the hands of the management, which can help it to add to the shareholders’ value. Internal audit can significantly help the management improve its operational efficiency through improved

Introduction to Financial Accounting

15

risk management and control systems and strengthening the overall governance mechanism of the entity. Internal audit covers review of all the functional areas of management—HR, Marketing, Production and is not restricted to just Finance and Accounts. With growing competition and increasing expectations of the stakeholders, the importance of internal audit is also gaining importance. In July 2002, the United States Congress passed the Sarbanes-Oxley Law (SOX). The SOX was primarily designed to restore investor confidence following well-publicised bankruptcies that brought chief executives, audit committees, and the independent auditors under heavy scrutiny. The SOX is applicable to all publicly registered companies under the jurisdiction of the Securities and Exchange Commission (SEC). The SOX is a far reaching legislation, effecting significant changes to laws affecting officers, directors and reporting obligations of public companies, and mandating a myriad of new regulations to prevent securities fraud and other abuses. The SOX called for the formation of a Public Company Accounting Oversight Board (PCAOB) and specified several requirements that included management’s quarterly certification of the financial results and management’s annual assertion that internal controls over financial reporting are effective among others. The SOX have extended the reach of the United States’ laws to many aspects of the internal affairs and governance regimes of foreign companies and their auditors.

ETHICAL ISSUES IN ACCOUNTING Objective 6 Accounting involves the systems that gather To know ethical issues in and transform the information, and involves accounting decision-making about the future based on that information. Accounting has been called ‘the language of business’ and, because of its pervasiveness, it affects the lives of individuals in all sectors of our society. Accounting requires significant judgements and assumptions. Different accountants, given a complex set of circumstances, will probably arrive at several different income or valuable figures. Considering fiduciary responsibility of an accountant (particularly auditors), their behaviour should be driven by ethical values. Frauds in financial statements can be of the following types: 1. 2. 3. 4. 5. 6.

Recording fictitious revenue—revenues not actually earned Concealment of liabilities and expenses Fraudulent asset valuation False statement of the inventory available Under provisioning for depreciation Showing day-to-day expenses as capital expenditure

16 Financial Accounting

7. Paying salary to ghost employees The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganisation in the American history at that time, Enron was attributed as the biggest audit failure. Enron’s non-transparent financial statements did not clearly depict its operations and finances with shareholders and analysts. In addition, its complex business model and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet to portray a favourable depiction of its performance. Between 1996 and 2000, Enron’s revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2–3% per year to be respectable. This was as a result of misleading accounting statements. These malpractices may lead to window dressing, reporting false income, evasion of taxes, and portraying a wrong financial position. According to the Code of Ethics issued by the ICAI, a professional accountant is required to comply with the following fundamental principles: (a) Integrity A professional accountant should be straightforward and honest in all professional and business relationships. (b) Objectivity A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional judgements. (c) Professional Competence and Due Care A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards while providing professional services. (d) Confidentiality A professional accountant should respect the confidentiality of information acquired as a result of professional and employment relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and employment relationships should not be used for the personal advantage of the professional accountant or third parties.

Introduction to Financial Accounting

17

(e) Professional behaviour A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.

FORMS OF ORGANISATIONS AND THEIR EFFECT ON ACCOUNTING There are various forms of organisations. The principles of accounting do not change with the form of organisation. However, disclosure requirements may change. In some instances transact recording also changes with the form of organisation. Table 1.5 summarises the various forms of organisations, their essential features and effect on accounting. TABLE 1.5

Various Forms of Organisations

Form of Organisation

Ownership

Financial Statements

Auditing

Regulations on Accounting and Disclosures

Suitability

Sole Proprietorship Single owner

No specific format Not compulsory Minimal

Small Business

Partnership Firm

No specific format Not compulsory Minimal

Small and Medium Business

Minimum: 2 Maximum: 20

Limited Liability Minimum: 2 Partnership (LLP) Maximum: no limit

Specific format

Compulsory

Medium Sized Very less (under Limited Business Liability Partnership Act, 2008)

Private Company

Minimum: 2 Maximum: 50

Specific format

Compulsory

Medium and Minimum Relatively regulation (Companies Act, Large Business 1956)

Public Company

Minimum : 7 Maximum: no limit

Specific format

Compulsory

Large Business Minimum Regulation (Companies Act, 1956)

Listed Public Company

Widespread

Specific format

Compulsory

Stiff Regulation (SEBI and Companies Act, 1956)

Large Business

Banks

Usually widespread

Specific format

Compulsory with stringent norms

Stiff Regulation (RBI and Companies Act, 1956)

Banking Business

(Contd.)

18 Financial Accounting Specific format

Compulsory with stringent norms

Stiff Regulation Insurance Business (IRDA and Companies Act, 1956)

Cooperative Society Minimum: 10 Maximum: no limit

Specific format

Compulsory

Minimum Regulation (Co-operative Societies Act, 1912 or State Cooperative Societies Acts)

Public Trust or Society

Specific format

Compulsory

Non-business Minimum Entities Regulation (Societies Registration Act or Indian Public Trust Act or State Public Trust Acts)

Insurance Companies

Not so widespread

Minimum: 2 Maximum: no limit

Medium Sized Business with social angle

ACCOUNTING AND CORPORATE GOVERNANCE Objective 7 “Corporate governance is the system by To relate accounting and which business corporations are directed and corporate governance controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.” —OECD April 1999 The issue of corporate governance has assumed greater significance ever since frauds in multinational and global corporations have come to light. The very purpose of having an entity clothed in separate legal personality in the form of a company is to enable easy and quick mobilisation of money in the form of share capital to take up activities requiring huge financial resources and also to distribute the profits or losses arising out of such ventures. The other reasons are like pooling talent for smooth management of the affairs of the entity, global presence, obtaining loans from banks and financial institutions, etc. In the Indian context, the need for corporate governance has been highlighted because of the scams occurring frequently since the emergence of the concept of liberalisation in 1991 such as the Enron Corp. Scam (1998), Harshad Mehta Scam

Introduction to Financial Accounting

19

(1992), Ketan Parikh Scam (1995), Satyam Scam (2007), etc. Scams like Satyam may decrease investor confidence about corporate governance and oversight in emerging markets, which are still reeling from the global financial crisis. Satyam Computers had been one of the major contributors to the IT revolution in India. A company which had been fourth largest Software Company of India came to ground on January 7, 2008 with its chairman Ramalinga Raju conceding that he has systematically fudged the accounts of the company. Cash and bank balance as reflected in the accounts, actually did not exist. According to a rough estimate total fraud was to the tune of around 8,000 crores.

SOME ACCOUNTING FRAUDS CRB Capital Markets (1996) Amount: Rs 1,200 crore Chairman Chain Roop Bhansali was accused of using CRB’s accounts in SBI to siphon off Rs 12 billion bank funds, claiming that the firm was encashing interest warrants and refund warrants. ITC-Chitalia’s Fera Violation (1996) Amount: $80 million ED investigation into export transactions between ITC and EST Fibres of the Chitalia group during 1990 and 1995 revealed violation of FERA provisions. Home Trade (2002) Amount: Rs 6,000 crore Eight cooperative banks, including Valsad People’s Cooperative Bank and Navsari Co-operative Bank among others collectively lost over Rs 80 crore. DSQ Software (2003) Amount: Rs 595 crore Dinesh Dalmia’s DSQ Software was accused of dubious acquisitions and biased allotments made in 2000 and 2001. Enron (2001) Amount: About $50 billion The company did not report the actual debts and losses in its financial statements.

20 Financial Accounting Arthur Andersen (2001) In 2002, Andersen was convicted for obstruction of justice for shredding documents related to its audit of Enron. AA.s CPA licences and its right to practise were confiscated by SEC in 2002. Parmalat (2001) Amount: $5.7 billion in debt and $6 billion in cash Tyco (2004) Amount: $600 million Former chairman and CEO Dennis Kozlowski and ex-CFO Mark H Swartz were accused of theft of $600 million from the company.

SUMMARY ➤

Accounting involves recording, classifying and summarising of past events and transactions of financial nature, with a view to enabling the user of accounts to interpret the resulting summary.

➤

Users of financial statements are management, shareholders, suppliers, creditors, government authorities.

➤

Accounting entails various steps, namely, Recording, Classifying and Summarising.

➤

Accounting plays an important role in the success of any business, social or regulatory organisation.

➤

Accounting involves the creation of financial records of business transactions, flows of finance, the process of creating wealth in an organisation, and the financial position of a business at a particular moment in time.

➤

Accounting has generally been oriented towards practical knowledge as opposed to theoretical abstractions.

➤

An auditor is an independent expert who examines the accounts of business concern and reports whether they present “true and fair view”.

➤

Internal control is a process affected by an organisation to provide reasonable assurance regarding the effectiveness and efficiency of operations, reliability of financial reporting and compliance with related rules and regulations.

➤

Internal audit is an independent appraisal activity within an enterprise for the review of accounting, financial and other operational controls as basis to service for management.

Introduction to Financial Accounting

21

➤

Accounting is considered as a profession as it requires specialised knowledge. Each country has its own accounting bodies to regulate the accounting profession.

➤

In the large organisations, professionals with accounting and finance background are placed at all the levels, i.e. higher, middle and lower level.

MULTIPLE CHOICE QUESTIONS* 1. The process of accounting involves (a) Recording the transactions (b) Classifying the transactions (c) Summarising the transactions (d) All the above 2. An account is a statement that shows all transactions related to (a) A particular asset, liability, income or expense (b) Any financial data (c) Any business event (d) None of the above 3. Who amongst the following is usually recognised as the father of modern accounting? (a) Adam Smith (b) Karl Marx (c) Luca Pacioli (d) Chankya 4. Which of the following types of accounting deals with recording and preparation of the statements revealing the income and financial position of the business on the basis of events that have happened in a particular period? (a) Financial accounting (b) Cost accounting (c) Management accounting (d) All of the above 5. Which of the following types of accounting deals with recording, analysing and estimating cost and also deals with cost computation, cost saving, cost reduction, etc.? (a) Financial accounting (b) Cost accounting (c) Management accounting (d) All of the above *Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

22 Financial Accounting

6. Which of the following types of accounting deals with the processing of data generated in financial accounting and cost accounting for managerial decisionmaking? (a) Financial accounting (b) Cost accounting (c) Management accounting (d) All of the above 7. In India, a qualified accountant must have passed examinations conducted by (a) Institute of Chartered Secretaries of India (ICSI) (b) Institute of Chartered Accountants of India (ICAI) (c) Institute of Cost and Works Accountants of India (ICWAI) (d) All the above 8. Auditing is (a) The independent examination of financial information (a) Process of recording accounting transactions (a) Analysis of financial information (a) Interpretation of accounting data 9. Which of the following systems provides the structure through which the objectives of a company are set, and the means of attaining those objectives and monitoring performance? (a) Corporate governance (b) Auditing (c) Internal control (d) Accounting 10. Internal control system comprises (a) Accounting controls (b) Administrative controls (c) Both the above (d) None of the above

THEORY QUESTIONS 1. 2. 3. 4.

What is accounting? What is its importance? Write a note on evolution of accounting. Who are the users of financial statements? Explain in brief. Distinguish between: (a) Financial and cost accounting (b) Financial and management accounting (c) Cost and management accounting

Introduction to Financial Accounting

5. Explain accounting as an academic discipline. 6. Write a note on: (a) Finance function and accounting (b) Accounting profession as a career 7. Write a note on ethical issues in accounting. 8. Explain relationship between corporate governance and accounting. 9. Explain auditing and internal control.

23

Accounting Concepts, Standards and IFRS

Learning Objectives After studying this chapter, you will be able to ❖

Understand accounting concepts and conventions

❖

Learn principles of accounting

❖

Know the International Financial Reporting Standards (IFRS)

❖

Understand Indian Accounting Standards (Ind AS)

2

Accounting Concepts, Standards and IFRS 25

LET US SET THE STAGE . . . Mr Ram started a sole proprietary concern and he bought machinery of Rs 2,00,000. Initially, he recorded it at purchase price and started making accounting records on his own. He used to record machinery and inventory at market value at the end of the year in the balance sheet. He was recording expenses and incomes as paid or received. He approached Mr Shayam, a Chartered Accountant, to convert all past data to correctly prepare accounting records. While looking at his records, Mr Shayam pointed out that recording of machinery at market value was not as per accounting concepts and principles. He explained that assets should be recorded at historical cost after providing relevant depreciation. Mr Shayam opined that accounting policies should be in conformity with the Accounting Standards (AS). ■ ■ ■

What are accounting concepts and principles? What are accounting policies and standards? Are they the same worldwide or differ from country to country?

All such questions will be answered by studying this chapter.

INTRODUCTION For making accounting information meaningful for the users, it is necessary that such information is reliable and comparable. This is possible only when it is provided with consistent principles and policies. Accounting transactions are recorded with certain basic assumptions and common practices which are called accounting concepts and conventions. The Institute of Chartered Accountants of India (ICAI), the regulatory body for standardisation of accounting policies in the country, has issued the Accounting Standards that are expected to be uniformly adhered to, in order to bring consistency in the accounting practices. Similarly, at international level, there are International Financial Reporting Standards, which aims at bringing uniformity in reporting practices across the globe. Let us discuss these issues in detail.

ACCOUNTING CONCEPTS AND CONVENTION Objective 1 Accounting concepts refer to the basic To understand accounting assumptions that are the basis for recording of concepts and conventions business transactions and preparing financial statement. These are tenets or postulates used by accountants. Accounting conventions refer to the common practices that are followed in recording and presenting accounting information. They are followed like customs,

26 Financial Accounting

traditions, etc., in a society. Accounting conventions are evolved through the regular and consistent practice over the years to facilitate appropriate recording in the books of accounts. Going concern, consistency and accrual are considered as Fundamental Accounting Assumptions as per the Indian Accounting Standards. The following are important accounting concepts and conventions.

Going Concern Concept This concept states that a business firm will continue to carry on its activities for an indefinite period of time. It will not be dissolved in the foreseeable future. Going concern concept implies that the resources of the concern would continue to be used for the purposes for which they are meant to be used. This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet. For example, a company purchases a machinery for Rs 1,30,000 and its useful lifespan is 10 years. According to this concept, every year, depreciation will have to be calculated to write off the asset in 10 years. The possibility of disposal of machinery before 10 years due to closure of entity is ruled out.

Consistency The convention of consistency means that same accounting principles, assumptions and methods should be used for preparing financial statements year after year. Comparison between financial statements of an enterprise will be possible only when accounting policies and practices followed by the enterprise are uniform and consistent over a period of time. If different accounting procedures and practices are used for preparing financial statements of different years, then the result will not be comparable. For instance, depreciation should be recorded using a particular method every year on consistent basis.

Accrual Concept Accrual refers to something that becomes due, especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognised when they become receivable, though cash may or may not be received and the expenses are recognised when they become payable though cash may or may not be paid. The transactions will be recorded in the accounting period to which they relate. The Cash System of accounting contradicts the accrual concept/Double-Entry System. Under the cash system, revenues and expenses are recorded and accounted as and when they are received and paid in cash, respectively. The Generally Accepted

Accounting Concepts, Standards and IFRS 27

Accounting Principles (GAAP) usually do not permit application of the Cash System of accounting. For example, if the firms make payment of salary every month for the earlier month, while recording salary in the books of accounts even outstanding salary has to be recorded.

Entity Concept This concept assumes that, for accounting purposes, the organisation and its owner are two separate independent entities. The business and personal transactions of its owner are separate. When the owner invests money in the business in the form of capital, it is recorded as liability of the business. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as business expense but it is considered as withdrawal of capital. Thus, the accounting records are made in the books of accounts from the point of view of the entity and not the person owning the business. Let us take an example. Suppose Mr Sandeep started business investing Rs 1,50,000. He purchased goods for Rs 80,000, furniture for Rs 25,000 and plant and machinery of Rs 35,000. Rs 10,000 remains in hand. These are the assets of the business and not of the owner. According to the business entity concept, Rs 1,50,000 will be treated by business as capital, i.e. a liability of business towards Mr Sandeep, the owner of the business.

Accounting Period Concept This concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes such as calculation of profit, ascertainment of financial position and tax computation. Profit/loss of the business is measured periodically. This is measured for a specified interval of time, called the accounting period. For the purpose of reporting to outsiders, one year is the usual accounting period, though quarterly reporting is required in certain cases. In India, the accounting year was traditionally followed from Diwali to Diwali. Different countries follow different accounting years (Table 2.1). TABLE 2.1

List of Accounting Years in Different Countries Country

Accounting year

Australia

1st July 1 to 30th June

Canada

1st April to 31st March

China

1st January to 31st December

India

1st April to 31st March

UK

1st April to 31st March

USA

1st October to 30th September

28 Financial Accounting

A common accounting/financial year is very useful for comparison of company performance, aggregation of national/international data, tax assessment and so on.

Dual Aspect Concept Dual aspect concept assumes that every transaction has two effects, i.e. it affects two accounts in their respective opposite sides. Each transactions has equal amount of debit and credit. For example, goods purchased for cash worth Rs 10,000 has two aspects: 1. Cash Paid Rs 10,000 2. Goods Received worth Rs 10,000 Both the aspects should be recorded.

Disclosure/Transparency Convention of full disclosure requires that all material and relevant facts concerning financial statements should be fully disclosed. Full disclosure means that there should be fair and adequate disclosure of information. The business provides financial information to all interested parties such as investors, lenders, creditors, and shareholders. The shareholder would like to know profitability of the firm while the creditor would like to know the solvency of the business. In the same way, other parties would be interested in the financial information according to their requirements. This is possible if financial statement discloses all relevant information in full, fair and adequate manner.

Materiality The convention of materiality states that, to make financial statements meaningful, only material fact, i.e. important and relevant information, should be provided in the financial statements. The materiality of a fact depends on its nature and the amount involved. The material fact means the information that will influence the decision of its user. An item worth Rs 5,000 may be immaterial for a firm whose turnover is in crores. This may not be the case for a firm whose turnover is a few thousands.

Conservatism/Prudence This convention is based on the principle: “Anticipate no profit, but provide for all possible losses.” It provides guidance for recording transactions in the books of accounts. It is based on the policy of playing safe in regard to showing profit. Profit

Accounting Concepts, Standards and IFRS 29

should not be overstated. Thus, this convention clearly states that profit should not be recorded until it is realised. But if the business anticipates any loss in the near future, provision should be made in the books of accounts for the same, for example, valuing closing stock at cost or market price whichever is lower and creating provision for doubtful debts.

Matching Concept The matching concept is an accounting principle that requires the identification and recording of expenses associated with revenue earned and recognised during the same accounting period. Accordingly, under the matching concept, the expenses of a particular accounting period are the costs of the assets used to earn the revenue that is recognised in that period. It follows, therefore, that when expenses in a period are matched with the revenues generated for the same period, the result is the net income or loss for that period.

Money Measurement Concept This concept assumes that all business transactions should be expressed in monetary terms. Further, the transactions that can be expressed in terms of money are alone recorded. For example, important business meeting may be valuable but it is not recorded. Similarly, a motivated and honest employee joining business is also not recorded in books of accounts. On the other hand, transactions like sale of goods worth Rs 2,00,000, purchase of raw materials Rs 1,20,000, rent paid Rs 13,000, etc. are expressed in terms of money, and so they are recorded in the books of accounts.

Cost Concept As per the cost concept, all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition and expenses incurred to put it for use. It means that fixed assets like building, plant and machinery, furniture, etc. are recorded in the books of accounts at the purchase price and not at the market price.

ACCOUNTING POLICIES Objective 2 Accounting policies encompass the principles, To understand principles of bases, conventions, rules and procedures accounting adopted by managements in preparing and presenting financial statements. There are many different accounting policies in use even in relation to the same subject. Accounting policies are the specific accounting

30 Financial Accounting

assumptions and the methods of applying these principles for the preparation and presentation of financial statements of an enterprise. These policies are based upon the accounting concepts and conventions. Since different enterprises follow different accounting concepts, there cannot be a single set of accounting policies, which can be applicable to every type of enterprise, under all the situations. They are usually as per the prevalent Generally Accepted Accounting Principles (GAAP) with limited choice to entity. The areas where different types of accounting policies are used by different enterprises are: ■ ■ ■ ■ ■ ■ ■ ■

Valuation of inventories Treatment of goodwill Valuation of fixed assets Treatment of contingent liabilities Valuation of investments Treatment of retirement benefits Treatment of depreciation Treatment of foreign exchange transactions

There are a few areas where adopting different accounting policies is permissible, depending upon the laws, customs, usage, and the business environment. Exhibit 2.1 illustrates Accounting Policies of Tata Motors Ltd. It will serve as an example of how various accounting policies are framed.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Generally Accepted Accounting Principles (GAAP) includes accounting standards, provisions of law and guidelines issued by regulators. These principles enable standardisation in recording and reporting of information so that the users, once they are aware of the principles, can read and understand the financial statements prepared by diverse organisations. “Generally Accepted Accounting Principles incorporate the consensus at a particular time as to which economic resources and obligations should be recorded as assets and liabilities by financial accounting, which changes in assets and liabilities should be recorded, when these changes are to be recorded, how the assets and liabilities and changes in them should be measured, what information should be disclosed and which financial statement should be prepared.” —Statement No. 4 of Accounting Principles Board (USA) on ‘Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises’

Accounting Concepts, Standards and IFRS 31

EXHIBIT 2.1

Extracts of Major Accounting Policies of Tata Motors Ltd.

(a) Fixed Assets (See Chapter 6, Fixed Assets and Depreciation for details.) (b) Depreciation/Amortisation (See Chapter 6, Fixed Assets and Depreciation for details.) (c) Leases: (i) Finance Lease: Assets taken on finance lease are accounted for as fixed assets in accordance with Accounting Standard (AS 19) “Leases”. Accordingly, the assets are accounted at fair value. Lease payments are apportioned between finance charge and reduction in outstanding liability. (ii) Operating Lease: Assets taken on lease under which all risks and rewards of ownership are effectively retained by the lessor are classified as operating lease. Lease payments under operating leases are recognised as expenses on straight-line basis. (d) Investments: Long-term investments are carried at cost, less provision for diminution other than temporary, if any, in the value of such investments. Current investments are carried at lower of cost and fair value. (e) Inventories: Inventories of stores and spare parts and loose tools are valued at or below cost. Cost is ascertained on weighted average basis. Work-in-progress is valued at lower of cost and net realisable value. Cost includes material costs, labour and manufacturing overheads on the basis of absorption costing. (f) Taxes on Income: Current tax is determined as the amount of tax payable in respect of taxable income for the year. Credit in respect of Minimum Alternate Tax Paid is recognised only if there is convincing evidence of realisation of the same. Deferred tax, which is computed on the basis of enacted/substantively enacted rates, is recognised, on timing differences, being the difference between taxable income and accounting income that originate in one period and are capable of reversal in one or more subsequent periods. Where there is unabsorbed depreciation or carry forward losses, deferred tax assets are recognised only if there is virtual certainty of realisation of such assets. Other deferred tax assets are recognised only to the extent there is reasonable certainty of realisation in future. (g) Research and Development Expenses: Research and Development costs of a revenue nature are charged as an expense in the year in which these are incurred. (h) Intangible Assets: Intangible assets are recognised only if it is probable that the future economic benefits that are attributable to the asset will flow to the company and the cost of the asset can be measured reliably. (i) Premium on Redemption of Debentures and Foreign Currency Convertible Bonds (FCCB): Premium payable on redemption of FCCB and debentures as per the terms of their respective issues is provided fully in the year of issue by adjusting against the Securities Premium Account. (j) Warranty Expenses: Anticipated product warranty costs for the period of warranty are provided for in the year of sale. Other warranty obligations are accounted for as and when claims are admitted. (k) Foreign Exchange Transactions: All monetary assets and monetary liabilities in foreign currencies are translated at the relevant rates of exchange prevailing at the year end. In respect of foreign exchange contracts, the premium or discount arising at the inception of such a contract is amortised as expense or income over the life of the contract. In case of monetary assets and monetary liabilities in foreign currencies the exchange differences are recognised in the profit and loss account. (l) Employee Benefits: (i) Defined Contribution Plan: Company’s contributions paid/payable during the year to Provident Fund, Superannuation Fund, ESIC, and Labour Welfare Fund are recognised in the profit and loss account. (ii) Defined Benefit Plan/Long-term Compensated Absences: Company’s liability towards gratuity, compensated absences, post retirement medical benefit schemes, etc., are determined by independent

32 Financial Accounting

(m)

(n)

(o)

(p) (q) (r)

actuaries, using the projected unit credit method. Past services are recognised on a straight-line basis over the average period until the benefits become vested. Actuarial gains and losses are recognised immediately in the profit and loss account as income or expenses. Obligation is measured at the present value of estimated future cash flows using a discounted rate that is determined by reference to the market yields at the balance sheet date on government bonds where the currency and terms of the government bonds are consistent with the currency and estimated terms of the defined benefit obligation. Revenue Recognition: (i) Revenue from power supply is accounted for on the basis of billings to consumers, inclusive of fuel adjustment charges and includes unbilled revenues accrued up to the end of the accounting year. (ii) The Company determines surplus/deficit (i.e. excess/shortfall of/in aggregate gain over Return on Equity entitlement) for the year in respect of its license area operations (i.e. Generation, Transmission and Distribution) based on the principles laid down under the (Terms and Conditions of Tariff) Regulation, 2005 notified by the Maharashtra Electricity Regulatory Commission (MERC) and the basis of Tariff Order issued by it. In respect of such surplus/deficit, appropriate adjustments as stipulated under the regulations are made during the year. Further, any adjustments that may arise on annual performance review by MERC under the aforesaid Tariff Regulations are made after the completion of such review. (iii) Delayed payment charges and interest on delayed payments for power supply are recognised, on grounds of prudence, as and when recovered. Accounting for Contracts: Income on contracts in respect of Transmission EPC, Strategic Electronics Business and Project Management Services are accounted on “percentage of completion” basis measured by the proportion that cost incurred up to the reporting date bear to the estimated total cost of the contract. Issue Expenses: (i) Expenses incurred in connection with issue of Rights Shares and Global Depository Shares are amortised over the remaining period of the license for supply of electricity, in accordance with the treatment adopted for the determination of “Clear Profit” under the repealed Electricity (Supply) Act, 1948. However, the closing balance of the expenditure in connection with Global Depository Shares carried forward under ‘Miscellaneous Expenditure (to the extent not written off)’ has been disclosed as an adjustment against Securities Premium Account. (ii) Expenses incurred in connection with the issue of euro notes, foreign currency convertible bonds and debentures are adjusted against securities premium account. (iii) Discount on issue of euro notes are amortised over the tenure of the notes. Expenditure on Amalgamation: The expenditure incurred is amortised over a period of five years. Payments under Voluntary Retirement Schemes (VRS): Compensation paid under VRS is amortised over a period of thirty-six months commencing from the month following the month of separation. Segment Reporting: The accounting policies adopted for segment reporting are in line with the accounting policy of the Company. Revenue and expenses have been identified to segments on the basis of their relationship to the operating activities of the segment. Revenue and expenses, which relate to the enterprise as a whole and are not allocable to segments on a reasonable basis, have been included under ‘Unallocated Income/Expenses’.

Accounting Concepts, Standards and IFRS 33

Accounting standards are concepts, policies and practices as notified by accounting bodies. It has been dealt with in detail later. To standardise the accounting information, every organisation would have to establish certain accounting policies based on GAAP. The Generally Accepted Accounting Principles are a combination of authoritative standards (set by policy boards) and the accepted ways of doing accounting. These differ from country to country, depending upon the accounting principles and standards adopted in that country. Table 2.2 gives a list of professional bodies determining the GAAP in select countries. TABLE 2.2

List of Accounting Standard Setting Bodies

Country

Standard Setting Board

Institute

India

Accounting Standards Board (ASB)

The Institute of Chartered Accountants of India (ICAI)

Canada

Canadian Accounting Standards Board (CASB)

Canada Institute of Chartered Accountants (CICA)

USA

Financial Accounting Standards Board (FASB)

American Institute of Certified Public Accountant (AICPA)

Australia

Australian Accounting Standards Board (AASB)

The Institute of Chartered Accountants of Australia (ICAA)

INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) Objective 3 International Financial Reporting Standards To become familiar with (IFRS) are a set of accounting standards, International Financial Reporting developed by the International Accounting Standards (IFRS) Standards Board (IASB), London, that are becoming the global standard for the preparation of public company financial statements. International Accounting Standards Committee (IASC) was constituted in 1973 to formulate accounting standards. International Accounting Standards (IAS) were issued by the IASC from 1973 to 2000. The IASB replaced the IASC in 2001 and all 41 IAS issued by IASC. Since then, the IASB has amended some IAS and has proposed to amend others, has replaced some IAS with new International Financial Reporting Standards (IFRS), and has adopted or proposed certain new IFRS on topics for which there was no previous IAS. Through committees, both the IASC and the IASB also have issued Interpretations of Standards. Financial statements may not be described as complying with IFRS unless they comply with all of the requirements of each applicable standard and each applicable interpretation. Figure 2.1 shows the structure of IFRS Board.

34 Financial Accounting

FIGURE 2.1

IFRS Board Structure

Source: http://www.iasplus.com/restruct/restruct.htm, accessed on 16 January 2012

The International Financial Reporting Standards (IFRS) are discussed in detail below.

IFRS 1: First-time Adoption of International Financial Reporting Standards The objective of IFRS 1 is to ensure that an entity’s first IFRS financial statements and its interim financial reports for part of the period covered by those financial statements contain high-quality information that: (a) is transparent for users and comparable over all periods presented; (b) provides a suitable starting point for accounting in accordance with International Financial Reporting Standards (IFRS); and (c) can be generated at a cost that does not exceed the benefits. An entity shall prepare and present an opening IFRS statement of financial position at the date of transition to IFRS. This is the starting point for its accounting in accordance with IFRS. An entity shall use the same accounting policies in its opening IFRS statement of financial position and throughout all periods presented in its first IFRS financial statements. In general, those accounting policies shall comply with each IFRS effective at the end of its first IFRS reporting period. Generally, this IFRS requires an entity to do the following in the opening IFRS statement of financial position that it prepares as a starting point for its accounting under IFRS:

Accounting Concepts, Standards and IFRS 35

(a) Recognise all assets and liabilities whose recognition is required by IFRS (b) Not recognise items as assets or liabilities if IFRS do not permit such recognition (c) Reclassify items that it recognised in accordance with previous GAAP as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity in accordance with IFRS (d) Apply IFRS in measuring all recognised assets and liabilities

IFRS 2: Share-based Payment The objective of this IFRS is to specify the financial reporting by an entity when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including the expenses associated with transactions in which share options are granted to employees. This IFRS requires an entity to recognise sharebased payment transactions in its financial statements, including the transactions with employees or other parties to be settled in cash, other assets, or equity instruments of the entity. There are no exceptions to the IFRS, other than for transactions to which other Standards apply. This also applies to transfers of equity instruments of the entity’s parent, or equity instruments of another entity in the same group as the entity, to parties that have supplied goods or services to the entity. This IFRS sets out measurement principles and specific requirements for three types of share-based payment transactions: (a) Equity-settled share-based payment transactions, in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options). (b) Cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity. (c) Transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash or by issuing equity instruments.

IFRS 3: Business Combinations The objective of the IFRS is to enhance the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. It does that by establishing principles and requirements for how an acquirer:

36 Financial Accounting

(a) recognises and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; (b) recognises and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (c) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This IFRS requires the acquirer to disclose information that enables users of its financial statements to evaluate the nature and financial effect of business combinations that occurred during the current reporting period or after the reporting date but before the financial statements are authorised for issue. After a business combination, the acquirer must disclose any adjustments recognised in the current reporting period that relate to business combinations that occurred in the current or previous reporting periods.

IFRS 4: Insurance Contracts The objective of this IFRS is to specify the financial reporting for insurance contracts by any entity that issues such contracts (described in this IFRS as an insurer) until the Board completes the second phase of its project on insurance contracts. In particular, this IFRS requires the following: (a) Limited improvements to accounting by insurers for insurance contracts. (b) Disclosure that identifies and explains the amounts in an insurer’s financial statements arising from insurance contracts and helps users of those financial statements understand the amount, timing and uncertainty of future cash flows from insurance contracts. The IFRS requires disclosure to help users understand: (a) The amounts in the insurer’s financial statements that arise from insurance contracts (b) The nature and extent of risks arising from insurance contracts

IFRS 5: Non-current Assets Held for Sale and Discontinued Operations The objective of this IFRS is to specify the accounting for assets held for sale, and the presentation and disclosure of discontinued operations. In particular, this IFRS requires the following: (a) Assets that meet the criteria to be classified as held for sale to be measured at the lower of carrying amount and fair value less costs to sell, and depreciation on such assets to cease.

Accounting Concepts, Standards and IFRS 37

(b) An asset classified as held for sale and the assets and liabilities included within a disposal group classified as held for sale to be presented separately in the statement of financial position. (c) The results of discontinued operations to be presented separately in the statement of comprehensive income.

IFRS 6: Exploration for and Evaluation of Mineral Assets The objective of this IFRS is to specify the financial reporting for the exploration for and evaluation of mineral resources. Exploration and evaluation expenditures are expenditures incurred by an entity in connection with the exploration for and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resource are demonstrable. Exploration for and evaluation of mineral resources is the search for mineral resources, including minerals, oil, natural gas and similar non-regenerative resources after the entity has obtained legal rights to explore in a specific area, as well as the determination of the technical feasibility and commercial viability of extracting the mineral resource. Exploration and evaluation assets are exploration and evaluation expenditures recognised as assets in accordance with the entity’s accounting policy. An entity shall disclose information that identifies and explains the amounts recognised in its financial statements arising from the exploration for and evaluation of mineral resources.

IFRS 7: Financial Instruments—Disclosures The objective of this IFRS is to require entities to provide disclosures in their financial statements that enable users to evaluate the following: (a) The significance of financial instruments for the entity’s financial position and performance (b) The nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. The qualitative disclosures describe management’s objectives, policies and processes for managing those risks. The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel. Together, these disclosures provide an overview of the entity’s use of financial instruments and the exposures to risks they create. The IFRS 7 applies to all entities, including entities that have few financial instruments (e.g. a manufacturer whose only financial instruments are accounts receivable and accounts payable) and those that have many financial instruments (e.g.

38 Financial Accounting

a financial institution most of whose assets and liabilities are financial instruments). When this IFRS requires disclosures by class of financial instrument, an entity shall group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. An entity shall provide sufficient information to permit reconciliation to the line items presented in the statement of financial position.

IFRS 8: Operating Segments An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates. The IFRS 8 requires an entity to report a measure of operating segment profit or loss and of segment assets. It also requires an entity to report a measure of segment liabilities and particular income and expense items if such measures are regularly provided to the chief operating decisionmaker. It requires reconciliations of total reportable segment revenues, total profit or loss, total assets, liabilities and other amounts disclosed for reportable segments to corresponding amounts in the entity’s financial statements. This IFRS requires an entity to report information about the revenues derived from its products or services (or groups of similar products and services), about the countries in which it earns revenues and holds assets, and about major customers, regardless of whether that information is used by management in making operating decisions. However, the IFRS 8 does not require an entity to report information that is not prepared for internal use if the necessary information is not available and the cost to develop it would be excessive. The IFRS also requires an entity to give descriptive information about the way the operating segments were determined, the products and services provided by the segments, differences between the measurements used in reporting segment information and those used in the entity’s financial statements, and changes in the measurement of segment amounts from period to period.

INDIAN ACCOUNTING STANDARDS (IND AS) Objective 4 The Institute of Chartered Accountants of India To know Indian Accounting (ICAI), recognising the need to harmonise the Standards (Ind AS) diverse accounting policies and practices in use in India, constituted the Accounting Standards Board (ASB) on 21 April, 1977. The main function of the ASB is to formulate Accounting Standards so that such standards may be established by the ICAI in India. While formulating the Accounting Standards, the ASB takes into consideration the applicable laws, customs, usages and business environment prevailing in India. The ICAI, being a full-fledged member of the International Federation of Accountants (IFAC), is actively promoting the

Accounting Concepts, Standards and IFRS 39

International Accounting Standards Board’s (IASB) pronouncements in the country with a view to facilitate global harmonisation of accounting standards. Accordingly, while formulating the Accounting Standards, the ASB gives due consideration to International Accounting Standards (IAS) issued by the International Accounting Standards Committee (predecessor body to IASB) or International Financial Reporting Standards (IFRS) issued by the IASB, as the case may be, and try to integrate them, to the extent possible, in the light of the conditions and practices prevailing in India. The Accounting Standards are issued under the authority of the Council of the ICAI. The ASB has also been entrusted with the responsibility of propagating the accounting standards and of persuading the concerned parties to adopt them in the preparation and presentation of financial statements. The ASB provides interpretations and guidance on issues arising from accounting standards. The ASB also reviews the accounting standards at periodical intervals and, if necessary, revises the same. The following is the list of the Indian Accounting Standards (Ind AS): AS 1: Disclosure of Accounting Policies AS 2: Valuation of Inventories (Revised) AS 3: Cash Flow Statements AS 4: Contingencies and Events Occurring after the Balance date AS 5: Net Profit/Loss for the Period Prior Period Items and Changes in Accounting Policies AS 6: Depreciation Accounting AS 7: Accounting for Construction Contracts AS 8: Accounting for Research and Development AS 9: Revenue Recognition AS 10: Accounting for Fixed Assets AS 11: Accounting for Effects of Changes in Foreign Exchange Rates AS 12: Accounting for Government Grants AS 13: Accounting for Investments AS 14: Accounting for Amalgamations AS 15: Accounting for Retirement Benefits in the Financial Statement of Employers AS 16: Borrowing Costs AS 17: Segment Reporting AS 18: Related Party Disclosures

40 Financial Accounting

AS 19: Leases AS 20: Earnings per Share AS 21: Consolidated Financial Statements AS 22: Accounting for Taxes on Income AS 23: Accounting for Investments in Associates in Consolidated Financial Statements AS 24: Discounting Operations AS 25: Interim Financial Reporting AS 26: Intangible Assets AS 27: Financial Reporting of Interests in Joint Ventures AS 28: Impairment of Assets AS 29: Provisions, Contingent Liabilities and Contingent Assets AS 30: Financial Instruments: Recognition and Measurement and Limited Revisions to Other Accounting Standards AS 31: Financial Instruments: Presentation AS 32: Financial Instruments: Disclosures and Limited Revisions to AS 19 As the markets expand globally, local standards have to be matched with international standards. The convergence with IFRS benefits the country by increasing the growth of its international business. It plays important role from the point of the investors who wish to invest in different countries. Investors want the information that is more relevant, reliable, timely and comparable across the countries. The financial statements prepared using a common set of accounting standards help the investors to better understand investment opportunities as opposed to financial statements prepared using a different set of national accounting principles. The convergence is also helpful from industry point of view as it will be able to raise capital from foreign markets at lower cost if it can increase confidence of the foreign investors that their financial statements comply with the globally accepted accounting practices. With the diversity in accounting standards from country to country, enterprises that operate in different countries face multitude of accounting requirements prevailing in the countries. The proposed converged accounting standards have been prepared after following a detailed consultative exercise through issue of exposure drafts by the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI), examination of comments received thereon and thereafter consideration of such standards by ICAI, National Advisory Committee on Accounting Standards (NACAS) and thereafter by the Central Government (Ministry of Corporate Affairs) in

Accounting Concepts, Standards and IFRS 41

consultation with the Minister of Law and Justice. ICAI has released the following new set of Indian Accounting Standards (Ind AS), which incorporate the requirements of IFRS. Ind AS 101 to 108 are similar to IFRS; other Indian Accounting Standards are listed below: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

Ind AS 1: Presentation of Financial Statements Ind AS 2: Inventories Ind AS 7: Statement of Cash Flows Ind AS 8: Accounting Policies, Changes in Accounting Estimates and Errors Ind AS 10: Events after the Reporting Period Ind AS 11: Construction Contracts Ind AS 12: Income Taxes Ind AS 16: Property, Plant and Equipment Ind AS 17: Leases Ind AS 18: Revenue Ind AS 19: Employee Benefits Ind AS 20: Accounting for Government Grants and Disclosure of Government Assistance Ind AS 21: The Effects of Changes in Foreign Exchange Rates Ind AS 23: Borrowing Costs Ind AS 24: Related Party Disclosures Ind AS 27: Consolidated and Separate Financial Statements Ind AS 28: Investments in Associates Ind AS 29: Financial Reporting in Hyperinflationary Economies Ind AS 31: Interests in Joint Ventures Ind AS 32: Financial Instruments: Presentation Ind AS 33: Earnings per Share Ind AS 34: Interim Financial Reporting Ind AS 36: Impairment of Assets Ind AS 37: Provisions, Contingent Liabilities and Contingent Assets Ind AS 38: Intangible Assets Ind AS 39: Financial Instruments: Recognition and Measurement Ind AS 40: Investment Property

INDIA’S ROAD MAP TO CONVERGENCE WITH IFRS On 22 January 2010, the Ministry of Corporate Affairs (MCA) issued a press release setting out the road map for International Financial Reporting Standards (IFRS)

42 Financial Accounting

convergence in India. The road map requires IFRS to be made applicable in a phased manner (Table 2.3). TABLE 2.3

Timeline for IFRS Implementation in India Class of companies

Insurance Companies

April 1, 2012

Scheduled Commercial Banks Banking Companies

Urban Co-operative Banks (UCB)

Opening Balance Sheet as per converged accounting standards April 1, 2013

Net worth in excess of Rs. 300 crores

April 1, 2013

Net worth in excess of Rs. 200 crores but not exceeding Rs. 300 crores

April 1, 2014

Net worth not exceeding Rs. 200 crores Regional Rural Banks (RRB)

Optional Optional

Companies which are a part of NSE - Nifty 50 Companies which are a part of BSE - Sensex 30

April 1, 2013

Companies, whether listed or not, which have a net worth in excess Non-Banking of Rs 1,000 crores Financial Listed Companies

April 1, 2014

(NBFC)1

Non-listed which have a net worth in excess of Rs 500 crores

April 1, 2014

Non-listed which have a net worth not exceeding Rs 500 crores

Optional

All NBFCs that do not fall in the above categories

Companies which are a part of NSE - Nifty 50 Companies which are a part of BSE - Sensex 30 Companies whose shares or other seecurities are listed on stock April 1, 2011 (Phase 1) exchange outside India

Other Companies

Companies, whether listed or not, which have a net worth in excess of Rs. 1,000 crores Companies, whether listed or not, which have a net worth in excess of April 1, 2013 (Phase 2) Rs. 500 crores but not exceeding Rs 1,000 crores Listed companies which have a net worth not exceeding Rs 500 crores April 1, 2014 (Phase 3) Non-listed companies which have a net worth not exceeding Rs 500 crores and whose shares or other securities are not listed on stock exchanges outside India

Optional

Other defined small and medium sized companies (SMC) 1

For NBFCs and companies whose financial year commences on any date other than April 1, the conversion of the opening balance sheet will be on the financial year commencement date immediately following April 1 of the relevant year.

Accounting Concepts, Standards and IFRS 43

There will be two separate sets of accounting standards under Section 211(3C) of the Companies Act, 1956, which are as follows: ■

■

The first set would comprise the Indian Accounting Standards that are fully convergent with IFRS and that are to be applied by specified companies. These standards are known as Ind AS. The second set would comprise the existing Indian Accounting Standards that are not fully convergent with IFRS and would be applicable to other companies, including Small-and Medium-sized Companies (SMC). These standards are known as AS.

INDIAN GOVERNMENT ACCOUNTING STANDARDS (IGAS) The Office of the Comptroller and Auditor General of India constituted the Government Accounting Standards Advisory Board (GASAB) in August 2002 “in order to establish and improve standards of governmental accounting and financial reporting and enhance accountability mechanisms for Union and the State Government accounts”. The Indian Government Accounting Standards, proposed by the Board and approved by the Comptroller and Auditor General of India are under consideration by the President of India for notification, are: ■ ■ ■ ■ ■ ■

■

Guarantees given by Governments: Disclosure Requirements (IGAS 1) Accounting and Classification of Grants-in-aid (IGAS 2) Cash Flow Statements (IGAS 3) General Purpose Financial Statement of Government (IGAS 4) Loans and Advances made by Governments (IGAS 5) Foreign Currency Transactions and Loss or Gain by Exchange Rate Variations (IGAS 7) Public Debt and Other Liabilities of Governments: Disclosure Requirements (IGAS 10)

All the IGAS are mandatory and financial statements cannot be described as complying with IGAS unless they comply with all requirements of IGAS. Consequent upon the recommendation of the Twelfth Finance Commission for introduction of accrual basis of accounting in government and acceptance by the Government of India in principle, GASAB has suggested an operational framework and road map of transition to accrual basis of accounting in governments. The operational framework will encompass the contours of the accounting system under accrual basis, including accounting and treatment of assets, liabilities, revenue and expenses and the final accounts of the governments consistent with the provisions of the Constitution, and duly meeting budgetary reporting requirements. This means

44 Financial Accounting

the operational framework to be suggested by GASAB would indicate the following broad accounting heads and treatment of transactions relating thereto: (a) (b) (c) (d) (e) (f)

Revenues and Expenditure Accounting Fixed Assets Accounting Long-term Liability Accounting Accounting for Current Assets and Current Liabilities Accounting for Period Costs (Interest and Depreciation) Non-Financial and Contingent Liabilities

Such transition would bring fundamental change in the present system of government accounting.

SUMMARY ➤

Accounting concepts refer to the basic assumptions that are the basis for recording of business transactions and preparing financial statement.

➤

Accounting conventions refer to the common practices that are followed in recording and presenting accounting information.

➤

Fundamental accounting assumptions are going concern, consistency and accrual. Other accounting concepts and conventions are business entity, money measurement, historical cost, accounting period, dual aspect, disclosures, materiality and matching.

➤

Accounting policies are the specific accounting assumptions and the methods of applying these principles for the preparation and presentation of financial statements of an enterprise.

➤

The Generally Accepted Accounting Principles (GAAP) include accounting standards, provisions of law and guidelines issued by regulators. These principles enable standardisation in recording and reporting of information so that the users, once they are aware of the principles, can read and understand the financial statements prepared by diverse organisations.

➤

Accounting standards are the concepts, policies and practices as notified by accounting bodies.

➤

The International Financial Reporting Standards (IFRS) are a set of accounting standards, developed by the International Accounting Standards Board (IASB), London, that are becoming the global standard for the preparation of public company financial statements.

Accounting Concepts, Standards and IFRS 45

MULTIPLE CHOICE QUESTIONS* 1. Accounting concepts refer to (a) The basic assumptions (b) Rules and regulations (c) Procedures (d) None of the above 2. The business entity concept assumes that, for accounting purposes, (a) The business enterprise and its owner are two separate independent entities (b) The business enterprise and its owner are same entities (c) Business is continued forever (d) None of the above 3. This money measurement concept assumes that (a) All business transactions should be expressed in non-monetary terms (b) All business transactions should be expressed in monetary terms (c) Either in monetary or non-monetary terms (d) None of the above 4. In accordance with which of the following basic accounting concepts, during the lifetime of an entity, financial statements are prepared periodically? (a) Conservation (b) Matching (c) Accounting period (d) None of the above 5. When information about two different entities have been prepared and presented in a similar manner the information shows the characteristic of (a) Verifiability (b) Relevance (c) Reliability (d) None of the above 6. A concept that a business organisation will not be closed down in the near future is known as (a) Going concern (b) Economic entity (c) Monetary (d) None of the above 7. The primary qualities that make accounting information useful for decisionmaking are (a) Relevance and freedom from bias *

Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

46 Financial Accounting

8.

9.

10.

11.

12.

13.

(b) Reliability and comparability (c) Comparability and consistency (d) None of the above Krishna Enterprises follows the written-down value method of depreciating machinery year after year due to (a) Comparability (b) Consistency (c) Convenience (d) All of the above A purchased a car for Rs 10,00,000 in 2011 and its market value goes down to Rs 7,00,000 in 2012. The accounting effects would be (a) It should be recorded at gross value of Rs 10,00,000 in 2011 and 2012 as well due to the cost concept. (b) It should be recorded at Rs 10,00,000 in 2011 and Rs 7,00,000 in 2012 due to the market value concept. (c) Either (a) or (b) (d) Neither (a) nor (b) The determination of expenses for an accounting period is based on the principle of (a) Objectivity (b) Materiality (c) Matching (d) Periodicity The ‘going concern concept’ is the underlying basis for (a) Stating fixed assets at their values (b) Disclosing the market value of securities (c) Disclosing the sales and other operating information in the income statement (d) None of the above Economics life of an enterprise is split into the periodic interval as per (a) Periodicity (b) Matching (c) Going concern (d) Accrual Salary of Rs 7,000 payable in the financial year has not been taken into account. Which of the following concepts is violated? (a) Accrual (b) Conservatism (c) Historical cost (d) Materiality

Accounting Concepts, Standards and IFRS 47

14. Mr A purchased an asset for Rs 75,000 but its fair value on the date of purchase was Rs 85,000. Mr A recorded the value of asset in his books at Rs 85,000. Which of the following concepts is violated? (a) Accrual (b) Conservatism (c) Historical cost (d) Materiality 15. Convention of full disclosure requires that (a) All material and relevant facts concerning financial statements should be fully disclosed. (b) Only monetary information should be fully disclosed (c) Only non monetary information should be disclosed (d) None of the above 16. On which of the following principles, the convention of conservatism is based? (a) Anticipate all possible profit, and provide for all possible losses (b) Anticipate no profit, but provide for all possible losses (c) Anticipate all possible profit, but no losses (d) None of the above 17. The areas wherein different accounting policies can be adopted are (a) Providing depreciation (b) Valuation of inventories (c) Valuation of investments (d) All of the above 18. Accounting policies refer to (a) Specific accounting principles (b) Specific methods of applying those principles (c) Both (a) and (b) (d) None of the above 19. The Generally Accepted Accounting Principles (GAAP) include (a) Accounting standards (b) Provisions of law (c) Guidelines issued by regulators (d) All of the above 20. Which of the following is becoming the global standard for the preparation of public company financial statements? (a) Ind AS (b) IFRS (c) IAS (d) None of the above

48 Financial Accounting

THEORY QUESTIONS 1. The proprietor of a firm withdrew Rs 56,000 for his personal use. This was shown as an expense of the firm. Profits were reduced to pay a lower tax. Is this right from accounting point of view? Justify your answer. 2. The CEO of a company is killed in a plane crash. To the extent “an organisation is the lengthened shadow of a man”, the real value of the company will change immediately and this will be reflected in the market price of the company shares. Will this have any effect as far as the accounts of the company are concerned? Give appropriate reasons. 3. A company revalues its buildings, which were purchased at a cost of Rs 10, 00,000 in 1995 to Rs 90, 00,000 in 2010, and records the difference of Rs 80, 00,000 as profit for the year 2003. Is this practice right? Give reasons. 4. The accounting year of a firm closes on 31st December each year. The rent for business premises of Rs 45,000 for the last quarter could not be paid to the owner on account of his being away in a foreign country. Should the rent payable be taken into account for computing the firm’s profit for the accounting year? Give reasons. 5. A government contractor supplies stationery to various government offices. Some bills amounting to Rs 10,000 were still pending with various offices at the close of the accounting year on 31st March. Should the businessman take the revenue of Rs 10,000 into account for computing the net profit of the period? 6. A company had been charging depreciation on a machine at Rs 10,000 per year for the first three years. Then it began charging Rs 9,000 for the fourth year and Rs 7,800 for the fifth year and so on. Is this practice justified? Give reasons for your answer. 7. Indicate which of the following transactions relate to Mr Keshav’s business as news agent and which are his personal transactions: (a) Rs 50,000 won from a lottery ticket (b) Rs 10,000 for placing advertisement on a local cricket ground regarding his up to date news service (c) Sale of unsold newspaper to local stationary shop (d) Payment to newspaper wholesaler Rs 20,000 (e) Purchase of new car for family use although it was used in each morning to collect newspapers from suppliers 8. At the end of the year 2012, an organisation had a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials. All these assets were disclosed as mentioned above in the balance sheet. Using accounting concepts, you are required to comment on this approach.

Accounting Concepts, Standards and IFRS 49

9. Using the realisation concept, offer your comments on recording the following transactions in the books of accounts: (a) N.P. Jewellers received an order to supply gold ornaments worth Rs 5,00,000. It supplied ornaments worth Rs 2,00,000 up to the year ending 31st December 2010 and rests of the ornaments were supplied in January 2011. (b) Bansal sold goods for Rs 1, 00,000 for cash in 2010 and the goods have been delivered during the same year. (c) Akshay sold goods on credit for Rs 50, 000 during the year ending 31st December 2010. The goods have been delivered in 2010 but the payment was received in March 2011.

RESEARCH ASSIGNMENTS 1. Collect annual reports of manufacturing, service and IT companies (one each). Identify differences in their accounting policies disclosures. Also list out and explain with examples as to how accounting concepts and conventions are used for preparing financial statements. 2. Study the annual report of Dabur India Ltd. for 2010–11. You will notice that the financial statements are disclosed as per the Indian GAAP as well as IFRS. You are required to identify major differences in both the reporting practices.

INTERPRETING FINANCIAL REPORTS Read the following case and answer the questions. The government accounting system in our country is rule based and follows primarily, cash-based accounting. The Comptroller and Auditor General of India have constituted Government Accounting Standards Advisory Board (GASAB) with the support of the Government of India to facilitate reforms in government accounting. The cash-based system of accounting is based only on the receipt and disbursement of cash and it fails in providing information required for a total picture of the financial position of the government. It does not provide a full picture of the government’s liabilities, because accrued liabilities are not taken into account. It keeps no track of the assets of the government, nor does it provide information on the costs of holding and operating them or of their consumption or use. Moreover, under the cash-based accounting system, taxes can be collected in excess during a period, to be refunded later; expenditures can be under recorded by deferring payments, etc. In contrast, accrual accounting provides financial flows at the time when economic value is created, transformed, exchanged, transferred or extinguished, whether or not cash is exchanged

50 Financial Accounting

at that time. Thus, all payables and receivables, whether or not paid or realised, get recorded. Costs of inventories used up during the accounting period are included in the operating costs while those of long-lasting assets are amortised over their life by charging depreciation.

Questions: 1. What are the major differences between cash method of accounting and accrual method of accounting? 2. What will be the major differences in reporting financial information under both the methods? You may support your answer with appropriate example.

BUSINESS CASE The following are the details of the accounting policies followed by Adani Mundra Port and SEZ Ltd. for the year 2010–11. 1. Fixed assets are stated at cost less accumulated depreciation and impairment losses, if any. Cost comprises the purchase price and any attributable cost of bringing the asset to its working condition for its intended use. (a) Borrowing cost relating to acquisition/construction of fixed assets, which take substantial period of time to get ready for its intended use, are also included to the extent they relate to the period till such assets are ready to be put to use. (b) Exchange differences arising on reporting of the long-term foreign currency monetary items at rates different from those at which they were initially recorded during the period, or reported in the previous financial statements are added to or deducted from the cost of the asset and are depreciated over the balance life of the asset, if these monetary items pertain to the acquisition of a depreciable fixed asset. (c) Insurance spares/standby tools are capitalised as part of mother assets. 2. Depreciation Depreciation on fixed assets, except for those stated in paras (ii) to (iv) below, is provided on the straight-line method (SLM) at the rates prescribed under Schedule XIV of the Companies Act, 1956, or the rates determined on the basis of useful lives of the respective assets, whichever is higher. Assets Estimated Useful Life (a) Leasehold Land Development, Marine Structure, Leasehold Land: Right to Use and Dredged Channel over the balance period of Concession Agreement or Supplementary Concession Agreement with Gujarat Maritime Board.

Accounting Concepts, Standards and IFRS 51

(b) (c) (d) (e)

Dredging Pipes: 1.5 years Nylon and Steel coated belt on Conveyor: 4 years and 10 years, respectively Fender, Buoy, Capstan installed at Jetty: 10–15 years Depreciation on individual assets costing up to Rs 5,000 and mobile phones, included under office equipment, is provided at the rate of 100% in the month of purchase. (f) Insurance spares/standby tools are depreciated prospectively over the remaining useful lives of the respective mother assets.

3. Intangibles Intangible assets are amortised on straight line basis over their estimated useful lives as follows: Intangible Assets Estimated Useful Life (Years) Goodwill arising on the amalgamation of Adani Port Limited over the balance period of Concession Agreement computed from the appointed date of the Scheme of Amalgamation, i.e. 28 years. Software: 3 years 4. Borrowing Costs Borrowing costs that are attributable to the acquisition or construction of qualifying assets are capitalised as part of the cost of such assets to the extent they relate to the period till such assets are ready to be put to use. A qualifying asset is one that necessarily takes substantial period of time to get ready for its intended use. All other borrowing costs are charged to revenue. Borrowing costs consist of interest and other costs that an entity incurs in connection with the borrowing of funds. 5. Investments Investments that are readily realisable and intended to be held for not more than a year are classified as current investments. All other investments are classified as long-term investments. Current investments are carried at lower of cost and fair value determined on an individual investment basis. Long-term investments are carried at cost. However, provision for diminution in value is made to recognise a decline other than temporary in the value of investments. 6. Inventories Stores and Spares: Valued at lower of cost and net realisable value. Cost is determined on a moving weighted average basis. Cost of stores and spares lying in bonded warehouse includes custom duty accounted for on an accrual basis.

52 Financial Accounting

Net realisable value is the estimated current procurement prices in the ordinary course of the business. 7. Revenue Recognition Revenue is recognised to the extent that it is probable that the economic benefits will flow to the Company and the revenue can be reliably measured. (i) Port Operation Services Revenue from port operation services including rail infrastructure is recognised on proportionate completion method basis based on service rendered. Income in the nature of license fees/royalty is recognised as and when the right to receive such income is established as per terms and conditions of relevant agreement. (ii) Income from Long-Term Leases As a part of its business activity, the Company leases/sub-leases land on long-term basis to its customers. In some cases, the Company enters into cancellable lease/sub-lease transaction, while in other cases, it enters into non-cancellable lease/sub-lease transaction. The Company recognises the income based on the principles of leases as per Accounting Standard 19. Leases and accordingly in cases the land lease/sub-lease transaction are cancellable in nature, the income as regards to upfront premium received/ receivable is recognised on operating lease basis, i.e. pro rata over the period of lease/sub-lease agreement/Memorandum of Understanding takes effect and annual lease rentals are recognised on an accrual basis. In cases where land lease/sub-lease transaction are non-cancellable in nature, the income is recognised on finance lease basis, i.e. at the inception of lease/sublease agreement/Memorandum of Understanding takes effect, the income recognised is equal to the present value of the minimum lease payment over the lease period (including non-refundable upfront premium) which is substantially equal to the fair value of land leased/sub-leased. In respect of land given on finance lease basis, the corresponding cost of the land is expensed off in the profit and loss account. (iii) Contract Revenue Revenue from construction contracts is recognised on a percentage completion method, in proportion that the contract costs incurred for work performed up to the reporting date stand to the estimated total contract costs indicating the stage of completion of the project. Contract revenue earned in excess of billing has been reflected under the head ‘Other Current Assets’ and billing in excess of contract revenue has been reflected under the head “Current Liabilities” in the Balance Sheet. Full provision is made for any loss in the year in which it is first foreseen.

Accounting Concepts, Standards and IFRS 53

(iv) Interest Revenue is recognised on a time proportion basis taking into account the amount outstanding and the rate applicable. (v) Dividends Revenue is recognised when the shareholders’ right to receive payment is established by the Balance Sheet date. You are required to analyse the above policy and compare with similar accounting policies disclosed in annual report of other companies (at least three).

Presentation of Financial Statements: Balance Sheet

Learning Objectives After studying this chapter, you will be able to ❖

Understand the concept of balance sheet

❖

Classify assets under various categories

❖

Classify liabilities under various categories

❖

Learn format of balance sheet

❖

Analyse transactions through balance sheet

❖

Prepare the balance sheet from simple transactions

3

Presentation of Financial Statements: Balance Sheet

55

LET US SET THE STAGE . . . Ms Krishna was waiting for her flight to be announced, when she found her purse full of bills, business cards, etc., apart from currency notes. She thought of arranging them as she had not looked at her purse since long besides using cash. She found that there was currency worth Rs 5,000. She had a silver credit card with credit limit of Rs 50,000. She also found a laundry bill amounting to Rs 1,500 which was not yet paid by her. She also came across a paper mentioning about Rs 2,000 paid by her to a carpenter as an advance for some furniture work in her house. She found a receipt of ATM transaction mentioning bank balance of Rs 25,000. There was also a laptop bill which she had bought for Rs 30,000 and a statement of her home loan for the flat she purchased recently for Rs 20,00,000. She had taken home loan of Rs 16,00,000 while current outstanding balance was Rs 15,25,000. By looking at all these she just recollected about her accountant friend who used to talk about assets and liabilities which she, being an engineering student, never used to understand. ■ ■ ■

What do all these signify? How much was she worth? What are the assets and liabilities? How such things are recorded? All such questions can be answered by studying this chapter.

CONCEPTUAL BASIS OF A BALANCE SHEET Objective 1 A balance sheet is a statement of assets and To understand the concept of liabilities of an individual or entity at any balance sheet particular date. At the end of each accounting period, every business organisation prepares a balance sheet to have a clear understanding of its assets and liabilities, which indicate the financial position. The balance sheet is not prepared for any particular period. The balance sheet is prepared on a particular day and the assets and liabilities as disclosed by the balance sheet show the position on that particular day and not for a period. That means, the figures shown in the balance sheet is the result of all transactions till that date. The balance sheet is a summary of financial position of an organisation at a specific point in time, showing assets and liabilities. Therefore, balance sheet shows the cumulative position of resources (assets) and sources of funds (liabilities) at the end of the year.

56 Financial Accounting

CAPITAL AND REVENUE EXPENDITURE AND RECEIPTS Expenditure refers to any cost incurred. If the benefit of expenditure extends up to one accounting period, it is termed as “revenue expenditure”. Generally, they are incurred for the day-to-day business operations. An example can be payment of salaries, rent, etc. If the benefit of expenditure extends more than one accounting period, it is termed as “capital expenditure”. An example can be payment to acquire furniture for use in the business. Furniture acquired in the current accounting period will give benefits for many accounting periods to come. The usual examples of capital expenditure can be payment to acquire fixed assets and/or to make additions/extensions in the fixed assets. The following are the points of distinction between capital expenditure and revenue expenditure: (a) Capital expenditure is incurred to acquire fixed assets for operation of business whereas revenue expenditure is incurred on day-to-day conduct of business. (b) Revenue expenditure is generally the recurring expenditure and capital expenditure is non-recurring by nature. (c) Capital expenditure benefits more than one accounting year whereas revenue expenditure normally benefits one accounting year. Sometimes, it becomes difficult to correctly decide whether the expenditure is revenue or capital. In normal usage, the advertising expenditure is termed as revenue expenditure. However, a heavy expenditure on advertising on launching a product is likely to give benefit for more than one accounting period, as people are likely to remember the advertisement for a slightly longer period. Such revenue expenditures, which are likely to give benefit for more than one accounting period, are termed as deferred ‘revenue expenditures’. Similarly, receipts can also be divided into capital and revenue. If the receipts create an obligation to return the money, they are ‘capital receipts’, for example capital brought in by the owner or a loan taken from the bank. If a receipt does not incur an obligation to return the money it is termed as “revenue receipt”, for example, sales made by the firm, interest on investment received by the firm, etc.

ILLUSTRATION 3.1 Classify the following expenses into capital, revenue or deferred revenue expenses: (a) (b) (c) (d) (e)

Salaries Wages for installing machine Repairs of machinery Heavy advertisement for launching a new product Research and development expenses

Presentation of Financial Statements: Balance Sheet

57

(f) Construction of additional room (g) Building maintenance Solution: Capital expenses: (b) and (f) Revenue Expenses: (a), (c), and (g) Deferred revenue expenses: (d) and (e)

CLASSIFICATION OF ITEMS ON A BALANCE SHEET The liabilities and assets are classified as the “long term” or “fixed” and the “short term” or “current”. The detailed classification of assets and liabilities has been explained below.

Objective 2 To classify assets into various categories

Assets Asset represent property owned, which usually provides benefit in future. Assets have debit balance. Anything of material value or usefulness that is owned by an entity is termed as an “asset”. It also results into future cash flows to an entity. An asset is a resource that is controlled by the entity as a result of past events for example, purchase or self-creation, and from which future economic benefits (inflows of cash or other assets) are expected. IAS 38 Assets can be classified as shown in Figure 3.1.

FIGURE 3.1

Classification of Assets

Fixed Assets (FA) The fixed or long-term assets are those assets that are purchased for a long-period usage. These are not meant for resale. The purpose of buying such assets is to generate returns for a long period and they remain within the organisation as long as they are usable and capable of generating revenue. Of course, when these assets become old or unusable or their productivity reduces drastically, they can be disposed of and replaced with new assets (see Figure 3.2).

58 Financial Accounting

FIGURE 3.2

Fixed Assets

Tangible fixed assets are those fixed assets that are physical in nature. They can be seen and touched. Plant and machinery, buildings, furniture, office equipments are some of the examples of Tangible Fixed Assets. Intangible fixed assets are those fixed assets which are not physical in nature and cannot be seen or touched. Goodwill, copyright, trademark are some of the examples of intangible fixed assets. Fixed assets can be used productively during their useful life. Since they have limited life the cost will expire along with the expiration of their useful life. Thus, value of the asset is reduced in proportion to the expired life of the asset. Depreciation is the continuous and permanent decline in the value of fixed assets due to usage, efflux of time and obsolescence. Fixed assets are valued at Written Down Value (WDV), i.e. Costless Accumulated Depreciation. We shall discuss about fixed asset and depreciation in separate chapter.

Investments Investments refer to money invested outside normal business. They are usually securities of one company held by another company in order to generate some return. Investment can be classified on the basis of its nature which is as follows (Figure 3.3):

FIGURE 3.3

Classification of Investments

Long-term investments are usually intended to be held for more than one year. Some examples are shares, debentures, land and gold. Short-term investments are intended to be held for less than one year for instance liquid funds, money market instruments, etc.

Presentation of Financial Statements: Balance Sheet

59

Current Assets Current assets are the assets that are used to fund day-to-day operations and to pay ongoing expenses. Cash, bank balance, the debtors, bills receivable and stock are some of the examples of current assets. Current assets can be easily understood with the help of operating cycle. The operating cycle is the duration of time taken by a unit of cash to circulate through the business operations and return back as cash. Figure 3.4 represents cyclical flow of current assets.

FIGURE 3.4

Cyclical Flow of Current Assets

The raw materials are purchased and put into process. Once they get converted into finished goods, they are sold to customers on credit basic. When the collection is received it is utilised for purchasing fresh raw materials and the cycle continues. Cash/bank is usually taken to include currency (including foreign currency), cheques or any other instruments which are easily convertible into cash. It is held for daily requirement. It also includes bank balance. Debtors’ represents balances receivable from customers by an organisation for credit sales made. Only receivables arising from credit sale of goods or services are included in debtors, therefore, it is also called as ‘accounts receivables’, ‘trade receivables’ or ‘trade debtors’. Bills receivable is negotiable instrument in the form of written promise from debtors towards account payable by him. Prepaid expenses are those expenses which are paid in advance, such as rent, taxes, insurance premium. They are considered as current assets as advance payment in current year will reduce cash payment during the subsequent period(s). Stock is

60 Financial Accounting

another important type of current asset. It includes raw material, work-in-progress as well as finished goods. It is discussed in detail in Chapter 7 on Inventory Valuation.

Fictitious Assets Fictitious assets are not assets in real sense, though they are disclosed on asset side of balance sheet. They represent losses which are not written off for instance company formation expenses, shares/debentures issue expenses, etc.

Contingent Assets These are those assets existence and value of which depends upon occurrence of specific event or on performance of specific act for example compensation claimed from service provider, which may be received on court’s decision.

Liabilities Objective 3 A liability is a financial obligation, debt, claim, To classify liabilities into various or potential loss. They are probable future categories sacrifices of economic benefits due to present obligations towards other entities (see Figure 3.5). Liability is defined as present obligation as a result of past events and its settlement is expected to result in an outflow of resources (payment). —IAS 37

FIGURE 3.5

Liabilities

Owner’s Fund Owner’s funds are amount payable to owners. It is considered as liability due to Entity Concept of Accounting which assume business as separate from its owner and hence amount contributed by the owner is considered as liability for the business. Owner’s Fund = Net Worth = Proprietor’s Equity = Equity Owner’s Fund = Capital + Reserves Owner’s Fund = Capital + Accumulated Profits

Presentation of Financial Statements: Balance Sheet

61

Long-term Liabilities The long-term liabilities are those liabilities which are to be repaid over a long period. That period should be normally of more than one year for instance term loan from bank or financial institutions, debentures, etc. Such liabilities are usually classified as under (see Figure 3.6).

FIGURE 3.6

Long-term Liabilities

Secured loans are loans taken on a hypothecation/pledge/mortgage of an asset of the organisation. Generally, fixed assets are assigned to the lender as a collateral security. In case of default, such assigned security can be confiscated by the lender. It usually includes debentures, bonds and borrowing from large financial institutions, payments for assets taken on lease. Unsecured loans are loans taken without providing any security in return. In case of default lender cannot have any control over asset of the firm.

Current Liabilities and Provisions The short-term or current liabilities are those liabilities which are to be repaid within a period of one year. They usually arise from normal business transactions. Current liabilities include bills payable, creditors, outstanding expenses, etc. Creditors’ represents accounts payable by an organisation for credit purchases made. It is also called as ‘accounts payables’, ‘trade payables’ or ‘trade creditors’. Bills payable is negotiable instrument in the form of written promise made towards account payable. Outstanding expenses are those expenses which are due but unpaid. It remains as current liability till the payment is made. It can include salary, wages, rent, etc., if payment for every month’s due is made in next month. Provision is money set aside for liability where amount cannot be substantially decided, e.g. provision for tax, proposed dividend, etc.

Contingent Liabilities These are not actual liabilities but their becoming actual liabilities depend on the occurrence of certain events which are uncertain. They are not recorded in balance sheet but shown by way of footnotes at the bottom of the balance sheet. For instance suit for damages against a company, bills receivable discounted, etc.

62 Financial Accounting

FORMAT OF BALANCE SHEET Objective 4 Balance sheet can be prepared either in horiTo learn format of balance sheet zontal format or vertical format. Let us understand the contents and presentation of balance sheet in both the formats (Exhibits 3.1 and 3.2). EXHIBIT 3.1

Horizontal Format of Balance Sheet

Balance sheet as on ______ Liabilities

Rs

Assets

Rs

Capital

xxxx

Goodwill

xxxx

Loans

xxxx

Land and Buildings

xxxx

Bank overdraft

xxxx

Machinery

xxxx

Bills payable

xxxx

Furniture

xxxx

Sundry creditors

xxxx

Closing stock

xxxx

Outstanding expenses

xxxx

Bills receivable

xxxx

Sundry debtors

xxxx

Cash at bank

xxxx

Total

xxxx

Cash in hand

xxxx

Total

xxxx

Note: Contingent liability ______

EXHIBIT 3.2

Vertical Format of Balance Sheet Liabilities

Amount

Capital

xxxx

Add: Accumulated Profit

xxxx

Less: Drawings

(xxxx) A

xxxx

Borrowed Funds Loan from Bank

xxxx B

Total Capital Employed (A + B)

xxxx xxxx

Fixed Assets Building

xxxx

Furniture

xxxx

Computer

xxxx (Contd.)

Presentation of Financial Statements: Balance Sheet

A Investments B

xxxx xxxx

Current Assets Stock

xxxx

Debtors

xxxx

Bank

xxxx

Prepaid Insurance Expenses

xxxx

Total Current Assets (a)

xxxx

Current Liabilities Creditors

xxxx

O/s Salary

xxxx

Total Current Liabilities (b)

xxxx

Net Current Assets (C) = (a) – (b)

xxxx

Total Assets Employed (A + B + C)

xxxx

ILLUSTRATION 3.2 You are required to prepare a balance sheet from balances as on 31/03/2012. Particulars

Amount

Capital at the beginning

4,00,000

Furniture

1,60,000

O/s Salary

10,000

Computer

86,000

Creditors

45,000

Debtors

60,000

Prepaid Insurance Expenses

25,000

Loan from Bank of India Bank

2,50,000 7,000

Building

4,88,000

Profit and Loss A/c

3,50,000

Investment

1,50,000

Capital introduced during Year

1,80,000

Drawings

2,19,000

Closing Stock

40,000

63

64 Financial Accounting

Solution: Balance Sheet as on 31 March 2012 Particulars

Amount

Amount

Liabilities Capital

4,00,000

Introduced in Year

1,80,000

Profit and Loss A/c

3,50,000

Drawings

(2,19,000)

7,11,000

Borrowed Funds Loan from Bank of India

2,50,000

Total Capital Employed

9,61,000

Assets Fixed Assets Building

4,88,000

Furniture

1,60,000

Computer

86,000

Investments

7,34,000 1,50,000

Current Assets Bank

7,000

Debtors

60,000

Prepaid Insurance Expenses

25,000

Closing Stock Total Current Assets

40,000 1,32,000

Current Liabilities Creditors O/s Salary Total Current Liabilities Net Current Assets Total Assets

45,000 10,000 2,55,000 77,000 9,61,000

Presentation of Financial Statements: Balance Sheet

65

BALANCE SHEET EQUATION Objective 5 The balance sheet is a position statement of To analyse transactions through assets and liabilities. Therefore, the two sides of balance sheet the balance sheet are known as the ‘liabilities’ (left hand side) and the ‘assets’ (right hand side). The total of the assets and liabilities of the balance sheet shall always be equal. This is because of the fundamental accounting equation. Owner’s Fund + Outside Liabilities = Assets In the balance sheet on the liabilities side we show the Owner’s Fund and the outside liabilities and in the asset side, we show all the assets, therefore, based on the fundamental accounting equation both sides shall be equal. Every business transaction can be analysed in terms of its effect on assets, liabilities and owner’s fund.

Analysis Business Transactions through Balance Sheet Equation Assets (A) = Liabilities (L) + Owner’s Fund (O) No.

A

L

1

+

+

O

Transactions Loan taken from bank (+ Bank, + Bank Loan Payable) Goods acquired on credit (+ Inventory, + Account Payable)

2

+

3

+

+

Shares issued for cash (+ Bank, + Equity Shares) Equipments purchased

–

(+ Equipment, – Bank) Collections from debtors (+ Bank, – Accounts Receivable)

4

–

–

Repayment of loan to bank (– Loan Payable, – Bank) Payment made to creditors (– Account Payable, – Bank)

66 Financial Accounting

PREPARING BALANCE SHEET Objective 6 We have already discussed the contents and To learn to prepare balance format of balance sheet in our earlier discussion. sheet from simple transactions We shall now see how an organisation prepares a balance sheet. Let us understand the process with the help of following illustration.

ILLUSTRATION 3.3 Show the effect of each transaction on the balance sheet of M/s Krishna Book Stores. 1. Shyam and Murlidhar sets up a book stall M/s Krishna Book Stores in their town. On 1st January 2012, Shyam opened a bank account in the name of their partnership by depositing Rs 1,00,000 in cash and Murlidhar purchased his own shop worth Rs 2,00,000 as capital. 2. On 2nd January 2012, store purchased books for Rs 75,000 and stationary for Rs 10,000 on immediate payment from SK International. 3. On 5th January 2012, Store supplied books of Rs 90,000 (costing 60,000) to Saraswati High School. School paid cheque of Rs 45,000 immediately and reaming amount was to be paid on 10th January 2012. 4. On 9th January 2012, books costing Rs 47,000 were purchased on credit from SSK and Associates. 5. On 10th January 2012, a cheque of Rs 15,000 was received from Saraswati High School. 6. On 15th January 2012, cheque of Rs 47,000 was paid to the creditors. Solution Let us understand the process by considering each transaction: 1. Shyam and Murlidhar sets up a book stall M/s Krishna Book Stores in their town. On 1st January 2012, Shyam opened a bank account in the name of their partnership by depositing Rs 1,00,000 in cash and Murlidhar purchased his own shop worth Rs 2,00,000 as capital. Balance Sheet as on 1st January 2012 Liabilities

Amount

Assets

Amount

Shyam

1,00,000

Shop Premises

2,00,000

Murlidhar

2,00,000

Bank

1,00,000

Capital

3,00,000

3,00,000

Cash received from Shyam is a current asset and it has created a liability towards Shyam.

Presentation of Financial Statements: Balance Sheet

67

Shop premises purchased by Murlidhar is a fixed asset and it has created a liability towards Murlidhar. 2. On 2nd January 2012, Store purchased books for Rs 75,000 and stationary for Rs 10,000 on immediate payment from SK International. Balance Sheet as on 2nd January 2012 Liabilities

Amount

Assets

Amount

Capital Shyam

1,00,000

Shop Premises

Murlidhar

2,00,000

Bank Less: Purchase of Stores and Stationary

2,00,000 1,00,000 (85,000)

Inventory (Stores + Stationary)

15,000 85,000

3,00,000

3,00,000

Inventory in the form of Store and Stationary has been purchased by utilising bank balance. 3. On 5th January 2012, Store supplies books for Rs 90,000 (costing 60,000) to Saraswati High School. School paid cheque of Rs 45,000 immediately and reaming amount to be paid on 10th January 2012. Balance Sheet as on 5th January 2012 Liabilities

Amount

Assets

Amount

Shyam

1,00,000

Shop Premises

2,00,000

Murlidhar

2,00,000

Bank Add: Cheque collection

15,000 45,000

60,000

Inventory Less: Cost of books sold

85,000 60,000

25,000

Capital

Profit and Loss A/c

30,000

Sundry Debtors 3,30,000

45,000 3,30.000

Books sold for Rs 90,000 against which a cheque of Rs 45,000 was received (Bank balance increases by same amount) and Rs 45,000 is receivable (Debtors created for the same). Cost of books being Rs 60,000 reduces inventory by that amount. 4. On 9th January 2012, books costing Rs 47,000 were purchased on credit from SSK and Associates.

68 Financial Accounting Balance Sheet as on 9th January 2012 Liabilities

Amount

Assets

Amount

Capital Shyam Murlidhar

1,00,000 Shop Premises 2,00,000 Bank

Profit and Loss A/c

2,00,000 60,000

30,000 Inventory Add: Purchased 47,000 Sundry Debtors

Sundry Creditors (SSK and Associates)

2,5000 47,000

3,77,000

72,000 45,000 3,77,000

Books purchased adds to the stock (Inventories) and liability in the form of creditors created for same amount since no payment is made in cash. 5. On 10th January 2012, Rs 15,000 was received from Saraswati High School. Balance Sheet as on 10th January 2012 Liabilities

Amount

Assets

Amount

Capital Shyam Murlidhar

1,00,000 Shop Premises 2,00,000 Bank Add: Cheque recd. 30,000 Inventory 47,000 Sundry Debtors Less: Cheque recd.

Profit and Loss A/c Sundry Creditors

2,00,000 60,000 15,000 45,000 15,000

3,77,000

75,000 72,000 30,000 3,77,000

Collection of cheque has increased bank balance and reduced debtors. 6. On 15th January 2012, cheque of Rs 47,000 was paid to the creditors. Balance Sheet as on 15th January 2012 Liabilities

Amount

Assets

Amount

Capital Shyam

1,00,000

Shop Premises

Murlidhar

2,00,000

Bank Less: Paid to creditors Inventory Sundry Debtors

Profit and Loss A/c Sundry Creditors Less: Paid

30,000 47,000 47,000

2,00,000 75,000 (47,000)

28,000 72,000 30,000

— 3,30,000

Payment to creditors reduces liability and asset (Bank balance).

3,30,000

Presentation of Financial Statements: Balance Sheet

69

SUMMARY ➤

➤

➤

➤

➤

➤

➤

A balance sheet is a statement of assets and liabilities of an individual or entity at any particular date. The balance sheet is prepared on a particular day and the position of assets and liabilities disclosed by the balance sheet are the position on that particular day and not for a period. The total of the assets and liabilities sides of the balance sheet shall always be equal. This is because of the fundamental accounting equation—Owner’s Fund + Outside Liabilities = Assets Anything of material value or usefulness that is owned by a person or company is termed as “asset”. It also results into future benefit to the organisation. Assets can be classified as fixed assets, investments, current assets and fictitious assets. They are a financial obligation, debt, claim, or potential loss. They are probable future sacrifices of economic benefits due to present obligations towards other entities as a result of past transactions. Liabilities can be classified as owner’s fund, long-term liabilities and current liabilities.

MULTIPLE CHOICE QUESTIONS* 1. Liabilities are (a) Office supplies (b) Accounts payable (c) Prepaid expenses (d) None of the above 2. Owner’s fund is (a) Outstanding reserves balance (b) Amount invested by owners (c) Debt on new building (d) Capital + Accumulation of net revenues 3. An asset is (a) What you own (b) Cash (c) Accounts receivable (d) All of the above 4. Which of the following liabilities is not recorded in a balance sheet? (a) Current (b) Contingent *Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

70 Financial Accounting

5.

6.

7.

8.

9.

10.

(c) Fixed (d) Owner’s fund Which of the following types of assets represents losses that are not written off? (a) Fixed (b) Current (c) Fictitious (d) Contingent Investment refers to (a) Money invested within the normal business (b) Money invested outside normal business (c) Amount brought by a proprietor (d) Amount withdrawn by a proprietor The fundamental accounting equation is (a) Owner’s Fund + Outside Liabilities = Assets (b) Owner’s Fund + Assets = Outside Liabilities (c) Assets + Liabilities = Owner’s Fund (d) None of the above Contingent liabilities refers to (a) Uncertain liabilities not to be recorded in balance sheet (b) Actual liabilities (c) Current liabilities and provisions (d) Cannot be determined If owner’s funds are Rs 50,000, outside liabilities are Rs 70,000, contingent liabilities are Rs 20,000, then total assets of the firm are (a) Rs 1,40,000 (b) Rs 1,20,000 (c) Rs 1,00,000 (d) None of the above If assets are worth Rs 1,00,000, outside liabilities are Rs 60,000, contingent liabilities are Rs 20,000, then owner’s fund is (a) Rs 40,000 (b) Rs 20,000 (c) Rs 60,000 (d) Rs 1,00,000

THEORY QUESTIONS 1. 2. 3. 4.

What is balance sheet? Why is it needed? Explain balance sheet equation. What do you mean by assets? How do you classify them? What do you mean by liabilities? How do you classify them?

Presentation of Financial Statements: Balance Sheet

71

PRACTICAL PROBLEMS Level 1: Easy 1. Classify the following receipts into capital and revenue receipts. 1. Sale of goods 2. Loan from banks 3. Interest on fixed deposits 4. Additional capital from proprietor 5. Public deposits 6. Rent received 7. Sale of machinery 2. Prepare a balance sheet of the concern from the following data: Bank Loan Closing Stock Creditors

1,00,000 30,000 47,000

Capital

2,85,000

Profit

1,00,000

Investments

1,20,000

Land and Building

2,00,000

Cash in Hand

16,000

Cash at Bank

30,000

Debtors

36,000

3. Prepare a balance sheet of the concern after each transaction. ■ On 1.3.2012, Parvati invested Rs 70,000 in her business, which were deposited in bank current account. ■ On 3.3.2012, Parvati took a loan of Rs 30,000 from Bank of India @ 20% p.a. ■ On 5.3.2012, Parvati bought furniture for Rs 25,000 and computer for Rs 20,000. ■ On 9.3.2012, Parvati purchased goods worth Rs 30,000. ■ On 15.3.2012, all goods were sold at Rs 60,000, of which Rs 20,000 were on credit. ■ On 28.3.2012, paid salary of Rs 15,000 and telephone bill of Rs 1,500. ■ On 29.3.2012, Parvati paid Rs 15,000 for her son’s tuition fees. ■ On 31.3.2012, Parvati paid interest to bank. 4. Prepare a horizontal and vertical balance sheet from the following information: Particulars Capital Creditors

Rs 3,00,000 1,00,000 (Contd.)

72 Financial Accounting Bank overdraft Cash in hand Furniture Debtors Plants Drawings Creditors Closing stock Bills payables Bills receivables Net profit

28,000 32,000 1,28,000 1,40,000 80,000 24,000 25,000 44,000 15,000 20,000 25,000

Level 2: Standard 5. Prepare balance sheet as on each of the dates as mentioned below. 1. On 2nd January, owners invest Rs 15,000 in Shri Ram Company to start the business. 2. On 3rd January, Shri Ram Company borrows Rs 10,000 from Dhan Lakshmi Bank. 3. On 5th January, Shri Ram Company purchases inventory worth Rs 18,000 from suppliers, on account. Payment was due on 8th January. 4. On 9th January, Shri Ram Company sells inventory that cost Rs 6,000 for Rs 8,000 in cash. 5. On 10th January, Shri Ram Company pays for inventory purchased on 5th January. 6. On 12th January, Shri Ram Company sells inventory that cost Rs 5,000 for Rs 6,000, on account. Payment is to be received on 31st January. 7. On 31st January, Shri Ram Company collects the account receivable and puts it in bank. 6. Ram starts a Store on 1st January, 2012 with an investment of Rs 2,00,000 from his personal savings. He decides to call this venture as M/s. Ram Store. On 2nd January, the Store purchases a shop for Rs 5,00,000 paying Rs 1,00,000 in cash and signing a mortgage for Rs 4,00,000. On 3rd January, the Store purchased merchandise worth Rs 50,000 in cash and Rs 1,50,000 worth of merchandise on credit from Mr Vanik. On 4th January, he sells half the merchandise inventory for Rs 1, 50,000 in cash. On 6th January, he sells half of the remaining inventory for Rs 75,000 on credit of 15 days to Mr Bharat. On 7th January inventory worth Rs 1, 50,000 was purchased from Mr Laxman on credit of 30 days. On 10th January inventory costing Rs 1,00,000 was sold for Rs 1,20,000 in cash. Prepare balance sheet as on each of the dates as mentioned above. 7. Accountant of Girdhari Industries, Mathura has already prepared P and L Account, he provides following information and request you to prepare vertical Balance Sheet for the year ended 31st March 2012.

Presentation of Financial Statements: Balance Sheet Particulars Opening Stock Purchases Closing Stock

Particulars 32,250 Sales 1,80,000 Returns Outward 26,250 Capital

Returns Inward

7,500 Discount (Cr)

Freight

4,500 Creditors

Rent Carriage Debtors

73

18,000 Cash at Bank (Cr) 3,000 Loan (Cr)

2,55,000 12,000 1,87,500 7,500 42,000 13,500 27,000

52,500 Bad Debts Recovered

750

Cash

6,000 Outstanding Expenses

16,950

Interest on Loan

2,700 Net Loss

21,450

Goodwill

12,000 Salaries

25,500

Furniture

18,000 Samples

7,500

Bad debts Wages

6,000 Land and Building

1,50,000

10,500

Bad debts recovered is not included in the Cash Balance

Level 3: Expert 8. Omkarnath, a software engineer, wants to be in business. He started providing computer maintenance services in the city of Pune. Prepare a balance sheet from the following information showing effect of each transaction separately at the end of March 2012. ■ Day 1, Omkarnath invested Rs 1,00,000. ■ Day 2, Omkarnath deposited Rs 50,000 for office premises taken on rent for Rs 5,000 p.m. ■ Day 3, Omkarnath contracts with SK International to provide services on monthly basis. Monthly charges will be Rs 10,000 and will be paid on the 15th of each month. ■ Day 10, Omkarnath provided services to JK Mehta Hospital and charged Rs 5,500 to them. ■ Day 16, he paid Rs 5,000 for office rent. ■ Day 18, Omkarnath appointed an employee for office administration at a salary of Rs 3,000 per month. In the current month, salary for half month will be paid. ■ Day 25, he purchased a computer chip for Rs 500. ■ Day 26, Omkarnath provided maintenance services to Mr Nityanand and replaced the computer hard disk, which was purchased by him. He charged bill of Rs 7,500. This was unpaid till the end of month. ■ Day 29, paid rent of Rs 5,000 for the month of April 2012 in advance.

74 Financial Accounting

RESEARCH ASSIGNMENT Study balance sheets of different forms of organisation, viz., sole trading concern, partnership firm, company and cooperative society. Explain major differences in presenting assets and liabilities.

INTERPRETING FINANCIAL REPORTS The following is the balance sheets of the Bharat Heavy Electronics Limited (BHEL). Observe the difference offer your comment on significant changes in company’s assets and liabilities in 2011 as compared to 2010 and project the balance sheet of 2012 based on following assumption. Balance Sheet of Bharat Heavy Electronics Ltd Rs in crore Mar. 2011

Mar. 2010

Sources of Funds Equity Share Capital Reserves

489.52

489.52

19,664.32

15,427.84

Revaluation Reserves

0

0

Secured Loans

0

0

Unsecured Loans Total Liabilities

163.35

127.75

20,317.19

16,045.11

8,049.30

6,579.70

Application of Funds Gross Block Less: Accum. Depreciation

4,648.82

4,164.74

Net Block

3,400.48

2,414.96

Capital Work in Progress

1,762.62

1,550.49

439.17

79.84

Inventories

Investments

10,963.03

9,235.46

Sundry Debtors

27,354.62

20,688.75

1,430.15

865.08

Cash and Bank Balance Loans and Advances Fixed Deposits Deferred Credit

13,267.07

4,801.24

8,200.00

8,925.00

0

0

Current Liabilities

31,469.58

28,097.73

Provisions

15,030.37

4,417.98

0

0

20,317.19

16,045.11

Miscellaneous Expenses Total Assets

Presentation of Financial Statements: Balance Sheet

75

Assumptions ■ ■ ■

■ ■

There is no change in share capital. Unsecured loan has increased by Rs. 50 cr. Assets under construction will be completed at a further cost of Rs. 1000 cr. and no new work has commenced. Depreciation has increased by Rs. 500 cr. All current assets have increased by 10% and current liabilities by 8%.

BUSINESS CASES Gati Transport Co. was formed on 1st January, 2012 and began operations on the same day. At the end of its first year i.e. on 31st December, 2012, following data was collected. The company’s bank account showed a balance of Rs 1,80,000 which was in agreement with the bank statement received on the same date. The company had Rs 12,000 (in cash) in the office and Rs 8,000 worth cheques received from various customers. On 31st December, receivables outstanding amounted to Rs 6,00,000. Company also had Rs 60,000 worth promissory notes signed by their customers. Employees had drawn Rs 12,000 as festival advance, which was outstanding. Gati Transport Co owed Rs 7,20,000 to the Southern Service Station as on 31st December, 2012. During the year Gati Transport Co. purchased on cash basis, stationery and office supplies costing Rs 22,000 from Ramlinga lyer & Sons. The use of stationery and supplies during the year was estimated at Rs 16,000. Gati Transport Co. purchased eight trucks during the year, each costing Rs 8,00,000. They owed Rs 40,00,000 to the Southern Sales and Finance at the end of the year on account of trucks purchased. The balance was paid in cash. Depreciation was Rs 1,60,000 per truck for the year. Spare parts and tyres inventory amounted to Rs 26,000. The company had rented a garage on a 30-year lease, office space and parking space at Rs 2,00,000 a year on the NH 47 within the city limits. Because of the real estate boom, Gati Transport Co. could easily sublet the premises for Rs 3,00,000 a year. On 1st January, 2012 when Gati Transport Co. started operations they had paid first two years’ rent in advance. On 31st December, 2012, Gati Transport Co. purchased an air conditioned car for office use costing Rs 2,00,000. Insurance and registration cost amounted to Rs 16,000. The company had a bulk storage tank for diesel needed for its trucks. The tank was filled on four occasions with 50,000 litres each. On 31st December, the meter reading indicated that 3,60,000 litres had been used during the year. Average cost per litre of diesel was Rs 6.00. Gati Transport Co. paid employees’ salary on the last day of each month. Bonus amount of Rs 4,24,000 was due for the employees (relating to 2012) and was to be paid along with the first salary in 2013. The owners of Gati Transport Co. originally invested Rs 12,00,000. Net income for 2012 was Rs 4,16,000. Drawings by the owners were not recorded. Prepare the balance sheet as on 31st December, 2012 for Gati Transport Co.

Preparation of Final Accounts: The Income Statements

Learning Objectives After studying this chapter, you will be able to ❖

Understand measurement of profit

❖

Draw profit and loss account

❖

Learn profit and loss appropriation account

4

Preparation of Final Accounts: The Income Statements

77

LET US SET THE STAGE . . . Kedar, a BTech in computer science from the IIT, started his own hardware business in January 2012. He was an enthusiastic entrepreneur. As he started a new business, he decided to maintain accounting records on his own. He calculated profit in the following manner in December 2012. Particulars Cash Receipts

Rs

Loan taken from SBI @ 10% pa

5,00,000

Revenue earned from hardware services

7,00,000

Capital contributed

3,00,000 15,00,000

Cash expenses incurred Salaries paid

1,65,000

Office expenses paid

80,000

Assets purchased

3,00,000

Sales and distribution expenses

1,00,000

Rent paid

1,20,000

Cash withdrawn for personal expenses

80,000

Electricity bills paid

10,000

Interest on loan taken

50,000 9,05,000

Profit earned (A —B)

■ ■

5,95,000

While looking at his records, he was happy as he made a huge profit in the first year of his business. While discussing these with his friend Mahesh, who was CA by profession, he realised that he did not follow proper accounting concepts. He provided the following additional information: (i) Salary for the month of December amounting to Rs 15,000 was yet to be paid. (ii) Assets purchased include fixed assets eligible for depreciation of 10% pa. (iii) He was yet to collect Rs 50,000 from the customer to whom he supplied goods in November What are the concepts related to calculation of profit? Why can’t it be simply difference of cash received and paid? All such questions can be answered by studying this chapter.

78 Financial Accounting

INTRODUCTION Objective 1 Profit and loss account shows the financial To understand measurement of performance of the business in the form profit of profit earned or loss sustained during a particular period. It shows the income earned from various sources and the costs/ expenses incurred under various heads. Profit and loss account is also known as Income Statement. Income refers to increases in economic benefits during the accounting period. Income encompasses both revenue and gains. Revenue is income that arises in the course of ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends and royalties (Ind AS−18).

Measurement of Profit Profit or gain arising from business can be measured as follows: Profit = Revenue − Cost Revenue includes the gross inflows of economic benefits received and receivable by the entity in its own account. Amounts collected on behalf of third parties such as taxes are not economic benefits which flow to the entity. Therefore, they are excluded from revenue. Similarly, in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission (Ind AS−18). Revenue arises from: ■ ■ ■

Sale of goods Rendering of services Interest, royalties and dividends, etc.

Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. Cost includes expenses incurred on various business activities. Generally, it is classified as: ■ ■ ■

Manufacturing expenses Administrative expenses Selling expenses

The matching concept is an accounting principle that requires the identification and recording of expenses associated with revenue earned and recognised during the same accounting period. It follows, therefore, that when expenses in a period are matched with the revenues generated for the same period, the result is the net income or loss for that period.

Preparation of Final Accounts: The Income Statements

79

FORMAT OF PROFIT AND LOSS ACCOUNT Objective 2 Profit and loss account comprises incomes and To draw profit and loss account expenses related to business activities carried out during a particular year. It can be understood in easier way by looking at simple format and detailed format. Simple format of profit and loss account gives list of incomes and expenses and calculates profit as excess of incomes over expenses. The following is the profit and loss account of Ekadant Ltd for the year ending March, 2012. Profit and Loss Account Rs Cr Income Sales Turnover Excise Duty Net Sales

4,100.70 413.64 3,687.06

Other Income

Nil

Total Income

3,687.06

Expenditure Raw Materials

540.62

Power and Fuel Cost

999.85

Employee Cost

276.81

Other Manufacturing Expenses

47.18

Selling and Admin Expenses

953.30

Miscellaneous Expenses

127.07

Interest

142.64

Depreciation

233.12

Tax

176.98

Total Expenses Profit ( Total Income – Total Expenses)

3,497.57 189.49

The above format is simple in nature as it just calculates profit as difference between incomes and expenses. However, users would like to know profits at various stages as it gives clear picture about company’s financial position. Detailed format of profit and loss account takes into account requirements of users, and analysis and calculate profits at various stages. Let us prepare a detailed profit and loss account of Ekadant Ltd.

80 Financial Accounting Profit and Loss Account Rs Cr Income Sales Turnover

4,100.70

Excise Duty

413.64

Net Sales

3,687.06

Total Income

3,687.06

Expenditure Cost of Goods Sold Raw Materials

540.62

Power and Fuel Cost

999.85

Employee Cost

276.81

Other Manufacturing Expenses

47.18

Cost of Goods Sold

1,864.46

Gross Profit

1,822.60

Selling and Admin Expenses

953.30

Miscellaneous Expenses

127.07

PBDIT

742.23

Depreciation

233.12

PBIT

509.11

Interest

142.64

PBT

366.47

Tax

176.98

Profit (PAT)

189.49

Corporate income statement also shows distribution of profit (in the form of dividend) and the retained earnings. We will discuss about dividend and reserves in Chapter 8 on Corporate Accounting. Let us understand profits earned at different levels. 1. Gross Profit: It is calculated as difference between sales turnover and cost of goods sold. It enables to know about company’s operating results. 2. Profit Before Depreciation, Interest and Tax (PBDIT): It is calculated as difference between gross profit and administrative and selling expenses. Depreciation and interest is not considered at this stage. This is also called as “cash profit”. This is some times referred to as Earnings Before Depreciation, Interest, Tax and Amortisation (EBDITA).

Preparation of Final Accounts: The Income Statements

81

3. Profit Before Interest and Taxes (PBIT): It is calculated as difference between PBDIT and depreciation. It represents a part of profit that is available to service the debt and owners. This is also referred to as Earnings Before Interest and Tax (EBIT). 4. Profit Before Tax (PBT)/EBT: It is the amount of profit before providing for Income Tax. 5. Profit After Tax (PAT)/EAT: It represents profit after tax which is available to owners. It can be used for distribution of dividends. Let us discuss various expenses incurred by a business entity. 1. Wages: Wages includes payment made to workers for manufacturing of goods. 2. Freight or Carriage/Carriage inward: It includes cost of bringing raw material or finished goods to the godown. 3. Factory Expenses: Factory lighting, power, factory rent, etc., incurred for manufacturing of goods. 4. Office and Administration Expenses: All expenses related to administration of business and maintenance of office are debited to profit and loss account. These include salaries, printing and stationery, office rent, legal charges, audit fees, telephone expenses, postage insurance premium, etc. 5. Selling and Distribution Expenses: Expenses incurred at the time of sale and delivery of goods to customers and losses in collection of sales revenue are included in this category. Examples are salesman’s commission, advertisement expenses, carriage outward, depreciation and repair expenses of vehicle used for free home delivery, bad debts, etc. 6. Financial Charges: Financial charges include interest on loan, interest on public deposits, interest on bank overdraft, interest on capital, etc. 7. Miscellaneous Expenses: These include donations, charity, loss by fire, loss by theft, etc. As net profit is calculated, after charging all expenses and losses for the current year, any expense or loss item not included in the above mentioned categories falls under this category. 8. Provisions: Provision is money set aside for liability which is not substantially decided. For example provision for bad debts, discount allowed are provided as they are likely to incur in future.

PROFIT AND LOSS ACCOUNT OF A MANUFACTURING CONCERN A manufacturing organisation purchase raw materials and converts it into finished product. It has to manage three kinds on inventories, namely, raw materials, finished goods and work-in-process.

82 Financial Accounting

Profit and loss account of a manufacturing concern is prepared in three parts, i.e. Manufacturing A/c, Trading A/c, and Profit and Loss A/c. All costs related to manufacturing are recorded in manufacturing account. These include all direct costs and the portion of indirect costs related to manufacturing of goods. The information, when contained in the account form, appears as shown below: Dr

Manufacturing Account

Cr

Opening Stock—Raw Material

XXX

Scrap

XXX

Purchase of Raw Material

XXX

Closing Stock-Raw Material

XXX

Closing Stock—Work-in-Process

XXX

By cost of manufactured goods transferred to trading account (bf)

XXX

Freight Inward Factory Overheads

XXX

Opening Stock—Work in-Process

XXX XXX

XXX

Trading account is prepared to find out gross profit/loss due to operation of business. Stocks of raw material and work-in-process have been adjusted in the manufacturing account whereas the stock of finished goods is adjusted in the trading account. Cost of Goods Sold = Opening Stock + Net Purchases (Purchases – Purchase Return) + Direct Expenses – Closing Stock Direct expenses include carriage inward, freight, wages, royalty on production, etc. Thus, trading account shows the result of buying of goods, bringing them in saleable condition and selling of goods. All transactions relating to goods affect the trading account. Trading account is a nominal account and closed by transfer of gross profit/ loss to profit and loss account. Performa of trading account appears as follows: Dr

Trading Account for the Year ending …

To Opening Stock

Cr

By Sales Less: Sales Return

To Purchases Less: Purchase Return To Direct Expenses (Wages, Freight, etc.)

By Closing Stock

To Gross Profit

Gross profit or gross loss as revealed by the trading account is transferred to profit and loss account. All expenses and losses not transferred to trading account are recorded in profit and loss account. These expenses are called “indirect expenses” because these are not directly related with purchase of goods and bringing them in saleable condition. Performa of profit and loss account appears as follows:

Preparation of Final Accounts: The Income Statements

Dr Date

Profit and Loss Account for the Year Ending… Particulars

JF

Amount Date Particulars Rs

Administrative Expenses

By Gross Profit

To Office Salaries and Wages

By Income from Investments

To Office Rent, Rates and Taxes

By Commission Received

To Office Lighting and Insurance

By Interest on Deposits

To Printing and Stationery

By Gain on Sale of Fixed Assets

83 Cr

JF

Amount Rs

To Postage and Telegrams To Legal Expenses To Audit Fees To Telephone Expenses To General Expenses Finance Expenses To Interest on Capital To Interest on Loans Selling and Distribution Expenses To Bad Debts To Carriage, Freight, Cartage outwards To Cost of Samples, Catalogue Expenses To Salesmen’s Salaries, Expenses and Commission To Advertising Expenses To Depreciation on Fixed Assets To Net Profit (Transferred to Capital Account)

APPROPRIATION OF PROFIT Objective 3 After determination of profit by matching To learn profit and loss revenue and expenses, net profit is allocated by appropriation account preparing profit and loss appropriation account. Appropriation A/c records the balance in the beginning of the year, net profit for the year transferred from profit and loss account and appropriations of profits such as interest on capital, salaries of partners, interest on drawings, transfer to reserve, payment of

84 Financial Accounting

dividends, etc. Thus, it incorporates various items of appropriation of profit, as against charges against profit which are recorded in profit and loss account. Profit and Loss Appropriation Account (For Partnership Firm) Particulars

Rs

To Interest on Capital

XXX

To Salary to Partner

Particulars

Rs

By Net Profit before Appropriation

XXX

By Interest on Drawings

XXX

XXX

To Net Profit after Appropriation XXX

XXX

Appropriation of profit for Ekadant Ltd. Particulars

Rs in Cr

PAT

189.49

Equity dividend Retained Earnings

61.43 128.06

ADVANTAGES OF PROFIT AND LOSS ACCOUNT Preparation of profit and loss account gives the following advantages: 1. It gives an overall view of the results of a business which can be used for intrafirm and inter-firm comparisons. 2. It provides details of various income and expense sources. 3. It provides profitability ratios which are of great interest to financial analysts such as net profit ratio. Operating ratio return on capital employed, etc., are based on figures contained in profit and loss account. 4. The figure of net profit as revealed by income statement can be suitably adjusted to ascertain cash from operating activities. The figure of cash flows is of major concern to security analysts and other users of accounting information.

ILLUSTRATION 4.1 The following balances were extracted from the books of Moonlight Ltd as on 31/03/2012. You are required to prepare trading and profit and loss account in horizontal format and income statement in vertical format.

Preparation of Final Accounts: The Income Statements

85

Particulars

Amount

Particulars

Amount

Purchases

1,70,000

Bank Loan

1,00,000

Closing Stock

30,000

Interest on Investments

Wages

20,000

Rent Received

Interest on Bank Loan

10,000

Sales

Bad Debts

8,000

14,000 24,000 3,40,000

Purchases Return

14,000 24,000

Salaries

40,000

Creditors

Salesman Commission

24,000

Discount

Advertising

16,000

Capital

Investments

1,20,000

Carriage

6,000

Land and Building

2,00,000

Repairs

5,000

Return Inwards

8,000 2,45,000

14,000

Cash in Hand

16,000

Freight

4,000

Cash at Bank

30,000

Debtors

36,000

Opening Stock

50,000

Tax payable is 40 per cent. Solution: Trading Account for the Year ending 31st March, 2012 Particulars Opening Stock Purchases Less: Returns Wages Freight Carriage Gross Profit c/d

Amount 50,000 1,70,000 14,000

1,56,000 20,000 4,000 6,000 1,20,000 3,56,000

Particulars Sales Less: Returns Inward Closing Stock

Amount 3,40,000 14,000

3,26,000 30,000

3,56,000

Profit and Loss Account for the Year ending 31st March, 2012 Particulars Repairs Salaries Interest on Bank Loan Bad Debts Salesman Commission Advertising Tax Net Profit after Tax

Amount 5,000 40,000 10,000 8,000 24,000 16,000 25,200 37,800 1,66,000

Particulars Gross Profit b/d Interest on Investments Rent Received Discount Received

Amount 1,20,000 14,000 24,000 8,000

1,66,000

86 Financial Accounting Income Statement for the Year ending 31st March, 2012 Particulars Sales (less returns) Less: Cost of goods sold: Opening Stock Add: Purchases (less returns)

Rs

50,000 1,56,000 2,06,000 30,000 1,76,000 20,000 4,000 6,000

Less: Closing Stock Add: Direct Expenses Wages Freight Carriage Gross Profit Less: Indirect Expenses: Repairs Salaries and Wages Bad Debts Salesman’s Commission Advertising Operating Profit Add: Other Incomes Interest on Investments Rent Received Discount Received Profit Before Interest and Tax (PBIT) Less: Interest on Bank Loan Profit Before Tax Less: Tax @ 40% Profit After Tax

5,000 40,000 8,000 24,000 16,000

14,000 24,000 8,000

Rs 3,26,000

2,06,000 1,20,000

93,000 27,000

46,000 73,000 10,000 63,000 25,200 37,800

SUMMARY ■

■

■

Profit and loss account or income statement shows the financial performance in the form of profit earned or loss sustained by the business. Revenue includes only the gross inflows of economic benefits received and receivable by the entity on its own account. Revenue arises from sale of goods, rendering of services, interest, royalties and dividends, etc.

Preparation of Final Accounts: The Income Statements ■

■

■

■

■

87

Revenue is recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. Trading account is prepared to find out gross profit/loss due to operation of business. Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock. Gross profit or gross loss as revealed by the trading account is transferred to profit and loss account. All expenses and losses not transferred to trading account are recorded in profit and loss account. Profit and loss appropriation A/c records the balance in the beginning of the year, net profit for the year transferred from profit and loss account and appropriations of profits such as interest on capital, salaries of partners, interest on drawings, transfer to reserve, etc.

MULTIPLE CHOICE QUESTIONS* 1. Revenue arises from (a) Sale of goods (b) Rendering of services (c) Goods are delivered (d) All of the above 2. Revenue is recognised (a) Only when it is probable that the economic benefits associated with the transaction will flow to the entity (b) Only when cash is received (c) When there is demand of goods (d) Both (a) and (b) 3. As per the accrual principle an income is recognised, (a) When right to receive the income arises (b) When the amount of income is known with reasonable accuracy (c) Both the above (d) Either (a) or (b) 4. As per the accrual principle an expense is recognised, (a) When it becomes due (b) When it is paid (c) Either (a) or (b) (d) Both (a) and (b) * Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

88 Financial Accounting

5. The matching concept is an accounting principle (a) That requires the identification and recording of expenses associated with revenue earned and recognised during the same accounting period (b) That requires any period income and expenses to be recorded any time in the year (c) Last year’s expenses to be recorded in the current year (d) None of the above 6. Cost of goods sold is calculated as (a) Cost of Goods Sold = Opening Stock + Net Purchases (Purchases – Purchase Return) + Direct Expenses – Closing Stock (b) Cost of Goods Sold = Opening Stock + Net Purchases (Purchases – Purchase Return) + Direct Expenses + Indirect Expenses – Closing Stock (c) Cost of Goods Sold = Closing Stock + Net Purchases (Purchases – Purchase Return) + Direct Expenses + Indirect Expenses – Opening Stock (d) None of the above 7. Trading account is prepared to find out (a) Gross profit/gross loss (b) Net profit/net loss (c) Cost of goods sold (d) None of the above 8. Profit and loss account is prepared to (a) Present financial position (b) Find out net profit/net loss (c) Find out cost of goods sold (d) None of the above 9. Which of the following is recorded in profit and loss appropriation account? (a) Interest on capital (b) Interest on bank loan (c) Salaries to partner (d) Both (a) and (c) 10. Interest on drawings by partner is transferred to (a) Trading account (b) Profit and loss account (c) Profit and loss appropriation account (d) None of the above

Preparation of Final Accounts: The Income Statements

89

THEORY QUESTIONS 1. 2. 3. 4. 5.

Define revenue and its recognition. Write short notes on (a) accrual concept and (b) realisation concept. Explain the concept of matching of revenue and expenses. Distinguish between manufacturing and trading account. Distinguish between profit and loss and profit and loss appropriation account.

PRACTICAL PROBLEMS Level 1: Easy 1. From the following information, prepare a profit and loss account for the year ending 31st March, 2013. Particulars Gross Profit Rent Salary Commission Paid Interest Paid on Loan Advertising Discount Received Printing and Stationery Legal Charges Bad Debts Depreciation Interest Received Loss by Fire

Rs 60,000 5,000 15,000 7,000 5,000 4,000 3,000 2,000 5,000 1,000 2,000 4,000 3,000

2. The following data has been extracted from the financial statements of Reliance Industries Ltd. You are required to arrange them into vertical income statement and calculate operating profit, PBT and PAT. Particulars Raw Materials Tax Power and Fuel Cost Employee Cost

March 2009 1,09,284 3,137 3,356 2,398

March 2010 1,53,689 4,325 2,707 2,331 (Contd.)

90 Financial Accounting Other Manufacturing Expenses Total Turnover Selling and Admin Expenses Interest Depreciation

1,163 1,43,651 4,737 1,774 5,195

2,154 1,99,128 5,756 2,000 10,497

3. From the following balances of Mr Shiva, a sole trader for the year ended 2012, prepare trading and profit and loss account. Particulars Cash Trade Debtors Rent Salaries Trade Creditors Insurance Petty Expenses Opening Stock Sales Purchases Capital Drawings Motor Vehicle Machinery Office Expenses Machinery Expenses Fuel and Lubricants Expenses Closing Stock

Rs 2,800 10,000 2,750 6,000 9,350 2,000 1,500 10,000 1,32,500 90,000 52,950 5,000 32,500 27,000 1,475 2,500 1,275 15,000

Level 2: Standard 4. The following balances is extracted from the books of a trader. Compute gross profit, net profit for the year ended 31st March, 2012, by preparing trading and profit and loss A/c. Particulars Sales Purchases Opening Stock Sales Return Purchases Return Rent

Amount (Rs) 75,250 32,250 7,600 1,250 250 300 (Contd.)

Preparation of Final Accounts: The Income Statements Stationary and Printing Salaries Misc. Expenses Travelling Expenses Advertisement Commission Paid Office Expenses Wages Profit on Sale of Investment Depreciation Dividend on Investment Loss on Sale of Old Furniture Closing Stock (31st March, 2012) valued at Rs 8,000

91

250 3,000 200 500 1,800 150 1,600 2,600 500 800 2,500 300

Level 3: Expert 5. From the following balances as on 31st March 2012, prepare trading and profit and loss account in the books of Sunrise Ltd. Serial No.

Particulars

Amount (Rs)

1.

Mr A’s Capital A/c

10,00,000

2.

Mr A’s Drawing A/c

3.

Purchase of Finished Goods Less Return

4.

Freight Inward for Finished Goods

5.

Wages

1,20,000

6.

Salaries

1,50,000

7.

Rates and Taxes

30,000

8.

Electric Power

60,000

9.

20,000 20,00,000 20,000

Electricity Charges for Lights Fans

25,000

10.

Office Rent

30,000

11.

Reserve Account

12.

Travelling Expenses

1,00,000

13.

Insurance Premium

1,80,000

14.

Advertisement Expenses

15.

Sales less Return

16.

Bad Debts Written-off

17.

Discount (Debit Balance)

18.

General Expenses

36,000

19.

Postage and Telegram

15,000

50,000

40,000 30,00,000 10,000 5,000

(Contd.)

92 Financial Accounting 20.

Opening Stock as on 1st April 2011

3,30,000

21.

Factory Land

80,000

22.

Factory Building

60,000

23.

Plant and Machinery

5,00,000

24.

Furniture and Fixtures

1,05,000

25.

Sundry Creditors

2,00,000

26.

Sundry Debtors

6,00,000

27.

Cash in Hand

20,000

28.

Cash in Bank

14,000

29.

Depreciation

50,000

30.

Closing Stock

3,50,000

6. Omkarnath started providing computer maintenance services in the city of Pune in March. You are required to prepare the profit and loss account from the following information at the end of 31st March 2012. ■

■

■

■

■ ■

■ ■

■

Day 1, Omkarnath invested Rs 1,50,000 and obtained a bank loan of Rs 50,000 @ 12% pa. Day 2, Omkarnath deposited Rs 75,000 for office premises, rent of Rs 7,500 to be paid in advance. Day 3, Omkarnath contracts with SK International to provide services on monthly basis. Monthly charges will be Rs 15,000 and will be paid on the 5th of each month for the last month. Day 10, Omkarnath provided services to JK Mehta Hospital and charged Rs 7,750 from them. Day 16, he paid Rs 7,500 for office rent. Day 18, Omkarnath appointed a graduate assistant for office administration at a salary of Rs 4,500 per month. In the current month, salary for half month will be paid. Day 25, he purchased a computer chip for Rs 750. Day 26, Omkarnath provided maintenance services to Mr Nityanand and used chip in the computer, which was purchased by him. He charged Rs 11,250. This was unpaid till the end of month. One time hiring cost of Rs 2,000 was paid. Day 29, paid rent of Rs 7,500 for the month of April 2012.

RESEARCH ASSIGNMENTS Study the profit and loss statement of Bharti Airtel (Telecom Sector), Ambuja Cements (Manufacturing Sector), HUL (FMCG Sector) and Bank of Baroda (Banking Sector) companies.

Preparation of Final Accounts: The Income Statements

93

You are required to: ■ ■ ■

Notice differences in format. Examine differences in the accounting policies adopted. Identify how these companies recognise their revenue.

INTERPRETING FINANCIAL REPORTS Case 1 ACC Limited is India’s foremost cement manufacturer with a countrywide network of factories and marketing offices. Established in 1936, ACC has been a pioneer and trend-setter in cement and concrete technology. Among the first companies in India to include commitment to environment protection as a corporate objective, ACC has won accolades for environment friendly measures taken at its plants and mines and has also been felicitated for its acts of good corporate citizenship. ACC is the most preferred cement brand name in India. ACC is now part of the worldwide Holcim Group. The following is its income statement (adapted) for 2009 and 2010. Profit and Loss Account of ACC

Rupees in crore

December 2010

December 2009

Income Sales Turnover Excise Duty

8,609.29

8,803.17

961.52

781.58

Net Sales

7,647.77

8,021.59

Total Income

7,647.77

8,021.59

Raw Materials

1,520.68

1,233.42

Power and Fuel Cost

1,598.67

1,539.65

Wages

461.89

367.71

Other Manufacturing Expenses

538.24

421.69

COGS

4,119.48

3,562.47

GP

3,528.29

4,459.12

Selling and Admin Expenses

1,594.53

1,658.79

313.33

262.72

1,907.86

1,921.51

1,620.43

2,537.61

Expenditure

Miscellaneous Expenses PBDIT

(Contd.)

94 Financial Accounting Depreciation PBIT

392.68

342.09

1,227.75

2,195.52

Interest

56.78

PBT

84.3

1,170.97

2,111.22

Tax

424.15

688.93

Profit (PAT)

746.82

1,422.29

You are required to identify the major increase/decrease in expenses and revenue and offer your comments.

Case 2 Followings are the details about income statement and schedules to income statements of Mahindra and Mahindra for the year ended 31st March 2010 and 2011. Profit and Loss Account for the year ended 31st March, 2011

Rupees in crore

Schedule SALES–Traded and Manufactured Goods Less: Excise Duty on Sales (Net) Net Sales Income from Operations Other Income Net Income EXPENDITURE: Raw Materials, Finished and Semi-finished Products Excise Duty Personnel Interest, Commitment and Finance Charges (Net) Depreciation/Amortisation [Note 5 (c)(i) & (d)] Other Expenses Less: Cost of Manufactured Products Capitalised Profit before exceptional items and taxation Add: Exceptional Items [Note 21] Profit before taxation Less: Provision for Tax-Current Tax -Deferred Tax (Net) Profit for the year Balance of Profit for earlier years

VIII A VIII B

IX X XI XII

2011 24,850.22 2,092.71 22,757.51 736.21 309.52 23,803.24

2010 19,832.06 1,794.01 18,038.05 564.06 199.35 18,801.46

16,263.94 (0.69) 1,445.56 (50.29) 413.86 2,379.60 20,451.98 50.87 20,401.11 3,402.13 117.48 3,519.61 761.67 95.84 2,662.10 4,588.37

12,332.92 13.29 1,198.47 27.81 370.78 2,161.74 16,105.01 59.55 16,045.46 2,756.00 90.75 2,846.75 749.33 9.67 2,087.75 3,365.32 (Contd.)

95

Preparation of Final Accounts: The Income Statements Add/(Less): Transfer from/(to) Debenture Redemption Reserve (Net)

35.71

(30.95)

4,624.08

3,334.37

7,286.18

5,422.12

General Reserve

275.00

210.00

Proposed Dividend

706.08

549.52

96.56

74.23

6,208.54

4,588.37

Total of Profit and Loss Account balances shown above Less:

Income-tax on Proposed Dividend Balance for 2010-2011 and earlier years carried to Balance Sheet EARNINGS PER SHARE (Note 24): (Face value Rs 5/- per share) (Rupees) Basic

46.21

37.97

Diluted

44.33

35.61

NOTES ON ACCOUNTS

XIII

Schedule VIII

Rupees in crore 2011

2010

341.72

343.83

92.86

70.14

181.80

72.49

16.88

—

102.95

77.60

736.61

564.06

Dividends on Investments in Subsidiaries/Joint Ventures-Gross

123.91

84.60

Dividends on other Investments-Gross-Non Trade [Note 10(a)]

56.31

48.16

Profit on sale of Investments (Net) [Note 10(b)]

27.65

10.40

3.66

—

97.99

56.19

309.52

199.35

Income from Operations and Other Income: (A) Income from Operations: Income from services rendered Scrap Sales Government grant and Incentives Profit on sale of Fixed Assets (Net) Other Operating Income Total (B) Other Income:

Profit on sale of Fixed Assets (Net) Miscellaneous Income Total

96 Financial Accounting Schedule IX

Rupees in crore 2011

2010

Raw Materials, Finished and Semi-Finished Products: (A) (Increase)/Decrease in Stock of Finished Goods, Work-in-Progress and Manufactured Components: Opening Stock: (i) Finished Products produced and purchased for sale (ii) Contracts and Work-in-Progress (iii) Manufactured Components Add: Stock Taken Over as per Scheme of Arrangement Less: Closing Stock: (i) Finished Products produced and purchased for sale (ii) Contracts and Work-in-Progress (iii) Manufactured Components

491.38

471.81

75.03 73.89

88.87 55.93 616.61 —

640.30 9.07 659.25

491.38

82.14 110.21

75.03 73.89 640.30 (23.69)

(Increase)/Decrease in Stock (B) Consumption of Raw Materials and Bought-out Components: Opening Stock 494.50 Add: Purchases [Including outside processing charges Rs 349.56 crores (2010: Rs 281.83 crores)] 14,998.23 15,492.73 Less: Closing Stock 783.79 (C) Purchases of finished Produces for sale Total

851.60 (202.23)

391.01

14,708.94 1,757.23 16,263.94

Schedule X

11,799.05 12,190.06 494.50 11,695.56 661.05 12,332.92

Rupees in crore 2011

2010

Personnel: Salaries, Wages, Bonus, etc.

1,200.57

988.10

Contribution to Provident and other funds

87.11

66.89

Gratuity

47.50

31.31

Welfare Total

110.38

112.17

1,445.56

1,198.47

97

Preparation of Final Accounts: The Income Statements

Schedule XI

Rupees in crore 2011

2010

Interest, Commitment and Finance Charges: On Term Loans and Debentures On Others (Net) Less: Interest Income: (i) Interest on Government Securities, Debentures and Bonds-Gross [Note 10(c)] (ii) Interest-Others-Gross [Note 10(d)] Total

68.23

148.91

2.63

7.94

70.86

156.85

10.84

4.68

110.31 121.15 (50.29)

124.36 129.04 27.81

Schedule XII 2011

2010

102.54 36.17 143.93 44.34 17.13 17.01

75.27 29.68 120.97 47.01 16.53 17.06

161.66 180.78 99.13 0.74 363.83 393.08 824.24 0.37 17.60 — 1.90 (24.85) 2,379.60

22.56 96.92 33.10 152.58 139.78 70.54 4.80 269.73 317.17 819.54 0.14 9.35 20.83 (0.26) 51.02 2,161.74

Other Expenses: Stores consumed Tools consumed Power and Fuel Rent including lease rentals Rates and Taxes Insurance Repairs and Maintenance [Note 11]: Buildings Machinery Others Advertisement Commission on sales/contracts (Net) Discount allowed Freight outward Sales Promotion Expenses Miscellaneous Expenses [Note 12] Directors’ fees Donations and contributions [Note 26] Loss on Fixed Assets sold/scrapped/written off (Net) Excess of cost over fair value of Current Investments (Net) Provision for doubtful debts/advances (Net) Total

15.74 98.33 47.59

You are required to identify the major expenses and revenue. Comment on movement of these items and their relationship with each other.

98 Financial Accounting

BUSINESS CASE India’s largest power company, NTPC was set up in 1975 to accelerate power development in India. NTPC is emerging as a diversified power major with presence in the entire value chain of the power generation business. Apart from power generation, which is the mainstay of the company, NTPC has already ventured into consultancy, power trading, ash utilisation and coal mining. NTPC ranked 341st in the ‘2010, Forbes Global 2000’ ranking of the world’s biggest companies. NTPC became a Maharatna company in May 2010, one of the only four companies to be awarded this status. The total installed capacity of the company is 36,014 MW (including JVs) with 15 coal based and 7 gas based stations, located across the country. In addition under JVs, 5 stations are coal based and another station uses naphtha/LNG as fuel. The company has set a target to have an installed power generating capacity of 1,28,000 MW by the year 2032. The capacity will have a diversified fuel mix comprising 56% coal, 16% gas, 11% nuclear and 17% renewable energy sources (RES), including hydro. By 2032, non-fossil fuel-based generation capacity shall make up nearly 28% of NTPC’s portfolio. NTPC has been operating its plants at high efficiency levels. Although the company has 17.75% of the total national capacity, it contributes 27.40% of the total power generation due to its focus on high efficiency. The following information is available regarding its incomes and expenses in Rs Cr for the years ending 31st March 2010 and 2011. Particulars Sales Turnover Excise Duty Other Income Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Admin Expenses Miscellaneous Expenses Interest Depreciation Tax Preference Dividend Equity Dividend

March 2011 55,216.69 278.01

March 2010 46,623.60 245.9

2,525.48 31.33 35,796.37 3,395.27 1,273.14 2,264.01 525.63 2,027.21 2,485.69 2,630.54 0 3,133.26

2,872.80 31.1 29,689.10 2,946.80 1,096.60 578.5 436.4 1,861.90 2,650.10 2,682.70 0 3,133.20

You are required to prepare income statement and calculate profit at various levels.

Mechanics of Accounting

Learning Objectives After studying this chapter, you will be able to ❖

Understand classification of accounts

❖

Understand accounting cycle

❖

Prepare journal and subsidiary books

❖

Post journal entries to ledger accounts

❖

Learn to prepare trial balance

❖

Prepare Bank Reconciliation Statement

❖

Know computerised accounting

5

Mechanics of Accounting

101

LET US SET THE STAGE . . . Mr Mayank started a general store in Mumbai on 1st April 2012. He invested Rs 1,00,000 in his business and borrowed a sum of Rs 2,00,000 from bank. He purchased furniture worth Rs 80,000. The premise which he was using was on rental basis, requiring him to pay refundable deposit of Rs 70,000 and rent of Rs 10,000 pm. He also purchased a refrigerator for Rs 30,000. After making these arrangements, he acquired stock of grocery items, cold drinks and ice cream from Mr Raghu and paid him Rs 1,00,000 out of which he paid Rs 30,000 in cash. He recorded all these transactions carefully on the same day in a simple diary. He started recording all his daily transactions in the same diary on different dates. After a month he thought of calculating profit from his new business. When he opened his diary he got confused looking at the various transactions. He approached his accountant friend Mr Jatin with this diary. Mr Jatin told him to follow a proper process of maintaining accounts with double entry system to avoid such confusions in future. What is an accounting process? What is double entry system? How can one maintain systematic records to determine his financial position?

■ ■

All such questions can be answered by studying this chapter. (This case is continued in Business Cases provided at the end of the chapter.)

INTRODUCTION We have seen the structure of financial statements in earlier chapters. A balance sheet discloses various assets and liabilities while an income statement shows incomes and expenses. The balance sheet equation is as follows: Owner’s Fund + External Liabilities = Assets or Owner’s Fund = Assets – External Liabilities It shows that total assets are equal to total liabilities. This equality arises due to the specific process of maintaining books of accounts to record various transactions. We shall discuss the entire process of recording various transactions in a systematic manner to arrive at financial statements.

CLASSIFICATION OF ACCOUNTS Objective 1 An account is a statement which shows all To understand classification of transactions related to a particular party, asset, accounts liability, income or expense. The types of accounts are personal, real and nominal (Figure 5.1).

102 Financial Accounting

FIGURE 5.1

Types of Accounts

Personal Account Account related to some party like individual, bank, firm, company, etc., is known as personal account. The personal account may be for natural persons, for example Sumit’s A/c, Krishna’s A/c, artificial persons for example Chaitanya Cements Ltd A/c, KP & Co. A/c and representative persons such as prepaid insurance A/c and outstanding salary A/c.

Real Accounts Real accounts are related to assets. Anything of material value or usefulness that is owned by a person or company is termed as asset. An asset results into future benefit to an organisation. Some examples of real accounts are building A/c, plant A/c, furniture A/c, cash A/c, goodwill A/c, etc. However, it may be noted that accounts of any parties like debtors A/c, bank A/c are always treated as personal accounts, though they may be assets. Nominal Accounts: The accounts for recording income, expenses, losses and gains are classified as nominal accounts. For example, wages A/c, salaries A/c, insurance premium A/c, rent received A/c, etc.

ILLUSTRATION 5.1 Classify the following accounts into three categories: personal, real and nominal account. 1. 2. 3. 4. 5. 6.

Cash Capital Furniture Wages Carriage Inward Power and Electricity

7. 8. 9. 10. 11. 12.

Bank Loan Interest Ms Vandana Advances from Customers Bank Prepaid Expenses

Mechanics of Accounting

103

Solution: Personal accounts: 2, 7, 9, 10, 11, 12; Real accounts: 1, 3; Nominal accounts: 4, 5, 6, 8.

DOUBLE ENTRY SYSTEM This is a scientific system of recording transactions. According to this every transaction has two fold aspects (debit and credit) and both these aspects need to be recorded in the books of accounts. It records every transaction with equal debits and credits. As a result the total of debits must equal to the total of credits. In case of double entry system, accounts are prepared with the help of the rules as shown in Figure 5.2.

FIGURE 5.2

Preparing Accounts in Double Entry System

104 Financial Accounting

Examples 1. Wages paid Rs 3,000 Wages: nominal account—debit all expenses Cash: real account—credit what goes out 2. Rs 10,000 collected from Mr Bharat Cash: real account—debit what comes in Mr Bharat: personal account—credit the giver 3. Commission received—Rs 5,000 through cheque Bank: personal account—debit the receiver Commission: nominal account—credit all incomes and gains

OVERVIEW OF ACCOUNTING CYCLE Objective 2 Accounting Cycle refers to the process which To understand accounting cycle starts with recording of opening entries in the Journal and ends with the preparation of financial statements. The steps included in the accounting cycle are shown in Figure 5.3.

FIGURE 5.3

Accounting Cycle

Mechanics of Accounting

105

PREPARING JOURNALS Objective 3 For recording any transaction it is necessary to To prepare journal and identify the accounts which are to be debited subsidiary books and credited and the amount of such debit/ credit. The affected account may be shown by way of Journal Entry. The transactions are recorded in the books of accounts is called Journal Entry. The process of recording transaction is called journalising. Journal entries are recorded chronologically that is date-wise. A journal is prepared in the following format: Date

Particulars

Ledger Folio

Debit (Rs)

Credit (Rs)

Date column mentions the date of transaction. In Particulars column, accounts involved in the transaction are recorded along with narration (Brief explanation starting with Being …). Ledger Folio provides with page number of ledger for cross-reference. In Debit and Credit columns, respective amounts should be mentioned. Journal entry can be a simple journal entry with one debit and one credit or else compound journal entries with more than one debit and/or credit. Let us understand this through the following practical question.

ILLUSTRATION 5.2 Journalise the following transactions in the journal of M/s Jay Enterprises. April 2012 1st

Started Business with Cash Rs 1,75,000, Goods Rs 1,25,000, Furniture Rs 1,10,000

nd

Deposited in Bank Rs 60,000

th

Discussed with Ramesh & Co for the Supply of Goods of the List Price of Rs 2,00,000

2

5

7th th

11

Ramesh & Co supplied Goods of the List Price of Rs 1,70,000 Purchased Goods from Mahesh Traders of the List Price of Rs 2,35,000 less 10% Trade Discount. Cheque issued to him under a Cash Discount of 2%

15th Goods sold to Sham Ltd of the List Price of Rs 1,09,250. It paid half of the Amount by Cheque 16th Goods costing Rs 70,000 sold to Mr Umesh for Cash at a Profit of 20% on Cost Price less 10% Trade Discount and 5% Cash Discount 18th Goods taken away by the Proprietor for the Personal Use, Amount Rs 10,000 (Sale Price Rs 13,000) 20th Sham Ltd became Insolvent and paid only 80 paise in rupee by Cheque towards full and final settlement (Contd.)

106 Financial Accounting 22nd Paid Ramesh & Co. 98% of the Amount due to him by Cheque towards full and final settlement of Account 23rd Goods (Cost Rs 6,500, Sale Price Rs 8,000) Stolen 25th Cash paid for the Life Insurance Premium Rs 1,800 for Proprietor 29th Cash embezzled by an Employee Rs 4,200

Solution: Date

Particulars

Dr/ Cr

LF

Debit Credit Amount (Rs) Amount (Rs)

1st April 2012

Cash A/c

Dr

1,75,000

Stock A/c

Dr

1,25,000

Furniture A/c

Dr

1,10,000

To Capital A/c

4,10,000

(Being the Cash, Goods and Furniture brought in as Capital) 2nd

Bank A/c

Dr

60,000

To Cash A/c

60,000

(Being the Amount deposited in Bank) 5th th

7

No Entry Purchases A/c

Dr

1,70,000

To Ramesh & Co. A/c

1,70,000

(Being the Goods purchased on Credit) 11th

Purchases A/c

Dr

2,11,500

To Bank A/c

2,07,270

To Discount A/c

4,230

(Being the Goods purchased for Cash) List Price Less: Trade Discount @10% Invoice Price Less: Cash Discount @ 2% Cash Received 15th

` 2,35,000 (23,500) 2,11,500 4,230 2,07,270

Bank A/c

Dr

54,625

Sham Ltd A/c

Dr

54,625

To Sale A/c

1,09,250

(Being the Goods sold to Sham Ltd, half of the amount is received in Cash) (Contd.)

Mechanics of Accounting 16th

Cash A/c

Dr

71,820

Discount Account To Sale A/c (Being the Goods sold to Mr Umesh for Cash)

Dr

3,780

Cost Price Add : Profit @ 20% on Cost List Price Less : Trade Discount @10% Invoice Price Less : Cash Discount @ 5% Cash Received 18th

107

75,600

Rs 70,000 14,000 84,000 (8,400) 75,600 (3,780) 71,820

Drawings Account

Dr

10,000

To Stock Account

10,000

(Being the Goods withdrawn by the Proprietor for Personal Use) 20th

Bank Account

Dr

43,700

Bad Debts Account

Dr

10,925

To Sham Ltd Account

54,625

(Being 80 paise in Rupee received from Sham Ltd. towards Full and Final Settlement) 22nd

Ramesh & Co A/c

Dr

1,70,000

To Discount A/c

3,400

To Bank A/c

1,66,600

(Being the 98% of Amount due to Ramesh & Co paid to him towards Full and Final Settlement of Account) 23rd

Loss by Theft Account

Dr

6,500

To Stock Account

6,500

(Being the Goods Stolen) th

25

Drawings Account

Dr

1,800

To Cash a/c

1,800

(Being Life Insurance Premium paid in Cash ) 29th

Loss by Embezzlement A/c

Dr

4,200

To Cash A/c

4,200

(Being Cash Embezzled by an Employee) Total

12,83,475

12,83,475

108 Financial Accounting

SUBSIDIARY BOOKS Business transactions can be classified as those transactions relating to purchase, sales, cash, etc. It is convenient to record these transactions in a separate register for each such class of transactions. Such registers are books of original entry and are known as subsidiary books. These books improve availability and accuracy of information without sacrificing the fundamental principle of double entry book keeping system. Types of Journals

Purpose

Purchase Day Book

To record transactions relating to credit purchases of goods in trade

Sales Day Book

To record transactions relating to credit sales

Purchase Return Book

To record transactions relating to purchase return

Sales Return Book

To record transactions relating to sales return

Cash Book

To record cash, bank and discount transactions

Journal Proper

To record other transactions for which no specific journal is maintained and for recording entries to rectify mistakes in books of accounts

Purchase Day Book This book is prepared to record transactions related to credit purchase of goods in trade. It does not record credit purchase of fixed assets. Cash transactions are not recorded in this journal. Purchase Day Book of … Date

Particulars

Inward Invoice No.

Ledger Folio

Amount

Net Amount

ILLUSTRATION 5.3 A & Co. deals in ladies garments. The rough book of the firm shows the following transactions for the month of January 2012: Purchased from B & Co. on credit: 1st January 10 cotton salwar suits @ Rs 500 per suit 10 silk salwar suit @ Rs 1,500 per suit Less: Trade discount @ 10% 10th January Purchased in cash from C & Co: 2 cotton salwar suit @ Rs 150 per suit 15th January Purchased a calculator for office use from D & Co. on credit for Rs 500 20th January Purchased from Y & Co. on credit:

Mechanics of Accounting

109

10 cotton sarees @ Rs 600 per saree 10 silk sarees @ Rs 2,000 per saree Less: Trade discount @10% 31st January Purchased 10 cotton suit lengths @ Rs 300 per suit length from Z & Co. on credit. Prepare the purchase day book of A & Co. for the month of January 2012. Solution Purchase Day Book of A & Co. Date

Particulars

Inward Invoice No.

Ledger Folio

Amount Rs

Net Amount Rs

2012 st

1 January

M/s B & Co. 10 cotton salwar suits @ Rs 500

5,000

10 silk salwar suits @ Rs 1,500

15,000 20,000

Trade discount @ 10% th

No Entry*

th

No Entry**

th

M/s Y & Co.

10 January 15 January 20 January

10 cotton sarees @ Rs 600 10 silk sarees @ Rs 2,000

−2,000

18,000

6,000 20,000 26,000

Trade discount @ 10% 31st January

−2,600

23,400

M/s Z & Co. 10 cotton suit lengths @ Rs 300

Total * Cash purchases are not to be recorded in purchase day book. **Purchase of fixed asset (calculator) will not be recorded in purchase day book.

3,000 44,400

Sales Day Book Enterprises record credit sales of stock-in-trade in a sales day book. The mechanics of posting entries from the sales day book to the general ledger and the subsidiary ledger for debtors are similar to those posting from the purchase day book.

110 Financial Accounting Sales Day Book of … Date

Particulars

Outward Invoice No.

Ledger Folio

Amount

Net Amount

ILLUSTRATION 5.4 A & Co. deals in ladies garments. The rough book of the firm shows the following transactions for the month of January 2012: Sold to Alpha & Co. on credit: 2nd January 5 cotton salwar suits @ Rs 600 per suit 5 silk salwar suits @ Rs 1,800 per suit Less: Trade discount @ 10% 3rd January

Sold old furniture to M & Co. for Rs 100 on credit 8th January Sold to Beta & Co. on credit: 5 cotton salwar suits @ Rs 600 per suit 5 silk salwar suits @ Rs 1,800 per suit Less: Trade discount @ 10%

th

15 January

Sold 2 silk sarees to M/s. Beauty for Rs 2,500 in cash

31st January

Sold to Gamma & Co. on credit: 10 cotton sarees @ Rs 800 per saree 10 silk sarees @ Rs 2,500 per saree Less: Trade discount @ 10%

Prepare the sales day book of A & Co. for the month of January 2012. Solution: Date

Particulars

Ledger Folio

Amount Rs

Net Amount Rs

2012 2nd January

M/s Alpha & Co. 5 cotton salwar suits @ Rs 600

3,000

5 silk salwar suits @ Rs 1,800

9,000 12,000

Trade discount @ 10%

(1,200)

10,800 (Contd.)

Mechanics of Accounting 3rd January th

8 January

111

No Entry* M/s Beta & Co. 5 cotton salwar suits @ Rs 600

3,000

5 silk salwar suits @ Rs 1,800

9,000 12,000

Trade discount @ 10% th

No Entry**

st

M/s Gamma & Co.

15 January 31 January

(1,200)

10 cotton sarees @ Rs 800

8,000

10 silk sarees @ Rs 2,500

25,000

10,800

33,000 Trade discount @ 10%

(3,300) Total

29,700 51,300

*Sale of fixed asset (furniture) will not be recorded in sales day book **Cash sales are not recorded in sales day book.

Purchase Return Book Purchase Return Book is prepared to record return of goods to supplier. It records transactions related to return of credit purchase of goods in trade. Purchase Return Book Date

Particulars

Outward Invoice No.

Ledger Folio

Amount

Net Amount

Sales Return Book Sales Return Book is prepared to record return of goods from customers. It records transactions related to return of credit sales of goods in trade. Sales Return Book Date

Particulars

Inward Invoice No.

Ledger Folio

Amount

Net Amount

112 Financial Accounting

Cash Book Cash and bank transactions are recorded in the “Cash Book”. A cash book is a book of primary entry. It also serves the purpose of a ledger account and, therefore, the cash account and bank account are not maintained in the general ledger. Balances in the cash book are taken directly to the trial balance that lists out balances in various account heads in the general ledger. Thus, a cash book serves the dual purpose of maintaining a journal to record cash and bank transactions and also maintaining cash and bank accounts in the general ledger. The following are the different types of cash books that are being maintained by enterprises: 1. Single-column cash book: It records only cash receipts and cash payments. 2. Double-column cash book: It has an additional column to record bank transactions. 3. Three-column cash book: It provides additional information on discount received and discount allowed.

ILLUSTRATION 5.5 A commenced business as A & Co. on 1st January, 2012 with a cash balance of Rs 2,000. Record the transactions for the month of January 2012 in a cash book with discount and bank columns. 1st January

Deposited Cash with Bank

1,500

4th January

Received Cheque from B & Co.

1,000

th

C & Co. is paid by Cheque Rs 330. He allowed a discount of Rs 20.

th

6 January

Received Cheque from M & Co. Rs 450 after allowing a discount of Rs 50.

10th January

Goods sold in Cash to R & Co.

500

12th January

5 January

Cash drawn for Office Use

500

th

Paid for Office Expenses in Cash

500

th

17 January

Goods sold on Credit to R & Co.

1,000

25th January

Paid salaries for January in Cash

500

25th January

Cheque received from Y & Co.

400

Cheque received from Y & Co. returned by Bank

400

15 January

st

31 January

Mechanics of Accounting

113

Solution: A & Co. Cash Book

Dr Date

Receipts Particulars LF Discount Cash Bank Rs Rs Rs

2012 st

1 January 1st January 4th January 6th January 10th January

12th January 25th January

Date

Cr Payments Particulars LF Discount Rs

Cash Bank Rs Rs

By cash

1,500

2012 To capital To Bank

2,000 C

1,500

To B & Co.

1,000

To M & Co. To Sales

To Bank

50

450 500

C

500

To Y & Co.

400 50

st

1 To Balance February b/d

3,000 3,350

1st January 5th January 12th January 15th January 17th January 25th January 31st January 31st January

C

By C & Co. By Cash

20

330

C

500

By Office Expenses No Entry *

500

By Salaries

500

By Y & Co.

400

By Balance c/d

500 20

2,120

3,000 3,350

500 2,120

* Credit sales are not to be recorded in cash book.

Petty Cash Book As a matter of convenience, an imprest (a predetermined amount of cash) is sanctioned to individuals authorised to make payments of small amounts of high frequency. Examples of such payments are postage, conveyance, carriage and stationery. The individual so authorised maintains a cash book known as a petty cash book. A petty cash book usually has multiple columns to accommodate different types of payment (see table on next page).

Journal Proper Those transactions which cannot be recorded in Objective 4 other subsidiary books are recorded in journal To post journal entries to ledger proper. Format of journal proper is similar to accounts the usual journal for recording journal entries. The transactions recorded in journal proper are: (a) Fixed assets introduced by owners as capital; (b) Exchange of assets; (c) Bad debts. Opening, closing and adjusting entries are recorded in journal proper.

Total

Bal. C/F (November 2011)

Sr No Particulars

Cash Balance at the End of Month

01/12/2011

Date

Cash Receipt Details Amount

Sr.No

Total

0

Particulars Total

0

0

Postage Conveand yances Telephone

0

0

0

0

Freight Freight Repair and Miscellaneous Inward Outward Maintenance Expenses

Cash Payment Details

Name of Company Petty Cash for the month of _____________

114 Financial Accounting

Mechanics of Accounting

115

LEDGER After recording transaction in the books of primary entry, the next phase in the accounting process is to prepare accounts in the general ledger. On the basis of journal entries, transactions are recorded in the ledger accounts. This process is also known as “posting” of journal entry. Periodically, accounts in the general ledger are balanced. For example, if in a particular account the total of the debit side comes to Rs 20, 000 and the total of the credit side comes to Rs 17, 000, the account shows a debit balance of Rs 3,000. Thus, a debit balance of Rs 3, 000 reflects that the total of the debits exceeds the total of the credits by Rs 3,000. The balances in ledger accounts at the end of accounting period are transferred to financial statements. The format of ledger account is as follows: Debit (Dr) Date

Credit (Cr) Particulars

Journal Folio

Amount Rs

Date

Particulars

Journal Folio

Amount Rs

Each ledger account has two sides—the debit side and credit side. Each of the side provides for date of posting, particulars (starts with “To” in case of debit side and “By” in case of credit side), journal folio number for cross reference and amount of transaction.

ILLUSTRATION 5.6 Using the information available in Illustration 5.2 prepare ledger accounts. Solution: In the books of Jay Traders: Ledger Cash Account Dr

Cr Date

Particulars

JF

Amount (Rs)

2012 st

1 April th

Date

Particulars

JF

Amount (Rs)

2012 To Capital

16 April To Sale

1,75,000 71,820

2,46,820

nd

2 April

By Bank

th

By Drawings

th

29 April

By loss by embezzlement

30th April

By Bal C/d

25 April

60,000 1,800 4,200 1,80,820 2,46,820

116 Financial Accounting Dr

Stock Account Date

Particulars

JF

Amount (Rs)

2012 st

1 April

Date

Cr. Particulars

JF

2012 To Capital

1,25,000

18th April

By Drawings

10,000

rd

23 April By Loss by Theft 30th April

6,500

By Bal C/d

1,08,500

1,25,000

Dr

1,25,000

Bank Account Date

Particulars

JF

Amount (Rs)

2012 st

1 April

Date

Cr Particulars

JF

Amount (Rs)

2012 To Cash

60,000

th

15 April To Sale

54,625

20th April To Sham

43,700

30th April To Bal C/d

th

11 April

By Purchase

2,07,270

nd

22 April By Ramesh

1,66,600

2,15,545 373,870

Dr

373,870

Purchase Account Date

Particulars

JF

Amount (Rs)

2012 st

1 April

Date

Cr. Particulars

JF

Amount (Rs)

2012 To Ramesh & Co.

1,70,000

th

11 April To Bank

30th April

By Bal C/d

3,81,500

2,07,270

To Disc. Recd.

4,230 3,81,500

Dr

3,81,500

Furniture Account Date

Particulars

JF

Amount (Rs)

2012 st

Amount (Rs)

1 April

Date

Cr. Particulars

JF

Amount (Rs)

2012 To Capital

1,10,000 30th April 1,10,000

By Bal C/d

1,10,000

Mechanics of Accounting

Dr

117

Sham Account Date

Particulars

JF

Amount (Rs)

2012

Cr.

Date

Particulars

JF

Amount (Rs)

2012

th

15 April To Sale

54,625

20th April

By Bank A/c

43,700

By Bad Debts A/c

10,925

54,625

Dr

54,625

Ramesh & Co. Account Date

Particulars

JF

Amount (Rs)

2012

Date

Cr. Particulars

JF

Amount (Rs)

2012

nd

22 April To Bank

1,66,600

To Discount

7th April

By Purchase

1,70,000

3,400 1,70,000

Dr

1,70,000

Capital Account Date

Particulars

JF

Amount (Rs)

Cr.

Date

Particulars

JF

Amount (Rs)

2012 th

30 April To Bal C/d

4,10,000 1st April

By Cash

1,75,000

By Stock

1,25,000

By Furniture

1,10,000 4,10,000

Dr

Discount Received Account Date

Particulars

JF

Amount (Rs)

Date 11th April

th

30 April To Bal C/d

7,630

Cr. Particulars

JF

By Purchase

Amount (Rs) 4,230

nd

22 April By Ramesh

3,400 7,630

Dr

Discount Allowed Account Date

Particulars

16th April To Sale

JF

Amount (Rs)

Date

3,780

30th April

Cr. Particulars

By Bal C/d

JF

Amount (Rs) 3,780

118 Financial Accounting Dr

Loss By Theft A/c Date

Particulars

JF

23rd April To Stock A/c

Dr

Amount (Rs)

Date

6,500

30th April

Cr Particulars

JF

By Bal C/d

Amount (Rs) 6,500

Loss By Embezzlement A/c Date

Particulars

JF

29th April To Cash A/c

Amount (Rs)

Date

4,200

30th April

Cr Particulars

JF

By Bal C/d

Amount (Rs) 4,200

4,200

Dr

Sales Account Date

Particulars

JF

30th April To Balance c/d

Amount (Rs) 1,84,850

Date 15th April th

16 April

Cr Particulars

JF

Amount (Rs)

By Bank

54,625

By Sham

54,625

By Cash A/c

71,820

By Discount Allowed

3,780 1,84,850

Dr

Bad Debts Account Date

Particulars

JF

16th April To Sham

Amount (Rs)

Date

10,925

30th April

Cr. Particulars

JF

By Balance c/d

Amount (Rs) 10,925

10,925

Dr

Drawings Account Date

Particulars

18th April To Stock A/c th

25 April To Cash

JF

Amount (Rs)

Date

10,000

30th April

Cr Particulars By Balance c/d

JF

Amount (Rs) 11,800

1,800 11,800

ILLUSTRATION 5.7 Pass the opening entry in the journal of Raj & Co. (as on 1st April, 2012) and post the same into the ledger: Cash at Bank: Rs 16,000 Land and Building: Rs 1,75,000 Prepaid Insurance: Rs 820 Loan from Y Ltd: Rs 30,000

Mechanics of Accounting

119

Solution: In the books of Raj & Co. Date

Particulars

LF

Dr Rs

Cr Rs

2012 Bank Land and Building Prepaid Insurance To Loan from Y Ltd. To Raj’s Capital A/c

Dr Dr Dr

16,000 1,75,000 820 30,000 1,61,820

(being the balance brought forward from last year)

Ledger of Raj & Co. Dr

Bank A/c Date

Particulars

J. F

Amount (Rs)

Cr. Date

Particulars

JF

Amount (Rs)

Particulars

JF

Amount (Rs)

Particulars

JF

Amount (Rs)

Particulars

JF

Amount (Rs)

2012 1st April

To Balance b/d

16,000

Dr

Land and Building A/c Date

Particulars

JF

Amount (Rs)

Date

Cr

2012 1st April

To Balance b/d

1,75,000

Dr

Prepaid Insurance A/c Date

Particulars

JF

Amount (Rs)

Date

Cr.

2012 1st April

To Balance b/d

820

Dr

Loan from Y Ltd A/c Date

Particulars

JF

Amount (Rs)

Date

Cr.

2012 st

1 April By Balance b/d

Dr

30,000

Raj’s Capital A/c Date

Particulars

JF

Amount (Rs)

Date

Cr Particulars

JF

Amount (Rs)

2012 st

1 April By Balance b/d

5,88,910

120 Financial Accounting

PREPARATION OF TRIAL BALANCE Objective 5 After balancing the ledger account, the next To summarise ledger balances step is the preparation of “Trial Balance”. A through trial balances trial balance is a list of all accounts with their balances. It is a statement which is prepared periodically, usually at the end of each month, which contains list of the ledger accounts at a specified date, showing their debit and credit (totals or balance). Trial balance is not an account. According to the double entry system of accounting, every entry should have same amounts of debit and credit. Therefore, the total of trial balance must tally. If the two sides of trial balance do not agree it indicates that the books of account are arithmetically incorrect. However tallying of trial balance is not a conclusive proof of accuracy. The standard form of a trial balance is as follows: Trial Balance of ____________ as on _____________ Particulars

Debit Total/ Balance Amount (Rs)

Credit Total/ Balance Amount (Rs)

Advantages of Preparing Trial Balance 1. A trial balance is prepared to check the arithmetic accuracy of books of accounts. 2. Trial balance contains a summary of ledger accounts balances on a particular date and it forms the basis for preparation of income statement and balance sheet.

ILLUSTRATION 5.8 Using solution (ledger balances) to Illustration 5.6, prepare trial balance. Solution: Trial Balance of Jay Traders Particulars

Debit Total/ Balance (Rs)

Cash

1,80,820

Stock Furniture Bank Overdraft Capital Sales

1,08,500 1,10,000

Credit Total/ Balance (Rs)

2,15,545 4,10,000 1,84,850 (Contd.)

Mechanics of Accounting Purchases Loss by Theft Loss by Embezzlements Discount Allowed Discount Received Bad Debts Drawings Total

121

3,81,500 6,500 4,200 3,780 7,630 10,925 11,800 8,18,025

8,18,025

ILLUSTRATION 5.9 From the following balances taken from the ledger of M/s Krishna Trading, prepare a trial balance as on 31st March, 2012. Particulars Cash Trade Debtors Rent Salaries Trade Creditors Insurance Petty Expenses Opening Stock Sales Purchases Capital Drawings Motor Vehicle Machinery Office Expenses Machinery Expenses

Amount (Rs) 5,600 20,000 5,500 12,000 18,700 4,000 3,000 20,000 2,65,000 1,80,000 1,05,900 10,000 65,000 54,000 2,950 5,000

Fuel and Lubricants Expenses

2,550

Solution: Trial Balance of M/s Krishna Trading As on 31st March, 2012 Particulars Cash Trade Debtors Rent

Debit Balance Amount (Rs)

Credit Balance Amount (Rs)

5,600 20,000 5,500 (Contd.)

122 Financial Accounting Salaries

12,000

Trade Creditors

18,700

Insurance

4,000

Petty Expenses

3,000

Opening Stock

20,000

Sales

2,65,000

Purchases

1,80,000

Capital

1,05,900

Drawings

10,000

Motor Vehicle

65,000

Machinery

54,000

Office Expenses

2,950

Machinery Expenses

5,000

Fuel and Lubricants Expenses

2,550

Total

3,89,600

3,89,600

There are certain errors that are disclosed by trial balance, but certain types of errors remain undetected. Thus, it is well known that the agreement of trial balance is not the conclusive proof of the accuracy of the books of accounts.

Errors Disclosed by a Trial Balance 1. 2. 3. 4. 5. 6. 7. 8. 9.

Omission in posting Posting on the wrong side of an account Posting of wrong amount Wrong totalling or balancing of ledger account Wrong totalling of subsidiary books An item posted twice Wrong totalling of trial balance Omission to post an amount in trial balance Missing of balances in the list of debtors or creditors

Errors shown by trial balance are avoided when accounting is done by using software. Hence, such errors are rare in today’s era. However, one needs to guard against other errors, as they may get unnoticed.

Mechanics of Accounting

123

ACCOUNTING ERRORS AND THEIR RECTIFICATION An accounting error is a non-fraudulent discrepancy in financial documentation. These errors may not be immediately traced but may be detected at much later stage. These are rectified as and when detected. Followings are classification of such errors: 1. Errors of Total Omission: If a transaction is not at all recorded in the books of original entry, both its debit and credit aspects would be omitted. The trial balance, therefore, shall not be affected. For example goods purchased from Milind for Rs 10,000. If the entry is not recorded in the purchase book at all, neither the purchases accounts will be debited nor will the Milind’s account be credited. So, the trial balance will tally. 2. Errors of principal: Such error arises because of lack of knowledge of principles of accountancy. It can be in any of the following ways: (a) Treating capital expenditure as revenue expenditure and vice versa (b) Treating capital income as revenue income and vice versa For instance, repairs of machinery for Rs 5,000 debited to Machinery A/c in this case—revenue expenditure has been treated as capital expenditure. Similarly, if building sold is credited to sales A/c, trial balance will be unaffected though principally wrong classification has been made of capital and revenue items. 3. Errors in the book(s) of Original Entry: The trial balance would be unaffected if an entry is in a wrong book of original entry or it is recorded in the proper subsidiary books but with a wrong amount. In both the cases, the trial balance would tally. For example, an item of credit purchases wrongly entered into the sales book will result into a wrong debit and a wrong credit. Similarly, if purchases of Rs 554 are wrongly entered into the purchase book as Rs 5,544 then both the purchases account and the account of the creditor, are affected to the same extent. Thus, the trial balance shall tally.

ILLUSTRATION 5.10 The following errors have been noted in the books of accounts: 1. 2. 3. 4.

Sales account credited with Rs 1,000 instead of Rs 5,000. Samir’s account debited with Rs 2,000 instead of Rs 3,000. in sales transaction. Repairs of machinery for Rs 1,000 credited to both repairs A/c and cash A/c. Krishan paid cash Rs 500 but his A/c has been wrongly credited with Rs 1,500.

Show the effect of the above errors on the trial balance. Also show the wrong, the correct and the rectification journal entries. Also prepare a suspense A/c.

124 Financial Accounting

Solution: Net Effect on Trial Balance S.No.

Particulars

Debit > Credit

Credit > Debit

1.

Sales account credited with Rs 1,000 instead of Rs. 5,000

4,000

2.

Samir’s account debited with Rs 2,000 instead of Rs 3,000

1,000

3.

Repairs of machinery for Rs 1,000 has been credited to repairs A/c wrongly but rightly credited to cash A/c

2,000

4.

Krishan’s A/c over credited by Rs 1,000

1,000

Total

4,000

4,000

Wrong Journal Entries Date

Particulars

Dr/Cr

1.

Debtors A/c

Dr

LF

Debit Amount Rs

Credit Amount Rs

5,000

To Sales A/c 2.

Samir A/c

1,000 Dr

2,000

To Sales A/c 3.

Repairs A/c

3,000 Dr

1,000

To Cash A/c 4.

Cash A/c

1,000 Dr

500

To Krishnan A/c

1,500

Correct Journal Entries Date

Particulars

Dr/Cr

LF

Debit Amount Rs

1.

Debtors A/c

Dr

5,000

2.

Samir A/c

Dr

3,000

To Sales A/c

5,000

To Sales A/c 3.

Repairs A/c

3,000 Dr

1,000

To Cash A/c 4.

Cash A/c To Krishnan A/c

Credit Amount Rs

1,000 Dr

500 500

Mechanics of Accounting

125

Rectification Journal Entries Date 1. 2. 3. 4.

Particulars

Dr/Cr

Suspense A/c To Sales A/c Samir A/c To Suspense A/c Repairs A/c To Suspense A/c Krishnan A/c

LF

Debit Amount Rs

Dr

4,000

Dr

1,000

Dr

2,000

Dr

1,000

Credit Amount Rs 4,000 1,000 2,000

To Suspense A/c

1,000

Suspense A/c Debit (Dr) Date 1.

Credit (Cr)

Particulars To Sales

Journal Folio

Amount Rs

Date

4,000

2nd 3rd 4th

Particulars By Samir By Repairs By Krishnan

4,000

Journal Folio

Amount Rs 1,000 2,000 1,000 4,000

BANK RECONCILIATION STATEMENT (BRS) Business entities maintains cash book to record bank transactions. If all the transactions that are entered in the cash book match with those in the bank statement there will not be any difference in the bank balance as per the cash book and bank statement. In practice this does not happen. Often the balances as per cash book and bank statement are different. So reconciliation becomes necessary. Bank reconciliation statement is a statement of that. It explains the reason for differences between the bank balance as per cash book and that as per bank statement, as on a particular day.

Reasons for differences The difference may arise because of the following reasons. 1. Cheques deposited but not cleared Bank takes time for cheque clearance. Usually, local cheques of other banks take 2–3 days while outstation cheques take 5–6 days for clearance. Due to this

126 Financial Accounting

collection lag, difference may arise in the balances shown by cash book and pass book. Example: Cheques worth Rs 5,000 are deposited on 06/08/2012 but not cleared till 09/08/2012. Bank balance as per cash book will increase by Rs 5,000 on 06/08/2012 whereas bank balance as per pass book will not change till the cheque is cleared on 09/08/2012. 2. Cheques issued but not presented for payments When payment is made by cheque, there Objective 6 may be lag in clearing of cheque due to To prepare bank reconciliation delay in presentation and collection of statement cheque. As soon as a cheque is issued, cash book is credited whereas bank debits parties account only when the cheque is cleared. Example: Cheque worth Rs 4,000 is issued on 05/08/2012 but not presented till 09/08/2012. On issue of cheques (05/08/2012), bank balance as per the cash book will decrease by Rs 4,000 whereas pass book balance will not change till they are presented for payments (09/08/2012). 3. Direct payments/collections by bank Sometimes, banks are given standing instruction for making certain payments, for example payment of life insurance premium. Receipts are directly credited to bank a/c. Such direct payments/receipts are not recorded in the cash book until the current account statement is received, or instruction is received from the paying party. 4. Dishonour of cheques Cheques deposited in the banks for collection are sometimes dishonoured. Bank debits the amount of dishonoured cheque to customer account along with dishonour penalty. No effect is given on the cash book about the dishonoured cheque until bank’s advice reaches the business entity who deposited the cheque for collection.

Preparing Reconciliation Statement Reconciliation can be made starting from one balance and sorting out the reasons for differences one after another till the other balance is reached. Let’s assume if one can start with balance as per cash book. All such transactions are to be added which have reduced the cash book bank balance and all such transactions should be deducted which have increased the bank balance as compared to the balance as per current account statement.

Mechanics of Accounting

EXHIBIT 5.1

127

Bank Reconciliation Statement (Starting with Cash Book Balance) Rs

Bank Balance as per Cash Book

Rs xxxx

Add: Cheques Issued but not Presented for Payment Direct Collections by Bank

xxxx

Direct Deposits by Debtors/Collection Agents

xxxx

Interest Credited by Bank

xxxx

Less: Cheques Deposited but not Cleared

xxxx

xxxx

Direct Payment by Bank

xxxx

Dishonoured Cheques and Related Charges

xxxx

Interest and Bank Charges

xxxx

Balance as per Pass Book

xxxx xxxx

BRS can also be prepared starting with pass book balance as per the following exhibit: EXHIBIT 5 2

Bank Reconciliation Statement Rs

Bank Balance as per Current Account Statement

Rs xxxx

Add: Cheques Deposited by not Cleared Direct Payments by Bank

xxxx

Dishonour of Cheques and Related Charges

xxxx

Interest and Bank Charges

xxxx

Less: Cheques Issued but not Presented for Payment

xxxx

Direct Collections by Banks

xxxx

Direct Deposits by Debtors/Collection Agents

xxxx

Interest Credited by Bank

xxxx

Bank Balance as per Cash book

xxxx

xxxx xxxx

ILLUSTRATION 5.11 Mr Brijesh, a sole-trader, found on 31st March Objective 7 To know computerised 2012 that bank balance as per cash book accounting and bank balance as per bank statement are different. He requests you to look into the matter. The following further information is available:

128 Financial Accounting

1. Bank balance as per cash book Bank balance as per bank statement 2. Cheques deposited but not cleared 3. Cheques issued but not debited in the bank statement 4. Direct payments by customers into bank account 5. Direct payments by bank: LIC premium against the policy taken on Mr Biren’s life Interest on term loan 6. Bank charges not recorded in the cash book 7. Cheques dishonoured but not reversed in the cash book

16,000 35,140 18,000 16,000 51,000 800 13,000 60 16,000

You are required to prepare a bank reconciliation statement Solution Particulars

Rs

Balance as per cash book

Rs 16,000

Add: Cheques issued but not deposited

16,000

Direct payment by customers

51,000

67,000

Less: Cheques deposited but not clear

18,000

Direct payment of LIC premium

800

Direct payment of term loan interest Bank charges Cheque dishonoured Balance as per pass book

13,000 60 16,000

47,860 35,140

COMPUTERISED ACCOUNTING Computerised accounting is a system which simplifies, integrates and streamlines transaction recording processes, cost-effectively and easily. It is designed to automate and integrate recording for all the business operations, such as sales, finance, purchase, inventory and manufacturing. Computerised accounting facilitates better control over the day-to-day business operations by providing access to latest, accurate and relevant information. Most of the human errors are removed from the equation since the calculations are done via machines that simply cannot get anything wrong except by the user’s fault. It can provide highly integrated application that transforms the business processes with its performance enhancing features which encompass accounting, inventory, reporting and statutory processes.

Mechanics of Accounting

129

The main advantages of a computerised accounting system are listed below: ■

■

■

■

■

■

■

■

■

■

■

■

■

■

Speed Computerised accounting saves time as it records transaction with better speed than manual accounting process. Easy and Accurate Data Entry Data entry into the computer with its formatted screens and built-in databases of customers and supplier details and stock records can be carried out far more quickly than any manual processing. Automatic Document Production Documents like invoices, credit notes, purchase orders, printing statements and payroll documents are all prepared automatically, with high speed and accuracy. Accuracy There is less room for errors as only one accounting entry is needed for each transaction rather than two (or three) for a manual system. Real Time Information The accounting records are automatically updated and so account balances (e.g. customer accounts) will always be up-to-date. Availability of Information The data is instantly available and can be made available to different users in different locations at the same time. Management Information Reports can be produced which will help management monitor and control the business, for example the age-wise debtors analysis will show which customer accounts are overdue, trial balance, trading and profit and loss account and balance sheet. Tax Compliance The automatic creation of figures for the regular GST/VAT returns. Legibility The onscreen and printed data should always be legible and so will avoid errors caused by poor figures. Efficiency Better use is made of resources and time; cash flow should improve through better debt collection and inventory control. Staff Motivation The system will require staff to be trained to use new skills, which can make them feel more motivated. Further to this with many “off-theshelf” packages like MYOB the training can be outsourced and thus making a particular staff member less critical of business operations. Physical fatigue is minimised. Cost Savings Computerised accounting programs reduce staff time doing accounts and reduce audit expenses as records are neat, up-to-date and accurate. Reduce Frustration Management can be on top of their accounts and thus reduce stress levels associated with what is not known. The Ability to Deal in Multiple Currencies Easily Many computerised accounting packages now allow a business to trade in multiple currencies with ease. Problems associated with exchange rate changes are minimised.

130 Financial Accounting

A typical computerised accounting package will offer a number of different facilities. These include: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

On-screen input and printout of sales invoices Automatic updating of customer accounts in the sales ledger Recording of suppliers’ invoices Automatic updating of suppliers’ accounts in the purchases ledger Recording of bank receipts Making payments to suppliers and for expenses Automatic updating of the general ledger Automatic adjustment of stock records Integration of a business database with the accounting program Automatic calculation of payroll and associated entries Tax and regulatory compliances

Data required for computerised accounting program can provide instant reports for management, for example: ■

■ ■ ■ ■ ■

Aged debtors’ summary—A summary of customer accounts showing overdue amounts Trial balance, trading and profit and loss account and balance sheet Stock valuation Sales analysis Budget analysis and variance analysis Payroll analysis

Manual Accounting vs Computerised Accounting The following example illustrates difference between manual and computerised accounting process.

Example On 15th June 2006, furniture was purchased for Rs 12,000. Journal entry in manual accounting is as follows: Date th

15 June

Particulars Furniture A/c To Cash A/c (Being Furniture purchased for Cash)

Ledger Folio Dr

Debit (Rs)

Credit (Rs)

12,000 12,000

Mechanics of Accounting

131

Further it is required to be Posted to ledger accounts Summerised to financial statement Transferred to income statement and/or balance sheet

■ ■ ■

In case of computerised accounting, it will be recorded as shown below:

In case of computerised accounting further process is automatic and it directly gives balance sheet as output to ascertain financial position.

SUMMARY ➤

An account is a statement that shows all transaction related to a particular party, asset, liability, income or expense.

➤

Account related to some party like individual, bank, firm, company, etc., is known as personal account.

➤

Real accounts are related to assets. Anything of material value or usefulness that is owned by a person or company is termed as asset.

➤

The accounts for recording income, expenses, losses and gains are classified as nominal accounts.

➤

Double entry system is a scientific system of recording transactions. According to this system, every transaction has two-fold aspects (debit and credit) and both these aspects need to be recorded in the books of accounts.

➤

Accounting cycle refers to the process which starts with recording of opening entries in the journal and ends with the preparation of financial statements.

➤

The transactions are recorded in the books of accounts is called journal entry. The process of recording transaction is called journalising.

132 Financial Accounting ➤

Business transactions can be classified as those transactions relating to purchase, sales, cash, etc. It is convenient to record these transactions in a separate register for each such class of transactions. Such registers are books of original entry and are known as subsidiary books.

➤

After recording transaction in the books of primary entry, the next phase in the accounting process is to prepare accounts in the general ledger. On the basis of journal entries, transactions are recorded in the ledger accounts. This process is also known as posting of journal entry.

➤

A trial balance is a list of all accounts with their balances. It is a statement which is prepared periodically, usually at the end of each month, which contains list of the ledger accounts at a specified date, showing their debit and credit (totals or balance).

➤

An accounting error is a non-fraudulent discrepancy in financial documentation. These errors may not be immediately traced but may be detected at much later stage. These are rectified as and when detected.

➤

Bank reconciliation statement is a statement that explains the reason for differences between bank balance as per the cash book and that as per bank statement, as on a particular day.

➤

Computerised accounting is a system which simplifies, integrates and streamlines transaction recording processes, cost-effectively and easily. It is designed to automate and integrate recording for all the business operations, such as sales, finance, purchase, inventory and manufacturing.

MULTIPLE CHOICE QUESTIONS* 1. A cash book (a) Is a journal (b) Is a ledger account (c) Servers the dual purpose of journal and ledger accounts (d) None of the above 2. A purchase day book is used to record (a) Only credit purchase of stock and fixed assets (b) Only credit purchase of stock-in-trade (c) Credit as well as cash purchases (d) None of the above

*

Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

Mechanics of Accounting

133

3. Dishonouring of cheques received from debtors are taken in books through (a) Sales day book (b) Journal proper (c) Cash book (d) None of the above 4. Trial balance fails to disclose errors in (a) Casting the book of subsidiary records (b) Balancing the account (c) Posting from the book of subsidiary record to the ledger (d) None of the above 5. A wholesaler dealing with stationery items purchases a motor van for Rs 1,00,000 for business purpose and issues a cheque to the supplier. As per the double entry system of accounting, he will (a) Debit motor van account and credit cash account (b) Debit motor van account and credit bank account (c) Debit profit and loss account and credit bank account (d) Debit profit and loss account and credit cash account 6. A journal proper records (a) The transactions related to credit purchase and sales (b) The transactions that are not recorded in other subsidiary books (c) The transactions related to purchase and sale of fixed assets (d) Both (b) and (c) 7. A purchase of machine for cash should be debited to (a) Cash account (b) Machine account (c) Purchase account (d) None of these 8. Cash withdrawn by the proprietor should be credited to (a) Drawings account (b) Capital account (c) Profit and loss account (d) Cash account 9. The book in which all accounts are maintained is known as (a) Cash book (b) Journal (c) Purchase Book (d) Ledger 10. When a firm maintains a cash book, it need not maintain (a) Journal proper

134 Financial Accounting

11.

12.

13.

14.

15.

16.

(b) Purchase book (c) Sales book (d) Cash account Double column cash book records (a) Only cash transaction (b) Cash and bank transaction (c) Only credit transaction (d) Purchase and sale transaction Credit balance of bank account in cash book shows (a) Overdraft (b) Cash deposited in our bank (c) Cash withdrawn from bank (d) None of these If wages paid for installation of new machinery is debited to wages account, it is (a) An error of commission (b) An error of principle (c) A compensating error (d) An error of omission A trial balance is prepared (a) After preparation of financial statement (b) After recording transaction in subsidiary books (c) After posting to ledger is complete (d) After posting to ledger is complete and accounts are balanced If wages paid for installation of new machinery are debited to wages account, it is (a) An error of commission (b) An error of principle (c) A compensating error (d) An error of omission A bank reconciliation statement is mainly prepared for (a) Reconciling the cash balance of the cash book (b) Reconciling the difference between the bank balance shown by the cash book and bank passbook (c) Both (a) and (b) (d) None of these

THEORY QUESTIONS 1. What are the types of accounts? Give appropriate examples.

Mechanics of Accounting

2. 3. 4. 5. 6. 7. 8.

135

Write a note on double entry book keeping system. What are the rules for debit and credit? Explain accounting cycle in brief. Distinguish between journal and ledger. What is trial balance? Explain its features. What are the errors in trial balance? Explain with appropriate examples. Explain the necessity of preparing bank reconciliation statement.

PRACTICAL PROBLEMS Level 1: Easy 1. M/s VK Pharmacy owned by Vivek had the following assets and liabilities as on 1st April, 2011: Cash Rs 5,000 Bank Rs 35,000 Stock Rs 55,000 Furniture Rs 20,000 Plant and machinery Rs 65,000 Land and building Rs 1,60,000 Sundry debtors Rs 30,000 Sundry creditors Rs 95,000 Bills payable Rs 25,000 Loan A/c Rs 85,000 Pass the necessary opening entry. 2. An accountant provides you with the following trial balance. In case you find it incorrect, redraft it. Debit Heads of Accounts Opening Stock

Amount (Rs)

Credit Heads of Account

Amount Rs

5,000

Furniture

15,000

Machinery

20,000

Salaries

5,000

Capital

30,000

Creditors

20,000

Sales

20,000

Discount Allowed

1,000

Debtors

14,000

Purchases

10,000

Total

80,000

60,000 Difference

20,000

136 Financial Accounting

3. Pass journal entries for the following transactions: Umesh started business with: Cash Rs 10,00,000 Goods Rs 2,00,000 Purchased building for cash Rs 4, 00,000 Purchased goods from Himanshu Rs 1,00,000 Sold goods to Ashmita (cost Rs 50,000) Rs 72, 000 Paid insurance premium Rs 6,000 Rent outstanding Rs 10,000 Depreciation on building Rs 16,000 Cash withdrawn for personal use Rs 40,000 Rent received in advance Rs 10,000 Cash paid to Hamu on account Rs 40,000 Cash received from Asha Rs 60,000 4. M/s Prashanna Readymade purchased the following items during the month of December, 2011: Purchased from M/s Goodwill Furnitures 4th December 100 shirts @ Rs 100 per shirt 25 trousers @ Rs 200 per trouser Less 10% discount th 10 December Purchased from M/s Naresh Motors One Maruti car for Rs 70,000 One scooter for Rs 7,000 th 15 December Cash purchases from Deepak Textiles 2 trousers @ Rs 250 each 12 T-shirts @ Rs 100 each Less 15% trade discount and 5% cash discount Prepare purchases book. 5. M/s Femina, who is dealer in readymade garments, sold the following items during the month of December 2011: Sold to M/s Style Corner 4th December 100 shirts @ Rs 80 per shirt 100 trousers @ Rs 300 per trouser Less trade discount 10% th 11 December Sold to M/s Mens Corner 140 ladies suits @ Rs 200 per suit 175 jeans @ Rs 250 per jean 1 second hand scooter for Rs 20,000

Mechanics of Accounting

14th December

137

Cash sales to customers 120 T-shirts @ Rs 100 per T-shirt 60 jeans @ Rs 230 per jean 80 ladies suits @ Rs 190 per suit 40 trousers @ Rs 280 per trouser Prepare sales book.

Level 2: Standard 6. An accountant provides you with the following trial balance. In case you find it incorrect, redraft it. Debit Heads of Accounts Opening Stock

Amount (Rs) 9,700

Machinery

25,000

Bank Overdraft

5,800

Discount Allowed

500

Debtors

15,000

Salaries

2,400

Credit Heads of Account

Amount Rs

Furniture

12,500

Capital

39,450

Creditors

12,000

Sales

35,800

Drawings Insurance Premium

850

Purchases

30,500

Investment

3,000

Interest on Loan

200

Interest on Investments

300

Returns Inwards

100

Returns Outwards

150

Carriage Inwards

600

Carriage Outwards

300

Advertisements

850

Total

93,500

Difference

20,000

Loan from Z

2,000 10,000

1,13,500

7. The transactions of the business for April are as follows: 1st April 2011 3rd

Started Business of Machinery Repairs by Depositing Rs 30,000 in a Bank Account in the Name of the Ganesh Equipments for 2,000 shares of Rs 15 each in the company

5th

Paid Two Months’ Rent in Advance for a Shop—Rs 4,000 by Cheque

6th

Purchased Machinery from Ram Tools Pvt Ltd for Rs 15,000. Amount paid by Cheque (Contd.)

138 Financial Accounting 8th

Purchased Goods on Credit from Ramesh & Co Rs 8,500 th

11

Machinery Repairing Charges received from Alok Tools & Equipment by Cheque Rs 23,500

15th

Advertisement Expenses Rs 1,500 paid to Karishma Yellow Pages through Bank

18th

Received Rs 14,800 by Cheque for Machinery Maintenance

th

20

Billed to Customers for Work Done (Machinery Repairing ) on Credit Rs 25,000

22nd

Paid Cheque to Mr Sham for Salaries Rs 3,000

th

Paid Electricity Charges, Rs 350 by Cheque

th

Received Partial Payment from Customers Billed on 20th April, Rs 15,000 by Cheque

25

28

You are required to: 1.

Prepare journal entries for the above transactions.

2.

Post the entries from the journal to the ledger accounts.

3.

Prepare a trial balance.

8. Pass a journal entry for each of the following: April 2012 2nd

Purchased Vehicle for Delivering Goods for Rs 60,000 and paid for one time RTO Tax of Rs 12,000 Both Amounts paid by Cheque

5th

Received Loan from Ramesh Finance Ltd for Rs 1,50,000 by Cheque, Interest @ 12% p.a.

8th

Purchased Goods from Sukanta Traders worth Rs 80,000 at 10% Trade Discount and 5% Cash Discount and Half of the Amount paid Less 5% Cash Discount on Rs 72,000 by Cheque

10th

Goods Sold to M/s Paresh & Co worth Rs 50,500 on Credit

15th

Goods worth Rs 1,00,000 are Insured against Loss by Floods. Actual Loss caused by Floods is Rs 60,000 The Insurance Company admits the Claim for Rs 48,000 and pays Claim Amount by Cheque

18th

Damaged (shop spoiled) Goods worth Rs 10,000 are Sold for Cash for a Loss of Rs 7,000

20th

Old Machine sold to Mr Rakesh for Rs 80,000 and Amount received by Cheque. Book Value of Machine was Rs 90,000

22nd

Purchased a new Machine on Credit for Rs 1,35,000 from Swaraj Machine Tools Ltd

25th

Amount paid by Cheque of Rs 1,35,000 to Swaraj Machine Tools Ltd

28th

Received a Bank Draft of Rs 50,000 from M/s Paresh & Co

Mechanics of Accounting

139

9. Journalise the following transactions of M/s Dilip and Co for the month of March 2012: Balances on 1st March, 2012 Cash—Rs14,000 Bank—Rs 40,000 Stock—Rs 30,000 Furniture—Rs 10,000 Building—Rs 80,000 Debtors: A—Rs 6,000 B —Rs 10,000 Bank loan—Rs 14,000 Creditors: X—Rs 14,000 Y—Rs 16,000 Transactions during the month of March 2012 were as follows: March 2nd Received Rs 5,600 cash from Mr A towards full and final settlement Purchased goods of the list price Rs 20,000 at 10% discount on credit from 6th Mr Z Sold goods to C on credit Rs 16,000 7th th C pays Rs 14,400 after getting 10% discount for prompt payment 11 th Salaries paid in cash Rs 4,000 15 th Interest on bank loan Rs 1,400 debited to the current account of the 18 business enterprise th Goods costing Rs 2,000 distributed as free samples 20 Cash withdrawn by Ramesh for personal use Rs 4,000 25th th Paid Rs 12,000 to X towards full and final settlement of his account 30 st Cash sales at list price Rs 10,000. Trade discount allowed Rs 1,000 31 10. Prepare ledger accounts on the basis of journal entries recorded for transactions given in Exercise 7. 11. There was an error in records on 31st March 2011 and the difference in books was carried to a suspense account. On going through the books, you find that: 1. Rs 10,800 recovered from Mr A was posted to the debit of his account. 2. Rs 2,000 being purchases return were posted to the debit of purchases account. 3. Discount received Rs 4,000 was posted to the debit of discount account. 4. Rs 5,480 paid for repairs to motor car was debited to motor car account as Rs 3,480. 5. Rs 8,000 paid to B was debited to A’s account.

140 Financial Accounting

Give journal entries to rectify the above error and ascertain the amount transferred to suspense account on 31st March 2011, assuming that the suspense account is balanced after the above corrections. 12. Prepare a cash book with cash and discount column from the following information for the month of March 2012: Rs March, 2012 1st 3rd 5th 7th 9th 11th 14th 15th 16th 18th 20th 22nd 24th 25th 28th 31st

Cash in Hand Paid to Ramesh towards Final Settlement of Rs 12,000 Cash Sales Cash Purchases Salaries Paid Telephone Bill Paid Credit Purchases from X Credit Sales to A Received from A towards Final Settlement Stationery Purchased Speed-post Charges Goods Received by V.P.P. & Paid Paid to X towards Full and Final Settlement Furniture of List Price purchased at 10% Trade Discount Tuition Fees Paid Paid for an Advertisement in Newspaper

70,000 20,000 24,000 30,000 8,000 2,000 20,000 20,000 19,000 1,000 1,000 2,000 18,000 20,000 4,000 1,000

Level 3: Expert 13. A book-keeper finds that the trial balance is out by excess debit of Rs 250. He puts the difference to a newly opened suspense account. Later on, he detects the following errors: 1. Goods worth Rs 7,500 purchased from Raj, but entered in the sales book. 2. Received a promissory note for Rs 12,500 from Arman, but entered in the bills payable book. 3. An item of Rs 1,750 relating to prepaid rent account was omitted to be brought forward. 4. An item of Rs 1,000 in respect of purchase returns to Rohan had been wrongly entered in the purchases book. 5. Rs 2,500 paid to Harish against acceptance was debited to Harendra. 6. A bill was received for repairs of furniture for Rs 1,250. The amount was debited to furniture account. Pass journal entries to rectify the above errors and prepare the suspense account. 14. Journalise the following transactions in the books of Laxmi Traders. Post them to the ledger and find out the balance.

Mechanics of Accounting

141

Debit Balance on 1st April, 2012: Cash in hand Rs 22,000 Cash at Bank Rs 1,05,000 Stock of goods Rs 50,000 Furniture Rs 28,000 Building Rs 60,000 Sundry debtors: Sham Industries Rs 22,000 Rajesh Traders Rs 15,000 Rajani Sales Rs 18,000 Credit Balances on 1st April, 2011 Sundry creditors: Sonal Trading Co Rs 19,000 Loan from Ashok Finance Rs 35,000 Outstanding Wages Rs 2,000 The following were further transactions in the month of April 2011: April, 2011 1st Purchased Goods in Cash worth Rs 25,000 for each less 10% Trade Discount and 2% Cash Discount rd 3 Received Cash of Rs 21,000 from Sham Industries and Allowed him Rs 1,000 as Discount th 5 Purchased Goods from Nilesh Traders Rs 35,000 8th Purchased Plant from Ganesh & Co Rs 20,000 and paid Rs 200 as Carriage charges for transporting the Plant to the Factory and Another Rs 500 as Installation Charges 9th Sold Goods to Gauri Trading on Credit Rs 5,200 11th Gauri Trading became an Insolvent and could pay only 50 paise in a rupee by Cash th 15 Sold Goods to Soham Traders for Cash Rs 18,600 20th Paid Cash for Salary to Ratan Rs 4,000 22nd Amount paid by Cash of Rs 17,600 to Sonal Trading Co towards Full and Final Settlement 25th Interest Received from Rajani Sales Rs 300 in Cash 28th Paid Cash to Ashok Finance for Interest on Loan Rs 600 30th Sold Goods in Cash of Rs 6,700 Sold Goods to Proprietor Selling Price Rs 1,450, Cost Price Rs 1,200 Outstanding Wages of Last Month has been paid and Wages accrued during the month is Rs 3,500 out of which Rs 1,500 has been paid 15. Record the following transactions of M/s Vishal Traders in journal. Post them to ledger and prepare the trial balance.

142 Financial Accounting Month April

Date st

1

2012

Particulars Assets : Cash-in-Hand Cash-at-Bank Stock of Goods Plant and Machinery Furniture and Fixtures Customer A/c Keshav & Co Customer A/c Madhav & Co Liabilities: Loan from Geeta Fincorp Ltd. Amount Due to Rajesh & Co (Supplier A/c )

Amount (Rs) 1,200 25,500 5,000 25,000 8,500 2,500 9,800 15,000 8,500

3rd

Purchased Goods on Credit from Ravindra & Co

4,800

5th

Sold Goods for Cash to Hari Kirana

5,500

7

th

Sold Goods on Credit to Sham General Stores

18,500

8

th

Received Cheque from Sham General Stores towards Full and Final Settlement.

18,200

10th

Paid Amount by Cheque to Rajesh & Co

8,500

Payment made to Ravindra & Co by Cheque (Ravindra & Co. allowed Discount Rs 300)

4,500

12th

Old Furniture Sold to Mr Prakash in Cash (Book Value Rs 1,600)

1,050

15th

Received Cheque from Keshav & Co deposited in Bank

2,000

16th

Paid Cash for Repairs

17th

Bought Goods from Rajan Sales on Credit

10

th

18

th

Paid Cash for Expenses of Carriage

18

th

Paid Cheque to Rajan Sales of Rs 17,000 and Discount Allowed by him Rs 600 towards Full Settlement of A/c

24th

Withdrawn Cash from Bank

25th

Paid Cash for Expenses of Printing and Stationery

650 17,600 1,250 17,000 2,500 550

25

th

Paid Municipal Taxes by Cheque

1,300

27

th

Paid for Advertisements by Cheque

1,800

28

th

Sold Old Newspapers Amount Received in Cash

350

29th

Paid Rent by Cheque

2,000

29th

Paid Salaries for the Month by Cheque

2,500

30

th

Drawn by Vishal for Personal Use

1,600

30

th

Interest for the Month of April Unpaid Fixed Assets are to be Depreciated by 10% pa Balance Receivable from Keshav & Co is considered as Bad Debts

30th

150

Mechanics of Accounting

143

16. Prepare a three-column cash book for the following (March 2012): March, 2012 1st Cash in Hand Rs 5,40,000 2nd Cash at Bank Rs 4,50,000 3rd Cash Sales Deposited in Bank Rs 18,000 5th Amount Deposited by a Customer Directly in Bank Rs 27,000 6th Sold Goods to Dhiraj for Rs 54,000 7th Deposited Cash for Opening a Fixed Deposit Account Rs 90,000 8th Received a Cheque from Jagannath for Rs 9,000 Discount Allowed Rs 600 th 10 Paid to Vinod by Cheque Rs 27,000 11th Goods Returned by Dhiraj Rs 9,000 12th Interest Allowed by Bank Rs 18,000 13th Cheque Received from Jagannath is Dishonoured. Bank charges Rs 30 for Dishonour of the Cheque th 14 A Bill Receivable for Rs 90,000 Discounted from Bank at 10% th 16 Received a Cheque from Dhiraj for Rs 42,000 towards Full and Final Settlement of his Account th 18 Withdrew from Bank for paying Medical Expenses of the Owner for Rs 18,000 th 19 Dhiraj Deposited Cheque in Bank 20th Purchased Building and payment made by Cheque Rs 6,00,000 21st Bad Debts Recovered Rs 6,000 25th An Insolvent Debtor pays 40% of Rs 30,000 due from him

RESEARCH ASSIGNMENTS Visit the website of any company providing various software solutions for computerised accounting and study different softwares available to simplify the accounting process. Collect details on computerised accounting process. Suggested websites: ■

Sapphire Systems (http://www.sapphiresystems.com/sap-business-one/ thesolution/finance.htm)

■

Tally Solutions (http://www.tallysolutions.com/website/html/index.php)

144 Financial Accounting

INTERPRETING FINANCIAL REPORTS The following is the financial statement of Crompton Greaves Ltd. for the financial year ending 31st March 2012:. (Figures in Rs lakhs) March 2012 Sources of Funds/Liabilities Equity Share Capital Reserves Secured Loans Unsecured Loans Total Liabilities

128 1,622 14 13 1,777

Application of Funds/Assets Gross Block Less: Accum. Depreciation Net Block Investments Inventories Sundry Debtors Cash and Bank Balance Total Current Assets Current Liabilities Total Assets Sales Turnover Interest Paid

1,172 638 534 1,149 304 1,213 112 1,629 1,535 1,777 5,628 20

Cash flow statement for the year ended March 2012 Cash Flow from Operating Activities Increase in Reserves

540

Profit after Tax

540

Add: Depreciation

91

Add: Interest Paid

21 651

Adjustment in Working Capital Less: Increase in Inventories

–102

Add: Decrease in Debtors

189

Add: Increase in Current Liabilities

100

Net Cash Flow from Operating Activities

838 (Contd.)

Mechanics of Accounting

145

Cash Flow From Investing Activities Purchases of Asset

–433

Purchase of Investment

–301

Net Cash Flow from Investing Activities

−734

Cash Flow from Financing Activities Issue of Equity Shares

172

Secured Loan Taken

2

Unsecured Loan Repayment

–8

Interest Paid

–21

Net Cash Flow from Financing Activities

145

Net Increase in Cash

250

Cash at the Beginning

112

Cash at the End

362

You are required to pass journal entries for the transactions during 2011−12, post them into ledger accounts and prepare Trial balance and Balance sheet as on March, 2012.

BUSINESS CASES Case 1* Mr Jatin opened Mr Mayank’s diary and showed that he had recorded the following transactions: 3/4

Cash Sales Rs 6,000 Purchase of Rs 8,000 from Mr Ram

7/4

Credit Sales Rs 20,000 to Mr Laxman

11/4

Cash Sales Rs 12,000

14/4

Cash Purchase Rs 10,000

16/4

Credit Sales Rs 30,000 to Mr Nakul

19/4

Office expenses Rs 5,000 paid in Cash

20/4

Rs 10,000 paid to Raghu

24/4

Cash Sales Rs 6,000

26/4

Cash Purchase Rs 10,000

Mr Jatin told Mr Mayank that though his records are useful, they are to be recorded in appropriate manner to ascertain financial position. *

Continued from the chapter-opening case, Let us Set the Stage . . .

146 Financial Accounting

Case 2 Mr Murliprasad, a recent pass out from the IIM, started his own venture InfoTechno as a retail store for selling electronic items of different brands. He started his first store in Bangalore. This being a high investment and ambitious project he raised a loan of Rs 20,00,000 from a bank financing venture capital @ 10% pa and also contributed Rs 10,00,000 from his own savings. He had hired store at a rent of Rs 15,000 pm. He maintained his own records and provides you with the following details of the transactions that took place during the first year of his business: ■ ■ ■

■ ■

■ ■ ■

He hired three employees at a monthly salary of Rs 10,000 each He took fire insurance policy and paid a premium of Rs 1,200 pm He had purchased his inventories for Rs 6,00,000 by cash payment and Rs 16,00,000 on credit basis out of which Rs 7,00,000 was still payable at the end of the year His cash sales during the year amounted to Rs 10,00,000 His credit sales amounted to Rs 20,00,000 out of which Rs 9,00,000 was receivable at the end of the year He paid electricity charges of Rs 36,000 during the year He also incurred miscellaneous expenses amounting to Rs 25,000 during the year Two of his employees were paid on the last day of the month whereas one of them was paid on 10th of the next month

This being his first year of business he has not opted for computerised accounting and he requests you to suggest him proper accounting procedures that he should follow and also advise him about the status of his financial position at the end of first year of his business.

Fixed Assets and Depreciation Accounting

Learning Objectives After studying this chapter, you will be able to ❖

Understand fixed assets

❖

Understand depreciation and its causes

❖

Compute cost of fixed assets

❖

Know various methods of depreciation

❖

Pass entries for fixed assets and depreciation

❖

Understand impairment of assets

6

Fixed Assets and Depreciation Accounting

149

LET US SET THE STAGE . . . Khelia Ram is a small manufacturer of toys. His annual turnover in the financial year 2011–12 was Rs 15 lakh with costs of Rs 13 lakh. Business prospects were very good. Due to robust demand, he thought of adding new machinery by spending Rs 5 lakh. New machinery was expected to have lifespan of 5 years and was expected to result in increased production and sales of Rs 6 lakh p.a. by incurring additional costs of Rs 4 lakh p.a. But he was worried that the business will become loss making during the financial year 2011–12 due to this additional machinery cost of Rs 5 lakh. Khelia Ram is confused on buying new machine. Can you help Khelia Ram by making current and projected income statement?

INTRODUCTION Objective 1 Any asset which is intended to be used for To understand fixed assets business and not intended to be processed or sold, is termed as fixed asset. Classification of an asset as fixed asset depends on the purpose for which it is held. For example, the land on which factory is proposed to be built is a fixed asset whereas similar piece of land purchased for resale is considered as current asset. Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business. —AS-10 Property, plant and equipment are tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period. —IAS-16 Fixed assets are classified as: (a) tangible and (b) intangible (Figure 6.1).

FIGURE 6.1

Fixed Assets

150 Financial Accounting

(a) Tangible Assets: These are the fixed assets that have physical existence and can be seen and felt. They include land, buildings, plant and machinery, vehicles, etc.

(b) Intangible Assets: Unlike tangible assets, these have no physical existence. However, they represent legal rights or economic benefits. Trademarks, patents, logo, software, franchise copyrights, copyright and goodwill are examples of intangible assets. An intangible asset is an identifiable non-monetary asset without any physical substance. (IAS-38)

COST OF FIXED ASSETS Objective 2 The cost of fixed asset comprises its purchase To compute cost of fixed assets price and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. The cost of an item of property, plant and equipment comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates. (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. (c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. —(IAS-16)

Fixed Assets and Depreciation Accounting

151

The recognition of an item as an intangible asset requires an entity to demonstrate that the item meets: (a) the definition of an intangible asset; and (b) the recognition criteria This requirement applies to costs incurred initially to acquire or internally generate an intangible asset and those incurred subsequently to add to, replace part of, or service it. An asset meets the identifiability criterion in the definition of an intangible asset when it: (a) is separable, i.e. it is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. An intangible asset shall be recognised if and only if: (a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and (b) the cost of the asset can be measured reliably. —(IAS-38) Examples of directly attributable costs are: (i) (ii) (iii) (iv) (v) (vi)

Site preparation Initial delivery and handling costs Installation cost, such as special foundations for plant Professional fees like fees of architects and engineers Taxes like import duties, Value Added Tax (VAT), octroi Carriage inward/transportation charges for bringing the assets to site

Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses are specifically attributable to construction of a project or to the acquisition of a fixed asset or bringing it to its working condition, may be included as part of the cost of the construction project or as a part of the cost of the fixed asset. The expenditure incurred on start-up and commissioning of the project is capitalised as the construction cost. However, the expenditure incurred after the plant has begun commercial production, i.e. production intended for sale is not capitalised and is treated as revenue expenditure. When a fixed asset is acquired in exchange for another asset, its cost is usually determined by reference to the fair market value of the assets given as consideration. It may be appropriate to consider the fair market value of the asset acquired if this is more clearly evident. When a fixed asset is acquired in exchange for shares or other securities

152 Financial Accounting

in the enterprise, it is usually recorded at its fair market value, or the fair market value of the securities issued, whichever is more clearly evident. As defined by AS 10 Fair Market Value is “the price that would be agreed to in an open and unrestricted market, between knowledgeable and willing parties dealing at arm’s length, who are fully informed and are not under any compulsion to transact.” An alternative accounting treatment that is sometimes used for an exchange of assets, particularly when the assets exchanged are similar, is to record the asset acquired at the net book value of the asset given up. In such case an adjustment is made for any balancing receipt or payment of cash or other consideration. Only expenditure that increases the future benefits from the existing asset beyond its previously assessed standard of performance is included in the gross book value, for example an increase in capacity. The cost of an addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is usually added to its gross book value. Any addition or extension, which has a separate identity and is capable of being used after the existing asset is disposed of, is accounted for separately. Let us understand calculation of cost of fixed assets with the help of following illustration:

ILLUSTRATION 6.1 M/s Shyam Industries acquires a machine; details of which are as follows: List Price Rs 40,000 Trade Discount Rs 1,500 Value Added Tax (VAT) Rs 8,000 Transit Insurance Rs 240 Freight-Inward Rs 800 Annual Maintenance Cost Rs 5,500 Installation Charges Rs 2,400 Estimated Scrap Value Rs 3,800 Calculate cost of acquisition of machine. Solution: List Price Less: Trade Discount Net Price Add: VAT Transit Insurance Freight Installation Charges Cost of Acquisition

Rs 40,000 1,500 38,500 8,000 240 800 2,400 49,940

Fixed Assets and Depreciation Accounting

153

DEPRECIATION Depreciation may be defined as gradual and continuous decline in the value of fixed assets due to usage, passage of time and/or obsolescence.

Objective 3 Understand Depreciation and its causes

Depreciation is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets less salvage (if any) over the estimated useful life in a systematic and rational manner. It is a process of allocation and not of valuation (adapted from AICPA). The use of the term depreciation should be avoided in connection with the valuation procedure for securities and investments and is not dependent on the amount of profit earned. “Depreciation is a measure of wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation is allocated so as to change a fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined.” —AS-10 Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. —IAS-16 Depletion is the process of measuring the exhaustion of natural resources such as mines. The term “amortisation” is used for recording the writing off intangible assets like patents, copyrights, leasehold properties, trademarks. It may be noted that all the three terms, i.e. depreciation, depletion and amortisation are slightly different, but there is a general tendency to use the term depreciation even for describing the depletion and amortisation as well (AICPA). Depreciation Tangible assets like machinery, vehicles

Amortisation Exhaustive assets like mines

Depletion Intangible assets like goodwill, patents

Causes of Depreciation Following are the causes of depreciation: 1. Wear and Tear: Tangible fixed assets (like building, machinery) are worn or torn out on account of use of an asset, strain, weathering out, poor maintenance,

154 Financial Accounting

improper handling, etc. Tangible fixed assets are bound to lose value on account of wear and tear. 2. Effluxion of Time: Fixed assets decrease in the value with the passage of time. It is applicable to both tangible assets like vehicles, buildings, equipments and intangible assets like leasehold properties, copyright, patents. 3. Obsolescence: Fixed assets lose value on account of obsolescence which is caused by new inventions, technological improvements, loss of demand due to change in fashion, tastes or habits of consumers. It reduces the economic life of assets. Assets like computers, mobile phones, patents, software have high level of obsolescence.

EXHIBIT 6.1

Fixed Assets Schedule (ONGC Ltd) FIXED ASSETS GROSS BLOCK

As at 1st April, 2010

Additions during the year

2,259.32

450.64

Deletions Adjustments during the year

As at 31st March 2011

Land (i) Freehold (ii) Leasehold Buildings and Bunk Houses Railway Sidings Plant and Machinery

—

2,709.96

5,611.13

5.41

—

5,616.54

12,700.00

3,348.06

(1.13)

16,049.37

89.95

—

—

89.95

675,589.82

94,265.25

4,078.48

765,776.59

Furniture & Fittings

8,133.45

889.96

258.01

8,765.40

Vehicles, Survey Ships, Crew Boats and Helicopters

5,402.45

313.30

1,286.92

4,428.83

709,786.12

99,272.62

5,622.10

803,436.64

Intangibles-Software

5,751.67

215.07

17.40

5,949.34

TOTAL

715,537.79

99,487.69

5,639.50

809,385.98

Previous Year

613,556.05

105,378.72

3,396.98

715,537.79

The above includes the Corporation’s Share in Joint Venture Assets

34,705.69

25,566.63

225.06

60,047.26

Previous year

31,032.55

3,868.97

195.83

34,705.69

Notes: 1. Land includes lands in respect of certain projects for which execution of lease/conveyance deeds are in process. 2. Registration of title deeds in respect of certain Buildings is pending execution. 3. Depreciation for the year includes `12.34 million taken to prior period (Previous Year `110.99 million). 4. Building includes cost of undivided interest in land. (Source: Annual Report, ONGC Ltd, 2010–11)

Fixed Assets and Depreciation Accounting

155

Fixed assets are required to be disclosed as a schedule to the balance sheet in the annual report of the company. Block refers to a category in which similar type of assets are put together. Gross block is the total cost of the block of assets. Net block is the written down value of the block. Exhibit 6.1 shows an extract of fixed assets schedule published in the Annual Report of Videocon Industries Ltd.

METHOD OF COMPUTING DEPRECIATION Objective 4 To know various methods of computing depreciation

Depreciation can be computed by using variety of methods which includes the following:

DEPRECIATION AND IMPAIRMENT

NET

For the year Up to 31st March 2010 13.85

Impairment Depreciation

Charged

—

—

Reversed 0.36

Deletions/ Adjustments during the year —

Up to 31st March 2011

As at 31st March 2011

13.49

2,696.47

358.55

50.93

—

—

—

409.48

5,207.06

7,001.78

574.24

—

0.47

(44.54)

7,620.09

8,429.28

83.16

0.94

—

—

—

84.10

5.85

539,145.71

65,971.97

596.46

141.43

3,479.67

602,093.04

163,683.55

3,939.30

913.03

1.33

1.23

206.02

4,646.41

4,118.99

4,771.27

210.71

—

1.13

1,227.50

3,753.35

675.48

555,313.62

67,721.82

597.79

144.62

4,868.65

618,619.96

184,816.68

3,739.15

640.63

—

—

9.21

4,370.57

1,578.77

559,052.77

68,362.45

597.79

144.62

4,877.86

622,990.53

186,395.45

509,412.32

52,537.58

233.58

181.80

2,948.91

559,052.77

156,485.02

26,393.82

11,190.72

100.71

—

218.78

37,466.47

22,580.79

23,557.07

2,901.22

—

—

64.47

26,393.82

8,311.87

156 Financial Accounting

1. 2. 3. 4. 5. 6. 7. 8.

Fixed installment method or Straight Line Method (SLM) Reducing Balance Method (RBM) Machine Hour Rate Method Sum of Year’s Digits Method Depreciation Fund Method Insurance Policy Method Annuity Method Provision for Depreciation Method

The most commonly used methods are the Straight-Line Method (SLM) and the Reducing Balance Method (RBM). The management of a business selects the most appropriate method(s) based on various important factors for example 1. 2. 3. 4. 5.

Type of asset The nature of the use of such assets Circumstances prevailing in the business GAAP prescription Legal/regulatory requirement

A combination of more than one method is sometimes used.

Fixed Installment Method or Straight Line Method (SLM) According to this method, a fixed proportion of the original cost of the asset is written off each year so that value of the asset is reduced to its residual value at that end of its estimated economic useful life. The same amount of depreciation is charged every year throughout the life of the asset. The amount of depreciation is calculated as follows: of the Asset—Scrap Value Amount of Depreciation (p.a.) = Cost —–——————————— Life of the Asset (In Years) Depreciation p.a. Rate of Depreciation (p.a.) = —–————–— ⫻ 100 Cost of Asset

ILLUSTRATION 6.2 Furniture is acquired at a cost of Rs 4,00,000. Its estimated useful life is 8 years. Installation expense amounted to Rs 10,000. Its scrap will realise Rs 10,000. Calculate the amount of depreciation pa, rate of depreciation pa and show WDV at the end of each year. Also show how the furniture will appear in the balance sheet, at the end of years 1, 2 and 3. Solution: The amount of depreciation will be calculated as under:

Fixed Assets and Depreciation Accounting

157

(4, 00,000 + 10,000) – 10,000 = Rs 50,000 Depreciation pa = ———————————— 8 The rate of depreciation is the reciprocal of the estimated useful life. This may be calculated as: 50,000 × 100 Rate of Depreciation = ————–— = 12.5% 4,00,000 Table 6.1 presents WDV over a period of life of an asset. TABLE 6.1

WDV over a Period of Life of an Asset

Year

Cost

Depreciation

1st 2nd 3rd 4th 5th 6th 7th 8th

4,10,000 4,10,000 4,10,000 4,10,000 4,10,000 4,10,000 4,10,000 4,10,000

50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

Accumulated Depreciation 50,000 1,00,000 1,50,000 2,00,000 2,50,000 3,00,000 3,50,000 4,00,000

WDV = Cost – Accumulated Depreciation 3,60,000 3,10,000 2,60,000 2,10,000 1,60,000 1,10,000 60,000 10,000

Furniture will appear in the balance sheet as under: Fixed Assets Furniture - Gross Block Less: Accumulated Depreciation - Net Block

Year 1 4,10,000 50,000 3,60,000

Year 2

Year 3

4,10,000 1,00,000 3,10,000

4,10,000 1,50,000 2,60,000

Merits of SLM are: 1. It is simple and easy to understand. 2. The value of the asset can be exactly written off to scrap value. 3. It is useful for assets with relatively uniform usage during its useful life. Demerits: 1. It does not take into account the effective utilisation of the asset. The same amount of depreciation is charged irrespective of use of the asset. 2. Even though the asset is used uniformly from period to period, the total charge for the use of the asset keeps on increasing every year. It is because cost of repairs rises when the asset gets older, though same amount of depreciation is charged every year. 3. Taxation authorities prefer RBM.

158 Financial Accounting

Diminishing/Reducing Balance Method or Written Down Value Method (RBM) Under this method, the depreciation is charged at a fixed annual rate on the reducing balance, i.e. cost less depreciation. The amount of depreciation charged in each year is not fixed but it goes on decreasing gradually every year. Thus, the amount of depreciation is higher in earlier periods and lower in subsequent periods when repairs and maintenance cost of the asset increases. The formula for calculating the rate of depreciation under diminishing balance method is as follows: Rate of Depreciation = 1 - n

Net Residual Value Cost of Acquisition

If residual value is zero, assume as 1. Here, n = life of the asset (in year)

ILLUSTRATION 6.3 The cost of the asset is Rs 20,000, residual value is Rs 2,000 and the life of the asset is 3 years. Compute the annual rate of depreciation. Solution: The rate of depreciation would be calculated as follows: Rate of Depreciation = 1 - 3

2,000 20,000

= 53.6%

ILLUSTRATION 6.4 A company buys equipment at a cost of Rs 10,000. It decides to depreciate the asset at the cost of 20% per annum based on the reducing balance method (RBM). Calculate the amount of depreciation and WDV for 5 years. Show how equipment will appear in the balance sheet at the end of years 1, 2 and 3. Solution: Year

Cost

1st

10,000

2,000

8,000

2,000

2nd

8,000

1,600

6,400

3,600

rd

6,400

1,280

5,120

4,880

4

th

5,120

1,024

4,096

5,904

5

th

4,096

819.2

3,276.8

6,723.2

3

Depreciation = Cost * 20%

WDV = Cost – Depreciation

Accumulated Depreciation

Fixed Assets and Depreciation Accounting

159

Equipment will appear in balance sheet as under: Fixed Assets

Year 1

Year 2

Equipment —Gross Block —Less: Accumulated Depreciation —Net Block

10,000 2,000 8,000

10,000 3,600 6400

Merits: (a) The charge for depreciation reduces every year, while maintenance cost is likely to rise thus total cost of use of asset will remain more or less constant. (b) Valuation of asset as shown in WDV is likely to represent its fair value. (c) This method reduces the impact of tax on profit during the earlier years of the life of the asset by charging higher amount of depreciation. (d) This method is approved by the income tax authorities. Demerits: (a) The amount of depreciation keeps on changing each year. (b) The value of the asset cannot be reduced to zero and some balance will always be left at the end of useful life of an asset. Table 6.2 compares SLM and RBM. TABLE 6.2

Comparison between SLM and RBM

Basis

Straight Line Method

Reducing Balance Method

Depreciation

It remains the same throughout the life of the asset. The book value of the asset can be reduced to zero. This method is not acceptable.

It goes on decreasing every year.

Book Value Income Tax Law

The book value of the asset cannot be reduced to zero. This method is acceptable.

Under the Companies Act, a company is free to choose either of the two methods: SLM or RBM. However, rates of depreciation are prescribed in Table 6.3 as per the Companies Act and 6.4 as per the Income Tax Act. TABLE 6.3

Rates of depreciation as per Companies Act

Provisions of Companies Act (Schedule XIV) Assets Factory Buildings Furniture Plant and Machinery (Single Shift) Computers Vehicles

Rate of Depreciation WDV SLM 10% 3.34% 18.1% 6.33% 13.91% 4.75% 40% 16.21% 25.89% 9.5%

160 Financial Accounting

The Income Tax Act provides for the following provisions: 1. Reducing Balance Method is permissible. 2. Block of Assets methodology is followed which provides for grouping of similar assets that carry same rate of depreciation. 3. Full depreciation for the year is allowed if the asset is used for 180 days or more during the year. In case of use for less than 180 days depreciation is restricted to 50% of the annual amount. It is compulsory to provide depreciation as per the Income Tax Act as it mandates reducing balance method. TABLE 6.4

Rates of Depreciation as per Income Tax Act Block of Assets

Rates as per RBM

Factory Buildings

10%

Furniture

10%

Plant and Machinery

15%

Computers

60%

Intangible Assets

25%

Pollution Control Equipments

100%

It is the duty of the company management to choose appropriate rate of depreciation. The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. —(IAS–16)

Disclosures of Depreciation as Accounting Policy The depreciation methods used, the total depreciation for the period for each class of assets, the gross amount of each class of depreciable assets and the related accumulated depreciation are disclosed in the financial statements along with the disclosure of other accounting policies. The depreciation rates or the useful lives of the assets are disclosed only if they are different from the principal rates specified in the statute governing the enterprise. In case the depreciable assets are revalued, the provision for depreciation is based on the revalued amount on the estimate of the remaining useful life of such assets. In case the revaluation has a material effect on the amount of depreciation, the same is disclosed separately in the year in which revaluation is carried out. A change in the method of depreciation is treated as a change in an accounting policy and is disclosed accordingly. Exhibit 6.2 shows depreciation policy of Reliance Petroleum Ltd.

Fixed Assets and Depreciation Accounting

EXHIBIT 6.2

161

Depreciation Policy of Reliance Petroleum Ltd—Annual Report 2009–10

Depreciation Policy Depreciation on fixed assets is provided to the extent of depreciable amount on written down value method (WDV) at the rates and in the manner prescribed in Schedule XIV to the Companies Act, 1956 over their useful life except: on fixed assets pertaining to refining segment and SEZ units, depreciation is provided on Straight Line Method (SLM) over their useful life; on fixed bed catalyst with a life of 2 years or more, depreciation is provided over its useful life; on fixed bed catalysts having life of less than 2 years, 100% depreciation is provided in the year of addition; on additions or extensions forming an integral part of existing plants, including incremental cost arising on account of translation of foreign currency liabilities for acquisition of fixed assets and insurance spares, depreciation is provided as aforesaid over the residual life of the respective plants; on development rights and producing properties, depreciation is provided in proportion of oil and gas production achieved, vis-à-vis, the proved reserves (net of reserves to be retained to cover abandonment costs as per the production sharing contract and the Government of India’s share in the reserves) considering the estimated future expenditure on developing the reserves as per technical evaluation; premium on leasehold land is amortised over the period of lease; technical know how is amortised over the useful life of the underlying assets and computer software is amortised over a period of 5 years; intangible assets others are amortised over the period of agreement of right to use, provided in case of jetty the aggregate amount amortised to date is not less than the aggregate rebate availed by the Company; on amounts added on revaluation, depreciation is provided as aforesaid over the residual life of the assets as certified by the valuers’; on assets acquired under finance lease from 1st April 2001, depreciation is provided over the lease term. Source: Annual Report of Reliance Petroleum 2009–10

ACCOUNTING TREATMENTS FOR TRANSACTIONS Depreciation may be recorded as reduction in asset account or by crediting it to provision for depreciation A/c. These entries are shown below.

Objective 5 To pass entries for fixed assets and depreciation

Recording Depreciation in Asset Account While accounting for depreciation for simple transactions, amount of depreciation may be shown as reduction from the value of fixed assets; in the balance sheet fixed assets are shown as written-down value for the year. The following journal entries are passed: For Recording Depreciation Depreciation Account

Dr

xxxx

To Fixed Assets

xxxx

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account To Depreciation Account

Dr

xxxx xxxx

162 Financial Accounting

ILLUSTRATION 6.5 Mr Laxman, a sole proprietor purchased machinery costing Rs 1,50,000 on 1st April, 2010 having a useful life of 10 years, with no salvage value at the end. If he decides to provide depreciation @ 10% pa as per WDV Method, let us pass journal entry for the years 1 and 2: Solution: In 2010–11 Depreciation: 150000 ¥ 10% = 15000 For Providing Depreciation Depreciation Account

Dr

15,000

To Machinery

15,000

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account

Dr

15,000

To Depreciation Account

15,000

Value of Machinery will be shown as under: Beginning of the Year Less: Depreciation WDV at the End

1,50,000 15,000 1,35,000

In 2011–12 Depreciation: 1,35,000 ¥ 10% = 13,500 For Recording Depreciation Depreciation Account To Fixed Assets

Dr

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account Dr To Depreciation Account

13,500 13,500

13,500 13,500

Value of Machinery will be shown as under: Beginning of the Year Less: Depreciation WDV at the End

1,35,000 13,500 1,21,500

163

Fixed Assets and Depreciation Accounting

Recording Depreciation in Provision for Depreciation Account The amount of depreciation to be charged in a particular year is credited to provision for depreciation account and debited to Profit and Loss Account. The asset continues to be shown as its original cost till it is sold off or destroyed or discarded. This method is generally used by companies to record the depreciation. The following journal entries are required in this connection: For Provision of Depreciation Depreciation Account

Dr

xxxx

To Provision for Depreciation Account

xxxx

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account

Dr

xxxx

To Depreciation Account

xxxx

ILLUSTRATION 6.6 Assuming same information as in Illustration 6.4 let us use provision for depreciation method to provide depreciation and pass journal entries for years 1 and 2. In 2010–11 Depreciation: 1,50,000 ¥ 10% = 15,000 For Provision of Depreciation Depreciation Account

Dr

15,000

To Provision for Depreciation Account

15,000

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account

Dr

15,000

To Depreciation Account

15,000

Value of Machinery will be shown as under: Gross Block at Cost

1,50,000

Less: Provision for Depreciation (Accumulated Depreciation)

15,000

Net Block at the End

1,35,000

In 2011–12 Depreciation: 1,35,000 ¥ 10% = 13,500 For Provision of Depreciation Depreciation Account To Provision for Depreciation Account

Dr

13,500 13,500

164 Financial Accounting

For Transfer or Depreciation to Profit and Loss Account Profit and Loss Account

Dr

13,500

To Depreciation Account

13,500

Value of Machinery will be shown as under: Gross Block at Cost

1,50,000

Less: Provision for Depreciation (Accumulated Depreciation) Net Block at the End

28,500 (15,000 +13,500) 1,21,500

Recording Sale of Asset The asset may be sold or discarded before or on the expiry of the useful life of the asset. It becomes necessary to calculate the profit or loss, if any on such sale. The book value of the asset at the date of sale is calculated by deducting the total depreciation from the date or purchase to the date of sale from the original cost. If sale price is greater than the book value, there is a profit on sale of the asset and if the sale price is less than the book value, there is a loss on the sale of the asset. When the asset is sold, the balance in provision for depreciation account is transferred to the asset account. Any amount which is realised on the sale of the asset is credited to the asset account. The balance, if any, in the asset account is taken to the Profit and Loss Account. (a) Recording amount received through sale Cash/Bank Account

Dr

xxxx

To Asset Account

xxxx

(b) The total accumulated depreciation for that asset is transferred to that asset account by the following journal entry: Provision for Depreciation Account

Dr

xxxx

To Asset Account

xxxx

(b) In case of profit or loss on sale of an asset: If profit: Asset Account

Dr

xxxx

To Profit and Loss Account

xxxx

If loss: Profit and Loss Account To Asset Account

Dr

xxxx xxxx

Fixed Assets and Depreciation Accounting

165

ILLUSTRATION 6.7 Assuming same information as in illustration 6.4 and as per the provision of depreciation method let us understand journal entries if the same machinery is sold on 1st October, 2012 for Rs 1,20,000 Solution: Calculation of Depreciation: 2010–11: Depreciation: 1,50,000 ¥ 10% = 15,000 2011–12: Depreciation: 1,35,000 ¥ 10% = 13,500 2012 (April to October): 1,21,500 ¥ 10% ¥ 1/2 (6 months) = 6,075 Total: 15,000 +13,500 + 6,075 = 34,575 On Sale of an Asset (a) For recording depreciation till the date of sale Depreciation Account

Dr

6,075

To Provision for Depreciation Account

6,075

(b) Recording amount received through sale Cash/Bank Account

Dr

1,20,000

To Machinery Account

1,20,000

(c) The total accumulated depreciation for that asset is transferred to that asset account by the following journal entry: Provision for Depreciation Account

Dr

34,575

To Asset Account

34,575

In case of profit on sale of an asset: Profit = Sale Value – WDV of machinery at the time of sale = 1,20,000 – 1,15,425 (1,50,000 – 34,575) = 4,575 Machinery Account To Profit and Loss Account

Dr

4,575 4,575

Change in the Method of Depreciation Objective 6 According o the GAAP, the depreciation method To know about impairment of should be consistently applied and followed fixed assets from year to year to ensure comparability of the reported profit or loss. However, sometimes a change in the method becomes inevitable. The GAAP permits the change in the method of depreciation under certain circumstances, provided it helps in better preparation and presentation of final accounts. When such a

166 Financial Accounting

change is made, the depreciation should be recalculated according to the new method from retrospective effect. The deficiency or surplus arising from retrospective calculation of depreciation according to the new method should be adjusted in the accounts in the year in which the method of depreciation is changed. The change in the method of depreciation should be treated as a change in the accounting policy and its effect should be disclosed and quantified in the books of accounts.

IMPAIRMENT OF ASSETS An unexpected or sudden decline in the utility of an asset due to physical damage to the asset or due to technological obsolescence is called impairment of the assets. An entity shall assess at each reporting date whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. Irrespective of whether there is any indication of impairment, an entity shall also: (a) test an intangible asset with an indefinite useful life or an intangible asset not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount. This impairment test may be performed at any time during an annual period, provided it is performed at the same time every year. Different intangible assets may be tested for impairment at different times. However, if such an intangible asset was initially recognised during the current annual period, that intangible asset shall be tested for impairment before the end of the current annual period. (b) test goodwill acquired in a business combination for impairment annually. —IAS 36 According to AS 28, an enterprise should assess, on each balance sheet date, whether there is any indication that an asset may be impaired. If any such indication exists, the enterprise should estimate the recoverable amount of the asset. If any asset is carried at more than its recoverable amount, the asset is described as impaired. AS 28 requires the enterprise to recognise an impairment loss. It ensures that its assets are carried at no more than their recoverable amount.

External Sources of Information 1. During the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use; 2. Significant changes with an adverse effect on the enterprise have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the enterprise operates or in the market to which an asset is dedicated;

Fixed Assets and Depreciation Accounting

167

3. Market interest rates or other market rates of return on investments have increased during the period and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially; 4. The carrying amount of the net assets of the reporting enterprise is more than its market capitalisation.

Internal Sources of Information 5. Evidence is available of obsolescence or physical damage of an asset; 6. Significant changes with an adverse effect on the enterprise have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include plans to discontinue or restructure the operation to which an asset belongs or to dispose of an asset before the previously expected date; and 7. Evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.

SUMMARY ➤

A fixed asset in an asset that is held for being used for day to day activities and is not held for sale in the normal course of business. Fixed assets include tangible (land, building, vehicle) and intangible assets (goodwill, patents, software).

➤

The cost of fixed asset comprises its purchase price and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price.

➤

Depreciation is a gradual fall in the value of depreciable fixed asset arising from use, effluxion of time or obsolescence. Depletion is the process of measuring the exhaustion of natural resources such as mines. The “amortisation” refers to the process of writing off intangible assets like patents, copyrights, leasehold properties, trademarks. It is compulsory to provide depreciation as per AS and as per law.

➤

Though there are various methods of providing depreciation, the most commonly used ones are the Straight-Line Method (SLM) and the Reducing Balance Method (RBM). The Income Tax Act mandates RBM.

➤

An unexpected or sudden decline in the utility of an asset due to physical damage or obsolescence is called impairment of assets. As per AS 28 it is compulsory to provide for loss due to impairment.

168 Financial Accounting

MULTIPLE CHOICE QUESTIONS* 1. Depletion method is more suitable for (a) Service industry (b) Mining industry (c) Intangible assets (d) All of the above 2. In case of SLM, the amount of depreciation (a) Fluctuates every year (b) Decreases every year (c) Increases every year (d) Remains same every year 3. Amortisation is related to (a) Tangible fixed assets (b) Intangible Fixed assets (c) Any Fixed assets (d) None of the above 4. A proprietor sold old furniture for Rs 12,000 which had a book value of Rs 30,000 and accumulated depreciation of Rs 24,000. What is profit/loss on sale of furniture? (a) Loss Rs 18,000 (b) Profit Rs 6,000 (c) Loss Rs 12,000 (d) Cannot be determined 5. Strawberry Ltd purchased a vehicle for Rs 6,00,000 on 1st April, 2012. The expected residual value is Rs 60,000 and its estimated lifespan is 6 years. What is net book value at the end of the year March 2014 if SLM of providing depreciation is followed? (a) Rs 4,00,000 (b) Rs 4,80,000 (c) Rs 5,40,000 (d) Rs 4,20,000 6. In case of Question 5, what is net book value at the end of the year March 2014 if RBM of providing depreciation @ 15% p.a. is followed? (a) Rs 4,33,500 (b) Rs 3,90,150 (c) Rs 5,40,000 (d) None of the above * Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

Fixed Assets and Depreciation Accounting

7.

8.

9.

10.

169

Using the following information, answer questions 7 to 10. As on 31 December 2012 machinery costing Rs 10,80,000 was reported on the balance sheet at a written down value of Rs 7,62,000. On 1 April 2013, Rs 4,20,000 was paid for another machine and Rs 60, 000 were incurred on freight, insurance and installation. On 1 July 2012, a machine which had been acquired for Rs 1,60,000 on 1 July 2009 was sold for Rs 24,000. Select an appropriate choice to identify the amount written off as depreciation in the year ended 31 December 2013 and the written down value of machinery as on 31 December 2013 in each of the following alternative scenarios: Machinery is depreciated at 10% per annum, using the Straight-Line Method; but full year’s depreciation is charged on the year of acquisition and no depreciation in the year of disposal, the amount of depreciation is (a) Rs 1,36,000 (b) Rs 1,56,000 (c) Rs 1,40,000 (d) None of the above If SLM is used, WDV as on 31 December 2013 will be (a) Rs 3,90,000 (b) Rs 10,06,000 (c) Rs 9,90,000 (d) Rs 9,94,000 Machinery is depreciated at 10% per annum, using the Reducing Balance Method; but full year’s depreciation is charged on the year of acquisition and no depreciation in the year of disposal, the amount of depreciation is (a) Rs 1,24,200 (b) Rs 1,56,200 (c) Rs 2,48,400 (d) None of the above WDV as on 31 December 2013 will be (a) Rs 10,21,160 (b) Rs 10,06,000 (c) Rs 9,90,000 (d) None of the above

THEORY QUESTIONS 1. What are fixed assets? How to determine cost of fixed assets? 2. What is depreciation? Is it necessary to provide for the same?

170 Financial Accounting

3. Distinguish between SLM and RBM. 4. What is an asset impairment? Why is it necessary to provide for the same?

PRACTICAL PROBLEMS Level 1: Easy 1. Amteck Ltd. bought a machine on 1.1.2012 costing Rs 5,00,000 with a useful life of 10 years. It is expected to have a scrap value of Rs 20,000 at the end of its useful life. The rate of depreciation applicable to RBM is 10%. You are required to calculate depreciation for the year 2013 and 2014 and also WDV as on 31.12.2013 and 31.12.2014 as per SLM and RBM and offer your comments. 2. Mr Omprakash purchased machinery costing Rs 1,80,000 on 1st April, 2012 having a useful life of 15 years, with no salvage value at the end. He decides to provide depreciation @ 10% pa as per RBM. You are required to pass necessary journal entries using provision for depreciation method for 3 years. 3. Complete the following fixed assets schedule: Rs in lacs Particulars

Gross Block

Depreciation

Cost as on 1/4/2011

Additions

50,000

—

—

Land and Building

1,80,000

5,000

50,000

Plant and Machinery

4,50,000 15,000

60,000

Furniture

1,55,000

10,000

Goodwill

Net Block

Cost as on Accu- Current AccuAs on As on 31/3/2012 mulated Year mulated 1/4/2011 31/03/2012 as on as on 1/4/2011 31/3/2012

5,000

You are informed that: Rate of depreciation for land and building is 10%, plant and machinery is 15% and furniture is 20% ■ Full depreciation is provided on assets purchased during the year ■ WDV is used for providing depreciation 4. The following information is available for Bharat Ceramic Ltd: ■

Particulars Cost of the Machine (Rs) Useful Life (Years) Scrap Value (Rs)

26,00,000 5 1,30,000

Fixed Assets and Depreciation Accounting

171

You are required to: 1. determine annual depreciation for first 3 years and rate of depreciation as per SLM 2. determine accumulated depreciation at the end of third year 3. show disclosure of machine in balance sheet at the end of third year 5. Omkar Silk Ltd. purchased machinery, the details of which are as under. Using the given information you are required to calculate cost of the machine. Particulars

Amount

Amount

Invoice Price: List Price Less: Trade Discount Balance Add: Sales Tax and Excise Duty Transportation Charges to Factory Site Installation Charges Travelling Charges for Manager for Monthly Visit Scrap Value

25,00,000 50,000 24,50,000 3,00,000

27,50,000 12,500 37,500 40,000 20,000

6. Aparna Pharmaceuticals Ltd purchased on 1.1.1997, a divisible plant for Rs 20,00,000. The plant had estimated useful life of 5 years. It was depreciated as per SLM. A major extension was carried out for Rs 4,00,000 which was operational from 1.1.1999. Prepare the machinery account for all the years assuming: (a) the extension will last only till the life of the existing asset (b) the extension is capable of being used independently of existing plant and is expected to last 5 years from its installation

Level 2: Standard 7. Complete the following fixed assets schedule: Rs in lakhs Particulars

Gross Block

Depreciation

Net Block

Cost Add- Cost as Accu- Current AccuAs on As on as on itions on 31/3/ mulated Year mulated 1/4/2011 31/3/2012 1/4/2011 2012 as on as on 1/4/2011 31/3/2012 Land and Building

3,50,000

25,000

Plant and Machinery

1,85,000

24,000

Furniture

1,20,000

16,500

Computer

2,25,000

59,000

172 Financial Accounting

You are informed that the rate of depreciation for land and building is 5%, plant and machinery is 10%, furniture is 10% and computer is 20% on per annum basis ■ assets purchased during the year included machinery worth Rs 4,500 on 1/7/2011 and computers worth Rs 40,000 on 30/9/2011 ■ WDV is used for providing depreciation 8. Prithvi Ltd purchased a machinery on 1 January 2011 for Rs 5,50,000 and spent Rs 50,000 on its installation. On 1 September 2011 it purchased another machine for Rs 3,70,000. On 1 May 2012, it purchased another machine for Rs 8,40,000 (including installation expenses). Depreciation was provided on machinery @10% pa on original cost method annually on 31st December. Pass journal entries and prepare: (a) machinery account and depreciation account for the years 2011, 2012, 2013 and 2014. (b) If depreciation is accumulated in provision for depreciation account then prepare machine account and provision for depreciation account for the years 2011, 2012, 2013 and 2014. 9. Azad Ltd purchased furniture on 1 October 2012 for Rs 4,50,000. On 1 March 2013 it purchased another furniture for Rs 3,00,000. On 1 July 2014 it sold off the first furniture purchased in 2012 for Rs 2,25,000. Depreciation is provided at 15% p a on written down value method each year. Accounts are closed each year on 31 March. Prepare furniture account and accumulated depreciation account for the years ended on 31 March 2013, 31 March 2014 and 31 March 2015. 10. M/s Ram Stores acquired a printing machine for Rs 2,70,000 on 1st April,1998. It was company’s policy to depreciate a machine on straight line basis at 20% p a. During 2000–01 a modification was made to the machine to improve its technical reliability, at a cost of Rs 25,000, which it was considered would extend the useful life of the machine by 2 years. At the same time an important component of the machine was replaced at a cost of Rs 5,000 because of excessive wear and tear. Routine maintenance during said accounting year cost Rs 3,750. Show the asset account, the provision for depreciation account and charge to Profit and Loss Account in respect of the machine for the year ended 31st March, 2001. ■

173

Fixed Assets and Depreciation Accounting

Level 3: Expert 11. Suman Ltd purchased the following assets during the year 2012. Asset

Cost

Residual Value

Useful Life

Plant

24,00,000

1,60,000

10

Building

30,00,000

1,80,000

20

Company used SLM for providing depreciation from the year of purchase. However from year 5, company decided to change depreciation method to WDV and decided to apply rate of 10%. Assuming company earning a profit of Rs 6,50,000 before depreciation which grows @ 10% pa, you are required to: Compute profit after depreciation for 5 years. Show the impact of change in method of depreciation in year 5 (assuming it is done retrospectively from year 1). 12. Carriage Transport Company purchased 5 trucks at the cost of Rs 2,00,000 each on 1 April 2001. The company writes off depreciation @ 20% p a on the original cost and closes its books on 31 December, every year. On 1st October, 2003, one of the trucks is involved in an accident and is completely destroyed. Insurance company has agreed to pay Rs 70,000 in full settlement of the claim. On the same date the company purchased a second hand truck for Rs 1,00,000 and spent Rs 20,000 on its overhauling. Prepare a truck account and provision for depreciation account for the three years ended on 31 December 2003. Also give truck account if truck disposal account is prepared. 13. The following is the schedule of fixed assets of Amtech Ltd for 2011–12:

Additions

Deductions

As at 31/3/2012

As at 31/3/2011

As at 31/3/2012

As at 31/3/2011

Building

4,00,000

—

—

4,00,000 1,00,000

30,000

—

1,30,000

3,00,000

2,70,000

Plant and Machinery Furniture and Fixtures Computer Systems Vehicles

5,00,000

—

—

5,00,000 2,50,000

50,000

—

3,00,000

2,50,000

2,00,000

2,00,000

—

—

2,00,000 1,00,000

30,000

—

1,30,000

1,00,000

70,000

1,55,000

—

—

1,55,000

77,500

15,500

—

93,000

77,500

62,000

3,00,000

—

—

3,00,000 1,50,000

60,000

—

2,10,000

1,50,000

90,000

15,55,000

—

—

15,55,000 6,77,500 1,85,500

—

8,63,000

8,77,500

6,92,000

Total

As at 31/3/2012

Net Block

Deductions

Depreciation/Amortisation/ Impairment

Additions

Gross Block

As at 31/3/2011

Particulars

174 Financial Accounting

Using the following information you are required to prepare fixed assets schedule for 2012–13. Company follows RBM to provide depreciation ■ On 1st July, 2012 company acquired new vehicle worth Rs 50,000 and sold out old vehicle for Rs 50,000 (WDV Rs 50,000 and cost Rs 1,00,000) ■ On 1st September, 2012 company acquired new building worth Rs 1,00,000 ■ On 1st January, 2012 company acquired furniture worth Rs 40,000 14. A company provides depreciation on plant and machinery at 20% per annum on diminishing balance method. On 1 April 2013, the balance in the plant and machinery account was Rs10,00,000, It was discovered during 2013–14 that: (a) Rs 50,000 being ordinary repairs to machinery incurred on 30 June 2011 had been wrongly capitalised. (b) Rs 1,00,000 being the cost of a generator purchased on 1 October 2010 had been wrongly treated as revenue expenditure and written off to stores. A plant which cost Rs 80,000 on 30 September 2012 was scrapped and replaced with a more sophisticated one on 31 December 2013 by spending Rs 1,20,000. Scrap worth Rs 20,000 was released. Prepare the plant and machinery account as would appear on 31 March 2014 after providing depreciation for that year. Also show the detailed working notes making all the calculation. ■

RESEARCH ASSIGNMENTS 1. Study annual report of Coal India Ltd, TCS Ltd and Infosys Ltd for 3 years and answer the following questions: (a) Compare depreciation method followed by companies. (b) Find out if assets are revalued and how revaluation effect has been reflected in the financial statements. (c) Suppose company wants to charge depreciation on revalued amount, explain how it would affect the profit. (d) Analyse intangible assets shown in financial statements of the company and comment on accounting policies adopted for the valuation. (e) Comment on assets impairment policy of the company and reflect whether it has affected companies profit or not.

INTERPRETING FINANCIAL REPORTS 1. Following details have been extracted from the Annual Report of Reliance Industries Limited. for the year 2010–11.

Fixed Assets and Depreciation Accounting

Balance Sheet of Reliance Industries Limited. Rs in Crores March 11

Rs in Crores March 10

Sources of Funds Equity Share Capital Reserves Revaluation Reserves Networth Secured Loans

3,273.37

3,270.37

142,799.95

125,095.97

5,467.00

8,804.27

151,540.32

137,170.61

10,571.21

11,670.50

Unsecured Loans

56,825.47

50,824.19

Total Debt

67,396.68

62,494.69

218,937.00

199,665.30

221,251.97

215,864.71

78,545.50

62,604.82

142,706.47

153,259.89

Total Liabilities Application of Funds Gross Block Less: Accumlated Depreciation Net Block Capital Work in Progress

12,819.56

12,138.82

Investments

33,019.27

19,255.35

Inventories

29,825.38

26,981.62

Sundry Debtors

17,441.94

11,660.21

604.57

362.36

Cash and Bank Balance Total Current Assets

47,871.89

39,004.19

Loans and Advances

17,320.60

10,517.57

Fixed Deposits

31,162.56

17,073.56

Total CA, Loans and Advances

96,355.05

66,595.32

Deferred Credit Current Liabilities Provisions Total CL and Provisions Net Current Assets Total Assets Contingent Liabilities Book Value (Rs)

0

0

61,399.87

48,018.65

4,563.48

3,565.43

65,963.35

51,584.08

30,391.70

15,011.24

218,937.00

199,665.30

41,825.13

25,531.21

446.25

392.51

175

1,49,628.70

Previous Year Capital Work-in-Progress

66,507.61

5,963.14

2,684.35

(Source: Annual Report, Reliance Industries Limited. 2010–11)

2,15,864.71

Total

64,505.08

Sub-Total

188.78 18.74 2,084.37 392.46

— — —

317.80 9.98 327.78 3,021.93 467.31 52,374.38 8,641.46

0.66 30.67 273.88 2,195.06 35.11 540.32 44.72 43.48 0.10 114.79 3,278.79

Additions

271.60

575.88

—

— — — —

— — —

0.01 4.93 47.40 306.16 2.91 58.89 3.54 37.25 — 114.79 575.88

Deductions/ Adjustments

Gross Block

1,556.01 1,136.29 7,366.66 1,30,478.49 3,480.33 5,804.77 477.32 277.80 385.76 68.42 1,51,031.85

As at 0104-2010

INTANGIBLE ASSETS**: Technical Knowhow fees Software Development Rights* Others

OWN ASSETS: Leasehold Land Freehold Land Buildings Plant & Machinery Electrical Installations Equipments Furniture & Fixtures Vehicles Ships Aircrafts & Helicopters Sub-Total LEASED ASSETS: Plant & Machinery Ships Sub-Total

Description

2,15,864.71

2,21,251.97

67,189.43

3,210.71 486.05 54,458.75 9,033.92

317.80 9.98 327.78

1,556.66 1,162.03 7,593.14 1,32,367.39 3,512.53 6,286.20 518.50 284.03 385.86 68.42 1,53,734.76

As at 3103-2011

Fixed Assets Schedule SCHEDULE ‘E’ FIXED ASSETS

13,477.01

16,241.33*

7,525.52

153.27 42.54 7,251.45 78.26

39.72 — 39.72

53.64 — 286.23 7,762.86 176.53 302.86 30.70 36.54 14.28 11.85 8,676.09

For the Year

62,604.82

78,545.50

17,566.73

1,565.17 411.53 14,827.54 762.49

151.30 9.98 161.28

186.67 — 2,298.12 54,965.23 1,392.90 1,247.01 303.97 155.64 239.79 28.16 60,817.49

Up to 3103-2011

Depreciation

1,53,259.89 12,819.56

1,42,706.47

49,622.70

1,645.54 47.52 39,631.21 8,271.43

166.50 — 166.50

1,369.99 1,162.03 5,295.02 77,402.16 2,119.63 5,039.19 214.53 128.39 146.07 40.26 92,917.27

12,138.82

1,53,259.89

54,462.87

1,610.03 98.32 44,798.29 7,957.23

206.22 — 206.22

1,422.98 1,136.29 5,350.63 83,027.47 2,263.27 4,839.79 201.55 139.52 160.25 48.05 98,589.80

As at 31-03- As at 31-032011 2010

Net Block

(Rs. in crore)

176 Financial Accounting

Fixed Assets and Depreciation Accounting

177

Significant Accounting Policies C. Own Fixed Assets Fixed Assets are stated as cost net of recoverable taxes and includes amounts added on revaluation, less accumulated depreciation and impairment loss, if any. All costs, including financing costs till the commencement of commercial production, net charges on foreign exchange contracts and adjustments arising from exchange rate variations attributable to the fixed assets are capitalised.

D. Leased Assets (a) Operating Leases: Rentals are expensed with reference to lease terms and other considerations. (b) (i) Finance leases prior to 1 April 2001: Rentals are expensed with reference to lease terms and other considerations. (ii) Finance leases on or after 1 April 2001: The lower of the fair value of the assets and present value of the minimum lease rentals is capitalised as fixed assets with corresponding amount shown as lease liability. The principal component in the lease rental is adjusted against the lease liability and the interest component is charged to Profit and Loss Account. (c) However, rentals referred to in (a) or (b) (i) and the interest component referred to in (b) (ii) pertaining to the period up to the date of commissioning of the assets are capitalised. (d) All assets given on finance lease are shown as receivables at an amount equal to net investment in the lease. Initial direct costs in respect of lease are expensed in the year in which such costs are incurred. Income from lease assets is accounted by applying the interest rate implicit in the lease to the net investment.

E. Intangible Assets Intangible Assets are stated at cost of acquisition net of recoverable taxes less accumulated amortisation/depletion. All costs, including financing costs till commencement of commercial production, net charges on foreign exchange contracts and adjustments arising from exchange rate variations attributable to the intangible assets are capitalised.

F. Depreciation Depreciation on fixed assets is provided to the extent of depreciable amount on written down value method (WDV) at the rates and in the manner prescribed in Schedule XIV to the Companies Act, 1956 over their useful life except: on fixed assets pertaining

178 Financial Accounting

to refining segment and SEZ units, depreciation is provided on Straight Line method (SLM) over their useful life; on fixed bed catalyst with a life of 2 years or more, depreciation is provided over its useful life; on fixed bed catalysts having life of less than 2 years, 100% depreciation is provided in the year of addition; on additions or extensions forming an integral part of existing plants, including incremental cost arising on account of translation of foreign currency liabilities for acquisition of fixed assets and insurance spares, depreciation is provided as aforesaid over the residual life of the respective plants; premium on leasehold land is amortised over the period of lease; technical know how is amortised over the useful life of the underlying assets and computer software is amortised over a period of 5 years; on intangible assets— development rights, depletion is provided in proportion of oil and gas production achieved, vis-à-vis, the proved reserves (net of reserves to be retained to cover abandonment costs as per the production sharing contract and the Government of India’s share in the reserves) considering the estimated future expenditure on developing the reserves as per technical evaluation; intangible assets others are amortised over the period of agreement of right to use, provided in case of jetty the aggregate amount amortised to date is not less than the aggregate rebate availed by the Company; on amounts added on revaluation, depreciation is provided as aforesaid over the residual life of the assets as certified by the valuers; on assets acquired under finance lease from 1 April 2001, depreciation is provided over the lease term.

G. Impairment of Assets An asset is treated as impaired when the carrying cost of asset exceeds its recoverable value. An impairment loss is charged to the Profit and Loss Account in the year in which an asset is identified as impaired. The impairment loss recognised in prior accounting period is reversed if there has been a change in the estimate of recoverable amount. You are required to: 1. Calculate what proportion of fixed assets in total assets in 2010–11? Is there any change in this proportion over 2009–10? Offer your comments. 2. Calculate what proportion of fixed assets is represented by intangible assets in 2009–10 and 2010–11? Explain if there is any significant change

BUSINESS CASES The financial year 2009–10 has been one of the worst for the aviation industry in living memory. Global industry losses during the period have been estimated at around US$10.4 billion or approximately Rs.52,000 crore. Of this, the share of the Indian aviation industry is estimated to be as high as about 19% approximately Rs 10,000 crore or US$2 billion though it accounts for only about 2.5% of the estimated 1.7 billion passengers carried globally. This situation has been caused by two main

Fixed Assets and Depreciation Accounting

179

factors. First, the very high costs of aviation turbine fuel, owing to the unprecedented escalation in the prices of crude oil during the first half of the year. While there was some abatement in the latter part of the year, crude prices have lately been rising again. The second has been the global economic downturn, which has led to a steep fall in the demand for air travel and intense pressure on yields. All major developed economies are now in recession. The effects of the “sub-prime” crisis in the United States triggered these adverse economic conditions. The aviation industry has always been one of the first victims of an economic slowdown and the present recessionary conditions have widely been described as the worst since the Great Depression of the 1930s. One of the key sectors affected by the economic meltdown has been the banking and financial services industries, which have hitherto been major generators of premium air travel. A fixed asset is a significant asset category for most airlines. Fixed assets often constitutes over half of the total assets of an airline and depreciation of these assets is a substantial operating expense. The depreciation methods and estimates used to determine the amount of this expense can vary widely from company to company. Moreover, the methods and estimates adopted can have a significant impact on a company’s reported earnings. Following details are available about Jet Airways a leading corporation in the aviation industry (Exhibit Nos. 6.2, 6.3 and 6.4):

Jet Airways EXHIBIT NO. 6.2 Balance Sheet of Jet Airways as on 31/03/2010 Balance Sheet as at 31st March, 2010 Schedule No.

As at 31st March, 2010 Rs. in lakhs

As at 31st March, 2009 Rs. in lakhs

8,633

8,633

8,633

8,633

328,473

333,206

337,106

341,839

I. SOURCES OF FUNDS 1. Shareholders’ Funds: (a) Share Capital Equity

(b) Reserves and Surplus

A

B

2. Loan Funds: (a) Secured Loans

C

383,618

450,092

(b) Unsecured Loans

D

992,330

1,154,761

1,375,948

1,604,853 (Contd.)

180 Financial Accounting

3. Deferred payment liability towards Investment in a wholly owned subsidiary company [Due within one year Rs. 13,750 lakhs (Previous Year Rs. 13,750 lakhs), Refer Note 5 of Schedule S]

13,750

Total

1,726,804

27,500

1,974,192

II. APPLICATION OF FUNDS 1. Fixed Assets:

E

(a) Gross Block

1,793,275

1,876,374

350,283

250,180

1,442,992

1,626,194

29,960

58,317

1,472,952

1,684,511

F

174,500

174,500

(a) Inventories

G

58,479

59,567

(b) Sundry Debtors

H

81,077

73,225

(c) Cash and Bank Balances

I

77,283

139,450

(d) Loans and Advances

J

161,381

162,828

378,220

435,070

(b) Less: Depreciation (c) Net block (d) Capital Work-in-progress

2. Investments 3. Current Assets, Loans and Advances:

Less: Current Liabilities and Provisions (a) Current Liabilities

K

357,355

328,150

(b) Provisions

L

14,421

17,883

371,776

346,033

6,444

89,037

72,908

26,144

1,726,804

1,974,192

Net Current Assets 4. Profit & Loss Account–Debit Balance Total Significant Accounting Policies and Notes to Accounts Source: Annual Report Jet Airways 2009-10

S

Fixed Assets and Depreciation Accounting

181

EXHIBIT NO. 6.3 Significant Accounting Policies and Notes to Accounts Schedule G. Fixed Assets: (a) Tangible Assets: Owned tangible fixed assets are stated as cost and includes amount added on revaluation less accumulated depreciation and impairment loss, if any. All costs relating to acquisition and installation of fixed assets to the time the assets get ready for their intended use are capitalised. The cost of improvements to leased properties as well as customs duty/modification cost incurred on aircraft taken on operating lease have been capitalised and disclosed appropriately. (b) Intangible Assets: Intangible assets are recognised only if acquired and it is probable that the future economic benefits that are attributable to the assets will flow to the enterprise and the cost of assets can be measured reliably. The intangible assets are recorded at cost and are carried at cost less accumulated amortisation and accumulated impairment losses, if any. (c) Assets Taken on Lease: Operating Lease: Rentals are expensed with reference to the lease term and other considerations. Finance Lease/Hire Purchase: The lower of the fair value of the assets and the present value of the minimum lease rentals is capitalised as fixed assets with corresponding amount shown as lease liability (outstanding hire purchase/finance lease instalments). The principal component of the lease rentals is adjusted against the leased liability and interest component is charged to the Profit and Loss Account. Schedule H. Impairment of Assets: An asset is treated as impaired when the carrying cost of assets exceeds its recoverable value. An impairment loss, if any, is charged to the Profit and Loss Account in the year in which an asset is identified as impaired. The impairment loss recognised in prior accounting periods is reversed if there has been a change in the estimate of recoverable amount. Schedule I. Depreciation/Amortisation: (a) Depreciation on tangible fixed assets has been provided at the rates and in the manner prescribed under the Schedule XIV to the Companies Act, 1956 on Written Down Value, other than narrow and wide body aircraft which are depreciated on SLM and expenditure incurred on improvements of assets acquired on operating lease are written off evenly over the balance period of the lease. Premium on leasehold land is amortised over the period of lease. (b) On revalued assets, depreciation is charged over the residual life and the additional charge of depreciation is withdrawn from the revaluation reserve. (c) Intangible assets are amortised on straight line basis as follows: 1. Landing rights acquired are amortised over a period not exceeding 20 years. Amortisation period exceeding 10 years is applied considering industry experience and expected asset usage. 2. Trademarks are amortised over 10 years. 3. Computer software is amortised over a period not exceeding 36 months. Source: Annual Report Jet Airways 2009-10

182 Financial Accounting EXHIBIT NO. 6.4 Schedule of Fixed Assets of Jet Airways as on 31/03/2010 Schedule-E FIXED ASSETS GROSS BLOCK (At Cost/Valuation) NATURE OF ASSETS OWNED TANGIBLE ASSETS Freehold Land Plant and Machinery Furniture and Fixtures Electrical Fittings Data Processing Equipment Office Equipment Ground Support Equipment Vehicles Ground Support Vehicles Simulators Leased \ Owned Assets Leasehold Land Aircraft and Spare Engine (Narrow Body) Airfcraft and Spare Engine (Wide Body) Improvement on Leased Aircraft Improvement on Leased Property INTANGIBLE ASSETS (Other than internally generated) Software Landing Rights Trademarks Total Previous Year Capital Work in Progress Including Captial Advances

As at 01.04.2009

Additions/ Adjustments during the Year

Deduction/ Adjustments

11 765 3,659 2,616 8,520 4,941 6,384 1,020 7,325 22,187

— — 187 47 156 19 67 — 89 —

— — 18 17 405 38 82 29 253 —

191,135 496,495 1,092,352 15,098 4,468

(4,722) 5,758 (97,464) 2,333 —

— 131 — — —

4,051 12,201 3,146 1,876,374 1,659,109

1,179 10,231 — (82,120) 391,128

6 — — 979 173,863

Notes: 1. All the Aircraft (except one Aircraft) are acquired on Hire-purchase / Finance Lease basis. Such Aircraft are charged by the Hirers / Lessors against the financing arrangements obtained by them. 2. Additions to Leasehold land / Aircraft / Simulators / CWIP during the year include Rs. (120,661) lakhs [Net] (Previous Year net of Rs. 215,556 lakhs) on account of Exchange (–) Gain / Loss during the year. (Refer Note 16) of Schedule S)

Fixed Assets and Depreciation Accounting

183

Rs. In lakhs DEPRECIATION/AMORTISATION As at 31.03.2010

Upto 31.03.2009

For the Year Ended 31.03.2010

Deductions

NET BLOCK Upto 31.03.2010

As at 31.03.2010

As at 31.03.2009

11 765 3,028 2,646 8,271 4,922 6,369 991 7,161 22,187

— 251 2,137 1,235 6,658 2,430 3,593 595 4,852 8,388

— 72 318 197 794 353 395 106 765 2,212

— — 11 13 398 28 68 11 242 —

— 323 2,444 1,419 7,054 2,755 3,920 690 5,375 10,600

11 442 1,384 1,227 1,217 2,167 2,449 301 1,786 11,587

11 514 1,522 1,381 1,862 2,511 2,791 425 2,473 13,799

186,413 502,122 994,888 17,431 4,468

3,073 119,654 78,754 5,945 2,751

2,407 28,572 59,312 2,699 692

— 51 — — —

5,480 148,175 138,066 8,644 3,443

180,933 353,947 856,822 8,787 1,025

188,062 376,841 1,013,598 9,153 1,717

5,224 22,432 3,146 1,793,275 1,876,374

3,098 5,610 1,156 250,180 250,692

865 856 314 100,929 94,714

4 — — 826 95,226

3,959 6,466 1,470 350,283 250,180

1,265 15,966 1,676 1,442,992 1,626,194 29,960

953 6,591 1,990 1,626,194 58,317

3. (a) Leasehold Land was revalued on 31st March, 2008 with reference to then current market prices; amount added on revaluation was Rs. 148,119 lakhs; the revalued amount substituted for historical cost on 31st March, 2008 was Rs. 184,500. (b) Narrow Body Aircraft was revalued on 31st March, 2008 with reference to then market prices; amount added on revaluation was Rs. 118.133 lakhs; the revalued amount substituted for book value on 31st March, 2008 is Rs. 346,396 lakhs. Source: Annual Report Jet Airways 2009-10

Following details are available about Air India a leading Government Owned corporation in the aviation industry (Exhibit Nos. 6.5, 6.6 and 6.7).

184 Financial Accounting

Air India EXHIBIT 6.5

Balance Sheet of Air India as on 31/03/2010 Balance Sheet as at March 31,2010 (Rupees in Million)

Particulars I. SOURCES OF FUNDS: Shareholders’ Funds: (a) Capital (b) Reserves and Surplus

Schedule

A B

As at March 31, 2010

As at March 31, 2009

1,450.0 633.5

9,450.0 624.8

2,083.5

10,074.8 Loan fund: (a) Secured Loans (b) Unsecured Loans Future Lease Obligations TOTAL II. APPLICATION OF FUNDS: Fixed Assets: (a) Gross Block Less: Depreciation (b) Net Block (c) Capital Work-in-Progress Investments: Deferred Tax Assets (Net): Foreign Currency, Monetary Items Translation Difference Account Current Assets, Loans and Advances: (a) Inventories (b) Sundry Debtors (c) Cash and Bank Balances (d) Other Current Assets (e) Loans and Advances Less: Current Liabilities and Provisions (a) Current Liabilities (b) Provision Net Current Assets Profit and Loss Account TOTAL Source: Annual Report, Air India, 2009-10.

C D

23,659.5 168,764.9

65,907.1 184,761.1

192,424.4 116,887.5 311,395.4

250,668.2 133,559.6 394,302.6

E

F 243,294.0 18,380.5 224,913.5 50,113.7

328,410.5 31,990.6 296,419.9 24,656.2

H I J K L

275,027.2 1,231.8 28,425.2 1,528.0

321,076.1 1,219.3 28,425.2 99.5

G

8,677.8 25,791.1 5,284.7 768.1 14,466.5 54,988.2

9,642.1 24,731.0 11,396.4 561.6 11,175.9 57,507.0

55,466.7 10,929.9 66,396.6

42,282.9 10,040.9 52,323.8

M

N

(11,408.4) 54,890.9 394,302.6

5,183.2 — 311,395.4

Fixed Assets and Depreciation Accounting

EXHIBIT 6.6

185

Significant Accounting Policies of Air India as on 31/03/2010.

B. Fixed Assets (i) (a) Aircraft are stated at purchase price. Other incidental costs including interest wherever applicable, are also capitalized up to the date of commercial operation. (b) Other assets, including aircraft rotables, are capitalized and stated at historical cost. (ii) Expenditure on major modernisation/modification/conversion of aircraft, resulting in increased efficiency/economic life, is capitalized. (iii) Aircraft Fleet and Equipment under leases, in respect of which substantially all the risks and rewards of ownership are transferred to the Company, are considered as Finance Leases and are capitalized. (iv) Physical Verification of Assets Physical Verification of Assets is done on a rotational basis so that every asset is verified once in every two years and the discrepancies observed in the course of the verification are adjusted in the year in which report is submitted. (v) Gain or loss arising out of sale/scrap of Fixed Assets including aircraft over the net depreciated value is taken to Profit & Loss account as Non-Operating Revenue or Expenses. C. Depreciation a) Depreciation is provided on all assets on straight-line method. b) The rates adopted are in accordance with the manner prescribed under Schedule XIV of the Companies Act, 1956 except for the following: (i) New Fleet of Boeing and A-320 family aircraft are depreciated upto 95% of the block value over 20 years instead of 16.96 years. (ii) Airframe/Aero Engine Rotables are depreciated upto 95% of the value over the residual average useful life of the related fleet. (iii) Increase/decrease in cost arising on account of conversion of foreign currency liability for acquisition of fixed assets is amortized over the residual life of the respective assets including the current year. (iv) Electrical fittings, Typewriter & Office Appliances, Other General Equipment and Cabin Catering Equipment are depreciated @ 6.33% instead of 4.75%. (v) Motor Cars are depreciated at 20% instead of 9.5% (vi) Depreciation on additions to “Other Fixed Assets” is provided for the full year in the year of acquisition and no depreciation is provided in the year of disposal. c) Major modifications/refurbishment, modernisation/conversion carried to leased assets are shown under improvement to leasehold assets and amortized over the balance period of lease. d) In case of owned aircraft namely B-737-200 and A-310 converted into freighters, the cost of conversion is over the further life of 10 years e) Leasehold Land other than perpetual lease is amortized over the period of lease. f) Intangible assets are amortized over 5 years. g) Assets of small value not exceeding Rs 5000 in each case are fully provided for/charged off. L. Impairment of Assets The carrying value of Fixed Assets of the identified cash-generating unit are reviewed for impairment at each Balance Sheet date to determine whether there is any indication of impairment. The aircraft are grouped at the fleet type level to constitute a cash-generating unit, for comparing the recoverable amount (higher of its net selling price and value in use) with the carrying amount. The net selling prices of aircraft fleet and equipment are estimated by the management using published sources as available. If the carrying value of a cash-generating unit exceeds its estimated recoverable amount an impairment loss is recognized in the Profit & Loss Account and the asset value of the cash-generating unit is reduced to its recoverable amount. Source: Annual Report, Air India, 2009-10

186 Financial Accounting EXHIBIT 6.7

Fixed Assets Schedule of Air India as on 31/03/2010.

SCHEDULE: “F”: FIXED ASSETS GROSS BLOCK (AT COST) PARTICULARS A. AIRCRAFT FLEET & ROTABLES 1. Airframes (a) Owned & Self Operated (b) Leased to AASL (c) Leased to Aryan Cargo Express 2. Aero Engines & Power Plants (a) Owned & Self Operated (b) Leased to AASL (c) Leased to Aryan Cargo Express 3. Simulators & Link Trainers 4. Airframe Rotables 5. Aero-Engine Rotables 6. Simulators Rotables SUB TOTAL “A” B. LAND, BUILING & VEHICLES 1. Land - Freehold 2. Land – Leasehold 3. Buildings 4. Vehicles SUB TOTAL “B” C. OTHER FIXED ASSETS 1. Workshop Equipment, Instruments, Machinery & Plants 2. Ground Support and Ramp Equipment 3. Furniture & Fixtures 4. Electrical Fittings and Installations 5. Computer System 6. Office Appliances & Equipment SUB TOTAL “C” D. INTANGIBLE ASSETS 1. Computer Software TOTAL Previous Year Capital Work in Progress GRAND TOTAL

As at April 1, 2009

Additions

Deductions/ Adjustments

As at March 31 2010

125989.3 410.4 533.1

64266.2 2.5 —

22684.9 — —

167570.6 412.9 533.1

14937.5 2.7 49.6 311.7 3235.0 597.9 0.2 146067.4

19180.8 — — 644.3 438.5 300.5 — 84832.8

(21951.2) — — — 45.6 33.5 — 812.8

56069.5 2.7 2.7 956.0 3627.9 864.9 0.2 230087.4

7057.8 63840.4 17840.9 246.2 88985.3

— 19.7 11.2 7.5 38.4

— — 3.0 16.2 19.2

7057.8 63860.1 17849.1 237.5 89004.5

2309.0

549.8

2.4

2856.4

4077.5 134.2 170.6 779.2 641.0 8111.5

407.2 16.4 10.3 73.5 37.3 1094.5

12.0 0.2 1.0 0.5 2.5 18.6

4472.7 150.4 179.9 852.2 675.8 9187.4

129.8 243294.0 186543.3

1.4 85967.1 58568.5

— 850.6 1817.8

131.2 328410.5 243294.0

Note: 1. Additions to and deductions from “Aircraft Fleet and Rotables” includes Exchange Rate Fluctuations on underlying monetary items in foreign currency: Rs. Nil (Previous Year: Rs. 19,476.2 Million) and Rs. 12,009.2 million (Previous Year : Rs.837.8 million) respectively. 2. Aircraft Fleet and Rotables includes 39 Aircraft (ten A-319, twelve A-321, eight B777-200LR, nine B777-300 ER) (Previous Year: 32 Aircraft- {ten A319, twelve A321, five B777-200LR, five B777-300ER}) & 4 Spare GE Engines (Previous Year 3 Spare GE Engines) and Registration of these 39 Aircraft & 4 Spare Engines continues to be in the name of SPV Company for which beneficial ownership is with NACIL. Gross Block Rs. 161,446.4 Million (Previous Year: Rs. 123,201.6 Million), Depreciation Rs. 13,394.5 Million (Previous Year: Rs. 5,586.9 Million), Net Block Rs. 148,051.9 Million (Previous Year: Rs. 117,614.7 Million). Future Lease rental obligations aggregate to Rs. 133,559.6

Fixed Assets and Depreciation Accounting

187

(Rupees in Millions) DEPRECIATION

NET BLOCK Total Upto March 31, 2010

As at March 31, 2010

1469.8 — —

16931.0 83.9 210.0

150639.6 329.0 323.1

116189.9 365.8 —

2927.0 — — 93.8 283.6 74.6 — 11696.6

(1211.2) — — — 24.7 15.1 — 298.4

6756.3 — 47.1 274.2 861.2 183.6 0.2 25347.5

49313.2 2.7 2.5 681.8 2766.7 681.3 — 204739.9

12321.9 2.7 — 131.3 2632.7 473.8 — 132118.7

— 306.8 2481.3 124.7 2912.8

— 116.1 1234.7 30.7 1381.5

— — 1.8 5.0 6.8

— 422.9 3714.2 150.4 4287.5

7057.8 63437.2 14134.9 87.1 84717.0

7057.8 63533.6 15359.6 121.5 86072.5

409.0

238.1

0.6

646.5

2209.9

1900.0

614.2 31.7 25.0 241.9 134.2 1456.0

342.1 16.1 12.8 142.1 58.8 810.0

0.3 — 0.2 (0.3) 1.3 2.1

956.0 47.8 37.6 384.3 191.7 2263.9

3516.7 102.6 142.3 467.9 484.1 6923.5

3463.3 102.5 145.6 537.3 506.8 6655.5

62.4 18380.5 7601.2

29.3 13917.4 10920.9

— 307.3 141.6

91.7 31990.6 18380.5

39.5 296419.9 — 24656.2 321076.1

67.4 — 224913.5 50113.7 275027.2

Up to April 1, 2009

For the year

10280.0 44.6 52.5

8120.8 39.3 157.5

2618.1 — 47.1 180.4 602.3 124.1 0.2 13949.3

Deductions/ Adjustments

As at March 31, 2009

million (Previous year Rs. 116,887.5 Million) for which liability of an equal amount is included in the year-end balance of “Future Lease Obligations”. 3. Deductions under the block of Aircraft Fleet & Rotables includes improvements to leasehold aircraft on account of Aircraft Registration No. VT-ESM and 1 A300 Aircraft Engine sold/scrapped during the year, Gross Block: Rs. 422.3 Million (Previous Year: Rs. 282.1 million) Provision for Depreciation Rs. 59.0 Million (Previous Year: Rs. 29.5 Million). 4. Reclassification amongst Assets is adjusted under ‘Additions’ and ‘Deductions’ of respective assets. 5. Capital Work in Progress includes advances against Capital Expenditure Rs. 19,482.4 Million (Previous Year: Rs. 40,434.2 Million) and Loss of Rs. 1,319.7 Million (Previous Year: 7,321.2 Million) on account of Exchange Rate fluctuation on underlying monetary items in foreign currency. Source: Annual Report, Air India, 2009-10

188 Financial Accounting

Read the case and answer the following questions. 1. Identify the major differences in the way the two airlines account for depreciation expense for their assets (methods, asset lives, residual values, etc). 2. Calculate what proportion of fixed assets is represented by intangible assets by both the companies. 3. Identify major differences in accounting policy disclosures made by both the companies.

Inventory Valuation

7

Learning Objectives After studying this chapter, you will be able to ❖

Understand what are inventories and become familiar with different forms of inventories

❖

Distinguish between periodic and perpetual inventory system

❖

Know different methods of valuation of inventories like FIFO, LIFO, Simple and Weighted Average methods

❖

Analyse efficiency of inventory management

Inventory Valuation

191

LET US SET THE STAGE . . . Mr Rangrajan, CEO, was evaluating operating performance of Swastik Manufacturing Ltd, a single product company. He was delighted to see operating data but was surprised to observe that though sales have increased by 60%, profit has increased by 34% only. One of the directors commented that it may be due to improper method of valuation of inventory. The CFO informed that they are currently using LIFO method. Mr Rangrajan requested the CFO to prepare accounting statement using the alternative methods as he was concerned about showing more profits. The CFO found out that as on 31st March, 2012 there were inventories consisting of 12 units valued @ Rs 5 and 2 units valued @ Rs 5.50. The CEO wanted to know whether different methods of inventory valuation can lead to different profit figures. Which method will provide true value of inventory on hand? You are provided with the following information: Swastik Manufacturing Ltd (Rs lakhs) Income Statement for the Month Particulars Sales COGS Gross Margin Selling, General and Administrative Expenses Income before Tax Income Tax Net Income Balance Sheet as on 31st March Fixed Assets Cash Accounts Receivable Inventory Total Assets Current Liabilities Long-term Liabilities Equity Capital Retained Earnings Total Liabilities

30 April 2012

31 May 2012

750 407 343 225 118 48 70

1,200 718 482 325 157 63 94

692 50 125 60 927 125 250 200 352 927

790 70 175 50 1,085 162 337 200 386 1,085

Inventory Details Particulars Purchases

Issues

31st March, 2012

30th April 2012 (units rates)

31st May 2012 (units rates)

—

50 @ 5.76 = 288 18 @ 6 = 108

20 @ 6.25 = 125 26 @ 6.5 = 169 48 @ 6.75 = 324

70 units

96 units

192 Financial Accounting

INTRODUCTION Objective 1 Inventory or stock refers to that portion of To understand what are material purchased or manufactured that remains inventories and become unconsumed or unsold. Inventory management familiar with different forms of inventories is primarily about specifying the size and placement of goods. Inventory management is concerned with managing purchase, sale and stock keeping of inventories. Inventories are assets:(a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. —AS-2 All business organisations are required to carry stocks or inventories. Such inventory may be in different forms: (a) Raw material (b) Components (c) Work-in-process (d) Finished goods (e) Spare parts (f) Consumables For a manufacturing concern, inventory consists of all the types mentioned above. However, for a trading concern it consists of finished goods only while service organisations maintain inventory in small quantities usually of spare parts and consumables. EXHIBIT 7.1

Inventories in Cement Industry for Manufacturing Concern

Inventories

Examples

Raw Material

Gypsum, Slag

Work in Progress

Semi-finished Cement

Finished Goods

Ready–Mixed Concrete Cement

Stores and Spares

Chemicals, Packing Material, etc.

For Trading Concern say Cement Distributor Finished Goods

Ready–Mixed Concrete Cement

There are three basic reasons for keeping an inventory: 1. Time: The time gaps present in the supply chain, from supplier to user at every stage, requires maintaining certain amount of inventory to be used during this time period.

Inventory Valuation

193

2. Uncertainty: Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. 3. Economies of Scale: Purchasing or producing goods in bulk gives benefits of economies of scale like quantity discount, bulk transportation, saving in set up time.

RECORD KEEPING FOR INVENTORY For proper inventory control, it is necessary to keep record of inflow and outflow of inventories and to verify it physically. We shall now discuss the methods of record keeping and physical verification of inventory before discussing the valuation aspect.

Periodic Inventory System The periodic stock taking is a process of physical verification of inventory by taking actual physical count (or weight) at periodic interval. Depending on the volume of inventory the periodic stock taking may need 1 or 2 days. Under this system, the Cost of Goods Sold (COGS) is computed as a residual amount. COGS = Opening Stock (Known) + Purchases (Known) – Closing Stock (Counted)

ILLUSTRATION 7.1 Opening stock is Rs 8,00,000, purchases Rs 10,00,000, closing stock Rs 5,00,000. You are required to compute the COGS. Solution: Calculation of COGS using Periodic Stock Taking Amount in Rs Opening Stock

8,00,000

Add: Purchases

10,00,000

Cost of Goods Available for Sale

18,00,000

Less: Closing Stock

5,00,000

Cost of Goods Sold

13,00,000

PERPETUAL INVENTORY SYSTEM The perpetual inventory system is a system of record keeping under which continuous records are maintained for the movement in inventory. Whenever, an item is purchased

194 Financial Accounting

or issued or sold or gets spoiled, the records are updated immediately to know the latest stock. Usually this system is supplemented by continuous stock taking which facilitates immediate comparison and reconciliation of discrepancies. The records of inventory are available on continuous basis and physical verification of inventory is done without any interruption in the operations. The perpetual inventory system is immensely popular and used by most of the organisations. The perpetual inventory system generates “Stores Ledger” which gives all the details of each item of inventory, in real time. Stores Ledger contains an account for every item of stores and makes a record of the receipts, issues and the balances, both in quantity and value. Periodic vs Perpetual Inventory System Suitability of periodic and perpetual systems: ■ Small enterprises may favour the periodic inventory system due to low operating cost. ■ The periodic inventory system causes stopping of operations for stock taking. ■ As business grows and becomes more complex, perpetual inventory system becomes necessary. ■ The perpetual inventory system provides more accurate and timely data. However, it is more time consuming and expensive. ■ Perpetual inventory system is becoming more popular because it enables better managerial control over operations.

INVENTORY VALUATION/MEASUREMENT Objective 2 An inventory valuation allows a company to To distinguish between periodic provide a monetary value for items that make and perpetual inventory systems up their inventory. Inventories are usually the largest current asset of a business, and their proper valuation is necessary to prepare financial statements. If inventory is not properly valued, expenses and revenues cannot be properly matched and a company could make poor business decisions.

Cost of Inventories The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

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195

The costs of purchase consist of the purchase price including duties and taxes, freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, not included in the cost of inventories. The inventory cost is the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It refers to production cost of those goods which are produced internally or acquisition cost of those goods which are purchased from outside.

Net Realisable Value The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs necessary to make the sale have increased. The practice of writing down inventories below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. —AS-2 Estimates of net realisable value are based on the most reliable evidence available, at the time the estimates are made, as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date.

196 Financial Accounting

Inventories should be valued at the lower of cost and net realisable value. —AS-2 Let us understand this with the help of a practical example.

ILLUSTRATION 7.2 Given the following details, determine the value of stock. Commodity

Inventory Quantity

Cost Price Rs

Market Price Rs

A

600

30,000

33,000

B

180

86,220

89,460

C

269

49,765

48,420

D Total

250

65,000

68,750

1,299

2,30,985

2,39,630

Solution: Commodity

Inventory Quantity

Cost (C)

Market (M)

Lower of C or M

A

600

30,000

33,000

30,000

B

180

86,220

89,460

86,220

C

269

49,765

48,420

48,420

D

250

65,000

68,750

65,000

1,299

2,30,985

2,39,630

2,29,640

Total

The value of stock Rs 2,29,640.

METHODS OF VALUATION OF INVENTORIES Valuation of inventories can be carried out by using the following methods (see Figure 7.1): ■ ■ ■ ■ ■

Specific identification method First-In First-Out (FIFO) method Last-In First-Out (LIFO) method Simple Average method Weighted Average method

Objective 3 To know different methods of valuation of inventories like FIFO, LIFO, Simple and Weighted Average methods

Inventory Valuation

197

Methods of Valuation of Inventories

Non-interchangeable Stocks

Specific Identification Method

Interchangeable Stocks

Historical Cost Method

Non-Cost Methods

FIFO

Standard Cost

LIFO

Adjusted Selling Price

Simple Average

NIFO

Weighted Average

FIGURE 7.1

Methods of Valuation of Inventories

Specific Identification Method Non-interchangeable stock includes specific identification method. This method requires the physical identification and matching of the particular items sold. The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs. This kind of identification is practically impossible for inventories with homogeneous items. Hence, the specific identification method continues to be largely confined to expensive individualised merchandise. In most business situations, materials kept in inventory are interchangeable and purchased in various lots at various prices and at various times. It is, thus, necessary to develop a method of pricing which is based on assumptions about the identity of the goods sold in relation to the identity of the goods purchased. There are several methods for identification of costs of goods held in inventory, primarily with a view to match the cost of goods sold against the revenue derived during an accounting period.

198 Financial Accounting

Interchangeable stock is divided into historical costs method and non-cost methods. Historical costs method includes FIFO, LIFO, Simple Average and Weighted Average.

First-In First-Out (FIFO) This method assumes that the goods purchased/manufactured first are issued first. That is the goods issued or sold currently are those which represent the earliest purchases amongst the goods held in inventory. This would mean that the goods which remain in stock are those which represent the most recent purchases.

ILLUSTRATION 7.3 The following are the receipts and issue transactions of Product Zed during March 2012 in a firm: 1st March Receipt of 150 units @ Rs 20 per unit 4th March Receipt of 100 units @ Rs 24 per unit 8th March Issue of 140 units 12th March Receipt of 150 units @ Rs 31 per unit 13th March Issue of 170 units 14th March Purchased of 90 units @ Rs 33 per unit 20th March Receipt of 75 units @ Rs 33 per unit 22nd March Issue of 200 units 25th March Receipt of 100 units @ Rs 37 per unit 30th March Issue of 45 units Find out the value of closing stock using the FIFO method of pricing the issues. Solution: Stores Ledger (FIFO Method) Receipts Date

Issues

Quantity

Rate Rs

150

20

3,000

100

24

2,400

Value

Quantity

Rate Rs

Balance Value Rs

Quantity

Rate Rs

Value Rs

150

20

3,000

2012 1st March th

4 March 8th March 12th March

– 150

– 31

– 4,650

–

140 –

–

20 –

–

2,800 –

150

20

3,000

100

24

2,400

10

20

200

100

24

2,400

10

20

200

100

24

2,400

150

31

4,650 (Contd.)

199

Inventory Valuation 13th March

–

–

–

10

20

200

24 31 –

2,400 1,860 –

14th March

90

33

2,970

100 60 –

20th March

75

33

2,475

–

–

–

22nd March

–

–

–

25th March

100

37

3,700

90 90 20 –

31 33 33 –

2,790 2,970 660 –

30th March

–

–

–

45

33

1,485

19,195

555

Total

665

15,165

90

31

2,790

90 90 90 90 75 55

31 33 31 33 33 33

2,790 2,970 2,790 2,970 2,475 1,815

55 100 10 100 110

33 37 33 37

1,815 3,700 330 3,700 4,030

The main advantage of this method is that the inventory is at the current prevailing prices because the latest purchased units remain in the stock. However, issues are priced from earlier lots and hence their cost may not be close to the current market rates.

Last-In First-Out (LIFO) This method is just the opposite of the FIFO method. This method assumes that the goods issued or sold out of the inventory are the ones most recently purchased and manufactured. Therefore, the goods held in stock represent the earliest purchases production.

ILLUSTRATION 7.4. Date 02/1/2012 02/3/2012 02/4/2012 02/6/2012 02/10/2012 14/2/2012 15/2/2012 19/2/2012 24/2/2012 26/2/2012

Purchases Purchases Sales Purchases Sales Sales Purchases Purchases Sales Sales

Number of Units

Price per Unit

Amount

1,00,000 20,000 10,000 20,000 90,000 36,000 40,000 30,000 60,000 8,000

10 8

10,00,000 1,60,000

12

2,40,000

15 16

6,00,000 4,80,000

Find out the value of closing stock using the LIFO method of pricing the issues.

200 Financial Accounting

Solution:

Price per Unit

10,00,000

1,00,000

10

10,00,000

02/3/2012

20,000

8

1,60,000

1,00,000

10

10,00,000

20,000

8

1,60,000

1,00,000

10

10,00,000

10,000

8

80,000

1,00,000

10

10,00,000

10,000

8

80,000

02/6/2012

10,000 20,000

12

14/2/2012

19/2/2012

40,000 30,000

15 16

12

2,40,000

12

2,40,000

40,000

10

4,00,000

10,000

8

80,000

0

60,000

10

6,00,000

0

36,000

10

3,60,000

4,000

10

40,000

4,000

10

40,000

40,000

15

6,00,000

4,000

10

40,000

40,000

15

6,00,000

30,000

16

4,80,000

4,80,000

26/2/2012 2,10,000

20,000 20,000

6,00,000

24/2/2012

Total

80,000

2,40,000

02/10/2012

15/2/2012

8

2,48,000

Amount

Number of Units

10

Amount

1,00,000

Price per Unit

02/1/2012

02/4/2012

Number of Units

Date

Amount

Balance

Price per Unit

Sales

Number of Units

Purchases

30,000

16

4,80,000

4,000

10

40,000

30,000

15

4,50,000

10,000

15

1,50,000

8,000

15

1,20,000

4,000

10

40,000

2,000

15

30,000

2,04,000

2,41,000

6,000

70,000

Under, this method the materials are issued to the production shop from the latest lot, therefore, the cost of production appears at the current market rates. However, the inventory is not at the current market rates because materials from the oldest lot remain in the inventory.

Simple Average Method This method is based on an assumption that since all the lots of materials are stored in one single physical location in the stores the individual identity of the various lots is lost.

Inventory Valuation

201

Therefore, the price to be considered for the issue of materials is the average price. The average price is calculated by adding the prices of the lots currently held and dividing the total by the number of lots currently in stock.

ILLUSTRATION 7.5 The following transactions of receipts and issue of item “EXE” took place during September 2012: 3rd September ……………….. Receipt of 200 units @ Rs 50 per unit 6th September ……………….. Receipt of 150 units @ Rs 56 per unit 10th September ……………… Issue of 250 units 14th September ……………… Issue of 60 units 20th September ……………… Receipt of 340 units @ Rs 58 per unit 24th September ……………… Issue of 255 units Find out the value of closing stock using simple average method of pricing the issues. Solution Stores Ledger Valuation of inventory under simple average method Date

Receipts Quantity

Rate Rs

Issues Value

Quantity

Rate Rs

200

50.00 10,000

–

–

150

56.00

8,400

–

–

–

–

–

250

53

th

–

–

–

60

53

th

340

58.00 19,720

0

th

0

0

255

38,210

565

Balance Value Rs

Quantity

Rate Rs

Value Rs

2012 3rd September th

6 September 10th September 14 September 20 September 24 September Total

690

–

–

200

10,000

–

350

18,400

13,250

100

5,150

3180

40

1,970

–

0

380

21,690

57

14,535

125

7,155

30,965

125

7,155

This method can be applied only if the prices are fairly stable and the size of every lot is more or less uniform.

Weighted Average Method The method takes care of the drawbacks of the simple average method. Under this method the number of units, i.e. the quantity of the materials is also taken into consideration to calculate the average price. To calculate the average price the weights

202 Financial Accounting

of the quantity are assigned to the value. That means, under this method the average price of a units is simply the total cost of materials in stores divided by the total quantity. This method evens out the price fluctuations and eliminates the disadvantages of FIFO and LIFO methods.

ILLUSTRATION 7.6 Using the information available in Illustration 7.3, find out value of closing stock using weighted average method. Solution Stores Ledger Valuation of inventory under weighted average method Date

Receipts Quantity

2012 3rd September 6th September 10th September 14th September 20th September 24th September Totals

200 150 0 0 340 0 690

Issues

Rate Rs

Value

50.00 56.00 0.00 10.00 58.00 0

10,000 8,400 0 0 19,720 0 38,120

Quantity

0 0 250 60 0 255 565

Balance

Rate Rs

Value Rs

0 0 52.57 52.57 0 57.43

0 0 13,142.86 3,154.286 0 14,644.29 30,941.44

Quantity

200 350 100 40 380 125 125

Rate Rs

Value Rs

50.00 52.57 52.57 52.57 57.43 57.43 57.43

10,000 18,400 5,257.143 2,102.857 21,822.86 7,178.571 7,178.571

Under this method the weighted average price is revised after every new lot is received. This price is applied to all the issues made till the next lot is received.

Comparison between FIFO, LIFO and Weighted Average Methods Of all the methods specified above the methods which are popularly used are FIFO, and weighted average. The Indian AS and tax laws allow use of FIFO, and weighted average methods only. Each of these methods has different impact on financial statements which can be understood from following illustration.

ILLUSTRATION 7.7 Following transaction took place during September 2012. Prepare stores ledgers on FIFO, LIFO and weighted average method of inventory valuation and show its impact on the balance sheet and income statement of these methods. September th

10 20th 26th

Product K

Units

Amount

Purchase Purchase Sales

10 7 5

200 196 175

Inventory Valuation

203

Solution: Valuation of Inventory under FIFO Method Date

Receipts

Issues Quantity

Rate Rs

Balance

Quantity

Rate Rs

Value Rs

Value Rs

Quantity

Rate Rs

Value Rs

0

0

0

10th September

10

20

200

0

0

0

10

20

200

20th September

7

28

196

0

0

0

10

20

200

7

28

196

2012 Opening Inventory

th

26 September Total

0

0

17

0

5

396

20

5

100 100

5

20

100

7

28

196

12

296

Valuation of Inventory under LIFO Method Date

Receipts Quantity

Rate Rs

Issues Value Rs

Quantity

Rate Rs

Balance Value Rs

Quantity

Rate Rs

Value Rs

2012 Opening Inventory th

0

0

0

10 September

10

20

200

0

0

0

10

20

200

20th September

7

28

196

0

0

0

10

20

200

7

28

196

10

20

200

2

28

56

th

26 September Total

0

0

17

0

5

396

28

5

140 140

12

256

Valuation of Inventory under Weighted Average Method Date

Receipts Quantity

Rate Rs

Issues Value Rs

Quantity

Balance

Rate Rs

Value Rs

Quantity

Rate Rs

Value Rs

2012 Opening Inventory th

0

0

0

10 September

10

20

200

0

0

0

10

20.00

200

20th September

7

28

196

0

0

0

17

23.29

396

26th September

0

0

0

5

23.29

116

12

23.29

280

396

5

116

12

Total

17

280

204 Financial Accounting FIFO

LIFO

WA

Closing Stock

296

256

280

COGS

100

140

116

It can be observed that closing inventory is higher in case of the FIFO method followed by WAM and LIFO method. While COGS is lower in case of the FIFO method followed by WAM and LIFO method. Now we will see how it affects the income statement and balance sheet. Income Statement for the month of September 2012

Sales

FIFO Method

LIFO Method

Weighted Average Method

175

175

175

Less: COGS 0

0

0

Purchases

Opening Stock

396

396

396

Closing Stock

296

256

280

Cost of Goods Sold

100

140

116

75

35

59

Profit

Effect on Balance Sheet FIFO Method

LIFO Method

Weighted Average Method

Value of Inventory

296

256

280

Profit and Loss A/c

75

35

59

ANALYSIS OF INVENTORIES Objective 4 A merchandise business should keep enough To analyse efficiency of inventories on hand to meet the needs of its inventory management customers. A failure to do so may result in lost sales. At the same time, too much inventory leads to excess funds lying idle in stocks. In addition, excess inventory increases expenses such as insurance, and stores overheads. Finally, excess inventory increases the risk of losses due to price declines, damages or changes in customers’ buying patterns. In view of this it becomes necessary to judge suitable level of inventory. To analyse the efficiency of inventory management, the important measures are inventory turnover and the number of days of inventory. Inventory turnover measures the relationship between the volume of goods sold and the amount of inventory carried during the period. It is computed as follows:

Inventory Valuation

Inventory Turnover =

205

Cost of Goods Sold Average Inventory

The average inventory can be computed using weekly, monthly, or yearly figures. To simplify, we may determine the average inventory by dividing the sum of the inventories at the beginning and end of the period by 2. As long as the amount of inventory carried throughout the year remains stable, this average will be acceptable enough for the analysis. The inventory turnover ratio helps in analysing the efficiency of utilisation of stock. The higher ratio indicates more efficiency. The number of days of inventory is a rough measure of the length of time it takes to acquire, sell, and replace the inventory. It is computed as follows: Number of Days’ Sales in Inventory =

Average Inventory COGS per day

The average daily COGS is determined by dividing the cost of merchandise sold by 365. Calculating inventory in terms of number of days makes it easier to understand and compare the level of inventory.

ILLUSTRATION 7.8 Particulars Cost of Goods Sold (Rs) Opening Stock (Rs) Closing Stock (Rs)

2012

2011

32,00,000 2,80,000 3,30,000

35,00,000 3,30,000 4,50,000

Calculate inventory turnover ratio and number of days. Solution Average Inventory = (Opening Stock + Closing Stock)/2 Year 2012 = (2,80,000 + 3,30,000)/2 = 3,05,000 Year 2011 = (3,30,000 + 4,50,000)/2 = 3,90,000 Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory Year 2012 = 32,00,000/3,05,000 = 10.49 Year 2011 = 35,00,000/3,90,000 = 8.97

206 Financial Accounting

Number of Days’ Sales in Inventory = Average Inventory/COGS per day Year 2012 = 3,05,000/ (32,00,000/365) = 34.78 days Year 2011 = 3,90,000/ (35,00,000/365) = 40.67 days It can be observed that the turnover ratio has declined and number of days’ sales in inventory has increased.

SUMMARY ➤

The correct valuation of closing stock is necessary to correctly calculate the profit and to show true and fair financial position.

➤

Periodic inventory system or perpetual inventory system can be used for record keeping of inventory.

➤

The inventory should be valued in the financial statements at lower of the cost or market price.

➤

The popular methods of inventory valuation are First-In-First-Out (FIFO), LastIn-First-Out (LIFO), Simple Average or Weighted Average Method.

➤

Financial analysis of inventories can be done by calculating inventory turnover ratio and number of days’ sales in inventory.

MULTIPLE CHOICE QUESTIONS* 1. Which system ensures continuous information regarding quantum and value of inventory? (a) Periodic inventory system (b) Perpetual inventory system (c) Both of the above (d) FIFO 2. Assuming no beginning inventory, what can be said about the trend of inventory prices if cost of goods sold computed using the FIFO method exceeds cost of goods sold when inventory is computed using the LIFO method? (a) Prices decreased (b) Prices remained unchanged (c) Prices increased (d) Price trend cannot be determined from information given * Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

Inventory Valuation

207

3. Under which method of stock valuation cost of production appears close to current market rate? (a) FIFO (b) LIFO (c) Simple Average Method (d) Weighted Average Method 4. An inventory should be valued at ______________________________. (a) Lower of cost or market value (b) Higher of cost or market value (c) Cost or market value as per the desire (d) Average cost The following information is available of Jim Jam Company: Opening Stock 1,000 units at Rs 9 each 1st Purchase 2,200 units at Rs 9.60 2nd Purchase 800 units at Rs 12 3rd Purchase 3,200 units at Rs 13.20 If sales during the year are 5,400 units answer question numbers 5 to 7: 5. What is the value of closing stock using FIFO method? (a) 23,760 (b) 16,680 (c) 20,490 (d) 16,700 6. What is the value of closing stock using LIFO method? (a) 23,760 (b) 16,680 (c) 20,490 (d) 16,700 7. What is the value of closing stock using Weighted Average Method? (a) 23,760 (b) 16,680 (c) 20,490 (d) 16,700 Hari & Company wants to know the effect of different inventory methods on financial statements. Given below is the information about beginning inventory and purchases for the month of January 2012. 2nd January

Beginning Inventory

500 units at Rs 3.00

th

Purchased

1,100 units at Rs 3.20

th

Purchased

400 units at Rs 4.00

th

Purchased

1,600 units at Rs 4.40

18 January 20 January 28 January

Sales during the year were 2,700 units at Rs 5.00.

208 Financial Accounting

8. If Hari & Co. used the FIFO method, ending inventory would be ___________. (a) Rs 2,780 (b) Rs 3,960 (c) Rs 9,700 (d) Rs 10,880 9. If Hari & Co. used the LIFO method, ending inventory would be ____________________. (a) Rs 2,780 (b) Rs 3,960 (c) Rs 9,700 (d) Rs 10,880 10. If Hari & Co. used the Weighted Average Method, ending inventory would be ___________. (a) Rs 2,780 (b) Rs 3,960 (c) Rs 9,700 (d) None of the above

THEORY QUESTIONS 1. 2. 3. 4. 5. 6.

What do you understand by the treatment and valuation of inventory? Which are the important methods used for record keeping of inventory? Distinguish Between the Periodic and Perpetual System of Inventory valuation. What is the main feature of FIFO? What is the main feature of LIFO? Write a note on financial analysis of inventories.

PRACTICAL PROBLEMS Level 1: Easy 1. Calculate closing stock under FIFO and LIFO methods from the following data. (You need not make stores ledger.) Inventory st

Purchases th

1 October 140 units at Rs 250 6 October 290 units at Rs 300 21st October 320 units at Rs 330

Sales 11th October 390 units 16th October 16 units 26th October 267 units

Inventory Valuation

209

2. Calculate closing stock under LIFO. FIFO and weighted average from the following data. Units 20 15 32 29 25 17

Beginning Inventory Sale First Purchase Sale Second Purchase Sale

Per unit Rs 10 30 15 30 20 40

3. Find out from the following data for the year 2011 the cost of goods sold, closing inventory and profit under the FIFO and LIFO methods of inventory valuation: 1 January 31 January 28 February 31 March

200 units at Rs 3 each 240 units at Rs 4 each 220 units at Rs 5 each 280 units at Rs 6 each

Inventory Purchases Purchases Purchases

Sales of 800 units at Rs 8 each. 4. Prepare stores ledgers on the basis of FIFO and LIFO methods. Date 1.4.10 20.6.10 17.9.10 18.11.10 12.12.10 31.1.11 31.3.11 Total

Inventory Purchase Sold 900 units Purchase Sold 5,500 units Purchase Sold 2,500 units

Units 500 1,600

Unit Cost 75 80

5,200

85

2,000

90

9,300

Level 2: Standard 5. From the following data, calculate the value of closing inventory according to LIFO method on 31st March, 2012, 1 March: Stock in hand 800 units @ Rs 7.50 each Purchases 5th March 15th March 25th March 30th March Issues 3rd March 10th March 17th March 26th March 31st March

1,200 units @ Rs 8 each 1,000 units @ Rs 9 each 800 units @ Rs 8.50 each 600 units @ Rs 9.50 each 600 units 1,000 units 800 units 1,000 units 400 units

210 Financial Accounting

6. Prepare store ledger as per FIFO and Weighted Average Method (WAM). Date of Purchase

Quantity

1.4.2002

1,000

10

7.4.2002

1,000

11

2.5.2002

1,200

8.5.2002

800

Rate (Rs)

Date of Issue

Quantity

10.4.2002

1,800

13.5.2002

2,100

12 11.5

st

7. A company, started on 1 January, 2012 purchased raw material during 2001 as stated below: 2 January 26 February 13 April 10 July 18 September 29 November

400 kg 600 kg 1,250 kg 1,500 kg 750 kg 500 kg

@ Rs. 62 per kg @ Rs. 57 per kg @ Rs. 59 per kg @ Rs. 56 per kg @ Rs. 60 per kg @ Rs. 65 per kg

While preparing its final accounts on 31st December, 2012, the company had 650kg of raw material in its godown. Calculate the value of closing stock of raw materials according to: (i) First-In First-Out basis, (ii) Last-In First-Out basis, and (iii) Weighted Average basis. 8. From the following data, calculate the cost of goods sold and closing inventory under FIFO, LIFO and Weighted Average Cost methods of inventory valuation: 1 March: Stock in Hand—500 units @ Rs 10 Purchases 3 March 10 March 18 March 24 March 30 March

500 units @ Rs 11 1,000 units @ Rs 12 600 units @Rs 10 500 units @ Rs 12 400 units @ Rs 13

Issues 2 March 9 March 16 March 23 March 31 March

400 units 500 units 900 units 500 units 600 units

9. On the basis that the last material to be received is first to be sold, find out the cost of the goods sold from the following information: Purchases made and sales therefrom: 4 January 15 January 21 January 27 January

1,000 kg @ Rs 2 per kg 700 kg @ Rs 2.10 per kg 800 kg @ Rs 2.25 per kg 1,200 kg @ Rs 2.35 per kg

16th January 24th January 30st January

1,500 kg 600 kg 1,240 kg

State briefly the merits and demerits of this method, of valuing stock, using the data above.

Inventory Valuation

211

10. The following are the details of S Ltd: 1 January 2013 Opening Stock Nil 1 January 2013 Purchases 100 units @ Rs 60 per unit 15 January 2013 Issues for consumption 50 units 1 February 2013 Purchases 200 units @ Rs 80 per unit 15 February 2013 Issued for consumption 100 units 20 February 2013 Issues for consumption 100 units 1 March 2013 Purchases 150 units @ Rs 100 per unit. 15 March 2013 Issued for consumption 100 units Find out the value of stock as on 31 March 2013 if the company follows: (a) FIFO (b) Weighted Average Method

Level 3: Expert 11. Prepare stock ledger for the following transactions under First-In First-Out (FIFO), Last-In First-Out (LIFO) and Weighted Average Method (WAM). Date

Number of Units

Price per Unit

Amount

1 Feb. 2012

Purchases

50,000

10

5,00,000

3 Feb. 2012

Purchases

10,000

8

80,000

4 Feb. 2012

Sales

6 Feb. 2012

Purchases

10,000

12

1,20,000

10 Feb. 2012

Sales

45,000

14 Feb. 2012

Sales

18,000

15 Feb. 2012

Purchases

20,000

15

3,00,000

19 Feb. 2012

Purchases

15,000

16

2,40,000

24 Feb. 2012

Sales

30,000

26 Feb. 2012

Sales

4,000

5,000

12. Navin Ltd was following the LIFO method of valuation of stock. Due to promulgation of revised accounting standard, they want to switch over to the FIFO method. From the following information: 1. Draw up stock ledgers under FIFO and LIFO methods of valuation of stocks. 2. Find out the closing stock and cost of materials consumed under each of the above two methods and comment about impact on his profit due to such changes under various economic scenario. Opening Stock 10,000 MT @ Rs 44 per MT Rs 4, 40,000

212 Financial Accounting

Purchases: 1 June 2013 5 June 2013 10 June 2013 15 June 2013 20 June 2013 28 June 2013 30 June 2013 Issues: 5 June 2013 10 June 2013 20 June 2013 25 June 2013 30 June 2013

2,000 MT @ Rs 60 per MT 4,000 MT @ Rs 70 per MT 3,000 MT @ Rs 76 per MT 3,000 MT @ Rs 70 per MT 4,000 MT @ Rs 64 per MT 4,000 MT @ Rs 70 per MT 3,000 MT @ Rs 60 per MT 4,000 MT 6,000 MT 8,000 MT 6,000 MT 9,000 MT

RESEARCH ASSIGNMENTS 1. Download annual report (2012–11) of ONGC, HPCL and BPCL, study current assets, inventory schedule and accounting policies related to inventories and answer the following questions. (a) What inventory costing methods are used by each? How does each company value its inventories? (b) Comment on accounting policies adopted by each company to compute and disclose inventories? (c) What is the amount of inventory reported by each company? What percent of total assets is invested in inventory by each company? (d) Compute and compare the inventory turnover ratios and days of each company and indicate why there might be a significant difference between the companies.

INTERPRETING FINANCIAL REPORTS 1. The following is the information of Rmox India Ltd. Rs in lakhs Current Assets, Loans and Advances

31/03/2012

31/03/2011

Inventories

74,775.80

54,434.09

6,623.19

3,493.73

Sundry Debtors

(Contd.)

Inventory Valuation

213

(Contd.) Cash and Bank Balances

3,531.23

1,921.68

24,105.74

21,579.13

1,09,035.96

81,428.63

Total Assets

2,24,312.12

1,50,451.50

Sales Turnover

5,51,450

4,60,740

COGS

3,80,210

3,60,450

Loans and Advances

Inventories Rs in Lakhs Particulars

31/3/2012

31/3/2011

Finished Goods

49,841.22

33,261.13

Semi Finished Goods

19,175.11

16,099.95

Raw Material

4,448.95

3,896.32

Consumables Stores

1,183.53

1,067.24

16.77

45.02

Spare Parts (Machinery) Packing Materials TOTAL

110.21

64.42

74,775.79

54,434.08

Significant Accounting Policies for Inventories ■

■

■

■

■

Raw materials, consumables, stores and spares are valued at cost as certified by the management. Work-in-progress is valued at direct raw material cost and appropriate cost of completed process. Finished goods are valued at lower of cost and net realisable value as certified by the management. Finished goods include cost of conversion and other costs incurred in bringing the inventories to their present location and condition. Cost of inventories is computed on the LIFO basis. Net realisable value is the estimated selling price in the ordinary course of business, less estimated costs of completion and to make the sale. You are required to (a) Comment on inventories policy adopted by Koutons Retails India Ltd. (b) Compute inventory to total assets and inventory to current assets ratio and comment on the same. (c) Compute inventory turnover ratio for the year ended March, 2011 and March, 2012 and interpret the same.

214 Financial Accounting

BUSINESS CASES Mr Shyamkant Iyer, MD of Aakash Ltd was going through the inventory records of his company. He found that the valuation of inventory was done as per the FIFO method. He was a young CEO who had recently joined with CFA (US) qualification. He asked his accountant about consistent use of the FIFO method for valuation and not LIFO or any other popular method for valuation. The accountant explained him about the Indian Accounting Standards. However, he insisted on producing records with alternate methods and doing a comparison following periodic system for record keeping of inventory. Assuming the following information about inventory how would you as an accountant value the stock using different methods and give your interpretations? Find out the closing stock value as on 31 July 2011. Model

Inventory, 1 July

Purchases Invoices 1st

2nd

Stock Count 31ST July

3rd

Units

Rate

Units

Rate

Units

Rate

Units

Rate

Units

K 08

11

10

10

11

13

12

8

15

7

M 88

8

12

5

12

9

12

5

13

5

MM8

9

11

7

13

6

15

1

20

1

08KM

14

8

9

8

0

11

10

9

MKM8

18

7

13

7

5

8

0

KKKM

20

13

9

16

8

18

15

K8M

10

5

6

10

15

10

0

4 20

8 3

Corporate Accounts

Learning Objectives After studying this chapter, you will be able to ❖

Understand company form of business organisation

❖

Know about shares and debentures

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Learn the accounting for issue of shares

❖

Learn the accounting for buyback of shares

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Become familiar with debentures and bonds

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Learn about the nuances of a balance sheet

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Know the contents of a company’s annual report

8

Corporate Accounts 217

LET US SET THE STAGE . . . Keshav, a stationery manufacturer, was approaching corporate clients as supplier, where he was told vendor validation norms do not allow him to bid, as only registered companies are permitted. He was wondering why this preference for companies, though he had good track record and required resources. Viraj, a school-going kid, knew that his father works for a company. He knew that they had a TV manufactured by a company. He was also aware that they have to pay to electricity company for use of electricity. Sachin Tendulkar also does advertisement for a company. He asked his mother what is this “Company”? When was it born? Where does it stay? Do we not see today’s business world dominated by companies. Most of the organised business activity is being done by companies. It is essential to understand what they are. Is their accounting different from that of other forms of organisation? It is very important for us to know company accounts.

INTRODUCTION TO COMPANIES Objective 1 According to Justice Marshall, “A corporation To understand company form of is an artificial being invisible, intangible and organisation existing only in the contemplation of law”. In India, a Company is formed and registered under the Companies Act, 1956.

Characteristics of a Company ■

■

■

■

Incorporated Association: A company comes into existence through the operation of law. Therefore, its incorporation under the Companies Act is imperative. Without such registration, a company cannot come into existence. The registration provides the status of domicile to the company. Separate Legal Entity: A company has a separate legal entity, which is not affected by changes in its membership. Perpetual Existence: Since a company’s existence is independent of its members, it continues to be in existence despite the death, insolvency, or change in the composition of its members. Limited Liabilities: The liability of every shareholder of a company is limited to the face value of shares allotted to that shareholder. If such shares are fully paid up, member has no further liability. There is also provision for unlimited liability company though such companies are not popular in India.

218 Financial Accounting ■

■

■

■

Separation of ownership and management: Shareholders are the owners of the company while the control and management of company’s affairs are entrusted to the directors; they carry on the business of the company on the basis of fiduciary relationship with the shareholders. Periodic Audit: A company has to get its accounts periodically audited through the Chartered Accountant appointed for the purpose by the shareholders on the recommendation of the board of directors. Memorandum of Association: It is a document of charter of company defining scope of the power with which company is established. Articles of Association: It determines the constitution of the internal management of the company. It defines the relationship between the members and with the companies.

TYPES OF COMPANIES ■

Statutory Company: All companies that operate under a special act passed by the state legislature or the Parliament, the Reserve Bank of India, are known as statutory companies. Such companies are not required to use the word “limited” as part of their names. For example, the Life Insurance Corporation of India (LIC), the Reserve Bank of India (RBI), etc.

■

Government Company: According to Section 617 of the Companies Act, 1956, “a government company means any company in which not less than 51% of the paid-up capital is held by the central government, or by any state government or governments. Such companies are also known as public sector company. For example Hindustan Petroleum Corporation Limited (HPCL), Oil and Natural Gas Corporation (ONGC).

Corporate Accounts 219 ■

Foreign Company: A foreign company is one that is incorporated outside India but has business operations in India. For example General Motors Company, Microsoft Corporation, Suzuki Motor, Hyundai, etc.

■

Subsidiary Company: A company is deemed to be subsidiary of another company when other company controls the composition of its board of directors or other company holds more than half in its nominal value of its equity share capital. Holding Company: A company is deemed to be a holding company if the other company is its subsidiary company, i.e. it owns 51% or more of paid-up share capital of subsidiary company. An example of a holding company and its subsidiaries is given below.

■

Holding company: TCS Ltd Some of its subsidiaries are:

● ● ● ● ● ● ● ● ●

CMC Limited WTI Advanced Technology Limited APONLINE Limited C-Edge Technologies Limited MP Online Limited Tata America International Corporation Tata Consultancy Services Netherlands BV Tata Consultancy Services Belgium SA Tata Consultancy Services Sverige AB

Source: Annual Report TCS Ltd, 2010–11 ■

■

■

Private Company: A private company means a company which restricts the rights of members to transfer its shares; or prohibits any invitation to the public to subscribe to any shares/ debentures of the company; or limits the number of members to 50. Public Company: “Public Company” means a company which is not a private company. Listed Company: Listed companies are those whose securities are listed on any recognised stock exchange. They are required to comply with corporate governance and other regulations laid down by SEBI. All big companies are listed companies like Reliance Industries Ltd, Tata Motors Ltd, Infosys Technologies Ltd.

220 Financial Accounting

SHARES AND SHARE CAPITAL Objective 2 Share capital is the amount of money contributTo know about shares and share ed by owners/shareholders for the furtherance capital of objectives of the company for which it was crated. Important terms related to share capital are: Authorised, registered, or nominal capital: This is maximum amount of capital that can be raised by a company. This is disclosed in the Memorandum of Association. ■ Issued capital: This is the part of authorised capital, which is offered for subscription. ■ Subscribed capital: It is that part of issued capital that represents the face or nominal value of shares subscribed by investors. ■ Called-up capital: It is the portion of subscribed capital that the directors require the shareholder to pay on the shares allotted to them. ■ Paid-up capital: The amount of called-up capital, which has been actually paid by the shareholders, is referred to as paid-up capital. ■ Reserve capital: A company may decide by special resolution that a certain portion of its uncalled capital shall not be available for being called up except in the event, and for the purpose, of liquidation. Such a portion is called reserve capital. Exhibit 8.1 shows details of share capital of Infosys Technologies Ltd while Exhibit 8.2 shows schedule of share capital of ONGC Ltd. ■

EXHIBIT 8.1

Details of Share Capital of Infosys Technologies Ltd

As on 31st March

Class of Share

Authorised Capital (Rs Cr)

Issued Capital (Rs Cr)

Paid Up Capital (Rs Cr)

2011

Equity Share

300

286.91

2010

Equity Share

300

2009

Equity Share

2008

Rs in crore Paid Up Shares (Nos)

Paid Up Face Value (Rs Cr)

286.91

57,38,25,192

5

286.91

286.91

57,38,25,192

5

300

286.42

286.42

57,28,30,043

5

Equity Share

300

286

286

57,19,95,758

5

2007

Equity Share

300

285.6

285.6

57,12,09,862

5

2006

Equity Share

150

137.78

137.78

27,55,54,980

5

Source: Annual Report Infosys Technologies Ltd 2010–11

Corporate Accounts 221

EXHIBIT 8.2 Schedule of Share Capital of ONGC Ltd Schedule-1

(Rs in million) st

As at 31 March, 2011

As at 31st March, 2010

SHARE CAPITAL Authorised: 30,00,000,000 Equity Shares of Rs 5 of each

150,000.00

150,000.00

42,777.64

21,388.92

42,777.45

21,388.73

0.14

0.14

(Previous Year 15,000,000,000 Equity Shares of Rs 10 each) Issued and Subscribed: 8,555,529,064 Equity Shares of Rs 5 each (Previous Year 2,138,891,502 Equity Shares of Rs 10 each) Paid up: 8,555,490,120 Equity Shares of Rs 5 each (Previous Year 2,138,872,530 Equity Shares of Rs 10 each) Add: Shares forfeited

Total 42,777.59 21,388.87 Notes: (i) Pursuant to the approval of the members dated 28.01.2011 one Equity Share having face value of Rs 10/each has been sub-divided into two Equity Shares of Rs 5/- each and bonus shares have been issued in the proportion of one new Equity bonus share of Rs 5/- each for every one existing fully paid equity share of Rs 5/- each held on 09-02-2011 (record date): (ii) The above includes: (a) 685,707,432 Equity Shares of face value of Rs 5 each (Previous year 342,853,716 Equity Shares of face value of Rs 10 each) issued as fully paid up to the President of India without payment being received in cash in terms of Oil and Natural Gas Commission (Transfer of Undertaking and Repeal) Act, 1993. (b) 7,856,540,812 Equity Shares of face value of Rs 5 each (Previous year 1,789,397,876 Equity Shares of face value of Rs 10 each) issued as fully paid up by way of bonus shares by capitalisation of General Reserve and Securities Premium. Source: Annual Report ONGC Ltd. 2010–11

ILLUSTRATION 8.1 A limited company has been incorporated with an authorised capital of Rs 10,00,000 divided into 1,00,000 shares of Rs 10 each. It offered 90,000 shares for subscription by the public and, out of which 85,000 shares were subscribed for. Company has called up Rs 6 per share and the amount called up has been paid by shareholders. You are required to show the information as required to be shown in the schedule of share capital for the company.

222 Financial Accounting

Solution: S.No.

Types of Share Capital

Shares (No)

Share Capital (Rs)

1.

Authorised capital

1,00,000 Shares of Rs 10 each

10,00,000

2.

Issued Capital

90,000 Shares of Rs 10 each

9,00,000

3.

Subscribed Capital

85,000 Shares of Rs 10 each

8,50,000

4.

Called-up Capital

85,000 Shares of Rs 10 each, Rs 6 each called up

5,10,000

5.

Paid-up Capital

85,000 Shares Rs 10 each, @ Rs 6 each paid up

5,10,000

Types of Shares A share is a fraction of the share capital and forms the basis of ownership interest in a company. The persons who contribute money through shares are referred to as “shareholders”. Any company can have two types of shares: preference shares and equity shares. 1. Preference shares are the shares that carry a preferential right to dividend and to the repayment of capital on the winding up of the company, before anything is paid to the equity shareholders. Preference shares carry with them a right to receive a fixed percentage of dividends. However, they do not receive any further share in profits for example 12% preference shares indicate that dividend of 12% on face value will be paid. However, the right to receive dividend is subject to the availability of profit. Types of Preference Shares: ● Cumulative preference share: In case no dividend is declared in a year due to any reason, the right to receive such dividend for that year is carried forwarded to next year. ● Non-cumulative preference share: In case no dividend is declared in a year due to any reason, the right to receive such dividend for that year expires. ● Redeemable preference shares: These are the shares that are issued on the condition that the company will redeem them and repay the face value of shares, after the certain period. ● Non-redeemable preference shares: These are preference shares that do not carry with them the arrangement regarding redemption. Currently companies are not allowed to issue such shares. ● Convertible preference shares: These shares give the right to the holder to get them converted into equity shares according to the terms and conditions of their issue. In real life preference shares are not popular as they are entitled to fixed dividend and not surplus. 2. Equity shares: Shares that entitle their holder to the whole of the profits earned by the company, after a fixed dividend on preference shares that has been paid by it, are equity shares. Equity shareholders are the real owners of the companies.

Corporate Accounts 223

In case of public companies, equity shares may be listed on stock market for trading. Equity shares are traded in huge volumes and stock exchange is treated as a very important financial market.

ISSUE OF SHARES The company issue shares to investor and raise long-term funds. The shares of a company can be issued for cash or for consideration other than cash.

Objective 3 To know the accounting for issue of shares

Issue of Shares for Cash When shares are issued against the payment in cash, it is referred to as “issue for cash”. Following is the accounting entry for recording such transaction. Bank A/c (Add) Dr (Total amount received) To Share Capital A/c (Add) (Being amount for shares @ Rs per share)

ILLUSTRATION 8.2 Amtech Ltd issued 10,000 shares of Rs 10 each and it has been fully paid up. Pass journal entry. Solution: Bank A/c

Dr

To Share Capital A/c

1, 00,000 1,00,000

(Being amount received for 10,000 shares @ Rs 10 per share)

Issue of Shares for Consideration other than Cash There are instances where a company enters into an arrangement with the vendors from whom it has purchased assets, whereby the latter agrees to accept, and the payment in the form of fully paid shares of the company issued to them. Normally, no cash is received for such issue of shares. These shares can also be issued either at par, at premium or at discount, and the number of shares to be issued will depend upon the price at which the shares are issued and the amount payable to the vendor. This is also applicable when shares are issued to promoters.

224 Financial Accounting

ILLUSTRATION 8.3 Rahul Limited purchased building from Honda Limited for Rs 5,40,000 and the payment is to be made by the issue of shares of Rs 100 each. Pass journal entries under following situations: Solution Date 1

st

2nd

Particulars

L/F

Building A/c To Honda Limited (Building Purchased)

Dr

Honda Limited To Share Capital A/c (Being 5,400 Shares Issued at Par)

Dr

Debit Rs

Credit Rs

5,40,000 5,40,000

5,40,000 5,40,000

Specialised Issues “Bonus share” is an equity share issued to current shareholders in a company free of cost, based on the number of shares that the shareholder already owns. Such issue will increase company’s equity shares; however, it reduces company’s reserves as they are generally issued out of general reserves or profit. Usually bonus shares impact stock prices positively.

ILLUSTRATION 8.4 Amay Ltd issues 50% bonus shares to their shareholder against the existing 20,000 equity shares of Rs 10 each. Company has general reserves of Rs 1,00,000 and Profit and Loss A/c balance of Rs 50,000. Pass necessary journal entries. Solution: 1. Profit and Loss A/c Dr Rs 50,000 General Reserve A/c Dr Rs 50,000 To Bonus to Equity Shareholders A/c (10,000 ¥ Rs 10) 2. Bonus to Equity Shareholders A/c (10,000 ¥ Rs 10) To Equity Share Capital A/c

Rs 1,00,000 Rs 1,00,000 Rs 1,00,000

“Right shares” are those shares which are offered to the existing shareholders, usually at a discount to market price. “Sweat equity shares” are the equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or for making available intellectual property rights provided that not less than one year has elapsed since the date of commencement of business.

Corporate Accounts 225

Employee Stock Option Plans (ESOPs): A choice given to whole time directors, officers, and employees, whereby they have the right to purchase or subscribe at a future date the securities offered by the company at a predetermined price is known as employee stock option.

Issue of Shares at Premium When a company issues its securities at a price that exceeds the face value, it is said to be an issue at premium. Premium is the excess of issue price over face value of the security. It is quite common for the financially strong and well-managed companies to issue their shares at premium, i.e. at an amount more than the nominal or par value of shares.

ILLUSTRATION 8.5 Amtech Ltd issued 10,000 shares of Rs 10 each at a premium of Rs 2 per share and it has been fully paid up. Pass journal entry. Solution: Bank A/c Dr To Share Capital A/c To Securities Premium A/c (Being amount received for 10,000 shares @ Rs 12 per share)

1,20,000 1,00,000 20,000

Issue of Shares at Discount There are instances when the shares of a company can also be issued at a discount, i.e. at an amount less than the nominal or par value of shares. The journal entry to record discount on the issue of shares is given below. Bank A/c Dr Discount on the Issue of Shares A/c (Add) Dr To Share Capital A/c (Add) (Being amount due on allotment of ___ shares @ Rs___ per share and discount on issue brought into account)

226 Financial Accounting

ILLUSTRATION 8.6 Amtech Ltd issued 10,000 shares of Rs 10 each at a discount of Rs 2 per share and it has been fully paid up. Pass journal entry. Solution: Bank A/c Dr Discount on Issue of Shares Dr To Share Capital A/c (Being amount received for 10,000 shares @ Rs 12 per share)

80,000 20,000 1,00,000

Initial Public Offer (IPO) and Follow-on Public Offer (FPO) Market IPO/FPO is a sale of shares by a company to public. FPO is used by existing companies to raise capital and IPO by new company to become listed company. IPO/FPO market is known as primary market. EXHIBIT 8.3

Reliance Power IPO (15th January 2008)

Reliance Power Ltd’s initial public offer has broken all records in the primary market as it drew a massive response from retail and institutional investors alike who bid to buy shares worth over Rs 1,00,000 crore. The first IPO from the Reliance ADA Group on Jan 15, 2008 received bids for 242 crore shares, or 10.6 times of the 22.80 crore shares on offer for the public. So much was the demand for the issue that investors encashed a part of their holdings in the secondary market to buy its shares, pulling the benchmark BSE Sensex down by almost 477 points. Even power stocks, including parent firm Reliance Energy Ltd, ended in losses on the bourses. The Qualified Institutional Buyer (QIB) segment of the IPO was oversubscribed 17 times, while the high net worth individual (HNI) segment was oversubscribed 7.4 times. The portion reserved for retail investors received bids for close to 1.4 times the shares on offer, market sources said. Overall, the IPO was oversubscribed 10.64 times, with demand worth about Rs 1,09,000 crore, according to data available with stock exchanges. The company looked set to make history with record proceeds of Rs 11,700 crores as almost all bids came at Rs 450, the top end of the price band. The issue proved to be a big disappointment to the investors, as it was listed below its issue price and company’s performance has been far from satisfactory.

SHARE ISSUE: PAYMENTS IN INSTALMENT Issue of shares can be collected in instalments, i.e. on application, on allotment and on calls.

Application for shares The starting point for the issue of share capital is the application for shares by prospective investors. When applications for shares along with the money have been received, the journal entry is as follows:

Corporate Accounts 227

Bank A/c (Add)

Dr

(Total amount received on application)

To Share Application A/c (Add) (Being amount received on application for_______ shares @ Rs _______ per share)

Allotment of Shares The allotment of shares means acceptance by the company of the offer made by the applicants to take up the shares applied for. 1. Transfer of Application Money Share Application A/c (less) (No. of shares allotted * Application money per share) To Share Capital A/c (Add) (Being application money on ______ shares allotted/transferred to share capital) 2. Money Refunded on Regretted Applications Share Application A/c (Less) (No. of shares regretted* Application money per share) To Bank A/c (Less) (Being application money returned on rejected application for _____ shares) 3. Amount Due on Allotment Share Allotment A/c (Add) (No. of shares allotted * Allotment amount per share) To Share Capital A/c (Add) (Being amount due on the allotment of _____ shares @ Rs ______ per share) 4. Adjustment of Excess Application Money Share Application A/c (Less) (Application amount received—(Application money transferred to Share Capital + Money Refunded)] To Share Allotment A/c (Less) (Being application amount of _____ shares @ Rs ____ per share adjusted to the amount due on allotment)

Dr

Dr

Dr

Dr

228 Financial Accounting

5. Receipt of Allotment Amount Bank A/c (Add) To Share Allotment A/c (Less) (Being allotment money received on ____ shares @ Rs ____ per share)

Dr

Call on shares In the event of share not being fully called up until the completion of allotment, the directors have the authority to call for the remaining amount on shares as and when they decide about the same. Any no. of calls—first call, second call, third call, and final call—may be made to get the full face value of share in cash.

Accounting Treatment When a call is made on the shares and the amount of the same is received, the journal entries are given below. 1. Call Amount Due Share Calls A/c (Add) (No. of Shares * Call amount per share) To Share Capital A/c (Add) (Being call money due on ____ shares @ Rs ____ per share)

Dr

2. Receipt of Call Amount Bank A/c (Add) To Share Call A/c (Less) (Being call money received)

ILLUSTRATION 8.7 On 1st April 2012, ABC Company Limited was incorporated with an authorised capital of Rs 5,00,000 divided into shares of Rs 100 each. It offered to the public for subscription 4,000 shares payable thus. On Application On Allotment On First Call (One Month after Allotment) On Second Call (Three Months after Allotment) The shares were fully subscribed for by the public and application money duly received on 15th April, 2012. The directors made the allotment on 1st May, 2012. Record journal entries in the books of the company to record these share capital transactions, assuming that amount due have been received within 15 days of making allotment and calls.

Rs 30 per Share Rs 20 per Share Rs 28 per Share Rs 22 per Share

Corporate Accounts 229

Solution: In the Books of ABC Limited Company Journal Entries

Date th

15 April

Particulars Bank A/C

Dr/Cr Dr

LF

Debit Amount Rs

Credit Amount Rs

1,20,000

To Equity Share Application A/c

1,20,000

(Being Money Received on Applications for 4,000 shares @ Rs 30 per Share) 1st May

Equity Share Application A/c

Dr

1,20,000

To Equity Share Capital A/c

1,20,000

(Being Transfer of Application Money on 4,000 Shares to Share Capital) 1st May

Equity Share Allotment A/c

Dr

80,000

To Equity Share Capital A/c

80,000

(Being Amount Due on the Allotment of 4,000 Shares @ Rs 20 per Share) 15th April

Bank A/c

Dr

80,000

To Equity Share Allotment A/c

80,000

(Being Allotment Money Received) 1st July

Equity Share First Call A/c

Dr

1,12,000

To Equity Share Capital A/c

1,12,000

(Being First Call Money due on 4,000 shares @ Rs 28 per Share) 15th July

Bank A/c

Dr

1,12,000

To Equity Share First Call A/c

1,12,000

(Being First Call Money Received) 1st August

Equity Share Second and Final Call A/c

Dr

88,000

To Equity Share Capital A/c

88,000

(Being Final Call Money due on 4,000 Shares Rs 22 per Share) 15th August Bank A/c To Equity Share Second and Final Call A/c (Being Final Call Money Received)

Dr

88,000 88,000

230 Financial Accounting

Calls-in-arrears Sometimes shareholders fail to pay the amount due on allotment or calls. The total unpaid amount on one or more instalments is known as calls-in-arrears or unpaid calls. For recording calls-in-arrears, the following journal entry is recorded: Calls-in-Arrears A/c (Add) Dr (Amount of unpaid calls) To Share Allotment A/c (Less) To Share Call A/c (Less)

ILLUSTRATION 8.8 Vedant Ltd issued 10,000 equity shares of Rs 10 each payable at Rs 2.50 on application, Rs 3 on allotment, Rs 2 on first call, and the balance Rs 2.50 on the final call. All the shares were fully subscribed and paid except of a shareholder having 100 shares who could not pay for the final call. Give journal entries to record these transactions. Solution In the Books of Vedant Limited Company Journal Entries

Date

Particulars Bank A/C

Dr/Cr Dr

LF

Debit Amount Rs

Credit Amount Rs

25,000

To Equity Share Application A/c

25,000

(Being Money Received on Applications for 10,000 Shares @ Rs 2.5 per share) Equity Share Application A/c

Dr

25,000

To Equity Share Capital A/c

25,000

(Being Transfer of Application Money on 10,000 Shares to Share Capital) Equity Share Allotment A/c

Dr

30,000

To Equity Share Capital A/c

30,000

(Being Amount Due on the Allotment of 10,000 Shares @ Rs 3 per Share) Bank A/c To Equity Share Allotment A/c

Dr

30,000 30,000

(Being Allotment Money Received) (Contd.)

Corporate Accounts 231 Equity Share First Call A/c

Dr

20,000

To Equity Share Capital A/c

20,000

(Being First Call Money Due on 10,000 Shares @ Rs 2 per Share) Bank A/c

Dr

20,000

To Equity Share First Call A/c

20,000

(Being First Call Money Received) Equity Share Second and Final Call A/c

Dr

25,000

To Equity Share Capital A/c

25,000

(Being Final Call Money Due on 4,000 Shares Rs 22 per Share) Bank A/c

Dr

24,750

Calls in Arrears A/c

Dr

250

To Equity Share Second and Final Call A/c

25,000

(Being Final Call Money Received)

Call-in-advance Some shareholders may sometimes pay part, or whole, of the amount not yet called up, such amount is known as calls-in-advance. Bank A/c (Add)

Dr

To Calls-in-Advance A/c (Add) When calls become actually due, calls-in-advance account is adjusted at the time of the call. For this the following journal entry is recorded: Calls-in-Advance A/c (Less)

Dr (Call Amount Due)

To Particular Call A/c (Less)

Forfeiture of Shares It may happen that certain shareholders fail to pay one or more instalments. In such circumstances, the company can forfeit their shares by giving due notice and following the procedure specified in the Articles of Association in this behalf. To forfeit a share means to cancel the allotment to defaulting shareholders and to treat the amount already received thereon as forfeited to the company within the framework of provisions embodied in the Articles of Association.

232 Financial Accounting

Forfeiture of Shares Issued at Par When the shares issued at par are forfeited, the journal entry required to record the forfeiture is as follows: Share Capital A/c (Less) To Share Forfeited A/c (Add) To Share Allotment A/c (Less) To Share Call/calls A/c (Less)

Dr (Amount called-up) (Amount received) (Amount called-up but unpaid) (Amount called-up but unpaid)

Reissue of Forfeited Shares The directors of a company have authority to reissue the shares once forfeited by them due to non-payment of calls. When forfeited shares are reissued at a discount, the journal entry is as given below: Bank A/c (Add) Dr (Amount Received) Shares Forfeited A/c (Less) Dr (Discount Allowed) To Share Capital A/c (Add) (Amount called up) (Reissue of ____ forfeited shares at Rs___ per share and discount on reissue debited to forfeited shares)

Closure of Forfeited Shares Account After all forfeited shares have been reissued, the credit balance left on the forfeited share account is transferred to capital reserve amount, the entry being: Share Forfeited A/c (Less)

Dr

To Capital Reserve A/c (Add)

ILLUSTRATION 8.9 Using the information provided in Illustration 8.5 pass journal entries if 100 shares on which there were calls-in-arrears have been forfeited and reissued at Rs 9 per share fully paid. Solution: Forfeiture 1. Share Capital A/c

Dr

1,000

To Share Forfeited A/c

750

To Calls in Arrears

250

Corporate Accounts 233

Reissue

2. Bank A/c Shares Forfeited A/c (Less)

Dr

900

Dr

100

To Share Capital A/c

1,000

Transfer to Capital Reserve

3. Share Forfeited A/c To Capital Reserve A/c

Dr

650 650

BUYBACK OF SHARES Objective 4 “Buyback of shares” implies the act of purchasTo learn the accounting for ing its own shares by a company either from buyback of shares free reserve, securities premium, or proceeds of any shares or securities. Company opts for buyback when they have excess cash surplus. Buyback signals to the stock market that companies’ shares are underpriced and company is willing to pay cash to buyback and cancel the shares. Buyback usually has a positive effect on stock prices (also true for bonus and right issue). A company can buy its own shares either from the existing equity shareholders on a proportionate basis, open market, odd lot shareholders, or employee of the company pursuant to a scheme of stock option or sweat equity. The following are the procedural rules: (a) Shares bought back are required to be cancelled immediately. (b) The buyback should be authorised by the articles and by special resolution which is to be passed in the general meeting of shareholders. (c) The buyback of the shares cannot exceed 25% of paid-up capital and free reserves in a financial year. (d) The debt-equity ratio should not be more than 2:1 after such buyback. (e) All the shares for buyback should be fully paid up. (f) Where a company completes the buyback of its shares, it shall not further issue shares within a period of 24 months.

ILLUSTRATION 8.10 Amtech buybacks 1,00,000 shares of Rs 10 each at Rs 15. Company has a balance of Rs 60,00,000 in their general reserve account and Rs 25,00,000 in bank account. Pass necessary journal entries.

234 Financial Accounting

Solution: Share Capital A/c

Dr

10,00,000

General Reserve A/c

Dr

5,00,000

To Bank A/c General Reserve A/c

15,00,000 Dr

10,00,000

To Capital Redemption Reserve

10,00,000

DEBENTURES AND BONDS Objective 5 A debenture/bond is an instrument of acknowlTo become familiar with edgement of debt. A debenture is issued by a debentures and bonds company as an evidence of its debt or loan. Debentures are freely transferable and can be listed and traded on stock exchanges. A debenture holder is a creditor of the company. A debenture holder receives fixed rate of interest on a due date. The principal amount is repaid on maturity. Debenture holders do not enjoy voting rights. Share capital is owner’s funds and debentures are borrowed funds. Dividend paid on the shares is distribution of profits, while interest paid on debentures is a charge against profits of the company. While shares are unsecured, debentures are generally secured.

Types of Debentures Debentures are classified as shown below. On the basis of security, debentures are classified as follows: (a) Unsecured debentures: No security for repayment of principal or interest. (b) Secured debentures: Secured against mortgage or fixed assets of the company On the basis of convertibility, debentures are classified as follows: (a) Non-convertible: They retain their debt character throughout their lifetime and cannot be converted into shares or any other form of security. (b) Convertible 1. Fully convertible: They are fully convertible into equity shares at the issuer’s notice or as per terms of issue. 2. Partly convertible: A part of these instruments are convertible into shares or other securities. The ratio of conversion is decided by the issuer at the time of subscription.

Corporate Accounts 235

Issue of Debentures Debenture may be issued at par, premium or discount. It may be issued for cash or for consideration other than cash. Similarly, it may be redeemed at par, at premium or at discount. “At premium” refers to issue at a price higher than the face value while “at discount” refers to issue at a price lower than face value.

ILLUSTRATION 8.11 Karnavati Plastics Ltd. issued 30,000, 6% debentures of Rs 100 each at par. Solution: Entries in the Books of Karnavati Plastics Ltd Particulars

Dr (Rs)

Bank A/c

Cr (Rs)

30,00,000

To 6 % Debentures A/c

30,00,000

(Being issue of 30,000, 6% debentures of Rs 100 each)

INCOME STATEMENT/PROFIT AND LOSS ACCOUNT Income statement has been discussed in detail in Chapter 4. However, in case of companies it is to be prepared in format as per revised Schedule VI of the Companies Act 1956 which is applicable for accounts closing on 31st March, 2012 although there was no specific format for period prior to 31st March 2012. Income statement is to be prepared in the following format (Exhibit 8.4) as per revised Schedule VI of the Companies Act, 1956 which is applicable for accounts closing on 31st March, 2012. EXHIBIT 8.4

Format of Income Statement (Rupees in________) Particulars

Year Ended 31st March, 2011

Year Ended 31st March, 2010

I.

Revenue from Operations

—

—

II.

Other Incomes

—

—

III.

Total Revenue (I + II)

—

—

IV.

Expenses:

—

— (Contd.)

Manufacturing Expenses Cost of Materials Consumed

236 Financial Accounting

Purchases of Stock-in-Trade

—

—

Work-in-Progress and Stock-in-Trade

—

—

Other Manufacturing Expenses

—

—

Employee Benefit Expenses

—

—

Other Administrative and Selling Expenses

—

—

Other Expenses

—

—

Finance Costs

—

—

Depreciation and Amortisation Expense

—

—

Total Expenses

—

—

Profit before Exceptional and Extraordinary

—

—

Changes in Inventories of Finished Goods

Administrative and Selling Expenses

V.

Items and Tax (III—IV) VI.

Exceptional Items

—

—

VII.

Profit before Extraordinary Items and Tax (V - VI)

—

—

VIII.

Extra Ordinary Items

—

—

IX.

Profit before Tax (VII—VIII)

—

—

X.

Tax Expense: (1) Current Tax

—

—

(2) Deferred Tax

—

—

Profit/(Loss) for the Period from Continuing

—

—

XI.

Operations (IX–X) XII.

Profit/Loss from Discontinuing Operations

—

—

XIII.

Tax Expense of Discontinuing Operations

—

—

XIV.

Profit/(Loss) from Discontinuing Operations (after Tax)

—

—

—

—

(XII–XIII) XV.

Profit/ (Loss) for the Period (XI + XIV)

Corporate Accounts 237

Exhibit 8.5 shows Income Statement of ONGC Ltd. EXHIBIT 8.5

Income Statement of ONGC Ltd (Rs in million) Schedule

2010-11

2009-10

INCOME Gross Sales

17

Less Excise Duty Net Sales

661,548.77

602,048.19

3,098.80

2,185.42

658,449.97

599,862.77

Other Income EXPENDITURE

18

59,007.70 717,457.67

41,866.86 641,729.63

(Increase)/Decrease in stock Purchases Production, Transportation, Selling and Distribution Expenditure Depreciation, Depletion, Amortisation and Impairment Financing Costs Provisions and Write-offs Adjustments relating to Prior Period (Net)

19

(129.11) 138.35 275,300.61 159,256.53 251.07 6,144.27 336.25 441,267.97 276,189.70

(1,180.38) 139.31 243,199.46 146,431.88 144.23 2,974.01 182.69 391.891.20 249,838.43

81,226.00

71,202.50

(4,517.94) 10,321.82 (80.20) 189,240.02 0.28 189,240.030

(199.41) 11,159.78 — 167,675.56 0.13 167,675.69

6,416.62 68,443.92 12,156.46 102,223.30 — 189,240.30 22.12

32,083.09 38,499.71 11,615.61 85,477.00 0.28 167,675.69 19.60

20 21 22 23 24

Profit before Tax Provision for Taxation — Current tax (including wealth Tax Rs 26.00 million, Previous year Rs 22.50 million) — Earlier years — Deferred Tax — Fringe Benefit Tax Profit after Taxation Surplus at the beginning BALANCE AVAILABLE FOR APPROPRIATION APPROPRIATIONS Proposed Dividend Interim Dividend Tax on Dividend Transfer to General Reserve Balance carried to Balance Sheet Earning per Equity Share – Basic and Diluted (Restated) (Rs) (Face Value Rs 5/- Per Share) (Previous Year Face Value Rs 10/- per Share) SIGNIFICANT ACCOUNTING POLICIES NOTES TO ACCOUNTS Schedules referred to above from an integral part of the Profit & Loss Account. Source: Annual Report ONGC Ltd 2010–11

25

26 27

238 Financial Accounting

There is a format prescribed under the US GAAP for income statement. Exhibit 8.6 is the Income Statement of General Motors as per US GAAP. EXHIBIT 8.6

Income Statement of General Motors 31st December, 2010

31st December, 2009

Total Revenue

13,55,92,000

10,45,89,000

Cost of Revenue

11,89,44,000

11,21,95,000

1,66,48,000

(76,06,000)

—

—

1,15,64,000

1,34,17,000

Non Recurring

—

—

Others

—

—

Total Operating Expenses

—

—

50,84,000

(2,10,23,000)

Total Other Income/Expenses Net

17,51,000

12,96,38,000

Earnings Before Interest and Taxes

66,39,000

10,98,04,000

Interest Expense

10,98,000

61,22,000

Income Before Tax

55,41,000

10,36,82,000

Period Ending

Gross Profit Operating Expenses Research Development Selling General and Administrative

Operating Income or Loss Income from Continuing Operations

Income Tax Expense

6,72,000

(21,66,000)

Minority Interest

(3,31,000)

(3,96,000)

Net Income from Continuing Operations

61,72,000

10,48,21,000

Discontinued Operations

—

—

Extraordinary Items

—

—

Effect of Accounting Changes

—

—

Other Items

—

—

61,72,000

10,48,21,000

Non-recurring Events

Net Income Preferred Stock and Other Adjustments Net Income Applicable to Common Shares

(15,04,000)

(1,31,000)

46,68,000

10,46,90,000

Source: http://finance.yahoo.com/q/is?s=GM+Income+Statement&annual, accessed on 10 February 2012

Peculiar Items in Profit and Loss Account 1. Dividends: Dividend refers to that part of profits which is distributed among its shareholders. However, sometime bonus share is referred to as “Stock Dividend”.

Corporate Accounts 239

The general practice is to declare the dividend for an accounting year at the annual general meeting of the company while presenting the Annual Report (including Financial Statements) for approval, and it is shown as proposed dividend in the appropriation part of the profit and loss account (debit side) and so also in the balance sheet on the liabilities side under the heading “Current Liabilities and Provisions”. Sometimes, the companies also declare and pay some dividend during the course of an accounting year in anticipation of profits. Journal entries for dividend payment are as follows: 1. P & L/Reserves Dr XXXX To Dividend A/c XXXX 2. Dividend A/c Dr XXXX To Bank A/c XXXX 2. This is known as interim dividend and since the same stands paid, it is simply shown in the appropriation part of the Profit and Loss Account (debit side). In such a situation, the dividend declared in addition to the interim dividend at the time of presenting the Annual Report is termed as final dividend which is treated in the same manner in accounts as the proposed dividend. It may be noted that no dividend is payable on the calls-in-arrears. Any amount of dividend, interim or final, which remains unclaimed (unpaid) is shown as unclaimed dividend under the heading “current liabilities”. In this context, there is another important aspect to be kept in view, namely, “dividend tax” payable by the company. While dividends are tax free in the hands of shareholders, the company has to pay tax on dividends declared at the prescribed rate which is termed as “dividend distribution tax” and a provision has to be made thereof. This is shown along with dividends in the appropriation part of the Profit and Loss Account on the debit side, and so also in the balance sheet under current liabilities and provisions. 3. Transfer to Reserves: Invariably, the companies transfer a part of their profits to reserves. The amount transferred to general reserve or any specific reserve is shown in the appropriation part of the Profit and Loss Account and added to the concerned reserve shown under the heading “reserves and surplus” in the balance sheet.

BALANCE SHEET Objective 6 The registered companies are required to To learn about the nuances of a follow Part I of Schedule VI of the Companies balance sheet Act, 1956 for recording assets and liabilities in the balance sheet. According to Section 211(i) of the Companies Act, the balance sheet shall be prepared in a prescribed format, depict true and fair view of financial position and follow general instructions for preparation of balance sheet under the

240 Financial Accounting

given headings with notes at the end. This format is not applicable to banking and insurance companies which have to follow the formats prescribed by their respective legislations. Balance sheet is prepared in the format mentioned in Exhibits 8.7A and 8.7B as per Schedule VI of the Companies Act, 1956 which is applicable for accounts closing on or before 31st March, 2011. EXHIBIT 8.7A

Balance Sheet Format on or Before 31st March, 2011

Particulars

Schedule No

Figures as at the End of Current Financial Year

Figures as at the End of Previous Financial Year

I. Source of Funds: 1. Shareholder’s Funds: (a) Share Capital (b) Reserves and Surplus 2. Loan Funds: (a) Secured Loans (b) Unsecured Loans Total (Capital Employed) II. Application of Funds 1. Fixed Assets: (a) Gross Block (b) Less: Depreciation (c) Net Block (d) Capital Work-in-Progress 2. Investments: 3. Current Assets, Loans and Advances: (a) Inventories (b) Sundry Debtors (c) Cash and Bank Balances (d) Other Current Assets (e) Loans and Advances Less: Current Liabilities and Provisions: Current Liabilities Provisions Net Current Assets 4. (a) Miscellaneous Expenditure to the Extent not Written-off or Adjusted. (b) Profit and Loss Account (Debit Balance, if any) TOTAL Note: A footnote to the balance sheet may be added to show the contingent liabilities.

Balance sheet is prepared in the following format as per revised Schedule VI of Companies Act, 1956 which is applicable to accounts closing on or after 31st March, 2012.

Corporate Accounts 241

EXHIBIT 8.7B

Balance Sheet Format on or After 31st March, 2012 (Rupees in________) Particulars

I. EQUITY AND LIABILITIES 1. Shareholder’s Funds (a) Share Capital (b) Reserves and Surplus (c) Money Received against Share Warrants 2. Share Application Money Pending Allotment 3. Non-Current Liabilities (a) Long-Term Borrowings (b) Deferred Tax Liabilities (Net) (c) Other Long-Term Liabilities (d) Long-Term Provisions 4. Current Liabilities (a) Short-Term Borrowings (b) Trade Payables (c) Other Current Liabilities (d) Short-Term Provisions TOTAL II. ASSETS 1. Non-Current Assets (a) Fixed Assets (i) Tangible Assets (ii) Intangible Assets (iii) Capital Work-in-Progress (iv) Intangible Assets under Development (b) Non-Current Investments (c) Deferred Tax Assets (Net) (d) Long-Term Loans and Advances (e) Other Non-Current Assets 2. Current Assets (a) Current Investments (b) Inventories (c) Trade Receivables (d) Cash and Cash Equivalents (e) Short-Term Loans and Advances (f) Other Current Assets TOTAL

As at current year

As at previous year

— — — —

— — — —

— — — —

— — — —

— — — — —

— — — — —

— — — — — — — —

— — — — — — — —

— — — — — — —

— — — — — — —

Note: A footnote to the balance sheet may be added to show the contingent liabilities.

242 Financial Accounting

Exhibit 8.8 shows the balance sheet of ONGC Ltd (As per the old Schedule VI of the Companies Act, 1956 as applicable up to 31st March, 2011). EXHIBIT 8.8

Balance Sheet of ONGC Ltd

(Rs in million) As at 31st March, 2011

Schedule

As at 31st March, 2010

SOURCES OF FUNDS SHAREHOLDERS’ FUNDS Share Capital

1

42,777.59

21,388.87

Reserve and Surplus

2

932,266.72

851,437.15

LOAN FUNDS Unsecured Loans

975,044.31

872,826.02

99,503.94

89,182.13

175,642.55

164,006.68

1,250,190.80

1,126,064.58

3

49.75

DEFERRED TAX LIABILITY (NET) LIABILITY FOR ABANDONMENT COST TOTAL APPLICATION OF FUNDS FIXED ASSETS

4

Gross Block

809,385.98

715,537.79

Less: Depreciation and impairment

622,990.53

559,052.77

NET BLOCK

186,395.45

156,485.02

CAPITAL WORKS-IN-PROGRESS

5

140,315.69

102,413.54 326,711.14

PRODUCING PROPERTIES

258.898.56

6

Gross Cost

930,522.72

Less: Depletion and Impairment

494,766.15

NET PRODUCING PROPERTIES

843,112.16 440,290.04 435,756.57

402,822.12

EXPLORATORY/DEVELOPMENT WELLSIN-PROGRESS

7

77,472.12

55,496.83

INVESTMENTS

8

53,328.38

57,720.33

CURRENT ASSETS, LOAND AND ADVANCES Inventories

9

41,189.84

46,785.72

10

38,458.98

30,586.37

Cash and Bank Balances

11A

143,310.46

108,279.29

Deposit with Scheduled Bank Under Site Restoration Fund Scheme

11B

81,155.06

74,031.06

12

8,755.18

6,333.05

Sundry Debtors

Other Current Assets

(Contd.)

Corporate Accounts 243

Loans and Advances

13

273,566.54

271,697.74

586,436.06

537,713.23

LESS: CURRENT LIABILITIES AND PROVISIONS Current Liabilities

14

188,148.86

120,875.63

Provisions

15

49,324.86

74,124.02

237,473.72

194,999.65

NET CURRENT ASSETS MISCELLANEOUS EXPENDITURE

16

348,962.34

342,713.58

7,960.25

8,413.16

1,250,190.80

1,126,064.58

(To the extent not written off or adjusted) TOTAL SIGNIFICANT ACCOIUNTING POLICIES

26

NOTES TO ACCOUNTS

27

Schedules referred to above form an integral part of the Balance Sheet Source: Annual Report ONGC Ltd 2010–11

Exhibit 8.9 shows balance sheet of General Motors. EXHIBIT 8.9

Balance Sheet of General Motors

Period Ending

31-Dec-10

31-Dec-09

22,301,000

36,596,000

Assets Current Assets Cash and Cash Equivalents Short Term Investments

5,555,000

134,000

Net Receivables

10,504,000

9,295,000

Inventory

12,125,000

10,107,000

Other Current Assets

2,568,000

3,115,000

Total Current Assets

53,053,000

59,247,000

8,197,000

—

Property Plant and Equipment

19,235,000

19,217,000

Goodwill

31,778,000

30,672,000

Intangible Assets

11,882,000

14,547,000

—

—

14,445,000

12,048,000

308,000

564,000

138,898,000

136,295,000 (Contd.)

Long Term Investments

Accumulated Amortisation Other Assets Deferred Long Term Asset Charges Total Assets

244 Financial Accounting

Liabilities Current Liabilities Accounts Payable Short/Current Long Term Debt

45,541,000

41,859,000

1,616,000

10,221,000

Other Current Liabilities

—

355,000

Total Current Liabilities

47,157,000

52,435,000

Long Term Debt

9,142,000

5,562,000

Other Liabilities

31,587,000

36,064,000

Deferred Long Term Liability Charges

13,021,000

13,279,000

979,000

708,000

—

—

102,718,000

108,048,000

Misc Stocks Options Warrants

—

6,998,000

Redeemable Preferred Stock

—

—

Preferred Stock

10,391,000

—

Common Stock

15,000

15,000

Minority Interest Negative Goodwill Total Liabilities Stockholders’ Equity

Retained Earnings

266,000

–4,394,000

Treasury Stock

—

—

Capital Surplus

24,257,000

24,040,000

1,251,000

1,588,000

Other Stockholder Equity Total Stockholder Equity

36,180,000

21,249,000

Net Tangible Assets

–7,480,000

–23,970,000

Currency in USD. Source: http://finance.yahoo.com/q/bs?s=GM+Balance+Sheet&annual, accessed on 12 February 2012

Contents of a Balance Sheet Followings are some of the important contents in corporate balance sheet: 1. Share Capital: It is the first item on the liabilities side of the balance sheet. The company is required to give schedule of share capital separately containing details of authorised capital and issued and paid-up capital in terms of the number and amount of each type of share, and so also the amounts of calls in arrears and the forfeited shares. 2. Reserves and Surplus: This item includes various reserves such as capital reserves, capital redemption reserves, balance of securities premium account which are indivisible and general reserve, credit balance of profit and loss account

Corporate Accounts 245

3.

4.

5.

6.

7.

8.

9.

10.

11.

which are divisible. The nature of each reserve and the amount in respect thereof including the additions during the current year has to be specified. Secured Loans: Long-term loans, which are taken against some security, are included under this head. Debentures and secured loans and advances from banks, subsidiary companies, etc fall under this category and are shown separately under this head. Unsecured Loans: Loans and advances for which no security is given are shown under this heading. This item includes public deposits, unsecured loans and advances from subsidiary companies, short-term loans and advances and other loans and advances from banks. Current Liabilities and Provisions: Current liabilities refer to such liabilities, which mature within a period of one year. They include sundry creditors, advance payments, un-expired discounts, unclaimed dividends, interest accrued but not paid, and other short-term liabilities. Provisions refer to the amounts set aside out of revenue profits for some specific liabilities payable within a period of one year. Those include provision for taxation, proposed dividends, provision for contingencies, provision for provident fund, provision for insurance, pension and similar staff benefit schemes, etc. Fixed Assets: The expenditure incurred on various fixed assets are to be shown separately which include goodwill, land, buildings, leaseholds, plant and machinery, railway sidings, furniture and fittings, patents, livestock, vehicles, etc. These assets are shown at cost less depreciation till the date. Investments: Under this head, various investments made such as investment in government securities or trust securities; investment in shares, debentures, and bonds of other companies, immovable properties, etc are to be shown separately in the balance sheet. Current Assets, Loans and Advances: Current assets include interest accrued on investments, inventories, sundry debtors, bills receivables, cash and bank balances, and other advances like prepaid expenses, etc. Miscellaneous Expenditure: The expenditure which has not been written of fully, its balance is shown under this heading. These expenses include preliminary expenses, advertisement expenditure, discount on issue of shares and debentures, share issue expenses, etc. Profit and Loss Account: When the Profit and Loss Account shows a debit balance, i.e. loss which could not be adjusted against general reserves, the same is shown as a last item on the asset side. Preliminary Expenses: This refers to the expenses that are incurred in connection with the formation of a company which include items like cost of printing various documents, fees paid to the lawyers for drafting of such documents, stamp duty, registration and filing fees paid at the time of registration of the company, etc. The amount spent on these items is put under one head called “preliminary expenses” which is written-off over a period of 3 to 5 years. The amount to be

246 Financial Accounting

written-off annually is debited to the Profit and Loss Account, and the balance is shown under the heading “miscellaneous expenditure” on the assets side of the balance sheet. 12. Provision for Taxation: This refers to the provision for income tax (corporation tax) chargeable on profits, and it is made by debiting the Profit and Loss Account and crediting the provision for taxation account which is shown on the liabilities side under the heading “current liabilities and provisions” in the balance sheet.

ILLUSTRATION 8.12 Mr Confused is the accountant of M/s Ultimate Confusion Ltd. He presents to you the following Trial Balance as on 31st March 2012. Particulars Bank Balance Calls in Arrears

Rs

Particulars

72,900 Subscribed Capital 7,500 6% Debentures

Rs 4,00,000 3,00,000

Land and Building

3,00,000 Profit and Loss Account (Cr)

13,625

Machinery

2,97,000 Sundry, Debtors

87,000

Interim Dividend Paid st

Stock (1 April, 2011)

37,500 Sales 75,000 Preliminary Expenses

Sundry Creditors

40,000 Sinking Fund

Bills Payable

38,000

Furniture

7,200

Purchases

1,85,000

Provision for Bad Debts Investments

4,15,000 5,000 75,000

4,375 75,000

Salaries and Wages Fuel

1,03,600 13,200

Rent, Rates and Taxes

3,800

Discounts Allowed

6,400

Directors Fees

5,700

Bad Debts

2,100

Debenture Interest Paid

9,000

Sundry Expenses Deposits from Public

2,350 10,000 12,95,625

12,95,625

After tracing the mistakes and making the following adjustments, prepare Trading and Profit and Loss Account for the year ended 31st March, 2012 and balance sheet as on the date in a vertical form. Ignore previous year’s figures.

Corporate Accounts 247

Additional Information 1. Authorised capital of the company is 60,000 equity shares of Rs 10 each. The calls in arrears are @ Rs 5 per share. 2. Stock 31st March, 2012 was Rs 1, 37,120 3. Write off 1/5th of the preliminary expenses 4. The cash in hand on 31st March, 2012 is Rs 750 5. Provision for bad debts is no longer required 6. The details of fixed assets are as under: Original Cost Rs

Depreciation till 31st March, 2012 Rs

Rate of Depreciation

Land and Building

3,50,000

50,000

5%

Machinery

4,00,000

1,03,000

20%

10,000

2,800

10%

Furniture

The depreciation during the year is to be charged on W.D.V. as at the beginning of the year. There were no additions or deductions during the year. Solution: Ultimate Confusion Ltd Balance Sheet As at 31st March, 2012 Scheduled No. I.

Rs

Rs

Rs

Sources of Funds: 1. Shareholders Funds (a) Capital

1

3,92,500

(b) Reserve and Surplus

2

1,16,350

(a) Secured Loans

3

3,09,000

(b) Unsecured Loans

4

10,000

5,08,850

2. Loan Funds

II

Application of Funds: 1. Fixed Assets

8,27,850 5

(a) Gross Block

7,60,000

(b) Less: Depreciation

2,30,920

(c) Net Block

5,29,080

(d) Capital Work-In-Progress

3,19,000

Nil

5,29,080 (Contd.)

248 Financial Accounting 2. Investments

6

3. Current Assets, Loans and Advances.

7

(a) Inventories

75,000 1,37,120

(b) Sundry Debtors

87,000

(c) Cash and Bank Balances

73,650

(d) Other Current Assets

Nil

(e) Loans and Advances Less: Current Liabilities and Provisions

Nil

2,97,770

8

(a) Current Liabilities

78,000

(b) Provisions

Nil

78,000

Net Current Assets

2,19,770

4. Miscellaneous Expenditure (Not Written off/Adjusted )

9

4,000

Total

8,27,850

Profit and Loss Account For the Year Ended on 31st March, 2012 Scheduled No I.

Rs

Rs

Rs

Income: 1. Sales

4,15,000

Other Income (Excess Provision for Bad Debts) Bad Debts

2,100

Less: RDD

4,375

2,275

Total Income II.

4,17,275

Expenses: 1. Cost of Goods Sold Opening Stock Add: Purchases

75,000 1,85,000 2,60,000

Less: Closing Stock 2. Salaries and Wages 3. Fuel

1,37,120

1,22,880 1,03,600 13,200

4. Rent, Rates and Taxes

3,800

5. Discount Allowed

6,400

6. Directors Fees

5,700 (Contd.)

Corporate Accounts 249 7. Debenture Interest

9,000

Add: Interest Accrued and Due

9,000

18,000

8. Sundry Expenses

2,350

9. Preliminary Expenses W/off

1,000

10. Depreciation: Land and Building

15,000

Machinery

58,400

Furniture

720

75,120

Total Expenses

3,52,050

Net Profit before Tax

65,225

Less: Provision for Tax

Nil

Net Profit after Tax

65,225

Add: Balance b/f from Last Year

13,625 78,850

Appropriations

III.

Interim Dividend

37,500

Balance c/d to Balance Sheet

41,350

Schedules to Balance Sheet Schedule 1 Capital

Rs

Rs

Authorised 60,000 Equity Shares of Rs 10 each

6,00,000

Issued, Subscribed and Paid-up: 40,000 Equity Shares of Rs 10 each, fully paid Fully called up Less: Call in Arrears (1,500 × Rs 5)

4,00,000 7,500

Total

3,92,500 3,92,500

Schedule 2 Reserve and Surplus

Rs

Sinking Fund

75,000

Profit and Loss Appropriation Account

41,350

Total

Rs 1,16,350 1,16,350

Schedule 3 Secured Loans

Rs

6% Debentures

3,00,000

Add: Interest Accrued and Due Total

9,000

Rs 3,09,000 3,09,000

250 Financial Accounting Schedule 4 Unsecured Loans

Rs

Rs

Deposits from Public

10,000 —

Total

10,000

Schedule 5 Fixed Assets Gross Block

Depreciation

Opening Rs

Additions Rs

Closing Rs

Land and Building

3,50,000

—

3,50,000

50,000

15,000

Machinery

4,00,000

—

4,00,000

1,03,000

10,000

—

10,000

7,60,000

—

7,60,000

Particulars

Furniture Total

Opening Rs

During Year Rs

Net Block Closing Rs

Opening Rs

Closing Rs

65,000

3,00,000

2,85,000

59,400

1,62,400

2,97,000

2,37,600

2,800

720

3,520

7,200

6,480

1,55,800

75,120

2,30,920

6,04,200

5,29,080

Schedule 6 Investments

Rs

Investments

75,000

Schedule 7 Current Assets: Loans and Advances 1.

Rs

Closing Stock 2.

3.

4.

Rs

Inventories 1,37,120

Sundry Debtors Due for More than 6 Months

—

Other Debtors

—

87,000

Cash and Bank Balances Cash

750

Bank

72,900

73,650

Other Current Assets

Nil

Total Current Assets

2,97,770

Loans and Advances (Unsecured, Considered Good) Total Current Assets, Loans and Advances

Nil 2,97,770

Corporate Accounts 251

Schedule 8 Current Liabilities and Provisions 1.

Rs

Rs

Current Liabilities Sundry Creditors

40,000

Bills Payable

38,000 78,000

2.

Provisions

Nil

Total Current Liabilities and Provisions

78,000

Schedule 9 Miscellaneous Expenditure (Not written off)

Rs

Preliminary Expenses

5,000

Less: Written off (1/5)

1,000

Total

Rs 4,000 4,000

Note: The accountant has prepared a trial balance wrongly. However, the trial balance has agreed by coincidence. While preparing final accounts the balance on the account should be placed correctly. There is no need to prepare a revised trial balance.

ILLUSTRATION 8.13 The following is the balance sheet of Wipro Ltd as on 31st March, 2010 and 31st March, 2011. You are required to rearrange as per revised format as applicable from 31st March, 2012. Balance Sheet of Wipro Ltd Rs in Crore March 2011

March 2010

Sources of Funds Equity Share Capital Share Application Money Preference Share Capital Reserves Revaluation Reserves Networth Secured Loans

490.8

293.6

0.7

1.8

0

0

20,829.40

17,396.80

0

0

21,320.90

17,692.20

0

0

Unsecured Loans

4,744.10

5,530.20

Total Debt

4,744.10

5,530.20

26,065.00

23,222.40

Total Liabilities

(Contd.)

252 Financial Accounting Application of Funds Gross Block

7,779.30

6,761.30

Less: Accumulated Depreciation

3,542.30

3,105.00

Net Block

4,237.00

3,656.30

603.1

991.1

10,813.40

8,966.50

Capital Work in Progress Investments Inventories

724.9

606.9

Sundry Debtors

5,781.30

5,016.40

Cash and Bank Balance

2,334.20

1,938.30

Total Current Assets

8,840.40

7,561.60

Loans and Advances

6,756.80

5,425.90

Fixed Deposits

2,869.10

3,726.00

18,466.30

16,713.50

0

0

Total CA, Loans and Advances Deferred Credit Current Liabilities

5,290.00

4,874.20

Provisions

2,764.80

2,230.80

Total CL and Provisions

8,054.80

7,105.00

10,411.50

9,608.50

Net Current Assets Miscellaneous Expenses Total Assets

0

0

26,065.00

23,222.40

Solution: Balance Sheet of Wipro Ltd (Rupees in crores) st

Particulars

As at 31 March, 2011

As at 31st March, 2010

490.8 20,829.40

293.6 17,396.80

0.7

1.8

4,744.10

5,530.20

I. Equity and Liabilities 1. Shareholder’s Funds (a) Share Capital (b) Reserves and Surplus (c) Money Received against Share Warrants 2. Share Application Money pending Allotment 3. Non-Current Liabilities (a) Long-Term Borrowings (b) Deferred Tax Liabilities (Net) (c) Other Long-Term Liabilities (d) Long-Term Provisions

(Contd.)

Corporate Accounts 253 4. Current Liabilities (a) Short-Term Borrowings (b) Trade Payables (c) Other Current Liabilities

5,290.00

4,874.20

(d) Short-Term Provisions

2,764.80

2,230.80

TOTAL

34,119.8

30,327.4

4,237.00

3,656.30

603.1

991.1

10,813.40

8,966.50

724.9

606.9

(c) Trade Receivables

5,781.30

5,016.40

(d) Cash and Cash Equivalents

2,334.20

1,938.30

(e) Short-Term Loans and Advances

6,756.80

5,425.90

II. Assets 1. Non-Current Assets (a) Fixed Assets (i) Tangible Assets (ii) Intangible Assets (iii) Capital Work-in-Progress (iv) Intangible Assets under Development (b) Non-Current Investments (c) Deferred Tax Assets (Net) (d) Long-Term Loans and Advances (e) Other Non-Current Assets 2. Current Assets (a) Current Investments (b) Inventories

(f) Other Current Assets TOTAL

2,869.10

3,726.00

34,119.80

30,327.40

COMPANY ANNUAL REPORT Every company is required to prepare an Annual Report. Annual Report is a publically available document which describes companies’ performance along with financial statements.

Objective 7 To know the contents of a company’s annual report

The following are the general contents of a company’s annual report: ■ ■ ■

Notice of AGM Attendance Slip and Proxy Contents

254 Financial Accounting

General Contents ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

■ ■

Corporate Objectives Reference Information Year at Glance Letter to Shareholders/Chairman speech Achievements and Accolades Graphs and Station-wise Generation Directors’ Profile Senior Management Team Directors’ Report Management Discussion and Analysis Report on Corporate Governance Annexure to Directors’ Report Comments of the Comptroller and Auditor General of India (For Public Sector Company) Employee Cost Summary and Revenue Expenditure on Social Overheads Annual Report of Subsidiary Companies

Financial Contents ■ ■ ■ ■ ■ ■ ■ ■ ■

Accounting Policies Selected Financial Information Balance Sheet Profit and Loss Account Cash Flow Statement Schedules for Balance Sheet and Profit and Loss Account Auditors’ Report Consolidated Financial Statements Segmental Accounting

SUMMARY ➤

A corporation is an artificial being invisible, intangible and existing only in the contemplation of law. In India a company is formed and registered under the Companies Act, 1956.

➤

Company can be of various types like statutory company, government company, foreign company, subsidiary company, holding company, private company, public company, listed company.

Corporate Accounts 255 ➤

Share capital is the amount of money contributed by owners/shareholders for the furtherance of objectives of the company for which it was created.

➤

A share is a fraction of the share capital and forms the basis of ownership interest in a company. The persons who contribute money through shares are referred to as shareholders.

➤

Preference shares are the shares which carry a preferential right to dividend and to the repayment of capital on the winding up of the company, before anything is paid to equity shareholders.

➤

Equity shares are the shares that entitle their holder to the whole of the profits earned by the company, after a fixed dividend on preference shares has been paid by it. Equity shareholders are the real owners of the companies.

➤

The company issue shares to investor and raise long-term funds. The shares of a company can be issued for cash or for consideration other than cash.

➤

Bonus share is an equity share issued to current shareholders in a company free of cost, based upon the number of shares that the shareholder already owns. Such issue will increase company’s equity shares.

➤

Right shares are those shares which are offered to the existing shareholders, usually at a discount to market price.

➤

Sweat equity shares are the equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing knowhow or for making available intellectual property rights provided that not less than one year has elapsed since the date of commencement of business.

➤

Employee Stock Option Plans (ESOPs) is a choice given to whole time directors, officers, and employees, whereby they have the right to purchase or subscribe at a future date the securities offered by the company at a pre-determined price.

➤

When a company issues its securities at a price that exceeds the face value, it is said to be an issue at premium.

➤

There are instances when the shares of a company can also be issued at a discount, i.e. at an amount less than the nominal or par value of shares.

➤

IPO/FPO is a sale of shares by a company to public. FPO is used by existing companies to raise capital and IPO by new company to become listed company. IPO/FPO market is known as primary market.

➤

Issue of shares can be collected in instalments, i.e. on application, on allotment and on calls.

➤

It may happen that certain shareholders fail to pay one or more instalments. In such circumstances, the company can forfeit their shares by giving due notice and following the procedure specified in the Articles of Association in this behalf.

256 Financial Accounting ➤

Buyback of shares implies the act of purchasing its own shares by a company either from free reserve, securities premium, or proceeds of any shares or securities.

➤

A debenture/bond is an instrument of acknowledgement of debt. A debenture is issued by a company as an evidence of its debt or loan. Debentures are freely transferable and can be listed and traded in stock exchanges.

➤

Dividend refers to that part of profits which is distributed among its shareholders.

MULTIPLE CHOICE QUESTIONS 1. The liability of every shareholder is (a) Unlimited (b) Limited to unpaid amount of face value of shares allotted (c) To the extent of company liability (d) None of the above 2. The control and management of the company is in the hands of (a) Board of Directors (b) Shareholders (c) Debenture holders (d) Promoters 3. Which of the following is a document of Charter to company? (a) Memorandum of Association (b) Articles of Association (c) Prospectus (d) Share Certificates 4. All companies that operate under a special act passed by the state legislature or Parliament, such as the Reserve Bank of India, are known as (a) Statutory companies (b) Government companies (c) Public companies (d) Banking companies 5. In which of the following conditions a company is deemed to be a subsidiary of another company? (a) The other company controls the composition of its board of directors. (b) The other company holds more than half in its nominal value of its equity share capital. (c) The other company is a subsidiary of any company, which is a subsidiary of the parent company (d) All of the above

Corporate Accounts 257

6.

7.

8.

9.

10.

11.

12.

(e) None of the above The maximum amount of share capital that a company can raise is called (a) Authorised capital (b) Issued capital (c) Subscribed capital (d) Paid up capital Preference shares are the shares (a) Which carry a preferential right to dividend and to the repayment of capital on the winding up of the company over equity share holder? (b) Which carry a preferential right to dividend and to the repayment of capital on the winding up of the company over debenture holders? (c) Which carry a preferential right to dividend and to the repayment of capital on the winding up of the company over debenture holders and equity shareholders both? (d) None of the above Right shares are those shares which are offered to the (a) Existing shareholders (b) Public (c) Institutional investors (d) Foreign investors The equity shares issued by the company to employees or directors at a discount or for consideration other than cash are called (a) Right shares (b) Bonus shares (c) Sweat equity shares (d) Ordinary shares Existing company’s shares can be issued (a) For cash only (b) For cash or consideration other than cash (c) Only at premium (d) For none of the above Employee Stock Option Plans (ESOPs) are offered to (a) Employees (b) Directors (c) Officers (d) All of the above A company can buy its own shares from the (a) Existing equity shareholders on a proportionate basis (b) Open market

258 Financial Accounting

(c) Either (a) or (b) (d) Neither (a) nor (b) 13. Which of the following is an instrument of acknowledgement of debt? (a) Debentures (b) Bonds (c) Preference Shareholders (d) Both (a) and (b) 14. Shares can be forfeited (a) For non-payment of call money (b) For failure to attend meetings (c) For failure to repay the loan to the bank for which shares are pledged as a security (d) For none of the above 15. Balance of share forfeiture account is transferred to (a) Capital reserve (b) General reserve (c) Statutory reserve (d) Profit and Loss Account

THEORY QUESTIONS 1. 2. 3. 4. 5.

What is a company? Explain its characteristics. What are different types of companies? Explain different types of shares. What procedure is to be followed for issue of shares by company? Define debentures and explain different types of debentures.

PRACTICAL PROBLEMS Level 1: Easy 1. Prakash Ventures Ltd issued 80,000 shares of Rs 10 each to the public for the subscription of its share capital, payable at Rs 4 on application, Rs 3 on allotment and the balance on first and final call. Applications were received for 80,000 shares. The company made the allotment to the applicants in full. All the amounts due on allotment and first and final call were duly received. Give the journal entries in the books of the company.

Corporate Accounts 259

2. Heena Limited issued 20,000 equity shares of 100 each payable as follows: Rs 20 on application, Rs 30 on allotment, Rs 20 on first call and Rs 30 on second and final call. 20,000 shares were applied for and allotment. All money due was received with the exception of both calls on 300 shares held by Surya. These shares were forfeited. Give necessary journal entries. 3. Pass journal entries for the following transactions: (a) Jeevan Ltd paid total dividend of Rs 10,000 to its shareholders for the year ended 31st March, 2012. (b) Mukund Ltd issued 10,000 bonus shares of Rs 10 each to its shareholders out of general reserves.

Level 2: Standard 4. Unique Pictures Ltd was registered with an authorised capital of Rs 5,00,000 divided into 20,000, 5% preference shares of Rs 10 each and 30,000 equity shares of Rs 10 each. The company issued 10,000 preference and 15,000 equity shares for public subscription. Calls on shares were made as under: Equity Shares

Preference Shares

(Rs)

(Rs)

Application

2

2

Allotment

3

3

First Call

2.50

2.50

Second and Final Call

2.50

2.50

All these shares were fully subscribed. All the dues were received except the second and final call on 100 equity shares and on 200 preference shares. Record these transactions in journal. You are also required to pass journal entries. 5. Prepare vertical balance sheet using the following information available for Zenith Infotech Ltd. March 2010 Equity Share Capital Reserves Miscellaneous Expenses Contingent Liabilities Secured Loans Unsecured Loans Gross Block

March 2009

12.68

12.24

142.32

137.14

0

8.37

0.41

0.96

0

0

307.45

319.44

285.2

237.38 (Contd.)

260 Financial Accounting Capital Work in Progress Investments Inventories Sundry Debtors Cash and Bank Balance Loans and Advances Fixed Deposits

7.58

3.63

77.93

2.58

8.79

9.67

96.16

80.76

19.7

16.87

102.37

74.41

16

111.92

Current Liabilities

36.4

34.86

Provisions

9.84

11.17

104.44

28.31

0.59

2.44

Accumulated Depreciation Revaluation Reserves

Level 3: Expert 6. Janta Papers Limited invited applications for 1,00,000 equity shares of Rs 25 each payable as under: On Application Rs 5.00 per share On Allotment Rs 7.50 per share On First Call Rs 7.50 per share (Due Two Months after Allotment) On Second and Final Call Rs 5.00 per share (Due Two Months after First Call) Applications were received for 4,00,000 shares on 1st January, 2006 and allotment was made on 1st February, 2006. Record journal entries in the books of the company. Capital transactions under each of the following circumstances: 1. The directors decide to allot 1,00,000 shares in full to selected applicants and the applications for the remaining 3,00,000 shares were rejected outright. 2. The directors decide to make a pro-rata allotment of 25 per cent of the shares applied for to every applicant; to apply the balance of application money towards amount due on allotment; and to refund the amount remaining thereafter. 3. The directors totally reject applications for 2,00,000 shares, accept full applications for 80,000 shares and make a pro-rata allotment of the 20,000 shares to the remaining applicants. The excess of application money is to be adjusted towards allotment and calls to be made. 7. High Light India Ltd invited applications for 30,000 shares of Rs 100 each at a premium of Rs 20 per share payable as follows: On Application Rs 40 (including Rs 10 premium)

Corporate Accounts 261

On Allotment Rs 30 (including Rs 10 premium) On First Call Rs 30 On Second and Final Call Rs 20 Applications were received for 40,000 shares and pro-rata allotment was made on the application for 35,000 shares. Excess application money is to be utilised towards allotment. Rohan to whom 600 shares were allotted failed to pay the allotment money and his shares were forfeited after allotment. Aman who applied for 1,050 shares failed to pay first call and his share were forfeited after first call. Second and final call was made. All the money due on second call have been received. Of the shares forfeited, 1,000 shares were reissued as fully paid-up for Rs 80 per share, which included the whole of Aman’s shares. Record necessary journal entries in the books of High Light India Ltd. 8. On 1st January, 2012, the director of Navjeevan Biotech Ltd issued for public subscription 50,000 equity shares of Rs 10 each at Rs 12 per share payable as to Rs 5 on application (including premium), Rs 4 on allotment and the balance on call in 1st May, 2012. The lists were closed on 10th February, 2012 by which date applications for 70,000 were received. Of the cash received Rs 40,000 was returned and Rs 60,000 was applied to the amount due on allotment, the balance of which was paid on 16th February, 2012. All the shareholders paid the call due on 1st May, 2012 with the exception of an allottee of 500 shares. These shares were forfeited on 29th September, 2012 and reissued us fully paid at Rs 8 per share on 1st November, 2012. The company, as a matter of policy, does not maintain a calls-in-arrears account. Give journal entries to record these share capital transactions in the books of Navjeevan Biotech Ltd. 9. The following are the trial balance, schedule of fixed assets and the additional information of Satyam Ltd as on 31st March, 2012. Particulars

Dr Rs

Cr Rs

Equity Share Capital (99,000 Equity Shares of Rs 10 each fully paid)

9,90,000

10% Cumulative Preference Share Capital (4,000 Preference Shares of Rs 100 each) st

Profit and Loss Account (31 March, 2012) Preliminary Expenses

4,00,000 4,09,000 14,000

Prepaid Expenses

9,000

Underwriting Commission

7,500

Forfeited Shares Account Fixed Assets (Net Block)

6,000 4,85,000

Sundry Creditors Sundry Debtors

1,85,000 3,45,000

262 Financial Accounting Loan from Bank of India (Secured against Machinery)

3,15,000

Interest Accrued but not Due on Loan

31,500

12% Deposits from Public

2,00,000

Deposits from Customers

35,000

Cash in Hand

3,85,000

Cash at Bank (Bank of India Current Account)

1,65,000

Interest Accrued and Due on Deposits from Public

24,000

Outstanding Expenses

17,500

st

Stock in Trade (31 March, 2012)

3,84,500 22,04,000

22,04,000

Schedule of Fixed Assets As on 31st March, 2012

Additions

Deductions

—

?

—

—

—

Building

1,50,000

—

?

?

18,750

2,500

6,250

Plant and Machinery

7,00,000

—

—

?

2,80,000

70,000

—

9,00,000

—

50,000

8,50,000

2,98,750

72,500

6,250

Closing 31 March 2012

Opening 1 April 2011

—

Opening 1 April 2011

Closing 31st March 2012

?

Land

Net Block Closing 31st March 2012

Deductions

Provision for Depreciation

Additions

Cost Opening 1 April 2011

Assets

—

?

50,000

?

85,000

?

?

?

3,65,000

?

?

15,000

Additional Information: 1. Authorised share capital of the company consists of 1,50,000 equity shares of Rs 10 each and 5,000 10% cumulative preference shares Rs 100 each. 2. Out of the above equity share capital 10,000 equity shares of Rs 10 each fully paid have been allotted for consideration other than cash. 3. Dividend on preference shares is in arrears for 3 years (including current years) 4. Of the sundry debtors Rs 1, 36,949 are due for more than 6 months. 5. Sundry debtors and advances are unsecured but considered good. 6. Bills receivable of Rs 25,000 maturing on 31st May, 2012 has been discounted with the Bank. 7. Ignore previous year’s figures.

Corporate Accounts 263

Complete the above schedule of fixed assets and prepare balance sheet of Satyam Ltd as on 31st March, 2012 as per the requirements of Schedule VI of the Companies Act, 1956 (in vertical form). 10. The following balances are extracted from the books of Sure Success Co Ltd as on 31st December, 2011. Rs

Rs

Freehold Factory Premises

6,00,000 2,00,000 Equity Shares of

Leasehold Office Premises

5,00,000 Rs 10 each

Bank Balance

60,500 5,000 6% Debenture of

Vehicles

3,15,000 Rs 100 each

Plant and Machinery

8,30,000 General Reserves

Sundry Debtors

2,40,000 Accumulated

Computer

20,00,000

5,00,000 75,000

30,000 Depreciation

15,000

Goodwill

2,00,000 Profit and Loss Account

Stock

1,30,000 Balance b/d

Cash in Hand

47,450

1,950 + Net Profit

Advance Income Tax:

After Tax

[Accounting year 2010]

1,45,000

[Accounting year 2011]

1,75,000 - Debenture

2,90,000 3,37,450

Interest

30,000

3,07,450

Provision for Tax (Accounting Year 2010)

1,50,000

Provision for Tax (Accounting Year 2011) 32,27,450

1,80,000 32,27,450

Adjustments: 1. During the current year, income tax assessment for the accounting year 2011 is completed with a gross demand of Rs 1,35,000 but no effect of the same is given in the accounts of the current year. 2. The board of directors decided to provide: (a) 20% bonus on the year’s salary Rs 1, 00,000 (b) 10% Depreciation on Leasehold Premises (c) Rs 5, 000 as Director’s Fees (d) 5% Dividend for the Year to the Shareholders (e) Transfer Rs 50,000 to General Reserves

264 Financial Accounting

Considering the above trial balance and the adjustments and assuming that there will be no change in the provision for tax for the accounting year 2012 on account of changes if any, prepare Profit and Loss Account for the year ended 31st December, 2012 and balance sheet as on that date in a vertical form keeping in mind the prescribed formats and applicable accounting standards. Ignore previous year’s figures.

RESEARCH ASSIGNMENTS Identify any five listed companies that had following corporate events in 2009: ■ Buyback of shares ■ Right issue ■ Bonus announcement You are required to answer the following questions: 1. What could be the reasons for such corporate actions? 2. Identify sources used for bonus issue. 3. Analyse and discuss impact on companies’ performance due to such actions.

INTERPRETING FINANCIAL REPORTS The following are some of the Employee Stock Option Plans (ESOPs) granted by listed companies in India: 1. Essar Ports Ltd has informed BSE that the compensation committee of the board of directors of the Company at its meeting held on 28th November, 2011 has approved grant of 7,08,380 stock options (convertible into equivalent number of equity shares of Rs 10 each of the Company) to eligible employees including full time directors of the Company and its subsidiaries (“eligible employees”), pursuant to the “Essar Ports Employees Stock Option Scheme—2011”. Further the board of directors and the compensation committee of the board of directors has approved grant of 31,954 stock options (convertible into equivalent number of equity shares of Rs 10 each) to the eligible employees subject to the approval of the members of the Company. These stock options have been granted at an exercise price of Rs 71.10 per equity share of Rs 10 each, i.e. the closing price of the equity shares of the Company on 28th November, 2011 on the National Stock Exchange Ltd, which has the highest quantity of trading in the Company’s shares.

Corporate Accounts 265

2. Lupin Ltd has informed BSE that the Company has granted 18,45,750 options to its employees under “Lupin Employees Stock Option Plan 2011” at the exercise price of Rs 455.65 on 2nd August, 2011. One equity share of Rs 2 each is covered by each option. The options issued are exercisable at the “market price” as defined in SEBI guidelines, in a phased manner after a minimum vesting period of 12 months but before the exercise period of 10 years from the date of grant. 3. Polaris Software Lab Ltd has informed BSE that the shareholders’ committee of board of directors of the Company vide Circular Resolution dated 22nd November, 2011 allotted 31,000 equity shares to three associates (employees) of the Company under the Associate Stock Option Plan (ASOP) 2003. Further under ASOP 2004 Scheme, 1,500 equity shares were transferred to an associate pursuant to exercise of options granted to them. You are required to study impact of ESOPs on companies’ market performance and analyse how it has affected companies’ market capitalisation. (Hint: Download relevant share price data before and after declaration of ESOPs.)

BUSINESS CASE Larsen & Toubro (L&T) is India’s largest technology, engineering, manufacturing and construction organisation with a record of over 70 years. L&T is also adjudged India’s best managed and most respected company on various attributes of customer delight and shareholder value. L&T is the largest construction organisation in the country. It figures among the World’s 77th Top Contractors and ranks 29th in global ranking as per the survey conducted by the reputed international construction magazine [Engineering News Record, USA (August 2010)]. L&T cutting edge capabilities cover every discipline of construction—civil, mechanical, and electrical and instrumentation engineering and services extend to large industrial and infrastructure projects from concept to commissioning. L&T has played a prominent role in India’s industrial and infrastructure development by executing several projects across length and breadth of the country and abroad. For ease of operations and better project management, in-depth technology and business development as well as to focus attention on domestic and international project execution.

266 Financial Accounting

The following are financial statements of the company: Balance Sheet of Larsen and Toubro Ltd Rs. In Cr. March 2011

March 2010

March 2009

March 2008

March 2007

121.77

120.44

117.14

58.47

56.65

Equity Share Capital

121.77

120.44

117.14

58.47

56.65

Share Application Money

368.31

25.09

0

0

0

0

0

0

0

0

21,334.05

18,142.82

12,317.96

9,470.71

5,683.85

Sources of Funds Total Share Capital

Preference Share Capital Reserves Revaluation Reserves

22.13

23.29

24.59

25.9

27.93

21,846.26

18,311.64

12,459.69

9,555.08

5,768.43

Secured Loans

1,063.04

955.73

1,102.38

308.53

245.4

Unsecured Loans

6,098.07

5,845.10

5,453.65

3,275.46

1,832.35

Total Debt

7,161.11

6,800.83

6,556.03

3,583.99

2,077.75

29,007.37

25,112.47

19,015.72

13,139.07

7,846.18

Gross Block

8,897.02

7,235.78

5,575.00

4,188.91

2,876.30

Less: Accumulated Depreciation

2,220.82

1,727.68

1,421.39

1,242.47

1,122.83

Net Block

6,676.20

5,508.10

4,153.61

2,946.44

1,753.47

785

857.66

1,040.99

699

471.22

Investments

14,684.82

13,705.35

8,263.72

6,922.26

3,104.44

Inventories

1,577.15

1,415.37

5,805.05

4,305.91

3,001.14

12,427.61

11,163.70

10,055.52

7,365.01

5,504.64

1,518.98

1,104.89

693.13

779.86

993.68

Total Current Assets

15,523.74

13,683.96

16,553.70

12,450.78

9,499.46

Loans and Advances

19,499.23

12,662.55

7,198.85

3,861.10

2,449.14

Net Worth

Application of Funds

Capital Work in Progress

Sundry Debtors Cash and Bank Balance

Fixed Deposits Total CA, Loans and Advances Deferred Credit Current Liabilities Provisions Total CL and Provisions Net Current Assets Miscellaneous Expenses

211.37

326.98

82.16

184.6

100.75

35,234.34

26,673.49

23,834.71

16,496.48

12,049.35

0

0

0

0

0

26,139.56

19,443.77

15,211.04

11,892.75

8,362.01

2,233.43

2,188.36

3,066.53

2,035.42

1,180.13

28,372.99

21,632.13

18,277.57

13,928.17

9,542.14

6,861.35

5,041.36

5,557.14

2,568.31

2,507.21

0

0

0.26

3.06

9.84

13,139.07

7,846.18

Total Assets 29,007.37 25,112.47 19,015.72 Source: http://www.moneycontrol.com/financials/larsentoubro/balance-sheet/LT#LT

Corporate Accounts 267

Profit and Loss Account of Larsen and Toubro Rs in Crores March 2011

March 2010

March 2009

March 2008

March 2007

44,055.55

37,187.50

34,249.85

25,280.49

17,983.37

Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income

398.84

317.31

393.31

334.38

338.08

43,656.71

36,870.19

33,856.54

24,946.11

17,645.29

1,781.28

2,321.67

1,612.58

616.69

459.8

559.49

-422.99

105.11

746.17

121.76

45,997.48

38,768.87

35,574.23

26,308.97

18,226.85

12,372.32

9,593.53

9,316.38

8,256.46

5,320.98

355.45

334.08

456.39

365.25

308.13

Expenditure Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Admin Expenses Miscellaneous Expenses Preoperative Expenses Capitalised

2,884.53

2,379.14

1,998.02

1,535.44

1,258.21

19,886.12

16,913.31

15,659.17

10,632.83

7,451.07

2,103.38

1,854.23

1,844.83

1,393.80

1,222.80

773.7

325.58

569.32

280.69

166.15

−37.87

−36.25

−24.48

−11.42

−3.3

Total Expenses

38,337.63

31,363.62

29,819.63

22,453.05

15,724.04

Operating Profit

5,878.57

5,083.58

4,142.02

3,239.23

2,043.01

PBDIT

7,659.85

7,405.25

5,754.60

3,855.92

2,502.81

Interest

1,199.23

995.37

770

501.83

331.46

PBDT

6,460.62

6,409.88

4,984.60

3,354.09

2,171.35

575.81

383.65

284.83

195.94

160.13

Depreciation Other Written Off

23.41

30.95

21.16

15.66

0

Profit Before Tax

5,861.40

5,995.28

4,678.61

3,142.49

2,011.22

Extra-ordinary Items

−49.05

−45.13

−21.09

12.21

−5.34

PBT (Post Extra-ordinary Items)

5,812.35

5,950.15

4,657.52

3,154.70

2,005.88

Tax

1,858.47

1,577.02

1,176.19

982.05

601.87

Reported Net Profit

3,957.89

4,375.52

3,481.66

2,173.42

1,403.02

Total Value Addition

25,965.31

21,770.09

20,503.25

14,196.59

10,403.06

Preference Dividend

0

0

0

0

0

Equity Dividend

882.84

752.75

614.97

495.32

368.25

Corporate Dividend Tax

112.82

110.25

101.83

76.26

53.34

Shares in Issue (lakhs)

6,088.52

6,021.95

5,856.88

2,923.27

2,832.71

Earning per Share (Rs)

65.01

72.66

59.45

74.35

49.53

725

625

525

850

650

352.4

303.28

212.32

325.98

202.65

Per Share Data (Annualised)

Equity Dividend (%) Book Value (Rs)

Source: http://www.moneycontrol.com/financials/larsentoubro/profit-loss/LT#LT, accessed on 12 February 2012

268 Financial Accounting

Company is contemplating to raise new fund for expansion. Company intends to maximise return on equity. Following alternatives are available: 1. Issue of Equity Shares at Rs 600 2. Issue of Equity Shares at Rs 750 3. Loan at Interest Rate of 16% You are required to analyse the alternative and suggest the best alternative/s for expansion.

Cash Flow Statement

9

Learning Objectives After studying this chapter, you will be able to ❖

Understand cash flow statements and realise its importance

❖

Classify inflows and outflows into operating, investing and financing activities

❖

Understand free cash flows

❖

Analyse cash flow statement

❖

Prepare a statement of cash flow from a comparative balance sheet and income statement

Cash Flow Statement 271

LET US SET THE STAGE . . . Tata Motors Limited is India’s largest automobile company. It is the leader in commercial vehicles in each segment and among the top three in passenger vehicles with winning products in the compact, mid-size car and utility vehicle segments. The Company is the world’s fourth largest truck manufacturer and the world’s second largest bus manufacturer. With the launch of Nano in 2008 and take over of Jaguar in 2009, it is recognised as a Company having the cheapest and the costliest car in its portfolio. The profitability and financial position of Tata Motors which had been steadily improving till year ended March, 2008, has been affected by recession in the year ended March, 09. Reported net profit of the Company has fallen from Rs 2,028.92 crores to Rs 1,001.26 crores. A look at the financial statement leads us to a few questions like though net profit has fallen to almost half: ■

■ ■

How could Company increase its investment from Rs 4,910 crore to Rs 12,968 crore? How could Company pay a dividend of 311 crore? How could Company manage to have a cash balance of Rs 638 crore?

All such questions can be answered after reading cash flow statement which shows the inflow and outflow of cash from various activities like operating, investing and financing.

INTRODUCTION TO CASH FLOW STATEMENT Concept and Definition Cash flow statement is a financial report that describes the sources of cash and how it was

Objective 1 To understand cash flow statements and realise its importance

272 Financial Accounting

spent over a specified time period. Cash flow statement, also known as statement of cash flows is a financial statement that shows how changes in balance sheet and income affect cash flows. The statement captures both the current operating results and the accompanying changes in the balance sheet. Cash flow statement classifies the cash receipts and payments according to whether they stem from operating, investing, or financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of an organisation. Because of the accrual accounting method and a variety of assumptions companies may employ, it is possible for a company to show profits while not having enough cash to sustain operations. A cash flow statement neutralises the impact of the accrual adjustments in the financial statements. It also classifies the sources and uses of cash to provide an understanding of the amount of cash generated and used in business operations, as opposed to the amount of cash provided by sources outside the company, such as borrowed funds or funds from stockholders. The cash flow statement also mentions as to how much money was spent for items that do not appear on the income statement, such as loan repayments and for long-term asset purchases. The statement of cash flows reports a firm’s major cash inflows and outflows for a period. It provides useful information about a firm’s ability to generate cash from operations, maintain and expand its operating capacity, meet its financial obligations and pay dividends. Cash flow statement is a financial statement that describes the sources and application of cash from various activities over a specified time period.

Importance of Cash Flow Statement It is useful to managers in evaluating past operations and in planning future investing and financing activities. It is useful to investors, creditors and others in assessing a firm’s profit potential. In addition, it is a basis for assessing the firm’s ability to pay its maturing debt. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company. People and groups interested in cash flow statements include: 1. Accounting personnel, who need to know whether the organisation will be able to cover expenses 2. Board of Directors, Managers (i.e. Management of company) 3. Employees, who need to know whether the company will be able to afford compensation 4. Contractors and service providers who need to judge capacity to pay short-term obligations

Cash Flow Statement 273

5. Shareholders and potential investors, who need to evaluate operating and financial performance 6. Existing and potential lenders, who want a clear picture of a company’s ability to repay

CASH AND CASH EQUIVALENTS Cash and cash equivalents are most liquid assets, comprising of cash on hand and demand deposits with banks and short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to less risk of changes in value. Cash equivalents are distinguished from other investments because of their liquidity; they are due to mature within 3 months whereas short-term investments are due to mature within 12 months and long-term investments are due to mature beyond 12 months. Another important condition a cash equivalent needs to satisfy is that the investment should have less risk of change in value; thus, equity shares cannot be considered a cash equivalent though they may be highly liquid. Cash and cash equivalents comprise cash in hand and demand deposits with banks and short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to less risk of changes in value.

How Cash Flow Statement Looks Like? Cash flow statement consists of three activities, i.e. operating, financing and investing. The cash flows from operating activities section always appears first, followed by the investing section (see Exhibit 9.1). EXHIBIT 9.1

Format of Cash Flow Cash Flow Statement For the Year Ending 31/03/XXXX

Particulars

Rs

Rs

Cash Flow from Operating Activities Net Profit Before Tax

XXX

Adjust Non Cash Items

XXX

Adjust Non Operating Items

XXX

Fund from Operations

XXX (Contd.)

274 Financial Accounting

Changes in Working Capital

XXX

Net Cash Flow from Operating Activities

XXXX

Cash Flow from Investing Activities Sale of Investments

XXX

Purchases of Fixed Assets

(XXX)

Net Cash Flow from Investing Activities

XXXX

Cash Flow from Financing Activities Issue of Equity Share Capital

XXX

Repayment of Unsecured Loan

(XXX)

Dividend Paid

(XXX)

Net Cash Flow from Financing Activities

XXXX

Net Increase in Cash

XXXX

Cash Balance at the Beginning of the Year

XXXX

Cash Balance at the End of the Year

XXXX

Detail Cash Flow Statement: Real Life Example Exhibit 9.2 depicts cash flow statement of Reliance Industries Ltd for the years 2008– 09 and 2009–10. It shows how a real life cash flow statement looks like with a variety of details. EXHIBIT 9.2

Cash Flow Statement for the Years 2008–09 and 2009–10 of Reliance Industries Limited

Rs in Crores 2009–10

Rs in Crores 2008–09

CASH FLOW FROM OPERATING ACTIVITIES Net Profit Before Tax as per Profit and Loss Account Net Prior Year Adjustments Diminution in the Value of Investment Investment Written off (Net) Loss on Sale/Discarding of Fixed Assets (Net)

20,547.44

18,433.23

1.35

2.14

0.15

3.44

18.38

—

0.60

7.08 (Contd.)

Cash Flow Statement 275

Depreciation

13,477.01

7,182.43

Transferred from Revaluation Reserve

(2,980.48)

(1,987.14)

Effect of Exchange Rate Change

(1,837.42)

575.57

(238.43)

(425.40)

Profit on Sale of Current Investments (Net) Dividend Income Interest/Other Income Interest and Finance Charges

(2.41)

(29.81)

(2,108.41)

(1,564.97)

1,997.21

1,745.23

Operating Profit before Working Capital Changes

8,327.55

5,508.57

28,874.99

23,941.80

Adjusted for: Trade and Other Receivables Inventories Trade Payables

(7,379.98)

(109.91)

(12,144.90)

159.01

14,223.40

(3,847.36) (5,301.48)

Cash Generated from Operations

—

(3,798.26)

23,573.51

20,143.54

(1.35)

(2.14)

Tax Paid

(3,081.94)

(1,895.54)

Net Cash from Operating Activities

20,490.22

18,245.86

(21,942.67)

(24,712.78)

Net Prior Year Adjustments

CASH FLOW FROM INVESTING ACTIVITIES: Purchase of Fixed Assets Sale of Fixed Assets

113.19

48.35

Purchase of Investments

(1,98,866.1)

(1,08,573.9)

Sale of Investments

1,97,660.74

1,10,986.78

Movement in Loans and Advances

2,626.01

(3,452.11)

Interest Income

2,201.93

1,589.66

2.41

29.81

(18,204.50)

(24,084.20)

53.54

15,164.79

Proceeds from Long-Term Borrowings

6,530.64

20,690.86

Repayment of Long-Term Borrowings

(11,598.22)

(3,382.93)

(234.86)

(2,238.39)

Dividends Paid (Including Dividend Distribution Tax)

(2,219.45)

(1,908.47)

Interest Paid

(3,531.25)

(4,593.28)

(10,999.60)

23,732.58 (Contd.)

Dividend Income Net Cash Used in Investing Activities CASH FLOW FROM FINANCING ACTIVITIES Proceeds from Issue of Share Capital/Warrants

Short Term Loans

Net Cash (Used in)/from Financing Activities

276 Financial Accounting

Net (Decrease)/Increase in Cash and Cash Equivalents Opening Balance of Cash and Cash Equivalents Add: On Amalgamation

(8,713.88)

17,894.24

22,176.53

4,280.05

0.00

2.24

Closing Balance of Cash and Cash Equivalents

2,2176.53

4,282.29

13,462.65

22,176.53

Note : Loans/Deposit given to Subsidiaries/Associate aggregating to Rs 196.86 crores. (Previous Year Rs 5,380.04 crores) have been converted into investments in Preference Shares. Source: Annual Reports, Reliance Industries Ltd.

CASH FLOW ACTIVITIES The cash flow statement is divided into 3 activities: cash flow resulting from operating activities, cash flow resulting from investing activities and cash flow resulting from financing activities (see Figure 9.1).

FIGURE 9.1

Objective 2 To classify inflows and outflows into operating, investing and financing activities

Cash Flow Activities

OPERATING ACTIVITIES Cash flows from operating activities are cash flows derived from the principal revenue-producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss. Operating activities include the production, sales and delivery of the product, collecting payment from customers, purchasing raw materials, advertising and other day-to-day expenses. Operating cash flows include: ■ ■ ■

Receipts from the sale of goods or services Payments to suppliers for goods and services Payments to employees or on behalf of employees

Cash Flow Statement 277

Cash flows from operating activities are cash flows derived from the principal revenue-producing activities of the enterprise.

Methods for Reporting Cash Flow from Operating Activities There are two alternative methods for reporting cash flows from operating activities in the statement of cash flows. These methods are the direct method and the indirect method. 1. Direct Method The direct method reports the sources of operating cash and the uses of operating cash. The major source of operating cash is cash received from customers. The major uses of operating cash include cash paid suppliers for merchandise and services and cash paid to employees. The difference between these operating cash receipts and cash payments is the net cash flow from operating activities. The primary advantage of the direct method is that it reports the actual sources and uses of cash in the statement of cash flows. Its primary disadvantage is that the necessary data may not be readily available. EXHIBIT 9.3

Calculation of Operating Cash Flow through Direct Method Cash Flow from Operating Activities for the Year ended 31/03/XXXX

Cash Receipts from Customers

xxxxx

Cash Sales

xxxxx

Total Cash Received

xxxxx

Less: Cash Paid to Suppliers

xxxxx

Cash Paid to Employees

xxxxx

Cash Paid for Other Operating Expenses

xxxxx

Income Taxes Paid

xxxxx

Total Cash Paid

xxxxx

Net Cash from Operating Activities

xxxxx

2. Indirect Method The “indirect method” reports the operating cash flows by beginning with net income and adjusting it for revenues and expenses that do not involve the receipt or payment of cash. In other words, net income on accrual basis is adjusted to determine the amount of cash generated from operating activities. A major advantage of the indirect method is that it focuses on the difference between the net income and cash flow from operations. In this sense, it shows the relationship between the income statement, the balance sheet and the statement of cash flows. Because the data are readily available, the indirect method is normally easier

278 Financial Accounting

to use than the direct method. The Accounting Standard (AS 3) makes it mandatory to use indirect method. Most firms use the indirect method to report cash flows from operations. EXHIBIT 9.4

Calculation of Operating Cash Flow through Indirect Method Cash Flow from Operating Activities for the Year ended 31/03/XXXX

Increase in Reserve

XX

Add: Dividend Declared Net Profit After Tax as per Profit and Loss A/c Add: Provision for Tax Net Profit Before Tax as per Profit and Loss A/c Adjust Non-Cash Expenses Depreciation on Fixed Asset Amortisation of Goodwill Adjust Non-operating Items Loss/Profit on Sale of Fixed Asset Interest/Dividend Received Funds from Operation Adjust Working Capital Changes Add: Decrease in Current Asset Add: Increase in Current Liabilities Less: Increase in Current Asset Less: Decrease in Current Liabilities Cash Generated from Operation Income Tax Paid Net Cash Flow from Operating Activities

XX XX XX XX XX XX XX (XX)

XX

XX XX

XX XX (XX) (XX) XX (XX) XX

ILLUSTRATION 9.1 From the following Profit and Loss Account of M/s Krishna Damodaram, calculate the amount of cash flow from operating activities. M/s Krishna Damodaram Profit and Loss Account for the Year ending 31 March 2011 Particulars To Salary To Depreciation To Losses on Sale of Machinery To General Expenses To Net Profit

Amount 20,000 28,470 48,000 58,000 3,52,230 5,06,700

Particulars By Gross Profit By Profit on Sale of Land By Interest By Dividend

Amount 3,70,000 60,000 68,700 8,000 5,06,700

Cash Flow Statement 279

Solution M/s Krishna Damodaram Cash Flow from Operating Activities for the Year ended 31/03/2010 Particulars

Amount

Net Profit as per Profit and Loss Account

3,52,230

Add: Depreciation (Non Cash Expenses)

28,470

Add: Non-operating Expenses Losses on Sale of Machinery

48,000 4,28,700

Less: Non-operating Income Profit on Sale of Land

(60,000)

Interest

(68,700)

Dividend

(8,000)

Cash Flow from Operating Activities

2,92,000

Note: It is assumed that there are no working capital changes.

ILLUSTRATION 9.2 Calculate the amount of cash flow from operational activities of the S.T. International Ltd. S.T. International Ltd Profit and Loss Account for the Year ending 31 March 2010 Particulars

Amount

Particulars

To Administration Expenses

25,000

By Sales

To Depreciation

30,500

By Interest

To Goodwill Written off

2,15,000 8,000

5,000

To Discount on Issue of Shares

35,000

To Selling Expenses

17,900

To Net Profit

Amount

1,09,600 2,23,000

2,23,000

Following additional information provided: Particulars Debtors Cash Creditors

31/03/2009

31/03/2010

25,000

30,000

2,800

1,900

58,000

51,000

280 Financial Accounting

Solution S.T. International Ltd Statement of Operating Cash Flow for the Year ended 31 March 2010 Particulars

Amount

Net Profit as per Profit and Loss Account

1,09,600

Add: Depreciation (Non Cash Expenses)

30,500

Add: Amortisation of Goodwill

5,000

Add: Non-operating Expenses Discount on Issue of Shares

35,000 1,80,100

Less: Non-operating Income Interest Received Funds from Operation

(8,000) 1,72,100

Adjust Working Capital Changes Less: Decrease in Creditors

(7,000)

Less: Increase in Debtors

(5,000)

Cash Flow from Operating Activities

1,60,100

Investing Activities Cash inflows from investing activities normally arise from selling fixed assets, investments and intangible assets. Cash outflows normally include payments to acquire fixed assets and investments. Investing activities are the activities related to acquisition and disposal of long-term assets and investments. However, purchase or sale of investment included in cash equivalent is not considered as investing activity. If the inflows are greater than the outflows, net cash flow provided by investing activities is reported. If the inflows are less than the outflows, net cash flow used for investing activities is reported. Examples of cash flow from investing activities are as follows: ■ ■ ■

Payments for acquisition of fixed assets including intangibles Receipts from disposal of fixed assets Payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint venture. This does not include an item covered in cash equivalents and items held for dealing or trading purposes

Cash Flow Statement 281 ■

■

■

■

■

Receipts from disposal of shares, warrants or debit instruments of other enterprises and interest in joint venture. This does not include an item covered in cash equivalents and items held for dealing or trading purposes Cash advances and loans made to third parties. This does not include loans and advances made by financial enterprises as these fall under operating cash flow Receipts from repayments of advances and loans made to third parties. This does include loans and advances made by financial institutions as these fall under operating cash flow Receipts from or payments for future, forward, option and swap contracts. This does not include contracts held for dealing or trading purposes or contracts which are classified as financing activities Interest and dividend received from investment like loan, debt instrument and shares. However interest/dividend received on investment covered in cash equivalent and on investments held for trading purposes is considered as operating cash flows. Similarly interest/dividend received by financial enterprises are considered as operating flows

Investing activities are related to the acquisition and disposal of long-term assets and investments. EXHIBIT 9.5

Calculating Cash Flow from Investing Activities Cash Flows from Investing Activities

Purchase of Fixed Assets Proceeds from Sale of Equipment Purchase of Shares

(XXX) XXX (XXX)

Interest Received

XXX

Dividends Received

XXX

Net Cash from Investing Activities

Financing Activities Financing activities are the activities which affect the long-term funds used by the entity like capital and debt. Cash inflows from financing activities include proceeds of shares or debentures issue. Cash outflows from financing activities include payments for buyback of shares, repayment of loans, redemption of debentures and payment of interest and cash dividend.

282 Financial Accounting

If the inflows are greater than the outflows, net cash flow provided by financing activities is reported. If the inflows are less than the outflows, net cash flow used for financing activities is reported.

Examples of Cash Flow from Financing Activities ■ ■ ■

■ ■ ■

Receipts from issuing shares or other equity instruments, face value plus premium Payments to owners redeem the enterprise’s shares, i.e. buyback of shares Proceeds from issuing debentures, loans, notes, bounds, mortgages and other short-term and long-term borrowings Re-payments of loans Payment for redemption of debentures and bonds Repayments by a lease for the reduction of the outstanding liability relating to a finance lease

Cash inflows financing activities normally arise from issuing debt or equity securities. Cash outflows from financing activities include paying cash dividends, repaying debt and interest payment. EXHIBIT 9.6

Calculating Cash Flow from Financing Activities Cash Flows from Financing Activities

Proceeds from Issuance of Share Capital

XXX

Proceeds from Long-term Borrowings

XXX

Repayment of Long-term Borrowings

(XXX)

Interest Paid

(XXX)

Dividends Paid

(XXX)

Net Cash used in Financing Activities

SOME SPECIAL ITEMS Interest, dividend, taxes and non cash transactions are carefully recorded in cash flow statement as it has varying impact on cash flows. Let us understand each of them separately as under.

Interest and Dividends Cash flows from interest, and dividends received and paid should each be disclosed separately. In the case of non-financial enterprises, cash flows arising from interest paid

Cash Flow Statement 283

should be classified as cash flows from financing activities while interest and dividends received should be classified as cash flows from investing activities. Dividends paid should be classified as cash flows from financing activities. Cash flows arising from interest paid, and interest and dividends received in the case of a financial enterprise should be classified as cash flows arising from operating activities. Interest paid, and interest and dividends received are usually classified as operating cash flows for a financial enterprise. However, there is no consensus on the classification of these cash flows for other enterprises. Some argue that interest paid, and interest and dividends received may be classified as operating cash flows because they enter into the determination of net profit or loss. However, it is more appropriate that interest paid, and interest and dividends received are classified as financing cash flows and investing cash flows respectively, because they are cost of obtaining financial resources or returns on investments. Some argue that dividends paid may be classified as a component of cash flows from operating activities in order to assist users to determine the ability of an enterprise to pay dividends out of operating cash flows. However, it is considered more appropriate that dividends paid should be classified as cash flows from financing activities because they are cost of obtaining financial resources.

Taxes on Income Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. If any individual transaction which is classified as investing or financing activity leads to an identifiable cash flow of taxes, it needs to be classified as investing or financing flow, respectively.While calculating cash flows from operating activities, we need to start from profit after tax, add back the provision for tax, and deduct the actual taxes paid as the last item. For example, dividend tax can be specifically identified with dividend paid, hence it is categorised as cash flow from financing activity.

Non-cash Transactions Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a cash flow statement. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities. A business may enter into investing and financing activities that do not directly involve cash. For example, it may issue shares to retire long-term debt. Such a

284 Financial Accounting

transaction does not have a direct effect on cash. However, the transaction does eliminate the need for future cash payments to pay interest and retire the bonds. Thus, because of their future effect on cash flows, such transactions should be reported to readers of the financial statements. Other examples of non-cash investing and financing transactions include acquiring fixed assets by issuing bonds or shares and issuing equity shares in exchange for convertible preference shares, taking over another concern by share swap.

FREE CASH FLOW Objective 3 Free cash flow is the cash that a company is left To understand free cash flows with after it pays out interest and dividends to its investors and pays for the capital expenditures it needs to maintain its productive capacity. This cash can be used for expansion, reducing debt, or other purposes. Free cash flow depends primarily on the company’s capacity to generate cash from operations, which in turn is heavily influenced by the company’s net income. Free cash flows can be computed by using the following formula: Free Cash Flow = Cash Flow from operating activities – Capital Expenses to keep current level of operation – Interest – Dividends The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock or reduce its debt. High or rising free cash flow is often a sign of a healthy company that is thriving in its current environment. Furthermore, since free cash flow has a direct impact on the worth of a company, investors often hunt for companies that have high or improving free cash flow but undervalued share prices—the disparity often indicates that share price will soon increase. Free cash flow measures a company’s ability to generate cash, which is a fundamental basis for stock pricing. This is why some people value free cash flow more than just about any other financial measure out there, including earnings per share. There are alternate views on calculation of free cash flows. Some of the experts calculate free cash flows by the following formula: Free Cash Flows to the Firm (FCFF) = Cash Flow from Operating Activities Capital Expenses to keep Current Level of Operation Free Cash Flows to the Equity (FCFE) = Cash Flow from Operating Activities Capital Expenses to keep Current Level of Operation + Net Borrowing Net Debt Repayment

Cash Flow Statement 285

ILLUSTRATION 9.3 Ambika Sugers Ltd had cash flow from operating activities of Rs 14,00,000. They invested Rs 4,50,000 in fixed assets to maintain productive capacity and another Rs 3,00,000 to expand capacity. Dividends were Rs 1,00,000. Calculate free cash flow during the same period. Solution Computation of Free Cash Flow

Rs

Cash Flow from Operating Activities Less: Cash invested in Fixed Assets to maintain Productive Capacity

4,50,000

Dividend Paid

1,00,000

Free Cash Flow

Rs 1,400,000 5,50,000 8,50,000

FUND FLOW STATEMENT The fund-flow statement is “a statement which summarises the sources from which funds were obtained and the specific uses to which the funds were put”. Profit and Loss account shows book profits for specific period of time and balance sheet shows the financial position of the concern at a particular point of time. Both these statements do not show the flow of funds of concern during a particular period. Hence, a separate fund flow statement is very useful. It is a statement which shows the sources of funds, i.e. it shows how the activities of a business are financed in a particular period. Further, it shows how the financial resources have been used during a same period. Preparation of fund flow statement requires analysis of financial statement. Analysis of balance sheet is done to ascertain the changes in working capital and other sources of finance and where these funds are employed. Profit and Loss A/c is analysed to ascertain the funds from operating activities.

FIGURE 9.2

Sources and Application of Fund

286 Financial Accounting EXHIBIT 9.7

Format of Fund Flow Statement

Sources

Rs.

Application

Rs

Funds from operation

XX

Loss from Operations

XX

Decrease in Working Capital

XX

Increase in Working Capital

XX

Sale of Fixed Assets

XX

Purchase of Fixed Assets

XX

Sale of Investment

XX

Purchase of Investment

XX

Issue of Shares/Debentures

XX

Redemption of Shares/Debentures

XX

Non operating Income

XX

Non operating Expenses

XX

Loan Taken

XX

Dividend Paid

XX

Loan Repayment

XX

Total

XX

Total

XX

ILLUSTRATION 9.4 Balance Sheet of Suzlon Energy March 2008 12 months

March 2009 12 months

Sources of Funds Total Share Capital

299

300

Equity Share Capital

299

395

Reserves

6,648

6,686

Net Worth

6,948

6,581

672

3,506

Unsecured Loans

2,412

3,323

Total Debt

3,085

6,829

10,031

13,910

Gross Block

778

916

Less: Accumulated Depreciation

267

364

Net Block

511

552

Capital Work in Progress

135

287

Investments

4,919

7,128

Inventories

1,483

1,384

Secured Loans

Total Liabilities Application of Funds

(Contd.)

Cash Flow Statement 287 Sundry Debtors Cash and Bank Balance Total Current Assets Loans and Advances Fixed Deposits Total CA, Loans and Advances Current Liabilities Provisions Total CL and Provisions Net Current Assets Total Assets

3,307 204 4,994

4,745 71 6,200

1,383 672 7,048 1,947 636 2,582 4,466 10,031

3,273 141 9,615 3,302 369 3,671 5,944 13,910

Solution Fund Flow Statement for the Year ended 31 March 2009 Sources Funds from Operation Issue of Shares/Debentures Secured Loan Taken Unsecured Loan Taken Total

Rs 135 96 2,834 911 3,976

Application Increase in Working Capital Purchase of Fixed Assets Expenditure on Capital Work in Progress Purchase of Investment Total

Rs 1,477 138 152 2,209 3,976

Workings: Calculation of Funds from Operations Retained Earnings [6,686—6,648] Add: Depreciation [364—267]

38 97 135

Computation of Increase/Decrease in Working Capital Particular

March 2008

March 2009

Inventories

1,483

1,384

–99

Sundry Debtors

3,307

4,745

1,438

204

71

–133

1,383

3,273

1,890

672

141

–531

1,947

3,302

–1,355

636

369

267

Cash and Bank Balance Loans and Advances Fixed Deposits Current Liabilities Provisions Increase in Working Capital

Increase/Decrease

1,477

288 Financial Accounting

ANALYSIS OF CASH FLOW STATEMENT Objective 4 In addition to the classification of cash flow To analyse cash flow statements in three different activities, i.e. operating, investing and financing, cash flow statement can also be analysed through following techniques:

Cash Realisation Ratios Cash realisation ratio is calculated by taking cash generated from operations as a proportion of net income. The ratio shows the relationship between cash generation and earnings. The ratio is considered to signal quality of earnings and is sometimes called the quality of the earnings ratio. It should be used with caution since cash management tactics, such as a slowdown in paying account payables, can increase the numerator and the ratio. Cash Realisation Ratio = Cash Generated by Operation/Profit After Tax

Coverage Ratio Coverage ratios are those ratios which are used to test the adequacy of cash flows generated through earnings for purposes of meeting debt and lease obligations, including the interest coverage ratio and the fixed-charge coverage ratio. A company’s ability to pay interest due to its creditors is often measured using interest cover. However, interest cover is calculated using accounting profits, which may not accurately reflect the actual amount of cash inflows a company, makes its interest payments out of. Cash interest cover uses operating cash flow rather than EBIT and net interest paid [interest paid – (minus) interest received] as shown by the cash flow statement instead of interest payable. It is: Cash Interest Cover = Operating Cash Flow ÷ Interest Paid

Fixed-Charge Coverage Ratio Fixed charge coverage ratio is a measure of a company’s ability to pay its fixed expenses, such as rent and interest, on debt without resorting to more debt. A ratio over one (1) indicates that the company is able to pay its fixed charges, while a ratio below one indicates the opposite. Fixed-charge Coverage Ratio = (EBIT + Fixed Charges Before Tax + Depreciation)/ (Fixed Charged Before Tax +Interest)

Cash Flow Statement 289

Sources and Usage Percentage In this technique, all inflows and outflows are listed separately and then the sum of all the outflows and inflows is obtained. Considering total inflows and outflows to be 100, percentage is obtained for each inflows and outflows as shown below: EXHIBIT 9.8

Calculation of Sources and Usage Percentage

Sources

Rs (1000s)

Funds from Operation

%

Application

Rs (1000s)

%

150

60

Increase in Working Capital

130

52

Sale of Fixed Assets

50

20

Purchase of Fixed Assets

100

40

Sale of Investment

10

4

Purchase of Investment

10

4

Issue of Shares/Debentures

30

12

Redemption of Shares/Debentures

10

4

250

100

Loan Taken Total

10

4

250

100

Total

The above exhibit shows that 60% of the inflow is from funds from operations, 20% from sale of assets, 12% from issue of shares/debentures and 4% each from sale of investment and borrowings. Similarly in the case of outflow 52% is due to increase in working capital, 40% is due to purchase of fixed assets and 4% each due to purchase of investment and redemption of shares/debentures.

PREPARATION OF CASH FLOW STATEMENT Objective 5 Unlike the balance sheet and income statement, To prepare a statement of cash which are prepared directly from the firm’s flow from a comparative balance accounts, the cash flow statement is derived sheet and income statement analytically from those accounts. This statement explains the changes in the cash and cash equivalents accounts between the beginning and ending the balance sheets of the period. Since it is impractical to analyse every transaction recorded in those accounts, we analyse the changes in all other assets accounts, as well as liabilities and owners’ equity, to determine their effect during the period. Therefore, a logical way to prepare cash flow statement is to identify and analyse the causes of the differences between account amounts in the beginning and ending the balance sheets. The process is explained in the following steps through Illustration 9.5.

290 Financial Accounting

ILLUSTRATION 9.5 From the following information, prepare cash flow statement: Balance Sheet (Rs in crores) March 2009

March 2010

Sources of Funds Owner’s Fund Equity Share Capital

728

731

Reserves and Surplus

13,368

21,097

Borrowed Funds Secured Loans

3,759

3,521

Unsecured Loans

5,886

14,501

23,741

39,850

16,029

16,480

Less: Accumulated Depreciation

7,486

8,223

Net block

8,543

8,256

Capital work-in-progress

2,497

4,367

Investments

6,106

4,103

Debtors

8,380

17,970

Inventory

1,715

9,020

Cash and Bank Balance

4,780

5,890

7,756

7,167

Total Application of Funds Fixed Assets Gross Block

Working Capital Current assets, loans & advances

Less : Current Liabilities and Provisions Creditors Outstanding Expenses Total Net Current Assets Total

524

2,589

6,595

23,124

23,741

39,850

Other Information (Rs in crores) March 2009

March 2010

Interest Paid

251

929

Rent Paid

600

900

1,169

2,087

Salary Paid

Cash Flow Statement 291

Solution The above illustration can be solved by explaining the procedure to prepare cash flow statement. Step 1: Calculate Changes in Beginning and Ending Balances In this step it is required to calculate difference between Ending (March 2010) and Beginning (March 2009) balance which is explained below: Balance Sheet (Rs in crore) March 2009

March 2010

Changes

Sources of Funds Owner’s Fund Equity Share Capital

728

731

3

Reserves and Surplus

13,368

21,097

7,729

Borrowed Funds Secured Loans

3,759

3,522

–237

Unsecured Loans

5,886

14,501

8,615

23,741

39,851

16,029

16,480

451

Less: Accumulated Depreciation

7,486

8,223

737

Net Block

8,543

8,257

–286

Capital Work-in-Progress

2,497

4,367

1,870

Investments

6,106

4,103

–2,003

Debtors

8,380

17,970

9,590

Inventory

1,715

9,020

7,305

Cash and Bank Balance

4,780

5,890

1,110

Total Application of Funds Fixed Assets Gross Block

Working Capital Current Assets, Loans and Advances

Less: Current Liabilities and Provisions Creditors Outstanding Expenses Total Net Current Assets Total

7,756

7,167

–589

524

2,589

2,065

6,595

23,124

16,529

23,741

39,851

292 Financial Accounting Other Information (Rs in crore) March 2009

March 2010

Interest Paid

251

929

678

Rent Paid

600

900

300

1,169

2,087

918

Salary Paid

Step 2: Identify the Concerned Cash Flow Activities After calculating the changes, identification of the nature of cash flow activities and whether it is an inflow or outflow as explained as under is important: We may use: F = Financing Activity O = Operating Activity I = Investing Activity XXX= No Activity only Information Balance Sheet (Rs in crore) March 2009

March 2010

Changes

Sources of Funds Owner’s Fund Equity Share Capital

728

731

3

F

Inflow

Reserves and Surplus

13,368

21,097

7,729

O

Secured Loans

3,759

3,522

–237

F

Outflow

Unsecured Loans

5,886

14,501

8,615

F

Inflow

23,741

39,851

16,029

16,480

451

I

Outflow

Less: Accumulated Depreciation

7,486

8,223

737

O

Net Block

8,543

8,257

–286

XXX

Capital Work-in-Progress

2,497

4,367

1,870

I

Outflow

Investments

6,106

4,103

–2,003

I

Inflow

Borrowed Funds

Total Application of Funds Fixed Assets Gross Block

(Contd.)

Cash Flow Statement 293 (Contd.) Working Capital Current Assets, Loans and Advances Debtors

8,380

17,970

9,590

O

Inventory

1,715

9,020

7,305

O

Cash and Bank Balance

4,780

5,890

1,110

Less: Current Liabilities and Provisions Creditors Outstanding Expenses Total Net Current Assets Total

XXX 7,756

7,167

–589

O

524

2,589

2,065

O

6,595

23,124

16,529

XXX

23,741

39,850

Other Information (Rs in crore) March 2009

March 2010

Interest Paid

251

929

F-O

Rent Paid

600

900

XXX

1,169

2,087

XXX

Salary Paid

Outflow

Step 3: Cash Flow Statement Preparation Cash Flow Statement for Year ended 31 March 2010 Cash Flows from Operating Activities Increase in Reserve

Rs

Rs

7,729

Add Depreciation

737

Add Interest Paid

929

Funds from Operations

9,395

Adj. for Working Capital Items Less: Increase in Debtors

(9,590)

Less: Increase in Inventory

(7,305)

Less: Decrease in Creditors

(589)

Add: Increase in Outstanding Expenses

2,065 (15,419)

Net Cash Flows from Operating Activities

(6,024)

Cash Flows from Investing Activities Fixed Assets Purchased

(451) (Contd.)

294 Financial Accounting Capital Work in Progress

(1,870)

(FA under Construction) Investments

2,003 (318)

Cash Flows from Financing Activities Equity Share Capital Issued

3

Secured Loans Repaid

(237)

Unsecured Loans Taken

8,615

Interest Paid

(929) 7,452

Net Increase in Cash

1,110

Cash and Cash Equivalents at the Beginning

4,780

Cash and Cash Equivalents at the End

5890

ILLUSTRATION 9.6 From the following information prepare cash flow statement of Madan Perfumes Ltd for the year ended 31 March 2010. Balance Sheet of Madan Perfumes Ltd Liabilities

2008–09

2009–10 Assets

2008–09

2009–10

Equity Share Capital

2,00,000

2,00,000 Fixed Assets

6,00,000

5,00,000

15% Preference Shares

1,00,000

1,00,000 Cash in Hand

15,000

5,000

Profit and Loss A/c

2,39,800

1,70,000 Bank Balance

5,800

9,050

General Reserve

25,000

50,000 Closing Stock

70,000

80,750

Bank Loan

50,000

20,000 Bills Receivables

58,000

43,000

Creditors

39,000

22,800 Short-Term Investments

30,000

15,000

25,000

10,000

8,03,800

6,62,800

Proposed Dividend

1,50,000

1,00,000 Goodwill

8,03,800

6,62,800

Additional information: ■

■

On first day of the accounting year fixed assets sold at Rs 1,50,000 having WDV 2,00,000. Depreciation charged during the year is Rs 75,000. Preference dividend is paid on 31.3.2010.

Cash Flow Statement 295

Solution Cash Flow Statement of Madan Perfumes Ltd for the Year ending 31 March 2010 Particulars

Rs

Rs

Cash Flow from Operating Activities Difference in Profit and Loss Account

(69,800)

Proposed Equity Dividend

1,00,000

Preference Dividend

15,000

Transfer to General Reserve

25,000

Net Profit as per Profit and Loss A/c

70,200

Depreciation

75,000

Loss on Sale of Fixed Assets

50,000

Goodwill Written off

15,000 2,10,200

Changes in Working Capital Decrease in Bills Receivables Increase in Closing Stock Decrease in Creditors

15,000 (10,750) (16,200) (11,950)

Net Cash Flow from Operating Activities

1,98,250

Cash Flow from Investment Activities Purchases of Fixed Assets Sale of Fixed Assets

(1,75,000) 1,50,000

Net Cash Flow from Investment Activities

(25,000)

Cash Flow from Financial Activities Repayment of Bank Loan Equity Dividend of 2008-09 Preference Dividend of 2009-10 Net Cash Flow from Financial Activities Net Decrease in Cash

(30,000) (1,50,000) (15,000) (1,95,000) (21,750)

Cash Balance at the Beginning of Month

50,800

Cash Balance at the End of Month

29,050

296 Financial Accounting Cash and Cash Equivalents

Opening Balance

Cash

15,000

Bank Short-Term Investments

Closing Balance 5,000

5,800

9,050

30,000

15,000

50,800

29,050

Workings Fixed Asset A/c Particulars

Rs

Balance B/d

6,00,000

Particulars Bank A/c (Sale Value)

Purchase of Fixed Assets*

1,75,000

Loss on Sale of Fixed Assets

50,000

Depreciation

75,000

Balance C/d 7,75,000

Rs 1,50,000

5,00,000 7,75,000

SUMMARY ➤

The purpose of a statement of cash flows is to provide information about the cash receipts and cash payments of the entity and how they relate to the entity’s operating, investing and financing activities. Readers of financial statements use this information to assess the solvency of a business and to evaluate its ability to generate positive cash flows in future periods, pay dividends and finance growth.

➤

Cash flows are classified as operating, investing and financing activities. Receipts and payments of interest are classified as operating activities.

➤

The major operating cash flows are cash received from customers, cash paid to suppliers and employees, interest and dividends received, interest paid and income taxes paid. These cash flows are computed by converting the income statement amounts for revenue, cost of goods sold and expenses from the accrual basis to the cash basis. This is done by adjusting the income statement amounts for changes occurring over the period in related balance sheet accounts.

➤

The direct and indirect methods are alternative formats for reporting net cash flows from operating activities. The direct method shows the specific cash inflows and outflows comprising the operating activities of the business. Under the indirect method, the computation begins with accrual-based net income and then shows adjustments necessary to arrive at net cash flows from operating activities. Both methods result in the same amount of net cash flows from operating activities.

Cash Flow Statement 297 ➤

Cash flows from investing and financing activities are determined by examining the entries in the related asset and liability accounts, along with any related gains or losses shown in the income statement. Debit entries in asset accounts represent purchases of assets (an investing activity). Credit entries in asset accounts represent the cost of assets sold. The amount of these credit entries must be adjusted by any gains or losses recognised on these sales transactions.

➤

Debit entries to liability accounts represent repayment of debt, while credit entries represent borrowing. Both types of transactions are classified as financing activities. Other financing activities include the issue of shares (indicated by credits to the paid-in capital accounts) and payment of dividends (indicated by a debit change in the retained earnings account).

MULTIPLE CHOICE QUESTIONS* 1. In the statement of cash flows an “increase (decrease) in cash and cash equivalents” appears as ______. (a) Cash flow from investing activities (b) Cash flow from financing activities (c) Cash flow from operating activities (d) None of the above 2. Uses of funds include a(an) ______. (a) Decrease in cash (b) Increase in any liability (c) Tax refund (d) Increase in fixed assets 3. Which of the following is NOT a cash outflow for the firm? (a) Depreciation (b) Dividends (c) Interest payments (d) Taxes 4. For a profitable firm, total sources of funds will always ______ total uses of funds. (a) Be equal to (b) Be greater than (c) Be less than

*

Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

298 Financial Accounting

5.

6.

7.

8.

9.

10.

11.

12.

(d) Have no consistent relationship to The following are balance sheet changes: (a) Rs 5,005 decrease in accounts receivable (b) Rs 7,000 decrease in cash (c) Rs 12,012 decrease in outstanding expenses (d) Rs 10,001 increase in accounts payable The outflow would be due to (a) Rs 7,000 decrease in cash (b) Rs 5,005 decrease in accounts receivable (c) Rs 10,001 increase in accounts payable (d) Rs 12,012 decrease in outstanding expenses An example of a cash flow from an operating activity is (a) Receipt of cash from the sale of shares (b) Receipt of cash from the sale of bonds (c) Payment of cash for dividends (d) Receipt of cash from customers on account An example of a cash flow from an investing activity is ______. (a) Receipt of cash from the sale of equipment (b) Receipt of cash from the sale of stock (c) Payment of cash for dividends (d) Payment of cash to acquire treasury stock An example of a cash flow from a financing activity is ______. (a) Receipt of cash from customers on account (b) Receipt of cash from the sale of equipment (c) Payment of cash for dividends (d) Payment of cash to acquire land The acquisition and disposal of long-term assets and investments is (a) Investing activity (b) Operating activity (c) Financing activity Acquiring and selling of a subsidiary is (a) Investing activity (b) Operating activity (c) Financing activity The activity resulting in changes in the size and composition of the owner’s capital and borrowing of the enterprise is (a) An investing activity

Cash Flow Statement 299

(b) An operating activity (c) A financing activity 13. Redemption of debentures by converting them into equity shares of Rs 40,000 will result into (a) Cash inflow (b) Cash outflow (c) None of the above 14. If the net profits earned during the year is Rs 50,000 and the amount of debtors in the beginning and the end of the year is Rs 10,000 and Rs 20,000 respectively, then the cash from operating activities will be equal to (a) Rs 50,000 (b) Rs 40,000 (c) Rs 60,000 (d) Rs 80,000 15. If the net profits made during the year are Rs 50,000 and the bills receivables have decreased by Rs 10,000 during the year then the cash flow from operating activities will be equal to (a) Rs 50,000 (b) Rs 40,000 (c) Rs 60,000 (d) Rs 80,000

THEORY QUESTIONS 1. 2. 3. 4. 5. 6. 7.

What is cash flow statement? Explain its importance. Define cash and cash equivalents. Give some examples. Explain cash from operating activities with suitable examples. Distinguish between cash from investing and financing activities. Explain the concept of free cash flow statement. Distinguish between cash flow statement and fund flow statement. What are non-cash items?

300 Financial Accounting

PRACTICAL PROBLEMS Level 1: Easy 1. Calculate cash from operations from the following figures: Particulars

2009 Rs

2010 Rs

Profit and Loss A/C (Balance)

60,000

Debtors

87,000

50,000

Bills Receivables

62,000

1,03,000

General Reserves

2,02,000

2,37,000

30,000

12,000

Salary Outstanding Wages Prepaid

65,000

5,000

7,000

Machinery

80,000

75,000

Goodwill

80,000

70,000

1. Machinery has been depreciated and Goodwill has been written off during the year. 2. Dividend received on shares held as investments Rs 25,500. 2. Calculate cash from investing activities from the following figures: Assets

Purchased Rs

Sold

Sold

Sold

Cost

WDV

Sale Proceeds

96,800

87,500

Equipments

7,70,000

1,50,000

Investments

3,15,000

1,15,250

Goodwill

3,50,000

Patents

1,75,000

Other information: 1. Interest received on debentures held as investment Rs 10,500 2. Dividend received on shares held as investments Rs 17,500 3. Interest paid Rs 12,500 4. Dividend paid on shares Rs 14,500

1,75,000

Cash Flow Statement 301

3. From the following information, calculate cash from financing activities: Balance Sheet (Extract) Liabilities

2011 Rs

Equity Share Capital

12,00,000

2012 Rs

Assets

16,00,000 Discount on Issue of Debentures

11% Preference Share Capital

8,00,000

4,00,000 Underwriting Commission on Issue of Shares

Securities Premium

2,00,000

2,60,000

12 % Debentures

4,00,000

6,00,000

2011 Rs

2012 Rs

10,000

12,000 20,000

Other information: 1. Interest received on debentures held as investment Rs 50,500 2. Dividend received on shares held as investments Rs 34,500 3. Debentures are issued on 31.12.2012 4. Dividend paid on shares Rs 1,84,500 4. Chirag Ltd made a profit of Rs 2,00,000 after charging depreciation of Rs 40,000 on assets and a transfer to general reserve of Rs 60,000. The goodwill written-off was Rs 14,000 and gain on sale of machinery was Rs 6,000. Other information available to you (charges in the value of current assets and current liabilities) are debtors showed an increase of Rs 12,000; creditors an increase of Rs 20,000; prepaid expenses an increase of Rs 400; bills receivables a decrease of Rs 6,000; bills payables a decrease of Rs 8,000 and outstanding expenses a decrease of Rs 4,000. Ascertain cash flow from operating activities. 5. Valmiki Ltd has given you the following information: (Rs) Machinery as on 1 April, 2012 25,000 Machinery as on 31 March, 2013 30,000 Accumulated Depreciation on 1 April, 2012 7,500 Accumulated Depreciation on 31st March, 2013 12,500 During the year, a Machine costing Rs 12,500 with Accumulated Depreciation of Rs 7,500 was sold for Rs 6,500 Calculate cash flow from Investing Activities on the basis of the above information. 6. From the following information calculate cash flow from investing activity. Particulars

Purchase (Rs)

Sales (Rs)

Plant

8,80,000

1,00,000

Investments

3,60,000

2,00,000

Goodwill

4,00,000

—

—

2,00,000

Patents

302 Financial Accounting

Interest received on shares and debentures held as investment is Rs 20,000 and Rs 1,20,000 respectively. A plot of land has been purchased for investment purpose has been let out for commercial use and rent received Rs 60,000.

Level 2: Standard 7. ABC and Associates is the partnership firm. Following is the last two years financial statements of the firm: Particulars

Year 2011

Year 2012

25,000 25,000 10,000 50,000 10,000 1,20,000

25,000 25,000 25,000 40,000 33,000 1,48,000

50,000 20,000 38,000 10,000 2,000 1,20,000

40,000 25,000 10,000 70,000 3,000 1,48,000

Liabilities Capital Accounts A B C Loan from State Bank of India Bills Payable Assets Fixed Assets Land Debtors Inventory Bank

Profit and Loss A/c for the Year ended 31 March 2012 Particulars Sale Opening Stock Purchases Closing Stock Wages Direct Expenses Gross Profit Depreciation Office Expenses Bad Debts Interest Paid Net Profit

Rs

Rs 2,55,000

10,000 2,00,000 (70,000) 20,000 10,000

1,70,000 85,000

10,000 20,000 50,000 5,000 85,000 —

Cash Flow Statement 303

8. Prepare cash flow statement for Narayan Ltd. Balance Sheet Liabilities

2010–11

2011–12

Assets

2010–11

2011–12

Equity Share Capital

3,00,000

4,00,000

Machinery

4,00,000

3,75,000

Debenture

1,00,000

40,000

Land

2,00,000

2,50,000

Profit and Loss A/c

2,00,000

2,25,000

Cash

5,000

8,000

Bank Loan

90,000

65,000

Debtors

85,000

87,000

Creditors

10,000

15,000

Closing Stock

10,000

25,000

7,00,000

7,45,000

7,00,000

7,45,000

Profit and Loss A/c Particulars

2011–12

Particulars

2011–12

Cost of Goods Sold

75,000

Sales

Depreciation

25,000

Interest Received

50,000

General Expenses

15,000

Dividend Income

35,000

Debenture Interest

2,00,000

7,000

Income Tax

38,000

Interim Equity Dividend

1,00,000

Net Profit

25,000 2,85,000

2,85,000

9. From the following information, prepare cash flow statement for Diamond Ltd. Liabilities

2011–12

2012–13

Assets

2011–12

2012–13

10,00,000

14,00,000

Patents

2,00,000

1,90,000

Profit and Loss A/c

4,00,000

7,00,000

Equipments

4,00,000

4,60,000

Bank Loan

2,00,000

1,00,000

Furniture

6,00,000

5,40,000

Proposed Dividend

1,00,000

1,40,000

Investments

60,000

1,00,000

Debtors

1,60,000

2,40,000

1,00,000

90,000

Stock

1,00,000

2,60,000

10,000

14,000

Cash

10,000

54,000

Bank

4,00,000

6,00,000

18,70,000

25,44,000

Equity Share Capital

Provision for Tax Creditors Outstanding Rent

18,70,000

25,44,000

2,00,000

During the year, equipment costing Rs 1,60,000 was purchased. Loss on sale of equipment amounted to Rs 10,000. Depreciation of Rs 30,000 and Rs 6,000 was provided for equipments and furnitures respectively.

304 Financial Accounting

Level 3: Expert 10. Rukmini, the CEO of Kausalya Ltd was finding cash management to be a tough job as the company was having a cash crunch in spite of net profit of Rs 20 crores. So she decided to request an accountant to prepare detailed cash flow statement. The following information is available: (Rs in lakh) Particulars

2010–11

2011–12

300

200

Outstanding Salaries

50

30

Closing Stock

50

180

Sundry Creditors

Prepaid Expenses Debtors

30

20

200

350

During the year following transactions took place: 1. Bank account was overdrawn by Rs 50 lakhs at the beginning of year 2. The bank loan of Rs 600 lakhs was repaid 3. The annual depreciation on machinery is Rs 10 lakhs 4. Sale of investments of Rs 250 lakhs costing Rs 150 lakhs 5. The purchases of fixed assets of Rs 1,500 lakhs 6. Payment of cash dividends of Rs 150 lakhs 7. Interest paid to debenture holders Rs 500 lakhs 11. From the following information, prepare a cash flow statement. (Rs’000) Assets Cash in Hand and Balances with Bank

2012

2011

400

50

Marketable Securities (having one month maturity)

1,340

270

Sundry Debtors

3,400

2,400

Interest Receivable

200

—

Inventories

1,800

3,900

Investments

5,000

5,000

Fixed Assets at Cost

4,360

3,820

(2,900)

(2,120)

1,460

1,700

13,600

13,320

300

3,780

Accumulated Depreciation Fixed Assets (Net) Total Assets Liabilities Sundry Creditors

(Contd.)

Cash Flow Statement 305 Interest Payable

460

200

Income Tax Payable

800

2,000

Long-term Debt

2,220

2,080

Total Liabilities

3,780

8,060

Share Capital

3,000

2,500

Reserves

6,820

2,760

Total Shareholders’ Fund

9,820

5,260

13,600

13,320

Shareholders’ Fund

Total Liabilities and Shareholders’ Fund

Statement of Profit or Loss for the Year ended 31 March, 2012 (Rs’000) Sales Cost of Sales Gross Profit Depreciation Administrative and Selling Expenses Interest Expense Interest Income Dividend Income Net Profit before Taxation and Extraordinary Items Extraordinary Items: Insurance Proceeds from Earthquake Disaster Settlement Net Profit after Extraordinary Items Income Tax Net Profit

61,300 (52,000) 9,300 (900) (1,820) (800) 600 400 6,780 280 7,060 (600) 6,460

Additional Information: (Rs’000) (a) An amount of Rs 500 was raised from the issue of share capital and a further Rs 500 was raised from long-term borrowings. (b) Interest expense was Rs 800 of which Rs 340 was paid during the period. Rupees 200 relating to interest expense of the prior period was also paid during the period. (c) Dividends paid were Rs 2,400. (d) Tax deducted at source on dividends received (included in the tax expense of Rs 600 for the year) amounted to Rs 80. (e) During the period, the enterprise acquired fixed assets for Rs 700. The payment was made in cash. (f) Plant with original cost of Rs 160 and accumulated depreciation of Rs 120 was sold for Rs 40. (g) Sundry debtors and sundry creditors include amounts relating to credit sales and credit purchases only.

306 Financial Accounting

RESEARCH ASSIGNMENTS Research Assignments—Oil Industry (Public Sector Companies) Read the following article appeared in livemint.com The Wall Street Journal on 20 August 2011 related to oil subsidies.

ONGC Profits to be Hit Due to Higher Oil Subsidies New Delhi: In what may impact investor interest in the Oil and Natural Gas Corp. Ltd (ONGC) follow-on public offer (FPO) due in July, the government has directed it and other upstream companies to pay Rs 30,295.75 crores as compensation to state-owned oil marketing companies (OMCs) to partially offset losses on account of retailing subsidised fuel. The other upstream companies are Oil India Ltd (OIL) and GAIL (India) Ltd. ONGC will share an additional burden of Rs 3,832 crores due to which its net profit for the last fiscal will take a hit of Rs 2,000 crores, chairman and managing director A.K. Hazarika said on Friday. The upstream companies will, for the first time, give more than their usual one-third share of the subsidy burden. For 2010-11, their share is estimated at 38.7%. The news sparked a drop in upstream oil companies’ stocks. ONGC posted a profit of Rs 16,100 crores for the first nine months of the last fiscal, compared with Rs 16,768 crores in the year before. The government plans to raise around Rs 13,000 crores by selling a 5% stake in the hydrocarbon exploration firm in which it holds 74.14%. “This is an aberration. The investors will have to take a long-term call”, finance director D.K. Saraf said. For the Rs 78,190 crores of underrecoveries—the difference between the market price and fuel retail rates—borne by OMCs such as Indian Oil Corp. Ltd (IOC), Bharat Petroleum Corp. Ltd (BPCL) and Hindustan Petroleum Corp. Ltd (HPCL) for 2010-11, the government has provided a cash subsidy of Rs 41,000 crores, with upstream companies asked to provide Rs 30,295.75 crores. Of this, ONGC will provide Rs 24,892.43 crores compared with Rs 11,554 crores in the last fiscal. OIL will provide Rs 3,293 crores, with the rest coming from GAIL. ONGC, which has already paid Rs 12,757 crores to the OMCs, will have to make a remaining payment of Rs 12,135.43 crores. IOC, BPCL and HPCL will have to absorb Rs 6,714 crores as losses for the last fiscal, which will affect their profitability. The increased burden sharing on the part of the companies will also affect the financial results of GAIL, ONGC, OIL, IOC, HPCL and BPCL, to be announced shortly. While ONGC got $55.94 (Rs 2,510 today) for every barrel of crude oil sold in 2009-10, the net realisation for the last fiscal was expected to be around $59 per barrel. This is now expected to come down to $52-53 per barrel, a loss of $6-7 per barrel. “While the profit will be more than last year, it could have been (even) more... It is for the first time that our (upstream) burden has risen beyond one-third of underrecoveries”, Hazarika said. ONGC fell 1.17% to Rs 274.05 on the Bombay Stock Exchange on Friday. The benchmark Sensex rose 1.02% to 18,326.09 points. GAIL fell 0.34% to Rs 426.60 and OIL fell 0.86% to Rs 1,313.45.With state-owned firms

Cash Flow Statement 307

expected to lose around Rs 1.8 trillion at current crude oil price levels from selling fuel below cost in the year to 31st March, they are looking at a fresh increase in the price of petrol. Prices were last increased on 14th May. The Congress-led United Progressive Alliance Government decided to free petrol prices from state control in June, but stateowned oil marketeers had maintained the prices since 16th January under a government directive. The government has also temporarily deferred a decision on increasing the prices of diesel and cooking gas till an empowered group of ministers on the pricing of petroleum products, headed by finance minister Pranab Mukherjee, meets. You are required to collect financial statements of ONGC, OIL, GAIL, HPCL and BPCL and study their financial statements so as to analyse impact of subsidies on their cash positions.

INTERPRETING FINANCIAL REPORTS Interpreting Financial Reports—Dabur India Ltd The following are the financial statements of Dabur India Ltd Dabur India Ltd Balance Sheet March 2010

March 2011

Sources of Funds Equity Share Capital

86.76

174.07

Reserves

662.48

927.09

Net Worth

749.38

1,101.16

Secured Loans

24.27

17.57

Unsecured Loans

81.80

235.78

Total Debt

106.07

253.35

Total Liabilities

855.45

1,354.51

Gross Block

687.23

766.88

Less: Accumulated Depreciation

236.28

269.32

Net Block

450.95

497.56

23.31

11.92

Investments

348.51

519.23

Inventories

298.44

460.58 (Contd.)

Application of Funds

Capital Work in Progress

308 Financial Accounting Sundry Debtors Cash and Bank Balance

130.48

202.46

48.8

26.08

Total Current Assets

477.72

689.12

Loans and Advances

348.94

461.81

Fixed Deposits

115.11

166.33

Total CA, Loans and Advances

941.77

1,317.26

Differed Credit

0

0

471.73

539.05

440.1

535.36

911.83

1,074.41

29.94

242.85

2.74

82.95

Total Assets

855.45

1,354.51

Particulars

March 2010

March 2011

2,891.00

3,305.42

(23.58)

(30.99)

2,867.42

3,274.43

27.95

39.16

Current Liabilities Provisions Total CL and Provisions Net Current Assets Miscellaneous Expenses

Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income

9.68

78.31

2,905.05

3,391.9

1,393.97

1,740.68

Expenditure Raw Materials Power and Fuel Cost

35.43

42.39

212.34

230.84

22.74

25.21

Selling and Admin Expenses

557.26

589.09

Miscellaneous Expenses

103.84

100.15

0

0

Total Expenses

2,325.58

2,728.36

Operating Profit

551.52

624.38

PBDIT

579.47

663.54

Interest

13.28

12.93

PBDT

566.19

Employee Cost Other Manufacturing Expenses

Preoperative Expenses Capitalised

650.61 (Contd.)

Cash Flow Statement 309 Depreciation PBT Tax

37.76

54.08

528.43

596.53

93.70

124.85

Reported Net Profit

433.33

471.41

Total Value Addition

931.61

987.68

Preference Dividend

0

0

173.6

200.19

Shares in Issue (Lakhs)

8,675.86

17,407.24

Earning per Share (Rs)

4.99

2.71

Equity Dividend (%)

200

115

Book Value (Rs)

8.64

6

Equity Dividend Per Share Data (Annualised)

Mahesh Bhai who believed that increase in profit is always reflected in higher cash balances, was very disturbed to observe that the cash balance has reduced from 48.8 crores to 28.6 crores though there has been increase in reported net profit. He requested his investment advisor Pranav Bhai to explain the fall in cash balance despite increase in net profit. He was wondering what the company has done with cash coming from profits.

BUSINESS CASES Case 1: Apollo Tyres Ltd Apollo Tyres Ltd is a high-performance company and the leading Indian tyre manufacturer. Headquartered in Gurgaon, a corporate-hub in the National Capital Region of India, Apollo is a young, ambitious and dynamic organisation, which takes pride in its unique identity. Registered as a company in 1976, Apollo is built around the core principles of creating stakeholder value through reliability in its products and dependability in its relationships. Apollo’s present strength and market dynamism steps from its early years of strife in establishing itself as a tyre manufacturer within the closed Indian economy. Over two decades, Apollo worked on a portfolio of products, tuned to customer needs and an array of innovative marketing initiatives to establish itself as a leader in its home market. Some of these include segmenting customers by their load and mileage requirements, running tyre loyalty programmes, establishing customer contact programmes which resulted in better health and driving habits, introducing India’s first farm radials and India’s first range of high-speed tubeless passenger car tyres.

310 Financial Accounting

For the first time, in 2006 Apollo ventured outside India in its quest to test itself outside its home comforts. Apollo acquired Dunlop Tyres International Pvt Ltd in South Africa (since renamed as Apollo Tyres South Africa Pty Ltd) and Zimbabwe, taking on southern Africa as the second domestic market. The company holds brand rights for the Dunlop brand across 30 African countries. In 2009, Apollo acquired Vredestein Banden B V in the Netherlands and thereby adding Europe as its third crucial market. The Company currently produces the entire range of automotive tyres for ultra and high speed passenger cars, truck and bus, farm, off-the-road, industrial and specialty applications like mining, retreaded tyres and retreading material. These are produced across Apollo’s eight manufacturing locations in India, the Netherlands and southern Africa. the ninth facility has been constructed in southern India.The major brands produced across these locations are: Apollo, Dunlop, Kaisen, Maloya, Regal and Vredestein. In the three domestic markets of India, southern Africa and Europe, Apollo operates through a network of branded, exclusive or multi-product outlets. In South Africa the branded outlets are called Dunlop Zones, while in India they are variously named Apollo Tyre World (for commercial vehicles) and Apollo Radial World (for passenger cars). Exports out of these three key manufacturing locations reach over 70 destinations across the world, with key comprising Europe, Africa, the Middle East and South-East Asia. The Company manufactures automobile tyres and tubes, camel back/retreading materials and rubber conveyor belts. The financial growth of Company has been excellent. The management of Company is discussing the possibility of expansion. Some of the directors are suggesting financing through internal accruals whereas some are advising to go for external financing. As a CFO you are assigned with the job of explaining the board of cash movement during the financial year. From the following information, prepare cash flow statement for the year ended 31 March 2010. Balance Sheet of Apollo Tyres Ltd Rs in crore March 2009

March 2010

Sources of Funds Equity Share Capital Reserves Revaluation Reserves

49

50

1,181

1,302

3

3 (Contd.)

Cash Flow Statement 311 Secured Loans

223

462

Unsecured Loans

238

233

1,694

2,050

1,570

1,838

Less: Accumulated Depreciation

599

695

Net Block

971

1,143

94

281

Investments

303

297

Inventories

513

417

Sundry Debtors

155

87

Cash and Bank Balance

156

176

Loans and Advances

539

591

Fixed Deposits

110

165

Total Application of Funds Gross Block

Capital Work in Progress

Total CA, Loans and Advances

1,473

1,436

Current Liabilities

718

627

Provisions

429

480

1,147

1,107

Total CL and Provisions Net Current Assets

326

329

1,694

2,050

3,706

4,091

Employee Cost

227

208

Equity Dividend

25

25

Total Assets Other Information Net Sales

Solution Cash Flow Statement of Apollo Tyres Ltd for the Year ending 31 March 2010 Particulars

Rs

Rs

Cash Flow from Operating Activities Increase in Reserves

121

Dividend

25

Net Profit as per Profit and Loss Account

146

Depreciation

96 242 (Contd.)

312 Financial Accounting Changes in Working Capital Add: Decrease in Debtors

68

Add: Decrease in Closing Stock

96

Add: Increase in Provision

51

Less: Increase in Loans and Advances

(52)

Less: Decrease in Current Liabilities

(91)

Less: Decrease in Provision

(55) 17

Net Cash Flow from Operating Activities

259

Cash Flow from Investment Activities Purchases of Fixed Assets

(268)

Increase in Capital Work in Progress

(187)

Sale of Investments

6

Net Cash Flow from Investment Activities

(449)

Cash Flow from Financial Activities Issue of Equity Share Capital Secured Loan

1 239

Repayment of Unsecured Loan

(5)

Dividend

(25)

Net Cash Flow from Financial Activities

210

Net Increase in Cash

20

Cash Balance at the Beginning of Month

156

Cash Balance at the End of Month

176

Case 2: Tata Motors Ltd Profile of the Company Tata Motors Limited is India’s largest automobile company, with consolidated revenues of Rs 70, 938.85 crores (USD 14 billion) in 2008–09. It is the leader in commercial vehicles in each segment and among the top three in passenger vehicles with winning products in the compact, mid-size car and utility vehicle segments. The Company is the world’s fourth largest truck manufacturer and the world’s second largest bus manufacturer. Established in 1945, Tata Motors’ presence indeed cuts across the length and breadth of India. Over 5.9 million Tata vehicles ply on Indian roads, since the first rolled out in 1954. The Company’s manufacturing base in India is spread across Jamshedpur (Jharkhand), Pune (Maharashtra), Lucknow (Uttar Pradesh), Pantnagar (Uttarakhand) and Dharwad (Karnataka). Following a strategic alliance with Fiat in 2005, it has set up

Cash Flow Statement 313

an industrial joint venture with Fiat Group Automobiles at Ranjangaon (Maharashtra) to produce both Fiat and Tata cars and Fiat powertrains. The Company is establishing a new plant at Sanand (Gujarat). The Company’s dealership, sales, services and spare parts network comprises over 3,500 touch points; Tata Motors also distributes and markets Fiat branded cars in India. Tata Motors, the first company from India’s engineering sector to be listed in the New York Stock Exchange (September 2004), has also emerged as an international automobile company. Through subsidiaries and associate companies, Tata Motors has operations in the UK, South Korea, Thailand and Spain. Among them is Jaguar Land Rover, a business comprising the two iconic British brands that was acquired in 2008. In 2004, it acquired the Daewoo Commercial Vehicles Company, South Korea’s second largest truck maker. The rechristened Tata Daewoo Commercial Vehicles Company has launched several new products in the Korean market, while also exporting these products to several international markets. Today two-thirds of heavy commercial vehicle exports out of South Korea are from Tata Daewoo. In 2005, Tata Motors acquired a 21% stake in Hispano Carrocera, a reputed Spanish bus and coach manufacturer and subsequently the remaining stake in 2009. Hispano’s presence is being expanded in other markets. In 2006, Tata Motors entered into joint venture with Thonburi Automotive Assembly Plant Company of Thailand to manufacture and market the company’s pickup vehicles in Thailand. The new plant of Tata Motors (Thailand) has begun production of the Xenon pickup truck, with the Xenon having been launched in Thailand in 2008. In January 2008, Tata Motors unveiled its People’s Car, the Tata Nano, which India and the world have been looking forward to. The Tata Nano has been subsequently launched, as planned, in India in March 2009. A development, which signifies a first for the global automobile industry, the Nano brings the comfort and safety of a car within the reach of thousands of families. The standard version has been priced at Rs 100,000 (excluding VAT and transportation cost). Designed with a family in mind, it has a roomy passenger compartment with generous leg space and head room. It can comfortably seat four persons. Its monovolume design will set a new benchmark among small cars. Its safety performance exceeds regulatory requirements in India. Its tailpipe emission performance too exceeds regulatory requirements. In terms of overall pollutants, it has a lower pollution level than two-wheelers being manufactured in India today. The lean design strategy has helped minimise weight, which helps maximise performance per unit of energy consumed and delivers high fuel efficiency. The high fuel efficiency also ensures that the car has low carbon dioxide emissions, thereby providing the twin benefits of an affordable transportation solution with a low carbon footprint. In May 2009, Tata Motors introduced ushered in a new era in the Indian automobile industry, in keeping with its pioneering tradition, by unveiling its new range of world

314 Financial Accounting

standard trucks called Prima. In their power, speed, carrying capacity, operating economy and trims, they will introduce new benchmarks in India and match the best in the world in performance at a lower life-cycle cost. Through its subsidiaries, the Company is engaged in engineering and automotive solutions, construction equipment manufacturing, automotive vehicle components manufacturing and supply chain activities, machine tools and factory automation solutions, high-precision tooling and plastic and electronic components for automotive and computer applications and automotive retailing and service operations. Tata Motors is committed to improving the quality of life of communities by working on four thrust areas—employability, education, health and environment. The activities touch the lives of more than a million citizens. The company’s support on education and employability is focused on youth and women. They range from schools to technical education institutes to actual facilitation of income generation. In health, our intervention is in both preventive and curative healthcare. The goal of environment protection is achieved through tree plantation, conserving water and creating new water bodies and, last but not the least, by introducing appropriate technologies in our vehicles and operations for constantly enhancing environment care.

Business Overview The automobile sector in India was severely impacted by the disruption in the Indian and global business environment. The GDP growth slowed down considerably from 9% in the FY 07–08 to 6.7% in the FY 08–09. While the slowdown in the Indian economy was less compared to other world economies, it did have a severe impact on most sectors. Both turnover and profitability of the automotive sector came under tremendous pressure. Double digit inflation and high material cost in the first half of the year leading to higher vehicle prices, higher fuel prices, unavailability of finance, higher cost of financing and uncertainty in the overall economic conditions impacted demand to a great extent. The slowdown in the economy resulted in a drop in industrial production, which reached new lows in the second half of the year. All these factors eroded the bottom-line of the companies in the automotive sector. Both the commercial and passenger domestic vehicles industry came under tremendous pressure as a result of these market conditions. The commercial vehicle industry which had already started showing signs of slowing down last year, declined by 17.4% compared to the 7.6% growth in the FY 07–08. The passenger vehicle industry, which had showed a growth of 11.3% in the previous fiscal, went into negative zone with a decline of 0.5%. Supported by stimulus measures undertaken by the government and the RBI, demand showed some signs of revival towards the end of the year. In such trying times, the Company’s sales of 506,421 vehicles were 13.5% lower than last year volumes. Even though domestic commercial vehicles volumes declined by 15.2%, the Company consolidated its leadership position in the domestic market by introducing new products to complement its existing product portfolio. The passenger vehicles

Cash Flow Statement 315

volumes declined by 4.8% in the domestic market, primarily due to the phasing in of the new Indica Vista in the second half of the year and sluggishness of the UV segment. The Company’s exports declined by 38.6% during the year, due to the meltdown in major international markets and the consequent swings in foreign exchange rates. The Company tried to mitigate the impact on margins by cost reduction measures and tight control on working capital. The focus on new product development remained and the Company introduced various new products in the marketplace.

Financial Position of Company Balance Sheets—Tata Motors Limited Rs in crore March 2005 12 months

March 2006 12 months

March 2007 12 months

March 2008 12 months

March 2009 12 months

Sources of Funds Equity Share Capital Reserves Secured Loans

344

395

401

405

537

3,750

5,128

6,458

7,428

11,855

490

823

2,022

2,462

5,252

Unsecured Loans

2,005

2,114

1,988

3,819

7,914

Total Liabilities

6,589

8,460

10,869

14,114

25,558

Gross Block

6,612

7,972

8,776

10,831

13,905

Less: Dep.

3,454

4,402

4,895

5,444

6,260

Net Block

3,158

3,570

3,881

5,387

7,645

539

951

2,513

5,065

6,954

Investments

2,912

2,015

2,477

4,910

12,968

Inventories

Application of Funds

Capital Work in Progress

1,601

2,012

2,501

2,422

2,230

Sundry Debtors

811

716

782

1,131

1,555

Cash and Bank Balance

345

328

536

750

638

Loans and Advances

2,831

5,965

6,209

4,831

5,910

Fixed Deposits

1,660

792

291

1,647

504

Total CA, Loans and Advances

7,249

9,812

10,318

10,781

10,837

Current Liabilities

6,143

6,674

6,957

10,040

10,969

Provisions

1,126

1,215

1,364

1,989

1,877

Total CL and Provisions

7,269

7,889

8,321

12,030

12,846

–20

1,923

1,997

–1,249

–2,010

6,589

8,460

10,869

14,114

25,558

Net Current Assets Total Assets

316 Financial Accounting

Operating Results and Profits The year 2008–09 was a difficult year faced by the automotive sector globally. The spread of the economic downturn of the Western world significantly affected business environment in India as well. The Company faced significant pressure in its domestic and overseas markets. Despite the challenges, the Company successfully completed the acquisition of Jaguar and Land Rover and launched the Tata Nano, overcoming serious impediments of a last minute plant dislocation amidst much political turmoil. In view of the fall in demand in the domestic and international markets, the Company’s turnover for the year declined by 13.6% to Rs 28,538.20 crores. The Company, however, continues to be the largest automobile company in India in revenue. Lower volumes and high input prices for major part of the year caused EBITDA margin to fall to 6.8% in the FY 09 compared with 10.2% in the last Fiscal. Currency volatility and high interest cost resulted in a PBT of Rs 1,014 crores, a decline of 60.7% over the last fiscal. The Profit after Tax was Rs 1,001 crores, a decline of 50.7% over the last year. Profit and Loss Account of Tata Motors (Extract) Rs in crore March 2005 March 2006 March 2007 March 2008 March 2009 Income Sales Turnover Excise Duty Net Sales Expenditures Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Admin Expenses Interest Tax Total Value Addition Equity Dividend Corporate Dividend Tax

20,263 3,063 17,199

23,491 3,402 20,089

31,090 4,426 26,664

33,124 4,356 28,768

28,538 2,877 25,661

12,245 238 1,039 593 890 234 416 3,098 452 63

14,633 259 1,143 671 1,061 350 525 3,566 498 70

19,880 327 1,368 873 1,505 456 660 4,548 578 98

20,891 325 1,545 905 2,197 472 548 4,806 578 81

18,801 305 1,551 867 1,652 705 13 4,898 312 34

Key Financial Ratios of Tata Motors March 2005

March 2006

March 2007

March 2008

March 2009

10

10

10

10

10

Investment Valuation Ratios Face Value

(Contd.)

Cash Flow Statement 317 Dividend per Share Operating Profit per Share (Rs) Net Operating Profit per Share (Rs) Free Reserves per Share (Rs) Bonus in Equity Capital Profitability Ratios Operating Profit Margin (%) Profit before Interest and Tax Margin (%) Gross Profit Margin (%) Cash Profit Margin (%) Net Profit Margin (%) Return on Capital Employed (%) Return on Net Worth (%) Return on Long-term Funds (%) Liquidity and Solvency Ratios Current Ratio Quick Ratio Debt Equity Ratio Debt Coverage Ratios Interest Cover Total Debt to Owners Fund Financial Charges Coverage Ratio Management Efficiency Ratios Inventory Turnover Ratio Debtors Turnover Ratio Investments Turnover Ratio Fixed Assets Turnover Ratio Total Assets Turnover Ratio Profit and Loss Account Ratios Material Cost Composition Imported Composition of Raw Materials Consumed Selling Distribution Cost Composition Expenses as Composition of Total Sales Cash Flow Indicator Ratios Dividend Payout Ratio Net Profit Dividend Payout Ratio Cash Profit

12.5 55.29 475.44 93.85 30.76

13 56.07 524.73 123.34 29.06

15 67.12 691.91 157.16 28.87

15 78.61 746.24 182.38 28.86

6 33.52 499.23 217.77 21.64

11.62 8.8 12.39 9.58 7.02 28.49 30.09 28.72

10.68 7.82 12.21 9.86 7.35 26.47 27.74 28.65

9.7 7.25 11.19 9.07 6.94 25.82 27.96 31.18

10.53 8.16 8.26 8.13 6.96 18.96 25.98 22.85

6.71 3.2 3.3 6.97 3.77 6.41 8.09 8.89

0.98 0.76 0.61

1.07 0.97 0.53

0.86 0.92 0.59

0.64 0.66 0.8

0.44 0.58 1.06

8.64 0.61 10.24

7.62 0.53 8.08

7.19 0.59 7.62

6.28 0.8 7.19

2.43 1.06 3.64

10.99 24.12 14.06 5 2.63

10.32 26.31 12.63 5 2.4

11.02 35.6 13.26 5.01 2.49

14.44 30.08 14.44 2.69 2.06

13.47 19.11 13.47 1.88 1.02

71.19 2.3 3.48 8.7

72.84 4.64 3.78 11.87

74.55 3.88 4 10.18

72.62 4.6 4.09 9.88

73.26 5.82 4.77 9.49

41.68 29.39

37.13 26.73

35.34 26.16

32.51 24.02

34.52 17.94

Earning Retention Ratio

58.18

58.31

59.9

60.13

62.49

Cash Earning Retention Ratio

70.54

70.98

71.32

72.18

81.29

1.43

1.5

1.7

2.65

7.13

Adjusted Cash Flow Times

318 Financial Accounting

Ms. Tanushree, a management trainee, was observing the Profit and Loss Account and Balance Sheet of Tata Motors. While the financials had been improving till the year ended 31st March 2008, have been affected by recession in the year ended 31st March 2009, the reported net profit of the company has fallen from Rs 2,028.92 cr to Rs 1,001.26 cr. The observation lead her to wonder that though the net profit has fallen to almost half, how could the company manage to have a cash balance of Rs 638 crore? How could the company pay a dividend of 311 crore? Why did the company increase its investment from Rs 4,910 crore to Rs 12,968 crore? Her friend Ms. Vijayshree told her that she will have to analyse cash flow statement to get answer to her queries.

Financial Statement Analysis

Learning Objectives After studying this chapter, you will be able to ❖

Understand Financial Statement Analysis (FSA) and its techniques

❖

Conduct horizontal FSA

❖

Conduct vertical FSA

❖

Learn calculating ratios

❖

Analyse stock and debtors

❖

Know working capital management

❖

Discuss about relation between stock prices and financial data

10

Financial Statement Analysis 321

LET US SET THE STAGE . . . Mr Nilesh is the proprietor of agency dealing in FMCG items. His business is doing well and he is planning to expand his business. He approaches a bank, with his financial statements of current year as well as previous years and expresses his desire to borrow a sum of Rs 25,00,000 as loan. The banker has asked Nilesh to provide a commonsize, comparative and trend statements. Further Nilesh has been asked to present information about liquidity, profitability and solvency position of his business. Mr Nilesh was wondering the reason for this additional information requirement despite submitting the financial statements. How to compare financial information? How to ascertain liquidity, profitability and solvency position of an organisation?

■ ■

All such questions can be answered by studying this chapter.

INTRODUCTION Financial statement analysis refers to detailed study of financial statements. Financial statement analysis may be defined as the process of identifying financial strengths and weaknesses of the firm by establishing relationship between the items of financial statements. Financial statements include the following: ■ ■ ■

Balance sheet Income statement Cash flow statement

The objective of financial statements is to provide data about the financial position, performance and cash flows of an enterprise. Financial statement analysis uses this data to generate information about relative performance and its trends.

TECHNIQUES FOR FINANCIAL STATEMENT ANALYSIS Objective 1 Financial statements are prepared for disclosure To understand FSA and its of financial data. They provide vital information technique to a variety of stakeholders. However, the information provided by the financial statements cannot be used to draw meaningful conclusions unless it has been properly analysed and interpreted. Analysis of financial statements can be carried out by using various techniques. These techniques are to be used concurrently, and are not substitute of each other.

322 Financial Accounting

Horizontal Analysis: Comparative Statement and Trend Statement Comparison of two or more years’ financial data of the same entity is known as horizontal analysis. It is conducted by preparing comparative statement or trend statement.

Comparative Statement This compares financial data for different periods of time. The comparative statement is usually prepared to compare the figures in income statement or balance sheet of the current year with the corresponding figures of previous year. In comparative statements changes are shown in absolute and in terms of percentage.

Trend Statements These are prepared to analyse long-term movement in financial figures. In trend statements initial year is taken as base (100) and percentage is calculated for the following years. It enables an analysis of performance of the same company for many years.

Vertical Analysis: Common Size Statement It is useful in comparing the performance and financial position of two or more companies. Comparison of companies in the same industry makes more sense. Since different companies are of different size, absolute figures cannot be compared. Comparison is possible by preparing common size statement. It is carried out to study changes in asset-liability mix in case of balance sheet and proportion of different expenses with respect to sales in case of income statement.

Ratio Analysis It is necessary to analyse financial statements, for the purpose of understanding the financial characteristics like, liquidity, profitability, solvency, turnover and cost. The most important technique of financial statement analysis is financial ratios. Ratio is relationship between the items. Financial ratios are either expressed in number or in percentage. If we are given profit figure of a Company X as 20 crore and of Company Y as 60 crore and ask which is more profitable company, our immediate answer is Company Y due to higher profit. But if we are also told that turnover of Company X is 200 crores and that of Company Y is 1,000 crore, then we can use ratio to calculate percentage of profit as under:

Financial Statement Analysis 323 Company X

Company Y

Profit (in Rs Crore)

20

60

Sales (in Rs Crore)

200

1,000

Profit Ratio (Profit/Sales)

10%

6%

Now for the same question our answer is Company X since profit ratio is higher.

Advantages of Financial Statement Analysis 1. Absolute figures are useful but they do not convey much meaning. Ratio analysis relationship between related figures makes them meaningful. 2. Accounting ratios give a better understanding of the financial condition and performance of an organisation. 3. Inter-company and intra-company comparison of financial performance is possible with the help of ratio analysis. 4. Analyst can use financial ratios as a tool to identify financial position with respect to liquidity, solvency, efficiency, etc.

Disadvantages of Financial Statement Analysis 1. Ratios are calculated from financial statements and hence its accuracy depends upon financial statements. Therefore, if data in financial statements is incorrect then ratios also will not give effective results. 2. Financial statements may be prepared by following different accounting policies. If different companies following different accounting policies are compared through ratios, it may not give appropriate conclusions. Now we will illustrate various techniques using financial statements of TCS Ltd. These are given in Exhibit 10.1. EXHIBIT 10.1

TCS Ltd Balance Sheet, From 2008–09 to 2009–10 Rs in crore March 2009

March 2010

Sources of Funds Equity Share Capital

98

196

Preference Share Capital

100

100

Total Share Capital

198

296 (Contd.)

324 Financial Accounting

Reserves

13,248

14,821

33

29

8

6

Total

13,487

15,152

Application of Funds

March 2009

March 2010

Gross Block

4,359

4,871

Less: Accumulated Depreciation

1,690

2,111

Net Block

2,669

2,761

685

941

5,936

7,893

17

7

3,718

3,332

480

212

Total Current Assets

4,215

3,551

Loans and Advances

3,911

4,102

Fixed Deposits

1,125

3,184

Current Liabilities

3,604

3,353

Secured Loans Unsecured Loans

Capital Work in Progress Investments Inventories Sundry Debtors Cash and Bank Balance

Provisions

1,450

3,927

13,487

15,152

2,924

3,293

18,541

22,432

Market Price per Share

270

780

Book Value per Share

136

77

14

20

Total Contingent Liabilities Total Assets

Dividend per Share

Profit and Loss Account Extract, From 2008–09 to 2009–10 March 2009

March 2010

22,402

23,044

Income Net Sales Other Income

-456

182

Total Income

21,946

23,227

54

24

Expenditure Raw Materials

(Contd.)

Financial Statement Analysis 325

Power and Fuel Cost

164

184

Employee Cost

7,370

7,882

Other Manufacturing Expenses

6,948

6,447

Selling and Administration Expenses

1,268

Miscellaneous Expenses Total Expenses Profit before Interest and Tax (PBIT)

629

571

16,383

16,376

5,563

6,851

7

10

5,556

6,841

340

738

5,216

6,103

Interest PBT Tax Profit After Tax (PAT)

HORIZONTAL ANALYSIS: COMPARATIVE AND TREND STATEMENTS Objective 2 Comparative statement compares financial data To conduct horizontal FSA for different periods of time. The following steps are taken while preparing comparative statement: Step 1: Arrange the given statement in proper format, i.e. rearrange to show owners fund and borrowed funds on the liability side and fixed assets, investments and working capital (current assets minus current liabilities) on the assets side. This is done for the current year as well as the previous year. Step 2: Calculate increase/decrease in absolute term for each item. Step 3: Calculate percentage increase/decrease for each item.

ILLUSTRATION 10.1 Prepare comparative balance sheet and income statement of TCS Ltd using data from Exhibit 10.1 and offer your comments. Solution Comparative Balance Sheet of TCS Ltd from 2008–09 to 2009–10 Rs in crore Sources of Funds Total Share Capital Equity Share Capital

March 2009

March 2010

Change

% Change

198

296

98

49%

98

196

98

100% (Contd.)

326 Financial Accounting Preference Share Capital

100

100

0

0%

Reserves

13,248

14,821

1,573

12%

Net Worth

13,446

15,117

1,670

12%

33

29

−3

−10%

8

6

−1

−16%

41

35

−6

−15%

13,487

15,152

1,666

12%

Secured Loans Unsecured Loans Total Debt Total Liabilities Application of Funds

March 2009

March 2010

Gross Block

4,359

4,871

512

12%

Less: Accumulated Depreciation

1,690

2,111

421

25%

Net Block

2,669

2,761

91

3%

685

941

256

37%

5,936

7,893

1,957

33%

17

7

−10

−60%

3,718

3,332

−385

−10%

480

212

−268

−56%

Total Current Assets

4,215

3,551

−663

−16%

Loans and Advances

3,911

4,102

191

5%

Fixed Deposits

1,125

3,184

2,059

183%

Total CA, Loans and Advances

9,251

10,837

1,586

17%

Current Liabilities

3,604

3,353

−251

−7%

Provisions

1,450

3,927

2,476

171%

Total CL and Provisions

5,054

7,279

2,225

44%

Net Current Assets

4,196

3,558

−639

−15%

13,487

15,152

1,666

12%

368

13%

Capital Work in Progress Investments Inventories Sundry Debtors Cash and Bank Balance

Total Assets Contingent Liabilities

2,924.33

3,292.50

Comments 1. The company is having healthy growth in their assets and liabilities by 12%. 2. There has been an issue of shares which has resulted in doubling of equity share capital. The increase has probably happened due to issue of bonus shares. 3. There is decrease of cash balance (–56%) and significant increase of fixed deposits (183%). 4. Provisions have increased substantially (171%). 5. Fixed deposits increases substantially (183%), and cash/bank by 56%, which implies that surplus cash is invested for short term.

Financial Statement Analysis 327

Comparative Income Statement of TCS Ltd Rs in crore Profit and Loss Account Extract

March 2009

March 2010

Change

% Change

22,402

23,044

643

3%

Other Income

−456

182

638

−140%

Total Income

21,946

23,227

1,281

6%

54

24

−30

−56%

164

184

19

12%

Employee Cost

7,370

7,882

512

7%

Other Manufacturing Expenses

6,948

6,447

−501

−7%

Selling and Administration Expenses

1,218

1,268

50

4%

629

571

−58

−9%

16,383

16,376

−7

0%

6,021

6,667

646

11%

7

10

2

28%

5,037

6,356

1,320

26%

Tax

340

738

398

117%

PAT

4,696

5,619

922

20%

Incomes Net Sales

Expenditures Raw Materials Power and Fuel Cost

Miscellaneous Expenses Total Expenses PBIT Interest PBT

Comments 1. The growth in sales seems to have stagnated (3%). 2. Other income was −456, has now become +182. The change has lead to increase profit by 638. However, this increase may not be recurring. 3. Income tax expense has increased considerably (117%). 4. PAT shows healthy growth (20%). Trend statement is prepared for several years. While preparing trend statement earlier year is considered as base year and all the items in the base year are considered as 100. For all the other years percentage is considered with respect to the base year.

ILLUSTRATION 10.2 Prepare trend statement of Reliance Industries Ltd using their income statement for the last 5 years provided in Exhibit 10.2.

328 Financial Accounting EXHIBIT 10.2

Reliance Industries Ltd Income Statements From 2006–07 to 2009–10 Rs in crore March 2010

March 2006

March 2007

March 2008

March 2009

83,556

1,12,591

1,38,534

1,43,651

1,99,128

59,739

80,792

98,832

1,09,284

1,53,689

Income Total Turnover Expenditure Raw Materials Power and Fuel Cost

1,146

2,262

2,053

3,356

2,707

Employee Cost

978

2,094

2,119

2,398

2,331

Other Manufacturing Expenses

668

1,112

715

1,163

2,154

5,872

5,478

5,549

4,737

5,756

Selling and Administration Expenses Miscellaneous Expenses/Adjustments

146

210

237

−2,703

−566

Total Cash Expenses

68,550

91,948

1,09,506

1,18,234

1,66,071

PBDIT

15,006

20,643

29,028

25,416

33,057

Interest

894

1,299

1,163

1,774

2,000

14,112

19,344

27,865

23,642

31,057

3,401

4,815

4,847

5,195

10,497

10,711

14,529

23,018

18,447

20,561

Tax

1,643

2,585

3,560

3,137

4,325

Net After Profit (PAT)

9,068

11,943

19,458

15,309

16,236

Equity Dividend

1,394

1,440

1,631

1,897

2,085

195

202

277

322

346

13,935

13,935

14,536

15,738

32,704

65

86

134

97

50

PBDT Depreciation Profit Before Tax (PBT)

Corporate Dividend Tax Per Share Data (Annualised) Shares in Issue (Lakhs) Earnings per Share (Rs)

Solution Trend Statement of RIL Income Statement Rs in crore March 2006

March 2007

March 2008

March 2009

March 2010

March 2006

March 2007

March 2008

March 2009

March 2010

1,12,591 1,38,534 1,43,651 1,99,128

100

134.75

165.80

171.92

238.32

135.24

165.44

182.94

257.27

Income Total Turnover 83,556 Expenditure Raw Materials 59,739

80,792

98,832

1,09,284 1,53,689

100

(Contd.)

Financial Statement Analysis 329 Power and 1,146 Fuel Cost Employee 978 Cost Other 668 Manufacturing Expenses Selling and 5,872 Administration Expenses Miscellaneous 146 Expenses/Adj Total Cash 68,550 Expenses PBDIT 15,006 Interest PBDT

2,262

2,053

3,356

2,707

100

197.31

179.09

292.78

236.13

2,094

2,119

2,398

2,331

100

214.02

216.60

245.03

238.22

1,112

715

1,163

2,154

100

166.42

107.01

174.02

322.26

5,478

5,549

4,737

5,756

100

93.29

94.50

80.66

98.03

210

237

−2,703

−566

100

144.25

162.91 -1,856.61 -388.71

91,948

1,09,506 1,18,234 1,66,071

100

134.13

159.75

172.48

242.26

20,643

29,028

25,416

33,057

100

137.57

193.45

169.38

220.30

894

1,299

1,163

1,774

2,000

100

145.35

130.14

198.57

223.81

14,112

19,344

27,865

23,642

31,057

100

137.07

197.46

167.53

220.08

Depreciation

3,401

4,815

4,847

5,195

10,497

100

141.58

142.52

152.76

308.64

Profit Before Tax (PBT) Tax

10,711

14,529

23,018

18,447

20,561

100

135.64

214.90

172.22

191.96

1,643

2,585

3,560

3,137

4,325

100

157.38

216.70

190.98

263.28

Net After 9,068 Profit (PAT) Equity 1,394 Dividend Corporate 195 Dividend Tax Per Share Data (Annualised) Shares in Issue 13,935 (Lakhs) Earning per 65 Share (Rs)

11,943

19,458

15,309

16,236

100

131.70

214.57

168.82

179.03

1,440

1,631

1,897

2,085

100

103.37

117.06

136.14

149.60

202

277

322

346

100

103.37

141.85

164.96

177.16

13,935

14,536

15,738

32,704

100

100.00

104.32

112.94

234.69

86

134

97

50

100

131.70

205.69

149.48

76.28

Comments 1. Company has shown steady growth trend in sales over a period of 5 years (138%). 2. Raw material cost, power and fuel and employee coat have increased in tandem in with sales (+157%, +136%, + 138%), while other manufacturing expenses have increased faster (+222%). 3. Selling and distribution expenses have been in control and it has been over the years, at same absolute value (−2%). 4. It is observed that increase in profits is not keeping pace with increase in sales (PBT +92%, PAT +79%).

330 Financial Accounting

VERTICAL ANALYSIS: COMMON SIZE Objective 3 A statement which shows each figure in a To conduct vertical FSA financial statement as a percentage to ‘total’. Profit and Loss Account items are divided by Sales, and Balance Sheet items are divided by Total Assets. It facilitates comparability with other entities of different sizes The following steps are taken while preparing common size statement. Step 1: Arrange the given statement in proper format, i.e. rearrange to show owners fund and borrowed funds on the liability side and fixed assets, investments and working capital (current assets minus current liabilities) on the assets side. This is done for the current year as well as the previous year. Step 2: In case of balance sheet total of sources/application of fund should be taken as 100 and all other related items should be calculated as a proportion to sources/ application. Similarly, in case of income statement turnover is taken as 100 and all other items are calculated in proportion to turnover.

ILLUSTRATION 10.3 Using the information provided in Exhibit 10.1, prepare common size income statement. Solution Profit and Loss Account Extract Rs in crore March 2009

March 2010

March 2009

March 2010

Income Net Sales

22,401.92

23,044.45

102%

99%

Other Income

−456.24

182.10

−2%

1%

Total Income

21,945.68

23,226.55

100

100

Expenditures Raw Materials

53.67

23.75

0%

0%

164.34

183.62

1%

1%

Employee Cost

7,370.09

7,882.43

32%

34%

Other Manufacturing Expenses

6,947.60

6,446.99

30%

28%

Selling and Administration Expenses

1,218.41

1,268.03

5%

5%

Power and Fuel Cost

Miscellaneous Expenses Total Expenses

628.71

571.08

3%

16,382.82

16,375.90

71%

2% 71% (Contd.)

Financial Statement Analysis 331 Operating Profit Interest PBT Tax PAT

6,020.83

6,667.17

26%

29%

7.44

9.54

0%

0%

5,036.58

6,356.40

22%

27%

340.37

737.89

1%

3%

4,696.21

5,618.51

20%

24%

Comments ■ ■

Profit after tax has increased from 20% to 24%. Total expenses have remained the same during both the periods.

ILLUSTRATION 10.4 Using the following data of TCS, Infosys and Wipro, prepare common size income statement. Rs in crore Particulars

TCS

Infosys

Wipro

23,044

21,140

22,922.00

Income Net Sales Other Income

182

967

Total Income

23,227

22,107

875.3

24

22

4,140.40

184

122

141.4

Employee Cost

7,882

10,356

9,062.80

Other Manufacturing Expenses

6,447

1,993

2,071.80

Selling and Administration Expenses

1,268

992

1,475.10

571

293

640

16,376

13,778

17,532

PBDIT

6,851

8,329

6,266

Interest

10

2

108

6,841

8,327

6,158

469

807

580

6,372

7,520

5,578

738

1,717

790

5,634

5,803

4,788

23,797

Expenditure Raw Materials Power and Fuel Cost

Miscellaneous Expenses Total Expenses

PBDT Depreciation Profit before Tax Tax PAT

332 Financial Accounting

Solution Common Size Income Statement for the year ended 31st March 2010 TCS Income

Infosys

Rs

%

Rs

Wipro %

Rs

%

Net Sales

23,044

99%

21,140

91%

22,922.00

99%

Other Income Total Income Expenditure Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Administration Expenses Miscellaneous Expenses Total Expenses PBDIT Interest PBDT Depreciation Profit before Tax Tax PAT

182 23,227

1% 100%

967 22,107

4% 100%

875.3 23,797

4% 100%

24 184 7,882 6,447 1,268

0% 1% 34% 28% 5%

22 122 10,356 1,993 992

0% 1% 45% 9% 4%

571 16,376 6,851 10 6,841 469 6,372 738 5,634

2% 71% 29% 0% 29% 2% 27% 3% 24%

293 13,778 8,329 2 8,327 807 7,520 1,717 5,803

1% 59% 36% 0% 36% 3% 32% 7% 25%

4,140.40 141.4 9,062.80 2,071.80 1,475.10 640 17,532 6,266 108 6,158 580 5,578 790 4,788

18% 1% 39% 9% 6% 3% 75% 27% 0% 27% 2% 24% 3% 21%

LIQUIDITY RATIOS: CURRENT AND QUICK RATIO Objective 4 “Liquidity” means ability of the entity to pay To learn how to calculate ratios its liabilities in the short run. This is also called “short-term solvency”. The popularly used liquidity ratios are current ratio and quick ratio.

Current Ratio/Working Capital Ratio Current ratio is given by Current Assets Current Liabilities

Financial Statement Analysis 333

Current assets include inventories, debtors, prepayments, cash and bank balances, current investments (which are intended to be held for a short period, not more than one year, and which are readily convertible into cash), short-term loans and advances and advance tax. CA = Inventory + Debtors + Prepaid Expense + Cash and Bank Current liabilities includes sundry creditors, outstanding expenses and wages, shortterm secured and unsecured loans, bank overdrafts, instalments of long-term loans which are due or will be due within one year, tax provision and proposed dividend. CL = Creditors + Outstanding Expenses + Bank O/D + Short-Term Loans The ratio indicates company’s ability to pay its short-term liabilities (payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its current obligations. However, high current ratio also indicates a large portion of working capital, which may reduce firm’s profitability. Hence, the ratio should be neither too high nor too low. By thumb rule 2:1 is considered as appropriate current ratio; however, it differs from industry to industry.

Quick Ratio/Liquid Ratio/Acid Test Ratio Quick ratio is given by Quick Assets Quick Liabilities

or

Liquid Assets Liquid Liabilities

Quick assets are those current assets which can be converted into cash easily. It includes debtors, cash and bank, current investments. It is usually calculated as current assets minus inventory and prepayments. Inventories cannot be termed as liquid assets because it cannot be converted into cash immediately. Prepaid expenses are also excluded from current assets because they are not expected to be converted into cash. QA = Cash + Debtors + Current Investments Quick liabilities include those current liabilities which are immediately payable, i.e. sundry creditors, bills payable, outstanding expenses, short-term advances. Bank overdraft may not be included in quick liabilities as it is usually sanctioned for about a year. QL = Creditors + Outstanding Expenses + Short-Term Advances However, many analysts consider all current liabilities to be quick liabilities. Quick ratio alternatively can be calculated as: Quick Assets Current Liabilities

334 Financial Accounting

The quick ratio is also called acid test ratio. It is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio.

Cash Ratio Cash ratio is calculated to determine availability of cash and bank balance to make payment of current liabilities. Cash Ratio = Cash + Cash Equivalents/Current Liabilities

ILLUSTRATION 10.5 Using the data of TCS Ltd available in Exhibit 10.1 calculate the current ratio, quick ratio and cash ratio. Solution Current Ratio = CA/CL For 2009: CR = 9,250/5,054 = 1.83024 For 2010: CR = 10,837/7,279 = 1.48874 It can be observed that current ratio has decreased which indicates that liquidity position of the Company has deteriorated in 2010 compared to 2009. Quick Ratio = QA/QL Quick Assets Sundry Debtors Cash and Bank Balance

2009

2010

3,717.73

3,332.30

479.93

212.31

Fixed Deposits

1,125.33

3,183.85

Total

5322.39

6728.46

Quick Liabilities

2009

2010

Current Liabilities

3,604.18

3,352.74

Provisions

1,450.23

3,926.61

Total

5,054.41

7,279.35

For 2009: QR = 5,322.39/5,054.41 = 1.053 For 2010: QR = 6,728.46/7,279.35 = 0.92434 It can be observed that quick ratio is marginally decreasing and therefore immediate liquidity position of a Company has slightly deteriorated in 2010 in comparison to 2009.

Financial Statement Analysis 335

Cash ratio is calculated as follows: In 2009: Cash Ratio = 479.93/5,054.41 = 0.09495 In 2010: Cash Ratio = 212.31/7,279.31 = 0.02917 From the calculation, it can be observed that cash availability has declined in 2010 as compared to 2009. Exhibit 10.3 provides a summary of liquidity ratios. EXHIBIT 10.3

A Summary of Liquidity Ratios

Ratio

Formula

Current Ratio

Current Asset Current Liabilities

BS Asset Portion BS Liability Portion

Indicates the ability to meet currently maturing obligations

Quick Asset Quick Liabilities

BS Asset Portion BS Liability Portion

Indicates the ability to meet immediately maturing obligations

BS Current Asset BS Liability Portion

Indicates the proportion of current obligations which can be met with cash or cash equivalents

Quick Test Cash Ratio

Location of Items

Cash + Cash Equivalents Current Liabilities

Explanation

SOLVENCY RATIOS: D/E, INTEREST COVERAGE “Solvency” refers to long-term solvency. It indicates whether the entity will be able to continue in the long run.

Debt Equity Ratio (D/E Ratio) It is given by Debt Borrowers’ Fund = Equity Owners’ Fund OR Debt Borrowers’ Fund = Debt + Equity Total Funds Debt means long-term loan funds; both secured and unsecured. Equity means share capital and free reserves net of any loss and preliminary expenses and other fictitious assets. Debt usually has lower cost and hence it is used to improve ROE. Raising finance through debt increases fixed liability in terms of payment of interest. It adds to financial risk. Such liability has to be met with even if business is not performing well. Entity may suffer loss if ROI is lower than cost of debt (interest); therefore D/E ratio should be reasonable.

336 Financial Accounting

The ratio is important as it indicates the risk level of a company which is as follows:

Let us calculate D/E ratio for Videocon Industries using the information provided in Exhibit 10.4. EXHIBIT 10.4

Extracts from the Balance Sheet of Videocon Industries Rs in Crore September 2008

September 2009

Equity Share Capital

229.3

324.41

Preference Share Capital

46.01

46.01

6,538.49

6,929.63

Sources of Funds

Reserves Net Worth/Owners’ Fund

6,813.8

7,300.05

Secured Loans

4,401.25

6,735.04

Unsecured Loans

3,604.34

2,349.51

Total Debt/Borrowers’ Fund

8,005.59

9,084.55

14,819.39

16,384.60

Total Liabilities

D/E Ratio = Debt/Equity For 2008 = 8,005.59/6,813.8 = 1.174 For 2009 = 9,084.55/7,300 = 1.244 D/E Ratio = Debt/(Debt + Equity) For 2008 = 8,005.59/14,819.39 = 54 = 54% For 2009 = 9,084.55/16,384.6 = 55 = 55% It can be observed that debt equity ratio is almost the same. There is higher proportion of debt compared to equity. This shows that company has high level of financial risk.

Financial Statement Analysis 337

Interest Coverage It is calculated as Profits Before Interest and Tax (PBIT) —–—————————————— Interest The lower the interest coverage ratio, the higher the company’s debt burden and there is high possibility of default. The ratio determines how easily company can make payment of interest on outstanding loan. Higher interest coverage ratio indicates strength of company to make payment of interest. Let us calculate the interest coverage ratio of Videocon Industries using Exhibit 10.5. EXHIBIT 10.5

Income Statement of Videocon Industries Rs in Crore September 2008

September 2009

Net Sales

9,753.66

9,163.04

Other Income

−133.22

−52.73

Total Income

9,620.44

9,110.31

5,293.35

5,626.84

86.77

80.84

115.82

126.42

Income

Expenditure Raw Materials Power and Fuel Cost Employee Cost Other Manufacturing Expenses

1,199.08

692.9

638.09

692.21

30.59

82.3

Total Expenses

7,363.70

7,301.51

PBDIT

2,256.74

1,808.80

660.21

577.15

1,827.18

1,155.50

431.00

665.00

Selling and Administration Expenses Miscellaneous Expenses

Depreciation PBIT/Operating Profit Interest PBT

1,167.69

652.03

Tax

312.67

177.68

PAT

982.11

400.66

338 Financial Accounting

Interest Coverage Ratio = PBIT/Interest In 2008: Interest Coverage Ratio = 1,827/431 = 4.23 In 2009: Interest Coverage Ratio = 1,156/665 = 1.73 Interest coverage ratio implies that interest burden has increased while PBIT has decreased. This has increased the possibility of default.

Proprietary Fund Ratio “Proprietary Funds” mean equity, i.e. share capital and free reserve net of losses and fictitious assets like preliminary expenses. It is given by Proprietary Fund Net Worth Proprietors’ Fund = or Total Assets Total Assets Total Fund Total assets exclude fictitious assets. This ratio explains the proportion of total assets financed out of proprietary funds. Higher the ratio, lower is the dependence on outside funds and more stable is the position of the company in the long run. In case of Exhibit 10.1, In 2009: Proprietary Fund Ratio = 13,446.25/13,486.62= 0.99701 In 2010: Proprietary Fund Ratio = 13,486.62/15,152.36 = 0.99764 Proprietary ratio is very high as most of the assets are financed by proprietors. Exhibit 10.6 provides summary of solvency ratios. EXHIBIT 10.6

A Summary of Solvency Ratios Leverage Ratios

Ratio

Location

Explanation

Borrowed Fund Owners’ Fund

Balance Sheet Balance Sheet

Indicates the proportion of funds provided by lenders/creditors versus the funds by owners

Proprietary Fund Ratio (%)

Net Worth Total Assets

Balance Sheet Balance Sheet

Indicates the proportion of funds provided by proprietors to total assets

Interest Coverage Ratio

Profit Before Interest and Tax (PBIT) Interest Charges

Income Statement Income Statement

Indicates the ability of the company to meet its interest obligations

Debt–Equity Ratio

Formula

Financial Statement Analysis 339

PROFITABILITY RATIOS: GP, NP, EBIT, EBDITA, EPS Profitability implies ability to generate earnings particularly with respect to turnover. Followings are important profitability ratios:

Gross Profit Ratio (GPR) Gross profit is calculated as the difference between sales and cost of goods sold (COGS). Gross profit ratio is the ratio of gross profit to net sales expressed as a percentage. It is given as follows: (Sales - COGS) ¥ 100 Sales It reflects the gross margin earned by the firm through manufacturing or trading as a proportion to sales. The gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges and dividends.

ILLUSTRATION 10.6 Calculate gross profit ratio from the following data: Sales: Rs 10,00,000 COGS: Rs 6,00,000 Solution GP Ratio = (Sales − COGS)/Sales = (10,00,000 – 6,00,000)/10,00,000 = 40%

Operating Profit Ratio Operating profit is the excess of sales over the COGS and operating expenses. Operating profit is earned from normal business operations of the concern. Operating profit is usually same as PBIT, i.e. profit before interest and taxes. It is calculated as: Operating Profit ¥ 100 Sales This ratio shows the profit generating ability of the business from its core activities. Let us calculate operating profit ratio for Videocon Industries from the details mentioned in Exhibit 10.5.

340 Financial Accounting

In 2008, Operating Profit Ratio = PBIT/Sales = 1,827/9,754 = 18.74% In 2009, Operating Profit Ratio = PBIT/Sales = 1,159/9,163 = 12.64% It can be observed that the operating profit has decreased substantially which shows deteriorating profitability position of the company.

EBIDTA/PBDIT Ratio Earnings Before Interest, Depreciation, Tax and Amortisation (EBDITA) or Profit Before Depreciation, Interest and Tax (PBDIT) ratio indicates cash profit earned from operating activities. PBDIT = PBIT + Depreciation PBDIT Ratio =

PBDIT ×100 Sales

PBDIT ratio for Videocon Industries can be calculated as follows: In 2008: PBDIT Ratio = 2,256/9,753 = 23% In 2009: PBDIT Ratio = 1,808/9,163 = 19% PBDIT ratio, which shows cash profit, has declined substantially.

Net Profit Ratio (NPR) Net profit after tax is obtained after deducting all expenses, interest and tax from sales. Net profit ratio is the ratio of net profit after taxes to net sales. It expressed as: Net Profit After Tax ¥ 100 Sales NP Ratio is used to measure the overall profitability and hence, it is very useful to owners. High NP Ratio will lead to higher returns. In case of TCS, Net Profit Ratio is as follows: In 2009, NP Ratio = 4,649/22,401 = 21% In 2010, NP Ratio = 5,619/23,041 = 24% The above calculation shows increase in profitability.

Earnings Per Share (EPS) It indicates profit available for each equity share. This ratio plays a very important role for the investors to take decision on investments. It is expressed as:

Financial Statement Analysis 341

EPS = Profit Available for Equity Shareholder/No of Equity Shares Profit available to equity shareholder is calculated after deducting all other charges like interest, tax and dividend to preference shareholders from the operating profit, i.e. EBIT. In 2009: EPS = 4,696/97.86 = 48 In 2010: EPS = 5,619/195.72 = 29 The above analysis shows that there has been decline in the EPS which shows lower profit per share for shareholders. As per IAS 33, Diluted EPS is a reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions. Table 10.1 provides summary of profitability ratios. TABLE 10.1

A Summary of Profitability Ratios

Ratio

Formula

Location

EBITDA * 100 Sales

Income Statement Income Statement

Indicates the EBITDA as Percentage of Sales

EBIT (%)

EBIT * 100 Sales

Income Statement Income Statement

Indicates the EBIT as Percentage of Sales

Net Profit Margin (NPM) (%)

PAT * 100 Sales

Income Statement Income Statement

Indicates the Profit after Tax (PAT) as Percentage of Sales

Earnings per Share (EPS) (Rs)

PAT Attributable to Shareholders Average Number of Equity Shares

Income Statement BS (Sometimes)

Indicates the Profit available per Equity Share

EBIDTA (%)

Explanation

RETURN RATIOS: ROI, ROE Return ratios indicates the rate at which company has generated return over its capital employed in the business.

Return on Capital Employed (ROCE)/Return on Investments (ROI) It is expressed as the amount of Earnings Before Interest and Tax (EBIT) earned as a percentage to capital employed in the business. ROCE = EBIT/Capital Employed

342 Financial Accounting

Earning Before Interest and Tax is the operating profit which is calculated by deducting all operating expenses from gross profit. Capital employed is the total amount of owners and borrowed fund which is employed in the business. For Exhibit 10.1 TCS Ltd, ROCE is as follows: In 2009: ROCE = 5,044/13,486 = 37% In 2010: ROCE = 6,365.94/15,152 = 42% The above analysis shows that ROCE has increased which shows improvement in return over capital employed.

Return On Equity (ROE) ROE is expressed as the amount of net profit earned as a percentage of shareholders equity. Return on equity measures a company’s profitability by calculating how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and is calculated as follows: Return On Equity = Net Income Available to Shareholders/Shareholder’s Equity = (PAT − Preference Dividend)/(Equity Share Capital + Reserves) = PAT/Net Worth Shareholder’s equity includes share capital, reserves and surplus and excludes miscellaneous expenses not written off. This is also known as “Net worth”. Net income available to shareholder is reported net profit which is after deducting interest and tax from EBIT. For Exhibit 10.1 of TCS Ltd, In 2009: ROE = 4,696/13,446 = 35% In 2010: ROE = 5,619/15,116 = 37% Profit available to equity shareholders has increased which shows ability of company to generate return over its equity fund has also improved.

Return On Total Assets (ROTA) It indicates profit earned on assets used. Total assets include fixed assets, capital work in progress, investments and total current assets, loans and advances. It is calculated as follows: ROTA = Profit After Tax/Total Assets

Financial Statement Analysis 343

In case of Exhibit 10.1 of TCS Ltd ROTA is calculated as follows: In 2009: ROTA = 4,696/18,541 = 25% In 2010: ROTA = 5,619/22,431 = 25% There is no change in return on total assets. Exhibit 10.7 provides summary of return ratios. EXHIBIT 10.7

A Summary of Return Ratios

Return on Capital Employed/ Return on Investment ROCE (%)

EBIT Capital Employed

Income Statement Indicates the return earned on Balance Sheet Capital Employed/Invested

Return on Total Assets ROTA (%)

Profit After Taxes Total Assets

Income Statement Indicates the profit earned on Balance Sheet Assets used

Return on Equity ROE (%)

Profit After Taxes Equity

Income Statement Indicates the return earned on Balance Sheet Owners Funds

TURNOVER RATIOS Turnover ratios indicate efficiency in asset use. Some popularly used turnover ratios are discussed below.

Assets Turnover This ratio explains sales generating capacity of a trading concern. It is calculated as Sales Total Assets In case of Exhibit 10.1 of TCS Ltd, In 2009: Assets Turnover Ratio = 22,401.92/18,541.03 = 1.21 In 2010: Assets Turnover Ratio = 23,044/22,431.71 = 1.03 There is decline in assets turnover ratio from 2009 to 2010.

Fixed Assets Turnover This ratio explains sales generating capacity of a trading concern with respect to fixed assets employed. It is calculated as Sales Total Assets

344 Financial Accounting

In case of Exhibit 10.1 of TCS Ltd, In 2009: Assets Turnover Ratio = 22,401.92/2,669 = 8.39 In 2010: Assets Turnover Ratio = 23,044/2,761 = 8.34 There is decline in assets turnover ratio from 2009 to 2010.

Working Capital Turnover This ratio explains how quickly working capital, i.e. net current assets rotates. Higher the turnover better is the working capital utilisation. Net current assets are calculated as current assets minus current liabilities. The ratio is given as Sales Net Current Assets CA

9,250.79

10,837.08

CL

5,054.41

7,279.35

Working Capital/Net CA

4,196.38

3,557.73

In 2009: Working Capital Turnover = 22,401.9/4,196.38 = 5.33839 In 2010: Working Capital Turnover = 23,044.45/2,760.52 = 6.47729

Creditors Turnover This ratio indicates movement of creditors. It is calculated with reference to credit purchases. The ratio is given as: Credit Purchases Average Payable

OR

Credit Purchase Closing Payable

Payables include creditors and bills payables. To assess the efficiency in the management of accounts payable, payable period can be calculated by using the following formula: Accounts Payable Purchases for Year/365 (Daily Purchases) Exhibit 10.8 provides summary of turnover ratios.

Financial Statement Analysis 345

EXHIBIT 10.8

A Summary of Turnover Ratios

Ratio

Formula

Location

Explanation

Asset Turnover

Sales Total Assets

Income Statement Balance Sheet

To assess the utilisation of Total Assets for generating sales

Fixed Asset Turnover

Sales Fixed Assets

Income Statement Balance Sheet

To assess the utilisation of Fixed Assets for generating sales

Working Capital Turnover

Net Sales Working Capital

Income Statement Balance Sheet

To assess the utilisation of Working Capital

Creditors Turnover

Credit Purchase Accounts Payable

Work Sheet Balance Sheet

To assess the efficiency in the management/payment of Accounts Payable

Average Payment Period (days)

Accounts Payable Credit Purchases /365

Balance Sheet Income Statement

To assess the efficiency in the management/payment of Accounts Payable

ANALYSIS OF STOCK AND DEBTORS Objective 5 To analyse stock and debtors

Inventories turnover

Inventory turnover ratio explains movement of inventories in relation to sales. Lower ratio indicates slow movement of inventories. This ratio is given as follows: Sales Average Inventories

Debtors Turnover This ratio indicates movement of debtors. It is calculated with reference to credit sales. The ratio is given as Credit Sales Average Receivable Receivable includes debtors and bills receivable. To assess the efficiency in the management/collection of accounts receivable, collection period can be calculated by using the following formula: Accounts Receivable Sales for Year/365 (Daily Sales)

346 Financial Accounting

For Exhibit 10.1, In 2009: Debtors Turnover = 22,401.9/3,717.73 = 6.0257 In 2010: Debtors Turnover = 23,044.45/3,332.30 = 6.915479 In 2009: Collection Period = 365/6.0257 = 61 days In 2010: Collection Period = 365/6.9154 = 53 days There is a decrease in collection period which shows efficiency in collection. Exhibit 10.9 provides ratios to analyse stock and debtors. EXHIBIT 10.9

Ratios to Analyse Stock and Debtors

Ratio

Formula

Location

Explanation

Inventory Turnover

Sales Inventory

Income Statement Balance Sheet

To assess the efficiency in the management of Inventory

Days of Inventory (days)

Inventory COGS/365

Balance Sheet Income Statement

To assess the efficiency in the management of Inventory

Accounts Receivable Turnover

Credit Sales Accounts Receivable

Work Sheet Balance Sheet

To assess the efficiency in the management/collection of Accounts Receivable

Average Collection Period (days)

Accounts Receivable Credit Sales/365

Balance Sheet Income Statement

To assess the efficiency in the management/collection of Accounts Receivable

WORKING CAPITAL MANAGEMENT Objective 6 Working capital is the difference between To know working capital current assets and current liabilities. It includes management items which are continuously circulating in the cycle of business operations. Cash is starting point of the circulation as it is used to buy raw materials. It results in production of goods which in turn results in cash when sold to customers. Ultimately, all current assets are converted into cash and current liabilities are paid in cash. Operating cycle begins on the date of purchase of raw materials and ends when it is converted into cash. The period between this duration is operating cycle which is calculated in number of days (see Figure 10.1).

Financial Statement Analysis 347

FIGURE 10.1

Operating Cycle

ILLUSTRATION 10.7 Calculate working capital cycle from the following information: Particulars

No of Days

Raw Material Storage

30

Processing Period

25

Finished Goods Storage

30

Debtors Collection Period

35

Creditors Payment Period

40

Solution: Working capital cycle is calculated as shown below: Particulars

No of Days

Raw Material Storage

30

Processing Period

25

Finished Goods Storage

30

Debtors Collection Period

35

Total Less: Creditors Payment Period Working Capital/Operating Cycle

No of Days

120 40

(40) 80

348 Financial Accounting

STOCK PRICES AND FINANCIAL DATA: P/E Objective 7 Share price of a company in the secondary To understand relation between market is determined by the demand and supply stock prices and financial data for the same. Expectations of the buyers and sellers work in opposite direction and the market mechanism leads to discovery of the stock price. Finance theory considers that market is supreme and it discounts everything (socio-economic, political, technological and other related factors). It presumes the value of the asset is based on future expectations. Hence, with every new information, the expectation of the market is liable to change and consequently the share prices. As the new information is erratic in nature so it influences the price in a random way. Stock prices are set by a combination of factors that no analyst can consistently understand or predict.We are giving chart showing the share price of TCS for March 2011 to February 2012

Source: http://money.rediff.com/companies/tata-consultancyservices-ltd/13020033/bse/year

Price to Earnings Ratio (P/E Ratio) This ratio assesses the amount that investors are willing to pay for each rupee of earnings. It is expressed as Market Price per Share Earnings per Share Market price per share is obtained from the stock market reports and it changes frequently. Earnings per share is the amount of profit available to each equity shareholder after payment of all other expenses.

Financial Statement Analysis 349

This ratio is useful to potential investors for taking investment decisions. In case of Exhibit 10.1, In 2009: P/E Ratio = 270/48 = 5.625 In 2010: P/E Ratio = 780/29 = 26.89

Market Price/Book Value Ratio This ratio compares market price of the stock with its book value. It is calculated by dividing the current market price of the stock by the book value per share. It is expressed as Market Price MP/BV Ratio = Book Value per Share Book value is the value at which an asset is carried on a balance sheet. A lower P/B ratio could mean that the stock is undervalued. For TCS, MP/BV ratio is as follows: For 2008–09:

MP/BV Ratio = 270/136 = 1.98

For 2009–10:

MP/BV Ratio = 780/77 = 10.12

Price to book value ratio has increased 10 times, which shows that the stock price has recovered heavily in the current year.

Dividend Yield Ratio A financial ratio shows how much a company pays out in dividends each year relative to its share price. It is expressed as: Dividend Yield = Dividend Per Share (DPS) Earnings Per Share (EPS) Let us calculate Dividend Yield for TCS Ltd. In 2008–09:

Dividend Yield = 14/48 = 29%

In 2009–10:

Dividend Yield = 20/29 = 69%

In the current year, dividend yield has increased by 40% which has generated higher returns for the investors.

Earnings Yield Ratio Earning yield ratio implies earning generated per share with respect to current market price. It is just inverse of P/E ratio. It is expressed as

350 Financial Accounting

Earning Yield = Earnings Per Share (EPS) Market Price

or

1 P/E Ratio

In case of TCS Ltd, Earning Yield Ratio is calculated as follows: In 2008–09:

Earning Yield = 48/270 = 17.77%

In 2009–10:

Earning Yield = 29/780 = 3.71%

Earnings yield has decreased substantially.

SUMMARY ➤

Financial statement analysis may be defined as the process of identifying financial strengths and weaknesses of the firm by establishing relationship between the items of financial statements.

➤

Comparison of two or more years’ financial data of the same entity is known as horizontal analysis. It is conducted by preparing comparative statement or trend statement.

➤

Vertical analysis is useful in comparing the performance and financial position of two or more companies. Comparison of companies in the same industry makes more sense.

➤

It is necessary to analyse financial statements, for the purpose of understanding the financial characteristics like, liquidity, profitability, solvency, turnover and cost. The most important technique of financial statement analysis is financial ratios. Ratio is the relationship between the items. Financial ratios are either expressed in number or in percentage.

➤

“Liquidity” means ability of the entity to pay its liabilities in the short run. This is also called “short-term solvency”. The popularly used liquidity ratios are current ratio and quick ratio.

➤

“Solvency” refers to long-term solvency. It indicates whether the entity will be able to continue in the long run. Important solvency ratios are debt equity ratio (D/E ratio) and interest coverage.

➤

Profitability implies ability to generate earnings particularly with respect to turnover. Important profitability ratios are gross profit ratio (GPR), operating profit ratio and net profit ratio (NPR).

➤

Return ratios indicate the rate at which company has generated return over its capital employed in the business. Important return ratios are return on capital employed (ROCE)/return on investments (ROI) and return on equity (ROE).

Financial Statement Analysis 351 ➤

Turnover ratios indicate efficiency in asset use. Some popularly used turnover ratios are: assets turnover, fixed assets turnover, inventory turnover and debtors turnover.

➤

Working capital is the difference between current assets and current liabilities. It includes items which are continuously circulating in the cycle of business operations.

➤

Share price of a company in the secondary market is determined by the demand and supply for the same. Expectations of the buyers and sellers work in opposite direction and the market mechanism leads to discovery of the stock price.

➤

Price to earnings ratio (P/E ratio) is the ratio which assesses the amount that investors are willing to pay for each rupee of earnings.

MULTIPLE CHOICE QUESTIONS* 1. A concern has an operating ratio higher than the industry’s standard ratio. This shows ___________. (a) Optimum level of production (b) Low efficiency in managing the operations of the concerns (c) Purchases made at low prices (d) Good inventory management 2. A concern has a net profit ratio lower than the industry’s standard ratio. This shows ___________. (a) Unusual gains e.g. recovery of bad debts written off (b) Great efficiency in managing all its activities (c) Low increase in the proprietor’s funds (d) Very good control over all costs 3. Operating cycle is equal to (a) Stock Velocity + Debtors Velocity – Creditors (b) Stock Velocity − Debtors Velocity + Creditors (c) Stock Velocity + Debtors Velocity + Creditors (d) None of the above 4. Debtors’ turnover ratio shows the number of days taken by the company to collect money from (a) Accounts receivable (b) Accounts payables (c) Bills payable (d) None of the above * Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

352 Financial Accounting

5. Which of the following indicates the Debt Service Coverage Ratio (DSCR) of 1.5 of a firm? (a) The total obligations are 1.5 times its PAT. (b) The post-tax cash earnings are 1.5 times its obligations. (c) The post-tax earnings after depreciation are 1.5 times its obligations. (d) The total obligations are 1.5 times the equity earnings. 6. If the debt equity ratio of a company is 2: 1 then it can be understood that for every (a) Two rupees of equity, there is one rupee of debt (b) Two rupees of total of total assets, there is one rupee of equity (c) Three rupees of total assets, there is one rupee of debt (d) Three rupees of total long-term funds, there is two rupees of debt 7. Return On Investment (ROI) and Return On Equity (ROE) are exactly 0.25. This indicates that (a) ROE has been calculated wrongly (b) ROI pertains to the previous year (c) The firm has no debts in their capital structure (d) None of the above 8. Interest coverage ratio of 6 indicates (a) Sales are 6 times of interest (b) Profit after tax is 6 times of interest (c) Profit before tax 6 times of interest (d) Earnings before interest and taxes is 6 times of interest 9. The current ratio and quick ratio of BCC Ltd are nearly the same. This suggests that (a) The company has a large investment in inventory (b) The company has a low investment in inventory (c) The quick assets of the company are low (d) The company is highly profitable 10. In which of the following cases, prices earnings ratio is applied for? (a) To determine the financial risk of a business entity (b) To determine the expected market value of the shares of a company (c) To access the earning potential of a company in the near future (d) To examine the operational efficiency of a company 11. If the current assets and current liabilities are Rs 2,000 lakh and Rs 1,200 lakh, respectively, how much amount can be borrowed on a short-term basis without reducing current ratio below 1.5? (a) Rs 400 lakh (b) Rs 1,000 lakh

Financial Statement Analysis 353

12.

13.

14.

15.

16.

17.

(c) Rs 1,200 lakh (d) Rs 1,400 lakh Balance sheet of a company indicates that its current ratio is 1.5. Company’s net working capital is Rs 1 crore. The current assets would amount to (a) Rs 3 crore (b) Rs 2 crore (c) Rs 1.5 crore (d) Rs 0.5 crore Earning after interest and tax is Rs 20 crore, interest is Rs 4 crores, income tax is Rs 16 crores, then interest coverage ratio would be (a) 10 (b) 5 (c) 9 (d) 6 The financial statements of a business enterprise include (a) Balance sheet (b) Profit and loss account (c) Cash flow statement (d) All the above The most commonly used tools for financial analysis are (a) Horizontal analysis (b) Vertical analysis (c) Ratio analysis (d) All of the above Comparative statement is also known as (a) Dynamic analysis (b) Horizontal analysis (c) Vertical analysis (d) External analysis Common size statements are also known as (a) Dynamic analysis (b) Horizontal analysis (c) Vertical analysis (d) External analysis Using the following information answer Questions 18 and 19. Particulars

Rs

Particulars

Rs

Stock

50,000 Cash

30,000

Debtors

40,000 Creditor

60,000

Bills Receivables

10,000 Bank Overdraft

40,000

4,000 Bills Payable

4,000

Advance Tax

354 Financial Accounting

18. Current ratio is (a) 1.29:1 (b) 1.25:1 (c) 1:1 (d) 1.2:1 19. Liquid ratio is (a) 0.77:1 (b) 1:1 (c) 0.96:1 (d) 1.25:1 20. X Ltd has a current ratio of 3.5:1 and quick ratio of 2:1. If excess of current assets over quick assets represented by stock is Rs 24,000, then current assets and current liabilities are (a) Rs 56,000 and Rs 16,000 (b) Rs 32,000 and Rs 16,000 (c) Rs 24,000 and Rs 16,000 (d) Rs 40,000 and Rs 24,000 21. Current liabilities of a company are Rs 5,60,000, current ratio is 5:2 and quick ratio is 2:1. Find the value of the stock. (a) Rs 2,80,000 (b) Rs 3,60,000 (c) Rs 3,00,000 (d) Rs 5,60,000 22. The _________ ratios are primarily measures of return. (a) Liquidity (b) Activity (c) Debt (d) Profitability 23. The _________ of a business firm is measured by its ability to satisfy its shortterm obligations as they come due. (a) Activity (b) Liquidity (c) Debt (d) Profitability 24. The two basic measures of liquidity are (a) Inventory turnover and current ratio (b) Current ratio and liquid ratio (c) Gross profit margin and operating ratio (d) Current ratio and average collection period

Financial Statement Analysis 355

25. The _________ is useful in evaluating credit and collection policies. (a) Average payment period (b) Current ratio (c) Average collection period (d) Current asset turnover 26. The __________ ratio provide the information critical to the long-run operation of the firm. (a) Liquidity (b) Activity (c) Solvency (d) Profitability

THEORY QUESTIONS 1. What is financial statement analysis? Explain various techniques to conduct financial statement analysis. 2. What is ratio analysis? Explain its advantages and disadvantages. 3. What do you mean by liquidity ratios? How do they differ from solvency ratios? 4. Write a note on: (a) Profitability ratios (b) Turnover ratios (c) Return ratios 5. Which ratios are used by shareholders and potential investors? Explain them in detail. 6. What is working capital management? Also explain convergence cycle.

PRACTICAL PROBLEMS Level 1: Easy 1. The following figures have been extracted from the books of Elite. Net sales Rs 30,00,000; cost of goods sold Rs 20,00,000; net profit Rs 3,00,000; current assets Rs 6,00,000; stock Rs 2,00,000; current liabilities Rs 2,00,000; trade debtors Rs 1,00,000; paid up share capital Rs 5,00,000; debentures Rs 2,50,000 Calculate: (a) Gross profit ratio (b) Net profit ratio

356 Financial Accounting

(c) Debt-equity ratio (d) Current ratio (e) Quick ratio 2. From the following information, calculate gross profit ratio, stock turnover ratio and debtors turnover ratio. Sales Rs Cost of Goods Sold Rs Closing Stock Rs Gross Profit Rs Opening Stock Rs Debtors Rs 3. Calculate stock turnover ratio from the data given below: Stock at the beginning of the year Rs Stock at the end of the year Rs Carriage Rs Sales Rs Purchases Rs

6, 00,000 4,80,000 1,24,000 1,20,000 1,16,000 64,000 10,000 5,000 2,500 50,000 25,000

Level 2: Standard 4. From the following information, calculate (a) debt equity ratio (b) total assets to debt ratio (c) proprietary ratio. Equity Share Capital Preference Share Capital General Reserve Accumulated Profits Debentures Sundry Creditors Outstanding Expenses Preliminary Expenses to be Written-off

Rs Rs Rs Rs Rs Rs Rs Rs

75,000 25,000 50,000 30,000 75,000 40,000 10,000 5,000

5. You are able to collect the following information about a company for two years: 2012 Book Debts on 1 April

Rs 4,00,000

Book Debts on 30 March

2013 Rs 5,00,000 Rs 5,60,000

Stock in Trade on 31 March

Rs 6,00,000

Rs 9,00,000

Sales (At Gross Profit of 25%)

Rs 3,00,000

Rs 24,00,000

Calculate stock turnover ratio and debtor turnover ratio if in the year 2013 stock in trade increases by Rs 2,00,000.

Financial Statement Analysis 357

6. From the following information, calculate: (a) gross profit ratio, (b) inventory turnover ratio, (c) current ratio, (d) liquid ratio, (e) net profit ratio, (f) working capital ratio Sales Rs 25,20,000 Net Profit Rs 3,60,000 Cast of Sales Rs 19,20,000 Long-term Debt Rs 9,00,000 Creditors Rs 2,00,000 Average Inventory Rs 80,000 Current Assets Rs 7,60,000 Fixed Assets Rs 14,40,000 Current Liabilities Rs 6,00,000 Net Profit before Interest and Tax Rs 8,00,000 7. Using the following information, calculate: (a) solvency ratio, (b) profitability ratio, (c) turnover ratio March 2008

March 2009

12 Months

12 Months

58

117

9,471

12,318

26

25

9,555

12,460

309

1,102

Unsecured Loans

3,275

5,454

Total Debt

3,584

6,556

13,139

19,016

Gross Block

4,189

5,575

Less: Accumulated Depreciation

1,242

1,421

Net Block

2,946

4,154

Sources of Funds Equity Share Capital Reserves Revaluation Reserves Networth Secured Loans

Total Liabilities Application of Funds

Capital Work in Progress

699

1,041

Investments

6,922

8,264

Inventories

4,306

5,805

Sundry Debtors

7,365

10,056

Fixed Deposits

185

82

Cash and Bank Balance

780

693

3,861

7,199

Loans and Advances Total CA, Loans and Advances

16,496

23,835 (Contd.)

358 Financial Accounting Current Liabilities Provisions Total CL and Provisions Net Current Assets Miscellaneous Expenses

11,893 2,035 13,928 2,568 3

15,211 3,067 18,278 5,557 0

Total Assets Contingent Liabilities Book Value Market Price

13,139 1014 326 2000

19,016 1372 212 1649.3

Sales Turnover Operating Profit

25,280 3,239

34,250 4,142

3,856 502 3,354 3,155 982 2,173

5,755 770 4,985 4,658 1,176 3,482

PBDIT Interest PBDT PBT (Post Extra-ord Items) Tax Reported Net Profit

8. The following is the balance sheet of India Cements Ltd. Balance Sheet of India Cements Ltd Rs in crore March 2011

March 2010

Sources of Funds Total Share Capital

307.18

307.17

Equity Share Capital

307.18

307.17

0

0

Share Application Money Preference Share Capital Reserves Revaluation Reserves Networth

0

0

3,232.48

3,221.09

550.1

607.56

4,089.76

4,135.82

Secured Loans

1,177.86

866.64

Unsecured Loans

1,278.21

1,266.09

Total Debt

2,456.07

2,132.73

6,545.83

6,268.55

5,925.99

5,710.20

Total Liabilities Application of Funds Gross Block

(Contd.)

Financial Statement Analysis 359 Less: Accumulated Depreciation

2,091.51

1,791.59

Net Block

3,834.48

3,918.61

Capital Work in Progress

1,039.83

702.89

Investments

160.31

313.97

Inventories

517.73

468.19

254.4

485.26

Sundry Debtors Cash and Bank Balance

32.33

2.62

804.46

956.07

2,116.78

1,889.82

0.76

51.19

2,922.00

2,897.08

0

0

1,335.08

1,454.10

75.71

109.91

Total Current Assets Loans and Advances Fixed Deposits Total CA, Loans and Advances Deferred Credit Current Liabilities Provisions Total CL and Provisions

1,410.79

1,564.01

Net Current Assets

1,511.21

1,333.07

0

0

6,545.83

6,268.54

Miscellaneous Expenses Total Assets Contingent Liabilities

525.28

532.04

Book Value (Rs)

115.23

114.86

The following is the income statement of India Cements Ltd. Profit and Loss Account of India Cements Rs in Crore March 2011

March 2010

Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income

3,888.07

4,100.70

474.78

413.64

3,413.29

3,687.06

125.32

163.34

11.4

15.24

3,550.01

3,865.64

565.84

540.62

Expenditure Raw Materials Power and Fuel Cost

1,020.08

999.85 (Contd.)

360 Financial Accounting Employee Cost

265.44

276.81

56.07

47.18

1,022.47

953.3

144.48

127.07

0

0

3,074.38

2,944.83

350.31

757.47

PBDIT

475.63

920.81

Interest

141.72

142.64

PBDT

333.91

778.17

Depreciation

244.03

233.12

Other Written Off

0

13.74

Profit Before Tax

89.88

531.31

0

0

PBT (Post Extra-ordinary Items)

89.88

531.31

Tax

21.77

176.98

68.1

354.34

Total Value Addition

2,508.55

2,404.21

Preference Dividend

0

0

46.08

61.43

7.65

10.2

Shares in Issue (lakhs)

3,071.77

3,071.76

Earning Per Share (Rs)

2.22

11.54

15

20

115.23

114.86

Other Manufacturing Expenses Selling and Administration Expenses Miscellaneous Expenses Preoperative Exp Capitalised Total Expenses Operating Profit

Extra-ordinary Items

Reported Net Profit

Equity Dividend Corporate Dividend Tax Per Share Data (Annualised)

Equity Dividend (%) Book Value (Rs)

Calculate the following ratios: (a) Solvency ratio (b) Profitability ratio (c) Turnover ratio

Financial Statement Analysis 361

Level 3: Expert 9. Following Balance Sheet and Income Statement is made available to you. Balance Sheet Liabilities Equity Capital Reserves and Surplus Sundry Creditors Loan 11%

Assets

Rs

40,00,000 Fixed Assets (Net)

Rs

28,00,000

6,00,000 Preliminary Expenses

50,000

12,50,000 Cash

2,40,000

2,00,000 Debtors

18,60,000

Inventories

11,00,000

60,50,000

60,50,000

Other Information Sales

75,00,000

Less: Cost of Production of Goods Sold

46,00,000 29,00,000

Less: Selling and Administration

12,50,000

Net Operating Profit

16,50,000

The current industry average of a few important ratios is given below: Current Ratio ROI FA Turnover ROE Liquid Ratio Debtors Turnover Inventory Turnover GP Ratio Debt Equity Operating Ratio NP Ratio Asset Turnover Ratio

1.4 24 9 42 1.2 8 10.2 25 0.54 85 14 2.7

Calculate the above ratios, compare the same with the industry average and comment briefly. 10. Nasdaq-listed IT services company iGate on acquired India’s sixth-largest software exporter Patni Computers and announced a new go-to-market brand called ‘iGate Patni’. following information is made available to you regarding Patni Computer Systems Ltd.

362 Financial Accounting Patni Computer Systems Ltd December 2009

December 2010 Rs in Crores

Sources of Funds Equity Share Capital Reserves Networth Secured Loans Total Debt Total Application of Funds Gross Block Less: Accumulated Depreciation Net Block Capital Work in Progress Investments Inventories Sundry Debtors Cash and Bank Balance Loans and Advances Total CA, Loans and Advances Current Liabilities Provisions Total CL and Provisions Net Current Assets Total Contingent Liability Share Price Other Information Sales Turnover 1,541 PBIT 487 Interest 6 Profit Before Tax 413 Tax 24 Reported Net Profit 389

26 2,490 2,516 2 2 2,518

38 3,166 3,204 1 1 3,205

946 419 527 247 1,652 0 559 97 175 832 535 205 740 92 2,518 492.51 484

1,085 477 607 134 2,267 0 340 104 239 683 281 205 486 196 3,205 506.81 450

1,735 611 7 582 39 543

Compute the following ratios for both the years. Also state whether the change indicates positive performance for the company. Solution

December 2009

December 2010

Positive/ Negative

Current Ratio Quick Test (Contd.)

Financial Statement Analysis 363 EBIT (%) Net Profit Margin NPM (%) Return on Capital Employed/Return on Investment ROCE (%) Return on Total Assets ROTA (%) Return on Equity ROE (%) Earnings per Share EPS Asset Turnover Accounts Receivable Turnover Average Collection Period (days) Debt-Equity Ratio Price/Earnings PE Ratio

RESEARCH ASSIGNMENTS 1. Make a comparative study of the ratios discussed in the chapter by accessing the web site of two manufacturing companies of your choice. Your analysis must cover at least three latest years. 2. Download the latest financial statements of Reliance Industries Limited from their web site and make the profitability ratio analysis for the last five years.

INTERPRETING FINANCIAL REPORTS Financial Report Analysis—1 Following information has been extracted from the books of L & T. you are required to analyse solvency, liquidity and profitability of company using ratio analysis. Balance Sheet March 2008 12 months

March 2009 12 months

58

117

9,471

12,318

26

25

Sources of Funds Equity Share Capital Reserves Revaluation Reserves Net Worth

9,555

12,460 (Contd.)

364 Financial Accounting Secured Loans Unsecured Loans Total Debt

309

1,102

3,275

5,454

3,584

6,556

13,139

19,016

4,189

5,575

Less: Accumulated Depreciation

1,242

1,421

Net Block

2,946

4,154

699

1,041

6,922

8,264

Total Liabilities Application of Funds Gross Block

Capital Work in Progress Investments Inventories

4,306

5,805

Sundry Debtors

7,365

10,056

Fixed Deposits

185

82

Cash and Bank Balance

780

693

Loans and Advances

3,861

7,199

Total CA, Loans and Advances

16,496

23,835

Current Liabilities

11,893

15,211

2,035

3,067

13,928

18,278

2,568

5,557

3

0

13,139

19,016

1,014

1,372

326

212

2,000

1,649.3

25,280

34,250

Operating Profit

3,239

4,142

PBDIT

3,856

5,755

Interest

502

770

PBDT

3,354

4,985

PBT (Post Extra-ordinary Items)

3,155

4,658

982

1,176

2,173

3,482

PBIT

3,657

5,428

PBT

3,155

4,658

502

770

Provisions Total CL and Provisions Net Current Assets Miscellaneous Expenses Total Assets Contingent Liabilities Book Value Market Price Sales Turnover

Tax Reported Net Profit WN

INTEREST

Financial Statement Analysis 365

Financial Report Analysis—2 Using the following financial statements of Mahindra and Mahindra perform detailed financial statement analysis using the following techniques: ■ ■ ■

Horizontal analysis: Comparative statement and trend statement Vertical analysis: Common size statement Ratio analysis Profit and Loss Account Rs in crore March 2011

March 2010

March 2009

March 2008

March 2007

12 Months

12 Months

12 Months

12 Months

12 Months

25,569.55

20,323.63

14,668.13

12,894.94

11,231.99

2,092.02

1,807.30

1,587.05

1,584.57

1,310.65

23,477.53

18,516.33

13,081.08

11,310.37

9,921.34

563.13

285.09

132.65

575.96

531.17

Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income

202.23

23.69

-156.29

149.11

6.41

24,242.89

18,825.11

13,057.44

12,035.44

10,458.92

16,604.88

12,461.56

9,208.71

7,963.82

6,937.16

Expenditure Raw Materials Power and Fuel Cost

143.93

120.97

98.69

91.33

65.19

1,445.56

1,199.85

1,024.52

853.65

666.15

98.33

96.92

75.36

73.35

68.8

1,735.63

1,439.26

1,109.96

1,108.33

891.29

261.1

264.21

165.83

257.84

210.03

−50.87

−59.55

−42.83

−46.49

−47.1

Total Expenses

20,238.56

15,523.22

11,640.24

10,301.83

8,791.52

Operating Profit

3,441.20

3,016.80

1,284.55

1,157.65

1,136.23

PBDIT

4,004.33

3,301.89

1,417.20

1,733.61

1,667.40

Interest

70.86

156.85

134.12

87.59

19.8

3,933.47

3,145.04

1,283.08

1,646.02

1,647.60

413.86

370.78

291.51

238.66

209.59

Employee Cost Other Manufacturing Expenses Selling and Administration Expenses Miscellaneous Expenses Preoperative Exp Capitalised

PBDT Depreciation Other Written Off

0

0

0

0.59

0.33

Profit Before Tax

3,519.61

2,774.26

991.57

1,406.77

1,437.68

0

72.49

48.97

0

Extra-ordinary Items

–19.19 (Contd.)

366 Financial Accounting PBT (Post Extra-ordinary Items)

3,519.61

2,846.75

1,040.54

1,406.77

1,418.49

857.51

759

199.69

303.4

350.1

Reported Net Profit

2,662.10

2,087.75

836.78

1,103.37

1,068.39

Total Value Addition

3,633.68

3,061.66

2,431.53

2,338.01

1,854.37

Preference Dividend

0

0

0

0

0

706.08

549.52

278.83

282.61

282.23

96.56

74.23

33.23

38.48

42.5

Shares in Issue (Lakhs)

5,872.47

5,659.08

2,726.16

2,390.73

2,380.33

Earning per Share (Rs)

45.33

36.89

30.69

46.15

44.88

Tax

Equity Dividend Corporate Dividend Tax Per share Data (Annualised)

Equity Dividend (%) Book Value (Rs)

230

190

100

115

115

174.85

138.02

191.91

181.43

148.72

Balance Sheet March 2011

March 2010

March 2009

March 2008

March 2007

Sources of Funds Total Share Capital

293.62

282.95

272.62

239.07

238.03

Equity Share Capital

293.62

282.95

272.62

239.07

238.03

33.97

8.01

0

0

0

0

0

0

0

0

9,974.62

7,527.60

4,959.26

4,098.53

3,302.01

11.18

11.67

12.09

12.47

12.86

10,313.39

7,830.23

5,243.97

4,350.07

3,552.90

407.23

602.45

981

617.26

106.65

Share Application Money Preference Share Capital Reserves Revaluation Reserves Net Worth Secured Loans Unsecured Loans

1,998.06

2,277.70

3,071.76

1,969.80

1,529.35

Total Debt

2,405.29

2,880.15

4,052.76

2,587.06

1,636.00

12,718.68

10,710.38

9,296.73

6,937.13

5,188.90

Total Liabilities Application of Funds Gross Block

5,849.27

4,866.18

4,653.66

3,552.64

3,180.57

Less: Accumulated Depreciation

2,841.73

2,537.77

2,326.29

1,841.68

1,639.12

Net Block

3,007.54

2,328.41

2,327.37

1,710.96

1,541.45

Capital Work in Progress

1,364.31

1,374.31

886.96

649.94

329.72

Investments

9,325.29

6,398.02

5,786.41

4,215.06

2,237.46

Inventories

1,694.21

1,188.78

1,060.67

1,084.11

878.48

Sundry Debtors

1,354.72

1,258.08

1,043.65

1,004.88

700.89 (Contd.)

Financial Statement Analysis 367 Cash and Bank Balance

447.62

475.17

635.61

310.58

415.89

Total Current Assets

3,496.55

2,922.03

2,739.93

2,399.57

1,995.26

Loans and Advances

2,653.52

2,034.47

1,402.45

866.19

1,011.50

167.02

1,268.06

938.82

550.65

910.18

6,317.09

6,224.56

5,081.20

3,816.41

3,916.94

0

0

0

0

0

Fixed Deposits Total CA, Loans and Advances Deferred Credit Current Liabilities

5,289.67

3,822.50

3,520.20

2,525.31

2,138.77

Provisions

2,005.88

1,796.54

1,277.56

943.46

715.43

Total CL and Provisions

7,295.55

5,619.04

4,797.76

3,468.77

2,854.20

Net Current Assets

−978.46

605.52

283.44

347.64

1,062.74

Miscellaneous Expenses Total Assets Contingent Liabilities Book Value (Rs)

0

4.12

12.55

13.53

17.55

12,718.68

10,710.38

9,296.73

6,937.13

5,188.92

2,632.10

2,307.70

1,220.39

985.35

1,008.27

174.85

138.02

191.91

181.43

148.72

BUSINESS CASES Case 1 Hindustan Unilever Limited Hindustan Unilever Limited (HUL) is India’s largest Fast Moving Consumer Goods Company; its journey began 75 years ago, in 1933, when the Company was first incorporated. HUL was formed in 1933 as Lever Brothers India Limited and came into being in 1956 as Hindustan Lever Limited through a merger of Lever Brothers, Hindustan Vanaspati Mfg. Co. Ltd. and United Traders Ltd. It is headquartered in Mumbai, India and has an employee strength of over 15,000 employees and contributes to indirect employment of over 52,000 people. The Company was renamed in June 2007 as “Hindustan Unilever Limited”. The Company affects the lives of two out of three Indians with over 20 distinct categories in Home & Personal Care Products and Foods & Beverages. It is also one of the country’s largest exporters. The Company has a distribution channel of 6.3 million outlets and owns 35 major Indian brands. HUL’s brands like Lifebuoy, Lux, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Sunsilk, Clinic, Pepsodent, Close-up, Lakme, Brooke Bond, Kissan, Knorr, Annapurna, Kwality Wall’s are household names across the country and span many categories soaps, detergents, personal products, tea, coffee, branded staples, ice cream and culinary products. They are manufactured in over 40 factories across India.

368 Financial Accounting

Sixteen of HUL’s brands featured in the AC Nielsen Brand Equity list of 100 Most Trusted Brands Annual Survey (2008). According to Brand Equity, HUL has the largest number of brands in the Most Trusted Brands List. It has consistently had the largest number of brands in the Top 50, and in the Top 10 (with 4 brands).

Industry and Economic Conditions The FMCG sector companies have shown strong sales growth despite high inflation in general and higher food inflation in particular in the quarter ended March 2011 (Q4 FY11). The aggregate standalone net sales of the 9 BSE FMCG Index companies grew by 20% for the quarter ended March 2011. The growth was mostly volume driven with small price hike, as most of the players were cautious on raising prices to pass on the input cost hike due to competition scenario. Owing to this, the gross margins have been under pressure, as a result the companies had reduced their ad spends to maintain operating margins. The raw material cost grew by 27.8 per cent, due to rise in the price of palm oil, tea and coffee. Although the companies raised their prices, they are unable to pass on the entire burden of the rise in input price to the end users. Besides this, rising power costs, and advertising costs, saw the operating margin contract from 170 basis points to 16.2 per cent in the previous quarter. The robust growth in consumer demand for beauty and personal care products and the low penetration of most products in rural areas spurred companies to aggressively expand their product portfolios, distribution networks and marketing activities. Also the sector has seen a large number of new players, both domestic and international, entering the market and existing players expanding their brand and product ranges, leading to intense competition. Despite tough competition from major players, Reckitt Benckiser and Dabur India increased their market share by benefitting from their association with niche brands like Dettol and herbal products. The FMCG industry as a whole saw low double digit volume growth in Q4 FY11. Meanwhile, input cost pressure will be there despite fall in palm and crude oil prices. Prices of key inputs including edible oils, linear alkyl benzene, packaging, etc, have been easing in the recent times, which can facilitate savings in costs, and boost margins. Thus, robust revenue growth of past quarters is unlikely to continue if input costs continue to rise. And rising of margin pressure across companies looks a more probable scenario. In this context, a good South West Monsoons 2011 can not only bring down the cost of inputs, but also boost rural income, and facilitate good volume growth and recovery in pricing power. As a result, the industry can restore strong volume growth, and improve its margins too. Although the industry’s sales are expected to grow by 11.8 per cent backed by higher volumes, its total expenses corresponding to sales are expected to increase by a faster 12 per cent as compared to growth in sales.

Financial Statement Analysis 369

Performance of HUL While HUL controlled over one-third of beauty and personal care sales in India, its market share recently started slipping. Domestic players like Dabur India Ltd and Emami Ltd have benefitted from their focus on developing products with traditional and ayurvedic ingredients and expanding their distribution networks in rural India. HUL’s drop in market share towards the end of the period resulted in the company undertaking several measures to consolidate its market position, including massive expenditure on mass media advertisements, rationalisation of non performing brands and new product launches. Harish Manwani, Chairman commented: “Our performance has been strong and consistent through the year, driven by our strategy of growing the core and leading market development of the segments and categories of the future. Input costs remain high with the added challenge of volatility, while the competitive environment has further intensified. In this context, we will continue to focus on the best value for our consumers and customers through innovations and strong cost efficiency programmes. The business is being managed even more dynamically to deliver long-term competitive, profitable and sustainable growth.” Being the largest company by market capitalisation in the sectoral index, HUL recorded a 12.8% increase in its share price. HUL has the highest credit quality rating of AAA. These ratings indicate the lowest expectation of credit risk. They are assigned only in case of exceptionally strong capacity for timely payment of financial commitments. This capacity is unlikely to be adversely affected by foreseeable events. Mr Murlidhar, working as a financial analyst at HUL needs to provide a detailed analysis about the financial position of the company and also its future outlook. The stakeholders of the company need to be able to quantify the various aspects of the business as well as diagnose the financial health of their company so that they can make decisions about investments or projects that the company is considering to take.

Key Data Income Statement Year

March 2011

March 2010

March 2009

20,285.44

18,198.15

21,615.31

904.43

696.47

1,410.18

INCOME : Sales Turnover Excise Duty

(Contd.)

370 Financial Accounting Net Sales Other Income Stock Adjustments Total Income

19,381.01

17,501.68

20,205.13

826.86

666.42

812.94

290.53

22.72

421.56

20,498.40

18,190.82

21,439.63

8,682.29

7,544.00

9,542.44

EXPENDITURE : Raw Materials Power and Fuel Cost

274.74

244.34

301.37

Employee Cost

947.86

1,094.75

1,205.84

Other Manufacturing Expenses

2,115.12

1,728.97

2,130.93

Selling and Administration Expenses

4,625.72

3,898.69

3,859.62

694.59

669.55

1,178.29

0

0

0

17,340.32

15,180.30

18,218.49

3,158.08

3,010.52

3,221.14

Miscellaneous Expenses Less: Pre-operative Expenses Capitalised Total Expenditure Operating Profit Interest

0.24

6.98

25.32

Gross Profit

3157.84

3003.54

3195.82

Depreciation

220.83

184.03

195.3

2,937.01

2,819.51

3,000.52

591.88

611.46

509.46

0

0

37.06

39.16

6.02

-42.45

Reported Net Profit

2,305.97

2,202.03

2,496.45

Extraordinary Items

210.09

96.09

16.45

Adjusted Net Profit

2,095.88

2,105.94

2,480.00

0

-55.33

0

802.19

531.66

197.5

0

0

0

Appropriations

1,872.56

1,876.17

2,162.29

P & L Balance carried down

1,235.60

802.19

531.66

Dividend

1,410.60

1,417.94

1,634.51

0

0

0

Equity Dividend %

650

650

750

Earnings per Share—Unit Curr

9.61

9

8.14

12.19

11.84

9.45

Profit Before Tax Tax Fringe Benefit tax Deferred Tax

Adjusted below Net Profit P & L Balance brought forward Statutory Appropriations

Preference Dividend

Earnings per Share(Adj—Unit Curr Book Value-Unit Curr

Financial Statement Analysis 371

Balance Sheet Year

March 2011

March 2010

March 2009

215.95

218.17

217.99

2,417.97

2,365.35

1,843.52

0

0

0

SOURCES OF FUNDS : Share Capital Reserves Total Equity Share Warrants Equity Application Money

0

0

0

2,633.92

2,583.52

2,061.51

Secured Loans

0

0

144.65

Unsecured Loans

0

0

277.29

Total Shareholders Funds

Total Debt

0

0

421.94

2,633.92

2,583.52

2,483.45

Gross Block

3,759.62

3,581.96

2,881.73

Less: Accumulated Depreciation

1,590.46

1,419.85

1,274.95

0

0

0

2,169.16

2,162.11

1,606.78

0

0

0

Total Liabilities APPLICATION OF FUNDS :

Less: Impairment of Assets Net Block Lease Adjustment Capital Work in Progress Investments

299.08

273.96

472.06

1,260.68

1,264.08

332.62

Current Assets, Loans & Advances Inventories

2,811.26

2,179.93

2,528.86

Sundry Debtors

943.2

671.6

536.89

Cash and Bank

1,640.01

1,892.21

1,777.35

Loans and Advances

700.72

624.02

757.86

Total Current Assets

6,095.19

5,367.76

5,600.96

Current Liabilities

6,074.87

5,291.66

4,255.82

Provisions

1,324.98

1,441.55

1,527.98

7,399.85

6,733.21

5,783.80

−1,304.66

-1,365.45

−182.84

Less: Current Liabilities and Provisions

Total Current Liabilities Net Current Assets Miscellaneous Expenses not Written off

0

0

0

399

451.13

439.09

Deferred Tax Liability

189.34

202.31

184.26

Net Deferred Tax

209.66

248.82

254.83

2,633.92

2,583.52

2,483.45

663

468.49

473.72

Deferred Tax Assets

Total Assets Contingent Liabilities

Investments

Learning Objectives After studying this chapter, you will be able to ❖

Define investments

❖

Know financial assets

❖

Understand subsidiaries

❖

Learn consolidated financial statements

❖

Know business combinations

❖

Carry out accounting for investments

11

Investments 373

LET US SET THE STAGE . . . On 31 January, 2007, Tata Steel Limited (Tata Steel), one of the leading steel producers in India, acquired the Anglo Dutch steel producer Corus Group Plc (Corus) for US$ 12.11 billion (€8.5 billion). The process of acquisition concluded only after nine rounds of bidding against the other bidder for Corus—the Brazil based Companhia Siderurgica Nacional (CSN). This acquisition was the biggest overseas acquisition by an Indian company. Tata Steel emerged as the fifth largest steel producer in the world after the acquisition. The acquisition gave Tata Steel access to Corus’ strong distribution network in Europe. Corus’ expertise in making the grades of steel used in automobiles and in aerospace could be used to boost Tata Steel’s supplies to the Indian automobile market. Corus in turn was expected to benefit from Tata Steel’s expertise in low cost manufacturing of steel. However, some financial experts claimed that the price paid by Tata Steel (608 pence per share of Corus) for the acquisition was too high. Corus had been facing tough times and had reported a substantial decline in profit after tax in the year 2006. Analysts asked whether the deal would really bring any substantial benefits to Tata Steel. Moreover, since the acquisition was done through an all cash deal, analysts said that the acquisition would be a financial burden for Tata Steel. Tata Steel outbid the Brazilian steelmaker Companhia Siderurgica Nacional’s (CSN) final offer of 603 pence per share by offering 608 pence per share to acquire Corus. Tata Steel had first offered to pay 455 pence per share of Corus, to close the deal at US$ 7.6 billion on 17th October, 2006. CSN then offered 475 pence per share of Corus on 17th November, 2006. Finally, an auction was initiated on 31st January, 2007, and after nine rounds of bidding, Tata Steel could finally clinch the deal with its final bid 608 pence per share, almost 34% higher than the first bid of 455 pence per share of Corus. Corus was four times larger than Tata Steel in terms of size and the largest steel producer in the UK. The deal, which creates the world’s fifth-largest steelmaker, such huge investments play an important role in the development of entire economy. In this chapter, we will understand the various forms of investments made by companies.

INTRODUCTION Objective 1 Investments refer to money invested outside To define investments normal business. They are usually securities of one company held by another company in order to generate some return. Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing

374 Financial Accounting

enterprise. Assets held as stock-in-trade are not “investments”. A “current investment” is an investment that is by its nature readily realisable and is intended to be held for not more than one year from the date on which such investment is made. A long-term investment is an investment other than a current investment. An investment property is an investment in land or buildings that are not intended to be occupied substantially for use by, or in the operations of, the investing enterprise (AS-13).

FINANCIAL INSTRUMENT, ASSETS AND LIABILITIES The following are the important definitions as per the Ind AS-32.

Objective 2 To know financial assets

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A financial asset is any asset that is: (a) cash; (b) an equity instrument of another entity; (c) a contractual right: (i) to receive cash or another financial asset from another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or (d) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or (ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments. A financial liability is any liability that is: (a) a contractual obligation: (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or (b) a contract that will or may be settled in the entity’s own equity instruments and is: (i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or

Investments 375

(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non derivative equity instruments. Apart from the aforesaid, the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency. Also for these purposes the entity’s own equity instruments do not include puttable financial instruments. An “equity instrument” is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. A “puttable instrument” is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. The following are the important definitions as per the Ind AS-39: A financial asset or financial liability is classified as held for trading if: (i) it is acquired or incurred principally for the purpose of selling or repurchasing it in the near term; (ii) on initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or (iii) it is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument). “Held-to-maturity investments” are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity. Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market other than: (a) those that the entity intends to sell immediately or in the near term, which shall be classified as held for trading, and those that the entity upon initial recognition designates as at fair value through profit or loss; (b) those that the entity upon initial recognition designates as available for sale; or (c) those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which shall be classified as available for sale.

376 Financial Accounting

An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a mutual fund or a similar fund) is not a loan or receivable. “Available-for-sale financial assets” are those non-derivative financial assets that are designated as available for sale or are not classified as: (a) loans and receivables; (b) held-to-maturity investments; or (c) financial assets at fair value through profit or loss. A “financial guarantee contract” is a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. A “hedged item” is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that: (a) exposes the entity to risk of changes in fair value or future cash flows; and (b) is designated as being hedged. A “hedging instrument” is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. “Fair value” is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. Under appropriate circumstances, market value or net realisable value provides an evidence of fair value.

JOINT VENTURES A “joint venture” is a business agreement of cooperation of two or more individuals or businesses in which each agrees to share profit, loss and control in a specific enterprise. In a joint venture, parties agree to develop a new entity and new assets by contributing equity. They exercise joint-control over the enterprise and consequently share revenues, expenses and assets. It is a strategic alliance where two or more parties, usually businesses, form a partnership to share markets, intellectual property, assets, knowledge, and, profit. However, there is no transfer of ownership. In some cases, a large company can decide to form a joint venture with a smaller business in order to quickly acquire critical intellectual property, technology, or resources otherwise hard to obtain, even with plenty of cash at their disposal. On the other hand, when two or more persons come together to form a temporary partnership for the purpose of carrying out a particular project, such partnership can also be called a joint venture where the parties are co-venturers (see Exhibits 11.1 and 11.2).

Investments 377

EXHIBIT 11.1

Kobe Steel Finalises Joint Venture Company with SAIL

KOLKATA: Kobe Steel has finalised a 50:50 joint venture company with the Steel Authority of India Limited (SAIL) to set up a commercial plant for making iron ore nuggets. The project will come up at Durgapur in West Bengal and will use the Japanese steel maker’s patented iron making technology. The deal coincides with the Japanese PM’s visit to India. The two partners have finalized all the commercial terms and conditions for the venture and are willing to invest Rs 1,500 crore in the project which will be operational in 2014. The plant will have a capacity to produce 0.5 million tonnes of iron nuggets per year. This will be only the second time that such a plant is being set up anywhere in the world. While the new plant will come up at the Alloy Steels Plant in Durgapur, Kobe Steel had earlier set up a commercial project using ITmk3 at Minnesota in the US. The new iron making technology, ITmk3, will be used to make iron ore nuggets which can be used in electric arc furnaces. The new project is likely to consist of one ITmk3 iron making plant and associated facilities. “We have applied for environmental clearances, following which we would start construction on the plant in another 7–8 months. About 80% of the iron ore required for the plant will be fresh arising out of SAIL’s mines while the remaining 20% will be sourced from dumps, “a top government source close to the developments told ET. ITmk3 technology is the latest generation iron making technology where high quality iron nuggets are produced by using iron ore fines and non-coking coal and is environment friendly. Conventional blast furnace route requires iron ore lumps, sinter and coking coal to produce pig iron. “Kobe Steel and SAIL will have the right to utilise the iron nuggets produced at the Durgapur plant in proportion to their equity share in the joint venture for their own use,” according to a Kobe Steel statement on its website. The proposed joint venture company SAIL-Kobe Iron India Pvt Ltd will be based in Delhi. For SAIL, this is a significant leap in iron making technology and is part of its plan to forge closer ties with leading steel makers. The two companies had earlier signed an MoU in March 2010 and has been jointly working on a preliminary study to utilize the ITmk3 process. The Economic Times, 29 December 2011

EXHIBIT 11.2

Joint Ventures of Ashok Layland Ltd as on December 2011

To avail the advantages of diversification and reap the benefits of entering profitable adjacencies, we have forged a series of 50:50 Joint Ventures (JV) with various global leaders.

To fill a significant gap in our range, we have joined hands with Nissan Motor Company, Japan, to develop and manufacture Light Commercial Vehicles, under both the Ashok Leyland and Nissan brands, in the 2.5 to 7.5 tonnes segment. The JV resides in three separate companies for Vehicle Manufacturing, Power Train Manufacturing and Technology Development. The first offering from this stable, the 2.5 tonne DOST, has just hit the Indian market.

378 Financial Accounting

With our JV with John Deere, USA, we aim to seize the opportunities of the robustly growing construction equipment sector with products like Backhoe Loaders, Four-wheel-drive loaders, Skid Steers and Excavators under both the Ashok Leyland and John Deere brands.

This is a JV with Continental AG, Germany to design, develop and adapt infotronics products and services for automotive customers and meet the requirements of our vehicles and, at the same time, avail of opportunities with other vehicle manufactures in India and overseas.

Ashley Alteams is a JV with the Alteams Group, Finland, and is in the business of producing High Pressure Die Casting (HPDC) aluminum components pre-dominantly for telecommunications and automotive sectors.

Investments 379

SUBSIDIARIES AND ASSOCIATES Objective 3 A “subsidiary company” is a company that is To understand subsidiaries completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary’s shares. Exhibit 11.3 lists out the Subsidiaries and Associates of Reliance Industries Ltd. EXHIBIT 11.3 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

Subsidiaries and Associates of Reliance Industries Ltd

Reliance Netherlands BV Reliance Retail Limited Reliance Jamnagar Infrastructure Limited Reliance Haryana SEZ Limited Reliance Industrial Investments and Holdings Limited Reliance Ventures Limited Reliance Strategic Investments Limited Reliance Exploration and Production DMCC Reliance Industries (Middle East) DMCC Reliance Commercial Associates Limited RIL (Australia) Pty Ltd Recron (Malaysia) Sdn Bhd Gulf African Petroleum Corporation (Mauritius) GAPCO Tanzania Limited GAPOil Tanzania Limited GAPCO Kenya Limited Transenergy Kenya Limited GAPCO Uganda Limited GAPCO Rwanda Sarl GAPOil (Zanzibar) Limited Reliance Fresh Limited Retail Concepts and Services (India) Limited Reliance Retail Insurance Broking Limited Reliance Dairy Foods Limited Reliance Retail Finance Limited RESQ Limited Reliance Digital Retail Limited Reliance Financial Distribution and Advisory Services Limited Reliance Hypermart Limited Reliance Retail Travel & Forex Services Limited

31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62.

Reliance Brands Limited Reliance Wellness Limited Reliance Footprint Limited Reliance Integrated Agri Solutions Limited Reliance Trends Limited Reliance Lifestyle Holdings Limited Reliance Universal Ventures Limited Reliance Autozone Limited Strategic Manpower Solutions Limited Reliance Gems and Jewels Limited Delight Proteins Limited Reliance F&B Services Limited Reliance Agri Products Distribution Limited Reliance Leisures Limited Reliance Retail Securities and Broking Company Limited Reliance Home Store Limited Reliance Trade Services Centre Limited Reliance Food Processing Solutions Limited Reliance Supply Chain Solutions Limited Reliance Loyalty and Analytics Limited Reliance Digital Media Limited Reliance-Grand Optical Private Limited Reliance Vantage Retail Limited Reliance People Serve Limited Reliance Infrastructure Management Services Limited Reliance Petroinvestments Limited Reliance Universal Commercial Limited Reliance Global Commercial Limited Wave Land Developers Limited Reliance Global Business BV Reliance Global Energy Services Limited Reliance Gas Corporation Limited (Contd.)

380 Financial Accounting 63. Reliance Global Energy Services (Singapore) Pte Ltd 64. Reliance Polymers (India) Limited 65. Reliance Polyolefins Limited 66. Reliance Aromatics & Petrochemicals Private Limited 67. Reliance Energy and Project Development Private Limited 68. Reliance Chemicals Limited 69. Reliance Universal Enterprises Limited 70. Reliance One Enterprises Limited 71. Reliance Personal Electronics Limited 72. International Oil Trading Limited 73. Reliance Review Cinema Limited 74. Reliance Replay Gaming Limited 75. Reliance Nutritional Food Processors Limited 76. Reliance Commercial Land & Infrastructure Limited 77. Reliance Eminent Trading & Commercial Private Limited 78. Reliance Progressive Traders Private Limited 79. Reliance Prolific Traders Private Limited 80. Reliance Universal Traders Private Limited 81. Reliance Prolific Commercial Private Limited 82. Reliance Comtrade Private Limited 83. Reliance Ambit Trade Private Limited 84. Reliance Corporate IT Park Limited 85. Reliance Petro Marketing Limited 86. LPG Infrastructure (India) Limited 87. RIL USA Inc. 88. Reliance Corporate Centre Limited 89. Reliance Corporate Services Limited 90. Reliance Convention and Exhibition Centre Limited

91. 92. 93. 94. 95. 96. 97. 98. 99. 100. 101. 102. 103. 104. 105. 106. 107. 108. 109. 110. 111. 112. 113. 114. 115. 116. 117. 118. 119. 120. 121.

Central Park Enterprises DMCC Reliance International BV Reliance Oil and Gas Mauritius Limited Reliance Exploration and Production Mauritius Limited Reliance Holding Cooperatief UA Reliance Holding Netherlands BV Reliance International Gas BV Reliance Exploration and Production BV Reliance Exploration and Production Limited Reliance Holding USA, Inc Reliance Marcellus LLC Reliance Strategic (Mauritius) Limited Indiawin Sports Private Limited Reliance Eagleford Midstream LLC Reliance Eagleford Upstream LLC Reliance Eagleford Upstream GP LLC Reliance Eagleford Upstream Holding LP Infotel Broadband Services Limited Mark Project Services Private Limited Reliance Energy Generation and Distribution Limited Reliance Marcellus II LLC Reliance Industries Investment and Holding Private Limited Reliance Security Solutions Limited Reliance Office Solutions Private Limited GenNext Innovation Ventures Private Limited Reliance Home Products Limited Reliance Style Fashion India Limited Reliance Styles India Limited Infotel Telecom Limited Rancore Technologies Private Limited Reliance Bio-fuel Holding BV

Major Associate: Reliance Industrial Infrastructure Limited

Associate Company An “associate company” (or associate) is a company in which another company owns a significant portion of voting shares, usually 20–50%. In this case, an owner does not consolidate the associate’s financial statements.

Investments 381

Exhibit 11.4 shows Associate Companies of Ashok Layland Ltd as on December 2011 while Exhibit 11.5 discusses the controversy over the definition of “Associate Company”. EXHIBIT 11.4

Associate Companies of Ashok Leyland Ltd as on December 2011

Albonair GmbH Albonair GmbH was established with a vision of being a complete solution provider for reducing automotive emissions and has, in the short period since inception, developed the complete solution for Selective Catalytic Reduction (SCR) and Urea Dosing System (UDS) conforming to Euro 4, 5 and 6 emission standards for commercial as well as passenger vehicles.

Ashok Leyland Project Services Ltd Ashok Leyland Project Services Ltd. assists the investment entities of the Group to identify and implement successfully projects and provides professional services to international companies interested in projects in India. Specialised services include undertaking pre-investment, project development—feasibility studies, appraisals, development of joint ventures, company formation and other professional services that are designated to deliver project opportunities from concept to commissioning.

Automotive Components and Coaches Ltd (ACCL) Automotive Components and Coaches Ltd (ACCL) promoted by Ashok Leyland and the Tamil Nadu Industrial Development Corporation has two divisions: ACCL and PL Haulwel Trailers that offer a wide variety of well-engineered after chassis solutions. ACCL makes tippers, bus bodies, front-end structures (FES), tankers, aluminum containers, OB vans, energy vans while PL Haulwel Trailers (PLHT—a Division of ACCL) manufactures Fifth Wheel Couplers and Hoists, adjustable couplers, double oscillating couplers and fifth wheel tip hoists, Semi-Trailers, Tip Trailers up to 35T capacity Flat beds (Skeleton /platforms).

382 Financial Accounting Defiance Technologies Defiance stands for the global capability to deliver end-to-end services in design engineering, prototyping, testing and validation through Defiance Technologies, sophisticated, high-end testing capabilities through Defiance Testing & Engineering (DTE), Detroit and technology-enabled manufacturing and enterprise solutions through Defiance-Tech.

Hinduja Foundries Ltd (HFL) Hinduja Foundries Ltd (HFL): Established in 1959, Hinduja Foundries is India’s largest automotive jobbing foundry with production capacity of 1,25,000 MT in Grey Iron and 3,000 MT in aluminum gravity die castings per annum. Certified to ISO 9001 and QS 9000 Quality Systems, HFL is also the largest manufacturers of Cylinder Block and Cylinder Head Castings in India.

Hinduja Leyland Finance Incorporated in November 2008, Hinduja Leyland Finance (HLF), jointly promoted by Ashok Leyland and the Hinduja Group, was formed to provide finance for the purchase of vehicles or equipment. HLF received the NBFC License in March 2010 and have started operations with an equity of Rs 225 crores. The strength of the Company lies in its core competence in fund-based lending for a diversified portfolio of commercial vehicles, cars, construction equipment, tractors and used vehicles and its network that covers 19 states with over 275 locations.

Lanka Ashok Leyland (LAL) Lanka Ashok Leyland (LAL): Established in 1982, this is a venture with the Government of Sri Lanka in which we have 28% equity holding. We supply chassis in both completely built-up and knocked down conditions to LAL, which, in turn, assembles the chassis and builds bodies for the local market. LAL has also established a fully owned subsidiary called Lanka Ashok Leyland Services, which takes care of marketing and after-sales service including sale of spares.

TVS IRIZAR TVS IRIZAR: To address the growing demand for luxury coaches in the country, this is a joint venture between Ashok Leyland, TVS & Sons Ltd and IRIZAR, the internationally reputed bus body builder from Spain. As a preferred supplier, IRIZAR-TVS provides a platform to introduce new bus body concepts and designs and fully built buses of international luxury to India.

Investments 383

EXHIBIT 11.5

Discussion on Associate Company

The 2G spectrum scandal involves illegal undercharging of mobile telephone companies for frequency allocation licenses leading to the shortfall between the revenue collected and the realistic value which is estimated to be Rs. 176,645 crore as valued by Comptroller and Auditor General of India. The case has highly placed accused, including former telecom minister, A Raja, and DMK MP Kanimozhi. The definition of “associate company” has become a centre of controversy in the case due to the differences of opinion between the Central Bureau of Investigation and the Ministries of Law and Corporate Affairs. The sustenance of charges against Swan Telecom promoter Shahid Usman Balwa and three executives of the Reliance ADA Group will depend on the interpretation of “associate company” which the courts accept.

CONSOLIDATED FINANCIAL STATEMENT “Consolidated financial statements” are the financial statements of a parent and all its subsidiaries (Group) presented are those of a single economic entity. Separate financial statements are those presented by a parent, an investor in an associate or a venturer in a jointly controlled entity, in which the investments are accounted for on the basis of the direct equity interest rather than on the basis of the reported results and net assets of the investees (Ind AS 27). In preparing consolidated financial statements, an entity combines the financial statements of the parent and its subsidiaries line by line by adding together like items of assets, liabilities, equity, income and expenses. In order that the consolidated financial statements present financial information about the group as that of a single economic entity, the following steps are then taken: (a) The carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary are eliminated; (b) Non-controlling interests in the profit or loss of consolidated subsidiaries for the reporting period are identified; and (c) Non-controlling interests in the net assets of consolidated subsidiaries are identified separately from the parent’s ownership interests in them. Noncontrolling interests in the net assets consist of: (i) The amount of those non-controlling interests at the date of the original combination calculated in accordance with Ind AS 103 Business Combinations and (ii) The non-controlling interests’ share of changes in equity since the date of the combination. Intragroup balances and transactions, including income, expenses and dividends, are eliminated in full. Profits and losses resulting from

Objective 4 To learn about consolidated financial statements

384 Financial Accounting

intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full. The financial statements of the parent and its subsidiaries used in the preparation of the consolidated financial statements shall be prepared as of the same date. When the end of the reporting period of the parent is different from that of a subsidiary, the subsidiary prepares, for consolidation purposes, additional financial statements as of the same date as the financial statements of the parent unless it is impracticable to do so. Consolidated financial statements are prepared using uniform accounting policies for like transactions and other events in similar circumstances. TCS has 54 subsidiaries. Table 11.1 lists out the standalone (unconsolidated) and consolidated (along with subsidiaries) financial results of TCS Ltd. TABLE 11.1

Unconsolidated and Consolidated Financial Results of TCS Ltd (Rs crores) Unconsolidated 2010–2011

(i) Income from Sales and Services (ii) Other Income (net) (iii) Total Income (iv) Operating Expenditure (v) Profit before Interest, Depreciation and Tax (vi) Interest (vii) Depreciation and Amortisation (viii) Profit before Taxes (ix) Provision for Taxes (x) Minority Interest and Share of Loss of Associates (xi) Net Profit for the Year (xii) Balance Brought Forward from Previous Year (xiii) Amount Available for Appropriation Appropriations (a) Interim Dividends on Equity Shares (b) Proposed Final Dividend on Equity Shares (c) Proposed Special Dividend on Equity Shares (d) Proposed Total Dividend on Equity Shares (e) Proposed Dividend on Redeemable Preferences (f) Tax on Dividends (g) General Reserve (h) Balance carried to Balance Sheet

Consolidated

2009–2010 2010–2011 2009–2010

29,275.41 494.73 29,770.14 20,511.88 9,258.26 20.01 537.82 8,700.43 1,130.44 — 7,569.99 10,458.13 18,028.12

23,044.45 177.60 23,222.05 16,372.78 6,849.27 9.54 469.35 6,370.38 751.87 — 5,618.51 9,990.41 15,608.92

37,324.51 604.00 37,928.51 24,146.15 11,782.36 26.48 735.26 11,020.62 1,830.83 121.75 9,068.04 13,604.84 22,672.88

30,028.92 272.07 30,300.99 21,334.37 8,966.62 16.10 660.89 8,289.63 1,196.97 92.02 7,000.64 11,835.03 18,835.67

1,174.32 1,565.78 — 2,740.10 11.00 450.82 757.00 14,069.20

1,174.32 782.89 1,957.22 3,914.43 17.00 657.51 561.85 10,458.13

1,174.32 1,565.78 — 2,740.10 11.00 459.15 827.58 18,635.05

1,174.32 782.89 1,957.22 3,914.43 17.00 663.18 636.22 13,604.84

(1 crore = 10 million) Source: Annual Report TCS Ltd 2010-11

Investments 385

BUSINESS COMBINATIONS Objective 5 A “business combination” is a transaction or To learn about business event in which an acquirer obtains control of combinations one or more businesses. A business is defined as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return directly to investors or other owners, members or participants. (IFRS 3) It takes place in the form of merger or acquisition which is defined as under: Merger A Merger may be defined as the combination of two or more independent business corporations into a single enterprise, usually involving the absorption of one or more firms by a dominant firm. For example, Reliance Power (R-Power) merged with sister firm Reliance Natural Resources (RNRL) Acquisition may be defined as an act of one enterprise of acquiring, directly or indirectly of shares, voting rights, assets or control over the management, of another enterprise. For example, Tata acquired Corus. As per the Ind AS 103 Business Combinations, acquisition method is used to record such transactions. Applying the acquisition method requires: (a) identifying the acquirer; (b) determining the acquisition date; (c) recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; and (d) recognising and measuring goodwill or a gain from a bargain purchase. Mergers and acquisitions are growing these days.The Indian companies are now aggressively looking at North American and European markets to spread their wings and become the global players. The Indian IT and ITES companies already have a strong presence in foreign markets, however, other sectors are also now growing rapidly. Table 11.2 shows some of the major acquisitions by the Indian companies outside India since 2000. TABLE 11.2

Major Acquisitions by the Indian Companies Outside India since 2000

Acquirer

Target Company

Country Targeted

Tata Steel

Corus Group plc

UK

Hindalco

Novelis

Canada

Videocon

Daewoo Electronics Corp

Korea

Deal Value ($ ml) 12,000

Industry Steel

5,982

Aluminium

729

Electronics (Contd.)

386 Financial Accounting Dr Reddy’s Labs

Betapharm

Germany

597

Pharmaceutical

Suzlon Energy

Hansen Group

Belgium

565

Energy

HPCL

Kenya Petroleum Refinery Ltd

Kenya

500

Oil and Gas

Ranbaxy Labs

Terapia SA

Romania

324

Pharmaceutical

Tata Steel

Natsteel

Singapore

293

Steel

Videocon

Thomson SA

France

290

Electronics

VSNL

Teleglobe

Canada

239

Telecom

ACCOUNTING FOR INVESTMENTS Objective 6 Present financial statements classify fixed To carry out accounting for assets, investments and current assets into investments separate categories. Investments are classified as long-term investments and current investments. Current investments are in the nature of current assets, although the common practice may be to include them in investments. Investments other than current investments are classified as long-term investments, even though they may be readily marketable. Shares, debentures and other securities held for sale in the ordinary course of business are disclosed as “stock-in-trade” under the head “current assets”. The cost of an investment includes acquisition charges such as brokerage, fees and duties. If an investment is acquired, or partly acquired, by the issue of shares or other securities, the acquisition cost is the fair value of the securities issued (which, in appropriate cases, may be indicated by the issue price as determined by statutory authorities). The fair value may not necessarily be equal to the nominal or par value of the securities issued. If an investment is acquired in exchange, or part exchange, for another asset, the acquisition cost of the investment is determined by reference to the fair value of the asset given up. It may be appropriate to consider the fair value of the investment acquired if it is more clearly evident. Interest, dividends and rentals receivables in connection with an investment are generally regarded as income, being the return on the investment. However, in some circumstances, such inflows represent a recovery of cost and do not form part of income. For example, when unpaid interest has accrued before the acquisition of an interest-bearing investment and is therefore, included in the price paid for the investment, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion is deducted from cost. When dividends on equity are declared from preacquisition profits, a similar treatment may apply. If it is difficult to make such an allocation except on an arbitrary basis, the cost of investment is normally reduced by dividends receivable only if they clearly represent a recovery of a part of the cost.

Investments 387

Current Investments The carrying amount for current investments is the lower of cost and fair value. In respect of investments for which an active market exists, market value generally provides the best evidence of fair value. The valuation of current investments at lower of cost and fair value provides a prudent method of determining the carrying amount to be stated in the balance sheet. Valuation of current investments on overall (or global) basis is not considered appropriate. Sometimes, the concern of an enterprise may be with the value of a category of related current investments and not with each individual investment, and accordingly the investments may be carried at the lower of cost and fair value computed category wise (i.e. equity shares, preference shares, convertible debentures, etc). However, the more prudent and appropriate method is to carry investments individually at the lower of cost and fair value. For current investments, any reduction to fair value and any reversals of such reductions are included in the profit and loss statement.

Long-term Investments Long-term investments are usually carried at cost. However, when there is a decline, other than temporary, in the value of a long-term investment, the carrying amount is reduced to recognise the decline. Indicators of the value of an investment are obtained by reference to its market value, the investee’s assets and results and the expected cash flows from the investment. The type and extent of the investor’s stake in the investee are also taken into account. Restrictions on distributions by the investee or on disposal by the investor may affect the value attributed to the investment. Long-term investments are usually of individual importance to the investing enterprise. The carrying amount of long-term investments is therefore, determined on an individual investment basis. Where there is a decline, other than temporary, in the carrying amounts of long-term investments, the resultant reduction in the carrying amount is charged to the profit and loss statement. The reduction in carrying amount is reversed when there is a rise in the value of the investment, or if the reasons for the reduction no longer exist.

Disposal of Investments On disposal of an investment, the difference between the carrying amount and the disposal proceeds, net of expenses, is recognised in the profit and loss statement.

388 Financial Accounting

When disposing of a part of the holding of an individual investment, the carrying amount to be allocated to that part, is to be determined on the basis of the average carrying amount of the total holding of the investment.

Reclassification of Investments Where long-term investments are reclassified as current investments, transfers are made at the lower of cost and carrying amount at the date of transfer. Where investments are reclassified from current to long-term, transfers are made at the lower of cost and fair value at the date of transfer.

Disclosure The following information should be disclosed in the financial statements: (a) the accounting policies for determination of carrying amount of investments; (b) classification of investments; (c) the amounts included in profit and loss statement for: (i) interest, dividends (showing separately dividends from subsidiary companies), and rentals on investments showing separately such income from long-term and current investments. Gross income should be stated, the amount of income tax deducted at source being included under Advance Taxes Paid; (ii) profits and losses on disposal of current investments and changes in the carrying amount of such investments; and (iii) profits and losses on disposal of long-term investments and changes in the carrying amount of such investments. (d) significant restrictions on the right of ownership, realisability of investments or the remittance of income and proceeds of disposal; (e) the aggregate amount of quoted and unquoted investments, giving the aggregate market value of quoted investments; (f) other disclosures as specifically required by the relevant statute governing the enterprise. Exhibit 11.6 provides for schedule of investment of TCS Ltd. for the year ending 31 March, 2010 and 2011. st

Investments 389

EXHIBIT 11.6

Schedule of Investment of TCS Ltd.

Rs in crore As at March 31, 2011

As at March 31, 2010

SCHEDULE ‘G’ INVESTMENTS LONG TERM INVESTMENTS (i)

Fully Paid Equity Shares (Unquoted) National Power Exchange Limited

1.40

1.70

Philippine Dealing System Holdings Corporation

4.01

4.04

Firstech Solutions Co. Limited

0.92

0.93

19.00

—

Taj Air Limited Yodlee, Inc.

—

—

ALMC HF (formerly Straumur – Burdaras Investment Bank hf.)

—

—

5.00

5.00

84.15

10.97

0.12

—

1305.87

1200.00

343.24

2459.44

1763.71

3682.08

(1.04)

—

1762.67

3682.08

1. Market value of quoted investments

83.42

11.37

2. Book value of quoted investments

84.15

10.97

1678.52

3671.11

(ii)

Fully Paid Preference Shares (Unquoted) 8% cumulative redeemable preference shares of Tata AutoComp Systems Limited

(iii)

Others Investment in Bonds (Quoted) Investment in Bonds (Unquoted) Investment in Debentures (Unquoted)

CURRENT INVESTMENTS Investments in Mutual Funds (Unquoted) Less: Provision for diminution in value of investments Notes:

3. Book value of unquoted investments (net of provision)

ILLUSTRATION 11.1 Moonstar Ltd invested Rs 10,00,000 in Equity Shares of Tata Steel Ltd on 1st April 2011. It received Rs 10,000 as dividend on 31st March, 2012. Pass accounting entries for the transaction.

390 Financial Accounting

Solution Date

Particulars

st

Debit Rs

1 April, 2011

Equity Shares in Tata Ltd A/c To Bank A/c

Dr

10,00,000

31st March, 2012

Bank A/c To Dividend on Investments A/c

Dr.

10,000

Dividend on Investments A/c To Profit and Loss A/c

Dr.

st

31 March, 2012

Credit Rs 1,00,000 10,000

10,000 10,000

ILLUSTRATION 11.2 Moonstar Ltd. invested Rs 1,00,000 in 10% debentures of the Reliance Industries Ltd on 1 April 2011. It received Rs 10,000 as interest on 31st March, 2012. Pass accounting entries for the transaction. Solution: Date

Particulars

st

1 April, 2011

Debit Rs

10% Debentures A/c To Bank A/c

Dr.

Credit Rs

1,00,000 1,00,000

st

31 March, 2012 Bank A/c To Interest on Investments A/c st

31 March, 2012 Interest on Investments A/c To Profit and Loss A/c

Dr.

10,000 10,000

Dr.

10,000 10,000

We will have to account for accrued interest if the amount is invested during the financial year.

SUMMARY ➤

Investments refer to money invested outside normal business. They are usually securities of one company held by another company in order to generate some returns.

➤

A “financial instrument” is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

➤

An “equity instrument” is any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities.

➤

“Held-to-maturity investments” are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity.

Investments 391 ➤

Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market.

➤

A “hedging instrument” is a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

➤

A “joint venture” is a business agreement in which parties agrees to develop, for a particular period, a new entity and new assets by contributing equity. They exercise control over the enterprise.

➤

A “subsidiary company” is a company that is completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary’s stock. The subsidiary can be a company, corporation, or limited liability company.

➤

Consolidated financial statements are the financial statements of a parent and all its subsidiaries presented as those of a single economic entity.

➤

A business combination is a transaction or event in which an acquirer obtains control of one or more businesses.

MULTIPLE CHOICE QUESTIONS* 1. Investments include (a) Securities held of other companies (b) Stock in trade (c) Fixed assets (d) None of the above 2. A current investment is an investment that is (a) Readily realisable (b) Intended to be held for not more than one year from the date on which such investment is made (c) Both (a) and (b) (d) None of the above 3. Fair value is usually the (a) Market value (b) Net realisable value (c) Either (a) and (b) (d) Cost of an asset * Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

392 Financial Accounting

4. A financial instrument is (a) Any contract that gives rise to a financial asset for both the parties (b) Any contract that gives rise to a financial liabilities for both the parties (c) Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity (d) None of the above 5. A financial asset does not include (a) Cash (b) An equity instrument of another entity (c) A contractual right (d) Stock in trade of an organisation 6. Which of the following is not true for a joint venture? (a) There is an agreement (b) There is a sharing of revenue (c) Transfer of ownership (d) Strategic alliance 7. Consolidated financial statements are (a) The financial statements of a parent (b) The financial statements of all subsidiaries (c) The financial statements of a parent and all its subsidiaries (d) None of the above 8. Merger includes (a) Two or more organisations combining their business (b) One entity takes over other entity (c) One company restructuring its own business (d) Either of (a), (b) or (c) 9. Acquisition includes (a) Two or more organisations combining their business (b) One entity takes over other entity (c) One company restructuring its own business (d) Either of (a), (b) or (c) 10. The carrying amount for current investments is (a) The lower of cost and fair value (b) Cost price (c) Market value (d) None of the above

Investments 393

THEORY QUESTIONS 1. What are investments? What are the different types of investment? 2. Explain the concept of financial asset and liability. 3. Write notes on the following: (a) Joint ventures. (b) Subsidiaries 4. What is consolidated financial statement? Why is it needed? 5. Explain the concept of business combinations in brief. 6. Explain the procedure of accounting for investment in detail.

RESEARCH ASSIGNMENTS Download the annual reports of NTPC and NTPC Electric Supply Company Limited for the year 2010–11 and answer following questions for both the companies. 1. Identify its investment in various instruments and classify in various categories as explained in the chapter. 2. List out various subsidiaries. 3. Identify if a company has any joint venture and/or associates and explain the same. 4. Find out differences between their standalone and consolidated financial statements.

INTERPRETING FINANCIAL REPORTS Visit the website of Mahindra and Mahindra Ltd (http://www.mahindra.com) and download annual report for the year 2010–11. Study the investments of Company in detail and answer the following questions: 1. What proportion of total assets consists of investments? 2. What do the investments comprise? 3. Find out details about Company’s investment in joint venture and identify revenue generated from the same. 4. How many subsidiaries does the Company have? How much they contribute to Company’s growth?

394 Financial Accounting

BUSINESS CASE Steel Authority of India Limited (SAIL) is the leading steel-making company in India. It is a fully integrated iron and steel maker, producing both basic and special steels for domestic construction, engineering, power, railway, automotive and defence industries and for sale in export markets. SAIL is also among the five Maharatnas of the country’s Central Public Sector Enterprises. SAIL manufactures and sells a broad range of steel products, including hot and cold rolled sheets and coils, galvanised sheets, electrical sheets, structurals, railway products, plates, bars and rods, stainless steel and other alloy steels. SAIL produces iron and steel at five integrated plants and three special steel plants, located principally in the eastern and central regions of India and situated close to domestic sources of raw materials, including the Company’s iron ore, limestone and dolomite mines. The Company has the distinction of being India’s second largest producer of iron ore and of having the country’s second largest mines network. This gives SAIL a competitive edge in terms of captive availability of iron ore, limestone, and dolomite which are inputs for steel making. SAIL’s wide range of long and flat steel products are much in demand in the domestic as well as in the international market. This vital responsibility is carried out by SAIL’s own Central Marketing Organisation (CMO) that transacts business through its network of 37 Branch Sales Offices spread across the four regions, 25 Departmental Warehouses, 42 Consignment Agents and 27 Customer Contact Offices. CMO’s domestic marketing effort is supplemented by its ever widening network of rural dealers who meet the demands of the smallest customers in the remotest corners of the country. With the total number of dealers over 2000, SAIL’s wide marketing spread ensures availability of quality steel in virtually all the districts of the country. SAIL’s International Trade Division (ITD), in New Delhi—an ISO 9001:2000 accredited unit of CMO, undertakes exports of Mild Steel products and Pig Iron from SAIL’s five integrated steel plants. With technical and managerial expertise and know-how in steel making gained over four decades, SAIL’s Consultancy Division (SAILCON) at New Delhi offers services and consultancy to clients world-wide. SAIL has a well-equipped Research and Development Centre for Iron and Steel (RDCIS) at Ranchi which helps to produce quality steel and develop new technologies for the steel industry. Besides, SAIL has its own in-house Centre for Engineering and Technology (CET), Management Training Institute (MTI) and Safety Organisation at Ranchi. Our captive mines are under the control of the Raw Materials Division in Kolkata. The Environment Management Division and Growth Division of SAIL operate from their headquarters in Kolkata. Almost all our plants and major units are ISO Certified.

Investments 395

Major Units Integrated steel plants ■ ■ ■ ■ ■

Bhilai Steel Plant (BSP) in Chhattisgarh Durgapur Steel Plant (DSP) in West Bengal Rourkela Steel Plant (RSP) in Orissa Bokaro Steel Plant (BSL) in Jharkhand IISCO Steel Plant (ISP) in West Bengal

Special steel plants ■ ■ ■

Alloy Steels Plants (ASP) in West Bengal Salem Steel Plant (SSP) in Tamil Nadu Visvesvaraya Iron and Steel Plant (VISL) in Karnataka

Ferro alloy plant ■

Chandrapur Ferro Alloy Plant

Joint ventures ■

■

■

■

■

■

NTPC SAIL Power Company Pvt Limited (NSPCL): A 50:50 joint venture between Steel Authority of India Ltd (SAIL) and National Thermal Power Corporation Ltd (NTPC Ltd); manages SAIL’s captive power plants at Rourkela, Durgapur and Bhilai with a combined capacity of 814 megawatts (MW). Bokaro Power Supply Company Pvt Limited (BPSCL): This 50:50 joint venture between SAIL and the Damodar Valley Corporation (DVC) is managing the 302-MW power generating station and 660 tonnes per hour steam generation facilities at Bokaro Steel Plant. Mjunction Services Limited: A 50:50 joint venture between SAIL and Tata Steel; promotes e-commerce activities in steel and related areas. Its newly added services include e-assets sales, events and conferences, coal sales and logistics, publications, etc. SAIL-Bansal Service Centre Limited: A joint venture with BMW Industries Ltd on 40:60 basis for a service center at Bokaro with the objective of adding value to steel. Bhilai JP Cement Limited: A joint venture company with Jaiprakash Associates Ltd on 26:74 basis to set up a 2.2 million tonne (MT) slag-based cement plant at Bhilai. Bokaro JP Cement Limited: Another joint venture company with Jaiprakash Associates Ltd on 26:74 basis to set up a 2.1 MT slag-based cement plant at Bokaro.

396 Financial Accounting ■

■

■

■

■

■

SAIL & MOIL Ferro Alloys (Pvt.) Limited: A joint venture company with Manganese Ore (India) Ltd on 50:50 basis to produce ferro-manganese and silicomanganese required in production of steel. S & T Mining Company Pvt Limited: A 50:50 joint venture company with Tata Steel for joint acquisition and development of mineral deposits; carrying out mining of minerals including exploration, development, mining and beneficiation of identified coking coal blocks. International Coal Ventures Private Limited: A joint venture company/SPV promoted by five central PSUs, viz, SAIL, CIL, RINL, NMDC and NTPC (with respectively 28.7%, 28.7%, 14.3%, 14.3% and 14.3% shareholding) aiming to acquire stake in coal mines/blocks/companies overseas for securing coking and thermal coal supplies. SAIL SCI Shipping Pvt Limited: A 50:50 joint venture with Shipping Corporation of India for provision of various shipping and related services to SAIL for importing of coking coal and other bulk materials and other shippingrelated business. SAIL RITES Bengal Wagon Industry Pvt Limited: A 50:50 joint venture with RITES to manufacture, sell, market, distribute and export railway wagons, including high-end specialised wagons, wagon prototypes, fabricated components/ parts of railway vehicles, rehabilitation of industrial locomotives, etc, for the domestic market. SAIL SCL Limited: A 50:50 JV with the Government of Kerala where SAIL has management control to revive the existing facilities at Steel Complex Ltd, Calicut and also to set up, develop and manage a TMT rolling mill of 65,000 MT capacity along with balancing facilities and auxilliaries.

Ownership and Management The Government of India owns about 86% of SAIL’s equity and retains voting control of the Company. However, SAIL, by virtue of its Maharatna status, enjoys significant operational and financial autonomy Following details are obtained from the annual reports of SAIL, a Maharatna PSU. Standalone Income Statement for 2009–10 and 2010–11 (Rs in crore) Schedule No

Year ended 31st March, 2011

Year ended 31st March, 2010

INCOME Sales Less: Excise duty

2.1

43934.70

47040.50 4321.79

42718.71

3383.32

40551.98 (Contd.)

Investments 397 (Contd.) Interest earned Other revenues Provisions no longer required written back

2.2

1381.17

1860.98

2.3

773.55

820.90

2.4

45.24

86.35

44918.67

43319.61

EXPENDITURE Accretion ( - }/ Depletion to stocks of

2.5

–1352.67

1161.01

2.6

22076.40

17340.18

4.22

2.79

2.7

7623.33

5416.81

3309.75

3163.43

3597.04

3369.35

finished/semi-finished products Raw materials consumed Purchase of finished/semi-finished goods Employees’ Remuneration & Benefits Stores & Spares Consumed Power & Fuel

2.8

Repairs & Maintenance

2.9

Freight outward

670.04

569.74

705.33

674.28

Other expenses

2.10

2863.80

2327.23

Interest & finance charges

2.11

474.95

402.01

Depreciation Total Less: Inter Account Adjustments

2.12

1485.80

1337.24

41457.99

35764.07

3629.93

37828.06

2553.27

10108.81

7090.61 Add: Adjustments pertaining to earlier years

2.13

Profit before tax

33210.80

103.70

23.22

7194.31

10132.03

Less: — Provision for taxation — Current tax

2367.38

3371.17

— Deferred tax

–63.04

81.72

— Earlier years

–14.77

2289.57

–75.23

3377.66

4904.74

6754.37

Balance brought forward from last year

24774.29

20345.05

Amount available for appropriation

29679.03

27099.42

72.29

54.58

Amount Transferred to General Reserve

500.00

680.00

Interim dividend

495.65

660.86

Profit after tax

APPROPRIATIONS Amount transferred to Bonds Redemption Reserve (net)

(Contd.)

398 Financial Accounting Proposed dividend (Final)

495.65

702.17

Tax on Interim Dividend

80.74

110.90

Tax on Proposed dividend (final)

80.41

116.62

Balance carried to Balance Sheet

27954.29

24772,29

29679.03

27099.42

Earnings per Share Profit after tax Average Number of Equity Shares (Face value Rs 10/- each)

4904.74

6754.37

4130400545

4130400545

11.87

16.35

Basic and Diluted Earnings per share (Rs) Significant Accounting Policies and Notes on Accounts

3

Schedules 2 and 3 annexed hereto, form part of the Profit & Loss Account Source: Annual Report SAIL (2010–11)

Standalone Balance Sheet for 2009–10 and 2010–11 Schedule No.

As at 31st March, 2011

(Rs in crore) As at 31st March, 2010

SOURCES OF FUNDS Shareholders’ Fund Share Capital

1.1

4130.40

Reserves and Surplus

1.2

32939.07

Secured Loans

1.3

11813.91

Unsecured Loans

1.4

8351.58

4130.40 37069.47

29186.30

33316.70

Loan Funds

Deferred Tax Liability (Net)

7755.90 20165.49

8755.35

16511.25

1491.07

1414.92

58726.03

51242.87

APPLICATION OF FUNDS Fixed Assets

1.5

Gross Block

35396.19

38263.20

Less: Depreciation

23180.54

21780.91

Net Block

15082.66

13615.28

Capital Work-in-Progress Investments

1.6

22225.83

1.7

37308.49

14953.13

28568.41 668.83

684.14

Current Assets, Loans & Advances Inventories

1.8

11302.79

9027.46

Sundry Debtors

1.9

4161.30

3493.90 (Contd.)

Investments 399 Cash & Bank Balances

1.10

17478.86

22436.37

Other Current Assets

1.11

489.56

780.34

Loans & Advances

1.12

4657.85

3416.09

38090.36

39154.16

Less: Current Liabilities & Provisions Current Liabilities

1.13

11474.86

10918.38

Provisions

1.14

5882.10

6230.15

17356.96

17148.53

Net Current Assets

20733.40

22005.63

58726.03

51242.87

Significant Accounting Policies and Notes on Accounts 3 Schedules 1 and 3 annexed hereto, form part of the Balance Sheet Source: Annual Report SAIL (2010–11)

Consolidated Income Statement for 2009–10 and 2010–11 (Rs in crore) Schedule No.

Year ended 31st March, 2011

Year ended 31st March, 2010

INCOME Sales

2.1

Less: Excise Duty

44001.68

47265.20 4450.81

42814.39

3424.68

40577.00

Interest earned

2.2

1403.20

1875.10

Other revenues

2.3

755.24

815.90

Provisions no longer required written back

2.4

50.58

91.31

45023.41

43359.31

EXPENDITURE Accretion (–}/ Depletion to stocks

2.5

–1408.20

1179.45

Raw materials consumed

2.6

22224.13

17404.29

5.14

16.95

7765.20

5527.03

3336.82

3202.16

Purchase of finished/semi-finished products Employees’ Remuneration & Benefits

2.7

Stores & Spares Consumed Power & Fuel

2.8

3226.68

3102.51

Repairs & Maintenance

2.9

740.86

607.30

723.20

674.28

2.10

2836.47

2337.61

Freight outward Other expenses

(Contd.)

400 Financial Accounting Interest & finance charges

2.11

Depreciation Total

581.64

473.95

1602.94

1429.62 35955.15

41634.88

Less: Inter Account Adjustments

2.12

Adjustments pertaining to earlier years

2.13

3898.74

Profit before tax

37736.14

2871.72

33083.43

7287.27

10275.88

102.36

23.18

7389.63

10229.06

Less: Provision for taxation: — Current tax

2430.72

— Deferred tax

–12.59

— Earlier years adjustments

–45.79

Profit after tax Share of profit of associate Minority Interest Balance brought forward Less: Brought forward loss of Steel Complex Limited Amount Available for Appropriation

3419.92 104.92 2372.34

–76.73

3448.11

5017.29

6850.95

0.07

–0.02

0.18

0.32

5017.18

6850.61

25139.59

20623.31

2.20

0.00

30154.57

27473.92

505.15

684.80

APPROPRIATIONS Transferred to General Reserve Interim Dividend

495.65

660.86

Proposed Dividend

495.65

702.25

Tax on Interim Dividend

80.74

110.90

Tax on Proposed Dividend

89.75

120.94

Amount transferred to Bonds Redemption Reserve (net)

72.29

54.58

28415.34

25139.59

30154.57

27473.92

5017.18

6850.61

Balance carried to Balance Sheet Earnings per Share (Face value Rs 10/each) Profit after tax

4130400545

4130400545

Basic Earnings per share (Rs)

Average Number of equity shares

12.15

16.59

Diluted Earnings per share (Rs)

12.15

16.59

Significant Accounting Policies and Notes on Accounts

3

Schedules 2 and 3 annexed hereto, form part of the Consolidated Profit & Loss Account Source: Annual Report SAIL (2010–11)

Investments 401

Consolidated Balance Sheet for 2009–10 and 2010–11 Schedule No.

As at 31st March, 2011

(Rs in crore)

As at 31st March, 2010

SOURCES OF FUNDS Shareholders’ Fund Share Capital

1.1

4130.40

Reserves and Surplus

1.2

33473.91

Share Application Money pending allotment

4130.40 37604.31

29613.06

11.88

33743.46 0.00

Loan Funds Secured Loans

1.3

12854.59

Unsecured Loans

1.4

8405.55

Deferred Tax Liability (Net) Minority Interest

1.16

8827.25 21260.14

8810.57

17637.82

1556.74

1430.13

1.20

1.02

60434.27

52812.43

APPLICATION OF FUNDS Fixed Assets

1.5

Gross Block

40465.81

37419.44

Less: Depreciation

23832.61

22310.43

Net Block

16633.20

15109.01

Capital Work-in-Progress Investments

1.6

22581.21

1.7

39214.41

15309.16

30418.17 44.67

60.80

Current Assets, Loans & Advances Inventories

1.8

11506.85

9161.70

Sundry Debtors

1.9

4180.13

3632.45

Cash & Bank Balances

1.10

17747.76

22718.52

Other Current Assets

1.11

494.49

786.32

Loans & Advances

1.12

4904.26

3736.08

38833.49

40035.07

Less: Current Liabilities & Provisions Current Liabilities

1.13

11613.06

11225.76

Provisions

1.14

6062.64

6460.22 17685.98

17675.70 Net Current Assets Miscellaneous Expenditure

1.15

21157.79

22349.09

1.27

0.50

60434.27

52812.43

(to the extent not written off or adjusted) Source: Annual Report SAIL (2010–11)

402 Financial Accounting

You are required to study the differences between standalone financial statements and consolidated statements and identify: ■ ■ ■

Revenue generated from standalone and subsidiaries Assets and liabilities of standalone and subsidiaries Contribution of subsidiaries in the growth prospect for the company

Contemporary Issues in Accounting

Learning Objectives After studying this chapter, you will be able to ❖

Understand foreign currency accounting

❖

Know creative accounting

❖

Understand forensic accounting

❖

Learn about environmental accounting

❖

Get introduced to lean accounting

❖

Know human resource accounting

❖

Learn inflation accounting

❖

Understand responsibility accounting

❖

Know transfer pricing

❖

Study segment reporting

❖

Get introduced to XBRL

12

Contemporary Issues in Accounting

405

LET US SET THE STAGE . . . Mr Rajesh, a postgraduate from IIFT, started his textile export business on 1 January, 2011. He entered into foreign transaction with different parties. He had a receivables (to be collected in July, 2011) of the US$ 2,00,000 on 31 March 2011, when 1 US$ was at Rs 49. He was happy as it was higher than the average rate of a single US dollar which was equal to Rs 44, when he entered into the transaction. In July 2011, his actual collections were lower than his expectation as he incurred a loss of Rs 3 per US dollar as the exchange rate of a single US$ was equal to Rs 41. He was nervous at this unpredictable fluctuation. Exchange rate fluctuations due to appreciation and depreciation in currency rates affect all foreign transactions. Accounting for such fluctuations plays important role for the exporters, importers, lenders, borrowers, tax authorities and regulators. Jyoti, a young MBA student, had read that Satyam overstated its number of employees and presented a rosy picture to its customers. She was looking out for human capital in Satyam’s balance sheet, but was unable to trace the same. She approached her accountant friend, Dipti, who told that employee value was not shown in the balance sheet. Jyoti felt little disturbed. Just like foreign currency transactions, many other developments in accounting are topics of discussion nowadays like accounting for price level changes through inflation accounting, accounting for environmental cost and benefits through environmental accounting, etc. We will discuss major developments in the field of accounting in this chapter.

INTRODUCTION Accounting is a dynamic field of specialisation where leaders in the field must be continuously responding to changes in the business society that imposes modifications and additions to accounting principles and practices. Traditionally, accounting as a discipline has been associated with “the process of measuring, analysing and communicating economic information” (American Accounting Association). The globalisation of businesses, the increasing complexities of business transactions, and advances in information technology are facilitating electronic commerce and communication that are challenging the relevance and usefulness of traditional accounting. This chapters aims at discussing various developments in the field of accounting like foreign currency accounting, human resources accounting, inflation accounting, responsibility accounting, etc. Except for foreign currency accounting, segment reporting, transfer pricing, other issues are not mandatory as per the GAAP.

406 Financial Accounting

FOREIGN CURRENCY ACCOUNTING Objective 1 The business transaction within a country Know Foreign Currency between two parties is recorded in home currency, as the amount incurred and paid is in home currency. But if the transaction is between a party in a country and another outside the county, the amount of transaction is to be paid or received in different currency. So, the transaction incurred in foreign currency is to be exchanged into home currency. Certain accounting rules are to be followed for the exchange of foreign currency into home currency. This translation is done by applying the foreign exchange rates prevailing at the time of transaction. Accounting Standard 11 deals with the recording and translation of such type of foreign currency transactions. The following are some important terms as defined by AS–11. 1. Average rate is the mean of the exchange rates in force during a period. 2. Closing rate is the exchange rate at the balance sheet date. 3. Exchange difference is the difference resulting from reporting the same number of units of a foreign currency in the reporting currency at different exchange rates. 4. Exchange rate is the ratio of exchange of two currencies. 5. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. 6. Foreign currency is a currency other than the reporting currency of an enterprise. 7. Forward rate is the specified exchange rate for exchange of two currencies at a specified future date. 8. Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money. 9. Non-monetary items are assets and liabilities other than monetary items. 10. Reporting currency is the currency used in presenting the financial statements.

Foreign Currency Transactions Foreign currency transaction may arise due to activities such as buying and selling of goods, borrowing and lending of funds, forward exchange contracts, etc. Each transaction arises at different points of time like date of purchase or sale of goods or fixed assets, date of payment, date of receipt, date of balance sheet, etc. It becomes essential to record transactions at different levels as the exchange rate changes due to fluctuations in foreign exchange markets. At the time of transactions home currency has to be converted into foreign currency and vice versa to maintain proper accounting records.

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Rates of Transactions 1. Spot Rate: Transactions are translated on the date of the transaction. 2. Average Rate: If the fluctuation in the currency is not significant then the translation is made at certain period—weekly, monthly, etc.

Translation of Transactions The transactions are translated in the following manners: 1. Transactions recognised for purchase or sale of goods translated at the spot rate or average rate. 2. Transactions recognised for purchase or sale of fixed assets translated at the spot rate or average rate. 3. Transactions realised on the receipt or payment, i.e. settlement of account translated at the spot rate. 4. At each balance sheet date, monetary items are translated at the current rate.

Foreign Exchange Difference The differences are arrived as one transaction is recorded at many times. 1. In case of sale or purchase of goods and fixed assets, the transactions are translated on the recognition at the spot rate. But the settlement if made during the same year at different dates needs transaction at the rate of transaction recognised. For example, goods are imported on 1 June 2012 for the US$ 4,00,000 but payment is made on 1 September 2012. This transaction of goods imported is recorded on 1 June 2012 at the spot rate. The transaction of payment is recorded on 1 September 2012 at the spot rate. But the rates on the dates may be different. 2. Other difference may arise due to translation of monetary transaction on the date of balance sheet. The actual transaction is recognised at the time before the balance sheet date and recorded at the spot rate. For example, if the goods are imported from USA on 1 March, 2013 are not paid till the balance sheet date of 31 March, 2013. The first transaction is recorded on the recognition on 1 March, 2013 at spot rate. As the payment is not made till the date of balance sheet, the creditors appearing in the balance sheet need to be translated at current rate. The two rates will be different. 3. At the end of the year, balance of foreign exchange fluctuation account is transferred to profit and loss account. Let us understand the concept of foreign exchange with the help of illustrations.

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ILLUSTRATION 12.1 Amrita Ltd of India has purchased goods from KRR Inc of the US for $ 2,00,000 on 1st June, 2012. On 30th June, 2012, the payment has been made. The foreign exchange rates are as follows: 1st June, 2012

$1 = Rs 48

30th June, 2012 $1 = Rs 50 Give entries in the books of Amrita Ltd. Solution: Date

Particulars

1/06/12

Purchase A/c To Creditors A/c (2,00,000 x 48) (Being Goods Purchased of $ 2,00,000 at Rs 48)

Dr.

Creditors A/c Foreign Exchange Fluctuation A/c To Bank A/c (2,00,000 x 50)

Dr Dr

Profit and Loss A/c To Foreign Exchange Fluctuation A/c

Dr

30/06/12

31/03/13

L/F

Debit Rs

Credit Rs

96,00,000 96,00,000 96,00,000 4,00,000 1,00,00,000 4,00,000 4,00,000

ILLUSTRATION 12.2 Deepak Ltd of India has sold goods to Jacob Martin Ltd of USA for $4,60,000 on 1 August 2012. Further, 30% was received on 1 September 2012 and $1,00,000 was received on 10 September 2012. Balance received on 30 April, 2013 Foreign Exchange Rate: 1 August 2012 $1 = Rs 50.50 1 September 2012 $1 = Rs 51.50 10 September 2012 $1 = Rs 49 31 March 2013 $1 = Rs 53 30 April 2014 $1 = Rs 52

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Solution Date

Particulars

L/F

Debit Rs

1/08/12

Debtors (John Martin) A/c To Sales A/c (4,60,000 50.50) ( Being Goods Sold of $ 4,60,000 at Rs 50.50)

Dr

2,32,30,000

Bank A/c ( 1,38,000 x 51.50) To Foreign Exchange Fluctuation A/c To Debtors (John Martin) Ltd A/c (1,38,000

Dr

01/09/12

10/09/12

31/03/13

31/03/13 30/04/14

31/03/14

Bank A/c ( 1,00,000 x 49) Foreign Exchange Fluctuation A/c To Debtors (John Martin) Ltd A/c (1,00,000

2,32,30,000 71,07,000 1,38,000 69,69,000

50.50) Dr Dr

49,00,000 1,50,000

50.50)

50,50,000

Debtors (John Martin) A/c To Foreign Exchange Fluctuation A/c (2,22,000 2.5 (53 − 50.50)

Dr

Foreign Exchange Fluctuation A/c To Profit and Loss A/c

Dr

Bank A/c ( 2,22,000 52) Foreign Exchange Fluctuation A/c To Debtors (John Martin) Ltd A/c (2,22,000

Dr Dr

Profit and Loss A/c To Foreign Exchange Fluctuation A/c

Credit Rs

5,55,000 5,55,000 5,43,000 5,43,000 1,15,44,000 2,22,000

53)

1,17,66,000 Dr

2,22,000 2,22,000

Objective 2 Creative accounting refers to the malpractice in To know creative accounting which accountants misuse and misguide funds making serious blunders in accounting operations. The numerous accounting scandals over the past decades have revealed that at least some accountants can be extremely creative with the finances they control. Such creativity can include the misdirecting or misusing of funds, understating expenses, overstating revenues, understating liabilities and overstating corporate asset values, thereby misrepresenting the financial state of a company. The rules of acceptable accounting practices can be misused to earn huge profits or save taxes, etc. This is referred to as creative accounting or innovative accounting. It is used by presenting assets and liabilities, income and expenditure, in a complicated way to incur huge profits. The frequency of large scale creative accounting fraud is seldom, but is, obviously, carried out with the support of key executives in a company, and may even rely on the cooperation of officials in other corporations or affiliated companies. The officials present the assets and liabilities (income and expenditure, profits and losses) in a very cunning manner, i.e. in very complicated ways with a motive of saving tax money. Creative accounting can also be used to manipulate the value of a publicly traded company’s shares for financial gain.

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Accounting fraud is often characterised by the following: ■ ■ ■ ■ ■

Misuse/misdirection of funds Understating/overstating of revenues Understating/overstating of expenses Overstating of corporate asset values Underreporting of liabilities

Some companies can gain advantage over other companies if they have some better information over the other party in a business transaction, etc. In the case of bidding, one company can come up with a relatively lower price and this lower price would make the company attractive for takeover bid. This business deal at reduced price will help the executives of the company who are taking over by saving money. At times, this may lead to huge losses for investors, may be due to the mismanagement of the company which is taking over. This is called as asymmetric information. Similar issues occur when a publicly held asset or non-profit organisation undergoes privatisation. The top management executives have the authority to consider any bid that they want, i.e. they can forge the details and facilitate the privatisation to earn huge monetary benefits. They can facilitate this process by making the entity appear to be in financial crisis—this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. It can create a public perception that private entities are more efficiently run which may trigger the selling of many more publicly held assets (by the government).

Prevention of Creative Accounting Government has taken measures to punish those found guilty of using such malpractices. There have been many cases of accounting frauds in the past. Accounting frauds have reached to the tune of billions of dollars in some cases. In 2002, big accounting firms like Arthur Andersen, Ernst & Young, Pricewaterhouse Coopers, etc., were charged in court or admitted negligence in their duties. These companies were held responsible for identifying and preventing the publication of bogus financial reports. Due to their neglect, their clients were able to publish reports which were misleading and gave a completely different impression of the client’s company financial status. Following this scandal and many more by companies like Adelphia, Tyco International, etc., the Sarbanes-Oxley Act was enacted as a US Federal Law in July 2002 to safeguard the investors. Government has set up some agencies which looks into such matters and reports any malpractice, if being practiced. In USA, Security and Exchange Commission (SEC) may be called upon to investigate whether creative accounting amounts to fraud. Sometimes, creative accounting can work in a company’s favour without actually

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breaking the law, although possibly still being considered as unethical. When unethical and unlawful tactics are suspected and detected, the government agencies may launch an investigation. During the investigation, at times, the one who participated in the accounting fraud discloses and admits of committing the fraud. Government has made provisions, such as the following: 1. Public companies should review their internal financial reports and enforce controls to prevent frauds and regularly check its effectiveness. 2. Independent auditors should follow the guidelines and get their finances checked. 3. A company listed at the stock exchange must have an independent audit committee to oversee the smooth working of the company with its auditor. 4. If any company is found to fudge the actual financial status or intentionally misstate the company facts, severe legal and criminal penalties can be imposed and even jail sentences may be granted to those who indulge in such malpractices. 5. Financial reports must be certified by CEOs and CFOs. 6. Personal loans to any director or executive officer are banned in most cases. 7. Government has kept benefits for any informant who exposes wrongdoing within an organisation in the hope of stopping it.

FORENSIC ACCOUNTING “Forensic”, according to the Webster’s Dictionary means, “Belonging to, used in or suitable to courts of judicature or to public discussion and debate”.

Objective 3 To understand forensic accounting

“Forensic Accounting” provides an accounting analysis that is suitable to the court which will form the basis for discussion, debate and ultimately dispute resolution. Forensic Accounting encompasses both litigation support and investigative accounting. As Forensic Accountants, we utilise accounting, auditing and investigative skills when conducting an investigation. Equally critical is our ability to respond immediately and to communicate financial information clearly and concisely in a courtroom setting. Forensic Accountants are trained to look beyond the numbers and deal with the business reality of the situation.

Forensic Audit Forensic audit is an examination of evidence regarding an assertion to determine its correspondence to establish criteria carried out in a manner suitable to the court. An

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example would be a forensic audit of sales records to determine the quantum of rent owing under a lease agreement, which is the subject of litigation. “Investigative Accounting”, is often associated with investigations of criminal matters. A typical investigative accounting assignment would be an investigation of employee theft. Other examples include securities fraud, insurance fraud, kickbacks and proceeds of crime investigations. A Forensic Accountant is often retained to analyse, interpret, summarise and present complex financial and business related issues in a manner which is both understandable and properly supported. Forensic Accountants can be engaged in public practice or employed by insurance companies, banks, police forces, government agencies and other organisations. A Forensic Accountant is often involved in the following: ■ ■

■

■

Investigating and analysing financial evidence Developing computerised applications to assist in the analysis and presentation of financial evidence Communicating their findings in the form of reports, exhibits and collections of documents Assisting in legal proceedings, including testifying in court as an expert witness and preparing visual aids to support trial evidence

In order to properly perform these services a Forensic Accountant must be familiar with legal concepts and procedures. In addition, a Forensic Accountant must be able to identify substance over form when dealing with an issue. A Forensic Accountant can be of assistance in various ways, including:

Investigative Accounting ■

■ ■

■

Review of the factual situation and provision of suggestions regarding possible courses of action Assistance with the protection and recovery of assets Co-ordination of other experts, including: (i) Private investigators (ii) Forensic document examiners (iii) Consulting engineers Assistance with the recovery of assets by way of civil action or criminal prosecution

Litigation Support ■ ■

Assistance in obtaining documentation necessary to support or refute a claim Review of the relevant documentation to form an initial assessment of the case and identify areas of loss

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■

■ ■

413

Assistance with examination for discovery including the formulation of questions to be asked regarding the financial evidence Attendance at the examination for discovery to review the testimony, assist with understanding the financial issues and to formulate additional questions to be asked Review of the opposing expert’s damages report and reporting on both the strengths and weaknesses of the positions taken Assistance with settlement discussions and negotiations Attendance at trial to hear the testimony of the opposing expert and to provide assistance in cross-examination

ENVIRONMENTAL ACCOUNTING Environmental accounting deals with computation of environmental costs of commercial and industrial decision using traditional accounting and financial principles.

Objective 4 To learn about environmental accounting

Environmental accounting is defined as the identification, allocation and analysis of material streams and their related money flows by using environmental accounting systems to provide insight in environmental impacts and associated financial effects. It is a growing field that identifies resource use, measures and communicates costs of a company’s or national economy’s actual or potential impact on the environment. Costs can include costs to clean up or remediate contaminated sites, environmental fines, penalties and taxes, purchase of pollution prevention technologies and waste management costs.

Types of Environmental Costs 1. Internal Cost ■ Conventional Costs: Cost of capital equipment, raw materials and supplies ■ Hidden Costs: ● Regulatory (fees, licenses, reporting, training, remediation) ● Up front and back end (site prep, engineering, installation, closure and disposal) ● Voluntary (training, audits, monitoring and reporting) ■ Contingent Costs: Environmental costs that are not certain to occur in the future but depend on uncertain future events like the costs involved in remediating future spills

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Image and Relationship Costs: Less tangible costs as they are incurred to affect subjective perceptions of management, customers, employees, communities, and regulators. The direct benefits that result from relationship or corporate image expenses often are intangible, but the costs themselves are not intangible.

2. External Cost ■ ■

Environmental degradation cost for which firms are not legally liable Human Impact Cost: Adverse impact on human being and their property

Forms of Environmental Accounting 1. Environmental Management Accounting (EMA) Management accounting focus on environmental cost information and energy flow information. It is further classified into: ■ ■ ■

Segment Environmental Accounting Eco Balance Environmental Accounting Corporate Environmental Accounting

2. Environmental Financial Accounting (EFA) Financial Accounting focus on reporting environmental liability costs and other significant environmental costs. 3. Environmental National Accounting (ENA) National Level Accounting focus on natural resources stocks, environmental costs and externality costs.

Need for Environmental Accounting ■

■

■

■ ■

It helps to know whether company has been discharging its responsibilities towards environment or not. It may result in more accurate costing or pricing of products and more environmentally desired processes. It helps in possible competitive advantages as customers may prefer environmentally friendly products and services. It may meet the regulatory requirements. It helps in appropriate disclosure of the amount and nature of the preventative measures taken by the management.

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It may control over costs for raw materials, waste management and potential liability. It may help in financing as certain investors may prefer “Green” accounting.

Methods of Environmental Accounting 1. Natural Resource Accounts These include data on stocks of natural resources and changes in them caused by either natural processes or human use. It covers agricultural land, fisheries, forests, minerals and petroleum, and water. Valuation is easier for resources when the goods are sold in markets, e.g. timber and fish. For environmental goods and services that are not sold, it is much harder to establish the value either of the flow or of a change in stock. 2. Emissions Accounting It structures the accounts in a matrix, which identifies pollutant emissions by economic sector. Data is separated by type of pollutant emission to understand the impact on domestic, trans border, or global environments. The emissions are valued in monetary terms, to determine the economic cost of avoiding environmental degradation and to compare costs and benefits of environmental protection. 3. Disaggregation of Conventional Accounts Data in the conventional accounts are taken apart to identify expenditures specifically related to the environment, such as those incurred to prevent or mitigate harm, to buy and install protection equipment, or to pay for charges and subsidies. It helps to observe links between changes in environmental policy and costs of environmental protection.

Limitations of Environmental Accounting ■

■

■

■ ■

There is no standard accounting method. Thus, comparison between two firms or countries is not possible if method of accounting is different. Input for EA is not easily available because costs and benefits relevant to the environment are not easily measurable. Many business and government organisations—even large and well-managed ones—do not adequately track the use of energy and material or the cost of inefficient materials use, waste management and related issue. It mainly considers the cost internal to the company and excludes cost to society. It is a long-term process; hence it is difficult to take short-term decisions with the help of it.

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EA must be analysed along with other aspects of accounting. Because costs and benefits relate to the environment itself, it depends upon the results of the financial accounting, management accounting, cost accounting, tax accounting, national accounting, etc.

LEAN ACCOUNTING Objective 5 Lean accounting is an accounting type that To get introduced to lean is designed for those companies who have accounting implemented lean manufacturing techniques. Traditional cost accounting does not always accurately reflect the positive measures (including cost saving) that a lean system provides. Since company’s decisions are usually based on the numbers generated by the accounting system, many of these benefits are overlooked due to traditional accounting methods. A few of the cost organisation methods that lean accounting includes are value streaming, changing inventory valuation techniques and modifying financial statements to include nonfinancial information. The principles of lean accounting are to measure the positive performance and motivate the good performance. Lean accounting can measure positive gains through initiating lean alternatives in ways like reducing inventory, reducing cycle time, or improving production floor moral and thereby increasing overall capacity. Lean accounting helps to motivate a company to continue to promote their lean initiatives rather than deliver numbers that are not necessarily an accurate reflection of company profitability such as is the case with attempting to meet machine efficiency quotas by producing an abundance of unnecessary inventory. Traditional accounting reports were developed to present an accurate view of the company to outsiders, mainly the shareholders and lenders. Their purpose was not to assist the managers to improve decision-making and run their operations in better manner. Certain non financial measures which are captured in lean accounting are not captured in traditional accounting. Lean manufacturers also view inventory differently than would those following a traditional accounting method. In lean accounting, inventory is not treated as an asset due to the costs associated with it like handling, storage and financial costs. Though the net income usually declines when a company switches to lean accounting, such a decline is usually temporary. Fall in profit is caused in the first year, due to changes in inventory valuation policy. Treating inventory as an asset in traditional financial statement only makes sense if those assets are a guaranteed sale, which they often are not. In fact, historically excesses in inventory are either not sold at all or sold for much less than the market value because the customers are constantly looking for the next thing or something better than what they have been

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offered before. In lean operations, the goal is to produce enough products to meet demand, this means reducing inventory to the point where there is no inventory at all in some cases. Having a guaranteed buyer for every product that is made translates into no wasted time, money, or resources on a product that will never make it past the doors of your warehouse.

Improvements Brought in by Lean Accounting Traditional accounting was designed to support mass production. As lean manufacturers do not necessarily believe that mass production is the most value-adding method of production, many of the traditional accounting assumptions contradict lean manufacturing. Hence, companies which have implemented lean initiative, usually implement alternative accounting concepts to better capture their performance. Rather than categorising costs by department, lean accounting organises costs by a process called “value stream”. Value streaming includes everything an entity does in creating value for a customer that it can reasonably associate with a product or product line. Among the costs in a value stream would be the expenses a company incurs to design, engineer, sell, market and ship a product as well as costs related to servicing the customer, purchasing materials and collecting payments on product sales. Organisations should supplement their traditional financial statements with the addition of lean accounting information, information that captures the improvements lean manufacturing brings with it that are not typically represented in traditional accounting methods. In addition to making changes to their financial statements, companies that adopt lean processes often also include non-financial data in their “financial statements”. For instance, the reports now show the number of sales leads generated by different promotional discounts.

Implementing Lean Accounting As with any implementation of a change in the traditional way of operating, implementing lean accounting will require the dedication of management as well as those accountants who will have the responsibility of doing their jobs in a new way. Most companies that choose to implement lean accounting will supplement traditional accounting statements with lean statements. Implementing lean accounting principles does not mean creating completely new books. The information needed to prepare lean financial statements already is available in accounting systems. For instance, instead of including labour and overhead expenses in the cost of goods sold, a lean financial statement will show materials, labour and overhead as separate line items. That way the company will recognise labour and

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overhead expenses when it incurs them rather than having them get wrapped into inventory on the balance sheet. In traditional accounting system, the goal is to fully allocate costs to precise and stable cost centers. In contrast, lean focuses on accounting for costs in a manner that’s reasonably accurate.

Lean Accounting Terms and Techniques Lean accounting and traditional accounting methods conflicts in several ways. They differ in certain concepts. Some of these are: ■

■

■

Product Costing Determining the true costs of individual products and components. Traditional accounting systems track only expenditures which leads to under or over valuing. Inventory Cost Analysis Conventional accounting methods track inventory level well but the cost of holding that inventory is only included in lean accounting. These costs include space, warehouse personnel, insurance, utilities, etc. Non-financial Metrics Traditional accounting does not effectively measure investment in longer range objectives (objective that go beyond simply making a profit). Lean accounting takes more into account than just the financial metrics of the organisation. Individual activities, processes and parameters within each activity or process require that metrics also contain non-rupee units that better represent the company’s standing.

The purpose of lean accounting is to support the lean enterprise as a business strategy. It seeks to move from traditional accounting methods to a system that measures and motivates excellent business practices in the lean enterprise.

Objectives of Lean Accounting 1. Provide accurate, timely, and understandable information for decision-making leading to increased customer value, growth, profitability, and cash flow. 2. Use lean tools to eliminate waste from the accounting processes while maintaining thorough financial control. 3. Support the lean culture by motivating investment in people, and empowering continuous improvement at every level of the organisation. In contrast to traditional mass-production operations, a lean company emphasises eliminating waste, boosting inventory turnover and reducing inventory levels. The focus is on achieving the shortest possible production cycle and producing only to meet customers demand. The benefits generally are lower costs, higher product quality and shorter lead times.

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HUMAN RESOURCE ACCOUNTING Human Resource Accounting (HRA) is accounting for the company’s personnel as human capital that provides future benefits. In the HRA approach, expenditures related to human resources are reported as assets on the balance sheet as opposed to the traditional accounting approach which treats costs related to a company’s human resources as expenses on the income statement that reduce profit. HRA suggests that in addition to the measures themselves, the process of measurement has relevance in decision-making involving organisations. As per the American Accounting Association’s Committee on Human Resource Accounting, “Human resource accounting is the process of identifying and measuring data about human resources and communicating this information to the interested parties”. The basic and inherent assumptions of human resource accounting system are given below: ■ ■

■

People are valuable resources of an enterprise. The usefulness of manpower as an organisational resources is determined by the way in which it is managed. Information on investment and value of human resources is useful for decisionmaking in the enterprise.

It helps in developing financial assessments for the people within the organisation and monitoring of these assessments from time to time. The purpose of HRA is to improve the quality of human resources decisions made both internally and externally relating to the organisation.

OBJECTIVES OF HUMAN RESOURCE ACCOUNTING ■

■ ■

■

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Objective 6 To assist the management in taking suitable To know human resources accounting decisions regarding investment on human resources To evaluate the earning potential of human resources of the organisation To assess the efficiency of human resources in obtaining productivity and profitability To provide comparative information regarding costs and benefits associated with investment in human assets To furnish cost value information for decision-making To disseminate information about the cost and value of organisations human capital

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Models of Human Resource Accounting 1. Cost Based Approaches (a) Replacement Cost Method—Flamholtz Method The cost of replacing individuals and rebuilding cost of human organisation to reflect the HR asset value. Remarks: ■ Human resource is not traded in the market; hence replacement cost may not identifiable. ■ There are a variety of replacement alternatives and assessment of correct alternative may be subjective. ■ In the absence of arriving at proper replacement cost of an employee, this model is not useful. (b) Brummet, Flamholtz and Pyle The cost of acquisition, training and development of individuals is capitalised with subsequent amortisation over the years to reflect the value of the individuals and the organisation. Remarks: ■

It is based on historic cost approach. This may not truly represent the HR value of an organisation.

■

Accumulated cost of HR acquisition and development may not reflect their value. Cost amortisation is illogical, due to performance rating of individuals.

■

Capitalisation of the cost, contrary to its expense nature in traditional accounting practices, may not be acceptable.

2. Opportunity Approaches (a) Competitive Bidding Model—Hekimian and Jones It is based on competitive bidding amongst the investment center managers to win the individual employees for use, based on the highest bid price to be included as value of human asset along with investment in physical assets while assessing the return on investment by individual investment centers. Remarks: ■ It requires assessing the likely contribution from each individual for future assignments. It is highly subjective and may not be uniform across the company. The assessment may be based on the perception of the individuals involved in bidding. ■ Due to high subjectivity, it cannot be used effectively.

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3. Economic Models (a) Goodwill Method—Harmonson Model Extra profits earned by organisation as compared to industry average rate is used to calculate goodwill, HR value = Goodwill* Investment in HR/Total Investments Remarks: ■ The contribution of various factors to the company’s goodwill is not established and is highly debatable. ■ This Model cannot be implemented if the rate of earnings of the company is less than the industry average. (b) Adjustment Discounted Future Wages Method—Harmanson Model Present value of future wages payable for the next five years discounted at the adjusted rate of return is the HR value. The adjustment rate of return refers to average rate of return on owned assets of all firms in the economy multiplied by the efficiency ratio of the organisation during the last five years on weighted average basis. Remarks: ■

The Model is subjective with respect to PV being restricted for five years, efficiency ratio calculated in the past five years, and assignment of weightage for the past rate of return.

■

It is illogical, as discounted value of future wages may not represent the value of HR.

(c) Lev and Schwartz Model Present value of likely future earning of an employee till his/her retirement. Wages are calculated as a function of age alone. It is done on a group basis. Remarks: ■

Future wages are considered to represent the PV of future contribution receivable from the employee.

■

This is easy to implement and use.

■

Also it is the most widely used Model as it can be easily adopted.

(d) Jaggi and Lau In this method, the HR value is dependent on rank and performance rating. It assumes that the past trend will continue in future and estimation on retirement, death and service movements is to be arrived at. Remarks: ■ This model does not recommend any method to evaluate the extent of services that may be available from the employees.

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It is based on the past trend. In a technology-intensive industry like software, past trends may not be representative of the future likelihoods.

(e) Myers and Flowers An employee’s attitude governs his productive behaviour on the job. The employee’s attitude index multiplied by the wages payable should reflect the likely benefits to the organisation and hence the HR asset. Remarks: ■ Weightings based on the job grade level and tenure of service may not be appropriate. ■ Attitude is not the only parameter to influence the employee’s behaviour. ■ Difficult to assess the attitudes of the individual employees and is more subjective. 4. Behavioural Model (a) Likert Model This model aims to establish through psychological test results, how a set of casual variables reflecting the management systems adopted by an organisation determine the depreciating or appreciating of human asset. Remarks: ■ In the absence of a valid relationship, the condition of HR may not be a true reflector of the HR performance. ■ Difficult to implement and is highly subjective.

HRA IN INDIA HRA as a concept has been discussed in India for long. In terms of awareness and acceptance, the level is still low as many companies take little initiative to make the numbers public to shareholders, despite having the data. The financial statements are prepared pursuant to the Indian Company Law and GAAP. There is no compulsion for showing any significant information about human resources in financial statements except the remuneration paid to them and the number of employees getting compensation beyond certain amount per annum. However, there is nothing to prohibit the companies to attach information about the worth of human resources and the results of their performance during the accounting period in notes or schedules.

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INFLATION ACCOUNTING Objective 7 Inflation is a condition in which value of money To learn inflation accounting is falling or prices are rising. Monetary inflation can be caused due to different reasons like excessive supply of new money or weakness in other economic value systems. The effect of inflation on an enterprise can be seen in two parts: 1. On Cost and Revenue Both cost and revenue will rise. But the change in profit will be determined by the stock available at old price and price trends in input and output markets. 2. On Assets and Liabilities In case of monetary assets and liabilities, usually a business enterprise suffers loss in case it is net creditor. However it gains if it is net debtor. In case of other assets like land, securities, etc., the company may have gain due to rise in price on one hand and loss due to reducing value of money on the other. Inflation accounting is an accounting system designed to correct problems arising from historical cost accounting in the presence of inflation. It is a financial reporting procedure which records the effect of inflation on a company’s financial statement or balance sheet.

Benefits of Inflation Accounting ■

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To account for the gains to the company due to rise in monetary value of assets due to inflation. Though depreciation is charged to spread the cost of asset in its useful life and may be used to make reserves for replacement in future, but it does not take into account the effect of inflation on replacement cost, thus inadequate depreciation is charged. To account for overstating the profits due to mixing of inventories acquired at the old price and revenue generated at current price after inflation. To ease the projection of future earning on the basis of historical earning.

Inflation Accounting Models Two most common methods are: 1. Current Purchasing Power (CPP) or Constant Rupee Method 2. Current Cost Accounting (CCA) Method

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Current Purchasing Power (CPP) Method Under CPP Method, all items in the financial statements are restated in terms of units of equal purchasing power. It adjusts the financial statements by removing the effects of changes in the general purchasing power of money on traditional accounts. A general price index is used for this purpose since it is the best indicator of the changes in the purchasing power of money as a whole. The CPP Method basically attempts to remove the distortions in financial statements, which arise due to change in the value of rupee. This method takes into account the changes in the general purchasing power of money and ignores the actual rise or fall in the price of a given item. CPP Method does not distinguish between monetary and non-monetary items. Value of asset as per CPP = Historical Cost of Asset Conversion Factor =

Conversion Factor

Price Index at the date of conversion Price at the date of transaction

ILLUSTRATION 12.3 A company purchased a machine for Rs 25,000 on 1st January 2012. The consumer price index on that date was 100 and it was 150 at the end of the year. What will be the value of machine on 31st December 2012 as per the CPP Method? Solution: Conversion Factor =

Price Index on 31st Dec Price index on 1st Jan

150 100 = 1.5 =

Value of Machine on 31 December 2012 = 25,000 × Conversion Factor = Rs 25,000 1.5 = Rs 37,500

ILLUSTRATION 12.4 From the following data calculate net monetary gain/loss as per the CPP Method: Item Cash Debtors Creditors Public Deposits Consumer Price Index

1st January 2012 Rs 5,000 Rs 20,000 Rs 15,000 Rs 20,000 100

Average Consumer Price Index for the year = 120

31 December 2012 Rs 10,000 Rs 25,000 Rs 20,000 Rs 20,000 150

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Solution: Impact on Assets: Assets as on 31/12/2012 = 35,000 out of which 25,000 are opening and rest 10,000 are additions during the year. Value of Assets as per CPP = 25,000 × (150/100) + 10,000 (150/120) = 37,500 + 12,500 = Rs. 50,000 Value of Assets as per Closing Balance Sheet = Rs 35,000 Resultant Monetary Loss = 50,000 − 35,000 = Rs 15,000 Impact on Liabilities: Liabilities as on 31 December 2012 = 40,000 out of which 35,000 are opening and rest 5,000 are additions during the year. Value of Liabilities as per CPP = 35,000 (150/100) + 5,000 (150/120) = 52,500 + 6,250 = Rs 58,750 Value of Liabilities as per Closing Balance Sheet = Rs 40,000 Resultant Monetary Gain = 58,750 – 40,000 = Rs 18,750

= Rs 3,750

Current Cost Accounting Method The CCA Method matches current revenues with the current cost of the resources which are consumed in earning them. The assets are valued at current cost which is the cost at which asset can be replaced on date. The items of the financial statements are restated in terms of current value of that item and in terms of general purchasing power of the money. This requires carrying out the following adjustments: ■ ■ ■ ■

Revaluation adjustment Depreciation adjustment Cost of sales adjustment Monetary working capital adjustment

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ILLUSTRATION 12.5 From the following information carry out Monetary Working Capital Adjustment under the CCA Method: Opening Balance Accounts Receivable Accounts Payable Price Index Average Price Index

12,000 9,000 150

Closing Balance 14,000 10,000 200 180

Solution: MWCA = Closing MWC – Opening MWC – Average Price Index (Closing MWC/ Closing Index – Opening MWC/Opening Index) Opening MWC = 12,000 – 9,000 = Rs 3,000 Closing MWC = 14,000 – 10,000 = Rs 4,000

= Rs 1,000

ILLUSTRATION 12.6 A company purchased a machine on 1 January 2007 for Rs 60,000 and its expected life was 10 years without any scrap value. On 1 January 2010, the same new machine would cost Rs 25,000 and on 31 December 2010, it would be Rs 35,000. Calculate the depreciation charge for the year 2010 as per CCA Method assuming that there is no change in the useful life of the asset. Solution: Depreciation under CCA Method = Average Replacement Cost/Useful life Average Replacement Cost = (25,000 + 35,000)/2 = Rs 30,000 Depreciation under CCA Method = 30,000/10 = Rs 3,000 Limitations ■ ■ ■

Change in the price level is a continuous process. Calculations are tedious because of too many conversions and calculations. This system has not been given preference by tax authorities.

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RESPONSIBILITY ACCOUNTING Objective 8 Responsibility accounting is an underlying To understand responsibility concept of accounting performance accounting measurement systems. The basic idea is that large organisations are difficult, to manage as a single unit, thus they must be decentralised or separated into manageable parts. These parts or segments are referred to as responsibility centres that include: 1. Cost Centres: A business segment that incurs expenses but does not generate revenue 2. Profit Centres: A part of the business that has control over both revenues and expenses, but no control over investment funds 3. Revenue Centres: A part of the business that is responsible for the revenue generation 4. Investment Centres: A profit centre which is autonomous to make capital investment decisions This approach allows responsibility to be assigned to the responsibility centre managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue centre (a segment that mainly generates revenue with relatively little costs), costs for a cost centre (a segment that generates costs, but no revenue), a measure of profitability for a profit centre (a segment that generates both revenue and costs) and return on investment (ROI) for an investment centre (a segment such as a division of a company where the manager controls the acquisition and utilisation of assets, as well as revenue and costs). Perhaps the most compelling argument for the responsibility accounting approach is that it provides a way to manage an organisation that would otherwise be unmanageable. In addition, assigning responsibility to lower level managers allows higher level managers to pursue other activities such as long-term planning and policymaking. It also provides a way to motivate lower level managers and workers. Managers and workers in an individualistic system tend to be motivated by measurements that emphasise their individual performances. An implicit assumption of responsibility accounting is that separating a company into responsibility centres that are controlled in a top down manner is the way to optimise the system. However, this separation inevitably fails to consider many of the interdependencies within the organisation. Ignoring the interdependencies prevents teamwork and creates the need for buffers such as additional inventory, workers, managers and capacity. Of course, a system that prevents teamwork and creates excess is inconsistent with the lean enterprise concepts of just-in-time and the theory of constraints. For this reason, critics of traditional accounting control systems advocate managing the system as a whole to eliminate the need for buffers and excess. They also argue that companies need to develop process oriented learning support systems, not financial results, fear oriented control systems.

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The information system needs to reveal the company’s problems and constraints in a timely manner and at a disaggregated level so that empowered users can identify how to correct problems, remove constraints and improve the process. According to these critics, accounting control information does not qualify in any of these categories because it is not timely, disaggregated, or user friendly. This harsh criticism of accounting control information leads us to a very important controversial question. Can a company successfully implement just-in-time and other continuous improvement concepts while retaining a traditional responsibility accounting control system? Although the jury is still out on this question, a number of field research studies indicate that accounting based controls are playing a decreasing role in companies that adopt the lean enterprise concepts. In a recent study involving nine companies, each company answered this controversial question in a different way by using a different mix of process oriented versus results oriented learning and control information. Since each company is different, a generalised answer to this question for all firms in all situations cannot be provided.

TRANSFER PRICING Objective 9 Transfer price refers to the amount used in To know transfer pricing accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. Transfer pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services. Transfer pricing systems are designed to accomplish the following objectives: ■

■

To provide each division with relevant information required to make optimal decisions for the organisation as a whole To promote goal congruence, that is actions by divisional managers to optimise divisional performance should automatically optimise the firm’s performance; and to facilitate measuring divisional performances.

The fundamental principle is that the transfer price should be similar to the price that would be charged if the products were sold to outside customers or purchased from outside vendors. Market-based transfer pricing system provides optimal results when the market for the intermediate product is perfectly competitive and the selling division can sell its output either to insiders or outsiders and as long as the buying division can obtain all its requirements from either outsiders or insiders. In such a situation the company as a whole has no additional cost of providing

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autonomy to divisions. For example, if Division A decides to sell its product at the market price of Rs 100 per unit and Division B decides to buy the same product from market at the market price, net cash flow to the firm will be zero. If the market for the intermediate product is imperfect, this system may lead to suboptimal utilisation of production capacity by the buying division. The transfer price will form an element of the total marginal cost and the buying division will restrict its output at the level where marginal cost = marginal revenue. Thus, the firm as a whole will lose an opportunity to improve its profit because actual marginal cost is lower than the transfer price. For instance, the intermediate product that the Sub-unit A of the firm uses is produced by the Sub-unit B of the firm and another firm. The market price of the product is Rs 100 per unit, while the variable cost of production in Division B is Rs 40 per unit. If, the transfer price is fixed at Rs 100 per unit (the market price) the Sub-unit A will consider Rs 100 per unit as a part of its marginal cost. It will restrict the output at the level where marginal cost = marginal revenue. If the Sub-unit B has excess capacity, the decision of the Sub-unit A is sub-optimal for the firm as a whole. Even in a situation where the Sub-unit B has no excess capacity, that is, it can sell its total output to outsiders at Rs 100 per unit, the decision of the Sub-unit A to restrict its output at a level lower than its achievable capacity might be sub-optimal for the firm as a whole. Assume that the firm earns a contribution of Rs 100 per unit on the final product, the output of the Sub-unit A. The contribution is higher than the contribution of Rs 60 per unit on the intermediate product. The firm loses the opportunity to earn higher profit by using the intermediate product internally in the Sub-unit A instead of selling the same to outsiders. If competitive prices are not available or it is too costly to obtain market prices, transfer prices may be determined based on the cost plus a profit. Cost-based transfer prices should be used only as a second option to market-based transfer prices because it involves complex calculations and results are less than satisfactory. Companies use variations of market-based and cost-based transfer pricing mechanisms to achieve the objective of goal congruence. Transfer-pricing system must have in-built mechanisms for smooth negotiation and conflict resolution. Although there is sound economic theory behind the selection of transfer pricing methods, companies use transfer price methods to achieve certain other objectives even at the cost of goal congruence. Often in family run businesses, decisions are taken at the group level. Therefore, decisions aim to optimise group performance. When group companies produce products that are used within the group, transfer price is established with an aim to optimise the group performance, although it may hurt the selling or the buying company within the group.

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An issue that is often ignored is that whether this practice undermines the interest of minority shareholders. If there is no minority shareholder in the company that is hurt, the ethical/corporate governance issue does not arise. Otherwise, this is an important issue and need to be addressed by the board of directors of individual companies. For multinational corporations, it may be advantageous to arbitrarily select prices such that most of the profit is made in a country with low taxes, thus shifting the profits to reduce overall taxes paid by a multinational group. However, most countries enforce tax laws based on the arm’s length principle as defined in the OECD Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, limiting how transfer prices can be set and ensuring that that country gets to tax its “fair” share. In India, the OECD principle was adopted in 2001. Applying transfer pricing rules based on the arm’s length principle is not easy, even with the help of the OECD’s guidelines. It is not always possible and certainly takes valuable time to find comparable market transactions to set an acceptable transfer price. The revenue authority and the MNCs should work together in good faith to implement regulations effectively. The question of ethics cannot be ignored even in tax planning.

SEGMENT REPORTING As 17 on Segment Reporting provides the following important definitions and disclosure requirement related to Segment Reporting.

Objective 10 To study segment reporting

A “business segment” is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. Factors that should be considered in determining whether products or services are related include: (a) (b) (c) (d) (e)

The nature of the products or services The nature of the production processes The type or class of customers for the products or services The methods used to distribute the products or provide the services If applicable, the nature of the regulatory environment, for example, banking, insurance, or public utilities

A “geographical segment” is a distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment

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and that is subject to risks and returns that are different from those of components operating in other economic environments. Factors that should be considered in identifying geographical segments include: (a) (b) (c) (d) (e) (f)

Similarity of economic and political conditions Relationships between operations in different geographical areas Proximity of operations Special risks associated with operations in a particular area Exchange control regulations The underlying currency risks

A “reportable segment” is a business segment or a geographical segment identified on the basis of foregoing definitions for which segment information is required to be disclosed by this statement. Enterprise revenue is the revenue from sales to external customers as reported in the statement of profit and loss. “Segment revenue” is the aggregate of: (a) The portion of enterprise revenue that is directly attributable to a segment (b) The relevant portion of enterprise revenue that can be allocated on a reasonable basis to a segment (c) Revenue from transactions with other segments of the enterprise Segment revenue does not include: (a) Extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies (b) Interest or dividend income, including interest earned on advances or loans to other segments unless the operations of the segment are primarily of a financial nature (c) Gains on sales of investments or on extinguishment of debt unless the operations of the segment are primarily of a financial nature “Segment expense” is the aggregate of: (a) The expense resulting from the operating activities of a segment that is directly attributable to the segment, and (b) The relevant portion of enterprise expense that can be allocated on a reasonable basis to the segment, including expense relating to transactions with other segments of the enterprise. Segment expense does not include: (a) Extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies

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(b) Interest expense, including interest incurred on advances or loans from other segments, unless the operations of the segment are primarily of a financial nature (c) Losses on sales of investments or losses on extinguishment of debt unless the operations of the segment are primarily of a financial nature (d) Income tax expense (e) General administrative expenses, head-office expenses, and other expenses that arise at the enterprise level and relate to the enterprise as a whole. However, costs are sometimes incurred at the enterprise level on behalf of a segment. Such costs are part of segment expense if they relate to the operating activities of the segment and if they can be directly attributed or allocated to the segment on a reasonable basis. “Segment result” is segment revenue less segment expense. “Segment assets” are those operating assets that are employed by a segment in its operating activities and that either are directly attributable to the segment or can be allocated to the segment on a reasonable basis. If the segment result of a segment includes interest or dividend income, its segment assets include the related receivables, loans, investments, or other interest or dividend generating assets. Segment assets do not include income tax assets. “Segment assets” are determined after deducting related allowances/provisions that are reported as direct offsets in the balance sheet of the enterprise. “Segment liabilities” are those operating liabilities that result from the operating activities of a segment and that either are directly attributable to the segment or can be allocated to the segment on a reasonable basis. If the segment result of a segment includes interest expense, its segment liabilities include the related interest-bearing liabilities. Segment liabilities do not include income tax liabilities.

Primary and Secondary Segment Reporting The dominant source and nature of risks and returns of an enterprise should govern whether its primary segment reporting format will be business segments or geographical segments. If the risks and returns of an enterprise are affected predominantly by differences in the products and services it produces, its primary format for reporting segment information should be business segments, with secondary information reported geographically. Similarly, if the risks and returns of the enterprise are affected predominantly by the fact that it operates in different countries or other geographical areas, its primary format for reporting segment information should be geographical

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segments, with secondary information reported for groups of related products and services. Segment information should be prepared in conformity with the accounting policies adopted for preparing and presenting the financial statements of the enterprise as a whole. Following information is obtained from the Annual Report (2010–11) of Glenmark Pharma related to segment reporting.

Operating Segments IFRS 8 defines an operating segment as follows. An operating segment is a component of an entity: [IFRS 8.2]: that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity) whose operating results are reviewed regularly by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance and for which discrete financial information is available

■

■

■

Exhibit 12.1 shows Segment Reporting of TCS Ltd for 2010–11. EXHIBIT 12.1

Segment Reporting of TCS Ltd for 2010–11

The Company’s Industry segment results are summarised below. Summary of segment result

Fiscal 2011 (Rs crore)

% of Revenues

Fiscal 2010 (Rs crore)

% of Revenues

% growth

Revenues

37,324.51

—

30,028.92

—

24.30

Segment result

11,064.09

29.64

8,564.54

28.52

29.18

647.47

1.73

546.98

1.82

18.37

10,416.62

27.91

8,017.56

26.70

29.92

Unallocable expenses (net) Operating Income Other Income (net) Profit before taxes

604.00

1.62

272.07

0.91

122.00

11,020.62

29.53

8,289.63

27.61

32.94

The following table presents each industry segment’s revenues as a percentage of total industry revenues and each industry segments result i.e. operating profit (excluding unallocated expenses) as a percentage of total industry segment result.

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Segment Revenues Fiscal 2011

Fiscal 2010

(Rs crore)

Fiscal 2011

Segment Result Fiscal 2010

Fiscal 2011

% of Revenues

Fiscal 2010

(Rs crore)

Fiscal 2011

Fiscal 2010

% of Segment Result

Banking Financial Services and Insurance

16,526.60

13,488.85

44.28

44.92

5,170.84

3,873.73

46.73

45.23

Manufacturing

2,751.76

2,433.80

7.37

8.10

704.30

743.01

6.37

8.68

Retail and Consumer Packaged Goods

4,105.05

3,181.43

11.00

10.59

1,071.68

846.53

9.69

9.88

Telecom

5,292.45

4,365.02

14.18

14.54

1,843.78

1,350.94

16.66

15.77

Others

8,648.65

6,559.82

23.17

21.85

2,273.49

1,750.33

20.55

20.44

Total

37,324.51

30,028.92

100.00

100.00

11,064.09

8,564.54

100.00

100.00

Source: Annual Report TCS Ltd 2010–11

EXTENSIBLE

BUSINESS REPORTING LANGUAGE (XBRL)

Objective 11 The eXtensible Business Reporting Language To get introduced to XBRL (XBRL), the new language for electronic communication of business and financial data, is on its way to revolutionise the approach in which information is consumed and transformed. This new reporting format is going to have far reaching impact on the financial reporting chains across the globe. Looking at the enormous advantages of XBRL, the regulatory authorities in India are on a drive to implant this concept into our current financial reporting system. EXHIBIT 12.2

Implementation of XBRL in India

The Ministry of Corporate Affairs (MCA) has mandated the following class of companies to file their balance sheet and profit and loss account along with their directors’ and auditors’ report for the year 2010–11 and onwards, using XBRL taxonomy: 1. All companies listed in India and their Indian subsidiaries 2. All companies having a paid up capital of INR 5 crores and above 3. All companies having a turnover of INR 100 crores and above.

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However, banking companies, insurance companies, power companies and non-banking financial companies (NBFC’s) are exempted for XBRL filing, till further orders. Further, it has been informed that the verification and certification of the XBRL document of financial statements on the e-forms would continue to be done by authorised signatory of the company as well as professional like chartered accountant or company secretary or cost accountant in whole time practice.

The idea behind XBRL, eXtensible Business Reporting Language, is simple. Instead of treating financial information as a block of text—as in a standard internet page or a printed document—it provides an identifying tag for each individual item of data. This is computer readable. For example, company net profit has its own unique tag. The introduction of XBRL tags enables automated processing of business information by computer software, cutting out laborious and costly processes of manual re-entry and comparison. Computers can treat XBRL data “intelligently”: they can recognise the information in an XBRL document, select it, analyse it, store it, exchange it with other computers and present it automatically in a variety of ways for users. XBRL greatly increases the speed of handling of financial data, reduces the chance of error and permits automatic checking of information. Companies can use XBRL to save costs and streamline their processes for collecting and reporting financial information. Consumers of financial data, including investors, analysts, financial institutions and regulators, can receive, find, compare and analyse data much more rapidly and efficiently if it is in XBRL format. XBRL can handle data in different languages and accounting standards. It can flexibly be adapted to meet different requirements and uses. Data can be transformed into XBRL by suitable mapping tools or it can be generated in XBRL by appropriate software.

How to Create Financial Statements in XBRL? Generation of XBRL formatted financial statements can be through the following modes: 1. Conversion: At the most basic level of adoption, an organisation takes information from various sources within the organisation and then copies or keys this information into an XBRL tool. There is no process change in this approach, merely a conversion of the results of the existing processes to a different format— including the existing inefficiencies. 2. Outsourced: A second alternative is to use a third-party service provider to generate the XBRL financial statements by interfacing with them with the financial reporting tool.

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Steps in Creation of XBRL Instance Document 1. Obtain audited financial statements. 2. These audited financial statements would preferably be in Excel and/or Word format. 3. Preparation of the source document based on the audited financial statement for XBRL conversion. 4. Mapping the source document to the Target Taxonomy as mandated by MCA. 5. Validating the mapped document to create instance document. 6. Eliminating errors arising out of validation based on error logs. 7. Approval of instances and mapping by the Board of Directors before creating XBRL instance document. 8. Creating XBRL instance document. 9. Validation of the XBRL instance document by the management using the tool provided by the MCA before filing with the Office of the Registrar of Companies (ROC). In the above procedure, Mapping or Tagging given in Step No 4 is the most important step for the creation of an instance document because it requires exercise of reasonable judgement and accounting knowledge in mapping the financial statement items to the appropriate tags in the taxonomy. Judgement has to be exercised having regard to the nature of the financial statement item/account head to ensure selection of the most appropriate tag. It has to be ensured that the XBRL financial statements so generated are as per the taxonomy defined by MCA. This includes ensuring completeness, accuracy, mapping and structure of the XBRL financial statements. 1. Completeness means that all required information is formatted at the required levels as defined by the entity’s reporting environment. Only permitted information selected by the entity is included in the eXtensible Business Reporting Language (XBRL) files. 2. Mapping means that the elements selected are consistent with the meaning of the associated concepts in the source information in accordance with the requirements of the entity’s reporting environment. 3. Accuracy means that the amounts, dates, other attributes (for example, monetary units), and relationships (order and calculations) in the instance document and related files are consistent with the source information in accordance with the requirements of the entity’s reporting environment. 4. Structure means that XBRL files are structured in accordance with the requirements of the entity’s reporting environment.

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5. Download MCA XBRL validation tool from MCA portal: Validating the instance document is a prerequisite before filing the balance sheet and profit and loss account on MCA portal. 6. Load the instance document in the validation tool: To load the instance document, you need to click on the open button, select the instance document and open it. The detail of the company is available under the General Information tag in the XBRL viewer. 7. Use the tool to validate the instance document. 8. Perform pre-scrutiny of the validated instance document through the tool: For pre-scrutinising the instance document, a working Internet connection shall be required. In the pre-scrutiny, the server side validations (i.e. validations which are to be validated from the MCA21 system) shall be performed. 9. Final verification post pre-scrutiny of the document: The next step is to generate pdf by using “Export to pdf” functionality in the tool to verify the final instance document. 10. Attach instance document to the Form 23AC-XBRL and Form 23ACA-XBRL: First Form 23AC-XBRL and 23ACA-XBRL are to be filled up. Thereafter, the validated and pre-scrutinised instance document for balance sheet is to be attached to Form 23AC-XBRL. Similarly, the instance document for the profit and loss account is to be attached to Form 23ACA-XBRL. Separate instance documents need to be attached with respect to standalone financial statements and consolidated financial statements. 11. Submitting the Form 23AC-XBRL and Form 23ACA-XBRL on the MCA portal: After the forms are filled, you are required to perform pre-scrutiny of the form, sign the form and then upload the same as per the normal e-form filing process. 12. Viewing of balance sheet and profit and loss submitted in XBRL form on MCA portal: The XBRL instance documents submitted along with Form 23AC-XBRL and 23ACA-XBRL are in machine readable format. Therefore, for viewing the same in a human readable format, these shall be converted into human readable format by the MCA21 system.

SUMMARY ➤

Foreign currency accounting plays very important role in the modern times due to cross border transactions. Since foreign transactions involve different currencies, its accounting becomes necessary.

➤

Creative accounting refers to the malpractice in which accountants misuse and misguide funds making serious blunders in accounting operations.

438 Financial Accounting ➤

“Forensic Accounting” provides an accounting analysis that is suitable to the court which will form the basis for discussion, debate and ultimately dispute resolution.

➤

Environmental accounting deals with computation of environmental costs of commercial and industrial decision using traditional accounting and financial principles.

➤

Lean accounting is an accounting type that is designed for those companies who have implemented lean manufacturing techniques.

➤

The principles of lean accounting are to measure and motivate. Lean accounting can measure positive gains through initiating lean alternatives in ways like reducing inventory, reducing cycle time, or improving production floor moral and thereby increasing overall capacity. Lean accounting works to motivate a company to continue to promote their lean initiatives rather than deliver numbers that are not necessarily an accurate reflection of company profitability such as is the case with attempting to meet machine efficiency quotas by producing an abundance of unnecessary inventory.

➤

Human Resource Accounting (HRA) is accounting for the company’s management and employees as human capital that provides future benefits. In the HRA approach, expenditures related to human resources are reported as assets on the balance sheet as opposed to the traditional accounting approach which treats costs related to a company’s human resources as expenses on the income statement that reduce profit.

➤

Inflation accounting is a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation.

➤

Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organisations are difficult, if not impossible to manage as a single segment, thus they must be decentralised or separated into manageable parts.

➤

Transfer price refers to the amount used in accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. Transfer pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services.

➤

A business segment is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments.

➤

eXtensible Business Reporting Language (XBRL), the new language for electronic communication of business and financial data, is on its way to revolutionise the approach in which information is consumed and transformed. This new reporting format is going to have far reaching impact on the financial reporting chains across the globe.

Contemporary Issues in Accounting

439

MULTIPLE CHOICE QUESTIONS* 1. The transaction incurred in foreign currency is to be translated into (a) Home currency (b) US dollar (c) Either home currency or US dollar (d) As per the directions of RBI 2. Closing rate is the exchange rate at (a) The closing of transaction (b) The balance sheet date (c) The end of calendar year (d) None of the above 3. At the end of the year, balance of foreign exchange fluctuation account is transferred to (a) Profit and loss account (b) Balance sheet (c) Cash flow statement (d) None of the above Questions 4 to 6 are based on the following information: E Ltd of Mumbai has sold the goods for $3,00,000 to B Ltd of USA on 31st January, 2008. On 1 February 2008, $50,000 has been received. On 1 March 2008, $80,000 has been received. On 30 April 2008, $90,000 has been received. Balance was received on 31 May 2008. Year ends on 31 March every year. Exchange rate: 31 January 2008, $1 = Rs 51 1 February 2008, $1 = Rs 50 1 March 2008, $1 = Rs 52 31 March 2008, $1 = Rs 51 30 April 2008, $1 = Rs 49 31 May 2008, $1 = Rs 53 4. On 1 Febuary 2008, foreign exchange fluctuation is (a) Debited with Rs 30,000 *Answers to Multiple Choice Questions are provided on the website of the book, www.mhhe.com/bapat-raithatha.

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5.

6.

7.

8.

9.

10.

(b) Credited with Rs 30,000 (c) Debited with Rs 50,000 (d) Credited with Rs 50,000 On 1 March 2008, foreign exchange fluctuation is __________________. (a) Debited with Rs 30,000 (b) Credited with Rs 80,000 (c) Debited with Rs 50,000 (d) Credited with Rs 50,000 The amount to be transferred to profit and loss account as at 31 March 2008 is (a) Rs 30,000 debit (b) Rs 80,000 credit (c) Rs 30,000 credit (d) Rs 50,000 debit Creative accounting refers to (a) Using innovative techniques to prepare financial statements (b) The malpractice in which accountants misuse and misguide funds making serious blunders in accounting operations (c) Effective accounting (d) None of the above Environmental accounting deals with (a) Framing pollution control legislations (b) Computation of environmental costs of commercial and industrial decision using traditional accounting and financial principles (c) Accounting standards to report environmental practices (d) None of the above Inflation accounting is (a) Accounting for inflation in government budgets (b) Taking corrective measures for rising prices (c) A range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation (d) None of the above Responsibility accounting is an underlying concept of (a) Accounting performance measurement systems (b) Management principles (c) Responsible and accurate accounting (d) None of the above

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11. eXtensible Business Reporting Language (XBRL) is (a) A new computer programming language (b) A new language for electronic communication of business and financial data (c) A new language for preparing audit reports (d) None of the above

THEORY QUESTIONS 1. What are foreign currency transactions? Explain reasons for foreign exchange differences. 2. What is creative accounting? How can it be prevented? 3. Write a note on forensic audit. 4. What are the functions of forensic accountant? 5. What is environmental accounting? Explain its need. 6. What are the forms of environmental accounting? 7. Explain different methods of environmental accounting. 8. What are the limitations of environmental accounting? 9. What is lean accounting? What improvements are brought in by lean accounting? 10. Explain objectives of lean accounting. How can it be implemented? 11. What is human resource accounting? Explain its objectives. 12. Explain various models of HRA. 13. What is inflation accounting? How is it useful? 14. Explain inflation accounting models in brief. 15. Distinguish between Current Purchasing Power (CPP) and Current Cost Accounting (CCA) methods. 16. Write notes on: (a) Responsibility accounting (b) Transfer pricing 17. Explain the concept of business segment and geographical segment. 18. Write notes on: (a) Segment assets (b) Segment liabilities (c) Segment revenue (d) Segment expenses 19. Explain the concept of operating segment with respect to IFRS. 20. What is XBRL? How financial statements are created through XBRL?

442 Financial Accounting

RESEARCH ASSIGNMENT Collect information about business segments of HUL, Dabur India and ITC. Compare their segment assets, liabilities, revenues and expenses. Identify their revenue generation with respect to business and geographical segment classification. Compute what percent of profitability and ROI is from export sales and offer your comments.

BUSINESS CASES Case 1 SAIL is India’s largest steel-producing company. With a turnover of Rs 47,041 crore, the company is among the five Maharatnas of the country’s Central Public Sector Enterprises. SAIL has five integrated steel plants, three special plants, and one subsidiary in different parts of the country. SAIL manufactures and sells a broad range of steel products, including hot and cold rolled sheets and coils, galvanised sheets, electrical sheets, structurals, railway products, plates, bars and rods, stainless steel and other alloy steels. SAIL produces iron and steel at five integrated plants and three special steel plants, located principally in the eastern and central regions of India and situated close to domestic sources of raw materials, including the Company’s iron ore, limestone and dolomite mines. The company has the distinction of being India’s second largest producer of iron ore and of having the country’s second largest mines network. This gives SAIL a competitive edge in terms of captive availability of iron ore, limestone, and dolomite which are inputs for steel making. SAIL’s wide range of long and flat steel products are much in demand in the domestic as well as the international market. This vital responsibility is carried out by SAIL’s own Central Marketing Organisation (CMO) that transacts business through its network of 37 branch sales offices spread across the four regions, 25 departmental warehouses, 42 consignment agents and 27 customer contact offices. CMO’s domestic marketing effort is supplemented by its ever widening network of rural dealers who meet the demands of the smallest customers in the remotest corners of the country. With the total number of dealers over 2000, SAIL’s wide marketing spread ensures availability of quality steel in virtually all the districts of the country. SAIL recognises that its business activities have direct and indirect impact on the society. The Company strives to integrate its business values and operations in an ethical and transparent manner to demonstrate its commitment to sustainable development and to meet the interests of its stakeholders.

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443

Exhibit 12.3 provides profit and loss account of SAIL. EXHIBIT 12.3

PROFIT AND LOSS ACCOUNT OF SAIL Profit & Loss Account For the year ended 31st March,2011

Schedule No.

Year ended 31st March, 2011

Year ended 31st Mach, 2010

Income Sales

2.1

Less: Excise duty

43934.70

47040.50 4321.79

42718.71

3383.32

40551.38

Interest Earned

2.2

1381.17

1860.91

Other revenues

2.3

773.56

820.90

Provisions no longer required written back

2.4

48.24

86.35

44918.67

43319.61

Expenditure Accretion(–) Depletion to stocks of finished/semi-finished products

2.5

–1352.67

1161.01

Raw materials consumed

2.6

22076.40

17340.18

4.22

2.79

7623.33

5416.81

3309.75

3163.43

Purchase goods

of

finished/semi-finished

Employees’ Remuneration & Benefits

2.7

Stores & Spares Consumed Power & Fuel

2.8

3597.04

3369.35

Repairs Maintenance

2.9

670.04

569.74

705.33

674.28

Freight outward Other expenses

2.10

2863.80

2327.23

Interest & finance changes

2.11

474.95

402.01

1485.80

1337.24

41457.99

35764.07

Depreciation Total Less: Inter Account Adjustments

2.12

3629.93

37828.06 7090.61

2553.27

33210.80 10108.81 (Contd.)

444 Financial Accounting

Add: Adjustments pertaining to earlier years

2.13

Profit before tax

103.70

23.22

7194.31

10132.03

Less Provision for taxation Current tax

2367.38

3371.17

Deferred tax

–63.04

81.72

Earlier years

–14.77

2289.57

–75.23

3377.66

4904.74

6754.37

Balance brought forward from last year

24774.29

20345.05

Amount available for appropriation

29679.00

27099.42

72.29

54.58

Amount Transferred to General Reserve

500.00

680.00

Interim dividend

495.65

660.86

Proposed dividend (Final)

495.65

702.17

Tax on Interim dividend

80.74

110.90

Tax on Proposed dividend (Final)

80.41

24774.29

Balance carried to Balance Sheet

27954.03

27099.42

4904.74

6754.37

Average Number of equity shares (Face value Rs 10/- each)

4130400545

4130400545

Basic and Diluted Earnings per share (Rs)

11.87

16.35

Profit after tax

Appropriations Amount Transferred to Bonds Redemption Reserve (net)

Earnings per share Profit after tax

Significant Accounting Policies and Notes on Accounts Schedules 2 and 3 annexed hereto, from part of the Profit & Loss Account Source: Annual Report SAIL, 2010–11.

3

VISL

Others

(693.54)

(1443.11) 2166.65)

(185.94)

(–22.05)

–3.52

871.89 (806.36)

(19.16)

22.14

8.31 (4.85)

1477.90 (970.74)

(–99.98) (1744.18)

–129.07 1360.19

85.64 (56.54)

(4403.49)

39.16

808.27 (387.10)

Previous year

1336.38

202.82 (253.12)

967.77

477.82

431.05 (315.47)

3598.39

1544.82 467.33 108.85 (1368.49) (500.57) (57.41)

SSP

7658.81 11875.52 2686.33 1319.53 1553.13 552.97 1586.75 (7092.69) (11550.09) (2220.58) (1215.83) (1373.34) (557.11) (1028.15)

ASP

18118.00 6663.92 (16606.04) (5917.24)

ISP

206.62 (100.45)

BSL

881.96 (731.74)

RSP

7452.10 11672.70 1878.06 447.64 (6992.24) (11296.97) (1833.48) (409.47)

DSP

17236.04 6232.87 (15874.30) (5601.77)

BSP

Current year Previous year –Inter Segment Sales Current year Previous year –Total Revenue Current year Previous year Result –Operating Profit/ (–) Loss (Before Interest Expenses) Current year

Revenue –External Sales

Particulars

A. Business Segment

Segment Information of the Year ended 31st March, 2011

EXHIBIT 12.4 Segment Information of SAIL

Exhibit 12.4 provides segment information of SAIL.

(Contd.)

(10534.04)

7669.26

–4974.46 47040.50 (–3626.37) (43934.70)

–4974.46 0.00 (–3626.37) (0.00)

47040.50 (43934.70)

Inter SAIL Segment Sales

(Rs in crore)

Annexure-I

Contemporary Issues in Accounting

445

–Interest expenses Current year Previous year –Income Tax Current year Previous year –Net Profit/Loss(–) Current year Previous year Other Information –Segment Assets Current year 10939.01 3210.61 Previous year (8650.51) (3325.36) –Segment Liabilities Current year 5052.36 1448.37 Previous year (4592.04) (1475.63) –Capital Expenditure Current year 1497.19 223.52 Previous year (1522.11) (102.39) –Depreciation Current year 307.25 314.28 Previous year (269.11) (311.31) –Net Cash expenses other than Depreciation Current year 1992 2.37 Previous year (6.34) (2.80) Source: Annual Report SAIL, 2010–11 10.41 (18.20)

10.21 (1.01)

0.14 (0.67)

5.17 (12.72)

7.04 (8.16)

1.31 (3.07)

14.32 (12.65)

42.92 (46.48)

17.70 (13.42)

295.21 (246.08)

332.77 (310.68)

49.62 (32.82)

664.69 7.22 (1010.37) (31.79)

2501.46 1346.82 3503.23 17.16 (1794.56) (1353.09) (4543.76) (15.38)

248.09 265.55

10.26 (18.10)

115.73 (94.69)

422.49 (775.08)

2614.65 2011.65

452.09 479.57

2484.24 3030.12 1707.74 (2592.82) (3226.88) 2152.24

319.30 352.15

3379.25 709.41 26941.91 (2749.47) (647.47) (30490.69)

9447.19 8800.05 12034.13 621.43 (6849.57) (6662.67) (8345.90) (669.76)

48.83 (71.07)

1485.80 1337.24

10183.78 (11148.53)

17356.96 17148.53

76082.99 (68391.40)

4904.74 (6754.37)

2289.57 (3377.66)

474.95 (402.01)

446 Financial Accounting

Contemporary Issues in Accounting

447

You are required to analyse the above statement and calculate the contribution of each business segment. Further compute gross profit and return on assets (ROA) for each segment and offer your comments.

Case 2 In the annual report of SAIL for 2010–11, geographical segments have been considered for secondary segment reporting, by treating sales revenue in India and foreign countries as separate geographical segments. Exhibit 12.5 provides geographical segment. EXHIBIT 12.5 GEOGRAPHICAL SEGMENT OF SAIL Geographical Segment (Rs in crore) Particulars Current year Amount Sales Revenue India 46059.96 Foreign Countries 980.54 Total 47040.50 Source: Annual Report SAIL 2010–11

Previous year Amount 43151.56 783.14 43934.70

Mr Kishore, an analyst, is asked to calculate effect of foreign exchange fluctuation on company’s profit for year ended 31 March 2012. He has made the following assumptions: The Company is predicated to have 10% increase in sales of which percentage of export sales will remain unchanged. Company does not have any import from other countries. All other expenses are assumed to be in same proportion as for last year. (Refer to Profit and Loss A/c provided in Exhibit 12.3 of Business Case 1.) The opening balance of debtors (1 March 2011) was collected on 30 May 2011. Export sales are on credit basic and Company has the following collection programme: Month April May June July

Sales (% of Total Export Sales) 30 25 35 10

Month of Collection from Debtors June July August September

There is depreciation of rupee during the above period; following table provides details for exchange rate. Month April May June July

Exchange Rate in Rs per US$ 48 48.75 49.25 50

Month June July August September

Exchange Rate in Rs per US$ 49.50 50.25 50.75 51.25

Reading an Annual Report

An Annual Report is a comprehensive report on a company’s activities during a particular financial year. Annual reports are intended to give shareholders and other stakeholders, information about the company’s activities and its financial performance. Annual report is treasure of rich information for a decision maker. It will be very useful if one learns the art of reading and interpreting annual report.

CONTENTS OF AN ANNUAL REPORT An annual report usually contains a letter to the shareholders, a summary of financial highlights, a description of the company, management’s discussion and analysis of the company’s operating results and financial condition, the financial statements, notes to the financial statements, a statement about management’s responsibilities and the auditors’ report. Following is a brief discussion on contents of annual report:

Letter to the Stockholders/Chairman’s statement Traditionally, an annual report begins with a letter in which the chairman/MD of the corporation informs stockholders about the company’s performance and prospects.

Notice A notice of Annual General Meeting and agenda which includes ordinary and special items proposed to be discussed.

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449

Financial Highlights The financial highlights section of an annual report presents key statistics usually of last five-year period. It may include information for a longer period (say a ten-year period). It is often accompanied by graphs.

Description of the Company An annual report may contain a detailed description of the company’s products and divisions. Some analysts tend to scoff at this section of the annual report because it often contains glossy photographs and other image-building material, but it should not be overlooked because it may provide useful information about the company’s past results and future plans.

Director’s Report It provides a brief review of business functions like production, marketing, finance and human resources. It also focuses on growth plan of company along with strategy initiatives. It gives details about projects accomplished and undertaken during the financial year. It may also contain brief overview of Corporate Social Responsibility policy, citizen charter, environment management, and directors’ responsibility statement.

Management’s Discussion and Analysis In this section, management describes industry situation and the strength and weakness of the company. Review of financial performance includes foreign exchange management, project management, research and development initiative of the company and the internal audit system and its effectiveness.

Financial Statements This is most important section of the annual report, containing Income Statement, Balance Sheet and Cash Flow statement. It may also include:

(a) Schedules/Notes to the Financial Statements To meet the requirements of full disclosure, a company must add notes to the financial statements. The notes are considered an integral part of the financial statements. In recent years, the need for explanation and further details has become so great that the notes often take more space than the statements themselves. The notes to the financial statements include a summary of significant accounting policies and explanation of some of the items.

450 Reading an Annual Report

(b) Consolidated Financial Statements It provides the overall health of an entire group of companies as opposed to one company’s stand alone position. They contain financial statements of subsidiaries.

(c) Segment Reporting Segment reporting provides information on the performance of company’s individual divisions. Business segment reporting includes each segment’s revenues, expenses, identifiable assets and liabilities.

Auditors’ Report Auditors certify whether the accounts are drawn up in accordance with GAAP. Auditors make a brief report to opine whether the accounts give a true and fair view of the firm’s financial position.

Corporate Governance Report Corporate governance report contains the philosophy of the company in relation to corporate governance, details about Board of Directors, information about board committee, audit committee, remuneration committee, investors’ grievance committee and other committees. It is prepared in accordance with requirement of Clause 49 of SEBI, which is applicable only to the listed companies.

Corporate Social Responsibility Under this section company discusses about projects and efforts taken for the betterment of the society. Only a few companies provide the detailed information.

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Account: A statement that shows all transactions related to a particular party, asset, liability, income or expense. Examples: Mohan’s A/c, Machinery A/c and Salary A/c. Accounting Concepts: They refer to the basic assumptions that are the basis for recording of business transactions and preparing a financial statement. These are tenets or postulates used by accountants. Example: Going Concern Concept. Accounting Conventions: They refer to the common practices that are traditionally followed in recording and presenting accounting information. Accounting Cycle: It refers to the process which starts with recording of opening entries in the journal and ends with the preparation of financial statements/final accounting statements. Accounting Error: An accounting error is a non-fraudulent discrepancy in financial documentation. These errors may be detected after a long time and are rectified as and when detected. Accounting Period Concept: This concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes such as calculation of profit, ascertainment of financial position and tax computation. Profit (or) loss of the business is to be measured periodically. Accounting Policies : It encompass the principles, bases, conventions, rules and procedures adopted by managements in preparing and presenting financial statements. Accounting policies are the specific accounting assumptions and the methods of applying these principles for the preparation and presentation of financial statements of an enterprise. Accounting Standards: They are accounting concepts, policies and practices as standardised and notified by accounting bodies/government.

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Accounting: It is a process which involves recording, classifying and summarising of past events and transactions of financial nature, with a view to enabling the user of accounts to interpret the resulting summary. Accrual Concept: Accrual refers to something that becomes due, especially an amount of money that is yet to be paid or received at the end of the accounting period. Due to this concept, the revenues and expenses are recognised when they become receivable/payable, though cash may or may not be received/paid. The transactions will be recorded in the accounting period to which they relate. Acquisition: An act of one enterprise of acquiring, directly or indirectly of shares, voting rights, assets or control over the management, of another enterprise. For example, Tata Steel Ltd. acquired Corus. Allotment of Shares: Acceptance by the company of the offer made by the applicants to take up the shares offered. On allotment the applicant becomes shareholder/member. Amortisation: The process of systematically writing off an intangible asset (like patent, copyright, leasehold property, trademark) over its useful life. Annual Report: A document published at the end of each financial year which contains financial statements and description of performance. Corporate annual report is required to be filled with a Registrar and is publically available. Asset: Anything of material value or usefulness that is owned by an individual or an entity and is expected to result into future benefit. Associate Company: It is a company in which another company owns a significant portion of voting shares, usually 20–50%. Auditor: An independent professional who examines the financial statements of an entity and opines whether they present “true and fair view”. In India, Chartered Accountants have an authority to sign audit report. Authorised, Registered or Nominal Capital: This is maximum amount of capital that can be raised by a company. Balance Sheet: A balance sheet is a statement of assets and liabilities of an entity (or an individual) at any particular date disclosing its financial position. Bank Reconciliation Statement: It is a statement that explains the reason for differences between bank balance as per the cash book and that as per bank statement, as on a particular day. Bills Payable: It is negotiable instrument in the form of written promise made towards account payable. Bills Receivable: It is negotiable instrument in the form of written promise to pay. Bonus Shares: Are equity shares issued to current shareholders in a company free of cost, based on the number of shares that the shareholder already owns. Such issue increases company’s equity capital, while it reduces company’s reserves. Business: It is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return to investors, owners, members or participants.

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Business Combination: It is a transaction or event in which an acquirer obtains control of one or more businesses. Business Segment: It is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. Buyback of Shares: It implies the act of purchasing its own shares by a company using its reserves. Shares bought back need to be cancelled. Calls-in-arrears: The amount due on allotment or calls which is unpaid. Capital Receipts: One time or non-recurring receipts. Example: capital brought in by the owner, loan taken from the bank. Cash and Cash Equivalents: The most liquid assets, comprising of cash on hand and demand deposits with banks and short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to less risk of changes in value. Cash Book: A book where cash and bank transaction are recorded. It serves as a book of primary entry and also as a ledger. Cash Flow Statement: A financial statement that describes the sources and application of cash from operating, investing and financing activities over a specified time period. Cash Realisation Ratio: A ratio of cash generated from operations to net income, which signals quality of earnings. Common Size Statement: A statement which shows each figure in a financial statement as a percentage to ‘total’. Profit and Loss Account items are divided by Sales and Balance Sheet items are divided by Total Assets. It facilitates comparability with other entities of different sizes. Company/Corporation: It is an artificial intangible entity which exists only in the contemplation of law. Comparative Statement: A statement which shows each figure in a financial statement as a change over previous period in absolute and percentage terms. It is useful for comparison of financial data over different periods of time. Computerised Accounting: It is a system which simplifies, integrates, automates and streamlines transaction recording processes, for various business operations, (like sales, finance, purchase, inventory and manufacturing) in cost-effective and efficient manner. Conservatism/Prudence: This convention is a guideline for accounting policies and is based on the principle: “Anticipate no profit, but provide for all possible losses.” Consistency: The convention states that same accounting principles, assumptions and methods should be used consistently year after year for financial recording and reporting.

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Consolidated Financial Statements: These are the financial statements of a group, that is a parent company and all its subsidiaries presented as if group is a single entity. Contingent Liabilities: These are not actual liabilities but their becoming actual liabilities depend on the occurrence of specific uncertain event(s). They are required to be shown as footnotes to the balance sheet. Examples: Legal case for damages against a company, bills receivable discounted. Convention of Disclosure/Transparency: This convention requires that all material and relevant facts concerning financial statements should be fully disclosed. Convertible Preference Shares: The preference shares give a right to the holder to get them converted into equity shares according to the terms and conditions of their issue. Corporate Governance: It is the system by which business corporations are directed and controlled. The corporate governance structure specifies the relationship between the different stakeholders such as the board, managers and shareholders and spells out the rules and procedures for corporate decisionmaking. Cost Accounting: It is a branch of accounting which records, analyses and estimates cost and facilitates cost control, cost reduction, budgeting etc. Coverage Ratios: Ratios which are used to test the adequacy of cash flows generated through earnings for purposes of meeting interest and debt service obligations, Example: Interest coverage ratio, the debt service coverage ratio. Creative Accounting: It refers to the malpractice in which accountants misuse the accounting procedures making serious blunders in recording and reporting of financial information. Creditors: It represents amounts payable by an organisation for credit purchases made. Also known as accounts payables, trade payables or trade creditors. Current Assets: These are the assets that are used for day-to-day operations and are expected to be held for less than one year. Examples: Cash, Debtors and Inventory. Current Cost Accounting Method: CCA Method matches current revenues with the current cost of the resources which are consumed in earning them. The items of the financial statements are restated in terms of current value of that item. Current Liabilities: Liabilities which are expected to be repaid within a period of one year. They usually arise from normal business transactions. Examples: Creditors, outstanding expenses and taxes payable. Current Purchasing Power (CPP): Under CPP Method, all items in the financial statements are restated in terms of units of equal purchasing power using a general price index.

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Debenture/Bond: A debenture/bond is an instrument of issued by as an evidence of debt. Debentures are transferable and can be listed on stock exchanges. Debtors: Amounts receivable from customers for credit sales made. Also called as accounts receivables, trade receivables or trade debtors. Depreciation: It is the continuous and permanent decline in the value of fixed assets due to usage, efflux of time and obsolescence. Direct Expenses: Costs incurred for supply of goods or service. Normally includes raw material cost, carriage inward, freight, wages and royalty on production. Dividends: A part of profits which is distributed among the shareholders in cash. However, sometime bonus share is referred to as “Stock Dividend”. Dividend Yield Ratio: A ratio of dividend to share price. Double Entry System: It is a scientific system of recording transactions. According to this system, every transaction has two-fold aspects (debit and credit) and both these aspects need to be recorded in the books of accounts. Dual Aspect Concept: Dual aspect concept assumes that every transaction has two effects, i.e. it affects two accounts in their respective opposite sides. Earnings Before Interest, Depreciation, Tax and Amortisation (EBDITA) or Profit Before Depreciation, Interest and Tax (PBDIT): It indicates cash profit earned from operating activities. Earnings Per Share (EPS): It indicates the profit available for each equity share. This ratio plays a very important role for the investors to take decision on investments. Earnings Yield Ratio: Ratio of profit generated per share to current market price. It is an inverse of P/E ratio. Employee Stock Option Plans (ESOPs): A choice given to whole time directors, officers and employees whereby they have the right to purchase or subscribe the shares at a predetermined price at a future date. Entity Concept: This concept assumes that, for accounting purposes, the organisation and its owner(s) are two separate independent entities. The business and personal transactions of its owner are separate. Environmental Accounting: It deals with computation of environmental costs of business or developmental activity. Equity Instrument: An “equity instrument” is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Equity Shares: Shares that entitle their holder to the whole of the profits earned by the company, after a fixed dividend on preference shares is paid. Equity shareholders are the real owners of the companies. Expenditure: It refers to any cost incurred. If the benefit of expenditure extends up to one accounting period, it is termed as revenue expenditure. Example: Salaries, rent. If the benefit of expenditure extends to more than one accounting period, it is termed as capital expenditure. Example: Acquisition of fixed assets.

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eXtensible Business Reporting Language (XBRL): It is the new language for electronic communication of business and financial data, is on its way to revolutionise the approach in which information is consumed and transformed. Factory Expenses: Costs incurred for manufacturing of goods. Example: Factory lighting, power and factory rent. Fair Value: It is the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm’s length transaction. It’s close to market value or net realisable value. Fictitious Assets: They represent expenses/losses which are not yet written off. Example: Company formation expenses, share issue expenses. Finance Function: It is related to procurement of funds as well as their effective utilisation. It covers financial planning, financial forecasting, raising finance, optimum use of funds and financial reporting. Financial Accounting: It is a branch of accounting which deals with recording of financial transactions and preparation of financial statements. Financial Asset: Include (a) cash; (b) an equity instrument of another entity; (c) a contractual right; d) a contract that will or may be settled in the entity’s own equity instruments. Financial Charges: Include interest on loan/public deposits/debentures, issue expenses for debentures and lease rentals. Financial Guarantee Contract: Is a contract that requires the issuer to make specified payments to reimburse the holder for a loss incurred due to bad debt. Financial Instrument: Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial Liability: It is any liability that is: (a) a contractual obligation: (b) a contract that will or may be settled in the entity’s own equity instruments and is: (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity. Financial Statement Analysis: A detailed study of financial statements. It involves a process of identifying financial strengths and weaknesses of the firm by establishing relationship between the items of financial statements. Financing Activities: Activities which affect the long-term funds used by the entity like capital and debt. Examples: Proceeds of shares or debentures issue, payments for buyback of shares, repayment of loans, redemption of debentures and payment of interest and cash dividend. First-In First-Out (FIFO): This method assumes that the goods purchased/ manufactured first are issued first. That is the goods issued or sold currently are those which represent the earliest purchases amongst the goods held in inventory and the goods which remain in stock are those which represent the most recent purchases.

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Fixed Assets: An asset that is held for being used for a long-term and is not intended to be sold in the normal course of business. Fixed assets include tangible (land, building and vehicle) and intangible assets (goodwill, patents, software). Foreign Company: A foreign company is one that is incorporated outside India but has business operations in India. Examples: General Motors, Microsoft Corporation, Suzuki Motor and Hyundai. Foreign Currency Accounting: A branch of accounting which deals with recording of foreign currency transactions. Forensic Accounting: A branch of accounting which provides information that is suitable in the court and describes engagements that result from actual or anticipated disputes or litigation. . Forfeiture of Shares: Cancellation of shares held by shareholders who fail to pay allotment or call money. Free Cash Flow: It is the surplus cash that is left after paying out interest and dividends and providing for the capital expenditure needed to maintain productive capacity. It can be used for expansion, reducing debt or other purposes. Fund Flow Statement: A statement which summarises the sources from which funds were obtained and the specific uses to which they were put. Generally Accepted Accounting Principles (GAAP): It includes accounting standards, provisions of law and guidelines issued by regulators. These principles enable standardisation in recording and reporting of financial information. Going Concern Concept: This fundamental accounting assumption which states that an entity will continue to carry on its activities for an indefinite period of time and it will not be dissolved in the foreseeable future. Government Company: A company in which not less than 51% of the paidup capital is held by the central government, or by any state government or governments. Also known as Public Sector Company. Example: Hindustan Petroleum Corporation Limited (HPCL), Oil and Natural Gas Corporation Limited (ONGC). Gross Profit: It is a difference between sales turnover and cost of goods sold. It enables to know about company’s operating results. Gross Profit Ratio or Gross Margin: A ratio of gross profit to net sales expressed as a percentage Hedging Instrument: It is a financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. Held-to-Maturity Investments: They are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity. Holding Company: A company which owns 51% or more of paid-up share capital of a subsidiary company.

458 Glossary ■

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Horizontal Analysis: Comparison of two or more years’ financial data of the same entity. It is conducted by preparing comparative statement or trend statement. Human Resource Accounting (HRA): It is accounting for the company’s management and employees as human capital that provides future benefits. Impairment of Assets: An unexpected or sudden decline in the utility of an asset due to physical damage or obsolescence. Inflation Accounting: It is a range of accounting systems designed to correct problems arising from historical cost accounting due to the changes in price levels. Intangible Fixed Assets: Those fixed assets which are not physical in nature and cannot be seen or touched. Examples: Goodwill, copyright and trademark. Internal Audit: It is an independent appraisal activity within an enterprise for the review of accounting, financial and other operational controls. Internal Control: It is a process affected by an organisation to provide reasonable assurance regarding the effectiveness and efficiency of operations, reliability of financial reporting and compliance with related rules and regulations. International Financial Reporting Standards (IFRS): A set of accounting standards, developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of financial statements. Inventory Cost: A sum of expenditure directly or indirectly incurred in bringing an article to its existing condition and location. It refers to production cost for the goods which are produced internally and acquisition cost for the goods which are purchased from outside. Inventory/Stock: It refers to that portion of material purchased or manufactured that remains unconsumed or unsold. Inventory management specifies the size and placement of goods and is concerned with managing purchase, sale and stock keeping. Inventory Turnover: It measures the relationship between the volume of goods sold and the amount of inventory carried during the period. Inventory Valuation: A process which provides a monetary value for items that are held as inventory. Investing Activities: Activities related to acquisition and disposal of long-term assets and investments. Investments: Money invested outside normal business, usually to generate some return. IPO/FPO: A sale of shares by a company to public. Initial Public Offer (IPO) is used by new companies to raise capital and get listed, while Follow-on Public Offer (FPO) is by existing listed companies to raise capital. IPO/FPO market is known as primary market. Issued Capital: A part of authorised capital, which is offered for subscription.

Glossary 459 ■

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Joint Venture: It is a business agreement of cooperation between two or more individuals or businesses in which each agrees to share profit, loss and control in a specific enterprise. Parties agree to develop a new entity by contributing equity. Journalizing: A process of recording transaction in the books of accounts. Last-In First-Out (LIFO): A method which assumes that the goods issued or sold out of the inventory are the ones most recently purchased and manufactured. Therefore, the goods held in stock represent the earliest purchases production. Lean Accounting: An accounting methodology that is suitable for those companies which have implemented lean manufacturing techniques. Ledger: A ledger is the principal book or computer file for recording monetary transactions in an account and is a permanent summary of all amounts entered in supporting journals which list individual transactions by date. Liability: It is a financial obligation, debt, claim or potential loss. They are probable future sacrifices of economic benefits due to present obligations towards other entities as a result of past transactions. Liquidity: It means ability of the entity to pay its liabilities in the short run. This is also called “short-term solvency”. Listed Company: Listed companies are those whose securities are listed on any recognised stock exchange. All big companies such as Reliance Industries Ltd, Infosys Technologies Ltd. and General Motors Ltd. are listed companies. Loans and Receivables: They are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. Long-term Investments: Are investments intended to be held for more than one year. Examples: Shares, debentures, land and gold. Long-Term Liabilities: Liabilities which are to be repaid over a longer period (more than one year). Management Accounting: It is a branch of accounting which facilitates planning and control of activities of organisation to assist in decision-making process. Management accounting deals with the processing of data generated in financial accounting and cost accounting for managerial decision-making. Market Price/Book Value Ratio: A ratio which of market price of a stock to its book value. Matching Concept: An accounting principle that requires identification and recording of expenses associated with revenue earned and recognised during the same accounting period. Materiality: The convention of materiality states that, to make financial statements meaningful, only material fact, i.e. important and relevant information, should be provided in the financial statements. Merger: A combination of two or more independent business corporations into a single enterprise, usually involving the absorption of one or more firms by a dominant firm.

460 Glossary ■

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Money Measurement Concept: This concept assumes that all business transactions should be expressed in monetary terms. Further, the transactions that can be expressed in terms of money are alone recorded. For example, important business meeting may be valuable but it is not recorded. Net Profit After Tax: Profit obtained after deducting all expenses, interest and tax from sales. Also known as Profit After Tax (PAT). Net Realizable Value: It is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Nominal Accounts: The accounts for recording income, expenses, losses and gains. Examples: Salary A/c, Interest A/c and Rent A/c. Office and Administration Expenses: Expenses related to maintenance of office and management of business. Examples: Salaries, printing and stationery, office rent, legal charges, audit fees, telephone expenses and postage insurance premium. Operating Cashflows: They are derived from the principal revenue-producing activities of the enterprise. Examples: Production, sales and delivery of the product, collecting payment from customers, purchasing raw materials and advertising. Operating Profit: It is the excess of sales over the COGS and operating expenses. Operating profit is earned from normal business operations of the concern. Outstanding Expenses: Expenses which are due but unpaid. Examples: Salary, wages and rent. It remains as current liability till the payment is made. Owner’s Fund: Owner’s funds are amount payable to owners and include capital and reserves. Also known as Networth, Equity. Paid-up Capital: The amount of called-up capital, which has been actually paid by the shareholders. Periodic Inventory System: A process of physical verification of inventory by taking actual physical count (or weight) at periodic interval. Personal Account: Account related to some party like individual, bank, firm, company. Petty Cash Book: A cash book which is prepared to record expenses with small monetary denominations like portage, conveyance, carriage and stationery. Posting: A process of recording journal entries in the ledger accounts. Preference Shares: Shares that carry a preferential right to dividend and to the repayment of capital on the winding up of the company, before anything is paid to the equity shareholders. Preliminary Expenses: Expenses incurred in connection with the formation of a company like cost of printing various documents, fees paid to the lawyers for drafting of such documents, stamp duty, registration and filing fees paid at the time of registration of the company. Premium: It is the excess of issue price over face value of the security. It is quite common for the well-managed companies to issue their shares at premium.

Glossary 461 ■

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Prepaid Expenses: Are expenses which are paid in advance, such as rent, taxes, insurance premium. Price to Earnings Ratio (P/E Ratio): It is a ratio of market price of a share to its EPS. It assesses the amount that investors are willing to pay for each rupee of earnings. Private Company: It means a company which restricts the rights of members to transfer its shares; or prohibits any invitation to the public to subscribe to any shares/debentures of the company; or limits the number of members to 50. Profit Before Depreciation, Interest and Tax (PBDIT): See Earnings Before Depreciation, Interest, Tax and Amortisation (EBDITA). Profit Before Interest and Taxes (PBIT): It is calculated as sales less all expenses except interest and income tax. It represents a part of profit that is available to service the debt and owners. This is also referred to as Earnings Before Interest and Tax (EBIT). Profit Before Tax (PBT)/EBT: It is the amount of profit before providing for Income Tax. Provision: It is money set aside for liability where amount cannot be substantially decided. Examples: Provision for tax, provision for bad debts. Provision for Taxation: This refers to the provision for income tax (corporation tax) chargeable on profits. Puttable Instrument: It is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event. Ratio Analysis: The most important technique of financial statement analysis which calculates and interprets various ratios. Ratio is a relationship between the items. Real Accounts: Accounts of assets. Examples: Land A/c, Patent A/c and Cash A/c. Reducing Balance Method (RBM) or Diminishing Balance Method or Written Down Value Method: Under this method, the depreciation is charged at a fixed annual rate on the reducing balance, i.e. cost less depreciation. Consequently, the amount of depreciation charged in each year is not fixed but it goes on decreasing gradually every year. Responsibility Accounting: An underlying concept of accounting performance measurement systems with the basic idea that organisations should not be managed as a single segment and must be decentralised into manageable parts. Return on Equity (ROE): It is expressed as the amount of net profit earned as a percentage of equity. A ratio of PAT to Networth. Return Ratios: These ratios indicate the rate at which profit is generated by using the capital for the business.

462 Glossary ■

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Revenue Receipts: A receipt which does not incur an obligation to return the money. Examples: Sales, interest received on investment. Right Shares: Shares which are offered to the existing shareholders, usually at a discount to market price. Secured Loans: The loans taken on a hypothecation/pledge/mortgage of an asset of the organisation. Selling and Distribution Expenses: Expenses incurred at the time of sale and delivery of goods to customers and losses in collection of sales revenue. Examples: Salesman’s commission, advertisement expenses, carriage outward, depreciation and repair expenses of vehicle used for free home delivery and bad debts. Share Capital: It is the amount of money contributed by owners/shareholders for the furtherance of objectives of the company for which it was crated. Shareholder’s Equity: It includes share capital, reserves and surplus and excludes miscellaneous expenses not written off. This is also known as “Net worth”. Short-term Investments: They are intended to be held for less than one year. For instance, liquid funds, money market instruments, etc. Specific Identification Method: Non-interchangeable stock includes specific identification method. This method requires the physical identification and matching of the particular items sold. The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs. Statutory Company: All companies that operate under a special act passed by the state legislature or the Parliament. For example: The Life Insurance Corporation of India (LIC) and the Reserve Bank of India (RBI). Stock: It is important type of current asset. It includes raw material, work-inprogress as well as finished goods. Straight Line Method (SLM) or Fixed Installment Method: A method of depreciation, where a fixed proportion of the original cost of the asset is written off each year so that value of the asset is reduced to its residual value at that end of its estimated economic useful life. The same amount of depreciation is charged every year throughout the life of the asset. Subscribed Capital: It is that part of issued capital that represents the face or nominal value of shares subscribed by investors. Subsidiary Books: Business transactions can be classified as those transactions relating to purchase, sales, cash, etc. It is convenient to record these transactions in a separate register for each such class of transactions. Such registers are books of original entry and are known as subsidiary books. Subsidiary Company: It is a company that is completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary’s shares.

Glossary 463 ■

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Sweat Equity Shares: These are the equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or for making available intellectual property rights provided that not less than one year has elapsed since the date of commencement of business. The Perpetual Inventory System: It is a system of record keeping under which continuous records are maintained for the movement in inventory. Whenever an item is purchased or issued or sold or gets spoiled, the records are updated immediately to know the latest stock. Trading Account: It is prepared to find out gross profit/loss due to operation of business. Stocks of raw material and work-in-process have been adjusted in the manufacturing account whereas the stock of finished goods is adjusted in the trading account. Transfer Price: It refers to the amount used in accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. Transfer pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services. Trend Statements: These are prepared to analyse long-term movement in financial figures. In trend statements initial year is taken as base (100) and percentage is calculated for the following years. It enables an analysis of performance of the same company for many years. Trial Balance: A trial balance is a list of all accounts with their balances. It is a statement which is prepared periodically, usually at the end of each month, which contains list of the ledger accounts at a specified date, showing their debit and credit (totals or balance). Unsecured Loans: These are loans taken without providing any security in return. In case of default lender cannot have any control over asset of the firm. Wages: Wages includes payment made to workers for manufacturing of goods. Working Capital: It is the difference between current assets and current liabilities. It includes items which are continuously circulating in the cycle of business operations.

Index

Accounting and Corporate Governance 18 Accounting and Economics 10 Accounting and Law 11 Accounting and Statistics 10 Accounting as a Career and Profession 11 Accounting as an Academic Discipline 10 Accounting as an Information System 3 Accounting Concepts and Convention 25 Accounting Errors and their Rectification 123 Accounting for Investments 386 Accounting Period Concept 27 Accounting Policies 29 Accounting Treatment 228 Accounting Treatments for Transactions 161 Accrual Concept 26 Advantages of Financial Statement Analysis 323 Advantages of Preparing Trial Balance 120 Advantages of Profit and Loss Account 84 Air India 184 Allotment of Shares 227 Analysis of Business Transactions through Balance Sheet Equation 65 Analysis of Cash Flow Statement 288 Analysis of Inventories 204 Analysis of Stock and Debtors 345 Application for shares 226 Appropriation of Profit 83 Assets 57 Assets Turnover 343 Associate Company 380 Auditing and Internal Control 13 Auditors’ Report 450

Balance Sheet 239 Balance Sheet Equation 65 Bank Reconciliation Statement (BRS) 125 Benefits of Inflation Accounting 423 Business Combinations 385 Business Overview 314 Buyback of Shares 233 Call-in-advance 231 Call on shares 228 Calls-in-arrears 230 Capital and Revenue Expenditure and Receipts 56 Cash and Cash Equivalents 273 Cash Book 112 Cash Flow Activities 276 Cash Ratio 334 Cash Realisation Ratios 288 Causes of Depreciation 153 Change in the Method of Depreciation 165 Characteristics of a Company 217 Classification of Accounts 101 Classification of Items on a Balance Sheet 57 Closure of Forfeited Shares Account 232 Company Annual Report 253 Comparative Statement 322 Computerised Accounting 128 Conceptual Basis of a Balance Sheet 55 Conservatism/Prudence 28 Consistency 26 Consolidated Financial Statement 383 Contents of a Balance Sheet 244 Contents of an Annual Report 448

Index 465 Contingent Assets 60 Contingent Liabilities 61 Corporate Governance Report 450 Corporate Social Responsibility 450 Cost Concept 29 Cost of Fixed Assets 150 Cost of Inventories 194 Coverage Ratio 288 Creative Accounting 409 Creditors Turnover 344 Current Assets 59 Current Cost Accounting Method 425 Current Investments 387 Current Liabilities and Provisions 61 Current Purchasing Power (CPP) Method 424 Current Ratio/Working Capital Ratio 332 Customers 7 Debentures and Bonds 234 Debt Equity Ratio (D/E Ratio) 335 Debtors Turnover 345 Depreciation 153, 177 Depreciation Policy 161 Description of the Company 449 Detail Cash Flow Statement 274 Diminishing/Reducing Balance Method or Written Down Value Method (RBM) 158 Director’s Report 449 Disadvantages of Financial Statement Analysis 323 Disclosure/Transparency 28 Disclosure 388 Disclosures of Depreciation as Accounting Policy 160 Disposal of Investments 387 Dividend Yield Ratio 349 Double Entry System 103 Dual Aspect Concept 28 Earnings Per Share (EPS) 340 Earnings Yield Ratio 349 EBIDTA/PBDIT Ratio 340 Employees 8 Entity Concept 27 Environmental Accounting 413 Errors Disclosed by a Trial Balance 122 Ethical Issues in Accounting 15 Evolution of Accounting 5 Examples of Cash Flow from Financing Activities 282 eXtensible Business Reporting Language

(XBRL) 434 External Sources of Information

166

Fictitious Assets 60 Finance Function and Accounting 9 Financial Highlights 449 Financial Instrument, Assets and Liabilities 374 Financial Position of Company 315 Financial Statements 449 Financing Activities 281 First-In First-Out (FIFO) 198 Fixed-Charge Coverage Ratio 288 Fixed Assets (FA) 57 Fixed Assets Turnover 343 Fixed Installment Method or Straight Line Method (SLM) 156 Follow-on Public Offer (FPO) Market 226 Foreign Currency Accounting 406 Foreign Currency Transactions 406 Foreign Exchange Difference 407 Forensic Accounting 411 Forensic Audit 411 Forfeiture of Shares 231 Format of Balance Sheet 62 Format of Profit and Loss Account 79 Forms of Environmental Accounting 414 Forms of Organisations and Their Effect on Accounting 17 Free Cash Flow 284 Fund Flow Statement 285 Generally Accepted Accounting Principles (GAAP) 30 Going Concern Concept 26 Government and Regulatory Agencies 8 Gross Profit Ratio (GPR) 339 Horizontal Analysis: Comparative and Trend Statements 325 Horizontal Analysis: Comparative Statement and Trend Statement 322 HRA in India 422 Human Resource Accounting 419 Impairment of Assets 166, 178 Implementing Lean Accounting 417 Importance of Accounting 6 Importance of Cash Flow Statement 272 Improvements Brought in by Lean Accounting 417 Income Statement/Profit and Loss Account 235

466 Index Indian Accounting Standards (Ind AS) 38 Indian Government Accounting Standards (IGAS) 43 India’s Road map to Convergence with IFRS Industry and Economic Conditions 368 Inflation Accounting 423 Inflation Accounting Models 423 Initial Public Offer (IPO) 226 Intangible Assets 177 Interest and Dividends 282 Interest Coverage 337 Internal Sources of Information 167 International Financial Reporting Standards (IFRS) 33–38 Introduction to Cash Flow Statement 271 Introduction to Companies 217 Inventories turnover 345 Inventory Valuation/Measurement 194 Investigative Accounting 412 Investing Activities 280 Investments 58 Issue of Debentures 235 Issue of Shares 223 Issue of Shares at Discount 225 Issue of Shares at Premium 225 Issue of Shares for Cash 223 Issue of Shares for Consideration other than Cash 223

41

Jet Airways 179 Joint Ventures 376 Journal Proper 113 Key Data

369

Last-In First-Out (LIFO) 199 Lean Accounting 416 Lean Accounting Terms and Techniques 418 Leased Assets 177 Ledger 115 Lenders/Bankers 7 Letter to the Stockholders/Chairman’s statement 448 Liabilities 60 Liquidity Ratios: Current and Quick Ratio 332 Litigation Support 412 Long-term Investments 387 Long-term Liabilities 61 Major Units

395

Management/Board of Directors 6 Management’s Discussion and Analysis 449 Manual Accounting vs Computerised Accounting 130 Market Price/Book Value Ratio 349 Matching Concept 29 Materiality 28 Meaning 3 Measurement of Profit 78 Method of Computing Depreciation 155 Methods for Reporting Cash Flow from Operating Activities 277 Models of Human Resource Accounting 420 Money Measurement Concept 29 Net Profit Ratio (NPR) 340 Net Realisable Value 195 Non-cash Transactions 283 Notice 448 Operating Activities 276 Operating Profit Ratio 339 Operating Results and Profits 316 Operating Segments 433 Overview of Accounting Cycle 104 Owners/Investors 6 Ownership and Management 396 Owner’s Fund 60 Peculiar Items in Profit and Loss Account 238 Performance of HUL 369 Periodic Inventory System 193 Perpetual Inventory System 193 Personal Account 102 Petty Cash Book 113 Preparation of Cash Flow Statement 289 Preparation of Trial Balance 120 Preparing Balance Sheet 66 Preparing Journals 105 Preparing Reconciliation Statement 126 Price to Earnings Ratio (P/E Ratio) 348 Primary and Secondary Segment Reporting 432 Profile of the Company 312 Profitability Ratios: GP, NP, EBIT, EBDITA, EPS 339 Profit and Loss Account of a Manufacturing Concern 81 Proprietary Fund Ratio 338 Purchase Day Book 108 Purchase Return Book 111

Index 467

Quick Ratio/Liquid Ratio/Acid Test Ratio

Simple Average Method 200 Solvency Ratios: D/E, Interest Coverage 335 Sources and Usage Percentage 289 Specific Identification Method 197 Stock Prices and Financial Data: P/E 348 Subsidiaries and Associates 379 Subsidiary Books 108 Suppliers/Creditors 7

333

Rates of Transactions 407 Ratio Analysis 322 Real Accounts 102 Reclassification of Investments 388 Recording Depreciation in Asset Account 161 Recording Sale of Asset 164 Record Keeping For Inventory 193 Reissue of Forfeited Shares 232 Responsibility Accounting 427 Return on Capital Employed (ROCE)/Return on Investments (ROI) 341 Return On Equity (ROE) 342 Return On Total Assets (ROTA) 342 Return Ratios: ROI, ROE 341

Taxes on Income 283 Techniques for Financial Statement Analysis Transfer Pricing 428 Translation of Transactions 407 Trend Statements 322 Turnover Ratios 343 Types of Companies 218 Users of Financial Statements

Sales Day Book 109 Sales Return Book 111 Segment Reporting 430 Share Issue: Payments in Instalment 226 Shares and Share Capital 220 Significant Accounting Policies 177 Significant Accounting Policies for Inventories

6

Vertical Analysis: Common Size 330 Vertical Analysis: Common Size Statement

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Weighted Average Method 201 Working Capital Management 346 Working Capital Turnover 344

322